Presentation by Konstantīns Beņkovskis (Bank of Latvia) at Country workshop: "EU Balance-of-Payments assistance for Latvia: Foundations of Success" organized by the European Commission, Directorate General for Economic and Financial Affairs, and the Bank of Latvia. Brussels, March 1, 2012

1. Latvia’s Competitiveness before
and after the Crisis
Konstantins Benkovskis
March 1, 2012

2. Outline
• Discrepancies between different competitiveness
indicators for Latvia
• Drawbacks of traditional REER indicators
• How to assess non-price competitiveness?
o Theoretical framework
o Dynamics in price and non-price competitiveness in Latvia
• Conclusions

3. REER shows losses in competitiveness
before crisis and gains afterwards
Different real effective exchange rates of Latvia (1999 = 100)
Source: Eurostat Source: Bank of Latvia

4. Latvia quickly regained competitiveness
by closing wage-productivity gap
Real wage and productivity index (2005Q1=100)
Source: Central Statistical Bureau of Latvia, Bank of Latvia calculations

5. Does market shares dynamics contradict
the previous conclusions?
• Despite significant real
appreciation signalled by
REER indicators, nominal
and real shares of Latvia’s
exports have a stable upward
trend
• Do traditional REER
indicators capture all the
relevant competitiveness
issues?
Source: UN Comtrade, Eurostat, Bank of Latvia calculations

6. Drawbacks of traditional REER: unit
labour costs is not the whole story
• Profit margins of
exporters (difference
between export prices and
ULC) can change as well:
• Profit margins decreased
before the crisis, partly
offsetting competitiveness
losses
• After the crisis profit
margins are on an
increasing trend
Source: Central Statistical Bureau of Latvia, Bank of Latvia calculations

7. Further drawbacks of traditional REER
• Structural issues are not captured:
o Differences in export structure are not taken into account
o Need to analyse competitiveness at disaggregated level
• Focusing on price competitiveness
o Some measures are adjusted for quality (e.g. CPI-based)
o However, many other important factors left aside (e.g.
taste, image of brands)
o Need to also consider non-price competitiveness issues

8. How to evaluate non-price
competitiveness?
• We have trade data on a very disaggregated level:
o prices (unit values, euro/kg)
o volumes (kg)
• Why shouldn’t we combine both sources instead of
focusing just on one?
o If real market share improves when relative export price is
increasing, it gives us some clue about non-price factors
• Consistent theoretical framework needed

9. Theoretical framework
Consumer’s utility function
• First-level CES utility function (imports and domestic good)
κ
⎛ κ −1 κ −1
⎞ κ −1
U t = ⎜ Dt
⎜
κ
+ Mt κ ⎟
⎟ ; κ >1
⎝ ⎠
• Second-level CES utility function (different imported goods)
γ
⎛ ⎞
γ −1 γ −1
M t = ⎜ ∑ M gt
γ ⎟
; γ >1
⎜ g∈G ⎟ elasticity of substitution
set of goods ⎝ ⎠ between products
• Third-level CES utility function (different varieties of a good)
σg
⎛ 1 σ g −1
⎞ σ g −1
M gt = ⎜ ∑ d gct mgct
σg σg ⎟
; σg >1
⎜ c∈C ⎟ elasticity of substitution
⎝ ⎠ between varieties
set of countries
quality or taste parameter

10. Theoretical framework
Change of a relative price in a single market
• Relative price of a good g imported from country k relative to
other origins:
−k
−k 1 wgct
wgct
⎛ p gkt p gct −1 ⎞ ⎛ λ− k ⎞ 1−σ g ⎛ d gkt d gct −1 ⎞1−σ g
RXPgct = ∏ ⎜ ⎟ ⎜ gt ⎟ ∏k ⎜ d d ⎟
⎜ ⎟
c∈C g k ⎝ p gct p gkt −1 ⎠
⎜ λ− k ⎟ ⎜ ⎟
−
⎝ gt −1 ⎠ c∈C g ⎝ gct
−
gkt −1 ⎠
1 2 3
1. Traditional relative price index – increase denotes worsening price
competitiveness
2. Adjustment for changes in monopoly power of exporters. If set of
partner countries is increasing, relative price index increase as well
3. Adjustment for changes in quality or taste. Rise in relative quality or
taste decrease relative price index and improve competitiveness
Source: K. Benkovskis, J. Woerz (2012) “Evaluation of Non-Price Competitiveness of Exports from Central and Eastern
European Countries”, Bank of Latvia working paper, forthcoming.

11. Theoretical framework
How to estimate quality/taste parameter?
• After solving utility maximization problem:
relative prices (UVX) relative quantities (kg)
1 ⎛ d gct ⎞ ⎛ p gct ⎞ 1 ⎛ xgct ⎞
ln⎜ ⎟ = ln⎜ ⎟+ ln⎜ ⎟
σ g ⎜ d gkt
⎝
⎟
⎠
⎜p
⎝ gkt
⎟ σ
⎠ g
⎜x
⎝ gkt
⎟
⎠
benchmark country
• Relative quality or taste depends on relative prices
and relative volumes of sales
• It also depends on elasticity of substitution
o relative quantities are not important for perfect competition

12. Database and coverage
Eurostat Comext data
• Eurostat Comext
o Import data for all 27 EU countries
o 8-digit CN classification level
• approx. 10 000 products
o 1999 to 2010, annual data
o 50 main partner countries
• All EU countries, US, Japan, China, India, Brazil, Canada,
Russia etc.
• Therefore, we are assessing competitiveness of Latvia on
EU market
o Still analysing the most part of Latvia’s exports (67.2% in 2010)

13. Price competitiveness of Latvia’s exports
to EU
• Aggregated export price-based
REER shows lower appreciation –
profit margins matters
• After evaluation of relative export
prices on every importing market
(27 countries, ~10000 products),
overall index obtained by
weighting according to Latvia’s
export structure
• Disaggregated export price-based
REER shows even lower
appreciation and losses in price
competitiveness
o Price competitiveness is better for
main export products of Latvia
Source: K. Benkovskis, J. Woerz (2012) “Evaluation of Non-Price Competitiveness of Exports from Central and Eastern
European Countries”, Bank of Latvia working paper, forthcoming.

14. Price and non-price competitiveness of
Latvia’s exports to EU
• Taking into account non-
price competitiveness factors
changes the perception of
Latvia’s performance
• Competitiveness of Latvia’s
exporters on the EU market
significantly improved:
o Quality and taste for Latvia’s
products increased faster then
one for our rivals
Source: K. Benkovskis, J. Woerz (2012) “Evaluation of Non-Price Competitiveness of Exports from Central and Eastern
European Countries”, Bank of Latvia working paper, forthcoming.

15. Conclusions
• Do not stick only to simple aggregate indices
o REER shows losses in competitiveness before crisis and
gains afterwards
o Market shares of Latvia’s exports contradicts it, showing
stable upward trend
• Use in-depth disaggregated analysis, when possible
o Price competitiveness of Latvia’s exports worsened only
marginally
o Non-price competitiveness factors (quality, taste) have a
significant positive contribution
o Overall, competitiveness of Latvia’s exporters on the EU
market improved before, as well as after the crisis