OREANDA-NEWS. July 18, 2011. The Bank of Latvia Council in its regular meeting discussed the latest trends in the development of Latvian economy and took decisions regarding the further directions of monetary policy, reported the press-centre of Bank of Latvia.

The main conclusions were as follows:

INFLATION
First about price dynamics as it has been since the last meeting of the Bank of Latvia Council. In May, the annual inflation reached 5% making some forecasters to expect a rise to 5.5% or even 6% in June. The latest data however point to a small drop in the annual inflation: in June inflation was 4.8%. The reason for the drop is a slower rise in heating tariffs than in June a year ago as well as a drop in vegetable prices in reaction to shrunken demand.

The annual inflation of the last six months was primarily determined by rises in the prices of energy resources and food, which we had predicted, and also the raising of value added and excise tax rates, which have generated one third of the current 4.8% inflation. Unfortunately, we must therefore raise our inflation predictions for this year to 4.7%.

By dividing inflation into components [Illustration], we see that it was almost equally the result of the appreciation of food (2.0 percentage points) and rise in energy resource prices. A substantial contributor to the higher inflation is also the increased tax rates of the last 6 months (1.6 percentage points). Therefore it is hardly surprising that the Latvian economy is experiencing a revival of inflation. The other factors related to economic development are however still "working" toward bringing the inflation down, especially taking into account the fact that lending is not on the rise and there is no reason to expect rapid change in this area in the near future.

As for price dynamics in the medium term, the central bank's outlook remains unchanged: the current rise in inflation has been caused by one-time transitional factors, and, as their impact dissipates, further price rises in the coming periods will abate. As the influence of global price and tax rises diminishes, we will see a much lower inflation -- 2.5 to 3.0 per cent as early as next year and not, as some say, "one-digit" inflation usually associated with a number closer to 8 or 9 percent instead of 2.5 or 3.

How could Latvia itself affect inflation? The Minister of Finance has repeated his clear announcement that in the next few years, the main tax rates will not be raised and no new taxes will be introduced. I would go further than that: to effect a substantial drop in inflation, no taxes should be raised in 2012 or 2013. That would also promote a more rapid economic growth. Such an approach should also be included in the anti-inflation measures, which the Ministry of Finance is planning to draft by the end of July and discuss at the end of August. These should also include provisions that salaries can be raised only along with increased productivity and that budget consolidation should be accomplished only on account of cut expenses instead of raised taxes. Structural unemployment, which we consider one of the additional pressures on salaries and inflation, should also be reduced; this could likely be accomplished by changing the education system: involving entrepreneurs themselves in the process instead of leaving it to the state, which leads to people going through re-education only to return to the ranks of the unemployed.

FISCAL POLICIES
The straightening of the budget deserves a more detailed description.

During these weeks when we have to make various political choices it is worth remembering that the Latvian economy also finds itself at a crossroads. Or rather: it finds itself at the end of a straight and narrow road. Two-and-a-half years ago, the state chose to straighten out its finances not by following some deceptively easy road lit by will-o'-the-wisp but one where hard work will be rewarded by long lasting fruit. Even though some detours have been made, a see-through edge of the forest has been reached and it is becoming ever clearer that any delays or false moves would cost dearly to the economy. If we translate this into budget facts: we are facing the possibility of cutting the budget deficit in a quick and determined fashion, by cutting the expenditure by 100-130 million lats. And there is the other alternative: to hesitate, raise taxes, impede entrepreneurship thereby raising the so-called consolidation to the initially quoted 150-180 million lats. The latter would lead to constant stagnation and uncertainty, ensuring that it would not be the last budget consolidation in Latvia – they would continue in 2013 and 2014 as well.

In 2012 we thus should finish up with the balancing of expenditure and revenue as the prime minister has also made clear. The good news is that at the moment there is the opportunity to do this in a timely manner, despite the possible election, i.e. this year, there is also the opportunity to do this in a strategically sound manner – i.e. without raising taxes.

It is a question of determination: do we want to live in a country following the roadmap toward safe ways of doing business, i.e. the Maastricht criteria; a country that has a good reputation or ratings and which stands on its own two feet and is able to borrow in the global financial markets? It almost does not bear saying that the problems Greece is facing – and which cause some to say that we should shun the euro area – have not been caused by the common currency but a faulty management of the budget, plus the problems have been exacerbated by the complicated and slow approaches to their solution. Luckily it is Germany, France, Austria, Finland, the Netherlands and other countries at the heart of the euro area that will determine the future of the euro. Its future will also be determined by smaller but exemplary EU member states such as Estonia which has shown that rational management of the economy can make a country immune to Greek style problems while continuing to enjoy all the advantages of the euro.

Even though Latvia is close to having straightened out its budget and introduction of the euro we have not yet been rewarded by outside confidence: our ratings are still very low, 2-5 degrees lower than in the other two Baltic countries. With our current rating, we will pay twice as much as Estonia for each lats we borrow and will overpay the interest by about 100 mil. lats a year. Should Latvia decide not to introduce the euro and not consolidate its budget then in ten years that figure would reach one billion lats. How will we pay? –We will have to pay with the education, healthcare and other services we will not provide because we cannot afford them. We will continue to spend money we have not earned, thus tightening the noose. Credit ratings are not an abstraction.

The debt accumulated by Latvia is reality and we will have to deal with it: pay interest, pay the principal, and the state revenue will sadly not be up to it in the next few years. Therefore, if there is a balanced budget and euro changeover in 2014, which will translate into solid state credit ratings, the financial markets will lend to Latvia at lower interest and our businesses and economy will grow at a faster rate. Neighbouring Estonia has straightened out its budget in a determined and quick fashion and introduced the euro. In the very first quarter of this year we could witness the difference between Estonia whose gross domestic product grew by 8% and Latvia where it grew only by 3.5%!

To close on the budget, I would like to emphasize: the 2012 budget is decisive, but to consolidate it, we cannot inject the rot in this year's budget by increasing the 2011 budget expenditure and increasing the deficit.

RESOLUTIONS OF THE BANK OF LATVIA COUNCIL
Finally about the resolutions of the Bank of Latvia Council. Even though inflation has been on the rise in recent months, it has been, as before, on account on several temporary factors: the rises in global oil and food prices and local Latvian decisions: the raised tax rates. – These factors are transitory. One of the factors that is related to additional inflows of funds in the economy, i.e. crediting has still been shrinking and has not acted to promote a faster development of the economy and thus, in the medium term, inflation will go down returning to the 2.5-3% level.