OREANDA-NEWS. March 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 progress of monetary policy, reported the press-centre of Bank of Latvia.

The main conclusions made concern inflation dynamics, the economic outlook and developments in the financial market.

First about inflation in February. As projected earlier, inflation continued on a downward trend, yet the constant political tensions in the Middle East oil producing regions still figure as a pressing factor of price hike risks.

Thus since January, the consumer price dynamics have been primarily driven by two factors. The first is elevation of oil prices due to which fuel prices in Latvia kept on rising. The second is closing seasonal sales of clothing, footwear and household appliances, i.e. those commodity groups for which declining prices were still observed. Overall as you already know, prices rose by a mere 0.1% in February. In annual terms, inflation already declined to 3.4% in February.

The average consumer price rise this year is expected to be considerably slower than in 2011, owing much to indirect taxes that were not raised. I would like to remind you that last year VAT and excise tax rates were raised on several occasions, both at the beginning of the year and in its middle. A steep rise in global food prices, which also made some contribution to higher inflation, was recorded in early 2011 as well.

Speaking about the oil prices, it should be noted that they continue to increase worldwide, [Ill.] directly affecting the fuel prices and supporting a rise in administered energy prices. If the oil prices of the beginning of year are to remain at the same elevated levels, we are likely to face higher energy costs in the course of the year, and they will affect the production of other commodities and services. This may increase upward risks to this year's inflation forecasts. At present, the prices of oil futures are posting a marginal downward trend, and the Bank of Latvia is not revising its annual average inflation forecast at this point, leaving it at 2.4%; however, we are concerned that inflation forecasts could be revised in the mid-year should this scenario not materialise.

Finally, fiscal measures that would or would not be implemented in the months to come this year may largely be crucial in deciding whether Latvia will manage to meet the Maastricht inflation criterion. In this connection, some ideas about the VAT rate revisions are circulating, e.g. that soon, i.e. probably at the beginning of the next year, the reduced rate of VAT for some commodities and services will be cancelled, thus, in fact, lifting the average effective VAT rate. Of course, we do not doubt in any way that the rates of personal income tax and taxes on labour are to be lowered, but we believe that this move is premature. It is particularly so if we know that at the beginning of next year the Maastricht qualification period prior to gaining the euro area membership sets in for Latvia. We believe that the revision of these tax rates would only support higher inflation. That is why it would in no case be the right time for tax adjustments or increases: a higher VAT and lower personal income tax rates would only support the elevation in inflation.

Economic growth, exports and competitiveness
Despite the good news about fourth quarter GDP as well as the positive trade and manufacturing performance indicators of the initial months of the current year, uncertainty remains high in the foreign markets. Last week (on 8 March), the European Central Bank revised its projections for euro area GDP growth significantly down, forecasting a drop of 0.1% instead of previously projected slight growth of 0.3% for 2012. In the fourth quarter of 2011, euro area GDP contracted by 0.3% quarter-on-quarter. We certainly closely follow the economic developments in Germany, and the decline in it and the rest of the region makes us assume that the situation in the euro area is unlikely to recover soon.

So it may be said that the positive indicators of the previous year's last quarter and initial months of the current year have been only separate occasions of glimmer of hope that generally offset the array of negative information only slightly. However, the risks to further growth remain at a relatively elevated level, primarily on account of a number of various external factors that Latvia cannot influence directly. But what we can and must do is to make ourselves appropriately ready for them.

It would be here opportune to remind of the economic developments that affect Latvia.

First, the major euro area countries cannot assert with much certainty that the economy will start to recover for sure. In Germany, the new orders unexpectedly contracted in January which may be indicative of a slower growth momentum in Germany in the first quarter than was expected quite a couple of weeks ago. The elevated oil prices pose risks to the growth both in Germany and the entire euro area on account of rising oil prices that will push up euro area inflation rates, which in turn will undeniably encumber the development.

Second, the solutions to Greece's situation have been mixed so far and have not calmed down the financial markets. Moreover, at present the financial markets are not fully ruled by assurance that other euro area countries will not face similar problems in the near future. No doubt, this affects market perceptions, investors' sentiments about the growth prospects and what lies ahead for the euro area in the quarters to come.

