OREANDA-NEWS. November 21, 2011. The Bank of Latvia Council in its regular meeting discussed the latest trends in Latvia's economic development and took decisions regarding the further course of monetary policy, reported the press-centre of Bank of Latvia.

The main conclusions were inevitably related to next year's budget currently under construction.

In the past three difficult years much has been achieved. In overcoming the crisis, it has been shown that, in terms of the budget, less is more:

-         less deficit is more growth, which returns faster,

-         less deficit is more competitiveness and production,

-         less deficit is more jobs and more export growth.

This seems self-evident. Yet there are audiences and people who seem to be.. disturbed by such recovery. The only way I can explain it: they dislike it because it means that their theories and myths are overthrown. These theories and myths are as follows

there was sweeter kinds of medicine to cure the crisis;

devaluation would have been a less painful route to follow.

The macroeconomic situation tells us something entirely different:

Latvia has fast returned to growth;

and only that can motivate the people to stay put or those who have left to return to Latvia.

Latvia has already become one of the fastest growing and export-capable countries in the EU! This should be reinforced! Not only by completing the consolidation which means a balanced budget in 2013 but also:

by including the lesson of the crisis – to save during years of growth – in the Constitution and the Law of Fiscal Discipline;

by turning to real budget planning for three years.

On what has been accomplished in drafting the 2012 budget

Given the short time that the new government has had at its disposal for drafting the budget, what has been accomplished is commendable. It has worked with the awareness that it is not just a regular budget but one with far reaching consequences: it will determine how we live for the next ten years and not just next year. It will likewise determine whether we live with the euro or without it.

We appreciate the fact that there is no longer any disagreement between the lenders and the Government and that the consolidation amount is close to 150 million lats, a figure proposed by the central bank. Unfortunately it contains no reserve! We should take into account the fact that we are witnessing an exacerbation of the global debt crisis in the world and particularly in Europe, which will act to reduce the growth predictions. Latvia will not remain unaffected. New, important developments are taking place every day, not just every month or week.

The second wave of the crisis has already beginning to roll, reducing the growth predictions substantially!

In November the European Commissioner for Monetary Affairs Olli Rehn warned of a possibility of a "repeated recession", i.e. about a renewed drop in production and services volumes.

I quote: "The future outlook is unfortunately gloomy. This forecast is the last wake-up call. The recovery in the EU has come to a standstill and there is a risk of a new recession."
The EU forecasts updated in autumn also point to an expected drop in growth.

The latest statistics point to a drop in industrial production already in the remaining months of this year (ill.). The regular survey of predictors conducted by the ECB also indicates a lower GDP in the euro area not only in the shorter term (0.8% in 2012), but slow growth for the next five years. The economies of many European countries, including the so-called nucleus of the euro area, are stagnating.

I will talk in more detail about Italy and France.

Italy
The focus of crisis observers has already shifted from the small country of Greece to Italy. Its government debt is 118% of the annual volume of the economy or GDP. That is much even taking into account the EU common practice, whereas Italy's growth in the last decade has barely topped zero. That has the financial markets worried that Italy, continuing to do nothing in terms of fiscal consolidation, may not be able to repay its debt.

In the worst case scenario, it can become a self-fulfilling market panic:

-         assuming that Italy won't be able to pay, it is concluded that in the future it may be very difficult or costly for it to borrow;

-       continuing to reduce Italy's credit rating a situation might emerge where Italy actually cannot manage to refinance its debt.

The financial markets in early November already asked 7% (7.6% on 9 November) for lending to the Italian government, which is the highest price since 1999 when the euro was introduced. To compare: Germany can borrow at 0.25%.

France
France's credit rating is still the highest possible (AAA), and, although its debt level is lower than Italy's (84% of GDP), the prospects for economic growth are worsening in France as well. It has resolved to conduct fiscal consolidation, yet the European Commission does not consider the amount adequate. The upcoming election in 2012 and low growth prospects imply that a greater amount of consolidation could be complicated to achieve.

