UPDATED LATVIAN ECONOMIC OUTLOOK

UNCLAS SECTION 01 OF 02 RIGA 000202

SIPDIS

SIPDIS

E.O. 12958: N/A
TAGS: ECON EFIN ETRD LG
SUBJECT: UPDATED LATVIAN ECONOMIC OUTLOOK

Ref: Riga 138


1. Summary. The consensus among sources continues to be that
Latvia's economy will slow throughout the year, though estimates
range from the Association of Latvian Commercial Banks' soft-landing
scenario of 6.7% GDP growth, to the IMF's hard-landing estimate of
3.1%. However, the inflation that had previously been forecast to
peak in mid-summer, is now projected by some experts to not reach
its high point until near the end of 2008. Central Statistics
Office figures showed that annualized inflation reached 16.8% in
March, but both government and private economists believe that rates
of 10-11% are possible by December. Producer price and wage
inflation has hurt Latvia's competitiveness, but the Latvian
Investment and Development Agency claims that foreign investment
into Latvia has remained unaffected up to now. While none of the
news on the Latvian economy is particularly good, a key question is
whether the slowdown will be gentle enough to prevent a spillover
into politics. End summary.

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Tap, Don't Stomp, on the Brake
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2. Economists and officials consulted by post (which included
representatives of the Bank of Latvia, Finance Ministry, Financial
and Capital Markets Commission, Confederation of Latvian Employers,
Association of Latvian Free Labor Unions, HansaBanka, Latvian
Commercial Banks Association, and the Latvian Investment and
Development Agency) agree that the overheated Latvian economy will
continue to cool throughout 2008, due to falling aggregate demand
and household consumption. In light of consistently growing
inflation and Latvia's large current account deficit, a certain
degree of economic slowing is much welcomed and anticipated in
Latvia. The GOL and Latvian economists, however, have expressed
concerns over excessive cooling of the economy. They point to the
fact that Latvia's economic development has mostly been
consumption-driven and worry that a drastic drop in consumption may
result in significantly slower growth or even a recession. The
recession scenario is considered unlikely; nevertheless, the
government and the Bank of Latvia recently agreed that the
government will not enact any further anti-inflation measures and
will even rescind a provision enacted last year mandating 10% down
payments for large consumer loans. Currently, the PM's office
projects 2008 GDP growth will be 6%, OECD forecasts 6.1%, the
Economics Ministry says 5.5%, and the IMF foresees a gloomy 3.6%.

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When Will the Wave Crest?
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3. The inflation rate will likely continue to climb, with one
HansaBanka analyst saying that a peak annualized monthly rate of 20%
is not out of the question. Inflationary pressures will
increasingly be cost-pushed rather than demand-pulled. At the start
of 2008, the GOL stated that inflation would peak in the summer,
with prices then moderating and coming under control near the end of
the year. However, in recent weeks, the Bank of Latvia and private
economists have been pushing back projections of when inflation may
peak, with some estimates projecting increasing inflation rates
until December. Energy and food prices will continue to account for
most of Latvia's high inflation. Electricity tariffs increased on
April 1 by an average of 37.6%, and natural gas tariffs are expected
to increase by 30-50% this summer. Soaring production costs for
local producers, coupled with rising global food demand and wheat
and milk shortages, will keep pushing food prices upward. Demand for
luxury goods and services has already slowed and is expected to fall
further.


4. In an effort to fight inflation, the government pledged to
exercise fiscal restraint and maintain a budget surplus equal to 1%
of GDP. However, concerns exist that the GOL might inject some of
the surplus funds back into the market if the economy begins slowing
too sharply. On April 9, Bank of Latvia Governor Ilmars Rimsevics
met with the Prime Minister, and told reporters afterwards that he
believes it is essential to maintain the surplus at 1% of GDP, and
that the current shortfalls in government revenues (about 1 percent
less than expected) should be matched by spending cuts. If the
government chooses to boost the economy with funds from the surplus,
at a time when substantial EU funds are coming into Latvia, the
stimulus could spur continued rapid price growth into 2009.


