Latvia's economy continues to grow on account of both positive trends in the euro area and strong domestic demand. At the same time, several risks remain, including those associated with the rise of wages in some sectors exceeding that of productivity as a result of the growing labour shortages. This causes concerns over a longer-term growth of the economy. Press conference by Zoja Razmusa, Deputy Governor of Latvijas Banka, addresses potential solutions to those structural problems.
Some six or seven months have passed since the disturbing events affecting both the work of Latvijas Banka and the financial sector overall.
The events that started to unfold in February left many of us concerned:
- detention of the Governor of Latvijas Banka;
- developments concerning ABLV banka;
- mitigating risks in the financial sector.
All this time, Latvijas Banka continued its business as usual and in a highly professional manner, and this is something I would like to express my gratitude to my colleagues at Latvijas Banka for.
Each of us carried out our daily routine tasks that have been entrusted to us, i.e.:
- ensuring interbank payments and the cash cycle;
- foreign currency and gold reserves management;
- ensuring the operation of the Credit Register;
- macroeconomic analysis and formulation and implementation of the monetary policy;
- compiling financial statistics
- and many other tasks.
Moreover, while managing to maintain high quality standards in our daily work, we also managed to think about development, modernisation of our business and the financial sector. A good example to mention is the development of the state-of-the-art interbank payment infrastructure, i.e. instant payments. We are confident that, with the number of banks joining the instant payment infrastructure increasing within the coming months, an absolute majority of interbank transfers in Latvia will be executed in a matter of a few seconds and 24/7, including on weekends and holidays.
Acting in the role of the government adviser, Latvijas Banka experts actively participated in improving the legislation concerning the management of the state funded pension scheme assets that will allow pensioners to economise tens of millions of euro in the coming years. At the moment, we have undertaken the initiative and are actively engaged in working on improvements in the field of payday loans, proposing to extend the functionality of the Credit Register maintained by Latvijas Banka; we also participate in a government working group to set an optimum interest rate cap.
Successful hosting of the external meeting of the Governing Council of the European Central Bank (ECB) in June is yet another proof to our professionalism and capacity. I would like to take this opportunity to thank our partners, the ECB and our colleagues from the euro area central banks and from the Latvian authorities, for their constructive cooperation and involvement.
It was the monetary policy pursued by the ECB that largely underpinned the euro area's economic growth in the most recent years. An accommodative monetary policy, particularly employing unconventional monetary policy instruments, implementation of the asset purchase programme has resulted in lower interest rates, thereby improving the financing conditions, enhancing the economic activity and increasing the household purchasing power both on account of new jobs and growing wages. As a result of all that, inflation has approached the ECB's target of below but close to 2% in the medium term. This is also confirmed by the path of inflation over the most recent months: euro area inflation has been lingering at the level of 2% for several consecutive months. According to forecasts, core inflation, excluding energy and food prices, can also be expected to follow a gradual upward trend.
This positive and sustainable path of inflation suggests that the euro area economies have finally recovered from the global crisis; therefore, the economic growth is resilient and allows us to hope and expect that our economy will be able to sustain this growth in the long term even in the absence of the currently strong monetary stimulus.
As you know, to this end, several important decisions affecting the development of the European economy already in the coming years were adopted by the Governing Council of the ECB at its June meeting in Riga: namely, to keep the key ECB interest rates unchanged, continue net AIP purchases at the monthly pace of 30 billion euro and, subject to forecasts confirming that inflation is approaching the ECB's inflation target, end the programme at the close of the year.
The Governing Council of the ECB assessed the current situation, its policy stance and forward guidance yesterday and decided to leave unaltered the monetary policy stance and stick to the view that the net AIP purchases could be ended at the turn of the year, depending on the incoming data. It was also decided to reduce the monthly pace of the net asset purchases to 15 billion euro until the end of December 2018 after September.
What is relevant for Latvia within the context of those decisions and forward guidance?
First of all, looking at the interest rate developments in Latvia, we can see that the lending rates applied to businesses and households in Latvia have also declined by 0.6 percentage point from the moment of enhancing the monetary policy stimulus. It means that, with the lending rates decreasing, businesses and households face lower loan repayments which can also be looked upon as an income increase.
On the one hand, lower rates certainly contribute to economic development and ensure sustainable economic growth. On the other hand, due to several important factors, lending growth in Latvia has been lower than that of the euro area overall.
Does this mean that the Eurosystem's monetary policy has been less effective in Latvia? The answer is "no" because Latvia's economy has benefited from significantly stronger economic growth in its trade partners, in the euro area, and that, in turn, has contributed to the performance of Latvia's exporters. As you can see, exports of goods and services have grown not only over the last few months of this year but also over the most recent years overall, and it has been a significant driver of the economy.
At the same time, private consumption has been and remains one of the most important growth factors and is following a significantly steeper upward trend. Average wage has again increased by more than 8% also in the first half of this year and, as we know, average gross wage has moved above the mark of 1000 euro in Latvia.
