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Created on 04.09.2015

The latest euro area growth projections make us act with circumspection when considering the medium-term growth of Latvia's economy. That is why Latvijas Banka has revised the GDP forecast for 2016 downwards, from 3% to 2.7%, and calls for caution to be used when planning next year budget. 

Though only three months have passed since the previous press conference, this has been a very interesting and tense period for the economies of both Latvia and the euro area. We stand at the threshold of very significant events and serious decisions; among them here in Latvia the most topical economic issue is the state budget for the coming year, which I will touch upon in more detail later.

But I will start with the analysis of the euro area economic development and Latvia's economic growth.  

1. On the situation in the euro area

Supported by monetary policy measures, the growth in the euro area continued in the first half of the year. Though in the second quarter the pace of the GDP quarterly growth decelerated slightly, it was still by 0.3% higher than in the first quarter. This growth was primarily on account of rising private consumption and investment; at the same time, it should be admitted, that foreign trade contributed to the overall euro area growth to a lesser extent than previously projected. This can mainly be explained by a weaker growth outlook for new emerging market economies.  

Yesterday, on 3 September, the Eurosystem released its latest projections for the growth of euro area economies.  

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According to these projections, the euro area GDP is expected to grow by 1.4% in 2015, and accelerate to 1.7% in 2016 and 1.8% in 2017. Nevertheless, this anticipated euro area growth is likely to be by around 0.1-0.2 percentage point behind the projections made in June of the current year. Moreover, the developments in foreign markets over recent months and weeks suggest that there are significant downward risks to this forecast.

The euro area inflation forecast has also been revised downwards, with the overall euro area inflation at around 0.1% in 2015, 1.1% in 2016, and 1.7% in 2017. These forecasts are by 0.1-0.3 percentage point lower than those made earlier in June. Amidst the environment of downward revisions to the euro area growth and inflation projections due to external pressures, the Eurosystem's non-standard monetary policy measures are important drivers of the economy. The very first positive outcomes of the programme are in place: the terms and conditions of financing are becoming more favourable for euro area businesses and households. The dynamics of loan issuance is also improving. Therefore, it is important to proceed, consistently with the plan, with the implementation of the extended asset purchase programme (APP) in the future as well. I would like to emphasize that the asset purchases amount to 60 billion euro per month and are planned to be carried out until at least end-September 2016 or at least until the time when sustained adjustment in the path of inflation towards the objective close to, but below 2%, is seen.

Speaking about the programme implementation, the total volume of assets purchased under the programme, as previously predicted, was smaller in August, amounting slightly above 50 billion, which can primarily been explained by the vacation season and a weaker market activity. The Eurosystem's member states had reckoned with it, and, in the previous months, assets slightly above the 60 billion limit, probably somewhat more in some months, had been purchased to compensate for the amounts not purchased in August.

From the point of view of extended APP's efficiency and impact in the future, the decision of the ECB's Governing Council yesterday to increase the issue share limit from the initial limit of 25% to 33% is undoubtedly a very positive decision. This decision will also enable Latvijas Banka to make additional purchases of securities, potentially worth around 213 million euro, issued by the Latvian government, and in such a way more directly enhance the economic growth in Latvia. As is known, due to the lacking supply of adequate government securities during recent months, Latvijas Banka was more often obliged to purchase securities of international organisations, which reduced the direct positive impact of the extended APP on Latvia's economy.

2. Now about the situation in Latvia's economy in short

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Though at a moderate pace, Latvia's economic growth continued in the first half of 2015: GDP increased by 2.0% in the first quarter and by 2.7% in the second quarter. Taking a short-term perspective,the recorded economic growth is satisfactory. At the same time, the latest euro area growth projections just mentioned above make us act with circumspection when considering the medium-term growth of Latvia's economy.

Moreover, some concerns arise due to the fact that the second quarter growth momentum was mainly determined by probably one-off factors which would lose their impact by the year's end or the respective quarter of the coming year.  For instance, the relatively good performance of manufacturing has primarily been underpinned by KVV Liepājas metalurgs resuming its operation. The time will show if it – the advanced growth of this factory – will last.

The performance of other manufacturing subsectors has also been uneven. On the one hand, the growth of wood industry and manufacturing of electronic products is robust and sustainable.  Meanwhile, the growth of food, construction materials and wearing apparel industries is slower. The manufacturing indicators for July, which were released yesterday, are very positive, with most of the subsectors recording increases. However, the good results of one single month cannot substantially change the overall outlook for the sector: the situation in a number of manufacturing subsectors remains complex, and a radical resolution of the situation in a short term is unlikely.

As has been known, the construction industry is facing some problems, and its production output has shrunk. It is to be primarily associated with the real estate market cooling after a change in terms and conditions of obtaining temporary residence permits in Latvia.  Geopolitical developments have had their impact on the transport sector problems, where volumes of freight loaded at ports and transported by rail are contracting. In addition, new potential risk factors for the transport sector have come to the foreground. The beginning of the year has unfortunately been unsuccessful for the energy sector: the comparatively warm weather was not supportive for the production output.  

