Arvils Ašeradens: During budget preparation it is evident that, compared to the EU average, the Latvian economy is handling external shocks quite well and is ready for growth

The surprisingly good ability of the Latvian economy to adapt to external shocks provides a good basis for adopting a budget that contributes to the sustainable development of the country.

As a rule, autumn is the most visible stage in the preparation of the State budget, with budget priorities being set and the budget portfolio being taken to the Saeima (Parliament) where it is reviewed, discussed, and where voting takes place. Primarily, the medium-term budgetary framework is being set up, determining the resources available for the medium term and their allocation in line with the priorities agreed the government. Each year, the government determines the total amount allowable for public expenditure and the breakdown of the State budget allocation by various areas and activities in the annual State budget, observing a medium-term “framework”. In fact, the State budget reflects Latvia’s fiscal policy, and also contains the government’s assessment of economic development processes in Latvia.

Detailed State budget planning for the next year starts in summer with the Ministry of Finance preparing assessment of the economy to update the forecasts of macroeconomic indicators and general government budget for the medium term, the Stability Programme of Latvia and the Draft Budgetary Plan of the General Government of Latvia.

In short, the Latvian economy has overcome the problems caused by the war and the rise in energy prices better than expected both last year and in the first half of this year. Global markets have experienced a significant fall in energy prices, but economic growth rates in Europe are still significantly lower than last year, with manufacturing industry demand falling and exports declining. Overall, Latvia has to face a mixed economic outlook: households and businesses will continue to feel the effects of inflation and the interest rate hikes by ECB to contain it, but along with reducing the impact of inflation, economic growth will concurrently resume; the volumes of investments and construction production already recovered sharply earlier this year. Experts expect inflation to stabilise at the level of 2.2% in 2024, unemployment to decline further, and wages to keep rising. However, prudence is required at this time and the economic growth forecasts for Latvia, as updated in June, are as follows: economic growth is expected to accelerate to a moderate 2.5% in 2024, while in the next two years – 2025 and 2026 – economic growth is forecast to achieve 2.9%. 

The overarching goal defined by the President of Latvia is to ensure sustainable growth of the Latvian economy and a consistent increase in welfare by 2030, to achieve the European Union (EU) average level of welfare, inter alia, with a special focus on education and science, attraction of investments and reduction of regional and economic disparities. To achieve this goal, Latvian economic growth must exceed at least 5% annually over the period until 2030.

In the middle of August, the government reviewed the status reports prepared by the Ministry of Finance on the annual State budget and the medium-term budgetary framework preparation cycle. The reports form a basis for both further works on the State budget and for the discussions of the new government on the economic policy and budgetary priorities.

Budgeting is a complex process involving several parties

Macroeconomic indicator forecasts developed for the preparation of the draft of the next year’s State budget outline the developments with no policy change, while factoring in all the known external factors. The medium-term macroeconomic development scenarios are developed in close cooperation with international partners – the International Monetary Fund and the European Commission (EC) – as well as local experts from the Bank of Latvia and the Ministry of Economics. The Fiscal Discipline Council, an independent collegial body supervising compliance with fiscal discipline conditions, approves macroeconomic indicator forecasts, while the Bank of Latvia and the Ministry of Economics give consent.

Based on updated macroeconomic and fiscal indicator forecasts, the Ministry of Finance, in accordance with the national and the EU fiscal discipline legal framework, sets medium-term balance objectives to be observed during budget preparation. The funds available for funding new priorities – the so-called fiscal space – are also determined. The next year’s and medium-term framework priorities and the funding allocated thereto (fiscal space distribution) are agreed upon by the Cabinet.

The prepared draft of the next year’s budget must be sent to the EC by 15 October each year, which reviews it and provides its assessment. In case material violations of the EU rules on fiscal discipline regulations to identified, the budget plan would be rejected and would have to be submitted repeatedly.

The opinion of the EC is binding on the national parliaments, when adopting the State budget in its final reading. In turn, if the draft State budget is not developed by 15 October, for example, in the situation where the country is holding elections, the budget plan to be submitted reflects the decisions applicable at the time. Once the new government has developed the draft State budget, it resubmits it to the EC.

Macroeconomic forecasts attest to economic resilience and mark the potential for development

The preparation of the State budget for 2024 is based on the macroeconomic indicator forecasts for 2023-2026, as updated in June. By linking tax revenue to macroeconomic indicators, it is possible to prepare tax revenue forecasts that are consistent with economic development, at the same time recognising that under the circumstances of high uncertainty, deviations are observed in both the forecast macroeconomic scenario and the forecast revenue.

Key macroeconomic indicators and forecasts:

General budget tax revenue and forecasts (MEUR)

* Medium-term budget framework forecasts for 2024-2026 at no policy change scenario

Gross domestic product (GDP) is the main indicator of the economic development of the country, and Latvia’s GDP growth forecast for 2023 was raised to 1% in June. In line with Latvia’s GDP growth by 1.4% forecast by the EC in spring, a small yet noticeable growth is observed. The EC forecasts for Latvia provide for a slightly higher economic growth, as they were prepared when the available macroeconomic indicators were more positive. Given the prevailing external uncertainty, the Ministry of Finance is using conservative forecasts.

The main driver of growth this year will be domestic demand, mainly investments, including a considerably faster investment of EU funds, which will bring about EUR 1.2 billion to the Latvian economy this year, as well as a relatively stable level of private consumption. In the baseline scenario for the coming years, economic growth is expected to accelerate to 2.5% in 2024 and even to 2.9% in the following two years, 2025 and 2026.

