BMI's Executive Summary

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From Q108 we will be calculating the Commercial Banking Business Environment Rating (CBBER) for each of the countries surveyed by BMI. This will permit a more systematic and comprehensive comparison of the conditions within the banking industries of the various countries than was possible in the past. For each country, it will also facilitate a comparison of the conditions within the banking sector and conditions prevailing in other sectors.

Latvia's overall CBBER, at 55.1, is towards the middle of the countries in Central and Eastern Europe that are surveyed by BMI. This rating is particularly held back by a weak score of 40.0 on the heavily weighted banking market element of the limits to potential returns. This, in turn, reflects the small scale of the Latvian economy and thus of the domestic deposit base available to the banking system. Nonetheless, the Latvian banking system presents considerable opportunities for development due to a very strong domestic economy, the country's integration into the EU and the growing scope for foreign bank activity. This is reflected in the comparatively high scores for each of the non-market structure scores, in particular the banking market structure component of the risks to the realisation of returns, which is much higher at 76.7. The country structure component of the limits to potential returns is also considerably higher than banking market component (64.6 versus 40.0) and the country risk rating of the risk to realisation of returns is also higher than the banking market component, at 61.4.

Government efforts to restrain domestic demand coupled with a tightening of financial conditions and a hardening of supply-side constraints should begin to weigh on domestic demand growth going into 2008. But a soft landing is not a sure thing. The economy is likely to slow going into 2008, but probably not by enough to fully assuage fears that it could be headed for a hard landing and a prolonged downturn.

The government is no longer complacent about the economy, as the symptoms of overheating are certainly evident. The annual rate of consumer price inflation accelerated to 10.4% in Q307 from 8.6% in Q2; producer price inflation was 16.7%; while labour costs almost certainly outpaced productivity gains as job market slack continued to diminish. The current account deficit also suggests that the external gap has remained at unsustainably high levels in the period since, leaving Latvia potentially exposed to a global credit crunch. Steering the economy away from its overheated path and delivering a more manageable rate of real income convergence with its wealthier EU peers hinges to some extent on the success of two policy initiatives: the anti-inflation plan adopted by the government in March 2007 with the aim of dampening domestic demand; and a longer-term national stabilisation plan, which is currently being finalised and will focus on structural and supply-side reforms.

Policy efforts to contain demand pressures should work with emerging cyclical constraints to drive real GDP growth progressively lower in 2008-2009, though a soft landing, which still forms part of BMI'score scenario, is far from assured. We expect the slowdown to be deeper than envisaged by the government and believe it has to be if the positive output gap and other macroeconomic imbalances are to be reduced significantly. We forecast a deceleration in real GDP growth from 10.2% in 2007 to 6.6% in 2008 and to 5.2-5.3% in 2009 and 2010 as domestic demand moderates and activity returns to more sustainable levels.

The first batches of anti-inflation measures were implemented in June and July 2007 and were therefore unlikely to have a significant effect on GDP before Q407. The initial focus was on curbing consumer borrowing and cooling the real estate market. Interest rates are rising and credit procedures have become stricter. In addition, the flow of foreign funds to banks for on-lending domestically is also likely to slow. Property prices have begun to decline from the bubbly levels reached in late 2006. The combination of falling property prices and quickly rising building costs – up by 24% year-on-year (y-o-y) in Q307 – will soon begin to weigh on activity, particularly in the more speculative segments of the new constructions market. We expect net exports to take up some of the slack created by the projected slowdown in domestic demand growth in 2008-2010. Export performance has been reasonably good in 2007. On the downside, international competitiveness is under threat from rising production costs, particularly for labour. Hence, the longer the consumption boom continues, the weaker the likely supply response from exporters when domestic demand eventually falters, and therefore the harder the landing.