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Recovery position

By Anatol Steven. 06.05.2010

A welder at work at Riga Shipyard, Latvia
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The just-released 2010 edition of “Baltic Rim Economies: By Country”, one of a series of regular reports on the economic health of the region prepared by the bank DnB NORD, examines the current situation in Latvia and Lithuania as they cope with the aftermath of the global crisis. Here we present some of the highlights of the report.



The DnB NORD report begins with a brief political forecast. Despite recent political upheavals in Latvia such as the decision of the People’s Party to pull out of the government, leaving Prime Minister Valdis Dombrovskis limping towards October’s parliamentary elections with a minority, the report is more optimistic about the situation here than in Lithuania.
The past year has been marked by remarkable political stability in Latvia, it says, especially given the extremely difficult economic circumstances. Opposition parties have said that they will support the government until the elections and there are signs of compromise in what has always been a fragmented political landscape.
However, for electoral reasons Latvia’s political parties are avoiding direct answers about how they are going to address the country’s still vulnerable financial situation, namely how to consolidate the fiscal balance by an additional 3-4 percent of GDP in the looming 2011 budget. Latvia has seen few public protests since a full-scale riot in January 2009, but this could change after the elections when people discover that further budget cuts may be necessary.
In Lithuania, the governing coalition led by Prime Minister Andrius Kubilius is under increasing pressure. Unpopular and, many critics say, inconsistent decisions made to tackle the public sector deficit have led to rising discontent among politicians and the public. The opposition has created alternative programs, but these tend to be overtly populist.
Typically for Lithuania, decision making is strongly aggravated by lack of unity and personal rivalries. The report explains that the coalition in power, uniting four parties with varying agendas, was from the very beginning not a stable structure. There is discord in key issues such as tax policy, education and social system reform.

Fighting back

Last year was the most difficult year for the Latvian economy since the bleak early 1990s and was marked by one of the most rapid output contractions ever recorded anywhere in peacetime. GDP shriveled by 18 percent, “frozen to the core” according to the DnB NORD report, by an unwinding consumption and real estate boom that was reinforced by the global financial crisis that deprived the economy of exports.
Most of the contraction had already occurred by Q2 2009, when exports began to recover. This led to q-o-q growth in manufacturing that nevertheless shrank by 19.2 percent for the whole year due to the disastrous downturn in the few months beforehand.
Agriculture was the only sector to grow in Latvia in 2009, but given the relatively small size of this sector this does not matter a great deal. However, there is broad agreement that the best performing sizeable sector this year will be manufacturing, which is benefiting from more than half of its sales being abroad. Close to 10 percent growth in manufacturing is possible in 2010.
The construction sector decelerated steeply in 2009, by 33.6 percent. The construction of new buildings has shrunk so much that the relatively stable infrastructure investment now dominates the sector. This is slowing the decline, but not enough to prevent construction from being Latvia’s worst-performing sector.
Unsurprisingly, gross capital formation was the weakest sector by expenditure, contracting by more than 50 percent.
Consumption and the sectors dependent on it continue to slump, but in Q4 2009 the pace slowed, from 23.5 percent y-o-y on average in first three quarters to 18.3 percent.
An improvement in confidence among businesses from September 2009 has now spread to consumers, leading to an unexpected increase in retail turnover in the first two months of 2010.
Banks are busy fighting a virus of insolvency. Widely anticipated instability in the financial sector has so far been avoided as banks deal with bad loans themselves, receiving capital injections from their owners amounting to over EUR 1.4 billion.
Exports from Latvia already have an advantage in the emerging recovery. They are likely to perform strongly in 2010, and in February exports of goods increased by as much as 18 percent y-o-y. Manufacturing associations have declared a comprehensively good outlook for exports.
Exports of services, which make up a third of total exports, have slipped to the lowest point in the cycle. There are signs of recovery in tourism, but the transit of goods suffers from disputes among the major industry players and stiff competition from the other Baltic countries.

Lower depths

Since the impact of the recession in Latvia has been so deep, DnB NORD says that it expects annual GDP to shrink by 3 percent in 2010, despite expected quarterly recovery from Q2 before rebounding to growth of 3.5 percent in 2011.
The report stresses that in the medium term, starting 2012, it is likely that the Latvian economy will for a few years accelerate above its sustainable growth rate of around 4 percent, as there is a substantial reserve of qualified labor.
Unemployment is higher in Latvia than anywhere in the EU. The harmonized unemployment rate almost doubled in 2009 to 22 percent. However, there are strong signs that it is peaking, with registered unemployment falling in early April and an increasing number of manufacturers reporting a re-hiring of staff.
As for inflation, there were no inflationary pressures last year aside from tax changes. But, in early 2010, prices rose by 0.6 percent in March from December 2009, driven by factors related to the global recovery. For example, the international market for industrial milk products is putting a floor under fresh product prices on the internal market, while increases in fuel prices could create an immediate impact as businesses operate on razor-thin margins.
The bulk of the wage reductions symptomatic of the crisis are behind Latvia now, but the downward slide will continue in 2010 as poor employment prospects give businesses the upper hand.
Generally in Latvia, the tough political decisions pushed through by the heavy hand of the IMF have led to a financial stabilization in the country. The public deficit is on a downward path and the net external debt is shrinking rapidly, down by EUR 2.43 billion (12.9 percent of GDP) as loans to the private sector are being amortized or replaced with equity.
The strengthening of private-sector balance sheets is paving the way for a recovery in both consumption and investment. However, there is still a lot of work to do in overcoming the consequences of complacency that followed EU accession in 2004, when, according to the DnB NORD report, the country had a 100 percent record on avoiding hard decisions.
Despite the deficit decreasing by 11 percent of GDP since late 2008, the structural component in 2010 is still estimated to be at 6 percent of GDP. The consolidation of the health and education sector has only just begun, and close to nothing has been accomplished in tertiary education, which, the report concludes, is largely dysfunctional.

