The Latvian Economy. Macro Research. Manufacturing back on its feet, but producers need to climb the value-added ladder faster

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1 Macro Research Macro Research - The Latvian Economy 3 June, 214 The Latvian Economy Newsletter Manufacturing back on its feet, but producers need to climb the value-added ladder faster Temporary weakness in manufacturing early this year Manufacturing to grow slowly in the coming months, downside Russia-related risks persist Producers edging up the value-added ladder Temporary weakness in January 214 After a sharp fall in January 214, manufacturing output recovered in the following three months, and in January-April overall was, by 1.8%, larger than a year ago. Most of the manufacturing industries are experiencing growth; the notable exception is base metals. The negative base effect from the closure of Liepājas Metalurgs, the largest steel plant, in the spring of 213 started to fade away slowly, but a bankruptcy process for yet another major base metal company was initiated, and base metal industry thus largely disappeared during the last year. Manufacturing expected to grow slowly in the coming months, downside Russia-related risks persist Foreign demand is expected to pick up in 214: we forecast a decline in Russia and Ukraine, but a recovery in Europe to compensate for that. This pickup, together with robust domestic demand, provides a good basis for manufacturing growth. Competitiveness has also remained solid. Moreover, investments are anticipated to recover, addressing capacity and labour constraints of producers. Manufacturers have the means to invest, since their balance sheets have improved and profitability remains good. We forecast 3-4% manufacturing output growth in 214, but there are downside risks related to developments in Russia and Ukraine. Latvian producers edging up the value-added ladder It is crucial to produce smarter to sustain growth in manufacturing. A shift towards more technologically advanced industries and sophisticated products is needed. There are signs that this is slowly happening, but more progress is needed. Policy support can accelerate this process, and, although there have been some positive changes, much remains to be done, especially in reforming the education system to improve the quality of vocational and tertiary education, strengthening cooperation amongst academic, business, and government counterparts, and supporting innovations. Mārtiņš Kazāks , martins.kazaks@swedbank.lv Lija Strašuna , lija.strasuna@swedbank.lv Kristilla Skrūzkalne , kristilla.skruzkalne@swedbank.lv June 3, 214 Please see important Please see disclosures important disclosures at the end at the of end this of document this Page 1 of 6

2 Manufacturing back on its feet, but producers need to climb the value-added ladder faster Manufacturing will grow, owing to recovery in Europe and rising domestic demand. Investments should recover, since producers need to deal with capacity and labour constraints. Russia-related risks remain, though. Latvian manufacturers have been edging up the value-added ladder, but they need to do it faster to boost productivity. This would raise living standards and reduce risks of labour market overheating. Weak January manufacturing data followed by robust recovery Most of the manufacturing industries are growing Robust recovery in manufacturing After a very weak start of the year (in January 214, manufacturing output was down by 9.5% in monthly terms and by 3.1% smaller than a year ago), manufacturing is now back on its feet. Manufacturing output has been growing for the past three months, and in January- April overall was larger by 1.8% than a year ago. The negative base effect of the closure of Liepājas Metalurgs (LM), the largest steel plant, in the spring of 213 (partly attributed to widespread problems in the metallurgy sector in Europe, but mostly due to shareholders disputes) is now slowly fading away. Yet another bankruptcy process was initiated in this sector in February 214 (AS Krāsainie lējumi), and the Latvian base metal industry has thus shrunk dramatically over the past year. In the first four months of this year, most of the manufacturing industries experienced growth. A pickup in growth in the food industry, which constitutes one-fifth of total manufacturing turnover, was helped both by a recovery in domestic demand and earlier investments in expanding production capacity. Export sales account for only 37% of the turnover in this industry, but their growth has been in double digits. Manufacturing of wood products, which accounts for nearly one-fourth of the total manufacturing turnover, is also growing steadily (owing both to external and domestic demand). A recovery in domestic demand contributed also to other sectors growth. Sales of manufactured goods in the local market grew by 8% in January-April compared with the same period a year ago, while those exported fell by 2% (due to the closure of LM). The share of exports in manufacturing sales rose to 63% in the first quarter of 214, which is still somewhat below the 65% a year ago. Repair and installation of equipm. Other Furniture Car vehicles, trailers Other machinery and equipment Electrics Computers, electronics Metal Nonmetalic Base products minerals - metals Rubber and plastics Chemicals Poligraphy Paper Wood, cork, straw Leather Clothing Textiles Beverages Food Manufacturing output annual growth in January-April 214 (calendar adjusted), % Manufacturing output, 27=1 (sa) Manufacturing Food pr. 2 Wood pr. Base metals Manufacturing remains dominated by food and wood industries Latvian producers are competitive and profitable In 213, the share of the main industries in manufacturing turnover inched up again, and half of the total turnover was made by food and wood producers (even a bit more in the first quarter of this year). The share of base metals and metal products manufacturing declined to 11% in 213 (and further to 9% in the first quarter) from 16% in 212. On the other hand, machinery and equipment processing continued to slowly increase its share (9% in 213, up from 8% a year ago), particularly helped by the outstanding performance of computers and electronics manufacturing. Manufacturing to grow slowly in 214, risks from Ukraine-Russia conflict Latvian manufacturers are in relatively good shape to raise production volumes this year. Their competitiveness remains good, despite an increase in unit labour costs in 213 and also early this year. Productivity fell in 213, but this is partly attributed to LM s fate (the plant was closed in the spring, but most of the employees were sacked only at the end of the year, until then receiving a minimum wage). While hiring actively in 212, especially in the June 3, 214 Please see important disclosures at the end of this document Page 2 of 6

