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Bank of Latvia projects GDP to fall 7.5% in 2020

BC, Riga, 05.06.2020.Print version
The Bank of Latvia has revised its gross domestic product forecast for Latvia in 2020 downward from -6.5% in its March forecasts to -7.5%, informs LETA.

At the same time, the central bank has also lowered inflation projections from 0.5% in March forecasts to 0%.

"In the light of the latest global economic developments, including the implications of the COVID-19 pandemic, the Bank of Latvia has revised its projections for Latvia's GDP growth in 2020 downwards from -6.5% in its March forecasts to -7.5%, and inflation projections from 0.5% in March forecasts to zero%. Economic growth is expected to rebound to 6.7% in 2021, while inflation will edge up to 0.2%," the central bank said.

In 2022, the Bank of Latvia's GDP growth projection is 5% and average annual inflation - 1.3%.

The Bank of Latvia also expects unemployment to amount to 9.6% in 2020 and 10.3% in 2021, and then decrease to 9.6% in 2022.

According to the Bank of Latvia's mild scenario, GDP will fall 6.3% this year, increase 7% in 2021 and increase 6.2% in 2022. Annual inflation is projected at 0.1% this year, 0.4% in 2021 and 1.6% in 2022. The mild scenario also projects Latvia's unemployment to be 9.2% this year, 9.7% next year and 9% in 2022.

According to the central bank's severe scenario, GDP could tumble 13.5% this year, increase 9.7% in 2021 and 4.8% in 2022. Average annual inflation is projected at zero% this year, followed by a 0.3 deflation in 2021 and inflation of 0.8% in 2022. Unemployment projection is 10.6% this year, 11.6% next year and 10.3% in 2022.

The Covid-19 pandemic has had a negative effect on global economic growth. Although the outbreak is past its peak and several countries already have plans for a gradual jump-start of their economies, the uncertainties surrounding the duration and extent of further restrictions to limit the virus spread and the ability of the economies to adjust to the new circumstances remain high.

The Bank of Latvia points out that international institutions project a decrease in the global GDP in 2020. The euro area has also already recorded a drop in economic activity in the first quarter, and the fact that the economic sentiment indicators have fallen to their historical lows signals an even deeper plunge in the second quarter.

According to the Bank of Latvia's assessment the economic environment has deteriorated since the publication of its March forecasts. "The most recent forecasts factor in an extension of the state of emergency until June 9 and a longer duration of the precautionary measures to limit the spread of Covid-19, even though part of the measures are being lifted gradually. A modest result was recorded for Latvia's GDP in the first quarter, industrial confidence indicators deteriorated significantly and the outlook for external demand is also weaker than at the onset of the Covid-19 crisis," explains the central bank.

The Bank of Latvia's updated forecast suggests that the restrictions imposed in the field of services (cancellation of public and private events) and travelling bans have a considerable downward effect on consumption, affected also by falling incomes. The uncertainty surrounding the gravity and duration of the consequences of the Covid-19 pandemic has resulted in a more cautious spending behavior of households; therefore, the fall in consumption is estimated to be deeper than that in disposable income.

Services exports are affected heavily as tourist flows and passenger transportation by air ceased due to the imposed state of emergency restrictions. At the same time, a broad-based weakening of activity in external markets reduces exports of goods.

The central bank points out that investment is expected to shrink significantly in 2020. Despite the favorable effect of the government's decisions to increase public investment, the high degree of uncertainty will act as a limiting factor to new private investment.The government's crisis support measures to businesses and households and the planned public investment to stimulate the economy have pushed the fiscal deficit above 7% of GDP (the cut-off date for fiscal measureincluded in the present forecast is May 25).

The European Commission has relaxed the fiscal deficit rules in this crisis, allowing flexibility in addressing the crisis consequences, to the extent that it does not undermine the sustainability of public finances. At the same time, the government can provide significant support, as, during the present crisis, Latvia is able to borrow in external markets, increasing the government debt to close to 50% of GDP.

