Investment Research General Market Conditions 15 August 2014 Periphery research: Greece Signs of improvement compared to the recovery in Latvia Latvia s economy went into free fall in H2 07 but due to significant adjustments in wages and prices it has been able to restore competitiveness and strong economic growth. Latvia is thus a clear example that comprehensive reforms that result in internal devaluations can lead to a fast return to strong economic activity after a significant slowdown. Comparing the economic situation in Greece to the development in Latvia, it appears that the Latvian economy has had an even faster deterioration than seen in Greece although the recession lasted longer. The comparison is encouraging for Greece, as it appears that other countries, which have experienced to some extent an equal or larger downturn than that in Greece, have rebounded and that the catch-up can happen strikingly fast. Significant adjustments seem necessary but Greece has adjusted both wages and prices. Although the adjustments have been slower and less considerable than in Latvia, we believe it will be sufficient to generate growth. Other periphery countries have also adjusted wages and prices and it seems that their recovery will look a bit like the one in Latvia, although the sovereign debt crisis delayed the process temporarily. Periphery research Spain: Higher domestic demand and improved competitiveness, 11 August Ireland: Virtuous cycles supported by credit rating upgrades 12 August Portugal: Pent-up demand to boost economic activity 13 August Italy: New political agenda and support from the ECB 14 August Greece: Signs of improvement compared to the recovery in Latvia 15 August Will the Greek recovery follow Latvia s? Senior Analyst Pernille Bomholdt Nielsen +45 45 13 20 21 perni@danskebank.dk Assistant Analyst Lars Sparresø Merklin mer@danskebank.dk Important disclosures and certifications are contained from page 7 of this report. www.danskeresearch.com
Downturn in Greece compared to Latvia The Latvian economy went into free fall very suddenly in H2 07 as domestic demand collapsed and the external environment deteriorated significantly. Following the onset of the crisis Latvian GDP moved into double-digit recession for four quarters in a row, while being in contraction for two years. With the huge economic downturn, exemplified by a negative yearly GDP growth rate of 18.8% in Q3 09, unemployment moved from 5.6% in early 2008 to 20.8% in late 2009. Comparing the economic situation in Greece to the development in Latvia, it appears that the Latvian economy has had an even faster deterioration than seen in Greece although the recession lasted longer. Greek GDP growth declined close to 8% in around two years compared to four quarters of double-digit recession in Latvia. On the other hand, Greece had negative yearly growth for more than six years, whereas it only lasted two years in Latvia. Additionally, the Greek unemployment rate has increased around 20 percentage points (pp) compared to around 15pp in Latvia. The Latvian economy went into free fall in 2007 Unemployment increased quickly but has declined again Nevertheless, when comparing the two countries and the future development in Greece, it gives encouraging signs. This follows as Latvian growth has been restored, with the economy on average expanding close to 5% since 2011. Hence, it appears that other countries, which have experienced to some extent an equal or larger downturn than that in Greece, have rebounded and that the catch-up can happen strikingly fast. However, as will be discussed below the recovery depends on sufficient economic reforms, improved competitiveness and a positive macroeconomic environment. Considering the latest development in Greece this seems to be the case and it suggests the Greek recovery will strengthen from here. Return to growth in Latvia due to adjusted prices and wages The return to strong growth in Latvia has followed as it has made an internal devaluation where domestic wages and prices have been adjusted down to restore competitiveness. First of all, core inflation declined from 10% in Q2 08, when it peaked, and went down at -5% two years later. The adjustment in prices reflected a significant decline in domestic wages. At end-2007, Latvian wage growth peaked above 45% y/y, but less than one and a half years later it was negative and in Q4 09 it bottomed at around 20% y/y. This significant adjustment in wages was possible as the labour market in Latvia was characterised by very flexible wages especially in terms of downward wages. 2 15 August 2014 www.danskeresearch.com
Internal devaluation both in Greece and Latvia Wage growth has been adjusted but much more in Latvia Source: ECB Moreover, the adjustments followed after very high wage growth ahead of the crisis. This had followed as the overheated housing market created strong real wage increases for workers of highly demanded professions, namely construction, real estate and furniture production and this wage pressure also spilled over to other sectors. Additionally, Latvia was characterised by strong labour force emigration both internally and externally, which added to tightness in labour markets and pushed up wages. The strategy of internal devaluation was necessary as Latvia did not have any leeway for expansionary policies. The monetary policy was based on a currency peg option, hence the burden of adjustments to shocks was mostly on fiscal policy. However, any attempt to raise domestic demand by running fiscal deficits was not possible as Latvia has been running budget deficits in the past ten years. Moreover, such a way out of the crisis would only widen trade deficits and current account imbalances and further stimulate imbalances in the economy. Will Greece obtain the same growth rates as Latvia? Like in Latvia, Greece has also made internal devaluation with adjusted wages and prices. However, the adjustments in inflation and wages have, similar to GDP growth, been smaller in Greece, partly reflecting the very high rates in Latvia when the economy went into free fall. In light of this a smaller adjustment should be sufficient in Greece. The comparison suggests that the adjustments will lead to a Greek recovery, where growth rebounds and the unemployment rate declines. This also follows as the structural reforms have reduced nominal unit labour costs and improved competitiveness. Current account in surplus in both Greece and Latvia Greek private consumption to increase further 3 15 August 2014 www.danskeresearch.com
