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Republic of Latvia: 2018 Article IV Consultation—Press Release; Staff Report; and Statement by the Executive Director for the Republic of Latvia

Author(s):
International Monetary Fund. European Dept.
Published Date:
September 2018
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Context

1. Latvia’s economy has gained momentum, but is facing constraints. Consumption growth, utilization of EU structural funds, and a favorable external environment allowed the Latvian economy to reach a growth peak in 2017. However, structural headwinds loom ahead. A shrinking labor force has exacerbated labor market tightness across all sectors. Weak credit growth is limiting the scope for sustained investment, which alongside high capacity utilization, poses constraints to increasing productivity further. Reforms are thus needed to sustain the growth momentum, increase productivity and support long-term growth and Latvia’s income convergence in the euro area.

2. The banking system is stable, but recent developments have, once again, dented its reputation. Of 21 banks operating in the Latvian economy at end-2017w, about half are actively engaged in domestic activity. The rest are tailored toward non-resident business. Despite a 50 percent outflow of non-resident deposits since end-2015, banks servicing foreign clients (BSFC) have failed to refocus their business model, amidst remaining gaps in the enforcement of AML/CFT regulations. Money laundering allegations involving BSFCs have put at risk the credibility of the financial system. Corruption allegations against the Bank of Latvia’s governor and his suspension have also tarnished the reputation of the system and raised concerns about central bank independence.

3. The upcoming elections are unlikely to cause a change in policy course. Parliamentary elections are scheduled to take place on October 6, 2018. Latvia has enjoyed policy continuity, and the current election cycle is not expected to put pressure on the government budget or put at risk reform implementation. Nonetheless, with lingering uncertainties about the costs and impact of the ongoing tax and health reforms, prudent fiscal policies will be critical for preserving Latvia’s sound public finances.

4. Recent policies broadly reflect the 2017 Article IV recommendations. The implementation of the tax reform has aimed to address several staff recommendations, including lowering the tax burden on labor, enhancing equity, reducing the grey economy, and mitigating the fiscal cost of the reform. The authorities have also introduced new measures to improve SMEs’ access to finance. Efforts to improve the insolvency and judicial regime are ongoing.

Recent Economic Developments

5. Growth rebounded with a strong, broad-based upswing. Domestic demand growth tripled from 2.5 percent in 2016 to 7.5 percent in 2017 (Figure 1). Private consumption continued to increase its contribution to overall growth, supported by increasing wages and strong consumer confidence. Investment recovered on the back of an accelerated absorption of EU funds, and implementation of private sector investment projects.1 Growth in construction peaked to over 19 percent, more than offsetting a 17 percent decline in financial and insurance services, while growth in manufacturing and retail trade picked up.

Figure 1.Latvia: Real Sector

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

1/ Difference with long-term average.

2/ Mining, manufacturing, and electricity.

Supply-side Real GDP Growth and Contributions

(In percent)

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

6. Fiscal policy in 2017 was expansionary. Government revenues overperformed, mainly due to higher income taxes and social security contributions, buoyed by strong economic activity and wage growth (Figure 2). EU-funded investment and a one-off advance payment to green electricity producers raised government spending.2 The 2017 budget deficit of 0.5 percent of GDP was about ¼ percent below staff’s projections. However, with a larger-than-projected positive output gap, this translated into a structural deficit of 0.8 percent of GDP and an expansionary fiscal impulse broadly in line with projections. During the first quarter of 2018, the general government recorded a cash surplus, supported by a strong increase in income tax revenues, VAT, and social security contributions.

Figure 2.Latvia: Fiscal Developments

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

7. Gross wages increased significantly as the labor market continued to tighten. Nominal gross wages rose by 7.8 percent in 2017 with private sector wages growing at 8.3 percent, about 1 percentage point higher than public sector wages (Figure 3). Wage pressures were the highest in sectors requiring higher-skilled labor, and in and around Riga. The unemployment rate declined significantly to 8.2 percent at end-2017—the lowest rate since 2008, and the labor force participation rate increased to an all-time high. However, this is largely a result of emigration, with employment having remained flat since the crisis. Against this backdrop, the labor market continued to tighten, with the job vacancy rate approaching its pre-crisis peak and labor shortages increasing in the industry, construction, and service sectors.

Figure 3.Latvia: Labor Market

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

HICP Inflation

(Yoy percent change)

Sources: Statistics Latvia; and staff calculations

8. Inflationary pressures have thus picked up. Average headline inflation reached 2.9 percent in 2017. Energy and food price inflation contributed about 0.6 and 0.5 percentage points respectively, partly driven by base effects that faded out toward year-end. Average core inflation has approached 2 percent, as wages have put pressure on service prices (Figure 4).

