Latvian Economy: development scenarios and challenges

Ilmārs RimšēvičsBank of Latvia Governor

Riga, November 2011

Latvia successfully recovered from the crisis, we predict this year’s GDP growth at 4.8%

2004 2005 2006 2007 2008 2009 2010 2011* 2012*-20

-15

-10

-5

0

5

10

15

8.710.6 12.2

10.0

-4.2

-18.0

-0.3

4.8

2.5

GDP growth, %

* - GDP forecast according to forecast base scenario

In the third quarter, GDP growth remained high

GDP growth (%)

2010 I II III IV 2011 I II III-6

-4

-2

0

2

4

6

8

+5.7%

Latvia has already implemented sizable fiscal consolidation

Breakdown of budget consolidation measures, % of GDP

Latvia has quickly regained its cost competitiveness: wage-productivity gap has narrowed considerably

Real hourly wage and labour productivity per hour (2005 Q1 = 100, seasonally adjusted)

2004 Q1

Q2

Q3

Q4

2005 Q1

Q2

Q3

Q4

2006 Q1

Q2

Q3

Q4

2007 Q1

Q2

Q3

Q4

2008 Q1

Q2

Q3

Q4

2009 Q1

Q2

Q3

Q4

2010 Q1

Q2

Q3

Q4

2011 Q1

Q2

80

90

100

110

120

130

140

150

Labour productivity Real wage

Competitiveness and export growth fostered recovery; countries with fixed exchange rate are European leaders in

terms of export growthGoods exports in 2010, % y/y

Estonia

Lithua

nia

Ruman

ia

Czech

Rep

ublic

Netherl

ands

Hunga

ry

German

y

Slovēn

ia

Belgium

Finlan

d

Portug

al

France

Greece

Luxem

bourg

-5

0

5

10

15

20

25

30

35

With economic recovery, unemployment has dropped. Employment growing in almost all branches

Registered unemployment, %

I 201

0

II III IV V VI VII VIII IX X XI XII I 201

1

II III IV V VI VII VIII IX X10

11

12

13

14

15

16

17

1817.3

11.5

Global economic prospects are unfortunately beginning to deteriorate; growth predictions for Latvia’s main

trading partners are being reduced substantially

GDP forecast for euro area in 2012, % (JP Morgan, time axis- moment of making forecast)

Jan-11 Feb-11 Mar-11 Apr-11 May-11 Jun-11 Jul-11 Aug-11 Sep-11 Oct-11-1.0

-0.5

0.0

0.5

1.0

1.5

2.0

2.5

1.9

2.3 2.2 2.2 2.22.0

1.8

0.9

-0.5-0.3

The European Commission has admitted: recession – a drop in production and services volumes possible.

On10 November, Commissioner Oli Rehn warned of possible“repeated recession" in Europe, when announcing the EC forecasts for EU countries, which point to an expected drop in growth.

“The future outlook is unfortunately gloomy. This forecast is the last wake-up call. The recovery in the EU has come to a standstill and there is a risk of a new recession unless decisive measures are taken.”

The resolution of the European debt crisis will not be fast, speculations and fluctuations in the financial

markets will continue     2009 2010 2011 2012 2009 2010 2011 2012Greece 127.1 142.8 157.7 166.1 -15.4 -10.5 -9.5 -9.3Italy 116.1 119.0 120.3 119.8 -5.4 -4.6 -4.0 -3.2Belgium 96.2 96.8 97.0 97.5 -5.9 -4.1 -3.7 -4.2Ireland 65.6 96.2 112.0 117.9 -14.3 -32.4 -10.5 -8.8Portugal 83.0 93.0 101.7 107.4 -10.1 -9.1 -5.9 -4.5Euro area 79.4 85.3 87.7 88.5 -6.3 -6.0 -4.3 -3.5Germany 73.5 83.2 82.4 81.1 -3.0 -3.3 -2.0 -1.2France 78.3 81.7 84.7 86.8 -7.5 -7.0 -5.8 -5.3EU27 74.4 80.0 82.3 83.3 -6.8 -6.4 -4.7 -3.8Austria 69.6 72.3 73.8 75.4 -4.1 -4.6 -3.7 -3.3Netherlands 60.8 62.7 63.9 64.0 -5.5 -5.4 -3.7 -2.3Spain 53.3 60.1 68.1 71.0 -11.1 -9.2 -6.3 -5.3Finland 43.8 48.4 50.6 52.2 -2.6 -2.5 -1.0 -0.7Slovakia 35.4 41.0 44.8 46.8 -8.0 -7.9 -5.1 -4.6Slovenia 35.2 38.0 42.8 46.0 -6.0 -5.6 -5.8 -5.0Estonia 7.2 6.6 6.1 6.9 -1.7 0.1 -0.6 -2.4Great Britain 69.6 80.0 84.2 87.9 -11.4 -10.4 -8.6 -7.0Hungary 78.4 80.2 75.2 72.7 -4.5 -4.2 1.6 -3.3Poland 50.9 55.0 55.4 55.1 -7.3 -7.9 -5.8 -3.6Latvia 36.7 44.7 48.2 49.4 -9.7 -7.7 -4.5 -3.8Denmark 41.8 43.6 45.3 47.1 -2.7 -2.7 -4.1 -3.2Lithuania 29.5 38.2 40.7 43.6 -9.5 -7.1 -5.5 -4.8Czech Republic 35.3 38.5 41.3 42.9 -5.9 -4.7 -4.4 -4.1Romania 23.6 30.8 33.7 34.8 -8.5 -6.4 -4.7 -3.6Sweden 42.8 39.8 36.5 33.4 -0.7 0.0 0.9 2.0Bulgaria 14.6 16.2 18.0 18.6 -4.7 -3.2 -2.7 -1.6

