Cablegate: Latvian Economy Struggling to Adjust

DE RUEHRA #0644/01 2961120
P 221120Z OCT 08



E.O. 12958: N/A

Ref: Riga 620

1. Summary: Significant internal economic instability, combined with
the adverse international financial climate, has hit the Latvian
economy hard. Nearly every macroeconomic indicator is showing
declining economic activity. The GOL is taking steps to help the
economy adjust and recover, but economic activity has been slow to
respond, as business and consumer confidence is low. The government
is struggling to adopt a budget that reflects economic reality,
given the political cost of an austere budget, and the bank of
Latvia charges that the government should push for a fully balanced
budget. On a more positive note, the Nordic banks that are dominant
in Latvia and crucial to the country's economy are stable for the
moment, providing some sense of security to Latvia's economic
outlook. End summary.

2. At the end of 2007, Latvian economic growth cooled, as quarterly
GDP growth rates slowly began to fall. Some degree of economic
slowdown was much welcomed and anticipated, since the previous
period of double-digit growth was beginning to overheat the economy
and create various economic abnormalities. Price inflation was
setting new records each month and the current account deficit had
reached unprecedented levels, hitting 26.9% of GDP in the second
quarter of 2007. The cooling of the economy became more evident
when the first quarter 2008 growth rate fell sharply to 3.3%. The
2008 second quarter GDP growth, which fell to 0.1% annualized,
confirmed that the Latvian economy was almost certainly headed for a

3. As part of the government's previous anti-inflation plan, the
Cabinet in 2007 mandated financial institutions to evaluate the
soundness of borrowers' finances more closely, in order to slow
lending. In response to the slowing economy and changes in
macroeconomic policy priorities, some of these mandated measures
have since been lifted. However, financial institutions have
voluntarily continued the increased scrutiny of borrowers. This
scrutiny has decreased credit availability for consumers, and since
much of the previous growth was based on credit-financed
consumption, the measures are having a negative effect on domestic
demand. Continued high inflation, which has hurt consumers' real
disposable income, is shrinking domestic demand even further. The
contraction of demand is reflected in retail sales which in August
experienced the largest drop in the EU - 8.9%, and in the import
rate which has been decreasing for several consecutive months,
reaching negative 11.1% in August.

4. While Latvia still registers the highest inflation in Europe
(14.9% year-on-year in September), it is showing a downward trend
since inflation peaked at 17.9% y-o-y in May of this year. This
downward tendency should persist, especially since Latvia's
inflation shows a large share of country-specific inflation which
implies domestic causes. One of these causes was, and to certain
extent still is, an overheated labor market. The weakening activity
in almost all sectors of the economy and increasing competition in
the labor market should give ground for disinflation. A few jumps
are nevertheless expected in the upcoming months due to higher
energy and heating tariffs that will be going into effect.
Disinflation might come at the cost of unemployment. By Latvian
standards, the registered unemployment rate is still quite low at
5.3%, but it has persistently been gaining a tenth of a percentage
point each month since May and several economists are forecasting
that it could reach 10% before the economy recovers.

5. Two items are showing signs of improvement. With imports
falling, Latvia's negative trade balance is narrowing, which is
helping to close the current account gap. The trade deficit has
been decreasing since mid-2007 and this has pushed the current
account deficit down to 15.6% of GDP in the second quarter of 2008.

6. Latvian export growth remains positive, but the rate of growth
has been declining and may turn negative as productivity and cost
issues mount. With global demand contracting and business
confidence being low, companies are finding it increasingly
difficult to find markets for their goods and services, and are
cutting back on production or going out of business altogether.
This has been particularly true in Latvia's wood-products sector,
with IKEA furniture closing its Latvian wood plate plant and the
Danish wood products company Pondus closing its production
operations in Latvia. Industrial output has been falling for four
consecutive months, reaching negative 11.1% in August, which was the
steepest drop in the EU. Many businesses are evidently on the
brink, as 23% more insolvency proceedings have been initiated in the
first nine months of this year than for the same period last year.
The Ministry of Economy has adopted additional measures aimed at
helping prevent businesses from going bankrupt, including extending
tax payment deadlines, waiving tax fees and penalties, as well as
lifting taxes on reinvested profit.

7. Next year's central government budget proposal, which the Cabinet
of Ministers has now submitted to the parliament for review, has

RIGA 00000644 002 OF 002

dominated the headlines in Latvian media in recent weeks. The
Cabinet has been struggling to prepare a budget with a target
deficit rate of 1.85% of GDP by reducing ministry spending,
eliminating staff positions, postponing planned wage increases for
public sector employees, and even proposing measures as drastic as
closing specific ministries and switching to open source software.
Labor unions and other affected parties have met these proposals
with strong condemnation.

8. As tax revenues fall and economic growth approaches zero,
preparing a fiscally-restrained, economically responsible budget is
proving to be an extremely difficult task for the government.
Freezes on public sector wages and reductions in other areas of
funding are politically unpopular. As the ruling coalition has
attempted to negotiate agreement on its budget proposal, the Bank of
Latvia has been advocating for reducing government spending even
further and calling for the adoption of a balanced budget, claiming
that a deficit would drain the banking sector, increase interest
rates and distort proper allocation of financial resources. The
rating agency Fitch also appears to be concerned about Latvia's
finances, more specifically, about its ability to finance its large
current account deficit. As a result, the agency downgraded
specific Latvian currency ratings and placed negative outlooks on
those items.

9. In the midst of such economic turbulence, it is indeed fortunate
that the Swedish banks which dominate the local financial market,
Swedbank and SEB, appear healthy and Latvia's banking sector remains
stable (reftel). This stability at least makes Latvia unlikely in
the short term to experience the type of financial collapse seen in


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