Figure 4.Latvia: Inflation

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

9. And while signs of weakening have emerged, competitiveness has held up. With import volumes rising by 9.5 percent, the current account swung into a moderate deficit of 0.8 percent of GDP in 2017 (Figure 5). Wage growth drove unit labor costs (ULCs) to pre-crisis highs, and export shares in neighboring markets—where ULC growth has been more moderate—have started weakening. Nonetheless, goods and services export volumes expanded by 4.8 percent, and world export shares edged up, reflecting a successful diversification of export markets. Profitability in export-oriented sectors also remained robust. The external sector position is assessed to be stronger than implied by medium-term fundamentals, with EU fund inflows and improved terms of trade contributing about 0.4 percentage points to the lower CA deficit (Annex I). Latvia’s policy gap of about 1.5 percent mostly reflects the average—accommodative—fiscal stance of the rest of the world.

Figure 5.Latvia: Balance of Payments

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.

Latvia: Unit Labor Cost – Manufacturing

(2005= 100)

Sources: Haver Analytics and IMF staff calculations.

Enterprise Profitability in Manufacturing

(percent)

Sources: Statistics Latvia; Haver; and IMF Staff Calculations.

10. The financial system remained stable despite pressures from the suspension of activities of Latvia’s third largest bank. In February 2018, the US Treasury’s financial intelligence unit proposed blacklisting ABLV Bank—Latvia’s third largest bank—on money laundering concerns. As ABLV’s liquidity situation deteriorated rapidly, the ECB subsequently determined that the bank was failing or likely to fail (Annex II). The suspension of ABLV’s activities put pressure on non-resident deposits, which declined by more than a third (Figure 6). Nonetheless, the banking system remains well capitalized and liquid, with capital-to-risk-weighted assets of 22.4 percent and liquid assets exceeding 80 percent of short-term liabilities at end-March, 2018.

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

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

Credit-to-GDP

(Percent)

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

11. Despite favorable macroeconomic conditions, credit growth is still subdued. Deleveraging of both households and nonfinancial corporations (NFCs) continued, with household debt to income now at half of its pre-crisis levels and corporate debt to GDP down by more than a quarter from its peak in 2010. The decline in credit to households leveled off, while credit to NFCs expanded modestly in 2017. Lending standards remained tight—an indication that banks are still cautious, as they continue to improve the quality of their lending portfolios. Non-performing loans have declined to 4 percent (Figure 7, Annex III). Non-bank credit notably to households, increased sharply after changes to the regulatory framework in 2016 led to lower non-bank lending rates, but remains at only 2 percent of GDP.

Figure 7.Latvia: Banking Sector Developments

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

1/ Data for non-financial corporation debt-to-income ratio for 2015 and 2016 is 2014 data.

2/ European Central Bank— Household Finance and Consumption Survey, April 2017.

12. Public and external debt have remained stable. Low spreads supported by Latvia’s investment-grade credit rating have created favorable financing conditions and allowed the authorities to refinance existing government debt at lower interest costs and longer maturities.

Outlook and Risks

13. The medium-term growth outlook is favorable, but increasingly binding constraints loom. Real GDP growth is projected to moderate to 3.7 percent in 2018, with a positive output gap of 1.2 percent of GDP. While strong domestic demand will continue to drive growth, supported by EU structural funds and rising wages, external demand has weakened. Investment growth is projected to moderate in the second half of the year. The downsizing of BSFC activity is also projected to weigh on growth by about ½ percentage point of GDP in 2018. Over the medium term, growth is projected to gradually converge to its potential rate of 3 percent, as EU investment funds level off and capacity constraints become increasingly binding, thereby driving a slowdown in wages.

Medium-term Outlook(percent change)
2017201820192023
GDP4.53.73.33.0
Consumption4.94.33.23.2
Gross investment17.513.46.55.0
Exports4.83.23.13.0
Imports9.57.14.54.0

14. Fiscal policy is projected to remain procyclical in 2018, against staff’s advice. The 2018 budgeted fiscal position is expected to remain at a deficit of 1 percent of GDP, as the new tax and healthcare reforms take effect along with a peak in EU-funded investment. Over the medium term, however, a deceleration in EU fund disbursements and a gradual consolidation of about 0.6 percent of GDP will ease domestic demand pressures and help close the output gap. Public debt is projected to remain at prudent levels and declining (Annex IV).

15. The labor market will continue to exert pressure on inflation. The inflow of EU funds will increase demand for labor in 2018, particularly in the construction sector, which attracts a significant share of these funds. The 13 percent increase in the minimum wage will put additional pressure on overall wages in 2018–19.3 With wage and excise tax increases taking effect, inflation is expected to peak at over 3 percent in mid-2018. Over the medium term, wage pressures are projected to remain strong, but ease up as capacity constraints deplete profitability and firms seek to align wage growth with productivity.4 Nonetheless, inflation will remain above 2 percent due to catch-up effects relative to the euro area.

