OREANDA-NEWS. July 19, 2012. In its regular meeting, the Bank of Latvia Council discussed the trends in the development of Latvian economy and took decisions regarding the future directions of monetary policy, reported the press-centre of Bank of Latvia. 

Economic growth
The gradual recovery of the economy from the crisis is reflected in the numbers pertaining to gross domestic product growth. The flash estimate by the Central Statistical Bureau of 6.8% (!) growth in the first quarter year-on-year was a pleasant surprise to us all. True, growth this fast was partly due to the leap year effect: there were more working days in the first quarter. Yet even with the seasonal and calendar effects excluded, the Latvian GDP growth in this period reached 5.5%, according to Eurostat data, which made it the fastest growing economy in the European Union.

The situation in Latvia's export markets has turned out to be more successful than previously predicted. An important role there was played by the emergency liquidity measures taken by the ECB, lending banks a trillion (!) euro for three years with one percent interest – a development that no analyst could have predicted. That allowed the euro are to avoid a deeper recession and financial crisis. It also provided some respite to the economy of Europe and lessened the tension in the banking system and financial markets in the euro area at the end of last and beginning of this year. Both producer and consumer confidence stabilized in the European countries as a result and demand for Latvian production in the export markets was greater than expected.

In the largest economy of the EU, Germany, as well as other countries, including our neighbouring Lithuania and Estonia, import growth notably exceeded their own predictions where the originally expected performance was much smaller.

The growth of Latvian exports– albeit having slowed -, because of the factors I just mentioned was nevertheless fast. In the first quarter of this year, the annual growth rate of goods exports reached 13%. That provided a positive impulse in the development of domestic demand as well – it is reflected in the relatively positive producer and consumer confidence in Latvia which was boosted also by last year's uproar regarding the security of the banking system: people took out money, which resulted in an increased amount of cash currency in circulation and some of it apparently was used for consumption.

Both the ECB's measures and a more positive mood among producers and consumers have helped overall, yet the level of uncertainty regarding further development of the economy both in the euro area and Latvia is still high enough. That is a clear indication that the growth rate in the coming quarters will continue to drop – it will not reach the 6.8% of the first quarter because the expected slowdown in the economy has not gone away, it has simply been delayed by one or two quarters. It is plain to see that growth in negative in Italy, Spain and Portugal: these countries are experiencing recession.

The growth rate of the Latvian economy will therefore slow down from now on: this is already obvious from both export and industry indicators. One should also keep in mind that the rapid GDP growth in the first quarter resulted also from several one-off factors: seasonal and calendar effects as well as an increase in cash currency, which means that this year overall GDP growth will be lower than in the first quarter and lower also than last year's 5.5%. The good news, however, is that growth will be higher than predicted earlier exceeding 3% in the year overall. Against the backdrop of the European debt crisis it is a commendable result! We did of course know that the consolidation measures taken to overcome the crisis will produce results, but we could not have known that the recovered competitiveness will be so great and the renewal of economic activity so robust – no one could have predicted it.

At the same time, we must remember that despite a better performance at the beginning of the year, uncertainty and risks in the global economy, particularly in the European countries, remain high. Whether or not they come to pass may have an important impact on the Latvian economy. We will publish an updated prediction as usual – as you know, we update it in January and July – after the regular council meeting in July after including the first quarter GDP utilization data that are to be published in June.

Price dynamics
As we turn to price dynamics, we should immediately state that we are happy that inflation is following the course we predicted. As previously predicted, the annual inflation continued to drop in the past two months, down to 2.8% in April. The impact of external factors on energy prices did not change substantially in March, but the drop in the annual inflation was primarily determined by a drop in base inflation as well as more moderate fluctuations in global food prices. In April, as predicted before, the drop in inflation resulted primarily from the abating of the base effect of electrical power tariffs that were raised last year.

The monthly inflation in March and April (0.6% in each month) was primarily determined by external factors, primarily because of persisting high – I would even say, unexpectedly high – oil prices. Seasonal factors also had an effect on price fluctuations in such goods groups as wearing apparel, footwear and some food products. Widespread nervousness regarding egg prices was observed in the food market around Easter time.

Since their maximum in March when they came close to 130 US dollars for a barrel, oil prices have already dropped by about 16%. That was yet to be reflected in the April inflation indicator because fuel prices react to developments in the world oil market with a slight delay and in April they still exceeded the level in March by 3%. It is however clear as of the end of April and beginning of May that fuel prices have dropped substantially, which will subsequently be reflected in a lower May inflation indicator. At the moment, food price dynamics are also favourable to Latvia: in March, the pressure from global prices did not increase in Latvia.

The above developments indicate that an inflation reduction trend will continue in the coming months as well and the inflation prediction made by the Bank of Latvia at the end of last year, 2.4%, is still in effect since the worry previously resulting from a rise in oil prices at the beginning of the year have abated for now; the average annual inflation, on which the Maastricht criterion is based, has gone down. As far as the possible amount of the Maastricht criterion can be seen at the moment, Latvia meets it hands down. Of course, we still have to live to the end of this year and the beginning of next year, but at the moment we expect no surprises: Latvia will be able to meet the inflation criterion.

The current account
As domestic demand, particularly investments that last year increased almost by a quarter, grew and the loss observed during the crisis years diminished and enterprises resumed earning, the current account surplus observed during the crisis years has dropped gradually and last year a small current account deficit at 1.2% of GDP appeared last year. Also at the beginning of this year, as investment activity continued, a small deficit was observed in the current account, which shrank slightly in March. In contrast to the experience of the "fat years" when the current account deficit in some quarters was as high as 25% of GDP, such a moderate deficit presents no danger to the growth of the Latvian economy. Quite the opposite, it is a reflection of the economic recovery and an increase in investment activity that was partially financed with inflowing foreign capital. For example, last year the inflows of foreign direct investment reached 5.5% of GDP, which more than compensates for the slight current account deficit.

Lending development
Finally a few words on developments in the area of lending. Even though the banks' loan portfolio continued to shrink per annum, a number of positive developments were observed in this area as well. The total balance of loans in April dropped only 20 mil. lats, but it was evident that business lending grew. In a breakdown by branch, the resumption of the positive trend in business lending was supported by the increased inflow of loans in the food and wood pulp production branches important for our economy, including loans for new investments that are certain to act to increase Latvia's production capacity in the future. A small drop was observed only in the euro loan portfolio whereas lending in both lats and other currencies grew. The annual loan drop rate, adjusting it to the impact of the reduction in the number of credit institutions that took place in March (as a result of annulling Parex bank's credit institution licence), improved to -6.8%, which is the slowest annual drop rate since 2009.

On the resolutions by the Bank of Latvia Council
Taking into account the above developments and the situation as I sketched it in – i.e. better than expected economic growth and a gradual improvement in lending as well as the still limited risks to price stability in the medium term, the Bank of Latvia Council evaluated the current conditions of the monetary policy as adequate to the economic situation and resolved to leave unchanged the interest rates set by the Bank of Latvia and the mandatory reserve requirement to the banking sector.