Country Report Latvia June 2009

Outlook for 2009-10

• The five-party, centre-right government is led by Valdis Dombrovskis. The government is unlikely to survive until the election due in October 2010, and there is still some chance of an early election.
• The budget deficit will widen sharply as the economy contracts. With revenue likely to be below government targets, the Economist Intelligence Unit expects deficits of 8% of GDP in 2009 and 6% of GDP in 2010.
• We forecast that real GDP will contract by 17% in 2009 and by 4% in 2010 as private consumption falls sharply and exports weaken. There is a high risk of a sharper contraction if domestic demand falls by more than expected.
• Average annual inflation is forecast to fall from 15.4% in 2008 to 2.5% in 2009 and -2% in 2010 as sharp rises in commodity and food prices come to an end, and as the economic recession generates deflationary pressures.
• The authorities are committed to keeping the lat within its current narrow band against the euro. However, there is a very high risk of devaluation.
• The current-account deficit is expected to narrow from 12.8% of GDP in 2008 to 2% of GDP in 2009 and 1.5% of GDP in 2010, initially as the fall in domestic demand slashes imports, and later as exports strengthen.

Monthly review

• Cracks are appearing in Latvia's commitment to maintaining the exchange-rate peg. In May Andris Skele, a former prime minister, called for the lat to be devalued, saying that the social costs of fiscal cuts were too high.
• The government has decided to sack the state secretary of the Ministry of Interior, Aldis Lieljuksis, after an investigation began into budgetary mistakes during his previous role as the head of the state police.
• The government continues to work on revisions to the budget for 2009, to be presented in June, including substantial spending cuts. However, the current measures are unlikely to be enough to stabilise the public finances.
• The Bank of Latvia (BoL, the central bank) cut its refinancing rate by 1percentage point, to 4%, in May. It would like to encourage easier credit conditions, but pressure on the exchange rate peg continues to constrain it.
• Real GDP decreased in the first quarter by 18% year on year, according to a preliminary estimate. The rate of manufacturing decline may be decreasing, but retail sales performance continues to worsen, on data from April.
• The current-account balance swung marginally into surplus in the first quarter of 2009, on preliminary monthly data, which is a welcome developmentbut Latvia's balance-of-payments situation still gives cause for concern.

Source: Country Report