Latvian economic outlook darkened by sanctions against Russia and Belarus
In 2022, the war in Ukraine brought a stop to the growth trend of the Latvian economy. Due to the geographical proximity, Russia was the fourth-largest import-partner for goods trade for Latvia and the fifth-largest export partner. Together with the smaller trade partner Belarus, they accounted for 11.5% of all Latvian goods imports and 9.4% of all exports before the war. Current EU sanctions are mainly affecting the machinery sector (representing 16% of Latvia’s exports), which was until recently highly dependent on Russian steel and iron, and has now to rely on other more expensive sources. Problems regarding the supply of input products from Russia that have either been halted by EU or by counter-sanctions also concern the pharmaceutical industry (the turnover of which fell by 30%), as well as agriculture and the wood industry as imports of fertilizers and lumber halved over the summer 2022. The whole economy is highly impacted by high energy prices and uncertainty regarding energy supply as Latvia has constantly reduced its imports from Russia (in mid-2022 it still represented 31% of the Latvian energy consumption). From January 2023, Russian gas supplies will be banned from the country. All companies are suffering from the high level of input prices, as well as from the loss of export markets. Exports to the EU should be lower because of a marked slowdown in Western Europe, although some of this will be balanced out by higher timber exports due to EU sanctions on timber imports from Belarus.
Household consumption will also suffer under the strong increase of prices, which, with around a 2% hike in autumn 2022, reached its highest level since Latvia’s independence. While the inflation rate should decrease in 2023 on the back of lower price pressure than in 2022, progression of the purchasing power will remain low, even if wages are partly adapted to the higher price level at the beginning of 2023. Accordingly, activity in the Latvian economy decreased sharply in autumn 2022 and will probably struggle over the winter and early spring 2023, before mildly recovering. The government should cushion some of the recessive trend via higher expenditures through programmes dealing with high energy prices (EUR 1.06 billion, 3.1% of GDP) between 2022 and late spring of 2023, as well as with the Ukrainian refugees, which reached 35,000, or 2% of the Latvian population. Furthermore, the EU’s Recovery Fund (NextGenerationEU) has reserved EUR 1.8 billion in grants (5.3% of GDP) for Latvia between 2021 and 2026, mainly for infrastructure investments. On the monetary policy side, the ECB is reacting resolutely to high inflation and has already hiked its interest rates by 250 basis points to 2.5% for the main refinancing rate until the end of 2022. More rate hikes are in the pipeline, with interest rates expected to rise to between 3.50% and 4.0% at the end of 2023. In addition, from March 2023, the balance sheet of the ECB will be reduced by EUR 15 billion per month. From the end of Q2, this monthly reduction will be increased. These further restrictive measures will reduce the financial headroom of companies and private households. The second measure will explicitly hurt the construction sector. This will dampen economic recovery in the second half of 2023.
Lower public deficit despite fiscal support
2023 will again be a year with a noticeable deficit, albeit half of what it was last year. One reason is that expenditures in 2023 should be noticeably lower as pandemic-related support payments ended in 2022, while measures aimed at coping with the high price of energy - even added to the financial liquidity to support Ukrainian refugees - are in total lower and, as matters stand, are only planned to remain in force until late spring 2023. The public debt should increase, but is likely to remain at a reasonable level.
The current account deficit should widen in 2023 to its highest level since 2008. The main reason is the higher costs of trade due to the rearrangement of trading flows. This will lead to higher import prices and lower export numbers. While the Latvian tourism sector (10% of GDP before the pandemic) already recovered noticeably in 2022, the surplus in the trade of services balance is not expected to widen further in 2023. Foreign debt has reached 108% of GDP owing to the high current account deficits of the early 2000s.
Latvian party system upset by October 2022 election
The general election in October 2022 turned the political Latvian landscape upside down. From the seven parties that entered Parliament, three were completely new creations, while the party with the highest share of votes in 2018 - the party of the local Russian minority representing 25.4% of the population) - failed to make it into Parliament. The election was strongly impacted by the war in Ukraine and the parties’ position regarding Russia. Hence, the liberal conservative party of Prime Minister Arturs Krišj?nis Kari?š, Jauna Vienotiba (VT – “New Unity”), won the election with 26 out of 100 seats (an increase of 18 seats). Out of his former coalition partners, only the national-conservative National Alliance (NA) were voted in with 13 seats (coming fourth).