Latvia economic and trade performance 2018

Complete analysis of Latvian economy

Introduction

The Republic of Latvia is a country in the Baltic region with a population of two million people. Since independence from USSR, the country joined the EU and NATO in 2004 and accepted the Euro as a primary currency in 2014. Latvia is a constitutional republic with representative parliamentary democracy in the face of the prime minister, as a head of government, and a multi-party system. The President holds primarily ceremonial role as a Head of State.

According to the World Bank, for the end of 2017, Latvia’s real GDP is worth of 30.2 billion USD, with 4.69% of annual growth (OECD, 2019). The unemployment rate for last 10 years has fallen from 8,9% to 7.7% (CEIC Data,2019) At the same time, the workforce in Latvia, counted as around 900 000 people with Labour Force Participation rate 69.7%, which are able to contribute for GDP P/Capita, which is worth of 15 700 USD. The inflation rate during the last six years was rather close to zero or the desired rate of approximately 2%. In 2017 and 2018, the inflation was higher than the objective; however, such inflation indicator is even beneficial for small and developing country like Latvia.

Latvia Inflation Rate (Statista)

Balance of Payment

Latvia Central bank (Latvijas Banka) is responsible for data collection and analysis of Balance of Payment information. After Latvia independence in 1990, the data started to be collected; however, it took years to achieve the international standards in transparency and accuracy. Latvia’s balance of payment is summarising transactions between Latvia’s residents and the rest of the world. It includes the current account, the capital account and the financial account. Residents are presented as all institutions, counting foreign institutions, registered and operating in the territory of the Republic of Latvia, as well as individuals whose households are located in Latvia and who do not leave Latvia for a period exceeding one year. (Latvijas Banka, 2018) The following table illustrates how current account, including goods and services, primary and secondary income, was changing through years compared in percentage related to the country’s GDP. For the last five years except 2016, Latvia was running a deficit in import and export balance, meaning it was a net borrower to the rest of the world.

Current account

Further investigation is going to illustrate the more in-depth analysis of divisions and significant fragments of balance of payment. In the Current Account 2017, Latvia has a deficit worth of 204 million EUR. At the same time, Latvia exports goods counting 12.4 billion EUR during 2017. The considerable share of that is performed through exporting wood (17%) Electrical machinery, equipment (10%) Machinery including computers (7%).

Regarding services import and export flows, Latvia performed a surplus of 2.24 billion EUR. In total Latvia has exported services for 4.89 billion EUR with high share covered by transport and travel sectors, 2.06 billion and 782 million EUR respectively. A higher amount captured by travel is a consequence of the development of air transport hub in the Baltic area. At the same time, import expenditure of Latvia’s economy in 2017 was equal to 2.64 billion EUR with the most active industries air, road and sea transport and travel.

Through analysing other activities for international trade performed by Latvia, it should be mentioned that financial services also create an added value in export balance. However, for the last three years, the amount of financial services has decreased from 461 to 370 million EUR. That could be explained by the bank crisis, which recently took place in Latvia. Therefore, the amount of imported financial services has increased by 34 % for the same period. (Latvijas Banka, 2018)

Capital Account

A balance of payments section reflecting acquisitions and disposals of non-produced non-financial assets and capital transfers between Latvia’s residents and the rest of the world.

Acquisitions and disposals of non-produced non-financial assets are transactions with assets used for the manufacture of goods and provision of services, but that are not produced themselves, and transactions involving non-produced intangibles (patents, copyright, trademarks, franchise, etc.). Capital transfers are transactions where financial or non-financial assets projected for investment are provided or received without any compensation. Generally, it measures inflow and outflow of public and private international investment activity.

Capital Account (Latvijas Banka, 2018)

Such a diminishing trend in capital account could be explained by bank crises in Latvia driven by a law banning Latvian banks from dealing with shell companies. Such action caused the declining performance of the significant driver of capital account — capital transfers. Capital transfer narrowed from 756 million to 217 million just in four years.

