Assessment of the Year 2016 and Forecasts for the Year 2017 of the Minister for Finance Dana Reizniece-Ozola 29/12/2016
After a comparatively strong growth in 2015, when the Latvian economy was able to demonstrate a solid stability in light of the shocks of external environment, the economic growth in 2016 slowed down by 1.4% (in the first three quarters of the year). This was largely due to continuously unfavourable situation in the external environment, as well as a slower introduction of the resources of the European Union (EU) funds, in light of the change of the fund planning periods.
The decline in the EU funds inflow reduced the scope of investments, most vividly affecting the construction sector, which face about 20% decrease in the first three quarters of the year. As the Russian cargo transit volumes declined, the cargo volumes in the ports and on railway reduced by more than 10%, also the population income growth slowed down, and the growth in work remuneration was not so steep as over the period of two previous years.
At the same time, the year 2016 again demonstrated the ability of Latvian entrepreneurs to overcome unfavourable external circumstances, and showed number of positive trends, allowing us to expect steeper development rates already in the nearest future. Despite the slow growth rate in the main markets, the processing industry reached 3.9% growth in the first ten months of the year. Similar to previous years, the wood processing sector continued to be one of the main economic growth providers, with strong growth results shown also in the sectors of metalworking and production of construction materials. The production of computers and electronic appliances once again reached the two-digit growth percentage, and, after a protracted slowdown, also the food industry started to show growth trends in the second half of the year.
Even though in 2016 the total exports of Latvian products slightly reduced, it was, nevertheless, largely on account of the reexport reduction and fall in prices of oil products. At the same time, the export of goods produced in Latvia, except for the key reexport groups, grew by almost 3%. Along the product export, which has been demonstrating a satisfactory stability in light of unfavourable external circumstances for several years already, in 2016 we were pleasantly surprised by the service export, which, despite the significant decline in transport sector, managed to reach 2.9% growth in the first ten months of the year.
The main role in this growth was played by the exports of the telecommunication services, as well as computer services and information services, which in the first three quarters has become bigger than half as compared to the year before, while, in total, the sector of information and communication services has grown by 4.9% during this period of time. Along with decline in volume of orders in Latvia, the builders managed to find orders abroad and the export of construction services grew by almost 70% in 2016.
As the role of exports grew, also the lending sector became more active in Latvian economy in 2016, by the volumes of new loans issued for national economy growing almost twice. This, along with the expected steeper introduction of the EU funds, shows that next year the investment volumes may experience a steep growth in Latvia.
Impact of the external environment
Both European and the global total economic growth failed to reach the expectations in 2016. This was triggered by such unexpected political turns as the UK vote for leaving the EU, the uncertainty with respect to the US presidential elections, as well as the slowdown of growth in the developing countries, as the prices for raw material goods continued to fall in the first half of the year. According to the latest economic forecasts of the European Commission (EC) the total economic growth in the EU in 2016 would comprise 1.8%, as compared to 2% forecasted at the end of 2015. And also the global economy in general, instead of the excepted 3.5%, would have grown only by 3% in 2016, constituting the lowest growth rate since the global financial crisis.
In June the UK residents voted for leaving the EU. This, first of all, triggered panic in the financial markets, however only a few days later stock markets launched a steep rise, and even the unexpected outcome of the US presidential elections could not stop it. On the contrary - the USA indices reached new records in December, encouraged by the forecasts of more expanding fiscal policy of the newly elected president of the USA.
The UK referendum and the US presidential elections have also affected the currency markets, with the euro rate facing drop with respect to the US dollar. Expecting a steeper economic development, in December the US Federal Reserves System also carried out the second interest rate increase during the postcrisis period, which made the dollar rate grow even more, and in December the value of euro to the US dollar dropped to the lowest level over the last 14 years. This euro depreciation is favourable for the Latvian exporters to the USA and other countries where the currency is pegged to dollar, but, at the same time, along with the rise in prices of imported goods, it can also increase the inflation rate in the country.
