LATVIA S COMPARATIVE ADVANTAGE: EXPERIENCE AND CHALLENGES

LATVIA S COMPARATIVE ADVANTAGE: EXPERIENCE AND CHALLENGES Aleksandrs Fedotovs Riga International School of Economics and Business Administration, Latvia, alexandrfedotov@yahoo.co.uk Abstract Problem of comparative advantage of a nation becomes increasingly important under global competition. It can be justified by the traditional theories of international trade that Latvia became a timber exporter to the EU. After 2000, however, the share of EU-15 and the share of wood products in Latvia s exports steadily decline. The country needs to identify new areas of comparative advantage. Latvia still is a country with educated and easily teachable labour. A serious threat to this advantage is caused by labour emigration. Also, Latvia s comparative advantage is endangered by situation in the country s educational system. The Lisbon Strategy set as the main goal to achieve that the EU becomes the world s most competitive and dynamic knowledge-based economy in 10 years. It is obvious that the programme has failed. This fact, as well as the experience of the global crisis, are a painful lesson from which we should derive benefit in the future. Keywords: comparative advantage, competitive advantage, exports, EU, economy of Latvia, Lisbon strategy. 1. Introduction: the Theoretical and Historical Background Problem of comparative advantage in international trade proves to be increasingly important for any country under modern global competition. This problem proves now especially important for Latvia. In terms of the traditional Ricardian model of comparative advantage, a country has a comparative advantage in producing a good if the opportunity cost of producing that good in terms of other goods is lower in that country than it is in other countries (Krugman & Obstfeld, 2003, p.12). It can be justified quite satisfactory on the basis of this theory that Latvia became a timber exporter to the EU market. According to the Heckscher Ohlin theorem, a country will tend to export goods whose production is intensive in factors which the country is abundantly endowed. In the context of Heckscher Ohlin theory, a country is abundant in a factor if it has a larger supply of this factor relative to its supply of other factors (Krugman & Obstfeld, 2003, p.86). In terms of labour/land ratio, Latvia proves to be relatively rich in land. Population of Latvia is now just above 2.2 million inhabitants per 64 thousand of square kilometres which makes less than 35 people per square kilometre. It is in fact one of the lowest indices in Europe. To compare, Denmark and the Netherlands with territories equal to 2/3 of Latvia have populations of 5.5 million and more than 16 million, respectively; Belgium with less than half of Latvia s territory has 10.5 million inhabitants. Among 27 EU member states, only Finland, Sweden, and Estonia have lower population density than Latvia (Central Statistical Bureau of Latvia, 2007, p. 520). So, it can be demonstrated in full accordance with the theory that Latvia has to produce and export land-intensive products, such as wood. Under the conditions of fierce market competition, this niche in European markets was spontaneously discovered by Latvian exporters. Soon after regaining national independence, share of wood products in Latvia s exports reached 30-35%; moreover, in Latvian exports to the EU-15 countries this category of products accounted for 60% of the total value. Today, relative importance of wood products for Latvia s exports to some countries can be seen from Table 1. Table 1. Share of wood products in Latvia s exports to selected European countries, 2008 (Produced by author on the basis of: http://www.em.gov.lv; Central Statistical Bureau of Latvia, 2007, p. 520) Populationper 1 Latvia s exports to the particular country Country km 2 Total commodity exports, Wood and wood products, Belgium United Kingdom Germany Italy Denmark France Austria Sweden Finland 343 247 231 194 126 110 98 20 15 millions of EUR 55.3 222.4 467.4 101.6 267.7 105.2 24.4 393.5 183.5 % of the total 38.2 56.1 22.3 15.9 16.8 29.5 28.0 47.8 31.8 68

