Latvia: recent economic developments on a way to EU
As a result of the macroeconomic policy implemented in Latvia, a low level of inflation, macroeconomic stabilization and re-establishment of positive real GDP growth have been achieved. It has also led to a stability of interest rates, which stimulates lending to the private sector, and that turn, is a precondition for further development in any economy. Although 1997 and 1998 were turbulent years for the world economy, especially for the developing countries, Latvia managed to prove itself as one of the most successful and financially most stable economies.
LATVIAN ECONOMY IN 1998
The Government continued to pursue strict fiscal policy, thus ensuring a balanced basic budget and encouraging the maintenance of low interest rates and sufficient credit to the productive sectors of economy. In 1997, the government budget in Latvia recorded a surplus of 39 mln. lats, or 1.2% of GDP. The budget recorded a surplus in 1998 as well - 8.1 mln. lats, or 0.1% of GDP. That is considerably better performance than in most of European Union countries and well below the Maastricht economic convergence requirements. General government debt is currently about 11% of GDP - also well below the Maastricht criteria. Besides, the authorities have managed to almost stop it from growing. This tendency is expected to continue in 1999.
As a result, the amounts of credits to domestic enterprises and private persons soared: at the end of 1998, for instance, the annual growth in domestic loans amounted to 52.0%. The growth in the proportion of long-term loans twice exceeded that of short-term loans. It is expected that these trends will favourably affect the development of the national economy in the future.
A tight fiscal and monetary policy secured the rapid decrease of the annual inflation which dropped to a level that was one of the lowest in Eastern Europe. At the end of 1998, the annual inflation in Latvia amounted to 2.8%.
The stability of the national currency has contributed to the booming exports. In the first half of 1998, Latvian exports increased by 23.1% over the first half of 1997. At the same time, the development of the national economy encouraged rise of the domestic demand which, in its turn, stipulated increase in goods import by 28.7% in the middle of 1998. In the second half of 1998 the growth rate of export slowed down due to the Russian crisis causing a related drop in import growth rates to 20.8% in 11 months of 1998 over the corresponding period of the preceding year. Although the trade balance deficit had risen, the inflow of foreign capital in Latvia ensured full financing of the deficit resulting in a positive balance of payments for Latvia. In November 1998, the Bank of Latvia's net convertible foreign currency reserves totalled the import of goods for 3.0 months.
The sound monetary and exchange rate policy implemented by the Bank of Latvia, committed to long term stability, has played a crucial role in the development processes. The independence of the Bank of Latvia is secured by provisions guaranteeing the right to set and implement monetary policy without interference from the government. Amendments to the Law "On the Bank of Latvia" recently passed by the Parliament bring the Law into full compliance with the relevant EU requirements. The Law explicitly forbids direct government borrowing from the central bank. The price stability is singled out as the main monetary policy objective of the Bank of Latvia. In its operational practice, the Bank of Latvia has developed a full set of monetary instruments intended for use by the European Central Bank.
It should be emphasised once again that behind all these positive developments of the national economy in Latvia were long-term stability orientated economic policies pursued by the Bank of Latvia and national government. This is unlikely to change in the years to come. However, being a small, open economy Latvia certainly could and will not escape the global financial turmoil taking place in various world regions. 1998 was marked by an increasing financial instability that reflected most spectacularly in Asia and Russia. From 1999 onwards, the introduction of the Euro will undoubtedly be a major milestone in the evolution of the international monetary system. Both these events will have important implications for the Latvian economy.
LATVIA AND THE RUSSIAN CRISIS
Financial crisis originating in the Asian countries did not affect Latvia directly due to rather weak economic ties between Latvia and Asia. Indirectly Latvia was hurt by a more cautious attitude foreign investors took evaluating markets in emerging and transition countries. However, the financial turmoil in Russia this year produced direct and sometimes rather painful effects on the Latvian economy with exporters and commercial banks particularly affected.
