OREANDA-NEWS. May 27, 2013. At its regular meeting the Bank of Latvia Council discussed the latest macroeconomic development trends in the Latvian economy and took decisions regarding the future directions of the monetary policy.

The main conclusions relate to inflation dynamics and near-term economic development prospects.

Price developments
First, let me remind you that we revised the annual inflation forecast downwards from the initial 2% to 1% already in March. The latest inflation data on April did not let us down. Inflation is not increasing, the month-on-month growth was zero and the year-on-year or 12-month average inflation remained at the level of 1.2%.

The medium-term price development trends also confirm that the adjustment of the forecast was justified: energy prices have contracted significantly and it is possible that they will continue to decline until the end of the year. This would also translate into a decrease in thermal energy tariffs in several major Latvian cities. Moreover, liberalisation of the electricity market has been postponed to 2014, along with the price rises for certain electricity consumers that were scheduled for this year. The contribution of other administered prices (e.g. gas and water supply tariffs) to inflation is also expected to be smaller this year in comparison with the average observed in the previous years.

Labour market developments also pose no risks to the price stability. Wage growth is moderate and commensurate with productivity gains, something which was absent from the scene some years before the crisis. Employment is on a rise and Latvia ranks among the top European Union countries in terms of employment changes. This means that the number of economically active population is also increasing. It approaches an all-time-high (75%) in Latvia, exceeding even the level observed during the period of overheating (70%).

As a result of the overall favourable price developments observed within the last year, Latvia ranks among the three best-performing European Union Member States in terms of inflation.

Economic development
As to the future development of the economy, one has to admit that the latest development trends, however, warrant caution. The forecast published by the Bank of Latvia at the beginning of the year expected 3.6% economic growth; the data on gross domestic product for the first quarter of this year, however, reveal that the economic activity is, indeed, improving, yet the pace is likely to be slightly slower.

Let's look into detail. Growth has decelerated both quarter-on-quarter as well as in comparison with the first quarter of the previous year. In order to see which economic sectors have had a negative effect on growth and measure the extent of this effect, we have to wait for the release of revised data which will happen in about a month's time; nevertheless, the preliminary data suggest that the deceleration was largely caused by the weakening economic activity in exports and industry. Only the currently persistent domestic demand has helped us to prevent an even steeper decline in the growth rates.

As to the current trends observed in the economy, let's first look at external demand.

Although the demand for Latvian exports has expanded in some markets and commodity segments, overall the growth is not significant. Global economic growth forecasts for this year have become more pessimistic. In April, the International Monetary Fund revised downwards this year's annual growth forecasts for major economies, including many Latvia's trading partners (Sweden, Poland, Finland).

Against the background of no overall growth or extremely slow growth in the external demand, Latvia's exports can only be boosted by expanding the existing export market shares or conquering entirely new export markets. The analysis of trade data shows that this is what is actually happening and it has helped Latvian exporters to maintain quite commendable growth rates even despite unfavourable external developments.

In the long-term, however, no matter how successful this strategy is, it cannot fully make up for such an important factor as economic growth in export markets. Protracted stagnation in our external markets will sooner or later act to decelerate the overall export growth of Latvia. This is evident in the latest data on Latvia's commodity exports demonstrating a decline in the annual growth rates for several consecutive months, particularly in March. Moreover, the latest business surveys reveal that the views of Latvian businesses on the near-term prospects for export sales as well as export orders have also deteriorated in March. The above developments suggest that commodity export growth will be lower this year in comparison with 2012.

In addition, March saw a significant drop of 5.7% in industrial output in annual terms, for the first time since December 2009. The negative trends in manufacturing of base metals came as no surprise, considering that the problems associated with Latvia's biggest manufacturer started already at the beginning of the year. Adverse development trends, at least in the short-term, can also be observed in other industrial sectors like manufacturing of pharmaceutical products, chemical products and wood. This suggests that the slow-down of growth is not driven by the performance of a single company. At the moment, the future of the JSC "Liepajas metalurgs" is also surrounded by uncertainty. Estimates show that in the worst case scenario the wound-up of the JSC "Liepajas metalurgs" could compress the GDP growth in 2013 by 0.6–0.7 percentage point.

As I already mentioned before, the current GDP growth rate is largely saved from an even steeper decline by the domestic demand which was able to sustain stable retail turnover in the first months of the year. Nevertheless, judging by experience, Latvia's domestic demand is unable to prop up the overall economic growth for long in the circumstances of stagnating external demand. If there are no improvements in the external environment, the contribution of the domestic demand can also be expected to decrease gradually. Because of that, the deterioration of the recently observed overall economic sentiment in Latvia gives rise to some concerns.

The above-mentioned trends will, no doubt, affect Latvia's budgetary position this year as well: being aware of the said uncertainties and risks it would be imprudent to plan additional spending from the budget in the second half of the year, something that could be plausible based on the relatively good budgetary revenue collections of the first months of the year.

Lending development
Domestic loans continued to shrink in the first months of the year. This was largely determined by both repayments of short-term loans as well as an increase in loan write-offs towards the end of the quarter. Nevertheless, even considering those one-off factors the annual rate of change of the loans continued on a downward path, with the year-on-year rate reaching 6.7% in February.

On the one hand, new corporate loans tend to grow, while, one the other hand, new household loans are contracting. We expect that the growth of corporate loans will finally gain some momentum next year at 3%–4%, whereas household lending will decrease further by 5%–7%.

To round up on lending, briefly about the free liquidity of banks and how it is used. In comparison with the all-time-high reached in 2010, bank deposits with the Bank of Latvia have shrank from almost a billion lats to 500 million lats. Consequently, banks still place significant liquidity with the central bank rather than grant loans to the economy.

On Resolutions Passed by the Bank of Latvia's Council
In summary, it has to be concluded that the current and forecast economic development poses no significant near-term risks to the price stability in Latvia. Economic growth remains high this year; moreover, there is still a considerable amount of free liquidity in the financial market, the liquidity surplus remains sizeable and commercial banks continue to place part of their liquidity with the Bank of Latvia. Therefore, this time the Bank of Latvia resolved to leave the interest rates and the reserve ratio set by the Bank of Latvia unchanged.