Mission Concluding Statement 

Republic of Latvia -- 2005 Article IV Consultation Mission, Preliminary Conclusions

April 25, 2005

1. During the past decade, Latvia earned an enviable reputation for rapid economic growth combined with macroeconomic stability. A sound policy framework and far-reaching structural reforms supported this performance, including a prudent fiscal policy that underpinned the exchange rate peg, and fundamental reforms of the business and wage-setting environments. These efforts paved the way for rapid investment--including substantial FDI--and job creation that have added to the economy's productive capacity.

2. At present, however, the pace of economic expansion is creating challenges for macroeconomic stability. Recently, rapid growth has been accompanied by a pickup in inflation and a widening of the current account deficit. Several one-off supply side factors contributed to these developments, but underlying levels also increased, indicative of overheating. While a decline in the private saving-investment balance--mainly due to a rising investment rate, and supported by a credit boom and low interest rates--is partly responsible, policymakers cannot ignore the resulting pressures on prices and competitiveness because to do so would amplify economic risks and undercut the ongoing process of real convergence with Western Europe.

3. Sustaining healthy economic growth therefore requires that domestic and external imbalances be kept in check. This will help ensure that Latvia prospers within ERM2 and later under the euro area's single monetary policy. From a demand management perspective and to add credibility to the authorities' medium-term fiscal goal, fiscal policy--which on present plans is likely to be significantly procyclical this year--should be scaled back to achieve broad neutrality in terms of its impact on aggregate demand. A moderation in the recent pace of credit growth would complement fiscal adjustment and limit the buildup in external indebtedness. Strict oversight of the financial sector remains critical to prevent the emergence of risks from rapid credit growth, foreign borrowing, and liquidity and currency mismatches. Looking beyond the demand side, efforts to increase the supply potential of Latvia's economy are also a priority. Relevant policies include ensuring that EU grants are used judiciously to improve infrastructure for private sector development, improving the business culture, and increasing the supply of skilled workers.

4. While we expect some moderation in the pace of domestic demand this year, it will not be sufficient to relieve overheating pressures. The ongoing credit boom, together with a pickup in corporate profitability, seem set to underpin further rapid growth in household and business spending this year, though at a somewhat weaker pace than in 2004 when anticipation of EU accession boosted private domestic demand, and owing to the dampening effect from surging world energy prices. A sharp rise in net EU grants will also provide a vigorous stimulus to growth this year.

5. Economic growth in 2005 will slow down only marginally despite our more conservative assumption on the use of EU grants compared with the budget. While the budget assumes that EU grants amounting to 6 percent of GDP will be spent by the public and private sectors, our expectation is that obstacles to implementation--including slower than anticipated project preparation and higher costs due to shortages of key inputs and higher world commodity prices--will lead to a lower realization, as observed in 2004. While a margin of error exists, our working assumption is that three quarters of the budgeted amount will actually be spent in 2005. On this basis, and taking into account the restraining effect from higher oil prices, GDP growth would moderate slightly to 7¾ percent.

6. With growth expected to remain somewhat above potential, we see risks to a reduction in underlying inflation and the underlying current account deficit (excluding net current EU transfers and bulky imports). While the unwinding of one-off price effects from early 2004 associated with EU accession will keep headline inflation on a downward track through mid-2005, demand pressures seem set to preclude a further reduction in core inflation thereafter and, with labor-intensive sectors (including housing construction and infrastructure) important contributors to demand, rising wages could also add to price pressures. Higher world oil prices and further increases in regulated prices and indirect taxes will also push up measured inflation and, although their direct contribution will be relatively small, the total impact could be magnified under strong demand conditions. In 2005, the current account deficit will narrow as a result of higher net current transfers from the EU and the absence of bulky one-off investments that pushed up imports in 2004. Excluding these, we see the underlying current account deficit rising slightly relative to 2004, consistent with rapid domestic demand and the effect of higher energy prices (a significant portion of which represents a permanent price shock as Latvia's energy imports converge to world prices).

Fiscal Policy

7. The challenge for fiscal policy is to balance the supply-enhancing potential of EU-financed investment spending with the risks associated with a ramping up of such spending while private demand pressures are present. While the authorities have stressed Latvia's restrained headline fiscal position in comparison with other EU countries, our concerns lie with the prospect of a strongly procyclical fiscal stance this year as reflected in the budget which will add to demand pressures. Such concerns are magnified given that Latvia's pegged exchange rate regime precludes an independent monetary policy, so that fiscal policy is the most potent--and arguably the only--policy lever for moderating the pace of domestic demand.

