Domestic demand powers growth
Following the financial crisis and severe recession in 2008-2010, Latvia’s economy rebounded strongly and showed resilience to the unfolding Eurozone crisis, growing by an average annual +5.1% in 2011- 2012, making it the fastest growing economy in the EU during that period. The recovery was broadbased but soaring gross capital formation was a particular growth driver. As a consequence, however, base effects led to declining capital formation in 2013-2014, curbing average annual growth to +2.7%, as well as in the first quarter of2015. External trade activity has also decelerated recently as a result of sanctions on and the economic slowdown in Russia.
In Q1-Q3 2015, real exports expanded by just +2.2% y/y and real imports by +2.6% y/y. Hence net exports subtracted -0.3pps from annual growth in this period. Gross capital formation has recovered since Q2 2015 and in the first nine months of the year, fixed investment increased by +2.8% y/y while inventories still subtracted -0.4pps from overall y/y GDP growth (solely due to a sharp drop in Q1). Meanwhile, private consumption (+3.6% y/y) and public spending (+3.5% y/y) continued to expand robustly in Q1-Q3. Euler Hermes expects full-year GDP growth of +2.6% in 2015. The negative impact from Russia should fade next year as trade with the eastern neighbour should stabilise, such that an acceleration of economic growth to +3% in 2016 and +3.3% in 2017 is forecast.
Banking sector continues to improve but credit still tight
Private sector credit growth has remained negative (-2.9% y/y in September 2015) since the credit bubble burst in 2009. Private agents remain burdened with legacy debts, while the banks’ significantly tightened lending standards after the crisis are only gradually eased, making the recovery slower. Meanwhile, capital adequacy and profitability in the banking sector overall have continued to improve. The share of non-performing loans to total loans has declined from 6.4% at end-2013 to 4.6% in Q1 2015.
Deflation to give way to mild inflation
Headline consumer price inflation has been subdued since early 2013 – as elsewhere across the Eurozone – averaging just +0.3% over the past three years. In September (-0.5% y/y) and October (-0.2% y/y) Latvia even returned to mild deflation as a result of falling global oil prices. Euler Hermes forecasts inflation to pick up to an average +0.5% in 2016 as the effect of low oil prices will gradually wane.
Public finances are sound
Thanks to sharp fiscal tightening, the fiscal deficit was reduced successively from -8.9% of GDP in 2009 to -0.8% in 2012. Thereafter it has widened slightly to -1.5% of GDP in 2014 and is forecast to reach similar ratios in 2015 and 2016, thus remaining well below one Maastricht criterion for sound public finances (fiscal deficit below -3% of GDP).
Gross government debt rose sharply from just 8.4% of GDP in 2007 to 46.8% in 2010 in the wake of the deep economic crisis. It has since fallen and should stabilise around 40% of GDP in the next few years, which is still relatively low by current EU standard and meets the other Maastricht criterion for sound public finances (public debt below 60% of GDP).