The Latvian Economy - No 6, August 4, 2011: Restocking has nearly petered out; future economic growth to depend on fundamentals

1. The Latvian Economy
Monthly newsletter from Swedbank’s Economic Research Department
by Lija Strašuna, Mārtiņš Kazāks, Dainis Stikuts No. 6 • 4 August 2011
Restocking has nearly petered out; future economic growth to
depend 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 in
from average quarterly growth of 0.9% (seasonally demand, slashed their inventories to levels below
adjusted) in 2010 in annual terms to just 0.3%. In what would typically correspond to the then
annual terms, GDP growth was 3.5% in the first economic activity. With economic growth resuming
quarter (not seasonally adjusted). A pickup in and the financial situations of businesses
imports made the net export contribution negative improving, they had to restore their inventories to
despite continuous export growth. “normal” levels, in line with economic activity (i.e.,
demand and production). As this inventory
Economic growth is expected to have picked up in undershoot is corrected for, restocking naturally
the second quarter of this year, owing to the comes to an end; future economic growth will thus
continuing good export performance, the pickup in depend on the fundamental strength of the
investment, and recovering household economy, i.e., consumption, investments, and
consumption. However, the so-called rebound exports.
effect that had been observed in the early recovery
stage is now fading. For instance, last year, Contribution to GDP annual growth, pp
economic growth was very much supported by the
restocking of businesses – changes in inventories 30
added nearly 6 percentage points to GDP growth in 20
1
2010 (the net export contribution was just 0.6 10
percentage point) – which is now coming to an
end.. 0
-10
We define restocking here as the following process.
-20
During the recession, businesses, running into
-30
1 -40
The Central Statistical Bureau (CSBL) calculates inventories
1Q 07 1Q 08 1Q 09 1Q 10 1Q 11
as a residual when balancing national accounts. This implies
Households Government
that data on inventories also contain possible errors and/or
Gross fixed capital form. Inventories
omissions. It is thus not possible to estimate how large is the
Net exports GDP growth
error and how large are actual changes in inventories per se. It Source: CSBL
is 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: ek.sekr@swedbank.com 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.

2. The Latvian Economy
Monthly newsletter from Swedbank’s Economic Research Department, continued
No. 6 • 4 August 2011
What is the inventory cycle? Changes in inventories,
contribution to annual GDP growth* (pp)
The inventory cycle can be observed not only in
15 1.5
Latvia, but also in other countries. In the economic
literature, there are two major theories of why firms 10 1.0
invest in inventories: the production-smoothing
theory (to reduce production costs under demand 5 0.5
uncertainty) and the stockout-avoidance theory (to
0 0.0
avoid possible losses if production cannot respond
immediately to a sudden increase in demand). 2 -5 -0.5
Investments in inventories/stocks are usually
procyclical, i.e., businesses normally accumulate -10 -1.0
stocks in times of increasing demand and reduce
stocks 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 for
GDP growth substantially – negatively when each country Source: Eurostat
demand and production decrease and positively
when the economy starts to recover from recession.
During times of falling demand, it is natural to sell Similar trends can be observed in data from
out 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 in
strong temporary boost from inventories to industry returned to the 2006 level in the first half of
economic growth, as companies not only need to 2011. Although the majority of manufacturers say
rebuild 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 to
facing a rise in demand. say what level is “normal” (and the “normal” after
the crisis may be lower than before, as outlined
At the same time, the optimisation of supply chains above). More interesting, therefore, is the dynamics
may imply lower necessary levels of inventories. In of business confidence, i.e., how perceptions of
case companies increased their productivity and/or manufacturers of their stock level have changed in
cut their costs via more effective supply chains, a recent years.
recovery in demand would result in a smaller
growth in inventories and thus have a weaker Assessment of current stock of finished products in
contribution to economic growth. industry, sa (points, balance of answers)
(+) denotes above normal, (-) below normal
Restocking has nearly petered out 25
20
In the next chart, an inventory cycle described
15
above can be clearly seen in Latvia and other
European countries. Time 0 denotes the start of the 10
recent recession in a particular country (in Latvia, 5
GDP started to fall in the first quarter of 2008). The 0
contribution of changes in inventories to GDP -5
growth was very negative in all countries after the -10
recession commenced. Then, when the recovery -15
started, the necessity of rebuilding inventories -20
temporarily boosted GDP growth. Finally, 10 -25
quarters after the recession started, the contribution 2005 2006 2007 2008 2009 2010 2011
of inventories begun to approach its pre-crisis EE LV LT EA EU27
levels. 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 level
2
See, e.g., Wen, Yi (2002), „Understanding the inventory is above ”normal” increases, companies do adjust
cycle”, CAE Working Paper #02-04. and decrease their inventories, thereby negatively
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3. The Latvian Economy
Monthly newsletter from Swedbank’s Economic Research Department, continued
No. 6 • 4 August 2011
contributing to economic growth. These confidence Forecasting inventories is difficult for several
data can thus be used as a leading indicator for reasons. First, the necessary (or “normal”) level of
inventories. inventories (and thus their sensitivity to economic
activity) may change. Second, data on inventories
Change in assessment of current stock and are highly volatile. Third, the Central Statistical
contribution 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 economic
Confidence 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 most
stock level is below “normal” is decreasing, implying likely be much smaller than in the three recent
a smaller contribution of inventories to GDP growth. years.
It has been already seen that, in the first quarter of
this year, the contribution of the change in Future economic growth will thus depend on
inventories to GDP declined notably (chart on first Latvia’s fundamental economic strength
page). It is very likely that there will be a small (consumption, investments in fixed capital, and
negative 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 improve
will be negative, but that it will be smaller than in the those fundamentals.
previous year).
Lija Strašuna
Mārtiņš Kazāks
Dainis Stikuts
Swedbank
Economic Research Department
Swedbank 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 in
Legally responsible publisher this publication. However, we cannot guarantee the accuracy or completeness of the report
Cecilia 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 5844
Lija Strašuna, +371 6744 5875
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