Presentation by Kārlis Bauze, CFA Head of Monetary Policy Department, Bank of Latvia on September, 2010

1. Unique case of Latvia:
internal adjustment
Kārlis Bauze, CFA
Head of Monetary Policy Department
Bank of Latvia
September, 2010

2. After double digit GDP growth Latvian
economy experienced sharp adjustment
Real GDP growth (y-o-y, %)
15
12.2
10.6 10.0
10 8.7
6.4 7.2
4.8
5 2.9
0
-5 -2.5
-4.6
-10
-15
-20 -18.0
2002
2003
2004
2005
2006
2007
2008
2009
2010 F
2011 F
2012 F
Source: Central Statistical Bureau of Latvia; F - (forecast) Bank of Latvia
2

3. A mix of fiscal, income and structural
policy as key adjustment mechanisms in
Latvia
 The fixed narrow band exchange rate of the lats as the
anchor for monetary policy until the euro adoption.
 Policy mix - as tools for restoration of competitiveness and a
precondition for the export-based economic recovery in
Latvia:
• Sizeable fiscal consolidation;
• Fiscal consolidation measures designed with the focus
on structural reforms and wage/employment cuts in
the public sector;
• Cost optimization and enhancing productivity in
private sector.
3

4. Sizeable fiscal consolidation in Latvia has taken
place already in 2009
Country Year Total Revenue Current Capital
consolidation measures expenditure expenditure
measures measures
Latvia 2009 9.9 1.8 5.7 2.4
2010 4.2 2.2 1.6 0.4
Lithuania 2009 3.5 0.2 1.3 1.9
2010 5.6 0.5 3.9 1.2
Estonia 2009 7.7 2.8 4.2 0.7
2010 2.3 2.3 0.0 0.0
Ireland 2009 2.0 1.1 0.5 0.4
2010 2.4 0.0 1.8 0.6
Hungary 2009 2.8 0.6 1.0 1.2
2010 1.4 0.0 1.4 0.0
Romania 2009 3.8 0.9 2.9 0.0
2010 3.1 1.0 2.1 0.0
Greece 2010 2.5 0.5 1.7 0.3
Source: Convergence programmes; Bank of Greece; Bank of Latvia
4

5. Institutional fundamentals ensure to
smooth economic adjustment through
wage flexibility in Latvia
Collective bargaining coverage (%)
Source: ETUI-REHS 5

6. Wage elasticity allow to restrain wages in both
public and private sector
Gross nominal hourly wage y-o-y growth (%)
40
30
20
10
0
Q2
Q3
Q4
Q2
Q3
Q4
Q2
Q3
Q4
Q2
Q3
Q4
Q2
2006 Q1
2007 Q1
2008 Q1
2009 Q1
2010 Q1
-6.3
-10
-20
-30
Total economy Manufacturing Construction
Trade Transport Public administration
Source: Central Statistical Bureau of Latvia
6

7. Cost optimization and enhancing productivity
contributed to narrowing the wage-productivity gap
Wages and productivity
(whole economy, seasonally adjusted, expressed per hours worked, 1Q 2005=100)
170
160
150
140
130
120
110
100
Q3
Q4
Q1
Q2
Q3
Q4
Q2
Q3
Q4
Q2
Q3
Q4
Q2
Q3
Q4
Q2
2005 Q1
2006 Q1
2007 Q1
2008 Q1
2009 Q1
2010 Q1
Productivity Real wage
Source: Eurostat, Bank of Latvia’s calculations
7

8. Price flexibility in Latvia is high and increasing
Frequency of price changes over time 2003-2009 (%)
70% Frequency of price changes:
60% Latvia 27.8%
Euro zone 15.1%
50% The United States 24.8%
40%
30%
20%
10%
0%
I VII I VII I VII I VII I VII I VII I VII
2003 2004 2005 2006 2007 2008 2009
Source: Bank of Latvia’s calculations

