Republic of Latvia: Selected Issues

International Monetary Fund. European Dept.

doi:10.5089/9781513510057.002.A001

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International Monetary Fund. European Dept.

International Monetary Fund. European Dept.
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Publication Date:: 07 Aug 2019

eISBN:: 9781513510057

Language:: English

Keywords:: ISCR; CR; firm; zombie firm; Latvia's competitiveness; REER gap; REER of Latvia; appreciations in VA REER; Latvia's GVC participation; Tariffs; Global value chains; Competition; Export performance; REER measure; exposure to shock

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Selected Issues

Abstract

Selected Issues

Latvia’S Participation in Global Value Chains: Implications for Competitiveness and Exposure to Shocks¹

Latvia, as many European countries, is open and relatively integrated into global value chains (GVCs) and hence competes over supplying value added in world markets. This paper analyzes the implications of GVC participation for Latvia’s competitiveness and exposure to risks. Using a structural model, it assesses Latvia’s competitiveness through different REER measures, and examines the main factors behind differences in the measures. Based on this analysis, the paper suggests policy options to strengthen Latvia’s competitiveness. The paper also estimates the impact of an appreciation of the GVC related REER measure on value added export growth and real GDP growth, and finds sizable effects, suggesting that a rapid labor market tightening could lead to erosion in competitiveness and reduction in growth. Finally, trade tension induced tariff hikes may have significant cost for Latvia, especially in terms of value added produced in the country.

A. Background: Latvia’s Participation in Global Value Chains

1. Countries’ participation in global value chains has altered the nature of international competition. Global value chains (GVCs) refer to the fragmentation of production stages geographically and internationally, as countries increasingly compete over the supply of domestic value added to the production and sale of final goods and services in world markets. In this context, trade in value added, rather than the gross amount of traded goods and services with trading partners becomes a more relevant indicator of a country’s competitiveness strength. Backward GVC participation refers to the amount of intermediate value added imported by a country to generate output for its own exports. Forward GVC participation captures the amount of a country’s valued added exported as inputs in other countries’ exports.

2. Latvia is relatively well integrated in GVCs. Its participation is lower compared to other Baltic countries but has increased over time.² The increase has been driven mainly by backward participation in industries such as manufacturing of basic metals, rubber and plastic products, transport equipment, and chemical products, as well as air transport. Latvia incorporates foreign value added mainly from Russia, Germany, Lithuania, Sweden and Finland. Forward participation is focused in industries such as manufacturing of wood and basic metals, land transport and transport via pipeline, wholesale trade (except of motor vehicles and motorcycles), and crop and animal production. Forward GVC participation is mainly with Estonia, Lithuania, Russia, and Belarus. This suggests that Latvia’s competitiveness is likely to be sensitive to price changes in Russia and Germany and demand from Estonia and Lithuania for example. Compared to other EU countries, Latvia’s GVC participation is lower and may reflect lower human capital and high unit labor costs than peers.³

GVC Participation Index

(In percent)

Citation: IMF Staff Country Reports 2019, 265; 10.5089/9781513510057.002.A001

Source: UNCTAD-Eora Global Value Chain Database.

Lavtia’s Participation in GVC

(In percent)

Citation: IMF Staff Country Reports 2019, 265; 10.5089/9781513510057.002.A001

Source: UNCTAD-Eora Global Value Chain Database.

3. This paper is closely related to recent research on GVC across countries and in Latvia. Bems and Johnson (2017) derive demand for value added and a novel REER based on value added (VA). We use their structural model to construct a VA-based REER measure for Latvia, investigate the implication of its appreciation for value-added export and growth, and to quantify the impact of tariff shocks. The paper is also related to Benkovskis et al. (2017) which investigates determinants of GVC participation and its gains for Latvia using micro level data. We investigate the macroeconomic implication of GVC participation for competitiveness and exposure to external shocks and refer to Benkovskis et al. (2017) for appropriate ways to strengthen competitiveness.

