Swedbank Analysis - June 14, 2011

Swedbank Analysis June 14, 2011Hazy inflation trends in the Baltic countries:it’s time to get lucid • Consumer price inflation in the Baltic countries during 2004-2009 was driven both by fundamental factors (e.g., price and productivity convergence with the advanced EU countries) and a mix of supply and demand factors at different stages of the business cycle. • Recent price developments in 2010-2011 are mainly driven by global commodity prices. As of local factors, there are hints that insufficient competition may also be playing a role, especially for food price inflation. • Inflation in the Baltic countries is expected to deceler- ate next year, mainly due to stabilising global commodity prices. But causes for concern are shortage of skilled labour (despite still high overall unemployment) and rising inflation expectations, which might exert upward pressure on wages. • Timely policy actions are appropriate and necessary. Structural reforms, especially in the labour market, to improve overall flexibility, cost efficiency and productivity, higher price transparency and stronger competition are some of the actions that can help to curb inflation in a sustainable way. Fiscal prudency, as well as stable and predictable tax policy are crucial too.This paper focuses on recent consumer price inflation developments inthe Baltic countries, comparing them with those in the European Union(EU). In May 2011, annual consumer price inflation reached 5.4% in Es-tonia, and 5% in Latvia and Lithuania. It is clear that global commodityprice growth has been the main factor behind the recent rise in inflation.However, it is crucial to understand what other factors affect price growthin order to forecast inflation and to know what local authorities can andshould do to curb inflation. Economic Research Department. Swedbank AB. SE-105 34 Stockholm. Phone +46-8-5859 1000 E-mail: ek.sekr@swedbank.com www.swedbank.com Legally responsible publisher: Cecilia Hermansson, +46-8-5859 7720

There are four main reasons why inflation developments are so importantto analyse. First, growth in costs of businesses and overall price level canhave a direct effect on competitiveness, which is particularly important forthe Baltic countries, since their economic recoveries are export driven.Second, since consumer price growth diminishes the purchasing powerof households and, very often, that of poorer ones relatively more, socialcohesion issues come to the fore. Third, rising inflation may serve as anearly sign of a build-up of domestic imbalances in the economy. Fourth,the exit strategy from the recent crisis for Latvia and Lithuania is the in-troduction of the euro in 2014. This implies the necessity to comply withMaastricht criteria, including the one on inflation.1. Economic backgroundThe accession of the Baltic countries to the EU in May 2004 was followed 2004-2007: boom yearsby large inflows of foreign capital and a very fast and excessive leverag-ing up of the private sector, resulting in a real estate boom-bust scenario.This process was driven by excessive optimism on future incomes,banks’ competition for market shares, and globally high risk appetite. Thecredit-to-GDP ratio grew to levels comparable to those in advancedeconomies – loans to resident households and nonfinancial corporationsin Estonia went up from 41% of GDP in 2004 to 94% in 2008, in Latviafrom 44% to 82%, and in Lithuania from 26% to 59%. In Latvia – and, to asomewhat lesser extent in Lithuania – an expansive fiscal policy has alsoplayed a role.Excessive credit growth and optimism in all three Baltic countries resultedin an unsustainable domestic demand expansion, mainly fuelled by pri-vate consumption. Wages grew faster than productivity, thereby worsen-ing external competitiveness (see Section 3 for more details). Ease ingetting credit and excessive optimism about future incomes boosted de-mand for real estate, thus causing housing prices to rise dramatically(supported also by an insufficient housing supply).Excessive growth in leverage resulted in rising current account deficits –which peaked at 22.3% of GDP in 2007 in Latvia, 14.5% in Lithuania, and17.2% in Estonia – ballooning foreign debt, and increasing vulnerability tovolatility in access to foreign financing.The correction of built-in imbalances started in 2008-2009 (real estate 2008-2009: recessionprices had started to retreat in 2007). The collapse of demand in domes-tic and foreign markets led to a dramatic fall in economic activity. Thecumulative fall in GDP was 25% in Latvia, 20% in Estonia, and 17% inLithuania. This led to an increase in unemployment and reduction inwages. In the first quarter of 2010, the unemployment rate peaked at20.4% in Latvia and 19.8% in Estonia, while in Lithuania it reached itsmaximum in the second quarter of 2010 at 18.3%. Gross averagemonthly wages declined in 2009 by 4.6% in Estonia, by 4.1% in Latvia,and by 4.4% in Lithuania.With diminished purchasing power and increased uncertainty about futureincomes, households’ willingness to spend decreased – domestic de-mand fell and savings rates increased. The household gross savings2 Swedbank Analysis • June 14, 2011

rate 1 rose most in Estonia – from 3.4% in 2008 to 13.3% in 2009; in Lat-via, over the same period, it increased from 5.0% to 9.4%, while inLithuania it soared from -2.3% to 6.6% (the savings rate was negative inall three countries in 2007). Credit overdues rose, as households losttheir incomes or incomes were significantly below those in the boomyears.The economic recovery of 2010-2011 has been export driven in all three 2010-2011: recoverycountries. From the trough in the second half of 2009 to the first quarterof 2011, GDP rose by 10.4% in Estonia, 8.2% in Lithuania, and 3.8% inLatvia. Domestic demand has remained weak, as labour markets natu-rally show signs of revival later than GDP. The structures of economieshave become more balanced, and economic restructuring is set to con-tinue (the longest path is for Latvia, where imbalances were the biggest).2. Fundamental factors that cause more rapidinflation in the Baltic countries than in the euroareaDuring 2004-2008, consumer prices 2 rose by 45% in Latvia, 29% in Esto-nia, and 26% in Lithuania. During the same period, prices in the euroarea increased by only 10%. What are the reasons behind this differ-ence? Longer-term and cyclical factors are both at work. In this section,we will look at fundamental longer-term issues and turn to cyclical factorsin the next section.Index of consumer prices, 2005=100 150 140 EU27 130 EA 120 EE LV 110 LT 100 HU PL 90 80 2004 2005 2006 2007 2008 2009 2010 2011 Source: EurostatConvergence and the Balassa-Samuelson effectThe more rapid inflation in the Baltic countries can be partly explained by As an economy improvesthe Balassa-Samuelson effect. This effect describes the mechanism of its productivity, pricethe catching-up process, when faster growth in relative productivity in levels rise …tradable sectors causes quicker wage increases, which are later transmit-ted into the nontradable sectors. This causes higher inflation in the catch-ing-up countries. The Balassa-Samuelson effect in Central and EasternEurope (CEE) has been widely analysed and by and large confirmed, seeLojschová (2003), Coudert (2004), Mihaljek and Klau (2009), and others.However, there is controversial evidence on the relative size of this effect,1 The gross savings rate of households is defined as gross savings divided by gross dis-posable income. Gross savings is the part of the gross disposable income that is not spentas final consumption expenditure (thus savings include also repayment of loans).2 Here, as well as later in the text and in the graphs, the harmonised index of consumerprices (HICP) is used (Eurostat data).Swedbank Analysis • June 14, 2011 3

