Mission Concluding Statement 

Republic of Latvia: Staff Concluding Statement of the 2023 Article IV Mission

June 13, 2023

Washington, DC: The key priorities are to contain inflation and to address long-standing challenges to productivity, investment, and labor supply. Fiscal policy would need to be tighter in the short-term to help reduce inflationary pressures, while ensuring that any energy support, if required, is well targeted. Fiscal reforms should focus on public investment, pension, health, education, and growth-enhancing tax reform. Financial sector policies should continue heightened monitoring of risks and devise contingency plans. Accelerating corporate reforms could help reverse Latvia’s decade-long pattern of weak investment. To further support investment and productivity, structural policies should facilitate the green transition, boost high-skilled labor supply, reduce the regulatory burden in the product and services markets, and strengthen the digital transformation.

Economic situation

Latvia is facing an inflation shock, slow growth, and geopolitical headwinds . After averaging 17.2 percent in 2022, headline inflation remained elevated at 12.3 percent y/y in May, largely driven by high energy and food price increases. Core inflation accelerated to 12.9 percent in April, as the second-round effects of energy prices were broad-based and much stronger than anticipated. Real GDP growth slowed to 2.8 percent in 2022 from 4.3 percent in 2021, largely reflecting lower increase in inventories and slower fixed investment growth. Real GDP growth for Q1 2023, while surprising on the upside, was only 0.8 percent year-on-year. Against this backdrop, the government will have to continue to deal with the spillovers in the Baltic region from the Russian invasion of Ukraine, the cost-of-living crisis, and energy security. Avoiding a wage-price spiral and loss in competitiveness is a key challenge for Latvia.

These short-term concerns are adding to the long-term policy challenge of sustaining the convergence process . Latvia’s income convergence has already been lagging the other Baltic countries. The geopolitical situation and high inflation will likely depress investment and productivity, with serious implications for future prosperity. To secure high long-term growth in a low inflation environment, Latvia needs to lift productivity, increase investment, and overcome skilled labor shortages.

Outlook and Risks

Amid high uncertainty, the balance of risks is tilted to the downside. Growth is projected to slow to 0.9 percent in 2023 from 2.8 percent in 2022, as high inflation weighs on consumption and external demand declines. In 2024, growth is projected to rebound to 2.7 percent. Headline inflation is projected to retreat to 10.4 percent in 2023, reflecting falling energy prices and weakening demand. In 2024, headline inflation is projected to slow to 3.4 percent. Given the lagged pass-through of energy prices, core inflation is projected to measure 11 percent in 2023, before falling to 5 percent in 2024. In the medium-term, growth is projected to rebound, underpinned by reforms, a rebound in consumption, and public investment. The main risks stem from an escalation of the war and associated sanctions, which could result in renewed increases in energy prices, energy supply disruptions in Europe, and weaker external demand. Global financial conditions could further tighten, with spillovers to Latvian banks and domestic credit growth.

Fiscal Policy: Supporting the Economy while Containing Inflation

Considering high inflation, staff recommends a tighter fiscal stance in 2023 . To ensure fiscal policy will indeed contribute to the disinflationary effort, staff recommends keeping the cash deficit at the 2022 level. Better targeting of energy support measures would help to reduce the cash deficit, while allowing the full pass-through of international fuel prices to domestic consumers. Fiscal policy should remain flexible, given high uncertainty. Automatic stabilizers should provide a first line of response to adverse scenarios with significantly lower inflation and growth.

Fiscal reforms should focus on public investment, pension, health, education, and growth-enhancing tax reform. The National Recovery and Resilience Plan (NRRP) will help boost public investment and productivity. Notably, significant investments are planned in green and digital transition, healthcare, education and skills, research and innovation, and affordable housing. The mission welcomes the government’s efforts to reform the pension system and the authorities’ plans to increase the retirement age by three months annually until it reaches 65 years in 2025. Additional reforms could include: (i) linking the official and early retirement ages to future life expectancy gains to encourage longer work lives once the retirement age reaches 65, and (ii) reviewing the minimum contribution period required for a pension. New emphasis should be put on growth-enhancing tax reform. Also, Latvia’s relatively high labor tax wedge could be reduced to strengthen work incentives and increase high-skilled labor supply. Given that Latvia’s overall tax-to-GDP ratio is below the euro area average, the revenue impact of the labor tax reduction could be offset by increasing revenues from property taxation, rationalizing tax exemptions, and introducing a carbon tax for sectors not covered by the EU Emissions Trading System (ETS).

Financial Sector Policies: Balancing Risks and Resilience

The financial sector has so far been resilient, though tighter financial conditions have accentuated risks . The banking sector remained well capitalized and liquid, with a low NPL ratio. Although new mortgage loans declined, domestic credit growth accelerated in 2022, mostly reflecting increased working capital loans to non-financial corporations (NFC) to deal with higher energy prices. Although rising interest rates have boosted banks’ profitability, they could put more pressure on the borrowers’ ability to service their debt and, therefore, heighten credit risks, especially given the prevalence of variable-interest-rate loans to both households and NFCs. Liquidity risks and interest-rate risks may also be rising, including among nonbank financial institutions.

