This Selected Issues paper and Statistical Appendix highlights that the strong economic expansion in Latvia that began in 1996 and accelerated in the following year reversed sharply in mid-1998 as a result of both external and domestic shocks. The initial expansion was fueled by accelerating domestic private and public demand, as well as growing demand for Latvia’s output in both new, mostly European Union, and the traditional Commonwealth of Independent States markets. Domestic consumer and investment demand were supported by growing real incomes and tax revenues and pent-up demand carried over from previous years.

Abstract

This Selected Issues paper and Statistical Appendix highlights that the strong economic expansion in Latvia that began in 1996 and accelerated in the following year reversed sharply in mid-1998 as a result of both external and domestic shocks. The initial expansion was fueled by accelerating domestic private and public demand, as well as growing demand for Latvia’s output in both new, mostly European Union, and the traditional Commonwealth of Independent States markets. Domestic consumer and investment demand were supported by growing real incomes and tax revenues and pent-up demand carried over from previous years.

III. An Assessment of Latvia’s External Competitiveness

A. Introduction

25. Following years of relatively small external current account deficit that was more than financed by foreign direct investment (FDI), Latvia’s current account deficit almost doubled to 9.5 percent of GDP in 1998 with only half financed by FDI. While this deterioration was largely a result of the Russia crisis, it has raised the issue of the external competitiveness of Latvia, especially in view of the large devaluations in CIS currencies. This chapter looks at this issue, starting with an overview of developments in Latvia’s trade and current account and its financing (section B). The chapter then calculates and analyses various competitiveness indicators, including Latvia’s market share in its now-major market, the European Union (section C). Finally, section D summarizes the main findings and conclusions.

B. The Current Account and its Financing

Trends in the current account and the underlying factors

26. Latvia’s current account balance moved from a surplus to an increasing deficit starting 1995. This trend mirrored a declining trend in the large services surplus, as well as a widening in the merchandise trade deficit (Table 42). While the former may largely reflect data problems rather than an actual reduction in transport receipts, the widening of the trade deficit reflected a successful transition to a faster economic growth trajectory as GDP real growth accelerated to 8.6 percent by 1997. This growth was supported by an increase in gross domestic investment form 17.6 percent of GDP in 1995 to 23 percent at present. National savings financed only part of this increase in investment; foreign saving also increased, as mirrored in a current account deficit. At the same time, per capita income increased, and this has contributed to an increase in consumer imports in an environment of liberalized trade. In 1998 the current account deficit almost doubled to 9.5 percent of GDP. The Russia crisis led to declines in transport receipts and exports to CIS countries. At first imports continued their fast growth but then decelerated in the second half of the year, due to a lag in adjustment to the slowdown in the economy.

Trends in imports and their composition

27. The increase in investment, especially foreign direct investment, led directly to an increase in imports, with the share of capital goods imports in total imports doubling from 9.3 percent in 1993 to 20 percent in 1998. At the same time, the share of consumer goods imports also increased at the expense of intermediate imports reflecting the liberalization of the trade regime. Between 1993 and 1998, the former increased from 12 percent to 26 percent while the latter declined from 79 percent to 54 percent of total imports (Table 45). This decline may reflect a reallocation of export activities from the processing of imported intermediate goods in the Soviet period, towards the strong comparative advantage in the wood products. There has also been a shift in the origin of imports with a substantial decline in the CIS shares, and a counterpart increase in imports from the EU (see Table 2).