16. Risks to the baseline are tilted to the downside. The key near-term risks to the outlook stem from domestic factors, especially excessive tightening of the labor market and a deepening of fiscal pro-cyclicality, which could trigger an accumulation of imbalances and overheating pressures. Failure to further advance structural reforms, particularly those that could ease labor market conditions, could undermine competitiveness and weaken the medium-term outlook. Failure to enforce AML/CFT regulations and/or a failure of the BSFC sector to refocus its business model could undermine confidence and put at risk financial sector stability (Annex II). External risks are related to trade channels and financial conditions. Potentially weaker growth in advanced economies, and a retreat from cross-border integration, could dent export growth; this is somewhat mitigated by Latvia’s high degree of diversification. An abrupt reversal of risk appetite in Europe and/or tighter global financial conditions could raise the cost of public debt financing. Spillovers from a significant retreat in the Nordic mortgage market—via parent bank funding—could halt the credit growth recovery in the medium-term. Upside risks to the outlook stem from a potential large stimulus to investment from the CIT reform and a faster-than-projected recovery of credit growth.

Authorities’ Views

17. The authorities broadly agreed with staff’s assessment of the outlook and risks. They recognized that EU structural funds will continue to have a strong positive impact on growth in 2018, especially in the construction sector, while the downsizing of the BSFC sector would dampen prospects somewhat. They considered that on balance domestic and external factors pose equal risks, as both could affect confidence negatively.

Policy Discussions: Strengthening Foundations while Riding the Upswing

Policy discussions focused on the need to stem overheating risks and use the cyclical recovery to redouble reform efforts to address risks to medium and long-term growth. Reforms should focus on fostering labor supply and lowering structural unemployment; enhancing productivity growth to mitigate the impact of adverse demographics; improving the growth-friendliness of fiscal policies and increasing fiscal buffers. Efforts are also needed to address lingering crisis legacies in the financial sector that prevent efficient financial intermediation and sustainable credit growth, and pose risks to financial stability.

A. Macro-structural Policies: Preserving Strong Growth

Mitigating Labor Market Risks

18. Labor market constraints pose significant challenges to the medium-term outlook. Emigration continues to deplete the country of needed skills while reducing the size of the labor force. Since Latvia regained independence in 1990, the country has lost about ¼ of its population, of which about 60 percent was caused by emigration. Latvia lost an estimated 1 percentage point of annual growth during the period 1999–2014 due to emigration and the resulting deterioration of skills.5 The loss of skilled labor is driving up wages and dampening productivity gains, and could discourage FDI.

19. Labor supply has been squeezed by structural factors. Labor force participation is at a historical high, but nevertheless trails participation rates in neighboring countries. Participation rates in Latvia are comparatively low for the youth (15–24) and for older workers who have struggled to update their skills. Skills mismatches and skills shortages are among the highest in the EU, contributing to high structural unemployment. Wage differentials with the euro area continue to trigger outward migration, while inward migration is not encouraged enough.6

20. Progress in addressing these challenges is ongoing. The authorities have implemented a set of policies that could address some of the labor market tightness. In particular, the implementation of the recent tax reform is projected to effectively reduce the tax wedge from 42 percent in 2016 below 40 percent (Annex VI).7 The ongoing public administration reform—which should be expanded to municipalities and SOEs—is also expected to increase the availability of skilled labor in the private sector. Recent reforms have improved the quality of vocational education and training (VET). Larger VET schools have been upgraded and modernized, and the law on vocational education was amended in 2017 to provide more flexibility in offered VET programs.

21. Steadfast efforts are needed to improve skills matching and encourage higher labor force participation and mobility. Relying solely on productivity-enhancing measures would not be sufficient to protect competitiveness. While such measures would be critical to support long-term growth, they are unlikely to yield quick results and prevent rising wages from eroding profitability. Several labor market policy options could ease capacity constraints over the medium term:

  • Increase participation in active labor market policies (ALMPs). While Latvia has made progress improving the effectiveness of ALMPs, participation remains low, and spending on ALMPs is among the lowest in the EU. ALMPs and training should be aimed at reducing skills mismatches and helping the long-term unemployed find jobs.

  • Continue to reform vocational education and training, and encourage lifelong learning. Improving links with employers, including by expanding workplace-based learning, would make Latvia’s VET system more effective. Lifelong learning programs should be more accessible and tailored to both employers’ needs and employees’ circumstances.

  • Improve access to housing. Current rental regulations discourage investment in rental housing. Below-market rents are common—a legacy of Soviet-era rental agreements—and rental dispute resolution mechanisms are time consuming and costly. More rental housing would facilitate labor mobility and help stem emigration.

  • Employ more foreign workers. Latvia could do more to attract skilled labor from abroad. Workers from outside the EU are not covered by public health insurance, and students from outside the EU, who finish their studies in Latvia, cannot easily integrate into the Latvian labor market.

  • Revisit the minimum wage structure. Unlike in many countries, Latvia has a unified statutory minimum wage, with no differentiation by region or group of workers. A generous minimum wage that applies across the board risks pricing first-time labor market entrants and other low productivity workers out of formal employment. Age-specific and regional-specific minimum wage provisions, by contrast, could help reduce unemployment.

  • Increase participation rates of targeted groups. This could be achieved by further increasing the retirement age, linking it to life expectancy, and limiting early retirement options. Providing more flexible work arrangements, including increased part-time work, for workers transitioning to retirement can also enable longer working lives for an aging workforce.

