Forecasts of Latvijas Banka
(with changes to the GDP and inflation forecast of 5 December 2014)
In the second and third quarters, stable growth persisted in the Latvian economy; recently, however, the annual growth rate of GDP gradually moderated due to weaker contribution from the sectors mostly driving GDP growth in the previous years (manufacturing, transportation, storage and energy). At the same time, growth is supported by the domestic-demand-oriented sectors such as trade, construction and public utilities.
Previously, the dynamics of the Latvian economy was almost equally affected by external and internal (or domestic) factors; in 2014, however, the external factors have been dominating. Of the internal factors, two aspects with a potential negative impact on the future growth are to be singled out. First, the period of subdued investment activity has lasted for too long now, and, most likely due to the current negative geopolitical situation, businesses, instead of making new investment, more often opt for running at full production capacity (presently in manufacturing, production capacity utilisation is at the highest post-crisis level). This has a milder effect on the short-term developments in the economy than on its medium-term and long-term growth potential. The amendments made to the Immigration Law and Insolvency Law of Latvia also figure as an important factor, as those to the former impose substantially higher threshold value on transactions entitling foreigners to temporary residence permits in Latvia, while the latter stipulate the introduction of liberalised personal bankruptcy regime (or the so-called clause of returned keys) in mortgage financing. The said amendments may have a potentially negative impact on Latvia's economic progress, particularly affecting the real estate sector and construction.
However in 2014, the external factors have primarily been driving the economic growth potential in Latvia and are likely to retain this role also in 2015. Undoubtedly, the regional economy has been adversely affected by aggravating geopolitical situation and the imposed economic and political sanctions in the last six months. That is why the 2014 growth in the Russian economy has so far been substantially weaker than projected and is likely to remain such also in 2015. The position of Latvian exporters in the Russian market notably deteriorated already in early 2014, primarily due to two factors – depreciation of the Russian ruble and sluggishness of external demand. However, in the recent months additional concerns about the sustainability and resilience of economic growth in Russia, triggered by the sharp depreciation of the ruble and a fall in the Brent crude oil price, have emerged. Even though the direct effect on Latvia's economy of the imposed sanctions has been quite mild so far, the indirect impact on the confidence of such economic agents as households and businesses may stronger affect deceleration of Latvia's economy. If geopolitical uncertainty continues to persist, risk aversion of businesses may mount and investment in business expansion contract; households, at the same time, may refrain from making large purchases, thus boosting savings.
In the second and third quarters, the growth was weaker than expected in the euro area as well, and the worries about the euro area growth outlook intensified in the reporting period. The ECB gradually addresses the issue of weak economic growth by actively using the monetary policy instruments which are at its disposal for enhancing lending; labour market and high sovereign debt level adjustments, on the other hand, are long-term issues that cannot be addressed in the absence of sustained economic growth.
At this junction, i.e. in mid-January 2015, it is obvious that the current geopolitical situation and the developments in the global economy are likely to result in a steeper slowdown of economic growth in Latvia. According to our new estimates, the economy may grow by 2% this year, which is considerably less than the 2.7% growth rate forecast before.
The previous preliminary projections of Latvijas Banka have been revised, duly taking into account the current geopolitical situation, which is having an adverse impact on the economy of the region, Latvia including. Russia's economic outlook is currently deteriorating, and this has a negative effect on Latvia's exports. The updated forecast assumes a contraction of the Russian economy by nearly 5% this year. Nevertheless, the situation is changing rather dynamically; hence the recession in Russia may yet prove to be deeper than currently projected. Undoubtedly, it will have a stronger adverse effect on Latvia's economy in the future. On the one hand, it would reduce the demand for Latvian goods and services. On the other hand, it would also slow down the growth in Latvia's major trade partners (primarily the Baltic and Scandinavian countries) as an indirect effect. Moreover, several other adverse factors impacting Latvia's economic growth will remain in place, with slower-than-previously-projected euro area growth, sluggish lending, confidence effects, etc. among them.
There are some upside risks to the Latvian and euro area's economies as well, resulting, e.g. from the resumed operation of the JSC KVV Liepājas metalurgs and the falling oil prices. Although it is too early to speak about the planned operational framework and potential capacity of the company; nevertheless, it is obvious that its resumed operation would add a positive impetus to macroeconomic indicators and GDP dynamics.
Chart 1. GDP CHANGES (annual percentage changes; forecast of Latvijas Banka*)
The impact on consumer prices in Latvia anticipated from the Russian trade embargo did not materialise fully in August and September. In a number of cases it was associated with hiking producer per-unit costs, while in some other the resilient demand was likely responsible for it. From the middle of the year, however, the impact of external factors on inflation has generally been downward, primarily on account of falling global oil and food prices as well as untypically low inflation in most euro area countries. The euro exchange rate dynamics was an external driver of inflation hikes, yet its impact in Latvia was substantially offset by the euro being the settlement currency in a large part of Latvian foreign trade transactions, which, thus, little depended on euro fluctuations. As a result, in the second half of the year overall, Latvia's inflation indicators were lower than projected. This is a confirmation for the downward-revised average inflation estimate, at 0.7%, announced on 26 September 2014 at Latvijas Banka's press conference.
The current oil price dynamics as well as the still slow and uneven economic growth in the European countries imply that the external environment is likely to cause rather modest inflationary pressures during 2015. Similarly, the outlook for Latvia's economy in 2015 is associated with low inflation risks in the near future. Wage rises will continue, albeit at a more moderate pace than in 2014; external-environment-related uncertainties, however, will push the building of household savings further. Consequently, the electricity market liberalisation for households figures as the only domestic factor positively contributing to overall inflation in 2015. Accounting for the latest global oil price dynamics, the revised inflation forecast of Latvijas Banka for January 2015 is lowered to 0.9% (instead of 1.4% projected in December; see Chart 7.2).
Moreover, the risks surrounding this inflation forecast are also assessed as mostly downward, due to the ongoing fall in global oil prices, which is likely to be only partly offset by the depreciation of the euro.
Chart 2. HICP CHANGES. (annual percentage changes; forecast of Latvijas Banka*)