Latvian Credit Downgraded As Retail Sales Continue Their Decline

As reported in this post, on Friday Fitch Rating Service announced they were cutting long-term sovereign ratings for Estonia, Latvia and Lithuania, citing worsening financial conditions in Europe. Latvia's long-term foreign-currency Issuer Default Rating was cut to BBB from BBB+. The outlooks were kept negative.

The move by Fitch follows an earlier decision by Moody's Investors Service to lower its Latvia outlook to negative. The outlook change affects Latvia's A2 foreign currency and local currency debt rating. The outlook on the Aa1 country ceiling for foreign currency bonds was kept at stable. Moody's A2 rating is five levels above investment grade. Kenneth Orchard, senior analyst at Moody's wrote in the statement: "Although it is not Moody's central scenario, Latvia's economy is vulnerable to a sharp reduction in foreign capital inflows.''

Latvia has low levels of government debt and no foreign bonds maturing for over five years, so there is little serious danger to Latvia's public sector funding. On the other hand Latvian interest rates to households and companies are expected to rise and the number of non-performing loans to grow as a by-product of the ratings changes and the global financial market turmoil which lead to them.

``Credit is becoming more difficult to access, and if you can access it, it will be in smaller sums and at a higher interest rate,'' Janis Brazovskis, vice-chairman of the Latvian Financial and Capital Market Commission, speaking in an interview on Latvijas Neatkariga Televizija's program 900 Seconds.

According to Brazovkis, interest rates will rise by between 0.5 and 2 percentage points for Latvian borrowers. Overdue loan payments may rise to 2 percent of total credits from the current 0.7 percent. Brazovkis stressed that Latvia's exposure to the U.S. financial system was "extremely minimal,'' and that Latvian lenders did not invest in "toxic financial instruments,''. This is undoubtedly true, but on the other hand I have never actually seen anyone suggest that Latvia's problems were a by-product of poor quality investments made in the US - in other words this would simply seem to be yet another one of those famous "red herrings". Latvian lenders also did not buy toxic instruments, since they were effectively selling them - to eg Swedish investors. Latvia, like the US, the UK and Spain, has a current account deficit, and it is the current account deficit countries who were effectively issuing the toxic instruments to finance their external borrowing at rates which were below the real level of the risk being assumed. If lending practices in Latvia were not lax (which is the normal argument directed towards the United States), then I simply do not understand the chart below - which shows bank lending going off a cliff once documentation and lending rules we tightened up in the spring of 2007.




So the problem is, it seems to me, that the people who bought instruments issued by the Latvian banking system (or who created instruments elsewhere to then inject funds into Latvian banks) are the ones who have the problems, and they are unlikely to be so forthcoming in the future, which is why credit will remain tight in Latvia (about this Brazovkis is undoubtedly right) and interest rates may well rise. Which is just one more reason why we should not expect any imminent revival in Latvia's flagging retail sales (see below) - and by imminent I do mean over the next few years. This recession is in for the long haul.

Retail Sales Continue To Decline



Month on month seasonally adjusted retail sales (at constant prices) were down by 1.2% In August. Compared to August 2007, and according to working-day adjusted data, at constant prices, total retail sales decreased by 8.9%.





The largest volume decreases were in food products – down by 10.3%.

Fitch Cuts Baltic Long Term Rating As Estonia's Industrial Output and Retail Sales Continues To Slide

Fitch Rating Service has today cut long-term sovereign ratings for the Baltic countries of Estonia, Latvia and Lithuania, citing worsening financial conditions in Europe. Estonian and Lithuanian long-term foreign-currency Issuer Default Ratings were reduced to A- from A, while Latva's rating was cut to BBB from BBB+. Outlooks were kept negative.

``The downgrade of the Baltic states reflects the risk that the deterioration in the European economic and financial environment will impose a more costly macroeconomic adjustment in the Baltic countries, given their large bank-financed current account deficits,'' Edward Parker, head of emerging Europe sovereigns at Fitch says in the accompanying statement.