Addressing Adverse Demographics

22. Latvia’s labor market and growth outlook face difficult challenges over the long term. Latvia’s population and workforce are projected to decline and age rapidly. By 2050, the population is projected to decline by one quarter and the labor force by about 20 percent, with the share of workers aged 55 years or older rising from about 20 percent in 2015 to 30 percent in 2050. Fewer workers produce less, which, if not offset by more capital or higher productivity, will reduce potential output. If shrinking and aging coincide, a higher dependency ratio can translate into lower per-capita GDP. Aging may also affect productivity due to depreciating skills and physical capabilities. In addition, population aging will pose severe challenges to government finances, as fewer workers provide social security contributions for old-age pensions, health and long-term care. The resulting financing need may lead to a substitution away from growth-friendly capital to current spending.

Contributions to Total Population Growth

(In thousands)

Sources: United Nations World Population Prospects 2017; and IMF Staff Calculations.

Size of the Labor Force and Age Composition

(In thousands)

Sources: United Nations World Population Prospects 2017; and IMF staff calculations.

Average Contributions to Growth 2020–2050

(Annualized, in percent)

Sources: UN WPP; ILO; Statistics Latvia; and IMF staff calculations.

23. Demographic shifts could decrease long-run growth by 1–2 percentage points. Under a no-aging scenario that assumes an unchanged population and labor force structure, TFP growth following historical trends, and capital accumulation on a balanced growth path, Latvia’s long-run growth is estimated at 3 percent8 Allowing for the projected natural population change in 2020–50 (i.e. births and deaths), and the corresponding population aging, but abstracting from projected migration, long-term growth could be lower by about 0.7 percentage points due to the projected decline in labor. Projected net migration trends could cut an additional 0.3 percentage points. Finally, the diminishing productivity of the aging workforce could reduce growth through a negative impact on TFP to about 1.1 percent on average in 2020–50—half as high as under the aging scenario. Consequently, absent any policy changes, demographic shifts can potentially turn into strong headwinds for Latvia in the coming decades.

24. Latvia’s income convergence with the euro area may slow as demographic headwinds take hold. Under the no aging scenario, per-capita income is projected to reach almost 60 percent of the EA-19 average by 2050—about 2.8 times higher than in 2015. As Latvia’s population declines and ages faster than the euro area’s, this likely presents an upper bound absent any reforms. Adding the projected natural population change as well as net migration to the underlying population dynamics could result in an income that is only about 2.5 times higher by 2050. Including the productivity-restraining effect of workforce aging would yield a per-capita income that is about 1.8 times higher by 2050. Consequently, swift implementation of policies to arrest the labor force decline and increase productivity will be paramount to counter these effects.

Income Convergence of Latvia and EA-19

(Euros and in percent)

Sources: UN WPP; ILO; WEO; and IMF Staff Calculations.

GDP per Capita in 2050

(Index, 2015=100)

Sources: UN WPP; ILO; and IMF Staff Calculations.

25. Structural reforms supporting TFP growth will be critical to mitigate the demographic impact on potential growth in the long run. Alongside the labor market reforms mentioned above, addressing structural and institutional obstacles that prevent the efficient use of available technologies, or lead to inefficient allocation of resources, will be key to reaching this goal. The largest efficiency gains are likely to come from improving the quality of institutions (such as protection of property rights and upgrading legal systems) and increasing access to financial services (especially for small, but productive firms).9 Furthermore, reducing the regulatory burden and red tape for businesses and further improving corporate governance of state-owned enterprises would foster competition and efficient resource allocation, as would greater technology diffusion.10 Fiscal structural reforms, aimed at improving efficiency in the tax system, can also boost firm-level productivity by reducing resource misallocation.11 Structural reforms in the areas of R&D and education would also help boost productivity and reduce costs.

Authorities’ Views

26. The authorities recognized that reducing structural unemployment could mitigate the risks that stem from the tight labor market. However, they expressed concerns about introducing administrative complexity in the minimum wage framework and skepticism about the effectiveness of work-based training due to the small size of Latvian companies. They also questioned whether rental market policies were hindering labor market mobility. They were well-aware of the significant implications that adverse demographic trends could have for long-term growth and income convergence, but stressed the difficulty of designing effective policies to address the labor force decline and the strong political sensitivities to relaxing immigration for non-EU workers. They thus agreed that efforts should focus on productivity-enhancing measures.

B. Fiscal Policy: Toward a More Inclusive and Growth-Friendly Policy Mix

27. Given Latvia’s position in the cycle, a stronger fiscal position is warranted to reverse procyclicality and build adequate fiscal buffers over the medium term. Inflationary pressures from fast wage growth and EU investment fund inflows have emerged during the cyclical upswing. Further pressures could arise if fiscal uncertainties stemming from the ongoing tax and healthcare reforms materialize. Given policy constraints within the currency union, carefully calibrated fiscal policies need to protect the economy from an accumulation of imbalances while providing room for growth-enhancing reforms. Seeking to balance these objectives, the authorities have set ambitious fiscal targets in the 2018 Stability Program. In staff’s assessment, these targets would allow public debt to remain firmly on a downward path and to regain buffers but will require policies that yield significant frontloaded savings of ½–¾ percent of GDP. Raising new permanent revenue of this amount and safeguarding growth-enhancing spending will help achieve these targets in a way that strengthens fiscal sustainability without compromising social sustainability.

