Friday, December 17, 2010

Emerging Markets Briefer ( Estonia , Latvia , Lithuania )

Estonia Macro Outlook 
• The Estonian recovery has picked up the pace. GDP growth of 5.0% in the Q3 might
point to a strong outcome for the full year. However, domestic demand grew
primarily due to the increase in changes in inventories. Household final consumption
expenditure moved into positive territory as well (+1% y/y) but its contribution to
growth in domestic demand was small, while gross fixed capital formation decreased
further by 10.3% y/y. However, the export growth  accelerated to (24% y/y). It is
clear that economic growth this year, despite expectations of a relatively weak fourth
quarter results would be significantly higher than our estimates in the last Estonian
macro monitor (1.8% y/y).
• Despite the positive outlook, some risks to the economy remain. The acceleration in
the economic recovery is likely to lead to wage and price increases, which would have
a negative impact on the country’s external competitiveness.
• Estonian industrial production (IP) figures continue to confirm an export-based
recovery: in October, IP increased by 37% y/y due to strong export growth – mostly
to the Nordic region.
• As had been broadly expected, high food and energy prices (close to two-year highs)
pushed up inflation in Estonia in November (5.3% y/y). As a result, the average
inflation rate in Estonia will come close to 3% y/y in 2010 and could exceed 4% y/y
in 2011. While part of the increase in inflation will be determined by external factors,
a significant element of inflationary expectations relate to the introduction of the
euro.The continuing growth of consumer prices could impede the recovery of
domestic demand.
• The rate of unemployment declined to 15.5% in Q3. This indicates that the cyclical
part of unemployment is declining together with the acceleration in the recovery and
we expect this trend to continue. However, we note that cyclical unemployment
accounted for a relatively small part of the total level of unemployment and the
majority is structural.  

FX and monetary policy outlook 
• Estonia will become the 17th member of the euro area on 1 January 2011. The
positive decision was made despite the ECB’s concerns that the inflation criterion is
not sustainable.

Risk factors 
• The euro will not solve the structural problems of the Estonian economy. Thus,
further implementation of structural reforms, which would raise productivity, is
essential for sustainable growth outlook.

Latvia Macro outlook 
• Latvia has begun to show more active signs of recovery. GDP growth was very strong
in Q3, increasing by 2.9% y/y. The strong positive upside came mainly from robust
consumption, inventories and strong exports. We do not expect that Latvia has gone
out of a recession this year, but it is clear that the downturn will be less sharp and
growth next year more robust than what we have forecast previously.
• The recovery in Latvian industrial production accelerated in October to 21% y/y (up
from 19% y/y in September). The most notable growth in manufacturing was
recorded in the manufacture of basic pharmaceutical products, and motor vehicles and
trailers. The recovery continues to be determined by the growth of external demand.
• Consumer prices in Latvia accelerated further in November. An upward trend in
consumer prices combined with a weak recovery trend represents an additional risk to
the growth outlook. However, for now at least, we do not expect a continuation of
strong inflationary pressure. We still expect Latvian deflation of 1.1% on average for
2010 and inflation of around 2.3% y/y for 2011.
• Unemployment declined to 18.2% in Q3. We think it is likely to remain around this
level for the remainder of 2010. Latvian labour survey statistics confirm that
unemployment is structural in nature and that the current gap between the skills
demanded and supplied could persist for some time.

FX and monetary policy outlook 
• The Latvian lat (LVL) is pegged to the euro through ERM II and today the situation in
financial market appears to be stable.
• In December 2010, Standard & Poor’s raised the Republic of Latvia’s foreign and
local currencies’ long-term sovereign credit rating to BB+ from BB. The upgrade was
mainly determined by the significant decline in the current account deficit and the
relatively good shape of the country’s public finances.

Risk factors 
• The government has approved a bill on the state budget for 2011. The budget deficit
will be 5.5% of GDP. The government has already approved almost all consolidation
measures accompanying the budget including an increase in VAT rates,
implementation of an excise duty on soft drinks, and some other revenue-raising
measures. Latvian consolidation ambitions are very high, which is leading to a
positive assessment from the rating agencies.

Lithuania Macro outlook 
• Lithuanian quarterly national accounts data is characterised by a significant correction
after the revision of the Q3 GDP data: the GDP growth rate rose from 0.6% to 1.1%
y/y. In Q3, final consumption expenditure continued to decline, albeit at a slower pace
of 1.1% y/y. Gross fixed capital formation grew by 15.0% y/y, exports increased by
14.6% y/y and imports increased by 20.2%  y/y. The latter is not a good trend,
suggesting that the recovery in domestic demand might once again turn the current
account balance to deficit.
• Substantial data revision reduces the reliability of our model forecast. However,
taking into account the recent changes, we believe the economy could expand up to
1% on average in 2010.
• In Lithuania, CPI inflation in November remained stable at 2.7% y/y – the same as in
October. The increase in food products, clothing and footwear prices did have an
impact on inflation in Lithuania, but this was offset by the decline in transport and
service prices. It is obvious that due to weak domestic demand there is no significant
inflationary pressure in the economy. Lithuanian inflation seems to be consistent in
our model and we continue to expect inflation of 1.3% in 2010 and 2.2% on average
in 2011.
• The unemployment rate declined by 0.5 percentage points to 17.8% in Q3. According
to labour survey data, long-term unemployed persons accounted 42.2% of all
unemployed. The fact that long-term unemployment continues to rise is a worrying

FX and monetary policy outlook 
• Lithuania has postponed the official euro target to 2014. However, euro adoption
continues to be the government's primary goal and main exit strategy.
• Lithuania successfully distributed 2 billion litas (EUR579m) in US dollardenominated bonds to international financial markets at an interest rate of 5.125%.

Risk factors 
• The main risk is associated with a planned tightening of fiscal policy. The budget
draft assumes a reduction in budget deficit to 5.8% of GDP in 2011 from a deficit of
8% of GDP expected in 2010. However, the new budget does not include significant
consolidation measures and the major part of additional revenue is expected to come
from the legalization of the shadow economy.
• There is lots of space for improvement and we are seeing indications that some
measures, such as strengthened border security, are already yielding results.
However, a higher tax discipline in the informal labour market might give much
higher results.
Full report: Emerging Markets Briefer ( Estonia , Latvia , Lithuania )

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