The Latvian Economy
Monthly newsletter from Swedbank’s Economic Research Department
by Mārtiņš Kazāks No. 2 • June 2010
Latvian Economy
Monthly newsletter from Swedbank’s Economic Research Department, continued
No. 2 • June 2010
2 (4)
speed o...
Latvian Economy
Monthly newsletter from Swedbank’s Economic Research Department, continued
No. 2 • June 2010
3 (4)
social ...
Latvian Economy
Monthly newsletter from Swedbank’s Economic Research Department, continued
No. 2 • June 2010
4 (4)
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The Latvian Economy - 2010, June


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The Latvian Economy - 2010, June

  1. 1. 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 started Detailed 1st quarter 2010 GDP data published by the Central Statistical Bureau in mid-June 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 2010 was reported to have grown by 0.3% (quarter on quarter, seasonally adjusted). After a cumulative 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 has broken, thereby by tangible data confirming steady improvements in household and business confidence surveys seen since around mid-2009. 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 quarter is followed by contraction in another. In terms of annual growth rates, Latvian GDP in the 1 st quarter of 2010 was still 6% below its respective last year’s level. So far, we see no reason to revise our April forecast of a 2.5% year-on-year contraction in 2010. Note that this forecast includes 2% growth vis-à-vis the last quarter of 2009, and that negative annual growth is due only to a large negative carryover effect of about 4%. We expect positive annual growth rates towards the end of this year. Chart 1. GDP by expenditure 1Q2007=100, 40 60 80 100 120 1Q 07 1Q 08 1Q 09 1Q 10 GDP Households cons. Government cons. Gross fixed capital Exports Imports Source: CSBL Chart 1. GDP by expenditure 1Q2007=100, s.a. A quick browse through GDP by expenditure data seems to suggest that growth was due to the wrong reasons – exports contracted while consumption picked up. Exports are reported to have shrunk by 2% (all data in this paragraph are quarter on quarter, seasonally adjusted), while household consumption inched up by 0.7%. Even government spending was up by 0.1% despite all the fiscal consolidation efforts, and imports were up by 8.6%. Almost all growth came from inventories (reported as a single entry, together with errors and omissions) whose contribution to quarterly growth was a staggering 6.3 percentage points. While the Economic Research Department. Swedbank AB. SE-105 34 Stockholm. Phone +46 8 5859 1000. E-mail: Legally responsible publisher: Cecilia Hermansson, +46 8 5859 1588. Mārtiņš Kazāks, +371 6744 5859. Lija Strašuna, +371 6744 5875. Dainis Stikuts, +371 6744 5844.
  2. 2. Latvian Economy Monthly newsletter from Swedbank’s Economic Research Department, continued No. 2 • June 2010 2 (4) speed of contraction in gross fixed capital formation halved, it was still in deep freeze – down by 6%. Chart 2. GDP by expenditure, contributions percentage points -25 -20 -15 -10 -5 0 5 10 15 1Q 09 2Q 09 3Q 09 4Q 09 1Q 10 Households cons. Government cons. Gross fixed capital Inventories and errors Exports Imports Source: CSBL A more careful look, however, suggests that such a conclusion is misguided and the economy is not back to its old tricks of unsustainable, domestic demand-driven growth. First, we are likely to see some data revisions. Second, the underlying growth is export driven. Significant data revisions are likely For instance, it is difficult to rationalize the dynamics of the government spending deflator – during the 1st quarter of 2010 it is reported to have grown by over 24% quarter on quarter, which is by far the highest climb over the past decade (including the boom years). At the same time, public sector gross wages, which are typically used as a 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 current prices remains unchanged, impressive real consumption growth would result, which would be at odds with fiscal consolidation? Data revisions are likely to address such inconsistencies. Possible directions for revisions are lower government spending, higher investment, and/or higher household consumption. One must also mention the seasonality filter – with such sharp structural changes and business cycle volatility, its pattern is unlikely to remain unaffected. Further quarters will provide more information on the changing shape of seasonality and will ex post revise the past data. Grey economy supports consumption Why is it that in the 1st quarter employment and wages were falling, unemployment benefits were running out for an increasing number of long-term 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 and retail sector business confidence. Of course, as they were getting used to a recessionary environment and with the contraction speed slowing, households may have released some of their precautionary savings held in cash at home. We see this in the growth of household bank deposits. Chart 3. Consumption over available resources*, % of consumption 0 10 20 30 40 50 60 1Q 06 1Q 07 1Q 08 1Q 09 1Q 10 Source: Swedbank estimates * Consumption + Change in deposits stock - Income - Change in loans stock Chart 4. Retail trade turnover, % -40 -30 -20 -10 0 10 20 30 Jan.07 Jan.08 Jan.09 Jan.10 mom yoy Source: CSBL Yet, we believe that a major reason for 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
