Bank of Latvia's Forecasts

Latvia's economic growth rate was the fastest among the EU Member States in the first three quarters of 2012. The Latvian economy managed to achieve considerable growth, despite the adverse developments observed in the global markets and major trade partner states. In 2013, the economic development will be affected by both external risks as well as risks stemming from domestic factors. External risks are mainly on the downside, whereas the risks associated with domestic developments lie largely on the upside.

Economic developments

Several international organisations (e.g. IMF and OECD) point out in their latest forecasts that the situation in the global economy is particularly fragile and have revised downwards the 2013 growth forecasts for several leading economies. The unstable economic conditions are also well reflected by various economic confidence indicators: both the business climate and consumer confidence indicators published by the EC as well as the PMI point to an overall negative mood.

These factors should be kept in mind when analysing Latvia's near-term economic growth prospects, as, at the moment, Latvia is more than ever dependent on external market developments. Nevertheless, on the other hand, one has to take into account also that, due to the regained competitiveness, Latvia's exporters have proven capable of operating successfully and boosting their exports even in complex external conditions. The ability to increase the market shares, export market diversification and steeper growth of exports to partners outside the EU, have so far helped the Latvian producers to compensate the falling demand for imports in some EU Member States. Therefore, it is possible that the Latvian export growth will continue to outpace the import growth in Latvia's trade partners, thereby supporting higher economic growth than currently expected.

Analysing the risks stemming from the domestic environment, several aspects should be mentioned. Firstly, private consumption can be expected to increase at roughly the same pace as the real wage bill. Moreover, if the increase of the share of consumer non-durables in the overall trade composition really is a signal for a potential improvement in the purchasing power of a larger part of the population, consumption can be expected to continue expanding steadily. In addition, with the conditions in the public finances sector improving, the tendency of making precautionary savings could weaken and thereby give an additional push to the rising consumption. On the other hand, private consumption growth could be dampened by the changing consumer sentiment. So far, the consumer outlook on future economic development has been unusually optimistic; nevertheless, with the confidence indicators in Latvia converging with those in other EU Member States, the growth of consumption could decelerate.

Secondly, the investment activity could weaken under the impact of the negative sentiment (businesses are concerned about the implementation of their investment projects because of the uncertainty surrounding the future developments). Moreover, it will be dampened by the expected delay in the implementation of a certain part of the big investment projects previously scheduled for 2013 which will now be completed only in 2014. At the same time, should the best circumstances combine and result in higher-than-expected lending expansion, particularly in the corporate segment, the investment growth could remain stable or even increase slightly year-on-year, instead of shrinking.

The overall GDP growth forecast for 2013 is 3.6%. According to this baseline scenario, the slowdown of growth in comparison with the previous year will be determined by both deceleration of exports and lower investment and private consumption growth. In 2013, the most significant deceleration of the year-on-year growth of economic activity is expected in construction and transport sectors as well as in some manufacturing sub-sectors (manufacture of metals and wood). Changes in the above factors may act to increase as well as to dampen the economic growth; therefore, the GDP growth could range from 3.1% to over 4% in 2013. Overall, the medium-term risks to the national economic growth prospects can be considered balanced (see Chart 1).

Chart 1. GDP changes (annual percentage changes; the Bank of Latvia forecast*)

Inflation

In the last months of 2012, inflation stabilised at the lowest level since October 2010. Both the stabilisation of the global commodity prices and domestic factors (for example, balanced average wage and salary and labour productivity growth and hence no upward demand side pressure on prices) contributed positively to the inflation rate developments.

The average annual inflation is expected to remain low in Latvia in the medium-term mainly due to supply-side factors. Currently, the stabilised oil and global food prices do not exceed the level of the beginning of 2012; hence their effect on the annual growth rate of Latvia's consumer prices will remain low in the course of 2013. As the global energy prices are stabilising, at this juncture, the local energy producers are also abstaining from proposing any new tariffs to the Public Utilities Commission. A relatively small number of heating tariff changes has been submitted so far and they generally offset one another. The latest gas tariff forecast for the first half of 2013 are also assuming lower nine-month average heating oil prices, which translates into reduced natural gas trading prices. The rise in electricity tariffs, in turn, is constrained by both the stable natural gas prices as well as the expected liberalisation of the electricity market that could take place in autumn of 2013. As opposed to Estonia where prices are expected to rise by up to 20% due the above reason, no increase is expected in Latvia as the price level currently exceeds the electricity prices for households in Estonia by more than one fourth.

On the other hand, the 2012 costs are gradually passing through to the core inflation, and both the import prices and producer prices have increased. Moreover, the upside risks to inflation will be increasingly more affected by the demand side factors: the expected positive increase in real wages and sustainable purchasing power could support a rise in consumption. However, considering the fact that the real purchasing power is reflected in the demand side inflation with a lag, the effect of the demand side factors is expected to grow in 2014.

Overall, the average inflation in 2013 is forecast at about 2%. At the beginning of the year, the inflation growth will be lower and it could accelerate gradually in the course of the year, although it is not expected to exceed 3% also at the end of the year. Currently, the risks to the inflation outlook are balanced (see Chart 7.2).

Chart 2. CPI changes (annual percentage changes; the Bank of Latvia forecast*)

* The coloured area represents 90% of potential scenarios (the lighter the colour, the lower the scenario's probability).