Discussion Paper - Demography and Its Economic Consequences in The Baltics: The Case of Latvia

Discussion Paper No.
25 October 8, 2012
Economic Research Department.
Swedbank AB. SE-105 34 Stockholm. Phone +46-8-5859 1000.
E-mail: ek.sekr@swedbank.com www.swedbank.com
Legally responsible publisher: Cecilia Hermansson, +46-8-5859 1588.
Mrti Kazks, +371 6744 5859. Lija Strauna, +371 6744 5875. Kristilla Skrzkalne, +371 6744 5844.
Demography and its economic consequences in
the Baltics: The case of Latvia
The Baltic States are ageing and their populations are decreasing. The 2011
population censuses find that, over the last decade, the populations of Lat-
via, Lithuania, and Estonia have shrunk by 13%, 12%, and 6%, respectively.
Their populations will continue ageing. With free labour mobility and wide in-
come gaps vis--vis more affluent EU countries, emigration will continue to
take its toll. Demographics is not the challenge of the future, it is the chal-
lenge of today.
Due to data availability, detailed analysis is limited to Latvia. Yet, most of the
challenges are also relevant to the other two Baltic States. Over the past
decade, the population of Latvia has decreased by 309 000 or 13%. Of this
total, 119 000 is due to a mortality rate being higher than the birth rate, and
190 000 is due to emigration. The decrease in population is across the
board. All major cities have seen their populations decrease. More remote
areas have emptied faster than centres of economic activity. Some adminis-
trative territories have even seen their populations shrink by nearly one-third.
European Commission (2012) projects that life expectancy will continue in-
creasing, fertility rates will rise but remain below the natural replacement
rate, and emigration will continue over the next decade or so and then turn
into immigration. If so, over the next 50 years the population of Latvia will
shrink by a further 25% and the working-age population by a whopping 43%.
This means moving from about four working-age persons for every person
aged 65 and above to a ratio of four to three. Of course, projections can be
wrong, but they do point to the major underlying trends unless government
policies are able to turn them around or soften them.
Such demographic trends are likely to have both their own economic implica-
tions and/or reinforce other trends with a negative impact on the economy:
- Economic growth is set to slow; also because the productivity gap vis-
-vis more affluent EU member states narrows. If reforms are imple-
mented, per capita GDP growth over the next five-seven years may
speed up to about 6% per annum; if reforms stop, growth is likely to
sink to below 3%. There is still a hefty productivity catch-up potential,
but this can be effectively realised only if reforms are implemented.
- The strong centres will get stronger; rural and economically weak ar-
eas will empty and age faster. Those of working age will tend to move
towards stronger centres of economic activity. The productive and
spending capacity will be increasingly concentrated around a small
2 Discussion Paper No.25 October 8, 2012
number of economically strong cities. Policy action will determine how
far and deep this process will run.
- With the population shrinking and concentrating around the major cen-
tres of economic activity, public infrastructure and services will be-
come increasingly unbalanced too little where needed and too much
elsewhere. Business costs will rise if the infrastructure quality wors-
ens. The rundown of public infrastructure and services depends on
policy action the longer the current status quo is maintained, the
worse the situation.
- To shield itself from the cost of ageing, the state has passed a large
part of the task of saving for retirement on to the population itself.
People are likely to underestimate their need for savings, which, when
they retire, creates risks of poverty and sharp falls in spending power.
This situation hides the risks of transfers from taxpayers to tax evad-
ers and tax increases.
Governmental policy is unlikely to reverse the long-term demographic trends,
but it can soften them and limit their negative economic impact. To start with,
an important task is to address demographic trends per se. This means rais-
ing fertility rates, reducing emigration, fostering re-emigration and work on
immigration. To do this, economic growth must speed up. This means mak-
ing the population more employable and improving labour productivity.
The general policy prescription is simple to achieve Western European
levels of productivity, a country must meet Western European benchmarks
for quality of the business environment, rule of law, education, investment in
research and development, etc. Hence, the outcome will depend on the poli-
cymakers ability to implement reforms. Reforms must be implemented now.
Failure to do so will lead to permanent slippages in growth, and emigration is
then likely to kick off yet another vicious cycle of demographic contraction,
putting at ever-higher risk Latvias economic and social sustainability.
Mrti Kazks
Contents: Page:
1. INTRODUCTION................................................................................................. 3
2. DEMOGRAPHY: what has been going on? .......................................................... 3
3. DEMOGRAPHY: where is it heading?.................................................................. 7
4. ECONOMIC IMPLICATIONS: what to expect? ................................................... 11
4.1. ECONOMIC GROWTH: slower going forward................................................ 11
4.2. REGIONS: strong ones survive, weak ones peter out ..................................... 15
4.3. PUBLIC INFRASTRUCTURE AND SERVICES: quality vs. coverage.............. 21
4.4. GOVERNMENT BUDGET: save for your retirement ....................................... 22
4.5. SAVINGS: need to rise, but will they?............................................................ 26
5. HOW TO SOFTEN ECONOMIC CONSEQUENCES OF NEGATIVE
DEMOGRAPHIC TRENDS?.................................................................................... 28
6. CONCLUSIONS................................................................................................ 35
APPENDIX 1: Estonia and Lithuania face similar demographic challenges as Latvia. 36
APPENDIX 2: GDP decomposition, data, and track record....................................... 38
Discussion Paper No. 25 October 8, 2012 3
1. INTRODUCTION
Europe is ageing. Latvia and the two other Baltic States Estonia and
Lithuania are, too. Yet, the Baltic States are not only ageing, their popula-
tions are shrinking. The shares of working-age population have peaked and
will decline going forward. Fertility is below its natural replacement rate, and
there will be fewer youngsters entering the labour market. Dependency ra-
tios are increasing, putting a burden on economic growth and the social
safety net. The 2011 population censuses, the data of which are being pub-
lished only bit by bit, are producing new insights into demographics. Due
negative net migration flows (i.e., emigration), many of the risks that through
the lens of official statistics had previously been viewed as problems of the
distant future have been fast-forwarded into the very near future or even the
present. Over the last decade, the Latvian and Lithuanian populations have
shrunk by 13% and 12%, respectively, and that of Estonia by 6%. This is
nearly twice the official pre-census estimates, as the true size of emigration
had been baldly underestimated. Many experts, including ourselves, have
been warning about this for years, and the recent population censuses pro-
vide hard supporting data. Demographics is not the challenge of the future, it
is the challenge of today.
The populations will continue ageing. Because of free labour mobility and
wide income gaps with the more affluent EU countries, emigration will con-
tinue to take its toll. Yet, by acting proactively it is possible to reduce the ex-
tent of such demographic trends and limit their negative consequences on
the economic sustainability of a country and the businesses operating there.
The aim of this report is, therefore, to analyse the implications for economic
activity and policy of such a demographic change.
Data from the 2011 population censuses are still very scant, which puts con-
siderable limitations on our analysis. This is the reason why we limit our
analysis to Latvia (it simply has been faster to publish its census data); how-
ever, most of the challenges discussed are relevant also to the other two
Baltic States. To put Latvian demographics and some of its economic impli-
cations within the Baltic context, we have added Appendix 1, which briefly
outlines the following issues for all three Baltic States: (i) demographic pro-
jections until 2060; (ii) estimates of ageing and population decrease on per
capita GDP growth; and (ii) estimates of the fiscal cost of ageing.
2. DEMOGRAPHY: what has been going on?
The 2011 population census data for Latvia are just rolling out of the statisti-
cal bureau, and at the time of writing this paper there is a full data set avail-
able only for the year 2011. The previous trustworthy data are for the year
2000, when the former population census was taken. In this chapter, we
shall therefore discuss only the change between the years 2000 and 2011
and leave aside the volatility of the in-between years, as those data have yet
to be revised to account for the dynamics of emigration.
The good, the bad, and the ugly
Ageing and the population decrease in Latvia have been driven by a mix of
good, bad, and ugly trends. The good part of the story is that life expectancy
has been rising. From 2000 to 2011, life expectancy at birth has improved
from 76.0 to 78.7 years for women and from 64.9 to 68.8 years for men.
Quite a spurt, but still far to go compared with the EU averages of, respec-
tively, 82.5 and 76.7 years (or, respectively, 83.4 and 79.4 years in
The Baltic States are
ageing and their
populations are
shrinking
demographics is not
the challenge of the
future, it is the challenge
of today
Good news: life
expectancy has been
rising, people are
enjoying longer lifetimes
neighbouring Sweden).
1
Such a wide difference in life expectancy at birth
between women and men is because of mens higher mortality earlier in their
life, particularly in the age group of 20-40. Upon reaching the age of 65, the
difference in life expectancy narrows to 5.2 years. Overall, Latvian life expec-
tancy is one of the lowest in the EU, both for women and men.
The bad news is the low fertility rates. Fertility in Latvia has come down from
its peak of 2.2 in the late 1980s to only 1.34 in 2011. This means that, during
her lifetime, a woman on average gives birth to 1.34 children. This rate is
amongst the lowest in the EU and way below the natural replacement rate of
2.1, which is necessary for a population to reproduce itself. The EU average
fertility rate is 1.6, with the highest being 2.1 in Ireland; it is 1.5 in Lithuania,
1.6 in Estonia, and 1.9 in Sweden.
Population size and age structure in 2011, thousands
20 000 10 000 10 000 20 000
0
10
20
30
40
50
60
70
80
90
100+
Women
Men
Correct ion aft er
2011 census
Source: CSBL
Note: The correction for the 2011 Population Census or the grey area captures the previously
underestimated emigration. So, the true size of the population is that in orange and green.
The ugly news is that emigration has been rife. The true population size in
early 2011 was significantly smaller than the official pre-census estimates
not 2.23 million, but 2.075 million. This is a shortfall of 155 000 persons.
From 2000 to 2011, the total population of Latvia decreased by 309 000, or
13%. Of this, 119 000 is due to natural growth (i.e., mortality higher than
birth rate), and 190 000 is due to net migration. Almost two-thirds of the de-
crease in population has been due to net migration. There are fewer people
around, and the age structure has shifted more towards the elderly than was
thought (because the emigrants are those of working age and their children).
As for the nationality composition, the share of Latvians has risen to 60.5%
of the total population in 2011. The largest share of non-Latvians is that of
Russians who constitute 26.8% of the total population. Of the total popula-
tion 14.3% do not hold any citizenship and 2.2% are citizens of other coun-
tries, most often of the Russian Federation.
What has been the true size of emigration?
Total emigration is estimated at 265 000 persons; roughly 200 000 more
than reported in official pre-census statistics. This is more than the net mi-
gration of 190 000, which implies that some of the emigrants must have re-

