Wednesday, June 24, 2009

European Commission Puts Economies of Struggling Britain and Ireland in the Same Category as Latvia : German Economy may be on the Upswing

We remain worried about the national finances of Latvia and see the threat of devaluation as a strong concern, but now breathe a sigh of relief to see that the Latvian government is in good company.

(See Financial Times Alphaville and Latvia Economy Watch on the economic situation in Latvia).

The June 24, 2009 headline from Gary Duncan at The Times Online reads European Commission Puts Economies of Struggling Britain and Ireland in the Same Category as Latvia, as the governments of Britain and the Irish Republic are facing similar economic problems caused by overspending, the impact of the credit crisis and the extent of the current world recession.

The long-term proposed solution to the world's financial problems - and also the major bone of contention in Europe - is increased regulation of the financial industry. We agree that more regulation is necessary and indeed inescapable.

Hans-J├╝rgen Schlamp at Spiegel Online International writes that Europe is split over the financial crisis and that the United Kingdom and Ireland are resisting the push from continental European countries for more regulation of the financial sector:

"London and Dublin, in particular, are blocking anything that could create problems in their respective financial industries. This is understandable, given the fact that Great Britain and Ireland have very few other future-proof industrial sectors. But this path is immensely dangerous for Europe.

"We have absolutely no risk management today," says David Wright, deputy director general of the European Commission. According to Wright, there were no warning signals before the financial meltdown because "the necessary mechanisms simply do not exist." Wright believes that it is high time for change."

In fact, the UK and Ireland are in much same boat as Latvia and will have no choice but to adopt sounder and more restrictive financial policies in the future.

We need merely to read (via the Edward.Hugh.Blog) an older (2007) International Monetary Fund (IMF) statement on the Latvian economy - as a representative example - to see that the present problems have been a longer time in the making:

"Statement by IMF Mission to Latvia on 2007 Article IV Consultation Discussions
Press Release No. 07/87, May 4, 2007

The following statement was issued on April 27 in Riga by Ms. Rachel van Elkan, the International Monetary Fund (IMF) mission chief for Latvia
:

"The IMF mission visited Riga during April 17-27 to hold the 2007 Article IV consultation discussions on economic prospects and policies....


Latvia, like other recent EU entrants, has benefited from an accession-related boost to income convergence. Closer integration with the rest of Europe in goods, financial, and labor markets, as well as through access to substantial EU grants, has helped create favorable investment opportunities and attract large inflows of foreign financing. Consequently, capital and technology stocks and consumption and living standards have risen. Employment opportunities—in Latvia and abroad—have allowed citizens to acquire new skills and work experience. As a result, Latvia has enjoyed very rapid convergence in income levels over the past decade.


Recently, however, fast credit and wage growth has caused the economy to diverge from a balanced and sustainable growth path, with domestic demand outstripping Latvia's supply capacity. As a result, overheating has intensified, bringing higher price and wage inflation, a sharply wider current account deficit, and greater external indebtedness. Rapid credit growth in euros has left large currency mismatches on the balance sheets of households and corporates and a boom in housing prices that has diverted resources from the tradable sector. A pervasive "buy now-pay later" mindset has settled in and is heightening systemic risk. These developments, if not tackled firmly, will thwart a recovery of export growth.


There is an urgent need for decisive action to unwind overheating pressures and narrow external imbalances by sharply curtailing domestic demand. Notwithstanding actions by the Bank of Latvia to raise risk awareness, recent pressure on the lats
[the Latvian currency] signals growing investor impatience with the limited policy response so far. A comprehensive strategy is therefore needed to curb domestic spending and wage growth, and moderate real estate prices to rebalance incentives for investing in tradables sectors....

The authorities' recent anti-inflation plan is a significant first step, and signals their recognition of the severity of macroeconomic conditions. In our view, however, the high level of imbalances and vulnerabilities warrants more decisive and comprehensive action. We therefore urge the Government, FCMC, and the Bank of Latvia to demonstrate unwavering commitment to a policy that would generate an appreciable near-term adjustment in the current account. A substantial front-loaded fiscal adjustment is essential to begin to counter demand buoyancy while helping convince the private sector of the government's willingness to shoulder its share of the burden. A strong communication strategy is also needed to signal the need for credit and wage restraint by the private sector. The mission's main recommendations are detailed below.


Fiscal policy: Against the balanced budget targeted in the anti-inflation plan, we consider that a headline general government surplus of 2¼ percent of GDP in 2007 and 4 percent of GDP in 2008 is appropriate. This could be achieved by saving in full revenue overperformance, restraining current and capital expenditures, and abstaining from cuts in taxes, including the personal income tax. Introducing medium-term budgeting, anchored within a conservative revenue envelope, can help balance the need for expenditure restraint with improvements in public sector efficiency. To enhance fiscal transparency and sustainability, all large public investment projects should be evaluated and prioritized within a single unified framework


Credit and prudential policies: Sharply curtailing and improving the risk profile of new lending is essential to mitigating macroeconomic and financial stability risks. Rebalancing incentives governing credit growth is therefore essential. The mission supports the effective implementation of the credit-restraining measures in the anti-inflation plan, including fully documenting legal income to secure a loan, establishing a comprehensive register of all loans, and requiring a 10 percent minimum downpayment. We also welcome the recent reimposition of limits on banks' open positions in euros. Additional regulatory measures are also needed to slow credit growth and induce banks to internalize systemic risk in real estate and currency markets. The FCMC, working with the Bank of Latvia, should increase its emphasis on monitoring systemic risk through more frequent on-site inspections of large banks and ensuring that foreign banks tailor their credit-risk models to the Latvian context.


Real estate policies: Rebalancing the structure of the economy away from the nontradables sector, especially real estate, is essential to underpin needed current account adjustment. The mission welcomes the increase in real estate taxation envisaged in the anti-inflation plan, as well as the periodic reassessment of cadastral values, beginning in 2007. To be effective, however, enforcement of real-estate related taxation should be stepped up. To further relieve overheating in the construction sector, it will be necessary to significantly scale back government capital expenditure (planned at 5 percent of GDP for 2007).


Labor market policies: Efficient labor utilization is critical to expand aggregate supply and contain surging wage costs, which are contributing to overheating and undermining Latvia's competitiveness. The greater flexibility allowed in the use of fixed-term employment contracts introduced in the 2006 Amendment to the Labor Law is welcome, and further steps to facilitate mobility between jobs and regions are needed. The recent decision to allow unfettered labor market access to the newest EU members may help relieve bottlenecks, and wider temporary access should also be considered. Public sector wage agreements should not provide grounds—through demonstration effects—for increases in private wages in excess of productivity. Social partners should secure a broad consensus for appropriate wage restraint. Shifting to higher value-added products requires increasing employer involvement in setting education curricula, and prioritizing EU structural funds to developing human resources, entrepreneurship, and innovation in traditional and new export sectors."


IMF EXTERNAL RELATIONS DEPARTMENT

Public Affairs Media Relations

Phone: 202-623-7300 Phone: 202-623-7100

Fax: 202-623-6278 Fax: 202-623-6772
"

By contrast, as written at Spiegel Online International, the German economy may be on the road to recovery, and as Germany goes, so - in the long term - goes Europe. But, as written in that article, there are no grounds for euphoria. National governments must get their finances in order, and that will take some time.

Hat tip to CaryGEE.

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