The adjustments made in both Latvia and Greece have implied that the current account deficits have been turned into surpluses. In Latvia, where the current account adjustment has been considerable, it reflects a large contribution from real exports due to the significant improvement in competitiveness. On the other hand, the small surplus in Greece is mainly the result of a slump in domestic demand. Greek private consumption is expected to start to increase after it showed positive growth in Q1 for the first time in four years. Like in Latvia Greek private consumption is likely to recover after the crisis. This will contribute to a current account deficit again but the improved competitiveness in Greece should counteract some of it. Other periphery countries compared to Latvia Spanish GDP growth can be compared to that of Latvia with a lag of two quarters until the sovereign debt crisis kicked in and resulted in a second slowdown. Despite this, the Spanish economy has recovered once again and we expect it to continue with positive growth rates going forward. The improvements in Spain have followed as it has implemented structural reforms and in that way adjusted wages to restore the competitive advantage like in Latvia. The adjustment in Latvia has been much more comprehensive than what has been observed in Spain but the need for adjustments was also larger and, in our view, the Spanish economy will continue to be supported by increasing domestic demand, see Spain: Higher domestic demand and improved competitiveness, 11 August. Spanish activity has picked up after a second slowdown Structural reforms have resulted in adjustments in wages Source: ECB The development in Irish GDP growth has to a large extent followed that of Latvia with a lag of one quarter, although Irish growth was weaker ahead of the crisis and the slowdown was milder in terms of less negative growth. Moreover, the latest couple of years have been characterised by very weak Irish growth not far from zero as a result of the sovereign debt crisis. Ignoring the second round of crisis in Europe the similar developments reflect that Ireland has also made internal devaluation through adjustments in wages. In light of this the development in inflation has been closely related among the two countries, although the adjustment has been much smaller in Ireland compared to Latvia. Again this reflects the overheated Latvian economy ahead of the crisis, where the need for adjustments was very pronounced. Consequently, we believe the future development in Ireland to some extent can be compared with the recovery in Latvia and in 2014 we expect the strongest growth rate since 2007, see Ireland: Virtuous cycles supported by credit rating upgrades, 12 August. 4 15 August 2014 www.danskeresearch.com
Development in Irish GDP very closely related to Latvian Adjustments in prices but much smaller than in Latvia Growth in Portugal recovered faster than growth in Latvia but also here the sovereign debt crisis resulted in a second dip. Nevertheless, it seems that after another round of weak economic activity Portugal is recovering to some degree. The latest growth figures show a small loss of momentum but as we argued in our research paper, there is still room for positive surprises and higher economic activity, see Portugal: Pent-up demand to boost growth, 13 August. Like in Latvia the internal devaluation should further support the recovery. The unemployment rate increased less sharply and peaked at a lower level compared to Latvia. This is likely to reflect that the slowdown in Latvia lasted longer and was characterised by double-digit recession for four quarters in a row. Moreover, relatively high labour market flexibility allowed the Latvian unemployment rate to adjust rapidly to external shocks. Portuguese activity should remain high due to adjustments Unemployment declines after it peaked at a lower level Italian GDP has also followed the movement in Latvia but has been affected by the sovereign debt crisis. In line with the situation in Latvia, Italy has also turned a current account deficit into a surplus, although it took longer after the crisis kicked-in in Italy. Moreover, the adjustment in Italy has been much smaller and has followed a combination of weak domestic demand and real exports growing faster than GDP as a result of an improved export performance. However, compared to the other periphery countries, the contribution from exports was small in Italy, reflecting lack of structural reforms, see Italy: New political agenda and support from the ECB. As described above the adjustment in Latvia reflects a large contribution from real exports due to the significant improvement in competitiveness. 5 15 August 2014 www.danskeresearch.com
Sovereign debt crisis resulted in a second slowdown in Italy Smaller adjustment in current account than in Latvia 6 15 August 2014 www.danskeresearch.com
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