Mission Concluding Statement 

Republic of Latvia: Staff Concluding Statement of the 2024 Article IV Mission

June 18, 2024

Washington, DC: The Latvian economy contracted in 2023 with significant disinflation against the backdrop of geopolitical headwinds. Notably, Russia’s war in Ukraine and the related geoeconomic fragmentation are adding to long-standing challenges to productivity, investment, and labor supply, amid multiple transitions around climate change and energy, aging and labor shortages, and rising defense costs. Considering the improving outlook, a less expansionary fiscal stance for 2024 is warranted, while the medium-to-long-term fiscal strategy should create fiscal space to support public investment and address long-term spending pressures. Although the financial sector continues to be resilient, continued monitoring of macro-financial vulnerabilities and spillovers is warranted. Structural policies should focus on boosting investment and productivity, meeting new challenges from Russia’s war in Ukraine and ongoing multiple transitions, while continuing to ensure social support and policy predictability.

Economic Situation

The Latvian economy contracted with significant disinflation. After the post-pandemic recovery, growth contracted by 0.3 percent in 2023, due to tighter financial conditions and weak external demand. Real GDP growth for Q1 2024 was 0.9 percent year-on-year, driven by private and public consumption and improving external demand. Headline inflation declined to 0.0 percent y/y in May 2024, compared to 0.9 percent in December 2023. However, core inflation still stood at 3.1 percent in April 2024, down from 4 percent in December 2023. Persistent service inflation, driven by strong nominal wage growth (11 percent y/y in Q1 2024) amid tight labor markets is keeping core inflation elevated. The financial sector has so far been resilient although risks are elevated. Fiscal performance in 2023 was stronger than expected, reflecting revenue buoyancy linked to inflation and less need for energy support measures. The current account deficit narrowed to 4 percent of GDP in 2023 from 4.8 percent in 2022, due to import contraction and lower energy prices.

Russia’s war in Ukraine and the related geoeconomic fragmentation are adding to structural challenges amid multiple transitions. Productivity growth has failed to match real wage increases, weighing on competitiveness. The Russia’s war in Ukraine continue to depress private investment and productivity, thus compromising further Latvia’s lagging income convergence. It is expected that the government will face long-term spending pressures related to its priorities and multiple transitions around climate change and energy, aging and labor shortages, and rising defense costs. The coalition’s priorities include dealing with the spillovers from the war in Ukraine, ensuring energy independence, addressing social issues, and pursuing tax reform.

Outlook and Risks

Growth is expected to regain momentum in the near-to-medium-term. Real GDP growth is projected to increase from -0.3 percent in 2023 to 1.7 and 2.4 percent in 2024 and 2025, respectively, largely driven by improved household purchasing power supported by real wage growth, higher public investment, and stronger external demand. The expansionary fiscal stance in 2024 will boost growth with upside risks to inflation. Growth in the medium-term is projected to continue at an average of around 2.5 percent, supported by public investment and reforms, including those outlined in the National Recovery and Resilience Plan (NRRP).

Inflation is expected to continue to moderate. Headline inflation (annual average) is projected to decline from 9.1 percent in 2023 to 2.0 percent in 2024, reflecting lower energy and food prices. A slight rise is expected in 2025, reflecting higher projected energy prices. Meanwhile, core inflation (annual average) is projected to slow from 9.8 percent in 2023 to 3.3 percent in 2024 but remain above headline inflation in 2024 and 2025, reflecting persistent service inflation, which is partly sustained by nominal wage growth. Both headline and core inflation are expected to approach the ECB’s 2 percent target after 2026.

Risks are tilted downwards, amid heightened uncertainty. The main risks stem from rising geopolitical tensions and deeper geoeconomic fragmentation, which could result in another surge of energy prices and renewed monetary tightening. Credit risks related to the prevalence of variable-rate loans and high interest costs may weaken consumption and investment growth. Weaker-than-expected external demand would adversely affect the Latvian economy. Risks to competitiveness can also arise given recent high wage growth. Over the medium-term, delays in public investment to boost productivity and structural reforms to address labor supply shortages could weigh on potential growth and delay the green transition.

Fiscal Policy: Balancing Risks while Creating Fiscal Space

Considering the improving outlook, a less expansionary, neutral fiscal stance for 2024 is warranted. The cyclically adjusted fiscal deficit is projected to increase by 0.5 percentage points to 2.4 percent of potential GDP in 2024, reflecting higher spending on the government’s priorities (e.g., security, health, and education). Keeping the 2024 cyclically adjusted deficit broadly unchanged, relative to 2023, would require an adjustment of 0.5 percentage points of GDP. While underspending and revenue overperformance may deliver the desired stance in the end, proactively identifying spending efficiency and better targeting social support, while protecting the most vulnerable, will help. Staff commends the authorities for the amended law on energy support, which improves the targeting of energy support measures.