The first to feel the impact of the Russian crisis were exporters with large export shares in this market (with producers exporting foodstuffs and chemical products hurt more severe than others). During the autumn months of 1998 several companies in these industries found it difficult to market their products in Russia. This was partly caused by the devaluation of the Russian rouble, yet a greater damage was done by the paralysed banking sector in Russia. All financial settlements with Russian export partners came to a halt and barter once again (after the break-up of the Soviet Union it practically ceased to exist) became a major way of doing business with Russia.
In these circumstances exports to Russia plummeted: the exports to Russia fell by 32.5% in 11 months, downgrading Russia from the first to the third most important trading partner of Latvia with a 12.4% export share. The drop of exports has lead to a reduction of output in these industries: for instance, in December the volume index of industrial output fell by 13.1% year-on-year (including an 17.7% decrease in manufacturing). The reduction of output has translated into layoffs of workers in several enterprises, pushing unemployment up to 9.2%.
On the bright side one can put the fact that the drop of exports to Russia has stopped, and it is expected that the current amount of exports to this country will likely stay on the new level for the next couple of years, perhaps even increasing somewhat in the future.
More importantly, a detailed analysis shows that producers hit most severe by the Russian crisis were exactly those whose business was focused almost solely on Russia with no diversification of their export markets whatsoever but rather with an almost blind reliance on just one - admittedly big but very unstable - market. Thus, punished were the producers who consistently ignored the message that the development of new products, increasing productivity and diversifying markets are key activities for a successful business. Hence, the crisis in Russia can be viewed as an catalyst which only speeded up a process that was already underway and had to be accomplished anyway - with or without Russia.
Turning to the banking sector, the current forecast indicates that the banking sector as a whole had to end the year 1998 without any profit due to considerable losses caused to several banks by their investments in GKOs. Looking at individual banks, the following picture emerges: two small banks, which had large exposures to Russia, has been declared insolvent, and a few other banks are experiencing difficulties for the same reason. This will primarily affect the banks' profits, which may be considerably less than expected in 1998, but the problems of individual banks will by no means endanger the stability of the banking system. Hence, the strict banking supervision and the prudential policies of credit institutions enabled the Latvian banking sector to overcome successfully these problems.
As with the trade, the Russian crisis may even contribute to some positive developments in Latvia. For Latvian banks, losing, at least partially, the excessively profitable and - as it turned out - excessively risky business opportunities in Russia will provide more incentives for expanding domestic business and foster consolidation of the banking system, first and foremost, through mergers. This will help in establishing an even more stable and reliable banking system in Latvia.
MONETARY DEVELOPMENTS
In 1998 lending rates ranged between 12% and 16% while interest rates on time deposits fluctuated between 4% and 6%. At the same time, the margin between deposit and lending rates has decreased demonstrating the improved efficiency in the financial sector: in 1995 the margin reached 10-20 percentage points while since May, 1997 the margin has been only 7 to 11 percentage points. As a result of falling inflation, the real interest rate on short-term deposits (which has been negative after independence was regained) has increased and now is positive, stimulating accumulation of savings in Latvia.
Due to the strong importance of foreign trade in Latvian economy, liberal foreign exchange policy and the need for imports of modern production equipment and up-to-date technologies to transform the economy, about one half of all deposits are held and credits granted in foreign currency. Deposit and lending rates in foreign currencies have generally been lower than the corresponding rates in lats, with the spread larger and more persistent on time deposits and other long-term financial instruments. However, along with macroeconomic stabilization, economic agents have demonstrated an increasing confidence in the national currency. This is confirmed by the fact that the interest rates on time deposits in lats and foreign currencies have gradually converged: in 1995 it was 1-3 percentage points, but in 1998 it was a mere 1.5-2 percentage points.
As the banking system continued to develop, separate interbank transactions translated into an interbank market that involved ever increasing number of banks. Initially, this market was rather underdeveloped with large fluctuations of interest rates. In 1993, when the Bank of Latvia started gathering information on this interbank market, as well as in 1994, lending rates ranged between 25% and 86% with a tendency to decrease. This tendency continued until the beginning of 1995 when the turmoil in the banking sector seriously impaired mutual confidence among banks. As a result, long-term lending went down sharply, about a half from all credits were dispensed in foreign currencies, and further fall of interbank interest rates was inhibited as well.