because of questions about data reliability, e.g., the empirical split be-tween tradable and nontradable sectors.Another part of the convergence process is an increase in prices, as pro-ducers shift to foreign markets, where prices are higher, and thus (giventheir constrained capacity), raise prices of their output also in local mar-kets. There is nothing wrong in inflation and price convergence per se,but it becomes more dangerous if prices and wages increase faster thanproductivity, thereby worsening external competitiveness. Unfortunately,this was exactly the case in all three Baltic countries.The largest excesses were visible in Latvia, where the ratio of the com- … but price convergenceparative price level to GDP per employed peaked at 134% in 2008 (being in the Baltics was swifterat par with the EU27 average would place the value of this ratio at 100%). than productivity con-This means that prices in Latvia had converged much faster than produc- vergence in 2004-2008.tivity and GDP per capita in the years following EU accession. In Estoniaand Lithuania, the excesses were smaller, but since 2004 they have bothlost competitiveness as well, as price levels have increased faster thanproductivity. The ratio of the comparative price level to productivitypeaked in Estonia in 2008 at 111% and in Lithuania at 106% in 2009.Relative price level, % of productivity level*, 2000-2009 140 120 100 80 60 40 20 0 EA EE LV LT HU PL * Comparativ e price lev el (% of EU27) / GDP per employ ed (PPP, % of EU27) Source: Eurostat, Swedbank estimationsIn 2009, Estonia and Latvia managed to reduce this ratio – it declined to Some of the imbalances106% in Estonia and 127% in Latvia, as both countries moved towards a corrected in 2009more balanced situation. Most of the rebalancing was achieved throughdeflation. It is very likely that the situation in these countries continued toimprove in 2010 (no data available so far), mostly via productivity gains.Comparative price level indices, EU27=100 80 70 EE LV 60 LT HU PL 50 40 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 Source: Eurostat4 Swedbank Analysis • June 14, 2011

During the recession, a bigger contraction in domestic demand caused adeeper deflation in Latvia – relative price levels declined from 69.2% ofthe EU27 average in 2008 to 67.3% in 2009. The adjustment in Estoniawas also deep – from 71.2% to 69.5%. In Lithuania, however, relativeprices remained at a broadly similar level – in 2008 and 2009, they were,respectively, 60.5% and 60.7% of the EU27 average.Compared with the Baltic countries, such CEE countries as Poland andHungary had more significant corrections of relative price levels in 2009.But this was achieved via depreciation of the zloty and forint. The Balticcountries chose to hold on to their fixed exchange rate regimes vis-à-visthe euro and achieved lower relative price levels via deflation.Comparative price level indices for main product groups, EU27=100 (2009) 120 100 EE 80 LV 60 LT 40 HU 20 PL 0 Housing Food and Transport Household Clothing and non- furnishings footw ear alcoholic beverages Source: EurostatIn 2009, the average price level was still below the EU average in the Average price levels inthree Baltics: by around 30% in Estonia and Latvia, and 40% in Lithuania. the Baltics are still belowHowever, clothing and footwear in the Baltic countries was more expen- EU average.sive. One possible reason is that the Baltic markets are relatively small –because producers, wholesalers, and retailers cannot benefit fromeconomies of scale, they may be introducing higher markups than theircounterparts in Western Europe. Furthermore, lower turnover also nega-tively affects retailers’ bargaining power and their ability to obtain thelowest wholesale prices. Another reason is the popularity of market-places, where a lot of trade is unaccounted for and not taxed and thuscheaper – further reducing the ability of retailers to achieve economies ofscale. Since cheaper clothes traded in the markets are at least partly un-accounted for, their prices are not reflected in official statistics and thusinflate the average clothing price level in the country. The recent reces-sion has also increased the popularity of second-hand clothing retail.There are unexpectedly large housing cost differences in the Baltic coun-tries. Lithuania’s price level is at 43.8% of the EU average, whereas Lat-via’s housing costs are at 60.6% and Estonia’s at 71.4% of the EU aver-age. One reason why housing costs are much lower in Lithuania than inthe other Baltic countries is the widespread government scheme of hous-ing expense discounts for poor households in the former, which signifi-cantly cuts the average price paid for utilities. Furthermore, Lithuania andLatvia, unlike Estonia, apply a reduced value-added tax (VAT) on heatingservices.Consumer basket is skewed towards necessitiesUnfortunately, current global developments have a stronger impact oninflation in the Baltic countries than in the euro area. In the former, food, Stronger impact fromenergy, housing, and transport make up 50-55% of the average house- global price growthhold consumer basket, which is above the EU average (47%), especiallySwedbank Analysis • June 14, 2011 5

for food. Furthermore, poorer households spend an even bigger fractionof their income on these products. 3 This means that current inflation hitspoorer households the hardest.Weights of main product groups in consumer basket, 2011 (%) 30 25 20 EE 15 LV 10 LT 5 EA 0 Household Clothing & Transport Housing Adm. reg. Food & equipm. footw ear prices nonalcoholic beverages Source: EurostatFood and nonalcoholic beverages make up 25.9% of the average Lithua-nian’s consumer basket, and 24.6% and 23.3% of the respective basketsin Latvia and Estonia. Except for Romania, no other EU country is ashighly dependent on food prices as the Baltic countries.Not surprisingly, housing expenses in Lithuania have a lower weight inthe consumer basket than in other Baltic or European countries’ baskets.This is directly related to housing costs – as we mentioned above, hous-ing prices are relatively lower in Lithuania, as is correspondingly theweight of these expenditures in the consumer basket. It is interesting thatLithuania has not only a somewhat lower weight for heating expenses,but also the lowest weight for water supply expenditures (4% vs. 7-8% inEstonia, Latvia, and the euro area). One of the possible explanations isthe distribution of population between urban and rural areas – house-holds in urban areas more often have self-sustained houses, without cen-tral heating and water. For example, in Lithuanian urban areas, only 6%were living without baths or showers in 2009, whereas there were 36%such households in rural areas. Currently, 66.9% of Lithuanians, 67.5%of Latvians, and 69.4% of Estonians live in urban areas; however, thisstatistics is slightly distorted, as not all within the country migrants declarethe change in their living place. 4Products with administered prices make up 16% of the consumer basket Larger share of adminis-in Lithuania, and 14% in Latvia – well above Estonia and the euro area tered prices in Latviaaverage (about 11%). The list of administratively regulated prices differs and Lithuania…somewhat among the countries. For instance, Estonia is less dependenton natural gas than Latvia and Lithuania, as heating production in Estoniais mainly oil shale based (which is locally produced), while in Latvia andLithuania mainly natural gas is used.3 For instance, for pensioners in Lithuania, the share of these products in the consumerbasket is about 67%; in Latvia, about 62%.4 Administrated (administratively regulated) prices are those that are set/ approved/ moni-tored by the local or state authorities, mostly in sectors with natural monopolies, e.g.,prices of energy, public transportation, health and education, post, railways, etc. An inde-pendent state institution in each country is responsible for regulation of these prices. InLatvia, these are energy (gas, electricity, and heating), telecommunications, water supply,post, and railway. In Lithuania, institutions regulate energy, water, and public transporta-tion, and, in Estonia, energy, water, railways, and electronic and postal communications.6 Swedbank Analysis • June 14, 2011

