OREANDA-NEWS. January 17, 2011. The Bank of Latvia Council in its regular meeting tday discussed the latest developments in the Latvian economy and took decisions regarding the future direction of monetary policy. The main conclusions are as follows.

The economic development this year will to a great extent be determined by global events as well as decisions in the area of budget consolidation. We must be aware of the fact that the global economic crisis is far from being over therefore the grounds for future development of the economy are still shaky. This should be taken into account by policy makers so as not to succumb to too much optimism and maintain a dose of healthy caution when planning the future directions of the economy.

ON PRICE DYNAMICS

According to the statistics published at the beginning of this week, prices were dropping on average last year, with the 12-month average inflation reaching -1.1%. The annual inflation in December, however, rose to plus2.5%, primarily because of the low base effect and global developments in the food and energy resource markets. As you know, we face two kinds of inflation and the one that we have to keep in mind as we move toward the euro is the 12-month average inflation, which is at the above mentioned low level.

In the last two months of last year inflation continued to be affected by rises in costs determined by external factors. The rise in consumer prices in the last few months was persistently influenced by supply side factors: rising global food prices, particularly the prices of grain as well as oil becoming more expensive. For the majority of goods and services included in basic inflation, however, we observed dropping prices over the year: excluding the rising prices of food and energy resources caused by global developments, annual deflation was still the case in Latvia.

This development of inflation components points to the fact that the persistently low level of domestic demand and high unemployment exert a downward pressure on inflation. The risks for price stability in the medium term are limited as a result. We have to be aware, however, that in the short term – in the coming months - we are likely to observe a slight rise in inflation that will subsequently abate. This will be determined both by global developments and domestic decisions, but in the second half of the year inflation is likely to stabilize and return to the low levels of the previous year.

By domestic decisions I mean raising taxes, i.e. the government's decision to accomplish much of the budget consolidation necessary this year on account of higher taxes. That will raise the 12-month average inflation by about one percentage point.

Therefore in some months at the beginning of the year the annual inflation will exceed 3%. Yet as early as this coming spring, with the rise in food and energy resource prices in the global markets abating and taking into account information included in the futures, the annual inflation may begin to drop. Thus the 12-month average inflation for 2011 can be predicted to hover around 2.7%.

This prediction contains several upward pointing risks.

First, the actual development of the price of oil could bring its corrections. As the demand for oil keeps rising, particularly in China, the global oil prices have been on a fast upward trend in recent months. Any further price development will depend on the ability of the global economy to resume growth. Taking into account a significant amount of uncertainty regarding the development of the European countries and the United States, rises in global oil prices are nevertheless predicted moderate in the near future.

Second, the development of food prices in the global markets could also bring certain adjustments. As predictions regarding the expected harvests deteriorate because of unfavourable weather conditions, global food prices have been undergoing rapid rises in the past few months. Even though the food production levels have dropped, the amount of food reserves is still substantial and is likely to counteract the upward pressure on prices.

If no stabilizing of oil and food product prices implied in the futures is not observed in the near future and, quite the opposite, the present rising trend continues, it will undoubtedly act to raise the inflation indicators in Latvia as well.

Third, inflation could rise at a faster rate if so does foreign demand. Last year it rose 14%, and, albeit this year the rise might be smaller, it is still expected to be significant, about 6%. Despite the fact that in many European Union countries demand will be counteracted by budget tightening measures, the most important Latvian export markets may still expand: this applies first to our neighbours, Estonia and Lithuania, as well as Germany and the Nordic countries and of course Russia. A greater rise in Latvian exports will mean greater income for businesses and their employees and consequently a greater demand by those with purchasing power, affecting the prices to a small measure.

Fourth, looking to a more distant future, an inflation raising risk is the situation on the labour market, i.e. the disparity between the available skills and market demand.

Since the economy is reorienting itself from the industries stimulated by the real estate bubble to export based growth, it has caused important changes in the professions demanded in the labour market. Employers need specialists in certain areas but often cannot find them despite the high rate of unemployment. This is occurring simultaneously with emigration of labour as people make use of offers in the EU labour market and with the growth of minimum wage from 180 to 200 lats.

This situation can impede further growth of the economy substantially by stimulating a rise in the cost of labour for producing one unit of production and thereby reducing competitiveness. That means risking a situation where salary rises outpace a rise in productivity. The government can provide a solution by rising the share of instruments aimed at retraining the unemployed as early as the beginning of the year and reducing the intensity of measures indirectly limiting employment. Of course we have always supported the idea that a part of the funding directed at retraining to eradicate structural unemployment be directly available to entrepreneurs or that the list of necessary professions be agreed with them.

To conclude the description of inflation risks, I would like to add that in the short term, upward risks can be created also by inflation expectations stimulated by global developments and raising of taxes. For some entrepreneurs it may serve as a pretext for testing the market by raising prices more than necessitated by greater costs.

Inflation expectations can unfortunately also be promoted by public commentary, e.g., "soon we will return to the historic peak in inflation", which a few days ago made it to the headlines and articles in the media. I am sure that they confused quite a few. So that, upon hearing things like this, people do not get the wrong impression that in the coming months we will return to two-digit inflation it is important to remind ourselves that at the moment price development is moderate; no substantial price rises are expected in the future; on the contrary, we expect stabilization and then, in the second half of the year, price reductions.

