In the second quarter of 2020, Latvia’s GDP growth fell by -9.2% compared to the last quarter of 2019. Private consumption and exports suffered the most, while employment fell by only 4.2% partly as a result of government cushioning. And although the spread of the virus and containment measures have been milder than in most other EU countries, production and trade in goods have remained well below pre-pandemic levels throughout the summer. The European Commission expects GDP to recover fairly quickly in the second half of 2020, with an overall decline of -5.5%. Consumption is expected to strengthen over the next two years, with the use of accumulated savings and the resumption of confidence-driven investment and projects such as Rail Baltica starting as early as the end of this year. On the other hand, exports are slower and hold back growth potential, with forecasts of GDP growth of almost 5% in 2021 and 3.5% the following year, excluding further financing measures and subsidies. The current account deficit is poised to increase due to a deterioration in the trade balance: imports of capital goods and foodstuffs, driven by undiversified domestic production, will exceed exports, of which 60% will be wood, capital goods, and foodstuffs.

Employment is expected to decline by around 3% this year and show slight growth in both 2021 and 2022, with construction balancing a struggling services sector. At the same time, the continuing decline in labor supply that dominated the labor market before the crisis will become increasingly felt by limiting the potential for employment growth. Overall inflation is expected to slow this year due to weak demand and falling energy prices, with 2021 estimates showing food and service prices rising by 1.5%, while inflation is expected to reach close to 2% in 2022. However, the recent increase in infection cases could affect the recovery path of the coming quarters, with an impact on demand and confidence.

Public spending has increased due to measures in response to the pandemic rising unemployment, with an overall impact of the measures taken estimated at around 4% of GDP. In this scenario, the government deficit on GDP is expected to increase from 0.6% in 2019 to 7.5% in 2020: the fall in tax revenues, consumption, and jobs must be added to the economic crisis and the consequent stimulus measures. The government deficit on GDP is expected to improve in 2021, as most of the stimulus measures taken are expected to end. In 2022, the deficit will narrow further, to stabilize at just over 3% of GDP, due to an increase in tax revenues. The government debt-to-GDP ratio will rise from 37% in 2019 to 47.5% in 2020, due to the aforementioned increase in the public deficit and a fall in GDP. The debt ratio is set to decline over the next two years, thanks to the economic recovery and the resulting reduction in public spending.

Coface points out that the steady decline in the labor force, linked to the aging and emigration of young workers, especially skilled workers, is leading to a reduction in unemployment and upward pressure on wages. Combined with under-control inflation, wage increases, thanks to a 13% increase in the minimum wage in 2019, will support household consumption. However, the decline in the stock of skilled labor is crippling productivity growth, thus influencing the country’s potential growth: in 2009/2016, more than 40% of migrants were qualified. Public consumption and investment should be less dynamic after the peaks reached in 2018, although always supported by the EU Structural and Investment Funds, with Latvia receiving €4.79 billion from the 2014/2020 budget. Despite favorable financing conditions, thanks to ECB policy, the growth of lending to the private sector is held back by the large informal sector (over 20% of GDP), the poor recovery in the event of defaults, and the continued consolidation of the financial system, which pushes banks to apply strict criteria.

A large number of Latvian banks serve foreign customers, most of them in CIS countries, with a high risk of money laundering. Moneyval‘s latest report highlighted the inadequacy of Latvian regulations to combat this problem: the country’s third-largest bank, ABLV, has been liquidated over allegations of institutionalized money laundering, prompting the government to reform the financial system to make it more transparent and prevent the country from being placed on the FATF‘s grey list. Banks serving foreign customers are thus seeking to redirect their business to the domestic market as a result of the reduction in deposits of non-residents.