Latvia's export perspectives amid weaker external environment
Brexit, trade wars and subdued global economic growth are just a few of the international topics that have been hitting the headlines recently. Global developments, no doubt, play an important role also in Latvia's economic development; therefore, this article will look at the current situation in Latvia's trade partners and its implications for Latvia's exports.
The US-China trade tensions
Latvia is a small and open economy whose economic growth is affected by global developments via exports. Unfortunately, the recent trends make one cautious when looking at this year's perspective for Latvia's exports, as the world's largest economies have seen a deceleration in their growth rates already since mid-2018. This has largely been a result of the rising protectionism and uncertainty surrounding political tension particularly inflamed by the US–China trade conflict having caused losses of several billions of dollars for the economies involved and affecting the sectors such as car production, technologies and agriculture. Although quite recently there was a hope that both superpowers could soon reach a trade deal, a renewed surge in trade tensions followed at the beginning of May, with the US announcing a further increase in tariffs from 10% to 25%, targeting Chinas exports worth 200 billion US dollars. Tariffs and government's endeavours to curb risky loans by restricting access to investment have already had adverse effects on China's economy that in 2018 grew at its slowest pace in 28 years. The economic growth is projected to moderate further also in 2019. Although the US–China trade war does not have a significant direct effect on Latvia, it poses indirect risks as, with the situation deteriorating, the growth in the trade partners is likely to lose momentum, thereby also reducing external demand for Latvia's exports.
Developments in Europe: Brexit and growth slowdown in Germany
Meanwhile, developments in the European Union (EU) have a more pronounced impact on Latvia, as 70% of Latvia's goods and services exports go to the EU. Unfortunately, the uncertainty surrounding Brexit (delayed until 31st of October) is still affecting the EU making the situation of companies doing business or having partners in the United Kingdom unenviable due to difficult planning. As the United Kingdom ranks among Latvia's major trading partners, we can expect a deceleration in export growth if stricter trade regulation comes into force after Brexit (see Chart 1).
The situation in other trade partners is not encouraging either. In the World Economic Outlook published in April, the International Monetary Fund lowered the euro area growth forecast for 2019 to 1.3%, compared to 1.8% in 2018. Although the latest information suggests that the euro area economy has grown more rapidly than expected in the first quarter, developments in the largest euro area economy Germany, where manufacturing has been facing problems since mid-2018, still need to be observed closely. Problems in manufacturing began in September 2018 when the introduction of the EU Regulation concerning carbon emission reduction led to a sharp decline in car production. The recovery has become protracted as the demand for cars in major markets (e.g. the US and China) has decreased. Other trade partners are also expected to witness a deceleration, albeit more moderate, in growth (see Chart 2).
The situation is even more aggravated by the US–EU trade dispute escalating in April when the US was threatening to impose new tariffs on imports coming from the EU. Moreover, there is a chance that worsening relations with the US could further weigh on the economic sentiment in the euro area, which reached a more than two year low in April (see Chart 3).
Latvia's exports have performed well; however, their growth is weakening now
Despite the fact that most trade partners experience a moderation in growth and a deterioration in sentiment, Latvia's exports, although moderating, remain stronger than could be expected against the background of weaker external demand. This has largely been supported by the composition of Latvia's export in terms of trade partners and goods and services.
The growth in exports of goods started to moderate at the end of 2018 and posted a mere 0.2% increase year-on-year in the first two months of 2019. Short-term factors have been playing a significant role in the decline of export growth. Looking at the exports growth by product group, agriculture and machinery and mechanical appliances have experienced the steepest decrease (see Chart 4). The fall in agriculture in the second half of 2018 can be explained by a substantial decline in the overall grain harvest due to weather conditions (winter crops harvest decreased by 35% due to flood in 2017, while the summer crops harvest was negatively affected by extremely hot summer in 2018). Meanwhile, the contraction recorded in machinery and mechanical appliances can be associated with exports of turbojet engines and different gas turbines relating to weaker re-export flows.
