OREANDA-NEWS. June 16, 2014. It is nice to see you after a somewhat lengthy pause. There was no press conference in spring, which can be explained by those Latvijas Banka's tasks that are related to its successful integration with the Eurosystem. From now on, we will meet three to four times a year to familiarize you with our outlook on the economic development and topical issues both in the euro area and Latvia.

I am also pleased to address you one day after the adoption of important monetary policy decisions; so I will start by briefly explaining the main considerations behind these decisions. In the second part, I will introduce you to the economic growth predictions for Latvia as revised by Latvijas Banka. And finally, I will talk about the importance of maintaining a stable, unchanging and predictable national budget policy.

Section 1. The economic situation in the euro area; its contributing factors and the resolutions of 05.06.2014 by the Council of the European Central Bank.

Assessing the development of the euro area in the last few months, we can observe trends of moderate recovery. Yet this growth is fragile and that continues to create a downward pressure on inflation, augmenting the risks that the level of inflation that is considerably lower than the target set by the ECB for the medium term, i.e. 2%, could be retained longer than predicted earlier. According to the latest inflation predictions, the average annual inflation this year will reach 0.7% in the euro area, and in the coming years as well inflation in the euro area will remain at a low level: 1.1% in 2015 and 1.4% in 2016.

Considering the macroeconomic development of the euro area in recent months, the impression that the euro area is currently at a crossroads is fully borne out. On the one hand, it is perfectly clear that the worst is almost behind us. We can see that capital flows have resumed to countries which earlier had important economic problems and in which it was necessary to take crucial steps in order to stabilize the macroeconomic situation. As a result of these capital inflows, the rates of government securities in the problem countries have fallen significantly, e.g., in Portugal, from the historic high of 13.85% to 3.82% and in Ireland from 12.45% to 2.90%.

That means that confidence in these countries and their policy changes has returned. It also means that the structural and budget reforms carried out as a result of the crisis have a real, tangible result. The primary budget deficit, which is calculated without factoring in the payments for servicing the public debt, has improved substantially compared to the situation before the crisis. Moreover, in terms overall economic growth, it is export growth that plays an increasingly important role in an increasing number of countries, replacing domestic consumption previously commonly experienced and resulting from increased indebtedness. This confirms that the corrections made to the economy have been successful.

On the other hand, we have to recognize that we have a long road ahead of us before the situation is fully brought back to normal: in several areas of economic policy, a more rapid progress is needed in the coming years. First of all, the level of government debt remains too high in many countries (it has grown significantly, compared to 2007). Second, the unemployment level in many countries is higher than in the pre-crisis period, and in many countries this unemployment is of a structural character, i.e. the skills sought by employers do not coincide with skills provided by the labour market. Third, in spite of overall improvement and resumed growth in the euro area, including Latvia, lending is developing very slowly. The latest data confirm that lending in the euro area is still weak: the balance of loans of monetary and financial institutions to non-financial businesses in April dropped by 2.7%.

Moreover, despite previous monetary policy decisions on cutting the benchmark interest rates and the drop in money market rates, the interest on bank loans remain high in many countries. This situation where the loan interest rates are high and overall lending is not growing is an obstacle for faster growth of the euro area economy and that in turn increases the risks of low inflation.

Assessing these factors at the 5 June meeting of the ECB Council, the heads of the central banks of the Eurosystem resolved to cut interest rates even further.

The deposit facility rate was cut from 0.00% (at this level, since July 2012) to minus 0.10%; the main refinancing operation rate was cut from 0.25% (at this level, since November 2013) to 0.15%; and the lending facility rate was reduced from 0.75% (at this level, since November 2013) to 0.40%.

To lend support to these resolutions on interest rates, the ECB Council agreed on several additional monetary policy instruments.

As of September 2014, new targeted longer term refinancing operations will be launched offering, at very low interest rates (0.25%), about 400 billion euro to credit institutions for lending to the economy.

A decision has been made to extend the auctions of fixed interest rate with full time allotment at least until December 2016.

It was decided to stop holding term-deposit auctions which were introduced to neutralize the growth in money amounts related to the "Securities Markets Programme".