DEVELOPMENT OF REAL ECONOMY

The annual changes of GDP in the third quarter turned positive in the third quarter for the first time since the beginning of recession in 2008. This resulted from the growth of the economy for a third consecutive quarter. Growth was primarily fostered by the real exports of goods and services: in the third quarter they increased 15.5% year-on-year. The most important factor here was the improvement in economic competitiveness evidenced by the increased share of Latvian export market shares in foreign markets as well as the renewal of foreign demand in a number of main trading partners. It is worth mentioning that it is the fastest increase in Latvian exports since the export boom in 2004-2005 caused by Latvia's accession to the EU.

Domestic demand is also on the rise. The unexpectedly rapid improvement in the area of investments. The formation of core capital in the third quarter reached the level of the previous year after dropping very sharply even in the previous quarter (by 36%). It was determined both by the lower base and the rise in investment over the quarter.

In the third quarter of 2010 the 12-month rise in private consumption resumed in the third quarter as it grew, albeit little, but still by 2.5%, yet according to the seasonally adjusted data a quarter by quarter improvement has not been recently seen. Some indicators characterizing private consumption exhibit contradictory trends and foreshadow future risks.

What are now the positive impulses behind the renewal trend regarding private consumption? Mostly these are developments in the labour market – drop in unemployment and rise in employment. The rise in employment in Latvia over the past few quarters has been among the fastest in Europe. At the same time we observe a renewed trend for forming deposits indicating caution. This in the third quarter was probably determined by several factors:

expectations of greater prices of utilities in the new heating season;

planned tax expenditures for the dwelling and land;

the pencilling in of the 2011 state budget consolidation measures also gave rise to greater uncertainty regarding future changes in purchasing power.

We can expect the economic recovery to continue, yet the quarter by quarter growth will slow somewhat. This will result both from the slower growth of foreign demand and from the tax raise. The annual growth of gross domestic product will increase under the influence of the low base and in 2011 we expect a 3.3% growth on average

We must remember, however, that the global economy is subject to substantial risks. The public debt crisis in Europe, its possible impact on the financial sector, and fiscal consolidation create important downward pointing risks for the global economic growth.  If they materialize, a further, more rapid growth of the Latvian economy may be impeded. If, on the other hand, the debt crisis is successfully overcome, the growth of foreign demand could be faster and, as I mentioned in my opening remarks, GDP could perhaps be a little greater.

Here we have to take into account also the prospects for the economies of Estonia and Lithuania, our most important trading partners: both countries have already accomplished a significant fiscal consolidation and, if the environment is favourable, could recover faster. Export development could also be positively impacted by an expanded economic cooperation with Russia that could be stimulated by the agreements recently signed in Moscow. Successfully continued reforms would ensure improved credit ratings for Latvia and economic growth could be stimulated by the inflows of new investments. That means that the GDP prognosis to a large extent will depend both on the development of the economic and financial situation in Europe and on the continuation of reform in Latvia. Additional fluctuations in the short term could give rise to changes in the confidence of or assessment of the situation by the population and the business community, which would bring recovery of consumption and investment closer or make them more remote.

ON THE STATE BUDGET

Straightening out the national budget and moving toward a balanced budget in the coming years is without any doubt the most important challenge to the Latvian economic policy makers. The success of this work will to a large extent determine the course of development of the economy.

Executing the budget consolidation to the expected extent, by 290 million lats, the budget deficit, i.e. the excess of expenditure over income, will drop under 6% of GDP. The work on the budget has begun, yet this amount of deficit is still very very large: it increases Latvia's government debt. In the coming years it will make servicing the debt more costly. Therefore the share of other expenditure items necessary for economic development will shrink in the total expenditure.

The government debt that quite recently was just 10% of GDP, during the crisis will have grown to about 50% of GDP: i.e. in a few years we will have turned into a country with a high rate of foreign debt. We should not forget that living with a budget deficit for a long time and increasing the government debt amounts to taking income away from future generations which will end up paying for our actions and expenditures today.

Here I must express my satisfaction that several members of the government have indicated quite clearly that further tax raises are insupportable and will not take place and that the debt burden will have to be lessened in the future. This is precisely why we should start working on structural reforms. In the next six months the government has an opportunity to come up with a clear plan for structural reforms, on which the 2012 budget should be based. No time should be wasted on reinventing the wheel – the necessary amount of consolidation can be found in the proposals worked out up to now on which we should find a way to agree.

ON THE RESOLUTIONS OF THE BANK OF LATVIA COUNCIL

Finally about today's decisions taken by the Bank of Latvia Council. The latest economic indicators confirm a gradual recovery of the Latvian economy: having grown for three consecutive quarters, gross domestic product is expected to have grown in the fourth quarter as well. At the same time we see that inflation at the beginning on the year will depend on short-term supply-side factors:  the rises in value added tax as well as food prices. In the medium term, inflation is expected to stabilize at a lower rate and risks to price stability are not significant.

In view of this, the Bank of Latvia Council today resolved to leave unchanged the Bank of Latvia set interest rates and the mandated reserve requirement.