8. Public expenditures are needed to expand the economy's infrastructure and supply potential, but concentrating in 2005 as much spending as is currently budgeted creates significant macroeconomic risks. A reasonable resolution of this tradeoff--between needed infrastructure spending and containing macroeconomic risks-is to pursue a broadly neutral fiscal stance; specifically, no change relative to 2004 in the cyclically-adjusted accrual balance excluding EU grants. Owing to uncertainties about the size and timing of the inflows and related spending of EU grants (where grants to both public and private beneficiaries are recorded as revenue in the budget), the relevant fiscal concept to target is the headline deficit excluding net EU grants. To implement the target of no stimulus, our calculations suggest the need to aim for a headline deficit excluding net EU grants of about 1 percent of GDP, some ⅓ percentage points of GDP below the outturn on the same definition in 2004. This estimate recognizes the significant demand-boosting effect of EU-financed government spending and the effect of the buoyant cyclical position on revenue collections. The expected strong performance of tax revenues this year--supported by first quarter tax revenues well above budget--combined with some restraint relative to budget in the spending of EU grants should bring this fiscal target well within reach, provided that no expansionary supplementary budget is introduced.

9. Beyond the need for fiscal restraint in 2005, there is a strong case to discontinue practices that institutionalize procyclicality in public finances. Our specific concern lies with the practice--evident in the past two years--of authorizing the spending of revenue overperformance in supplementary budgets, and thereby intensifying cyclical demand pressures. Instead, we recommend to allow full operation of the automatic fiscal stabilizers in order to moderate demand pressures and the amplitude of the cycle, and saving additional revenues for reducing the deficit.

10. While a single set of national priorities informs the selection of investments in the budget, in practice, EU-funded investments have squeezed out projects financed with own fiscal resources. To guide project selection, a single document defining national investment priorities was prepared from the list of projects supported with EU structural and cohesion funds, and line ministries' medium-term strategic plans. Nonetheless, only projects financed with earmarked EU grants were included in the 2005 budget, thereby freeing up for other spending those own-funds that in previous years were used to finance investment. Moreover, approving only projects with identified outside financing is likely to reduce the overall efficiency of investment and bring about a somewhat smaller payoff in terms of future rates of economic growth.

11. The better-than-budgeted fiscal outturn in 2004 and the costs of ongoing pension reform underscore the need for more conservative fiscal targets than set out in Latvia's Convergence Program. With the stronger fiscal outturn last year and our recommended strengthening of the fiscal position for 2005, there is need to adjust down the targeted deficit path through 2007 to preserve the government's objective of broad neutrality of the fiscal stance over the medium term. Beyond this, the diversion of contributions from the pay-as-you-go pension system to the second pillar scheme according to the pension reform law makes a case for a more ambitious fiscal path. Our recommendation is to improve smoothly the nonpension structural balance during 2006-10 so as to pre-finance the cost of pension reform and offset the associated buildup in explicit government liabilities that would otherwise take place given the permanent loss in fiscal revenue. While recent changes to the Stability and Growth Pact (SGP) allow for some relaxation of deficit ceilings to cover pension reform costs, such exemptions-being only temporary-do not obviate the need to respect the Maastricht ceiling or the SGP's "close-to-balance or surplus over the cycle" rule.

ERM2/euro adoption and credit growth issues

12. The mission supports the authorities' euro adoption strategy, but would caution that its success depends on containing risks that could undercut competitiveness over the medium term. The successful repegging of the lats to the euro at the beginning of 2005 was an important step, and market expectations for a smooth and timely transition to full EMU membership are high. Solid export volume growth and a rising export market share amid a strong competitiveness position supports the view that the current market exchange rate is appropriate for the ERM2 central parity. Moreover, some 2 percentage points of the deterioration in the current account in 2004 is attributable to self-financed reinvested earning, itself an indicator of the soundness of competitiveness. The issue at present is to keep the official euro adoption strategy on track--especially in relation to ensuring that inflation remains low over the medium term and that competitiveness is not compromised.