However, during 1995 2008, the product and geographic pattern of Latvia s exports underwent substantial changes. Figure 1 presents changing share of wood products in Latvian exports in relation with share of exports to EU-15. It can be clearly seen on the graph that in 1995 2001 the share of EU-15 countries in total volume of Latvia s exports steadily increased (from 44% in 1995 to 65% in 2000). After 2000, a completely opposite trend takes place and the share of EU-15 countries in Latvia s exports consistently declines. % of total exports 70 60 50 40 30 Exports to EU-15 20 10 Exports of wood and wood products 0 1990 1995 2000 2005 2010 Figure 1. Exports to EU-15 countries and exports of wood products as % of total exports from Latvia, 1995 2008 (Produced by author on the basis of: Ministry of Economics, Republic of Latvia, 2001, p.28; Ministry of Economics, Republic of Latvia, June 2002, p.32; Ministry of Economics, Republic of Latvia, 2003, p. 35; Ministry of Economics, Republic of Latvia, 2004, p.31; Ministry of Economics, Republic of Latvia, 2005, p.27; Ministry of Economics, Republic of Latvia, 2006, p.28; Ministry of Economics, Republic of Latvia, 2007, p.22; Ministry of Economics, Republic of Latvia, 2009, p.19; Central Statistical Bureau of Latvia, 1995, pp. 269, 276; Central Statistical Bureau of Latvia, 1997, p.266; Central Statistical Bureau of Latvia, 1999, p.266) As follows from the data presented in Figure 1, share of Latvia s exports to the old member states of the European Union (EU-15 countries) has dropped from 65% in 2000 to 37% in 2008. Along with decreasing share of EU-15 countries, percentage share of wood products in Latvia s exports decreases year by year. It is worth reminding here that from the last third of the 20 th century, the share of raw materials in international trade turnover has demonstrated a substantial decrease (Krugman & Obstfeld, 2003, p. 80; Daniels et al., 2004, p. 158; Medvedev, 2002, p.229).taking into account this global trend and the worsening prospects of exports of raw materials, problem of identifying new areas of the nation s comparative advantage has become especially acute also for Latvia. 2. Productivity and unit labour costs It has become a well-known statement that Latvia s economy needs to switch to production and exports of goods with a higher value added. Unfortunately, no progress in this field took place yet. As admitted in official publications, [ ]Latvia has not substantially improved its positions in this respect during the last years; [ ] no considerable reorientation to production of goods with higher value added has occurred on the supply side of Latvian economy (Ministry of Economics, Republic of Latvia, 2007, p.62). However, it remains a disputable question which sectors of economy or which products must be chosen as national priorities and whether they need a special support: are they wood processing, biological agriculture, food industry, chemical industry, pharmaceutics, or some other. Answer to this question depends first of all on productivity and unit labour costs of potential exports. According to theory, specialization of a country in international market is determined by the condition a L * / a L > w / w*, (1) where a L * / a L is the ratio of unit labour requirements abroad and in the particular country, 69

w / w* is the ratio of wage rate in the country to the wage rate abroad (Krugman & Obstfeld, 2003, pp.26 27). It means that a country would become an exporter of a certain product if ratio of domestic productivity to productivity abroad exceeds the ratio of domestic wage rate to wage rate abroad. Latvia, along with the other two Baltic states, Estonia and Lithuania, continues to demonstrate a very low degree of productivity of national economy. Figure 2 depicts comparative levels of productivity in manufacturing of several EU countries. It can be seen from the diagram that, among the countries surveyed, the three Baltic states are in the very end of the list with extremely big gap from the leaders. 250 200 203 150 100 124 123 119 109 106 78 72 69 Germany = 100 50 43 33 33 30 27 27 24 17 0 Ireland* Finland Belgium* Sweden Luxembourg Netherlands* Greece* Italy Spain* Slovenia Slovakia Hungary Czech Rep.