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Mysteries Of Peaks And Throughs In Latvia

Economic activity was increasing in Latvia almost 10% per year during 2003-2007 peaking in 2007, contracting in 2009 and slowly growing again in 2011. This peak-through development provides Latvia, a small, open and green Baltic economy, with plenty of free marketing as bloggers around the world ranging from eminent economists to common folk twist and turn this story from a parable of success to a laughing stock depending primarily on what macro-economic policies a particular commentator favours in the current global economic environment (quantitative easing vs fiscal austerity).

This article is not meant to be an analysis of whether post-crisis policies adopted by the government of Latvia of keeping the nominal peg of Latvian Lat (NYSE:LVL) to Euro (opposed by IMF at the time, backed by the European Commission) were successful. This is not because the author is in favour of taking the peg to its logical conclusion of joining the Euro (true to my beliefs my assets are in Latvian Lats (yielding attractive returns), true to the average situation in Latvia, my liabilities are in Euro and, in any case, I already suffered from a material depreciation of EUR against the dollar, as my tuition expenses are in US dollars).

The aim of this article is to provide a brief analysis on an industry level of what at first drove speedy development and then a sharp contraction of economic activity in Latvia. It is left for the reader to conclude whether expansionary domestic policies in Latvia - whether monetary or fiscal - should have been used by the government more actively during the phase of contracting economic activity.

This article looks at Latvia's gross value added data for the period 2003-2011. 2007 was the peak year for annual economic activity and four years around the peak (2003-2006 and 2008-2011) are taken for analysis.

Coming from the business world, I don't take an achieved peak in economic activity as a point towards which economic activity should return naturally. On a micro level, in case a company was overly dependent on one client , one market or one product and that sales channel became effectively closed for the company, it may take a completely different strategy and a set of actions for the company to return to its previous peak level of sales or profits.

The same is true on a macro level for a small, fairly concentrated economy like Latvia's. It is strange when an analyst looks at such an economy from outside and considers it a failure of domestic policies to replace evaporated domestic demand (and much reduced external demand due to the global nature of the crisis) in order for the economy to speedily return to its previous level of economic activity without analyzing the causes of the previously higher economic activity; especially, given that the previous level of domestic demand was the result of increased money supply and poor financial intermediation decisions - market forces and ineffective incentive structures failed in signaling efficient allocation of resources. It is not obvious that an economy operating under such circumstances could speedily return its level of activity to the peak level without further harming the interests of a particular group of population (like savers in case of inflation or future generations in case of additional borrowing).

In 2003 gross value added of Latvia was 5.2 billion LVL (at constant year 2000 prices) (or 9.1 billion USD). In 2007 it reached 7.6 billion LVL and then fell to 6.3 billion LVL in 2009. Figure 1 graphs development of total and sector gross value added of Latvia during 2003-2011.

Had global financial crisis not happen, had former owners of Parex bank sold their bank for a reported 1 billion USD instead of seeking state bailout, had the government of Latvia approved Blackstone led MBO of Lattelecom ... Latvia might have continued on a fine business textbook model 10% development path. However, Latvia peaked in 2007 and by the end of 2009 its economic activity fell to levels recorded in 2005. And by the end of 2012, Latvia is expected to record similar levels of economic activity as in 2006.

Some commentators likened this contraction to the Great Depression. It did feel awkward at the end of 2008 and during 2009 as boutique shops were clearing their stock, repossessed SUVs were traveling back to Germany and ghosts of concrete were lingering over the city. However, this was far from what was experienced in the early 1990's following the collapse of Soviet Union supply chains. And during 2011, Latvia generated 26% more in economic activity at constant prices with smaller workforce than in 2003 (or ca 3% in average annual real growth in value added).

Figure 1: Development of Latvia's Gross Value Added by sectors 2003-2011 (2003 = 100%)

Source: author's calculations on the basis of national accounts data available from Department of Statistics of Latvia at

Decomposing sources of the increase in economic activity, one can see that wholesale and retail trade contributed 30% of increase in gross value added during 2003-2007, followed by construction at 16%, logistics at 12% and operations with real estate at 8%. These four sectors accounted for 67% of the increase in value added during the period; while manufacturing sector contributed just 6% of the increase (one more sector with contribution higher than 5% was business services sector).