1
In this chapter, Latvian data are from the Central Statistical Bureau of Latvia, with the last
observation for the year 2011. The data for other countries are for 2010 from European Com-
mission (2012).
Bad news: fertility rates
are way below the
natural replacement rate
Ugly news: emigration
has been rife
turned. There has been some inflow of immigrants from other countries, but
their numbers are relatively small.
Over the last decade, Latvia has experienced two major waves of emigra-
tion. The first wave was in the first half of the 2000s, driven by income gaps
with more affluent EU member states. Outflows peaked at around 25 000
persons per year. Two of the first countries to legally open their labour mar-
kets to Latvian residents were Ireland and the UK. At the time, these coun-
tries were experiencing solid economic growth and became major destina-
tions for Latvians. After Latvia's EU accession in 2004, its credit-fuelled real
estate boom swiftly gained strength. By 2007, wage growth had accelerated
to above 30% per annum, and emigration flows had subsided to about
16 000. Yet, with the implosion of the real estate boom (housing prices col-
lapsed by two-thirds in less than two years), the 20082009 recession (with
a cumulative GDP contraction of 24%), massive wage cuts, and unemploy-
ment rising to above 20%, emigration sped up again, peaking at 38 000 in
2010. Since then, emigration flows have gradually subsided as the economy
has returned to growth, job creation has resumed, unemployment is falling,
and moderate wage growth has started again. Anecdotal evidence suggests
that, with the economic situation worsening globally, there is a growing inflow
of re-emigration. Yet, the net migration flow is still negative and will remain
such for at least the near future.
What has happened with regional population density?
The decrease in population is across the board. More remote areas have
emptied faster than regional centres, where economic activity is stronger.
The major driver has been emigration, both to other places in Latvia and
abroad in search of better living standards and incomes.
Latvia by major administrative regions
Of the six major administrative regions, only Pierga has registered an in-
crease in its population, but this is illusory. The increase is due to (i) the for-
mer residents' of the capital Rga moving out to the nearby municipalities,
where new housing developments are located, while still commuting to Rga
for work; and (ii) former residents' of other regions moving closer to the capi-
tal in search of work. When Rga and Pierga are taken together, their popu-
lation loss is 8.3%. Latgale, the easternmost and least-developed region
economically, has lost 21%.
Emigration has been
driven first by income
gaps and then by job
loss during recession
The decrease in
population is across the
board, but strongest in
economically less-
developed territories
Population by major regions, thousands
0
150
300
450
600
750
900
2000 2011 2000 2011 2000 2011 2000 2011 2000 2011 2000 2011
Rga Pierga Vidzeme Kurzeme Zemgale Latgale
>64
15-64
0-14
Source: CSBL
-14%
+4%
-17%
-16% -13%
-21%
% change
Population of the largest cities and towns, thousands
-12%
-9%
-14%
-19%
-6%
-12%
-8%
-14%
-18%
0
200
400
600
800
R
g
a
D
a
u
g
a
v
p
i
l
s
J
e
l
g
a
v
a
J
k
a
b
p
i
l
s
J
r
m
a
l
a
L
i
e
p
j
a
R
z
e
k
n
e
V
a
l
m
i
e
r
a
V
e
n
t
s
p
i
l
s
2000
2011
Source: CSBL
% change
All major towns and cities have seen their populations decrease. Of the 110
administrative territories, only 15 have seen their populations increase, and
all of them are within commuting distance of Rga; 50 territories have seen
their populations shrink by more than 20%. Some administrative territories
have seen their populations shrink by nearly one-third. This decrease has,
however, been quite evenly split between rural and urban areas registering
declines of, respectively, 12.1% and 13.3%.
Old-age dependency ratio (aged 65 and above vs. those aged 15-64), %
0
5
10
15
20
25
30
35
Rga Pier ga Vidzeme Kurzeme Zemgale Latgale
2000
2011
Source: CSBL
Old-age dependency ratios (persons aged 15-64 over the population aged
65 and above) have risen over the past decade as a result of ageing, low
fertility rates, and emigration of those of working age and their children.
When viewed at the level of the six major regions, the worsening in the
population structure has so far been rather similar, and the shares of those
of working age and old-age dependency ratios are not that different across
regions. But when viewed at the level of smaller administrative units, where
the population decrease has been most sharp, the differences in depend-
ency ratios are massive.
3. DEMOGRAPHY: where is it heading?
The most comprehensive recent analysis of demographic trends in the EU
has been provided by the European Commission (2012) study titled The
2012 Ageing Report. The report employs the same methodology for all the
EU member states, and the results are comparable across countries. It sets
2010 as the departure point and extends the analysis until 2060.
Life expectancy at birth (years), Women
60
63
66
69
72
75
78
81
84
87
90
93
B
G
R
O
L
T
L
V
H
U
S
K
C
Z
P
L
E
E
E
L
D
K
P
T
S
I
I
E
D
E
M
T
B
E
C
Y
E
U
2
7
N
L
U
K
A
T
F
I
S
E
L
U
I
T
E
S
F
R
2010-2060
2010
Source:
EC(2012), CSBL
2011 census
Life expectancy at birth (years), Men
60
63
66
69
72
75
78
81
84
87
90
93
L
T
L
V
E
E
B
G
R
O
H
U
S
K
P
L
C
Z
S
I
P
T
F
I
D
K
I
E
B
E
E
U
A
T
D
E
L
U
M
T
E
L
F
R
C
Y
N
L
U
K
E
S
I
T
S
E
2010-2060
2010
Source:
EC(2012), CSBL
2011 census
European Commission (2012) projects
2
that life expectancy at birth will con-
tinue improving across the EU and faster in those member states, where it is
currently the lowest. By 2060 in Latvia, life expectancy will have risen to 87.2
years for women and to 81.1 years for men. The gap with the EU average
will then have been narrowed from the current 3.8 years to 1.9 for women
and from 7.9 years to 3.5 for men (or 2.1 years fewer for women and 4.4
years fewer for men than in Sweden). Life expectancy at age 65 will increase

2
European Commission (2012) clearly points out that these are projections, not forecasts.
Life expectancy and
fertility rates are
projected to rise, net
migration flows to remain
negative in the medium
term and then turn
positive
as well and is projected by 2060 to reach 24.4 years for women and 20.6
years for men.
And while European Commission (2012) projects that the improvement in
Latvian fertility rates will be one of the fastest in the EU, climbing to 1.51 in
2060, this will still be much below the natural replacement rate. Net migration
flows negative until about 2020 and positive afterwards are projected at
first to worsen the demographic situation and then to be insufficient to coun-
teract the effects of low fertility and rising life expectancy.
As a result, both total population and working-age population will keep de-
creasing. European Commission (2012) projects that over the next 50 years
the population of Latvia will shrink by 25% to 1.7 million (i.e., on average fal-
ling by about 0.6% per annum) whereas the drop in working-age population
(aged 15-64) will be a whopping 43%, decreasing to just 0.87 million (i.e., on
average falling by about 1% per annum). Moreover, while the participation
rate for those aged 15-64 is projected to improve from the current 73% to
about 77%, this will give some respite only until about 2015, when labour
supply sets itself firmly on a continuously downward trend. The number of
those employed will fluctuate yearly, depending on the dynamics of the par-
ticipation and unemployment rates before settling on a trend of a sustained
decrease in the late 2020s.
The size and structure of population, millions
52
54
57
59
61
63
64
65
66
67
67
69
0.0
0.5
1.0
1.5
2.0
2.5
2010 2011
census
2015 2020 2025 2030 2035 2040 2045 2050 2055 2060
65+
15-64
0-14
Source:
EC(2012), CSBL
% of total population
Population and labour force developments, millions and %
0.0
0.4
0.8
1.2
1.6
2.0
1
9
9
0
2
0
0
0
2
0
1
0
2
0
2
0
2
0
3
0
2
0
4
0
2
0
5
0
2
0
6
0
Population (15-64)
Labour force (15-64)
2011 census
60
65
70
75
80
85
1
9
9
0
2
0
0
0
2
0
1
0
2
0
2
0
2
0
3
0
2
0
4
0
2
0
5
0
2
0
6
0
Participation rate (15-64)
Source: CSBL, EC(2012) forecasts
Sweden
2011 census
Note: Labour force is economically active part of the population aged 15-64, i.e. population in
that age group multiplied by the respective participation rate.
total population is
projected to decrease
working-age
population is projected to
decrease faster
The current still quite favourable age structure of Latvia's population is pro-
jected to deteriorate. The share of the working-age population in the total
population peaked in the late 2000s and will keep decreasing, i.e., the
demographic dividend has run out. If current trends continue, the shares of
persons aged 0-14 and 15-64 will decline while that of those aged 65 and
above will increase. According to European Commission (2012) projections,
the total age dependency ratio (persons aged 19 and younger plus those
aged 65 and above over the population aged 20-64) is projected to increase
from 59.4 in 2010 to 108.1 by 2060. This means that for every person aged
20-64 there will be more than one person either being retired or not yet old
enough to be employed. The old-age dependency ratio will rise from 27.6%
to 74.1% by 2060. This means a move from about four working-age (20-64)
persons for every person aged 65 and above to a ratio of four to three. The
burden on economic growth and social safety net will become heavier.
Total age dependency ratio (aged 19 and less plus those aged 65 and
above vs. those aged 20-64), %
0
20
40
60
80
100
120
I
E
L
U
D
K
A
T
C
Y
B
E
U
K
N
L
P
T
F
I
F
R
I
T
S
E
E
U
M
T
E
S
H
U
C
Z
E
L
D
E
L
T
S
I
E
E
S
K
B
G R
P
L
L
V
2010-2060
2010
Source: EC(2012),
CSBL
2011 census
Yet, we should take the European Commission (2012) projections just out-
lined with a hefty pinch of salt. The 2012 Ageing Report is based on data
prior to Latvia's 2011 population census, and it underestimates the true size
of the past emigration. When available, we have included the new data in
the charts to make clear the discrepancy with the pre-census data. By the
metric of European Commission (2012) projections, Latvia, in terms of its
population size, is already in 2030 and close to 2020 in terms of its age
structure. Consequently, the true starting point for the European Commission
(2012) projections is worse than previously envisaged.
But a projection is not necessarily the picture of the future
European Commission (2012) projections are a depressing read, indeed.
And since Latvia's 2011 population census does worsen the starting point of
those projections, the situation in 2060 could be worse. But projections are
only projections they are based on assumptions that may turn out to be
wrong.
For instance, a key assumption is that of no policy change, reflecting legis-
lation enacted through December 2011. Certain reforms have been imple-
mented since then (e.g., starting in 2014, the retirement age is to increase
from the current 62 years, reaching 65 years in 2025), and many others are
being discussed (e.g., higher income tax allowances for parents with chil-
dren, improved access to kindergartens, relocation benefits to improve the
physical mobility of the labour force, etc.) that may improve demographics
and boost the labour supply and employment rates. Employment growth in
Latvia may turn out to be more durable if employment rates were to reach
dependency ratios will
rise, and the burden on
economic growth will
become heavier
those of the Nordics (they are currently about 5 percentage points below
those in Sweden, and, while Latvian rates are projected to rise, the gap in
European Commission (2012) projections would narrow only a little). Fertility
rates can rebound sooner and stronger than projected, thus slowing the
speed of depopulation. On the contrary, if fertility rates were to recover later
than projected, the number of women of reproductive age would by then be-
come smaller and the demographics would deteriorate faster. For instance,
in Latvia there are about 300 000 women aged 2040 and, assuming that
there is no migration, 20 years later such will be only about 220 000. Unless
fertility rates improve now, in the future fertility rates will need to rise to
unlikely high levels in order to stop population decrease. Projected net mi-
gration flows are quite benign (only about a thousand per year, which looks
out of line from what was seen previously) and may turn out to be larger and
more volatile.
Decreasing and ageing populations is a problem of many European econo-
mies. This means that regional competition for labour is likely to be strong
and increasingly intense going forward.
Projections of the population size, millions and percentage change
Country 2010 2060 Change
DK 5.5 6.1 10%
DE 81.7 66.2 -19%
EE 1.3 1.2 -13%
LV 2.2 1.7 -26%
LT 3.3 2.7 -20%
PL 38.2 32.6 -15%
FI 5.4 5.7 7%
SE 9.4 11.5 23%
NO 4.9 6.6 35%
RU* 141.8 101.5 -28%
UA* 45.9 31.8 -31%
Baltic Sea Region 339.6 267.5 -21%
EU27 501.8 516.5 3%
Source: EC(2012)
* 2010 and 2050, source: UNFPA
One way or the other, the European Commission (2012) projections are not
to be taken at face value as a predictor of the future. But they do point to the
major demographic trends that are likely to unfold unless government poli-
cies are able to turn them around (in our view, by and large impossible) or
significantly soften them (in our view, very possible and utterly necessary).
What are the take-away points from this chapter?
Over the last decade the population of Latvia has shrunk by 309 000 or 13%.
Of this, 119 000 is due to natural growth (i.e., mortality higher than birth rate)
and 190 000 is due to emigration. The population is smaller and older than
the official pre-census estimates suggested. Whatever the exact outcome,
the major underlying trends going forward are likely to be the following:
- Rising life expectancy and fertility rates below the natural replace-
ment rate will lead to rising age dependency ratios that increase the
burden on economic growth and the social safety net.
- The working-age population is decreasing faster than the total popu-
lation, but employment may still grow in the near future if participa-
tion rates rise and unemployment falls.
- Emigration is a major risk in the short-to-medium term as it has the
potential to sharply cut the size of the population and speed up age-
Policy actions can soften
negative demographic
trends
ing. Emigration is driven by income gaps with and labour demand
from abroad (i.e., many countries face similar demographic trends).
4. ECONOMIC IMPLICATIONS: what to expect?
The year 2060, of course, is the very distant future for todays business and
policy decisions. Yet, it sets the background. In the rest of the paper, we
shall keep in mind these underlying long-term trends but in our analysis will
focus on the near and medium term.
4.1. ECONOMIC GROWTH: slower going forward
There are two aspects of interest: (i) GDP, i.e., the size of the economy; and
(ii) per capita GDP, i.e., the spending power of an average individual. When
the population is falling, the growth of GDP falls behind that of per capita
GDP. The size of the overall economy, hence, expands slower than an aver-
age individuals ability to consume and save.
The growth of GDP is driven by two major factors: the number of those em-
ployed and the average productivity of those employed. To support GDP ex-
pansion, it is therefore necessary to improve the employability of a countrys
population and/ or raise its average labour productivity.
The number of those employed is itself determined by: (i) the number of per-
sons of working age, i.e., the potential labour force pool; (ii) their participa-
tion rate, i.e., the willingness of those of working age to participate in the la-
bour market; and (iii) the unemployment rate, i.e., the share of those of work-
ing age willing to participate in the labour market but unable to find a job.
Average labour productivity in a standard neoclassical model is determined
by two components: (i) capital per employee, i.e., the presumption that more
capital means more advanced methods of production, which permit more
production within the same time period; and (ii) a set of directly unobservable
improvements in average labour productivity, such as technological progress
and improving labour skills. The first component is termed as capital deep-
ening and the second as total factor productivity. A formal and more in-
depth treatment of these relations is provided in Appendix 2.
What is the Latvian track record so far?
Despite the recent devastating recession, the Latvian economy over the last
16 years has expanded by a remarkable 95%, and per capita GDP has more
than doubled. Per capita incomes have expanded on average by 5.3% per
annum. The contribution of employment to GDP growth has been minor, av-
eraging only 0.1 percentage point per annum. The positive contribution from
employment was possible because of improving labour force utilisation: a
decrease in the unemployment rate and an increase in the participation rate.
GDP growth depends on
the number of employed
and their productivity
Historically, contribution
of employment growth to
GDP growth has been
minor
Annual GDP growth, %
-20
-15
-10
-5
0
5
10
15
1996 1999 2002 2005 2008 2011
Employment
Average labour
productivity
GDP
Source: CSBL,
Swedbank estimations
Note: time-series data are not corrected for the 2011 population census; thus employment is
overestimated and average labour productivity is underestimated. For details, see Appendix 2.
Average labour productivity growth has been the dominant driver of GDP
growth in Latvia and is found to have been positive each year (including dur-
ing the 1997 Russian crisis), except for 2008 and 2009. Measured in full-time
equivalents,
3
which capture the shift from full-time to part-time employment,
labour productivity fell only in 2008 and was growing again in 2009. The ma-
jor reason for this was the labour hoarding in 2008 since, at the onset of re-
cession, companies held on to their employees, hoping that the recession
would be short-lived. This all changed when Lehman Brothers went bust in
September 2008 and the global economy dived into recession, pushing Lat-
via into the abyss. Labour was rapidly shed, and average labour productivity,
as measured in full-time equivalents, rose sharply, with a cumulative growth
of nearly 16% in 20092010. Companies have been incredibly quick to
adapt to the changing environment. The other reason for the fall in average
labour productivity was capital investments in real estate and related indus-
tries when the real estate bubble imploded, the value of that capital largely
went up in smoke and capital (i.e., means of production) per employee fell.
4
GDP and per capita GDP growth, %
Indicator
Cumulative
growth,
1995-2011
Average an-
nual growth,
1996-2011
(1) GDP 95.0 4.5
(2) Employment 0.7 0.1
(3)=(1)-(2) Average labour productivity 94.3 4.4
GDP per capita 118.7 5.3
Source: Eurostat, CSBL, Swedbank estimations
Note: time-series data are not corrected for the 2011 population census; thus employment is
overestimated and average labour productivity is underestimated. For details, see Appendix 2.
What will drive growth going forward?
Let us start with employment. The number of persons of working age will de-
crease, thus deducting from GDP growth. Yet, much room is still available to
boost participation rates and reduce unemployment. Unless emigration
speeds up again, falling unemployment and rising participation rates can ini-
tially outweigh the negative effect of the shrinking working-age population.