Structural Balance

(In percent of GDP)

The difference between the staff baseline and authorities’ projections is due to the difference in assessment of the tax reform cost, which staff assesses as permanent.

Source: MoF and IMF staff calculations.

28. The recently-adopted tax reform should help reduce inequality and enhance growth, but will further constrain fiscal space. The change to the PIT structure is an important initial step to reduce Latvia’s high labor tax wedge and income inequality, while changes to the CIT system could improve corporate balance sheet transparency and investment incentives. The medium-term impact of these changes will largely depend on whether they succeed in boosting labor force participation and corporate investment. Staff simulations suggest that the reform could have a positive impact on the economy over the medium term. In a scenario with the most favorable assumptions, in which corporates fully invest additional income provided by the CIT reform, the PIT and CIT reforms could increase real GDP by about 1.5 percent over the medium term. However, tax revenues will be permanently lower. Revenue-balancing measures would prevent further constraining fiscal space (Annex VI).

29. With limited flexibility in the budget and lingering uncertainties about revenues, room for policy maneuver will be constrained. Latvia has many spending needs to advance the country toward income convergence with the euro area, reduce the existing high levels of poverty and inequality, and address spending pressures related to the projected adverse demographic trends. The fiscal policy mix thus needs to combine more efficient and growth-friendly spending with better revenue mobilization.

30. There is scope for reallocating spending to improve growth and income equality. Efforts should focus on increasing investment and social protection spending, while streamlining government consumption:12

  • Investment. Given Latvia’s relatively low capital-output ratio in comparison with advanced economies, greater investment is needed to support long-term growth.13 Staff estimates suggest that a permanent increase in capital expenditure of 0.5 percent of GDP per year—upon the deceleration of EU-funded investment— financed by a reduction in government consumption, could gradually add about 0.7 percentage points to cumulative real GDP growth over the medium term.

  • Health and education. While there is significant uncertainty about the magnitude of the potential gains, cross country-studies suggest that efficient healthcare and education spending can directly reduce market income inequality, and increase human capital and labor productivity.14 Savings could be secured by streamlining institutions with high teacher-student ratios and reallocating resources to fewer institutions to help improve the quality of education.

  • Social protection. Latvia spends significantly less than other EU countries on social protection, especially on means-tested (MT) programs. Experience from other countries suggests that significant gains in reducing inequality and poverty can be achieved by relying more on properly designed MT programs. With relatively high levels of income inequality, the case for relying on targeted programs is more compelling in Latvia, and thus strengthening the guaranteed minimum income and social housing programs would be a step in the right direction. Further savings and efficiency gains can be secured by reducing the size of the wage bill, recalibrating the design of existing safety nets, and improving administrative capacity in the implementation of existing programs.

Real GDP Growth

Sources: Latvian Authorities; and IMF staff calculations.

Redistributive Impact of Means-tested Programs

Sources: FAD Expenditure Assessment tool; and IMF staff calculations.

31. Achieving the targeted fiscal path and development goals requires new and stable sources of revenue. While there is some scope to improve spending efficiency, the savings would be minimal given that Latvia is already close to the efficiency frontier in many areas. Given Latvia’s low intake from property taxes compared to EU peer countries, raising property revenues is a growth-friendly alternative to securing needed savings. There is also scope to reduce VAT tax expenditures by simplifying the VAT rate structure and to further reduce VAT noncompliance by strengthening the tax administration. These measures could provide additional revenue, while promoting fairness among taxpayers and a level playing field for companies.

Tax on Property, 2016

(In percent of total revenue)

Source: OECD (2018), Tax on property (indicator). doi: 10.1787/213673fa-en (Accessed on 10 May 2018).

Authorities’ Views

32. The authorities agreed that reversing fiscal procyclicality would be necessary to mitigate overheating risks and build fiscal buffers. However, they expressed reservations about the need to raise additional savings in 2019–20, given that fiscal policies remain consistent with their EU stability pact commitments and domestic fiscal rules. They considered their fiscal objectives to be achievable under current policies as the stimulus impact of the tax reform would gradually compensate for the revenue loss. Nonetheless, they agreed that structural reforms to boost productivity, particularly those related to improving the quality of healthcare and infrastructure, would require fiscal space. They thus emphasized their commitment to strengthening the revenue administration and saw merit in reforming the property tax as sources of additional permanent revenue.

C. Macro-financial Policies: Ensuring Efficient Financial Intermediation

Restoring Credit Growth

33. Credit growth has been slow to recover, as supply and demand constraints are not easing. On the supply side, this has partly been a result of continuing regulatory efforts to repair banks’ balance sheets and preserve financial stability, including through macroprudential policies aimed at building safer capital cushions (Annex III). Furthermore, banks’ lending standards remain tight in the face of weak borrower collateral and equity, lengthy insolvency procedures, and the shadow economy. On the demand side, while there are some indications that loan demand has increased, nearly three quarters of SMEs report no need for credit, either because they have no plans to expand or because they intend to finance their investments with internal resources. The pickup in non-bank credit—mainly due to businesses tapping EU funds—has not been sufficient to resuscitate the overall timid credit growth.

