The CEE and the Baltics - Moving Towards the Center of the Storm?

by Claus Vistesen: Lausanne

As I peer out my window over towards the Alps and the northern entrance to Le Vallé du Rhône I can't help asking myself whether some of those experiments which are habitually conducted a mere 40 kilometers from my current habitat haven't gone terribly wrong? With every passing day getting I find it more and more difficult to avoid associating all those worthy attempts to uncover that illusive Hick's Particle with the all-encompassing black hole into which our financial markets seem to be getting sucked with a disturbing velocity, despite the numerous efforts by the global financial authorities to invent some sort of monetary equivalent to "anti-matter".

But while the current crisis is pretty much a generalised global one, if there is one region where the crisis is making its presence more acutely than elsewhere, that place is Eastern Europe, and among the ranks of the regional casualties high on the list come the three Baltics countries, Estonia, Latvia and Lithuania. That this is the case should not really strike us as so strange. On many occasions since the credit crisis went global back in the summer of 2007 many analysts (including yours truly) have been flagging the risk of a hard landing in Eastern Europe. This unfortunate situation has now by and large materialised and the only question which really arises is how hard is "hard" going to be? A couple of recent tentative signs suggest that the big eye of the credit crunch, not unlike Sauron with his glance toward Frodo et al., is fixing Eastern Europe fast in its gaze.

In terms of Russia, we have already witnessed the speed with which financial markets have turned the tide for the erstwhile high powered economy. Now that oil is dipping into negative on an annual basis, the screw may just get turned a little more.

In Ukraine, the market for the state's sovereign debt almost collapsed during the past week as credit default swaps (insurance against loses on debt) rose almost 40% to 1700 basis points as rumours mounted on an early election as well as the government made steps to take over one of the country's big banks. Furthermore and as could be expected the Hryvnia took another beating. A similar situation seems be unfolding in Hungary where prominent government and central officials were dipatched spent part of their Friday trying to avoid a rout on the Forint in the spot markets. Meanwhile, and as a natural bed-fellow to this the stock market, and especially financials, were pumelled. In many ways, the Hungarian predicament resembles more and more a tragedy in the making which is also why the IMF is moving in to calm things down as well as attempt to bring the boat back on course.

The situation in Ukraine and Hungary is important. It highlights the flipside of de-pegging from the Euro (and in the case of the Hryvnia, the USD) in the expectation that subsequent appreciation will help quell inflation. Such a strategy perhaps seemed clever at the time (personally, I always had my doubt), but now as the tide turns downside risk is substantial. From a macroeconomic point of view this is extremely significant. a major part of Eastern Europe's expansion has been supplied by foreign credit and more importantly with loans denominated in foreign currency (mostly Swiss and Euro loans in Hungary and Ukraine). It does not take much of an economist to see the potential abyss of downside risk in the form of translation exposure. As Edward puts it in a recent note;

Basically, the crossover we need to be thinking about in macroeconomic terms is the one between the Swiss Franc and the Hungarian Forint, given the exposure of Hungarian households to Swiss Franc denominated mortgages, and the impact on internal demand which is to be expected if the current dramatic decline continues.

To cap it all off, the significant increase in stress levels of Eastern Europe aslo appears to be sending tremors towards Austria where the banking sector is highly involved as intermediary for swiss denominated consumer and housing finance.


And in the Baltics?

While things are likely about to get very interesting in Eastern Europe the recent tumultous events in financial markets seem to have spared the Baltics from the worst repercussions. This only goes for the more theatrical "Iceland type" events however. If we look at the real economy it is evident that a sharp correction has now begun, something which was confirmed as the data from Q1 2008 rolled in. If we take a look at the most important data pieces, the Baltics have now almost entered a collective recession (even if Lihuania is performing above par).

Both in Estonia and Latvia output contracted for the second consecutive quarter in the second quarter while output in Lithuania stayed surprisingly strong. On the inflation front it finally seems that the pressure is abating somewhat even if of course this is a process that works with considerable rigidities relative to the decline in output. In this way, the Baltics still find themselves in a situation of stagflation.

One very interesting development in this regard however is the evolution of labour costs. If we look at the development up until Q1 2008 the y-o-y increase was one of 7-10% per quarter, but that changed strikingly in Q2. As such, in Estonia and Latvia quarterly labour costs fell to 2.9% and 2.4% respectively Lithuania entered wage deflation. It is still too early to gauge a trend here but it is obvious that for the Baltic economies to correct while simultaneously maintaining a fixed exchange rate regime the correction mechanism would fall entirely on the domestic sector's ability to become more competitive.

And this is now becoming more than a passing preoccupation.

