OREANDA-NEWS. January 10, 2007. Gross Domestic Product. For Latvia the year 2007 has been rich in changes and marked by new economic tendencies, reported the press-centre of „Latvijas Krajbanka".

Very conservative policy of the banks regarding mortgage credits and the unacceptably high dwelling price levels have stimulated the pricing adjustment and a decrease in activity in several real estate segments. The economy of Latvia continued to show a high growth rate, although in separate sectors of the economy an increase in the development rates, including such important economic drivers as retail sales and civil engineering, is already noticeable. Together with a moderate growth of imports all these tendencies indicate to an internal consumption decrease. Considering that the economy of Latvia is by 70% dependent on public consumption, such tendencies in any case will be reflected in the GDP indices. Most probably, the economic growth rates will decrease during the last quarter of the year.

In this regard even bigger concerns are raised by the stagnation in the manufacturing industry. This year the specific weight of the manufacturing industry in the economy of Latvia has continued to fall and in the 3rd quarter of 2007 it was only 10.7%, which was stimulated both by the still rapidly increasing rates of the service industry growth rates and also a downslide in the manufacturing industry itself. Considering that manufacturing is the main export industry in Latvia future perspectives for export are even more pessimistic. Already today the export indices are not consolatory, because in many industries the growth of export is being observed only due to exported goods' becoming more expensive and not owing to an increase in volumes.

Forecast for 2008
During the next year, most probably, a substantial fall of economic growth rates is anticipated. High prices will restrict consumption growth. Due to this fact the growth of several service sector development rates will continue; also the cooling of the real estate market will not end. The main risk for the economy of Latvia is connected to the fact that together with a sad situation in the manufacturing sector all these tendencies could promote a too rapid decrease in the development rate of the Latvian economy, which in no case is acceptable. Unfortunately we are unable to exclude such a scenario. Its reality could be confirmed by the Estonian example, where, owing to a substantial adjustment in the real estate market, the manufacturing industry rate decrease and the not quite successful development of several service sectors, the gross domestic product growth rates decreased from 10-12% in the previous years to 7-6% in the middle of the current year, and the increase in the economic processes in the neighbouring country will most probably continue.

It is rather difficult to forecast the real Latvian GDP growth, because in the economy the shadow economy legalization process is presently going on. Neither its volumes nor the "disclosure" rates are actually known. Thus, the "grey" economy, on the one hand, does not allow for evaluating the real GDP volume, and on the other hand it artificially improves the GDP growth indices.

Inflation
This year the Latvian inflation index has reached its highest level for the last decade: In August the annual inflation has passed the psychological border of 10% and in November it already reached 13,7%. The inflation is constantly stimulated by the same factors - the rise of food products' and catering services' prices as well as the administratively regulated prices. This year the oil prices on the world's markets have reached their historical records as well as have reflected in the Latvian inflation indices. The excise tax rise has increased the prices on tobacco products which account for about one percentage point from the total 2007 inflation.

This year the inflation indices were substantially influenced by the rise of the prices on services. It has noticeably exceeded the rise of the prices on products - in average by 3 to 5 percentage points. Such effect could often be observed in countries with rapid economical development and it partly explains why the young economies in general experience a greater inflation than the developed countries. Also it should be considered that mostly the services are untradable goods and a rapid increase in prices on them partly indicates on a lack of competition in Latvia. By offering the tradable goods the entrepreneur also pays attention to the world prices but the service providers mostly only focus on the internal market.

Forecast for 2008
It is unlikely that the inflation tendencies will change during the next six months. In 2008 the gas supply price increase will continue which will be followed by the rise of other administratively regulated prices. The growth of administratively regulated prices constitutes about 15% of the inflation, thus a greater increase in the gas, electricity and other tariffs will limit the possibilities of diminishing the inflation.

Also it should be understood that the inflation is a passive index which is by a great extent dependant on its past experience. For example, during the planning of the budget for the next year the entrepreneurs anticipate the increase of expenses by at least 10%, which also reflects in the prices on their offered services and products. Thus the stable high inflation figures further increase the anticipated inflation.

In the second half of the next year the decrease of domestic consumption, which is already observed at present, will start facilitating a gradual fall of the inflation rate. The present high prices and the decrease of purchasing capacity of a part of the Latvian residents is reducing the demand on the individual products and services. Such tendency in the course of time is becoming a powerful factor of restricting the rise of prices. However, considering the possible inflation rise at the beginning of the year, the average inflation indices in the next year could become even greater than they are now.

Foreign trade and the current account deficiency
It is positively evaluated that this year the export characterizing indices have improved. At the same time the increase in the import growth is observed. However the current account deficiency rate is remaining at a very high level (24,8% of the GDP in the first nine months of 2007). Also it should be considered that the increase of the export and import indices usually is not calculated by the comparable prices (as, for instance, the GDP and the growth of the industries of the economy - minus the increase in the figures which has resulted from the appreciation of products and services). This means that the real annual export growth is by 10 to 15 percentage points less than that shown by the nominal growth (23,4% in October), whereas that of the import is by 4 to 6 percentage points (12,1% in October) less.

Forecast for 2008
It must be admitted that the current account deficiency is remaining unacceptably high , despite its gradual decrease. The main deficiency promoting factor is the rapid import growth rate which exceeds the export growth. Considering the current tendencies in the Latvian economy - the intense consumption, which is stimulating import, and very weak indices of the manufacturing (the basic Latvian export industry), prove that the improvement of the current account balance will go on slowly.