* Poland* Lithuania Estonia Latvia * 2006 Figure 2. Productivity in manufacturing, 2007 (Germany = 100) (Ministry of Economics, Republic of Latvia, 2008, December, p.14). As concerns wage rate in Latvia, it is also among the lowest in the EU. In 2003 it was only 15% of the EU average (Ministry of Economics, Republic of Latvia, 2007, p. 79). Certain increase in labour costs due to rising wage levels took place in recent years when unit labour costs in Latvia increased more rapidly than in any other EU country (Ministry of Economics, Republic of Latvia, 2007, p.77 78). Nevertheless, Latvia still can be considered a country with relatively cheap, educated and easily teachable labour resources, with potential for production of high-technology products. One of modern concepts in the area of international competition is the model of nation s competitive advantage known as Porter diamond. It explains a nation s competitive advantage in global markets as interaction of the four determinants: 1) factor endowments, 2) demand conditions, 3) relating and supporting industries, and 4) firm strategy, structure, and rivalry. In particular, factor endowments is interpreted as a nation s position in factors of production such as skilled labour or the infrastructure necessary to compete in a given industry (Hill, 2003, p. 158 162; Daniels et al., 2004, p.161 164). For a long time, there is a widespread belief inherited from the Soviet era that Latvia, being poor in natural resources, possesses the advantage of skilled labour force. In the context of European Union, this statement was later supplemented in the phrasing: skilled and cheap labour force. Comparatively cheap Latvian labour attracted foreign investment and facilitated economic growth in the country. A serious threat to this Latvia s comparative advantage is created now by intensive labour emigration. In general, globalization objectively accelerates draining out of resources from more poor countries and regions to more developed ones. This seems increasingly true for Latvia in last years. As a result, the drain of labour resources substantially erodes Latvia s economic and intellectual potential. 3. Lisbon Strategy: A Failed One The competitiveness of Latvia in the modern world must be considered now within the context of a broader problem the global competitiveness of the EU as a whole. The strategic development programme approved by the European Council in Lisbon in March, 2000 (Lisbon Strategy) set as the main goal to achieve that the EU becomes the world s most competitive and dynamic knowledge-based economy in 10 years, which would ensure sustainable economic growth with more and better workplaces and greater social cohesion (Ministry of Economics, Republic of Latvia, 2007, p.84). In fact, it seemed obvious from the very 70

beginning that the declared ambitious goal would not be attained. There were neither effective mechanisms nor strong incentives to carry out the programme. Therefore, the claim very much reminded N.Khrushchows notorious slogan in the USSR: Догоним и перегоним Америку! ( Catch up and overcome America! ). There are no indications of any special success achieved by the EU due to Lisbon programme in terms of economic growth, competitiveness, or social cohesion. Table 2 presents dynamics of economic growth in selected countries of the world in comparison to the EU. Table 2. GDP growth rates by countries and regions, 2002 2009 (www.imf.org) USA Japan EU CIS China Countries 2002-2004 average World in total 4.1 2.7 1.5 1.8 Euro area 7.2 2005 2006 2007 2008 2009 (f) 4.8 5.4 5.2 3.2-1.3 3.1 2.9 2.0 1.1-2.8 1.9 2.2 2.4-0.6-6.2 2.0 3.2 3.1 1.1-4.0 1.5 2.8 2.7 0.9-4.2 6.6 7.7 8.6 5.5-5.1 10.4 11.1 13.0 9.0 6.5 Greater social cohesion seems to be also unattained in the EU. As EU officials admit, the number of poor has rather increased than decreased in the European Union, especially during the period of crisis (Антоненко, Телеграф, 2010, 22 янв. [Antonenko, Telegraph, Jan. 22, 2010]). The General competitiveness indexes regularly prepared for World economic forums imply that even the principal vehicles of the EU economy such countries as Germany, United Kingdom, France are not in the very top of the list in terms of competitiveness (Table 3). In total, the EU member states rank from the 3 rd to the 76 th in the list of 134 countries listed. Such a great diversity proves once more the heterogeneity of the European Union one of the core problems of modern EU. It is also obvious from Table 3 that the Baltic states along with other new EU members demonstrate very modest performance. As concerns Latvia, it occupies one of the last places among the EU member states in this evaluation. Table 3. General competitiveness indexes for selected countries (The Global Competitiveness Report) Ranking Country GCI 2008-2009 score 1 United States 5.74 2 Switzerland 5.61 3 Denmark 5.58 4 Sweden 5.53 5 Singapore 5.53 6 Finland 5.50 7 Germany 5.46 12 United Kingdom 5.30 16 France 5.22 32 Estonia 4,67 33 Czech Republic 4.62 43 Portugal 4.47 44 Lithuania 4,45 49 Italy 4.35 53 Poland 4.28 54 Latvia 4,26 62 Hungary 4.22 67 Greece 4.11 68 Romania 4.10 76 Bulgaria 4.03 Over the period of restored national independence, a lot of good intentions and declarations, a great variety of officially approved programmes has appeared in Latvia. No doubt, many good ideas are embraced in the above-mentioned official documents. As an example, the following goal can be quoted from joint 71