Third, slower growth is also predicted for Estonia and Lithuania, i.e. the countries so important for Latvia's exports. In the latest EC projections, the outlook for both Baltic States has been reduced significantly: by more than 1 percentage point for Lithuania (from 3.4% to 2.3%) and by 2 percentage points for Estonia (from 3.2% to 1.2%). I think it is clear that at the current juncture this forecast continues to deteriorate. The Bank of Latvia is not changing its forecasts at this point; however, when we come out with our half-year projections in the middle of the year, the first quarter indicators could likely serve as the basis for potential revisions to these forecasts.

Budget 2012
The budget deficit stood at 4% of GDP last year; it is planned at 2.5% of GDP this year. With regard to the budget revenue, the year has started better than planned: in line with the growing tax revenue, the general government consolidated budget ran a surplus in January, and this trend persisted in February as well. In the meantime, expenditure in the central government basic budget increased only slightly in the course of the first two months of the year, and uncertainty surrounding the outlook for Latvia's exports to European markets, which could be impaired by euro area recession, demand prudent stances.

In addition, we know that the EU has delayed the disbursement of more than 180 million lats to Latvia. We would certainly welcome the persistence of better than projected tax revenues, nevertheless, the government needs to maintain this reserve, usually accumulating at the beginning of each year, for balancing macroeconomic risks and covering extraordinary expenses (like those related to AirBaltic last year), or any other expenditure needed in the pursuit of government tasks. Then, in my opinion, it is very good that the government can use the opportunity to redistribute this money without increasing budget deficit or external debt.

The financial markets are nervous and their perceptions of Latvia may change swiftly; we must understand it extremely well. I think that in the event of Latvia turning away from the financial sustainability path and yielding to temptation to spend more than earned, interest rates in Latvia are likely to rise steeply. Financial markets would interpret it also as a political failure to secure country's financial sustainability. The revival of such an uncertainty would seriously affect Latvia's near-term economic outlook.

Firstly, this would mean that Latvia would run the risk of failing to introduce the euro in 2014. Without the euro, we would be unable to reduce debt servicing costs already often referred to. It should also be borne in mind that the euro is a long-term project. The slow and gradual pace of resolving the European debt crisis can render many people in Latvia sceptical about the euro as such and the need of its introduction in 2014. We must not venture emotionally based or otherwise superficial decisions with regard to such strategically important issue as the euro changeover in 2014. We must not forget that the small EU economies, which have introduced the euro of late, in the circumstances of global crisis have happily used the respite offered by the euro, for the latter ensures notably lower interest rates and a more stable and predictable growth in the future.

I would like to remind you that Latvia is to start enormous debt repayments of 2.3 billion lats in 2014–2015. We do not earn so much, hence we shall have to borrow or refinance. If we manage to cut the deficit and introduce the euro, borrowing from the market will be cheaper: to borrow the needed 2.3 billion at 2%–3% interest with introduced euro or at 5% –6% without it makes an extreme difference! In the worst case, this would mean around one billion of overpaid-in-interest lats over 10 years! In my opinion, it is an amount worth thinking about. It would be to Latvia's advantage to channel this money into the domestic economy and its development, for the solution of various social problems and project implementation rather than paying it away to international lenders.

Crediting
Now shortly about the situation in lending. Regretfully, the overall bank lending continued to contract, with lending to both businesses and households shrinking; the total bank credit portfolio in annual terms posted a fall of 8.2% in January 2012. Even though the Bank of Latvia's resolution at the previous Council meeting to reduce the reserve ratio created more favourable conditions for the availability of funding needed for economic growth, economic tensions across the world, including Latvia's export markets, and in the euro area were not favourable for boosting lending activities.

Resolutions of the Bank of Latvia Council
Interest rates and the reserve ratio set for banks by the Bank of Latvia remained unchanged; however, in view of the fact that Latvia's financial market tensions of the crisis period have been overcome and the financial system has returned on a stability path, with the country actually having overcome the crisis and economic hardships, the Bank of Latvia Council resolved today to lower marginal lending facility rates, which were raised at the onset of the crisis in December 2008, and namely, if banks use marginal lending facility for no more than 5 days, 5% annual interest rate will be applied in the future; if banks borrow for 10 days, 10% annual rate will be applied; if banks borrow for more than 10 days, the applied annual interest rate will be 15% instead of 30% at present.