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RR RUEHAG RUEHAST RUEHDA RUEHDF RUEHFL RUEHIK RUEHKW RUEHLA RUEHLN
RUEHLZ RUEHPOD RUEHROV RUEHSR RUEHVK RUEHYG
DE RUEHRA #0202/01 1081406
ZNR UUUUU ZZH
R 171406Z APR 08
FM AMEMBASSY RIGA
TO RUEHC/SECSTATE WASHDC 4853
INFO RUEATRS/DEPTTREAS WASHDC
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RUEHZL/EUROPEAN POLITICAL COLLECTIVE

UNCLAS SECTION 01 OF 02 RIGA 000202 
 
SIPDIS 
 
SIPDIS 
 
E.O. 12958: N/A 
TAGS: ECON EFIN ETRD LG
SUBJECT: UPDATED LATVIAN ECONOMIC OUTLOOK 
 
Ref: Riga 138 
 
¶1. Summary.  The consensus among sources continues to be that 
Latvia's economy will slow throughout the year, though estimates 
range from the Association of Latvian Commercial Banks' soft-landing 
scenario of 6.7% GDP growth, to the IMF's hard-landing estimate of 
3.1%.  However, the inflation that had previously been forecast to 
peak in mid-summer, is now projected by some experts to not reach 
its high point until near the end of 2008.  Central Statistics 
Office figures showed that annualized inflation reached 16.8% in 
March, but both government and private economists believe that rates 
of 10-11% are possible by December.   Producer price and wage 
inflation has hurt Latvia's competitiveness, but the Latvian 
Investment and Development Agency claims that foreign investment 
into Latvia has remained unaffected up to now.  While none of the 
news on the Latvian economy is particularly good, a key question is 
whether the slowdown will be gentle enough to prevent a spillover 
into politics.  End summary. 
 
--------------------------------------- 
Tap, Don't Stomp, on the Brake 
--------------------------------------- 
 
¶2. Economists and officials consulted by post (which included 
representatives of the Bank of Latvia, Finance Ministry, Financial 
and Capital Markets Commission, Confederation of Latvian Employers, 
Association of Latvian Free Labor Unions, HansaBanka, Latvian 
Commercial Banks Association, and the Latvian Investment and 
Development Agency) agree that the overheated Latvian economy will 
continue to cool throughout 2008, due to falling aggregate demand 
and household consumption.  In light of consistently growing 
inflation and Latvia's large current account deficit, a certain 
degree of economic slowing is much welcomed and anticipated in 
Latvia. The GOL and Latvian economists, however, have expressed 
concerns over excessive cooling of the economy.  They point to the 
fact that Latvia's economic development has mostly been 
consumption-driven and worry that a drastic drop in consumption may 
result in significantly slower growth or even a recession. The 
recession scenario is considered unlikely; nevertheless, the 
government and the Bank of Latvia recently agreed that the 
government will not enact any further anti-inflation measures and 
will even rescind a provision enacted last year mandating 10% down 
payments for large consumer loans.  Currently, the PM's office 
projects 2008 GDP growth will be 6%, OECD forecasts 6.1%, the 
Economics Ministry says 5.5%, and the IMF foresees a gloomy 3.6%. 
 
----------------------------------- 
When Will the Wave Crest? 
----------------------------------- 
 
¶3. The inflation rate will likely continue to climb, with one 
HansaBanka analyst saying that a peak annualized monthly rate of 20% 
is not out of the question.  Inflationary pressures will 
increasingly be cost-pushed rather than demand-pulled.  At the start 
of 2008, the GOL stated that inflation would peak in the summer, 
with prices then moderating and coming under control near the end of 
the year.  However, in recent weeks, the Bank of Latvia and private 
economists have been pushing back projections of when inflation may 
peak, with some estimates projecting increasing inflation rates 
until December.  Energy and food prices will continue to account for 
most of Latvia's high inflation.  Electricity tariffs increased on 
April 1 by an average of 37.6%, and natural gas tariffs are expected 
to increase by 30-50% this summer.  Soaring production costs for 
local producers, coupled with rising global food demand and wheat 
and milk shortages, will keep pushing food prices upward. Demand for 
luxury goods and services has already slowed and is expected to fall 
further. 
 
¶4. In an effort to fight inflation, the government pledged to 
exercise fiscal restraint and maintain a budget surplus equal to 1% 
of GDP.  However, concerns exist that the GOL might inject some of 
the surplus funds back into the market if the economy begins slowing 
too sharply.  On April 9, Bank of Latvia Governor Ilmars Rimsevics 
met with the Prime Minister, and told reporters afterwards that he 
believes it is essential to maintain the surplus at 1% of GDP, and 
that the current shortfalls in government revenues (about 1 percent 
less than expected) should be matched by spending cuts.  If the 
government chooses to boost the economy with funds from the surplus, 
at a time when substantial EU funds are coming into Latvia, the 
stimulus could spur continued rapid price growth into 2009. 
 
