Estonia's Economy "Only" Contracts By 9.4% in Q4 2009

Hard on the heals of yesterday's Latvian GDP numbers we now have news that Estonia’s economy shrank at the slowest annual pace in a year at the end of 2009 as a modest recovery in exports and one-time stock-building helped offset the impact of the continuing decline in consumer spending. In fact gross domestic product fell 9.4 percent, which compares with a 15.6 percent drop in the third quarter, and a 16.1 percent decline in the second one. So the recession is evidently easing.



Indeed, startling as it may sound, the economy even grew during the quarter - by a seasonally adjusted 2.6 percent when compared with the third quarter. The news caused some surprise as even the Estonian Finance Ministry had been expecting worse results - an annual contraction of something in the region of 11 to 12 percent. The critical little detail is that the numbers were skewed, since they were affected by a one-off stock- building effect, according to the Finance Ministry, since companies built up their inventories in anticipation of a January tax increase on tobacco, alcohol and motor fuels. As the ministry also added, economic growth will thus see a “negative effect” in the first quarter of 2010 as inventories will inevitably be run down again.

"The alcohol, tobacco and motor fuel excises were applied in the beginning of the year, so the stocks of those products were increased, and that gave a positive move to the GDP in the fourth quarter, but will give a negative influence in the beginning of this year,” according to Andrus Sääsk Head of Macroeconomy at the Ministry of Finance.

No Sign Of Any Real Recovery




So, as we are seeing in the other Baltic States, the recession is gradually winding down, but there is no end to the agony in sight, since structural distortions in the economies produced by the earlier boom will impede any immediate recovery. If we look at retail sales the pattern is similar to what we are seeing elsewhere, and these are now down about 28% from their February 2008 peak.

A similar situation is to be observed in industrial output, which fell back again in December (by a seasonally adjusted 2.2% from November) according to statistics office data. Industrial output is now down 32.5% from the February 2008 peak.

And while exports have picked up slightly from the first quarter 2009 trough, momentum has not been strong enough yet to reverse the deadweight drag of domestic consumption.

The goods trade deficit has improved - indeed the 2009 deficit was the smallest since 1995 - but it is still a deficit, although the country does run a healthy services balance.

And the services balance is what makes the difference in turning the current account deficit into a surplus.

On the other hand unemployment continues to rise, and is the third highest in the European Union (after Latvia and Spain), hitting 15.2% in September - which is the last month for which the Eurostat has data at this point. Indeed statistics regularity and quality is one of the issues which Estonia will need to attend to as part of its general euro ambitions, as the ECB took the trouble to point out recently.



Demographic Issues Also Need To Be Addressed

Estonia's population fell again in 2009 - by 400 - and was estimated by the statistics office to be in the region of 1,340,000 at the end of the year. A falling death rate meant the population decline slowed down over the year, but the number of live births decreased for the first time in eight years (see chart below), raising issues about the longer term impact of the crisis. Some 15,807 live births were registered in total in 2009 - 221 birth less than in 2008.

While the situation is a lot less serious than the one Latvia faces, the downturn in Estonian births is a rather bitter blow for a country where fertility had rebounded substantially from earlier lows, and while the 1.6Tfr was still a long way from population replacement level, the improvement had been a welcome one.


Credit Rating Improvement

Estonia's credit rating outlook was raised this week by Standard & Poor’s, from negative to stable. More than the improvement, what is interesting is the reason given, since the agency cited improving prospects for euro adoption next year. This has both a positive and a negative reading. The positive reading is that S&Ps think Estonia will meet the eurozone membership criteria. The negative one is that the improvement is not due to any underlying change in the country's growth prospects, which are at the end of the day the main area of immediate concern.

Indeed S&Ps have an A- rating, the fourth-lowest investment grade, on Estonia and the move to stable from negative, means the rating is more likely to be left unchanged than raised or lowered. The rating was in fact cut from A last August, and evidently losing the A- rating would give a rather negative signal given that the ECB is about to return to at least one A- as the minimum collateral condition.

“Estonia has stabilized its public finances, which significantly increases its prospects for eurozone accession in 2011,” S&P’s Frankfurt-based Kai Stukenbrock and London-based Frank Gill said in a statement. The “outlook reflects our view of Estonia’s improving economic flexibility and the prospect of near-term eurozone accession against the challenges inherent in adapting the economy to lessen its reliance on external funds.”

Fitch currently has a BBB+ rating on Estonia, and the outlook on this was also raised to stable from negative on February 5. Moody’s Investors Service has an A1 rating on Estonia with a negative outlook.

Euro adoption terms require countries to maintain fiscal deficits below 3 percent of GDP, limit debt to 60 percent of GDP and ensure inflation isn’t more than 1.5 percentage points above the Eurozone average, and Estonia has met all the criteria, according to Prime Minister Ansip speaking yesterday. Whether Ansip's optimism is totally justified or not the EU Commission and the European Central Bank will publish their report assessing Estonia’s readiness to join sometime in May, and (assuming this is favourable) the Ecofin council of EU finance ministers will take the critical decision on entry on June 8.