Financial Account

A balance of payments component reflecting financial assets and financial liabilities such as direct investment, portfolio investment, financial derivatives, other investment and reserve assets between Latvia’s residents and the rest of the world. (Latvijas Banka, 2018)

Financial Account (Latvijas Banka, 2018)

In total, the financial account has a volatile performance though previous half of decade. In theDirect Investment, a slight slowdown in equity (excluding reinvested earnings) and a dramatic increase in liabilities to direct investments led to negative indicators. Regarding portfolio investments, it has to be mentioned that Latvia was accumulating a high number of valuable assets like debt securities and MFIs, while at the same covering a considerable share of liabilities. The major part of liabilities was covered during 2015 and 2016, which explains such a high spread of indicators from year to year.

In overall, it could be concluded that Latvia has a strategy to manage its Portfolio Account, and some regulatory tools are implemented to stimulate needed results in other activities that fall under the financial account.

Current account and trade trends

The Latvian market is open and competitive, with foreign trade representing 122.2% of GDP in 2017 (World Bank). The country mainly exports sawn or chipped wood, radio-telephony transmission tools, alcohol products and medicaments; while imports are focused on petroleum oil, cars, radio-telephony transmission tools and medicines. The major trends in international trade of Latvia are based on global political decisions. Due to sanctions on agro-food implemented by the Russian government, Latvia is taking advantage and exporting dairy, meat and seafood preparations to the Russian Federation. According to Worldexports, these sections of exports has increased dramatically over the last years, only in 2017 dairy production hiked up by 52%, while meat and seafood preparations by 30%. However, the contribution into total export balance is not significant; approximately 150 million EUR. However, financial services have slumped, and import part increased dramatically, which was also determined by the world political arena. As it was mentioned in Balance of Payment section, the country has a structural trade deficit (notably due to its energy imports), which stood at 1.3% of GDP in 2017 (computing also the trade in services, World Bank).

Trade composition

Export

As it was mentioned in Current Account, Latvia has exported 12.4 billion EUR (12.8 billion USD) worth of goods in 2017.

  1. Wood: US$2.1 billion (15.5% of total exports)
  2. Electrical machinery, equipment: $1.4 billion (10.4%)
  3. Machinery including computers: $1 billion (7.4%)
  4. Beverages, spirits, vinegar: $872.5 million (6.3%)
  5. Vehicles: $721 million (5.2%)
  6. Mineral fuels including oil: $560.8 million (4%)
  7. Pharmaceuticals: $508.1 million (3.7%)
  8. Iron, steel: $496.5 million (3.6%)
  9. Cereals: $470.4 million (3.4%)
  10. Articles of iron or steel: $439.3 million (3.2%)

Three major export channels create 3.4 billion USD in profits. In order to understand if Latvia has a comparative advantage, there should be dome the analysis of characteristics of each market. Wood sector is based on natural resource capacity of each region. Therefore, any country that exports wood materials are limited within its PPF, and there is no option to increase capacity for obtaining more wood resource, except conquering additional territory.

Moreover, in this industry, there is no technological advantage, as all needed technologies are shared in the global market. Thereby, the only benefit that Latvia has is cheap labour force. However, such an advantage would not affect exporting price. Latvia doesn’t have any valuable comparative advantage in international trade of wood. Other two sectors: electrical machinery and computers are two similar industries. Again, Latvia’s only comparative advantage is the cheap human resource; what in this case could optimise production costs; however, the number of the total labour force is incomparable to other machinery producing countries. This factor does not allow Latvia to compete in pricing on a global arena, while more prominent countries achieve lower pricing strategy through economies of scale.

Imports

On the other hand, Latvia has imported goods and services worth of 16.4 billion USD during 2017. Therefore, the trade balance is negative by 4 billion USD in net imports. The chart represents the trade balance for the last ten years (figures represented in billion EUR)

Trade Balance (OEC, 2018)

Latvia imports goods and services from a high number of industries. The major ones are (Observatory of Economic Complexity, 2018):

  • Machines and supplements (21%) ex. Broadcast equipment (4%)
  • Transportation (12%)
  • Mineral products (12%)
  • Chemical products and medicaments (10%)
  • Food (8,6%)
  • Metals (7,7 %)
  • Plastic and rubber (5,6 %)

