The Latvian Economy

Monthly newsletter from Swedbanks Economic Research Department by Lija Stra una No. 1 February 27, 2013

Productive investments are the key for future sustainable growth

Investments have been driving economic growth since 2011. However, after a strong performance in early 2012, growth of gross fixed capital formation slowed markedly in the third quarter despite quite robust economic sentiment. Most likely, investments have been rather weak also in the fourth quarter of 2012. There is still a big potential and need for investment to expand. In 2011, Latvian gross fixed capital formation per inhabitant was only 66% of the EU average in purchasing power terms, while average labour productivity was 62%. To close these gaps and promote sustainable economic growth, more investments are needed, especially in export capacity and public infrastructure. The corporate sector has the means to invest, since balance sheets and profit margins are comfortable. Investments of local nonfinancial corporations are expected to rise gradually, but their growth will be hindered by global uncertainty. General government investment growth is expected to be sluggish although the fiscal stance has improved, the budget deficit (below 2% in 2012) still has to be cut. There are also less EU funds allocated for Latvia (as % of GDP) in 2014-2020. In light of the limited private and public investment, Latvia needs to attract foreign investments to support productivity convergence with developed EU countries. Rates of returns of foreign direct investment (FDI) have risen, thus highlighting opportunities for larger FDI inflows, although competition with other Baltic countries is very tough. An acceleration of structural reforms and adoption of the euro in 2014 might provide another boost for FDI.

Gross fixed capital formation (hereinafter, GFCF) has been the largest contributor to economic growth since the beginning of 2011. However, GFCF growth slowed markedly in the third quarter of 2012, despite economic sentiment's staying robust. It is also likely that investments were relatively weak in the fourth quarter: goods import volumes stagnated, and construction growth picked up only marginally (from 8.3% annually in the third quarter to 9.3% in the fourth). The question is whether this is a temporary pause in investment activity, and whether investments will be able to pick up again during the coming years. Investment dynamics in a small country like Latvia are always volatile. One of the possible explanations for the recent slowdown in investments is that some large projects initiated in previous years have ended. Before undertaking new investments, businesses might want to see the results (i.e., cash flows) from already-completed projects.

Investment annual growth and economic sentiment

80 60 40 20 0 -20 -40 -60 -80 2006 2007 2008 2009 2010 2011 2012 75 65
Source: Reuters, CSBL

Nominal GFCF growth, % Real GFCF growth, % Sentiment index (rs)

125 115 105 95 85

The investment dynamics differ significantly across industries. Large projects notably influenced investment flows in the energy sector. For instance, costs of the second stage of reconstruction of the

Economic Research Department. Swedbank AB. SE-105 34 Stockholm. Phone +46 8 5859 1000. E-mail: ek.sekr@swedbank.com www.swedbank.com Legally responsible publisher: Magnus Alvesson, +46 8 5859 3341. Mrti Kazks, +371 6744 5859. Lija Strauna, +371 6744 5875. Kristilla Skrzkalne, +371 6744 5844.

The Latvian Economy Monthly newsletter from Swedbanks Economic Research Department, continued No. 1 February 27, 2013

Riga cogeneration power plant TEC2 were estimated at EUR 360 million (just below 2% of 2011 GDP); most of this occurred in 2011-2012, boosting investments in the energy sector. Now, the construction of TEC2 is nearly over, causing a substantial fall of nonfinancial investment1 in the sector already in the third quarter of 2012 (but still up by 27% in annual terms in the first nine months). Nonfinancial investments in manufacturing also fell in the third quarter, although this is partly explained by the hike in investments in the respective quarter last year. In the first nine months of 2012, manufacturing investments were still 7% higher than a year ago. The fall in the third quarter is mostly explained by fewer machinery and equipment purchases. Still, dynamics differ across industries decent growth was observed in food, metal, and machinery, but investments declined in wood processing.
Contribution to annual growth of nonfinancial investments (nominal) in manufacturing, pp
100 80 60 40 20 0 -20 -40 -60 -80 1Q 09 1Q 10 1Q 11 1Q 12
Source: CSBL

Manufacturing surveys reveal that insufficient demand remains the main factor limiting production. Only for a negligible part of respondents are financial constraints limiting their production, while a shortage of materials and/or equipment (i.e., need for investments) is mentioned by only 8%.
Factors limiting production in manufacturing, % of respondents
70 60 50 40 30 20 10 0 2006 Demand Financial None Equipment Labour Other

Other Machinery & equipment Building & structures Nonfin. inv. growth, %

2007

2008

2009

2010

2011

2012

2013

Source: Reuters

Is there potential to invest more?