Trends in exports and their destination and composition

28. The structure of exports exhibited a clear transformation between 1993 and 1998 with the shares of wood products and textiles in total exports increasing significantly from 10 percent and 13 percent to 37 percent and 16 percent respectively. On the other hand, the food products, machinery and chemicals, and vehicles fell reflecting a reorientation towards Latvia’s comparative advantages. The destination of exports also changed as the share of exports to CIS countries in total exports declined, and the share of exports to the EU increased (see Table 1). This shift was facilitated by quality improvements as well as an increase in the marketing capability brought about in large part by accumulated foreign direct investment. Latvia has been able to develop niche markets for textile in particular, and also wood products (such as furniture, sawn wood, and wood panels) in important EU markets, including Germany, the UK, and Sweden.8

Trends in the financing of the current account deficit

29. A notable dimension of Latvia’s current account deficit is its financing by non-debt creating inflows, in particular foreign direct investment. The ratio of inward foreign direct investment to the current account deficit was about 180 percent in 1996 and 1997 (Table 42). This ratio, however, declined to 45 percent in 1998 due the doubling of the current account deficit in the one hand, the less favorable international sentiments in the aftermath of the Asian and Russia crises, and delays in Latvia’s large scale privatization program. As a result, the share of loan financing increased, although this has been largely medium-term and private. Public debt and publicly guaranteed external debt remained at about 7–8 percent of GDP, and increased to a still relatively low 10.5 percent of GDP in May 1999 as a result of a eurobond issue which is being allocated to future maturing debt service, rather than to current account financing.

C. Competitiveness Indicators

30. In view of the recent widening of the current account deficit and the sharp devaluation of CIS currencies, it is necessary to reassess Latvia’s external competitiveness. This section starts by calculating and analyzing trends in the real effective exchange rate. However, while the real effective exchange rate is one of the most frequently used competitiveness indicators and can be readily calculated, it suffers from important shortcomings.9 First, it is a static measure of competitiveness because it is influenced by the existing, rather than the potential, shares of trade partners. Second, it is not always conclusive because an appreciation or a depreciation in that rate may not be evidence of a change in competitiveness, but, rather, in productivity. This problem is especially relevant in transition economies where large changes in productivity are expected as resources are reallocated and reform progresses.10 Third, looking at the trend in the real effective exchange rate provides information about a change in the level of competitiveness, rather than about whether a country is competitive or not at the new rate. This section therefore proceeds by looking at trends in various calculations of the real effective exchange rate using alternative weights, and then looks at other indicators of competitiveness such as dollar wages, productivity, until labor cost, the equilibrium exchange rate, and market share, emphasizing the trend relative to the EU market as well as other transition economies that compete with Latvia’s exports in that market.

REER using updated trade weights

31. Figure 1a plots the real effective exchange rate for Latvia, calculated using CPI data and shares of significant trading partners in Latvia’s trade. The real effective exchange rate of the lats has appreciated by about 325 percent since the beginning of 1992. Two phases of appreciation are noticeable. The first phase was during the period 1992–1994 when Latvia’s inflation was well above the EU levels. During that period, the lats appreciated by about 260 percent in real effective terms. After a few years of relative stability in the real effective rate, it entered into a second phase of appreciation with the collapse of the Russian ruble and other CIS countries starting mid-1998. This appreciation has been much smaller, however, and amounted to about 13 percent thus far. It is therefore clear that the real effective exchange rate of the lats was relatively stable since the mid-nineties until the Russia crisis in mid-1998 when it started appreciating somewhat due to the collapse of CIS currencies.

Figure 1.
Figure 1.

Latvia: Real Effective Exchange Rates, 1996–99

Citation: IMF Staff Country Reports 1999, 099; 10.5089/9781451824483.002.A003

Source: INS data system, adjusted weights.

REER against western trading partners

32. Assuming that the current re-orientation of exports to Latvia’s western trading partners will continue, it is useful to measure real effective changes in the lats versus these partners in order to help inform a forward looking analysis (Figure 1b). This shows the lats has been virtually stable in real effective terms vis a vis these partners since mid-1997. A small appreciation occurred in the first quarter of 1999 due to the appreciation of the US dollar which is an important components of the SDR basket, against which the lats is pegged.

