Latvia Commercial Banking Report Q1 2008: Industry Research Report

Latvia Commercial Banking Report Q1 2008

Published Date: March 2008

Published By: Business Monitor International

Page Count: 32

Order Code: R302-2364

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

Latvia’s overall CBBER, at 55.1, is towards the middle of the countries in Central and Eastern Europethat are surveyed by BMI. This rating is particularly held back by a weak score of 40.0 on the heavilyweighted banking market element of the limits to potential returns. This, in turn, reflects the small scaleof 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 avery strong domestic economy, the country’s integration into the EU and the growing scope for foreignbank activity. This is reflected in the comparatively high scores for each of the non-market structurescores, 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 alsoconsiderably higher than banking market component (64.6 versus 40.0) and the country risk rating ofthe 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 ahardening 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 byenough 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 arecertainly evident. The annual rate of consumer price inflation accelerated to 10.4% in Q307 from 8.6% inQ2; producer price inflation was 16.7%; while labour costs almost certainly outpaced productivity gainsas job market slack continued to diminish. The current account deficit also suggests that the external gaphas remained at unsustainably high levels in the period since, leaving Latvia potentially exposed to aglobal credit crunch. Steering the economy away from its overheated path and delivering a moremanageable rate of real income convergence with its wealthier EU peers hinges to some extent on thesuccess of two policy initiatives: the anti-inflation plan adopted by the government in March 2007 withthe aim of dampening domestic demand; and a longer-term national stabilisation plan, which is currentlybeing finalised and will focus on structural and supply-side reforms.

Policy efforts to contain demand pressures should work with emerging cyclical constraints to drive realGDP 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 thegovernment and believe it has to be if the positive output gap and other macroeconomic imbalances are tobe reduced significantly. We forecast a deceleration in real GDP growth from 10.2% in 2007 to 6.6% in2008 and to 5.2-5.3% in 2009 and 2010 as domestic demand moderates and activity returns to moresustainable levels.

The first batches of anti-inflation measures were implemented in June and July 2007 and were thereforeunlikely to have a significant effect on GDP before Q407. The initial focus was on curbing consumerborrowing and cooling the real estate market. Interest rates are rising and credit procedures have becomestricter. 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 offalling property prices and quickly rising building costs - up by 24% year-on-year (y-o-y) in Q307 - willsoon begin to weigh on activity, particularly in the more speculative segments of the new constructionsmarket. We expect net exports to take up some of the slack created by the projected slowdown indomestic demand growth in 2008-2010. Export performance has been reasonably good in 2007. On thedownside, international competitiveness is under threat from rising production costs, particularly forlabour. Hence, the longer the consumption boom continues, the weaker the likely supply response fromexporters when domestic demand eventually falters, and therefore the harder the landing.

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