Public debt, % of GDP* Budget balance, % of GDP*

*highlighted=non-compliance with Maastricht criteria; data source: European Commission (forecasts accordingly unchanged as per political scenario)

Recent experience shows: those countries that manage to straighten their finances are more successful in

staying above the waterGDP annual growth rate; 2nd quarter, %

-10.0

-8.0

-6.0

-4.0

-2.0

0.0

2.0

4.0

6.0

8.0

10.0

Still much to do to straighten out state finances: budget deficit implies higher interest payments and

increased debt

* Bank of Latvia forecast, ** along with FISIM

General Government debt and interest payments (EKS’95 methodology)

2007 2008 2009 2010 2011* 2012*0

5

10

15

20

25

30

35

40

45

50

0

50

100

150

200

250

300

350

General government debt Interest payments** (right axis)

% o

f GD

P

mil.

lat

s

In a short time, Latvia has become a country with a debt burden

Total debt of state and local governments (% of GDP, ESA’95 methodology)

Latvia Estonia0

5

10

15

20

25

30

35

40

45

50

9.03.7

44.7

6.7

20072010

Total expenditure of state consolidated general budget is higher than in 2007

2005 2006 2007 2008 2009 2010 2011p0

1,000

2,000

3,000

4,000

5,000

6,000

7,000State consolidated general budget (ESA’95), mil. lats

Revenue Expenditure

mil.

lats

p - predicted

Latvia’s credit ratings are low! That means: fewer jobs, higher interest payments

Jan/00

Jan/01

Jan/02

Jan/03

Jan/04

Jan/05

Jan/06

Jan/07

Jan/08

Jan/09

Jan/10

Jan/11

Latvia Lithuania Estonia

Standard&Poor’s rating agency’s long-term currency liability ratingA+

A+

A–

BBB+

BBB+

BBB–

BB+

BB+

BB–

2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021 >=20220

200

400

600

800

1000

1200

1400 2.8 billion LVL

What do low credit ratings mean for the public sector?

Schedule of central government debt repayment by nominal, mil.lats

2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021 >=20220

20

40

60

80

100

120

140

415

27

55

80 83 8593

103 103110

121

If euro is not introduced and credit ratings are not improved, it may cost the budget an additional billion

lats in interest payments in the next 10 yearsAdditional annual interest payments if euro not introduced and borrowing and refinancing

the debt in the financial market, mil. lats

In 10 years, we will overpay by almost 1 billion LVL

-15

-10

-5

0

5

10

15

I 200

9 II III

IV V VI

VII

VII

IIX X X

IX

III 2

010 II III

IV V VI

VII

VII

IIX X X

IX

III 2

011 II III

IV V VI

VII

VII

IIX

%

Loans to domestic businesses and households, annual growth rate (%)

What do low credit ratings mean for the private sector?Further drop in lending and limited opportunities to

finance new investments

State budget will be the decisive factor that will determine future development of the economy

Determining clear steps towards the balanced budget

Adopting the Fiscal Responsibility Law

In 2012, budget deficit must be under 2.5% and continue to shrink in subsequent years

Maximum permitted budget deficit (accg to ESA’95) levels, to stop the excessive deficit procedure instigated against Latvia (will substantially improve confidence in state finances; a precondition for meeting the Maastricht criterion):

–in 2012 – 2.5% of GDP–in 2013 – 1% of GDP–in 2014 – balanced budget

2007 2008 2009 2010 2011 2012 2013 2014-12

-11

-10

-9

-8

-7

-6

-5

-4

-3

-2

-1

0

-0.3

-4.2

-9.7

-7.7

-4.3

-2.5

Budget must be consolidated independently of euro introduction plans. Yet euro changeover would be an

additional advantage

Measure

EUROBudget strategy

Budget balance (% of GDP)

We are predicting that inflation in 2013 will approach the Maastricht criterion. Yet if negative risks materialize,

inflation may exceed the criteria

Forecast of inflation and Maastricht criterion, %

Countries with the lowest inflation in EU2011 2012 2013 III

Evaluation of Maastricht criterion

3.0 2.4 2.4

1st place IE 1.1 IE 0.7 GR 0.8

2nd place SE 1.5 GR 0.8 IE 0.8

3rd place CZ 1.8 ES 1.1 ES 1.2

I 2010

II III

IV

V VI

VII

VIII

IX

X XI

XII

I 2011

II III

IV

V VI

VII

VIII

IX

X XI

XII

I 2012

II III

IV

V VI

VII

VIII

IX

X XI

XII

I 2013

II III

IV

V VI

VII

VIII

IX

X XI

XII

-3.0

-1.0

1.0

3.0

5.02.4

2.2

Maastricht criteria*12 month average inflation in Latvia

* EC autumn forecast BoL calculations

2000

I III

2001

I III

2002

I III

2003

I III

2004

I III

2005

I III

2006

I III

2007

I III

2008

I III

2009

I III

2010

I III

2011

I III

2012

I III

2013

I III

2014

I III

2015

I III

2016

I III

-6

-3

0

3

6

9

12

15

18

Value of Maastricht inflation criterion and its forecast

Latvia's 12m average SPCI and its forecast

EU

RO

w

indo

w o

f op

port

unity

It must be noted that “the window of opportunity” for euro introduction may very possibly be shut after 2014

Inflation and Maastricht inflation criterion, %