Latvia Business Forecast Report Q1 2009

Impending Crisis

The political and economic risks in Latvia have risen substantially since Q408 Latvia Business Forecast Report. The economic outlook for Latvia now looks very bleak indeed, with key macroeconomic indicators already revealing that the slowdown of growth will be both protracted and severe. Indeed, the country's reliance on rapid consumercredit fuelled growth in recent years has resulted in a host of problems including a wide current account deficit and a large external debt pile which pose a threat to macroeconomic stability. We caution that the political and economic situation in Latvia is likely to get a lot worse before it gets better. Furthermore, the Latvian electorate's dissatisfaction with the governing coalition has risen further as the outlook for the economy worsens. Going forward, we are concerned that the government will be reluctant to introduce the harsh but necessary economic policies in a bid to prevent further damage to its popularity ahead of the 2010 parliamentary election.

We are concerned that the worsening outlook for key Latvian macroeconomic indicators poses a risk not only to the country's growth outlook and economic stability, but also to the government's longevity. The risks of a collapse of the coalition government, which is led by Prime Minister Ivars Godmanis's Latvia's First Party/Latvia's Way, before the scheduled 2010 parliamentary election, are now elevated. As such, we have revised our shortterm political risk rating, to 77.7 (with 0 representing high risk and 100 representing no risk) from 84.8. A reduction was seen in three subcomponents of our ratings. 'Social stability' was lowered to 62.5, from 77.5, and 'policy continuity' was downgraded to 85.0, from 95.0. Finally, 'policymaking' dropped to 76.7, from 80.0.

Due to the worsening external environment and the slowdown in domestic demand, we have revised our mediumterm growth forecast for Latvia sharply to the downside. We now project growth to contract by 1.0% and 2.0% in 2008 and 2009, respectively (compared to our previous forecast for an expansion of 1.3% and 1.5% this year and next). This is a substantial reduction from the impressive 10.3% outturn seen in 2007, and indicates the extent of the pressures facing the Latvian economy. BMI's shortterm economic risk rating has fallen to 59.3 (from 62.3), due to the downward revision of the 'growth' subcomponent of our ratings (which fell to 66.7, from 76.6).

Latvia and Belarus completed a 13year process of mapping out their joint border on November 6. Officials from the two countries signed a final demarcation accord in the Latvian capital, Riga, establishing the 141km frontier. The accord was held up in recent years due to bureaucratic issues, rather than any territorial dispute. The preparation over final documents alone took three years to complete, according to General Alexander Arkhipov, the Belarusian joint chairman of the border commission. While we anticipate that the EU will be pleased with Latvia's progress on securing the fareastern border of the EU, Latvia continues to have border disputes with both Lithuania and Russia which need to be addressed.