B. Assessing Latvia’s Competitiveness with Different REER Measures

Conventional REER Indexes versus Value-Added REER

4. The conventional framework features demand switching as the main channel through which changes in international relative prices affect both economic activity and the external balance. However, global supply chains challenge this conventional view because they link countries on the supply side. For instance, in the conventional framework, a depreciation of the euro, will make goods produced in Latvia more competitive, and consumers will switch their expenditure toward them, lowering demand for other EU trading partners outside of the euro area. This conventional view is not complete when one takes into account trade in inputs. If Latvia uses imported inputs from other non-euro area members in its production, then the expenditure switching in favor of goods produced in Latvia will also benefit its input suppliers. In addition, the depreciation of the euro will also benefit trade partners to which Latvia supplies input as the production cost of the latter will decrease and they will become more competitive. Overall, the VA-REER allows analyzing demand switching over value added, consistently with GVCs shaping the nature of competition toward the supply of domestic value-added and making therefore the product-focused approach of the conventional framework less relevant.

5. Using a structural model that accounts for supply chain linkages and trade in value added we assess Latvia’s competitiveness in a world dominated by global value chains. We employ a structural framework developed by Bems and Johnson (2017) with the objective to compute a REER index replacing the weights of trading partners based on their gross trade flow shares with Latvia (conventional REER weights) with weights based on trade in value added.⁴ We use the 2016 vintage of the World Input-Output Database (WIOD, Timmer et al., 2015) to compute the value added REER of Latvia, taking into account bilateral trade in value added.⁵

6. The conventional REER is derived from a log-linearization of the standard Armington CES demand system as follows:⁶

C o n v R E E R_{i} = Σ_{j \neq i} [\frac{1}{s_{i}} Σ_{k} (\frac{p_{i} D_{i k}}{p_{i} D_{i}}) (\frac{p_{j} D_{j k}}{P_{k} E_{k}})] ({\hat{p}}_{i} - {\hat{p}}_{j}) (1),

w h e r e S_{i} = 1 - Σ_{k} (\frac{p_{i} D_{i k}}{p_{i} D_{i}}) (\frac{p_{i} D_{i k}}{P_{k} E_{k}})

In this expression, D_ik denotes country k’s demand for output from i,P_k is the price index for real expenditure by country k on output from all countries (E_k), and D_i is the total demand for country i’s output. This conventional REER thus features the so-called double export weights for bilateral relative price changes, with a weighting scheme accounting for head-to-head competition between i and j in all destinations k (through $\frac{p_{j} D_{j k}}{p_{k} E_{k}}$ ) and the share of each destination in country i’s total sales (through $\frac{p_{i} D_{i k}}{p_{i} D_{i}}$ ).

7. The value-added REER (VA-REER) is derived from a theoretical framework that explicitly distinguishes between gross output and value-added, by modeling production and trade in final goods and inputs. The general expression of the VA-REER is given by:

V A R E E R_{i} = Σ_{j \neq i} [Σ_{k} (\frac{- T^{i j}}{T^{i i}})] ({\hat{p}}_{i}^{v} - {\hat{p}}_{j}^{v}) = Σ_{j \neq i} [\frac{1}{s_{i}} Σ_{k} (\frac{p_{i}^{ν} V_{i k}}{p_{i}^{ν} V_{i}}) (\frac{p_{j}^{ν} V_{j k}}{p_{k}^{f} F_{k}})] ({\hat{p}}_{i}^{v} - {\hat{p}}_{j}^{v}) (2),

w h e r e S_{i} = 1 - Σ_{k} (\frac{p_{i}^{v} V_{i k}}{p_{i}^{v} V_{i}}) (\frac{p_{j}^{ν} V_{i k}}{p_{k}^{f} F_{k}})

In this general formula, the REER index features weights $\frac{- T^{i j}}{T^{i i}}$ attached to bilateral relative value-added price changes. The second part of the expression shows a version that assumes equal elasticities (elasticity of substitution across final goods, across inputs, and between inputs and value added in production). Here, V_ij denotes the value added produced by country i that is ultimately absorbed in country $j, p_{i}^{v} V_{i j}$ is the value-added exports from country i to country j. This second part of the expression is similar to the conventional REER index as it features a double-weighting scheme but focusing on value added (V_ik denotes country k’s demand for value added from i) and final goods ( $p_{i}^{f} F_{k}$ refers to expenditure on final goods).

8. We use the VA-REER that accounts for the global input output linkages where weights are a complex function of trade flows and elasticities. In its version capturing the full global input-output linkages, it is assumed that the elasticity of substitution across inputs and the elasticity of substitution between input and value added in production are zero (Leontief production function). This property captures the well-known view of inflexible or rigid production chains, which implies that it is difficult for producers to substitute across suppliers in the short run (see for instance Boehm, Flaaen, and Nayar, 2019, Bayoumi et al., forthcoming). This measure of VA REER has also the property of putting more weight on final goods trade, and lower weights on country with strong bilateral input linkages as discussed further below.