Nevertheless, in general, the impact of both of these political events on the global and Latvian economic development is still not completely clear and is difficult to forecast. Despite the fact that the UK is the sixth largest Latvian export partner with 5.2% share in the general product exports (in 2015), the largest impact of exit from the EU is related not to reduction of the direct trade links, but rather to the uncertainty generated by the vote and its potential adverse effect on the combined growth in Europe. The outcome of the US presidential elections, in turn, gave signal regarding increasing protectionism trends worldwide, which potentially may influence also the Latvian export.
Last year marked harsh fluctuations in the raw materials product markets, as the oil price at the beginning of the year dropped to the lowest level of the last 12 year - under 30 dollars per barrel. Later during the year, the price slightly recovered, as the Brent crude oil price grew to 55 dollars per barrel after the agreement of the Organisation of the Petroleum Exporting Countries Products Exporting Countries (OPEC) with other countries on reducing oil extraction volumes. Despite the fact that the level is still comparatively low, within the context of the last decade, along with the rise in prices of metal and separate food raw materials it will increase the inflation rate in Europe, and it will come closer to the desirable level of slightly under 2% stated by the European Commission.
The tax revenue growth rate in 11 months of 2016 comprised 7.2%, considerably exceeding the GDP growth in actual prices, which, over the period of 9 months of 2016, as compared to the respective period in 2015, has grown by 1.8%.
As compared to the macro data forecasts generated in 2015, the actual data demonstrate lower development rates in 2016 - both lower GDP growth ratio is forecasted, as well as slower work remuneration fund growth and consumption, thus also the tax revenue should be forecasted lower. It is indicatively estimated that by lower corresponding macroeconomic base, the tax revenue is to be reduced by approximately 45-50 million euro.
However, it is forecasted that the total budget revenue in 2016 will exceed that which was planned, and it means that the effectiveness of the operation of the State Revenue Service (SRS) has increased and we should continue working on the implementation of the launched reforms.
Combating grey economy and budget for 2017
By way of continuing the dialogue with the social and cooperation partners and other public administration authorities, the action plan of the measures restricting grey economy is adopted and the fulfilment of the tasks contained therein is launched, thus heading towards the reduction of the grey economy share defined in the Governmental Action Plan. The most important in this plan is that many measures were offered by the sectors themselves.
For example, we managed to find the solution for the grain sector already this year and it has shown its result. Up to now VAT fraud was expressly characteristic to this sector. Having assessed the taxpayers' data from 1 July this year and compared them to the data for the previous period, it can be concluded that the amount of the VAT refund has reduced considerably - by more than 10 million euro.
With the support from the Saeima (Parliament), at least 20 of the measures contained in the plan will be implemented already next year, thus reducing grey economy in the taxometer sector, construction; minimising the VAT fraud risk; establishing more rigid regulation for cash circulation and electronic transactions.
The system in the field of anti-money laundering and counter-terrorism financing has also been enhanced, strengthening the sanctions for the credit institutions for violations in this field. Such sanction system operates on a preventive basis, effectively precluding the credit institutions from engaging into money laundering and terrorist financing.
To arrange the system and prevent the use of the Latvian financial system for criminal purposes, as well as to accelerate the information exchange between the financial market participants and the law enforcement authorities, the legal basis for setting up Account Register has been established, where it is planned to include data on actual beneficiaries in transactions closed in the credit institutions in Latvia. The law will take effect on 1 June 2017. We have also elaborated the system of reporting suspicious and unusual transactions.
Also when forming the budget for 2017, the main vectors were combating grey economy, more effective use of resources, limiting tax optimisation, as well as enhancing the competitiveness and business environment.
Thus, the Government managed to prepare a well-balanced budget, without introducing significant changes in the largest taxes. All tax policy changes are currently discussed and elaborated in close cooperation with the social and cooperation partners of the Government, inter alia, continuing the work on the preparation of the National Tax Policy Strategy for 2017 - 2021, where the existing system of the Latvian tax policy is assessed and the particular courses of action are developed for the tax policy development in the medium term.
