IMF Program in Latvia Explained, examined

AmCham 20 October 2009

Morten Hansen

Head of Economics Department

Stockholm School of Economics in Riga

morten@sseriga.edu.lv

Outline

• The program – short description• First Review (30 September

2009) – reading between the lines• Core features of the program• Possible alternatives to the

program and their viability• Some suggestions• Some words of warning• Viability of the program• Concluding remarks

Lots of pages….

Request for Stand-By Arrangement - Staff Report, 9 January 2009 http://www.imf.org/external/pubs/cat/longres.cfm?sk=22586.0

Memorandum of Understanding, 28 January 2009http://www.fm.gov.lv/preses_relizes/dok/MoU_ENG_versija.pdf

Supplemental Memorandum of Understanding, 13 July 2009http://www.fm.gov.lv/preses_relizes/dok/Supplementary_MoU_13%2007%202009_ENG.pdf

First Review and Financing Assurances Review Under the Stand

By Arrangement, 30 September 2009http://www.imf.org/external/pubs/cat/longres.cfm?sk=23330.0

A quick view at the IMF/EU program

Stabilization programPublic sector, sustainable public financesBanking sectorExternal stability (balance of payments, exchange rate)

Not a “stimulus” programBut: No program no budget deficit, i.e. even more cuts needed

Note: Full of sensible proposals that would have to be implementedanyway; with or without the IMF/EU

Note: Builds on the idea of the existence of a budget constraint – whichis very sensible but seems to elude some policy makers and somepundits

Note: Not a dictate from the IMF; an agreement between the IMF andLatvia

First Review (30 September 2009) – reading between the lines

IMF not happy:

“weak program implementation” (item 9)

“ the public sector wage bill remains high” (item 11)

“The government took time to respond…” (item 22)

“Structural reforms are modest” (item 22)

IMF highlighting serious problems:

“… a fall in the level of potential output” (item 17)

“… across the board cuts could impair the quality of public services” (item 24)

“Risks to the program are many, inter-related, and unusually high”

(item 50)

“Implementation of fiscal policy will need to be significantly strengthened for the

strategy to succeed” (item 60)

And that ever-recurring theme:

“The authorities’ strategy of correcting real exchange rate misalignment without

a nominal depreciation remains challenging” (item 50)

“Latvia faces daunting obstacles on its way to euro adoption” (item 55)

Core features of the program

Fiscal stabilization Procyclical fiscal policy needed due to procyclical fiscal policy in the “years

of abundance”

Maintaining the fixed exchange rateThus internal devaluation instead of external devaluation to restore

competitiveness – “undoing the wage excesses of the past”

Does the internal devaluation work?And, if so, fast enough and “enough enough” (!) ?

Joaquin Almunia Commissioner for Economic and Monetary Affairs

“Just tighten (pull)

enough and you will get the money”

Latvian wage development 2004-I – 2009-VIIn percent of the corresponding period one year ago

80

90

100

110

120

130

140

I II III IV V VI VII

VIII IX X XI XII I II III IV V VI VII

VIII IX X XI XII I II III IV V VI VII

VIII IX X XI XII I II III IV V VI VII

VIII IX X XI XII I II III IV V VI VII

VIII IX X XI XII I II III IV V VI

2004 2005 2006 2007 2008 2009

Latvian inflation 2004-I – 2009-IX, %, year on yearSteepest decline in the EU – but still not enough (?)

024

68101214

161820

Possible alternatives to the program and their viability

Krišjānis Kariņš, MEP, JL

Immediate euro introduction; fast track into the eurozonehttp://www.diena.lv/lat/politics/viedokli/izeja-no-nestabilitates-2009-10-09-1

Jürgen StarkMember of the Executive Board of ECB Forget about fast track…

• ECOFIN Council, qualified majority of all Member States, having consulted the European Parliament and the European Council, decides that a country fulfils the necessary conditions for the adoption of the euro

• ECOFIN Council, unanimity of the euro area Member States and the Member State concerned, having consulted the ECB adopts the Regulation establishing the conversion rate

• ECOFIN Council, unanimity of euro area Member States and the Member State concerned after having consulted the ECB adopt amendments to Regulation 974/98 on the introduction of the euro

Torbjörn Becker, Stockholm Institute of Transition Economics

Unilateral euro introduction; euroizationhttp://www.tp.lv/ekonomikas-konference

- Latvia will become a pariah in the EU…

- would also need a devaluation first

Andris Šķēle, People’s Party

Widen the band around the exchange rate to +/- 15%http://www.tp.lv/ekonomikas-konference

- Possible…

Eurotower ECB HQ, Frankfurt Big HQ, missing institution

A devaluation?Need to reorient the economy

towards the tradable sector

Contagion?

Currency collapse?

Floating exchange rate?No, overshooting effect

Certainty needed…

A prerequisite for economic

development is predictability:

• Exchange rate

• But also on tax rates and, bank legislation etc.

Hasn’t exactly prevailed…

Unity needed…

(Too) many players:

Government coalitionIndividual parties

Bank of Latvia

IMF

EU

Sweden

Hasn’t exactly prevailed

either…

So obviously jeopardizes the

program

Starting to sum up:

Exchange rate: Credibility needed, whatever happens to it

Other options: No “stimulus money” available – please remember this….Attract investment – long runAddress Latvia’s relative poverty – long run

Technical assistance:Cut the stupid pride and ask for more!

My fear: Populist surge – “evil IMF!”, nasty foreign banks, George Soros, oligarchs….

Viability of the IMF program: Hmmm….

• Drop the peg to the euro• Don’t answer the phone

when the foreign creditors call the government.

• Have the banks declared insolvent and convert their external debt to equity

• Enact a 0% rate policy • Offer a local currency

minimum wage job that includes healthcare to anyone willing and able to work

Just an example of some “suggestions” and “analysis”

Author’s claim:

Full employment and economic prosperity would come

in no time at all.

Viability of the program

Superior program:

<blank screen>

But will it survive?Lack of political unity

Lack of political will

Too harsh for a democracy?

The Economist 26 September 2009

Quoting ‘one weary international banker’:

“Latvia’s biggest asset is its neighbours’ popularity”