Meanwhile, exports in 2018 and the first two months of 2019 have been mainly driven by wood accounting for 18% of total exports of goods. In 2018 the export value of wood increased by 17.7% as a result of favourable export conditions. Firstly, the high price of wood, coupled with weather conditions that were favourable for working forests and allowed access to felling sites that are otherwise difficult to reach, provided an opportunity to increase the volume of exports, to Scandinavia and the United Kingdom in particular. Secondly, with the previously planned Brexit date approaching, exports of wood to the United Kingdom were supported by stockpiling of input supplies. It is difficult to predict whether the stockpiling will continue also in 2019 due to the delayed Brexit. At the same time, although the prices of wood gradually return to their long-term average levels, wood continues to play an important role in exports also early this year. It can be partly explained by the fact that the high prices of wood in 2018 have helped businesses generate higher profit, thus enabling them to make long required investments and expand production. The planned investment in wood processing also seems promising. If used for improving efficiency and raising value added, it would promote competitiveness and help maintain export growth in an environment of weaker external demand.
Slower growth is also recorded for services exports having increased by a mere 3.2% in the first two months of 2019: this is already the third consecutive quarter witnessing lower growth rates (see Chart 5). Exports of financial services have contracted most; this is related to outflows of foreign customer deposits. Meanwhile, at the end of 2018 the contribution of the construction sector was also negative and the contribution of exports of transportation services likewise declined due to weaker external demand. The transportation sector, very closely related to global developments, is unlikely to grow rapidly in the future. The increase recorded in mid-2018 can be mostly attributed to short-term factors such as repair and modernisation works at Russian ports due to which freight flows were directed via Latvia. Although freight unloading in the new Krievu Island Terminal with the annual capacity of 20 million tons was started recently, it can be assumed that the cargo volume from Russia, which is currently the main partner for freights loaded and unloaded at Latvian ports, will decline. The construction sector can be expected to see further growth, although the buoyant pace of growth observed last year may not be considered sustainable. Consequently, the growth rate will most likely moderate this year. Meanwhile, the information and communication technologies sector accounting for 15% of total services exports and having recorded an impressive growth of 24.6% in 2018 continues to provide a positive contribution to services exports. The latest indications are that, with demand persisting, the information and communication technologies sector could continue its growth also in 2019. At the same time, the capacity of the supply side is dampened by labour shortage and therefore the growth might be less pronounced this year. Overall, the growth in exports of services is expected to moderate, with negative contribution coming from financial services exports and the growth of transportation services decreasing, while the information and communication technologies sector is most likely to support exports of services in 2019.
Taking a closer look at Latvia's export partners, one can notice that almost 25% of Latvia's exports of goods and services go to the neighbouring Baltic countries, which in 2018 recorded nearly twice as fast growth as in the euro area overall, exceeding 3.5%. Like in Latvia, the growth has broadly been determined by lower unemployment, higher wages that have boosted private consumption and further investment growth resulting from EU funding inflows. Although growth in the Baltic countries will also slow down this year, it will, however, still remain robust, thus helping to maintain exports in the region. Meanwhile, the export product structure has helped Latvia, for the time being, in major trade partners where growth is expected to slow down more rapidly, e.g. Germany and Sweden,. Latvia's export products in Germany are not closely related to the automotive sector, which largely explained the more subdued economic activity in this country in 2018. Nevertheless, there is a risk that industrial problems could spill over to other sectors. In such a situation, exports can also be expected to decelerate further due to weaker external demand. Wood and articles of wood play the major role in exports to Sweden; however, some caution should be taken when making predictions. Firstly, a fall in the prices of wood is already recorded in the Scandinavian market, and this does not contribute to export growth such as the one recorded in 2018. Moreover, there is a risk that Latvia's exports could be replaced by lower-price exports by other countries. Secondly, housing investment, which is related to exports of wood and raw materials, has contracted; thus, with the situation deteriorating, Latvia's exports could also record a significant decline.
Overall, it can be concluded that although so far exports have been more resilient than could be expected in the face of weaker external demand, this is largely due to wood processing and ICT service providers. However, export growth will decelerate this year. It means that, judging by the external environment, the economic growth is unlikely to be as strong as in 2018. Businesses operating internationally can no longer expect such stability, while for households this could imply slower wage and employment growth. Developments in the near term will mostly determine the medium term prospects: whether any further escalation in the US–China trade conflict will follow and whether a solution to the Brexit issue will be finally found. In any case, exporters have to consider ways to raise competitiveness and focus on producing higher value added products to prevent export substitution in an environment of weaker external demand. If this is not the case, it is unlikely that the Latvia's Baltic neighbours, which have purchased Latvian products quite actively so far, will be able to continue supporting Latvia's exports, and everyone will feel it.
 Data: The Central Statistical Bureau of Latvia and Latvijas Banka, author's estimates
 IMF WEO April 2019