3
Not reported here but available upon request from the author.
4
For those interested in technicalities, we report detailed empirical results of GDP and per
capita GDP growth accounting in Appendix 2.
while productivity
catch-up has been the
major driver of growth
There is a considerable
potential to increase
employment
Economic, regional, educational, and social policies can be skilfully used to
postpone the turnaround. Yet, pressure from the demographics will build up
and eventually dominate. European Commission (2012) projects that in the
late 2020s a sustained decline in the number of employed will kick in.
Participation rates by age for
men,%
Participation rates by age for
women,%
0
20
40
60
80
100
1996 2001 2006 2011
15-24 25-54
55-64 65-74
Source: CSBL,
Eurostat
Sweden 2011
0
20
40
60
80
100
1996 2001 2006 2011
15-24 25-54
55-64 65-74
Source: CSBL,
Eurostat
Sweden 2011
One should not take comfort by assuming that the turning point is that dis-
tant, as it may well happen sooner (e.g., as the 2011 population census
shows, emigration is underestimated in the projections of European Com-
mission (2012) and employment growth potential thus may be overesti-
mated). Besides, the impact from employment is projected to be asymmetric
the positive effects from employment growth will be rather muted, whereas
the negative ones that kick in later will be of a much larger magnitude (rang-
ing from 0.4 to a massive 1.6 percentage points per annum, with an identical
negative hit to GDP). Nevertheless, it is somewhat encouraging that the im-
pact, because it will not immediately be huge, gives some space for preven-
tive policy action.
As has been the case, the dominant driver of economic growth will be gains
in labour productivity. A standard framework to assess growth prospects is
that of productivity convergence or catch-up, where the distance to the tech-
nological frontier determines the speed of technology adoption. In other
words, the larger the gap, the swifter the growth.
Per capita GDP growth vs. income level, EU-27
0.0
3.0
6.0
9.0
0 50 100 150 200 250
Income level % of EU27, 1995**
A
v
e
r
a
g
e

g
r
o
w
t
h
,

1
9
9
6
-
2
0
1
1
*
Source: Eurostat
* 1996-2010
for Bulgaria,
Ireland,
Poland;
1997-2010 for
Romania
** 1996 for
Romania
LV
but productivity catch-
up will remain the
dominant source of
growth
Although Latvian average labour productivity has nearly doubled since 1995,
it is still only 62% of the EU average (or 54% of that in Sweden). Latvia is still
poor by European standards, and the room for productivity and income
catch-up is substantial. Of course, there is a world of difference between po-
tential for growth and actual growth. Many of the old drivers of growth have
already run their course e.g., quick wins from the post-communist transi-
tion and the EU accession have been exhausted, and rapid across the
board, credit-fuelled growth will not (and should not) come back any time
soon. New drivers of growth need to be found. Investments will need to
grow. Productivity growth will depend on the policymakers ability to imple-
ment productivity-enhancing reforms. We return to this issue in Chapter 5.
How will aging affect the structure of the economy?
Awareness is growing of an intricate link between productivity growth and
population age structure; see Prskawetz et al (2007) and references therein.
Ageing affects productivity through its impact on savings, investments, hu-
man capital formation, technological change, etc. Different age groups may
affect productivity differently. Prskawetz et al (2007) find that the group most
positively linked to economic growth is those aged 30-49. For technology
absorption, the crucial group is highly educated youth aged 15-29. When this
group is small, technological advance is more difficult and growth is slower.
Given its low fertility rates, Latvia will struggle with this issue.
Economic structure is likely to change. The mechanisms at work range from
demand shifts away from manufacturing towards elderly care services where
labour productivity is lower to higher cost of capital due to lower savings
rates. All in all, it seems to be generally accepted in the literature that ageing
will hurt economic growth, but the impact depends on institutions when in-
stitutions are of higher quality, the impact is less negative as they are more
flexible to take advantage of different growth opportunities (e.g., are more
successful to engage elderly in employment).
How fast will incomes grow?
A common finding in the literature is that income growth slows as the pro-
ductivity gap closes and the population ages.
European Commission (2012) projects Latvian per capita GDP to grow by
2.4% to 3.1% per annum over the next two decades before falling to just
above 1 percent per annum. The projection is based on the assumption of
an EU-wide convergence of total factor productivity growth to its long-term
average rate and swifter growth when per capita GDP is low. Prskawetz et al
(2007) employ a different approach, carefully accounting for the shifts in the
populations age structure. Using a different set of population projections
from Eurostat, they end up with quite similar growth projections just above
3% in 2015, slowing to a tad below 2% in 2030 and 2045. IMF (2011b) use
yet another approach and estimates standard growth regressions that cap-
ture a wide set of country-specific variables, such as per capita GDP level,
schooling, institutional quality, economic openness, investment ratio, etc.
They run two different model specifications, and both come up with quite
similar predictions of medium-term growth in the 3.25-4.25% range. The IMF
(2011b) forecast horizon seems to be shorter (medium-term is not specified
but the data seem to imply that it is 2016) and may factor in more precisely
the post-recession rebound hence, a prediction of a somewhat faster
growth than in the other two studies. These three studies also assess Esto-
nia and Lithuania the results are very similar to those for Latvia.
Productivity gap is still
wide and room for
productivity and income
catch-up is substantial
With ageing the role of
service sectors rises. The
negative impact on
growth is smaller when
quality of institutions is
higher
With productivity gap
closing and population
ageing, growth will
slow
The above estimations imply a sharp slowdown in Latvia's per capita GDP
growth from 7.0% per annum prior to the EU accession and 10.5% in the
heyday of the real estate boom to just 2.5-4%. And this is over the next dec-
ade; later, growth is forecast to become even more sluggish. Assuming the
European Commission (2012) projected growth rates for the EU-27, Latvia
will not reach the EU average level by 2060. Same is true for Estonia and
Lithuania.
Of course, one must keep in mind that these three sets of estimates are in
one way or another based on a productivity convergence story that assumes
that productivity and per capita incomes grow faster when the gap is wide
and gradually converge to a certain average as the gap is closing. Latvia,
like Estonia and Lithuania, has indeed climbed up the value-added ladder
quite quickly during the last two decades; the pulling power of the productiv-
ity gap has somewhat weakened and growth is naturally slowing. While this
indeed is the case on average, it need not be the case for every country. An
economy may well grow faster than an average productivity gap pulling
power would imply, thereby exceeding the productivity and income levels of
others. But to do this, it must outperform them. Hence, the need for produc-
tivity-enhancing structural reforms!
Our own estimates of the Latvian per capita GDP growth for the next five to
seven years are, cautiously, more upbeat than those just outlined on aver-
age 4-5% per annum. This is for two reasons: (i) the post-recession rebound
effect is somewhat stronger, and (ii) the government has started to imple-
ment certain structural reforms, such as improving vocational education and
reducing labour taxes to improve job creation and external competitiveness.
In general, we see three scenarios for growth going forward. The first one is
the normal or things as usual-type of a scenario where reforms do take
place, but they are patchy and belated. Under this scenario, over the next
five-seven years average per capita GDP growth is likely to be about 4% per
annum. If the reform process generally stops and there are only minor if any
improvements, which is the second scenario, growth would sink to below
3%. The third scenario is that of decisive and well implemented reforms that
could take growth over the next five-seven years to about 6% per annum.
Hence, our current view is a tad above the normal scenario, but certainly not
yet that of fast sustainable growth. It looks promising, but much more needs
to be done.
What are the take-away points from this section?
Growth is set to slow markedly (and permanently!) unless there is a break-
through in reforms. If reforms are implemented, per capita GDP growth over
the near future may speed up to about 6% per annum; if reforms stop,
growth is likely to sink to below 3%. Labour participation rates must improve
and unemployment must decrease. Everything that sustainably boosts la-
bour productivity is good. Time is money (i.e., jobs and wages); therefore,
reforms must take place now. Re-emigration must be on the top of the poli-
cymakers agenda. And with some controversy it is very unlikely to get
away without significant immigration, i.e., better start early so that it is based
on skills.
4.2. REGIONS: strong ones survive, weak ones peter out
Those of working age will tend to move towards stronger centres of eco-
nomic activity. Rural areas and remote and economically weak towns will
empty and age faster. Per capita incomes in such places will grow slower,
and without policy
support growth could
disappoint
The current growth
outlook seems to be
promising, but more
needs to be done
and their spending power will decline as their populations dwindle and
wages are replaced by pensions. The strong economic centres will get
stronger and the weak ones will peter out. Many territories are likely to have
passed the point of no return. Productive and spending capacity will be in-
creasingly concentrated around a small number of economically strong cit-
ies. Policy action will determine how far and deep this process will run.
Why will the rural population shrink?
The share of the rural population
5
has been rather stable over the past 30 or
so years. This situation is unlikely to continue. One of the drivers of this
process is the countrys economic structure. Let us take an example of agri-
culture (in statistics this sector also includes forestry and fishing, but is
dominated by agriculture).
In Latvia, nearly 9% of those employed report that they are employed in ag-
riculture. In the Nordics, the number is about 3%, and the EU average is
about 5%. The quality of arable land and pasture in Latvia is good, but aver-
age productivity is relatively low. A major reason is the large number of small
(many of them self-subsistence) farms they are too small both financially
and in terms of acreage to improve their productivity to acceptable levels.
Their per capita incomes are low. They are often located in remote areas
and infrastructure is poor. Their access to market is difficult. There are very
few alternative or supplementary part-time jobs to come by.
Employment and productivity in agriculture, forestry, and fishing, 2011
0
100
200
300
400
R
O
P
T
P
L
S
I
E
L
L
T
L
V
E
U
2
7
A
T
B
U
E
E
C
Z
I
E
U
K
D
K
I
T
C
Y
D
E
E
S
B
E
F
I
N
L
F
R
S
L
H
U
S
E
M
T
0
9
18
27
36
Producti vity in the sector, % of EU27
Employment in the sect or, % of total empl. (rs)
Source: Eurostat
Note: Productivity is measured as GDP in purchasing power parity terms divided by the number
of employed. Employment figures from the Labour Force Survey are used; for Latvia data are
adjusted according to 2011 census results. Productivity is likely to be underestimated due to the
grey economy; however, the graph still captures the major relations.
After Latvia regained its independence in 1991, farms and land that were na-
tionalised during the Soviet occupation were returned to their former owners
or their descendants. This meant going back to the farm size of the late
1930s, which is too small for industrial farming. The newly created farmers
often had no relevant skills they had left their jobs in cities and towns to re-
turn to their land driven by emotional reasons. This movement was fostered
by deindustrialisation as the Soviet trade bloc fell apart and many industries
and jobs disappeared almost overnight. Because of certain vested political
interests these structural issues have never been adequately tackled and the