3 second half of the year, producers became more cautious in 213. At the same time, wages are continuing to grow, in the first quarter of 214 supported also by a minimum wage hike. According to preliminary data from the Central Statistical Bureau of Latvia (CSBL), the average profit margin in manufacturing (profits after tax, as a percent of turnover) in 213 and the first quarter of was similar to that in 212 and 211 (2-3%). This is somewhat lower than the pre-crisis level (the average was about 4%). The leverage of producers has continued to decline as well: in the first quarter of 214, bank loans were 31% of value added in manufacturing (38% a year ago). According to the CSBL, the total debt-toequity ratio in manufacturing declined to 1.7 in 212 from 2.5 in 29, i.e., it was back to the 26 level Annual growth of productivity and real gross wage in manufacturing, % Productivity of an employed Productivity of a full-time equivalent Real gross wage 1Q 6 1Q Profit margins, % (212) Repair and installation of equipm. Other Furniture Other transport Car vehicles, trailers Other machinery and equipment Electrics Computers, electronics Metal products Base metals Nonmetalic minerals Rubber and plastics Pharmaceuticals Chemicals Poligraphy Paper Wood, cork, straw Leather Clothing Textiles Beverages Food Demand is expected to pick up this year, but capacity and labour constraints require investments, which are anticipated to grow Foreign demand for Latvian manufacturers is expected to pick up in 214: we forecast a decline in Russia and Ukraine, but a recovery in Europe to compensate for that. This pickup, together with robust domestic demand, provides a good basis for manufacturing growth, although with Russia and Ukraine the risks are on the downside. The impact from the Ukraine-Russia conflict and from a recession in Russia is expected to be limited to some (more exposed) manufacturing sectors, e.g., food, especially canned fish (for more details, see our recent analysis 2 ). The pharmaceutical industry is also very dependent on the Russian and Ukrainian market, but so far there has not been seen any significant impact. Since a large part of trade with Russia is re-exports, in many cases the transport and logistics sector is more exposed than are manufacturers. There are also several local constraints that could limit manufacturing growth in Latvia. While the share of producers who claim demand is limiting production has declined substantially during the last four years, the share of respondents who mention labour constraints has increased somewhat. Capacity utilisation in manufacturing hit pre-crisis levels and has remained at 72% for more than a year already. This calls for investments to expand production facilities and to decrease dependence on labour, as, with falling unemployment, wages and, hence, cost pressures will keep rising. Nonfinancial investments in manufacturing were very weak last year, both in buildings and structures, as well as in machinery and equipment, in total, falling by nearly one-third (in current prices). In the first quarter of 214, there was a pickup (+33% annual growth, owing to more investments in machinery and equipment), but from low levels. Amongst the largest industries (food, wood, metal, and machinery), the wood industry continues to show an increase in investments, while the food industry returned to positive annual investment growth only in the first quarter of 214. The latest available data on building permits and construction of production buildings and warehouses do not indicate a breakthrough in investments in the near future. New loans issued to manufacturers were up by 8% in 213, but the first quarter of 214 was somewhat weaker than a year ago. Given the great need for investments, strengthened balance sheets, and solid profitability of producers, we expect investments to pick up in 214, which will support manufacturing growth going forward. However, there are Russia-related risks those companies trading with Russia might postpone their investment plans, given the uncertainty with respect to their sales and/or possible trade barriers. 1 Preliminary quarterly data do not match precisely annual data that are published much later, but they give a feeling of where things are going. 2 Macro Focus The Russia-Ukraine conflict: Impact on the Baltics (April 214), can be found here June 3, 214 Please see important disclosures at the end of this document Page 3 of 6