When we look at the decline of economic activity by 2010 in comparison with 2007, wholesale and retail trade sector was responsible for 37% of the decline and construction sector for 29%; therefore, just two sectors accounted for 66% of the decline in economic activity.

How do you efficiently boost domestic demand when you are short on natural resources like fish, geothermal energy or awesome landscapes and when demand for your core national resource - wood - drops sharply because of contraction in trading partners' construction volumes, while at the same time not only supply of new external funding necessary to support working capital for companies' operations dries but existing credit lines are called for early repayment.

How economic activity managed to recover? Looking at growth in activity in 2011 from the bottom of 2010, wholesale and retail trade made up 31% of growth and manufacturing made up 27% of growth (or 58% for those two sectors in total). Austerity, internal devaluation, spillover effect of looser monetary policy of Latvia's trading partners.

In order to provide a more detailed picture behind the contributors to growth and decline of economic activity in Latvia we can look at value added created in industry sectors. Such information is available from Department of Statistics of Latvia only for period 2005-2010 but it still provides some interesting insights. [Industry level value added numbers differ slightly from sector value added numbers from national accounts (aka GDP) because of methodology used in compiling the two. Industry level value added represents aggregated individual company data from financial statements, while sector value added in national accounts adds layers of „statistical fog" (inclusion of unreported activity and similar) to come up with economy-wide data.]

Remembering that trade, construction, logistics and real estate operations were the key drivers responsible for 67% of the increase in activity during 2003-2007, what was happening on specific industry levels.

If we look at the trade sector value added (figures 2 and 3), 5 sub-sectors contributed 62% of the increase in value added during 2005-2007 and 5 sub-sectors contributed 48% of the decline in value added during 2008-2009. All of them were consumption / increase in well-being related - from increase in value added in grocery sales (responsible for 27.1% of increase), to DIY sales (19.4%), pharmacy sales (7.4%), repair of cars and sale of apparel (4% each). The single largest sub-sector leading decline in the trade sector was DIY sales.

Figure 2: Main contributors to increase in value added in the trade sector 2005-2007

Figure 3: Main contributors to decline in value added in the trade sector 2008-2009

Source: author's calculations on the basis of national accounts data available from Department of Statistics of Latvia at

In the construction sector, building construction led the increase in value added with 42% contribution during 2005-2007 and the decline with 38% contribution during 2008-2009.

In the logistics sector, freight transportation by roads led value added and decline (58% and 72% respectively), while in the real estate sector - it was renting of real estate sub-sector with 78% and 43% contribution respectively.

A natural question is the funding side of this largely consumption / increase in well-being led growth. And figure 4 provides an illustration on what was happening on the retail funding side during the period of analysis.

Figure 4: Development in retail loans outstanding in Latvia 2003-2011, December 31, 2002 = 100

Source: author's calculation. Data from Financial and Capital Markets Commission

At the end of 2002, retail loans outstanding made up only 6.6% of the peak level of retail loans achieved at the end of IIIQ 2008. Consumers discovered credit and push and pull factors led to retail loans almost doubling every year from 2003 until 2006 - perfect fuel for increase in economic activity. When the magic fuel became scarce, revs were capped.

As mentioned in the beginning, the aim of this article was to provide some light on how expansion and contraction of economic activity in Latvia occurred during 2003-2011. To a large extent it was down to uncontrolled expansion of consumption by largely debt free population funded by growth oriented banks. Abundance of cheap money, poor financial intermediation decisions, quest for speedy convergence in living standards (or bond risk premium rates in case of individual EU/Euro area countries) has been a global phenomenon.

In this light, suggestions from eminent economists that a small open economy with a leveraged domestic consumer, minimal natural resources and a relatively low overall value added output should add additional leverage to stimulate domestic demand might be misguided. On the contrary, de-leveraging should happen through higher write-offs by the lending banks.

Furthermore, migration of domestic workforce in search of demand for their services elsewhere is certainly a poorer alternative to establishing a domestic manufacturing or service center to serve such external demand via exports, however, migrants do not only alleviate existing leverage of the domestic consumer but upon return will also bring back extremely valuable international skills that might slowly work through the economy to create a new breed of entrepreneurs. There is still an exciting life ahead for the rehabilitated Baltic bison.

July 2012

Adomas Navickas, CFA is founder of Vikado Capital, corporate finance firm focusing on Central and Eastern Europe and student at TRIUM Global Executive MBA Class 2014.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.