5
The definition of rural population perhaps needs some explanation. In Sweden population
is often split in urban, provincial, and rural population. Latvian rural population should be
viewed largely as provincial population in Sweden. Given the small size of Latvia, there is
really no rural population as it would be understood in, e.g., the Northern part of Sweden.
Agricultural employment
in Latvia is too large and
the rural population is set
to shrink
problem of self-subsistence farms is solving itself on the go: they are gradu-
ally bought up by larger and more efficient farms.
In view of the still wide productivity gap and, thus, profitability potential
(compare Latvian productivity with that in the Nordics!), the expansion of an
average farms acreage will continue. The current employment and produc-
tivity levels imply that there is still far to go, and the shrinking of the rural
population will continue. Self-subsistence farms are unable to retain youth as
the incomes they can offer are low. Large farms can provide good wages to
their workers, but, given their better efficiency, they will need only a fraction
of the labour force currently employed in agriculture. Of course, there will be
small farms that will survive, but these will be smart, highly specialised and
skilled not a realistic goal to achieve for a large number of farms.
How likely are urban areas to attract migrating rural population and re-
tain their existing populations?
So, rural areas will see their population decrease. Where will they migrate
to? The answer depends on the financial muscle of municipalities and their
ability to offer adequate income levels and infrastructure. This depends on a
municipalitys initial position: the size and quality of its labour force, wage
level, infrastructure quality, etc.
Of course, the example of agricultural employment is just one of the factors
expected to drive reduction of the rural population. Shrinking of the rural
population is not necessarily the outcome of the overall decrease in the size
of the population. Urban population is increasing also in the countries where
populations are growing. One of the reasons is an increasing role of services
sectors. Global dynamics show that growth is increasingly created in urban
areas and the share of rural population is decreasing.
6
The Latvian rural and urban populations are split 32% and 68%, respec-
tively, which is comparable to other post-communist countries. In the Nor-
dics, the share of urban population is close to 85%. When Rga is excluded,
Latvias urbanisation level is only 53%.
Urbanization rates, %
0
10
20
30
40
50
60
70
80
90
LV LV, net of
Riga
LT EE DE UK SE
Source: Deutche Bank, UN, CSBL
Note: Latvian data for 2011 (i.e., corrected for the 2011 Population Census), for other countries
the data is for 2010.
What counts as an urban area in Latvia? The list of urban areas is approved
by the Cabinet of Ministers. The list has developed historically, and there are
no formal criteria, such as number of residents or density of population. A
detailed look at the list uncovers some interesting findings. There are only 8

6
There is a large and growing literature on this, e.g. see World Bank (2009).
The ability to retain those
migrating away from
economically weak areas
will depend on the fiscal
muscle of municipalities
cities with a population above 25 000. The smallest town is Durbe with a
population of just 554 residents. This very beautiful and cosy town is indeed
the smallest, but its residents should not feel that unique there are 22 other
towns out of the total of 76 with fewer than 2 000 residents. One may per-
haps claim (in the sense of resource concentration) that the true urbanisation
level in Latvia is therefore smaller.
Towns provide better public infrastructure than most rural areas, but, with so
few residents, they are very unlikely to provide strong enough pulling power
to attract businesses and create jobs to retain their own residents and/ or at-
tract those migrating away from surrounding rural territories. With the num-
ber of their own residents and the residents of neighbouring rural territories
decreasing and with the ageing process, they will increasingly lose their fi-
nancial muscle. Low wages and few jobs on offer will force people away.
Small in numbers and poorly skilled labour will deter businesses to create
jobs. Being financially weak, municipalities will be unable to provide neces-
sary support infrastructure for businesses to set up their activities.
Which regions are better positioned to gain or lose?
As seen in Chapter 2, the current age structure is rather similar across the
major regions. A major difference is the size of the population and, thus,
labour supply and spending power as Rga and its neighbouring munici-
palities clearly dominate. The critical mass that Rga can offer to businesses
is larger.
What are the labour market qualities of the six major regions? If assessed by
the metric of educational achievement, Rga and Pierga clearly stand out for
their better labour supply quality. Rga and its neighbouring area attracts
more talent for being the major hub of academic activity in the country. Also,
infrastructure is better developed, and there are more jobs available.
Share of those aged 15-74 with the respective education levels (2011), %
0
10
20
30
40
Tertiary
Vocational
Secondary
Primary
Source: CSBL
The labour force is more active in Rga, and participation rates are the high-
est. In the least well-off region Latgale, participation rates are the lowest and
a whole 9 percentage points lower than in Rga. Also, wages are the highest
in Rga and the lowest in Latgale.
Quality of labour supply
is better in Rga, wages
are higher, too
Participation rates (2011), %
77.2
72. 6
69.0
70.0
73.3
68. 2
20
30
40
50
60
70
80
90
Participation
rate (15-64)
Source: CSBL
Standard wage data, reported by Central Statistical Bureau of Latvia (CSBL),
have been obtained from company reports (hereafter referred to as com-
pany data). It is grouped according to the employers corporate registration
address, which tends to distort regional data. For instance, when a retail
chain pays wages to its staff in regional branches, a statistical entry is made
for the administrative territory where its headquarters are registered, which
for the largest companies typically is Rga.
Another characteristic of company data is that a wage is reported per full-
time equivalent. It is therefore impossible to estimate full wage income as the
full-time equivalents are likely to be assigned to wrong regions. Standard
statistics are as a result likely to overestimate the role of Rga in the econ-
omy and underestimate the role of the other regions.
Average net monthly wage (2011), lats
0
100
200
300
400
LFS data
Company data
Source: CSBL
Note: Labour Force Survey (LFS) and company wage data are not directly comparable. For
instance, company data are per full-time equivalent but a person may work more or less than
that; hence, it is not possible to calculate full net wages. LFS data are full net wage income per
employee.
To avoid the problems of company data, we have acquired Labour Force
Survey (LFS) data from CSBL. From this unique data set, we can distinguish
the residency (i.e., in which municipality the person lives) of a person receiv-
ing his or her wage. An employee reports his or her full net wages per
month. Hence, there is no need to account for full-time equivalents. Another
advantage of LFS data over the company data is that they may capture
wages from the grey economy, as persons responding to the survey are less
likely to hide their actual incomes than companies providing wage informa-
tion to the State Revenue Service. On the other hand, LFS data may under-
estimate wages as it is difficult to access affluent households through sur-
veys. Our preferred source for wage income estimates is LFS data.
7
Income volume and its structure can be used as a measure of consumer
spending power as well as labour market attractiveness and quality. We use
LFS data to obtain average net wages and calculate regional wage bills for
employed persons. The next major item is social transfers (i.e., pensions and
benefits); these transfers, according to Household Budget Surveys along
with wages constitute more than 90% of household disposable income. So-
cial transfer data were kindly provided to us by the State Social Insurance
Agency. These data are available by declared residencies of recipients. We
approximate total net income of a region by adding up the wage, pension
and benefits bills (i.e., unemployment, parent, children, and sickness bene-
fits; we forgo other benefits but their importance is minor).
Of course, there are other types of incomes such as dividends, incomes from
other forms of employment such as self-employed, other regular and irregu-
lar social benefits provided by municipalities, etc. We forgo capturing these
incomes as it would be very cumbersome and in many cases impossible,
and the impact for an average individual would most likely be minor.
Average annual net income per capita (2011), lats
70
70
63
65
66
59
26
25
33
30
30
36
0
500
1 000
1 500
2 000
2 500
Benefits
Pensions
Wages
Source: CSBL, SSIA,
Swedbank
calculations
% of total
There are a few interesting data points in the income data. First, Rga has by
far the largest spending power both per capita and its residents as a group.
Per capita income of a Rga resident is 17% higher than the country average
and 48% higher than in Latgale, which is the poorest region. Residents of
Rga account for 37% and residents of Pierga for yet another 18% of the
countrys total income. Second, Latgale has by far the smallest share of
wages in its income, which reflects both low participation rates and wages. A
striking 41% of incomes in Latgale originate from pensions and benefits.
Poverty risk of is also higher in Latgale, which may endogenously lead to an
ever-farther lagging behind and an ever-larger population loss for instance,
poverty reduces access to education, thereby negatively affecting future in-
comes.
Such differences in wage levels, labour supply quality, and size are likely to
drive an ever-wider wedge between regional demographics and economic
activity. Rga and its neighbouring area so far clearly seem to be a winner in
this race, while Latgale is clearly lagging behind. Vidzeme is not positioned

