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1. The Latvian Economy
Monthly newsletter from Swedbank’s Economic Research Department
by Mārtiņš Kazāks No. 2 • June 2010
Recession is over, robust recovery still to root in
• After eight quarters of uninterrupted contraction and a cumulative drop of about 25%
from the business cycle peak in 2007, Latvian GDP in the 1st
quarter of 2010 grew
by 0.3% (seasonally adjusted, quarter on quarter). The recession was ended by
export-related growth and, to some extent, also by income tax evasion that
supported household consumption.
• The recent IMF/ EC joint review mission concludes that good progress is being
made in stabilizing the Latvian economy; the programme remains on track.
Government finances are relatively stable. Due to a stronger financial position,
Latvia intends to slow the speed of borrowing and perhaps will borrow less from
foreign donors than previously forecast.
• The Ministry of Finance has produced a reasonably good policy paper on how to
tackle the grey economy. In contrast, the draft tax policy paper goes only halfway,
but it is somewhat naïve to expect a “true” tax policy overhaul plan until after the
October general elections.
Recession is over and fragile recovery has
started
Detailed 1st
quarter 2010 GDP data published by
the Central Statistical Bureau in mid-June
confirmed our view that the economy had hit rock
bottom late last year. After eight quarters of
uninterrupted contraction, GDP in the 1st
quarter of
2010 was reported to have grown by 0.3% (quarter
on quarter, seasonally adjusted). After a cumulative
drop of 25% from the business cycle peak in late
2007, this sounds more like stabilisation, not
growth. Yet, it does show that the downward trend
has broken, thereby by tangible data confirming
steady improvements in household and business
confidence surveys seen since around mid-2009.
The economy is clearly on track to recovery, but
growth will be fragile at the beginning – for at least
a few quarters, we may see that expansion in one
quarter is followed by contraction in another.
In terms of annual growth rates, Latvian GDP in the
1
st
quarter of 2010 was still 6% below its respective
last year’s level. So far, we see no reason to revise
our April forecast of a 2.5% year-on-year
contraction in 2010. Note that this forecast includes
2% growth vis-à-vis the last quarter of 2009, and
that negative annual growth is due only to a large
negative carryover effect of about 4%. We expect
positive annual growth rates towards the end of this
year.
Chart 1. GDP by expenditure 1Q2007=100,
40
60
80
100
120
1Q 07 1Q 08 1Q 09 1Q 10
GDP Households cons.
Government cons. Gross fixed capital
Exports Imports Source: CSBL
Chart 1. GDP by expenditure 1Q2007=100, s.a.
A quick browse through GDP by expenditure data
seems to suggest that growth was due to the wrong
reasons – exports contracted while consumption
picked up. Exports are reported to have shrunk by
2% (all data in this paragraph are quarter on
quarter, seasonally adjusted), while household
consumption inched up by 0.7%. Even government
spending was up by 0.1% despite all the fiscal
consolidation efforts, and imports were up by 8.6%.
Almost all growth came from inventories (reported
as a single entry, together with errors and
omissions) whose contribution to quarterly growth
was a staggering 6.3 percentage points. While the
Economic Research Department. Swedbank AB. SE-105 34 Stockholm. Phone +46 8 5859 1000.
E-mail: ek.sekr@swedbank.com www.swedbank.com
Legally responsible publisher: Cecilia Hermansson, +46 8 5859 1588.
Mārtiņš Kazāks, +371 6744 5859. Lija Strašuna, +371 6744 5875. Dainis Stikuts, +371 6744 5844.

2. Latvian Economy
Monthly newsletter from Swedbank’s Economic Research Department, continued
No. 2 • June 2010
2 (4)
speed of contraction in gross fixed capital formation
halved, it was still in deep freeze – down by 6%.
Chart 2. GDP by expenditure, contributions
percentage points
-25
-20
-15
-10
-5
0
5
10
15
1Q 09 2Q 09 3Q 09 4Q 09 1Q 10
Households cons. Government cons.
Gross fixed capital Inventories and errors
Exports Imports Source: CSBL
A more careful look, however, suggests that such a
conclusion is misguided and the economy is not
back to its old tricks of unsustainable, domestic
demand-driven growth. First, we are likely to see
some data revisions. Second, the underlying growth
is export driven.