But as Fitch pointed out when they raised their Estonia outlook, while eurozone membership looks increasingly possible it is not yet certain. Fitch warned in their report that even if Estonia meat all the formal Maastricht reference criteria for euro entry there is still a risk that the European authorities' interpretation of these same criteria could lead them to reject Estonia's application. According to Fitch, in Estonia's case uncertainty surrounded whether the idea of "sustainable price performance" was going to be consistent with the deflation which is to be expected from such a severe recession, after inflation had so recently been in the double digit range. The agency also added that one-off measures taken by the government to reduce the budget deficit in 2009 could also count against it in the EU authorities' judgment of whether the medium-term budget plans are credible.



The first point is an important one I think, and is reiterated by the ECB's own Jürgen Stark in an interview given to the German magazine Der Spiegel for this weekend: "But when taking on board new members, we will need to take an even closer look, concerning the data and the sustainability of convergence," he is quoted as saying.

Indeed if we go back to the 172 page EU Commission document leaked to the German magazine Der Spiegel last month, the EU Stability and Growth Pact is increasingly going to focus on issues surrounding competitiveness as well as on fiscal deficit ones. That is what the whole deabate over the Greek and Spanish economies which EU leaders are engaging in this week is all about. And any country which is not considered to be in completely good health under the SGP criteria is hardly likely to get the green light from the ECB and Ecofin.

It is obvious that the Estonian economy is still suffering from earlier structural distortions which have not yet been corrected. If we come to the consumer price index, this was only down about 2% in 2009, far short of the deflationary adjustment which will be needed to restore growth and competitiveness.



The producer price index has also not moved as far and as fast as will be needed, since it was only down some 3% on the year.



So the sad truth is that, whether from inside or outside the eurozone, despite some extensive and painful sacrifices made in not having government spending to fall back on during an extraordinarily deep recession - but then, as Krugman would say, Estonia's problems were never fiscal ones anyway, they were always competitiveness ones - there is still a long hard road out there in front. Whatever the advantages and disadvantages of the chosen path one thing is for sure, it will be absolutely impossible for the country to leave the job half done.

Latvia's Economy Contracts Almost 18 Percent in Q4 2009

Well, as we say in English, it never rains but it pours. Latvia, which has had the deepest recession of all 27 European Union member states, contracted by nearly 18 per cent in the fourth quarter of 2009. 'Compared to the same period of 2008, gross domestic product (GDP) value has decreased by 17.7 per cent,' according to the national statistics office statement.




The fall was led by a 30-per-cent annual drop in the retail sector. Retail sales are now down by 36% from their April 2008 peak and there is little sign of any turnaround at this point.





Industrial output, which rose slightly over the quarter, fell back again in Deecember (by a seasonally adjusted 4.2%) following a sharp rise in November. Output is still down more than 17% from the February 2008 peak.



Latvian exports were down again in December, making for the second consecutive monthly fall. Despite all the fuss about internal devaluation the CPI was only down by 3.1% in January over January 2009. Prices are still far from being competitive, and no early rebound in export growth is to be expected. Over 2009 as a whole exports - at 3,571.6 mln lats – were down over 2008 by 19.4%, but imports - at 4,633.7 mln lats – fell even further, by 38.4% which is why the trade deficit reduced substantially, but note there was still adeficit. The deficit fell from 225.3 mln Lats in January to 69.7 mln Lats in December. Over 2009 as a whole foreign trade turnover totalled ay 8.2 billion lats, a drop of 31 per cent when compared to 2008.



Unemployment hit 22.8% in December according to Eurostat data, the highest in the European Union.



And even that famed "internal devaluation" seems to be working hellishly slowly. As I say, prices were only down by 3.1% in January 2010 over January 2009 (and probably even less on the EU HICP measure) according to the latest data from the Latvian statistics office.



Even the statistics office statement that GDP actually grew by 2.4 per cent compared to the third-quarter offers cold comfort, since this data is not seasonally adjusted, and the economy will almost certainly be back down again in the first quarter of 2010.


Meanwhile the consequences of this strong recession in Latvia - more and more Latvians are leaving in search of work elsewhere, while fewer and fewer young people feel confident enough to have children (see chart below) - will leave a long scar, which will be hard to heal, and which make the long term future and sustainability of the country even more uncertain.



As the Washington based CEPR argue "the depth of the recession and the difficulty of recovery are attributable in large part to the decision to maintain the country’s overvalued fixed exchange rate, because it prevents the government from pursuing the policies necessary to restore economic growth". Maybe next time someone will learn the lesson before tragedy strikes, and not afterwards.

Latvia Is Back In The News, And Expect More To Come

The Latvian government is getting nervous about the level of lending coming from Swedish banks. According to the Financial Times, "Latvia’s prime minister has warned Swedish banks they risk choking off recovery in the Baltic state’s crisis-hit economy unless they resume lending". The Latvian authorities are complaining, it seems, that banks such as Swedbank and SEB, which dominate the Latvian market, have reined in credit as they struggle to contain rising bad loans amid the deepest recession in the European Union.

