OREANDA-NEWS. January 23, 2012. In its regular meeting, the Bank of Latvia Council discussed the latest developments in the Latvian economy and took decisions regarding the subsequent directions of monetary policies. The main conclusions are as follows, reported the press-centre of Bank of Latvia.

PRICE DYNAMICS
As the impact of external factors abated, the annual inflation, i.e. the rise in consumer price level year-on-year dropped to 4.0% in December. So inflation is one percentage point lower than in the middle of last year when it reached 5.0% in May. As we look forward, it is important to realize what determined price rises in 2011– i.e., these were one-off, transitional factors: the rise in global oil and food prices as well as the impact of indirect taxes raised in Latvia.

As we may recall, in January 2011, the following happened:

the basic VAT rate was raised (from 21% to 22%) as was the reduced VAT rate (from 10% to 12%);

the paragraph that provided for the application of a reduced rate to electrical power supplies to the population was struck from the law; the rates increased from 10% to 22% as a result.

As we go on regarding raised taxes:

in June, the excise tax rates were raised for fuel and alcohol,

in July, the excise tax rates were raised for tobacco products and natural gas used for producing heating energy and

the application of a reduced VAT rate to the supplies of natural gas was cancelled, and this tax rate rose 10 percentage points as a result (to 22%).

So far about last year.

The central bank's view regarding the development of inflation remains unchanged, i.e. at the moment we do not see any risks to price stability in the medium term. [Ill.] As the impact of the raises in oil and food prices and taxes abates, inflation will be much lower this year – by the end of 2012 it can be predicted at slightly less than 2%, compared to 4.0% last December. As a result, we can also predict a drop in average annual inflation from 4.4% in 2011 to 2.4% this year. In view of the Government's goal to introduce the euro in 2014, it is this average annual inflation indicator that is of interest to us because it is used to measure compliance to one of the Maastricht criteria, i.e. price stability.

What is this projection based on? The development of global oil product prices is an important factor, and her the key word is 'insecurity'. This factor is of course out of the control of the Government or the central bank: its direction will to a large extent be determined by the resolution of tensions in the Middle East oil producers. The global prices will also be impacted by the growth of global consumption – particularly in Asia – and whether the stable growth in the region will compensate the impact of the European debt crises. Our current assessment is that the global oil prices will not undergo large leaps either up or down. An important aspect to consider regarding this factor is the fluctuations of the exchange rate of the U.S. dollar, which may have a short-term impact on the inflation in Latvia as the energy resource prices change as expressed in euro and thus also lats. With the demand stable in the developing countries, we predict a continued rise in food prices in the global markets, albeit at a slower rate than thus far.

Unfortunately, inflation is kept up in Latvia also by such a factor as appreciating natural gas and heating energy that have already found reflection in the new gas tariffs.

On the other hand, the domestic demand in 2012 will remain moderate, thus limiting price rises.
The development of inflation processes this year will be equally dependent on external factors –the global prices of oil and food – and Latvian economic policy decisions. The Maastricht criterion figure is a moving target and in this respect we will be dependent on countries that find themselves at the the early stages of resolving the debt crisis and can experience drops in their inflation levels, i.e. possibly even a very low inflation. It is therefore important that the Government holds in front of itself and is ready to use an up-to-date anti-inflation measure schedule. The schedule was developed last year, taking into account the mistakes of the so-called "fat" years, i.e. this time avoiding raising salaries at the expense of increased efficiency. It is also essential to promote competition in the domestic market as well as continue work on reducing structural unemployment by approximating the skills of long unemployed people to the demand of the labour market and providing opportunities for conducting the re-qualification process of the unemployed not by the bureaucratic apparatus as up to now but by entrepreneurs themselves.