REER using a basket of competitors in EU markets (other Baltics, Finland, Sweden)

33. Figure 1c plots the real effective exchange rate of the lats against a basket of currencies of the other Baltics as well as Finland, Poland, and Sweden which are three important competitors in Latvia’s main export; wood products. Belarus is another important wood producer which was, however, excluded because it appears less of a competitor with Latvia as the latter managed to upgrade the quality of it products. Indeed Latvia has started importing Belarussian wood material for reexporting at higher prices and value added after processing. The figure shows that the lats has been virtually stable in real terms over the last two years against the currencies of the above mentioned countries. As in the case of the appreciation against western trading partners, the lats mild appreciation vis a vis Latvia’s main competitors has been in part a result of the dollar appreciation against the currencies of those competitors.

The relative price of nontradable to tradable goods

34. Another measure of the real exchange rate which encompasses the various domestic costs and exchange rate competitiveness factors is the price of tradable relative to non-tradable goods. Movements in this price importantly affect the allocation of resources between these two commodity categories. One methodological problem in calculating this measure is determining whether a particular commodity is tradable or not as certain traditionally non-tradables, including many services are becoming more tradable (and this is particularly relevant in Latvia with its important services sector). It is, however, beyond the scope of this paper to accurately investigate and determine the tradability of each good and service. It has been common in the literature to use the price indices of agriculture and manufacturing as a proxy for the price of tradables, and the price indices of all other sectors as a proxy for the price of non-tradables.11 Figure 2 shows the movement in the real exchange rate defined as the ratio of the price index of non-tradable to tradable goods. The rate exhibited an appreciation of about 18 percent over the period 1993 to 1995 and then started to depreciate steadily since then. The accumulated depreciation thus far amounts to 32 percent. This is in contrast with the results we get from calculating the real effective exchange rate as reported above. The reason for these conflicting outcomes may be data problems in the deflators used in calculating the price indices of tradable and non-tradable goods, the shortcomings of the efficiency in the real effective exchange rate as a measure of competitiveness as described above, or a combination of both. This contrast in the results emphasizes the need for caution in interpreting the trend in any one measure of competitiveness.

Figure 2.
Figure 2.

Latvia: The Ratio of the Price of Non-tradable to Tradable Goods, 1993–98

(1995 = 100)

Citation: IMF Staff Country Reports 1999, 099; 10.5089/9781451824483.002.A003

Source: Implicit deflators calculated from data provided by the Central Bureau of Statistics.

Dollar wages

35. Table 10 shows that while Latvia’s dollar wages are above dollar wages in Russia, they remain below dollar wages in the other Baltics and Central European economies. In fact, Latvia’s dollar wages have risen the least in the three Baltic states since 1994. It therefore seems that according to this indicator of competitiveness that Latvia has lost some of its competitiveness vis a vis Russia and other CIS countries but remains competitive vis a vis the other Baltics and central European states.

Table 10.

Latvia: Monthly Wages, 1993–98

(In U.S. dollars)

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Sources: Latvian authorities; and Fund staff estimates.

Equilibrium dollar wages

36. The equilibrium dollar wage rate is calculated using proxies for potential productivity and human capital. A useful competitiveness indicator is to compare the actual wage level with a calculated equilibrium level. Krajnyak and Zettlemeyer (1997) estimate the determinants of the equilibrium wage using a panel of 85 countries.12 They regress the dollar wage on a set of fundamentals and indicators of human capital such as the purchasing power parity GDP per capita, the share of agriculture in the economy as a proxy for the level of development, and secondary school enrollment as a proxy for the stock of human capital. Their study covered the period 1990–95 and found that most transition economies, including Latvia, had room for appreciation before reaching their equilibrium level. Table 11 updates the calculation for Latvia using Krajnyak and Zettlemeyer estimated equation.13 The table shows that while the gap between the equilibrium and actual wage levels is narrowing, the actual level remain below the equilibrium level by about 35 percent which indicates that there is still some margin for further appreciation and wage increase. Furthermore, compared to the other Baltic countries, the remaining gap between the actual and equilibrium rates for Latvia is somewhat smaller than for Estonia but much larger than for Lithuania.