communiqué by the government of Latvia and the Council of Foreign Investors in Latvia: To concentrate available resources for economic research and in a medium-term facilitate establishment of an independent economic research capacity, thus helping to evaluate the government policies and their effect on national economy [ ] (Ministry of Economics, Republic of Latvia, 2009, p.97). Unfortunately, the realization of this good idea is apparently left to independent initiative and enthusiasm. Switzerland Sweden Finland Germany Denmark United Kingdom Austria Ireland Luxembourg Belgium France Netherlands Cyprus Iceland Estonia Slovenia Czech Rep. Norway Spain Portugal Greece Italy Malta Hungary Slovakia Poland Lithuania Croatia Romania Latvia Bulgaria Turkey EU average 0 0,1 0,2 0,3 0,4 0,5 0,6 0,7 0,8 Figure 3. Innovation indexes in 2008 (Ministry of Economics, Republic of Latvia, 2009, p. 98) The way to international competitiveness and to the knowledge-based society lies via innovations. European Innovation Scoreboard, a report annually published by the European Commission, values the 72

progress made by EU member states in implementation of innovation policy. It shows that Latvia remains in one of the last places among the countries surveyed. Latvia s innovation index has not substantially changed over the last years. In 2006, Latvia was in the 29 th place among 34 countries, in 2007 and 2008 in the 35 th place among 37 countries (Figure 3). In 2007, only Romania and Turkey, but in 2008 only Bulgaria and Turkey had lower total scores (Ministry of Economics, Republic of Latvia, 2009, pp. 97 98; Ministry of Economics, Republic of Latvia, June 2008, p.112). Innovative potential of a country depends on financial resources devoted to science and education. And, again, Latvia s performance in this area proves to be among the poorest in Europe. According to official data, the total amount of financing of R&D in Latvia by 2006 reached only 0.7% of GDP (Figure 4). It is one of the lowest indices in the European Union. The EU average was 1.84% in 2006 and the Lisbon strategy required raising it to 3% by 2010 (Ministry of Economics, Republic of Latvia, June 2008, p.112). In Latvia s government budget, expenditures on science are reduced from almost 22 million LVL in 2009 to 16.5 million LVL in 2010 (Aнтоненко, Телеграф, 2010, 14 янв. [Antonenko, Telegraph, Jan. 14, 2010]). As Western scholars admit, there is no perfect correspondence between the percent of a country s GDP spent on education and the quality of education; nevertheless, the level of spending reflects a nation s commitment to education (Hill, p.106). Potentially the most dangerous threat to Latvia s comparative advantage is caused now by the situation in the country s educational system. In this respect, there is again a contradiction between declarations and reality in Latvia. On one hand, officially there are statements that training of highly educated labour, investment in human capital, society s motivation for acquisition of knowledge are crucial for Latvia s future development and competitiveness in the 21 st century (Latvija: no vīzijas uz darbību, 2000 [Latvia: From vision to action, 2000]). On the other hand, in spite of good slogans and appeals for innovations, government s financing of higher education in Latvia continues to decrease. Expenditures on higher education in government budget for 2010 are cut to slightly less than 45 million LVL as compared to 53.6 million LVL in the previous year; simultaneously, expenditures on support and development of higher schools are reduced to nearly 30.8 million LVL instead of 38.1 million LVL a year ago. As a result, government financing per 1 student in Latvia proves to be among the lowest in the EU (Aнтоненко, Телеграф, 2010, 14 янв. [Antonenko, Telegraph, Jan. 14, 2010]). Systematic neglect of needs of education and science, chronically insufficient and continuously reduced financing of them may lead to total degradation of education level in the country with irreversible consequences for the national economy. In fact, it is by no means a coincidence that Latvia is now in one of the last places among the EU countries in terms of general competitiveness of national economy, productivity, GDP per capita, innovations score, and spending on R&D and education. All these facts are mutually related. This, as well as the effects of recent economic crisis, is a painful lesson from which we should learn in the future. 0,8 0,7 0,6 0,5 0,4 0,3 0,2 0,1 0 0,37 0,19 0,09 0,13 0,19 0,18 0,26 0,18 0,26 0,13 0,15 0,08 0,09 0,1 0,05 2002 2003 2004 2005 2006 Private sector Public sector Foreign Figure 4. Funding for R&D in Latvia as % of GDP, by source of investment (Ministry of Economics, Republic of Latvia, June 2008, p.112). 73

