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The Latvian Economy

Monthly newsletter from Swedbank’s Economic Research Department

by Mārtiņš Kazāks No. 2 • June 2010

Recession is over, robust recovery still to root in

• After eight quarters of uninterrupted contraction and a cumulative drop of about 25%
from the business cycle peak in 2007, Latvian GDP in the 1st quarter of 2010 grew
by 0.3% (seasonally adjusted, quarter on quarter). The recession was ended by
export-related growth and, to some extent, also by income tax evasion that
supported household consumption.
• The recent IMF/ EC joint review mission concludes that good progress is being
made in stabilizing the Latvian economy; the programme remains on track.
Government finances are relatively stable. Due to a stronger financial position,
Latvia intends to slow the speed of borrowing and perhaps will borrow less from
foreign donors than previously forecast.
• The Ministry of Finance has produced a reasonably good policy paper on how to
tackle the grey economy. In contrast, the draft tax policy paper goes only halfway,
but it is somewhat naïve to expect a “true” tax policy overhaul plan until after the
October general elections.

Recession is over and fragile recovery has Chart

1Q2007=100, s.a.
Detailed 1 quarter 2010 GDP data published by
the Central Statistical Bureau in mid-June 100
confirmed our view that the economy had hit rock
bottom late last year. After eight quarters of
uninterrupted contraction, GDP in the 1st quarter of 80
2010 was reported to have grown by 0.3% (quarter
on quarter, seasonally adjusted). After a cumulative 60
drop of 25% from the business cycle peak in late
2007, this sounds more like stabilisation, not
growth. Yet, it does show that the downward trend 40
1Q 07 1Q 08 1Q 09 1Q 10
has broken, thereby by tangible data confirming GDP Households cons.
steady improvements in household and business Government cons. Gross fixed capital
confidence surveys seen since around mid-2009. Exports Imports Source: CSBL
The economy is clearly on track to recovery, but
growth will be fragile at the beginning – for at least
a few quarters, we may see that expansion in one A quick browse through GDP by expenditure data
quarter is followed by contraction in another. seems to suggest that growth was due to the wrong
reasons – exports contracted while consumption
In terms of annual growth rates, Latvian GDP in the picked up. Exports are reported to have shrunk by
1 quarter of 2010 was still 6% below its respective 2% (all data in this paragraph are quarter on
last year’s level. So far, we see no reason to revise quarter, seasonally adjusted), while household
our April forecast of a 2.5% year-on-year consumption inched up by 0.7%. Even government
contraction in 2010. Note that this forecast includes spending was up by 0.1% despite all the fiscal
2% growth vis-à-vis the last quarter of 2009, and consolidation efforts, and imports were up by 8.6%.
that negative annual growth is due only to a large Almost all growth came from inventories (reported
negative carryover effect of about 4%. We expect as a single entry, together with errors and
positive annual growth rates towards the end of this omissions) whose contribution to quarterly growth
year. was a staggering 6.3 percentage points. While the

Economic Research Department. Swedbank AB. SE-105 34 Stockholm. Phone +46 8 5859 1000.
Legally responsible publisher: Cecilia Hermansson, +46 8 5859 1588.
Mārtiņš Kazāks, +371 6744 5859. Lija Strašuna, +371 6744 5875. Dainis Stikuts, +371 6744 5844.
Latvian Economy
Monthly newsletter from Swedbank’s Economic Research Department, continued

No. 2 • June 2010

speed of contraction in gross fixed capital formation Grey economy supports consumption
halved, it was still in deep freeze – down by 6%.
Why is it that in the 1st quarter employment and
Chart 2. GDP by expenditure, contributions wages were falling, unemployment benefits were
percentage points running out for an increasing number of long-term
15 unemployed, and the credit stock was shrinking, but
household consumption was recovering? Better
household consumption is no data fluke and is well
backed up by, e.g., improving retail trade turnover
0 and retail sector business confidence. Of course, as
-5 they were getting used to a recessionary
-10 environment and with the contraction speed
-15 slowing, households may have released some of
their precautionary savings held in cash at home.
We see this in the growth of household bank
1Q 09 2Q 09 3Q 09 4Q 09 1Q 10 deposits.
Households cons. Government cons.
Gross fixed capital Inventories and errors Chart 3. Consumption over available
Exports Imports Source: CSBL resources*, % of consumption

