Mission Concluding Statement 

Republic of Latvia: 2012 Article IV and Second Post-Program Monitoring Discussions Concluding Statement of the IMF Mission

November 26, 2012

Latvia’s economy continues to recover strongly. Following real GDP growth of 5.5 percent in 2011, growth is expected to exceed 5 percent again this year despite recession in the euro area. Labor market conditions are improving. The unemployment rate fell from 16.3 percent at the beginning of the year to 13.5 percent at the end of the third quarter, despite an increase in participation rates. Real wage growth remains restrained. Consumer price inflation has declined sharply, easing to 1.6 percent at end-October after peaking at 4¾ percent in mid-2011. Robust export growth is expected to keep the current account deficit at about 2 percent despite recovering import demand.

Economic growth is expected to weaken slightly in 2013 due to the unwinding of base effects and continuing weakness in the euro area, before picking-up in the medium term. The economy’s expansion would be based upon a catch-up in business investment, continued recovery of consumption—fueled by an increase in disposable income due to improved conditions in the labor market and—and a gradual increase in exports as global external conditions improve. Inflation is projected to remain low in the medium term, reflecting low projected imported inflation and a still-negative, but closing, output gap. Higher growth than in trading partners, as well as the closing output gap, is projected to lead to a modest widening of the current account deficit in the medium term—but to remain well within sustainable bounds.

As a result of present and past efforts, euro adoption in 2014 appears within reach. On the basis of fiscal outturns so far this year and the 2013 budget approved by parliament, the general government deficit and debt for 2012–13 would be well below their respective Maastricht reference values. Inflation and interest rates have declined to low levels, although the reference values for these criteria are yet to be determined by the European institutions. The Latvian authorities’ policy record to date—including the difficult adjustment effort over the past few years—provides assurances for continued stability-oriented policies. Latvia’s accession to the euro area would remove residual currency risk and, by addressing vulnerabilities stemming from foreign-currency exposures, enhance the stability of the already highly euroized financial system.

Despite Latvia’s generally favourable medium-term outlook, risks are tilted to the downside because of the fragile external environment. If adverse developments in the euro area were to cause renewed stress in international financial markets, this could raise Latvia’s borrowing costs in the face of high external debt. A prolonged slowdown in European partner countries would dampen Latvia’s recovery and increase its current account deficit. That said, Latvia does have upside potential if it can attract greater foreign direct investment and create more jobs quickly. Full implementation of the structural reform agenda would make this favourable scenario likelier.

Fiscal Sustainability

With the 2012 budget deficit coming in at under 2 percent of GDP, the 2013 budget further cements past fiscal gains. Taking into account a 2-percentage point redirection of state social contributions to the second pillar, the budget should achieve an underlying structural improvement of about 0.5 percent of GDP, thus complying with both the Maastricht deficit criterion and the Stability and Growth Pact (SGP). Additional priority spending is well distributed, addressing some of the bottlenecks in health and reforming lower-end teachers’ salaries. However, some elements of the budget could have been better targeted, such as the one-percentage point cut in the personal income tax (PIT) already legislated. The cuts to and decentralization of the guaranteed minimum benefit (GMI) could adversely affect the most vulnerable segment of society. This measure should be reconsidered following the study being prepared by the World Bank, and replaced with benefit reforms consistent both with improving incentives to work and ensuring adequate safety net coverage.

Over the medium term, the authorities should take advantage of the ongoing economic recovery to continue building fiscal space. The planned cumulative PIT cuts of 5 percentage points over 2013–15 should be reconsidered, at least for 2014 and beyond: better options could include a two-tier system or an increase in the minimum non-taxable allowance. Compensatory structural reforms would be needed under unchanged PIT policies and in any case to offset numerous other headwinds, such as restored indexation of paid-out pensions, partial restoration of second-pillar pension contributions, and the gradual lowering of required dividend ratios for state-owned enterprises (SOEs). Offsetting measures could include, inter alia, strengthened property taxation, the elimination of some wasteful subsidies, and more careful targeting of social insurance and tax exemptions.

Maintaining the momentum on structural fiscal reforms will be crucial for medium-term fiscal sustainability. The Fiscal Discipline Law (FDL) pending in parliament should be passed expeditiously. Its passage would allow the Medium Term Budgetary Framework (MTBF) to set binding expenditure ceilings for three years, reducing the risk of budgetary slippages, and helping the country stay on the path towards its Medium Term Objective (MTO). Containing fiscal risks from the SOE sector should remain high on the agenda and requires longer term solutions to improve the management and transparency of public corporations. Pending legislation will establish a partially centralized ownership agency and require regular publication of financial information; its passage should be a priority.

External and Financial Sector Resilience

The rather rapid increase of non-resident deposits (NRDs) in the banking system warrants vigilance. While the expansion of NRDs is associated with an accumulation of foreign assets, the increasing size of the sector represents a source of vulnerability to international reserves and—via sovereign backing for the deposit guarantee scheme—a significant contingent fiscal liability. The supervision of NRD-specialized banks should be sufficiently intensive and frequent given their relatively higher risks. Appropriately, minimum capital requirements on NRD-specialized banks are already higher than for others. Going forward, NRDs should be required to be backed by more liquid assets than other deposits, in the context of Basel III implementation.

Reserve cover remains low in relation to short-term external debt. This is due mainly to the expansion of non-resident deposits in the banking system, although these are accompanied by an accumulation of foreign assets. External shocks such as re-intensification of the euro area crisis, or greater deleveraging by Nordic parent banks could potentially put pressure on foreign reserves. In this context we welcome the authorities’ plans to lock-in current favourable yields by issuing debt and thereby pre-funding debt service due in 2013.

Structural Reforms to Enhance Competitiveness

Latvia’s competitiveness has been improving steadily, but further structural reforms are needed. After declining by over 20 percent between 2008 and 2010 in unit labor cost terms, the real effective exchange rate has continued to depreciate more gradually since 2010. We assess that the real exchange rate is now broadly in line with fundamentals. But continued micro-economic reforms are needed to bring down the stubbornly high rate of structural unemployment, close the modest remaining competitiveness gap, and beyond that, to preserve competitiveness in a fixed exchange rate system.

While Latvia’s labor market demonstrated remarkable flexibility during the crisis, there remains scope to promote work incentives. Several fiscal reforms should be considered from this perspective. The guaranteed minimum income (GMI) benefit—which currently phases out one-for-one with income—places a very high tax wedge for GMI recipients entering employment. Consideration should be given to reducing the benefit more gradually with rising income levels. Separately, a shift towards in-work tax credits and benefits could be considered as these have proven to be effective in increasing employment of lower skilled workers.

Building on strong efforts to date, several other reforms are needed to improve the business environment and attract foreign direct investment. These include reforms to the judicial system, to address court system delays and curb abuses of the insolvency framework; the governance structure and transparency of SOEs; and the quality of higher and vocational education. The authorities’ plans for reform in each of these high-priority areas, while well advanced, still depend on political agreement and parliamentary approval of the necessary legislation. Full and timely implementation of these reforms would result in a significantly better business environment, in turn improving prospects for sustainably higher investment, employment, and living standards.

The IMF team is grateful to the authorities for their generous hospitality and open and constructive discussions during the mission, and also to the many social partners and non-government representatives who made time to meet with us.