34. Healthy credit growth is needed to support investment and the economy in the medium term. Given the shrinking labor force, investment will be an important component for supporting medium-term growth. Structural and regulatory reforms will be particularly important to prepare the banking system to extend credit as EU funds decelerate. The completion of the ongoing ambitious reform of the insolvency regime to address concerns about abuse and lack of transparency should also help unlock credit, especially if it results in shortening the length of insolvency procedures and improving creditors’ recovery rates. Further efforts are also needed to bring more of Latvia’s economic activities into the formal economy and to encourage voluntary income and asset disclosure. This requires improving public trust in government institutions, including through the ongoing efforts to strengthen Latvia’s tax administration, Financial Intelligence Unit (FIU) and the Corruption Prevention and Combating Bureau. The rollout of new instruments to support credit (e.g. financial and non-financial support for startups) as well as regional cooperation in developing capital markets are also welcome steps to further deepen financial intermediation.

Strengthening the AML/CFT Framework and Refocusing the BSFC Sector

35. The suspension of activities of Latvia’s third largest bank has highlighted important deficiencies in the existing regulatory and supervisory framework. These deficiencies cut across several areas of supervision of BSFCs. While Latvia has made improvements to its AML/CFT legislation in recent years, ABLV’s proposed designation as an institution of primary money laundering concern exposed serious shortfalls in the implementation of AML/CFT preventive measures in the BSFC sector. It also raised doubts as to the capacity of the supervisors to effectively identify and address AML/CFT compliance breaches. Furthermore, allowing ABLV to proceed with a voluntary liquidation after the ECB’s determination of the bank as “failing or likely to fail”—and the SRB’s decision not to resolve the bank for lack of public interest—demonstrates weaknesses in a legal framework that does not provide sufficient powers for compulsory liquidation in such cases. Ineffective application of AML/CFT controls in the liquidation process could also lead to payouts to depositors without sufficient customer due diligence checks. ABLV’s case highlights the limitations arising from the absence of a common EU-wide AML/CFT supervision framework, and from fragmentation in the bank resolution regime within the euro area.

36. A multi-pronged strategy is needed to address these deficiencies. The focus needs to be on developing more effective AML/CFT enforcement, preventing high-risk activities of BSFCs, and repairing bank governance.

  • Strengthening AML/CFT enforcement and implementation. The authorities need to ensure that financial institutions apply preventive measures (including verification of the beneficial owner), particularly in relation to high-risk customers. AML/CFT supervision needs to more stringently evaluate banks’ risk mitigation models, ensure that customer due diligence requirements are properly followed, and apply corrective actions and sanctions when deficiencies are identified. Information sharing could be improved through enhanced cooperation mechanisms among key stakeholders (i.e., FCMC, FIU, tax administration, corporate registry, and law enforcement agencies). Furthermore, the authorities are encouraged to swiftly implement the actions recommended by the AML/CFT assessment adopted by Moneyval in July 2018. Finally, establishing a regional AML/CFT supervisory arrangement could enhance convergence of supervisory practices, improve the quality of domestic AML/CFT supervision through training and capacity building, and minimize regulatory arbitrage.15

  • Refocusing the BSFC sector. In view of the high reputational and governance risks, it is critical to reassess the sustainability of business models involving opaque entities. Although new legislation now prohibits banks from engaging with some narrowly-defined types of shell companies, further measures are needed to ensure the transparency of Latvian companies and identify the customer’s beneficial owners. The FCMC should carefully oversee the voluntary liquidation of ABLV, the payout of insured deposits, and the consolidation of the BSFC sector to mitigate the risks of payments to entities associated with money laundering, and the potential impact on confidence and financial stability. Furthermore, the FCMC should ensure that new BSFC activities do not increase financial stability risks or create contingent liabilities for the government.

  • Upgrading the banking and insolvency framework. The national authorities should have adequate legal tools to liquidate a bank that has been deemed “failing or likely to fail”. Efforts to strengthen the integrity, accountability, and qualification requirements of insolvency administrators are welcome. Upgrades are also needed to the domestic banking and insolvency legislation, alongside harmonization within the EU, to include clear requirements for the FCMC to impose compulsory liquidation upon a bank that has been determined as “failing or likely to fail” by the ECB, but will not be resolved by the SRB. Continued vigilant application of fit-and-proper rules, including strengthening the assessment of the reputation of bank owners and senior managers should also be pursued.

Authorities’ Views

37. The authorities emphasized the financial stability gains that resulted from conservative lending policies after the 2008 crisis. Nonetheless, they concurred that restoring credit growth is a medium-term priority and addressing deficiencies in insolvency administration and combating the shadow economy would be critical in this effort. They also agreed that legal amendments to enhance the regulatory tools and powers, alongside harmonization within the EU, would be useful. National authorities emphasized their commitment to work toward minimizing risks to financial stability related to ABLV’s liquidation and the refocusing of the BSFC sector. Finally, they recognized the need for enhanced enforcement of AML/CFT regulations and considered the new legislation on shell companies as one of the appropriate ways to manage the high risks. They also expressed strong support for a regional AML/CFT supervisory arrangement, and for further domestic efforts to improve information sharing and supervisory capacity.