On 24 November 2016, the Saeima in the final reading adopted the law on the state budget for 2017 and the law on the medium-term budget framework. Budget priority sectors in 2017 are defence, public safety and order, health, social security and education. As compared to the budget of 2016, the most significant expenditure growth was in the field of defence, where the financing grew by 27.9%, mainly for the purposes of increasing the fighting capacity of the National Armed Forces, provision of military equipment, procurement and recruitment thereof, as well as the re-armament of the Latvian National Guard units, whereas the financing for public order and security grew by 18.2%, mainly for the remuneration reform of the firefighters, rescuers, policemen and border guards.
As compared to the budget of 2016, the growth of financing is also planned in the health sector - by 6.4%, mainly for reducing queues to the out-patient and in-patient services, as well as for improving availability of the specialists. Additionally, in the medium-term the possibility is ensured to implement the deviation from the budget balance target, thus, by 2019, ensuring the possibility to allocate additional resources to the implementation of the health care reforms in the amount of even up to 0.5%.
Financing for education will grow by 2.5%, mainly for introduction of the new work remuneration model for the teachers, whereas for the social security - by 7.5%, mainly for support of the children who lost their provider, as well as for the support of the alternative family care forms.
This year we have established a new process - continuous and systematic revision of the state budget expenditures. The revision of expenditures has two key purposes - to optimise expenditures and to link the financing to the performance indicators. In accordance with the initial results of the revision of expenditures, the Government supported the resource optimisation measures in 2017 and 2018 in the amount of 61.3 million EUR each year. Based on the indicative assessment, during the course of development of the state budget for the year 2017 the line ministries have actually introduced the measures even to a larger extent than offered in the initial results of the revision of expenditures. Henceforth, the budget and function assessment will be carried out on an annual basis.
Additionally, the budget explanations have been considerably enhanced this year. From this year on, the emphasis shifts to the achievable sectoral indicators in each of the policy fields. This way we both make public information about the public gain from the allocated resources, and also promote the responsibility of sectors to ensure effective operation to a maximum extent possible. Linking of the financing to the performance indicators will henceforth serve as the decisive tool for the assessment of effectiveness.
If we compare the state budget of the year 2017 with the state budget of the year 2016, then next year the expenditures will grow by 8.3%, whereas the revenue will grow by 8.4%. The entire growth mentioned herein above will be allocated to the priority sectors. For example, the financing for the national defence will reach 2% of the GDP already in 2018.
This year the government for the first time decided to establish also the fiscal provision reserve for the medium-term. The aim of the reserve is to ensure the planned level of the budget balance, in case of minor macroeconomic fluctuations, and to compensate the increase in expenditures due to fiscal risks, thereby also ensuring the sustainable approach to the medium-term budget planning.
2017 for local governments
In 2017 also the local governments can expect the tax revenue growth. It is forecasted that in 2017, as compared to 2016, the tax revenue in the budgets of the local governments will grow by 6.5% or by 95 million EUR.
2017 will be the first year, when the new financial equalisation principles of the local governments will start operating in full without the transitional period. We see that the conditions incorporated in the law ensure the availability of equal resources to all local governments in Latvia, which the new law was exactly intended for. Nonetheless, another equally significant purpose of the new model is to promote the interest of the local governments to develop economic activities in their territories and encourage the economic growth, because the tax revenue increase also provides the equalised revenue increase for all local governments.
To ensure fiscally responsible attitude towards the liabilities assumed by the local governments and to guarantee the availability of financial resources for implementation of investment projects for each local government, the conditions and purposes of borrowing set for the local governments in 2016 are preserved also for the next year, supplementing them with 3 new objectives (Development of the Technical Design of the Investment Projects, Reconstruction of the Mežaparks Grand Stage, Investment Projects of the Culture Institutions with the Amount of the Actual Co-Financing of the Local Government Budget of at least 40%). In 2017 we abolish the restrictions (purposes) for the local governments to provide sureties regarding the loans of their capital companies.