Latvia (as well as other Baltic countries) experienced an investment boom in 2004-2007, following its accession to the EU.
GFCF flows per inhabitant (in purchasing power terms), % of EU-27
140 120 100 80 60 40 20 0
2000 2001 2002 2003

Nonfinancial investment in the third quarter of 2012 fell also in state administration (fewer infrastructure projects) but continued to rise in transport (e.g., developing the rail network and expanding the capacity of main ports). In the first nine months of 2012, investments in these sectors were 8% and 47%, respectively, higher than a year ago. Overall, while business confidence remains surprisingly stable in Latvia, the external environment is still rather uncertain. Even if it is not reflected in the confidence indicators, anecdotal evidence suggests that businesses became more cautious in the second half of last year.
1

Latvia Lithuania Germany Poland

2004 2005 2006 2007 2008

Estonia Sweden Hungary Czech Rep.

2009 2010 2011

Avots: Eurostat

Nonfinancial investment data by the CSBL include only large private and public companies with more than 50 employees. Only nonfinancial investment data are available by industries. Nonfinancial investments accounted for just above a half of GFCF in the first nine months of 2012.
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Investment growth was biased towards the real estate sector. As a result, Latvian GFCF flows per inhabitant in purchasing power terms reached 92% of the EU average in 2007. During the crisis, investments plummeted to 53% in 2010. The recovery is ongoing, but the potential for investment's

The Latvian Economy Monthly newsletter from Swedbanks Economic Research Department, continued No. 1 February 27, 2013

catching up to the EU average is still there (even more so than to the level of Germany or Sweden). For this convergence to occur, Latvia needs to invest more than other countries each year. Taking into account that the productivity level in Latvia is just about 62% of the EU average, such investment growth is also necessary. However, it is of course of the utmost importance what kind of investments are made and by whom. The largest role is obviously that of businesses; e.g., in 2011 investments by nonfinancial corporations made up 67% of total GFCF.
Structure of GFCF flows in Latvia, % of GDP
40 Nonfinancial corp. Government Households Financial corp.

GFCF of nonfinancial corporations, % of GDP

25 20 15 10 5 0 Latvia Lithuania Sweden Hungary Czech Rep.
2000 2001 2002 2003 2004 2005 2006 2007 2008

Estonia EU27 Germany Poland

2009 2010 2011 2012f 2013f 2014f

Source: Eurostat

30

Note: Swedbank forecasts for 2012-2014, assuming constant share of nonfinancial corporations in GFCF.

% of total

20
67%

10
12% 20%

0
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

2011

Overall, as we have argued many times, there is a need for investment in the corporate sector, not least to be able to notably expand the existing export base (exports were 61% of GDP in the first nine months of 2012, compared with 93% in Estonia and 81% Lithuania). Capacity utilisation in some manufacturing sectors is at historically high levels, implying that without investments in production facilities export growth cannot be sustained.
Capacity utilisation in manufacturing, %
85

Source: Eurostat

Household investments constitute only about 12% of GFCF and are mostly in residential real estate. In this newsletter, we limit ourselves to analysing corporate and government investments, since they are more important in promoting productivity growth.

75 65 55 average 2005-2007 45 2008 2009 2010 2011 2012 1Q 13 Metal products Food products Wood products Electrical equipm. Machinery & equipm. Wearing apparel Total manufacturing Source: DG ECFIN

Corporate investments
Business investment is a key driver of productivity and economic growth. Currently, business investments in Latvia as a share of GDP are significantly below the pre-crisis years, despite being higher than in many EU countries. This can partly be explained by the structural changes in the economy that require investments. At the same time, however, a return to pre-crisis years investment levels is not necessary per se. A part of the investments made in the boom years were unproductive (e.g., residential real estate of poor-quality or never-used production facilities). Moreover, the structure of the economy is now different with a larger share of productive and exporting activities.

