The Latvian EconomyMonthly newsletter from Swedbank’s Economic Research Departmentby Lija Strašuna, Mārtiņš Kazāks, Dainis Stikuts No. 6 • 4 August 2011Restocking has nearly petered out; future economic growth todepend on fundamentals • In 2010, economic growth was strongly supported by restocking – businesses needed to rebuild inventories that had been depleted during the crisis. Similar developments were observed in other countries as well. Changes in inventories added nearly 6 percentage points to Latvian growth last year. • GDP growth slowed in the first quarter of 2011, mostly due to the pickup in imports and the slowdown in inventory buildup. Growth is expected to have picked up again in the second quarter of the year; however, such growth will be more difficult to achieve in the future because the post-recession rebound effect is fading. • Future economic growth will not be driven as much by inventory rebuilding. The pace of GDP growth will depend on economic fundamentals, i.e., consumption, investments in fixed assets, and exports. Faster implementation of broad reforms in the labour market, education, and the business environment can substantially promote economic development.Economic growth slowed in the first quarter of 2011, liquidity problems and/or expecting further drops infrom average quarterly growth of 0.9% (seasonally demand, slashed their inventories to levels belowadjusted) in 2010 in annual terms to just 0.3%. In what would typically correspond to the thenannual terms, GDP growth was 3.5% in the first economic activity. With economic growth resumingquarter (not seasonally adjusted). A pickup in and the financial situations of businessesimports made the net export contribution negative improving, they had to restore their inventories todespite continuous export growth. “normal” levels, in line with economic activity (i.e., demand and production). As this inventoryEconomic growth is expected to have picked up in undershoot is corrected for, restocking naturallythe second quarter of this year, owing to the comes to an end; future economic growth will thuscontinuing good export performance, the pickup in depend on the fundamental strength of theinvestment, and recovering household economy, i.e., consumption, investments, andconsumption. However, the so-called rebound exports.effect that had been observed in the early recoverystage is now fading. For instance, last year, Contribution to GDP annual growth, ppeconomic growth was very much supported by therestocking of businesses – changes in inventories 30added nearly 6 percentage points to GDP growth in 20 12010 (the net export contribution was just 0.6 10percentage point) – which is now coming to anend.. 0 -10We define restocking here as the following process. -20During the recession, businesses, running into -301 -40 The Central Statistical Bureau (CSBL) calculates inventories 1Q 07 1Q 08 1Q 09 1Q 10 1Q 11as a residual when balancing national accounts. This implies Households Governmentthat data on inventories also contain possible errors and/or Gross fixed capital form. Inventoriesomissions. It is thus not possible to estimate how large is the Net exports GDP growtherror and how large are actual changes in inventories per se. It Source: CSBLis also not known how big inventories are in exporting vs.domestic demand sectors. Economic Research Department. Swedbank AB. SE-105 34 Stockholm. Phone +46 8 5859 1000. E-mail: firstname.lastname@example.org www.swedbank.com Legally responsible publisher: Cecilia Hermansson, +46 8 5859 7720. Mārtiņš Kazāks, +371 6744 5859. Lija Strašuna, +371 6744 5875. Dainis Stikuts, +371 6744 5844.
The Latvian Economy Monthly newsletter from Swedbank’s Economic Research Department, continued No. 6 • 4 August 2011What is the inventory cycle? Changes in inventories, contribution to annual GDP growth* (pp)The inventory cycle can be observed not only in 15 1.5Latvia, but also in other countries. In the economicliterature, there are two major theories of why firms 10 1.0invest in inventories: the production-smoothingtheory (to reduce production costs under demand 5 0.5uncertainty) and the stockout-avoidance theory (to 0 0.0avoid possible losses if production cannot respondimmediately to a sudden increase in demand). 2 -5 -0.5Investments in inventories/stocks are usuallyprocyclical, i.e., businesses normally accumulate -10 -1.0stocks in times of increasing demand and reducestocks in times of recession. -15 -1.5 -10 -8 -6 -4 -2 0 2 4 6 8 10 EE LV LT EA (rs) EU27 (rs)Volatility in inventories is high and can influence * 0 denotes the 1st quarter of recession forGDP growth substantially – negatively when each country Source: Eurostatdemand and production decrease and positivelywhen the economy starts to recover from recession.During times of falling demand, it is natural to sell Similar trends can be observed in data fromout the stocks as production and sales retreat. business confidence surveys – managers’When recovery commences, there is usually a assessment of current stock of finished products instrong temporary boost from inventories to industry returned to the 2006 level in the first half ofeconomic growth, as companies not only need to 2011. Although the majority of manufacturers sayrebuild the reserves depleted