On the one hand, this is very good news to all employed and will support economic development in the short-term.
On the other hand, however, this exerts a cost pressure on businesses and impairs their global competitiveness. If we look over a longer-term horizon and try to measure the sustainability of Latvia's economic growth, then the pressure on labour costs is, of course, one of the factors that could weaken this sustainability. What could be the potential solutions then? We have heard some proposals to open the gates to immigration, that this could be a solution. We believe that we should rather look at improving vocational education and skills and at improving internal migration as a second option. Unfortunately, even if we do manage to improve mobility in the short run, this is not going to address the problem at a fundamental level.
Therefore, increasing productivity and professional skills are the key words for Latvia's future growth. Because of those reasons, Latvijas Banka has contributed significantly to shaping an education reform, preparing of a new content for teaching economics at school as well as has promoted public discussions. Articles published on our economic analysis website macroeconomics.lv contain conclusions proving that solutions will be very difficult to find in the absence of a significant increase of research and development financing. As we see, out of all EU member states, Latvia ranks among the lowest in terms of the financing allocated to research, science and development. We should also keep in mind that in the countries where the proportion or volume is much bigger this is achieved on account of private sector investments (investments by businesses and higher education establishments) rather than government spending. Government spending ranges from 0.4% to 0.7% of gross domestic product (GDP). It is obvious that the current growth achieved in those areas cannot be sustained in the absence of an active engagement.
Looking at the inflation developments in Latvia, it is important to note that, despite the overall decline in inflation that could be observed in the first half of the year, strong domestic demand has an increasingly more significant effect on this indicator as well. It is expected that core inflation (inflation excluding energy and food prices) will be higher both this year and next year, and it will reflect the growing labour costs as well as the pass-through of higher oil prices. Nevertheless, there is no reason to be concerned at the moment. Inflation, currently close to 3%, reflects gradual income convergence with West European countries and healthy economic growth.
Finally, looking at the economic developments in Latvia, we should definitely mention the significant changes affecting the financial sector. In the public domain, it is mostly seen as a reduction in deposits with the banks servicing foreign customers that cannot be offset by the rising domestic deposits. A drop in deposits of such magnitude usually involves rather negative macroeconomic consequences, yet there are several factors that could suggest that this is not going to be the case.
The expansionary monetary policy pursued by the ECB provides ample liquidity to Latvia's financial sector and deposit outflows cannot have and will not have any significant effect on the financial sector.
Second, even historically, deposits received by the financial sector from foreign customers were never invested in Latvia's economy but were rather placed abroad.
The current structural changes in the financial sector will, no doubt, have some minor effect on the overall economic growth, yet this insignificant negative effect will be offset by the growth achieved in several sectors of the economy.
These developments have already been taken into account in the latest macroeconomic forecasts of Latvijas Banka published in June. We still expect GDP growth of 3.9% this year and of 3% next year. We have left our forecasts unchanged. With the financial sector reforms continuing and strengthening the reputation of Latvia's financial sector, this is bound to have a favourable effect on the economy in the long term.
To sum up. All the above-said confirms that Latvia's economy is going to continue along the path of cyclical development. Nevertheless, we should not forget about the risks. Negotiations about the British exit from the EU are approaching the final stages and the probability of a failure to agree on a favourable solution is ever increasing. The growing risks relating to protectionism and trade wars also remain a major source of significant instability. Latvia should be prepared also for more adverse scenarios. Therefore, it is very important at the moment to build up a budget buffer, so that to have the room to adjust policies in the event of any of the more adverse scenarios materialising.
A surplus is accumulating in the budget, reflecting both a rise in social security contributions on account of growing wages and in value added tax and excise tax revenues due to increasing domestic consumption. The year 2017 is characterised by a notable rise in corporate profits reflecting the effect of the cyclical factor.
At the same time, we should really be aware that this cyclical component is very important also in the context of the budget outcome: if we look at the structural balance which does not consider this cyclical component, Latvia has already reached a level where we can no longer afford any additional spending. We can see the lack of room for new policy initiatives also in the Stability and Growth Programme. If we look at the budget proposals submitted by ministries (totalling up to 1 billion euro), then it is obviously clear that there is no budget capacity to satisfy those claims. If all of them were satisfied, the structural deficit would amount to 4% of GDP. Therefore, it is essential for the government to abstain from procyclical policies, remember the lessons we learned during the crisis, build on that experience and implement a responsible fiscal policy.
Before we move on to your questions, I have an pleasant announcement to make: Mārtiņš Kazāks has joined the team of Latvijas Banka. Many of you know Mārtiņš as one of the leading economists in Latvia, and we are truly happy that he has started working at the Council of Latvijas Banka and will contribute to the analytical capacity of the central bank. After joining Latvijas Banka Mārtiņš remains open for inquiries from media representatives and other audiences.
Thank you! Time for your questions now.