In 2025, the fiscal stance should be tighter to build buffers for future spending needs. The 2025 budget should aim to reduce the cyclically adjusted deficit to about 2 percent of potential GDP, implying an adjustment of about ½ percent of potential GDP. Policy options to achieve this include reducing tax exemptions, raising revenue from property taxation by updating cadaster values with market prices, strengthening tax enforcement, and improving investment spending efficiency, while protecting the most vulnerable. Fiscal policy should remain flexible and evolve if risks materialize.

Although Latvia has some fiscal space, structural fiscal measures are needed to provide buffers for future spending challenges. Over the medium-term, options for fiscal consolidation include (i) broadening the bases of corporate income tax (CIT) and personal income tax (PIT), including by reducing the shadow economy; (ii) broadening the base of property taxes; (iii) reducing tax exemptions and fossil fuel subsidies, and (iv) rationalizing spending on goods and services. This will also create the needed room for higher public investment in infrastructure and research and development.

Additional reforms are needed to accommodate long-term spending pressures. Significant investments are planned in green and digital transitions, healthcare, education, and affordable housing. Given this scaling-up of public investment amid high uncertainty and the large cost overrun in Rail Baltica (originally estimated at 4.6 percent and now at about 22.6 percent of 2024 GDP), urgent improvement in public investment management is warranted to mitigate fiscal risks. The mission welcomes the healthcare reform aimed to generate efficiency gains, while mitigating risks and supporting solidarity. Recent reforms raised the minimum contribution period required for a pension from 15 years to 20 years effective January 2025. Staff also welcomes the government’s pension reform efforts to increase the retirement age by three months annually until it reaches 65 years in 2025 and recommends linking both the official and early retirement ages to future life expectancy gains to encourage longer work lives after reaching 65. Latvia should swiftly implement investments outlined in the NRRP and strike the right balance among fossil fuel subsidies, pricing/carbon taxes and norms to achieve climate goals efficiently, while supporting sustainability.  

Financial Sector Policies: Balancing Risks and Resilience

The financial sector has so far been resilient although risks are elevated. The banking sector remained well capitalized and liquid, with a low NPL ratio. Bank profitability was boosted by the rise in interest rates on loans. Despite the higher interest rates on term deposits, the share of term deposits remained low, thus attenuating the increase in banks’ funding costs. Domestic credit growth moderated in 2023, reflecting the slowdown in growth and higher borrowing costs. The main vulnerabilities relate to corporate and household credit risks given the prevalent share of variable-interest-rate loans to both households and non-financial corporations (87 and 94 percent of outstanding loans respectively). Housing prices are still high by historical standards in Latvia, though housing price-to-wage ratios suggest a slight improvement in affordability in 2023.

Continued monitoring of financial sector vulnerabilities and macrofinancial spillovers is warranted. Given heightened credit risks due to rising interest rates and the prevalence of variable-interest-rate loans, regular risk-based monitoring of banks’ asset quality supported by tailored stress testing should continue. Staff welcomes the authorities’ enhanced climate risk oversight. The mission also welcomes the continued efforts to mitigate cybersecurity risk, including participation in ECB 2024 cyber resilience stress tests, education of market participants, and regular crisis preparedness exercises.

The current macroprudential policy stance is broadly appropriate. The overall policy stance strikes the right balance between maintaining financial stability and the need to extend credit to the economy. Staff welcomes the authorities’ recent decision to gradually raise the countercyclical capital buffer requirement from zero to a positive neutral rate.

Any households’ financial distress related to variable-interest-rate mortgage loans should be addressed through the consumer bankruptcy framework. The social protection system could provide additional support outside this framework for the most vulnerable. While the new untargeted interest subsidy scheme for variable-rate mortgage loans is budget-neutral, financed by the mortgage borrower protection fee (MBPF) on credit institutions, it may hamper the transmission of monetary policy. The MBPF may also affect banks’ profitability and capital adequacy. Such discretionary fiscal measures should not be renewed at the expiration of the current law in 2024.

The authorities should refrain from further fiscal initiatives to increase taxes on bank profits. The government implemented a 20 percent corporate income tax advance payment for credit institutions, based on last year’s earnings instead of distributed profits. While this measure is likely to have limited effect on bank profits and capital adequacy given the temporary profit boost from rising interest rates, further tax increases may undermine banks’ capacity to extend credit to the economy, reduce their capital headroom, and weaken financial stability.

Latvia has made further progress in strengthening its AML/CFT framework and governance reforms. Staff commends the authorities’ effort to pursue AML/CFT reforms and supports the authorities’ priorities to prepare for the 6th round of MONEYVAL evaluation. The mission also welcomes the authorities’ reforms to digitalize the procurement system and the continued implementation of Latvia’s anti-corruption plan and national strategy.