9. Value added weights of Latvia’s traditional trading partners are lower than conventional weights.⁷ A feature of the GVC-based model is that bilateral trading partners with stronger input linkages tend to have lower cross-price elasticities and hence lower value-added (VA) than conventional weights.⁸ Indeed, as supply chains are regional in the EU (See Bems and Johnson,2017; Bayoumi et al., 2018, and Huidrom et al., 2019), bilateral VA weights tend to be lower than conventional weights for most EU countries. In this context, the value added embodied in each production step is often much lower than the gross trade flow. In particular, the VA weights of Lithuania and Estonia, Germany, Sweden, and Russia are about 2.3 percentage points lower than their conventional rates, while USA and China’s weight are 2 percentage points higher. It thus appears that the USA and China have somewhat greater importance for Latvia’s competitiveness than Lithuania and Russia.

Latvia: Bilateral Conventional and Value added weights (2013–2015)

(In percent)

Citation: IMF Staff Country Reports 2019, 265; 10.5089/9781513510057.002.A001

Sources: Bems and Johnson (2017); Timmer et al (2015); and IMF staff calculations.

10. Latvia’s VA REER index has appreciated more rapidly than the conventional REER. The conventional REER and VA REER have moved in the same direction, but the latter has appreciated more than the former since 2010. While a significant share of the current gap between the two indices built in 2012 (see below), it has continued to increase over time. In particular, the VA REER increase appears to be in line with the rise in unit labor cost and the correlation between the two is high (0.9). This suggests that Latvia’s competitiveness in supplying its domestic value added is highly dependent on the increase of labor costs.

Conventional, Value-added REER and ULC

(Index, 2010=100)

Citation: IMF Staff Country Reports 2019, 265; 10.5089/9781513510057.002.A001

Sources: Bems and Johnson (2017); Timmer et al (2015); and IMF staff calculations.

What drives the Gap Between the VA REER and the Conventional REER?

11. The gap between the VA REER and the conventional REER contains a price and a weight component as follows:

V A R E E R i - C o n v R E E R i = \underset{J \neq 1}{Σ} (ω_{i j}^{v} - w_{i j}^{A r \min g t o n}) ({\hat{p}}_{i}^{v} - {\hat{p}}_{j}^{v}) + \underset{J \neq 1}{Σ} w_{i j}^{A r \min g t o n} [({\hat{p}}_{i}^{v} - \hat{C P} I_{i}) - ({\hat{p}}_{i}^{v} - {\hat{E}}_{i / j} - \hat{C P} I_{j})]

where the first part captures the role of differences in weights between the value-added and the conventional REER. The second term captures the differences in prices used in constructing the two REER indexes. This price component also has two subcomponents, which are the own-price component $({\hat{p}}_{i}^{v} - \hat{C P} I_{i})$ showing the difference between the GDP deflator and the CPI, and the partner price component $({\hat{p}}_{i}^{v} - {\hat{E}}_{i / j} - \hat{C P} I_{j}) . \hat{C P} I a n d {\hat{E}}_{i / j}$ are respectively the log changes in the CPI index and the nominal exchange rate, respectively.

12. The REER gap is largely explained by price differentials. About 70 percent of the REER gap is explained by the price component while the remaining part is explained by the weight component. Decomposing further shows that half of the price gap is due to the differential in Latvia’s prices used in VA REER (the GDP deflator) relative to those used in the conventional REER (CPI) as opposed to the differential of partner prices. Value added weights account for 21 percent of the gap, with a smaller role (9 percent) for elasticities, that is the role of rigid production chains. Again, the VA-REER features mainly elasticities of substitution across final goods, which implies putting more weight on these final goods in determining cross-price elasticities of demand for value added.

Contributions of Prices and Weights

(In percent)

Citation: IMF Staff Country Reports 2019, 265; 10.5089/9781513510057.002.A001

Sources: Bems and Johnson (2017); Timmer et al (2015); and IMF staff calculations.

