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The Latvian Economy, February 27, 2013

The Latvian Economy, February 27, 2013

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Published by Swedbank AB (publ)
The Latvian Economy, February 27, 2013: Increase in electricity prices compensated by the decrease in transport costs influenced consumer prices the most in February
The Latvian Economy, February 27, 2013: Increase in electricity prices compensated by the decrease in transport costs influenced consumer prices the most in February

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Published by: Swedbank AB (publ) on Mar 14, 2013
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The Latvian Economy
Monthly newsletter from Swedbank’s EconomicResearch Department by Lija StrašunaNo. 1 February 27, 2013
Economic Research Department. Swedbank AB. SE-105 34 Stockholm. Phone +46 8 5859 1000.E-mail: ek.sekr@swedbank.com www.swedbank.comLegally responsible publisher: Magnus Alvesson, +46 8 5859 3341.
Mārtiņš Kazāks, +371 6744 5859. Lija Strašuna, +371 6744 5875. Kristilla Skrūzkalne
, +371 6744 5844.
Productive investments arethekey for future sustainable growth
Investments have been driving economic growth since 2011. However, after a strongperformance in early 2012, growth of gross fixed capital formation slowed markedly inthe third quarter despite quite robust economic sentiment. Most likely, investmentshave been rather weak also in the fourth quarter of 2012.
There is still a big potential and need for investment to expand. In 2011, Latvian grossfixed capital formation per inhabitant was only 66% of the EU average in purchasingpower terms, while average labour productivity was 62%. To close these gaps andpromote sustainable economic growth, more investments are needed, especially inexport capacityand public infrastructure.
The corporate sector has the means to invest, since balance sheets and profit mar-gins are comfortable. Investments of local nonfinancial corporations are expected torise gradually, but their growth willbe hindered by global uncertainty. General gov-ernment investment growth is expected to be sluggish –although the fiscal stancehas improved, the budget deficit (below 2% in 2012) still has to be cut. There are alsoless EU funds allocated for Latvia (as % of GDP) in 2014-2020.
In light of the limited private and public investment, Latvia needs to attract foreign in-vestments to support productivity convergence with developedEU countries. Rates of returns of foreign direct investment (FDI) have risen, thus highlighting opportunitiesfor larger FDI inflows, although competition with other Baltic countries is very tough.An acceleration of structural reforms and adoption of the euro in 2014 might provideanother boost for FDI.
Gross fixed capital formation (hereinafter, GFCF)has been the largest contributor to economic growthsince the beginning of 2011. However, GFCFgrowth slowed markedly in the third quarter of 2012,despite economic sentiment's staying robust. It isalso likely that investments were relatively weak inthe fourth quarter: goods’ import volumes stag-nated, and construction growth picked up only mar-ginally (from 8.3% annually in the third quarter to9.3% in the fourth).The question is whether this is a temporary pausein investment activity, and whether investments willbe able to pick up again during the coming years.Investment dynamics in a small country like Latviaare always volatile. One of the possible explana-tions for the recent slowdown in investments is thatsome large projects initiated in previous years haveended. Before undertaking new investments, busi-nesses might want to see the results (i.e., cashflows) from already-completed projects.
Investment annual growthand economic sentiment
65758595105115125-80-60-40-200204060802006200720082009201020112012Nominal GFCF growth, %Real GFCF growth, %Sentiment index (rs)
Source: Reuters,CSBL
The investment dynamics differ significantly acrossindustries. Large projects notably influenced in-vestment flows in the energy sector. For instance,costs of the second stage of reconstruction of the
The Latvian Economy 
Monthly newsletter from Swedbank’s Economic Research Department, continued No. 1 February 27, 2013
Riga cogeneration power plant TEC2 were esti-mated at EUR 360 million (just below 2% of 2011GDP); most of this occurred in 2011-2012, boostinginvestments in theenergy sector. Now, the con-struction of TEC2 is nearly over, causing a substan-tial fall of nonfinancial investment
in the sector al-ready in the third quarter of 2012 (but still up by27% in annual terms in the first nine months).Nonfinancial investments in manufacturing also fellin the third quarter, although this is partly explainedby the hike in investments in the respective quarter last year. In the first nine months of 2012, manufac-turing investments were still 7% higher than a year ago. The fall in the third quarter is mostly explainedby fewer machinery and equipment purchases. Still,dynamics differ across industries –decent growthwas observed in food, metal, and machinery, butinvestments declined in wood processing.
Contribution to annual growth of nonfinancial in-vestments (nominal) in manufacturing, pp
-80-60-40-200204060801001Q 09 1Q 10 1Q 11 1Q 12Other Machinery & equipmentBuilding & structuresNonfin. inv. growth, %
Source: CSBL