In this way, and while the external deficits have been reduced (mainly due to a sharp drop in imports) the imbalances are still very much present, not least because a negative income balance remains to keep the balance in red. As I have argued before this can only go on until it can't, which is a cryptic way of saying that something at some point has got to give. Unfortunately for the Baltics, the watchdogs of global credit markets (the rating agencies) have begun to seriously turn their scent on to the contradictory fundamentals of these three economies.

Last week, the Baltics's sovereign ratings were consequently collectively downgraded by Fitch Ratings which followed an earlier decision by Moodys to lower the region to negative. The reason cited will not surprise regular observers of these economies (indeed readers of this blog's eastern europe installments). Head of sovereings in Europe Edward Parker from Fitch consequently noted that the worse than expected correction in financial markets coupled with the vulnerable macroeconomic enviroment as the main reasons for the downgrade. More specifically, the mixture of external deficits funded to a large extent by inflows of credit (e.g. some 30% for Lithuania) supplied by foreign banks lies at the root of the decision and incidentally, as it were, also at the root of the macroeconomic vulnerabilities of the Baltic economies.[1]

In this context it is interesting to initially peruse the graphs plotting cross currency exposure and overall leverage (Latvia data only for households).

The point conveyed by the graphs above is one of the main reasons for an increasing risk of a more than traditional adverse outcome from this crisis. It is thus important to understand that the Baltics are still dependent on inflows of foreign credit even as the economy slows and that this shows up, in part, through the substantially higher leverage in foreign currency relative to the total leverage ratio. Especially the extra graphs in the Lithuanian case is interesting in that it shows how the marginal increase in total leverage from 2003 and onwards almost exclusively can be attributed to an increase in leverage of foreign currency loans relative to foreign denominated demand deposits.

This is of course where things begin to get interesting because if we look at the companies supplying the credit to the Baltics, they are increasingly looking to get sucked down into the maelstroem that has fit financial markets. Most prominently is of course the Swedish bank Swedbank which perhaps has the biggest exposure to Baltic markets (through Hansabank). Analysts have persistently been voicing warnings on Swedbank's aggressive lending policy in the Baltics, but if we look at activity in Q2 Swedbank continued to expand credit to the Baltics. And this is not a mere problem of a Swedish bank potentially having to retreat from a growth market gone sour. No, this has the potential to become a full blown macro catastrophe in which the Swedish Riksbank will be faced with the rather odd dilemma of having to bail out a domestic bank, in part, in order to allow the relatively benigh unwinding of macroeconomic imbalances in the Baltics.

It is extremely important in this regard to be aware of the narrative that Swedbank and the rest of the short term credit providers effectively are the only ones keeping the boat afloat. The logic, as brilliantly detailed by John Hempton here, goes as follows. The credit needed on a flow basis to sustain the Baltics' external deficit is being supplied by foreign banks and mostly through loans denominated in Euros (this last thing being very important). Consequently, this presents Swedbank et al. with a rather delicate problem. For the Baltic currencies (or one of them) not to devalue they need funding and more importantly, they need funding on their way down into whatever abyss that may now have opened. Now, as my colleague Edward pointed out in another context it is not the most pleasant of dilemmas to be confronted with the choice of having your throat slit with the stanley knife or the chainsaw. However, this may the situation which now confronts Swedbank, the Baltics, as well as potentially the Swedish Riksbank in the current situation which increasingly resembles some of Kafka's best creations. Hempton makes it very clear when he says;

If the Lati doesn't devalue its only because people (i.e. Swedbank) are prepared to continue to fund it. This is not pretty at all. All in Hansa owes Swedbank over 30 billion Swedish Kroner – all denominated in Euro and which can't be paid. The equity capital of Hansa (roughly 7 billion Swedish Kroner) is also going to default.

The juicy point here is of course the presence of massive translation risk which would arise as the liabilities (denominated in Euros) multiplied in value relative to the asset side.[2] More importantly, this would not only potentially crash Swedbank but also potentially the Baltic economies, and this is something we should attempt to avoid.

However, it is not easy to see where to go from here. One fascinating correlation between micro and macro data is epitomized in the graphs below which shows the evolution in the total stock of loans broken up on currency denomination.

First of all, it is very interesting to peruse the graphs shown above in connection with the graphs plotting cross currency and overall leverage (Latvia data only for households). In my opinion these graphs, taken together, resemble the epitomy of the kind of risk the Baltics face. As such, it is not only a case of devleveraging which, given the multiples, would be bad enough; it is also about the crisis that would emerge if the pegs were abandoned to restore competitivness. However, whether to keep the pegs or not may not be entirely up the Baltic economies themselves. Rather we can easily imagine a situation in which the decision of whether to keep the pegs would reside within the halls of a Swedish bank and perhaps even ultimately the Swedish Riksbank.

How does this compute then?