EU funds in 2016 and 2017
The risk management and fiscal discipline measures taken in 2016 within the scope of the previous planning period (2007 - 2013) give us the confidence regarding the ability of Latvia to fully make use of the Cohesion Policy financing for investments in the interests of Latvia, allowing to invest 4.5 billion EUR of the EU funds allocation in the Latvian economy. This has let us create more than 5 thousand new jobs, train and requalify almost 150 thousand unemployed and job seekers, modernise 27 scientific institutions, provide considerable support to more than 1, 200 companies for provision of growth, increase the energy efficiency of more than 740 apartment houses, build and reconstruct more than 1, 000 km of the roads and 52 km of the rail tracks.
We have also successfully continued to launch the introduction of the new EU funds planning period (2014 - 2020). In 2016, under the management of the Ministry of Finance and in cooperation with the line ministries and social and cooperation partners, the Government managed to approve binding conditions for the investments, which would allow investing 2.7 billion EUR of the EU funds financing. In 2016 alone we have managed to accomplish at least two and a half times more than over the previous two years together.
Likewise, the second half of 2016 already marked the forthcoming and increasingly steeper project selection and project implementation stage. Project contracts are concluded for almost one third of the total EU allocation for the planning period - 4.4 billion EUR. Thus, 2017 should be viewed as the fully-fledged project implementation stage, considerably contributing to the particular sectors and the economic development in general. For the EU funds to be more successfully invested into the Latvian national economy, regular monitoring of the concluded contracts and risk analysis is taking place.
In total, 96 project proposal selections have been announced, in the sum total of more than 3 billion EUR, comprising almost 70% of the EU funds financing allocated to Latvia in this period. The launched programmes cover the entire range of all planned priority sectors - starting from the social and employment facilitation block till the aid to entrepreneurs and scientists. Within the scope of selections, the Central Finance and Contracting Agency (CFCA) has already approved about 200 projects, with the sum total whereof comprising about 1.4 billion EUR. This indicator is dynamically followed by the concluded contracts - 155, in the sum total of more than 1.2 billion EUR. It is also important to note that this year Latvia has reached the third place in the EU, in terms of the received interim payments.
At the same time, we are currently already preparing for negotiations regarding the scope of the EU funds financing available to Latvia after 2020. During the 2007-2013 EU funds planning period, Latvia, as admitted also by the EC, has been one of the success stories on a pan-European scale, allowing the national economy to grow by about additional 5% during this time period from 2007 - 2015. Thus, for Latvia it is essential to also henceforth preserve the Cohesion Policy as the essential component of the EU internal development and convergence, at the same time easing the requirements for the EU funds investments and staying focussed on the solution of the local development needs.
Economic development forecasts
In general, the developments of 2016 in the Latvian and global economy allow us to expect considerably steeper economic growth already by the end of this year and for the entire 2017. Over the last few month, the investing of the EU funds resources has become considerably more active and also other state expenditures have increased, facilitating the combined economic growth. Additional incentive for the economic growth will be the growth of expenditures provided for in the state budget for the year 2017 by approximately 7%, allocating the majority of the increase of the funds to such fields as defence, public order and security, health care and education.
Notwithstanding various political and economic problems, the spirit of entrepreneurs and consumers continue to improve in the EU Member States, providing for good prospects for the Latvian processing industry and exports, the potential whereof has already been confirmed by the results achieved in 2016. Likewise, also the low euro exchange rate may have a positive impact, promoting Latvian exports to the countries outside Eurozone. Even though the European economic development forecasts for the next year are reduced, the situation continue to improve exactly in the main foreign trade partners of Latvia (Lithuania, Estonia, Germany, Russia, Sweden, United Kingdom, Poland), and in 2017 the combined growth of these countries according to the EU forecasts will accelerate to 2.1%, as compared to 1.6% forecasted for this year. Therewith, even though, more recently, global economic instability has not reduced and the external risks for Latvian economic growth are still high, at present we see quite favourable preconditions for the economic development to become much more powerful in 2017.