On the one hand, the larger share of administratively regulated prices inLithuania and Latvia means higher level of state intervention; on the other … implies larger influ-hand, price regulation must ensure higher consumer protection, at least ence of local authoritiesin theory. This also means that Lithuania should have more levers than on inflation.Latvia or Estonia to control inflation, at least in the short term. But in prac-tice it does not always guarantee lowest prices. For instance, the solenatural gas supplier to Baltic countries Gazprom kept the delivery pricefor Lithuania unchanged in 2011 (arguably because of a conflict due toLithuania’s recent plans to liberalise its gas market in line with EU energypolicy), whereas for Latvia and Estonia it was reduced by 15%.3. Cyclical factors affecting inflationThe development of general economic situation and the stage of a busi-ness cycle definitely influence price trends as well. During the threestages of economic development in 2004-2011 (as outlined in Section 1),inflation was supported by a combination of different factors. In the boomyears (2004-2007), inflation was mainly demand driven. Rising globalcommodity prices in 2008 added to consumer price inflation in the Baltics(supply factors). The following recession and demand contraction causedprices to fall in 2009-2010. Currently, domestic demand is still weak andinflation is largely driven by supply factors (see the next section).Demand factorsRising private consumption definitely supported consumer price growth in Rising consumption dur-2004-2007. As already outlined in Section 1, cheap and easily receivable ing 2004-2007…credit, together with excessive optimism about future incomes of house-holds, was one of the factors that stimulated consumer demand andmade it easier for companies to increase their margins, which, in turn, af-fected the overall price level.Annual growth of credit stock and private consumption, % 75 50 Consumpt., EE Consumpt., LV Consumpt., LT 25 Credit, EE Credit, LV 0 Credit, LT -25 2004 2005 2006 2007 2008 2009 2010 Source: ReutersThe overheated labour market due to the booming local economies andthe opening up of labour markets after the Baltic countries joined the EUin 2004 (i.e., emigration to the old member states) resulted in labour de-mand sharply exceeding quality labour supply. In competition for labour,companies were outbidding each other, pushing wages above productiv-ity, which increased overall wage expectations. Households’ ability tospend improved, which put additional pressure on inflation. For instance,in 2004-2008, real gross average wages grew by 57% (while average la-Swedbank Analysis • June 14, 2011 7

bour productivity by just 17%) in Latvia, 46% (23%) in Lithuania, and 39%(13%) in Estonia. 5With the collapse of economic activity in 2008-2009, unemployment rock- … a dramatic fall in de-eted, wages declined, and consumer pessimism replaced the previous mand in 2008-2009optimism; meanwhile, households needed to repay their loans. House-hold purchasing power decreased dramatically, putting downward pres-sure on wages – with a lack of demand, firms tend to lower prices to keepthose few consumers who are still willing to spend. In Estonia, priceswere decreasing in annual terms from June 2009 until February 2010. InLatvia, the period of deflation was from October 2009 until August 2010,while the shortest period of deflation was in Lithuania – only three monthsat the beginning of 2010.Nominal gross wage annual growth, % 40 30 20 Estonia Latvia 10 Lithuania 0 -10 -20 2004 2005 2006 2007 2008 2009 2010 2011 Source: ReutersSupply factorsWage growth during the boom years affected firms’ production costs – Increase in labour costsgiven the widespread optimism engendered by productivity and wage was transferred to con-convergence with the old member states and booming consumption, ris- sumer prices in booming labour costs were easily passed onto consumers. However, such a years.swift and sustained increase in costs eroded the external competitivenessof local producers – see, e.g., Benkovskis et al (2009). In Latvia, thewage increase in 2005-2007 was higher than in the other two countries,indicating that this increase might have put more pressure on consumerprices in Latvia than in Estonia and in Lithuania (thus explaining higherinflation rates and then deeper deflation in Latvia; see the next section).5 It should be taken into account that average labour productivity had already started tofall in 2008 in Estonia and Latvia due to the decline in economic activity (in Lithuania,the fall began in 2009).8 Swedbank Analysis • June 14, 2011

Difference between real gross wage and real average labour productivity annualgrowth rates, pp 20 10 Estonia Latvia 0 Lithuania -10 -20 2004 2005 2006 2007 2008 2009 2010 2011 Source: ReutersAll three Baltic countries are small and open economies, with fixed ex- Some of the inflation haschange rates; this makes them extremely open to developments in for-eign markets. If a global shock occurs (e.g., in commodity prices), it will been imported.feed through import prices into local consumer prices. For instance, thesubstantial increase in global commodity prices (especially oil) in 2008affected import prices in all three countries and, through that, consumerprices. 6 Higher global commodity prices have not only direct effects, likean increase in prices of fuel, but also indirect effects, e.g., a rise in hous-ing tariffs (e.g., gas and heating), which are usually linked to oil price de-velopments. Benkovskis et al (2009) show that the largest changes inadministrated prices indeed accrue from changes in energy prices.Global commodity prices, 2005=100 300 150 Total 250 120 Food 200 90 Non-food agriculture* Metals 150 60 Crude oil (Brent), 100 30 USD (rs) * cotton, timber, w ool, 50 0 rubber, oils, hides 2005 2006 2007 2008 2009 2010 2011 Source: Reuters EcowinIn 2004-2008, inflation was also supported by tax harmonisation with the Tax harmonisation withEU (e.g., gradual increases in excise tax rates on tobacco, alcoholic bev- the EU added to inflationerages, and fuels). Tax hikes were also transferred by wholesalers and in the Baltics.retailers to consumer prices.6 Lithuania differs a bit from Estonia and Latvia, as it has the Mažeikiu Nafta oil refineryplant. Therefore, the share of oil products in Lithuania’s import prices is larger, whichmeans that its import prices are more vulnerable to changes in oil prices in the world mar-ket. However, the effect of this on the HICP is very small.Swedbank Analysis • June 14, 2011 9