4. Conclusions The traditional theoretical approaches Ricardian model of comparative advantage and the Heckscher Ohlin theorem prove applicable to explain Latvia s trade with the EU-15 countries. Share of wood products in Latvian exports steadily decreases after 2000 along with decrease of share of Latvia s exports to the EU-15 countries. The problem of identifying new areas of comparative advantage is especially acute for Latvia. Latvia still can be considered a country with relatively cheap, educated and easily teachable labour resources. The ambitious goal set by the Lisbon strategy, are not achieved by the European Union. In Latvia, as well as in the EU in general, a lot of well-written programmes had been created, but they lack efficient mechanisms of carrying them out. The fact that Latvia is now in one of the last places in the EU in terms of general competitiveness of national economy, productivity, industrial output per capita, innovations score, and spending on R&D and education are mutually related and dependent facts. A serious threat to Latvia s comparative advantage is created now by intensive labour emigration. In addition, by destroying the country s science and educational system, present government policy threatens to completely eliminate Latvia s competitive advantage skilled labour. References 1. Central Statistical Bureau of Latvia (1995). Statistical Yearbook of Latvia 1995, Riga. 2. Central Statistical Bureau of Latvia (1997). Statistical Yearbook of Latvia 1997, Riga. 3. Central Statistical Bureau of Latvia (1999). Statistical Yearbook of Latvia 1999, Riga. 4. Central Statistical Bureau of Latvia (2007). Statistical Yearbook of Latvia 2007, Riga. 5. Daniels, J.D., Radebaugh, L.H., Sullivan, D.P. (2004). International business: Environments and operations, 10 th ed., Pearson Prentice Hall. 6. Hill, Ch.W. (2003). International business: Competing in the global marketplace, 4 th ed., McGraw-Hill, Irwin. 7. http://www.em.gov.lv/em/2nd/?cat=12684 (site of Ministry of Economics, Republic of Latvia) 8. www.imf. org 9. Krugman P., & Obstfeld M. (2003). International Economics, 6th ed., Addison Wesley. 10. Latvija: no vīzijas uz darbību. Ilgspējīgas attīstības koncepcija (2000). Rīga. (Latvia: From vision to action. A sustainable development concept. Riga, 2000, in Latvian) 11. Ministry of Economics, Republic of Latvia (2001). Economic Development of Latvia: Report, June, Riga, 2001. 12. Ministry of Economics, Republic of Latvia (2002). Economic Development of Latvia: Report, June, Riga. 13. Ministry of Economics, Republic of Latvia (2003). Economic Development of Latvia: Report, June, Riga. 14. Ministry of Economics, Republic of Latvia (2004). Economic Development of Latvia: Report, June, Riga. 15. Ministry of Economics, Republic of Latvia (2005). Economic Development of Latvia: Report, December, Riga. 16. Ministry of Economics, Republic of Latvia (2006). Economic Development of Latvia: Report, December, Riga. 17. Ministry of Economics, Republic of Latvia (2007). Economic Development of Latvia: Report, December, Riga. 18. Ministry of Economics, Republic of Latvia (2008). Economic Development of Latvia: Report, June, Riga. 19. Ministry of Economics, Republic of Latvia (2008). Economic Development of Latvia. Report, December, Rīga. 20. Ministry of Economics, Republic of Latvia (2009). Economic Development of Latvia: Report, June, Riga. 21. The Global Competitiveness Report 2009-2010 /http://www.weforum.org/pdf/gcr09/gcr20092010fullreport.pdf 22. Антоненко О. Правительство рассмешило учёных. Телеграф, 2010, 14 янв. (Antonenko O. Government made scientists laugh. Newspaper Telegraph, Riga, Jan. 14, 2010, in Russian). 23. Антоненко О. Бедность не порок. Телеграф, 2010, 22 янв. (Antonenko O. Poverty is no sin. Newspaper Telegraph, Riga, Jan. 22, 2010, in Russian). 24. Meдведев, A.Г. (2002). Международный менеджмент, ИМИСП, СПб. (Medvedev A.G., International Management, IMISP, St. Petersburg, in Russian). 74