Consequently, close monitoring and contingency plan preparedness are warranted. Continued monitoring of financial sector vulnerabilities is important, given heightened risks, including from recent global financial tensions. Notably, regular, risk-based monitoring of banks’ asset quality and liquidity should continue, supported by tailored stress tests to identify specific vulnerabilities. Facilitating early debt restructuring and out-of-court settlement between households and banks can help address potential problems resulting from households’ variable and rising mortgage interest rate obligations, while the social protection system can provide support for the most vulnerable. Also, continued efforts are needed to counter cyberattacks and prepare contingency plans to mitigate risks from cyberattacks. In this regard, the mission welcomes Latvia’s efforts through the Nordic-Baltic Stability Group to conduct regular crisis preparedness exercises.

While the current macroprudential stance is broadly appropriate, consideration could be given to increasing the capital buffer to further build resilience. The current macroprudential stance strikes the right balance between maintaining financial stability and the need to support credit to the economy. However, housing prices could surge, if the already low supply of housing is further constrained by the rising costs of capital, labor, materials, and delays in the construction sector. Given that these factors could widen the imbalances on the housing markets going forward, consideration could be given to increasing capital buffer, to avoid a procyclical move later.

Latvia has made significant progress with AML/CFT framework, and the authorities should continue to strengthen it and implement the country’s Anti-Corruption Plan and National Strategy. The progress has been made through (i) implementation of key AML/CFT reforms, (ii) ongoing risk-assessment of banks and non-financial institutions (including independent providers of legal and accounting services), and (iii) training and outreach activities to obliged entities. Steps taken to enhance the risk-based supervision of banks and strengthen the virtual asset service providers framework are welcome. The authorities are encouraged to continue to further improve the effectiveness of their AML/CFT regime, including the beneficial ownership framework and continued focus on emerging risks (e.g., sanctions evasion). Furthermore, implementing the newly adopted Anti-Corruption Plan and National Strategy should be a priority.

Structural Policies:Investing for a Sustainable and Inclusive Recovery and Growth

Latvia should continue to enhance energy security, boost investment in clean energy and connections, and adapt to climate change. Planned measures to address climate change, such as implementing a tax for combustion installations outside the EU ETS, phasing out fossil fuel subsidies, increasing the supply of wind and solar energy, investing in grid connections and interconnections, and supporting the electrification of transport, should be swiftly implemented to facilitate the transition to renewable energy. As a large share of greenhouse gases remains without a price or with a price well below the EU ETS price, Latvia could extend carbon pricing in sectors not covered by the EU ETS. Furthermore, adaptation to climate change should be mainstreamed in all government activities.

Accelerating corporate recapitalization and improving the insolvency regime could help reverse Latvia’s decade-long pattern of weak investment . 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. To improve the insolvency regime,faster implementation of the EU restructuring directive will help simplify debt restructuring through out-of-court and hybrid procedures.

Latvia should advance reforms to boost high-skilled labor supply, given the aging population and emigration. Plans to address the shortage of high-skilled labor as part the NRRP, should be prioritized. Latvia should also continue to leverage active labor market policies (ALMPs) like job search assistance and counseling, vocational training, employment incentives, direct job creation, and support for micro-entrepreneurs and self-employed workers. Improving labor market flexibilityand promoting inward labor migration could mobilize workers not currently available to Latvia’s labor market. Also, stimulating the green labor market through stronger environmental policies and providing targeted training would help to facilitate the move to green jobs.

The regulatory burden in product and services markets could further be reduced to support investment and firm growth. Indicators of Regulatory Policy and Governance (iREG) of the OECD show that Latvia is above OECD average in stakeholder engagement in developing regulations, close to average in regulatory impact assessment (RIA) and below average in ex post evaluation of regulations. Given the longer time it takes to approve construction documentation in Latvia when compared to peers, further streamlining spatial planning and construction regulation could benefit the housing market and investment. The authorities should also accelerate streamlining the regulations for green transition.

Strengthening Latvia’s digital transformation could help reduce labor shortages and support productivity. Latvia’s digital transformation should focus on enhancing connectivity, increasing adoption and use of digital technologies, and unleashing digital innovation. Planned measures to enhance the digital agenda as part of the NRRP should be implemented well and without delay to boost labor supply and positively contribute to future productivity.

An IMF team conducted meetings in Riga during May 31–June 13, 2023. The mission was led by Mr. Bernardin Akitoby and comprises Bingjie Hu, Keyra Primus (all EUR) and Gregor Schwerhoff (RES). Carlos Acosta and Bonolo Namethe (all LEG) participated virtually in meetings. 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.