13. Beyond the need to avoid procyclical fiscal policy discussed above, we would stress that a successful euro adoption strategy depends on securing a moderation in credit growth. While rapid credit growth is not a new issue for Latvia, the demand effects were until recently limited by higher domestic saving and deposit accumulation. Since 2004, however, external bank borrowing, rather than domestic saving, has become a major source of banks' funding, heightening demand pressures associated with the credit boom. Appropriately, the Bank of Latvia responded by extending reserve requirements to banks' short-term foreign liabilities, a move we support. But at this point, our view is that further increases in reserve requirements (or indeed in the interest rate differential vis-à-vis the euro area) would be counterproductive, raising incentives for foreign and foreign-currency borrowing rather than moderating demand pressures at home.

14. We therefore see the need to consider other steps to reduce the very rapid pace of credit growth, especially mortgages. With such loans a very important segment of the market, one area of focus is incentives provided by the tax system that could be fuelling real estate purchases, including regulations on capital gains which are generous, or uneven compliance with reporting requirements (e.g., the fact that the basis of stamp duty is low cadastral values--or in the case of mortgages, an appraiser's assessment--rather than transaction prices). A step that we believe would help to limit speculative real estate purchases is to narrow the scope of the capital gains tax exemption only to an individual's primary residence. This would also provide an incentive for accurately reporting the transaction price in order to measure capital gains correctly (and hence avoid overstating the associated tax liability) when the property is subsequently sold.

Financial sector issues

15. Recent improvements in monitoring and stress testing of the financial system have strengthened the quality of supervision and management of financial sector risks. Progress has been made in refining risk scenarios used in stress tests, and the results suggest considerable resilience to individual shocks. Beyond this, the upgrading of data on loan performance by borrower type and credit instrument is helping to improve supervision. The recent broadening of the coverage of the credit register for bad debts to include insurance companies and those leasing and factoring firms that are bank subsidiaries will also pay dividends for monitoring and supervision.

16. The pace of the credit boom and expansion in banks' activities more generally add to financial sector risks and heightened demand pressures, placing a premium on further upgrading of monitoring and supervisory practices. We see a number of areas where additional supervisory measures could be contemplated and transparency can be enhanced. First, stress tests could better capture the impact on banks of shocks to different groups of borrowers, using the newly-available sectoral data on household and corporate nonperforming loans. Second, separate financial soundness indicators could be compiled for banks with and without significant exposure to nonresident deposits given the very different liquidity, capital, and profitability ratios between the groups which could mask conditions in individual bank groups when relying on aggregate indicators. Third, we see merit in disclosing separate liquidity ratios for banks with very high turnover liabilities (including liabilities with low aggregate variability) in order to signal the risks from a sudden shift in bank funding sources. And fourth, notwithstanding the repeg to the euro and the corresponding increase in relative riskiness of U.S. dollar indebtedness, the supervisor should encourage banks to apply lower loan-to-value norms, and higher interest rates and credit-assessment standards in situations of currency mismatch between borrowers' income and debt to reflect the greater riskiness of unhedged foreign-currency borrowing.

Structural issues

17. Sustaining the high pace of potential growth that is essential to achieving income convergence highlights the need to expand infrastructure and instill in the corporate sector principles of fairness and transparency. Notwithstanding weaknesses in the structural sphere, growth to date has been very strong, consistent with the early phase of income catch-up. Unless addressed, however, these deficiencies could increasingly impede growth going forward. To do so requires the efficient use of EU funds to support infrastructure development through project selection and tendering procedures that are transparent and open. Concerted efforts to strengthen anti-money laundering protections and reduce corruption in business and political spheres should also continue in order to maintain Latvia's attraction to foreign investors.

18. Increasing demand for labor and ensuring a ready supply of trained workers is also key for long-term growth. We are concerned that raising the minimum wage--while encouraging higher labor force participation and increasing tax collections by legitimizing a part of the grey economy--would add to the employers' cost of hiring and discourage demand for low-skilled labor. Instead, we recommend reducing the tax wedge for low wage workers. The recent increase in the personal income tax exemption will contribute in this direction, but consideration should be given to measures that better target low income workers, including reducing social security contributions for low wage earners. To help resolve the skill mismatch between labor demanded and supplied, the business community should have a greater voice in setting the curriculum for secondary and tertiary education in order to increase the likelihood of graduating students with in-demand skills.

In conclusion, provided Latvia maintains a balanced growth path as it continues to narrow the income gap with the EU, it will be well positioned to reap the benefits of full integration with its European partners. We wish the authorities every success in this endeavor.

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We thank our many counterparts, in both the public and private sectors, for their generous hospitality and cooperation, and for the stimulating discussions during our time in Riga.