OREANDA-NEWS. July 15, 2013. In its regular meeting, the Bank of Latvia Council discussed the latest macroeconomic development tendencies in Latvia, updated the Bank of Latvia predictions of the main macroeconomic indicators for this year and took decisions regarding further directions of its monetary policy.

Price stability
First about inflation. Already after the previous discussions at the Council earlier in the year, I have been able to say: price dynamic at the moment presents no risks for price stability. The actual price rises in the country from the beginning of the year has consistently been lower than most economist predicted at the beginning of the year.

The latest data on inflation indicate that price rises are minimal; in June it was only 0.2%, and the 12-month average inflation was also only at 0.9%. As we predicted earlier, the current price dynamic indicates that this year the inflation level could even be lower than one percent. Given that the economy in Latvia is growing at a reasonably rapid rate, such inflation level should be considered unusually low. There are several – both internal and external – explanations.

Firstly, even though the world food prices are currently relatively stable, the agricultural product futures are lower than in December (the agricultural product futures index in June 2013 is 7% lower than in December 2012). The predictions for the new grain harvest (for 2013-2014) are also higher than in previous season. That could have a favourable effect on foodstuffs prices in the world markets. As a result the prediction for the rise in unprocessed foodstuffs prices in Latvia should also be reduced.

The second factor is the global oil prices. They too are currently lower than last December (106 USD right now, 111 USD in December 2012). Predicting the future dynamic of oil prices, we take into account the value of oil futures. Calculated in lats, it almost completely matches the value of July-August transaction value at the end of 2012. Thus, if other conditions should remain unchanged, there is no reason to expect significant changes in energy resource prices in Latvia.

At the same time, we see a rather substantial drop in the sales prices of natural gas, compared to the level predicted at the beginning of the year. The drops in the prices of natural gas affect the thermal energy tariffs as well: in the largest towns in Latvia they have decreased or reductions are planned by the beginning of this year’s heating season. Lower tariffs of natural gas and thermal energy also allow manufacturers to maintain their production costs thus having a favourable effect on the overall price level.

In the second half of the year, inflation indicators could be slightly higher than in the first half, but right now there are no worries about a rapid rise in inflation in the future:

first, salaries have up to now kept pace with productivity. Similar developments are expected also in the foreseeable future until the end of the year;

second, the hitherto slow development in lending also gives no rise to worry about a new rapid rise in consumption that could threaten price stability in the country.

In view of the lower than predicted prices of foodstuffs, gas and thermal energy as well as the expected price dynamic in the second half of the year, the Bank of Latvia predicts the 2013 inflation at 0.7%.

Gross domestic product
As far as economic developments in Latvia are concerned, our GDP growth prediction for this year was 3.6% at the beginning of the year, and it was accompanied both by upward and downward risks. Some of these risks have come to pass. Export growth indicators in the first months of the year were stable even though the external environment has not improved. Domestic consumption in the country has also grown more rapidly than previously predicted (in the first quarter, the annual growth of private consumption was at 4.7%). Taken by branch, developments in construction (annual growth of 9.8%), transport (annual growth of 4.3%), real estate (annual growth of 9.4%) and financial services (annual growth of 2.2%) have been registered as substantially better than predicted.

The situation in manufacturing, however, has unfortunately deteriorated at the beginning of 2013.  The branch that in previous years was one of the engines of economic growth has slowed down in recent months. The main detrimental impact on the manufacturing production volumes without a doubt rests with Liepajas Metalurgs, which is experiencing problems, however, a year-on-year drop in the first half of the year has also been registered in pharmaceutical and chemical industries.

Looking ahead – although the business confidence indicator improved in the first quarter compared to the end of last year, it was mostly a result of the positive evaluation of domestic order volumes. The evaluation of export orders, in the meantime, has deteriorated, albeit only a little. Even though the current signals from surveys vary, overall worries regarding the future development of the branch are on the rise. Given the problems in Latvia’s largest manufacturing enterprise as well as in the production of wood pulp, wood and cork product manufacturing, it is most likely that in the second quarter, just like in the first quarter, the contribution of manufacturing to GDP growth will be negative.

