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The Latvian Economy, No. 2 March 2011


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The Latvian Economy, No.2, 1 March 2011. Can authorities hold back rising inflation in Latvia?

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The Latvian Economy, No. 2 March 2011

  1. 1. The Latvian EconomyMonthly newsletter from Swedbank’s Economic Research Departmentby Lija Strašuna No. 2 • 1 March 2011Can authorities hold back rising inflation in Latvia? • The hike in inflation in January 2011 was largely due to tax rises. There are perhaps more to come in July. Upward price pressures come from abroad, causing increases in such first-necessity items as food, housing, and transport (e.g., the planned rise in electricity tariffs in April). Price growth for these items is increasing social problems, as inflation hits poorer households harder. • Among possibilities to hold back inflation and reduce its negative effects on the lower- income inhabitants are to improve competition in product markets and the labour market situation (e.g., supporting job creation), as well as tax policy. • In view of the planned euro introduction in 2014, the government now faces a tax policy trade-off between inflation and budget deficit reduction in moving to fulfil the Maastricht criteria. (HICP) of constant tax rates was flat in January 2 – itHike in inflation in January 2011 due to tax should be noted, though, that this indicator reflectsrise the theoretical influence of a change in the VAT andConsumer price index (CPI) annual inflation soared excise tax rates (i.e., assuming a full pass-throughto 3.7% in January 2011 (1.3% month-on-month), on prices).largely driven by a value-added tax (VAT) rise. 1 It can be seen from the chart below that inflation isAccording to the Central Statistical Bureau of Latvia mostly driven by food and transport price increases,(CSBL), the harmonized consumer price index as well as by a rise in housing tariffs.Harmonized consumer price growth, % Contribution to CPI annual growth, pp 20 4 20 15 tax rises 3 15 10 2 10 5 1 5 0 0 -5 -1 0 -10 -2 -5 Jan.08 Jan.09 Jan.10 Jan.11 Jan.07 Jan.08 Jan.09 Jan.10 Jan.11 HICP, mom (rs) Food Transport constant tax rates, mom (rs) Source: Housing Other HICP, yoy Total CPI grow th constant tax rates, yoy CSBL Source: CSBL 2 The dynamics of HICP and CPI is very similar, but the HICP series are available in more cuts (e.g., of constant tax rates). The HICP is used to calculate Maastricht criterion, as it is1 The VAT base rate rose from 21% to 22% and reduced VAT comparable across EU. The consumption expenditure of non-rates from 10% to 12% (e.g., for natural gas, heating, hotels, residents in the country is included in the HICP but excludedbooks, and medical products). The VAT rate for electricity is from the CPI, expenditure on gambling is included in the CPIup from 10% to 22%. but excluded from the HICP. Economic Research Department. Swedbank AB. SE-105 34 Stockholm. Phone +46 8 5859 1000. E-mail: Legally responsible publisher: Cecilia Hermansson, +46 8 5859 7720. Mārtiņš Kazāks, +371 6744 5859. Lija Strašuna, +371 6744 5875. Dainis Stikuts, +371 6744 5844.
  2. 2. The Latvian Economy Monthly newsletter from Swedbank’s Economic Research Department, continued No. 2 • 1 March 2011Apart from taxes, the major explanation is global alcohol, and tobacco, as well as the VAT rate forcommodity price growth (food products and oil). natural gas as of July are approved, we will raiseOther items are still contributing negatively to total our average inflation forecast for this year (currentlyannual CPI inflation. 3%). 3 In view of the planned euro introduction in 2014, the government is strongly committed to notGlobal commodity prices, 2005=100 raising taxes next year (except for the real estate tax), so CPI growth rates are forecast to decelerate 300 150 in 2012. 250 120 The worrying issue, however, is the notable increase in consumer inflation expectations, most 200 90 likely driven by food price growth and recurrent tax rises. Businesses are testing the market, and 150 60 increasing inflation expectations make it easier to raise prices. Even though household consumption 100 30 growth is very fragile and slow, income inequality is rising, and those having jobs might be able to 50 0 accept higher prices. Jan.06 Jan.07 Jan.08 Jan.09 Jan.10 Jan.11 Total Food * cotton, timber, w ool, Inflation and its expectations, % Non-food agriculture* rubber, oils, hides Metals 25 100 Crude oil (Brent), USD (rs) Source: Reuters Ecow in 20 80 15 60Consequently, we argue that so far inflation inLatvia has been driven by the supply side – largely 10 40by increased costs due to more expensive inputs 5 20and a rise in local taxes. Annual core inflation 0 0(excluding unprocessed food, fuel, and -5 -20administratively regulated prices) remains notablybelow the baseline CPI rate. Domestic demand, -10 -40remaining weak, is not expected to exert upward -15 -60pressure on prices this year. Jan.08 Jan.09 Jan.10 Jan.11 Inflation expectations, pointsHarmonized consumer price growth, % CPI, yoy Food, yoy Services, yoy Source: CSBL 20 4 15 3 Research by the Bank of Latvia 4 shows that demand factor (as a proxy, retail trade turnover was 10 2 used) is less important than accumulated inflation for Latvian firms when deciding upon a price 5 1 change. It should be noted that demand effect appears to be a more important factor for price 0 0 reductions than for price increases. Prices are quite flexible in Latvia – the average duration of a price -5 -1 spell (i.e., an episode with a fixed price) was 3.5 Jan.08 Jan.09 Jan.10 Jan.11 months in 2003-2009 (meaning that on average HICP, mom (rs) 28.7% of prices were changed each month). This is w /o energy and unprocessed food, mom (rs) more frequent than on average in the euro zone HICP, yoy Source: w /o energy and unprocessed food, yoy EurostatWill rising inflation expectations add toactual inflation? 3 To be published in our new Swedbank Economic Outlook thisThe January hike in inflation was largely in line with spring. 4our expectations. However, if recently announced Beņkovskis et al (2011), “Price setting behaviour in Latvia:plans to increase excise tax rates further for fuel, econometric evidence from CPI micro data”, Working Paper 1/2011, Bank of Latvia. 2 (4)