“The . . . abrupt stopping of credit is a very problematic issue,” said Valdis Dombrovskis, the prime minister. “We expect Swedish banks to start [lending] again. “Of course you can say that Latvians were borrowing irresponsibly but to borrow irresponsibly you need someone to lend irresponsibly,” he said. “We had very easy credit in a very overheated economy. Now we have almost no credit in a very deep recession.”

Well, here is some of the background. After an extended period when private credit was rising at nearly 60% a year, the Latvian credit bubble suddenly burst, with very unpleasant consequences for everyone. Since mid 2007 the annual rate of new credit has been falling rapidly, and turned negative in June this year. In fact total credit has been falling since October 2008.

Lending to households alone has also fallen back, after shooting up dramatically over several years.

And Latvian base money (M1) has also been falling.


In fact, and unsurprisingly (given that it is what we are seeing everywhere in the exploded bubble economies) the only sector which isn't deleveraging at this point is the government one.



So it seems hard to me to simply blame mean banks for not doing enough about a situation which many saw coming, but few were willing to do anything to avoid. Sure, the banks made a lot of bad decisions, but so did many other people, and each and every party is trying to extricate themselves from the mess as best they cab. In fact total Latvia debt is not in fact falling at this point in time, since while many individual Latvians have been frantically deleveraging, the government has been borrowing at a faster rate than ever, in part to bail out Parex bank, and in part to fund the ongoing fiscal deficit. In the meantime Latvian GDP has dropped sharply, falling back again in the third quarter at an even faster rate than in the second one. Which means that despite the fact that private indebtedness is falling, the level of private debt to GDP is still probably rising.

This unfortunate situation is only further reinforced by the fact that prices are falling - not too fast as yet, only an annual 1.4% in November, but they are falling, and they will fall further, and this means that the percentage of debt to GDP will again rise, and this is especially bad news for the Latvian government (even though the drop in prices is a desired objective, no win-win strategy left to use now) since any fall beyond that anticipated is likely to push up the total debt level of 60.4% of GDP currently being forecast by the EU Commission for 2011.

And the pain doesn't stop, since having cut 500 million lati ($1 billion) in spending in its 2009 supplementary budget, the government initially resisted the idea of finding an additional 500 million lati of savings in the 2010 budget arguing that with no policy change the deficit was expected to be lower than the 8.5 percent target. Valdis Dombrovskis said in October his government could cut only 325 million lati in the 2010 budget and still meet the 8.5 percent target agreed with international lenders. The lenders did not agree, and Swedish Premier Fredrik Reinfeldt even intervened to tell Latvia it “must correct” its deficit. Following the rebuke further measures were passed equal to 500 million lati for 2010, and the country now targets a deficit of 7.6 percent of GDP. This is to be followed by a budget deficit target of 6 percent of gross domestic product in 2011, in order to finally arrive at the magic number of 3 percent deficit in 2012.

But considerable doubt exists over the ability of the Latvian authorities to fulfil these objectives. Which is why Mark Griffiths, IMF mission head in Latvia, describes the situation facing the government as challenging, and why the EU Commission base their Autumn forecasts on much higher deficit levels. The problem is that with domestic prive deflation (which is, remember, what Latvia is aiming for, the so called "internal devaluation" what is called nominal GDP (that is current price, unadjusted GDP) is likely to fall faster that the so called "real" GDP (adjusted for inflation) and this has two very undersireable consequences. In the first place debt to GDP goes up even faster, and the revenue which government receives (which is based on actual prices) drops faster than GDP, causing more instability in public finances. The deflator has shown falling prices since early this year and the EU commission is forecasting a drop of 5% for 2010.



So basically, in this climate, with unemployment rising, and wages falling, and an economy contracting at nearly 20% a year, it isn't hard to understand why not that much new bank lending is going on. Those who are creditworthy are trying hard to save, while those who need to borrow normally aren't that creditworthy, so Dombrovskis' plea is rather like asking the bank to subsidise new bad debts, and that is really not something you can do, and especially not when you are going along the course you are following because you wanted to, and against one hell of a lot of external advice. What kicked the whole process off was a short sharp credit crunch, but now it is the contraction in the real economy which is following its own dynamic, till someone finds a way to put a stop to it. It is the drop in output that is preventing banks from lending, and not banks being unwilling to lend that is causing the contraction to continue.

But there is another point in the FT article which should give food for thought.

Mr Dombrovskis...ruled out devaluation of the lat. While breaking the currency’s fixed exchange rate with the euro would help Latvia’s exporters, it would increase the burden of euro-denominated loans, which account for 85 per cent of lending, he said.

“We would not see much benefit from devaluation because we are a very small and open economy which means that any competitiveness gains we may get would be very short-lived,” he said. “We would redistribute wealth from pretty much all the population to a few exporters.”

