After relatively strong growth in 2015, Latvia’s economy managed to demonstrate good resilience against external shocks, demonstrating economic growth of only 1.4% in the first three quarters of 2016. The reason for that was the unfavourable situation in the external environment, slower introduction of EU funds and changing fund-planning periods, as reported by Finance Ministry.
Decline in the inflow of EU funds reduced investment volumes, impacting construction sector the most, which had also experienced a 20% decline in the first three quarters. As Russian cargo transit volumes continued to decline, cargo volumes transshipped by ports and railway also declined by 10%. Residents’ income growth also became slower and wage growth was no longer as rapid as it was in previous years.
At the same time, the ability of Latvian businessmen to overcome complicated external risks was demonstrated again in 2016. It was observed in multiple positive trends that allow experts to predict more rapid development rates for the future. In spite of slow growth in the main markets, processing industry did achieve 3.9% growth in the first ten months. Logging industry remained among the main economic sectors that secured growth. Metalworking and construction material production industries also demonstrated growth. Computer and electronic equipment manufacturing industry demonstrated double-digit growth. Food industry began demonstrating growth in the second half of the year.
Although overall exports of Latvian goods had declined somewhat in 2016, it had been mostly due to the decline of re-exports and oil prices. At the same time, exports of Latvian products, aside from goods from the main re-export categories, had increased by at least 3%. In addition to exports, which have been very stable against external risks for years, a pleasant surprise was provided by exports of services, which, in spite of major decline in transport industry, had managed to achieve 2.9% growth in the first ten months.
Influence from external environment
European and world economies failed to reach their goals this year. It was dictated by unexpected political turns, including Brexit and US presidential elections. According to latest economic estimates of the European Commission, EU’s general economic growth will have been 1.8% in 2016 instead of the 2% previously predicted in 2015. Instead of the predicted 3.5%, the world economy has grown by 3% in 2016, which is the lowest growth rate since the global economic crisis.
British citizens voted in favour of their country leaving the EU in June. This piece of news initially caused panic on financial markets. Several days after the initial shock, however, stock markets began rapid growth. Even the unexpected outcome of the US presidential elections failed to impact it. US indexes had even reached new records in December, which had also contributed to the new US president’s more expansive fiscal policy.
Brexit vote and US presidential elections did have an impact on the currency markets: euro suffered a decline against US dollar. Expecting more rapid economic development, US Federal Reserve system performed the second interest rate rise in the post-crisis period. This stimulated US dollar exchange rate. In December, euro value against US dollar dropped to the lowest level in the past fourteen years. This euro value decline was beneficial for Latvian exports to USA and other countries whose currencies are tied to dollar.
The influence of both of those political events on the world’s and Latvia’s economic development remains unclear and hard to predict. Although Britain is Latvia’s sixth largest export partner with 5.2% proportion of the total export market (2015), the biggest influence from Brexit is related the most to uncertainty and the possible negative influence on Europe’s growth, not direct impact on trade relations, Finance Ministry explains.
Last year was also notable with rapid fluctuations in commodity markets, with oil price dropping to the lowest level in the past twelve years – below USD 30 per barrel. Following an agreement by OPEC in regards to the reduction of oil production, Brent price reached USD 50 per barrel in December.
Tax revenue growth rate was 7.2% in the first 11 months of 2016. It was significantly above GDP growth in actual prices, which had increased by 1.8% in nine months of 2016 when compared with the same period of 2015.
Compared with macro-data predictions of 2015, real data indicates more towards lower development rates in 2016. Experts predict lower GDP growth index, lower job wage growth, lower consumption and lower tax revenue. It is indicatively estimated that with a lower macro-economic base, tax revenue may be reduced by approximately EUR 45-50 million.
It is also predicted that general budget revenue will have exceeded expectations in 2016. This means SRS activities have become more effective and work on the realization of initiated reforms should be continued.
Grey economy combating and 2017 budget
Continuing the dialogue with social and cooperation partners and other state institutions, it has been decided to approve the grey economy limitation plan. Work has commenced on the development of goals listed in the plan to ensure the reduction of grey economy. The most important part of the plan is that most measures were submitted to the plan by different industries.
For example, it was possible to find a solution for the grain industry this year. Efforts have borne fruit. This industry used to suffer from countless cases of VAT fraud.
Saeima’s support has helped initiate efforts to realize at least 20 of the plan’s detailed measures next year. Those efforts are aimed at reducing grey economy in taxi industry and construction sector, as well as reduce VAT fraud risks and increase control over cash money in turnover and transactions in the electronic environment.
The system for the prevention of money laundering and terrorism financing has been improved as well.
To sort out the system and prevent the abuse of Latvia’s financial system for criminal goals and make information exchange more convenient between market participants and law enforcement institutions, a legal basis has been created for the creation of the Accounts Register, which is planned to house information regarding actual beneficiaries in transactions performed using Latvian credit institutions. Appropriate legislative regulations will come into force on 1 July 2017. The system for reporting suspicious and unusual transactions has also been improved.