7
For a detailed description of this unique data set that we use to estimate regional incomes
and their structure, see our forthcoming Swedbank Analysis titled Latvian household well-
being: regional developments, in which we present an in-depth analysis of Latvias regional
demographics, labour market, income trends, and living standards.
Rga and Pierga account
for nearly 60% of total
incomes
More than 40% of total
incomes in Latgale are
pensions and benefits
that nicely either and has been doing similarly poorly. Of course, the situa-
tion is not that straightforward the major cities of the regions, not the re-
gions as such, will play the key roles. An additional advantage for Rga is
that its average labour productivity is significantly higher than in the rest of
Latvia and is close to the EU-27 average. It may potentially reduce benefits
of emigration but it is unlikely to stop it as migrating to the EU areas with
productivity and income levels significantly above the EU-27 average would
still provide motivation for emigration.
Of course, all of Latvia will not (and should not) converge in a single Rga.
But the above analysis clearly shows the trends and underscores that there
is likely to be more collateral damage in terms of emigration and poor eco-
nomic growth if the policy response lags or is insufficient. The total popula-
tion of Latvia is projected to decrease, which means that major cities such as
Rga, Liepja, Ventspils, Valmiera, and others will scramble for labour and
consumers. But this is not a race amongst Latvian cities and towns. It is an
international race. For Latvian cities to win it, they must be competitive at
least on the scale of the Baltic Sea region.
What is the role of administrative fragmentation?
Just a few years ago Latvia underwent a reform to reduce the number of
administrative territorial units to 110. But this is still way too many. There are
39 territorial units with fewer than 5 000 residents, and only 30 units have
more than 10 000 residents. Many of the small ones clearly have too little
financial and labour muscle to create sustainable jobs. They are subsidised
through the state budget. But by keeping such units administratively inde-
pendent a more precise description would be administratively isolated
one obstructs economic activity and supports emigration.
Rural areas and remote and economically weak towns will empty and age
faster. Incomes in economically weak areas are heavily dependent on bene-
fits. Fragmentation of administrative territories obstructs growth and supports
emigration. By putting weak territorial units on life support with the knowl-
edge that they will fail soon, one squanders resources and risks losing oth-
ers. Economic activity will increasingly converge in the strongest economic
centres.
4.3. PUBLIC INFRASTRUCTURE AND SERVICES: quality vs.
coverage
With total population shrinking and increasingly concentrating around the
major centres of economic activity, it will be increasingly costly to maintain
the existing network of public infrastructure and services.
Elements of this are already seen. For instance, road quality is poor and Lat-
via ranks only 99
th
(Estonia 61
st
, Lithuania 32
nd
, and Sweden 25
th
) out of 144
countries in the World Economic Forums just published 2012 Global Com-
petitiveness index. There are too many tertiary education institutions that will
be unable to fill their auditoriums as the youth cohorts become smaller (see
Cunska (2010) for an in-depth analysis).
If the goal is to maintain the current networks of public infrastructure and
services, public investment will continue to be insufficient and infrastructure
will become increasingly unbalanced there will be too little of it in the main
centres of economic activity and too much of it elsewhere. Quality will suffer,
which will discourage private investment, hamper economic growth, and en-
courage emigration. This is relevant across the board: the road network,
Latvian cities must be
internationally
competitive to attract
migrants from rural areas
Administrative
fragmentation obstructs
growth and supports
emigration
Unbalanced public
infrastructure: too little of
it in the main centres of
activity, too much
elsewhere
public transportation, electricity grid, education system, firemen and police
services, provision of and access to health care services, etc.
Length of electricity grid and electricity consumption
0
20
40
60
80
PL DE CZ AT LV EE LT SE FI
0
5
10
15
20
Length of
electricity grid,
km/1000
inhabitants
Electricity
consumption per
inhabitant, MWh
(rs)
Source: CEER 5th
Benchmarking Report (2011)
Here, we provide an example of the electricity grid. Given the relatively low
population density, the grid is very expensive compared with the volumes of
consumption. Hence, the choice may be either to: (i) raise the cost of elec-
tricity provision, which will hit the least well-off strata of the population the
hardest and hurt the international competitiveness of exporters; (ii) optimise
the network by cutting off the least profitable extensions and substituting
their electricity provision, e.g., by locally installed gasoline fuelled genera-
tors; or (iii) reduce the quality of service provision, e.g., by lengthening the
permitted time period when electricity supply needs to be re-established fol-
lowing the supply interruptions due to heavy snow falls. A suboptimal deci-
sion (and continuation of the status quo is one such suboptimal decision) will
foster migration away from rural areas, discourage private sector investment
and hamper overall economic growth.
The nature of the public services will change with the shift towards the needs
of older cohorts. For instance, education services will increasingly shift to-
wards lifelong learning; youth cohorts will dry up and those in older cohorts
will need to update their skills to adapt to the changing requirements of the
labour market. Also, because of longer life expectancy, the older cohorts will
work longer.
Infrastructure is unbalanced there is too little of it in the main centres of
economic activity and too much of it elsewhere. These problems will mount
going forward. This is true across the board: it will affect the road network,
education system, etc. Business costs will rise if the infrastructure quality
worsens. The model and/or catchment area of public service provision is
likely to change.
4.4. GOVERNMENT BUDGET: save for your retirement
According to the European Commission (2012) projections, the old-age de-
pendency ratio (persons aged 65 and above over the population aged 20-
64) is projected to increase from the current 27.6% to 74.1% in 2060. This
means a movement from about four working age (20-64) persons for every
person aged 65 and above to a ratio of four to three. What is the impact of
such trends on the governments fiscal position?
Poor public infrastructure
discourages private
investment and puts at
risk growth
Total age-related spending, % of GDP
10
15
20
25
30
35
40
L
V
E
E
B
G
P
L
R
O
L
T
S
K
U
K
C
Z
C
Y
P
T
H
U
E
S
I
T
E
L
L
U
M
T
I
E
D
E
S
E
N
L
A
T
D
K
S
I
F
R
F
I
B
E
2010 2020 2060
Source: EC (2012)
Total age-related spending, Latvia and EU-27 average, % of GDP
0
3
6
9
12
15
LV EU27 LV EU27 LV EU27 LV EU27 LV EU27
Pensions Health care Long-term care Education Unemployment
benefits
2010 2020 2060
Source: EC (2012)
The European Commission (2012) projections find that the cost of ageing
(i.e., pensions, health care, long-term care, education, and unemployment
benefits) on the Latvian budget will decrease going forward. While projec-
tions indeed are only projections and may turn out to be wrong, they do cap-
ture major trends and the forward-looking structure of fiscal spending.
Why is the fiscal cost of ageing estimated to decrease?
Let us deal with the pension expenditures, which are the largest item. It is
important to first discuss the starting point of the projections. In 2010, pen-
sion expenditures reached an historic high of 9.7% of GDP. The key reasons
for this are: (i) during the years of the real estate boom, pensions were in-
creased and more generous future obligations were assumed; (ii) pensions
were indexed to consumer price inflation, which soared to 18% in 2008; (iii)
in 2008, the economy dived into recession, wages were severely cut, GDP
contracted by 24% peak-to-trough and deflation set in; and (iv) pensions
were not cut (there was a failed attempt to do so). Therefore, pensions were
by and large safeguarded from recession. The starting point for projections is
therefore very high because GDP was very low.
Fiscal cost of ageing is
projected to be small...
Average pension to average net monthly wage ratio, %
20
40
60
80
1Q 05 1Q 06 1Q 07 1Q 08 1Q 09 1Q 10 1Q 11 1Q 12
Average net
pension /
average net
wage
Source: CSBL
What about the future dynamics? Although pensions were not cut during the
recession, the government was quick to limit the future costs. For instance,
indexation of pensions has been suspended from 2009 to 2013. While nomi-
nal GDP grew by 11% in 2011, pensions were not indexed, and their propor-
tion to GDP shrank compared with 2010. Previously pensions were indexed
to consumer price inflation and real growth of wages; going forward pensions
will be indexed only to consumer price inflation.
The Latvian pension system is built on three pillars: (i) first level pay as you
go; (ii) second level mandatory personalised pension fund contributions as
a set percentage of gross wages; and (iii) third level voluntary contribu-
tions. This is a mixture of a public transfer (first level) and asset-based (sec-
ond and third levels) system. The replacement ratio, or the ratio of the pen-
sion from the first and second levels to the pre-retirement wage, is forecast
to be about 40-50%. Budget pension expenditures are set to grow slower
than GDP, and their proportion is projected to decline from 9.7% of GDP in
2010 to 7.2% by 2020, and further to 5.9% by 2060.
Total age-related budget expenditures, of course, will grow in nominal terms,
but the economy will grow faster and the cost of ageing to the budget is,
therefore, set to decrease. The share of the age-related expenditure from
the budget was among the lowest in the EU in 2010 (19.2% of GDP, com-
pared with 26% in the EU on average and 27.9% in Sweden) and, if the pro-
jections are correct and other countries do not carry out radical reforms (but
many of them will need to), it will be by far the lowest in the EU in 2060
(15.4% vs. the EU average of 29.7% and 31.7% in Sweden). Latvia from its
budget is set to spend less than the Nordics and the EU on average as per
cent of GDP in all four segments: pensions, health care, long-term care,
education, and unemployment benefits. In health care and long-term care,
this is less than a half of the EU average. The shortfall will need to be made
up by the elderly and their families themselves (in contrast to Western
Europe, family net transfers to the elderly are quite important, but the direc-
tion of these flows depends on the age and financial situation of the elderly).
When judged by these metrics, Latvia has a significantly smaller social wel-
fare system than the Nordics and the EU on average. And it is projected to
become smaller going forward as the population is ageing.
The fiscal and pension system sustainability is likely to be good in Latvia, but
the government has implicitly transferred the need to save for retirement to
the population itself. The population must become fully aware of such a so-
cial contract. If the population does not save enough, poverty among the
elderly is likely to be high. This is especially so in more remote areas where
as the task of saving
for retirement has been
passed on to people
themselves. Public
spending support will be
scant
Poverty among elderly is
likely to be high
their incomes during working age have been low, tax evasion has been high
and public infrastructure to access public services is poor.
What are the risks of the fiscal cost of ageing growing larger?
The government has created a number of good financial vehicles for the
population to save for its retirement (e.g., contributions to the third level pen-
sion and life insurance allow people to recover personal income tax of up to
20% of annual gross wages); however, the overall savings rates are still very
low. People spend rather than save, as they are likely to both: (i) underesti-
mate the size of savings they will need (e.g., they may underestimate their
life expectancy and misjudge their health condition)
8
, and (ii) expect to free
ride on the state when they retire.
Tax evasion is the major problem for the second-level pensions. One can
maximise his or her savings when evading taxes. Yet, if too large a share of
the population is evading taxes, the credibility of the pension system disap-
pears. For instance, close to 25% of employees earn minimum wage (which
is currently set at LVL 200 or about EUR 290 per month) or less. Wage data
does not fit household consumption data and clearly points to tax evasion.
For those currently employed, second-level pension contributions will be a
major share of their pensions when retiring. When evading taxes, they do not
contribute to their second level pension, which means that their true wage
replacement ratio at the time of their retirement will be very low. This means
a sharp drop in their incomes and living standards, and a large risk of elderly
poverty.
If there are enough individuals like this, there is a high probability that politi-
cians will give in to the pressure to adjust the pension system in favour of
those who evaded taxes at the expense of those employed at the time
and/or those who truthfully paid taxes and rightly contributed to their second-
level pensions. The risk of such transfers in the future (i.e., the breaking of
the existing social contract) undercuts the credibility of the pension system
now and endogenously motivates individuals to evade taxes. If left on its
own, such a process is likely to become a self-fulfilling prophecy.
Overall, the fiscal cost of ageing to the state budget is likely to be larger than
European Commission (2012) projects. Yes, the parliament has just passed
a law to increase the retirement age from the current 62 years to 65 in 2025,
which will reduce the age-related cost to the budget. But other factors, in our
view, are very likely to erode these gains. The population size and structure
are less favourable than the projections assume. Tax evasion is hefty, pri-
vate savings are likely to be inadequate, and politicians are likely to give in
to claims for greater age-related spending assistance from the state budget.
The extended period of low interest rates caused by the ongoing global eco-
nomic weakness is likely to have damaged profitability of the second-level
pensions, and cut into future pension payouts.
Tax evasion puts the budget and pension system at risk. People are likely to
underestimate the volumes of their necessary savings, which creates risks of
poverty and redistribution of public transfers from those paying taxes to