In this regard it is important to note that great current account deficiencies are almost inevitable in the developing countries. For the purpose of achieving the level of the developed countries sooner, the Latvian economy is borrowing whileresting upon future income, in order to cover the present consumption and investments.

Labour market
The lack of the workforce and the growing expenses has facilitated the growth of income in Latvia: In 2007 the average gross salary across the country will increase by 30%. Undoubtedly, such a rapid income growth has appeared only in a part of the inhabitants of Latvia, whereas in the biggest part of the population the income has not grown or it has insignificantly, and their purchasing capacity is continuing to diminish under conditions of rapidly growing prices. Besides, a part of that rapid growth is explained by the residents' income legalization process. Thus, in Latvia there is markedly evident a trait of a developing country - along with the development of the economy the disparity of the income and the standards of living increases.

At the same time the income level in Latvia still significantly differs from that of the most European countries, while the prices for separate product groups in Latvia already are comparable with those in the richer countries or they even exceed those of the latter. Low payment is the main factor which is stimulating the intensive workforce outflow to foreign countries, which alongside with the economic development is promoting the unemployment decrease in Latvia.

Forecast for 2008
The possibilities of the unemployment decrease in Latvia are quite limited because this process is already approaching its natural level (the theory of economy provides that even under conditions of complete employment, unemployment in the country is still possible). However, considering a different situation in the regions of Latvia, the unemployment diminishing possibilities are not yet exhausted. At the same time along with the economy tempo increase, the demand for labour force could weaken, which would result in the growth of the unemployment level in a long-term perspective.

The growth of expenses on workforce in the next year will show a decrease of the tempos, which would be mainly influenced by the restriction of salary growth for those employed in the State sector. At the same time the private sector salary indices will continue to grow rapidly, however they will be dramatically influenced by the "envelope" payment disclosure, in conditions of growing of the minimum salary and the tax-free allowance as well as the continuation of the struggle against unofficial incomes in the country.

Bank sector
In 2007 the Latvian commercial bank credit portfolio showed an increased tempo in the growth, which was stimulated by a more cautious policy of the most active market participants towards the mortgage credit issue. Thus, at the end of September the amount of the issued credits has grown by 47,6% (56% in the respective period of the last year).

The volumes of credit financing in Latvia have achieved a rather high level: The Latvian commercial bank credit portfolio has already exceeded 100% of the GDP, which is the biggest index among the new EU Member States and which is already comparable with the situation in the developed EU States. Considering that the further development of credit financing in Latvia is related to the increased risk, the credit financing potentiality is quite limited. Already at the end of this year the credit growth rates will slow down by up to 40%, and in the next years they could diminish more than twice as much.

However this does not mean that the credit financing in Latvia will stop. There has come the moment when the economy of Latvia is no more able to absorb such a great influx of the credit funds. Taking into account the situation in the real estate market, the diminishing of the credit financing tempos will go on through a much more moderate mortgage credit growth.

Also the fact, that the biggest part of the Latvian commercial banks' credit portfolio is related to the foreign banks' subsidiary companies and branches, should be taken into consideration. Thus, the financial crisis and the liquidity difficulties, which the world's financial markets have experienced this year, obligatorily will reflect in the resource availability to the Latvian banks.

This year the annual growth of the investments will slightly increase and achieve 25,3% in the end of the year's third quarter (22.7% in the respective period of the previous year). However in the third quarter of the current year the residents' deposit decrease was observed, for which there could be various reasons:
Slower activity in the real estate market, which results in the current account shrinkage;
High inflation, which diminishes the customers' purchasing capacity and their interest to the deposits;
The money is no longer deposited but it is used for the credit or consumption payment;
A part of the depositors prefer to deposit into the investment funds;
The Latvian workforce outflow intensity has increased, which means that the influx of the "Irish money" is not growing so rapidly as earlier;
The Latvian entrepreneurs have to invest into technologies, upgrade and restructuring.

Could we name these factors "tendencies" and anticipate the decrease of the residents also in future? Both yes and no. On the one hand, the customers' wish to deposit is stable, in its turn the growing incomes of the part of the Latvian population and the improvement of the financial situation for the part of the Latvian enterprises increase the total amount of the deposits. At the same time it is necessary to be aware that the banks also include the current accounts in their deposit portfolio - the money that is circulating in the customer accounts in which in the separate months a slight fall is observed, which also explains the total figure decrease.

Conclusions
The disproportionalities of the economic processes in Latvia - the rapid growth of the price and service sector added value, high deficiency of the current account, huge state gross external debt, relatively big bank credit portfolio and other processes - indicates to economic overheating. The banks' more conservative credit policy and the activity decrease in the real estate market is resulting in the drop of the domestic demand, however is only one of the ways to promote the stabilization of the economic processes. Undoubtedly, a more active position of the government regarding the decrease of expenses and the facilitation of commercial activity and export is necessary. In order to diminish the possibility of the "heavy landing", the further development of the State economy stabilization plan is necessary. Yet we must admit that even after the successful implementation of the stabilization its impact on the economy will become visible only in the second half of the next year.

Considering the noticeable increase in the economic processes, in the next years the GDP growth tempos will significantly decrease and reach 5 to 7% per annum. The decrease in the domestic consumption not only will be one of the main factors of facilitating the economic growth tempo and the inflation increase, but also will help decrease the external unbalancedness, namely the trade balances and the current account deficiencies. The main risk for the Latvian economy is related to the possibility that these processes will go on much too rapidly and painfully for the Latvian entrepreneurs and residents, thus drastically increase the number of bankruptcies and reducing the purchase capacity of the bank customers.