Disastrous GDP drop may signal economy bottoming.

From wire reports

RIGA -- Latvia's economy continues to sink, with second quarter GDP figures just released showing a 19.6 percent drop in the country's output, reports news agency LETA. The pace of decline however has slowed when compared with this year's first quarter loss of 18 percent against the year earlier period. Manufacturing output and retail sales are leading the plunge.

"Even though the number is bad, nonetheless there won't be the need for additional tightening, other than what is already planned, to ensure the budget deficit is what was agreed with the European Union and the International Monetary Fund," said head of emerging markets at Danske Bank, Lars Christensen, reports news agency Bloomberg.

Government austerity measures have hit households that are increasingly struggling to make ends meet. Retail sales are down 28.5 percent, with industrial output figures down 18.7 percent, compared to year earlier numbers.

Wage cuts, in both the government and private sectors, and drops in spending, feed into and exacerbate the downward cycle of recession. "We haven't seen declines in western Europe like this, except possibly during the war," said head of economics department at the Stockholm School of Economics in Riga, Morten Hansen.

"The output slump is threatening to roll back economic gains made during the boom Latvia enjoyed after joining the EU in 2004," Hansen said. Output expanded more than 10 percent on average in 2005 and 2006, slowing to just under 10 percent in 2007.

Latvia, which allows its currency to move 1 percent around its peg to the euro, is trying to bolster competitiveness through wage cuts and structural measures that will involve closing some hospitals and schools, instead of devaluing its currency.

"Austerity measures are starting to yield gains in competitiveness as inflation slows and producer prices fall," remarks SEB Latvia's chief economist, Andris Vilks. "There has been very strong deflation" in producer prices, says Vilks, and from July the outlook for deflation will be "very supportive."

Consumer prices rose at an annual rate of 2.5 percent in July year-on-year, with prices for goods up 1.2 percent and for services higher by 5.7 percent. Annual inflation in June was 3.4 percent.

Vilks said he expects the outlook for the third and fourth quarters to improve and sees an average decline in GDP that could be 12 percent in the second half.

Latvia saw its credit rating downgraded again by Standard & Poor's as this worsening recession threatens to drain the state finances as it struggles to meet the budgetary conditions of the international bailout. Latvia's long-term foreign currency rating was lowered to BB, two notches below investment grade, from BB+, with a negative outlook.

The outlook for growth beyond that remains highly uncertain," said S&P. "Not least due to highly leveraged household balance sheets." Latvia's general government debt, which at the end of last year was at 19 percent of GDP, could now jump to more than 80 percent of GDP 2011, estimates S&P.

"There is also a risk that the Latvian government may be saddled with some of the costs connected to the need to recapitalize the local banks further, though funding for recapitalization may be provided by official lenders," said the rating agency. They also warned that "Parent banks are rolling over considerably less than 100 percent of their cross-border advances to their Latvian subsidiaries and branches in the face of the latter's rising non-performing loans and falling credit demand."