Latvia Business Forecast Report Q3 2009

Having endured six straight quarters of plummeting growth, preliminary GDP data for the first quarter of 2009 further confirm that Latvia's recession has deepened and that the road to recovery is likely to a long and painful one. Moreover, while we believe that Q209-Q309 will likely mark the bottom of the recession in most economies across emerging Europe, we note that Latvia may already be close to the base of its recession trough given how far the downturn has already run. While it is difficult to conceive of an even deeper recession in Latvia than is currently being experienced, we believe that there are risks of a prolonged period of stagnant growth. In this regard, we believe that a key risk would be the failure of the government to devalue the currency. Should the government remain firm in its resolve to keep the lat pegged, with exporters failing to pick up the slack from weak domestic demand, the economy will struggle to gather momentum going forward.

Though the formation of a new broader coalition government in Latvia (following the collapse of the previous government in February) was intended to bolster public support and strengthen the previous coalition, we believe that the risks to political stability will remain elevated through the medium term. Moreover, we believe that risks will emanate largely from sustained social unrest as unemployment swells, private sector defaults soar and social spending is curbed to prevent the fiscal deficit from ballooning. As such, we have revised down our short-term political risk ratings to 57.9 from 66.5.

Having ballooned to 23.8% of GDP in 2007 and deflating to 10.9% in 2008, Latvia's current account deficit looks more likely to balance in 2009. The latest balance of payments data provided by the Bank of Latvia show the current account posting its first surplus during January-March since the beginning of the central bank's data series in 2000. While monthly deficits may yet emerge at some point during 2009, we have nonetheless revised our forecast to reflect what we believe to be balanced pressures on the current account. As such, we now project a mild current account surplus of 0.4% of GDP, revised from a previous 5.4% deficit forecast.

As domestic demand slumps, capacity utilisation plummets, and deleveraging gathers momentum, Latvian inflation continues to slow and will likely turn deflationary. Our view that disinflation will run into deflation is based largely on the severity of domestic demand destruction. Indeed, alongside the collapse in international trade and deterioration in external demand for Latvian goods, the weakening of domestic demand as lending winds down and actual and perceived job losses rise, will continue to have a significant impact on headline inflation going forward.