  3. 3. The Latvian Economy Monthly newsletter from Swedbank’s Economic Research Department, continued No. 2 • 1 March 2011(15.1%) or the USA (24.8%). 5 In our view, this price not motivate those used to low incomes to searchflexibility is likely to increase the risk of inflation for jobs and thus do not improve the situation in theexpectations’ entrenching into actual inflation longer term. To lessen the negative effect of pricefigures, as businesses are used to changing prices growth on individuals with less wealth, job creationquite often. should be supported more actively, and a reduction of the tax burden on those with lower incomesInflation increases social problems should be considered.In the beginning of 2011, the CSBL published a Has competition weakened?new structure for the consumer basket, implying achange in CPI weights. As expected, the shares of Research by the Bank of Latvia 6 shows that thefood, housing, and transport increased. There are probability of a price change by a Latvian firm istwo interlinked explanations for this change in mostly driven by overall inflation, and only to ashares. First, with constrained incomes, households lesser extent by inflation at a sectoral level. In ourwere forced to adjust their consumption behaviour, view, one possible explanation for this finding mightand expenditures on first-necessity goods/services be that the competition factor is not very importantincreased more than on other spending. Second, for firms when deciding on whether to changethe prices of these first-necessity products rose prices.faster than of other goods and services, which alsoincreased expenditures of the former. There are several signals that point to perhapsUnfortunately, the increase in shares for these worsened competition during the recession.goods/services implies that the growth in global According to the World Economic Forum’s Globalcommodity prices and the following rise in housing Competitiveness Report 2010-2011, Latvia’s ranktariffs will influence overall inflation figures even on the domestic competition declined from 57th (outmore from now on. of 134 countries) in 2009 to 74th (out of 139) in 2010. Furthermore, pre-tax profit margins (afterStructure of consumer basket (2011), % interest) of companies in manufacturing and domestic trade have increased notably during Hotels and 7 Other 2010. Still, it is too early to say whether this marks restaurants restaurant a return to “normal” margins after the negative ones Education Food, non- alcoholic experienced during the recession or it is an Recreation beverages indication of lack of competition. and culture 25.4 Several conflicts have been reported in the media Communic between food manufacturers and retailers regarding ations Alcohol the retailers’ markups. The most recent one is and about dairy products, and the case has been 13.3 tobacco submitted to the Competition Council. There were Transport recently two cases (one in late 2010 in the dairy 16.3 Clothing industry and another in January 2011 in the bread Health and industry) in which the Competition Council imposed care footw ear fines on the two biggest retail chains for abusing Household Housing their dominant position. equipment Source: CSBL As Latvia cannot influence global prices, improvingThis exacerbates the social problems that Latvia competition (e.g., making the price-settingfaces. Poorer households spend more on first- mechanism more transparent, starting withnecessity goods, which means that they get hit by government procurements) is one of the fewinflation harder. There are currently various benefits remaining few possibilities for easing pricethat a person who is officially recognised as poor pressures locally.may apply for, like a guaranteed minimum income(LVL 40-45 for a person), payments of housing bills,food packs, etc. However, these measures provideonly short-term relief and are quite small andsometimes ill-structured, as in many cases they do 6 Beņkovskis et al (2011), “Price setting behaviour in Latvia: econometric evidence from CPI micro data”, Working Paper5 Beņkovskis et al (2010), “Price setting behaviour in Latvia: 1/2011, Bank of Latvia. 7descriptive evidence from CPI micro data”, Discussion Paper Bank of Latvia (2011), “Macroeconomic Developments1/2010, Bank of Latvia. Report”, January 2011. 3 (4)
  4. 4. The Latvian Economy Monthly newsletter from Swedbank’s Economic Research Department, continued No. 2 • 1 March 2011Tax policy trade-off: inflation vs. budget Budget deficit, % of GDP (ESA basis)deficit reduction 3It turns out that Latvia is now facing a trade-off interms of tax policy – the revenue expansion 0measures implemented to reduce the budget deficithave increased inflation. Further fiscal consolidation -3is still necessary to reduce the budget deficit to 3%in 2012 to fulfil the Maastricht criterion and be ableto introduce the euro in 2014. However, inflation -6should also be diminished – the government iscommitted to not increasing consumption taxes in -92012, but this may be not enough. If tax decreasesare being considered, then other ways to reduce -12the budget deficit should be employed, i.e., a 2000 2002 2004 2006 2008 2010ereduction in spending. Will this imply cuts in social Maastricht criterion LVspending cuts (pensions)? Social budgetexpenditures constitute about 30% of total general Source: Eurostat, Sw edbank estimatesgovernment expenditures, with the largest beingpensions, but so far this has been consideredlargely an untouchable sphere. The governmenthas difficult decisions to make.Harmonized consumer price inflation, % Lija Strašuna 20 15 10 5 0 -5 Jan.06 Jan.07 Jan.08 Jan.09 Jan.10 Jan.11 Maasticht criterion (12M average) 12 month average, LV Annual inflation, LV Source: EurostatSwedbankEconomic Research Department Swedbank’s monthly newsletter is published as a service to our customers. We believe thatSwedbank AB. SE-105 34 Stockholm. 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 reportLegally responsible publisher and cannot be held responsible for any error or omission in the underlying material or itsCecilia Hermansson, +46 8 5859 7720 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 4 (4)