OREANDA-NEWS. September 26, 2011. In its regular meeting the Bank of Latvia Council discussed the latest trends in Latvia's economic development and took decisions regarding the future directions of monetary policy. The main conclusions are as follows, reported the press-centre of Bank of Latvia.

On price dynamics
As predicted, over recent months, inflation has stabilized and next year will continue to drop to the level of 2-3% [Ill.]. In June and July of this year, annual inflation dropped by 0.7 percentage points to 4.3%, determined by the stabilizing of raw materials prices in global markets and the drop in the prices of certain food products. A more rapid drop in prices was prevented by changes in the VAT and excise tax rates: one third of the rise in this year's inflation was accounted for by raising the tax rates.

We must recall that on 1 June excise tax was raised on hard liquor and petrol and on 1 July excise tax went up on cigarettes and other tobacco products and the reduced VAT rate on natural gas and medicine supplies was abolished. If we exclude all impact of tax changes on prices, i.e. pretending that taxes were not raised since the beginning of the year, inflation in July would have reached a mere 2.5% and in August just 2.8% [Ill.].

On resuming economic growth
The latest economic data and developments both in Latvia and elsewhere in the world clearly point to the crossroads that Latvia finds itself in on the eve of adopting the budget for 2012. At the end of 2008 confusion reigned. The discussion on whether or not to devalue the lats was interesting and, to a certain degree, had valid basis. The Latvian government and parliament have adopted a number of difficult and unpopular decisions. Latvia has chosen the right direction – it is quite obvious how quickly Latvia is recovering from the crisis. It is evidenced by the data on gross domestic product, exports, manufacturing and dropping unemployment.

There are other countries where the situation is unfortunately getting more complicated – decisions are postponed, the external debt has grown, in some the national currency has been devalued and uncertainty is continuing to grow dramatically. It is obvious which route has been the right one. Yet even some Nobel laureate is perplexed and asking himself: how can it ever be that less is more?! Namely, how is it possible that reduced budget expenditure and deficit can help the economy grow? How can it be that decisions of this kind provide for new jobs and the budget revenue increases? How can it be that by consolidating the budget the economy has not been "squeezed" and Latvia, along with Estonia and Lithuania, are the fastest growing economies in the European Union? As far as Latvia is concerned, if the budget deficit had been reduced sooner, more and at the expense of expenditure, we might have found ourselves much closer to Estonia's situation where salaries and pensions are already 20-25% higher and taxes lower than in Latvia!

It is only the United States that keeps obstinately using Keynesian instruments and printing money to revive the economy. The debt keeps growing, exceeding 100% of GDP, yet the real economic activity gains little from this but the rating of this major power is reduced… Time of course will tell. Yet one thing is clear: there is nothing easier than printing money but it takes real skill to ensure that it flows into the economy and bank granted loans increase. Otherwise it leads to a paradox: money is being printed knowing full well that it ends up in bank accounts to wait for better times, i.e. for when the government will stop printing money and growing the deficit and debt.

The situation is different in Europe: here a discussion is taking place on cutting expenditure and not living on debt as a secure and growth promoting strategy. Europe has understood that its problems stem from crisis-related problems in certain countries. It has understood that a common currency requires greater effort, responsibility and financial discipline. That will allow the euro area to overcome the crisis by sorting out the mistakes made before.

While others are still deliberating how to get out of the crisis, it is important that we do not resort to reinventing the wheel. We must finish what we have started, taking the route that is easy to understand and has proved itself. It is becoming ever more obvious that in countries that fail to execute responsible budget policies, the economy is stagnating [Ill.], spiralling through deficit and debt, inability to compete and unemployment. The causal relationships are quite plain to see.

To wit, a larger deficit implies a greater debt which implies lower confidence in the state which in turn implies higher lending interest rates, reduced lending and fewer new jobs. Consequently, there are fewer growing businesses, less taxes paid and less revenue. Finally it means a reduced opportunity to invest in people: in education, health, salary and pension increases etc.

Resolute actions, on the other hand, by straightening out the budget provides for renewed economic growth as early as right now. It means to stop to spend what has not been earned, to stop ruining the lives of children and grandchildren by borrowing at their expense. If it sounds like an abstraction, the latest data on the GDP or economic growth of the countries of the European Union are an eloquent illustration of either approach.