All three Baltic economies are in the global top 10 of those with the largest gap between outstanding bank credit and bank deposits relative to both gross domestic product and total bank credit, Fitch said. Gross external financing requirements plus short-term external debt will be at around 400 percent of end- 2008 foreign exchange reserves in Latvia, 350 percent in Estonia and 250 percent in Lithuania, the highest ratios in emerging Europe.

Industrial Output Onwards and Downwards


Meanwhile in Estonia the whole real economy continues to meander along its steady downward course. According to Statistics Estonia, industrial output was down 2.6% in August when compared to August 2007. Month on month outpot was up 1.6% on a seasonally adjusted basis.

Manufacturing output was down 2% year on year. According to the statistics office statemet The main reason for the decline was the decrease in orders, both on the external and internal markets.




The decrease in manufacturing was mainly influenced by food production, and wood and building materials. The decrease in the manufacturing of food is obviously affected by the large price increases and by the decrease in consumption which follows. Compared to August 2007, 20% less beer, 15% less soft drinks and 10% less meat products were produced. Although the rate of price increases has eased back in recent months, food product prices increased 17% in August year on year.

As in previous months, production increased in August primarily in the export-oriented branches of industry — in the manufacture of metal products, chemical products, electrical machinery etc. Output was also up in the manufacture of machinery, precision instruments and motor vehicles, sectors where there is a sjgnificant export share. The share of exports was 89% in the manufacture of motor vehicles and 93% in the manufacture of precision instruments.

And if we look at the longer term evolution in the working day and seasonally adjusted output index, It is clear that output levels hit a maximum in the first two or three months of this year, since which time they have been moving gradually downwards. In the present climate we are unlikely to see any change in this trend anytime soon.





Retail Sales Also Continue Their Decline


According to Statistics Estonia, retail sales of goods of retail trade enterprises were down 6% in August over August 2007 at constant prices. Compared to July 2008, retail sales decreased by 4% in August at constant prices.



In August, retail sales ran to a total of 4.8 billion kroons. In grocery stores rsales were down by 3% compared with August of the previous year. The decrease in sales was significantly influenced by a rapid growth in the prices of food products (and of course this decline in sales then fed back into industrial output). Retail sales in stores selling manufactured goods decreased by 9% compared with the same month of the previous year. Compared to August of the previous year, retail sales decreased in most economic activities except mail order sale, which increased 24% during the year. The main reason for the increase in the mail order sale was the low reference base of the previous year. Mail order sales do not significantly influence the retail sales in retail trade enterprises, because the share of this activity is very small: it was only 2% in August 2008. The retail sales of stores selling household goods and appliances, hardware and building materials suffered the greatest decrease (15%) as compared to the previous year.

Estonia Producer Price Inflation Slows Slightly In August

According to Statistics Estonia, Estonia's producer price index rose by 0.3% month on month in August over July and by 7.3% compared to August 2007. The principal month on month influences on the index were the increase in the price of metals and metal products and in the manufacture of rubber and plastic products. Compared to August 2007 the principal factor was the increase in the price of energy.




Export prices were down month on month, and the percentage change in the export price index was -0.1% compared to July and 3.8% compared to August 2007.

Latvian Inflation Continues To Be A Major Problem

Consumer Price Inflation

The annual rate of increase in Latvian consumer prices was 15.7% in August 2008. Month on month the situation did imporve slightly, since prices decreased by 0.4% when compared with July. The average price of goods decreased by 0.9%, but the price of services continued to increase, and were up by 0.7%. Prices of vegetables and fuel fell, but the price of clothing, catering and rent were all up. Thus while the trend is for annual inflation to moderate, the news is far from unambiguous, with widespread secondary price shocks continuing to make their impact felt.

Food prices were down - by 2.2% - but this was mainly influenced by seasonal decreases in the price of fruit and vegetables and fruit. Bread, dairy products and cheese prices also fell. Fuel prices were down by 4.3%, as were motor vehicle prices.

The widespread presence of discounts meant that the prices of non-durable household goods, individual care goods, bicycles, sports and recreational equipment all decreased. Purchase of new cars became cheaper, as did the prices of data processing equipment, airline tickets, furniture and furnishings, carpets and floor coverings diminished.

