Latvia's Economic Outlook by Nordea: as of 2014 - sailing into deeper, yet calmer waters

• GDP growth in 2013 expected to be approximately 4%.
• Private consumption was the main driver of growth this year.
• Average price level remains unchanged this year.
• Next year is expected to be a "fat" year.

As regards economic sectors, the growth in 2013 was powered by four sectors, namely, trade, construction, transactions with real estate and commercial services. Thus, from the point of view of economic sectors, clear dependence of the economy on the domestic market demand is apparent. The transportation and logistics sector has experienced modest growth this year, and the indices of the processing industry are approximately at the level of last year. Regarding the latter, it should be added though that the stagnation reflects the average index, which was reduced considerably by the downturn in the metal processing industry.

"This has been the first year in a longer while when forecasting Latvia's economy turned out to be a relatively easy task, as the actual result does not differ considerably from what most analysts predicted at the beginning of the year. The pace of domestic demand growth decelerated slightly at the end of the year and economic growth could turn out to be slightly below 4% in the fourth quarter. The overall annual economic growth could reach approximately 4%. Of course, external factors will continue impacting Latvia's economy next year, in particular this applies to developments in the Euro area and on the Nordic markets, however, changes in the taxation policy will also have a fairly significant effect," according to the Chief Economist of Nordea bank in Latvia Andris Strazds.

The GDP forecast for 2013 is 4% which is one percentage point below the 2012 result

During the first 9 months of this year, the volume of Latvia's economy has increased by 4.2% year-on-year. This speed of growth is a considerable achievement given several factors that hindered growth, for example, stagnation on several export markets important for Latvia and the problems of "Liepājas metalurgs". As a result, export, which was the "growth guarantor" during a couple of preceding years has grown by only 1.4% during the first nine months. Looking from the point of view of consumption, so far growth has been almost fully secured by the increase in domestic demand, in particular, the increase in the final consumption by households amounted to 5.7% this year. The growth in the final government consumption increased by 2.8% and the contribution to the economic growth from investments (-1.8%) was negative.

"During the last quarter this year, the consumption of households could grow at about the same pace as during the preceding 9 months, and the government consumption and export could even boast a slightly more rapid growth. However, considering the weak performance of export and investments so far and the high growth of the Gross Domestic Product at the end of 2012, growth during the last quarter this year will most probably decline below 4% and the overall annual GDP growth will equal approximately 4% or one percentage point below the result of last year," economist A. Strazds concludes.

Unlike the economic growth that does not differ at the end of the year too much from the forecasts made at the beginning of the year, changes in the consumer prices brought a surprise this year, in particular, during the last six months of the year. This was partly related to postponing of the electricity market liberalisation for households and lower prices of gasoline, gas and heat due to the impact of external factors; besides, prices also turned out to remain unexpectedly stable in a number of other sectors. It is quite likely that we will see no inflation or deflation in Latvia this year, i.e. the mean value of consumer price index at the end of this year will be exactly the same as it was in 2012. This is an indirect indication of the economy of Latvia not having reached its potential capacity following the recent crisis," Strazds explains.

A "fat year" expected in the economy of Latvia in 2014

There are at least three reasons why the economy of Latvia is expected to show better growth figures next year than this year. As the economic situation gradually improves both in the Euro area and in Nordic countries that are important markets for the Latvian exporters, the export growth should increase by a few percentage points. Several amendments in the taxation policy will enter into force next year and increase the income of households, consequently raising also household consumption. As private individuals mostly do not tend to accumulate savings in Latvia, it can be expected that almost all additional income will be directed into additional consumption, thus contributing to maintaining a consumption growth equal to the level of this year also next year. Also investment should be growing at a comparatively high pace next year following the stagnation this year, in particular, taking into account the expected increase of demand on export markets. Due to the above reasons, a "fat year" can be expected in the economy of Latvia next year. Finally, the unadjusted GDP growth will increase also due to disappearance of the base effect caused by the leap year of 2012, which reduced it by close to 0.3 percentage points in 2013," says Strazds.

"Considering the comparatively high increase of consumption and the fact that it will have to increasingly face capacity restrictions on the supply side, inflation is due to return to Latvia next year. However, taking into account the very low average price increase in the  Euro area, it is hard to imagine that inflation in Latvia could exceed 2%, even if the expected liberalisation of the electricity market for households is included in the assessments. A higher increase in prices is only possible if the prices of energy resources and/or food increase considerably on the global market, which does not seem to be realistic now," Strazds forecasts.

Investments will return to growth next year

The financial position of the government will be stable also next year, despite the adopted amendments to the tax legislation, and the ratio of public debt to GDP will continue to decrease slightly. Thus, the re-financing of the remaining part of the international loan on financial markets will not cause any trouble. Most probably, we will also witness further increase of credit ratings by international credit rating agencies. The Parliamentary elections in October are the only reason that prevents forecasting a zero budget deficit for next year, because additional budget revenue will most likely be distributed as additional expenditure instead of covering the deficit in the second half of the year.

The current instability in the political environment of Latvia will not reduce growth considerably next year. Investment decisions that are usually the most sensitive to unexpected political developments will mostly depend on developments in the external environment. Assuming that the uncertainty on export markets that are important for Latvia decreases, the volume of investment can be expected to resume growth next year.

Cautious forecast regarding further economic development beyond 2014

Further future prospects are less optimistic. Similarly to a number of reasons allowing for an optimistic outlook as regards Latvia's economy next year, there are at least two reasons that justify a cautious view of the development beyond 2014. It is highly possible that populist forces focusing on protection of certain interest groups will gain more influence in the government following the next Parliamentary election. Thus, there will be an increasing focus on re-distribution of resources instead of reforms aimed at encouraging further growth of productivity and income in the economy. It should also be taken into account that, as Latvia approaches the productivity level of developed countries, attainment of further productivity improvements will become an increasingly challenging task. In order to achieve this, a more efficient court system, higher quality vocational and higher education, more capable public administration and more possibilities of attracting financing are required. If we draw parallels, although the income level in Latvia is somewhere between those of Moldova and Finland, the road from Latvia to Finland is harder and longer than the way from Moldova to Latvia. Quite a few countries have got stuck on this way, and it is now difficult to justify why Latvia would outpace them," concludes Strazds.