Moderate economic recovery ahead

Latvia’s economic prospects have significantly deteriorated as a result of the war in Ukraine. This is mostly due to the country’s geographic proximity to Russia and its significant (pre-war) trade relations (accounting for 7% of Latvia’s exports, 9% of its imports and, notably, 100% of its natural gas imports). Following a strong post-Covid-19 recovery with +6.7% real GDP growth in 2021, economic activity in Latvia slowed down markedly in 2022 (+3%) and moved into recession in 2023 (-0.3%) amid surging inflation, rising interest rates, weakening external demand and deteriorating business confidence. Additionally, the sharp economic slowdown in Western Europe weighed on trade in Latvia with the second year of recession in 2024 (-0.1%). Going forward, government fiscal stimulus and EU funding inflows as well as a gradual rebound in external demand should support a moderate recovery in Latvia in the next two years. We forecast full-year real GDP to expand by an average of around +2.5% in 2025-2026.

Inflationary pressures have subsided for now but upside risks remain on the cards in 2025-2026. Consumer-price inflation began to rise in mid-2021 and surged to well over 20% y/y in the second half of 2022 and early 2023, driven by soaring energy and food prices as well as interrupted supply chains. It then decelerated rapidly to single digits by mid-2023 and to just 0.1% y/y in May 2024, thanks to base effects, monetary tightening by the ECB and slowing domestic demand. As these effects gradually fade, headline inflation has picked up to 2.2% y/y in November 2024 and it is forecast to increase further to the range of 2-3% in 2025-2026. Upside risks to this forecast include a renewed energy price shock, potential supply disruptions or tightening labor markets. Meanwhile, Eurozone membership provides for moderate transfer and convertibility risk in Latvia.

The Latvian business environment is generally strong. The World Bank Institute’s annual Worldwide Governance Indicators surveys suggest that the regulatory and legal frameworks are generally business-friendly while a certain level of corruption is still perceived as present. The Heritage Foundation’s Index of Economic Freedom 2024 survey assigns Latvia rank 19 out of more than 180 economies, an improvement from rank 30 three years ago. The country scores well with regard to property rights, judicial effectiveness, tax burden, trade freedom and investment freedom while there remains some room for improvement in terms of government integrity and labor freedom. Meanwhile, our proprietary Environmental Sustainability Index ranks Latvia 19st out of 210 economies, reflecting strengths in energy use and CO2 emissions per GDP, water stress, as well as its exposure to climate events and its readiness to protect itself against such events. However, there are still weaknesses in renewable electricity output and the recycling rate.

Overall systemic political risk has deteriorated somewhat from a previously low level because geopolitical risk in the region has increased with the war in Ukraine. Latvia is a well-established democracy and has good international relations – except with Russia – reflected in its EU, OECD and NATO membership. However, there is a risk that social and cultural push-back is emerging from the sizeable Russian-speaking minority in Latvia.