  3. 3. Latvian Economy Monthly newsletter from Swedbank’s Economic Research Department, continued No. 2 • June 2010 3 (4) social security contributions, which directly depend on wage income, shrunk. A survey made by the State Employment Agency earlier in the year found that about 20% of those found illegally employed were in the books as receivers of unemployment benefits. The widening of the grey economy should not be tolerated and requires immediate and decisive efforts by the government. Imports are export driven What drove import growth? We believe that it was significantly pushed up by export industries rebuilding their foreign input inventories. Balance sheet analysis shows that, due to a lack of funding, export industries heavily depleted their inventories over the last year and, with the recovery strengthening, were increasingly squeezed on their own deliveries by lack of inputs. To address this problem, inventories were rebuilt. In the coming quarters, this activity is most likely to slow because the inventory deficit gap must have narrowed. Chart 6. Goods exports Jan.2009 - Apr.2010, 0 10 20 30 40 50 60 70 80 90 Foodand agricultural products Wood,etc Machines and equipment Metaletc Chemical products Mineral products Others Source: CSBL Chart 5. Goods exports Jan.2009 - Apr.2010, LVL 2009 2010 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 to report negative year-on-year growth rates, for traditional tradable sectors these rates were positive.1 After a rather bleak performance early in 2010, goods exports have been picking up each month, in current prices growing by 33% year on year in April (the latest data available so far). Export order flows suggest that good performance will continue. On the other hand, exports of services have seen a gradual worsening, contracting by 9% year on year in April due to tough regional competition. 1 Seasonally adjusted data by industries are not reported; therefore, we must use annual growth rates here. Investment still weak, but infrastructure and export sectors to become more active Why is gross fixed capital formation so weak? It has shrunk by close to 60% from its peak in mid-2007 and by about 45% year on year in the 1st quarter of 2010. This fall is very much due to a stalling real estate market, formerly a major contributor. With economic activity low, manufacturing capacity utilisation is gradually rising but still at low levels on average. This situation is, however, changing. While housing activities will certainly take years to develop, the government has taken steps to speed up absorption of EU structural funds to improve infrastructure. Capacity utilisation data often are like an average temperature in a hospital – they hide hot spots. With typically very slow insolvency procedures, industrial capacity often gets stuck in between owners. By using industry average, the data often underestimate actual capacity utilisation. For instance, wood industry volume since early 2009 has grown by nearly 60%, recovering more than it lost during the crisis. Given that not all the companies survived the recession (some currently have idle plants but not gone bankrupt yet), capacity utilisation for survivals in many cases is higher than in the boom years. Such (typically export-oriented) companies are gradually looking for possibilities to invest. We expect that gross fixed capital formation will post positive quarterly growth figures towards the end of this year. Access to inexpensive funding will be crucial here. Chart 6. Consumer and business confidence -100 -80 -60 -40 -20 0 20 40 Jan.07 Jan.08 Jan.09 Jan.10 Consumer Construction Manufacturing Retail Services Source: Eurostat IMF/EC support programme on track, Latvia to borrow less Confidence continues to strengthen, which is a good indicator of further improvements in economic activity. Unemployment expectations are also gradually retreating, as is unemployment itself –
  4. 4. Latvian Economy Monthly newsletter from Swedbank’s Economic Research Department, continued No. 2 • June 2010 4 (4) registered unemployment in mid-June was down to 15.8% from its peak of 17.3% in March. Despite indications of widening income tax evasion, government tax revenues are in line with the plan as, e.g., consumption taxes perform better than forecast. Thus, the overall fiscal situation is stable. The recent IMF and EC joint review mission in June concluded that good progress is being made in stabilizing the economy. It was agreed that Latvia should continue the programme, by and large following the same criteria as previously agreed. The budget deficit is not to exceed 8.5% of GDP this year, 6% in 2011, and 3% in 2012. It was agreed that next year’s budget must include fiscal consolidation of LVL 395-440 million, about 3.5% of GDP. Part of this will be covered by the growing economy, but significant cuts in spending will still be necessary. More revenue is to be raised by eradicating the grey economy and raising taxes. The draft plan to reduce the grey economy 2 was made public in mid-June. It makes a better use of the “stick and carrot” strategy and promises to yield better results than any of the previous attempts. 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 change3 goes only halfway in shifting the tax burden away from labour income and toward 2 3 Available in Latvian consumption and real estate. The final version of this paper is due by end-June, but it is unlikely that we shall see a “true” version of it until after the October general elections. Such a delayed wake-up call for more fiscal consolidation down the line, coupled with the expected fiscal tightening in the rest of the EU towards the end of 2010, is likely to slow somewhat the speed of recovery late this year and/ or early next year. Due to its strong financial position, the Latvian government will postpone and perhaps reduce its borrowing within the IMF/ EC-coordinated support programme. This year, it aims to draw only the amount available from the IMF/ EC and World Bank (about EUR 400 million total), and take future drawing decisions on a review-by-review basis. The government intends to use EUR 1 billion from the Nordic countries as a credit line only when necessary, rather than keep all the allotment at the Treasury and pay interest on extra reserves. The recent progress of Estonia toward attaining euro membership by next year should provide an additional boost for Latvia to get its economy going and target 2014 as the year to join the euro. Mārtiņš Kazāks Swedbank Economic Research Department Balasta dambis 1a, Riga, LV 1048, Latvia Martiņš Kazāks, +371 6744 5859 Dainis Stikuts, +371 6744 5844 Lija Strašuna, +371 6744 5875 Legally responsible publisher Cecilia Hermansson, +46 88 5859 1588 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 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 use. Readers are encouraged to base any (investment) decisions on other material as well. Neither Swedbank nor its employees may be held responsible for losses or damages, direct or indirect, owing to any errors or omissions in Swedbank’s monthly newsletter. 2 3 Available in Latvian Abbreviations: EC – European Commission EU – European Union IMF – International Monetary Fund CSBL– Central Statistical Bureau of Latvia