valdisdombrovskis.lv

by Anders Aslund, October 29th, 2009

http://www.piie.com/realtime/?p=1003

The International Monetary Fund (IMF) has had a good year in Eastern Europe. It has been called to help numerous countries and it has acted fast and generously. It has learned several lessons from the East Asia financial crisis of 1997-98, which was very similar. The East European crisis is primarily a current-account crisis, not a systemic or structural crisis. The external payment crisis has resulted in sharp falls in output, which in turn has resulted in temporary but large budget deficits after a long time of more or less balanced budgets and tiny public debt.

Sensibly, the IMF has focused on macroeconomic balances and bank restructuring. It has provided much more financing than before and not only for central bank reserves but also for budget financing. Yet Latvia stands out as a case particularly poorly managed by the IMF. The shortcomings stand out when comparing Latvia with its neighbor Lithuania, which faces a very similar conundrum.

Both countries will have budget deficits this year of about 10 percent of GDP and an anticipated decline in GDP of almost 18 percent. They maintain fixed exchange rates and are cutting public expenditures and wages like crazy, which has resulted in accelerating deflation. The Lithuanian government is cutting public expenditures by 8 percent of GDP this year and plans further cuts of 5 percent of GDP. Latvia’s numbers are similar. They are cutting public wages sharply and prices are currently falling. Also politically, Latvia and Lithuania are similar. They are ruled by center-right coalition governments that may prove unstable. Both have new prime ministers with high moral reputations.

The big difference is that Latvia’s foreign debt in relation to GDP is about twice as large as Lithuania’s. Another distinction is timing. Latvia was hit by the crisis almost half a year before Lithuania. Latvia hit bottom in the first quarter of 2009, while Lithuania’s nadir was reached in the second quarter. Moreover Lithuania’s big GDP fall was a greater surprise than Latvia’s. Financial markets were frozen for both after the Lehman bankruptcy on September 15, 2008, and Latvia needed funds then, so it had little choice but to turn to the IMF, while Lithuania could start large eurobond borrowing in June after the global liquidity freeze had subsided.

After recent personal meetings with both Lithuania’s Prime Minister Andrius Kubilius and Latvia’s Prime Minister Valdis Dombrovskis, I dare say that these are very fine and insightful policymakers. Admittedly, Kubilius is older, more experienced and comfortable, because he was prime minister also in 1998-99 and handled the Russian financial crisis. But both prime ministers have similar views and pursue almost identical policies.

In the international media, however, Dombrovskis is abused as an incompetent lightweight, while few write about Lithuania. The reason is that Latvia obtained an IMF/EU loan package of nearly $10.5 billion in December 2008 (of which the IMF contributed only one-third), while Lithuania borrows on the eurobond market. Lithuania’s yields peaked at 9.5 percent per annum last June, but have now fallen to 6.8 percent per annum.

In fact, the Latvian government record appears much stronger than international media currently suggest. Last June, the Latvian government forecasted that its budget deficit for this year would stay at 9 percent of GDP, while the IMF-incredibly-insisted it would be 15.5 percent of GDP. Dombrovsikis persisted and gained support from the European Union, which decided to issue its second tranche on July 2. Eventually, the IMF yielded and approved its second tranche on July 27. At present, 10 percent of GDP appears the right number, approximately what the Latvian government claimed and far better than the IMF assessment.

In October, the IMF and the European Union demanded that the Latvian government cut public expenditures by another 1.5 percent of GDP ($350 million) for next year. Initially, Dombrovskis refused because he believed that the IMF GDP forecasts once again were far too pessimistic. However, everybody came down like a ton of bricks on him and he had to give in.

In particular, European voices demanded that Latvia raise taxes, but that was poor advice. No post-Soviet economy has exited a financial crisis through significant revenue measures. On the contrary, they typically cut public expenditures by 10 percent of GDP or more over two years exactly as Latvia and Lithuania are doing. Because it was forced to do so Latvia has raised its value-added tax, but that move has not resulted in any higher revenues, as tax collection becomes more problematic with higher tax rates.

Latvia’s IMF program has become a topic of international discussion. The country is persistently scolded, primarily by American economists who want to devalue the lat. All the three Baltic countries stubbornly stick to their pegs to the euro, because they see this as the best means of adopting the euro early, while a slough of American economists argue that devaluation is necessary, which is apparently also the view within the IMF. In fact, Lithuania is likely to adopt the euro in 2013 and Latvia in 2014.

The IMF has gotten every number about the Latvian economy widely wrong, and has been forced to change its mission chief three times in half a year. But evidently the rumors reflected in multiple international media about the incompetence of the Latvian government are being spread from the IMF. Poor Dombrovskis is treated like an outlaw, even though he is resolving his country’s crisis and keeping his fragile coalition government together. JPMorgan predicts the Latvian current account deficit of 22.5 percent of GDP in 2006 and 2007 will turn into a surplus of 4.4 percent of GDP this year, and output has been rising sharply since June.

Do you recognize the East Asian crisis in 1997-98? The IMF is on its way to discrediting itself in Latvia, as it did in South Korea, by exaggerating the length of the crisis and pretending that systemic problems are greater than they are. Very soon, South Korea’s economy came roaring back, and the Baltic economies are now recovering in sharp V curves. After all, the Baltic economic systems were among the finest in the world, and they remain so.

No doctor is supposed to slander his or her patients, but that is what the IMF is doing in Latvia, although its overt public voice is missing. My colleague Arvind Subramanian calls the IMF the Euro-American Monetary Fund, but the IMF underperformance in Latvia detracts from its reputation even in Europe.

Not surprisingly, the Lithuanian government is adamant that it will not ask the IMF for help. It prefers to borrow on the market even when the yields are high, not least because of the international publicity about Latvia. Its policies are not questioned, and it largely escapes unjustified international criticism. The IMF and European Union are not pushing the government around but leaving Kubilius fully in charge,

Although the IMF has improved its policies since the East Asian crisis, the IMF program and the related international public discussion are not reinforcing the Latvian government and its austerity policy but undermining it. The IMF is detracting from Dombrovskis’ political authority, when it should strengthen it.

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