8
It has been shown repeatedly that individuals do not behave rationally in dealing with their
retirement savings and investment needs. For instance, it is common to hear men arguing in
Latvia that there is no need to contribute to their second- and third-level pensions and retire-
ment savings as their life expectancy at birth is only 64.9 years, while the retirement age is 62
(raised to 65 by 2025). Of course, this is a misconception that arises because of the high mor-
tality in the cohorts of 20-40-year-old men. Life expectancy of men at 65 is high 13.5 years
(18.1 years for women).
Tax evasion puts at risk
state budget and tax
payers
The fiscal cost of aging is
likely to be significantly
higher than estimated by
European Commission
(2012)
those evading taxes. Those close to retirement are likely to be very active in
the labour market to save up for their retirement, and those already retired
are likely to be very active in the labour market to supplement their pensions.
Since the share of age-related public spending is likely to decrease going
forward, this gives more room for the government to intervene if needed.
There is a risk of sharp falls in spending power of consumers when they re-
tire. As long as substantial tax evasion persists, the purchasing power of
those employed will grow significantly faster than that of pensioners, i.e.,
pensioners will become comparatively poorer. Taxes may be increased to
raise revenues for age-related expenditures.
4.5. SAVINGS: need to rise, but will they?
A standard way to analyse savings pattern is the life-cycle hypothesis pro-
posed by Modigliani and Brumberg (see, e.g. Modogliani (1966)). This hy-
pothesis assumes that an individual aims to smooth his or her consumption
over the lifetime by adjusting the savings pattern as needed. Assuming a
standard, age-related income flow, this means that an individual dissaves
when young and old, and saves during the working age. Empirical evidence
suggests that the elderly dissave less aggressively than the hypothesis
would suggest because of altruistic motives (i.e., willingness to leave be-
quests) and precautionary savings (e.g., health reasons and unexpectedly
long life). Also, smoothing consumption can be difficult when access to fi-
nancial markets is limited. With all these disclaimers, the life-cycle hypothe-
sis is nevertheless a reasonable framework to follow.
Given that both the share of those of working age in the total population of
Latvia and the number persons of working age are decreasing, the house-
hold savings rates and volumes should decrease going forward. The elderly,
whose share in the total population is rising, are likely to dissave or save less
of their incomes than when they were working. Yet, it is not this straightfor-
ward because divergent factors are at work. This is especially over the me-
dium term of the next 10 years or so while the share of those of working age
is still relatively large.
Those of working age are likely to save more when they realise that their life
expectancy is rising. Ageing is, to a large extent, due to low fertility rates.
People thus have fewer children to rely on when old; therefore, savings need
to be larger. Low fertility is often found to induce increased investment in the
human capital of children (i.e., the so-called quantity-quality trade-off), which
improves labour productivity, incomes, and, thus, the ability to save. Faster
income growth would reduce emigration and might foster re-emigration,
thereby improving savings rates through an increase in the share of those of
working age. Low fertility typically increases the labour force participation of
women, which might also increase savings. In contrast, fewer children
means that altruistic motives to leave bequests are likely to be weaker (i.e.,
fewer to share with), and, therefore, the elderly might save less; see Lee et
al (2010) for a wider general discussion and references.
The savings pattern is likely to depend on whether the elderly finance their
life-cycle consumption smoothing via private (i.e., personal savings and as-
sets) or public transfers. While public transfers generate important economic
gains by pooling risks (health issues, longevity, etc.), they might create dis-
incentives to work, save, and maintain a healthy lifestyle. Such wrong moti-
vational effects are reduced when elements of private transfers are mixed in.
This is what is done by Latvias three-level pension system. The structure of
Consumption smoothing
is to determine savings
pattern
such a transfer system is, in fact, the social contract that we pointed to in the
Section 4.4. The current social contract is designed to make individuals
save, as the size of age-related public transfers is promised to be rather
scant.
How large are the assets held by Latvian households?
If their assets are large enough, households could do well without boosting
their savings. Unfortunately, there is no trustworthy estimate of households
total wealth. Thus, we try to piece the puzzle together from different pieces
of information to make an informed guess.
Kazks and Stikuts (2007) estimate the size and structure of Latvian house-
holds financial assets. They find that in 2006 per capita gross financial as-
sets were just above EUR 2000, or only 10% of the EU-15 average when ad-
justed for purchasing power parity. When expressed as a percentage of
GDP, these assets were almost five times smaller. As productivity and in-
comes will converge to the EU average, one would also expect that asset
holdings by and large do the same. Of course, it is net financial assets that
matter most. It was found that Latvian households net financial assets were
negative due to rapid credit growth while they were positive in the EU-15 on
average. One of the reasons was that households were aiming to smooth
their consumption on account of better future incomes. Unfortunately, exces-
sive optimism about future incomes ended up in a real estate boom-bust
scenario and falling rather than rising incomes.
Since then, households have improved their financial situation, and deposits
have increased. Also, deleveraging is soon to be over. Households expecta-
tions of income growth have become more down to earth (at least for the
time being), which means less aggressive consumption at the expense of
future savings i.e., they are likely to save more now.
Households savings rates, %
-15
-10
-5
0
5
10
15
20
1Q 07 1Q 08 1Q 09 1Q 10 1Q 11 1Q 12
Household
savings, % of
disposable income
Source: Bank of Latvia
But the households financial situation still needs to be improved. For in-
stance, a survey commissioned by Swedbank Institute of Private Finances in
mid-2011 found that only 46% of households save.
9
Other surveys have
found that an average household has financial savings to carry on consum-
ing for only one-two months if their incomes were to stop. Household savings
rates have been unsustainably low and need to rise also for macroprudential
reasons.

9
http://www.manasfinanses.lv/en/2011/06/16/986/#more-986
Households holdings or
financial assets are
rather small and are
likely to rise as
productivity convergence
continues
What improves households wealth is their real estate assets. Due to the pri-
vatisation in the 1990s, most households own real estate that they can sell.
For instance, about 70% of households possess their own mortgage-free
dwellings. However, the true market value of such assets is very difficult to
assess. This is a potential source of retirement income, but, with population
decreasing, demand for housing will decline, especially in remote and eco-
nomically weak areas. Ironically, this is exactly where the most support is
likely to be needed. Furthermore, unless they move in with their children,
they would still need to by another real estate to live in and would be able to
cash-in only from downsizing to a smaller and/or lower quality dwelling.
Given the above discussion, our conclusion is that over the medium term
savings need to increase, and are very likely to increase. But whether they
indeed will depends to a large extent on the social contract i.e., whether
the population trusts that it will not be changed.
An increase in household savings is important not only to address the nega-
tive trends of ageing and decreasing population, but also to support sustain-
able growth. As we shall discuss in Chapter 5, it is crucial to grow per capita
income investments in productive capacity and infrastructure. Depending
heavily on foreign financing may require running large current account defi-
cits a practice that is prone to financial market volatility and sudden capital
stops. The target of euro entry may somewhat reduce such risks.
Households financial assets are small. Savings are likely to increase, but tax
evasion and uncertainties surrounding the social contract are likely to lead to
too little saving.
5. HOW TO SOFTEN ECONOMIC CONSEQUENCES OF
NEGATIVE DEMOGRAPHIC TRENDS?
Governmental policy is unlikely to reverse the long-term demographic trends,
but it can certainly soften them and limit their negative economic impact. To
start with, an important task is to address these trends per se. This means
raising fertility rates and reducing the negative effect of migration. Fertility
rates and migration are closely related to the economic situation; therefore,
economic growth must be sped up in a sustainable manner so that the qual-
ity of life is constantly improving. This means making the population more
employable and improving labour productivity. The poverty of the elderly is a
major risk. Solving this problem also means providing adequate incentives
for individuals to save for their retirement.
At a risk of oversimplification, from a purely economic viewpoint, addressing
the extent of negative demographic trends and their economic conse-
quences boils down to the governments ability to create incentives and insti-
tutional infrastructure that foster swift and sustainable economic growth. The
general policy prescription, hence, is simple to achieve Western European
levels of productivity and income, a country must meet Western European
benchmarks for quality of business environment, rule of law, education, in-
vestment in research and development, etc. Therefore, the outcome will de-
pend on the policymakers ability to implement reforms.
Savings volumes need
to and are likely to rise
To achieve Western
European levels of
productivity, Latvia must
meet their benchmarks in
quality of business
environment, education,
etc.
In this chapter, we point to some of the reform vectors that we see as most
important in the context of the above discussion.
10

1. Demography policy: child support, re-emigration, immigration
The top priority is to raise fertility rates and foster re-emigration. But skills-
based immigration is equally important and not to be postponed into the in-
definite future both to use the regional first-mover advantage and to sup-
port high-growth industries that lack highly qualified staff. A more general
immigration policy is also necessary; however, to effectively implement it, a
key prerequisite is to improve the policy for integrating non-citizens already
living in Latvia.
As to raising fertility rates, we see it necessary to, e.g.:
- Increase means-tested child benefits; introduce significant and compre-
hensive tax relief for parents (e.g., it is nave to expect the fertility rate to
rise sharply if the poverty risk is high among families with children).
- Cap child monetary benefits and shift more towards a voucher-type sup-
port of services in kind, such as guaranteed free access to kindergartens
and after-school activities. This would improve the quality of services via
competition between service providers, ensure that a child is the one to
receive the benefit, and provide more support to those with lower in-
comes, thereby reducing the currently very high poverty risk for families
with children and the high overall income inequality (see the charts be-
low).
Poverty risk (%)
0
15
30
45
60
75
90
2004 2005 2006 2007 2008 2009 2010
Total
1 adult (65 yrs)
Single parent ( 1
child)
2 adults w/o children
2 adults, 2 children
2 adults, 3 children
Source: CSBL
Note: Share of inhabitants whose incomes are below 60% of median disposable income.

10
For those interested in a broader discussion, see an excellent recent structural assessment of
the Latvian economy by BICEPS (2012). Shearing (2012) gives a brief helicopter view
from a regional perspective. IMF (2011a) provides an in-depth discussion on long-term
growth differentials within Europe and outlines the structure of successful reforms in selected
countries.
Gini coefficient, 2010
0
10
20
30
40
S
I
H
U
S
E
C
Z
F
I
N
L
S
K
A
T
B
E
D
K
L
U
M
T
C
Y
D
E
F
R
P
L
I
T
E
E
E
L
U
K
B
G
I
E
R
O
P
T
E
S
L
V
L
T
Source: Eurostat
Note: Gini coefficient measures income inequality; the higher it is, the larger the inequality.
2. Labour market policies to improve employability of population:
participation rates, skills, mobility
Labour market participation rates must improve, and most of the slack is in
the pre-retirement age group, and generally outside the capital. More flexible
working schedules such as part-time jobs and work from home must be
promoted. The unemployment rate, which stood at 16.1% in the second
quarter of 2012, is way above equilibrium, estimated at about 10% (see, e.g.,
Zasova (2011)); this points to an unused labour supply.
11
If active labour
market policies are skilfully designed, the equilibrium unemployment rate will
decrease. This will also happen if labour mobility both physical and that of
skills is improved.
Unemployment is lower among those with a better education achievement.
Currently, 23% of those aged 15-74 have a tertiary education, which is below
the Swedish level of 29%. The quality of education quality must be improved
(see below).
Unemployment rates by level of education, %
0
10
20
30
40
2002 2005 2008 2011
Tertiary
Vocational
Secondary
Primary
Source: CSBL