ECONOMIC ACTIVITY RESUMES
Last year was a time of successful stabilization of the economy. Along with its Baltic neighbours – Estonia and Lithuania –, that have also cutd their excessive budget expenditure substantially, Latvia is among the leaders of economic growth in the European Union. It is safe to say that in manufacturing and exports it was a model year – in these branches the pre-crisis level has been exceeded. Growth was also apparent in retail signifying a slow recovery of the domestic market. It is obvious that timely and decisive actions in consolidating the budget allows us to attract new investment, create new jobs and allows growth to resume, which in turn generates budget revenue. I understand that it may grate on some to use last year's least popular word, i.e. consolidation, but I am convinced that from the economic point of view this word is relevant; it means, as any dictionary will tell us, stabilization and strengthening. A budget that is built on real present and future income instead of a burden of debt to be paid by our children and grandchildren and unmanageable by the state stabilizes and strengthens both state finances and, as we have already seen, the economy at large.

In terms of export growth, Latvia has been at the vanguard of the EU [Ill.]. In the third quarter, the annual growth of goods and services exports in real terms, 10.3%, was the second fastest after Estonia and it was significantly supported by the renewed competitiveness. [Ill.] The excessive increase in salaries observed during the overheating of the economy, in recession years has been brought to par with efficiency. That has allowed businesses to compete successfully in the export markets, increasing the market shares of Latvian products at the expense of the producers of other countries.

This has found reflection in the increase of production volumes as well. Latvijas apstrades rupniecibas gada izaugsme saskana ar pedejiem pieejamajiem datiem bijusi visstraujaka Eiropas Savieniba, pern novembri tas gada pieaugumamAccording to the latest available data, the annual growth of Latvian manufacturing has been the fastest in the European Union [1], reaching 12.1%. The results are very good in transportation as well. Both the cargo turnover in Latvian ports (+12.5%) and the volume of transports by rail (+20.8%) reached a twenty year high. The operational data indicate that the year has been successful also for the transport by road. Sales also were up, particularly in the area of durable goods. The annual growth of retail turnover, which includes also automobile sales, reached 11.1% last November. Construction has recovered from deep minuses, finally reaching growth in the third quarter of 2011. Investment, which grew by one fourth in the third quarter, has been a good signal. It gives rise to hope that the prospects for Latvia's economic development are very good in the medium term.

[Ill.] Investors too have had a positive outlook on Latvia: the latest data on the inflows of foreign direct investment indicate that in the first nine months of 2011 they increased more than fourfold, reaching 621 million lats, substantially above the 145 million in the corresponding period of 2010. The Baltics taken together are EU leaders in terms of attracted investment and Latvia has been closely following the lead of Lithuania and Estonia. These developments are also reflected in the increase of the number of new jobs and falling unemployment. The registered unemployment dropped from 14.5% at the beginning of last year to 11.5% by the end of the year. The number of the employed, according to the latest labour survey, had increased by 25 thousand a year by the third quarter of last year.

CURRENT ACCOUNT
One of the basic economic indicators that attracted much attention in the period before the crisis was the current account of the balance of payments [Ill.]. Right now the current account balance is a measure of the reinforced macroeconomic stability of Latvia. The balance between exports and imports has been restored to a great degree. That indicates that the country at large (and not just the budget) is already capable of living with what it earns and does not have to borrow increasingly larger sums abroad as was the case in the so-called fat years. A further reduction of the budget deficit and further balancing of the budget in 2013.-2014 would allow the state finances to reach a balance and gradually reduce the government debt accumulated during the crisis.

UPDATED PROJECTION REGARDING GROSS DOMESTIC PRODUCT FOR 2012
Albeit the economy is recovering successfully and the macroeconomic situation is stabilizing, making Latvia much stronger and better able to resist the turmoil elsewhere in the world, in the short term, we predict weakening of the economic activity. Unfortunately, ever darker clouds have been gathering over Europe. As late as September there was – albeit slower, but still a positive development of gross domestic product in the euro area countries, yet now the outlook has worsened perceptibly. The European Commission and Olli Rehn, the Commissioner for Economic and Financial Affairs, allowed for the possibility of a recurring recession in the EU already in November of last year. [Ill.] The European Central Bank also downgraded its projection of gross domestic product growth in the euro area. In September it still ranged from 0.4% to 2.2%, but at the end of the year it slid to the range between minus 0.4% to plus 1%, thus including a very significant possibility for a drop. This projection moreover holds on the proviso that the financial crisis in Europe will not deepen and will stabilize.