Well, we haven't advanced too far in all these months, now have we, if we are still wheeling out the argument that "external" devaluation will hit holders of euro denominated loans, since it should be generally recognised that the (very painful) internal devaluation which is now taking place is hitting Euro loan and Lati loan holders alike. And the argument is a strange one to use just shortly after the statistics office announced that due to the rapid reduction in the number of those employed and to the fact that many of them changed their working conditions from full-time to part-time, the number of hours worked in the 3rd quarter of 2009 fell by an annual 27.3%, while labour costs fell during the same time period by 30.1%. This fall in disposable income, and the continuing prolongation thereof, poses a far greater threat to the continuity of Latvian loan payments than the 15% reduction in the value of the Lat as compared to the Euro which the IMF proposed in the autum of last year would have done. Indeed, it is, in and of itself, one of the pernicious consequences of having resigned yourself to an "L" shape non-recovery. Stress on the banking system only goes up and up, as incomes and employment fall, and the government has less and less ammunition left to counteract the contractionary pressure.

It is like sitting it out in freezing weather at the North Pole, in the vain hope that help will arrive. But help will not arrive, and the cruel truth about the post-crisis shock world we live in, is that nobody is coming to help you if you will not help yourself. In this sense, what Latvia doesn't need is more international borrowing (hasn't there been enough of that already) but some kind of meaningful strategy to start paying back the debt. But this means putting people back to work, and selling abroad, and financing Latvian lending from Latvian savings, and not pleading for yet more capital inflows to finance non-productive activities (attracting investment would be another matter, but as things stand right now the environment is far from "appetising", and according to the latest data from the Statistics Office, non-financial investment in Latvia was only 402.8 mln lats in the third quarter, a fall of 39% on the 3rd quarter of 2008).

And just to be clear, what we have seen to date is not a 30% drop in unit labour costs (which would, of course, mean a great boost to competitiveness), rather it is a drop in earnings due to the fact that the output people could have produced just isn't needed, since no one is willing and able to buy it. In fact according to the data of the Statistics Office to hourly labour costs fell by only 3.9% in the 3rd quarter when compared with the same period a year earlier. Hardly a massive drop, and especially not when the large annual increases of ealier quarters are taken into account (see chart below). The internal devaluation has a long course still to run!

Pensions Dilemma

But Latvia is back in the news today for more reasons, since the constitutional court has just ruled against the government pension cuts, drawing a question mark over Latvia's ability to meet the terms of its international lending commitments.

"The decision to cut pensions violated the individual's right to social security and the principle of the rule of law," the court said in its judgement, which cannot be appealed. The pension cuts - in place since July - formed a vital part of the Latvian government's list of austerity measures, as it struggles comply with terms of the IMF-lead bailout, and the constitutional inability to implement them is another hammer blow against the credibility of the current Latvian administration.

According to the Baltic Course, Valdis Dombrovskis told Latvian State Radio that the Constitutional Court's ruling on pensions must be carried out, and not debated. I am sure this will really come as music to the ears of people in Brussels and Washington. Basically pension reform forms a key part of the mid term strategy for sustainability of Latvian finances, and without the ability of the Latvian government to carry these out, then frankly the coherence of the whole strategy falls apart. If the Latvian constitution does not permit pension changes, then the Latvian constitution has to be changed, and the only surprising thing is that all this wasn't forseen when the initial loan negotiations took place in late 2008. Basically, it is impossible for the EU Commission and the IMF to accept any other view, since if any state could ring fence a whole part of social provision before entering debt negotiations, then non of the structural reform programmes could possibly work. This may seem harsh, but it is the price you have to pay for becoming insolvent as a society. Latvia's problems are NOT short term liquidity ones, but problems of the sustainability of an entire economic and demographic model, and, as in the case of Greece, these problems will not be solved by two or three years of (rather painful) fiscal deficit cosmetics. Real changes need to be made, and especially in raising the long term growth potential of the country, and frankly it is these changes which we have yet to see evidence for.

The issue is not simply one of limping into the Euro in 2012, even if as Mark Griffiths, the IMF’s mission head in Latvia, said in Riga last week the Latvian government does face a lot of “hard work” in trimming the budget deficit enough to qualify for euro adoption, and how much more so if they cannot constitutionally implement the cuts they agree to.

“The key is meeting the deficit targets, and meeting the Maastricht criteria and euro adoption, that’s the path,” Griffiths said. “The government needs to work hard over the next year to find the measures which will deliver that adjustment to meet those targets. It’s going to be a challenging task.”

Oh yes, and Latvia was also in the news yesterday for another reason, since Latvian stocks dropped the most among equity markets worldwide as small investors sold stocks before the government starts to tax investment gains. The OMX Riga Index fell as much as 4.3 percent to 271.55, its lowest intraday level since August 21. In dollar terms, the drop was the biggest among 90 benchmark indexes tracked by Bloomberg. The reason for the sell off was that Latvia’s 2010 budget includes measures which will impose taxes on dividends, gains from trading stocks and bonds and interest income. These measures were agreed to in order to ensure the continued transfer of the 7.5 billion-euro bailout from the European Commission and the International Monetary Fund.