Staff Appraisal

38. Latvia’s economy has continued to recover since the crisis, but the path toward income convergence remains challenging. Consumption growth, utilization of EU structural funds, and a favorable external environment allowed the economy to reach a growth peak in 2017, and are projected to support strong growth in 2018. The external sector position is stronger than implied by medium-term fundamentals. However, the economy is facing increasingly binding constraints. A shrinking labor force exacerbates labor market tightness, driving up wages and eroding competitiveness, while labor force aging is likely to dampen productivity in the long run. Weak credit growth limits the scope for sustained investment and poses constraints to increasing productivity further. The challenge is thus to smoothly navigate the ongoing cyclical upswing, while setting the stage for robust and inclusive growth in the medium and long term.

39. The policy mix needs to be calibrated to mitigate overheating risks and keep the economy on a path of sustainable long-term growth. To prevent excessive tightening of the labor market, which could result in rapid loss of competitiveness and higher inflation, reforms need to focus on easing labor market constraints by encouraging greater labor force participation and reducing structural unemployment. These reforms include greater use of skill-matching and skill-building policies, better access to housing, revisiting the minimum wage structure, improving labor participation of targeted groups, and encouraging labor immigration. Productivity-enhancing reforms will also be critical for the economy to face demographic headwinds to growth in the long run.

40. Near-term fiscal policy priorities need to prevent the accumulation of imbalances. The procyclicality of fiscal policies raises near-term risks of overheating, especially as uncertainties linger about the economic impact of the recent tax reform. Given policy constraints within the currency union, a stronger fiscal position would be warranted to reverse procyclicality and build fiscal buffers. The authorities’ fiscal objectives are appropriate, but will require steadfast implementation supported by upfront consolidation. Greater revenue mobilization, including to mitigate the costs of the recent tax reform, would support these objectives.

41. Improving the growth-friendliness and inclusiveness of the fiscal policy mix has long-term benefits. Despite dampening revenues, the recently adopted income tax reform is a step in the direction of reducing the high tax wedge, improving progressivity of the tax system, and encouraging firms’ investment. Reallocating government spending toward productive investment will help the economy weather the gradual deceleration of EU structural funds in the medium term. More efficient health and education spending and better targeted social protection programs would help build human capital, improve labor productivity, and address Latvia’s high poverty and inequality rates.

42. The financial system needs to become more supportive of investment in the medium term. Tight macroprudential regulations and lending standards since the crisis have helped improve banks’ balance sheets and have supported financial sector stability. But in the medium and long term, robust investment will be needed to raise Latvia’s capital-output ratio. The financial system could become more supportive of investment as reforms address risks stemming from the insolvency framework and the shadow economy. In particular, completing the reform of the insolvency regime and the licensing of insolvency administrators would help improve creditors’ recovery rates, while efforts to encourage voluntary income and asset disclosure would help reduce credit risk.

43. Steadfast actions are necessary to restore the reputation of Latvia’s financial system. Effective enforcement of AML/CFT regulations should focus on mitigating risks from non-resident depositors and opaque companies. Changes in banking legislation, alongside harmonization at the EU level, should provide more adequate tools to liquidate banks deemed to be failing or likely to fail. More vigilant application of fit and proper rules, including assessment of the reputation of bank owners and managers, would help improve bank governance and business models. These reforms, and careful management of the refocusing of BSFCs, will be key to minimize financial sector stability risks.

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

Box 1.Risk Assessment Matrix1

Source of Risk and LikelihoodImpact if RealizedPolicy Recommendations Mitigation/Response
MediumHigh
Retreat from cross-border integration: Fraying consensus about the benefits of globalization leads to protectionism and economic isolationism, resulting in reduced global and regional policy and regulatory 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 and confidence channels.Pursue structural policies that enhance productivity.
Continue to diversify product and export markets.
Participate in coordinated policy response at the European level.
HighHigh
Structurally weak growth in key advanced and emerging economies. Low productivity growth (U.S., euro area and Japan), high debt, and failure to fully address crisis legacies by undertaking structural reforms amidst persistently low inflation (euro area and Japan) undermine medium-term growth.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.
High/MediumMedium
Tighter global financial conditions. (High)

Continued monetary policy normalization and increasingly stretched valuations across asset classes, an abrupt change in global risk appetite, could lead to sudden, sharp increases in interest rates and associated tightening of financial conditions. Higher debt service and refinancing risks could stress leveraged firms, households, and vulnerable sovereigns.

