Journal Issue

Republic of Latvia: Staff Report for the 2017 Article IV Consultation

International Monetary Fund. European Dept.
Published Date:
July 2017
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1. Latvia continues to make steady economic progress, but growth seems to be settling at a more modest pace. Macroeconomic conditions remain sound: the economy has grown consistently since the crisis; the current account and fiscal deficits have been reduced to sustainable levels; public debt is low; and domestic credit is recovering. Nevertheless, growth over the past 3 years has averaged only 2¼ percent, and income per capita remains about 40 percent below the EU-15 average. Indicators suggest that the economy is operating below, but, close to its potential.

2. Investment needs are very large and remain a key obstacle to catching up with Western Europe. Latvia lags EU countries in various investment-related respects: it has the lowest capital-output ratio in the EU-28; and capacity utilization, despite having rebounded strongly since the crisis, is still lower than in most EU countries. Therefore, higher investment rates and modernizing the capital stock are key to raising potential medium-term growth.

3. Lingering effects from the global financial crisis are likely hindering potential growth. While some productivity gains have been reaped in the recent past, there are signs that scars left by the global financial crisis (GFC)—tight credit markets, weak investment environment, and high structural unemployment—may be constraining further productivity gains and limiting potential growth. In addition, pre-existing structural conditions—unfavorable demographic trends, lack of investment in innovation—represent headwinds that will make the road to convergence more challenging.

4. A number of the 2016 Article IV policy recommendations have been broadly implemented. Notably, the authorities are considering a tax reform package with elements consistent with Fund advice, including lowering the tax burden on labor, enhancing equity and boosting the revenue share. Efforts to reform the insolvency regime and judicial system are ongoing. Vigilant supervision of banks servicing foreign clients (BFSFCs), along with strengthened AML/CFT frameworks and enforcement are further strengthening the sector. Reforms in education to reduce skills mismatches are progressing.

Recent Economic Developments

5. Growth slowed somewhat in 2016, held back by the slow absorption of EU funds. Growth, driven primarily by consumption, eased to 2 percent, as gross investment contracted significantly by 11.7 percent on the back of a lower than expected absorption of EU funds. Stricter EU regulations for the current investment cycle, as well as reforms to the domestic implementation system are cited as reasons for slower absorption.1 This effect was compounded by a drag from net exports, as import volume growth accelerated markedly while export growth remained modest. Growth accelerated in Q1 2017, to 4.0 percent year-on-year, faster than expected, on the back of strong consumption and exports, and a pick up in investment.

GDP Growth and Contributions

(Real, annual percent)

Sources: Latvian Central Statistical Bureau and IMF staff calculations.

6. The current account balance rebounded strongly, turning into a surplus in 2016. Despite a strong increase in import volumes, the current account reached a surplus of 1.5 percent in 2016 as the terms of trade, driven largely by falling energy prices, improved by over 4.7 percent—the largest improvement in 10 years.

7. Inflation remained low in 2016, but picked up quickly in the first months of 2017. Headline HICP inflation in 2016 at 0.1 percent was well below the ECB’s 2 percent target for the Eurozone, with the largest drivers being declining energy prices and very low food price inflation throughout the year. Core inflation increased moderately to 1.3 percent but has been rising in recent months.2 Similarly, headline inflation has increased strongly, reaching 3.3 percent in April, on the back of increasing international energy prices and strong base effects.

HICP Inflation

(Yoy percent change)

Sources: Statistics Latvia; and staff calculations

8. Labor market conditions remain challenging. Despite a slight decrease in employment in 2016, the unemployment rate fell modestly to 9.6 percent, as the decline in the number of jobseekers outpaced the decline in the economically active population. Still, unemployment remains high, reflecting a large structural component (about 41 percent of total unemployment in 2016 was long-term) along with skills and regional mismatches. Tight conditions are still observed in some segments of the labor market, especially in the high skilled segment.

9. Wage pressures eased somewhat, but competitiveness must be preserved. Real wage growth decelerated slightly to 4.6 percent in 2016, but still exceeded productivity growth by about 2.6 percentage points. Unit labor cost increases have outpaced peer countries’, and, if continued, this trend could potentially harm company profitability, further constrain investment, and erode Latvia’s external competitiveness in the medium term.

Labor Productivity and Wages

(Index, 2000Q1=100)

Sources: Haver and IMF staff estimates.

Latvia: Unit Labor Cost - Manufacturing


Sources: Haver Analytics and IMF staff calculations.

10. The general government deficit narrowed significantly in 2016. The general government basic deficit (on a cash basis) narrowed to −0.4 percent of GDP, an improvement of more than percent of GDP from 2015. This translated into a structural surplus of 0.2 percent of GDP (ESA definition) compared to the 2016 deficit target of 0.9 percent of GDP. Total revenues (excluding foreign assistance) overperformed by about 0.4 percent of GDP, following measures adopted by the authorities.3 At the same time, expenditures were under executed; both investment related, due to lower than projected disbursement of EU investment Funds (by about 0.8 percent of GDP), and other current spending (by about 0.2 percent of GDP).

11. The financial system remains well capitalized, liquid, and profitable, despite pressures on BSFCs. The capital adequacy ratio, at 21.1 percent in 2016, exceeds the regulatory minimum; the share of liquid assets in total assets is high at 33.8 percent in 2016, and Latvijas Banka’s stress tests show that banks’ capacity to absorb potential liquidity shocks is adequate. Banks remain profitable, maintaining a wide spread between lending and deposit rates. While resident deposits grew by 12.2 percent y-o-y through 2016, system wide deposits declined by 7.4 percent led by a decline of 26.5 percent of non-resident deposits (NRDs). The decline in NRDs, which started in late 2015, together with the significant reduction in USD clearing volumes, has continued in the context of ongoing strengthening of enforcement of AML/CFT requirements and sanction regimes, financial sanctions against Russia, and loss of European-based correspondent banking relationships. Against this background, banks servicing foreign clients are actively exploring options to maintain or reestablish US dollar clearance for their clients. Despite this changing landscape, financial stability has not been impaired to date (Annex II).

12. Credit growth is resuming, albeit slowly. Supported by the moderate economic environment and low inflation, together with a decrease in debt levels, the financial position of domestic borrowers improved and credit growth started to pick-up in 2016 (Figure 4). Credit to the non-financial private sector grew by 2.3 percent y-o-y in March 2017, reflecting growth of 5.1 percent to corporates and −1.1 percent to households. In the case of households, the demand for loans improved as credit institutions eased their credit standards somewhat, and partly on the back of the steadily rising disposable income. However, even though the loan portfolios of households are shrinking at an increasingly slow pace, the annual rate of change remains negative. At the same time, the quality of the loan portfolio improved. The share of loans past due over 90 days shrank to 4.9 and 2.9 percent by end-March 2017 for household and corporates respectively (from 7.6 and 4 percent in 2015).

Figure 1.Republic of Latvia: Real Sector

Sources: Latvian Central Statistical Bureau; Haver Analytics; and IMF staff calculations.

1/ Difference with long-term average.

2/ Numbers under country label are Latvia’s export shares in 2016.

Figure 2.Republic of Latvia: Inflation and the Labor Market

Sources: Eurostat; Haver Analytics; Latvian Central Statistical Bureau; and IMF staff calculations.

Figure 3.Republic of Latvia: Fiscal Developments

Sources: Latvian authorities; Haver Analytics; and IMF staff estimates.

Figure 4.Republic of Latvia: Banking Sector Development

Source: Bank of Latvia; FCMC; and IMF staff calculations.

1/ Data from January 2012 onwards exclude Parex Bank, which lost its banking license in March 2012, and Latvijas Krajbanka, which was suspended in November 2011 and lost its banking license in May 2012.

2/ Data from March 2012 onwards exclude Parex Bank and from May 2012 exclude Latvijas Krajbanka.

3/Alternative methodologies to estimate the credit gap may deliver different findings.

Cumulative Changes in Lending Standards to NFC

(Positive values indicate a tightening)

Sources: European Commission and IMF staff calculations.