13. Latvia’s price differential reveals large discrepancies between the GDP deflator and the CPI. Despite narrowing after crisis, the cumulative difference between the GDP deflator and the CPI has increased substantially since 2010. The GDP deflator has grown cumulatively by 23 percent since 2010, while the CPI has increased by 13.6 percent during the same period. A closer look at the rapid increase of the GDP deflator shows that a rise in prices of capital goods accounted for the opening of the gap early in the period. However, prices of capital goods have largely stabilized since 2012. Decomposing the GDP deflator using the income definition of GDP reveals that unit labor costs have remained a steady driver of final output prices, increasing by about 5 percent annually since 2012. The rapid growth in Latvia’s term of trade may also partly explain this dynamic. That is, a rapid growth of Latvia’s export price relative to import prices may have induced a sizeable increase in profit margins of Latvian companies, which is captured in the unit profits component of the GDP deflator.⁹ Furthermore, while some of Latvia’s euro area trading partners may have also experienced a more rapid increase in the GDP deflator in recent years, the gap between the GDP deflator and CPI appears to be particularly large in Latvia.

Difference Between GDP Deflator and CPI

(Cumulative difference, in percent)

Citation: IMF Staff Country Reports 2019, 265; 10.5089/9781513510057.002.A001

Sources: Haver Analytics; World Economic Outlook; and IMF staff calculations.

Latvia: Components of GDP Deflator

(Y-o-y percentage change)

Citation: IMF Staff Country Reports 2019, 265; 10.5089/9781513510057.002.A001

Sources: Eurostat; World Economic Outlook; and IMF staff calculations.

C. Latvia’s Exposure to Shocks in a World of Global Value Chains

VA-REER Shocks, Value Added Export Performance, and Growth

14. The impact of VA-REER shocks on value added export growth can be estimated empirically. A local projection approaches a la Jordá (2005), could be used to estimate the dynamic effect of VA-REER shock on real value-added export growth. This methodology has the advantage of being robust to misspecification as the impulse responses can be defined without knowing the data generating process and even when its Wold decomposition does not exist (see for instance Koop et al., 1996; Potter, 2000 and Jordá, 2005).¹⁰,¹¹

15. The model specification is as follows:

Δ Y_{c, t + h} = δ_{j} Σ_{j = 0}^{h} Δ \ln {(V A R E E R)}_{c, t - 1 + j} + θ_{h} X_{c t - 1} + α_{c} + τ_{t} + ε_{c, t + h} (3)

Where the dependent variable (ΔY_c,t+h) is the change in the logarithm of real value added exports at horizon h; δ_j are the coefficients of interest for each horizon h=0,1,2,3; α_c is a country fixed effect; τ_t is a time fixed effect; X is a set of control variables including (inflation, real GDP per capita, net foreign direct investment inflows and external demand).¹²

16. Appreciations in VA REER are estimated to have a negative and persistent effect on value added exports growth. Our estimates use panel data of 27 European countries over the 2003–13 period and the VA REER index constructed using the structural framework above. The regressions results suggest that a 10-percentage point appreciation (increase in the VA REER index) leads to a statistically significant reduction in value-added export growth by 0.4 percentage point the first year which cumulates to 0.5 percentage point the second year.¹³

The Effect of VA-REER Shocks on Real Value-Added Export Growth

Citation: IMF Staff Country Reports 2019, 265; 10.5089/9781513510057.002.A001

Sources: IMF Staff estimates.Notes: These figures show the impulse response functions (for a 1 percentage point appreciation). The dependent variable is the real value-added export growth. Regressions include the full list of control variables, as well as country fixed effects and year fixed effects. Year 0 is the year of the shock. We corrected the local projection method following Teulings and Zubanov (2014). Dashed lines show the 95-percent confidence interval.

17. VA REER appreciation thus has an impact on real GDP growth through trade channels.¹⁴ Using the Local projection specification, we estimate the impact of VA export growth on real GDP growth. The empirical results suggest that a 1 percentage point increase in real value-added export is associated with a 0.3 percentage point increase in real GDP growth cumulatively over the 4 years. These estimates are used to calculate the impact of a 10 percent appreciation in VA-REER on growth as follows:

\frac{Δ Re a l G D P g r o w t h}{Δ (V A - R E E R)} = \frac{Δ R e a l G D P g r o w t h}{Δ V A \exp o r t g r o w t h} * \frac{Δ V A \exp o r t g r o w t h}{Δ (V A - R E E R)} (2)

A 10 percent appreciation in the VA-REER could reduce growth rate by 0.2 percentage point.¹⁵ These findings suggest that VA-REER appreciation could be associated with a significant loss in competitiveness and growth.¹⁶

The Impact of Value-Added Export Growth on Real GDP Growth

Citation: IMF Staff Country Reports 2019, 265; 10.5089/9781513510057.002.A001

Sources: IMF Staff estimates.Notes: These figures show the impulse response functions (for a 1 percentage point appreciation). The dependent variable is the real GDP growth. Regressions include the full list of control variables, as well as country fixed effects and year fixed effects. Year 0 is the year of the shock. We corrected the local projection method following Teulings and Zubanov (2014). Dashed lines show the 95-percent confidence interval.