Latvian retail sales we should remember were down again in July, both on June 2008 and on July 2007. Compared to July 2007, the seasonally and working day adusted constant price index was down by 8.5%. The largest volume decrease was in non-food products group which were down by 9.4%. There was a slighly smaller decrease in food products, which were down by 6%. The only increases were in mail order business – up by 7.2% and in retail trade in pharmaceutical and medical goods – up by 3.2%. In the face of such a decline in demand the more competition driven sectors have little alternative but to lower their prices.




On the other hand, prices in the non competition driven sectors continued to rise, and rent in municipal flats and houses, the cost of refuse collection and other publicly administered services were up, as were liquefied gas prices.

Alcoholic beverages, cereal products, meat and meat products, fish and fish products, eggs, oils and fats, sugar, sweets and non-alcoholic beverages all went up, as did clothes, textiles, household goods, and school textbooks.


Producer Prices Accelerate In August


Latvian industrial producer prices rose in August at a 13.1% annual rate, up frm the 12.4% annual rate registered in July. Month on month producer prices increased by 0.9%.

On an annual basis it has been the increase in the cost of energy components like electricity and gas, and the price of manufactured food products and beverages which have made the biggest impact on the overall level of producer prices,contributing 4.5 and 4.1 percentage points, respectively.

As can be seen in the chart below, Latvian producer prices are now up over 50% on the start of 2005, and with the Lat effectively tied in value to the euro (which is either used by, or a reference point for, nearly all Latvia's major external customers) this represents a huge loss of competitiveness for Latvian industry and service companies.





Energy Prices

In terms of the outlook for Latvian inflation moving forward we need to think about just when it will be that year on year crude oil turn negative, and when this does happen, what will this mean for Latvian inflation? An interesting question this one since it will really show us the "naked truth" about how resistant Latvian prices are to correcting themselves as the economy continues to languish in recession.


Oil prices have fallen substantially recently, even if with considerable volatility in the process. Last Friday, for example, , the first time oil had closed at over $100 in more than a week. Oil prices in fact shot up by more than $6 a barrel on Friday, with light, sweet crude for October delivery rising $6.67 to settle at $104.55 a barrel on the New York Mercantile Exchange, after earlier rising as high as $105.25. The increase followed the announcement of the sweeping US government financial rescue plan which emboldened investors to re-enter equiity and commodity the markets.

Crude thus climbed over $13 in the space of three days, but prices will more than likely resume their downward trend, at least in the short term, since demand for energy is likely to remain weak as the economic slowdown continues to bite in the US, Europe and Japan, while key emerging markets maintain tight monetary policy (although not Latvia unfortunately, since the Lat peg means there is no monetary policy to implement) in the battle to contain inflation (I am talking here of countries like Brazil and India). So, despite the coming and going, the trend in oil is decidedly down, and crude has now fallen around $43 — or over 30 percent — from its all-time trading record of $147.27 reached July 11.





So we are now hitting prices which were reached on the way up in the middle of February, but how long will it be before we are below the same price y-o-y? Then annual inflation rates will start to notice what is called the "high base effect", and it will be interesting to examine the precise differences between those countries where secondary effects have made their presence felt (like Latvia unfortunately), and those where core inflation has basically remained low.

Latvian Wages Continue To Rise

At the same time Latvian wages, and despite the recessionary backdrop, continue their steady upward march, at a rate which is well above consumer price inflation plus productivity. Compared to the second quarter of 2007, gross hourly wages in Latvia were up by 26.1%, according to the most recent data from the Central Statistical Bureau.



The statistics office noted that the seasonally adjusted rate of increase has been reducing since 4th quarter of 2007, but this is very small consolation for a process that is effectively blowing a massive hole in the side of the Latvian economy's ability to compete internationally. And indeed they also point out that compared to the second quarter of 2007 the most rapid increases in hourly labour costs have been in economic activities like education – up 30.5%, hotels and restaurants – up 29.3%, mining and quarrying – up 27.7%, construction – up 27.4%, and trade – up 27.3%.