Outlook and Risks

13. Growth is expected to pick up to 3.2 percent in 2017, and the current account to return to deficit. An accelerated pace of disbursement of EU funds in 2017 will provide a boost to investment and public consumption as EU-funded projects come on stream. At the same time, private consumption growth is expected to remain robust, supported by slowing, but continued wage growth, a recovery of domestic credit, and improving sentiment. While the general government deficit is projected to increase to accommodate EU-funded investment projects, it is expected to remain within its structural deficit target of 1 percent of GDP. Headline HICP inflation is projected to rise significantly to 3 percent on average in 2017 due to rising energy prices and stronger external price pressures. Second-round effects from the pass through of energy prices, as well as continued real wage growth, will likely affect core inflation, albeit at a much slower pace. The current account is projected to return to a deficit, and widen in the medium term, driven by domestic demand, increasing investment, and the unwinding of the 2016 terms of trade gains. The external position is currently assessed to be stronger than implied by medium term fundamentals (Annex I).

14. A sustained rise in inflation could pose policy challenges. Core inflation, which accounts for about 75 percent of overall inflation, is projected to increase moderately to 2 percent in 2017. While the uptick in headline inflation to 3 percent is projected to be temporary, a continued rebound in energy prices and sustained wage pressures, if not equally matched by productivity gains, could pose risks to the inflation outlook—particularly against the backdrop of a closing output gap. Higher EU fund absorption and thus public investment spending and an increase in minimum wages by 2.7 percent in 2017 could add further demand pressures. The challenge will be to ensure the most efficient use of such investment to boost productive capacity over the medium term.

15. While growth is forecast to pick up in the short run, prospects for further acceleration over the medium term are challenging. A faster absorption of EU structural funds is expected to boost growth in the short run. However, staff’s outlook for potential growth for the medium term has been revised down to 3 percent, due to projected slow growth of total factor productivity (TFP), especially compared to pre-crisis levels, along with low investment, and a persistent demographic drag. This phenomenon—of slower potential growth—is common amongst both advanced and emerging economies. Redoubling of the authorities’ efforts to implement growth-friendly policies will be vital to raise potential growth further. (See section A below).

Note: Upper and lower bou nds of the fans are based on staff judgement, taking into account risks to the forecasts, with uniform probability distribution between the central projection and the bounds.

16. Lower potential growth will tend to slow the pace at which Latvia can converge with the rest of the EU. Absent relative purchasing power movements over time, a change in relative potential—and by extension actual—growth rates over time will directly impact the speed of Latvia’s income convergence. Staff simulations suggest that a 1 percentage point decrease in potential growth could delay the closure of the income gap with the EU-15 by about 12 years.4 As the labor force is projected to decline faster than the overall population, implementation of policies to increase investment and support TFP growth will be essential to ensure more rapid income convergence going forward.

17. Risks to the baseline are more balanced, but are still tilted to the downside. Slower than projected absorption of EU funds and/or failure of credit to the economy to resume would hold back domestic demand, and undermine future growth. While core inflation is projected to remain below the ECB target, headline inflation could remain above 3 percent or rise further should energy prices continue to increase. Failure to implement structural reforms would hold back productivity growth, erode competitiveness, and undermine prospects for increasing potential growth. On the external side: structurally weak growth in advanced economies and a retreat from cross-border integration would pose a risk as an additional drag on the external sector, as would an intensification of security dislocation in Europe. Risks of regional financial instability could impact the domestic economy and financial sector. (Box 1).

Authorities’ view

18. The authorities broadly agreed with staff’s outlook and risk assessment. They agreed that the economy was gaining momentum, but noted that there are no current concerns regarding overheating, with exports performing relatively well and credit to the economy only recently starting to pick up. At the same time, they acknowledged that pressures could materialize in the medium term in some sectors, such as construction, as EU funds and large investment projects come on line. While the external position is assessed to be stronger than implied by fundamentals, the authorities noted that this is largely driven by temporary factors, in particular the recent terms of trade gain. Regarding risks to the outlook, the authorities agreed that efficient absorption of EU funds is key to boosting growth. They noted that economic exposure to some geopolitical risks was more limited than in the past, and identified regional financial links as more pertinent to monitor. They noted that maintaining prudent policies, effectively implementing their tax reform, and continuing their strong record of structural reforms are keys to mitigating risks, and boosting medium term growth.

Policy Discussions: Medium-Term Challenges

Policy discussions centered on the outlook for medium-term potential growth, and the key policies to enhance productivity to increase the pace of convergence with Western Europe. Structural policies will need to focus on addressing legacies from the financial crisis and structural headwinds. Carefully calibrated fiscal policy can play an important role through measures to boost productive investment, improve labor supply, and strengthen social safety nets. Financial sector policies to unlock credit growth are key to boosting investment and supporting medium-term growth.

A. Potential Growth Outlook: Confronting Crisis Legacies

19. Growth rates appear to have settled on a much lower path after the GFC, affecting the outlook for Latvia’s convergence path. While pre-crisis growth, which was unsustainably high during boom years, averaged 9.9 percent over 2003–07, average growth slowed significantly to about 2.7 percent over 2012–16. This phenomenon is common amongst many ad vanced and emerging economies as crisis legacies in the form of weak corporate balance sheets combined with tight credit conditions, an adverse feedback loop of weak aggregate demand, investment, and capital-embodied technological change, and elevated economic and policy uncertainty have undermined particularly TFP growth.5 From a demand-side perspective, the largest factor contributing to this slowdown was gross fixed investment with its contribution to growth dropping from 4.8 percent to about −0.2 percent on average over these horizons. As noted previously, if this trend persists, the convergence path for Latvia, whose GDP per capita (in purchasing power standards) was about 62 percent of the EU-15 average in 2015, would flatten significantly.

Latvia: Real GDP Growth


Sources: Latvian Statistical Office and IMF staff calculations.

20. New estimates suggest that the potential growth rate of the economy is lower than before the crisis. Staff’s estimates suggest that potential growth has declined considerably, on average from about 6.9 percent in the pre-crisis period (2003–07), to about 2.2 percent more recently (2012–16). And while the immediate post-crisis period saw a spurt in potential growth, this proved short-lived having settled at a much lower level, about 2.5 percent in 2016. The output gap in 2016 is estimated to be about −0.5 percent suggesting that the economy is operating close to its potential. Such an assessment is borne out by inflation below the ECB target in 2016 and an unemployment rate, which is close to the NAIRU. And although pre-crisis growth rates were unsustainable and thus undesirable going forward, this represents a significant downward shift in potential growth, reflecting the lasting effects of the GFC, which seem to have undermined a significant part of the economy’s productive capacity.

Latvia: Potential Growth Estimates

(In percent)

Sources: Statistics Latvia; Haver; and IMF staff calculations.

21. Multiple factors contributed to the decline in potential growth, with the largest being total factor productivity (TFP). A growth accounting exercise, which takes factor utilization into account, shows that while capital accumulation contributed about 48 percent to overall potential growth in 2003–07 and about 54 percent in 2012–16, the contribution of TFP decreased from 50 percent to about 3 percent in the same period. (see Republic of Latvia-2017 Selected Issues Paper) This drastic reduction is in line with other countries, which are displaying symptoms of “TFP hysteresis.”6

22. Nevertheless, there is scope to raise growth—a goal of the authorities—through strong reform efforts. Raising TFP will require redoubling policy efforts as crisis scars are limiting potential (so called “TFP-hysteresis”). This effort is the most important given that negative demographics will limit the contribution of labor, while gains from improved capacity utilization are finite. Labor utilization through increased hours worked can also provide further gains. Productivity-friendly structural policies, stepped up high-return public investments, and improved labor market performance are key to raising TFP. Drawing on cross country, and Latvia-specific, analysis, priority should be given to three areas: 7

Total Factor Productivity

(Year-on-year percent change)

Source: IMF staff calculations.

  • Structural and institutional reforms to improve the allocation, and efficient use, of resources. The largest efficiency gains are likely to come from improving the quality of institutions (such as protection of property rights, upgrading legal systems including insolvency and judicial reforms), and increasing access to financial services (especially for small, but productive firms). Furthermore, reducing regulatory and administrative burdens on businesses and further improving corporate governance of state-owned enterprises would foster competition and efficient resource allocation, as would greater technology diffusion. Fiscal structural reforms, aimed at improving efficiency in the tax system, can also boost firm-level productivity by reducing resource misallocation.

