The big correction in Latvia

An interesting Box from IMF's Republic of Latvia: Request for Stand-By Arrangement - Staff Report;

Latvia’s consolidation is relatively large. With the general government’s structural primary balance improving by 14 percent of GDP between 2009 (constant policy scenario) and 2012, Latvia’s fiscal consolidation plans would fall among the largest consolidation episodes in comparable countries during the past two decades, along with Denmark, Finland, Greece, New Zealand, or Sweden. Latvia’s consolidation is twice larger than Lithuania’s 1999-2003 adjustment motivated by EU accession. Similar results are obtained if one focuses on the primary balance of the central government.

The consolidation will need to be sustained over 3-5 years. Successful consolidations tend to be gradual, spanning over a period of time that allows savings from structural reforms to materialize. Long consolidation episodes include Japan in the 1980’s and Finland, New Zealand, Sweden, the United Kingdom and the United States in the 1990’s. Latvia’s consolidation is front-loaded, with three quarter of the structural adjustment happening in the first year versus 40 percent on average in comparable countries. However, articulated around the medium-term objective of meeting the Euro adoption criteria, Latvia’s consolidation plan is expected to last three to five years, with savings from major structural reforms materializing progressively over 2010-2013.

Latvia’s approach is expenditure heavy yet more balanced than the average. The composition of consolidations is a crucial determinant of their success. Expenditure-based consolidations tend to be associated with deeper structural reforms increasing government productivity—more important than its size in ensuring sustainable growth and development—and to be eventually more successful. Revenue-based adjustments have a greater risk of reversal in industrial economies, but can be sustained when associated with tax policy or administration reforms, particularly in emerging market and developing countries. Latvia’s consolidation is relatively expenditure-heavy, with 60 percent of the adjustment coming from expenditure cuts, but more balanced than the average.

Clear medium-term objectives, strong political leadership and mobilization of public support will be key. Consolidations tend to be more successful when perceived by markets and the population at large as durable and sustainable. In many European countries in the 1990s, consolidations were justified by the objective of the Euro adoption, which is also the case for Latvia. On the other hand, most consolidations tend to be led by new governments and under a broad consensus. Latvia’s Parliamentary elections in 2010 represent a risk.

Selected sources: “Experience with Large Fiscal Adjustments”, Occasional Paper No. 246; “Fiscal consolidation: Lessons from past experiences”, OECD, 2007; “Fiscal Adjustments: Determinants and Macroeconomic Consequences”, IMF WP 07/178, Kumar et al., 2007.