One way to approach the answer is to look at the total evolution of loan stocks (accounted on a flow basis. One striking feature is that the growth of loans denominated in Euros continue to markedly outpace loans denominated in local currency. This is a well known story in the Baltics and one which I have discussed several times [3], but the key point here is that as the economic edifice now visibly crumbles credit flows continue to enter the Baltic economies. Given the rapid deteriration of the real economy this seems rather contradictorary. However, it is is not, and it essentially means two things.

First of all, it means that whoever is doing the credit service increasingly is throwing good (and presumably scare) money after bad money. From a standard profit maximizing point of view this would seem and odd behavior unless of course there is more to the story than meets the eye. This brings us to the second point and was detailed above in the context of Swedbank et al. and their exposure in foreign currency (with receivables in domestic currency). Ultimately, the situation in the Baltics surrounding the pegs is beginning to resemble more and more like the attempt to cling on to something which is becoming more and more unsustainable by the day. Obviously, the foreign banks could stick it out, but the question is whether they can afford it.

In fact, I believe the only scenario which we, with certainty, can say will not continue is the current one in which lending is expanded on a linerging basis. As such, we need de-leveraging and we are going to get it one way or the other. The only question is whether it will be through Swedbank et al. closing the tap or through a move by Baltic authorities to loosen the peg (in which case Swedbank would be in grave trouble). The alternative would of course be a significant bout of internal deflation which we, with the incoming wage cost data, may already be seeing. The problem with this process though is that it takes time at the same time as it is politically unacceptable. I would seriously question in this regard the usefulness of continuing to look toward the future for potential Euro membership. At some point it should dawn on market participants and politicians alike that this is very unlikely to materialize.

Finally, we may ask the question of whether it is enough? I don't think so and while it still may end up being part of the correction I think that the extent to which these economies need to shore up their competiveness will also include a tweak of the currency peg [4].

Where do We Go From Here?

At the current juncture in financial market the answer to such a question is bound to riddled with uncertainty. In Lithuania, the people just elected a new parliament and while people may be more worried about the immediate need to secure stable gas deliveries from Russia and winter approaches, it is difficult to see how the attention on the crisis can anything but increase as we move forward. In this respect, and as an aside, Lithuania does seem to somewhat different from its northern bretheren in that the leverage ratios and debt multiples are not as high as in neither Estonia nor Latvia. Obviously, this may ultimately come down to comparing one ugly duckling with a slightly less ugly duckling.

As regards Latvia, Alf Vanags and Morten Hansen recently published a detailed analysis on the future path of the Latvian economy faced with the incoming financial crisis and potential global recession. Their conclusion is rather dire with respect to the potential loss of output between and now and 2010. As the authors make painfully clear, this fact obviously brings into the question the whole idea of convergence towards the illusive EU15 living standards not to speak of the convergence towards their own steady state which we really don't anything about at this point.

I would tend to apply the same analysis to Estonia even if Estonia seems to benefit from a stronger external environment and in particular with the economy's strong affiliation with the Finnish economy.

Ultimately however the immediate challenge for the Baltics at this point in time is damage control and more specifically how to wrigle themselves out of the current vice of dependence on credit inflows at the same time as the economy needs to restore competiveness. So far, the show goes on with Swedbank in particular continuing to supply the credit. However, if the recession rolls in, in a manner predicted by most analysts the ensuing squeeze of consumers may make it difficult for Swedbank not to sustain massive losses, not to mention what would happen with the peg and households and companies' liabilities.

The end point of all this clearly appears to envision a fiscal response; at least as a part of the solution. What is critical for the Baltics at this point is consequently that the currenct economic downturn is managed in such a way to minimize the risk of a collapse of the financial system as foreign banks shut down operations. Whether this entails the maintaining of the Euro peg is a difficult question to answer. One thing is pretty certain however and this is that the kind of wage and price deflation needed to correct the imbalance would be a disaster for any political leadership.

Of the three economies Latvia clearly seems to be the most vulnerable to a rout, and given the proximity of the economies sudden unexpected events in one country could easily spread to the others. Here is to hoping that it does not come to that.

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[1] - Sometimes things actually fit together.

[2] - Here the asset side would be both deposits as well as future cash flows which would be in domestic currency (for households). For Swedbank itself, main point Hempton highlights is simply the fact that Hansabank would become an immensely heavy ball and chain since the whole thing would have to be written down with the devaluation itself.

[3] - See for example Christoph Rosenberg's brilliant piece on drivers of FX loans in Eastern Europe. As per reference to my own analysis (limited to Lithuania though) Rosenberg finds that lower interest rates on Euro loans as well as the fact that these economies effectively has outsourced the developmentment of their financial system to foreign banks are strong explanatory factors.

[4] - One thing which could provide relief here would be a slump of the Euro which would allow the CEE economies to restore competitiveness at the same time as maintaining the peg to the Euro. However, I think this is rather unlikely because it would imply a level of the Euro which would be in accordance with either the US' need to correct nor the ECB's inflation focus.

