What affects labor compensation in Latvia?

The Latvian central bank (Latvijas banka, LB) has published a new commentary on the current state of labor market trends in the country, written by  LB economists Andrejs Migunovs, Ieva Opmane and Andrejs Bessonovs.

The Covid-19 pandemic has caused an increase in unemployment in Latvia. Employees with low qualifications or limited work experience are often at a higher risk to become unemployed when the labor market eases. These workers are also more prone to quit the labor market because they face greater obstacles in finding a job due to less choice of jobs. This is exactly what has occurred during the Covid-19 pandemic when the number of people willing to work in Latvia decreased (see Chart 1), reducing participation rates in several sectors, which were more affected by restrictions.

The decline in the number of people willing to work was particularly noticeable among the younger age groups, where employees typically have less work experience (see Chart 2). There are various reasons why individuals become economically inactive. Compared to the pre-pandemic period, there has been an increase in the share of individuals who choose not to seek a job due to either personal reasons, or education, or due to illness or disability.

Demand for workers remains high

There is still a high demand for employees in Latvia. A significant number of entrepreneurs indicate that the labor shortage is a significant factor limiting production or business development. Although in the services sector and manufacturing this assessment of the lack of employees has recently slightly decreased, it still remains high or is even increasing in the construction sector.

The indicator characterising the “temperature” of the labor market (the ratio of vacancies to the unemployed) shows that the labour market is currently tight. The total number of vacancies per unemployed person is about the level that has been seen before the financial crisis. At the same time, flows of employees from unemployment to employment are currently high. The labor market has drawn resources from both the short-term unemployed and those who have been looking for work for a longer time.

The Latvian labor market, expressed through the lens of the Beveridge curve space, indicates that currently there is high tightness of the labor market. However, there are no signs of a structural deterioration or a significant drop in the efficiency of labor market.

The Covid-19 pandemic has affected economic sectors unevenly. Due to the restrictions, it was more difficult for workers in certain sectors  to find a job, as their qualifications were less in demand than before. As a result, the index of skills imbalances has been slightly higher in recent years.

What determines an increase in labor compensation?

As the unemployment rate changes, so does the wage dynamics. If the unemployment rate is relatively low and there is a shortage of workers in the labor market, employers are forced to compete with each other, not only by offering higher wages in new job advertisements, but also by increasing the wages of existing workers so that they do not leave to work elsewhere.

However, the unemployment rate is not the only factor that determines changes in wages. It is affected by productivity and by how efficiently employers and employees find each other in the labor market. During the last year, it became increasingly relevant what the role of inflation in the wage determination mechanism was. To find out what the impact of these factors on labor compensation is and how it changes over time, we have assessed the wage Phillips curve model.

The low unemployment rate contributes to the growth of wages in Latvia. After the financial crisis, there was relatively high unemployment in Latvia, which limited the increase in wages. In recent years, even despite the economic upheavals caused by the pandemic and the war, the unemployment rate in Latvia is low. As labor demand remains high, this puts significant upward pressure on wages.

Inflation reinforces wage growth. Since the financial crisis, the impact of inflation on wages has been relatively low. This can be explained by the fact that there are no automatic wage indexation mechanisms that translate to price increases in Latvia. Moreover, in an environment of low inflation, employees do not feel like demanding compensation for the real loss in purchasing power of wages. The increase in wages occurs due to the increase in skills and abilities of the employees, and is also driven by labor market tightness. However, the situation changed significantly when inflation in Latvia reached 17.2% last year. The importance of inflation in compensation growth has increased in the second half of 2022. Despite the fall in energy prices and the drop in headline inflation, there is a risk that the delayed impact of inflation on wage growth will manifest itself more strongly in 2023.

But the increase in wages is somewhat limited by the decrease in the labor market matching efficiency. In recent years, matching efficiency has been one of the factors dampening wage growth. For example, when the labor market is tight and the number of job seekers is low, it is more difficult for companies to find potential employees whose skills fully match the needs. Therefore, the hirings of new employees are accompanied by the trainings for specific skills, and this probably might be reflected in the lower pay.

How to improve the labor market?

Currently, the labor market is relatively tight and the demand for workers remains high, resulting in high vacancies and low unemployment. As inflation has overtaken wage growth, the real purchasing power of employees’ wages has fallen. Therefore, in the second half of last year, inflation has emerged as one of the main factors of wage growth.

This is essential to improve the labor market matching efficiency, both in terms of the labor market-appropriate education, practical skills and regional accessibility. Increasing productivity is significant both at the level of an individual company and the entire country. The (funds of the) European Union funds planned in the coming years can help here ‒  a significant part of them is intended for digitization, research and innovation. However, we cannot rely on the fact that the increase in productivity will take place only within the framework of such European projects, local solutions of companies can also increase their productivity. As a result, the profitability of companies will increase, which will allow them to increase salaries and compete with other companies for the valuable resource of the Latvian economy ‒  the employee.

More economic analysis and commentary is available at Latvijas banka's dedicated english-language website: https://www.macroeconomics.lv/

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