5. Inflation and increasing labor costs are having a negative effect
on the competitiveness of Latvian businesses. Latest foreign trade
data shows that export growth is slowing, and this trend is likely
to continue throughout 2008. Businesses are increasingly calling
for government action to enact policies such as export credit
guarantees and tax breaks for re-invested profit. The economy is
also expected to begin undergoing various structural changes as
numerous sectors and industries become less profitable. Import
growth is also showing a tendency to slow, which should bring down
Latvian's current account deficit. Figures for the 4th quarter of

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2007 already indicate that the current account deficit decreased to
17.7% of GDP, down from 27.1% of GDP in the 4th quarter of 2006.

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Consumer Lending Slows
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6. Credit growth this year is still expected to decline, as observed
in the second half of 2007, but the banking sector should remain
stable. The Financial and Capital Market Commission notes that this
decline in lending growth indicates a normalization of the market
after a period of extremely high and unsustainable growth.
Projections are that mortgage lending will be slowing more than
commercial lending; the latter possibly even experiencing some
growth. Currently, approximately 80% of loans are issued in euros,
rather than in local currency, and the share of Euro denominated
loans is expected to grow. The large volume of Euro-denominated
debt had been the subject of public and press concern in the wake of
rumors last year that Latvia may devalue its currency, the Lat.
However, the Bank of Latvia says it continues to hold enough foreign
currency reserves to cover every Lat in circulation, and government
and banking officials almost unanimously discount the likelihood
that Latvia would alter the Lat' peg to the Euro.

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Wages Go Up, Productivity...Not So Much
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7. Wage growth is forecast to slow whereas unemployment is expected
to increase. The most often cited wage growth figures projected for
2008 are between 16 to 17%. This rapid wage growth, without
corresponding improvements in productivity, is one of the principal
reasons for the decline in Latvia's business competitiveness. Wage
growth, nevertheless, is forecast to remain relatively high due to
continued labor shortages and the fact that wage levels remain low
relative to other EU countries and workers are leaving Latvia to
take higher paying jobs elsewhere in the Union. It is thought that
unemployment will grow in response to economic slowdowns in sectors
such as construction and real estate. Rural regions are
experiencing the highest levels of unemployment and most business
activity is concentrated around urban areas. The GOL will continue
to work on a territorial reform plan this year, which aims in part
to address the economic disparities between urban and rural
regions.

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Optimism on Foreign Investment
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8. In discussions with post, the Latvian Investment and Development
Agency (LIAA) asserted that the high levels of inflation have not
had a negative effect on foreign investment growth - pointing to
data that shows that despite high inflation in 2006 and 2007,
foreign investment in Latvia continued to grow. LIAA adds, however,
that investment growth could slow this year in response to several
other factors - among them, downgraded credit ratings and increased
production costs. Lower labor costs relative to Scandinavian
countries still provide a continued advantage for investing in
Latvia. It is projected, though, that the number of investment
projects which rely on cheap labor will decrease, and that more
attention and resources will be directed toward the promotion of
technology intensive, rather than labor intensive, projects.


9. Comment: Inflation is likely to peak this calendar year, though
later in the year than originally thought. Predicting the peak has
been difficult due to continued external factors, such as energy and
food costs, but also in the difficulty of identifying the
inflationary pressures that are already in the pipeline from 2007.
As many in the ruling coalition have a preference for continued high
GDP growth and wage convergence with the EU, the political
temptation to use the planned government budget surplus to make up
for lower revenues may be too strong for the government to resist.
If the surplus drops below 1%, Latvia may not only suffer increased
inflation from the extra stimulus, but it may also lose the
confidence of the major credit rating agencies that Latvia is
serious about fighting inflation, and further downgrading of
Latvia's credit rating may follow. While not fatal to Latvia's
economy, rating agency concerns could make foreign investors bypass
opportunities in Latvia, and decrease its long-term growth
prospects. Hopes of entering the Euro zone also depend on reigning
in inflation and delays in Euro usage also could reduce foreign
investment into Latvia.


10. Comment, contd. The other key question is whether the economic
downturn is gentle enough not to spill over into politics. As noted
in reftel, a sharp drop in the economy could have negative
consequences for the stability of the current coalition government.