Macroeconomic Review of Latvia January 2014

Macroeconomic Review of Latvia January 2014 In Focus On 14 January, after a six-year break, Latvia successfully issued seven-year bonds in the amount of EUR 1 billion with an interest rate of 2.625% and a yield of 2.815%. The current account deficit during the last nine months of the previous year was LVL 172 million or EUR 244.73 million, which amounts to 1.5 % of the GDP. The consolidated State budget of 2013 concluded with a financial surplus in the amount of LVL 4.4 million or EUR 6.26 million. Last year 70.48 million tonnes of cargo were handled in Latvian ports, which is 6.3% less than in 2012. In Riga Port, 35.5 million tonnes of cargo were handled, which is 1.6% less than the year before. In Ventspils Port, this amount was 28.8 million tonnes of cargo (-5.2%), while Liepāja Port saw 4.8 million tonnes of cargo or 34.9% less compared to the previous year. During the first 11 months of 2013, Latvia exported goods with a value of EUR 9.2 billion, which is 1.8% more than in the respective period of 2012. Imports grew by 0.5% and amounted to EUR 10.4 billion. Industrial output decreased by 0.1% in the first 11 months of 2013. The volume of the manufacturing exceeded the previous year s level by 0.4%, while the mining industry and quarrying exceeded by 3.1%. Due to the influence of the warm weather conditions, the power and gas supply decreased by 2%. Dainis Gašpuitis Macroeconomics Expert Telephone: 67779994 dainis.gaspuitis@seb.lv Edmunds Rudzītis Socioeconomics Expert Telephone: 67215933 edmunds.rudzitis@seb.lv A/S SEB banka Meistaru iela 1, Valdlauči Ķekavas pagasts Ķekavas novads LV 1076 http://www.seb.lv ww.seb.lv

Latvia s key economic data and forecasts GDP growth (%) -1.3 5.3 5.2 GDP at current prices (mln EUR) 18190 20312 22083 2010 2011 2012 2013 2014f 2015f 4.2 16975 4.8 4.8 23850 25600 Consumer prices index (% annual average) -1.1 4.4 2.3 0.0 1.8 3.3 Fiscal balance of the Government consolidated budget (ESA 95, % of GDP) Current account balance (% of GDP) 2.9-2.2-2.5 Foreign direct investment flow (mln EUR) 286 1045 863 Cumulative foreign direct investment (mln EUR) 8184 9360 10258 Foreign trade balance (% of GDP) -9.5-12.1-12.0 Government foreign debt (mln EUR) 5884 6382 6897 Manufacturing output (% yoy) 14.0 11.5 9.4 Retail trade turnover (% yoy) -3.0 2.4 7.3-8.1-3.6-1.4-1.3* -0.8-0.8-1.5 I-X 430 11298-11.7 XI 6919 I-XI 0.4 I-XI 3.8-1.7-2.3 650 800 12050 13150-12.5-13.2 - - 4.5 6.5 5.8 6.1 Unemployment rate (%, end of period) 14.3 11.5 10.5 9.5 8.2 7.5 Job seekers rate (%, end of period) 16.9 15.0 13.8 Average gross salary growth (% yoy) -3.5 4.3 3.7 Real wage and salary index (% yoy) -6.5 0.1 1.6 11.8 5.1 6.3 10.5 9.1 5.5 6.0 4.2 3.5 Standard & Poor s long-term credit rating BB+ BB+ BBB BBB+ - - * Provisional data. Sources: Central Statistical Bureau of Latvia, the Bank of Latvia. SEB banka s forecasts. The Baltic economies: Resilient growth Despite complicated global conditions, the Baltic countries will be among the leaders in terms of growth in the European Union also in 2014. So far the growth of Estonia has clearly slowed down as a result of a drop in exports and investment activity. However, growth will accelerate, and the Estonian GDP is expected to increase by 2.6% and 2.9% in 2014 and 2015, respectively. Latvia and Lithuania will also maintain healthy growth. In the next two years, the growth of the Latvian GDP will be faster, amounting to 4.8% accordingly. In Lithuania, it is expected to be within 3.5-4.5%. For all three Baltic countries, the main driving force is private consumption, which is facilitated by a good increase in real income. It is expected that Lithuania will qualify for euro-zone membership in 2015. Latvia: better growth prospects in 2014 In 2013, a slow-down in economic activity was observed, albeit more moderately than expected. GDP growth in 2013 might reach 4.3%. In view of global economic conditions, this is a very good result. In the meantime, it can be seen that the benefits of positive trends fall far short of public expectations, because positive changes reach the public unevenly and to a limited extent. www.seb.lv 2