Nonfinancial investment in the third quarter of 2012fell also in state administration (fewer infrastructureprojects) but continued to rise in transport (e.g., de-veloping the rail network and expanding the capac-ity of main ports). In the first nine months of 2012,investments in these sectors were 8% and 47%,respectively, higher than a year ago.Overall, while business confidence remains surpris-ingly stable in Latvia, the external environment isstill rather uncertain. Even if it is not reflected in theconfidence indicators, anecdotal evidence suggeststhat businesses became more cautious in the sec-ond half of last year.
 Nonfinancial investment data by the CSBL include only large private and public companies with more than 50 employees.Only nonfinancial investment data are available by industries. Nonfinancial investments accounted for just above a half of GFCF in the first nine months of 2012.
Manufacturing surveys reveal that insufficient de-mand remains the main factor limiting production.Only for a negligible part of respondents are finan-cial constraints limiting their production, while ashortage of materials and/or equipment (i.e., needfor investments) is mentioned by only 8%.
Factors limiting production inmanufacturing, % of respondents
0102030405060702006 2007 2008 2009 2010 2011 2012 2013Demand EquipmentFinancial LabouNone Othe
Source: Reuters
Is there potential to invest more?
Latvia (as well as other Baltic countries) experi-enced an investment boom in 2004-2007, followingits accession to the EU.
GFCF flows per inhabitant(in purchasing poweterms), % of EU-27
   2   0   0   0   2   0   0   1   2   0   0   2   2   0   0   3   2   0   0   4   2   0   0   5   2   0   0   6   2   0   0   7   2   0   0   8   2   0   0   9   2   0   1   0   2   0   1   1
Latvia EstoniaLithuania SwedenGermany HungaryPoland Czech Rep.
Avots: Eurostat
Investment growth was biased towards the real es-tate sector. As a result, Latvian GFCF flows per inhabitant in purchasing power terms reached 92%of the EU average in 2007. During the crisis, in-vestments plummeted to 53% in 2010. The recov-ery is ongoing, but the potential for investment's
The Latvian Economy 
Monthly newsletter from Swedbank’s Economic Research Department, continued No. 1 February 27, 2013
catching up to the EU average is still there (evenmore so than to the level of Germany or Sweden).For this convergence to occur, Latvia needs to in-vest more than other countries each year. Takinginto account that the productivity level in Latvia is just about 62% of the EU average, such investmentgrowth is also necessary. However, it is of course of the utmost importance what kind of investments aremade and by whom. The largest role is obviouslythat of businesses; e.g., in 2011 investments bynonfinancial corporations made up 67% of totalGFCF.
Structure of GFCFflows in Latvia, % of GDP
   2   0   0   0   2   0   0   1   2   0   0   2   2   0   0   3   2   0   0   4   2   0   0   5   2   0   0   6   2   0   0   7   2   0   0   8   2   0   0   9   2   0   1   0   2   0   1   1
Nonfinancial corp. HouseholdsGovernment Financial corp.
Source: Eurostat
% of total
Household investments constitute only about 12%of GFCF and are mostly in residential real estate. Inthis newsletter, we limit ourselves to analysing cor-porate and government investments, since they aremoreimportant in promoting productivity growth.
Business investment is a key driver of productivityand economic growth. Currently, business invest-ments in Latvia as a share of GDP are significantlybelow the pre-crisis years, despite being higher than in many EU countries. This can partly be ex-plained by the structural changes in the economythat require investments.At the same time, however, a return to pre-crisisyears’ investment levels is not necessary per se. Apart of the investments made in the boom yearswere unproductive (e.g., residential real estate of poor-quality or never-used production facilities).Moreover, the structure of the economy is now dif-ferentwith a larger share of productive and export-ing activities.
GFCF of nonfinancial corporations, % of GDP
   2   0   0   0   2   0   0   1   2   0   0   2   2   0   0   3   2   0   0   4   2   0   0   5   2   0   0   6   2   0   0   7   2   0   0   8   2   0   0   9   2   0   1   0   2   0   1   1   2   0   1   2   f   2   0   1   3   f   2   0   1   4   f
Latvia EstoniaLithuania EU27Sweden GermanyHungary PolandCzech Rep.
Source: Eurostat
Note: Swedbankforecasts for 2012-2014,assuming constantshare of nonfinancial corporationsin GFCF.
Overall, as we have argued many times,
there is aneed for investment in the corporate sector, notleast to be able to notably expand the existing ex-port base (exports were 61% of GDP in the firstnine months of 2012, compared with 93% in Esto-nia and 81% Lithuania). Capacity utilisation in somemanufacturing sectors is at historically high levels,implying that without investments in production fa-cilities export growth cannot be sustained.
Capacity utilisation in manufacturing, %
45556575852008 2009 2010 2011 2012 1Q 13Metal products Food productsWood products Electrical equipm.Machinery & equipm. Wearing apparelTotal manufacturingaverage 2005-2007
Source: DG ECFIN
Companies also have the means to invest, sincetheir financial situation has improved. Balancesheets are in much better shape than a few yearsago –e.g., the loan-to-deposit ratio of nonfinancialcorporations had declined to 2.6 by the end of 2012
See, e.g., latest
Swedbank Economic Outlook 
(January 2012),http://www.swedbank-research.com/english/swedbank_economic_outlook/2012/q4/index.csp

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