Latvian investors have increasingly sold their holdings ahead of the Dec. 31 deadline. Dividends and interest income will be taxed at 10 percent, while tax on gains from trading stocks and bonds will be 15 percent.

As Unemployment Climbs, Latvians Start To Pack Their Bags

Finally one that wasn't in the news, but should have been, since while everyone knows that at 20.3% Latvia's unemployment is the highest in the European Union (see chart below), what they don't know is that more Latvian's than even are now being forced to leave their country in search of work.



According to a report by Oļegs Krasnopjorovs, economist with the Bank of Latvia, during the first half of 2009 8,300 Latvian residents left for Great Britain, a twofold increase over the year earlier period. 3,600 people emigrated to crisis-ridden Ireland in the first 11 months of 2009 - 3% more year-on-year. Among the new EU member states, Latvia has seen the sharpest increase in emigration to these two countries.

According to Krasnopjorovs, the data (which comes from the UK and Irish social security systems) confirm the trend identified by the Latvian Statistics Office, who examined data on long-term migration. In the first ten months of 2009, the number of long-term emigrants was 6,300, up 18% more year-on-year; moreover the steepest rise took place in the last few months, reaching a ten-year peak. For several years now the number of emigrants has exceeded that of immigrants in Latvia, with the exception of the second half of 2007 when a sharp rise in salaries and a steep drop in unemployment were fuelled by the credit and construction boom, leading to labour force shortages and the expectation that incomes would rise even further.


Exports Still The Key

The real problem here, of course, is that the Latvian economy remains mired in deep recession, and shows few signs of real recovery, something which is not surprising given that domestic consumption is in limbo land (where it is likely to stay), while the Prime Minister seems to attach little priority to boosting exports, and regaining competitiveness. Indeed, the contraction has rather gathered than lost momentum in recent months, and on a seasonally adjusted basis Latvian GDP fell another 4% between the second and third quarters of 2009. This was much faster than the 0.2% contraction between Q1 and Q2.



Year on year Latvian GDP fell by 19.0% in the third quarter.The decrease was largely due to a 28.7% drop in external trade (share in GDP 15.6%), a 18.2% one in transport and communications (12.5% GDP share), an 17.4% fall in manufacturing (10.2% GDP share, incredible) and by a 36% drop in construction (7.5% GDP share, not far below manufacturing).

Private final consumption fell by 28.1%. Government final consumption decreased by 12.4%, while expenditure on gross capital formation fell 39.4%. Goods exports (68.2% of total exports) fell by 11.7% and services exports by 20.5%. Goods imports (82.1 % of total imports) were down much more sharply - by 36.6% -and services imports by 29.1%. Which meant net trade was positive, otherwise the fall in GDP would have been greater, and nearer to the levels seen in domestic demand.

And entering the fourth quarter there were few signs of any real improvement. Retail sales fell in October by 1.3% from September (on a seasonally adjusted, constant price basis).



As compared to October 2008 sales were down by 29.1%. The drop was even larger in the non-food product group – 32.3%. According to Eurostat data, sales are now down nearly 35% from their April 2008 peak.




Industrial output, however, seems to be holding up a little better, and output has stabilised since the spring. The problem is that manufacturing industry is now such a small share in GDP that it will be hard to pull the entire economy on the basis of anything other than very strong rates of increase. Industrial production was up in October by 0.1% over September, marginal, but at least it wasn't a fall. Unfortunately most of the increase was in the energy sector, with electricity and gas up by 10.3%, mining and quarrying contracted, by 2.1% as did manufacturing, by 1.9%.



Compared to October 2008 industrial output was down by 13.5%, Output in manufacturing fell by 15.8%, in mining and quarrying by 11%, while in electricity and gas output was only down by 2%. Output is now down around 21% since the February 2008 peak.


There is one positive glimmer on the Latvian horizon at the present time, and that is, of course, exports which were up by more than 4.4% (or 31.7 mln lats) when compared with September.



As a result, the surplus in the current account of Latvia's balance of payments reached 10.1% of gross domestic product (or LVL 327.9 million) in the third quarter. The surplus is however rather smaller than in the second quarter, which was 14.2% of GDP.



With export growth exceeding that of imports, the combined goods and services balance was positive for the second consecutive quarter, standing at 0.3% of GDP (or LVL 11.2 million). This effect is more due to services than to goods exports, since the goods trade balance is still in deficit (see chart), so there is still a long road to travel.


The largest third quarter capital inflows registered under the capital and financial account were the result of government borrowing from the IMF-lead support programme. There was some new foreign direct investment in Latvian companies to the amount of LVL 370.2 million, which to some extent offset direct investment outflows. Net external debt shrank by LVL 0.5 billion in nominal terms, but due to the fall in GDP (as I explained earlier) the ratio of net external debt to GDP posted only a tiny drop, reaching 56.4%, and gross external debt to GDP (excluding foreign assets) was up, reaching 145.8%.