During the crisis years, wages were reduced (see Section 1), and enter- During recession, pro-prises tried to raise effectiveness and productivity. The decrease in la- duction costs were re-bour costs allowed many firms to decrease prices as well. Global com- duced, and profit mar-modity prices also fell, thus diminishing prices of imported inputs. Theprice decrease would have been much deeper, but the governments de- gins squeezed.cided to increase their melting revenues by raising taxes (VAT, excise,income tax, etc). These were at least partially transferred into consumerprices – as the domestic demand was very weak and households ex-tremely sensitive towards the price increases (especially of necessities), 7the companies were forced to squeeze their profit margins as well.4. Current inflation trends: is there a cause forconcern?Despite the ongoing deleveraging and still high unemployment rates,which undermine consumer spending and thus put downward pressure Demand factors are stillon prices, inflation rates are again rising in all three Baltic countries. In very weak.April 2011, annual inflation reached 5.4% in Estonia, 4.4% in Latvia, and4.3% in Lithuania. 8 Inflation in Estonia accelerated well before it did in theother Baltic countries; this can partly be explained as an attempt by busi-nesses and households to pre-empt the euro effect. 9 Accession to EMUincreased household expectations and consumption, which could havecaused some demand-driven inflation. Furthermore, facing somewhatstronger demand in the second half of 2010, producers and retailers inEstonia may have been expecting scrutiny after January 1, 2011 andraised some prices in advance.Annual growth of consumer prices, % 20 16 EA 12 EE 8 LV 4 LT HU 0 PL -4 -8 2004 2005 2006 2007 2008 2009 2010 2011 Source: EurostatOne of the (supply) factors behind price growth in all three countries is Part of inflation is im-developments in world commodity markets; for instance, global foodprices have already exceeded their previous peak in 2008. Still, compar- ported.ing HICP developments across Europe, it can be seen that price growthis somewhat higher in the Baltics and CEE countries than in the euroarea.7 It is hard to say, though, how big the pass-through was – while in 2009 and early 2010,consumer prices might have risen less than taxes increased, in late 2010-early 2011 theopposite might have been the case (most likely owing to higher inflation expectations).8 In May 2011, annual growth of national consumer prices reached 5.4% in Estonia, and5% in Latvia and Lithuania (harmonised consumer price indices are not available yet).9 Estonia joined the euro zone on 1 January 2011. The official decision on this was madeby the EU authorities in July 2010.10 Swedbank Analysis • June 14, 2011

It should also be considered that the tax changes in 2010 and early 2011also influenced current annual price growth. A closer look at annual Part is due to tax hikes.growth in prices at constant tax rates (i.e., disregarding the impact of taxchanges on consumer prices) 10 indicates that inflation in Latvia is muchlower (just 2.8% vs. 4.1% in March). This is due to the January 2011changes in VAT and excise tax rates. As there were no major changes inconsumption taxes this year in Lithuania and Estonia, their inflation net oftaxes is almost the same as the usual HICP inflation (in Estonia, only theexcise for tobacco was raised, first in early 2010 and again in 2011).Annual growth of consumer prices (constant tax rates), % 20 16 EA 12 EE LV 8 LT 4 HU PL 0 -4 -8 2004 2005 2006 2007 2008 2009 2010 2011 Source: EurostatA closer look at the main product groups of the consumer basket revealsthat, currently, consumer price inflation is mainly driven by food, housing,and transport prices (especially in Latvia and Lithuania). Although thereare differences in the growth rates of prices for transport and housing be-tween the Baltic countries and the euro area, these differences are notunusually big. For instance, the annual growth of fuel prices in April 2011was 17.6% in Latvia (partly explainable by excise tax hikes), 11 15.6% inLithuania, 14.6% in the euro area, and 10.5% in Estonia (due to an earliermore rapid rise in the first half of 2010). The annual growth of housing re-lated prices was 7.3% in Latvia (partly explained by VAT changes forelectricity, gas, and heating), 6.3% in Lithuania, 5% in the euro area, and4.1% in Estonia. However, the largest differences in inflation rates areobserved for food prices, which is a topic of the next section.Contribution to annual inflation in the first quarter of 2011, pp LT LV Food Housing EE Transport Other EA EU27 Source: Eurostat, -1 0 1 2 3 4 5 6 Swedbank calculation10 This indicator reflects the theoretical influence of a change in the VAT and excise taxrates (i.e., assuming a full pass-through on prices and no second round effects).11 Unfortunately, Eurostat does not provide data on HICP at constant tax rates for particu-lar product groups.Swedbank Analysis • June 14, 2011 11

5. Current inflation trends: food inflation isdisquietingIn April 2011, food prices in Estonia were 12.2% higher than a year ago; Higher food inflation inin Latvia and Lithuania, 9.9% and 10.3% higher, respectively. These in- the Baltics than increases are much higher than in the euro area (2%), albeit similar to such EU27…Central and Eastern European countries as Hungary and Poland.Annual growth of consumer prices (food and non-alcoholic beverages), % 24 20 EA 16 EE 12 LV 8 LT HU 4 PL 0 -4 -8 2004 2005 2006 2007 2008 2009 2010 2011 Source: EurostatDemand remains weak in all three Baltic countries due to the still-high … mostly due to supplyunemployment and slow rise in wages; for instance, annual growth of re- factorstail trade turnover of food items is still negative in Latvia and just about1% in Estonia and Lithuania (at constant prices). Emigration flows alsoundermine private consumption since a shrinking population demandsless. This implies that supply factors are leading to food price growth. Aswas shown above, global commodity price growth certainly plays a role;however, the extent it influences consumer price inflation differs acrosscountries. Moreover, price developments differ for various food items. Tounderstand what is behind the more rapid growth of food prices in theBaltic countries vs. that in the euro area, it is important to examine microfactors (i.e. characteristics of particular industries) that might affect con-sumer prices.Annual growth of retail trade turnover – food, beverages, and tobacco(constant prices), s.a. % 30 20 10 EA EE 0 LV -10 LT -20 -30 2004 2005 2006 2007 2008 2009 2010 2011 Source: EurostatAnnual price growth for meat products is much lower than for food on av- Price of meat productserage, both in the Baltics and in the euro area (although somewhat more still lower than two yearsrapid in Estonia). Meat product prices in Estonia, Latvia, and Lithuania ago; growth rates areare still lower than two years ago (i.e., the peak). This can be explainedpartly by the fact that it is a more expensive good, which can be given up similar to euro area.12 Swedbank Analysis • June 14, 2011

if incomes are under pressure. Meat also has shorter due dates and can-not be kept for long. Its price mainly depends on the price of grains,which are the main source of nutrition for livestock, and labour costs.While grain prices surely were rising, producers were also cutting theirlabour costs. Another issue is regional competition – for local consump-tion, pork (which is the most popular meat) is often imported, Meanwhile,local producers mainly export their meat to Russia, as they find it difficultto compete with cheaper imported products at home.Annual growth of consumer prices (meat), % 24 20 16 EA EE 12 LV 8 LT 4 HU 0 -4 -8 2004 2005 2006 2007 2008 2009 2010 2011 Source: EurostatPrices of bread and cereals, on the other hand, have already surpassed Prices of bread and ce-previous peaks, particularly in Estonia and Lithuania. Annual inflation in reals already exceed pre-this sector in April 2011 was much more rapid in the Baltics than in theeuro area (2%):14.3% in Estonia, 7.1% in Latvia, and 12% in Lithuania. vious peaks; growth ratesPrices of bread and cereals in the Baltics follow quite closely global grain are higher than in europrice developments. However, grains and wheat are not the largest cost area.position for bread producers – the share of labour, energy, and logisticscosts is bigger. Still, the fact that Baltic producers seem to be much moreaffected by global grain price developments than European producers onaverage is a bit puzzling. It may be the case that, while retailers in theBaltics transfer the increase in producer prices straight to consumers,European retailers take part of the price increase on themselves. Anotherpossibility is differences in contract setting between farmers, producers,wholesalers, and retailers – how flexible/rigid are the terms with respectto changes in input prices as well as the length of contracts. These issuesrequire additional micro-level research, which is out of this paper’s scope.Annual growth of consumer prices (bread and cereals), % 35 30 25 EA 20 EE 15 LV 10 LT 5 HU 0 -5 -10 2004 2005 2006 2007 2008 2009 2010 2011 Source: EurostatSwedbank Analysis • June 14, 2011 13