Significant data revisions are likely
For instance, it is difficult to rationalize the
dynamics of the government spending deflator –
during the 1st
quarter of 2010 it is reported to have
grown by over 24% quarter on quarter, which is by
far the highest climb over the past decade
(including the boom years). At the same time, public
sector gross wages, which are typically used as a
guide for this deflator, were contracting by 3.7%. If
deflator dynamics is put more in line with the wage
growth pattern and if government consumption in
current prices remains unchanged, impressive real
consumption growth would result, which would be
at odds with fiscal consolidation? Data revisions are
likely to address such inconsistencies. Possible
directions for revisions are lower government
spending, higher investment, and/or higher
household consumption.
One must also mention the seasonality filter – with
such sharp structural changes and business cycle
volatility, its pattern is unlikely to remain unaffected.
Further quarters will provide more information on
the changing shape of seasonality and will ex post
revise the past data.
Grey economy supports consumption
Why is it that in the 1st
quarter employment and
wages were falling, unemployment benefits were
running out for an increasing number of long-term
unemployed, and the credit stock was shrinking, but
household consumption was recovering? Better
household consumption is no data fluke and is well
backed up by, e.g., improving retail trade turnover
and retail sector business confidence. Of course, as
they were getting used to a recessionary
environment and with the contraction speed
slowing, households may have released some of
their precautionary savings held in cash at home.
We see this in the growth of household bank
deposits.
Chart 3. Consumption over available
resources*, % of consumption
0
10
20
30
40
50
60
1Q 06 1Q 07 1Q 08 1Q 09 1Q 10
Source: Swedbank estimates
* Consumption + Change in deposits stock - Income -
Change in loans stock
Chart 4. Retail trade turnover, %
-40
-30
-20
-10
0
10
20
30
Jan.07 Jan.08 Jan.09 Jan.10
mom yoy
Source: CSBL
Yet, we believe that a major reason for
consumption growth is the widening of the grey
economy. Income tax evasion boosts incomes,
which translate into higher consumption. This
hypothesis is supported by tax revenue data – the
value-added tax registered improvement whereas

3. Latvian Economy
Monthly newsletter from Swedbank’s Economic Research Department, continued
No. 2 • June 2010
3 (4)
social security contributions, which directly depend
on wage income, shrunk. A survey made by the
State Employment Agency earlier in the year found
that about 20% of those found illegally employed
were in the books as receivers of unemployment
benefits. The widening of the grey economy should
not be tolerated and requires immediate and
decisive efforts by the government.
Imports are export driven
What drove import growth? We believe that it was
significantly pushed up by export industries
rebuilding their foreign input inventories. Balance
sheet analysis shows that, due to a lack of funding,
export industries heavily depleted their inventories
over the last year and, with the recovery
strengthening, were increasingly squeezed on their
own deliveries by lack of inputs. To address this
problem, inventories were rebuilt. In the coming
quarters, this activity is most likely to slow because
the inventory deficit gap must have narrowed.
Chart 6. Goods exports Jan.2009 - Apr.2010,
0
10
20
30
40
50
60
70
80
90
Foodand
agricultural
products
Wood,etc
Machines
and
equipment
Metaletc
Chemical
products
Mineral
products
Others
Source: CSBL
Chart 5. Goods exports Jan.2009 - Apr.2010, LVL
2009 2010
Analysis of GDP by value added shows that export
industries remain the key driver of recovery – while
all nontradable sectors in the 1st
quarter continued
to report negative year-on-year growth rates, for
traditional tradable sectors these rates were
positive.1
After a rather bleak performance early in
2010, goods exports have been picking up each
month, in current prices growing by 33% year on
year in April (the latest data available so far). Export
order flows suggest that good performance will
continue. On the other hand, exports of services
have seen a gradual worsening, contracting by 9%
year on year in April due to tough regional
competition.
1
Seasonally adjusted data by industries are not reported;
therefore, we must use annual growth rates here.
Investment still weak, but infrastructure
and export sectors to become more active
Why is gross fixed capital formation so weak? It has
shrunk by close to 60% from its peak in mid-2007
and by about 45% year on year in the 1st
quarter of
2010. This fall is very much due to a stalling real
estate market, formerly a major contributor. With
economic activity low, manufacturing capacity
utilisation is gradually rising but still at low levels on
average. This situation is, however, changing.
While housing activities will certainly take years to
develop, the government has taken steps to speed
up absorption of EU structural funds to improve
infrastructure. Capacity utilisation data often are like
an average temperature in a hospital – they hide
hot spots. With typically very slow insolvency
procedures, industrial capacity often gets stuck in
between owners. By using industry average, the
data often underestimate actual capacity utilisation.
