Mission Concluding Statement 

Republic of Latvia: Staff Concluding Statement of the 2022 Article IV Mission

June 16, 2022

Washington, DC: Tackling the spillovers of the war in Ukraine is now the dominant policy challenge facing the authorities. In the short term, fiscal policy needs to help alleviate pressures due to the war including mitigating the impact of higher energy prices on the most vulnerable while improving the composition of public investment spending to ensure energy security and support the recovery and resilience of the economy. Although the financial sector has been resilient so far, the spillovers of the war to the financial sector warrant close monitoring and contingency plan preparedness. In the longer term, the overriding policy priority is to accelerate the structural transformation of the economy and make it more inclusive. Notably, policies should (i) facilitate labor reallocation, (ii) address long-standing challenges of inclusiveness, and (iii) accelerate the transition toward a greener and smarter growth.

Economic Situation

The economy fared relatively well during the pandemic. New COVID-19 infections have so far declined substantially, while progress on vaccination helped reduce hospitalization and mortality rates. About 70 percent of Latvia’s population had been fully vaccinated by end-May 2022. With the improved health conditions, real GDP rebounded by 4.5 percent in 2021, thus exceeding its pre-crisis level, thanks to strong consumption and investment supported by significant fiscal support. GDP growth for Q1 2022 surprised on the upside (6.7 percent year-on-year), as households drew down savings accumulated during the pandemic to finance private consumption.

However, the war in Ukraine may have major repercussions for Latvia’s economy. Vulnerabilities come mainly from trade exposure to Russia, notably Latvia’s high dependence on imported Russian gas until recently. The spillover effects from the war are already manifested in spikes in energy and food prices, supply disruptions, refugee inflows, and increased budgetary pressures. In May, inflation accelerated to 16.8 percent year-on-year---the highest level since 2009--, as prices surged for food, housing, utilities, and transport. The rise in energy and food prices prompted a fiscal response of about 1.1 percent of GDP to cushion the impact on the population. So far, the government has also provided crucial support for the almost 32,000 Ukrainian refugees in Latvia.

Outlook and Risks

The balance of risks to growth is tilted to the downside. The war in Ukraine constitutes the dominant downside risk to Latvia’s economic outlook. Growth is projected to slow down to about 2.5 percent in 2022 and 2.7 percent in 2023, as high inflation starts to weigh on private consumption and the negative confidence shock reduces private investment. Inflation is forecasted to remain elevated due to continued high energy and food prices and lingering supply bottlenecks. Average inflation is projected to peak this year at 14.5 percent before declining to 7.5 percent in 2023. In the medium term, output is projected to rebound somewhat, supported by higher domestic demand and an increase in EU-financed capital spending. Key downside risks include disruptions of gas supplies and a further surge in energy and food prices, which would hurt output and intensify inflationary pressures, as well as the potential for new COVID-19 variants to appear.

Fiscal Policy: Supporting the Recovery and Alleviating the Spillovers from the War

Fiscal policy should be flexible and stand ready to respond to the changing circumstances. As most COVID-19 relief measures will be phased out, the structural fiscal balance is projected to strengthen by about 1 percent of GDP this year, although discretionary current spending and investment are slated to rise. However, given the unusually high uncertainty, fiscal policy must be flexible in the short term. Notably, automatic stabilizers should provide a first line of defense, while fiscal policy remains attuned to short-term developments. If ongoing or future shocks lead to a material worsening of the economic environment, high-quality discretionary spending should be used to mitigate the impact on the economy and protect the vulnerable. Moreover, non-priority spending should be contained to help relieve inflationary pressures and free up scarce fiscal resources to support higher spending associated with the war. Contingency plans are advisable in case the crisis is more prolonged and the need for policy response is larger than envisaged.

Fiscal support to alleviate the impact of high energy prices should be temporary, timely, and targeted. Time-bound fiscal support was quickly deployed to cushion the impact of high energy prices on households. However, a large portion of this support was not targeted. Scarce public resources should be used to target energy support measures to the most vulnerable. Broad-based measures not only reduce available resources that could otherwise be used to support the most vulnerable groups, but also add to inflationary pressures. Targeted support could rely more on income transfers through strengthened social safety nets and less on blunting the signal from higher prices. Over the medium term, it is advisable to allow the pass-through of international energy prices to domestic consumers and adjust utility prices in line with the change in costs to ensure the much-needed energy efficiency. Measures that cause disruption to tax policy and undermine commitments to the green transition should be avoided to the extent possible.

Financial Sector Policy: Strengthening Resilience and Reviving Credit Growth

Although the financial sector has so far been resilient to the pandemic, the spillovers of the war warrant close monitoring. The financial sector remains well-capitalized and liquid. Bank profitability has recovered, almost reaching pre-COVID-19 levels in 2021. The overall NPL ratio has continued to be on a downward trend. Bank deposits were boosted by household savings, which grew by about 10 percent in 2021. While credit to households has accelerated, corporate lending remains weak. The war in Ukraine and related sanctions pose new risks to the financial sector. Although direct exposures to deposits from Russia have been drastically reduced thanks to the AML/CFT reforms, the real-financial feedback loop requires close monitoring. Consequently, supervisors should continue to monitor banks’ sectoral portfolios and conduct related risk assessments and stress tests. Moreover, the authorities have already stepped-up contingency plans to mitigate risks from cyberattacks.