Despite the worsening of public sentiment in late 2013, the economic growth rate in the third quarter accelerated compared to the first two quarters, demonstrating an increase of 4.5%. Sales maintained its leading role (+5.4%). Construction also continued to grow steadily (+11.6%). Growth in residential construction of 83% was one of the drivers of activity. The rapid recovery of the manufacturing, which already showed an increase of 2.5% in the third quarter, was a positive surprise. lines in the allocation of EU Funds, investment activity might also increase. With exports and investments lagging slightly, households have become the main drivers of growth recently. Thus, in the third quarter consumption increased by 4.9%. Investments were back to positive again in the third quarter and increased by 3%. Public spending increased by 1.4%. Meanwhile, both exports and imports decreased. However, alongside with the more rapid decrease of imports, these trends had a positive impact on GDP. The trends observed in the previous year will continue this year. Household consumption will still play the main role. An increase in real income will be one of the preconditions. In view of global forecasts, exports should become more active. Moreover, in the second half of the year, alongside more positive trends in external markets and the delineation of new This year, growth will continue in relevant sectors of such as sales and construction. The manufacturing is also expected to make a contribution in the future. If Liepājas Metalurgs returns to operation (most probably, with a more limited capacity than before the initiation of insolvency proceedings), growth might be much higher than in 2013. Growth can be expected in the commercial services sector as well. If the improvements observed in the external environment continue to strengthen, this will be reflected in public sentiment and activity will also continue to raise in the real estate sector. Complications are possible in the field of transit, where both the speed of recovery of the euro-zone and geopolitical considerations, including the policy pursued by Russia and the Latvian industry capacity, will play big roles. It is likely that the entertainment and recreation sector will show the most dramatic growth; however, due to its share, the potential economic impact is small. During the next two years, overall growth might remain at 4.8%, which indicates that in many fields improvements will be still gradual as well as uneven. The low inflation environment globally will deter prices from rising Global inflation continues to fall due to the drop in energy and food prices. The low, full load of production capacity in coming years will be the main factor in ensuring a low inflation environment globally. This will allow the central banks to continue supporting growth and maintaining low interest rates. Also, structural and economic problems will continue to maintain the inflation at the low level. Despite short-term measures, such as an increase of indirect taxes or commodities price fluctuations, no factors that could cause global inflation pressure in the nearest future can be seen. In the euro-zone, deflation www.seb.lv 3

risk can be observed, while in the USA inflation is gradually returning to normal, although decisive factors hampering inflation can still be observed. Meanwhile, the consumer price level in Latvia in December remained unchanged in comparison with November. The increase in food and fuel prices and decrease in clothing and footwear prices have had the largest influence on consumer price fluctuations during the month. As a result, the annual inflation was -0.4%. The average annual inflation was at the statically level of 0.0%. Last year, the prices of milk and dairy products, housing management, as well as catering services had the largest impact on the rise in price levels. However, the fact that the overall price level has remained, to a large extent, unchanged has been due to global factors which resulted in the drop of fuel and heating prices. This year, the main trends will continue to be dictated by global factors, although the level of prices will increase under the influence of local conditions. The base effect will play a role. It is expected that the introduction of the euro will have a certain effect, although the potential rise has partially already taken place in 2013. With economic growth, increases in wages and a drop in unemployment continuing, there Favourable prospect for the labour market The registered unemployment rate recorded in late 2013 was 9.5%. During the year, it dropped by one percentage point, which means that the recorded number of registered job-seekers decreased by 10, 731. This year, the recorded unemployment rate could slide to close to 8%. A slightly higher rate will continue to reflect in the Central Statistical Bureau s survey regarding the job-seekers in the country; last year s rate ( 2013) of 11.8% could drop down to 10.5% by the end of this year. The positive trends of this year will continue, but no sharp decrease can be expected. A more pronounced increase in activity is to be expected in the second quarter of the year. There could be demand from all sectors of the economy. Demand for workers with specific knowledge and other skills can be expected. Also, a large number of the positions and wage levels offered will be unacceptable for some of the workers who meet such requirements. will be sectors, goods and services which will not be able to overlook these processes and will be forced to increase prices. It is very likely that an increase in the prices of individual food products will continue as well. Hence, a selective price increase will be a coherent response to this. The development of the Latvian economy is at good pace, which has its consequences. The opening of the electricity market to households will be one of the most important events affecting prices. Inflation in 2014 is expected to be 1.8% and 3.3% next year. Therefore, specific sectors will search for workers discreetly, by addressing potential candidates directly. In the meantime, sectors such as sales and services will be forced to search more actively, since the conditions offered will represent challenges in www.seb.lv 4

