OREANDA-NEWS. October 02, 2009. The fastest downturn is over for Latvia, yet the depth of the recession and recovery path largely depend on government's action, reported the press-centre of Swedbank. 

“The fastest economic slowdown is behind for Latvia, yet the depth of the trough, the time it will be reached, and the path of the recovery are all still open questions. The view on both global and Latvian economy has become more positive, but whether and how this emerging confidence will evolve depends largely on the government's decisions in the near future,” concludes the new Swedbank Economic Outlook report.

As the world's recovering, recession is also slowing down in the Baltics
The good news is that the world is seeing signs of stabilization and the speed of recovery is beating expectations. Confidence is gradually improving on global financial markets, and so is the sentiment of households and businesses. However, one should recognize that the stabilization, for the larger part, is a result of fiscal and monetary policy stimuli. The risk of “backslide” is still there, and the speed of the world’s economic recovery is set to be slow.

In the second quarter, the contraction of the gross domestic product (GDP) decelerated in all Baltic countries, while development going forward is expected to be bumpy. Estonia seems to be close to bottoming out, and fragile recovery might already resume late this year. For Lithuania and Latvia, in turn, the bottoming out is forecasted in 1H 2010.

Structure of Latvia's economy is changing, green sprouts in export industries
This year’s second-quarter cumulative fall in Latvian GDP from the highs reached in end-2007 amounted to 21%, and the volume the economy has relapsed to 2005. By mid-2010, the contraction of GDP will reach ca 25%, with the economy shrinking to levels seen in 2004. It means a 17-19% decline in GDP this year and a 0-3% decline next year, with slow-paced growth resuming in the second half of the next year and reaching 2-5% in 2011.

Late last year and early this year, contraction of Latvian GDP was affected by plummeting domestic consumption and exports. With incomes diminishing and unemployment on the rise, domestic consumption will continue to sink, yet slower. Consequently, the economy will recover from excessive consumption gradually allowing to strike a balance between too rapidly growing indebtedness and assets. Exports, however, are already seeing some stabilization since spring, and with the global economy recovering, growth in exports, although slow yet steady at first, is expected as early as in the beginning of 2010. The volume of orders for export markets has levelled off in manufacturing industry, and business sentiment has also improved. Industrial output is close to hitting the bottom, and fragile, export-driven growth can be observed in, for instance, wood industry.

Businesses are cutting costs and improving productivity
The drop in wage bill is in line with Swedbank's forecasts, namely, 22% down from the start of the year. In the private sector, labour costs have been cut predominately on account of decreasing working hours and layoffs, while in the public sector - on account of monthly wage cuts. As structural reforms get deeper, decreasing working hours and layoffs will become increasingly notable in the public sector, while tendency to cut wages will become more pronounced in the private sector.

Deflation is deepening in Latvia, caused by weak demand on the part of households due to increasing unemployment, sinking incomes and the need to deleverage. Although month-on-month consumer price movement is already seeing deflation since end-2008, due to tax increases in the first half of the year this year's average annual inflation will still reach 3-3.5%, in 2010 we will already see 2-4% deflation (depending on whether or not the VAT rate will be raised), but in 2011 stabilization of prices is expected. The deflation is absorbing some part of the negative effects that falling incomes are having on the purchasing power of households.

The cost and price drop to-date has improved the competitive strength of Latvia. Labour productivity per one hour worked has also started to grow. Moreover, in manufacturing industry productivity is growing faster then on the average in the economy, reflecting improved competitiveness of export companies and clearly implying a greater growth potential and the need to direct more capital towards export sectors. It should, however, be noted that the spare capacity has rapidly increased in manufacturing, in the short-term leading to a reduced desire and ability to invest.

Despite rapid adjustments taking place in the labour market, productivity improvements must become more profound and wider. If labour productivity gains don’t arrive soon enough, improvement of competitive strength will require even deeper wage and/or job cuts. It is, therefore, extremely important to aim at raising efficiency in processes, creating greater added value for products and services, and at elimination, by the government, of various administrative obstacles hindering business.

The depth of the pit and the progress of recovery greatly depend on the government's actions
The key risk, which may jeopardize the recovery of Latvia's economy, lies in domestic socio-political factors – the course of adoption the 2010 budget, consistency in government’s decisions and actions, social tensions.

On the upside, tax revenues have been relatively steady since April. The largest contraction of the GDP is already in the past, which also means a slightly lesser pressure on the state budget. However, it does not mean that the job is done – Latvia must deliver on its commitments with international lenders. Comprehensive and profound structural reforms based budget expenditure cutting instead of only taking some steps in the right direction, straightening out the tax burden through levying taxes on capital gains and residential property, improved administration of existing taxes are all vitally important. That would not only enable receiving financial aid, but more importantly would: (1) add competitive strength for the economy and (2) allow to avoid raising VAT and introducing progressive personal income tax, giving businesses the much needed clarity and boost for development.

“Many reforms are well underway; for example optimisation measures are being taken in state administration, education and health care. As reforms are painful, it is vital that they are implemented fully and not abandoned half-way through. To illustrate, if, while on his way from Liepaja to Riga, the driver decides that the journey has been too exhausting and he should make a stop in Kuldiga, the result will be more time and money spent”, notes Martins Kazaks, the Chief Economist with Swedbank, adding that “well thought-out and timely implementation of reforms, having the courage not to stop half way through, effective communication of the decisions with the society are imperative for our country today.”

About Swedbank Economic Outlook:
Swedbank Economic Outlook is a new analytical report by Swedbank Group based on the Baltic Macro Outlook, now also including a review of Swedish economy. Swedbank Economic Outlook will be published three times a year and made available on Swedbank's website at www.swedbank.lv