Growing together: Croatia and Latvia

Thorvaldur Gylfason, Eduard Hochreiter

Croatia and Latvia both gained independence in the early 1990s. This column tracks their progress since. It shows that the two are growing but at different rates and with varying cycles. It argues that investment in human capital, good governance, and institutional reform have been vital for development and while Latvia is catching up, Croatia remains the more efficient and wealthier of the two.

Croatia and Latvia regained independence in the early 1990s. While Latvia could promptly start adjusting its policies to prepare for its integration into the EU (and NATO), Croatia suffered a bloody war of independence that, including its political aftermath, set its EU ambitions back by about a decade. Latvia used its time well and pursued radical reform policies that led to EU accession in 2004. After nearly five years of war, Croatia opted for more cautious, gradual reforms, and opening up.

With a fall in output of around 50%, the decline in Latvia was not only deeper than the roughly one-third plunge in Croatia, it also lasted longer. Yet as a result of the deeper decline, the lower level of initial income, and the more aggressive economic policies, Latvia subsequently enjoyed a substantial boom. Latvia’s average growth rate of close to 10% per year had a time limit, however. The boom ended in bust once the financial crisis hit and the real-estate bubble burst in 2008, piling pressure on its currency peg (Levy-Yeyati 2009). In contrast, Croatia’s growth rate, while significant at around a real 5% per year on average, was spared such an output collapse, so Croatia remained ahead of Latvia (Figure 1).

Figure 1. GDP per capita 1980-2008 (constant 2005 international dollars at purchasing power parity)

Source: World Development Indicators 2010.

Economic growth can be either extensive, focusing on investing in physical capital, or intensive, relying on more efficient use of existing capital through the accumulation of human capital through education, on-the-job training, and health care. Free trade enables countries to break outside their production frontiers. Good institutions and good governance help generate sustained growth.

Simple growth accounting allows us to isolate the contributions of education, investment, and efficiency to the relative growth performance of Croatia and Latvia. A standard Cobb-Douglas constant-returns-to-scale production function yields the result that per capita output in Croatia relative to that of Latvia is directly related to three key factors:

economic efficiency in Croatia relative to Latvia;

Croatia’s share of investment in GDP relative to that of Latvia;

the difference between the number of years of schooling in Croatia and Latvia.

The relationship is easily quantifiable, and involves a square root as well as a cube that follow from the Cobb-Douglas formulation and standard assumptions about relevant parameters (for more details see Gylfason and Hochreiter 2010).

To understand the different growth trajectories of the two countries under consideration we need to estimate the relative contributions of investment, education, and efficiency.

Investment, exports, and education

Domestic and foreign investment and education at all levels are key sources of growth. Croatia invested 21% of GDP in machinery and equipment on average from 1989 to 2007 compared with 27% in Latvia. Since independence and after the end of the war of independence both countries have successfully attracted foreign investment. Latvia has been somewhat more open and, on average, been more successful in attracting foreign capital than Croatia, but, its capital inflows have also been more volatile. Net inflows of foreign direct investment to Latvia averaged 5% of GDP between 1992 and 2007 compared with 4% in Croatia.

Exports of goods and services from Latvia amounted to 47% of GDP on average 1990-2008, slightly more than Croatia’s 44%. However, with the recovery of tourism as well as on the strengthened EU perspective, Croatia’s export performance caught up with that of Latvia. Today, even considering the onslaught of the financial crisis, both countries enjoy a markedly higher standard of life than they did under Soviet rule or within Yugoslavia.

As regards investment in human capital, in the decade to 2007, Latvia has consistently spent more on education (5.5% of GDP) than Croatia (4.5% of GDP). Nearly all Latvian youngsters attend secondary schools compared with 90% in Croatia. In 2007, over two-thirds of young Latvians attended colleges and universities against 41% in Croatia. None of these input measures capture the quality of education, however, a common problem in quantitative education research. With early reforms, Latvia sought harmonisation with EU standards, another benefit of the early EU perspective. Education reform in Croatia started more recently. Education is clearly conducive to a business-friendly climate for domestic as well as foreign investment.

Overall, doing business in Latvia continues to be easier than in Croatia. In 2007, the World Bank’s Ease of Doing Business Index that ranks 183 countries puts Latvia in 27th place, far ahead of Croatia in 103rd place. Croatia’s low rank is surprising in view of the fact that the government of Croatia is trying hard to prepare for EU accession. The low rank reflects, among other things, the ongoing difficulties entrepreneurs have in gaining construction permits and processing the paper work for employing staff.