At the end of 1995, the harmful impact of banking crisis on the Latvian financial sector started to diminish, and in 1996 and 1997 the interbank market showed signs of positive development: lending turnover and the share of lats in interbank transactions increased while interest rates went down from 20%-22% to 4%-6%. In just one year (from April 1996 to April 1997), the Bank of Latvia refinancing rate decreased from 24% to 4%.
1998 has witnessed a stable development in the interbank market: the turnover reached 3.7 billion lats: 20 times greater than in the entire 1995. Lending in lats accounts for 70% to 80% of all lending in this market: a sign of increased confidence in the Latvian national currency. As for types of credit, the most popular are overnight credits that are commonly used as a daily liquidity management instrument by the commercial banks. In January 1999, the average weighted lending rate in lats for overnight credits was 5.5%, for credits with maturity of 1 month and less the rate was 6.3%, while for credits with maturity of 1 to 3 months the rate fluctuated around the 9% level.
To stimulate further development of the interbank market, the Bank of Latvia at the beginning of 1998 introduced a daily fixing of interbank money market indices RIGIBID and RIGIBOR that are distributed to the electronic mass media. It provides the market participants and all interested agents with necessary information on the market situation. RIGIBID and RIGIBOR consist of lending and interest rates on credits and deposits with 6 different maturities that are quoted in the seven most active banks that are interbank market participants.
MONETARY POLICY IN LATVIA
In a liberalized financial system, as in Latvia, with full convertibility of current and capital accounts, the central bank cannot set both: the exchange rate and the monetary (money supply or interest rate) targets. Due to the huge structural changes in the economy, money demand in Latvia was and still is rather unstable and changing over time. Transmission mechanism of the monetary policy is not steady as well. Therefore monetary targets do not possess the necessary qualities of intermediate targets (namely, stable and predictable influence on the final goal - price stability) and the exchange rate targeting could be considered as the optimum monetary policy strategy during the transition period for a country like Latvia.
The fixed exchange rate policy could be considered favourable in a small open economy like Latvia, which, to a great extent depends on international trade (imports and exports account for about 80% of GDP). The fixing of the exchange rate, if it is durable and credible, reduces uncertainty, eliminates exchange rate risk and provides businesses with a solid basis for planning and pricing, thereby fostering investment and international trade relations. A stable exchange rate imposes a constraint on domestic monetary policy (nominal anchor), and can thus be regarded as a useful guard against unsound policies, which diverge significantly from those in the anchor countries. In the long run the Bank of Latvia's exchange rate policy leads to reduced overall inflation through the convergence of price and inflation levels in the non-sheltered sector.
Therefore after leaving the rouble zone in 1992, the Bank of Latvia launched a strategy of exchange rate stabilization. Initially a managed float was adopted as the exchange rate regime. At that time, the most important goal of the Bank of Latvia was to stop hyperinflation and achieve stability. That required a tight monetary policy and an efficient control over the growth of money supply, which was achieved through high interest rates and limited lending to the commercial banks and government.
At the beginning of 1994, the achieved stability in foreign exchange markets, as well as the potential loss of competitiveness due to the excessive real appreciation of the national currency, stimulated the Bank of Latvia to introduce a fixed exchange rate. Choosing the fixed exchange rate regime was also preferred as a means to avoid the possible high volatility of the exchange rate, due to the then rather thin foreign exchange market in Latvia. In February 1994, the Bank of Latvia pegged the lats to the XDR basket of currencies (1 XDR = 0.7997 LVL). The advantage of such arrangement is that it is transparent to all economic agents and excludes uncertainty about the future value of the national currency. If the national currency is pegged to some trade-weighted basket, it is more open to manipulations.
The decision to peg the lats to the XDR was also prompted by the importance of the US dollar and the German mark both in the domestic market and foreign trade, as well as by the fact that the XDR basket is on the average more stable than any single currency. The exchange rate of the lats against the XDR basket was based on the prevailing exchange rates of the lats against major trading currencies at the moment of pegging.