Grain prices in Europe, EUR/t 600 500 400 Rapeseed 300 200 Milling w heat 100 0 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11 Source: FOB W-EuropeDairy product inflation poses the biggest conundrum. In April, prices ofmilk, cheese, and eggs in Lithuania exceeded those of a year earlier by The most rapid price14.6%. Corresponding prices in Estonia rose by 15%, and in Latvia by a growth for dairy prod-staggering 21%. These rates by far exceed the annual inflation of these ucts, exceeding previousproducts in the euro area (2.3%). No other country in the EU has double- peaks in Latvia anddigit inflation of dairy products; the next biggest inflation is in Bulgaria, Lithuania, after swift de-where prices are 9.4% higher than a year ago. Of course, it should be clines of 2009taken into consideration that this rapid growth in dairy prices in the Balticsfollows a period of swift price declines. However, dairy prices in Latviaand Lithuania have already exceeded their peaks of early 2008, and inEstonia have nearly reached it.Annual growth of consumer prices (milk, cheese, and eggs), % 40 30 EA 20 EE LV 10 LT 0 HU -10 -20 2004 2005 2006 2007 2008 2009 2010 2011 Source: EurostatAt the same time, the dynamics of raw milk price developments are much Raw milk prices still be-more similar across Europe. In addition, the peak price levels of early low previous peaks2008 have still not been reached. Of course, price levels differ acrosscountries, as they depend on the size and concentration of dairy marketsand regional competition, as well as purchasing power. In the Baltics, Es-tonian and Latvian farmers enjoy somewhat stronger pricing power thanthose in Lithuania, as there is a bigger share of larger farms in these twocountries. Another factor that significantly influences raw milk prices inLatvia is the strategy of Lithuanian dairy producers, who buy a largeshare of available Latvian raw milk (by offering more attractive pricesthan Latvian dairy producers), process it in Lithuania, and then sell part ofthe final production back to Latvia at lower prices than Latvian producerscan afford.14 Swedbank Analysis • June 14, 2011

Raw milk price, EUR/100kg 45 40 35 Italy 30 Germany Lithuania 25 Estonia 20 Latvia 15 10 2005 2006 2007 2008 2009 2010 2011 Source: CLALOne of the reasons why Lithuanian producers are able to do this is that Consumer dairy pricesthey enjoy larger economies of scale and have greater market power. depend on producers…Lithuania is definitely a leader in the Baltics, based on the turnover ofdairy processing companies. There is also the largest concentration inLithuania – the top four dairy producers constitute about 80% of the mar-ket. The market is most fragmented in Latvia, where the top four dairyproducers form just about 60% of the market; meanwhile, in Estonia, thisgroup accounts for about 64%. 12 Furthermore, in Latvia, capacity utilisa-tion is lower than in Estonia and Lithuania, 13 implying inefficiencies inproduction. In Estonia, an additional factor that drives prices up is theability of dairy producers to charge higher prices in the local market (asimports constitute a small share of consumption) – the recent pickup indemand from Russia has allowed Estonian dairy producers to increaseprices for exports and also motivated them to ask for higher prices in theirlocal market.Food prices depend not only on the pricing strategy and power of manu-facturers, but also on those of retailers. The retail market is quite concen- … and retailerstrated in Latvia and Lithuania, but less so in Estonia. In Lithuania, the twolargest retail chains (Maxima and Palink) account for close to 60% of themarket; in Latvia, about 55% (Rimi Latvia and Maxima Latvia); and in Es-tonia, about 43% (ETK and Rimi). 14 In Latvia and Lithuania, the two larg-est retail chains gained market shares during the last years, thus enhanc-ing their dominating position, while in Estonia the two largest lost groundsomewhat. In Latvia, all other players are very small (market shares ofless than 5% each).In the case of Latvia, recent discussions in the media and a review by the There are indicationsLatvian Competition Council 15 suggest that retail chains is the most im- that retailers might beportant and often the only possibility to distribute locally produced prod- exploiting their dominantucts; retailers thus exploit their bargaining power and impose discountson producer prices, which producers have to accept as they lack an al- position in the market,ternative way to sell their production in the local market. The Competition especially in Latvia.Council also concludes that retailers might actually gain additional profitsby passing through the increase in commodity and producer prices fullyto consumers, since retailers’ markup is usually defined in percentageterms. In Lithuania and Estonia the situation may be better since thereare more local retail chains; however, a similar cost pass-through issueexists.12 Data from annual reports of companies and national statistics.13 Industry analysts’ estimates suggest that capacity utilisation of milk manufacturers isabout 50-60% in Latvia, while close to 80-90% in Estonia and Lithuania.14 Data from annual reports of companies and national statistics.15 Latvian Competition Council (2011).Swedbank Analysis • June 14, 2011 15

A recent study by the Bank of Estonia shows that the increase in dairy There are cases when re-prices for consumers in Estonia was larger than explained by input price tailer prices are raiseddevelopments. 16 Also, the Lithuanian Competition Council in autumn more than justified by in-2010 concluded that increase in prices of raw materials did not alone ac- put price growth.count for the rise in certain food products. The Latvian CompetitionCouncil claims that, although, in the majority of cases, dairy and breadprice increases of producers and retailers are symmetric, there werecases when retailers were increasing final prices to a larger extent thanproducers. 17 When domestic demand is weak (as it currently is) and ifcompetition is high, one would expect that prices of producers and retail-ers should absorb part of the input price increases, and that final pricesshould not rise to the same extent.Overall, in these areas, we have more questions than answers. More mi-cro level data are necessary, which we do not have access to, in order todraw conclusions. However, there are hints that regional competition as-pects, as well as possibly inadequate domestic competition, have playeda role in food price developments.5. Room for improvement in product marketcompetitionResearch supports the relationship between product market competition(usually proxied by markups) and inflation, although there are different Stronger product marketopinions on whether this relationship is long-term or short-term. There are competition curbs infla-studies showing that stronger product market competition leads to a per- tion pressures…manently lower inflation rate, see, e.g., Cavelaars (2002), Przybyla andRoma (2005), but also some concluding that the intensification of compe-tition is a temporary means of curbing price increases and competitionloses its explanatory power for inflation rates when longer time spans areconsidered, e.g., Janger and Schmidt-Dengler (2010).The economic literature also points to the importance of competition in … and eases labour mar-product markets for easing labour market pressures. Namely, the less ket imbalances.competitive are product markets, the more depressing is the effect on la-bour reallocation because of less dynamic firm entry and exit (OECD,2010). Taking into account sizeable structural unemployment in the Bal-tics, labour reallocation is one of the crucial factors that might help toease potential imbalances building up in the labour market that may oth-erwise spill over into excessive wage growth and then into inflation. 18As it was shown above, there are some indications that competition prob-lems in food processing and retailing might be one of the factors behindthe more rapid price growth in the Baltic countries. These indications cer-tainly call for more detailed research. For instance, the Global Competi-tiveness Report by the World Economic Forum suggests that domesticcompetition in all three Baltic countries has worsened recently relative toother countries. Estonia scores better that Latvia and Lithuania.16 Lindpere et al (2011).17 Latvian Competition Council (2011).18 See our Swedbank Analysis (2010), “High unemployment in Latvia – is it here tostay?” for more details.16 Swedbank Analysis • June 14, 2011