18. The implied estimates of the impact of VA REER appreciation for Latvia are however modest. Since 2010, Latvia’s VA REER has appreciated by roughly 5 percent. Using our estimates, this implies a reduction in value added export by 0.2 percent and a reduction in growth by 0.1 percentage point. Absent the appreciation in VA REER since 2010, and thus the rise in ULC owing to the strong pass-through previously discussed, growth could have been higher by 0.1 percentage point in Latvia. The modest effect of VA REER appreciation on growth in Latvia could be attributed to the relatively low GVC participation over the period in the sample.

Transmission of a Tariff Shock Through Global Value Chains

19. In a world dominated by global value chains, the imposition of a tariff would have far reaching consequences beyond the country and sector directly targeted. A tariff penalizes not only the assembler of the product, but also the suppliers, amplifying trade costs and potentially affecting the competitiveness of an entire value chain (Yi, 2003, and Miroudot et al., 2013). Moreover, as international trade in goods is increasingly integrated with services (OECD, 2013), tariffs on goods can also spillover to the service sector. Finally, escalating trade tensions could impact global economic growth through a combination of direct and indirect factors (IMF, World Economic Outlook, October 2018). The direct factors relate to higher trade costs while the indirect factors include lower business confidence, weaker private sector investment, and tighter financial conditions.

20. Europe’s trade openness and deep integration into GVCs make the region vulnerable to escalating trade tensions. European countries have a larger exposure to US tariff shocks in value-added terms than in gross trade terms (See Huidrom et al, 2019).¹⁷ Through rising uncertainties, trade tensions may lead to lower investment (See IMF,2018b and Ebeke and Siminitz, 2018) and thus could have significant impact on competitiveness. For instance, countries using foreign value added in their exports—such as Latvia—may become less competitive as their cost increases due to a tariff hike in the US and China.

21. The structural model developed by Bems and Johnson (2017) can be used to estimate the short-run impact of changes in relative international prices induced by tariffs on demand for gross trade and value-added flows.¹⁸ We estimate the impact of trade tensions on both gross trade and value-added using scenarios in the October 2018 World Economic Outlook. To do so, we analyze the effect of a tariff imposed by the United States on its imports, with retaliation by all countries using the same tariff.¹⁹ As the structural model assumes a single price of output per country, we proceed sequentially. First, we calculate a tariff-induced price change for all goods (except for the US) and estimate how the US demand reacts. Second, we calculate the tariff-induced change in the prices of US goods and estimate how other countries’ demand adjusts. We use the elasticities built in the structural model to estimate the tariff impact in both steps. Given that in the structural model, demands for value added are obtained holding countries’ real expenditure levels constant, the impact of price changes on the reallocation of production across countries should be viewed as a short-run partial equilibrium effect. The model does not however account for potential realignment of supply chains in the long-run.

22. Latvia’s exposure to trade shocks from China, USA, and the UK are significant. The bilateral weights implied by the VA REER are higher than conventional ones for China, USA and UK, suggesting a weaker input linkage. Thus, competition with these countries is mainly on final goods rather than on inputs. Because the value added embodied in each production step between countries with strong input linkages is often much lower than the gross trade flow, the VA weights are lower for these countries. Therefore, higher VA weights imply a weaker input linkage. Also, it follows that these three countries become more important to determine Latvia’s competitiveness once we account for supply chain linkages as compared to gross trade.²⁰ Overall, accounting for trade in value-added, Latvia would be more exposed to external trade shocks originating in these countries than currently captured by gross trade. Our estimates show that a 5.9-percent tariff imposed by the US on its imports (Layer 1), with retaliation from all countries using the same tariff, would lead to a reduction of 0.2 percent in Latvia’s value added (four times larger than the reduction in gross turnover flows).