  • Higher investment rates and improved capacity utilization to boost potential growth. Latvia has the lowest capital-output ratio in the EU-28. Improving and modernizing the capital stock would therefore provide significant scope to lift potential growth above the baseline. Higher public investment in infrastructure, such as further improving the connectivity to the EU electric network, enhancing the quality of transport infrastructure, and promoting port efficiency, may induce greater private investment and risk-taking and improve capital allocation, provided high-return projects are undertaken and compatibility with fiscal space is ensured. This makes rapid and efficient absorption of EU structural funds even more important. Attracting more foreign investment could also provide avenues going forward. Capacity utilization, despite having rebounded strongly since the crisis, is still lower than in most EU countries and increasing it would provide further, yet limited scope for higher medium-term growth.

Capacity Utilization, 2016

(In percent)

Sources: Eurostat and IMF staff calculations.

  • Strengthening labor market policies to help offset negative demographic dynamics, and preserve competitiveness. Active labor market policies, along with tax and benefit reform aimed at improving incentives for work would support labor force participation and generate higher employment (e.g., in-work tax credits, improvements in tapering of benefits to reduce the high labor tax wedge especially for low-income earners). Efforts to reduce skill mismatches will improve labor market performance and help ameliorate wage pressures (e.g., strengthening vocational education and improving links with employers, further efforts to attract high-skilled foreign workers). Care should also be taken to avoid wages outstripping productivity gains, including by prudent increases in the minimum wage.

23. Structural reforms designed to boost the potential of the economy can also reduce incentives to participate in the shadow economy. Policies aimed at improving the overall environment for doing business (e.g. reducing the regulatory burden and red tape, and improving the quality of government services) would boost incentives for businesses and individuals to participate in the formal economy, and reduce opportunities for corruption. By the same token, minimizing skills mismatches (e.g. by helping students develop skills demanded on the labor market) would improve incentives and scope to participate in the formal economy and also lower structural unemployment.

Authorities’ View

24. The authorities broadly shared staff’s analysis of the drivers of potential growth and agreed with the need to continue with reforms to raise it. They pointed out that heightened risk aversion lingers post-crisis, but could slowly unwind as the external environment improves. Moreover, the turning of the credit cycle could lift potential growth as investment picks up. They noted that in addition to their tax strategy, a broad structural reform agenda is underway to boost TFP, including several elements: education and health reforms, an action plan to combat the shadow economy, gas market liberalization, and work to improve the insolvency regime. The scope for increases in the labor force through immigration is limited, but tax and benefit reform along with active labor market policies have a role to play.

B. Fiscal Policy: Addressing Fiscal Headwinds

25. The 2017 budget is in line with Latvia’s Fiscal Discipline Law and its European commitments. The expenditure measures in the budget include an increase in funding for education and social protection as well as growing defense spending, and an increase of about 2.7 percent in the average monthly minimum wage.8 With a surge of EU investment funds expected in 2017, a corresponding increase in project investment is also foreseen. On the revenue side, several revenue-enhancing measures were adopted, including an increase in excise and natural resource taxes and a reduction of some tax exemptions. A comprehensive expenditure review was also conducted allowing for some prioritization and expenditure savings, including tightening of eligibility requirements for receiving unemployment benefits. In addition, the budget makes use of national and EU-permitted flexibility for financing structural reforms in the healthcare and pension systems.9

26. Considering the smaller-than-budgeted deficit in 2016, the 2017 fiscal stance is expansionary.10 With no financing constraints, modest gross financing needs and low public debt there is fiscal space to accommodate such a stance without threatening fiscal or debt sustainability. Furthermore, in the context of a small, yet still negative, output gap this seems appropriate as it can provide a needed boost to investment and growth without raising overheating concerns. Moreover, there is little evidence to suggest Latvia is at risk of a wage-price spiral: real wage growth is expected to be more muted than in previous years, and broadly in line with productivity growth.11 Fiscal policy is therefore not expected to put competitiveness at risk.

27. Fiscal policy over the medium term is consistent with fiscal sustainability, but fiscal headwinds are on the horizon. 12 Based on the current medium term objectives outlined in the 2017–20 Stability Program—under a no tax reform scenario—the fiscal stance is expected to become broadly neutral over the medium term as the economy reaches its potential, and public debt is expected to remain at low levels, and on a downward path (see Annex III). Such a stance seems appropriate. Looking towards the medium to long-term, the possible reduction of revenues associated with the phasing out of EU funds (which account for an average of 3 percent of GDP over the next 4 years) would pose a challenge for meeting their medium-term growth objectives. This means that the authorities will need to prepare well in advance to find revenue-enhancing measures. Looking forward:

  • The authorities need to be mindful of policy constraints within the currency union. Fiscal stimulus this year needs to be followed by a more neutral stance over the medium term, especially if inflation continues to rise. To this end, the quality of spending will play a key role in ensuring that spending is directed to investments that help reduce economic slack in 2017 and support medium term growth. Given the large share of EU funds in total revenues, their efficient allocation in areas that have been identified as having the highest return in Latvia (e.g. upgrading infrastructure) will be key in achieving these objectives.13 Furthermore, if growth disappoints on the downside, automatic stabilizers should be allowed to operate fully.

  • Efforts to develop a tax strategy are welcome and could help address medium-term challenges. The authorities have presented draft proposals to reform their tax system with the goal of adopting measures that would help raise growth, improve equity, and gradually raise tax revenues to around 1/3 of GDP. These efforts are broadly in line with staff’s previous calls for reform which have been anchored on key principles: i) improving work incentives; ii) increasing tax compliance (including by addressing the shadow economy); and iii) adopting revenue-enhancing policies.

  • The fiscal impact of the final tax package should be carefully assessed. The tax package as currently formulated is estimated to entail a fiscal cost of about 1.5% of GDP over the first three years of implementation. While this could be mitigated through a positive indirect impact from the changes (particularly for labor and corporate taxes), the extent of such benefits need to be assessed carefully. Taken in isolation, various individual elements seem to go in the right direction; however, some measures may yield less than expected, or may support one objective, but conflict with another (Box 2). While a system based on taxation of distributed earnings has attractive features (e.g. neutrality towards investment), this may result in a suboptimal outcome if corporates lock in cash and pass on other (potentially profitable) investment opportunities. Furthermore, the proposed increase in the minimum wage, while likely positive on equity grounds, could have some negative employment or competitiveness impact on low wage sectors and regions. While likely bringing some growth and equity benefits, the draft tax reform package is estimated to entail a short-term revenue loss, making even more challenging the authorities’ objective of raising tax revenues to 1/3 of GDP. Against this background, the final package should include measures to sustainably achieve this goal. Measures could focus on property, environmental, or consumption taxes, and/or a reduction in exemptions.

  • A carefully calibrated tax reform can also help combat the shadow economy, and vice versa. Experience in other European countries shows that various measures can boost revenues, and help to reduce the shadow economy, including: increased tax compliance for high-net-worth taxpayers; the mandatory use of certified invoicing programs for SMEs; and cross-checking VAT declarations with merchant point-of-sale transactions. Strengthening revenue administration and improving capacity to address compliance risks can also play a role. Combining both “sticks” and “carrots”, can be an effective tool in curtailing the shadow economy and boosting revenues.

Authorities’ View

28. The authorities agree on the importance of maintaining prudent fiscal policies and compliance with fiscal rules. They see the proposed tax reform as a necessary step to address the economic challenges ahead. To this end, their priorities are to support growth, increase equity, and boost revenues. They are aware of the revenue costs of some individual measures, but expect that the reform package will stimulate growth and, over time, revenues. Over the medium term, they see improved incentives for labor participation and investment, along with ongoing efforts to reduce the size of the shadow economy, as the basis for revenue gains. They see the increase in the minimum wage as a necessary measure to reduce income inequality, and see little effect on competitiveness, in part given the relatively higher wages in the tradable sector. Nevertheless, they acknowledge the importance of maintaining competitiveness over the medium term, and hence the need to avoid procyclical policy, and ensuring that wage increases remain aligned with productivity growth over time.

C. Financial Sector: Unlocking Credit Growth while Maintaining Financial Stability

29. Latvia’s protracted period of credit stagnation is ending. While turning points are difficult to pinpoint, indicators suggest that Latvia’s credit cycle has turned (Figure 4).14 Households have been deleveraging since the crisis, and along with non-financial corporates, their debt servicing capacity has strengthened. Following a long period of balance sheet repair, NPL ratios, both for households and corporates, continue to shrink. At the same time, credit growth has returned at the aggregate level and across most segments, although the household sector is lagging. In addition, the credit gap—on some measures—calculated as the percentage deviation of credit to GDP from its long-run trend, has turned slightly positive. Taken together these indicators suggest that Latvia is in the very early stage of the expansion phase of the credit cycle.