The largest EU economy – Germany –, which already adjusted its gross domestic product from 1.8 to 1% in October, announced yesterday that it expects its growth to be even lower, at only 0.7%. Nine EU countries last week saw their credit ratings downgraded because of the concern generated by the euro debt crisis. This week, the World Bank downgraded its growth projections, warning of the possibility of a financial shock if some large European economy could no longer borrow on the financial markets and adding that the consequences would be even direr than the global financial deep freeze after the Lehman Brothers bankruptcy in 2008. Meanwhile, Latvia's most important export partners, Estonia and Lithuania, have also downgraded their growth projections [Ill]. The central bank of Estonia expects a 1.9% GDP growth this year, a substantial reduction from the expected 7.9% growth in 2011. The projections in Lithuania are likewise much worse. According to the last November's estimate by the Lithuanian Ministry of Finance, growth will drop from the expected 7.0% in 2011 to 2.0-2.5%.

The Bank of Latvia has also updated its projection of the 2012 gross domestic product growth: we have downgraded it to 1.3% from the 2.5% we predicted as late as September. The reduction is by and large the result of lower external demand and thus a slower growth of exports that will be reflected in weaker household-population consumption, for more finances will be directed to deposits. It also implies smaller investment as businesses are confronted with increasing uncertainty in the markets. Already the negative trend in lending is taking root, which is a reflection, on the one hand, of the increasing uncertainty and concern about future development and, on the other hand, of lesser possibilities of obtaining financing for business development.

In such conditions, Latvia has not been able to regain full confidence of the financial markets. An unpleasant surprise at the end of last year was the deterioration of the future prospects of Latvia's credit rating – instead of the expected improvement. That is yet another indication that the stability that has been achieved is still fragile and the success story has yet to be finished: the success has to be reinforced by continuing toward a balanced budget and reducing Latvia's dependence on the financial markets.

Yet along with the downgraded GDP projection, we should admit that the projection scenario is subject to both upward and downward pointing risks. One of these scenarios would come to pass if the brief moment of respite offered by the monetary policy measures adopted by the European Central Bank is used to improve the financial situation in the euro area countries, clearly delineating the trajectory of reducing the budget deficit and indebtedness and convincing the financial market participants on the sustainability of the finances of the relevant EU member states. Along with the recent drop in the euro exchange value against the US dollar may force the export engines of Germany and other euro area countries to move faster and improve confidence in or future outlook on the development of the domestic markets in these countries. In such a situation, the Latvian economy too would receive a new impulse for faster growth.

Unfortunately, a more negative scenario is equally possible. Economic activity may prove even weaker in case the financial situation in Europe continued to worsen, confidence among the financial market participants dropped even further and that caused significant problems in the European banking system. The inability to bring the finances of a euro area country under control may actually lead it to default. Moreover, the aforementioned negative processes may combine. In such circumstances it is unlikely that the Latvian economy could manage to avoid repeated recession. It is however clear that even if it came to pass the shrinking of the economy this time around would be much less than we experienced in 2008-2009. In contrast to the previous recession, no macroeconomic unbalance is the case in the Latvian economy and it is much more resistant to external shocks. Yet if such a chain of negative events took place, the possibility of a drop in gross domestic product in Latvia cannot be ruled out. It is therefore utterly important to follow the developments in the economic situation carefully and prepare for the worst scenario. If it came to pass, Latvia would have a real plan of action – the so-called Plan B – for limiting the negative consequences for the economy.

