Latvia: Risk Assessment
Country Risk Rating
Business Climate Rating
- Member of the eurozone (2014) and the OECD (2016)
- Domestic financial system dominated by Swedish banks (47% of all assets)
- Efforts to improve the regulation of the offshore financial system
- High level of digitalization
- Russia was a main trading partner as Latvia is a transit point between the EU and Russia (coastline and ports)
- Except for the Baltic states, inadequate land links with the rest of the European Union
- Declining workforce (low birth rate, emigration) and high structural unemployment
- High labor taxation, which hits people on low wages and encourages under-reporting
- Wealth concentrated in the capital, high income inequality
LATVIAN ECONOMIC OUTLOOK DARKENED BY SANCTIONS AGAINST RUSSIA AND BELARUS
In 2022, the war in Ukraine stopped the growth trend of the Latvian economy. Due to geographical proximity, Russia was Latvia's fourth-largest import partner for goods trade and the fifth-largest export partner. Together with the minor 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 the 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 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 substantial price increase, 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 due to lower price pressure than in 2022, the 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 trends via higher expenditures through programs 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. It has hiked its interest rates by 250 basis points to 2.5% for the primary refinancing rate until 2022. More rate hikes are in the pipeline, with interest rates expected to rise to 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 the 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 will likely stay at a reasonable level.
The current account deficit should widen in 2023 to its highest since 2008. The main reason is the higher trade costs 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 trade of services balance surplus is expected to remain relatively high 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 Latvian political landscape upside down. Of the seven parties that entered Parliament, three were entirely 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 war strongly impacted the election in Ukraine and the parties’ position regarding Russia. Hence, the liberal-conservative party of Prime Minister Arturs Krišjānis Kariņš, Jauna Vienotiba (VT – “New Unity”), won the election with 26 out of 100 seats (an increase of 18 seats). Only the national-conservative National Alliance (NA) was voted in out of his former coalition partners with 13 seats (coming fourth).