So, as I say, a start has been made, even if there is still a long, long road to travel. Internal devaluation is the chosen path of the Latvian people, the best thing I can suggest at this point is to get it moving in earnest (in fact there is some evidence from November producer prices that the rate of price fall is now accelerating), and that Latvia's leaders start to value what they have (that is, export potential) instead of dreaming of what they can no longer have (dynamic domestic consumption driving growth). Living in the past is never a good idea, not even in the sentimental moments of Yuletide. A Merry Xmas to you all!

Latvia's Agony Continues In The Second Quarter - With Little Relief In Sight

Latvia’s economy shrank a revised 18.7 percent in the second quarter of 2009 over a year earlier in what was the second-steepest drop in the entire European Union (worsted only by Lithuania) according to detailed data released by the statistics office yesterday. The contraction, which is now the largest since quarterly records began in 1995, was revised down from a preliminary estimate of a 19.6 percent annual drop. And Latvia's problem can easily be seen in the above charts which show the most recent movement in exports, and quarterly data for constant price imports and exports. The Latvian economy grew driven by domestic consumption and increased borrowing during 2006 and most of 2007, but then the country ran out of extra sources of cash, and so imports slumped, followed by exports as the global economy entered crisis. Now its time to pay back, which means the lines we see in 2006 and 2007 will now need to be repeated, only this time with exports on the top and imports below. Of course, really doing this will only be possible once the global economy recovers. But the key question is, will Latvian export capacity be ready when that critical moment comes, or will Latvia's agony continue, stuck in a horrid "L" shaped "non-recovery"? The most recent data on foreign trade, which saw exports fall and the trade deficit once more widen suggest that the latter danger is far from being a mere theoretical one.

And I am not the only one to be raising it, since according to the latest report out from Nordea Bank, Estonia, Latvia and Lithuania, may well suffer deeper economic contractions than previously estimated as government austerity measures simply serves to sap domestic demand while export growth remains muted.

So well done Nordea! But please permit me to say that this discovery does come as a bit rich from analysts who have persistently remained in denial that the key to Latvia's recovery was a substantial reduction in the price level in order to facilitate exports (on my view better achieved by formal devaluation, but by the express desire of the elected political leaders of the Latvian people now being carried out via a convoluted and painful process known as "internal devlauation").

Still, it is interesting to see mainstream analysts starting to question the current orthodoxy that fiscal prudency will (due to the impact on investor confidence) lead to recovery in Eastern Europe, while here in the West our leaders have just re-affirmed the need to maintain fiscal stimulus, given the fragility of even those earliest signs of recovery.

Indeed the analyst consensus is becoming more and more pessimistic. Danske Bank say the following in their latest Emerging Markets report:

"Worries over Latvia’s public finances continue. Despite aggressive cuts in public spending so far this year, total central government spending in August 2009 was, extraordinarily, exactly the same as in August 2008. This is partly due to spending cuts being offset by increased social spending, and partly to some ministries and agencies awarding their employees big pay increases in June this year before imposing cuts in July as part of the IMF/EU programme. It is still too early to say that everything is fine in the state of Latvia."

In the following monthly report I will examine just what evidence there is for the idea that Latvia's economy has actually bottomed out.

The Fall In GDP Continues


Latvia’s economy shrank an annual 18.7 percent last quarter, following a drop in gross domestic product of 18 percent in the first quarter. The charge downwards was lead by a decrease in private final consumption which fell an annual 23.21% (year on year - see chart). Government final consumption dropped bya mere 6.9%, but expenditure on gross capital formation (which includes the critical investment item) crashed by 38.1% - with construction (which forms part) down 29.5% (see chart below). Goods exports (63.6% of total exports) was down by 19.1% and the export of services by 15.7%. The slump in imports was, of course) even worse with the volume of goods imports (78.8% of total imports) down 39.4%, and the volume of services imports by 38.2%.





But Slows On A Quarterly Basis

Quarter on quarter, however, the rate of contraction did slow slowed substantially, from an 11% rate in the first quarter to a 1.6% rate in the second quarter. But even though the rate of contraction is now much, much slower, the economy is still contracting, so I think it is not quite accurate to say we have hit bottom yet. And hitting bottom is not the same as recovering, since there is unlikely to be any rapid bounce back, and any "recovery" is likely to have an "L" shape with a slight upward slope.

Meanwhile, and hardly surprisingly, during the month Latvia’s credit rating was lowered by Standard & Poor’s, with the long-term foreign currency rating being lowered to BB, two notches below investment grade, from BB+, with a negative outlook. According to S&P's:

“The rating action reflects our view of the political and economic challenges as a result of rapidly contracting nominal and real incomes and the associated pressures on public finances, as the country struggles to improve its growth prospects while maintaining a fixed exchange rate regime.....The outlook for growth beyond that remains highly uncertain, not least due to highly leveraged household balance sheets.”

S&P's estimate that Latvia’s general government debt, which stood at 19 percent of GDP last year, will grow to over 80 percent in 2011, an estime which is broadly in line with current EU Comission forecasts.