11
It is often claimed that the youth unemployment rate is twice the economy's average and
requires an urgent intervention. An analysis shows, however, that this high unemployment
rate is due to the low participation rate because a large number of youth are students. When
adjusted for this, youth unemployment rates are similar to the economy's average; see Kras-
nopjorovs (2012b).
3. Tax policy: shift tax burden from labour to residential real estate
The tax burden should be shifted from labour to residential real estate. The
labour tax wedge should be lowered (both by reducing the tax rate and in-
creasing tax allowances) to at least the level of major regional competitors
(see the international comparison in the chart below) to encourage job crea-
tion and promote legal employment. Shifting the tax burden to real estate will
permit a reduction in tax evasion as real estate is impossible to hide. Cadas-
tral values must be adjusted to more closely reflect a propertys market
value, so that the tax on real estate is a wealth tax. Temporary compensa-
tion mechanisms should be introduced to shield the least-well-off strata of
the population from the real estate tax increases.
Labour tax wedge, 2010 (%)
0
20
40
60
M
T
I
E
L
U
U
K
B
G
P
T
P
L
N
L
E
L
S
K
F
I
E
S
D
K
S
I
E
E
L
T
C
Z
S
E
R
O
A
T
L
V
I
T
H
U
D
E
F
R
B
E
Source: Eurostat
Note: Calculations for a single person without children, 67% of an average wage.
4. Social safety net: improve incentives to work, reduce poverty traps
A partial, temporary continuation of means-tested benefits should be granted
to those seeking employment in order to reduce the unemployment trap (i.e.,
the amount of gross earnings taxed away via higher taxes and social secu-
rity contributions, and via the withdrawal of unemployment and other benefits
when employment is found), which stands at about 90%. Low-wage earners,
especially single-earner families with children, are heavily penalised as their
incomes increase; e.g., in 2010 the low-wage trap (i.e., the share of earnings
taxed away as gross earnings increase from 33% to 67% of the average
wage) stood at 79%. Therefore, the share of means-tested benefits in the
family's state benefits system (e.g., child and parental benefits) should be
increased.
Unemployment trap, 2010 (%)
0
20
40
60
80
100
S
K
M
T
R
O
E
E
U
K
A
T
E
L
L
T
F
I
I
E
D
E
S
E
F
R
I
T
P
T
C
Z
B
G
P
L
H
U
E
S
S
I
N
L
L
U
D
K
L
V
B
E
Source: Eurostat
Note: Calculations for a single person without children, 67% of an average wage.
5. Education policy: consolidate infrastructure, improve quality
The state- and municipality-owned tertiary education institutions (currently 17
higher education institutions and 18 colleges), as well as vocational institu-
tions (currently 50) should be consolidated to reduce administrative costs,
pool infrastructure, and improve quality. The state financing of such institu-
tions must be closely linked to internationally accepted measures of quality.
The state-owned tertiary education institutions should be exposed to interna-
tional influence, e.g., restrictions should be lifted on the language of instruc-
tion (currently, instruction in any language other than Latvian is capped at
25% of course content) and language requirements for professorship (cur-
rently, for all permanent professorship positions, the Latvian language test
must be passed at the highest level, which makes it virtually impossible to
hire foreign professors). The governance structure of such institutions should
be opened by including representatives of external bodies (e.g., chambers of
commerce) on their boards when strategy decisions are being made, in or-
der to make these institutions more adaptable to changes in the external en-
vironment. The means-tested repayment of student loans should be intro-
duced to reduce future income inequality.
There is scope for reducing the number of schooling years. For example,
secondary school is currently completed at the age of 19; if the currently
three months long summer holidays during primary and secondary educa-
tion were cut by a month, one would easily gain a year, which could be used
to hasten students' entry into tertiary education or directly into the labour
market, thereby improving the employability of the population.
Lifelong learning should be supported to facilitate the labour market partici-
pation of older cohorts.
6. Regional policy: pre-emptive consolidation to support centres of
activity
It must be politically accepted that aiming to maintain the current population
density across the whole of Latvia is impossible. Hence, it is necessary to do
the following:
- Reduce administrative fragmentation by forming financially and eco-
nomically sustainable administrative units (e.g., cut the number of ad-
ministrative territories from the current 110 and provide more support to
the major cities and centres of economic activity so that they are able to
absorb migration from economically unsustainable territories).
- Pre-emptively strengthen public infrastructure and the provision of pub-
lic services in the economically viable centres by reducing support
elsewhere (e.g., ensure a quality road network along the major routes of
activity and reduce support to economically inactive areas, and create
incentives for neighbouring municipalities to cooperate and share ser-
vices). This needs to be done carefully in order not to destroy still viable
and sustainable regional and peripheral economic and social activity.
- Provide relocation support to those individuals willing to move from
economically unsustainable areas to centres of economic activity.
7. Innovation and investments: support labour productivity growth
Innovation should be facilitated by channelling the EU structural funds tar-
geted for innovation mainly via business companies rather than scientists. A
more favourable tax regime should be provided for reinvested profits in the
export sector (goods and services). Government policy should be targeted to
attract foreign direct investment by providing infrastructure (e.g., connection
to electricity grid, road network, and regional industrial parks) and temporary
tax relief for greenfields. Corporate governance of municipality-owned ports
must be improved and red tape cut (e.g., speed up the assignment of con-
struction permits).
Business expenditures on research and development, 2011 (% of GDP)
0.0
0.5
1.0
1.5
2.0
2.5
3.0
C
Y
R
O
P
L
L
V
L
T
S
K
B
G
M
T
I
T
H
U
E
S
P
T
E
E
N
L
C
Z
U
K
L
U
I
E
E
U
2
7
B
E
F
R
S
I
A
T
D
E
D
K
S
E
F
I
Source: Eurostat
Investment in public infrastructure must be targeted towards the main cen-
tres of economic activity. This is true across the board the road network,
education system, etc. The strong centres should be strengthened pre-
emptively at the expense of those economically unsustainable.
8. Rule of law: improve efficacy of judicial system, reduce tax eva-
sion
The legal framework for settling disputes should be made more efficient by
reducing the time of proceedings (Latvia ranked 106
th
in the Global Eco-
nomic Forums 2012 Global Competitiveness Report). Tax evasion should
be reduced by tightening administrative controls in high-risk areas, e.g., by
shifting the tax burden from labour to real estate. Reducing tax evasion will
have wide-reaching positive consequences. For instance, when companies
evade taxes, in order to avoid the radar of the State Revenue Service, they
tend to remain small, which limits their productivity growth, and external
competitiveness. Tax evasion means less transparent risk assessment and,
therefore, more expensive financing, which again reduces external competi-
tiveness. Tax evasion reduces the efficacy of the social safety net and em-
ployee protection, and therefore fosters emigration during recessions. Tax
evasion puts at risk pension system sustainability and increases the risk of
poverty. Reducing tax evasion reduces the risks of corruption.
9. Alternative financial markets: stock market, risk capital, etc.
The banking system cannot and should not cover all of the financial market
segments. The development of the stock market must be encouraged by
floating major state-owned companies (this would also improve their corpo-
rate governance). Support should be provided to risk capitalists and other
financial market players who provide an alternative to banks' means of fi-
nancing.
10. Improve incentives to save: social contract, investment vehicles
The social contract presumed by the existing pension system must be clearly
explained to society to strengthen the incentives to save. More appealing
long-term investment vehicles should be created (e.g., floating major state-
owned companies in the stock market would make it possible for pension
funds and individuals to invest in the local economy) and provide more fa-
vourable terms for retirement savings (e.g., third-level pension savings cur-
rently have less favourable terms than life insurance; this locks in savings for
a significantly shorter period than pension savings).
The government must ensure fiscal discipline and stick to a long-term strat-
egy; macroeconomic stability and predictability in the regulatory environment
supports investment and productivity growth. Trade and capital market inte-
gration needs to deepen. Inflation needs to be kept under control and fiscal
policy must adapt accordingly. The process of rebalancing growth has
started but has to deepen. The role of the tradable sectors needs to grow in
terms of both labour input and investment.
Contribution to average annual
GDP growth, pp
Contribution to average annual
employment growth, pp
-12
-8
-4
0
4
8
12
2004-2007 2008-2009 2010-2011
Tradables Non-tradables
Source: CSBL
-6
-4
-2
0
2
4
2004-2007 2008-2009 2010-2011
Tradables Non-tradables
Source: CSBL
Note: Tradables comprise following sectors: agriculture, forestry, fishing; industry (including min-
ing, quarrying, energy and water supply), transport, storage, and communications; and accom-
modation and food services.
6. CONCLUSIONS
The population in Latvia has been decreasing and ageing, and this trend is
set to continue. Ageing takes time. In contrast, emigration is like a time ma-
chine it fast-forwards seemingly distant future problems into today at the
blink of an eye. Income gaps with those more affluent EU member states will
remain wide, and emigration will remain a major demographic risk in short-
to-medium term. Low fertility rate is a less visible but not a less important risk
as it decreases the size of the future reproductive population. In fact, the ef-
fect from low fertility rates on population is likely to be bigger in the long term
than that from emigration. The only effective way to reduce the risk of emi-
gration and support an increase in fertility rates is to promote swift and sus-
tainable economic growth, permitting job creation and an increase in wages
and living standards.
The previous chapter outlined some of the reform vectors that we believe are
the most urgent to be addressed. The list is long, and it is impossible to im-
plement all of the reforms simultaneously. This list is like a smorgasbord
from which one can pick and mix to yield the most appropriate and desired
outcome. To make the right choices, Professor Dani Rodrik of Harvard Uni-
versity advises policymakers to perform growth diagnostics in order to single
out the major bottlenecks to growth, the removal of which would provide the
greatest impetus to growth (e.g., see Rodrik (2011)).
Growth depends on reforming institutions. These reforms depend on politi-
cians. Politicians get elected. This situation opens up yet another intricate
link between economic growth and demographics. Reforms often need to
shift the policy perspective from the short to the long term, to spend less to-
day so as to invest into the future, and redistribute resources from the elderly
to youth. When a population is ageing, such a redistribution is likely to be-
come ever more difficult because the time perspective of the elderly typically
is shorter and they are numerous, well-organised, and politically more active
than most other age groups. If this version of the tribalism hypothesis is true,
no time can be wasted. Reforms must be implemented now. Failure to do so
would lead to permanent slippages in growth, and emigration would then
very likely kick off yet another vicious cycle of demographic contraction, put-
ting at ever-higher risk Latvias economic and social sustainability.
Emigration and low
fertility rates are major
demographic risks going
forward
Latvia needs to create
jobs and boost
productivity to reduce
these risks
Structural reforms need
to be implemented
without delay
APPENDIX 1: Estonia and Lithuania face similar demo-
graphic challenges as Latvia
European Commission (2012) demographic projections are a depressing
read, indeed. While in quite a few areas Latvia does score close to the bot-
tom of the EU comparison list, Estonia and Lithuania are often close nearby
faring just a tad worse or better. Hence, the problems that Estonia and
Lithuania face are very similar to those in Latvia.
According to the European Commission (2012) projections, by 2060 the
population in Latvia will have decreased by 26% (Bulgaria is the worst with
27%), in Lithuania by 20% (same as Germany!), and in Estonia by 13%. This
is in stark contrast to Sweden where the total population is projected to rise
by more than 20%. For the whole of the EU supported by immigration from
the countries outside the EU population in 2060 is seen to be up by 3%
over 2010, but this is due only to a strong increase over the next few dec-
ades, as the population size is expected to peak in 2040 and decline after-
wards.
Over the next 50 years, the working-age population aged 20-64 is projected
to shrink by 43% in Latvia, 35% in Lithuania, 33% in Germany, and 30% in
Estonia; however, it will increase by 8% in Sweden. Age dependency ratios
in Latvia are not dramatically different than in its neighbouring countries. The
total age dependency ratio (20-64) is projected to reach 108% in Latvia, just
above 100% in Lithuania and Estonia, and 95% in Sweden. Old-age de-
pendency ratio from the current level of around 27% in the Baltic States and
31% in Sweden are projected to worsen to 74% in Latvia, about 62% in
Lithuania and Estonia, and 51% in Sweden. Latvian situation is projected to
worsen somewhat faster because of the low fertility rates.
Yet, the government fiscal position in Latvia is found to be more resilient
than its neighbours to age-related costs: age-related public spending is pro-
jected to fall by 3.8% of GDP in Latvia and remain unchanged in Estonia, but
to rise by 4.5% of GDP in Lithuania and by 3.8% in Sweden. Hence, Latvia
has more fiscal space than these other countries to increase age-related
public spending if needed.
The above projections are only projections and can be wrong. Also, they are
subject to the revisions following the 2011 population censuses (particularly
in Latvia and Lithuania). The size of the population and the extent of ageing
have been found to be worse than assumed in the starting point of projec-
tions. Namely, since the previous population census taken in 2000 the popu-
lation of Latvia has shrunk by 13%. This is almost twice the size that official
pre-census statistics had estimated. The reason is that emigration was five
times larger than official estimates.
As the most recent data publications show, the decline in the Lithuanian
population since their previous population census done in 2001 has been
akin to that of Latvia down by 12%. As in Latvia, this decline is twice the
size of the official pre-census estimate. In Estonia, emigration seems to have
been significantly smaller, and the negative surprises are smaller the popu-
lation is reported to have decreased by 6%, which is somewhat above the
pre-census official estimate of 4%. Yet, the census may have underesti-
mated the true Estonian emigration. Even if so, the geographical proximity of
Finland, which is the main destination of Estonian immigrants, means that
emigration is likely to be more of a pendulum type where emigrants regularly
commute and maintain close ties with their homeland. Thus it might be eas-
ier for Estonia to win them back. For Latvians and Lithuanians, whose major
destinations have been Ireland, the UK, and Germany, such ties are weaker,
and the permanent loss of population is likely to be larger.
As for the of per capita GDP growth projections, various studies (see Section
4.1) for all three countries imply a rather similar dynamics. Growth rates are
expected to slow and depend on the policymakers ability to implement pro-
ductivity-enhancing structural reforms.
To sum up, there are certain differences across the three Baltic States, but
the overall demographic challenges are similar. This means that the implica-
tions of demographics for economic growth in Estonia and Lithuania can be
analysed along the same lines as in Latvia.
APPENDIX 2: GDP decomposition, data, and track record
Using an accounting relation, per capita GDP can be split as follows:
where GDP = gross domestic product,
POP = total population,
POPWA = working-age population,
POPWAEA = economically active working age,
UR = unemployment rate,
EMPL = number of those employed, and
EMPL = (1-UR)POPWAEA.
Thus, per capita GDP depends on physical labour utilisation and average
labour productivity. Physical labour utilisation is determined by both the
share of working-age population in total population and those in the working-
age population actually employed. The employment rate of those of working
age and actually employed is driven by the participation rate (i.e., those of
working age economically active) and unemployment rate (i.e., those of
working age economically active but unable to find a job).
A standard way to describe average labour productivity is a neo-classical
constant-returns-to-scale Cobb-Douglass production function:
(A2.2) TFP CAPITAL EMPL GDP =
o o 1
where CAPITAL = capital stock,
TFP = total factor productivity, and
o = capitals share in national income.
Dividing both sides of eq.(A2.2) by employment, one obtains:
Thus, average labour productivity is determined by two components: the size
of capital per employee and total factor productivity. The first component
presumes that more capital means more advanced methods of production,
which permit more production. The second accounts for the latent, or by
Economic growth
depends on physical
labour utilisation and
average labour
productivity
Labour productivity
depends on quality of
capital and labour force.
TFP
EMPL
CAPITAL
EMPL
GDP
|
.
|
\
|
=
o
Average
labour pro-
ductivity
Capital
deepening
Total factor
productivity
(A2.3)
EMPL
GDP
POPWAEA
POPWAEA UR
POPWA
POPWAEA
POP
POPWA
POP
GDP