For instance, wood industry volume since early
2009 has grown by nearly 60%, recovering more
than it lost during the crisis. Given that not all the
companies survived the recession (some currently
have idle plants but not gone bankrupt yet),
capacity utilisation for survivals in many cases is
higher than in the boom years. Such (typically
export-oriented) companies are gradually looking
for possibilities to invest. We expect that gross fixed
capital formation will post positive quarterly growth
figures towards the end of this year. Access to
inexpensive funding will be crucial here.
Chart 6. Consumer and business confidence
-100
-80
-60
-40
-20
0
20
40
Jan.07 Jan.08 Jan.09 Jan.10
Consumer Construction
Manufacturing Retail
Services Source: Eurostat
IMF/EC support programme on track, Latvia
to borrow less
Confidence continues to strengthen, which is a
good indicator of further improvements in economic
activity. Unemployment expectations are also
gradually retreating, as is unemployment itself –

4. Latvian Economy
Monthly newsletter from Swedbank’s Economic Research Department, continued
No. 2 • June 2010
4 (4)
registered unemployment in mid-June was down to
15.8% from its peak of 17.3% in March.
Despite indications of widening income tax evasion,
government tax revenues are in line with the plan
as, e.g., consumption taxes perform better than
forecast. Thus, the overall fiscal situation is stable.
The recent IMF and EC joint review mission in June
concluded that good progress is being made in
stabilizing the economy. It was agreed that Latvia
should continue the programme, by and large
following the same criteria as previously agreed.
The budget deficit is not to exceed 8.5% of GDP
this year, 6% in 2011, and 3% in 2012. It was
agreed that next year’s budget must include fiscal
consolidation of LVL 395-440 million, about 3.5% of
GDP. Part of this will be covered by the growing
economy, but significant cuts in spending will still be
necessary. More revenue is to be raised by
eradicating the grey economy and raising taxes.
The draft plan to reduce the grey economy
2
was
made public in mid-June. It makes a better use of
the “stick and carrot” strategy and promises to yield
better results than any of the previous attempts.
One of its weak points is its feeble integration with
the proposed changes in tax policy. This needs to
be improved. The current draft paper on tax policy
change3
goes only halfway in shifting the tax
burden away from labour income and toward
2
http://www.fm.gov.lv/?eng/news/49982
3
Available in Latvian
http://www.fm.gov.lv/?lat/aktualitates/jaunumi/49836/
consumption and real estate. The final version of
this paper is due by end-June, but it is unlikely that
we shall see a “true” version of it until after the
October general elections. Such a delayed wake-up
call for more fiscal consolidation down the line,
coupled with the expected fiscal tightening in the
rest of the EU towards the end of 2010, is likely to
slow somewhat the speed of recovery late this year
and/ or early next year.
Due to its strong financial position, the Latvian
government will postpone and perhaps reduce its
borrowing within the IMF/ EC-coordinated support
programme. This year, it aims to draw only the
amount available from the IMF/ EC and World Bank
(about EUR 400 million total), and take future
drawing decisions on a review-by-review basis. The
government intends to use EUR 1 billion from the
Nordic countries as a credit line only when
necessary, rather than keep all the allotment at the
Treasury and pay interest on extra reserves.
The recent progress of Estonia toward attaining
euro membership by next year should provide an
additional boost for Latvia to get its economy going
and target 2014 as the year to join the euro.
Mārtiņš Kazāks
Swedbank
Economic Research Department
Balasta dambis 1a, Riga, LV 1048, Latvia
www.swedbank.lv
Martiņš Kazāks, +371 6744 5859
Dainis Stikuts, +371 6744 5844
Lija Strašuna, +371 6744 5875
Legally responsible publisher
Cecilia Hermansson, +46 88 5859 1588
Swedbank’s monthly newsletter is published as a service to our customers. We believe that
we have used reliable sources and methods in the preparation of the analyses reported in
this publication. However, we cannot guarantee the accuracy or completeness of the report
and cannot be held responsible for any error or omission in the underlying material or its
use. Readers are encouraged to base any (investment) decisions on other material as well.
Neither Swedbank nor its employees may be held responsible for losses or damages,
direct or indirect, owing to any errors or omissions in Swedbank’s monthly newsletter.
2
http://www.fm.gov.lv/?eng/news/49982
3
Available in Latvian
http://www.fm.gov.lv/?lat/aktualitates/jaunumi/49836/
Abbreviations:
EC – European Commission
EU – European Union
IMF – International Monetary Fund
CSBL– Central Statistical Bureau of Latvia