by Andris Šuvajevs | 30th November, 2022
In July 2022 Latvia recorded its highest inflation since the early 1990s, at 21.5 per cent. Inflation is running hot everywhere, but the Baltic states have turned out to be involuntary leaders in price build-up across the economy. The record inflation even exceeds the level attained just before the global financial crisis in 2008/2009, when it hit 19.5 per cent. Inflation in Latvia is twice as high as the European Union average (9.6 per cent in June 2022) and there are as yet no signs of it slowing down. The numbers look even more striking if one compares the rate of increase to 2015, since when the prices of consumption goods have risen by 39.1 per cent, compared with 27.3 per cent for services. The inflation dynamic has been similar to elsewhere in Europe and the world, picking up slowly in the summer of 2021 after many years of moderate rates. Inflation in Latvia has always tended to be slightly higher than in the rest of the euro-zone, at around 2 to 3 per cent, while the rest of the Monetary Union barely exceeded 1 per cent. The reasons for this are likely to be found in Latvia’s overall level of wealth and the significant proportion of people spending most of their income on housing and food.
At the end of 2021, the inflation rate had climbed to nearly 8 per cent, but since Russia’s attack on Ukraine it has continued to climb relentlessly. In March 2022 it was already 11.5 per cent and it has added 2 to 4 percentage points every month since then.
As elsewhere, the record-breaking numbers are driven by specific services and goods. Housing, food and transport are the three areas that have basically determined the rate of inflation overall and therefore it is fairly safe to conclude that inflation is not (or not yet) broad-based across the entire economy. For instance, the cost of housing and related services (electricity, heat, gas and so on) have risen by 83.8 per cent since July 2021, constituting more than 8 percentage points of the entire increase in prices. Food comes only slightly behind: since July 2021 food prices have jumped by 24.3 per cent, making up more than 6 percentage points of the entire increase. The cost of transport, which includes oil, comes in third, constituting another 4 percentage points of the entire rise in the general price level. It is worth highlighting the skyrocketing price of gas, which has shot up by 151 per cent in comparison with July 2021. The price for firewood and pellets (used by many households) has also soared by 99.8 per cent.
Because the cost of gas and electricity will be more socially salient in autumn and winter, right now people are experiencing inflation mostly at the grocery store. The basket of goods based on milk and associated products is the area in which prices have risen most: from cheese and milk to yoghurt and cottage cheese, prices in this category have gone up by 30 to 40 per cent. Flour and grain products have also increased by 56.8 per cent in one year, whereas the price of bread has grown by half that (28.3 per cent). Meat, which tends to be the main source of protein for most households, has seen a similar increase: beef is up by more than a third (32.7 per cent) and poultry by a quarter (24.8 per cent), which makes the price of pork look relatively affordable, as it has gone up by ‘only’ 10.8 per cent.
As these numbers suggest, the causes of inflation are not to be found on the demand side of the economy, as usually supposed in past instances of inflation. If excessive demand was at fault, manifesting itself not only through the general level of prices, but also through wage increases, then inflation would be broad-based and affect every sector of the economy. But this is clearly not the case. The causes are mainly on the supply side of the economy and can be grouped under the following headings.
Russia began interfering with gas supplies even before its invasion of Ukraine, stoking up uncertainty in the gas markets, which increased the cost of electricity and heating in Latvia enough to warrant a set of government policies aimed at supporting the economy (outlined below). The war continues to be the number-one driver of inflation as Russia has cut its supplies to Europe even more and there is likely to be a complete cut-off of gas flows once the heating season begins. It needs to be noted that in spring 2022 the government of Latvia already decided it would ban the import of gas from Russia in order to cease financing Russia’s war effort. Any Russian supplies entering the country at present elicit an immediate response, even though they are not yet illegal. But as long as gas prices remain elevated, there will be notable inflation because Latvia depends on gas for its energy needs.
A central reason for the high inflation has been Latvia’s dependence on Russian fossil fuels. About a third of Latvia’s energy mix is composed of natural gas and about 90 per cent of it was usually imported through Russia. While the share of natural gas has been slowly declining, it is still prevalent and used for district heating. At the same time, the share of renewables has been steadily increasing and now exceeds 40 per cent. Most of it is hydropower, however, as Latvia has lagged behind in developing solar and wind farms. A full-on ban of Russian natural gas will come into effect on 1 January 2023, to be replaced with LNG supplies.
Before the war in Ukraine, the supply chain disruption because of Covid-19 was the most often cited reason for inflation. Because the production and transport of commodities had been thrown out of sync and returning to the pre-Covid production levels took more time than expected, some inflation came about as a result of producers hoarding supplies, ordering more than necessary or paying more for insurance in response to the uncertainty. This inevitably impacted Latvia, too, especially the construction sector as a result of shortages of materials and uncertainty over future orders.