Latvian Exports Continue To Slow In August

The total turnover in Latvian foreign trade at current prices was 952.0 mln lats in August 2008 – down 60.4 mln lats or 6.0% over July and down 59.6 mln lats or 5.9% than in August last year, according to Central Statistical Bureau data. The reduction is largely the result of falling imports, although the rate of increase in exports steadily reduces.

Exports were down month on month by 1.9% and year on year they were up by 4.1%, but these are current, non inflation corrected prices. Imports were down 8.3% on the month and 11.1% on the year.



Latvia's monthly foreign trade deficit stood at 226.2 million Lats in August, down from the 272.6 million Lats registered in July, although the change here is really the product of the substantial decline in imports which is taking place as a result of the recession.




Month on month the most rapid decrease at current prices was in exports of inorganic chemical products – by 92.6%, of wheat and meslin – by 53.3%, of pharmaceutical products – by 23.1%, of perfumery and cosmetics – by 16.3%, machinery and mechanical appliances – by 8.0%, of sawn wood – by 7.0%, but there was an increase in exports of articles of apparel and accessories knitted or crocheted – by 25.0%, of prepared or preserved fish, crustaceans, molluscs – by 21.1%, of iron and non-alloy steel – by 20.0%, of articles of iron or steel – by 12.7%.

Compared to August 2007, the most notable increase was in exports of wheat and meslin (exported to Morocco, Norway and Estonia) – up by 320% times, of iron and non-alloy steel – by 69.3%, of articles of iron or steel – by 32.7%, of electrical machinery and equipment – by 8.7%, but the exports of wood in the rough decreased by 43.4%, of sawn wood – by 43.2%, of semi-manufactures and articles of plastics, scrap – by 6.7%, of articles of apparel, not knitted or crocheted - by 3.5%.

Latvian Credit Downgraded As Retail Sales Continue Their Decline

As reported in this post, on Friday Fitch Rating Service announced they were cutting long-term sovereign ratings for Estonia, Latvia and Lithuania, citing worsening financial conditions in Europe. Latvia's long-term foreign-currency Issuer Default Rating was cut to BBB from BBB+. The outlooks were kept negative.

The move by Fitch follows an earlier decision by Moody's Investors Service to lower its Latvia outlook to negative. The outlook change affects Latvia's A2 foreign currency and local currency debt rating. The outlook on the Aa1 country ceiling for foreign currency bonds was kept at stable. Moody's A2 rating is five levels above investment grade. Kenneth Orchard, senior analyst at Moody's wrote in the statement: "Although it is not Moody's central scenario, Latvia's economy is vulnerable to a sharp reduction in foreign capital inflows.''

Latvia has low levels of government debt and no foreign bonds maturing for over five years, so there is little serious danger to Latvia's public sector funding. On the other hand Latvian interest rates to households and companies are expected to rise and the number of non-performing loans to grow as a by-product of the ratings changes and the global financial market turmoil which lead to them.

``Credit is becoming more difficult to access, and if you can access it, it will be in smaller sums and at a higher interest rate,'' Janis Brazovskis, vice-chairman of the Latvian Financial and Capital Market Commission, speaking in an interview on Latvijas Neatkariga Televizija's program 900 Seconds.

According to Brazovkis, interest rates will rise by between 0.5 and 2 percentage points for Latvian borrowers. Overdue loan payments may rise to 2 percent of total credits from the current 0.7 percent. Brazovkis stressed that Latvia's exposure to the U.S. financial system was "extremely minimal,'' and that Latvian lenders did not invest in "toxic financial instruments,''. This is undoubtedly true, but on the other hand I have never actually seen anyone suggest that Latvia's problems were a by-product of poor quality investments made in the US - in other words this would simply seem to be yet another one of those famous "red herrings". Latvian lenders also did not buy toxic instruments, since they were effectively selling them - to eg Swedish investors. Latvia, like the US, the UK and Spain, has a current account deficit, and it is the current account deficit countries who were effectively issuing the toxic instruments to finance their external borrowing at rates which were below the real level of the risk being assumed. If lending practices in Latvia were not lax (which is the normal argument directed towards the United States), then I simply do not understand the chart below - which shows bank lending going off a cliff once documentation and lending rules we tightened up in the spring of 2007.




So the problem is, it seems to me, that the people who bought instruments issued by the Latvian banking system (or who created instruments elsewhere to then inject funds into Latvian banks) are the ones who have the problems, and they are unlikely to be so forthcoming in the future, which is why credit will remain tight in Latvia (about this Brazovkis is undoubtedly right) and interest rates may well rise. Which is just one more reason why we should not expect any imminent revival in Latvia's flagging retail sales (see below) - and by imminent I do mean over the next few years. This recession is in for the long haul.