Companies also have the means to invest, since their financial situation has improved. Balance sheets are in much better shape than a few years ago e.g., the loan-to-deposit ratio of nonfinancial corporations had declined to 2.6 by the end of 2012

See, e.g., latest Swedbank Economic Outlook (January 2012), http://www.swedbank-research.com/english/swedbank_econom ic_outlook/2012/q4/index.csp
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The Latvian Economy Monthly newsletter from Swedbanks Economic Research Department, continued No. 1 February 27, 2013

(i.e., back to the 2005 level) from over 5 in 2009. Profit margins have also risen.
Profit margins of nonfinancial corporations (profit-toturnover ratio), %
8 6 4 2 0 -2 -4 Before taxes After taxes

A major driver of both private and public investment growth remains EU funds. Anecdotal evidence suggests that the majority of investment projects recently done in manufacturing are using EU financing. Agreements have been signed for most of the resources for the 2007-2013 period,3 although there is still uncertainty with respect to EUR 140 million that was assigned for passenger train purchase4). However, only about half of the financing is paid out to final beneficiaries (this should be done by end2015). When businesses finally receive the money for investments already made, they might then think of new projects. A preliminary agreement about EU financing for the 2014-2020 planning period suggests that Latvia will get about 2.6% of GDP per annum from Cohesion Policy instruments a decline from about 3.1% of GDP in the previous planning period. In addition to this allocation, Latvia is able to apply for EU-wide projects. Activity in the first years of the new period is likely to be weaker, while the administrative framework is developed. Yet, EU funds will remain an important driver of investment growth.

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011

Note: quarterly data are less reliable and do not always match annual data that become available later.

Interest rates have gone down, owing to historical lows of the EURIBOR. However, new lending to resident nonfinancial corporations in 2012 was roughly unchanged from last years level (LVL 655 million, or -1%). Partly, this can be explained by the good financial results of businesses, which could invest their own money instead of borrowing it. Companies are cautious about taking on new liabilities interest rates will rise when the situation in the euro area stabilises and it returns to growth. At the same time, rising global competition and local labour market pressures will limit profit margins and, thus, the possibility to invest own resources.
Interest rates on euro loans to nonfinancial corporations (new loans), %
8

1Q 11 2Q 11 3Q 11 4Q 11 1Q 12 2Q 12 3Q 12
Source: CSBL

Government investments
Investments of the general government in Latvia (and other Baltic countries) still remain higher than in the EU on average, even after the fall induced by the crisis. This, however, seems to be common among Central and Eastern European countries and can at least be partly attributed to the necessity to build public infrastructure during the convergence process. The fiscal stance has improved, and 2012 ended with a smaller-than-planned deficit. Investments have increased as well. However, taking into account the gradual movement towards a balanced budget, as well as shrinking EU funds (as % of GDP) in the next planning period, government investments are unlikely to surge.

4
3

0 Jun.10

Loans up to EUR 0.25m Loans EUR 0.25-1m Loans over EUR 1m Dec.10 Jun.11 Dec.11 Jun.12 Dec.12

Source: Bank of Latvia

Note: floating interest rates, up to one-year initial-rate fixation and original maturity of over one year.

Agreements had been signed on 94% of the financing available from the European Regional Development Fund and the Cohesion Fund by the end of 2012. 4 The signed contract between Pasaieru Vilciens (railway carrier) and the Spanish contract producer CAF was deemed to be inconsistent with EC requirements and thus not eligible for pre-approved Cohesion Fund financing. If ongoing negotiations between CAF and Pasaieru Vilciens do not succeed, the government will try to redistribute the planned EU funds to other projects.
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The Latvian Economy Monthly newsletter from Swedbanks Economic Research Department, continued No. 1 February 27, 2013