All these decisions, which are primarily directed at achieving the goal of price stability, make the monetary conditions even more conducive for economic growth. These decisions will motivate the banks to become more active in lending to the economy. That will be stimulated by the decision to stop holding bank term deposit auctions; the negative interest rates on bank deposits with the euro area central banks (which means that banks will pay for their deposits to the central bank), and the allotment of additional long term financing to banks the amount of which will depend on the particular bank's activity in granting loans to the private sector.

Moreover, speaking of the future, the ECB Council adopted the decision to continue preparatory work for the initiative to buy up asset-secured bonds should such a course of action become necessary in the future. The ECB Council asserts that interest rates will remain at the current level in the longer term and that it is ready to resort to non-traditional monetary policy instruments if necessary.

You may ask what these decisions will mean for Latvia.

First of all, the consolidation of growth in the euro area will have a beneficial effect on Latvia's economy as well. Yet, in addition to this indirect effect, the decisions will also have a direct impact on the Latvian financial system. Latvian banks too take a cautious approach to lending to the economy and are keeping substantial free financial means with the central bank. In recent months, the amount of such disposable finances has been fluctuating around 2 billion euro.

With the decision of the ECB Council, the former strategy of banks will no longer be effective. There will be no possibility for term deposits but, if banks simply keep their financial means with the central bank instead of circulating them, they will suffer losses. Do not misunderstand: the point of this decision is not to punish banks. Just the opposite, it is aimed at promoting more active lending to the economy. Therefore, banks will be offered additional finances for a historically longest term (up to four years) and at the historically lowest rates (currently 0.25%).

Analyzing the situation as the head of a central bank, I can say that these are the best possible conditions for financing newly granted loans and I am appealing to banks to make an active use of this opportunity.

I must add that the financing at hand the banks will not be able to use to lend for real estate.

Section 2. Economic situation in Latvia

Now I will turn to a more detailed analysis on the economic trends in Latvia. The first piece of news: no matter what sceptics and ill-wishers might say, Latvia continues to be among the most rapidly growing economies in the euro area.

According to the data of Eurostat flash estimate, which allows a comparison among all the euro area countries, Latvia's real, seasonally adjusted GDP in the first quarter grew 0.7% quarter-on-quarter and 2.4% year-on-year, yet growth was slightly weaker than predicted.

It is a positive development that the situation is improving in most of the developed countries, including many EU countries where Latvia sells more than 70% of its total goods exports. Yet we have to be cautious regarding growth forecasts because of the weakening of several export markets important to us. Here I have to mention Estonia, Finland and Russia.

As a result of the geopolitical situation in Russia and Ukraine, uncertainty and risks in the economy are on the rise. Yet the negative impact on Latvia's economy in the first quarter was primarily determined by internal developments, which lowered the results both in manufacturing and energy production.

I will start with good news in three service branches: transport, tourism and construction.

In Latvian ports in the first quarter of this year, 9.4% more cargoes were handled than in the corresponding period of a year ago, and the amount of cargoes shipped by railroad grew by 7.6%. The operational information on April points to a small further improvement yet, taking into account the great importance of Russian demand in the development of the transport sector, worries regarding persistence of the situation remain.

In the tourism sector, where about 1/3 of the guests serviced at guest houses are from Russia, a rise was observed in the first quarter: the number of tourists, including from Russia, grew by 19.8%.

Growth was rapid in the first quarter in construction, particularly in the construction of non-residential buildings, yet a rise was observed also in the construction of residential buildings and utilities.

But in several sectors, economic growth was slower than predicted.

The output volumes in manufacturing at constant prices in the first quarter dropped by 5.6% quarter-on-quarter and was a mere 0.3% above the level of the corresponding level of the previous year. Even though the businesses of some branches reported the negative impact of the drop in Russian demand, overall the drop was determined by domestic factors, particularly the drop in output in metals production (48.0% quarter-on-quarter), which can be explained by problems at several enterprises of the metals branch.