Retail Sales Continue To Decline



Month on month seasonally adjusted retail sales (at constant prices) were down by 1.2% In August. Compared to August 2007, and according to working-day adjusted data, at constant prices, total retail sales decreased by 8.9%.





The largest volume decreases were in food products – down by 10.3%.

Latvian Inflation Continues To Be A Major Problem

Consumer Price Inflation

The annual rate of increase in Latvian consumer prices was 15.7% in August 2008. Month on month the situation did imporve slightly, since prices decreased by 0.4% when compared with July. The average price of goods decreased by 0.9%, but the price of services continued to increase, and were up by 0.7%. Prices of vegetables and fuel fell, but the price of clothing, catering and rent were all up. Thus while the trend is for annual inflation to moderate, the news is far from unambiguous, with widespread secondary price shocks continuing to make their impact felt.

Food prices were down - by 2.2% - but this was mainly influenced by seasonal decreases in the price of fruit and vegetables and fruit. Bread, dairy products and cheese prices also fell. Fuel prices were down by 4.3%, as were motor vehicle prices.

The widespread presence of discounts meant that the prices of non-durable household goods, individual care goods, bicycles, sports and recreational equipment all decreased. Purchase of new cars became cheaper, as did the prices of data processing equipment, airline tickets, furniture and furnishings, carpets and floor coverings diminished.

Latvian retail sales we should remember were down again in July, both on June 2008 and on July 2007. Compared to July 2007, the seasonally and working day adusted constant price index was down by 8.5%. The largest volume decrease was in non-food products group which were down by 9.4%. There was a slighly smaller decrease in food products, which were down by 6%. The only increases were in mail order business – up by 7.2% and in retail trade in pharmaceutical and medical goods – up by 3.2%. In the face of such a decline in demand the more competition driven sectors have little alternative but to lower their prices.




On the other hand, prices in the non competition driven sectors continued to rise, and rent in municipal flats and houses, the cost of refuse collection and other publicly administered services were up, as were liquefied gas prices.

Alcoholic beverages, cereal products, meat and meat products, fish and fish products, eggs, oils and fats, sugar, sweets and non-alcoholic beverages all went up, as did clothes, textiles, household goods, and school textbooks.


Producer Prices Accelerate In August


Latvian industrial producer prices rose in August at a 13.1% annual rate, up frm the 12.4% annual rate registered in July. Month on month producer prices increased by 0.9%.

On an annual basis it has been the increase in the cost of energy components like electricity and gas, and the price of manufactured food products and beverages which have made the biggest impact on the overall level of producer prices,contributing 4.5 and 4.1 percentage points, respectively.

As can be seen in the chart below, Latvian producer prices are now up over 50% on the start of 2005, and with the Lat effectively tied in value to the euro (which is either used by, or a reference point for, nearly all Latvia's major external customers) this represents a huge loss of competitiveness for Latvian industry and service companies.





Energy Prices

In terms of the outlook for Latvian inflation moving forward we need to think about just when it will be that year on year crude oil turn negative, and when this does happen, what will this mean for Latvian inflation? An interesting question this one since it will really show us the "naked truth" about how resistant Latvian prices are to correcting themselves as the economy continues to languish in recession.


Oil prices have fallen substantially recently, even if with considerable volatility in the process. Last Friday, for example, , the first time oil had closed at over $100 in more than a week. Oil prices in fact shot up by more than $6 a barrel on Friday, with light, sweet crude for October delivery rising $6.67 to settle at $104.55 a barrel on the New York Mercantile Exchange, after earlier rising as high as $105.25. The increase followed the announcement of the sweeping US government financial rescue plan which emboldened investors to re-enter equiity and commodity the markets.

Crude thus climbed over $13 in the space of three days, but prices will more than likely resume their downward trend, at least in the short term, since demand for energy is likely to remain weak as the economic slowdown continues to bite in the US, Europe and Japan, while key emerging markets maintain tight monetary policy (although not Latvia unfortunately, since the Lat peg means there is no monetary policy to implement) in the battle to contain inflation (I am talking here of countries like Brazil and India). So, despite the coming and going, the trend in oil is decidedly down, and crude has now fallen around $43 — or over 30 percent — from its all-time trading record of $147.27 reached July 11.





So we are now hitting prices which were reached on the way up in the middle of February, but how long will it be before we are below the same price y-o-y? Then annual inflation rates will start to notice what is called the "high base effect", and it will be interesting to examine the precise differences between those countries where secondary effects have made their presence felt (like Latvia unfortunately), and those where core inflation has basically remained low.

Latvian Wages Continue To Rise

At the same time Latvian wages, and despite the recessionary backdrop, continue their steady upward march, at a rate which is well above consumer price inflation plus productivity. Compared to the second quarter of 2007, gross hourly wages in Latvia were up by 26.1%, according to the most recent data from the Central Statistical Bureau.



