OREANDA-NEWS. May 20, 2011. In regular meeting, the Bank of Latvia Council discussed the latest development trends in the Latvian economy and took decisions regarding the subsequent directions of monetary policy. The main conclusions were as follows, reported the press-centre of Bank of Latvia.

INFLATION DYNAMICS
The dynamics of annual inflation was still primarily determined by fuel and food price rises as well as the influence of the changes in the value added tax rates. This trend corresponds to what we predicted at the end of last and beginning of this year. The fluctuations in the global prices, however, have been even more dramatic than expected. It should also be noted that in the summer prices will be additionally influenced by the expected rises in tax rates: a rise in the excise tax on fuel, alcohol, and cigarettes and the abolition of the reduced VAT rate on natural gas supplies. That implies that in the short term, inflation risks will continue to point upward.

Consequently, the inflation predictions will definitely have to be adjusted upward at the next review in July, factoring in both the effect of the new tax rates unknown at the beginning of the year and a more rapid rise in fuel prices. Yet it is important to remember: – the central bank's outlook on the price dynamics in the medium term remains unchanged. The reason is that the high inflation of 2007-2008 is not returning because the current rise in inflation is caused by transitional factors. As their effect abates, so will further overall price rises in the subsequent periods. We expect the 2012 inflation level to be lower than this year: it could be between 2% and 2.5%.

One of the main reasons why there currently is no basis for rumors and worries about the return of a steep inflation, is the lending situation, which just a few years ago stimulated a rapid rise in domestic demand. The amount of newly granted loans does not even cover the drop in the total loan balance in the course of paying them off. Second, the high inflation periods of before were accompanied by similarly steep rises in salaries, therefore a large part of the population did not even feel the rise in inflation. At the moment, salary rises are substantially lower than before the crisis and cannot cover the rise in inflation. Thus price rises are currently a factor that substantially limits real purchasing power and domestic demand.

INFLATION AND EURO 2014
To conclude my remarks on the subject on inflation, I would like to draw your attention to another important detail: the planned transition to the euro. Being aware of the dynamics of the inflation factors in which external factors also play a substantial role impossible to affect by decisions made in Latvia, we have to agree with finance minister Andris Vilks who talked about the need for a goal-directed discipline in introducing the euro in reference to the strategic goal of the government to change over to the euro in 2004. The government is to be commended for realizing the importance of this period for a further stability and growth of the country and for being ready to act, assessing the dynamics of the main macroeconomic indicators, including inflation, from the euro introduction perspective as well.

As the minister has pointed out, we must carefully weigh the state's expenses, calculating their influence on inflation in the evaluation period when Latvia's readiness for participation in the euro zone will be determined. Moreover, remembering the lesson learned by neighbouring Lithuania, which missed meeting the inflation criterion by less than 0.01 percentage points, it is important for the government to have recourse to additional measures to be used in an emergency so that inflation could be adjusted by a few fractions of a percentage point. Avoiding further tax raises and surveying the effects of administered prices is the absolute minimum for Latvia to bring down inflation and avoid the same kind of mistakes our southern neighbours made.

DEVELOPMENT OF THE REAL SECTOR OF THE ECONOMY
First let us talk about the positive. At the beginning of 2011, goods exports grew substantially faster than predicted. Even though globally there are new negative developments (natural and other kinds of disasters in Japan, further political turmoil in Northern Africa and Middle East, problems in some of the euro area countries, a high US budget deficit), the forecasts as to growth in Latvia's main partners are still being upgraded.

At the same time, several risks to growth remain and in some cases even worsen. In the first quarter, a downturn was experienced in manufacturing and, though growth has been gradually resuming in recent months, uncertainty regarding industrial development still persists. First, the load of production capacity has returned to the pre-crisis level in the large industries: metal processing, wood processing, textile industry and, in part, the food industry. Second, ever more enterprises announce that they are not planning major investment in 2011, because there is no certainty either regarding the external environment or consolidation measures, including tax changes in 2012, planned by the Latvian government.

Retail data also currently indicate a lower rate of growth. Caution in spending on the part of the population and the increases in tax rates detrimental to purchasing power are hardly a beneficial background to any rise in sales. It can therefore be assumed that growth in trade this year will remain sluggish and unstable. The April confidence indicators published by the European Commission likewise point to a worsening of the mood among the population and traders alike. As for the first quarter's GDP flash estimate, I think we did not expect any particular growth and the forecasters and economists at the Bank of Latvia were hardly surprised. It would be important for the future to assert again and again that there will be no further tax raises.

