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RIGA, Latvia—This Baltic nation, which withstood something close to a depression during the global financial crisis, looks to be on the mend: The International Monetary Fund said Thursday in a report that Latvia's recovery plan is working. Standard & Poor's this week raised the country's sovereign-credit rating. And though unemployment remains at 18%, the economy has grown for three straight quarters.
But some economists say the signs that appear to show Latvia's resurgence—its shrinking trade deficit, stable currency and falling budget deficit—may also obscure serious obstacles on the country's road back to economic health.
Latvia is regarded as an experiment of sorts. After an economic collapse that saw its gross domestic product fall 25%, Latvia is attempting to create an export-driven recovery without devaluing its local currency, the lat, which is pegged to the euro.
Currency devaluation, which makes exports and manufacturing more competitive internationally, is the traditional route to this end. But the Latvian government was determined to fight devaluation—even after taking €7.5 billion ($9.9 billon) in emergency financing in 2009 from the European Commission, the IMF and a group of Scandinavian banks—because keeping the peg is a precondition for Latvia's cherished goal of adopting the euro.
Latvia instead attempted to make its goods and services cheaper by pushing down wages across the economy, a process known as internal devaluation. That is similar to what Ireland, Greece and other weaker euro zone countries are attempting to return to growth without the flexibility of their own currencies.
Some economists now question whether Latvia's peg to the euro, one of the world's strongest currencies throughout the crisis, has worked. While wages are nearly 12% below levels of a few years ago and the country's trade gap has shrunk, exports haven't risen markedly since before the crisis and manufacturers haven't gone on a hiring spree. Instead, a combination of low wages and high unemployment has the country's strapped consumers pulling back on spending.
"There's a big question as to whether the internal devaluation was effective," said Vyacheslav Dombrovsky, an economist at the Baltic International Centre for Economic Policy Studies in Riga. "We have so far not seen substantial changes in relative prices."
"It is impossible to earn money here in Latvia," said Igor Rozitis, 37, after a recent morning of work in Vermanes Garden, an elegant park in central Riga.
Mr. Rozitis is an employee in a public-works program, conceived by the Latvian government during the crisis, that pays 100 lats ($188) a month for 40 hours a week. Despite the low pay, the program has been wildly popular in this country of 2.2 million: About 69,000 people have participated since September 2009, with 46,000 more on the waiting list. With unemployment high, workers count themselves lucky to have these jobs, even though they last for only six months.
But Mr. Rozitis, who lost his job cleaning ships at Riga's docks, says 100 lats isn't enough to live on in Riga. The father of three has moved to a smaller apartment and cut other spending but says he will likely look for work in Lithuania or elsewhere in Europe when his six-month stint ends.
If internal devaluation can work anywhere, it should be here, a country with flexible labor markets featuring almost no unions. Wages in the private sector averaged 16% annual growth from 2001 through 2008, amid a decade of expansion fueled by easy credit. When the government proposed slashing public-sector wages last year, the brief protests were nothing like those staged by unions against austerity measures in Greece, Spain and elsewhere in Europe.
Government salary cuts and other efforts have helped cut overall wages in Latvia by 11.7% from October 2008 to July 2010.
But the problem, according to some economists, is that most of the wage decrease can be attributed to cuts in the public sector. Private-sector wages—the ones that would need to fall to help make Latvian exports cheaper—fell only 5.3% over the period, according to data from Eurostat, the EU's statistics agency. Latvia has demonstrated a tendency that economists have noted the world over: Wages rise much more easily than they fall.
That has been the case for wood processor Latvijas Finieris, one of the most competitive companies in one of the country's most competitive export industries. The company, whose main product is birch plywood, had losses in both 2008 and 2009. It was hit particularly hard because its competitors in Russia, Ukraine and Poland all benefited from major declines in the value of their currencies, says Uldis Bikis, Latvijas Finieris's chief executive. That made the need for wage cuts only more acute.
"For companies that are working in some regions like Russia, currency devaluation helps much faster," Mr. Bikis said. "This situation was very difficult for our company and the country. But we made much more, probably, structural changes that help for the future."
The company cut expenses by 25% from 2007 to 2009, most in nonlabor costs. Latvijas Finieris fired some employees over the past three years, but its remaining 2,100 workers are earning more on average than they did in 2007, Mr. Bikis says. The company's birch plywood sales are near to what they were in 2007, but the company's wage costs may still be too high to hire many more workers and, in turn, further spur Latvia's economy.
Latvijas Finieris's experience sheds light on another indicator that appears to support the view that Latvia is on the mend: that its once-large trade deficit, which stood at 22% of GDP in 2006, has nearly disappeared.
As the firm's roughly steady exports show, the equalization wasn't achieved by spurring sales abroad. While Latvia's exports have largely recovered from a plunge during the crisis, its falling wages, high unemployment and government spending cuts have cratered domestic consumption, slashing the country's demand for imports.
"The improvement we've seen in Latvia's international position is 90% due to a collapse in domestic demand rather than an improvement in competitiveness," said Lars Christensen, an economist at Danske Bank.
Mark Griffiths, the IMF's mission chief to Latvia, says it is unclear how much more competitive the economy has become. "What is clear is that competitiveness has improved compared to two years ago—and what's also clear is that the estimates of the competiveness improvement are very uncertain," he said. In its Thursday report, the IMF said Latvia's economy is stabilizing but that more wage cuts and "structural reforms" are needed to close the country's competitiveness gap.
Latvian wages next year are actually expected to rise, said Finance Minister Andris Vilks. "We should see in some sectors at least 3% wage increases next year," Mr. Vilks said in an interview. "That is still very moderate—it wouldn't be painful or crucial for the productivity level."
The Latvian government and central bank have stoutly defended the euro peg. Officials note that the economy has grown 2.2% so far this year while unemployment has begun to fall. They say devaluation would have made much of Latvia's euro-denominated debt unbearable, while possibly triggering currency crises across Eastern Europe.
"Let's not heat up old soup," said Latvian Central Bank Governor Ilmars Rimsevics. "For the third consecutive quarter, Latvia has experienced positive growth, which really proves that the chosen polices have been the right ones," he said in an interview.
Now that the economy is growing again, the government says, crisis measures like the 100-lat work program can be cut. But Mr. Griffiths of the IMF calls that a bad idea. "With unemployment so high, we need to strengthen social support programs, such as the 100 lats work program and health benefits for the poor," he said.
Write to Matthew Dalton at Matthew.Dalton@dowjones.com
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