9. Price adjustment resulted into deflation
Consumer price inflation (12-month average) and core inflation (y-o-y, %)
20.0
15.0
10.0 Forecast
5.0 6.5
0.0
-1.8%
-5.0 -3.3%
-10.0
IV
IV
IX
IX
IV
IX
III
V
X
III
V
X
III
V
X
I 2011
II
VII
VIII
II
XII
VII
VIII
II
XII
VII
VIII
XII
I 2009
I 2010
VI
XI
VI
XI
VI
XI
12 month average inflation Core inflation
Source: Central Statistical Bureau of Latvia; Bank of Latvia’s calculations
9

10. Gains in competitiveness are reflected by
increase in market shares in major trading
partner countries
Export market shares
(% of major trading partners’ imports in Q4 2008 – Q2 2010;
3-months moving average)
0.45
12
9
0.30
6
0.15
3
0.00
0
Finland
UK
Poland
Russia
Germany
Denmark
EU 27
Sweden
Lithuania
Estonia
Source: Bank of Latvia’s calculations
10

11. Improvement in competitiveness boosted export
growth since mid 2009
Nominal export growth (I 2005=100)
200
190
180
170
160
150
140
130
120
110
100
IX
IX
IX
IX
IX
V
V
V
V
V
V
III
III
III
III
III
III
VII
VII
XI
VII
XI
VII
XI
XI
VII
XI
VII
2005 I
2006 I
2007 I
2008 I
2009 I
2010 I
Source: Central Statistical Bureau of Latvia
11

12. In manufacturing structural changes towards
re-orientation to export markets are taking place
Share of export (in % of total turnover in particular sectors)
Source: Central Statistical Bureau of Latvia
12

13. With improvements in employment prospects
in export-oriented sectors, unemployment
started to decline
Unemployment rate (% of economically active population)
25
20.4
19.7 19.4
20 18.4
16.7
15 13.9
9.9
10
7.2
6.5 6.3
5
0
VI
XI
VI
XI
VI
VII
VIII
XII
VII
VIII
XII
VII
VIII
IV
V
IX
X
IV
V
IX
X
IV
V
II
II
II
III
III
III
2008 I
2009 I
2010 I
Registered unemployment rate Unemployment rate (Labour Force Survey)
Source: Central Statistical Bureau of Latvia; State Employment Agency
13

14. Improvement in business and consumers
sentiment supports ongoing economic recovery
Economic sentiment and confidence indicators (balance, %)
Source: European Commission
14

15. Export-based economic growth is on track
GDP growth (%)
4 9.0 9.3 11.4 10.0 15
2 10
0
5
-2
-4 0
0.8
-6 -1.5 -2.1 -5
-4.7 -6.0
-8 -10
-10 -10.1
-15
-12
-17.8 -16.8 -20
-14 -18.1 -19.1
-16 -25
Q2
Q2
Q3
Q4
Q3
Q4
Q2
Q2
2007 Q1
2009 Q1
2008 Q1
2010 Q1
Q4
Q3
q-o-q, SA y-o-y, NSA (right-hand side)
Source: Central Statistical Bureau of Latvia
15

16. Central bank has replenished its foreign currency
reserves which were drained in the market turmoil
following Lehman’s collapse in 2008
Lats exchange rate against euro and Bank of Latvia interventions
0.710 200
150
100
Bought / sold million lats
0.705 50
EUR/LVL
0
-50
0.700 -100
-150
-200
0.695 -250
Jan-08 Apr-08 Jul-08 Oct-08 Jan-09 Apr-09 Jul-09 Oct-09 Jan-10 Apr-10 Jul-10
Foreign exchange interventions (RHS) BoL ask BoL bid Market ask Market bid
Source: Bank of Latvia
16

17. Money market rates have reached their historical
lows reflecting among other the significant
improvement in financial market sentiment
Money Market Index RIGIBOR (%)
35
30
25
20
15
10
5
0
Jan-08 Apr-08 Jul-08 Oct-08 Jan-09 Apr-09 Jul-09 Oct-09 Jan-10 Apr-10 Jul-10
O/N 1M 3M 6M 1Y
Source: Bank of Latvia
17

18. Conclusions
• Internal adjustment is undergoing
• Structural changes in the economy have taken place
• Economy is recovering