Recovery-hungry

The similarly haggard economy in Lithuania is bottoming out and is now hungering for elements to help drive the recovery. In 2009, the Lithuanian economy registered one of the deepest GDP declines in the EU. The value added created in the economy last year was 15 percent smaller than it was a year ago. In 2010, the development of Lithuanian GDP will remain negative, at -1 percent, but the first signs of recovery will be seen in the second half of the year.
Evaporated consumer confidence, decreasing purchasing power and unfavorable borrowing conditions have translated into diminishing domestic demand, which resulted in the exceptionally poor performance of internal economic activities. Retail trade turnover slumped by 27.7 percent y-o-y.
Construction and real estate were affected the worst by the economic downturn. After several years of rapid expansion, construction stayed roughly the same in 2008, but then nosedived by as much as 43 percent y-o-y for the first three quarters of 2009.
Due to the stasis in the market the number of residential real estate transactions almost halved, while commercial RE developers suffered from market stagnation and increasing vacancy rates.
The global downturn and negative trends in key Lithuanian export markets triggered a sharp contraction in two large economic sectors – manufacturing and transport – which together account for almost 30 percent of Lithuania’s GDP and the majority of its export volumes.
Lithuanian foreign trade and current account balances improved significantly in 2009 – unfortunately not because of a spurt in exports, but due to imports decelerating at a higher rate than exports. The volume of visible exports generated last year declined by 26.6 percent, while imports slumped 38.2 percent.
Looking ahead, DnB NORD expects exports to recover this year, albeit modestly, due to the anticipated rebound of the key Lithuanian export markets – Russia and Germany. This will boost externally oriented economic activities and gradually translate into positive stimulus to domestic demand.
However, Lithuania is still failing to attract foreign investments. FDI flows to Lithuania in 2008 were very modest at 3.9 percent of GDP (compared to 8.2 percent in Estonia). Then, in 2009, the FDI ratio to GDP fell back to just 0.9 percent.
Despite the fact that the attraction of FDI is one of the Lithuanian government’s priorities, the lack of skilled employees coupled with an unreformed and inefficient public sector makes it difficult to improve on the FDI results.
Also to have severe long-term consequences is Lithuania’s painfully high unemployment. The number of unemployed has already passed the record reached during the Russian economic crisis and in March 2010 topped 300,000.
The harmonized unemployment rate went from 8.2 percent at the end of 2008 to 15.8 percent in Q4 2009. There is little doubt that it will grow to around 20 percent in Q1 2010.
Consequently, a new wave of mass emigration is rising and will not abate any time soon, something that will have long-term negative consequences, especially considering the poor demographic situation of Lithuania. The country faces an increasing brain drain, which adds to the shortage of highly skilled professionals.
As in Latvia, the inflationary pressures observed up to 2008 evaporated on the back of the economic downturn. At the end of 2009, the harmonized index of consumer prices was 1.2 percent higher than a year ago. By March 2010 it was already negative, at -0.4 percent.
Deflationary processes in the economy were triggered by labor market imbalances and the weakening purchasing power of households. But rising energy and heating prices after the shutdown of the nuclear power plant at Ignalina at the end of last year are likely to feed consumer inflation throughout 2010.

Government debt

After several years of profitable operations, in 2009 Lithuania’s credit system registered a EUR 0.8 billion loss, largely due to mounting special loan provisions. Lending conditions were tightened substantially through 2008-09, and credit flows became negative from the end of 2008.
As a result, the loan portfolio to the private sector diminished last year by 7.1 percent. Loans to non-financial corporations and households shrank by 9.4 percent and 4.3 percent, respectively, while the stock of deposits was 4.8 percent higher than in 2008.
The quality of the credit portfolio worsened as the ratio of loans overdue by more than 60 days to the loan portfolio increased by 2.2 percent over the year and on 1 January 2010 stood at 3.4 percent. The number of outstanding loans is expected to shrink through 2010, reflecting tight credit conditions and a generally poor economic environment, although a slight rebound is expected in the second half of the year.
Concern about future economic development is evoked by what DnB NORD calls misty government finances. Since treasury revenues fell well short of their primary target, the fiscal deficit of the country rose from 3 percent of GDP in 2008 to almost 9 percent in 2009. There is little hope that it will fall to below 7.5 percent in 2010.
So far, the fiscal deficit has been covered by expensive loans, adding to the rapidly growing costs of government debt servicing and increasing the future burden to the national treasury. Further borrowing in 2010 may escalate debt to a damaging level, the DnB NORD report concludes. The Lithuanian government has declared a euro introduction target date for 2014, which means that the general government deficit will have to be within Maastricht boundaries in 2012.

 




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