It is also important that the French banking sector has become seriously involved with the debt securities of Southern Europe. The French banks own not only a large part of the debt of Greece and Spain but also almost one half of the Italian banking sector debt.

If it becomes necessary to conduct a recapitalization of European banks in the amount of 200 billion euro, 30 billion will be up to the French banks. It must be noted that the French government recently assumed guarantees in the amount of 33 billion euro (1.7% of GDP) for the rescue of Dexia Bank.

So that much about the overall prospects of the EU and euro area and France in particular. Recent experience shows that under such circumstances it is those countries that have been able to put their public finances in order that are most successful. We do not have to look far for such experience: in neighbouring Estonia ratings, investments, jobs have all gone up and salaries and pensions are larger than in Latvia.

There is still much to be done in straightening out the finances (illustration): the state will continue to spend a million lats a day on credit and state expenditure remains at the level of 2007. If the downturn risks become a fact of life in Europe, Latvia may have to carry out additional consolidation in the middle of next year. The amount of consolidation then could be much larger than if it is planned for ahead of time and the burden distributed over 12 months.

Aiming for euro in 2014
Despite the fact that the situation is worsening in the EU and euro area; despite the fact that Latvia may be hit by the second wave of the crisis which has already reached Europe: it may not sidetrack us from the wish to improve our credit rating and introduce the euro! From the goal that will ensure much greater stability, predictability and smaller costs of the debt. I will repeat myself: in the coming years the state will have to repay the debt it accumulated during the crisis years – 2.3 billion lats. It will have to be refinanced in 2014. and 2015 (illustration). It is important at what interest rate we do this: at 2-2.5% or 5 -5.5%. The difference over ten years will be a billion lats or paying off an amount equal to the healthcare or education budget.

The budget must be consolidated independently of the plan for the euro introduction but with the euro introduced we will be able to pay it off more cheaply. And let us calculate along when someone tries to scare us with the great costs for saving other countries supposedly assumed now by Estonia and in the future for Latvia if we introduce the euro.

Latvian participation in the resolution of the European debt problem?
Statements have been made that Latvia, just as Estonia, might have to invest large sums of money to rescue the old European countries and that Latvia could lose millions. This is not true! Estonia is not paying anything and is not losing billions in Greece! As part of the temporary lifeline, it is participating in the European finance stabilization mechanism and extending guarantees within its framework. As of 2013 it is planned to replace the temporary mechanisms with a permanent rescue system, the European Stability Mechanism.

That would apply likewise to Latvia when it joins the euro club: just like Estonians, we would pay into the capital of this rescue mechanism: 30 lats a year or altogether 150 million lats over five years. Latvia will thus become a co-owner of the fund: the state will own shares of the fund capital and will be able to receive dividends. Such an investment is not lost: nobody gets anything without paying back. The borrowers will be obliged to pay the money back even after insolvency. Estonia as a lender will actually earn money! This fund can be compared to a sort of self-help facility or, more precisely, to an insurance policy with accruals. To continue with this comparison: the euro area is a club and its members who observe the rules have a number of advantages:

cheaper to borrow and investments,
ECB liquidity support to banks,
and this insurance policy that would not be just given to anyone, it will have to be purchased and will earn interest.
Latvia thus has to continue on a goal-oriented path, to make use of this short period, the next couple of years until the state is ready to meet the euro criteria.

Resolutions of the Bank of Latvia Council

Finally about the resolutions taken by the Bank of Latvia Council today. The central bank's outlook on price dynamics in the medium term remains unchanged:

as the influence of the prices of global energy resources and food prices abates and

if the government does not raise any taxes,

any further rise in prices will abate and as early as next year we will be able to observe a noticeable drop in inflation. There is an additional risk that Latvia's economic growth will slow down next year, primarily because of the global debt crisis. The monetary policy conditions thus remain topical and the Bank of Latvia Council today resolved to leave the interest rates set by the Bank of Latvia and the mandatory reserve requirement set for the banking sector unchanged for the time being.