During the formation of the 2017 budget, the main directions for the budget had been grey economy combating measures, more effective use of resources, limitation of tax optimization and improvement of the competitiveness of the business environment, as explained by the ministry.
The government has succeeded in preparing a balanced budget. No significant changes were added to the biggest taxes. All tax policy changes are currently being discussed and developed in close cooperation with the government’s social and cooperation partners. Work will continue on the State Tax Policy strategy 2017-2021.
Foundation on a new process was laid this year as well. This process is the review of the state budget expenditures. There are two goals for the review – ensure more effective expenditures and better results. In accordance with initial expenditure review results, the government supported measures aimed to make resource use more effective in 2017 and 2018. According to indicative assessment, ministries have introduced initiatives to the 2017 budget worth more than what the budget can afford. Budget and function reviews will be carried out annually from 2017 onward. In addition, it is also important to clarify budget documentation. The focus is put on achievable industry indexes in each political field.
A comparison between the 2016 and 2017 state budgets, next year’s expenditures will have grown by 8.3% next year. Revenue is expected to grow 8.4%. All of the additional funds will be diverted to priority industries. For example, funding for defence will reach 2% of GDP in 2018, Finance Ministry states.
This year, the government decided to form a medium-term fiscal security reserve. The goal of this reserve is to ensure budget balance at the appropriate level in the event of economic fluctuations and in order to compensate the possible rise of expenditures because of fiscal risks, ensuring a better approach for budget planning processes.
2017 for municipalities
2017 will mean tax revenue rise for municipalities. It is predicted that 2017, when compared with 2016, will result in tax revenue growth of 6.5% or EUR 95 million for municipal budgets.
2017 will be the first year when new municipal financial equalization principles will start working without a prior transition period. «We see that conditions listed in the law ensure equal resource availability for all Latvian municipalities. This is the main goal of the new law. However, it is no less important for the law to motivate municipalities to develop businesses in their territories, as well as contribute to economic development, because tax revenue rise ensures equalized revenue growth for all municipalities,» – says Finance Minister Dana Reizniece-Ozola.
EU funds in 2016 and 2017
Risk management and financial discipline contributing measures implemented in 2016 as part of the previous planning period (2007-2013) offer confidence about Latvia’s ability to use the funding offered by the Cohesion polity in the country’s best interest, opening the way for investments of EUR 4.5 billion in the country’s economy. EU funds have already helped create more than five thousand new jobs, train and re-qualify nearly 150,000 unemployed people and job seekers, modernize 27 scientific institutions, offer support to more than 1,200 companies to ensure growth, raise energy efficiency of more than 740 homes, build and reconstruct approximately 1,000 km of roads and 52 km of railway.
Commencement of the new EU fund planning period (2014-2020) has continued successfully. In 2016m the finance ministry and the government’s social and cooperation partners managed to approve conditions for investments worth EUR 2.7 billion from European funds.
The second half of 2016 also stood out with a more transparent selection and realization of projects. Contracts have been signed in relation to one-third of the financing available for the planning period – 4.4 billion. With that, 2017 is viewed as a year rich with different projects. To ensure successful integration of EU finances in Latvia’s national economy, officials regularly perform monitoring and risk assessments.
Preparations have commenced for talks regarding the funding available to Latvia from EU funds after 2020. As confirmed by EC, Latvia was one of the main stories of success in the 2007-2013 planning period. In the period of time between 2007 and 2015, Latvia had secured national economic growth of approximately 5%. Because of that, it is highly important for Latvia to retain Cohesion fund’s policy as an important component of EU’s internal development and convergence, simplifying EU fund investment requirements and maintaining emphasis on local development needs, adds the minister.
Economic development outlooks
Developments in Latvia and elsewhere in the world in 2016 allow for more rapid economic development in 2017. Overall economic development had improved in recent months thanks to EU investments and rise in state expenditures. An additional stimulus for economic development in 2017 will be the expected increase of state budget expenditures by 7% and larger expenditures for areas like defence, public order, healthcare and education, as BNN was informed by the ministry.
In spite of different political and economic problems, the mood of businessmen and consumers in the EU continued to improve, which offers good perspectives for Latvia’s processing industry and exports. Positive influence may be noticed for euro exchange rate, improving Latvia’s exports to countries outside of Eurozone. Although economic growth perspectives for Europe has reduced for next year, the situation in Latvia’s main external trade partner countries (Lithuania, Estonia, Germany, Russia, Sweden, UK and Poland) continued to improve in 2016, and the general growth, according to EC, will speed up to 2.1%. With that, political instability in the world has not reduced lately and external risks for Latvia’s economy remain high. In spite of that, economic development will likely become stronger in 2017, Finance Ministry states.