A more careful look, however, suggests that such a 50
conclusion is misguided and the economy is not
back to its old tricks of unsustainable, domestic 40
demand-driven growth. First, we are likely to see 30
some data revisions. Second, the underlying growth
is export driven. 20

Significant data revisions are likely
For instance, it is difficult to rationalize the 1Q 06 1Q 07 1Q 08 1Q 09 1Q 10
dynamics of the government spending deflator – * Consumption + Change in deposits stock - Income -
during the 1st quarter of 2010 it is reported to have Change in loans stock
Source: Swedbank estimates
grown by over 24% quarter on quarter, which is by
far the highest climb over the past decade
Chart 4. Retail trade turnover, %
(including the boom years). At the same time, public
sector gross wages, which are typically used as a 30
guide for this deflator, were contracting by 3.7%. If
deflator dynamics is put more in line with the wage
growth pattern and if government consumption in 10
current prices remains unchanged, impressive real
consumption growth would result, which would be
at odds with fiscal consolidation? Data revisions are -10
likely to address such inconsistencies. Possible -20
directions for revisions are lower government
spending, higher investment, and/or higher -30
household consumption. -40
Jan.07 Jan.08 Jan.09 Jan.10
One must also mention the seasonality filter – with
mom yoy
such sharp structural changes and business cycle
volatility, its pattern is unlikely to remain unaffected. Source: CSBL
Further quarters will provide more information on
the changing shape of seasonality and will ex post Yet, we believe that a major reason for
revise the past data. consumption growth is the widening of the grey
economy. Income tax evasion boosts incomes,
which translate into higher consumption. This
hypothesis is supported by tax revenue data – the
value-added tax registered improvement whereas

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Latvian Economy
Monthly newsletter from Swedbank’s Economic Research Department, continued

No. 2 • June 2010

social security contributions, which directly depend Investment still weak, but infrastructure
on wage income, shrunk. A survey made by the and export sectors to become more active
State Employment Agency earlier in the year found
that about 20% of those found illegally employed Why is gross fixed capital formation so weak? It has
were in the books as receivers of unemployment shrunk by close to 60% from its peak in mid-2007
benefits. The widening of the grey economy should and by about 45% year on year in the 1st quarter of
not be tolerated and requires immediate and 2010. This fall is very much due to a stalling real
decisive efforts by the government. estate market, formerly a major contributor. With
economic activity low, manufacturing capacity
Imports are export driven utilisation is gradually rising but still at low levels on
average. This situation is, however, changing.
What drove import growth? We believe that it was While housing activities will certainly take years to
significantly pushed up by export industries develop, the government has taken steps to speed
rebuilding their foreign input inventories. Balance up absorption of EU structural funds to improve
sheet analysis shows that, due to a lack of funding, infrastructure. Capacity utilisation data often are like
export industries heavily depleted their inventories an average temperature in a hospital – they hide
over the last year and, with the recovery hot spots. With typically very slow insolvency
strengthening, were increasingly squeezed on their procedures, industrial capacity often gets stuck in
own deliveries by lack of inputs. To address this between owners. By using industry average, the
problem, inventories were rebuilt. In the coming data often underestimate actual capacity utilisation.
quarters, this activity is most likely to slow because For instance, wood industry volume since early
the inventory deficit gap must have narrowed. 2009 has grown by nearly 60%, recovering more
than it lost during the crisis. Given that not all the
Chart 6.
5. Goods exports
exports Jan.2009
Jan.2009 - Apr.2010,
Apr.2010, LVL companies survived the recession (some currently
90 have idle plants but not gone bankrupt yet),
80 capacity utilisation for survivals in many cases is
70 higher than in the boom years. Such (typically
60 export-oriented) companies are gradually looking
50 for possibilities to invest. We expect that gross fixed
40 capital formation will post positive quarterly growth
30 figures towards the end of this year. Access to
20 inexpensive funding will be crucial here.
0 Chart 6. Consumer and business confidence
Metal etc