Power output was reduced by the uncharacteristically warm weather conditions of last winter. After the downturn of the last six months, the annual growth of nominal goods export in the first quarter was up 2.3% quarter-on-quarter. Yet worry about the sustainability of the growth of branches is caused by the dropping demand in some markets, particularly in branches more closely tied to the Russian market. The export of Latvian goods to Russia has dropped substantially in recent months.

The situation in lending supply and demand has not undergone much change. The total amount of loans granted by banks continues to drop slowly. I hope that ECB's decisions taken yesterday will stimulate a positive turn in lending in Latvia.

Thus in the first quarter, economic activity in Latvia was weaker than forecast last year, and caution is augmented by the geopolitical situation in the region. Latvijas Banka has revised its gross domestic product growth forecast for 2014 from 4% to 3.3%.

Speaking of inflation, the annual inflation in Latvia ever closer matches the current growth of the Latvian economy. After a gradual rise in 2013, the annual core inflation stabilized in the first months of 2014, exceeding 1%. It reflects moderate economic growth, also including a small impact of indirect taxes related to the increase in excise tax on tobacco products. The total annual inflation in April was at 0.7%, lower than core inflation, which was the result of the drop in energy prices last year; yet lowering impact of energy prices on inflation is abating. This year, no rapid fluctuations in oil prices, which on average are remaining at last year's level.

The most important price-impacting factors will continue to maintain the inflation at a low level in Latvia. The domestic factors, first, rising productivity as the main engine behind the rise in salaries; second, a lower drop in the unemployment level and third, the weak development of lending will not create a substantial rise domestic demand or pressure on inflation. The pressure of the increase in food prices in the world has abated as the conditions and grain productivity forecasts improve and the supply of dairy products grows and the demand for them falls in the largest markets.

The actual inflation data match the forecast ones and the downward adjustment of the inflation form 1.7% to 1.1% is actually determined by the fact that the liberalization of the household power market has been postponed until 2015.

Section 3. The significance of reasonable budget policy

The reduction in economic growth in Latvia this year will have an impact on the state budget as well. A lower than planned economic growth means also smaller budget revenue, which, at an unchanged expenditure, increases the government budget deficit. According to calculations by specialists of Latvijas Banka, the reduction of growth from 4.0% to 3.3% and the possible increase in expenditure increases this year's budget deficit by about 0.3 percentage points. Another possible 0.2 percentage point increase in the budget deficit, expressed in accordance with the EKS95 methodology used in Europe, is created by the so-called adjustment amount. The EKS budget adjustment means an adjustment in the budget money flow in accordance to the time to which it refers.

Our forecasts thus indicate that the general government consolidated budget deficit this year could reach 1.5%, which is a deterioration of 0.5 percentage points against the already planned government expenditure excess over revenue.

It means that now is the time to remember and not repeat the mistakes that were made during the years of plenty ten years ago, which led to a deep crisis in Latvia:

the state lived over its means;
there was a great structural budget deficit;
the state did not make savings for a rainy day;
the state weakened its competitiveness or rather that of its businesses;
the balance of payments situation deteriorated.

Moreover, we have to keep in mind that there exist substantial risks in the region and our latest forecasts are not etched in stone: the situation may change. In these circumstances, caution dictates an ever more careful assessment of the budget expenditure and taking of decisive steps in stabilizing the economy and preventing the impact of external risks.

One of the crucial measures is caution and reason when planning the budget. Latvijas Banka is of the opinion that the total budget expenditure must not be raised in 2014 and that the budget deficit which will increase because of the slower economic growth must not be expanded by distributing money that has not been earned. In previous years, Latvia has put in a solid foundation for economic growth, including reinforcing fiscal discipline by means of a special law and a council of fiscal discipline. You must have noticed that "Standard&Poor's" just raised Latvia's credit rating and we have reported the record low rates at which the State Treasury is borrowing money in the financial markets. Let me express my most sincere hope that we will not let go of all these benefits carelessly. I think we all are fully aware that there are two alternatives. One is to maintain low debt servicing costs, which basically means retaining the status of a country trustworthy of investment and to save dozens of millions of euro in the state budget. The other is to spend more and raise the costs of debt; not to save anything for the rainy day, reducing Latvia's competitiveness, worsening its balance of payments and prospects of future growth.