Structural Policies to Enhance Productivity and Resilience

(i) Boosting Investment by Corporate Reforms

Corporate reforms could boost investment and productivity by improving capital allocation and access to finance. By facilitating the exit of unproductive firms, insolvency reforms can facilitate the reallocation of resources towards more productive firms. Staff commends the authorities on the transposition of the EU Directive 2019/1023 on restructuring and insolvency and looks forward to the initial assessment of the latest reforms. Regarding access to finance, the share of firms considering availability of finance as a major obstacle to investment is among the highest in the EU. Ongoing efforts to recapitalize firms with negative equity and develop domestic capital markets could improve firms’ access to finance and reverse Latvia’s decade-long weak investment growth. The listing of SOEs could also help improve their corporate governance and productivity.

(ii) Boosting Productivity by Labor and Product Market Reforms, and Digitalization

Reforms to boost high-skilled labor supply could enhance investment and productivity. Latvia faces skilled labor shortages due to an aging population and emigration, although the net migration was positive in 2023. Efforts should focus on promoting training and internal labor mobility towards priority sectors (green transition, digitalization, health), adopting technology (including AI) and enhancing and strengthening migration processes, reducing employment protection, and improving labor force participation for women aged 25-44 to further reduce gender inequality.   

Further streamlining product and service markets regulations could boost competition, innovation, and productivity. For instance, there is still some room to reduce entry barriers in sectors where the presence of state-owned enterprises is high. Additionally, according to the BoL’s survey of real estate developers, it takes longer to approve construction documentation in Latvia than in Estonia and Lithuania. To expedite the construction documentation approval and boost housing market and investment, Latvia should streamline spatial planning and construction regulation. The authorities should expedite the “Green Channel” initiative to reduce regulatory burdens and boost green and high-value-added foreign direct investments. The mission welcomes the ongoing overhaul of the administrative procedures and the digitalization of administrative procedures related to the construction sector.  

Implementing measures to promote digital transformation could help reduce labor shortages and support productivity. Latvia’s authorities should: (i) enhance connectivity, increase adoption, and use of digital technologies, and unleash digital innovation; and (ii) implement NRRP measures focusing on digitalization.

(iii) Climate Change Policy and Energy Security

More vigorous climate policy is needed because Latvia’s greenhouse gas emissions have increased since 2000, against the trend in the EU. The climate law and the National Energy and Climate Plan (NECP) are expected to be adopted by the end of the year to ensure policy predictability and certainty. Latvia’s NECP specifies several useful measures to address climate change. These include implementing a tax for combustion installations outside the EU ETS, phasing out fossil fuel subsidies, increasing investments and transitioning to renewable energy (mainly wind energy), energy efficiency, investing in grid connections and interconnections, and supporting the electrification of transport. In addition, Latvia intends to reduce GHG emissions from land use and build carbon sinks. The NRRP also aims to enhance energy efficiency in private and public buildings and modernize and green electricity networks.

The authorities should aim to achieve a robust balance between fiscal support, carbon pricing or taxation, and norms, while addressing distributional concerns.

• Pricing/carbon taxation. At 20 percent, the share of Latvia’s emissions covered by the European Union’s ETS is the lowest in EU. Efforts should focus on designing measures to extend carbon pricing to emissions not covered by the EU ETS and enhance effectiveness of carbon taxation on sectors with the largest non-ETS emissions, such as transport and agriculture.
• Implicit fossil fuel subsidies. Removing implicit subsidies, particularly the favorable tax treatment of diesel for vehicle use would help equalize abatement costs across activities, promoting efficient decarbonization.

Given the damages from recent extreme climate events in Latvia (extreme heat waves, floods, and hail), staff welcomes the ongoing work on climate adaptation focusing on: (i) integrating adaptation into long-term planning frameworks of the government; (ii) adaptation with large positive externalities (e.g., climate risk research, updating building codes, strengthening infrastructure, early warning systems), and (iii) addressing distributional concerns. Work on updating the adaptation strategy is also ongoing in close coordination with municipalities.

Latvia should continue to enhance energy security in line with staff advice, including by increasing the share of renewable energy in the energy mix and boosting investment in clean energy and connections. This could entail (i) setting a more ambitious target for renewable energy share than the current target of 57 percent of gross final energy consumption by 2030; and (ii) specifying measures to achieve this target.

An IMF team conducted meetings in Riga during June 4–17, 2024. The mission was led by Mr. Bernardin Akitoby and comprises Nina Budina, Bingjie Hu, and Keyra Primus (all EUR). Carlos Acosta (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.