Trade destinations

With its 530 km-long Baltic coastlines on the west, Latvia is bordered by Belarus and Russia to the east, by Estonia to the north and by Lithuania to the south. This geographical position permits the country to function as a hub between the two major economic blocks: EU and CIS. However, in response to the EU’s economic sanctions towards Russia in the context of the intervention into Ukraine, a Russian ban on certain EU agro-food goods has been in place since August 2014 and was extended in June 2017 until the end of 2018. This policy harms Latvia’s economy as it had been more closely attached to the Russian market. The volume of trade with Russia now accounts for less than 10% of the total, while the EU has a greater share with nearly 70%. In the meantime, the country is also looking for new prospects beyond Europe, with China and several countries in Central Asia. For 2017, the main partner countries were:

Export Partners 2017 (Statista)
Import Partners 2017 (Statista)

Foreign Direct Investment

Since Latvia joined the EU, the inflow of FDI increased dramatically, achieved its highest numbers in 2018. (LIAA, 2019)

After the world crisis in 2007, the Latvian government has formulated several investment-friendly policies to encourage FDI. Reformation of bureaucratic set up for foreign business, developing transparent, unbiased legal system and entrance into EU, which creates an advantage in legal and trade opportunities.

Several factors are driving the inflows: stable monetary policy, geographical advantage (between EU and CIS) and developed infrastructure. Three primary industries that obtain investments from abroad are financial and insurance (24 %), wholesale and retail (15,8 %), real estate (15,1 %) and manufacturing (11,5 %). The most engaged country that invests in Latvia is Sweden, which contribute 17,5 % from the total of FDI. Sweden was able to fulfil the gap and perform legitimate banking service in Latvia. Afterwards, other Swedish industries entered the Latvian market. Due to the linguistic capabilities of both countries, lower taxes, stable bureaucracy set up and similar business climate Swedish are willing to invest a lot in Latvia. (Business- Sweden, 2018) For example, IKEA recently opened a new store in Riga, in August 2018. The next countries that investing a lot are Russia, which contributes 11,1 % of all FDI stock, Estonia (9,96 %), Netherlands (7,46 %) and Cyprus (7,12 %).
The following chart represents the data in billion EUR.

FDI in Latvia (Investment and Development Agency of Latvia, 2019)

Portfolio investment and reserves

Following chart represents Latvia’s total reserves expressed in billion EUR. It includes monetary gold, currency and deposits, debt securities and other financial instruments. All assets are managed and stored under the central bank of Latvia, not by central government.

Reserve Assets (Latvijas Banka, 2018)

The significant decrease in national reserves is related to the join to the European Union and shift to new currency. Nevertheless, it can recover its reserves and enhance control over fiscal and monetary policies. Latvia’s reserve assets mostly include long-term securities worth of 3,1 billion EUR. Another part is covered by monetary gold (230 million), currency and deposits (50 million) and others (Latvijas Banka, 2018). Such a strategy for saving assets is chosen to minimise risk related to the gold market. All debt instruments are relatively safe and create long- term stability.

Banking crisis

Except for the world financial crisis in 2008, Latvia recently had its banking crisis that affected all major industries. After the global crisis, Latvia managed to become a financial bridge between East and West of Europe. At the same time, Russians that were gaining money from increasing oil prices were interested in keeping money at Latvia’s banks. Latvia has long historical relationships with Russia, and there are no cultural or linguistic barriers; therefore, Latvia was able to perform an excellent banking service for Russian middle and upper class.

However, after the Russian intervention in Crimea and US economic sanctions, there was an in-depth investigation of all banking services provided to Russian citizens. US government found money-laundering and sanctions-busting activities in almost all the biggest Latvia’s banks. ABLV, the third lender in Latvia had to close down, as well as Ilmars Rimsevics — the long-serving central bank governor, had to leave his position. (Financial Times, 2018)

The consequence was that the banking system was discredited and Latvia was asking 7,5 billion EUR from the IMF to sustain the banking system. Such illegitimate conduct made Latvia to rescue all banking industry. Today, Swedish banks are dominating in Latvia and offering their services for residents and non-residents.

Conclusion

Latvia has a lot of advantages like cheap labour force, investment-friendly legislation, simple taxation system, enhanced transportation and logistics with strategic geographical location. Country’s external position is favourable for such a small country and creates a convenient perspective for EU, US and other big players. However, Latvia has a tiny population (working population) and lack of capital.

The country is following the open model and attracting some investments in the technological, industrial sector. However, some industries could be not safe and stable, according to the example of the banking crisis. Overall development of a country that obtained independence in 1991 is impressive and attractive for international trade.

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