The International Monetary Fund also agreed on August 27 to disburse the second installment (of around 200 million euros) of the 1.7 billion-euro credit line approved last December. The decision followed a long period of uncretainty. Latvia’s government is trying to cut spending/or raise revenue by 500 million lati ($1 billion) a year between now and 2012, in a bid to get the budget deficit below 3 percent of GDP as part of an attempt to meet euro adoption criteria.

The IMF said in their statement that the program had been adjusted to reflect:

- a significant increase in the program’s fiscal deficit ceiling in 2009 (up to
13 percent of GDP, compared with 5 percent in the original program) to avoid
measures that would harm the most vulnerable, and

- an allowance of 1
percent of GDP in additional resources for social safety nets.

The statement which Moody's following the IMF decision asserting that Latvia’s Baa3 government bond rating - the lowest investment grade, - was being kept at stable was hardly surprising, although the justification they gave - that the bond issuance was supported by “significant, extraordinary fiscal assistance” from international lenders - surely was significant, and very much to the point. The EU Commission and the IMF are now guaranteeing and in order to do this have effectively assumed sovereign responsibility fo the country (see Appendix below).

Moody's were also a little more optimistic than S&Ps on government debt, since they estimated it would only rise to about 60 percent of gross domestic product in 2010 and fluctuate from about 60 percent to 65 percent over the medium term. I think this is too optimistic, basically for the sort of reasons S&Ps are giving. On the other hand they did also state that a currency devaluation, while not being their central scenario, "was a clear risk, along with additional problems in the banking sector".

Little Sign Of Any Recovery In Main Indicators

If we now come to the future, we have to note there is little hard evidence at this point for any real recovery - nor should we expect to see any. Industrial output is still falling, and was down 1.4 percent in July over June, and 17.7% year-on-year (over July 2008). This compared with a 18.5% annual fall in the previous month.



Latvia's industrial output started falling in February 2008, and has now fallen 22.4% from it peak.



Retail sales were down 1% in July over June, and 29.5% over July 2008.



Retail sales have now been falling since April 2008, and are now 31.18% below their peak.

The Trade Defict Widens in July As Exports Drop Back

Latvia's July trade deficit was 95.2 million Lati up from 67 million Lati in June. This was the first increase since December 2008. Latvian foreign trade turnover came in at 613.3 mln lats in July, down by 3.8% or 24.5 mln lats in current price terms than a month earlier and and down by 41.1% over July last year.

In the January – July 2009 period foreign trade turnover was 4517.6 mln lats – down by 36.1% or 2547.5 mln lats over the same period in 2008.



In July exports were down by 32.6% over July 2008 and imports down 46%. Over January to July exports were down by 27.2% or 705.4 mln lats, while imports were down by 41.2% or 1842.1 mln lats over the same period a year ago.

Unemployment Continues To Rise, And As It Does Bad Loans Pile Up In the Banking Sector

Latvia's unemployment rate hit 17.4% in July according to Eurostat data, and again this was the second highest level in the European Union (after Spain). Naturally with unemployment rising to such levels the number of distressed loans continues to rise and bad debt provisions in the banking sector wnet up again - to 6.6 percent of the total credit portfolio in July from 6.1 percent the month before, according to credit supervisor FKTK.

The FKTK also said in a statement that bank losses by the end of the first seven months had hit 400 million lats ($817.6 million), up from 346.8 million lats at the end of the first half.

Lending was again down, and the total credit portfolio fell by 0.7 percent in July. The level of debts with delayed payments of more than 90 days rose to 13 percent of the credit portfolio from 12 percent at the end of June.

What About The Internal Devaluation, Is It Working?

Well, prices have started falling, and the consumer price level was down in August by 1.0% compared to July. The average prices of goods fell by 1.3%, and of services by 0.4%. But if we compared to August 2008 we find that consumer prices (as measured on the Latvian national index) have incredibly still increased by 1.8% (down admitdely from the 2.5% rate of increase in July), which leads me to ask, given the pain that all of this is evidently causing, are prices still falling too little and too late to do any real good.

The central bank seems to think the process is working, since they point out on their website that the real effective exchange rate of the lat, which is one measure of the price competitiveness of Latvian goods versus those of the country's major trading partners, improved between April and July, marking the first four-month gain since the beginning of 2005. We need to remember howvere that the REER index showed prices developing far faster than trading partners all the way from 2006 through to April 2009 (see comparative chart with Finland below) so there really is a long long way back down to go. And if we look at the chart immmediately below, we will see that while the gap is closing Latvian prices are still in a worse position in August 2009 (as compared to other Eurozone countries) than they were in August 2008 - that is over the last year as a whole the position has even deteriorated.





A similar picture can be found in producer (factory gate) prices, which have only recently moved into negative territory on an annual basis. To get a comparison, German producer prices were down 7.8% year on year in July, while

In fact, while export prices are dropping substantially, import prices are also falling (see chart), and thus the real rate of price correction is still quite small.