4 Demand Equipment Financial Labour None Other Source: DG ECFIN A shift towards more technologically advanced industries and sophisticated products needed Factors limiting production in manufacturing, % of respondents Value added (VA) and employment in manufacturing, % of total VA per employee (25 prices), EUR (rs) Value added (4Q sum) Employment Issued building permits and construction of production buldings and warehouses Overall, we anticipate manufacturing output to continue recovering after a weak start in 214, although average monthly growth is expected to be weaker during the summer and autumn than during the last three months. We forecast 3-4% manufacturing output growth this year overall. If production at LM resumes, we will see a notable pickup. However, this is unlikely to happen this year although there has been some interest from investors, the selloff can at the earliest occur only towards the end of summer. One should also continue monitoring the situation in Russia and Ukraine. Are Latvian producers climbing the value-added chain? It is crucial to produce smarter to sustain growth in manufacturing. The Ministry of Economy targets the share of manufacturing to rise to 2% of value added by 22 from its current 14%, to support sustainable, export-driven economic growth. This implies that manufacturing needs to grow swifter than the economy overall. However, this cannot be achieved without significant increases in productivity. In recent years, producers have managed to make their production processes more efficient and less labour intensive, and this process will continue. However, to achieve a breakthrough in productivity, the manufacturing structure should change as well, shifting towards more technologically advanced industries and more sophisticated products. This shift can be promoted by, amongst other things, attracting new investors, thus bringing in new knowledge and opening up new export possibilities. Although it is very hard to measure this movement toward more technologically advanced industries and more sophisticated products, anecdotal evidence from Latvian industries suggests that this process is under way and that companies are slowly climbing the valueadded ladder Construction, annual growth (%) Number of permits, 4Q average Planned capacity, thousand m2 (4Q average, rs) Manufacturing output, 12m average, 21=1 (sa) Manufacturing High-tech Medium high-tech Medium low-tech Low-tech Source: Eurostat but progress has been rather slow so far According to Eurostat, although the manufacturing output of high-technology goods was rising by a solid 7% per annum in , this growth was slower than the 9% recorded in manufacturing overall. In the first quarter of 214, high-tech manufacturing growth surged to 24%. 3 Growth in the medium-to-high-technology segment was outstanding in (21% per annum); it stalled in 213 before picking up again in the first quarter of 214. The fall in medium-to-low-technology production in 213 is explained by the closure of LM. Note that these data may underestimate actual progress, since the split of the industries 3 According to Eurostat methodology, the high-tech industries are pharmaceuticals, computers and electronics, and air and spacecraft. The latter is negligible in Latvia. June 3, 214 Please see important disclosures at the end of this document Page 4 of 6

5 according to their technology levels is quite simplistic. For instance, the whole woodprocessing industry is considered to be a low-technology sector, although the product mix there is quite diversified. According to the Latvian Forest Industry Federation, about onethird of exported wood production in 212 was actually secondary processing (i.e., goods with more value added) vs. 26% accounted for by sawn wood, and wood-processing companies continued to slowly climb the value-added ladder in 213. To support the growth of value added in manufacturing and attract new investors, policy action is important. In recent years, some piecemeal actions have already been taken; however, progress has been modest. The national Industrial policy framework developed by the Ministry of the Economy is a very welcome programme, but it remains to be seen how it will work out and how effective it will be. Our policy suggestions thus largely stay the same as we outlined three years ago in our Swedbank analysis. 4 These include (i) strengthening cooperation amongst academic, business, and government counterparts and supporting research and development; 5 (ii) distributing EU funds more efficiently and in a more focused way; (iii) improving the availability of alternative financing besides traditional bank loans; and (iv) continuing to ease the labour tax burden, and compensating for this in the government budget by hiking residential property taxes and curbing the grey economy. Lija Strašuna 4 Swedbank analysis, Recent manufacturing trends in Latvia are there reasons to worry? (May 211), can be found here. 5 For more details see also Swedbank newsletter, Weak business innovation activity needs a boost (May 214), can be found here. June 3, 214 Please see important disclosures at the end of this document Page 5 of 6

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