To sum up, the economic growth has, up to now, been driven by the so-far relatively good performance of manufacturing and also good trade indicators. Likewise, a large contribution comes from industries with significant public financing. At the same time, internal risks have tightened. In addition we see that each new day comes with more negative surprises domestically: fish and dairy farmers are facing a very complicated situation in their sectors, the transport sector is shrinking, and uncertainty is on the upside.  

In the meantime, there is some positive news as well. Manufacturers and exporters have proved to be crisis-tempered and managed, even in the current complex circumstances, to capture new export markets, diversify their activities and expand production.  

Speaking about inflation,its annual level has notably fallen since May. The given price developments have been substantially affected by lower food and energy prices.  

During recent months, the global oil prices have been gradually declining. In line with the global energy price trends in June–August, the JSC Latvijas Gāze continued to reduce natural gas tariffs for households and industrial customers.

Meanwhile, Russia extended the on-going period of sanctions on food products from the EU countries, and later imposed new food trade restrictions on Latvia. In such a way, the above-stated downward pressure on food prices is persisting.  

3. Speaking about the latest GDP and inflation forecasts,

the data for the first and second quarters of 2015, and the positive July data released yesterday in particular, allow for some slight upward revision of the GDP forecast. According to our estimates, GDP could grow at somewhat faster pace in 2015 than previously projected, i.e. by around 2.3% (vis-à-vis previously estimated 2%). But, of course, it must be remembered that we live in the circumstances of very high uncertainty, and the forecast may have been revised by the end of the year.

Referring to the development of Latvia's economy in 2016, the current growth forecast of Latvijas Banka was 3%, but we see that since the summer months when we conducted the previous forecasting round the global economic situation has deteriorated. The worsening has been driven by the following developments and processes:

  •        weakening growth in China and almost all new emerging market economies;
  •        adjustments in stock markets;
  •        intensifying general uncertainty and falling "risk appetite" which do not stimulate new investment;
  •        additional problems for exporters to the Russian market.

All these factors have compelled us to revise the GDP forecast for 2016 downwards – from 3% to 2.7%.

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Due to the downwards-revised economic activity forecast, our inflation forecast for the current year stands at 0.4% (a downward revision from 0.7%). In 2016, the price rise is expected to amount to 1.3%.

4. About the budget for 2016

The stances taken by the Prime Minister and Minister of Finance who have strictly stated that they would not agree to a budget deficit above 1% deserve praise. It is positive that the new draft budget has been reviewed by the government and submitted to the Saeima for approval in due time, with no support for the proposal to raise the value added tax. We would like to stress today, however, that with regard to the budget of the coming year a number of risks are in place.

First, the budget draft for the next year foresees a GDP growth of 3%. As I have already stated, duly accounting for the latest Eurosystem's projections, we also revised our forecast yesterday, providing for a GDP growth in 2016 below 3%. Smaller GDP in nominal terms means smaller tax revenue to the budget, and, accordingly, also a slightly larger budget deficit, i.e. 1.3% instead of 1% of GDP. Consequently, taking into account this above stated, our appeal would be not to plan any additional expenditure in the 2016 budget when it reaches the Saeima.  

Second, on the back of uncertainty, concerns arise due to the plans to give up the formation of fiscal safety reserve in 2016 stipulated by the law. I shall remind that the fiscal safety reserve is stipulated by the Fiscal Discipline Law and is to be assessed as a budget safety buffer. The Law stipulates that this reserve should be projected in the amount of around 0.1% of GDP. Practice shows that the building of such financial safety reserve is absolutely indispensible for Latvia! We know that the government has such unforeseen expenses from month to month, and, if they are not projected, the risk of even a larger deficit emerges.

Third, unfortunately, the zero budget approach will not be used in drawing the budget this year either. This approach means that any budgetary activity would be assessed from the very start, i.e. assessing the usefulness of particular positions, not increasing the base without careful evaluation of whether any particular expenditure is reasonable or not.  

This issue was discussed by the working group formed following Prime Minister's resolution. Yet, the group was deemed to work for only three weeks. We do hope that it will resume its activities in a new status, i.e. under the auspices of the State Secretary of the Ministry of Finance, and proceed with the drawing of a balanced (zero) budget. It would be extremely important that next year, when the situation for Latvia is unlikely to be much easier, the government of Latvia would have a reserve at its disposal to be allocated among ministries for their needs.

Viewing the budget drawing process from the positions of macroeconomic stability and risks, we come, once again, to the conclusion that, despite the economic growth in Latvia and its economy being among the fastest growing within the EU, we keep on spending more than we earn, thus jeopardising budget sustainability in shorter and longer terms and placing the burden on future generations.