Credit Growth

(In percent, Year-on-year)

Sources: Bank of Latvia; and IMF Staff Calculations .

30. However, credit growth remains constrained by both demand and supply factors. Demand factors tend to be more relevant for larger firms, while supply constraints tend to be more relevant for SMEs and households.15 A survey by the ECB suggests that credit standards have been eased slightly by credit institutions in Latvia.16 However, they are still conservative when lending to non-financial corporations (NFCs) and point to insufficient equity, lack of positive credit history, shortcomings of the legal framework, and the shadow economy as the main reasons to be cautious. At the same time, credit demand from NFCs may be constrained as they are putting investment plans on hold due to economic and geopolitical uncertainty. As investment related to the new programing period of EU structural funds picks up, this constraint may be alleviated and the demand for credit stimulated. For households, the demand for loans has been picking up in part due to the state guaranteed mortgage loan program, which has also helped push housing prices slightly upwards.17 However, the relatively low level of income as well as savings, constrains households’ overall credit demand.

  • Turning the persistently weak lending around, particularly for SMEs, would be key to boosting investment and growth. Stimulating credit growth is essential as the ability of companies to self-finance investment, which is needed to support growth in the medium and long term, remains weak. The implementation of programs of the European Fund for Strategic Investments would be helpful in this respect. Within this framework, more SMEs would be eligible to receive guarantees from the Development Finance Institution Altum as well as directly from the European Investment Bank. These programs would improve access to financing for SMEs that lack credit history. Specifically, firms and individuals shifting out the shadow economy, diminishing the regulatory burden, and promoting an investment-friendly environment could boost credit to the private sector.

  • Closer monitoring of financial interconnectedness is appropriate. Banks in the Nordic-Baltic region are highly interconnected via banks’ group structures, and have common exposures at the firm level and in the property sector. 18 Even though the reliance of Latvian subsidiaries on parent bank financing has decreased considerably, closer monitoring as well as supervisory collaboration, building on the informal Nordic-Baltic Macroprudential Forum, is appropriate. Specifically, cross-border crisis preparedness and management would help address potential spillovers from vulnerabilities in Nordic parent banks.

  • Continued strengthening of supervision and enforcement, including of AML/CFT, can safeguard financial stability, underpin sustainable credit growth, and support Latvia’s role as a regional financial center. For banks servicing domestic clients, strong capital and funding positions, along with ample liquidity, provide the foundation to expand credit portfolios. For BSFCs, while the recent decline of the sector’s size may reduce vulnerabilities, ongoing strengthening of AML/CFT supervision, along with banks’ own efforts to improve their internal compliance processes, should help bolster the sector as it responds to the changing landscape of dwindling business, withdrawal of correspondent banking relationships, and a continued reduction of deposits. Close monitoring of financial innovations such as crowdfunding and virtual currencies is also encouraged.

  • Shifting segments of the shadow economy into the formal sector would help increase financial inclusion and thus boost credit to the economy. More economic agents participating in the formal economy would stimulate credit demand as more people and firms would have the necessary proof of income and assets to apply for credit.

Authorities’ View

31. The authorities concurred with staff that the credit cycle has turned, and that the resumption of credit is key to boosting investment and growth. They shared the view that both supply and demand factors constrain credit growth to varying degrees for corporates and households. However, measures to boost credit growth should not come at the expense of financial stability, and prudential standards should be maintained. They agreed that shifting segments of the shadow economy to the formal sector would support financial inclusion. The authorities are also of the view that close monitoring of regional financial interconnectedness is important, and are working with Baltic and Nordic neighbors. Furthermore, the authorities underscored the importance of continued vigilant supervision and regulation of the banking sector, along with their ongoing efforts to strengthen implementation of AML/CFT measures and enforcement. Taken together this will support Latvia’s role as a regional financial center.

Staff Appraisal

32. Latvia has made great strides since the crisis. After some modest slowing in 2013–16, growth is expected to rebound in the short term to around 3.2 percent on the back of a resumption of EU funds and a recovery of domestic credit alongside a favorable external environment. However, post-crisis growth seems to have settled at a more modest pace than the rapid pace achieved immediately post-crisis: low hanging fruits from productivity gains have been picked, and the challenge now is to raise potential growth by addressing crisis legacies and combatting economic headwinds such as demographics.

33. Policies to raise potential growth will need to focus on boosting productivity. For Latvia to accelerate its convergence path with western Europe, policies priorities should include: i) structural and institutional reforms to boost TFP growth, for example protection of property rights, improving the legal system, increasing access to finance and reducing regulatory and administrative burdens; ii) raising investment and capacity utilization including through efficient use of EU funds, improved energy and transportation networks, and attracting FDI, and iii) improved labor market policies, such as active labor market policies, tax and benefit reform to improve incentives and efforts to reduce skills and regional mismatches. Many of these reforms could also help reduce incentives to participate in the shadow economy.

34. Fiscal policy, if properly calibrated, can support medium term growth, but needs to become more neutral over the medium term. With low gross financing needs and public debt, and given the small yet still negative output gap, there is some fiscal space to accommodate a temporary boost to the economy. In the short term, the main challenge for fiscal policy is to make the most efficient use of the large inflow of EU investment funds and allocate these resources to growth-enhancing investments. In addition, action is needed to boost the revenue share to compensate for the future loss of EU funds and finance stronger social safety nets. Looking forward, fiscal policy should become more neutral over the medium term, to avoid risks of procyclical policy.

35. The initiative to reform the tax system is welcome. The goals of supporting growth, increasing equity, and boosting revenues are appropriate. As the details of the final proposal are yet to be determined, the authorities face three immediate challenges to ensure these objectives can be achieved: 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, and iii) sustainably boosting the revenue share to ensure robust public finances even after EU funds phase out.

36. Continued efforts to address the shadow economy can bring multiple benefits. The shadow economy hinders economic development—preventing Latvia from reaching its full potential—and complicates policy making. Efforts to improve the business environment, reduce regulatory and administrative barriers, and improve transparency, will not only strengthen incentives to operate in the formal economy, but will also support growth. Reducing the share of the shadow economy is also associated with greater tax compliance and higher revenues. In parallel, such efforts can support credit growth by increasing financial inclusion, and improving the transparency of corporate and household balance sheets.

37. Financial stability is the necessary foundation for sustainable credit growth to boost output in the medium term. Recent financial indicators suggest that the credit cycle in Latvia has turned, yet credit growth remains somewhat constrained by demand and supply factors. Continued and sustainable credit growth will be needed to support investment and boost long term growth. The authorities should pursue policies to address lingering market failures from the crisis, including by promoting programs that facilitate SMEs access to credit, and continuing the implementation of insolvency reforms (e.g., through promoting the rescue of viable businesses, strengthening the oversight and supervision of insolvency administrators, and developing a system to assess the efficiency of the insolvency framework). Furthermore, vigilant supervision and enforcement are needed to safeguard financial stability and underpin sustainable credit growth. Continued strengthening implementation of AML/CFT measures will also support this objective.

38. The next Article IV is expected to be completed on the standard 12-month cycle.

Box 1.Risk Assessment Matrix 1

Source of Risk and LikelihoodImpact if RealizedPolicy Recommendations Mitigation/Response

Retreat from cross-border integration: A fraying consensus about the benefits of globalization could lead to protectionism and economic isolationism, leading to reduced global and regional policy collaboration with negative consequences for trade, capital and labor flows, sentiment, and growth.

As a small open economy, Latvia could be significantly impacted mainly through trade channels.
Pursue structural policies that enhance productivity.

Continue to diversify product and export markets.

Participate in coordinated policy response at the European level.

Structurally weak growth in key advanced and emerging economies. Low productivity growth, a failure to fully address crisis legacies and undertake structural reforms, and persistently low inflation undermine medium-term growth in advanced economies. Resource misallocation and policy missteps, including insufficient reforms, exacerbate declining productivity growth in emerging markets.

The Euro Area remains Latvia’s single largest trade partner. A protracted slowdown would have a direct impact on exports while also eroding business and consumer confidence.
Participate in coordinated policy response at the European level.

Allow automatic stabilizers to operate.