In contrast to the ease of doing business, Latvia’s economic freedom, overall, continues to lag behind that of Croatia despite Latvia’s liberal economic policies, its presumed long adherence to the Copenhagen criteria of the EU, and Croatia’s legacy of the war of independence.

Democracy and governance

Democracy is good for growth because it improves governance. On a scale of democracy from -10 to +10 (Polity IV Project), Latvia has consistently scored a high 8 since reclaiming its independence in 1991. Croatia embraced democracy a decade later than Latvia. Before 2000, Croatia scored poorly within a range of -1 and -3. Since then, its democracy index increased markedly, but it remains one point lower than in Latvia. Democratisation can be viewed as an investment in social capital. Social capital, inter alia, includes trust and the absence of rampant corruption.

According to the World Bank’s Enterprise Surveys, a similar proportion of managers surveyed in 2005 said they lacked confidence in the court system’s ability to uphold property rights (27% in Croatia, 21% in Latvia). Even so, in Croatia, 10% of the managers surveyed described crime as a major business constraint compared with a whopping 26% in Latvia. Still, both countries have made progress against corruption, at least until the onset of the financial crisis. This improvement should stimulate growth because corruption is not good for growth. On the other hand, the more recent sharp deterioration of this index does not bode well for Latvia.

Accounting for the income differential

In 2008, Croatia’s per capita GDP was 1.1 times larger than that of Latvia. The average investment ratio stood at 21% in Croatia and 27% in Latvia. The imputed years of schooling amounted to 12.5 years for Croatia and 14.5 years for Latvia. Inserting these estimates into our equation above, we find that the difference in investment would, by itself, only account for a 13% difference in per capita incomes in Latvia’s favour, while the difference in schooling and, hence, in human capital accumulation accounts for 172% income difference in Latvia’s favour. Yet, Croatia remains ahead in terms of per capita income. This must mean that Croatia has a 131% efficiency advantage over Latvia. Presumably, Croatia’s efficiency advantage benefits from lower inflation, higher manufacturing exports, greater economic freedom, and longer life expectancy.

To sum up, our simple computation suggests that education matters a good deal more than investment for explaining the growth differential between Latvia and Croatia from 1991 to 2008 while some advantages in efficiency must be the reason why Croatia has managed to stay ahead.

Conclusion

Our story of Croatia and Latvia’s economic advances since 1991 suggests policy implications that seem to be of general relevance for many countries, particularly for those that aspire to rapidly catch up with others. Among other things, rapid convergence requires:

Policies that foster education and training, embrace free trade, and focus on investment in a business-friendly environment;

Macroeconomic policies that support price stability and fiscal sustainability, sound private banking and other financial intermediation, and international, consumer-friendly competition,

Sound and transparent societal institutions that support the rule of law, and

Good governance in both the public and the private sectors.

The implementation of the above-mentioned policies might be supported by the prospect of EU membership. Such an EU perspective may also help to forge a broad-based political consensus on the policy actions required for change.

In a nutshell our main findings are:

Latvia has invested more relative to GDP than Croatia, thereby fostering long-term growth. Net foreign direct investment, marginally higher in Latvia, could have also contributed.

Latvia has invested more in education at all levels, thereby increasing the human capital stock. The build-up of human capital in Latvia relative to Croatia manifests itself in two extra years of schooling.

Latvia started earlier and more aggressively to raise economic efficiency, that is, total factor productivity, and thereby to lay a basis for rapid long-run growth. These efforts were, in particular, driven by Latvia’s EU integration process. Croatia moved more cautiously. Corruption, despite improvements, remains a significant problem. Still, in view of the main determinants of growth, Croatia scores higher in terms of economic efficiency than Latvia. EU accession, now expected in 2012 or 2013, should provide another confidence boost, lifting investment, exports, consumption, and growth. So far, on balance, Latvia caught up, but Croatia remains ahead.

References

Gylfason, T and E Hochreiter (2010), “Growing Together: Croatia and Latvia”, CESifo Working Paper 3202, October.

Levy-Yeyati, Eduardo (2009), “Is Latvia the new Argentina?”, VoxEU.org, 22 June.

World Bank (2010), Doing Business – Economy Rankings.