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Monday, May 11, 2009

The Agony Continues - Latvian GDP Falls By 18%

Latvia's economy shrank by nearly a fifth (year on year) in the first quarter, according to the latest flash estimate from the national statistics office. Obviously this is a dreadful state of affairs, and illustrates just how difficult the country's chosen adjustment path is proving to be.

Gross domestic product fell 18% year-on-year, and Statistics Latvia reported that the decline was broad-based, with manufacturing down 22%, retail trade down 25% and hotel and restaurant services output 34% lower from a year earlier. "The economic situation is of course very serious," Latvian Prime Minister Valdis Dombrovskis reportedly told a press conference in Stockholm, and who could disagree.

GDP fell by an annual 10.3% in the fourth quarter of 2008, while the economy contracted over the whole of 2008 by 4.6% following 10% growth in 2007. This is evidently what is meant by the expression "boom-bust".

The latest GDP numbers from Latvia suggest that the actual situation is in fact worse than the already pretty gloomy expectations. In many ways the “worst case” scenario for the medium term outlook for Latvia has now become a reality. Taking into account further tightening on the fiscal front the downturn could become even more pronounced in the coming quarters.

The weaknesses in the economy seem to be pretty broadly. The decline in both the manufacturing and the service sectors continued in Q1. The export sector has been contracting steadily, due both to slack global demand and uncompetitive domestic prices.

Industrial output was down by 23.4% in March, according to working day adjusted data from the statistics office. Manufacturing fell by 26.6%, electricity and gas supply by 14.1%, while mining and quarrying activity actually increased of 25%. The strongest reductions in industrial output were in textiles - down by 59.2%, in the manufacture of motor vehicles, trailers and semi-trailers – down by 52.9%, and in the manufacture of machinery and equipment - down by 47.2%.

Foreign trade has been dropping, and in March 2009 total trade turnover at current prices was 700.6 mln lats, up 8.3% (or 53.7 mln lats) on February, but down 29.7% (or 296.3 mln lats) on March 2008. Exports reached a low in January, and have climbed slightly since then.

Over the whole quarter trade was down by 32.7% (or 963.9 mln lats) over the first quarter of 2008. Exports fell by 26.0%, while imports were down year on year by a whopping 36.5%.

70.8% of Latvia’s March exports went European Union countries, and another 15.1% went to CIS countries. The principal export partners were Estonia (13.3% of total export), Lithuania (13.0%), Germany (10.2%), Russia (8.7%) and Sweden (7.2%). Since all five of these main trade partners are themselves in strong recessions at this point the outlook for improved exports (even were Latvia competitively priced) is not exactly promising at this point.

The drop in imports does, of course, mean that the trade deficit has been steadily improving (see chart below), which means that despite the drop in exports, net trade has actually been positive for GDP in the first quarter.

Price Inflation Still Far Too Strong

One of the key points in Latvia's "non-devaluation" strategy is to get the wage and price level down quickly. Since the only relief can come from exports as the global recovery starts to take shape it is important that as much of the internal deflation process should have been carried out by that point. However when we come to the reality it is important to note that progress has been slow, and far from satisfactory. The consumer price level was down in April by 0.4% with respect to March, but compared to April 2008, consumer prices had still increased by 6.2%. Obviously much of this inflation is already inbuilt, but in the absence of independent monetary policy it is obviously clear that the Latvian government should be doing more to speed this up, otherwise all this is going to take an eternity, the pain will be unendurable, and much of the structural damage well nigh permanent. The Latvian economy could look worse than the Florida coast after a hurricane has passed.

The only really bright spot is that the tradeable sector does seem to have responded rather more rapidly than the rest (as theory would predict) and export producer prices are now falling rapidly.

Company finances are strained, as internal demand is weak and financing conditions tough. In addition, the position of the Latvian consumers is difficult, as unemployment has shot up and wage growth has slowed. 2009 is likely to be a very difficult one for Latvia, and the government faces the twin challenge of both keeping the budget deficit within a limit accepted by the IMF in order to receive the rest of the emergency loan, and of breaking the back of the economic contraction which is currently spiralling away out of control.

Households are obviously also having a hard time, and incoming data on the rise of non performing loans in Latvia is becoming preoccupying. NPLs (loans that are more than 90 days overdue) as a proportion of the total rose to 7.8% in March (see chart below), and while this level is still not excessive, it is that rate of increase that causes concern.

Retail Sales In Freefall

Retail trade turnover was down in March by an astonishing 27.3%.

Compared to February sales decreased by 2.6% on a seasonally adjusted basis. Compared to the last quarter of 2008 retail sales decreased by 14.1% in Q1, while compared Q1 2008 there was a 24.5% drop.

