The Russian invasion of Ukraine – what will it mean for the Latvian economy?

The price of freedom will always be high. Although the military offensive is currently ongoing in Ukraine's territory only, the information and economic warfare has been taking place on the global stage already for quite some time.

Latvia has also joined this non-military frontline therefore consequences of war will be felt by businesses and households in our country.

Russia is a huge country in territorial terms and population-wise (more than 150 million people together with Belarus). However, in economic terms it is far from being a heavyweight against the backdrop of the world, representing only about 2% of the global economy in 2020 [1]. At the same time, there are several reasons why Russia's aggression in Ukraine and the following response of Western countries will affect the Latvian economy.

Find new markets

First, Russia is the fifth largest trade partner of Latvia therefore export and import restrictions will entail a turnover decline for a number of firms [2]. This also refers to the goods and services not subject to the restrictions, since any transactions with Russian businesses are highly risky due to the financial sanctions. The good news is that Latvian firms have reduced their exposure to the Russian market over the past decade, i.e. exports to Russia constituted almost 12% of all Latvia's exports in 2014, but in 2021 – less than 6%. Moreover, the experience gained after the annexation of Crimea suggests that it does not take long for businesses to find new markets. Thus, assuming that all Latvia's exports to Russia (and Belarus) stop, and Latvian firms are able to find export markets just for half of their products, the adverse effects on Latvian economy would be rather limited.

Chart 1. Share of goods and services exports to Russia in Latvia's total exports (%)

 

Share of goods and services exports to Russia in Latvia's total exports (%)

Source: Latvijas Banka

Second, Russia is an important exporter of oil and natural gas, and has capacity to affect global energy prices. Heating bills and fuel prices have increased considerably over the past few months due to the soaring global energy prices. The Russian invasion of Ukraine is only making matters worse. Moreover, it is unlikely that we can look forward to a major fall in prices in the near future. European countries, being aware of the risks arising from dependence on Russia's resources, will have to speed up their search for alternatives which, for the most part, are more expensive.

Energy costs rising

Energy resources play an important role in the production of numerous goods and provision of services therefore prices of other goods can also skyrocket relatively soon. This naturally has a negative effect on economic activity which hits people on low incomes particularly hard. The government has a major role to play in this situation, i.e. it should not only ensure a smooth transition to alternative energy sources but also provide financial support to the most vulnerable households. It is fairly complicated to estimate the precise economic impact of price increases, since it depends on a number of assumptions [3], but one thing is clear – the price rise will not be negligible. It is worth mentioning that the adverse effect of soaring energy prices on the Latvian economy will, to some extent, be mitigated by an increase in wood and grain prices which will result in higher revenue of Latvia's exporters.

Geographic challenge

Third, the Russian invasion of Ukraine likely impairs the attractiveness of Latvia (and the Baltics as a whole) from a purely business standpoint. We cannot change the country's geographical location. Although we are part of NATO and our military security is higher than ever, the international press mentions the name of the Baltics quite often but unfortunately in the context of a higher risk. It is difficult to estimate the costs of these adverse confidence effects, since nobody compiles statistics on unrealized investment and failed ideas. It is likely that we will get rid of the "higher risk stamp" only when democracy prevails beyond our eastern border and the two aggressive neighbouring countries are led by people with no imperial ambitions.

In brief, I think we have to appreciate the fact that our burden in this war is of economic nature only. Although it is practically impossible to measure this burden precisely, it is hardly an excessive burden – far from the one borne during the global financial crisis. Moreover, Latvian businesses have proved that they are able to shift their activities to other markets and our dependence on the eastern neighbour has notably decreased.

Looking hopefully to the future, I would like to believe that Western unity and response to the aggression will also make the Russian society change in the long run and become a cooperation partner rather than a constant source of threat.

This article was originally published on the Latvian central bank's Macroeconomics site, where you can find lots of other useful material.

[1] Taking into account the impact of sanctions, this figure is much lower.
[2] Measured by the total volume of export goods.
[3] For a more detailed description, see the Macroeconomic Developments Report of Latvijas Banka published at the end of March
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