If the shock is of sufficient magnitude, discretionary fiscal action could be considered.
Financial conditions: High/Medium

Significant further strengthening of the US dollar and/or higher rates. (High) Investors reassess policy fundamentals, term premia decompress, or there is a more rapid Fed normalization

European bank distress. (Medium) Strained bank balance sheets amid a weak profitability outlook could lead to financial distress in one or more major banks.

Reduced financial services by correspondent banks - “de-risking”-. (High): Significant curtailment of cross-border financial services in emerging and developing economies.

Could lower funding for Nordic parent banks reliant on wholesale funding, raising the cost of financing and hindering credit growth.

Non-resident deposits (NRDs) could be susceptible to sudden stops in case of a sufficiently constrained access to clearing services in USD.
Euro area monetary policy is first line of defense against liquidity stress, supported if needed, by activation of backstops and resolution mechanism.

Risk from correspondent banks retreat are mitigated by separation between BSFC and the domestic economy, with BSFC not playing a material role in domestic lending or attracting domestic deposits.

Continue strengthening risk-based implementation of AML/CFT framework.

Failure of credit growth to pick up in a sustained manner

Persistently weak bank credit growth would constrain investment and growth.
Purse policy to address market failures, and ensure appropriate macro-prudential policy settings.

Failure to continue advancing on structural reforms.

In the absence of structural reforms productivity growth and the business environment would suffer, harming competitiveness and employment.
Seek to build base for support to continue with the reform agenda focusing on improving the business environment, labor markets, infrastructure, and human capital.

The Risk Assessment Matrix (RAM) shows events that could materially alter the baseline path (the scenario most likely to materialize in the view of IMF staff). The relative likelihood is the staff’s subjective assessment of the risks surrounding the baseline (“low” is meant to indicate a probability below 10 percent, “medium” a probability between 10 and 30 percent, and “high” a probability between 30 and 50 percent). The RAM reflects staff views on the source of risks and overall level of concern as of the time of discussions with the authorities. Non-mutually exclusive risks may interact and materialize jointly.

The Risk Assessment Matrix (RAM) shows events that could materially alter the baseline path (the scenario most likely to materialize in the view of IMF staff). The relative likelihood is the staff’s subjective assessment of the risks surrounding the baseline (“low” is meant to indicate a probability below 10 percent, “medium” a probability between 10 and 30 percent, and “high” a probability between 30 and 50 percent). The RAM reflects staff views on the source of risks and overall level of concern as of the time of discussions with the authorities. Non-mutually exclusive risks may interact and materialize jointly.

Box 2.Proposed Tax Reform

The authorities have presented a set of “tax policy guidelines” to form the basis of a reform of the tax system. The reform aims to support growth, increase equity, and boost revenues. Three elements underpin the reform: i) a review of tax structure and rates; ii) efforts to improve tax administration; and iii) steps to reduce the shadow economy.

Several changes are proposed to the current tax structure: i) reforming the labor tax system, including by the introduction of a phased out tax-free allowance system, along with a lower PIT rate for lower incomes and a higher tax rate for people with high incomes, eliminating the “solidarity tax”, and a 13% increase in the minimum monthly wage; ii) reforming the CIT system to tax reinvested profits at 0% and raise the rate on distributed profits to 20%; iii) equalizing PIT rates for various types of income; and iv) reforming the regime for micro-enterprises and small or “lifestyle” businesses. Some revenue raising measures to compensate for losses include: reductions in VAT registration thresholds, a gradual increase in excise taxes, and a higher ceiling on social security contributions.

Steps to improve tax administration and combat the shadow economy are a key element of the reform. The authorities are focusing on improving the efficiency of tax administration activities, including the introduction of single accounts, and improving the accessibility and quality of services. In their efforts to combat the shadow economy, a key measure is the expansion of the application of the “reverse” VAT payment in key “problematic sectors” as well as reduction of VAT thresholds and introduction of online trade transactions register.

Various elements seem to move in the right direction to meet the authorities’ objectives, but an overall assessment is not yet possible. On personal taxation, a phased-out tax free allowance, and a progressive marginal tax schedule with a lower tax rate for people on lower incomes, support the equity goal, and would also help reduce the tax wedge on labor. The new CIT proposal would introduce neutrality towards investment, aimed at supporting growth. However, the elimination of the solidarity tax is both revenue losing and moves in the opposite direction of improving equity. In addition, increasing the PIT rate for capital gains alongside the proposed CIT reform could create incentives for tax planning.

The tax reform will entail direct fiscal costs in the near term. Based on authorities’ estimates, the direct fiscal impact of the tax reform could imply an increase in the deficit of about 0.7 percent, 0.5 percent and 0.3 percent of GDP from 2018 through 2020. The largest revenue loss would come from the introduction of the progressive PIT regime and differentiated non-taxable minimums, and the change in the CIT regime, estimated at 1 percent and 0.6 percent of GDP respectively. At the same time, the authorities estimate that the tax reform would also provide an indirect positive impact on the economy via changes in behavior of workers and enterprises, which through higher growth could over the medium term partly offset the initial negative impact on public finances. While some of these growth benefits may well materialize, their magnitude is uncertain and needs to be carefully assessed, to avoid overestimating the impact on the economy. This is particularly difficult for measures where there is little empirical evidence (e.g. the impact of the new CIT regime on boosting investment).

A tax package along these lines would impart a fiscal impulse into the economy in the first year, and risks of procyclical policy will need to be offset by targeting a neutral fiscal stance over the medium term. This said, considering only the direct impact of the fiscal measures, the stimulus implied by the tax reform is estimated to have a limited impact on GDP given Latvia’s likely small fiscal multipliers and the assumed subsequent unwinding of the fiscal stimulus.

Structural Deficit

(share of GDP)

Fiscal Impulse

(share of GDP)

Figure 5.Republic of Latvia: Balance of Payments, 2007–16

Sources: Bank of Latvia; ECB; EC; and IMF staff calculations.

1/ Real effective exchange rates are based on IC-37 countries for ULC and IC-42 countries for CPI.

Figure 6.Republic of Latvia: External Debt and Vulnerabilities in the Banking System

Sources: Bank of Latvia; FCMC; and IMF staff calculations.

1/ Exclude foreign loans and non-resident deposits.

Table 1.Latvia: Selected Economic Indicators, 2011–18
National accounts(Percentage change, unless otherwise indicated)
Real GDP6.
Private consumption3.
Public consumption3.
Gross capital formation49.8−1.0−5.8−4.3−
Gross fixed capital formation24.014.4−6.00.1−1.8−
Exports of goods and services12.
Imports of goods and services22.05.4−
Nominal GDP (billions of euros)20.321.922.823.624.425.026.628.0
GDP per capita (thousands of euros)9.810.711.311.812.312.713.614.4
Savings and Investment
Gross national saving (percent of GDP)22.022.621.221.221.321.420.820.7
Gross capital formation (percent of GDP)
Private (percent of GDP)21.122.420.219.518.317.318.318.8
HICP Inflation
Period average4.
Labor market
Unemployment rate (LFS; period average, percent) 1/
Real gross wages0.
(Percent of GDP, unless otherwise indicated)
Consolidated general government 1/
Total revenue35.637.436.736.
Total expenditure38.837.237.337.837.736.738.238.1
Basic fiscal balance−3.20.2−0.6−1.7−1.5−0.4−0.8−0.5
ESA balance−3.4−0.8−0.9−1.6−1.30.0−0.7−0.7
General government gross debt37.536.735.838.534.837.235.934.5
Money and credit
Credit to private sector (annual percentage change)−8.3−11.6−6.6−7.4−
Broad money (annual percentage change)
Balance of payments
Current account balance−3.2−3.6−2.7−2.0−0.81.5−0.4−1.4
Trade balance−12.4−12.0−11.5−9.3−8.4−7.0−8.3−9.1
Gross external debt145.8138.2133.9143.0141.6147.3140.2134.8
Net external debt 2/47.039.836.632.928.528.626.122.6
Exchange rates
U.S. dollar per euro (period average)1.391.291.331.331.111.11
REER (period average; CPI based, 2005=100)124.0120.1120.1121.9120.4121.6
Terms of trade (annual percentage change)3.0−2.80.6−−1.0−0.2
Sources: Latvian authorities; Eurostat; and IMF staff estimates.

National definition. Includes economy-wide EU grants in revenue and expenditure.

Gross external debt minus gross external debt assets.