Food prices had been trending upwards well before the war and even before Russia began meddling with global gas markets. Not only is this a sign that food prices are likely to continue to increase, but the causes of food price inflation are likely to be different, too. In this regard, the extreme weather conditions across much of the globe have surely contributed to damaged supply systems and speculative uncertainty around food prices.
The magnitude of inflation is also partly due to the overall level of economic well-being in the country. As is customary in relatively poorer societies, the bulk of household income is spent on food and housing. This is the case in Latvia, too, as the average household spends 23.3 per cent of its income on food, 14.6 per cent on housing and another 14.6 per cent on transport. This is further differentiated among income quintiles. Thus, the bottom 20 per cent spend a third of their income (31.5 per cent) on food and 18.1 per cent on housing services – in other words, half their income goes towards covering basic costs. The numbers are nearly the same in the second quintile, in which food constitutes 28.4 per cent of monthly costs while housing sits at 16.9 per cent. These numbers suggest that inflation is impacting lower-income households disproportionately.
There has been some discussion that the fiscal stimulus launched during the Covid-19 pandemic increased household savings, which are currently being spent, thus further fuelling inflation. While there are some data that confirm the increased rate of savings, it is still the case that about 20 per cent of households have no savings at all and about half of all households do not have sufficient income to overcome unexpected financial difficulties. Thus it is unlikely that pent-up demand is driving inflation in Latvia.
The impact of inflation on the general state of the economy has been uneven. In the first quarter of 2022 there was even rapid economic growth, measured at 6.7 per cent, which dropped quite significantly to 2.6 per cent in the second quarter. The globally expected recession in the latter half of 2022 will certainly impact Latvia, too, and there is every reason to believe the rate of growth will slow down even more.
As a result of a combination of growth and inflation, the public coffers have been filling up very well, which gives the government some leeway for support measures in autumn and winter. Thus, revenue has exceeded last year’s level by over 770 million euros. There is still an overall deficit but the state’s financial position is stable.
The manufacturing sector has done well in the first six months of 2022, growing by 3.8 per cent. Nevertheless, future prospects seem less positive; there is a risk of reduced demand in export markets and already a slowdown in output in Estonia and Lithuania. The retail sector mirrors the manufacturing sector; it has grown by 7.1 per cent, but it is likely to grind to a halt as households spend a larger share of their income on heating. Private consumption has generally been one of the factors driving economic growth in Latvia and if a recession takes hold, overall growth will suffer as a result.
Latvia is in the Eurozone; thus its monetary policy is determined by the European Central Bank (ECB). In July 2022, the ECB hiked its policy rate by half a percentage point for the first time in 11 years. Because inflation began to pick up pace last year, the ECB was reluctant to raise rates, fearing it would endanger growth prospects after the pandemic. Nevertheless, the US central bank Federal Reserve (Fed) raised rates, which put pressure on the euro through increased capital outflows and the euro reached a temporary parity with the US dollar. The increased rate will further deteriorate household balances, which may prove alarming because the level of new consumer credit increased by over 60 per cent in the first five months of the year relative to the same period in 2021. Mortgages and student loans will become more expensive to service at a time when households face the pressure of increased heating costs. Unemployment will probably rise, however, and the orthodox view is that it will bring down inflation.
The ECB also adopted an anti-fragmentation tool, mainly in relation to Italy’s fiscal predicament and its bond spreads. Thus, for the past months, the ECB has been selling maturing German bonds and buying Italian bonds in order to sustain their viability in an effort to prevent a situation in which Italy cannot service its debts. Latvia has not seen any swings in its debt structure, however, and if the country’s fiscal outlook deteriorates, the ECB will be there to backstop it.
Last winter, the Latvian government passed a series of policy measures in order to shelter consumers and businesses from soaring energy costs. The response was tepid and took time to be worked out, even though warnings about a difficult situation were enunciated already in September 2021. Initially, the government slightly increased benefits to the elderly (if they had been vaccinated, thus hoping to provide further incentives). When the heating bills began to arrive, however, the policy package was expanded to include a reduced distribution tariff, increased monetary support to protected households and increased housing benefit. In some municipalities where the heating tariff exceeded 68 euros per MWh, the government covered the entire mark-up above this rate. The entire cost of these measures amounted to 450 million euros and was criticised by some for its universal character, whereby many received financial support even though they did not necessarily need it.