during crisis times that the current stock level is below normal, this has(i.e., restocking), but also to increase their stocks also been true for pre-crisis years. It is very hard tofacing a rise in demand. say what level is “normal” (and the “normal” after the crisis may be lower than before, as outlinedAt the same time, the optimisation of supply chains above). More interesting, therefore, is the dynamicsmay imply lower necessary levels of inventories. In of business confidence, i.e., how perceptions ofcase companies increased their productivity and/or manufacturers of their stock level have changed incut their costs via more effective supply chains, a recent years.recovery in demand would result in a smallergrowth in inventories and thus have a weaker Assessment of current stock of finished products incontribution to economic growth. industry, sa (points, balance of answers) (+) denotes above normal, (-) below normalRestocking has nearly petered out 25 20In the next chart, an inventory cycle described 15above can be clearly seen in Latvia and otherEuropean countries. Time 0 denotes the start of the 10recent recession in a particular country (in Latvia, 5GDP started to fall in the first quarter of 2008). The 0contribution of changes in inventories to GDP -5growth was very negative in all countries after the -10recession commenced. Then, when the recovery -15started, the necessity of rebuilding inventories -20temporarily boosted GDP growth. Finally, 10 -25quarters after the recession started, the contribution 2005 2006 2007 2008 2009 2010 2011of inventories begun to approach its pre-crisis EE LV LT EA EU27levels. Source: Eurostat As one would expect, the assessment of stock levels by manufacturers is negatively correlated with inventories’ contribution to GDP growth (see the chart below). This means that, when the proportion of companies saying that the stock level2 See, e.g., Wen, Yi (2002), „Understanding the inventory is above ”normal” increases, companies do adjustcycle”, CAE Working Paper #02-04. and decrease their inventories, thereby negatively 2 (3)
The Latvian Economy Monthly newsletter from Swedbank’s Economic Research Department, continued No. 6 • 4 August 2011contributing to economic growth. These confidence Forecasting inventories is difficult for severaldata can thus be used as a leading indicator for reasons. First, the necessary (or “normal”) level ofinventories. inventories (and thus their sensitivity to economic activity) may change. Second, data on inventoriesChange in assessment of current stock and are highly volatile. Third, the Central Statisticalcontribution of the change in stocks to GDP growth Bureau of Latvia (CSBL) reports inventories together with errors/omissions, and thus “clean” 8 inventory data are not available. 6 4 However, errors/omissions are unlikely to be pro- 2 cyclical, as inventories are. Therefore, the 0 underlying cyclicality and trend of the data series -2 must be that of inventories. Of course, to obtain a -4 more precise grasp of the economic dynamics and -6 to improve forecasting precision, it would be useful -8 if the CSBL would split up the series and report 2004 2005 2006 2007 2008 2009 2010 1Q11 2Q11 inventory data separate from errors/ omissions. Change in assesment of current stock, points (industry)* Change in inventories, pp contribution to GDP growth * (+) implies relatively less companies say their What does this imply for economic growth? stock levels are below normal, (-) relatively more Source: Eurostat, companies say their stock levels are below normal Swedbank Analysis of the inventory cycle suggests that the calculations temporary boost from inventories to economic growth is by and large over, and future economicConfidence data for the first half of this year show growth cannot rely too much on inventory buildup.that the proportion of companies saying that the The contribution of inventories henceforth will moststock level is below “normal” is decreasing, implying likely be much smaller than in the three recenta smaller contribution of inventories to GDP growth. years.It has been already seen that, in the first quarter ofthis year, the contribution of the change in Future economic growth will thus depend oninventories to GDP declined notably (chart on first Latvia’s fundamental economic strengthpage). It is very likely that there will be a small (consumption, investments in fixed capital, andnegative contribution of inventories in 2011 overall exports), as well as the depth, breadth, and prompt(this does not mean that the change in inventories implementation of structural reforms that improvewill be negative, but that it will be smaller than in the those fundamentals.previous year). Lija Strašuna Mārtiņš Kazāks Dainis StikutsSwedbankEconomic Research DepartmentSwedbank AB. SE-105 34 Stockholm. 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 inLegally responsible publisher this publication. However, we cannot guarantee the accuracy or completeness of the reportCecilia Hermansson, +46 8 5859 7720 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,Martiņš Kazāks, +371 6744 5859 direct or indirect, owing to any errors or omissions in Swedbank’s monthly newsletter.Dainis Stikuts, +371 6744 5844Lija Strašuna, +371 6744 5875 3 (3)