Sources: Latvian authorities; Eurostat; and IMF staff estimates.

National definition. Includes economy-wide EU grants in revenue and expenditure.

Gross external debt minus gross external debt assets.

Table 2.Latvia: Macroeconomic Framework, 2012–22
(Percentage change, unless otherwise indicated)
National accounts
Real GDP4.
Private consumption3.
Public consumption0.
Gross capital formation−1.0−5.8−4.3−
Gross fixed capital formation14.4−6.00.1−1.8−
Exports of goods and services9.
Imports of goods and services5.4−
Contributions to growth
Domestic demand1.
Net exports2.−1.1−1.1−1.2−0.7−0.5−0.4−0.4
HICP inflation
Period average2.
Labor market
Unemployment rate (LFS, percent)15.011.910.
Employment (period average, percent)1.62.1−1.01.3−
Real gross wages1.
(Percent of GDP)
Consolidated general government 1/
Total revenue37.436.736.
Total expenditure37.237.337.837.736.738.238.137.536.836.636.0
ESA balance−0.8−0.9−1.6−1.30.0−0.7−0.7−0.5−0.5−0.3−0.3
ESA structural balance−0.4−0.7−1.0−1.20.2−0.6−0.7−0.6−0.5−0.3−0.3
General government gross debt36.735.838.534.837.235.934.533.331.830.729.5
Saving and investment
Gross national saving22.621.221.221.321.420.820.720.820.920.820.7
Public 2/
Foreign saving 3/−
Gross capital formation26.223.923.222.119.921.322.122.422.622.822.8
External sector
Current account balance−3.6−2.7−2.0−0.81.5−0.4−1.4−1.7−1.7−1.9−2.1
Net IIP−67.8−66.5−64.2−62.5−58.2−53.3−48.3−44.2−40.5−37.5−35.0
Gross external debt138.2133.9143.0141.6147.3140.2134.8132.7129.7123.8122.3
Net external debt 4/39.836.632.928.528.626.122.619.717.215.113.6
Memorandum items:
Nominal GDP (billions of euros)21.922.823.624.425.026.628.029.631.232.834.5
Output gap (percent)−2.4−0.7−0.5−0.3−0.5−
Potential output growth (percent)
Terms of trade (annual percentage change)−2.80.6−−1.0−0.2−0.10.0−0.2−0.2
Sources: Latvian authorities; and IMF staff estimates.

National definition. Includes economy-wide EU grants in revenue and expenditure.

Includes bank restructuring costs.

Current account deficit

Gross external debt minus gross external debt assets.

Sources: Latvian authorities; and IMF staff estimates.

National definition. Includes economy-wide EU grants in revenue and expenditure.

Includes bank restructuring costs.

Current account deficit

Gross external debt minus gross external debt assets.

Table 3.Latvia: General Government Operations, 2012–221
(percent of GDP)
Total revenue and grants37.436.736.
Tax revenue27.928.228.328.729.729.930.029.929.929.829.8
Direct Taxes16.616.916.516.717.217.317.417.317.417.417.4
Corporate Income Tax1.
Personal Income Tax5.
Social Security Contributions8.
Real Estate and Property Taxes0.
Indirect Taxes11.311.311.712.112.512.612.612.612.512.512.4
Other indirect taxes0.
Non Tax, self-earned and other revenue4.
EU and miscellaneous funds5.
Total expenditure 2/37.237.337.837.736.738.238.137.536.836.636.0
Current expenditure33.433.534.133.934.035.234.834.333.733.833.3
Wages and Salaries5.
Goods and Services4.
Subsidies and Transfers18.618.218.718.118.519.118.718.518.018.418.0
Subsidies to companies and institutions7.
Social Support10.510.510.410.610.810.810.911.011.010.910.9
International cooperation0.
Payments to EU budget1.
Capital expenditure3.
Fiscal balance0.2−1.2−1.7−1.5−0.4−0.8−0.5−0.6−0.2−0.4−0.4
Financing (net)−
Domestic financing2.12.4−3.36.4−−2.4−1.71.6−2.3
External financing−2.3−1.25.0−4.83.5−−1.12.7
Errors and omissions0.
Memorandum items
ESA balance−0.8−0.9−1.6−1.30.0−0.7−0.7−0.5−0.5−0.3−0.3
ESA structural balance 3/−0.4−0.7−1.0−1.20.2−0.6−0.7−0.6−0.5−0.3−0.3
General government debt36.735.838.534.837.235.934.533.331.830.729.5
Nominal GDP (billions of euros)21.922.823.624.425.026.628.029.631.232.834.5
Sources: Latvian authorities; and IMF staff estimates.

Fiscal accounts are on a cash basis as provided by the authorities

The bank restructuring costs are calculated in accordance with ESA 95 definitions.

In computing structural balances part of the bank restructuring costs are treated as one-offs.

Sources: Latvian authorities; and IMF staff estimates.

Fiscal accounts are on a cash basis as provided by the authorities

The bank restructuring costs are calculated in accordance with ESA 95 definitions.

In computing structural balances part of the bank restructuring costs are treated as one-offs.

Table 4.Latvia: Medium-Term Balance of Payments, 2012–22
(Percent of GDP, unless otherwise indicated)
Current account−3.6−2.7−2.0−0.81.5−0.4−1.4−1.7−1.7−1.9−2.1
Goods and services (fob)−4.6−3.7−1.9−1.10.5−1.0−2.1−2.6−2.9−3.1−3.4
Goods (fob)−12.0−11.5−9.3−8.4−7.0−8.3−9.1−9.5−9.7−10.0−10.1
Primary Income−0.6−0.3−0.1−0.20.2−0.5−
Compensation of employees2.
Investment income−4.3−3.8−3.7−3.7−3.4−3.6−3.4−3.0−2.8−2.8−2.8
Secondary Income1.
Capital and financial account2.−
Capital account3.
Financial account−0.9−1.0−2.70.8−2.1−3.0−2.2−1.6−1.4−1.0−0.7
Direct investment3.−
Portfolio investment and financial derivatives4.50.1−0.3−9.2−4.50.2−
of which: general government net issuance7.4−0.36.9−−1.12.9
Other investment−5.1−1.0−−5.1−3.1−8.6−6.4−2.9−6.5
Reserve assets−3.6−1.70.5−1.3−
Errors and omissions1.61.21.5−2.8−
(Percent change, unless otherwise indicated)
Goods and Services
Export value (fob)
Import value (fob)12.70.9−0.30.8−
Export volume9.
Import volume5.4−
Gross reserves (billions of euros)
Gross external debt (percent of GDP)138.2133.9143.0141.6147.3140.2134.8132.7129.7123.8122.3
Medium and long term (percent of GDP)87.978.877.470.674.671.
Short term (percent of GDP)150.455.163.865.767.366.566.165.665.264.663.9
Net external debt (percent of GDP)239.836.632.928.528.626.122.619.717.215.113.6
Memo items
Nominal GDP (billions of euros)21.922.823.624.425.026.628.029.631.232.834.5
U.S. dollar per euro (period average)1.291.331.331.111.11
Sources: Latvian authorities; and IMF staff estimates.

Based on detailed data until 2013. Extrapolated for debt outside the public sectors and MFIs starting 2014.

Gross external debt minus gross external debt assets.

Sources: Latvian authorities; and IMF staff estimates.

Based on detailed data until 2013. Extrapolated for debt outside the public sectors and MFIs starting 2014.

Gross external debt minus gross external debt assets.