In early summer 2022, the government began preparing another set of support measures intended for the upcoming autumn and winter. The objective was to make sure the support was targeted well-enough to avoid the situation of the previous winter, when support was rushed and universal. Thus, some social groups will receive extra benefits (for example, the elderly, people with disabilities), however most of the targeted support will be designed as a housing benefit for which households will have to apply at their municipality. The municipalities have signalled that it will be challenging to cope with the increased administrative burden of these applications. The new policy proposals include a partial price ceiling on heating costs that includes not only gas but also biomass.
Since the outbreak of war in Ukraine, discussions about a new liquefied gas terminal have been reinvigorated as fears have grown over supply. Nevertheless, there is very little public information available on the state of these discussions and the expected guarantees the state will have to make in order to have the terminal built.
There has been very little debate about the price-wage and price-profit spiral. While economists have warned of the former, there are no structural indications that it may occur. The rate of unionised workers is extremely small (about 10 per cent) and trade unions are generally weak. Though the unemployment rate has been falling, the workers are too individualised to insist on wage gains and thus most of the population has been experiencing a fall in real income. There has been no debate at all about a profit-price spiral and a potential windfall tax. The major state-owned company Latvenergo, which produces electricity and heat, pays most of its profits back into the state budget anyway. The major supplier of gas Latvijas Gāze recorded a profit of 3.1 million euros in 2021. Their profits for this year might be a lot higher, though, prompting further discussions about a windfall tax here too.
It is likely that these policies will not go far enough in providing meaningful support to households. The current price ceiling for district heating is 68 euros/MWh, after which every extra euro will be compensated by the state in the order of 50 per cent. In September, this measure was further developed and every euro above 150 euros/MWh will be compensated at 90 per cent. Thus, if the tariff turns out to be 100 euros/MWh, the state will compensate 16 euros and the household will still pay 84 euros/MWh. If the tariff is 340 euros/MWh, then the final cost after deductions will be 128 euros/MWh. This is still twice or even three times more than in previous winters. For many households, this will be unbearable and there will be enormous pressure on municipal social services to help with costs. A proper social democratic response would be to set a hard ceiling above, for example, 90 euros/MWh. The high prices have already incentivised savings and so there is reason to use the high price as a signal that encourages energy saving. Unfortunately, the state lacks any kind of knowledge about the potential impact the current proposals will have on household budgets and what the risk of higher indebtedness is. The government is currently waiting for the first heating bills to arrive to gauge the societal response and then react accordingly.
Notably, the initial policies did not stipulate any support for electricity consumption, other than for heating. In September, the government agreed that the first 100 KWh will be priced at 160 euros/MWh, while any consumption above that will be priced by the market. This is intended to incentivise savings and is likely to be successful, although the price of electricity will be much higher than in previous winters. As in the case of district heating, there are no models available regarding the potential impact of current prices and measures on various households, although it can be expected that low-income households will be the hardest hit, whereas households in the second quintile will see any of their savings evaporate as they will struggle to qualify for municipal support. It has to be commended, however, that the price ceilings will be applied to user bills automatically.
A similar scheme will be applied to electricity costs for enterprises: the government will cover 50 per cent of the price that exceeds 160 euros/MWh. There will be a separate programme for energy-intensive enterprises eligible for grants covering up to 30 per cent of energy costs, but not exceeding 2 million euros for a single company. As in the case of households, it has not been estimated what the actual economic impact on competitiveness will be, but the employers’ organisations have praised the support programme.
The government will finance these support measures through the increased tax receipts, as well as by borrowing, if necessary. Due to inflation and better-than-expected growth, tax revenue has been much higher than in previous years (nearly a billion euros more than anticipated), though the overall budget is still in deficit. In late October, the government re-financed a part of its debt (850 million euros), though at more elevated interest rates (nearly 4.2 per cent).
Unfortunately, the use of the financial resources from the EU Recovery and Resilience Facility intended for improving the energy-efficiency of buildings has been stalling. Buildings’ energy-efficiency is very poor and not enough has been done to improve energy savings. At the same time, there has been a boom in the installation of solar panels and the two biggest state-owned enterprises announced a joint investment project for wind farms, which will significantly increase wind-produced energy.
There is also reason to be sceptical about the necessity of a new LNG terminal. Investing in new gasification facilities when Lithuania has one and Estonia will soon have one too may be excessive and even go against the objectives of the green transition. If public support is given to this project it comes with many unforeseeable fiscal risks and a commitment to gas beyond what might be necessary. Instead, the state should focus more on securing energy supplies on the Baltic level in close cooperation with Estonia and Lithuania, using the gas storage facilities at Inčukalns as a nationally-owned leverage point.
Andris Šuvajevs is a political economy analyst and researcher.