¶5. Inflation and increasing labor costs are having a negative effect 
on the competitiveness of Latvian businesses. Latest foreign trade 
data shows that export growth is slowing, and this trend is likely 
to continue throughout 2008.  Businesses are increasingly calling 
for government action to enact policies such as export credit 
guarantees and tax breaks for re-invested profit. The economy is 
also expected to begin undergoing various structural changes as 
numerous sectors and industries become less profitable.  Import 
growth is also showing a tendency to slow, which should bring down 
Latvian's current account deficit.  Figures for the 4th quarter of 
 
RIGA 00000202  002 OF 002 
 
 
2007 already indicate that the current account deficit decreased to 
17.7% of GDP, down from 27.1% of GDP in the 4th quarter of 2006. 
 
----------------------------------- 
Consumer Lending Slows 
----------------------------------- 
 
¶6. Credit growth this year is still expected to decline, as observed 
in the second half of 2007, but the banking sector should remain 
stable.  The Financial and Capital Market Commission notes that this 
decline in lending growth indicates a normalization of the market 
after a period of extremely high and unsustainable growth. 
Projections are that mortgage lending will be slowing more than 
commercial lending; the latter possibly even experiencing some 
growth.  Currently, approximately 80% of loans are issued in euros, 
rather than in local currency, and the share of Euro denominated 
loans is expected to grow.  The large volume of Euro-denominated 
debt had been the subject of public and press concern in the wake of 
rumors last year that Latvia may devalue its currency, the Lat. 
However, the Bank of Latvia says it continues to hold enough foreign 
currency reserves to cover every Lat in circulation, and government 
and banking officials almost unanimously discount the likelihood 
that Latvia would alter the Lat' peg to the Euro. 
 
--------------------------------------------- ------ 
Wages Go Up, Productivity...Not So Much 
--------------------------------------------- ------ 
 
¶7. Wage growth is forecast to slow whereas unemployment is expected 
to increase.  The most often cited wage growth figures projected for 
2008 are between 16 to 17%.  This rapid wage growth, without 
corresponding improvements in productivity, is one of the principal 
reasons for the decline in Latvia's business competitiveness.  Wage 
growth, nevertheless, is forecast to remain relatively high due to 
continued labor shortages and the fact that wage levels remain low 
relative to other EU countries and workers are leaving Latvia to 
take higher paying jobs elsewhere in the Union.  It is thought that 
unemployment will grow in response to economic slowdowns in sectors 
such as construction and real estate.  Rural regions are 
experiencing the highest levels of unemployment and most business 
activity is concentrated around urban areas.  The GOL will continue 
to work on a territorial reform plan this year, which aims in part 
to address the economic disparities between urban and rural 
regions. 
 
------------------------------------------ 
Optimism on Foreign Investment 
------------------------------------------ 
 
¶8. In discussions with post, the Latvian Investment and Development 
Agency (LIAA) asserted that the high levels of inflation have not 
had a negative effect on foreign investment growth - pointing to 
data that shows that despite high inflation in 2006 and 2007, 
foreign investment in Latvia continued to grow.  LIAA adds, however, 
that investment growth could slow this year in response to several 
other factors - among them, downgraded credit ratings and increased 
production costs.  Lower labor costs relative to Scandinavian 
countries still provide a continued advantage for investing in 
Latvia.  It is projected, though, that the number of investment 
projects which rely on cheap labor will decrease, and that more 
attention and resources will be directed toward the promotion of 
technology intensive, rather than labor intensive, projects. 
 
¶9. Comment: Inflation is likely to peak this calendar year, though 
later in the year than originally thought.  Predicting the peak has 
been difficult due to continued external factors, such as energy and 
food costs, but also in the difficulty of identifying the 
inflationary pressures that are already in the pipeline from 2007. 
As many in the ruling coalition have a preference for continued high 
GDP growth and wage convergence with the EU, the political 
temptation to use the planned government budget surplus to make up 
for lower revenues may be too strong for the government to resist. 
If the surplus drops below 1%, Latvia may not only suffer increased 
inflation from the extra stimulus, but it may also lose the 
confidence of the major credit rating agencies that Latvia is 
serious about fighting inflation, and further downgrading of 
Latvia's credit rating may follow.  While not fatal to Latvia's 
economy, rating agency concerns could make foreign investors bypass 
opportunities in Latvia, and decrease its long-term growth 
prospects.  Hopes of entering the Euro zone also depend on reigning 
in inflation and delays in Euro usage also could reduce foreign 
investment into Latvia. 
 
¶10. Comment, contd. The other key question is whether the economic 
downturn is gentle enough not to spill over into politics.  As noted 
in reftel, a sharp drop in the economy could have negative 
consequences for the stability of the current coalition government.