Good performance of manufacturing in May, Brexit effects will be felt in the future

According to the data published by the Central Statistical Bureau, manufacturing output in May 2016 increased by 2.9% month-on-month (seasonal effects excluded). Year-on-year, output increased by 5.3%. Because of these results, there is reason to hope both for a good manufacturing result in the second quarter and to a relatively good gross domestic product (GDP) growth (assuming that the performance of construction is not as bad as it was in the first quarter).

The year-on-year manufacturing growth in May was determined by the rise in wood industry output by 6.0% (in terms of output level, there has been a drop in the sub-branch performance for the last two months). A positive contribution was also made by the production of fabricated metals (+19.6%) and computers, electronic and optical equipment (+24.8%), as well as by the repairs and instalment of equipment and appliances (+17.1%; mostly repairs of the rolling stock of railways). A negative impact on the output of the industry still came from the Russian sanctions affected production of electrical equipment (-12.2%) and food industry (-1.5%), as well as wearing apparel production that has been output-dampening for a long time (-9.2%). May again was good for the energy industry, which recorded a 4.8% rise, determined by a substantial increase in the amount of electrical energy produced by hydroelectric plants and cogeneration stations.  

In the last month, the most important news that might have an impact of Latvian manufacturing was of course the referendum which took place in the United Kingdom and in which the country residents voted for leaving the European Union. The exposure of Latvian manufacturing to the United Kingdom is not very large, yet it is important. The main potential victim of Brexit will be the wood industry, for which the United Kingdom is one of the largest markets.

Overall, the Brexit effect on Latvian manufacturing has three channels of influence.

1) Direct foreign trade – the exports of goods to the United Kingdom in 2015 accounted for 5.3% of total Latvian goods exports. The bulk (68.3%) was the exports of wood and its products. The good news is that it is primarily saw-timber that is exported to the United Kingdom, a product with a relatively lower added value. Before any further decisions have been made regarding the exit (and its form) of the United Kingdom from the European Union, there can be no talk of the external trade channel effect under the impact of institutional decisions (e.g., trade tariffs).

2) Yet it must be noted that foreign trade will be influenced by currency fluctuations (here the weakening of the British pound is what I have in mind) – according to the Latvian Forest Industry Federation, the supply contracts of the industry have been concluded in British pounds. It means that Latvian wood industry business will receive fewer euro for the production delivered to the United Kingdom (unless measures have been taken to cover against the currency fluctuations). The deterioration of terms of trade because of the weakening of the pound can lead to the worsening of the profitability indicators of wood industry enterprises (and some bankruptcies/consolidations).

3) The confidence effects channel. In all likelihood, it is the most crucial of all channels yet, at the same time, the one that is the most difficult to estimate. It has two aspects. Namely, confidence effects will be felt both in the United Kingdom and in Latvia. The UK is currently undergoing a time of political chaos: it is not clear what will happen and how. The domestic situation has likewise become 'frozen'. That will certainly not promote new investments into the United Kingdom, which will reduce the demand for construction services and thus also for Latvian wood whose main market is the construction industry.

Second, the uncertainty created by the British referendum and its repercussions create additional uncertainties to investment decision makers both in Europe and in Latvia. If before we hoped that the period of low investments could gradually draw to an end, right now, the British referendum results push this hypothesis back into the uncertainty zone.  

Last month, there was another piece of news related to the external markets: the European Commission extended the sanctions against Russia for six months (until 23 June 2017), with Russia also extending its sanctions until the end of 2017. It means that there is hardly any reason to hope (that primarily applies to the food industry) for the opening up of the Russian market and work must continue on acquiring new markets.

Despite the negative news, the industry confidence indicator of the European Commission has improved for Latvian manufacturing in the past few months – a larger number of orders and a larger output in the coming months are both reported. These indicators were however aggregated before the British referendum and thus they do not reflect its effect.

Overall, the Brexit effect can be projected to have an impact on Latvian manufacturing. The most important and most visible will be the currency channel effect, which is in place already now. The rest will much depend on further developments and the reactions of market participants. In all likelihood, some businesses will postpone their planned investments for a time, awaiting further developments. In the long run, the introduction of tariff barriers is possible, yet these are too early to speculate about.