Latvia: Economy will slow down gradually in 2019 and 2020 | Luminor

Key highlights

It would be very hard to do better than in 2018

GDP growth accelerated last year to 4.8% from 4.6% in 2017 that was already an excellent result. The country enjoyed a fortunate confluence of growth-boosting events. Double-digit investment growth brought by peaking EU fund flows coincided with favourable export markets.

Not only was the overall growth strong, economy performed well on several points:

In late 2018 export markets cooled down significantly and are unlikely to bounce back sharply though fears of immediate recession started to dissipate in February.
Growth will slow down, but gradually

Consensus view is probably correct about the overall growth slowdown in 2018-2020 period, but wrong about timing. Average forecast assumes that almost all of this will happen in 2019. We predict that the deceleration will be more evenly split between 2019 and 2020. So GDP growth in 2019 will slow by a percentage point to 3.8%. We switch back to the forecast that was downgraded in Q4 when global business cycle indicators nosedived.

While our GDP forecast for 2019 is relatively optimistic, we do not close our eyes to risks, we see a sharp slowdown in some areas and continued contraction in financial services.

Value added growth in key sectors 2018-2020, fact and forecast

Source: Statistics Latvia data, Luminor forecasts

While the risks of EU fund flow tapering have been exaggerated, these definitely can slow down expansion. We predict that investment growth will be positive in the forecast period, but just above zero in 2020. Building construction will remain quite strong, pulled ahead mostly by rising demand for housing. Building permit data signal intentions to add substantial new office and industrial space. Outlook for infrastructure investment is less favourable. Road construction financing after 2019 is highly uncertain, large port and powerline projects are at or near completion.

Overall expansion will be mostly sustained by consumption as a follow-up of rapid wage growth (8.4%) and employment growth (1.6%) in 2018. For 2020 prospects are more uncertain, but still good.

While it is self-evidently true that sustainable growth largely depends on exports, moments of global weakness do not doom Latvian economy to crisis. Past experience shows that Latvian export dynamics are not tightly correlated to business cycle in EU, the main market. Growth rate in other Baltics, industry specific developments can be very important. While a lot of attention has been paid to negative surprises in global trade data, declining confidence indicators in euro area, the most direct evidence about likely production trends — industry survey results from Latvia tend to be disregarded. The forward looking indicators are quite strong.

Industry confidence sub-indices vs their historic averages, points

Source: European Commission data, Luminor calculations

Any macro projections beyond 2020 are very uncertain. In 2021 and following years a lot will depend on the timing of RailBaltica construction. The macro effects of this enormous project can easily swamp all other drivers. It is also important to see how the interaction of the labour market and structural developments will play out.

Labour market pressure cooker will accelerate productivity growth

Unless global economy goes through a very strong upward or downward swing, the medium term future of Latvian economy mostly depends on the labour market. It is both a hope and a worry. It may slow down expansion if companies hit a hard wall in their attempts to increase the number of employees. This is a possibility, but not the only scenario. Media coverage is mostly based on the views of those who see the problematic aspect of recent trends. There are also others. Labour market tightness can drive three positive feedback cycles:

Recent developments are favourable. Employment grew by 1.6% in 2018. Gross wages increased at the fastest pace since 2008 — by 8.4%. Also the real net wage growth was strong, at 7.2%, helped by moderate inflation and tax cuts. Wage growth is predicted to slow by about a percentage point in both 2019 and 2020, but the direction of change is especially uncertain in this area.

While the employment ratio is rising, Latvian indicator still lags roughly five percentage points behind the Estonian one. By closing it, Latvian economy would get 40-50 thousand extra workers. Unlike Lithuania, Latvia lags behind also in prime working age (25-54 year olds) employment ratio that points to insufficient geographic labour mobility.

Employment ratios in prime working age (25-54 year olds)

So it doesn’t surprise that there are still large rural areas with very low incomes, where the median gross wage is around 500 euros or even below, questioning the need for large scale labour immigration – there is surplus labour in the countryside that can be employed in cities with labour shortage.

Banking sector will continue to change

In 2018 Latvian banking sector changed profoundly. As financial service export activity is reduced, sector will continue to shrink as the share of the economy in the forecast period. In the long run financial service exports from Latvia probably will grow again, but these will be very different from the past, based on financial technologies in which Latvia and other Baltic states are quite strong.

Also those banks that mostly serve local businesses and residents go through a period of rapid change, driven by changes in technology and consumer habits. As the provision of financial services takes up a declining share overall working time in the economy, the share of the sector in GDP will probably continue to shrink. It is a sign of success, not failure. Banks should function so well that they are almost unnoticeable. This is not a part of the economy that drives growth by itself; it serves other parts of the economy that do.

There are indeed also growth areas in the sector. Savings will rise faster than income in the future as people take on an increasing share of responsibility for pension provision and increasing affluence increases the capacity of households to reduce old age and other financial risks. Increasing savings is one aspect of increasing financial intermediation, the other is lending. Ratio of total household and business loans to GDP is still a fraction of that in a typical rich country. This gap will close, but gradually.

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