The statistics office noted that the seasonally adjusted rate of increase has been reducing since 4th quarter of 2007, but this is very small consolation for a process that is effectively blowing a massive hole in the side of the Latvian economy's ability to compete internationally. And indeed they also point out that compared to the second quarter of 2007 the most rapid increases in hourly labour costs have been in economic activities like education – up 30.5%, hotels and restaurants – up 29.3%, mining and quarrying – up 27.7%, construction – up 27.4%, and trade – up 27.3%.


Unemployment Rises While Employment Stagnates

On the other hand unemplyment has started to rise, slightly, and according to the labour board there were 56333 people unemployed in August - nudging up the unemployment rate to 5.2%. To put things in perspective, the number of unemployed is still below that registered in August 2007 (57940), when the economy was, to all appearances, still booming.



Employment, on the other hand, has been more or less stagnant over the last 3 quarters, although year on year rates of employment increase have been healthy (an average of 4% during the last three quarters) and total emplyment has not started to decline in any notable form.





Household Indebtedness


Internal demand, as we have noted, has collapsed, and the Latvian economy is in recession.




So what is the answer to this mystery? How can employment be stable, real wages rising considerably, and yet the economy slumping. Well, the answer isn't too difficult to find, it revolves around household borrowing, and the rate of increase in household debt. If we look at the chart below, we can see that the Latvian "boom" was being fuelled by truly massive y-o-y rates of increase in household borrowing. So the high rates of growth were not due to large productivity gains pushing a supply side expansion, but due to rapid increases in domestic consumption fuelled by growing debt, a process which pushed the Latvian labour market (given Latvia's unusual demography) way beyond capacity limits, and stocked-up a huge inflation bonfire.

As we can see in the above chart, this all really became "one big party" after mid 2005. Now I say Latvia has no available monetary policy, but this isn't entirely the case. Had the Latvian central bank imposed very strict credit restrictions starting in 2005 (and not in the spring of 2007), and had the Latvian government operated a large (liquidity and demand draining) fiscal surplus of 5% of GDP or so starting in 2005, then maybe much of the worst of the distress which is now about to come could have been avoided.

But it is always easy to be right after the event, and I am not claiming to have had any better idea than anyone else at that point. Certainly even the IMF staff economists (who seem to me to be normally much more on the ball than their Brussels and Frankfurt equivalents) only started pushing the idea of fiscal surpluses strongly rather late in the day, and I am sure if we could rerun all this they would have acted differently. But then, you know, the owl minerva only flies after dusk, and all that.

But, as we can see, once the credit restrictions were put in place to some extent, the rate of increase in new credit did slow, and what is so remarkable is how quickly the whole economy itself slowed as this increase in credit lost steam. We are still seeing a year on year rate of increase in household credit of around 25%, and yet the economy is contracting, so what happens if credit stops growing is anyone's guess.

So what is the future? Well basically, given what we have just seen about the debt side of the equation, I think we can safely say you can forget about Latvian domestic demand as a driver of growth. And since government spending is not going to be the answer given the impending liabilities which will be hitting the Latvian state from the ageing population phenomenon (health, pension costs etc), exports would seem to be the only way out. But this is where, after all that inflation, we hit a snag.


As can be seen in the chart below, Latvian exports, far from having risen to the role which falls upon them, have rather weakened over the last six months or so.




True, in year on year terms, they have been rising, but the rate of increase has been slowing steadily, even if - due largely I think to an especially weak month in June and a low base effect in July 2007 - they did rebound a bit in July. The weakness in Latvian exports as a growth driver has been rather masked by the much more dramatic decline in imports, which have moved strongly into negative y-o-y territory despite the high level of oil costs, and this has obviouly been a headline GDP growth positive (that is GDP would have been worse had imports not shrunk so considerably). The decline in imports has also prevented the trade deficit from deteriorating further.



But of course, if exports are now to drive growth (and if Latvians are to start paying back all that foreign debt they have been accumulating) then what is needed is a surplus not a deficit. Well, Latvia needs to start selling more abroad, whatever, however, and I think that in order to do this, Latvian relative prices now need a very substantial adjustment, which either means very substantial internal price deflation, or that horrible and unmentionable "D" word. If people sit back with their arms folded and simply wait to see what happens (out of idle curiousity, perhaps?), then the former will inevitably happen, but the thing is the process could become so violent that it provokes the second inevitably in its wake, which raises the question as to whether it might not be better in the longer run to grasp the bull by the horns, and go down the second road now and dircetly. Whatever happens, none of the possible solutions for the current predicament are going to be easy.