Ensuring price stability will remain the main objective of the Bank of Latvia monetary policy. However, it should be taken into account that the monetary policy measures alone will have a rather limited impact on further reduction of inflation, as it is caused by and large by the ongoing liberalization of prices in the utilities sector, mainly controlled by state monopolies. Further privatization of these state monopolies should accelerate the liberalization and price adjustment process thus in a medium term approximating the inflation to the Maastricht criteria level.
LATVIA AND EURO
The Bank of Latvia remains strongly committed to exchange rate stability and intends to pursue this policy in order to achieve long-term stability. In the medium term, exchange rate stability has been set as the monetary policy target, with the view of accessing to full membership of the EU and subsequent participation in the European Monetary Union. The Bank of Latvia treats Maastriht criteria for the introduction of a single currency as indicators of sound macroeconomic policies, and targets the criteria, specifically, those under a more direct influence of the central bank (inflation and exchange rate stability) as its policy goals.
Introduction of the Euro is event of major international importance and certainly it has implications for Latvian economic policies. Probably one of the most important questions of our exchange rate policy has been whether Latvia has to peg its currency to Euro right from the introduction of Euro or it is more reasonable to consider other options. Although the Bank of Latvia is technically prepared to switch the peg to the Euro at any time and the central bank is fully authorised to do so, the Bank of Latvia feels obliged to consider thoroughly all possible consequences of revising the exchange arrangement.
Latvian foreign trade is growing rapidly and it experiences significant changes in the structure of the main trading partners. The share of EU countries in Latvian exports has increased from 39.2 % in 1994 to 56.0% in November 1998, but in imports - from 40.6% to 55.6%. Taking into account these tendencies one could expect that the share of EU currencies in the structure of the clearing currencies also would increase. Statistical data prove this assumption and EU currencies have increased their share from 30.4% in 1994 to 43.8% in 9 months of 1998.
But at the same time significance of the US dollar still is quite tangible: in 9 months of 1998 47.0% of all foreign trade settlements were cleared in US dollars. This could be explained by size of dollar market (which allows to reduce transaction costs) as well as fluctuations of the Russian rouble vis-à-vis US dollar.
Euro zone itself has strong potential to become large, stable market with single currency. Therefore we could expect further reorientation of Latvian exports towards EU and following increase of the importance of Euro as international clearing currency. On the other hand we must take into account the effect of historical inertia which will prevent immediate switch to Euro as settlement currency as well as remaining quite significant share of the CIS countries in the structure of Latvian foreign trade. Therefore we could expect US dollar to remain one of the most important clearing currencies in Latvian foreign trade.
In 1999 after introduction of Euro two of the XDR basket currencies (namely German mark and French franc) technically turn into Euro and structure of the XDR basket has changed. New XDR basket retains the qualities of the previous basket which are essential for Latvia. It will be dominated by the USD, it will also include Euro as an important component and fluctuations of the basket vis-à-vis each of the major currencies on average will be smaller than fluctuations of the bilateral exchange rates.
If Latvia decides to peg its currency to Euro then fluctuations of Euro exchange rate vis-à-vis US dollar will translate into fluctuations of the same magnitude of the lats vis-à-vis US dollar. Currently it is too early to come up with meaningful assessment of the developments of the Euro - dollar exchange rate as well as to predict possible future volatility. Anyway, taking into account substantial share of the US dollar in the Latvian foreign trade payments increasing volatility as well as magnitude of Euro-US dollar exchange rate could have quite negative impact on our foreign trade. Therefore keeping peg vis-à-vis XDR basket will be more beneficial in this situation and it will remain the policy of the Bank of Latvia in the medium term.
To sum up, the Bank of Latvia will have to carefully watch for possible changes in the behaviour of various foreign trade agents and, equally important, closely follow the performance of the Euro in world financial markets. Pegging the national currency to the Euro would be a logical step, perfectly in tune with Latvia's pre-accession strategy, and the Bank of Latvia will be prepared to take that step in due time.
15-02-1999
* Member of the Executive Board, Head of Monetary Policy Department. Bank of Latvia Helmuts@bank.lv