ON THE BUDGET
The latest statistics indicate that in 2010 Latvia met its obligations regarding the maximum budget deficit at 8.5% of GDP agreed upon with the international lenders. Provisional data of the Central Statistical Bureau suggest that the amount of last year's deficit was 7.7% of GDP; this is the deficit of the consolidated general budget according to the methodology used in calculating the Maastricht criterion. The agreement has been met, which is important, yet we must realize that such a budget deficit is still high and the government debt has thus grown substantially – now it amounts to 45% of GDP as compared to 37% in 2009. By the end of 2011 it will approximate 50% of GDP (47.3% of GDP, to be exact).

To avoid negative consequences in the future, the public debt must not continue to grow at such rates. The reason is the inevitably growing costs of servicing the debt, which swallow up the financial means that could be used for other budget expenditure as well as the growing long-term interest rates both for the government and for businesses, which reduces the amount of investment in the economy.

One of the safest means of reducing the debt is budget consolidation based on cutting expenditure. That would improve the country's credit rating and costs of servicing the debt could thus be reduced for at least 100 million lats per year. This simple relationship is good to keep in mind when something like "consolidation exhaustion" appealed to during the previous budget amendment process sets in or one feels lack of confidence in the country's ability to pay the debt off.

With this in mind, we are emphasizing that it is critical for a successful development of the economy to plan for the 2012 budget deficit to be substantially lower than 3% of GDP. It is our opinion that 2.5% of GDP would be a prudent goal with a security margin, which, in addition to the aforementioned benefits, would preclude unnecessary doubt as to the country's euro strategy. It is useful to remember that in a similar situation Estonia drafted its 2009 budget with a deficit of 1.7% of GDP and even during the global crisis ended the year with a 2.2% deficit. That was enough to convincingly meet the Maastricht criterion. It is a good reminder of how important cautious planning is; it is likewise noteworthy that the adjustment or security valve also was within the 0.5 percentage point range.

How does it look in concrete numbers? According to our economists, the amount of the 2012 budget consolidation should be about 150 million lats – a part of this amount will possibly be gained taking into account the measures taken this year. It is not a small amount but it is not the previously discussed 400 million. It is not even the 300 or 250 million used to scare the country by the international institutions and some of our politicians. As I mentioned before: the sooner we know the structure of the 2012 consolidation, the sooner we will experience a reflection of putting our budget in order in economic growth.

I deliberately put an emphasis on this because hesitating in the concluding period of stabilization can have a seriously detrimental effect on the consolidation efforts of previous years and the results achieved. There is no doubt that if uncertainty among the ratings agencies, investors, and financial markets had been dispelled sooner, then the Latvian economy would have recovered even faster.

In 2013-2015 Latvia must begin repaying large amounts of the debt: almost 3 billion (2.8 billion, to be exact) lats within three years. It is obviously much for the size of our economy, therefore the opinion of global financiers be very important for Latvia as will the improvement of its credit rating, which, because of the budget deficit and unfinished reforms lags behind Lithuania and Estonia by 2-5 degrees.

It will not be possible to pay the principal from the budget: we will have to borrow in the global financial markets and refinance the debt. What amounts are we talking about? At our current rating, we will pay twice as much as Estonia for every borrowed lats and will pay excessive interest in the amount of more than 100 million lats. If the budget is balanced – or close to balanced – and the euro introduced in 2014 as scheduled, our credit ratings will improve. Then the financial markets will lend to Latvia at lower interest rates and the cost of paying off the debt will be cheaper, without having to use money that could be used for development, for any budget function – from education to healthcare. In other words, it is not impossible an economy of Latvia's size and capacity to gradually pay off the debt, but it will be cheaper to do so with a straightened-out budget.

The aforementioned Latvian economic development reaffirms Bank of Latvia's assessment so far. The first order of things that could serve as a positive impulse for further economic growth is fast fiscal policy decisions without any further tax raises, followed by improved credit ratings and added investment. In the short term, the weak domestic demand will slow down economic development. The present uncertainty regarding the 2012 budget consolidation is another impediment to investment and new job vacancies, i.e. further economic recovery.

ON THE RESOLUTIONS OF THE BANK OF LATVIA COUNCIL
Albeit the inflation indicators have increased in recent months, it has been on account of several temporary factors: rising global oil and food prices and rising tax rates in Latvia. In the medium term, inflation will drop and return to the 2-3% range. With this in mind, the Bank of Latvia Council today resolved to leave unchanged both the interest rates set by the Bank of Latvia and the mandatory reserve requirement set by it for the banking sector.