Namely, in countries that face serious budget problems and a high national debt – Greece, Portugal, Spain, Ireland and Italy – the economy is stagnating or dropping. On the other hand, countries that have solved or almost solved their budgetary problems – and here I do mean the Baltic countries –are currently European leaders in terms of gross domestic product growth.

Even though our neighbours have recovered at a faster pace, in Latvia too recovery is evident. Industry has reached its pre-crisis output volumes [Ill.], replacing with exports much of the production manufactured for domestic consumption for which a short-lived demand was created by the real estate bubble. In the second quarter of this year, the annual value added growth reached +14.6%. Transport likewise grew rapidly, by 8.1%. Domestic demand is also recovering, especially investments whose annual growth in the second quarter of this year has reached 21.7% -- of course, against the background of rapidly dropping investment during the crisis. The improvement in the labour market situation is also reflected in the growing household consumption, which reached 4.4% growth during this same period. Registered unemployment has dropped from 17.3% to 11.8% over the last eighteen months [Ill.], and growth in employment is observed in almost all branches of the economy.

As a result of all of the above developments, the Latvian GDP has also been invigorated, reaching 5.6% growth in the second quarter. The growth rate is faster than expected: it is one of the fastest in Europe and will lead to GDP growth exceeding 4% for 2011. What is the significance of these developments for next year's budget consolidation?

Choice between falling back into the crisis precipice and economic recovery
Latvia is still continuing to climb out of crisis and is yet to be able to see over the top of the hole. That means the obvious: the budget must be adopted by performing the planned consolidation in the amount of 100-130 million lats. That must be done without raising taxes and reaching a deficit that does not exceed 2.5% of gross domestic product. Even a small step back from the course of balancing the budget investors will consider political inability to straighten out the state's finances.

That would mean that Latvia is taking the risk of not taking the opportunity to introduce the euro in 2014. It will not suffice to almost fulfil the Maastricht criteria: it will not help us to cut the costs of the debt and invest this money in the development of the country, education or healthcare. I am convinced that those in Latvia who are sceptical about the euro and the need to introduce it in, are careless in their assessment. We cannot afford this regarding such a strategically important issue. We should not forget that the small EU countries which have introduced the euro in recent years have been sheltered by the euro during the global crisis! We should not forget that the euro guarantees much lower interest rates and that, in the absence of the euro, Latvia will overpay on its external debt almost one billion lats in 10 years [Ill.]! What does this amount consist of? In 2014 and 2015, Latvia will have to begin to pay back large amounts of the debt, 2.3 billion lats. We do not earn that much, so borrowing is inevitable. If Latvia has reduced its deficit and introduced the euro, the market will lend to Latvia at cheaper rates. The difference is huge –to borrow at 2-3% once we are a part of the euro area or at 5-6% without the euro! At worst it means that the annual interest to be paid will swallow all of our education or healthcare budget.

The other factor that makes us stick to the planned amount of consolidation is the risks inherent in the global economic development. Albeit Latvia's growth will be faster than planned this year, that does not apply to next year. Over recent months, the trend of slower development has become more obvious in the world [Ill.], which is also demonstrated by a more pessimistic outlook by manufacturers on the expected development. As a result of yet another outbreak of the debt crisis, the mood and future outlook of the economic participants have been substantially shaken and are reflected in the economic activity indicators. Growht in the United States and the biggest European economy, Germany, as well as several other countries has been much slower than expected.

It is already plain to see that Latvian exporters will have to live with the fact that the demand in the export markets for their goods will drop. Consequently, growth in the exporting branches will slow down and domestic demand will also grow at a slower pace. The GDP growth and tax revenue growth in the budget will be less in 2012. It is even possible – if we are hard hit by the second wave of the crisis – that even more consolidation will be needed. Therefore, any optimism regarding setting the amount of consolidation would be groundless and harmful and would act to worsen the situation.

The best preparation for this second wave or Plan B is ... the same Plan "A". It means a timely 2012 budget of high quality. As mentioned above, investors, lenders and businessmen in Europe and elsewhere in the world are preoccupied with the debt issue. If Latvia manages to cure this illness faster and better than others it will fare much better.