Yet there are positive developments as well. A rather rapid growth in the first four months of 2013 was observed in the food industry. The investments made in the branch in previous years are apparently bringing returns; moreover, a positive development is the fact that most of the production is being exported. The manufacturing of electrical equipment and furniture is also developing sufficiently well. As a result, it can be expected that the drop in manufacturing volumes caused by the problems at Liepajas Metalurgs will be short-lived and as early as 2014, growth of possibly 5-7% will resume in the branch.

Growth in construction in the first quarter of 2013 was considerably faster than previously expected: year-on-year, construction output in real prices increased 15.8%. The greatest contribution, for the first time in the post-crisis period, was made by the growth in the construction of residential buildings.

In the real estate and rental branch in the first quarter of 2013, substantial growth was observed, which, to a great extent, determined the unexpectedly rapid GDP growth in the quarter overall. The turnover of real estate businesses is growing substantially. The growth in the branch is undeniably caused by non-resident investments in real estate as well as an increase in activity in the agricultural lands trade segment.

Finally, the value added in the transport branch has also grown more rapidly in the first quarter than was expected (4.3% year-on-year). Most operational indicators hitherto pointed to a slowdown in the value added of the branch: for instance, the amounts of cargoes handled in Latvian ports as well as those transported by rail are going down. That is caused by the deteriorating global situation that involves a drop in demand for cargo transports. Yet the drop in cargo amounts in the turnover of ports and railway can be compensated – at least according to statistics – by a substantial growth of cargo amounts in transportation by road. Thus it can be expected that the value added in the transport branch in 2013 could grow by 3.3%.

Economic growth in the first quarter of this year has thus been more rapid than predicted and the drop in manufacturing was more than compensated by the unexpectedly rapid growth in exports and private consumption. That makes us review the overall GDP prediction for this year. We should keep in mind, however, that the negative impact of the financial problems of Liepajas Metalurgs on the Latvian economy can turn out to be greater – or smaller – than we expect right now. If, however, Liepajas Metalurgs should resume production already this year, it would have a favourable effect on GDP growth. Moreover, we cannot exclude the possibility that in their expectations of euro introduction, some of the residents will rush to purchase various durable goods at the end of this year, thus transferring some of the consumption of next year to this one and correspondingly increasing GDP growth this year and decreasing it slightly next year.

The Bank of Latvia predicts GDP growth at 4.1%.

On Resolutions of the Council
Recapitulating what was said earlier, we must conclude that inflation is continuing to drop, but the rate of economic growth, albeit higher in recent months than expected, will be slower this year than in 2012. Overall, neither the current nor the predicted economic development poses risks for price stability. With that in view, the Bank of Latvia Council at today’s meeting resolved to reduce the Bank of Latvia refinancing and lending facility rates. To wit:

The Bank of Latvia refinancing rate was reduced from 2.50% to 2.00% per annum;

the interest rates on the marginal lending facility at the Bank of Latvia were reduced as follows:

from 3% to 2.5% per annum if the credit institution has used the loan for no more than 5 working days within the previous 30 day period;

from 6% to 4.75% per annum if the credit institution has used the loan for 6 to 10 working days within the previous 30 day period;

from 9% to 7% per annum if the credit institution has used the loan for more than 10 working days within the previous 30 day period.

The Bank of Latvia Council left the deposit facility rates and reserve requirement unchanged.

The new rates will be effective as of 24 July.

And finally – on the invitation to introduce the euro and transitional exchange rate

Ladies and Gentlemen! A couple of days ago, on 9 July, the countries of the European Union made their final decision regarding Latvia’s euro changeover as of 1 January 2014. At the same time the transitional exchange rate was irreversibly fixed at 0.702804 lats per euro, which is the Bank of Latvia current official exchange rate.

It is important for me to mention and emphasize this. We have managed to defend, explain and protect this exchange rate! It is a very important decision for the residents for Latvia and for a smooth introduction of the euro as well as for further growth of our businesses and our economy at large.