Unemployment Rises While Employment Stagnates

On the other hand unemplyment has started to rise, slightly, and according to the labour board there were 56333 people unemployed in August - nudging up the unemployment rate to 5.2%. To put things in perspective, the number of unemployed is still below that registered in August 2007 (57940), when the economy was, to all appearances, still booming.



Employment, on the other hand, has been more or less stagnant over the last 3 quarters, although year on year rates of employment increase have been healthy (an average of 4% during the last three quarters) and total emplyment has not started to decline in any notable form.





Household Indebtedness


Internal demand, as we have noted, has collapsed, and the Latvian economy is in recession.




So what is the answer to this mystery? How can employment be stable, real wages rising considerably, and yet the economy slumping. Well, the answer isn't too difficult to find, it revolves around household borrowing, and the rate of increase in household debt. If we look at the chart below, we can see that the Latvian "boom" was being fuelled by truly massive y-o-y rates of increase in household borrowing. So the high rates of growth were not due to large productivity gains pushing a supply side expansion, but due to rapid increases in domestic consumption fuelled by growing debt, a process which pushed the Latvian labour market (given Latvia's unusual demography) way beyond capacity limits, and stocked-up a huge inflation bonfire.

As we can see in the above chart, this all really became "one big party" after mid 2005. Now I say Latvia has no available monetary policy, but this isn't entirely the case. Had the Latvian central bank imposed very strict credit restrictions starting in 2005 (and not in the spring of 2007), and had the Latvian government operated a large (liquidity and demand draining) fiscal surplus of 5% of GDP or so starting in 2005, then maybe much of the worst of the distress which is now about to come could have been avoided.

But it is always easy to be right after the event, and I am not claiming to have had any better idea than anyone else at that point. Certainly even the IMF staff economists (who seem to me to be normally much more on the ball than their Brussels and Frankfurt equivalents) only started pushing the idea of fiscal surpluses strongly rather late in the day, and I am sure if we could rerun all this they would have acted differently. But then, you know, the owl minerva only flies after dusk, and all that.

But, as we can see, once the credit restrictions were put in place to some extent, the rate of increase in new credit did slow, and what is so remarkable is how quickly the whole economy itself slowed as this increase in credit lost steam. We are still seeing a year on year rate of increase in household credit of around 25%, and yet the economy is contracting, so what happens if credit stops growing is anyone's guess.

So what is the future? Well basically, given what we have just seen about the debt side of the equation, I think we can safely say you can forget about Latvian domestic demand as a driver of growth. And since government spending is not going to be the answer given the impending liabilities which will be hitting the Latvian state from the ageing population phenomenon (health, pension costs etc), exports would seem to be the only way out. But this is where, after all that inflation, we hit a snag.


As can be seen in the chart below, Latvian exports, far from having risen to the role which falls upon them, have rather weakened over the last six months or so.




True, in year on year terms, they have been rising, but the rate of increase has been slowing steadily, even if - due largely I think to an especially weak month in June and a low base effect in July 2007 - they did rebound a bit in July. The weakness in Latvian exports as a growth driver has been rather masked by the much more dramatic decline in imports, which have moved strongly into negative y-o-y territory despite the high level of oil costs, and this has obviouly been a headline GDP growth positive (that is GDP would have been worse had imports not shrunk so considerably). The decline in imports has also prevented the trade deficit from deteriorating further.



But of course, if exports are now to drive growth (and if Latvians are to start paying back all that foreign debt they have been accumulating) then what is needed is a surplus not a deficit. Well, Latvia needs to start selling more abroad, whatever, however, and I think that in order to do this, Latvian relative prices now need a very substantial adjustment, which either means very substantial internal price deflation, or that horrible and unmentionable "D" word. If people sit back with their arms folded and simply wait to see what happens (out of idle curiousity, perhaps?), then the former will inevitably happen, but the thing is the process could become so violent that it provokes the second inevitably in its wake, which raises the question as to whether it might not be better in the longer run to grasp the bull by the horns, and go down the second road now and dircetly. Whatever happens, none of the possible solutions for the current predicament are going to be easy.