On 11 September, the EC published its latest forecasts, reducing the Eurozone economic growth for 2023 by 0.3 percentage points to 0.8%. The growth forecast has also been lowered for the next year – by 0.3 percentage points to 1.3%. The next EC forecasts, which will also include Latvia, are expected in autumn this year, while the Ministry of Finance will update its macroeconomic forecasts in February 2024, when it prepares Latvia’s Stability Programme for 2024-2026.

The latest data show that EU economic growth has stalled in the second quarter of this year, after the constant increase over the period of two years before that. According to the EC economic forecasts, economic decline is expected in significant export markets of Latvia such as Estonia, Sweden and Germany. In other major market outlets, such as Poland and Lithuania, the economic upturn will decelerate this year, adversely affecting Latvia’s export development. In 2023, export to GDP will be about 63%, and the acceleration in export growth forecast by the Ministry of Finance this summer is around 4%, which brings us closer to our medium-term objective – export to GDP ratio of 85%.

In view of the potential negative risks, the Ministry of Finance is also developing a pessimistic economic scenario in the summer, which is included in the status report. According to this scenario, GDP at constant prices could decline by 0.4% in 2023 and increase by only 0.3% in 2024. More stable growth, in turn, would only resume in 2026. At present the implementation of this scenario is not forecast.

Inflation is also an important indicator, describing the process of price increase, and it is measured as the change in the average level of prices in percentage over a certain period of time. Based on the latest data, inflation is now receding, with annual inflation comprising 5.4% in August – the lowest level since October 2021.  It should be noted that this reduction follows a period of historically very high inflation, when, under the influence of the war initiated by Putin, the two-year cumulative inflation exceeded 30% and significantly decreased the purchasing power of households. Average inflation is projected to decrease to 3% at the end of the year and to comprise 10% in 2023. In 2024, in turn, inflation of 2.2% is projected, with the price increase being projected correspondingly at 2.5% and 2.3% for the next two years. The purchasing power of households is expected to return to the level of 2021 in 2025, meaning that the government has to pay particular attention to ensure targeted support to the vulnerable population in 2024 and 2025.

Latvia should aim to achieve and maintain an investment-to-GDP ratio of 25-27% in the medium term. According to the MoF’s forecasts, investments will be one of the main drivers of economic development this year, rising to 22.5% thanks to more active inflows of EU funds and the implementation of large-scale infrastructure projects. This will also ensure a significant multiplier for private investments, which should be strongly encouraged overall.

In 2022, Latvia’s productivity was 73.8% of the EU average. Sectors outperforming the government’s goal, namely, 85% of the EU average, are those of the non-manufacturing industry (electricity, gas, water and heat supply, as well as mining), information and communication services, financial and insurance services, and real estate activities. The largest productivity gap compared to the goal is observed in services related to arts and entertainment, as well as in construction and public services. The level of productivity of the manufacturing industry is 74.5% of the EU average.

Several macroeconomic indicators are linked to the labour market – wages, unemployment and employment. Overall, labour market indicators show no signs of a slowdown: unemployment continues to fall, and wages continue to rise following the increase of the minimum wage. The unemployment rate forecast for 2023 is 6.5%, remaining at this level for the next three years as well. The total wage growth forecast for 2023 is 11%, while the wage growth forecast for 2024 is 7.5%. The wage growth rate is expected to become slightly slower in the coming years, getting closer to the productivity growth rate and stabilising at 5%.

Even though the total employed workforce in the national economy will remain stable this year and the year to come, starting from 2025, a decline in total workforce is expected, mainly determined by the decrease in the number of working age population. This indicator requires special attention, as we are rapidly approaching the moment of losing the balance between the working population of Latvia and those who must be supported by this working population. The optimal number of employed in Latvia would be around 900,000. This is why the focus of the new government is on attracting and retraining the labour force as well as the development of human capital.

Public finance forecasts are stable; the new government should make use of the growth potential of the country

The macroeconomic forecasts are still being made against a background of very high uncertainty and demonstrate the economic development of the country under the circumstances of a constant policy and current geopolitical situation. The main negative risks are related to the geopolitical situation, unexpectedly sharp deterioration of the economic situation in the Eurozone, as well as possible sharp fluctuations in energy prices and the limited availability of these resources. Economic growth can also be adversely affected by delays in EU fund investments and a decline in external competitiveness.

In the middle of August, the previous government reviewed the macroeconomic forecast and the budget framework at a constant policy. Currently, at the stage of preparation of the State budget, it is planned that the State budget for 2024 would comprise about EUR 15.5 billion, being EUR 1.1 billion more than the plan year end  2023. This includes the already planned increase of the base expenditure of the budget, for example the already planned increase of the minimum wage to EUR 700 in 2024, the increase of teachers` wages, but it does not include the fiscal space (that is the amount of funds the government can allocate to implement political priorities). The fiscal space available for 2024 comprises EUR 148 million.

Based on the expert assessment, the general government budget deficit will comprise 2.7% of GDP this year, and a lower deficit, at a constant policy, is also forecast over the entire medium term: 2.2% of GDP in 2024, 1.3% of GDP in 2025 and a surplus of 0.1% of GDP in 2026. According to the Treasury, over the next three years, the refinance of debt obligations, amounting to around EUR 5.5 billion is planned, and the general government debt could be around 39.7% of GDP at the end of 2023 and 40.5% of GDP at the end of 2024. Under the influence of high interest rates, the debt servicing costs are projected to rise from EUR 199 million in 2023 around EUR 359 million by the end of 2024.

The new government must take into account the fact that its first budget will be carefully assessed by the European Commission, international rating agencies and other international partners. The new government has been approved and now the budget has to be approved in record time, reaching the agreement on the total allowable amount of public expenditure and the breakdown of the State budget allocations.