Table 5.Latvia: Financial Soundness Indicators, 2007–16(In percent, unless otherwise indicated)
Commercial banks
Capital Adequacy
Regulatory capital to risk-weighted assets 1/11.111.8014.614.617.417.6018.921.022.821.5
Regulatory Tier I capital to risk-weighted assets 1/9.810.5011.511.514.215.2017.318.319.818.2
Capital and reserves to assets7.97.307.
Asset Quality
Annual growth of bank loans37.211.2−7.0−7.1−8.1−10.9−6.5−
Annual growth of bank loans to residents30.315.867.2−8.7−8.3−10.5−6.2−7.6−1.53.1
Annual growth of bank loans to companies36.316.9−6.5−8.0−7.6−9.0−5.6−9.6−1.61.6
Sectoral distribution of loans (in % of total loans, stock)100.0100.0100.0100.0100.0100.0100.0100.0100.0100.0
Agriculture, hunting and related service activities1.
Construction and real estate activities18.819.620.820.420.018.618.117.917.316.7
Industry and trade21.623.122.322.022.024.324.222.723.322.5
Financial intermediation6.
Foreign clients12.111.211.413.113.212.912.614.015.415.4
Loans past due over 90 days0.83.616.419.017.511.
Loans to households4.716.818.419.315.
Loans to corporations2.818.520.816.
Earnings and Profitability
ROA (after tax)2.00.3−3.5−1.6−
ROE (after tax)24.34.6−41.6−20.4−
Liquid assets to total assets25.021.621.127.327.432.336.539.940.233.8
Liquid assets to short term liabilities55.752.862.867.963.959.864.463.166.761.9
Customers deposits to (non-interbank) loans68.258.861.977.584.1106.3124.9151.3158.5141.2
Sensitivity to Market Risk
FX deposits to total deposits 2/70.769.474.572.673.576.275.940.343.134.2
FX loans to total loans 2/81.885.087.188.986.384.588.513.013.812.5
Memorandum Items
Share of non-resident deposits to total deposits41.744.038.041.647.248.947.351.753.442.8
Source: CSB, BoL, FCMC, Latvian Leasing Association, staff calculations

Regulatory Tier 1 capital to risk weighted assets as from Dec 2009 is calculated as Tier 1 capital (including deduction)/risk-weighted assets Regulatory capital to risk-weighted assets and Regulatory Tier 1 capital to risk-weighted assets in the column of Dec 2014 uses data from Sep 2014.

Euro-denominated positions are included in and before 2013, but not in 2014.

Source: CSB, BoL, FCMC, Latvian Leasing Association, staff calculations

Regulatory Tier 1 capital to risk weighted assets as from Dec 2009 is calculated as Tier 1 capital (including deduction)/risk-weighted assets Regulatory capital to risk-weighted assets and Regulatory Tier 1 capital to risk-weighted assets in the column of Dec 2014 uses data from Sep 2014.

Euro-denominated positions are included in and before 2013, but not in 2014.

Annex I. External Sector Assessment

Foreign assets and liabilities. The NIIP has improved gradually and stood at around −58 percent of GDP by end 2016; it is projected to continue declining to about −35 percent of GDP over the medium term. Gross assets stood at 134 percent of GDP in 2016, while gross liabilities stood at 192 percent. Debt securities comprised only 15 percent of these liabilities. At the same time, net external debt stood at 29 percent of GDP at the end of 2016.

Current account. The current account moved to a surplus of 1.5 percent of GDP in 2016, driven by large terms of trade gains, weak investment growth, and a lower-than-budgeted fiscal deficit. This outturn was atypical, with the current account having averaged a deficit of −2.4 percent of GDP over 2011–15.1 The current account is projected to swing back into modest deficit in 2017 and 2018 as investment gathers steam and consumption continues to be strong. While the current account position is stronger than implied by fundamentals and desirable policies, the unusually strong cyclical components inflate the gap estimates. In addition, the CA regression does not properly account for certain features of economies like Latvia’s, especially the impact of demography-related variables.2 Taking into consideration all these caveats, results from the CA approach are subject to some uncertainty, thus suggesting a range for the CA gap of around 2–4 percent of GDP in 2016.

Real exchange rate. The REER appreciated by about 1 percent between 2015 and 2016. The CA regression model suggests an undervaluation of 5–15 percent using standard trade elasticities. However, many of the factors accounting for the unusually strong current account should unwind, bringing down the balance without a need for the exchange rate to adjust. The EBA-lite REER model finds a small overvaluation of around 1 percent, which is largely consistent with the evolution of the REER (Figure 5) and rising unit labor costs.

Capital and financial accounts. The capital account is dominated by EU structural fund inflows, which slowed in 2016, but are expected to increase in 2017–18. FDI inflows slowed in recent years, making portfolio and other investment flows the main drivers of the financial account. High foreign holdings of government bonds and cross-border linkages of the banking sector in the region indicate potential vulnerabilities.

FX intervention and reserves level. The Euro has the status of a global reserve currency. As such, reserves held by euro area economies are typically low to standard metrics, but the currency is free floating.

The external position in 2016 was stronger than implied by medium term fundamentals and desirable policies. This is broadly in line with the CA-based REER assessment. However, this largely reflects temporary improvements in the CA driven by improved terms of trade, slowing investment, and a lower-than-budgeted fiscal deficit. A widening of the current account deficit from 2017 onwards is expected, on the back of a pick-up in investment and unwinding of terms of trade gains.

Annex II. Banks Servicing Foreign Clients (BSFCs) in Latvia

The banking sector in Latvia has a dual nature, with a sizeable segment servicing foreign clients. The two segments have distinct business models: domestically active banks (comprising 7 branches and 3 subsidiaries), mainly from the Nordic countries cater predominantly to the Latvian population and are responsible for most of the lending in the economy; the remaining 13 banks cater predominantly to foreign clients, with limited participation in the domestic economy, and with a large share of their deposit base coming from foreign clients, mostly from the CIS. In light of their business model, BSFCs depend on correspondent banking relationships (CBRs), which allow them to make direct settlements in foreign currencies.

Despite a changing landscape, with dwindling business, and a sharp decline in deposits and turnovers, BSFCs remain broadly sound. System wide non-resident deposits declined by 26.5 percent y-o-y through 2016, with some BSFCs experiencing declines well in excess of that amount. USD clearing declined by 39 percent over the same period. The sharp decline of non-resident deposits has been attributed to the withdrawal of global correspondent banks; ongoing strengthening of AML/CFT requirements and enforcement; and financial sanctions and economic downturn in Russia. While most banks servicing foreign clients have found alternative arrangements to CBRs with global banks, ongoing pressures could lead to further decline in deposits and turnover.

So far, no risks to financial stability have been identified. In part this reflects the banks’ strong capital and liquidity buffers, the fact that investments are made mostly in foreign liquid assets and deposits with Latvijas Banka, and the limited linkages between the BSFCs and the domestic banking sector. In addition, the FCMC applies more stringent liquidity and capital requirements to BSFCs, and is closely monitoring developments, including by stress testing the sector for scenarios of further outflow of NRDs. Furthermore, BSFCs, in dialogue with the FCMC have undertaken independent audits of their AML/CFT frameworks, procedures, and practices and are working together to implement recommendations. There are also limited linkages between the domestic economy and BSFCs, which do not play a material role in lending to residents (accounting for around only 12 percent of such lending), or seeking domestic deposits.

Going forward, and building on the authorities’ ongoing efforts, continued vigilant supervision is needed to mitigate real and reputational risks The FCMC continues to take welcome steps to tighten as well as strengthen the enforcement of AML/CFT requirements, notably in BSFCs, and additional resources have been dedicated to AML/CFT supervision. While the decline in non-resident deposits should lower banks’ risks associated with these types of deposits, further strengthening internal controls and addressing the AML/CFT shortcomings identified by the 2016 independent audits are central to mitigating risks and ensuring the sustainability of BSFCs. Some of these banks affected by the withdrawal of USD CBRs and experiencing a decline in non-resident deposits are also reviewing their business models, including by considering switching from a transactional to an investment model, broadening the customer base beyond the CIS region, and increasing their presence in the domestic market

Annex III. Public Debt Sustainability Assessment

Latvia Public DSA–Composition of Public Debt and Baseline Scenarios

Sources: Bloomberg Finance L.P. and IMF staff.

1/ Public sector is defined as general government.

2/ Based on available data.

3/ Long-term bond spread over German bonds.

4/ Defined as interest payments divided by debt stock (excluding guarantees) at the end of previous year.

5/ Derived as [(r - π(1+g) - g + ae(1 + r)]/(1+g+π+gπ)) times previous period debt ratio, with r = interest rate; π = growth rate of GDP deflator; g = real GDP growth rate; a = share of foreign-currency denominated debt; and e = nominal exchange rate depreciation (measured by increase in local currency value of U.S. dollar).

6/ The real interest rate contribution is derived from the numerator in footnote 5 as r - π (1+g) and the real growth contribution as -g.

7/ The exchange rate contribution is derived from the numerator in footnote 5 as ae(1 + r).

8/ Includes asset changes and interest revenues (if any). For projections, includes exchange rate changes during the projection period.

9/ Assumes that key variables (real GDP growth, real interest rate, and other identified debt-creating flows) remain at the level of the last projection year.

