Latvian GDP growth: miracle or mirage? 0

So we have a ‘dream’ outcome – high growth and low inflation. Can we explain this performance? Is it reflected in a real increase in Latvian living standards? Is it sustainable?

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According to official data Latvian GDP grew by 7.7% last year and by nearly 15% over the last two years - the highest growth rate among the EU candidate countries and one of the highest in the world. Most forecasters expect growth to remain strong at over 5% in 2002. Moreover, this is combined with inflation that is low by both historic and international standards. So we have a ‘dream’ outcome – high growth and low inflation. Can we explain this performance? Is it reflected in a real increase in Latvian living standards? Is it sustainable?

Looking more closely at the components of GDP it can be seen that investment has been growing very strongly in Latvia – by 11.6% in 2001 and by an average of 18.6% over the last five years (again the best performance in Eastern Europe). This is natural and normal. Latvia’s Soviet capital stock needed replacing and new growth industries, such as financial services and IT have acquired new capital.

Despite such strong figures, after EU accession, Latvia will very likely be the poorest country in the EU and, as today, will contain the poorest individual regions in the EU. Moreover, opinion polls suggest that many people here do not feel better off. So how do we reconcile official data with the reality of people’s experience? One part of the explanation lies in the very origin of the boom – investment. Investment does not show up a direct household benefit, though indirectly generates jobs and cheaper or better goods.

Nevertheless household consumption also increased by 7% last year, so in aggregate households did experience an increase in material welfare. How was this possible? Real wages increased by only 3.5% in 2001 so the resources used to finance consumption had to come from somewhere and they came from borrowing.

Currently Latvia is experiencing a credit boom. Over the last two years bank credit to the private sector has increased by more than 70%. Bank lending has been secured against property, often in the form of mortgages, and the easy availability of mortgages has also been behind the boom in the prices of residential property. Much of the mortgage credit has actually been used to finance consumption. Because mortgage credit is available only to those who have both property and income, the many Latvian residents who do not have much of either have not enjoyed growing consumption. Thus the benefits of growth have been spread rather unevenly.

With the election coming up it is natural to ask if the government can take credit for the good economic performance. The verdict must be a qualified yes/no! On the one hand the government has delivered a stable macro-environment and introduced some structural reforms, such as the new regulators in public utilities and financial services. However, much of actual macroeconomic and structural policy has been dictated by the requirements of EU accession rather than actively created by the government. On the other hand, real policies (as opposed to statements) on corruption, small and medium sized enterprises, regional disparities, poverty reduction, and unemployment, to name just a few, are practically non-existent.

Also there are storm clouds looming. A corollary of the high consumption is low savings, and low savings combined with high investment means that the current account must be in deficit. In plain words that means a country is spending more than it earns. Last year Latvia’s current account deficit was about 10% of GDP and the deficit in goods trade was nearly 20% of GDP. These are high ratios. So far foreign direct investment (FDI) has financed much of the current account deficit, but most FDI has been linked to privatization and with privatization very nearly completed Latvia will have to attract a different kind of FDI.

So, there must be question marks about the sustainability of the current account deficit and hence of the consumer boom and hence of the high growth rates. The real test of government policy-making will come if and when the crisis hits.

Do the programmes of the political parties inform us about which of them would be best placed to deal with a real crisis or more generally to promote a well-functioning economy in Latvia? This question is rather difficult to answer for at least two reasons: In the first place, even if we could predict the outcome of the election it is impossible to predict the composition of the government and hence the team of ministers and the government’s actual economic programme.

And secondly, the economic programmes of the main parties are rather similar – they all promise to reduce taxes (especially enterprise taxes) and to increase expenditures. Looking more closely, at least Jaunais Laiks (New Era) attempts to show how these apparently contradictory promises may be reconciled. They appeal (without explicitly mentionig him) to the ideas of the US economist Arthur Laffer whereby a reduction in tax rates and a simplification of procedures would encourage people to come out of the shadow economy to become taxpayers with the result that aggregate tax revenues would rise even though tax rates were lower. The experience of Russia, which implemented such a policy, to some extent confirms this.

In the event of a crisis Jaunais Laiks also has the advantage that in Einars Repse they have an internationally known leader. However, given intrigues of Latvian politics it is perfectly possible that even if Jaunais Laiks is the biggest party it may not be in the governing coalition.

On the other hand, because of its voting support PCTVL (For Human Rights in United Latvia) is proposing to take the problem of regional disparities more seriously by appointing a Minister for Latgale.

However, except in the unlikely event of a ‘no’ vote in next year’s EU referendum, the next government, just like previous governments, will surely remain constrained by the requirements of EU accession, the IMF and the credit rating agencies.

So, what is left for the voter? Perhaps to go for parties that have not been in government before in the hope that they will deliver something new? If they do we may yet see the emergence of an unlikely coalition!

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