Reveries

This is the English version of the article published in Latvian on Diena.

Devaluation in Latvia and the fallacy of socio-economic development

Jānis Bērziņš1

A lot has been discussed about the desirability of a devaluation in Latvia. The main idea is that through devaluation Latvian products are going to be more competitive in the international market, resulting in boosting exports. It also would assure economic development and would help to solve the imbalances of the Balance of Payments. Although this idea is theoretically correct, in Latvia’s case it’s not so simple.

By the macroeconomic side, Latvia’s economy has passed through a process of restructurization with the establishment of unsustainable sectors that amounted for about half of the GDP in 2008 (speculation with real estate actives, consumption of durable goods, financial intermediation and transports and storage). This was the consequence of years of equivocated economic policy and predatory behavior by politicians and civil servants,  which has resulted in the establishment of a system that discourage investment in the real sectors of the economy.

By the microeconomic side, Latvia has one of the worst levels of productivity in relation to the European Union. There are problems of standardization, quality and losses in the productive process, as there is also a lack of investment in new equipments, technology and development. Of course there are exceptions. Besides, some of Latvia’s businessmen still have the Soviet culture of “We don’t do business. We settle things”, what’s different from the Western logic. Also, most of the Latvian firms are small, what results in diseconomies of scale.

It’s true that the real exchange rate is over-evaluated2 and that almost fixed exchange rate never should be adopted by the Bank of Latvia, as it always results in crisis.3 It’s also true that an over-evaluated exchange rate decrease exports, therefore, reduces the level of economic activity. However, due to Latvia’s economy lack of sustainable development, a direct devaluation would rather have the following consequences:

a) Latvia imports most of what is consumed in the country. A devaluation would immediately result in inflation, deepening recession. Inflation results in smaller real salaries. The consequence is the increase of assaults, robbery, alcoholism, suicide, etc. Also, it would increase immigrations, leaving the country without qualified workers, making very difficult to start some business due to the lack of qualified workforce and/or the high costs of labor.

b) As most of the inputs are imported, a devaluation would increase a significant part of the costs of most of the inputs of the productive and services sectors, considerably reducing or even neutralizing the artificial competitiveness gained with the devaluation.

c) The productivity of Latvia is one of the lowest in EU affecting the competitiveness of the Latvian exports. The experience of other countries suggests that strong devaluations  results in the decline of private sector investments. In this case, devaluation would rather act as a disincentive to innovation and investments. Also, as there is a significant difference between the costs of electricity, water and wages between the EU and Latvia, low levels of competitiveness are the result of inefficiency or high profit rates. Competitiveness must be gained by real productivity gains and reduction of the profits margins.

d) Latvia’s private sector foreign currency exposure is around 70% of GDP, with the corporate sector’s foreign currency open position practically double that of the household sector.  A devaluation of 15% – to remain under the limits of the Maastricht criteria – would increase private sector net foreign currency exposure by 11 percent of the GDP of 2008, two thirds in the corporate sector and one third in the household sector. Private consumption would fall, house prices decline, debt service costs increase, and consumer confidence deteriorates.

Due the problems above, a devaluation would be desirable only as part of a strong policy to promote sustainable economic development. However, the truth is that a devaluation is already occurring in Latvia through the recession, deflation and increase of unemployment of the last months, and that tends to be worse after the summer. Deflation and economic recession are reducing our relative prices in the international market.

That’s the same effect of a direct devaluation and that’s exactly what the IMF and Latvia’s government have agreed to do. In the IMF’s own words, “(…) real exchange rate overvaluation would need to be addressed through (…) a recession in the short run, and slow growth for several years to come”. However, Latvia needs to develop its economy and not to face years of slow economic growth. That’s why a new model of development is necessary.

The first thing to be done is to change the tax system. Latvia’s tax system is inverted. It must be changed, simplifying and reducing the taxes of the real sector and people, while imposing taxes to Real Estate business and property, financial capital gains and natural monopolies. Also, a special regime of tax exception to new business in innovative sectors or using innovative methods should be established. Also, all bureaucracy related not only to start a business but to maintain it must be reduced, including a “grāmatvedības reforma”. The third point is that the state must provide physical space and infra-structure, by donating or allowing investors to use state-owned land to form technological and industrial parks for free.

After the nationalisation of Parex Bank, Latvia now has two state-owned banks; thus, it is desirable to concentrate commercial operations in one bank, preferably Parex, and to turn the Hipotēku Banka into an investment bank committed to socio-economic development. As a development bank, it must establish a strong program of credit directed to the establishment and development of companies producing or using innovative products or technologies. This credit must be given at the lowest possible interest rates through a transparent process supervised by the Latvian Chamber of Commerce and Industry, by the Employer’s Confederation of Latvia and by the unions. Finally, like Slovakia and Slovenia, Latvia must initiate a special program of incentives to attract foreign direct investments, like Slovakia, Slovenia and even Finland.

These are only some examples of possible policies and not a closed system. The  Latvian politicians that captured the state still don’t understand that their survival depends on the reforms to promote real economic development, which are dependent of the establishment of successful competitive business. It’s important to understand that the politicians and civil-servants are responsible for what happen in the country. Also, that Latvia’s problems are the result of the wrong application of the neoliberal policies of the last years. That’s why the solution depends of a new political pact to promote growth, together with the development of a more realistic and sophisticated view of economic development policies, breaking with the ideological neoliberal populism of the last two decades.

1) Riga Stradins University.
2) Near 20% in comparison to 2005. The real exchange rate is the nominal exchange rate taking in consideration inflation. It’s a more accurate indicator than the nominal exchange rate. In this sense, in relation to 2005, the Latvian Lats would be devaluated about 20% against the euro in a free exchange rate mechanism.
3) Concrete examples of countries who adopted a fixed exchange rate and faced serious crisis include Argentina, Brazil and Thailand in the nineties.

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