OECD Economic Outlook, Volume 2022 Issue 2

Latvia

Economic growth will slow to 2.3% in 2022 and -0.2% in 2023, before rebounding to 2.3% in 2024. The negative confidence shock that followed Russia’s invasion of Ukraine as well as very high and broad-based inflation are weighing on private consumption. Business investment will continue to slow due to high uncertainty and worsening financial conditions, while high energy prices and lower external demand weigh on industrial production. Inflation will reach 17% in 2022 in year average terms and decline only gradually, to 10.7% in 2023 and 5% in 2024.

Fiscal policy will become less supportive as most pandemic-related spending is phased out. Support measures to mitigate the impact of higher energy prices should be better targeted to limit additional inflationary pressure on non-energy components and incentivise energy savings. Creating fiscal space to increase public investment in energy security and support structural change is key. Active labour market policies should be expanded to reduce skill mismatches and facilitate job reallocation.

The economy is slowing due to high inflation and uncertainty

GDP declined by 1.7% (seasonally adjusted quarterly rate) in the third quarter of 2022. Business confidence has fallen since Russia’s war of aggression against Ukraine began. Consumer price inflation reached 21.8% in October, mainly driven by energy and food prices, whose share in the consumption basket is considerably higher than in the euro area. Nonetheless, electricity tariffs fell in October as a price cap was introduced. Inflation has become broad-based: prices of about 70% of the CPI basket rose by more than 4% in September. The unemployment rate declined in the first half of 2022 but remained unchanged in the third quarter while the vacancy rate remained elevated, reflecting skills mismatches.

Latvia

1. Headline inflation refers to the harmonised index of consumer prices, core inflation refers to the harmonised index of consumer prices excluding food, energy, alcohol and tobacco, energy inflation refers to the harmonised index of consumer prices of energy goods, producer prices refer to the producer prices index for all industry.

Source: OECD Prices database; and Statistical Central Bureau of Latvia.

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Latvia: Demand, output and prices

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Latvia has been particularly vulnerable to the war in Ukraine because of its high dependence on imported Russian oil and gas. Russia provided almost 100% of Latvia’s gas needs, although the reliance on Russia in total energy supply was much smaller (about 26%). As Latvia has secured enough gas reserves to satisfy demand over the 2022/2023 winter by switching to other energy sources and relying on imported liquefied gas, economic activity should not be hindered by gas rationing. Exports of goods to Russia, Belarus and Ukraine accounted for 9.8% of Latvia’s exports in 2021. This share has declined to about 7.6% on average since March 2022. At the same time, the total value of exports increased by 30%, reflecting a successful reorientation of trade to other countries.

Fiscal policy is tightening

Fiscal policy will be contractionary due to the phasing-out of substantial COVID-19 support measures, declining from 6.9% of GDP in 2021 to 3.7% in 2022 and 0.8% in 2023. The government has introduced new measures to shield households and firms from rising electricity and heating prices, including non-targeted price-caps, transfers to pensioners and low-income families and grants to energy-intensive firms. These are expected to amount to about 2% of GDP and to be partially phased out in 2024. The government has also provided crucial support to the more than 30 000 Ukrainian refugees (1.7% of Latvia’s population) who entered Latvia since the beginning of the crisis. Defence spending will rise from 2.2% of GDP in 2022 to 2.5% by 2025. Latvia will receive about 6.7% of its 2020 GDP in grants from the Next Generation EU fund by 2026, one-third of which is expected to be spent in 2023 and 2024.

Economic growth will slow while inflation remains high

High inflation and uncertainty will reduce private consumption, especially during the forthcoming winter due to higher utility bills. Exports will decline in 2023 due to weak external demand. EU-funded investments will expand and support medium-term growth, but high uncertainty, increasing interest rates and rising construction costs due to labour and material shortages will weigh on private investment. Inflation will remain elevated as high producer prices are passed on to consumers. Nonetheless, price pressures are expected to ease in 2023 as oil, gas, and food prices stabilise and ECB monetary policy tightening takes effect. The minimum wage (earned by 17% of Latvian employees) is set to increase by 24% in 2023 and 13% in 2024. Overall, nominal wages are expected to grow more moderately than inflation over 2022 and 2023, as automatic indexation is not widespread, but will exceed inflation in 2024. This and phasing out the energy price caps will keep inflation above target in 2024. Despite the slowdown in growth, the fiscal balance is projected to strengthen by about 2.4 percentage points of GDP in 2023. There is a risk that high inflation could become entrenched due to further energy market disruptions and increasing labour shortages. Upside risks include a swifter-than-expected use of EU recovery funds and fast integration of Ukrainian refugees into the labour market.

Investing in energy security and addressing labour shortages

Fiscal policy measures should target vulnerable households and maintain price incentives to shift towards low-carbon energy sources. Accelerating investment in renewables and completing the integration of regional power and gas markets are key to raise energy security. This will also require tackling rising labour shortages. Facilitating the recognition of qualifications would promote the labour market integration of refugees. Supplying more affordable housing and improving public transport services would help to improve labour mobility. Providing tertiary students with greater financial support and improving access to, and the quality of, training (including through establishing training funds) would boost productivity and ease labour shortages.