Wood, etc


Food and



2009 2010 0
Source: CSBL
Analysis of GDP by value added shows that export
industries remain the key driver of recovery – while
all nontradable sectors in the 1st quarter continued -60
to report negative year-on-year growth rates, for -80
traditional tradable sectors these rates were
positive. 1 After a rather bleak performance early in -100
Jan.07 Jan.08 Jan.09 Jan.10
2010, goods exports have been picking up each
Consumer Construction
month, in current prices growing by 33% year on Manufacturing Retail
year in April (the latest data available so far). Export Services Source: Eurostat
order flows suggest that good performance will
continue. On the other hand, exports of services
have seen a gradual worsening, contracting by 9% IMF/EC support programme on track, Latvia
year on year in April due to tough regional to borrow less
Confidence continues to strengthen, which is a
good indicator of further improvements in economic
Seasonally adjusted data by industries are not reported; activity. Unemployment expectations are also
therefore, we must use annual growth rates here. gradually retreating, as is unemployment itself –

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Latvian Economy
Monthly newsletter from Swedbank’s Economic Research Department, continued

No. 2 • June 2010

registered unemployment in mid-June was down to consumption and real estate. The final version of
15.8% from its peak of 17.3% in March. this paper is due by end-June, but it is unlikely that
we shall see a “true” version of it until after the
Despite indications of widening income tax evasion, October general elections. Such a delayed wake-up
government tax revenues are in line with the plan call for more fiscal consolidation down the line,
as, e.g., consumption taxes perform better than coupled with the expected fiscal tightening in the
forecast. Thus, the overall fiscal situation is stable. rest of the EU towards the end of 2010, is likely to
slow somewhat the speed of recovery late this year
The recent IMF and EC joint review mission in June and/ or early next year.
concluded that good progress is being made in
stabilizing the economy. It was agreed that Latvia Due to its strong financial position, the Latvian
should continue the programme, by and large government will postpone and perhaps reduce its
following the same criteria as previously agreed. borrowing within the IMF/ EC-coordinated support
The budget deficit is not to exceed 8.5% of GDP programme. This year, it aims to draw only the
this year, 6% in 2011, and 3% in 2012. It was amount available from the IMF/ EC and World Bank
agreed that next year’s budget must include fiscal (about EUR 400 million total), and take future
consolidation of LVL 395-440 million, about 3.5% of drawing decisions on a review-by-review basis. The
GDP. Part of this will be covered by the growing government intends to use EUR 1 billion from the
economy, but significant cuts in spending will still be Nordic countries as a credit line only when
necessary. More revenue is to be raised by necessary, rather than keep all the allotment at the
eradicating the grey economy and raising taxes. Treasury and pay interest on extra reserves.
The draft plan to reduce the grey economy was The recent progress of Estonia toward attaining
made public in mid-June. It makes a better use of euro membership by next year should provide an
the “stick and carrot” strategy and promises to yield additional boost for Latvia to get its economy going
better results than any of the previous attempts. and target 2014 as the year to join the euro.
One of its weak points is its feeble integration with
the proposed changes in tax policy. This needs to
be improved. The current draft paper on tax policy
change 3 goes only halfway in shifting the tax Mārtiņš Kazāks
burden away from labour income and toward

Available in Latvian

EC – European Commission
EU – European Union
IMF – International Monetary Fund
CSBL – Central Statistical Bureau of Latvia

Economic Research Department Swedbank’s monthly newsletter is published as a service to our customers. We believe that
we have used reliable sources and methods in the preparation of the analyses reported in
Balasta dambis 1a, Riga, LV 1048, Latvia this publication. However, we cannot guarantee the accuracy or completeness of the report and cannot be held responsible for any error or omission in the underlying material or its
Martiņš Kazāks, +371 6744 5859 use. Readers are encouraged to base any (investment) decisions on other material as well.
Dainis Stikuts, +371 6744 5844 Neither Swedbank nor its employees may be held responsible for losses or damages,
Lija Strašuna, +371 6744 5875 direct or indirect, owing to any errors or omissions in Swedbank’s monthly newsletter.
3 responsible
Available publisher
in Latvian
Cecilia Hermansson, +46 88 5859 1588

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