Forecasts of Latvijas Banka

26.06.2015.

Economic developments

In 2014, Latvia's real GDP grew by 2.5%, recording an annual low of the post-crisis period. In view of the geopolitical situation, however, it should be considered a positive result. 2014 saw a gradual deceleration of the GDP growth rate on a quarterly basis. In 2013, the quarterly growth averaged 1.1%, while recording a mere 0.5% in 2014. The external environment had a negative effect on Latvia's economy in 2014. On the one hand, economic growth in Latvia was limited by the persistently weak and unsustainable growth of the euro area. On the other hand, already from the beginning of the year the economic situation also grew considerably worse in the nearby regions on account of a weaker demand in Russia and depreciation of the Russian ruble. Although the direct impact of applying the economic sanctions on the Latvian economy was not too pronounced (the products subject to the sanctions accounted for merely a small share in the exports of Latvian goods), they had a substantial effect on the overall economic situation: the confidence of the economic agents regarding their future income declined. The rapid changes in the economic situation and the subsequent impact of the negative sentiment of the economic agents is a key reason underlying the weak dynamics of investment and lending recovery.

In the time of extremely complex external environment, sectors supporting domestic consumption were the main drivers of economic growth in Latvia. In 2014, trade, construction and public utilities were the major contributors to the economic growth. Growth in the sectors largely dependent on the domestic economic developments was mostly supported by gradually improving labour market conditions. With unemployment on a downward path and average wages and salaries on the rise, household spending also increased, finding reflection in the operation of the above sectors. The low oil prices and lower-than-usual housing maintenance costs on account of the warm weather conditions also facilitated such household spending in late 2014 and early 2015.

Various survey leading indicators suggest that the economic growth rates observed in the euro area at the beginning of 2015 were slightly higher than projected. The monetary policy implemented by the ECB had a positive effect on the economic agents' confidence regarding the economic outlook; such response, how­ever, may be unsustainable. Robust growth lasting for at least several quarters will be a factor testifying to sustainable recovery of the euro area economy. Un­certainty regarding the question whether the improve­ment in the economic confidence indicators will also find reflection in the real economy data still persists. Moreover, the solvency issue of Greece may also provoke further negative confidence effects any time.

Upon making decisions on purchases, households have also taken account of the high degree of uncertainty: spending dynamics lagging behind the rate of change in wages and salaries and an increase in household savings in 2014 testify to that. Moreover, according to Latvijas Banka's estimates, the expected changes in wages and salaries in 2015 will be more moderate than in 2014, thus also slightly limiting the increase in domestic consumption, the major driver of the economic growth so far.

The previous forecasts of Latvijas Banka were published on 13 January 2015 when, in view of the geopolitical developments, a further depreciation of the Russian ruble and deterioration in the economic situation in Russia, the latest macroeconomic data and the weak growth in the euro area, the forecast for 2015 was revised downwards, from 2.7% to 2.0%. At this stage, the growth forecast for 2015 remains unchanged at 2.0% (see Chart 7.1). Data for the first quarter of 2015 and preliminary statistics for the second quarter suggest that Latvijas Banka's perception regarding the economic growth in 2015 was realistic enough. The beginning of 2015 was quite successful for trade and also manufacturing as the JSC KVV Liepājas metalurgs started its operation; the transport and energy sectors, however, were less successful. In 2016, subject to gradual improvement in the external environment, GDP might record slightly faster growth of approximately 3%.

Risks related to the country's economic development are currently balanced. As regards positive risks, a possibility of a more positive than anticipated pass-through of the low oil prices (the price effect provides additional opportunities for households to buy other goods and services) and the impact of the monetary policy decisions adopted by the ECB (implementation of the expanded APP) on the Latvian economy (mostly indirect effects as a result of the increasing economic activity of the euro area countries). Speaking about negative risks, they are mostly related to the developments associated with the external environment, particularly in the context of the regional geopolitical conflict. Further turmoils in the external environment may result in additional negative confidence effects, thus affecting the household private consumption and the amount of investments made by businesses.

Chart 1. GDP CHANGES (annual percentage changes; forecast of Latvijas Banka*)

Inflation

The current inflation (HICP) estimate for 2015 stands at 0.7% (see Chart 7.2), slightly lower than the previous publicly stated estimate of 0.9%. Due to energy and food prices, the actual data for January reduced the base of the overall price index considerably. However, on account of the new public transportation tariffs introduced by Riga municipal company Rīgas satiksme Ltd. and higher prices of oil futures contracts the reduced base effect is fading.

One of the factors likely to sustain the impact of the demand side on inflation is a rise in wages, albeit probably slightly slower in 2015 than initially projected. For example, the positive effect of launching the operation of JSC KVV Liepājas metalurgs on growth and income, Latvia's Presidency of the EU Council (will maintain the hotel and catering prices and probably also cultural services prices) and the Nordic-Baltic Choral Festival to be held in June, albeit a less extensive event than the 8th World Choir Games held in Riga in 2014, are factors likely to maintain the demand side effect on inflation. Part of these factors, however, will not be present in the second half of the year.

An increase in the excise tax on tobacco in the middle of the year and the potential changes in the excise tax on alcoholic beverages might have just a minor effect on inflation.

Risks to the inflation forecast are balanced. More accelerated renewed surges in commodity (oil) prices are possible. A small upside risk to the inflation outlook is also associated with the domestic energy prices if the transmission services tariff raised by the Latvian transmission system operator JSC Augstsprieguma tīkls is incorporated in the energy consumer price; however, it is highly unlikely this risk could materialise in 2015.

A minor downside risk to the price level could be associated with Lithuania's potential connection to Sweden's SE4 bidding area in 2016 where the energy price is slightly lower than in Latvia; however, a decline in price levels on account of price differences is reduced by the costs of transmission services through Lithuania, as well the fact that the contribution of large energy consumers, such as JSC KVV Liepājas metalurgs, is more significant for the economic growth.

Chart 2. HICP CHANGES. (annual percentage changes; forecast of Latvijas Banka*)

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