Latvia: Implications of Trade Tensions Impact of Tariff Shocks Related to Trade Tension

(In percent)

Citation: IMF Staff Country Reports 2019, 265; 10.5089/9781513510057.002.A001

Sources: Bems and Johnson (2017); Timmer et al (2015); and IMF staff calculations.Note: Layer 1: United States imposing a 10 percent tariff on all aluminum imports, a 25 percent tariff on all steel imports, a 25 percent tariff on $50 billion of imports from China, and a 10 percent tariff on an additional $200 billion of imports from China that subsequently increases to 25 percent.Layer 2: United States imposing a 25 percent tariff on a further $267 billion of imports from China and China responding by raising both the base that tariffs apply to and the tariff rates, such that all goods imports from the United States also face a 25 percent tariff (roughly $130 billion in imports from the United States).Layer 3: United States following through on the proposal to impose a 25 percent tariff on all imported cars and car parts (worth about $350 billion).Cumulative: A cumulated tariff shock from the three layers.Gross turnover is the sum of all intermediate and final goods transactions that occurs across sector in Latvia.

23. Latvia’s exposure is relatively moderate compared to the European (EU28) average. We estimate the US tariff impact (under the Layer 1) and find similar effects for most European countries. Germany exhibits the largest exposure to trade tensions (owing to the vulnerability of the car industry), with a reduction in domestically produced value added about 50 percent higher than the average EU impact, while Latvia’s impact is slightly smaller than the EU average.

Impact of US Tariffs Under Layer 1

(Percent change in demand)

Citation: IMF Staff Country Reports 2019, 265; 10.5089/9781513510057.002.A001

Note: Gross turnover is the sum of all intermediate and final goods transactions that occur across sectors in an economy, including gross exports.Sources: Bems and Johnson (2017); Timmer et al (2015); and IMF staff calculations.

D. Conclusions and Policy Implications

24. The value-added REER (VA REER) index accounting for input-output linkages suggests that Latvia may be less competitive than indicated by a standard REER index based on gross trade. The recent rise in unit labor cost may have been a drag on Latvia’s ability to supply its domestic value added on world markets, reflecting rising labor costs and wage growth. Preventing a long-term misalignment between wage growth and productivity would help preserve Latvia’s competitiveness.

25. Trade tension induced tariff hikes are likely to have moderate costs for Latvia in terms of value added produced in the country. In this regard, policies aimed at enhancing product sophistication or quality and export market diversification could mitigate Latvia’s exposure to trade shocks in GVCs.

26. There is significant scope to improve Latvia’s competitiveness in the context of GVCs.

Backward GVC Participation. Latvia’s involvement in GVCs has mainly been toward backward participation, that is the country incorporates significant foreign value added into its own exports. Latvia’s competitiveness could be enhanced by improving the degree of sophistication of Latvia’s production, which would require greater use of imported intermediate goods with high-technological content. Yashiro et al. (2017) show that Latvia is not taking enough advantage from using imported inputs in producing its exports, as foreign value added in exports is lower than in peer countries. Indeed, using imported inputs allows countries to benefit from knowledge transfers, diversify their export, and improve product quality (Amiti and Konings, 2017).
Forward GVC Participation. The participation in upstream activities, such as exporting intermediate goods, re-exports, and non-transport services, have been found to generate substantial productivity and employment gains in Latvia (Kowalski et al., 2015, and Benkovskis et al., 2017). Improving allocation and incentives for innovation—through better access to credit and skilled labor with knowledge of foreign markets—could yield significant productivity gains particularly for firms operating in upstream GVCs.

27. Attracting FDI inflows can also spur Latvia’s GVC participation through an intra-firm trade flow channel. For instance, multinationals entering Latvia through FDI would likely increase trade with different countries in which they are present both in intermediate and final goods. Kowalski et al. (2015) find that inward FDI is an important determinant of backward participation. This empirical finding is confirmed in CEE countries by Buelens and Tirpák (2017), suggesting that policies to attract FDI would contribute to enhance Latvia’s participation in GVCs. More specifically, given Latvia’s backward participation, FDI inflows aiming at establishing export processing facilities could play an important role, including by improving Latvia’s product diversity and sophistication.