Unemployment Also Up Sharply

Obviously one of the factors driving the increase in non-performing loans is the rapid rise in unemployment. In fact, as elsewhere the rate of increase eased in April, but still the rate of unemployment rose to 11% and the numbers unemplyed to over 120,000, according to the latest data from the State Employment Agency.

At the present time the government is working towards a deficit of 7% of GDP, above the 5% initially agreed to with the IMF. According to the Prime Minister discussions with the IMF about allowing a larger deficit are ongoing. Maintaining the deficit within the 5% of GDP limit is turning out to be increasingly difficult as the economy has contracted much more sharply than anyone anticipated.

According to Latvian economy Economy Minister Artis Kampars the economy has now reached the bottom and on the point of recovery. Kampars said this in an interview with LNT television. Asked about the gross domestic product decrease of 18% in the first quarter, Kampars said that it was logical and expected, but the GDP will start increasing later on this year.

He also said that regardless of the significant fall in the GDP, the government is not planning to revise the budget amendments, which are based on a 12% GDP drop.

Basically this whole view could not be farther from the truth, since the worst is yet to come, even if this may not be in terms of ever stronger rates of contraction. 18% is we have to hope "unrepeatable", as a year on year figure, and the contraction in the future may well be slower. But this is not what matters. The hardship of the Latvian people will undoubtedly increase, as will what is called the level of "distress" when it comes to paying loans. I see no recovery on the horizon, and even though the rate of contraction will almost certainly decline, positive growth is a long time away, and it would be a brave person who was willing to forcast any sort of growth in any quarter before we hit 2011.

Worst of all, the government, the European Commission and the IMF seem to have no exit strategy here. Like the Vietnam war, this recession may prove to have been a lot easier to get into than it was to get out of. Hanging on in the hope of a euro entry which may never be possible is no strategy. Those who didn't want to devalue got the Latvian people into all this, now perhaps they can explain to them how to get out, since the answer isn't obvious, as budget cut upon budget cut only feeds the contraction, which feeds the unemployment, which feeds the rise in non performing loans which feeds the bailouts which feeds the need for more spending and more cuts in services and staffing, which feeds the contraction and so on.

We need to break the circle, or are we just, like Dicken's Mr Mikawber simply going to hang around and wait for something or other to turn up? And if we are, then I'd be firmly locking and bolting the back door, since all those able bright young and educated people will be sneaking off elsewhere as soon as recovery starts up across Europe, and they won't be coming back, and then we really will be in a pickle, won't we? Or are we hoping they will be like his wife Emma, who let her maxim be "I will never desert Mr. Micawber!"


Robert said...

This only makes it even more obvious that a devaluation and supported by structural reforms must be put in place.
I see the case of Finland in 1992 as a good example.
If not "How will Lativans have anything to live of since they do not produce any competetive products at the moment?"

PS I really like Latvia and also married to a Latvian. I hate to see what is being destructed in Latvia now.

A said...

Government do not want to hear anything concerning devaluation.
The last thing I heard from Mr.Rimsevics was a thought that people who talked about devaluation just wanted to make profits of their EUR savings.

Hynek Filip said...

I would say that the Latvian Government simply does not believe that devaluation will be necessary. You know, once you get (with few strings attached) an IMF/EU lifeline worth 7.5 billion, you will easily believe in anything.

Given the size of the Latvian economy, the 7.5 billion is a staggering figure indeed. In fact, it is about the same as if Poland got some 120 billion. Nobody would ever give Poland 120 billion (or anything even remotely close to that), but Latvia did get its 7.5. In other words, as long as the Latvian Government is made believe that the IMF/EU is going to support Latvia no matter what, the Government will act accordingly and nothing whatever will be done.

Robert said...

To Hynek Filip, You are totaly right in your analysis.
I just hope that the IMF and EU change there view soon because this capital destruction going on in Latvia now is crazy.
What will Latvians live of in the future? 50% of the population wish to leave Latvia.

Hynek Filip said...

To Robert: We have found ourselves in very much the same hole some 15 years ago. The Czech industry produced nothing worth a second look, the infrastructure was in a terrible state and the banks were in shambles. Now, we are certainly not the most advanced nation south of Riga, but we are fairly reasonably prosperous. So what helps?

One, cut taxes. Two, sell your industry to the Germans and the Japanese (lock stock and barrel) and learn from them as much as you can. Three, attract as much new foreign direct investment as you can. Four, attract foreign human capital.