Extent of domestic competition, rank out of 139 countries(1 is the best-performing country) 120 -13 change in rank -17 -16 -13 2009 -2010 100 -17 -5 -15 80 -13 EE 60 -11 -9 5 40 -5 LV 20 LT 0 competition dominance competition, Intensity of Effectiveness Extent of Domestic market monopoly of that local of anti- policy Source: Global Competitiv eness Report, 2010-2011Competition authorities have become more active recently in monitoringproduct markets (especially in Latvia and Lithuania) and inviting produc- Competition authoritiesers to complain if they face unfair terms and conditions in their contracts in the Baltics have be-with retailers. In Lithuania, a web portal was created where consumers come more active.can see maximum, minimum, and average prices for the most importantfood items in the retail network (updated each week). There have beencases in Latvia recently in which the Competition Council imposed fineson the two biggest retail chains for abusing their dominant position (e.g.,one in late 2010 regarding the dairy industry and another in January 2011regarding the bakery industry).Profit margins 19 of retailers and manufacturers have widened over thelast year. 20 In Estonia and Lithuania, these groups managed to retain Profit margins have wid-positive profitability throughout the recession. Of course, an increase in ened.profit margins does not necessarily imply a reduction in competition or anincrease in prices of final production – companies need to regain profit-ability after a crisis when the profit margins were in most cases squeezedbelow sustainable levels. Still, profit margins in manufacturing have al-ready approached the levels of 2006-2008 in Latvia and Lithuania (datafor 2010 for Estonia are not available).Profit margins, % 10 EE LV LT 8 6 4 Manufacturing 2 Domestic trade 0 -2 -4 9M 2010 9M 2010 2006-07 average 2008 2009 2006-07 average 2008 2009 2006-07 average 2008 2009 Source: ESA, Bank of Latv ia, LDS19 Calculated as a profit before tax divided by a turnover.20 It should be taken into account that a large part of manufacturing output goes to exportmarkets, where the margins could be higher and the average margin in manufacturing islikely to exceed that in domestic market.Swedbank Analysis • June 14, 2011 17

6. Inflation outlookOne of the forward-looking measures (or leading indicators) that mighthelp to forecast inflation is inflation expectations. The idea behind this isas follows: if households believe that prices will grow faster in the nearfuture, they might cut back their future consumption and increase currentconsumption. When households believe that prices will rise, they aremore ready to accept higher prices; this makes it easier for businesses toincrease their final prices. 21According to a consumer confidence survey, the share of consumers Inflation expectationswho think that prices will continue to rise in the next 12 months has risen have risen.in all three countries. Inhabitants see that prices are increasing and tendto believe that they will rise in the future as well (i.e., adaptive expecta-tions).Price expectations over next 12 months, points (balance of answers) 100 80 60 Estonia 40 Latvia 20 Lithuania 0 Euro area -20 -40 -60 2004 2005 2006 2007 2008 2009 2010 2011 Source: DG ECFINOur recent analysis using Granger tests 22 show mixed results on the link-ages between inflation expectations and actual inflation. In the case ofEstonia, the test shows that actual inflation is the explaining factor of in-flation expectations (a similar result is presented in Benkovskis et al(2009)), which might, in turn, mean that expectations in Estonia aremostly a backward-looking phenomenon. In the case of Latvia, the resultsshow no clear direction of causality – both variables include informationabout the other. In the case of Lithuania, expected inflation describes themovements of actual inflation. Therefore, one may conclude that the rela-tionship between inflation expectations and inflation differs across coun-tries. Inflation expectations certainly cannot be used as the sole leadingindicator to forecast inflation; other cyclical and fundamental factors, de-scribed above, should also be taken into consideration. However, rapidlygrowing inflation expectations (similar to the pre-crisis years) should defi-nitely be taken seriously.21 Data from DG ECFIN.22 See Swedbank discussion paper, to be published in June 2011. Granger causality testsexamine whether information in one variable helps to predict the other (i.e., they may notindicate a strong one-way relationship or the direction of the influence). Monthly datafrom 1997 till 2011 are used. Test results are available upon request.18 Swedbank Analysis • June 14, 2011

We expect prices and productivity to continue to converge in all three Bal- Inflation rates to peaktic countries with that in the advanced EU economies, and a mix of sup- this yearply and demand factors to drive inflation in the nearest future. We are ofthe opinion that annual inflation in all three Baltic countries will peak thisyear. It should be emphasized that we do not see a risk of uncontrolled,runaway inflation; however, we do see certain risks that might cause amore rapid inflation than our base scenario assumes.The influence of demand-side factors is still very weak, although eco- Demand-side factors willnomic recovery is on the way in all countries. In the first quarter of 2011, become more importantEstonia’s GDP was 8.5% higher than a year ago, Lithuania’s GDP rose in the near future...by 6.9%, and Latvia’s by 3.5%. Labour markets are slowly improving, asare consumer expectations (wage expectations are rising, and fear of un-employment decreasing), and consumer spending is expected to growslowly. At the same time, deleveraging and growing consumer prices arehindering households’ willingness to spend. Banks have become moreconservative in issuing loans than in the boom years but willingness tolend is gradually improving. The outlook for the next two years has im-proved, and the impact of demand-side factors will gradually grow as allthree economies continue recovering (a bit slower in Latvia than in Esto-nia and in Lithuania).Supply-side factors will also play a significant role. The main one is global … but supply-side factorsprices of commodities and energy, especially as food, transport, and will still play a role.housing constitute a large share of consumer expenditures. We expect oiland food prices to grow much more slowly next year, partly owing to theslowdown in emerging economies; 23 however, the uncertainty with regardto this forecast is high. Labour costs will also grow, thereby increasingproduction costs, but this growth, at least for now, is expected to be slow.We anticipate inflation rates to fall somewhat in 2012: in Estonia, from3.8% this year to 3.2% next year; in Latvia, from 4.2% to 2.6%; and, in Inflation rates to fall nextLithuania, from 3.2% to 2.5%. These are April 2011 forecasts, and it is year, but there are riskslikely that we will revise our 2011 forecast upwards somewhat in August. to this forecast.This is our base scenario, which is, however, prone to several risks (es-pecially on the supply side): • There is a concern that imbalances might build up again in the labour markets. For instance, wages were already growing in line with productivity in Estonia and Latvia in the first quarter of this year (see the graph on page 9). In an environment of free labour mobility (and wages in the advanced EU countries that are significantly higher than those in the Baltics), growing economies (which will need larger labour forces), and poor labour supply (due to emigration, structural unemployment, aging populations, and lack of immigration policies), there is a risk that labour demand in the Baltics will significantly exceed the labour supply, and, consequently, that wage growth will exceed that of productivity. Especially taking into account that it will be impossible to hold up such swift productivity growth rates as in the beginning of recovery period – it can be seen that productivity growth is already slowing. Of course, given the recent experience, both fiscal policy and bank lending in the foreseeable future will be more conservative and will not support a buildup of such imbalances as in 2005–2007; nevertheless, it seems that the labour market may still be vulnerable to the same old ills that spurred inflation previ- ously.23 See Swedbank’s latest Energy and Commodities: May 16, 2011, April 15, 2011, as wellas Swedbank Economic Outlook, April 2011Swedbank Analysis • June 14, 2011 19

