In the second quarter of 2020, Latvia's GDP growth fell by -9,2% compared to the last quarter of 2019. Private consumption and exports suffered the most, while employment decreased by only 4,2% in part thanks to government-provided cushioning. AND despite the spread of the virus and the containment measures have been milder than in most other EU countries, production and trade in goods remained well below pre-pandemic levels throughout the summer. The European Commission expects a fairly rapid recovery of GDP in the second half of 2020, with an overall drop of -5,5%.
Consumption should strengthen over the next two years, with the use of accumulated savings and the recovery of investments driven by renewed confidence and projects such as Rail Baltica due to start up already at the end of this year. On the other hand, the recovery of exports is slower, despite forecasts for GDP growth of almost 5% in 2021 and 3,5% the following year, excluding additional funding measures and subsidies. The current account deficit is poised to widen due to a deterioration in the trade balance: imports of capital goods and foodstuffs, driven by poorly diversified domestic production, will exceed exports, of which 60% are wood, capital goods , foodstuffs.
Employment is expected to decline about 3% this year and post slight growth in both 2021 and 2022, with construction balancing a struggling services sector. At the same time, the continued decline in labor supply that dominated the labor market before the crisis will be increasingly felt limiting the potential for job growth. Headline inflation is expected to slow this year on weak demand and falling energy prices, with 2021 estimates for food and services prices to rise by 1,5% , while in 2022 inflation should reach close to 2%. However, the recent increase in infection cases could affect the recovery path in the coming quarters, impacting demand and confidence.
Public spending has increased due to the measures in response to the pandemic to the increase in unemployment, with an overall impact of the measures adopted estimated at around 4% of GDP. In this scenario, the public deficit on GDP is expected to increase from 0,6% in 2019 to 7,5% in 2020: the drop in tax revenues, consumption and jobs must be added to the economic crisis and the resulting stimulus measures . In 2021, the public deficit is expected to improve on GDP, as most of the stimulus measures adopted are expected to end. In 2022 the deficit will narrow further, to stabilize at just over 3% of GDP, by virtue of an increase in tax revenues. The public debt/GDP ratio will go from 37% in 2019 to 47,5% in 2020, due to the aforementioned increase in the public deficit and decline in GDP. The debt/GDP ratio is destined to decrease in the following two years, thanks to the economic recovery and the consequent reduction in public spending. Coface points out that the constant decline of the workforce, linked to aging and the emigration of young workers, particularly skilled ones, is leading to a reduction in unemployment and upward pressure on wages.
Combined with subdued inflation, wage increases, thanks to the 13% increase in the minimum wage in 2019, will support household consumption. However, the declining stock of skilled labor is paralyzing productivity growth, thus affecting the country's potential growth: in the period 2009/2016, more than 40% of emigrants were skilled. Public consumption and investment are expected to be less dynamic after the peaks reached in 2018, albeit still supported by EU structural and investment funds, with Latvia receiving €4,79 billion from the 2014/2020 budget. Despite favorable financing conditions, thanks to ECB policy, the growth of loans to the private sector is held back by the large informal sector (over 20% of GDP), by the poor recovery in the event of defaults and by the continuous consolidation of the financial system, which pushes the banks to apply rigorous criteria.
A large number of Latvian banks serve foreign clients, most of them in CIS countries, with a high risk of money laundering. The latest Moneyval report highlighted the inadequacy of Latvian regulations to combat this problem: the third largest bank in the country, ABLV, was liquidated due to allegations of institutionalized money laundering, prompting the government to reform the financial system to make it more transparent and prevent the country from being placed on the FATF gray list. Banks serving foreign customers are thus trying to refocus their activities on the domestic market following the reduction of non-resident deposits.