Annex I. Calculation of Conventional Weights

Conventional weights are calculated as described in Bayoumi et al. (2006). Under the assumption of perfect substitutability between individual commodities, the associated weights depend on the importance of other countries in the overall supply and demand for a commodity. However, manufactured goods are assumed to be differentiated and thus the weights in this case depend on bilateral flows across countries, augmented by the influence of third-market competition in export markets. Regarding services, only trade in tourism is included for countries for which tourism represent an important part of overall trade. Service weights are calculated using bilateral data on tourist arrivals. Based on the importance of different types of trade, these weights are combined as follows:

W_{i j} = α_{M} W_{i j} (M) + α_{C} W_{i j} (C) + α_{T} W_{i j} (T)

where W_ij (M), W_ij(C) and W_ij(T) denote weights calculated for manufactures, commodities, and tourism, respectively—between countries i and j—and α_M, α_C, and α_T represent the shares of these three types of trade in the overall trade of country i.

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Prepared by Kodjovi Eklou.

We assess Latvia’s participation in GVC using the GVC index. The GVC participation index includes both backward and forward participation expressed as share of gross exports.

See Ignatenko et al. (2019) who show that high unit labor costs and low human capital reduce GVC participation in a sample of 189 countries. Regarding human capital, Benkovskis et al. (2017) highlight the importance of skilled workers as a determinant of GVC participation in Latvia.

This value-added REER is obtained as an aggregation of bilateral value-added price changes into an index that measures the average multilateral price of domestic relative to foreign value added. In this index, the weight attached to bilateral price changes depends on the cross-price elasticity of demand, that is the elasticity of demand for value added from a given country with respect to another country’s value-added price. In addition, this cross-price elasticity depends on the interaction of the global input-output structure with relative elasticities in production versus consumption.

Given high persistency in the weights, we assume that they remain constant from 2014 through 2018.

See Bems and Johnson (2017) for details on the derivation. The terms $\hat{x}$ represent a first difference in logarithm of x.

See short appendix and Bayoumi et al. (2006) for details on the methodology for calculating conventional weights.

The conventional macro framework features weights based on gross trade flows and production as there is no distinction between gross output and value-added data nor between inputs and final goods.

ECB (2016) contains an extensive discussion of the decoupling of the GDP deflator and HICP in the euro area after 2014, attributing it largely to the increase in profit margins due to an improvement in terms of trade (euro depreciation and decline in energy prices).

To reduce potential bias, we implement the correction suggested by Teulings and Zubanov (2014) to control for innovations in the regressors between periods t and t+h when estimating the impulse response at horizon h.

External demand is measured as the weighted growth rate of Latvia’s trading partners. In order to address potential multicollinearity between inflation and the VA REER, we also tested the robustness of our results by excluding inflation. The robustness test found similar results.

We also explored the link between VA REER appreciation and the degree of integration into GVCs. We ran the same regression on the subsample of countries with a GVC participation index higher than the sample median of 69.8 versus the subsample below this sample median. The results provide evidence that a 10-percentage point appreciation in the VA REER index leads to a reduction in VA export growth by 0.6 percentage point in the first year and cumulates up to 1 percentage point in the third year in countries that are above the sample median of GVC participation index.

We also estimate the reduced form effect of VA-REER on real GDP growth and found no statistically significant effect. In addition, we do not find any statistically significant effect of conventional REER on value added export growth or real GDP growth.

Using the formula, we calculate the impact as 0.3*(-0.5).

For countries above the sample median of the GVC participation index, the implied impact is larger and could reach 0.3 percentage point loss in growth.

Huidrom et al. (2019) estimate the effect of a 5 percent tariff on all US’ imports for Europe and find that it would lead to a decrease in total value added by 0.2 percent, while in gross output terms it would be only 0.1 percent. In addition, they also find that most European countries are less competitive in value-added terms than in gross trade flow terms.

We use the MATLAB code provided in the online Additional Materials of Bems and Johnson (2017) to calculate gross and value-added trade flows, partner weights, effective elasticities of substitution and demand spillovers https://www.aeaweb.org/articles?id = 10.1257/mac.20150216). We use the 2016 vintage of the World Input-Output Database (http://www.wiod.org/database/wiots16) to estimate the effect of tariffs for 43 countries, from 2000 to 2018. Bilateral exchange rates, CPI, and GDP deflator are taken from the World Economic Outlook.

We use the equivalent of a tariff on all US imports implied by the tariffs in each layer. See chapter one of October 2018 WEO

Germany has the largest weight with both concepts, but the value-added weight is lower than the conventional one.

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