And, obviously, allow the lat to devalue. Since mid-2008, the koruna is down by about 25%, having dropped very sharply and stabilising at the current level some four months ago. It did wonders. In March alone, our trade balance was plus USD 1.2 billion and we have just lent the IMF a billion dollars to lend to countries like Latvia (by the way, we are also sending EUR 100 million to Latvia directly). The trick is to produce German goods at half the German price...

As I say, the Czech republic is by no means the most advanced nation around. But, for the time being, we are stable and even able to help others a bit. So I would not see the Latvian future so dire, it can be turned around quite quickly.

Anonymous said...

Latvian politics is not farsighted. Hasnt understood the worldwide economic crisis. There is no intellectual potential this crisis to understand.Latvia becomes the big loser of this crisis

Hynek Filip said...

I fear that a farsighted government is something very much like the Himalayan yetti. Lives FarFarAway and has not been seen since 1358.

So do not blame the Latvian government. They simply live in their own universe, where a fixed exchange rate is a demigod, banks may never be allowed to fail and everything is backstopped by Helicopter Ben and Company, or rather their printing presses. The problem is that this particular universe seems to be shared by most western governments, the IMF, the EU and god knows who else.

Nobody seems to bother that the 7.5 billion lifeline, which is now almost sure to be wasted to the last eurocent, could pay for every centimeter of new highway, bridge and railroad that Latvia may need in the next 50 years.

Let us do the simplest of calculations: a kilometer of flat highway costs about EUR 10 million. One kilometer of four- lane highway tunnel costs about EUR 80 million.

So the 7.5 billion is some 600 kilometers of perfect, brand new motorways with all sorts of eco-friendly extra features, plus 20 extra kilometers of shiny new highway tunnels. I guess that it would be quite nice to have a highway system better than that of Germany...

However, highways, tunnels, hospitals or factories are good for us here, not for them over there in their parallel universe. In that world, food is generated at bank accounts and trucks have wings.

Edward Hugh said...


Well look, basically, and as he well knows, I don't by any means agree 100% with Hynek. But he is scratching in the right area.

Deutsche Bank (see report below) suggests that governments facilitate the conversion of all those euro denominated loans into local currency ones. So, rather even than building motorways and tunnels, would it not have been better to use the loan to finance this transition, devalue the currency, and then put the people back to work. Borrowing money to pay people to stay at home can never be a good idea. Work is what pays off debts.

Just a thought.



Postimees Online: the Deutsche Bank wrote in its recent analysis that the decline in Estonian, Latvian and Lithuanian GDP might reach 20% in this year, writes LETA.

The bank doubts that Estonia will be able to keep its budgetary deficit below 3% – the criterion established for the adoption of the euro. Estonia's deficit reached this limit last year already.

According to the analysis, the main problems in the Baltic States are excessive loan burden of the private sector, weak competitiveness and too lenient budgetary policy. The Deutsche Bank estimated that one of the solutions for the current crisis might be re-converting the loans of the private sector that are based on the euro into local currencies – that would make it possible to devalue the national currencies, if necessary, as well as to improve growth options and increase the capacity to service loans.

The bank's analysts are also of the opinion that an alternative is to force Latvia to devalue its currency; this would probably hit the monetary committee systems of Estonia and of Lithuania and would remind the banks operating in the new EU Member States of the risks involved in this region. This in turn would mean another blow to the economic activity and to prices in Central Europe.

Edward Hugh said...

Here's another one, the personal bankruptcy law. If you read the original IMF document, one of the biggest obstacles to a rapid solution of this problem was the absence of adequate bankruptcy laws.


The Seimas has decided to consider the issuing of the law on bankruptcy of natural persons especially actual in the face of the current economic crisis. The drafted law, being presented by the parliamentary group of the party Order and Justice is intended to protect an insolvent natural person from impoverishment and restore his solvency, informs ELTA.

In a vote in the Seimas on Tuesday, the drafted law was approved by 63 MPs, 1 MP was against it and 13 MPs abstained from voting. The MPs set a preliminary date for consideration at a parliamentary sitting, June 23.

Under the drafted law, the bankruptcy proceedings could be launched only after the natural person submits an application and only in the case when this natural person cannot pay a debt to his creditor, which exceeds the sum of 12 minimum monthly payments for work. Presently, this sum amounts to 9,600 litas (2,779 euros). Currently, only legal persons are able to go bankrupt. "When the insolvency proceedings are launched, a plan for restoring the solvency of the natural person and a plan for covering creditor debts and other expenditures would be drawn up. Data about the bankruptcy proceedings would be made public and the proceedings against a natural person, who is not involved in business, would last up to 3 years," said elder of the parliamentary group Valentinas Mazuronis.