• There is a very high uncertainty with regard to global commodity price developments. It is hard to predict how the political situation in the Middle East and North Africa will evolve, or what will hap- pen with agricultural production (weather conditions, protection- ism risks, etc.). A more rapid global price growth would result in more expensive imports in the Baltics and, thus, higher consumer prices. • Domestic competition might become a more serious problem. There is a risk that, given the opportunity to raise prices (which, with the rising inflation expectations, is likely), retailers may aim to return to profit margins seen in the boom years more quickly than economic fundamentals would justify.It can be seen that, for Latvia and Lithuania, the 2012 inflation forecasts 24are already on the margin of not fulfilling the Maastricht criterion, imply- Policy action is neededing that close monitoring of price developments is necessary and that the to curb inflation.authorities should step in to ensure that the countries actually introducethe euro in 2014. This stepping in should not be seen as a one-off ma-nipulation, as this would not be perceived as sustainable and would nothelp to fulfil the Maastricht criterion. In Estonia, the more topical issuesrelated to the relatively high inflation rates are external competitivenessand social cohesion. The next, and concluding, section thus makes policysuggestions to local authorities for reducing inflation rates.7. Policy options: what to do and not to do to curbinflationUndoubtedly, the recent rise in inflation in Estonia, Latvia, and Lithuaniato a large extent has been driven by commodity price growth in the worldmarkets, which local authorities, businesses, and households cannotinfluence. However, there are also domestic issues that can and shouldbe addressed – by doing so it is possible to reduce price pressures.There are three policy areas in which action can be taken to address theinflation problem: monetary, fiscal, and structural policies. By alteringbank reserve requirements, adjusting interest rates, and raising publicawareness of the issue, a central bank can affect inflation and itsexpectations. However, given the existing exchange rate regimes,monetary policy is largely exogenous in the Baltic countries, having onlya very remote and indirect impact on inflation dynamics. Fiscal policy,especially in Latvia and Lithuania, is constrained by the necessity to carryon with budget consolidation – its main avenue to curb inflation is via thedeflationary effects of expenditure cuts and the clear communication offuture actions so as to reduce uncertainty and inflation expectations.Thus, the most versatile and influential – but, unfortunately, also the mostcomplex and time-consuming – policy area is structural policy, whichextends over a wide range of fields: competition, corruption, labourmarket, etc. To have a strong and lasting result on inflation, all threepolicy areas must be explored concurrently.One of the major issues is competition policy and the transparency of a DO: strengthen competi-price formation mechanism. Strengthening competition, especially tion and improve pricebetween retailers, would weaken their ability to raise profit margins andpass cost increases on to consumers. Measures include strengthening transparency24 12-month average inflation should not exceed the result of the three best-performingEU countries (i.e., those with the lowest inflation) by more than 1.5 percentage points.According to the autumn 2010 forecasts of the European Commission, this criterion couldbe about 2.4% in 2012.20 Swedbank Analysis • June 14, 2011

Competition Councils’ capacity to monitor the market’s micro structure inorder to identify abuses of the dominant position, easing entry of newmarket players, and making it easier for consumers to compare pricesacross shops (e.g., online weekly monitor of average, maximum, andminimum prices of the main food items has been introduced in Lithuania).Bringing competition into the public sector service provision (e.g., byprivatisation and/ or introduction of “money follows” schemes, likestudents’ vouchers in Lithuania) is yet another solution.The source of the problem should not be misunderstood, though. Forinstance, in Lithuania, an outright regulation of mark-ups has beenproposed several times (especially when elections approach). Althoughthe setting markups is a must in administratively regulated sectors, itwould by and large be a mistake to try to enforce similar regulations inthe private sector – a well-designed and strong competition policy wouldprovide a more efficient, transparent and sustainable solution.Another area where improvements can be made is by raising productivity DO: raise productivityand cost efficiency. Whatever permits to cut costs will lower prices if and cost efficiencycompetition is fierce. This certainly is in the companies’ competence, butauthorities can support and speed up this process by lifting administrativebarriers and encouraging a more effective and targeted acquisition of EUfunds. Given that energy costs have been particularly volatile and directly(e.g., heating) and/ or indirectly (e.g., as food producers’ costs) form akey part of HICP, improving energy efficiency in order to reduce energydependency should be one of the key objectives (especially since EUfunds support this objective). It also includes strengthening the capacity 25of the regulatory authorities that oversee monopolies and the provisionof public services to set the lowest possible tariffs by being able tocarefully vet their cost structures.The factor that has definitely added to inflation during the last two years istax hikes. Further government budget consolidation attempts in Latvia DO NOT: increase taxand Lithuania must exclude tax burden increases (especially that of VAT burdenand excises) and centre on expenditure cuts and the eradication of theshadow economy. Unfortunately, the shadow economy has expanded inall three countries. This, however, does not preclude a rebalancing of theoverall tax burden by, for instance, reducing labour taxes to foster jobcreation and compensating for this reduction by raising the real estatetax. For instance, a decrease in labour taxes is planned in 2013 inEstonia. A clear and timely communication of tax changes (or none ofthem) is crucial to diminish consumers’ inflation expectations.One of the measures recently discussed in the Latvian media to curb DO NOT: freeze wagesinflation is a wage freeze in the public sector (and possible agreementswith social partners to do the same in the private sector). We are of theopinion that such a measure would clearly be counterproductive andmisplaced – inflation is driven predominately by supply-side factors, whileprivate consumption remains very weak. Furthermore, when wage growthis justified by productivity gains (which is currently the case in the Baltics,especially in the exporting sectors), wage growth controls in the privatesector with free labour market mobility would simply boost emigration andpush wages even higher, due to the lack of labour. It should be noted thatthe current slow income growth is largely “eaten up” by inflation, andhouseholds’ purchasing power is thus improving only marginally.Yet, keeping a close track of labour market developments is important DO: improve labourand should not be underestimated. To reduce the labour market risks market efficiency anddescribed in the previous section, reforms in labour markets must sustainability25 The Public Utilities Commission in Latvia, Regulatory Division of Competition Au-thority in Estonia, and National Control Commission for Price and Energy in Lithuania.Swedbank Analysis • June 14, 2011 21

