Mister: Monetary Policy and Latvian Government Essay

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Macroeconomic Imbalances, Policies and the Economic and Financial Crisis:

Latvian Monetary and Fiscal Policies during 2008 and 2009 in the context of and in relation to the Economic Crisis

Introduction: Latvia in crisis

While enjoying a sustained period of rapid economic growth and increasing prosperity, it once appeared that the Latvian economy was almost effortlessly converging towards its new European Union (EU) partners post-accession in 2004. Indeed in the period 2005-2007, before recession hit the Republic of Latvia, annual real growth in gross domestic product (GDP) averaged beyond 11%, unemployment hit lows of 6% and (table 1 of annex II).

Due to the openness of the recently acceded EU member state, this growth however was compounded by the accumulation of external imbalances with a recorded current account deficit of the order of -21.8% of GDP in 2007 (table 1 and 4 of annex I). Furthermore, signs of overheating of the Latvian economy were omnipresent. Vast levels of accessible private financing (mostly euro-denominated, and via the foreign owned banking sector) were used for mortgage loans and thus resulting in rapid increases in real estate prices (EC, 2010, pp.14); substantial nominal wage growth ( 5); and rises in regulated prices and the price of food reinforced these wage-related cost shocks to secure ‘inflation hitting record highs' (EC, 2008a, pp.83) as the Harmonised Index of Consumer Prices (HICP) surpassed 15% (table 1).

To the surprise of many the booming progress of a post-transition success story, however came to an abrupt halt in 2008 as the wheels of the Latvian motorcar destabilised and the economy entered into recession by the second quarter of 2008 with negative GDP growth of -1.8% ( 1 of annex I). The initial recession can in large part be attributed to the fairly quick decline of growth below -4% in both the trade and industrial sectors of the economy ( 2 of annex I) following ‘a marked deceleration' in domestic demand (EC, 2008a). By the third quarter, the recession had deepened and the 2.26 million inhabitants of Latvia in expecting a further easing of house prices contributed to a sharp contraction in the overheated construction market by -7.9% ( 2).

The global economic and financial crisis sparked off by the spectacular failure of the Lehman Brothers Investment Bank in September 2008, aggravated the downturn in the domestic Latvian economy. At a time of low consumer and business confidence, the crisis led to a concomitant downturn in external demand as Latvia's EU and eastern European partners' economies import demands eased (EC, 2008a). Whilst the consequent tightening credit availability and increasing cautiousness of banks amplified the reversals in lending and house prices (EC, 2008b) in a ‘self-reinforcing spiral' (EC, 2010, pp. 15).

As the global financial crisis deepened and such reinforcing mechanisms became more extreme, the small Baltic economy found itself exposed by the structural and external imbalances it had accumulated in the previous years of growth (LREM, 2009b). The increasingly risk averse international environment and lack of access to external financing was starkly brought to light when Latvia's second largest domestic bank, Parex ran into significant problems leading to its ultimate nationalisation in November 2008 (EC, 2009a).

By year end 2008, unable to finance its external deficits and showing no signs of internal recovery, the Latvian economy was brought to the very brink of economic collapse. The government was forced to sacrifice a part of its sovereignty and turn to institutional financing for assistance and was duly granted an emergency loan worth €7.5 billion from the International Monetary Fund (IMF) and the EU, conditional on the implementation of certain reforms. (IMF, 2009)

The recession however showed no such mercy, as the dual contraction in domestic and external demand persisted ( 3) contributing to a drop in real GDP growth