Hynek Filip said...

Maybe we should really stop calling the USD 11 billion a loan. Can anybody really believe that Latvia, with a GDP of maybe USD 25 billion and falling fast, will ever be able to repay such an amount? It will not, so let us call it a donation, or subsidy. It will either be rolled over forever or written off.

To spend such a massive donation on something as obscure as a change of denomination of certain loans would be bizarre indeed.

Let us go back to basics: what do we really need? Material things, such as food, water, hospitals, roads, power plants. How do we create such things? By employing lots of people for quite some time. What do the people do with their wages? Buy things and repay their debts. Do the roads, hospitals, powerplants, ports, factories and fire stations vanish into thin air? No, they remain useful for many decades.

So I would suggest that instead of doing all sorts of wizardry with fiat money, somebody takes the trainload of good euros and starts creating things and employing people now.

In my earlier post, I went back to 1358. At about that time, the Roman Emperor Charles IV decided to help the poor. Obviously, he could just give them a few bits of gold. Instead of that, he decided to do what I am advised against: build bridges, city walls and towers. As those who visited Prague will probably confirm, his was the right decision. The structures and public buildings are serving their seventh century and still remain the best Prague has to offer.

Anonymous said...

hi guys,

The problem is that more than a few officials in Latvia are deep in EUR debt and devaluation would be major blow for them. For example, Central Bank governor owe around 0.5 mln euros on apartment he bought last year. The Minister of Finance also has personal debts worth more than 1.4 mln eur (backed by real estate and some business). So these guys will fight until last breath to keep the peg.

Anonymous said...

So the article in "Baltic states have postponed devaluation of national currencies because it would hurt their elite" in Finnish news paper Kauppalehti would be correct? http://www.bbn.ee/Default2.aspx?ArticleID=5d00b931-3f4c-4722-8493-69e2af781148&open=sec

Edward Hugh said...


"So the article in "Baltic states have postponed devaluation of national currencies because it would hurt their elite" in Finnish news paper Kauppalehti would be correct?"

Well, I think there is certainly more of a grain of truth in this.

Here's a comment from a Finnish reader on the Baltic blog on the same topic.The argument largely concerns Estonia and Finland in this case:


"Estonia is now following the economic policy of "internal devaluation" through wage cuts and cuts in public expenditure. In Finland the right-wing government tried to push through this policy in 1990-1991, but couldn't do it because of unions opposed it. The end result was forced devaluation.

In Estonia there isn't such opposiotion, and therefore "internal devaluation" is possible. This strategy of "internal devaluation" has different set of winners and losers (of course, winners only in relative terms, because the situation is so dire almost everyone will be hit more or less). In the present strategy losers are those whose wages and benefits are cut, winners are firm owners and those wage earners (in some sections of the private sector) who escape cuts. What is essential, is that debts remain constant.

On the other hand, the option of real, external devaluation would mean a sudden spike in relative debts (because majority of the the loans are euro nominated--a totally irresponsible economic policy). The direct losers would be those households and firms that are in debt. Those who don't have debt (maybe because they have been thrifty, maybe because they are without means) would relatively win. To put it cruedly: the Estonian goverment is putting the burden on the backs of the wage earners and the poor (who receive public benefits). For those Estonians in debt and functioning in a sector that is likely to be less hit by the depression (say, tourism) the current path suits well.

Unfortunately they are a minority of Estonians.

For Finnish and Swedish companies it really doesn't matter is their profitability restored through internal or external devaluation. Certainly Finnish firms producing something in Estonian for export, would see their competitiveness restored quicker through external devaluation. Those concentrated on real estate speculation, for instance, are a totally different league altogether."

j said...

By the way, latest idea in Latvia is to issue vouchers as a substitute to LVL (thats in case Latvia doesnt get any money from IMF). So if you work in public sector, your salary partly will be paid in vouchers which you can use to buy food. And yes - it would also mean 'stable' LVL, at least on paper.
I still don't really understand how it could possibly work in free capitalist economy. But it underlines how strong is the will to keep current LVL rate at any means, even if it means total collapse.

Edward Hugh said...

"By the way, latest idea in Latvia is to issue vouchers as a substitute to LVL"

Oh, that's very interesting. This means you are running out of Lat liquidity. This is normally what happens when you try unrealistically to hold a peg. It is the begininning of the end. The same, exactly happened in Argentina (where they ran out of pesos) and the issued Lecops, Patacones etc.

See this post here in my Spanish blog where I detail what happened in Argentina. I fear something similar might happen in Spain at some point, if the government has difficulty funding euro liquidity. It all depends on whether we get those EU bonds or not.