Latvia: Staff Concluding Statement of an IMF Article IV Consultation

IMF News, May 31, 2017

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Economic fundamentals are sound, though a continued prudent and balanced policy mix will be needed to maintain sustainable growth, and to preserve past competitiveness gains.
While the economy is gaining momentum, ongoing reforms will be needed to address crisis scars, and to combat economic headwinds, e.g., demographic challenges, in the years ahead.
The financial sector has a key role to play in supporting growth and maintaining stability; while efforts to address the shadow economy can bring multiple benefits.

Macroeconomic conditions remain broadly sound:
- Fiscal and current accounts are at prudent levels.
- Public debt is low.
- Unemployment continues to fall.
- Inflation remained below the ECB's 2 percent target for the euro zone in 2016, but began to pick up later in the year as energy and food prices reversed.
- For the first time in 5 years, credit growth to the private sector was positive, and indicators suggest that the credit cycle has turned.
Growth outlook:
- Growth is forecast to pick up to around 3¼ percent in 2017.
- Drivers: rebound in investment, continued solid private consumption, and support from net exports as the global economy expands.
Risks:
- Downside risks: prolonged slowdown in key trading partners (notably the Euro Area); geopolitical tensions; financial market disruptions; failure to sustain credit growth; failure of structural reforms.
- Upside risks: faster than anticipated pick up in investment; stronger consumption growth; greater support from net exports.
Policy imperatives:
- Continued sound policy making is vital: balanced policy mix, ambitious reform efforts, vigilant financial sector regulation and supervision.
- Prudent macro policies are important amid rising price pressures driven partly by supply factors, to safeguard competitiveness within the currency union.

The shadow economy hinders economic development and complicates policy making.
Authorities’ action plan is already beginning to deliver results.
Benefits of addressing the shadow economy:
- Strengthen incentives to operate in the formal economy through improved business environment, reduced regulatory and administrative barriers, and improved transparency.
- Associated with greater tax compliance and higher revenues.
- Support credit growth by increasing financial inclusion and improving transparency of corporate and household balance sheets.

Assessment:
- “Crisis scars” and economic headwinds could constrain growth in the years ahead.
- Actual and potential growth rates appear to have settled at more moderate levels since the global financial crisis.
- So-called “crisis scars”: elevated uncertainty, weak corporate balance sheets, tighter credit conditions for SMEs, and high structural unemployment.
- In the absence of meaningful structural reforms, the underlying medium-term potential growth rate of the economy is around 3 percent per year.
Policies to raise potential growth:
- Structural and institutional reforms to support productivity growth (including protection of property rights, legal and insolvency reforms, and increasing access to financial services).
- Higher public investment in infrastructure and human capital.
- Active labor market policies aimed at lowering structural unemployment to help offset negative demographics.
- Careful wage policy to avoid having wage increases outstrip productivity growth.

Current stance:
- The general government balance (ESA definition) narrowed to around zero in 2016, consistent with both Latvian and EU fiscal rules.
- The 2017 budget targets a deficit of 0.8 percent of GDP and is broadly appropriate given Latvia’s low gross financing needs, modest debt, and a still negative output gap.
Short-term guidance:
- Make best use of the pick-up in EU investment funds and allocate these resources to growth-enhancing investments.
Medium-term guidance:
- Fiscal policy should become more neutral over the medium term to avoid risks of procyclical policy.
Tax strategy considerations:
- The Tax Policy Guidelines offer an important opportunity, but the final policy package needs to be clarified and implemented prudently.
- Stated goals: support growth, increase equity, and boost revenues.
- Three key challenges:
- i) finalizing plans swiftly to reduce uncertainty for households and firms,
- ii) carefully managing the macro impact to avoid procyclical policy and undermining future competitiveness,
- iii) sustainably boosting the revenue share to ensure robust public finances even after EU funds diminish.

System condition:
- The banking system remains well capitalized, liquid and profitable.
- Latvia’s protracted period of credit stagnation is over.
- In the sector serving domestic clients, balance sheet repair has continued and credit growth has finally resumed, although households still lag non-financial corporates.
Banks servicing foreign clients:
- Face pressures on correspondent banking relationships, dwindling business, and a continued reduction of deposits.
- Additional buffer requirements for this sector, and low interconnectedness with the rest of the financial system, limit its potential impact on financial stability to date.
Policy recommendations:
- Further actions to strengthen the AML/CFT frameworks and their enforcement will be helpful.
- Continued vigilant supervision is needed to mitigate real and reputational risks, as is close monitoring of regional financial interconnectedness.
- Prudential standards should be maintained while supporting sustainable credit growth to back investment and long-term growth.
- Pursue policies to address market failures lingering from the crisis (both supply and demand elements), for example through programs that facilitate SMEs’ access to credit, and continuing the implementation of insolvency reforms.

Latvia: Staff Concluding Statement of an IMF Article IV Consultation — May 31, 2017