Latvia's Economy Has Now Been Shrinking For At Least Two Quarters

Well I think it's now official, or at least as official as its going to get: the Latvian economy is now in recession, as defined by two successive quarters of contraction (quarter on quarter, on a seasonally adjusted basis). The Latvian economy contracted by 0.2% in the second quarter from the first, and by 0.3% in the first quarter from the last quarter of 2007. Not that you would be able to read this information on the data release from Latvijas Statistika, nor would you find any great enthusiasm anywhere for having a technical "linejudge" (like the US NBER recession dating commission) to present this datapoint in a semi official way it seems to me. Indeed Bloomberg seems to have needed to take the bull by the horns and phone the statistics office direct in order to have a conversation with Alla Vanaga, the central statistics office's deputy head of national accounts, and thus extract this otherwise well-guarded piece of information.

The root of the problem is that the statistics office do not publish seasonally adjusted quarterly data, and there may well be very good explanations for this, since, apart from any other reason, with the very violent recent movements in output, they may have difficulty in establishing weights to use in the seasonal adjustment in which they have any great degree of confidence (another example of this type of problem could be found in the seasonally "adjustments" applied to the  data we got for retail sales and industrial output - which was often scarcely credible - from statistics offices all across the globe in April, simply because Easter this year was in March). So they have my sympathy, and I'm sure the data Alla Vanga has provided needs to be treated as only a first approximation, which is why I still am reluctant to give up completely my initial feeling that the recession may even go back to Q4 2007. Certainly GDP contracted in Q4 last year, and the only real issue is the seasonal correction to be applied. My gut feeling is we may see some later revisions which will change things slightly, in the meantime, Latvia officially entered recession on 1 January 2008.

Anyway, on to the data, which really is pretty horrible. First off the quarterly evolution of GDP as we now have it.



Now looking at this chart, is there still anyone around out there who is willing to own up to having imagined Latvia was going to have a "soft" landing - and unfortunately, we need to bear in mind that the worst isn't over yet, this is only just starting.

If we look at the annual growth rate - given as 0.1%, but even this number is the effect of a decimal rounding operation, and the accurate number is a miniscule 0.05% - or put another way, the Latvian economy only grew by a bare, inflation corrected, 1.1 million Lats between July 1 2007 and June 30 2008.



And the situation is almost guaranteed to get worse, since we are more than likely about to see some more quarter on quarter contraction, and hence the annual number is also going to head into negative territory. Final private consumption was down 5.02% year on year. As we can see in the chart below, there is no mistaking the boom-bust. The question is really what is likely to happen now to private consumption. I will try and go more into this in the coming months, but there is just no way we are going to see a sudden leap back in consumption. Obviously it won't simply continue shrinking (or at least I hope it won't), but the kind of positive growth we see may be more like what we are seeing in Hungary now, something in the 1% to 2% y-o-y growth range (and this is when the situation "normalises", which is still some distance ahead, and with some hard bridges to cross in between).



And Gross Fixed Capital Formation was down 6.77% on the year. As can be seen in the chart (again below), the slope is rather smoother than in the case of consumption, which is not surprising, since investment obviously comes to a halt some time before consumption does. Equally, we could expect this part to pick up more quickly, and pull consumption along behind it, but for that Latvia has to become an attractive destination for export activity, and this involves putting all the distortions in relative prices straight. Its like you just crashed a bike at the moment, the frame is intact, but all the wheels are bent and buckled, and the chain has snapped.



Finally, if we come to look at foreign trade, we find that imports were down 8.16% on the year, while exports were up 2.49%. This position is more complicated than it seems, since the rate of increase in exports is falling, not rising, and this does not bode well for a sector that now needs to pull the economy, while imports are down strongly on the back of falling domestic demand. But this decline in imports produces a statistical effect whereby the NET trade balance in Latvia improved in Q2, which actually helped GDP growth, that is if imports had held up better, the contraction in the domestic economy would have been worse (i know this must seem a strange result, but GDP accounting is like that). But the rate of import decline cannot be expected to continue indefinitely at the current strong rate, and with the Lat pegged to the euro, and continuing inflation well above the eurozone average, then Latvian products will only become less competitive (oh, I know, people will increase productivity, but everyone else will be trying to do that too), so my feeling is that what we will now see is a slowdown in the rate of contraction in consumer demand, but an increase in the negative component in the trade balance (due to the bottoming out of the import decline, in part supported by the internal demand for imports as internal demand itself bottoms, and remember, with the high Lat, Chinese - eg - imports are quite cheap) and hence we should envisage GDP lingering in contraction territory for some time to come.

Well, that is a brief resumé of where we are at this point. Clearly there are huge downside risks out there, in particular associated with the slowdown in the eurozone, and the future of the Lat peg. There is also a demographic risk associated with the possibility that more people may leave looking for work abroad. But I think we can safely cross all these issues as and when we get to them. For the time being there is enough to digest in what we already have, I think.