GFCF of the government, % of GDP

10 8 6 4 2 0 Latvia Lithuania Sweden Hungary Czech Rep. Estonia EU27 Germany Poland

where inflows would raise productivity and create the basis for sustainable employment and economic growth. It is promising, therefore, that FDI inflows recently have increased also in domestic trade and other services sectors. We anticipate FDI to continue to expand, despite the fierce competition in the Baltic Sea region for foreign investors. The rates of returns of FDI in Latvia have been lower than those in Estonia and Lithuania over the past few years. As the economy has recovered from the recession, however, the rates of return have risen and in 2011 exceeded the EU average. The improvement is likely to have continued in 2012. The manufacturing sector is the bright spot in 2011, its rate of return on FDI was 9% in Latvia and Lithuania, and almost 15% in Estonia.5
FDI rate of return (income earned during year t divided by the stock at the end of year t-1)
20% 15% 10% 5% 0% -5% -10% Estonia Latvia Lithuania EU27 2001 2003 2005 2007 2009 2011 3Q 12*

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012f

2013f

Source: Eurostat

Note: Swedbank forecasts for 2012-2014, assuming constant share of the government in GFCF.

Will FDI inflows strengthen?

In a small country with a low saving level, like Latvia, foreign investors are needed to ensure that productivity convergence occurs. The advantages of foreign direct investment (FDI) are: (i) raising companies equity makes it easier also to borrow; (ii) equity financing is more stable than debt financing and, thus, reduces risks of balance of payments volatility; and (iii) possibility to obtain know how and access to foreign markets.
FDI inflows, LVL millions
300 FDI, % of GDP (4Q average) 200 2005-2007 average 9

2014f

-15%

* 4-quarter sum for income

Source: national central banks, Eurostat

100

-100

-200 1Q 09

Other Transport Real estate 1Q 10 1Q 11

Financial interm. Domestic trade Manufacturing 1Q 12

-3

The economic and financial situation in Latvia is improving, and sovereign ratings are being raised. This is creating a favourable environment for more foreign investments, although there is certainly much to be done by the Latvian authorities to further improve the legislative framework and business environment.

-6 2005-07

Source: Bank of Latvia

FDI inflows in Latvia have recovered after the crisis and stayed relatively robust during the last two years in nominal terms. Yet, as a share of GDP, FDI inflows declined somewhat last year. A substantial part of the inflows ended up in the real estate and financial sectors; these are less beneficial for the economy than, say, manufacturing,
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These rates of return obtained from official statistics are likely to be underestimated in Latvia as, due to loopholes in tax administration and weak tax discipline, it is possible that profits are underreported and/or transferred to other countries or tax zones where tax regimes are more favourable.

The Latvian Economy Monthly newsletter from Swedbanks Economic Research Department, continued No. 1 February 27, 2013

Time to invest for future growth!

To boost productivity and promote sustainable economic growth in the medium term, Latvian companies need to invest more. However, taking into account the low savings level in the Latvian economy, it is also crucial to attract more FDI inflows. This is also an opportune time to invest to sustain the hardwon competitiveness gains made in previous years, taking advantage of low interest rates, available EU financing, and good financial situation of corporates.

However, to increase growth potential, investments should be high quality and productive. This could be accomplished by, both in the private and public sectors, expanding research and development activities. Investments in public infrastructure are also vital to improve the business environment and facilitate the expansion of the private sector. The continuation of the authorities ongoing work on the industrial policy framework and on higher and vocational education reform is crucial. It is also of the utmost importance to strengthen the framework for the distribution of EU funds in the new planning period so that it encourages companies to make qualitative investments. Lija Stra una

Swedbank Economic Research Department

Swedbank AB. SE-105 34 Stockholm. Legally responsible publisher Magnus Alvesson, +46 8 5859 3341 Mrti Kazks, +371 6744 5859 Kristilla Skrzkalne, +371 6744 5844 Lija Stra una, +371 6744 5875 Swedbanks monthly newsletter is published as a service to our customers. We believe that we have used reliable sources and methods in the preparation of the analyses reported in this publication. However, we cannot guarantee the accuracy or completeness of the report and cannot be held responsible for any error or omission in the underlying material or its use. Readers are encouraged to base any (investment) decisions on other material as well. Neither Swedbank nor its employees may be held responsible for losses or damages, direct or indirect, owing to any errors or omissions in Swedbanks monthly newsletter.

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