Article

Baltic Countries To Continue Leading Eurozone Inflation

Fitch Solutions / Country Risk / Latvia / Fri 12 Aug, 2022

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Key View

  • At Fitch Solutions, we now forecast 2022 average inflation of 15.7% y-o-y in Latvia (previously 13.0%), 17.1% in Lithuania (previously 15.5%) and 17.8% in Estonia (previously 16.0%).
  • Our revisions reflect continued uncertainty surrounding energy supplies to Europe which will place upward pressure on inflation, which was above 20% in July in all three countries.
  • Although weakened demand, moderating energy prices and negative base effects will subdue inflation in 2023, we expect the rate to remain well above the European Central Bank’s 2% target.

Reflecting our expectation that energy prices will rise in the months ahead due to uncertainty over adequate supply, we have revised up our average 2022 annual inflation forecasts for the Baltic states. We now forecast average annual inflation of 15.7% y-o-y in Latvia (previously 13.0%), 17.1% in Lithuania (previously 15.5%) and 17.8% in Estonia (previously 16.0%). Since the war in Ukraine began (February 24), the Baltic countries have registered the highest inflation in the Eurozone with upward pressure on the rate stemming from high food and energy prices. In July, Latvia, Lithuania and Estonia recorded inflation of 21.0%, 20.8% and 22.7% respectively. In our view, inflation will peak in Q422, after which point strong negative base effects will subdue the rate. Hence, we forecast average annual inflation to moderate in 2023 to 6.6% in Latvia, 5.6% in Lithuania and 6.7% in Estonia. Upward pressures will ease as a result of weakened domestic demand, lower energy prices in H223 and negative base effects from 2022.

The Baltic Countries To Experience Highest Inflation In The Eurozone
Baltic Countries And Eurozone Average - HICP Inflation, % chg y-o-y & Average Annual Inflation Forecasts
Source: Eurostat, Fitch Solutions

While adopting the euro has yielded significant economic benefits for the Baltics, the single interest rate leaves them vulnerable to steep price rises as these countries often experience higher than eurozone average inflation. In July, the European Central Bank (ECB) made its first rate hike since 2011, raising its three key interest rates by 50 basis points (bps). This contrasts with earlier and more aggressive hikes seen in Central and Eastern Europe (CEE) (see chart below). Since May 2021, CEE countries have led the way in monetary tightening with Hungary, the Czech Republic and Romania imposing a cumulative 1000bps, 675bps and 425bps respectively. We expect the ECB to raise its deposit rate to 0.75% by the of the year (from 0.50% currently). Thus, according to our forecasts, real interest rates in the Baltics will remain deeply negative in 2022 and 2023.

Low Interest Rates Leave Baltics Vulnerable
European Countries - policy rate bps change since May 2021 (when CEE began tightening)
Source: D-Maps, Fitch Solutions

Maintaining public support against a backdrop of high inflation and slowing growth will be a significant challenge for the Baltic governments over the next year. In our view, policy-makers will be pressured to choose between unpopular fiscal consolidation measures which subdue inflation and supportive policies such as subsidies which tend to fan inflation. To date, Estonia has taken a mixed approach. While the Estonian government has introduced subsidies for households tackling high energy bills, the Minister of Health and Labour has outlined plans to increase tax by raising unemployment insurance contributions. In the Latvian case, the upcoming election in October 2022 is likely to dissuade the government from imposing significant tax increases until 2023. Latvia has instead supported households by imposing a package of subsidies and new benefit schemes. Lithuania has primarily targeted inflation via price caps on heating and electricity with no significant tax raises announced. In our view, all three countries will hold off substantial fiscal tightening until 2023 to prevent a more painful slowdown. In the meantime, domestic demand is likely to be cooled by low confidence, an uptick in unemployment and declining real wages.

This backdrop will weigh on the Baltics' growth outlook for 2022 and 2023 as we expect double-digit inflation to limit private consumption. Although Baltic labour markets are tight relative to historical levels, unemployment picked up in Latvia and Estonia in Q122 and real wage growth is negative in all three countries. Furthermore, high input costs will place a major burden on the Baltic manufacturing industries, with negative implications for gross fixed capital formation and exports. Beyond energy, Baltic manufacturers relied heavily on Russia for steel, iron and timber imports prior to sanctions imposed by the European Union in response to the war in Ukraine. We believe the increased transportation cost associated with replacing these goods from Russia in addition to weakened external demand will maintain pressure on manufacturing output into 2023. Against this backdrop we see Latvia growing by 1.9% in 2023 (2022 forecast: 2.8%), Lithuania growing by 2.6% (2022 forecast: 2.5%) and Estonia growing by 1.5% (2022 forecast: 1.5%).

Baltic Citizens Spend More On Energy And Food Than Eurozone Peers
Baltic Countries And Eurozone - Weights In HICP Baskets (LHS) & Contributions To June Inflation (RHS)
Source: Eurostat, Fitch Solutions

Due to their structural characteristics, the Baltic countries are likely to continue to record higher than eurozone average inflation for years to come. Firstly, citizens in the Baltic countries have spent more on energy and food than the eurozone average over the last ten years. This is reflected in higher item weights in their 2022 HICP baskets (see chart above). In June, energy contributed 4.2pp (percentage points) to inflation across the eurozone, compared with 10.3pp in Latvia, 9.2pp in Lithuania and 14.1pp in Estonia. As prices of these products are experiencing the strongest upward pressure from the war in Ukraine, this spending pattern will push up rate of inflation until supply chains normalise. Secondly, energy and food prices have accelerated faster in the Baltic countries than elsewhere in Europe owing to the structure of energy contracts. Thirdly, as smaller countries, Baltic traders have less negotiating power to limit price increases whereas traders in larger countries are in stronger positions to limit price increases. In particular, Lithuania and Latvia are highly exposed to international energy price volatility owing to low levels of domestic production.

This report from Fitch Solutions Country Risk & Industry Research is a product of Fitch Solutions Group Ltd, UK Company registration number 08789939 ('FSG'). FSG is an affiliate of Fitch Ratings Inc. ('Fitch Ratings'). FSG is solely responsible for the content of this report, without any input from Fitch Ratings. Copyright © 2021 Fitch Solutions Group Limited. © Fitch Solutions Group Limited All rights reserved. 30 North Colonnade, London E14 5GN, UK.

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