The Decline In Latvian Industry Accelerates Again in July

Latvian industrial output contracted again in July 2008, indicating that GDP contraction will almost certainly continue into at least Q3 2008.

Industrial production at constant prices decreased in July 2008 by 0.7%, according to seasonal and working day adjusted data released today by the Latvia statistics office. Manufacturing was down by 1%, electricity, gas and water supply by 0.5%, while in mining and quarrying there was a monthly increase of 7.7%. The drop in industrial output was largely due to adecrease in the manufacturing of other transport equipment (repairing and construction of ships and boats) which was down by 34.7%, the manufacturing of chemicals, chemical products and man-made fibres, which was down by 8.7%, and in the manufacture of wood, wood products and cork, down by 3.7%.




Compared to July 2007 industrial output dropped by 6.9%, according to working day adjusted data. Manufacturing was down by 9.1%, electricity, gas and water supply by 1.6%, and mining and quarrying increased by 20.9%. The decrease was mainly influenced by the volume reduction in the manufacturing of furniture – down by 44.7% - the manufacture of wood, wood products and cork – down by 15.5% - and the manufacture of food products and beverages – down by 9.5%.



As we can see in the chart above, output peaked in August 2007 and has been declining steadily since.

Latvia Retail Sales Continue Their Fall, As Does Housebuilding, Even While Real Wages Continue To Rise

Latvian retail sales were down again in July, both on June 2008 and on July 2007. Compared to July 2007, the seasonally and working day adusted constant price index was down by 8.5%. The largest volume decrease was in non-food products group - by 9.4%. There was a slighly smaller decrease in food products, which were down by 6. The only increases were in mail order business – up by 7.2% and in retail trade in pharmaceutical and medical goods – up by 3.2%.

In July compared to June 2008 (seasonally adjusted data, at constant prices),sales were down by 0.2%. Retail sales of food products were down by 3.3%, but non-food products increased by 1.6% on the month.






In the January—July period, retail sales were down by 3.9% (working day adjusted data, at constant prices) when compared with the same period in 2007. Food products were down by 5.3%, and non-food products by 3.1%.




Housebuilding Continues To Decline


Latvian construction was up in the 2nd quarter of 2008 by 5.7% (at constant prices), when compared with the 2nd quarter of 2007, according to data from the Lavian Statistics Bureau.

There was however a big change in the composition of construction activity: new construction and repairs of main pipelines, communication and power lines were up 71%, motorways and streets 50.3%, factories and warehouses 32.9%. on the other hand the construction and repair of residential buildings was down 27.7%, the construction of hotels and similar buildings was down 41.5%, and wholesale and retail buildings were down 25.7%.


And Real Wages Continue To Rise

On changes of wages and salaries in the 2nd quarter of 2008 The information compiled by the Central Statistical Bureau shows that, compared to the 1st quarter,


Monthly average gross wages and salaries increased in Latvia increased in Q2 2008, when compared with Q1 2008 from 453 to 477 lats, or by 5.3%, while compared to Q2 2007 they increased by 23.6%. Gross wages and salaries grew slightly more rapidly in private sector (up by 23.9%), while in public sector the increase was 22.5%.

Net monthly wages and salaries in this period increased by 25.6% and reached 348 lats. Allowing for consumer price growth of 17.7% on the quarter, the real increase in wages and salaries amounted to 6.7%. So while the rate of increase declines steadily (see chart below) even in the midst of recession Latvian wages continue to rise far more rapidly than any accompanying productivity gains.




In private sector wages and salaries still were lower than in public sector. There in the 2nd quarter of this year they reached 568 lats, and, if compared to the same period of previous year, that is 104 lats more. In private sector 434 lats and increase comprised 84 lats, respectively.

If examining the gross wages and salaries in breakdown by kinds of economic activities, it may be concluded that, compared to the 2nd quarter of previous year, in the 2nd quarter of this year the most rapid increase of wages and salaries was in economic activities as education - by 28.8% (from 361 to 465 lats), hotels and restaurants – by 27.0% (from 233 to 296 lats), other community, social and personal services – by 24.8% (from 346 to 432 lats), real estate, renting and business activities – by 24.6% (from 401 to 500 lats) and trade – by 24.4 % (from 319 to 397 lats).

Among the Baltic States the highest gross wages and salaries in the 2nd quarter of this year, just like in all quarters of previous year, were in Estonia – 850 euro, in Latvia – 679 euro, but the lowest – in Lithuania – 648 euro. Compared to the 2nd quarter of 2007, Latvia witnessed the highest increase – 23.6%, Lithuania – 22.5%, and Estonia – 15.2%. But compared to the 1st quarter of this year, the highest increase in the 2nd quarter was in Estonia – 7.9%, in Latvia – 5.3%, and in Lithuania – 4.0%.