BUDGET 2012
Therefore, as we discuss the 2012 budget, this plan should first of all include possible measures for additional budget consolidation already this year. However, I will have to digress a little here. Before I turn to this year's state budget prospects in greater detail, I must remark that the budget deficit has been brought under control [Ill.], if we compare it to 2008.-2009, when the excess of expenditure over revenue threatened to reach 20% of gross domestic product. Last year the budget deficit was around 4% of gross domestic product and this year it's planned at 2.5% of gross domestic product. We are moving in the right direction, yet it is still deficit – this year too every day we will spend about a million lats of money we have not earned. In order to finance this, Latvia will have to borrow in the capital market and we will depend on investor confidence [Ill.].

We will have to pay interest also on the state debt accumulated during the crisis, almost 300 million lats: it is money that is being paid away but which could be used, for example, for the development of our health and education systems. It is therefore of utmost importance to stop the debt from growing and to ensure that in the eyes of the investors Latvian economic policies are trustworthy. That is the only path to new jobs and additional budget revenue – moreover in a situation where the financial markets are nervous and their view of Latvia can shift momentarily at the slightest suspicion that Latvia could step back from the path of sustainability of state finances and submit to the temptation to spend more than we have earned this year and the next.
People would naturally prefer optimistic assumptions that Europe will avoid new shocks and the situation will gradually improve this year. We can only hope that that will be the case. From the perspective of state finance and business planning, however, it is more pragmatic to be cautious because there is much uncertainty and many unknowns. Therefore we have to consider the possibility that if the GDP projections that are at the basis of the budget do not come true, we may have to review the budget as early as the first half of the year and cut expenditure accordingly. We have to reckon with such a possibility and develop a plan so that in spring or mid-summer Latvia is not once again faced with spontaneous and slapdash decisions in the area of budget consolidation, which would represent another shock to the economy.

If in our budget we do not react to changes in the external environment in a timely manner, we run the risk of again facing the situation where the confidence restored over several years is lost and the opportunities for the Government to borrow in the financial markets are again limited. A cautious approach, on the other hand, would not only provide more security but also a greater stimulus to the economy. The additionally consolidated sum the budget would regain in income – the lower the interest rates, the smaller the debt interest payments from the budget and, as a result of greater economic activity, greater tax revenue.

EURO 2014
No need to add that greater caution in budget planning this year would provide us with a greater possibility to meet the Maastricht criterion which assesses a country's financial stability based on the budget deficit indicator.

Correcting the errors hitherto made in its budgetary policies, the euro area is gradually recovering from the crisis or illness. I think that in 2012 the most difficult part of straightening the budgets will already be accomplished. We can therefore expect that Latvia will enter a stronger euro area than before. Decisions on cutting the deficit and debt are painful and are not made quickly. We will hear much discussion as to how the EU should better coordinate the financial policies of its member states. [Ill.] We will also hear various speculations – just as was the case with the lats in the crisis years. We have to realize that there is and always will be a plethora of views regarding the euro and it is important for us not to get sidetracked but to continue on the road we have started out on toward the goal that right now is realistically within our reach. As it is put in a good and popular TV show: Latvia can. Latvia can introduce the euro in 2014!

RESOLUTIONS OF THE COUNCIL
Finally about today's resolutions of the Bank of Latvia Council.

In view of the fact that inflation is on a downward trend and, without posing a danger to price stability, it is possible to promote the availability of free resources at the disposal of the financial sector to businesses, the Bank of Latvia Council today resolved to reduce the reserve ratio by one percentage point. For bank liabilities above two years, it means a reduction from 3% to 2% and for the rest of bank liabilities included in the reserve base, from 5% to 4%.

By reducing the reserve ratio, additional resources are freed for lending and better conditions are created for the availability of lending resources needed for economic growth. A simultaneous reduction in the reserve ratio for liabilities of different maturities will provide an even impact on the availability of free resources in the banking sector and will continue to stimulate bank motivation in attracting long-term resources.

The interest rates set by the Bank of Latvia remained unchanged.

[1] According to data adjusted to the number of working days.