The economy of Latvia had tremendous growth in the period from 2003 to 2007: the gross domestic product (GDP) increased by 10.3% and 12.2% in 2007 and 2006, respectively. At this period, there were some factors that led the economy to overheating. One of the main factors for overheating the economy is that credit grew at an annualized rate of more than 50%, even though the stock of credit had risen to close to the EU average. Real estate prices jumped more than 60% in both 2005 and 2006.
Another factor is the excessive growth of domestic demand, especially private consumption and real estate investment, so that the current account deficit peaked in late 2006 at more than 25% of GDP. Also, in early 2007 wage and price inflation accelerated, with core inflation rising to almost 10% by mid-2007. Substantial wage increases and low productivity growth significantly weakened competitiveness of Latvia.
The additional vulnerabilities that appeared in the economy of Latvia as a result of overheating increased the effects of global financial downturn that started to develop in this period. Gross external debt has risen above 130% of GDP, — was the highest level among EU new member states — Latvia becoming very exposed to the risk of a sudden capital stop.
Starting from the fourth quarter of 2007, GDP started to level off. The main factor that caused this was the slowdown in lending that started in early 2007, driven by concerns among foreign banks about their overexposure to the Baltic states. In 2008 and 2009, consumption and investment fell. While the overheated non-tradables sector needed to slow down, manufacturing output also dropped sharply due to weaker export demand and the effects of the past deterioration in competitiveness. Wage growth has started to slow down and employment to decline.
It can be said that starting from 2009 the economy of Latvia has entered a correction phase from imbalances accumulated during the years of overheating. Probably this correction will create conditions for sustainable economic growth in the future. As a part of the correction, real wages have started decreasing significantly in all the sectors of the economy.
In 2009, due to lower domestic demand a slowdown in inflation took place. In 2008 annual inflation was 15.4%, while in the beginning of 2009 it has decreased. Due to a slowdown in economic growth, unemployment in January 2009 has increased to 7.6%, from 7% at the end of December 2008.
Central government debt has increased substantially — from 7.4% in 2007 to 17.3% of GDP in 2008.
The government of Latvia has run a small budget deficit of 0.8%, 0.5% and 1.3% of GDP in the years 2005, 2006 and 2007, respectively. In 2008, budget deficit reached 3.5% due to deteriorating macroeconomic indicators, which has resulted in lower tax revenues.
The Latvian lat is fixed to the euro, and the aim of the government of Latvia is to introduce the Euro in the possibly nearest future.