Assuming a gradual recovery of the economy as of the second half of 2020, the Bank of Latvia projects a 6.7% GDP growth in 2021. This scenario, however, expects that the recovery of the economic activity, following significant restrictions as well as demand and confidence shocks, will be uneven, failing to reach the levels projected before the crisis over projection horizon, i.e. by 2022 and returning to the pre-crisis level at the end of 2021, with significant differences across sectors.

Data suggest that construction was one of the sectors where growth was affected less in the first quarter. Moreover, the sector will be further underpinned by the government's investment support measures. Demand for basic goods (for example, agricultural products) can be expected to remain more resilient. The need for new IT solutions is also anticipated. These factors could support activity in the above-mentioned sectors.

At the same time, the sub-sectors relating to hospitality services and cultural and entertainment events with large attendances are expected to resume growth only gradually with household caution persisting. The recovery of the transport sector will be additionally hampered by earlier factors, unrelated to the Covid-19 pandemic. Therefore, the growth of those sectors is expected to recover more slowly and undershoot the previous levels longer.

Inflation retreated below zero% in April and May, as a result of both the effect of the oil price dives on fuel and heating prices and more moderate services price developments due to the measures to limit the spread of Covid-19. According to the Bank of Latvia's projections, the annual inflation will linger around zero% in 2020 and 2021 (zero% and 0.2% respectively). The projections have been revised slightly downwards in comparison with the March forecast, as the oil prices remained at low levels longer than expected.

The Bank of Latvia also points out that the restrictive measures to fight the COVID-19 pandemic had an immediate effect on the labor market as businesses were forced to downsize. "The increase of unemployment, however, is expected to be lower than during the previous global financial crisis, as the government provides crisis support to businesses and individuals. Because of the low economic activity, businesses have to consider cost optimization solutions and consequently also the ways of reducing their labor costs. Moreover, labor availability is growing on account of rising unemployment and therefore unlikely to exert an upward pressure on wages even after the economy has started recovering, thereby hindering increase in prices next year as well," said the Bank of Latvia.

The significant Eurosystem's monetary policy support and fiscal policy support provided by governments help to mitigate the economic consequences of the Covid-19 pandemic at the height of the crisis as well as provides a strong economic recovery stimulus after the crisis, the central bank points out.

A substantial additional support is provided by the updated proposal of the European Commission on the next EU long-term budget and the recovery fund that would allow to draw additional financing to stimulate the economies of the member states and improve the future outlook of investors. Under this scenario, a reduced spread of Covid-19 in Europe and easing of the current precautionary measures both domestically and abroad would increase the degree of household optimism and enable a speedier recovery of consumption, depleting precautionary savings built up at the beginning of the crisis unlocking the pent-up demand. "A speedy and successful containment of the Covid-19 pandemic as well as the use of effective support instruments would allow to project a smaller GDP decline in 2020 (6.3%) and a swift economic recovery in the subsequent years in the mild scenario," the Bank of Latvia explained.

At the same time, the baseline scenario of the economic growth forecasts does not include a second wave of the virus spread. Nevertheless, should Covid-19 restart spreading after the social restrictions are gradually lifted and should there be no medical remedy available yet, tight restrictions would need to be renewed and vigorously imposed. According to this severe scenario of the Bank of Latvia, GDP would decrease by 13.5% this year and the economic recovery would also take longer, with no return to the pre-crisis levels seen over the forecast horizon (up to 2022). "Even if the society had already partly adjusted to living in the "new normal" and the economic implications of the restrictions were less significant than at the start of the state of emergency, the elevated uncertainty surrounding the future prospects would cause considerably stronger confidence and demand shocks for economic agents," said the central bank.

According to the Bank of Latvia, more cautious behavior of households and investors would weaken and postpone the recovery of consumption and investment even more, while the affected businesses would have to review their expenses, including labor costs, more considerably. Less investment and higher structural unemployment would also weaken the economic potential in the medium-term.

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