=
) 1 (
Per
capita
GDP
Average
labour
produc-
tivity
Employment rate of
those of working
age and economi-
cally active
Working-
age popu-
lation in
total popu-
lation
Participation
rate of those
of working-
age popula-
tion
Physical labour utilization
(A2.1)
capital deepening, unexplained part of labour productivity growth, which is
thought to capture technological progress, improving labour skills, etc. Tak-
ing logarithms and first differences would transform eq.(A2.3) into growth
rates.
A few remarks on data
First, labour market data have not yet been corrected for the 2011 popula-
tion census, and average labour productivity is hence underestimated. Em-
ployment data originate from Labour Force Surveys, in which a sub-sample
of the population is surveyed and the proportions found are extrapolated to
the whole of the population. Given that the population size was overesti-
mated, so is the number of employed. The census-adjusted labour market
data are so far available only for 2011, for which year productivity per em-
ployed is in fact 13% higher than our time-series calculations show.
Second, one would ideally use hours worked or full-time equivalents to
measure employment. Such data are available only since 2005; thus, we re-
sort to date for the number of employed aged 15-64.
12
This may underesti-
mate labour productivity as part-timers are given the same weight as those
employed full-time. Equally, it may overestimate hourly productivity because
Latvians work extra hours and have one of the longest working weeks in the
EU.
Third, to construct the time series of capital stock, we use the seed value of
capital stock at the beginning of 1995 (National Accounts position AN11),
adding the flow of gross fixed capital formation; the annual depreciation rate
is set at 0.1, which is standard in the literature. The choice of is not clear
cut, and its estimates for Latvia range from 0.36 in Kazks et al (2006) to
0.225 in Stikuts (2003). Setting a larger assigns higher importance to capi-
tal deepening and reduces the importance of gains in total factor productiv-
ity. We choose to use 0.28, as in Arrabitel et al (2007), which is close to the
middle of the range.
Fourth, total factor productivity is measured as a residual. It contains not only
such desirable effects as technological progress but also all measurement
errors.
What is the Latvian track record so far?
With some year-to-year volatility, employment on average has contributed to
GDP growth only 0.1% per annum (0.6% per annum until 2005, i.e., exclud-
ing the periods of overheating and recession). Over the last decade, em-
ployment growth peaked in 2006-2007, the height of the real estate boom
that lead to the recession of 2008-2009. The boost in employment over
these years was by no means sustainable, and some of the job loss during
the ensuing recession was clearly warranted. Overly optimistic domestic
demand led to massive labour shortages, annual wage growth in excess of
30%, and an unemployment (job-seekers) rate collapsing to below 6% way
below equilibrium estimated at about 10% (see, e.g., Zasova (2011)). Not
surprisingly, consumer price inflation peaked at nearly 18% in 2008.

12
This age group is chosen to be consistent with European Commission (2012) projections. If
one uses the age group 15-74, the results are similar.
Historically, contribution
of employment growth to
GDP growth has been
small
Output, employment and gross fixed capital formation
50
100
150
200
250
1995 1999 2003 2007 2011
0
11
22
33
44
Gross fixed
capit al form., %
of GDP (rs)
Employment (15-
64),1995=100
GDP,
1995=100
Source: Eurost at
Per capita GDP growth, %
-25
-20
-15
-10
-5
0
5
10
15
1996 1999 2002 2005 2008 2011
POPWA/ POP
POPWAEA/ POPWA
EMPL/ POPWAEA
Capit al deepening
TFP
GDP per capita
Source: CSBL,
Swedbank estimati ons
Although the recession had already started in the first quarter of 2008, the
global environment was still manageable, and companies were hoarding la-
bour in hope that the recession would be short-lived. This all changed when
Lehman Brothers went bust in September 2008 and the global economy
dived into recession, pushing Latvia into the abyss. Latvias GDP collapsed
by 24% peak-to-trough, and unemployment rose to 20% in early 2010. The
true job loss was larger as many companies shifted to part-time employment.
Job creation resumed later in 2010, and employment contribution to GDP
growth is again positive.
Average labour productivity has been the major driver of growth in Latvia
and is found to have been positive each year (including during the 1997
Russian crisis), except for 2008 and 2009. Measured in full-time-
equivalents
13
, which capture the shift from full-time to part-time employment,
labour productivity fell only in 2008 and started growing again in 2009. The
major reason for this was the labour hoarding in 2008. Average labour pro-
ductivity, as measured in full-time equivalents, rose sharply in 2009 and
2010, with a cumulative growth of nearly 16%. Companies have been very
quick to adapt to the changing environment.
Notice that technically the fall in average labour productivity has been attrib-
uted entirely to total factor productivity. One should be very careful in making
such conclusions. Capital stock data are notoriously bad. Over the boom
years, much of capital investment was made in real estate, which lost a ma-
jor share of its value almost overnight after the real estate market imploded

13
Not reported here but available upon request from the author.
productivity catch-up
has been the major driver
of economic growth.
in 2007 (housing prices collapsed by two-thirds in less than two years).
Hence, the value of capital stock is overstated. Such measurement errors
may also explain a rather awkward fall in capital per employed in 2011, when
investment activity was exceptionally strong gross fixed capital formation
grew by 28%, most of it in infrastructure and productive export capacity, i.e.,
quality capital. It is more likely that both capital per employed (due to a sharp
loss in the value of real estate investments) and total factor productivity (due
to, e.g., labour hoarding) contracted. Similarly, one should be very careful in
reading too much into the historical importance of capital deepening vs. total
factor productivity since the results are very sensitive to the choice of . For
instance, setting above 0.30 would attribute most of the gains to capital
deepening. Given the difficulties in measuring capital stock, we refrain from
reaching definite conclusions on the past relative importance of these two
drivers of labour productivity. However, it would be fair to conclude that both
these factors have been important.
GDP and per capita GDP growth, %
Indicator
Cumulative
growth,
1995-2011
Average an-
nual growth,
1996-2011
(1) GDP 95.0 4.5
(2) Employment 0.7 0.1
(3)=(1)-(2) Average labour productivity 94.3 4.4
(4) GDP per capita 118.7 5.3
(5)
15-64 population, % of total
population
4.9 0.3
(6) Participation rate (15-64) 1.5 0.1
(7)
Employment rate of those eco-
nomically active (15-64)
6.1 0.4
(8)=(4)-(5)-
(6)-(7)
Average labour productivity 106.2 4.4
(9) Capital deepening 44.1 2.3
(10)=(8)-(9) Total factor productivity 62.1 2.1
Source: Eurostat, CSBL, Swedbank estimations.
Note: Since time series data are not corrected yet for the 2011 Population Census, employment
is overestimated and average labour productivity is underestimated. Estimates of average la-
bour productivity differ for GDP and per capita GDP calculation due to rounding errors etc.
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DEFINITIONS AND ABBREVIATIONS:
Total age dependency ratio: persons aged 19 and less plus those aged 65
and above vs. population aged 20-64.
Old-age dependency ratio: persons aged 65 and above vs. population aged
15-64.
EU-27 European Union (27 countries)
BE Belgium
BG Bulgaria
CZ Czech Republic
CSBL Central Statistical Bureau of Latvia
DK Denmark
DE Germany
EE Estonia
GDP Gross Domestic Product
IE Ireland
EL Greece
ES Spain
FR France
IT Italy
CY Cyprus
LV Latvia
LT Lithuania
LU Luxembourg
HU Hungary
MT Malta
NL Netherlands
AT Austria
PL Poland
PT Portugal
RO Romania
RU Russia
SI Slovenia
SK Slovakia
FI Finland
SE Sweden
UA Ukraine
UK United Kingdom
Swedbank
Economic Research Department
SE-105 34 Stockholm
Phone +46-8-5859 1028
ek.sekr@swedbank.com
www.swedbank.com
Legally responsible publisher
Cecilia Hermansson, +46-8-5859 1588
Mrti Kazks, +371 67445859
Lija Strauna, +371 67445875
Kristilla Skrzkalne, +371 67445844
Swedbanks Discussion Paper is distributed as a service to our customers. We have
used what we believe to be reliable sources and working processes when preparing the
analyses in our publication. We cannot, however, guarantee the accuracy or complete-
ness of the analyses, and assume no liability for any inaccuracies or deficiencies in the
basic data, or the adaptation thereof. Readers are encouraged to base any (investment)
decisions on other materials as well. Neither Swedbank nor its employees or other con-
tributors can be held liable for loss or injury, direct or indirect, due to any inaccuracies or
deficiencies published in Swedbanks Discussion Paper.

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