Table 11.

Baltic Countries: Equilibrium Monthly Wage Estimates, 1993–98 1/

(In U.S. dollars)

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Staff calculations based on Krajnyak and Zettelmeyer (1998), and using updated IMF estimates of PPP-GDP per employee.

Productivity

37. Detailed productivity data are available only for the manufacturing sector (Table 12). They indicate that labor productivity in manufacturing has been growing at quite high rates. Cumulative productivity in the period 1994–1997 has ranked in the top tier in transition economies according to the EBRD. In a group of 12 transition economies, Latvia came second from the top (Figure 3). However, wages in the sector have been growing even faster than productivity, resulting in a positive growth in unit labor cost in this sector (Table 12) (unit labor cost as a measure of competitiveness is investigated below). Among important industries, wood and paper industries, and food industries appear to have the highest output per worker (Figure 4).

Table 12.

Latvia: Productivity and Unit Labor Cost in Manufacturing, 1993–96

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Source: Latvian authorities.
Figure 3.
Figure 3.

Latvia: Cumulative Productivity in Manufacturing, 1994–97

(In percent)

Citation: IMF Staff Country Reports 1999, 099; 10.5089/9781451824483.002.A003

Source: EBRD Transition Report, 1998.Note: Calculated as the ratio of manufacturing production over manufacturing employment in 1994–97.
Figure 4.
Figure 4.

Latvia: Manufacturing Productivity, 1998

(In percent)

Citation: IMF Staff Country Reports 1999, 099; 10.5089/9781451824483.002.A003

Source: Central Statistical Bureau of Latvia.Note: Productivity measured as output per employee, average output-weighted manufacturing productivity was USD 18.2 thousand.

Unit labor cost

38. Unit labor cost is one of the preferred indicators of competitiveness and is measured by dividing wages by output. Accurate calculations of unit labor cost for Latvia are difficult to make because of data shortcomings. Using available data, staff estimates indicate that unit labor cost index in Latvia has not changed much over the last few years. However, in relative terms, unit labor cost in Latvia has been growing and is now almost 30 percent higher than in Poland. This growth has been significantly faster than in Estonia, although slower than in Lithuania (Table 13). While it seems that Latvia’s competitiveness measured by ULC somewhat deteriorated, it should be noted that this measure indicates more the relative change in the level of competitiveness rather than whether the country is competitive or not in absolute terms.

Table 13.

Latvia: Unit Labor Cost Indicators, 1993–98

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Source: Latvian authorities, and Fund staff estimates.

Calculated from sectoral data on output, average wages and employment.

Calculated using IMF PPP GDP estimates.

Market share

39. This is perhaps the most direct ex-post measure of competitiveness and reflects all the relevant factors. Table 14 shows the calculations of Latvia’s market share in goods and in goods and services. The calculations indicated that Latvia market share in goods has been growing at about 10 percent over the last two years. The share of Latvia’s exports of goods and services has been growing and an average rate of about 8 percent over the last three years. Latvia has been successful in shifting its trade to new markets in the west as discussed earlier in this chapter. This has been reflected in its share of EU imports (excluding intra-EU trade) which has increased fourthfold since 1992 from 0.057 percent to 0.230 percent (Table 15). Latvian exports have been particularly successful in penetrating new markets in important EU economies, including Germany and Scandinavian countries, in which Latvia’s market share has been growing steadily over the last three years (Table 16).

Table 14.

Latvia: Analysis of Global Export Market Share, 1993–98

(Percentage change)

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Sources: WEO database; and Fund staff estimates.
Table 15.

Selected Country’s Share in Total EU Imports 1/, 1992–97

(In percent)

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Sources: Direction of Trade Statistics; and Eurostat.

Excluding intra-EU-trade.