Latvia Public DSA–Composition of Public Debt and Alternative Scenarios

Source: IMF staff.

Republic of Latvia: External Debt Sustainability Framework, 2012–22(in percent of GDP, unless otherwise indicated)
20122013201420152016201720182019202020212022Debt-stabilizing non-interest current account 6/
1Baseline: External debt138.2133.9143.0141.6147.3140.2134.8132.7129.7123.8122.3−5.7
2Change in external debt−6.3−4.39.1−1.45.7−7.1−5.5−2.1−3.0−5.8−1.6
3Identified external debt-creating flows (4+8+9)−6.5−5.8−4.62.0−4.8−6.0−4.6−4.1−3.9−3.6−3.2
4Current account deficit, excluding interest payments−0.8−0.6−1.3−1.9−3.8−2.9−1.2−1.0−1.3−0.60.0
5Deficit in balance of goods and services4.−
8Net non-debt creating capital inflows (negative)−3.3−1.8−1.8−2.80.3−1.9−1.9−1.8−1.8−1.8−1.8
9Automatic debt dynamics 1/−2.4−3.4−1.66.7−1.2−1.2−1.5−1.3−0.7−1.2−1.5
10Contribution from nominal interest rate4.
11Contribution from real GDP growth−5.9−3.4−2.7−4.5−2.7−4.6−4.1−3.9−3.8−3.7−3.5
12Contribution from price and exchange rate changes 2/−1.0−3.3−2.18.5−0.9
13Residual, incl. change in gross foreign assets (2-3) 3/0.11.413.7−3.410.5−1.1−−2.21.6
External debt-to-exports ratio (in percent)225.5222.5240.2240.3254.0240.4232.9230.2226.0215.7213.2
Gross external financing need (in billions of US dollars) 4/20.122.322.422.720.022.223.324.125.426.225.2
in percent of GDP71.473.671.384.172.110-Year10-Year76.475.273.673.672.366.5
Scenario with key variables at their historical averages 5/140.2140.5142.4142.9139.5139.9−2.1
Key Macroeconomic Assumptions Underlying BaselineHistorical AverageStandard Deviation
Real GDP growth (in percent)
GDP deflator in US dollars (change in percent)−−
Nominal external interest rate (in percent)
Growth of exports (US dollar terms, in percent)−
Growth of imports (US dollar terms, in percent)3.24.2−0.2−15.8−2.14.422.
Current account balance, excluding interest payments0.
Net non-debt creating capital inflows3.−

Derived as [r - g - r(1+g) + ea(1+r)]/(1+g+r+gr) times previous period debt stock, with r = nominal effective interest rate on external debt; r = change in domestic GDP deflator in US dollar terms, g = real GDP growth rate, e = nominal appreciation (increase in dollar value of domestic currency), and a = share of domestic-currency denominated debt in total external debt.

The contribution from price and exchange rate changes is defined as [-r(1+g) + ea(1+r)]/(1+g+r+gr) times previous period debt stock. r increases with an appreciating domestic currency (e > 0) and rising inflation (based on GDP deflator).

For projection, line includes the impact of price and exchange rate changes.

Defined as current account deficit, plus amortization on medium- and long-term debt, plus short-term debt at end of previous period.

The key variables include real GDP growth; nominal interest rate; dollar deflator growth; and both non-interest current account and non-debt inflows in percent of GDP.

Long-run, constant balance that stabilizes the debt ratio assuming that key variables (real GDP growth, nominal interest rate, dollar deflator growth, and non-debt inflows in percent of GDP) remain at their levels of the last projection year.

Derived as [r - g - r(1+g) + ea(1+r)]/(1+g+r+gr) times previous period debt stock, with r = nominal effective interest rate on external debt; r = change in domestic GDP deflator in US dollar terms, g = real GDP growth rate, e = nominal appreciation (increase in dollar value of domestic currency), and a = share of domestic-currency denominated debt in total external debt.

The contribution from price and exchange rate changes is defined as [-r(1+g) + ea(1+r)]/(1+g+r+gr) times previous period debt stock. r increases with an appreciating domestic currency (e > 0) and rising inflation (based on GDP deflator).

For projection, line includes the impact of price and exchange rate changes.

Defined as current account deficit, plus amortization on medium- and long-term debt, plus short-term debt at end of previous period.

The key variables include real GDP growth; nominal interest rate; dollar deflator growth; and both non-interest current account and non-debt inflows in percent of GDP.

Long-run, constant balance that stabilizes the debt ratio assuming that key variables (real GDP growth, nominal interest rate, dollar deflator growth, and non-debt inflows in percent of GDP) remain at their levels of the last projection year.

Republic of Latvia: External Debt Sustainability, Bound Tests 1, 2

(External Debt in Percent of GDP)

Sources: International Monetary Fund, Country desk data, and staff estimates.

1/ Shaded areas represent actual data. Individual shocks are permanent one-half standard deviation shocks. Figures in the boxes represent average projections for the respective variables in the baseline and scenario being presented. Ten-year historical average for the variable is also shown.

2/ For historical scenarios, the historical averages are calculated over the ten-year period, and the information is used to project debt dynamics five years ahead.

3/ Permanent 1/4 standard deviation shocks applied to real interest rate, growth rate, and current account balance.

4/ One-time real depreciation of 30 percent occurs in 2017.

During the previous cycle, there were 6 contracting agencies; under the new system, there is only one. Looking forward this should help reduce the time for designing and approving strategic project documents.

Core inflation is defined as HICP inflation excluding energy and unprocessed food.

These included the introduction of the so-called solidarity tax, an increase in excise duties, as well as measures to broaden the tax base and improve tax compliance.

This assumes that the historical relationship between real GDP growth and PPP GDP per capita income convergence remains the same going forward,

International Monetary Fund (IMF), 2015, “Where Are We Headed? Perspective on Potential Output,” in World Economic Outlook, April, Chapter 3, p. 69–110 (Washington).

The persistent TFP loss from a large and seemingly temporary shock (see International Monetary Fund (IMF), 2017a, “Gone with the Headwinds: Global Productivity,” Staff Discussion Note. April, Washington, D.C.).

International Monetary Fund (IMF), 2016a, “Selected Issues Paper: Post-crisis adjustment in Latvia: Evidence from firm level data”, IMF Country Report No. 16/17; International Monetary Fund (IMF), 2016, “Regional Economic Issues: Central, Eastern and Southeastern Europe”, chapter II. How to Get Back on the Fast Track? published May 2016, Washington, D.C., International Monetary Fund. 2017b. Fiscal Monitor. Washington, DC, April.

These measures are in line with the authorities’ medium-term policy priorities outlined in the Stability Program for 2016–19.

The budget accommodates a deviation from the national medium term objective—MTO—for funding of the reforms of the pension and health care systems.

The 2016 budget targeted a structural deficit of 0.9 percent of GDP. Compared to the original target, the fiscal stance in 2017 would have implied a much smaller fiscal impulse.

Evidence suggests that productivity-adjusted real wage growth has had little impact on core inflation, other than during the pre-crisis boom years, when such wages grew by nearly 10 percent on average.

The tax reform package is not included in the baseline as its final details have not been determined, and hence have not yet been legislated. It is expected that the package will be legislated in the context of the 2018 budget.

Latvia is one of the major beneficiaries of the European Structural and Investment Funds. Its allocation for the current investment cycle (2014–20) is over EUR 5.6 billion. With a national contribution of EUR 1.27 billion, Latvia has a total budget of EUR 6.9 billion—over 25 percent of GDP—to be invested in various areas, from creating jobs and growth to promoting innovation as well as protecting the environment and supporting social inclusion. See link to Box 2.1 for a detailed allocation of these resources.

Using October 2015 GFSR methodology.

See Latvia 2016 Article IV Consultation.

Under this program the state guarantees loans to families with children granted by credit institutions for house purchase or construction. The guarantee covers 10 to 20 percent of the loan depending on the number of children in the family.

See Sweden 2016 FSAP: IMF Country Report No 16/355.

Assuming 2016 trade volumes at 2015 prices, i.e. absent any terms of trade effects, the current account deficit would be −1.3 percent.

The CA regression is sensitive to the underlying series and projections used, which vary by source, coefficients for demographic variables are derived from a very broad sample, and are thus likely not particularly applicable to the Latvian economy, which is aging rapidly.

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