attracting the necessary workforce. The construction sector will face a growing deficit in the labour force of both specialists and workers. Despite the drop in the unemployment rate, the rate of employment increases Wages continue to grow The increase in economic activity continues to push up wages, which increased by 5.1% in the third quarter of 2013, as compared to the same quarter of the previous year. The increase in wages in the public sector was 5.3%, including the general government sector, where it reached 6.2%. It was closely followed by the private sector, where the increase was 5%. The slightly larger increase of wages in public administration is in line with projected trends, and there is reason to believe that a similar trend will continue in the future as well. The strong grip of austerity loosens, and preconditions for the wage increases improve. Those who work in local governments and public and municipal capital companies have far more chance of having their wages increased. The State budget will not be able to satisfy all the demands for wage increases for quite some time. Wages in the private sector will be contingent upon the profitability of each individual sector and company as well as labour market conditions. Part of the potential increase will partly dissolve in the shadow economy. Therefore, variations between sectors and companies will continue to be very uneven and different in pace, as a result of which quite a large share of workers will not experience any change in their wages this year either. Accordingly, the wage increases will not be comprehensive, but rather selective for the time being. as the number of persons interested in returning into the labour market increases. This will be one of the factors hindering a drop in the unemployment rate. It will depend on the development and HR policy of each individual company and the labour market situation. Sector specialists and workers in rapidly developing sectors will be in a better situation. Evidence suggests that in the mid-term, the pressure to increase wages will only increase, and this will pose risks to competitiveness in the longer term. In the third quarter, the sharpest increase of wages in the Baltics was observed in Estonia (+8.8%) and Lithuania (+6.2%). This year, the expected average increase of wages is 5.5% and could reach 6.0% next year. Weak inflation will continue to have a positive impact on purchasing power. The sales activity increases at the end of the year In November 2013, a more rapid increase in retail sales than during the previous months was observed, that is to say by 5.0%. Food product turnover increased more rapidly by 7.2%, while the turnover of non-food products increased by 3.7%. Not taking the retail sales of transport fuel into account, the turnover of non-food products was 5.1%. During the first 11 months of 2013, retail sales grew by 3.8%, with an increase of 4% for food products and 3.6% for nonfood products. An increase in household income, alongside an increase of the total number of employees and their average wage, as well as low inflation, has promoted a rise in spending by the population. This allowed households to buy more food and non-food products last year than in 2012. At the same time, the price of a product is the decisive factor in making purchases, as is evidenced by both the popularity of discounted products and the increase of sales turnover of second- www.seb.lv 5

hand products and activity of online and mail-order sales. In November of last year the sharpest turnover increase during the year was recorded in mail-order and online retail sales (41.5%); retail sales of secondhand products (22.5%) were also remarkable. In late 2013, apart from traditional holiday spending, retail turnover was also influenced by the process of euro introduction, since a large share of the population chose to spend their cash savings. In 2014, the purchasing power of the population will continue to increase, thereby maintaining the increase in consumption. Interest rates will remain low Taking into account the necessity to support the economy in the area, the European Central Bank (ECB) might decide in the near future to implement quantitative easing measures, while the Federal Reserve (FRS) will gradually limit the monthly amounts of monetary stimulus. Such a move by the ECB could be justified by the willingness to stabilise expected inflation and promote crediting. During this and next year, the FRS will not increase the key rate. The strategy of the existing policy will be based on the willingness to see a drop in unemployment to below 6%. Low interest rates will begin demonstrating a weak increase, although, under the influence of deflation risks and the ECB s policy, this will happen to an even more limited extent. The current monetary policy of the ECB was beneficial to Latvian borrowers, since the low EURIBOR money market index rate allowed savings at the expense of monthly payments for housing loans. During 2013, the average interest rate on housing loans with a maturity of more than 5 years shrunk by 0.13 percentage points down to 2.54%, which is a historic low. It is expected that in 2014, the cheap money era will continue, but interest rates will not remain historically low for a very long time. Therefore, in the foreseeable future an increase (to a limited extent) of EURIBOR can be expected, which would have to be taken into account by borrowers subject to variable interest rates. www.seb.lv 6

SEB banka 2012 This edition is intended for general circulation only and does not constitute a personal recommendation. The information in this document was obtained from sources believed to be reliable, but its accuracy or completeness cannot be guaranteed. Any opinions expressed herein are given in good faith, but are subject to change without notice. www.seb.lv 7