Corporate recapitalization and an improved insolvency regime could help revive bank credit. Latvia’s decade-long credit-less recovery has been unusually protracted, reflecting both supply and demand factors. Policy priorities should continue to focus on corporate recapitalization and the ongoing reform of the insolvency regime. While the existing recapitalization fund for large enterprises is welcome, it is important to assess the size of the corporate equity gap and policy options to support SMEs and micro firms. Grant-based support would be the best suited option for micro enterprises. Recapitalization programs should be based on a “triage” approach (sorting companies into viable, viable with restructuring, and non-viable categories. In the meantime, the ongoing implementation of the EU Restructuring Directive should be accelerated to address remaining gaps in the insolvency regime, including upgrading the rehabilitation process and simplifying corporate debt restructuring through out-of-court and hybrid restructuring procedures.

Macroprudential policy should stand ready to respond to changing housing market conditions. Although real-estate prices have increased, they appear to be in line with wage growth and remain less buoyant than in the other Baltic countries. Already in 2020 the authorities took preventive action to introduce new borrower-based measures to strengthen the resilience of credit institutions and protect borrowers from potential future shocks. Given the new risks caused by the war, the frequent reviews of macroprudential measures should continue to ensure the right balance between financial stability and the need for credit in the economy.

Latvia continues to make significant progress in strengthening its AML/CFT framework. Further progress has been made through legislative amendments, enhanced investigative powers, application of risk-based supervision, and provision of additional staff to the relevant agencies. The authorities should persevere with their plan to further strengthen the effectiveness of their AML/CFT regime, including through renewed emphasis on emerging risks (including sanctions evasion) and enhanced risk-based supervision of banks. The reform aimed at banks formerly serving foreign clients (BSFCs) should continue to be executed.

Structural Policies: Investing for a Sustainable and Inclusive Recovery

and Growth

The highly uncertain environment calls for strengthened management of the National Recovery and Resilience Plan (NRRP), which underpins the government’s structural reform agenda. The more protracted disruptions to global supply chains and the rising costs of materials will likely complicate the execution of the NRRP. Long completion delays and the surging costs of capital and labor will put pressure on the budget. The government should, therefore, devise strong contingency plans. Reducing efficiency gaps in the public investment management process and improving public procurement transparency take on renewed urgency to achieve value for money. Latvia’s structural transformation hinges on the timely achievement of the NRRP’s milestones and targets.

Measures to enhance energy security should be compatible with Latvia’s green transition goals. In the near term, stepping up crisis preparedness and contingency planning should be a top priority. The authorities have already implemented measures to ensure uninterrupted gas supplies in the near term, including through building up reserves. In the medium term, diversification of supplies, including through expanding LNG import capacity, strengthening network connections, and boosting investment in clean energy would significantly enhance energy security. Inefficiency in energy use should be reduced, supported by the pass-through of international prices and well-targeted fiscal measures. Latvia has already achieved significant greenhouse gas (GHG) emissions reduction relative to 1990 and is on track to meeting its climate goals. While actions have been taken to reduce the carbon footprint of transport, more could be done to incentivize decarbonization in the sectors not covered by the EU’s emission trading system (ETS). In particular, consideration could be given to increasing the level and coverage of carbon pricing and using the proceeds to support vulnerable households, boost green investment or reduce labor taxation.

Adverse demographic developments and skill mismatches call for a comprehensive response. The declining population and shortages of qualified workforce are viewed as the main constraints to long-term growth. Recognizing this challenge, the government has put in place a wide range of programs to enhance employment. Given the still high structural unemployment and the acute shortages of skilled workers, the government should work with social partners to increase the take up of ALMPs and improve the design where necessary, leveraging its social dialogue with employers and trade unions. The use of targeted labor market policies to enhance employment should be supplemented with measures aimed at improving the business environment and strengthening the social safety net to support those who are unable to return to work. Consideration could also be given to easing the access of migrants to the labor market. The ongoing integration of Ukrainian refugees provides useful experience in this respect.

Efforts to reduce inequality and promote social inclusion should continue. Income inequality in Latvia is among the highest in the EU and largely reflects weaker social protection in comparison with peers. Vast regional differences in employment opportunities are another important contributor to inequality. The authorities are taking a range of measures to improve outcomes, including strengthening the adequacy of minimum income benefits, old-age pensions, and support to people with disabilities, along with reforms and investments to improve education and infrastructure in the regions, with support from the RRF. Given that Latvia has both one of the lowest levels of health care spending relative to GDP and one of the shortest life expectancies, adjustments to the pension system should be accompanied by increased investment in the health sector. In this regard, forceful implementation of the new health care strategy could help.

Pressing ahead with the digitalization agenda is key to boosting productivity and innovation. Latvia has made important progress in fast broadband coverage and digital public services. At the same time, performance in areas like acquisition of basic and advanced digital skills, digitization of business processes and creation of high-tech products and services suggests room for improvement. Closing the gaps in digital skills, including through closer cooperation between educational institutions and businesses, support for the digitization of SMEs, promoting the use of big data and AI, and incentives for innovative start-ups, would enhance considerably Latvia’s economic potential. Investment in VHCN “last-mile” infrastructure will address the problem of bringing fast internet connection to end-users in rural areas, thus helping reduce the digital divide. The main constraint to the digitalization agenda is the availability of skilled IT workers. A close cooperation between employers, educational institutions, and the government to update curricula and promote studies in STEM disciplines could help address this challenge.

An IMF team conducted meetings in Riga and virtually during June 1–15, 2022. The mission was led by Mr. Bernardin Akitoby and comprises Keyra Primus, Rossen Rozenov, Bogdan Lissovolik, and Carlos Acosta. Inese Allika (OED) participated in the meetings. The mission would like to thank the authorities for their open collaboration, generous availability, and the candid and constructive discussions.