I therefore contend that this weeks statement from Unicredit Group Chief Economist Marco Annunziata to the effect that, “For the region as a whole and for Latvia, we have gone through the worst,” is way too premature. Conditions are not improving, and as Moody's suggested pressures in the banking system are still building up. It is an open empirical question at this point whether we have the worst behind us. Even over a longer term horizon it is hard to see the grounds for optimism, since there are certainly no "green sprouts" to be seen on the new babies front, with year on year three month moving average being stuck around the 8% drop level. This depression is going to cast a long shadow over the future of the Latvian people, let's hope for everyone's sake that all those responsible (the government, the IMF, and the EU Commission) are fully aware of their hsitoric responsibilities here.




Appendix: IMF and EU Conditions from the respective Letters of Intent.



According to the letter of intent signed by the Latvian Government, The Central Bank and the IMF, a number of new reporting obligations were agreed to. These include:

* Consolidated central (basic and special budgets), local and general government operations based on the IMF fiscal template
* Detailed information on revenues from EU funds at the general government level, and EU-related spending by the central government, including transfers to local governments for EU-related spending
* Consolidated central and general government bank restructuring operations
* Privatization receipts received by the general government budget (in lats and foreign exchange, and payments in governments bonds)
* Information on debt stocks and flows, domestic and external (concessional and non concessional), by currency, and guarantees issued by the (i) consolidated central, local and general governments and (ii) public enterprises (including the Latvian guarantee agency and
the Rural guarantee fund), including amounts and beneficiaries
* Information on new contingent liabilities, domestic and external, of the consolidated central, local and general governments
* Data on general government arrears, including to suppliers
* Data on operations of extrabudgetary funds
* Data on the stock of the general government system external arrears
* Balance sheet of the BoL, including (at actual exchange rate) (i) data on components of program NIR; (ii) government balances at the BoL, broken into foreign exchange balances—distinguishing various program partner sub-accounts for program financing—and balances in lats.
* Balance sheet of the BoL (in program and actual exchange rates) (i) data on components of program NIR; (ii) government balances at the BoL, broken into foreign exchange balances—distinguishing various program partner sub-accounts for program financing—and balances in lats.
* Consolidated accounts of the commercial banks
* Monetary survey
* Currency operations, including government foreign receipts and payments and breakdown of interbank market operations by currencies (interventions)
* Aggregated data on free collateral—available, unpledged collateral held at the Bank of Latvia
* Daily data with banks’ current accounts, minimum reserve requirements, stock of repos and fx swaps
* Foreign exchange rate data
* Volume of foreign exchange lats trades
* Projections for external payments of the banking sector falling due in the next four quarters, interest and amortization (for medium and long-term loans)
* Projections for external payments of the corporate sector falling due in the next four quarters interest and amortization (for medium and long-term loans)
* The stock of external debt for both public and private sector

The Letter of Intent follows the earlier signing of a Supplementary Memorandum of Understanding between the Latvian government and the European Union. The terms of this understanding contained the following Monitoring and Reporting protocols.


Monitoring fiscal developments

• Monthly revenue and expenditure break-down of social budget, including data on social
benefits' hand-outs (unemployment, family, etc).
• Monthly state basic budget expenditure breakdown per type of expenditure for each
ministry or other relevant budget entity.
• Monthly revenue and expenditure break-down of local governments, including data on
GMI hand-outs and other benefits included in category "other social support".
• Monthly information on debt stocks and flows and guarantees given on new debt,
contracted by the (i) consolidated central, local and general governments and (ii) public
enterprises.
• Monthly data on new contingent liabilities of the consolidated central, local and general
governments.
• Monthly data on state budget loans and PPP projects.
• Monthly information on central government (i.e., ministries and agencies) and state
owned companies' staff and remuneration levels, institution-by-institution, showing last
months'/years' trends.
• Monthly data on general government arrears, including to suppliers.
• Bi-weekly Treasury cash-flow assessment of central government financing needs.


Monitoring financial developments

• Monthly statements of the operations on the special account.
• Monthly report on the amount of mortgage loans converted from EUR to LVL.
• Monthly report on outstanding loans split by currency and detailed to households
(housing, consumer, other) and non-financial corporations (by sector).
• Notify DG ECFIN whenever there is a consultation process with DG COMP related to
financial sector stabilization (i.e., Parex).
• Monthly report on banking sector stabilization measures.

Monitoring structural reforms

• Monthly data on budget allocations to and appropriations of line ministries for financing
of EU Structural funds and Cohesion fund projects (including which programming
period they are related to).
• Monthly data on the amounts disbursed to final beneficiaries for project
implementation, by ministry and by EU Structural funds and Cohesion fund projects
(including which programming period they are related to).
• Monthly data on the amounts spent by state budget financed entities as final
beneficiaries on EU Structural funds and Cohesion fund project implementation, by
ministry and by EU fund (including which programming period they are related to).
• Monthly financial reports on reaching the Structural Funds and Cohesion Fund
expenditure targets by the Managing Authority.
• Quarterly qualitative assessment reports on reaching the Structural Funds and Cohesion
Fund expenditure targets by the Managing Authority.
• Quarterly assessment of policy options taken by the government regarding poverty,
health and pensions.