deepen. To mention just a few of the major avenues for economic policyaction: cut structural unemployment by improving skills of job seekersand support labour reallocation between sectors and regions (inside thecountries), discuss and design skills based immigration policies, andpromote the alignment of wage growth with that of the underlying labourproductivity. Lija Strašuna Mārtiņš Kazāks Nerijus Mačiulis Annika Paabut22 Swedbank Analysis • June 14, 2011

AbbreviationsCEE – Central and Eastern EuropeDG ECFIN – European Commissions Directorate-General for EconomicEA – Euro areaEE – EstoniaEMU – European Monetary UnionESA – Statistics EstoniaEU – European UnionHICP – Harmonized index of consumer pricesHU – HungaryLDS – Lithuanian Department of StatisticsLT – LithuaniaLV – LatviaPL – PolandReferencesBenkovskis, K., Kulikov, D., Paula, D., Ruud, L. ”Inflatsioon Balti riikides”[”Inflation in Baltic States”], Kroon ja Majandus 2/2009, Bank of EstoniaCavelaars, Paul (2002), “Does competition enhancement have perma-nent inflation effects?”, De Nederlandsche Bank Research reportCoudert, V. (2004). Measuring the Balassa-Samuelson effect for thecountries of Central and Eastern Europe? Banque de France Bulletin Di-gest.Ed. Lindpere, M. (co-authors Soosaar, O., Pungas, K., Lambing, M.)“Kuidas Eesti toiduaineteturg turuosalisi teenib? Valik mõttearendusi”[“How food market serves the market participants? Selection of lines ofreasoning”] May 2011, Bank of EstoniaJanger, Jürgen, Philipp Schmidt-Dengler (2010), ”The relationship be-tween competition and inflation”, Monetary policy and the economyQ1/10, Austrian Central Bank, p.53-65Latvian Competition Council (2011). “Secinājumi par piena produktu unmaizes tirgu” (Conclusions about dairy and bakery markets),http://www.kp.gov.lv/uploaded_files/KPPP085PienaSecinajumi.pdf (inLatvian)Lojschová, A. (2003). Estimating the Impact of Balassa-Samuelson Effectin Transition Economies.Mihaljek, D. and Klau, M. (2009). Catching Up and Inflation in the Balticsand Southeastern Europe: the Role of Ballasa-Samuelson effect.OECD (2010), “Moving beyond the jobs crisis,” OECD Employment Out-look 2010, Chapter 3: Institutional and policy determinants of labour mar-ket flowsPrzybyla, Marcin, Moreno Roma (2005), Does product market competi-tion reduce inflation? Evidence from EU countries and sectors, WorkingPaper No. 453, European Central BankSwedbank Analysis • June 14, 2011 23

Economic Research DepartmentSwedenCecilia Hermansson +46 8 5859 7720 cecilia.hermansson@swedbank.seGroup Chief EconomistChief Economist, SwedenMagnus Alvesson +46 8 5859 3341 magnus.alvesson@swedbank.seSenior EconomistJörgen Kennemar +46 8 5859 7730 jorgen.kennemar@swedbank.seSenior EconomistAnna Ibegbulem +46 8 5859 7740 anna.ext.ibegbulem@swedbank.seAssistentEstoniaAnnika Paabut +372 888 5440 annika.paabut@swedbank.eeActing Chief EconomistElina Allikalt +372 888 1989 elina.allikalt@swedbank.eeSenior EconomistLatviaMārtiņš Kazāks +371 6 744 5859 martins.kazaks@swedbank.lvDeputy Group Chief EconomistChief Economist, LatviaDainis Stikuts +371 6 744 5844 dainis.stikuts@swedbank.lvSenior EconomistLija Strašuna +371 6 744 5875 lija.strasuna@swedbank.lvSenior EconomistLithuaniaNerijus Mačiulis +370 5 258 2237 nerijus.maciulis@swedbank.ltChief Economist, LithuaniaLina Vrubliauskienė +370 5 258 2275 lina.vrubliauskiene@swedbank.ltSenior Economist24 Swedbank Analysis • June 14, 2011

DisclaimerThis research report has been prepared by economists of Swedbank’s Economic Re-search Department. The Economic Research Department consists of research units inEstonia, Latvia, Lithuania, and Sweden, is independent of other departments of Swed-bank AB (publ) (“Swedbank”) and responsible for preparing reports on global and homemarket economic developments. The activities of this research department differ fromthe activities of other departments of Swedbank, and therefore the opinions expressed inthe reports are independent from interests and opinions that might be expressed byother employees of Swedbank.This report is based on information available to the public, which is deemed to be reli-able, and reflects the economists’ personal and professional opinions of such informa-tion. It reflects the economists’ best understanding of the information at the moment theresearch was prepared and due to change of circumstances such understanding mightchange accordingly.This report has been prepared pursuant to the best skills of the economists and with re-spect to their best knowledge this report is correct and accurate, however neither Swed-bank nor any enterprise belonging to Swedbank or Swedbank directors, officers, or otheremployees or affiliates shall be liable for any loss or damage, direct or indirect, based onany flaws or faults within this report.Enterprises belonging to Swedbank might have holdings in the enterprises mentioned inthis report and provide financial services (issue loans, among others) to them. Aforemen-tioned circumstances might influence the economic activities of such companies and theprices of securities issued by them.The research presented to you is of an informative nature. This report should in no waybe interpreted as a promise or confirmation of Swedbank or any of its directors, officers,or employees that the events described in the report shall take place or that the forecaststurn out to be accurate. This report is not a recommendation to invest into securities or inany other way enter into any financial transactions based on the report. Swedbank andits directors, officers, or employees shall not be liable for any loss that you may suffer asa result of relying on this report.We stress that forecasting the developments of the economic environment is somewhatspeculative in nature, and the real situation might turn out different from what this reportpresumes.IF YOU DECIDE TO OPERATE ON THE BASIS OF THIS REPORT, THEN YOU ACTSOLELY ON YOUR OWN RISK AND ARE OBLIGED TO VERIFY AND ESTIMATE THEECONOMIC REASONABILITY AND THE RISKS OF SUCH ACTION INDEPEND-ENTLY.

Swedbank Analysis - June 14, 2011

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