Mission Concluding Statement 

Republic of Latvia: Concluding Statement of the 2015 Article IV Mission

March 2, 2015

1. Latvia has made remarkable economic progress since the financial crisis. The economy is performing close to potential; unemployment, although still high, is now mainly structural in nature; and the real effective exchange rate is broadly in line with fundamentals. Prudent fiscal policy is underpinned by the Fiscal Discipline Law. The country experienced a smooth entry into the euro area.

2. The recovery has recently slowed considerably. GDP growth decelerated to 2.4 percent in 2014, reflecting the prolonged closure of steel manufacturer Liepajas Metalurgs (LM), and weak economic performance in the euro area and Russia amid rising geopolitical tensions. In 2015 the anemic external environment—particularly the sharp slowdown in Russia—will continue to weigh on exports and investment. This is expected to be mitigated, but not fully offset, by higher disposable income due to lower oil prices and robust real wages, the reopening of LM, and the accommodative monetary stance of the ECB.

3. Over time, growth is expected to strengthen as the external climate improves and investment picks-up. Medium-term growth of around 4 percent—higher than in core economies—should be achievable as the economy converges towards euro area average income levels. But this is predicated on strong reform efforts to enhance competitiveness, and continued prudent macroeconomic management. The outlook is subject to significant downside risks. A prolonged slowdown in Russia and the euro area would further dampen confidence and thwart a pick-up in economic activity, while a failure to tackle the structural reform agenda would impede productivity growth and diminish competitiveness over the medium term.

A. Reviving Bank Credit

4. Bank credit to the private sector continues to contract, and is increasingly likely to constrain investment. For several years after the crisis, productivity grew faster than wages, allowing firms to finance investment through retained earnings. But with tightening labor markets and recent high growth in real wages, reviving credit growth should be a policy priority. Efforts to catalyze SME lending by providing loan guarantees and developing credit bureaus with standardized information should be encouraged.

5. Reforms to further reduce the private sector’s debt overhang could help revive the demand for credit, lower perceptions of credit risk and underpin a rebound in investment. To this end, increasing the efficiency of the judicial system—particularly in connection with bankruptcy procedures—should be prioritized. Initiatives to increase access to mediation and arbitration facilities, thereby reducing the caseload on regular courts, are welcome. The recent compromise on amendments to the insolvency law should help foster a better environment for credit growth to households.

B. Fiscal Policy

6. The 2015 budget is in line with the authorities’ Fiscal Discipline Law. The structural balance target of -1 percent of GDP strikes an appropriate balance between the need to rebuild fiscal space over the cycle, while avoiding fiscal drag in a less robust economic environment. Given the unusually large uncertainties surrounding the external environment, the budget should be flexibly implemented, allowing automatic stabilizers to operate fully in case economic growth falls below the forecast. However, discretionary spending should remain in accordance with the Fiscal Discipline Law.

7. While the budget contains some measures to address high levels of inequality, more is needed. The cuts to Latvia’s Guaranteed Minimum Income (GMI) benefit in 2013, and the de-centralization of the scheme’s financing should be reconsidered, in line with the recommendations of the World Bank study.

8. Over the medium-term, fiscal policy will need to contend with several potential headwinds. Planned declines in the PIT rate and a gradual reduction in SOEs’ payout ratios will act as a drag on revenue. The shrinking revenue envelope may constrain much needed infrastructure and social spending. Reductions to the PIT rate should be reconsidered. A better way to improve work incentives would be to implement a more gradual phase-out of the GMI benefit, which currently falls one-to-one with income. Efforts should be made to improve revenues from land taxation. Measures to reduce the scale of the grey economy—which have already yielded good results—should be continued.

C. Financial Sector Supervision

9. Latvia’s three largest banks passed the ECB’s Comprehensive Assessment with flying colors. The wider banking system is also well capitalized and liquid, with average capital ratios and liquidity coverage ratios substantially above the required minimum.

10. Non-resident deposits (NRDs)—which account for about 50 percent of all deposits in the banking system—should continue to be monitored vigilantly. Recent geopolitical tensions have highlighted the need for intensive supervision, although to date there has been little indication of significant disruptions to NRD flows. The regulators should continue to strengthen due diligence and maintain frequent on- and off-site bank inspections. Appropriately, minimum capital and liquidity requirements on NRD-specialized banks are already higher than for others.

D. Productivity Growth and Competitiveness

11. Latvia’s most important medium-term challenge is to maintain competitiveness within the euro area currency union. Recent wage growth in excess of productivity growth points to a possible erosion of the hard-won gains in competitiveness achieved since the crisis. In order for Latvia to consistently exceed average euro area growth and thereby close the income gap with core economies, productivity growth must be supported by appropriate policies.

12. Labor market reforms to improve work incentives should be implemented. A system of in-work tax credits and benefits should be considered because empirical evidence suggests that these have proven effective in increasing employment of lower skilled workers. In light of recent wage developments including large increases in the minimum wage, future raises of the minimum wage should not exceed the rate of productivity growth.

13. Reforms in several other areas would help enhance competitiveness. The recommendations of the World Bank study on ports should be implemented expeditiously. Centralizing SOE management while divesting non-core activities—in line with long-planned reforms—would improve efficiency and accountability. Reforms to higher and vocational education, which could help reduce skills mismatches and lower structural unemployment should also be prioritized.

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 private sector representatives, social partners and non-government stakeholders who made time to meet with us.