Table 16.

Latvia: Export Market Shares in Selected EU Countries, 1996–98

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Source: Latvian authorities.

D. Conclusions

40. Motivated by the recent widening in the current account deficit and the decline in the share of foreign direct investment in financing that deficit, this chapter has attempted to examine recent developments in Latvia’s external competitiveness. Alternative calculations of the real exchange rate give a mixed picture. On the one hand, many indicators show some degree of deteriorating competitiveness. On the other hand, the relative appreciation or increase in costs is very small vis a vis Latvia’s main trading partners, and its principal competitors in its major exports. Furthermore, it appears that the margin of competitiveness, even before including future productivity changes, is still considerable. Thus, in assessing if this deterioration relative to the past, has resulted in Latvia becoming seriously incompetitive, this chapter investigated Latvia’s dollar wages relative to their equilibrium level as well as trends in Latvia’s market share. The results indicate that, while Latvia’s wages have been converging to their equilibrium level, they remain well below them and, therefore, there remains scope for further appreciation. Furthermore, it appears that Latvia has been successful in increasing its exports market share, in particular in the EU. This was possible as a result of the positive impact of accumulated foreign direct investment on the quality of Latvian exports and the countries marketing capabilities. The continued maintenance of Latvia’s external competitiveness will therefore be partly dependent on Latvia’s ability to continue to attract foreign direct investment and to maintain progress in its reform efforts.

References

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  • Havrylyshyn, Oleh, 1998, “The Impact of EU Enlargement on Countries Beyond the New Frontiers,” A paper presented at a conference on Starting the New Europe: Challenges of EU Eastern Enlargement, the Vienna Institute for International Economic Studies, Vienna, November 11–13.

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  • Havrylyshyn, Oleh, and Hassan Al-Atrash, 1998, “Opening Up and Geographic Diversification of Trade in Transition Economies,” IMF Working Paper 98/22 (Washington: International Monetary Fund).

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  • Krajnyak, Kornelia and Jeromin Zettlemeyer, 1997, “Competitiveness in Transition Economies: What Scope for Further Appreciation?IMF Working Paper 97/149 (Washington: International Monetary Fund).

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  • Lipshitz L. and D. McDonald, 1991, “Real Exchange Rates and Competitiveness: A Clarification of Concepts and some Measurements for Europe,” IMF Working Paper 91/25 (Washington: International Monetary Fund).

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  • Marsh, Ian W. and Stephen P. Tokarick, 1994, “Competitiveness Indicators: A Theoretical and Empirical Assessment,” IMF Working Paper 94/29 (Washington: International Monetary Fund).

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8

For a study of the experience of the BRO countries in reorienting their trade see Havrylyshyn and Al-Atrash (1998).

9

For reviews, and assessments, of various competitiveness indicators, see Lipshitz and McDonald (1991), Turner and Van’t dack (1993), and Marsh and Tokarick (1994).

10

Furthermore, the likely impact of EU expected accession on Latvia’s productivity cannot be underestimated. See for example Havrylyshyn (1998).

11

This has been typical in Dutch Disease empirical literature. See for example the various studies in Gelb and associates (1988).

13

It is important to note that this methodology has two pitfalls. First, it is assumed that the equation is stable over time, so it can be used beyond the period in which it was estimated for. Second, the data used in the estimation suffer from important data problems especially in relation to estimates of purchasing power parity GDP.

Latvia: Selected Issues and Statistical Appendix
Author: International Monetary Fund
  • View in gallery

    Latvia: Real Effective Exchange Rates, 1996–99

  • View in gallery

    Latvia: The Ratio of the Price of Non-tradable to Tradable Goods, 1993–98

    (1995 = 100)

  • View in gallery

    Latvia: Cumulative Productivity in Manufacturing, 1994–97

    (In percent)

  • View in gallery

    Latvia: Manufacturing Productivity, 1998

    (In percent)