Significant retreat in the Nordic mortgage market. (Medium)
Could raise the public cost of debt financing. Domestically, sharp increases to interest rate could further hinder credit growth.Perception of Latvia as a safe asset and the issuance of long-term sovereign debt are mitigating factors.
Continue implementing prudent debt management and macroprudential policies and build fiscal buffers.
Could lower funding for Nordic banks reliant on wholesale funding, raising cost of financing and hindering credit growthHigh bank capitalization and liquidity are mitigating factors.
High/MediumHigh/Medium
Delays in the enforcement of AML standards (High)Could result in further actions taken by foreign regulators, affecting financial sector stability and growth.Maintain strict AML/CFT regulations and improve their enforcement.
Failure to refocus the business model of the BSFC sector and/or fast consolidation of the BSFC sector, including due to intensification of sanctions on Russia. (Medium)Rapid downsizing of deposits could undermine confidence and have a larger-than-expected impact on growth.Reassess the sustainability of a business model involving opaque entities. Closely monitor and manage the withdrawal of nonresident deposits to minimize spillovers and costs.
MediumHigh
Failure to advance structural reforms, including those that ease the labor market and pose risks of overheating. (Medium)Could lead to overheating labor market, harming competitiveness. Delay in other reforms could undermine productivity growth and the business environment.Focus on improving the labor market, business environment, infrastructure, and human capital.
Deepening of fiscal pro-cyclicality (Medium)Could trigger an accumulation of imbalances and overheating pressuresReduce the structural balance faster to avoid procyclicality.
1 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.

Figure 8.Latvia: Inequality and Poverty

Source:: OECD (2018), Poverty rate (indicator). doi: 10.1787/0fe1315d-en (Accessed on 12 April 2018); Eurostat; Statistics Latvia; IMF FAD; and IMF staff calculations.

1/ Active population aged 25–64.

Table 1.Latvia: Selected Economic Indicators, 2013–19
2013201420152016201720182019
Proj.
National accounts(Percentage change, unless otherwise indicated)
Real GDP2.41.93.02.24.53.73.3
Private consumption5.11.42.53.35.14.33.5
Public consumption1.61.91.92.74.14.43.5
Gross capital formation-5.2-8.92.70.217.513.46.5
Gross fixed capital formation-6.00.1-0.5-15.016.014.06.5
Exports of goods and services1.16.03.04.14.83.23.1
Imports of goods and services0.41.22.14.59.57.14.5
Nominal GDP (billions of euros)22.823.624.324.926.928.930.6
GDP per capita (thousands of euros)11.311.812.212.713.814.915.8
Savings and Investment
Gross national saving (percent of GDP)21.620.921.821.020.720.821.0
Gross capital formation (percent of GDP)24.322.722.219.621.523.123.6
Private (percent of GDP)20.519.018.516.917.919.620.4
HICP Inflation
Period average0.00.70.20.12.92.72.4
End-period-0.40.30.42.12.22.72.4
Labor market
Unemployment rate (LFS; period average, percent) 1/11.910.89.99.68.78.28.1
Real gross wages4.66.16.64.94.85.14.3
(Percent of GDP, unless otherwise indicated)
Consolidated general government 1/
Total revenue36.736.136.236.435.836.636.0
Total expenditure37.337.837.836.836.737.837.0
Basic fiscal balance-0.6-1.7-1.5-0.4-0.8-1.2-1.0
ESA balance-1.2-1.5-1.40.1-0.5-0.9-1.0
General government gross debt 3/35.838.534.937.436.335.034.2
Money and credit
Credit to private sector (annual percentage change)-6.6-7.4-2.33.51.2
Broad money (annual percentage change)2.035.57.56.62.7
Balance of payments
Current account balance-2.7-1.7-0.51.4-0.8-2.4-2.6
Trade balance-11.5-10.1-9.1-7.7-9.7-10.9-11.1
Gross external debt133.9144.1143.6148.8140.8136.6136.8
Net external debt 2/36.633.729.328.824.430.131.6
Exchange rates
U.S. dollar per euro (period average)1.331.331.111.111.13
REER (period average; CPI based, 2005=100)120.3122.2120.8121.9122.9
Terms of trade (annual percentage change)0.6-1.20.72.80.71.60.6
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.

Gross public debt of the general government consistent with the cash deficit.

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.

Gross public debt of the general government consistent with the cash deficit.

Table 2.Latvia: Macroeconomic Framework, 2013–23
20132014201520162017201820192020202120222023
Proj.
(Percentage change, unless otherwise indicated)
National accounts
Real GDP2.41.93.02.24.53.73.33.13.03.03.0
Consumption4.31.52.43.24.94.33.53.33.23.23.2
Private consumption5.11.42.53.35.14.33.53.33.23.23.2
Public consumption1.61.91.92.74.14.43.53.23.03.03.0
Gross capital formation-5.2-8.92.70.217.513.46.55.05.05.05.0
Gross fixed capital formation-6.00.1-0.5-15.016.014.06.55.05.05.05.0
Exports of goods and services1.16.03.04.14.83.23.13.03.03.03.0
Imports of goods and services0.41.22.14.59.57.14.54.04.04.04.0
Contributions to growth
Domestic demand2.0-1.02.52.57.56.64.54.03.93.94.0
Net exports0.42.80.5-0.3-3.0-2.7-1.2-0.9-0.9-1.0-1.0
HICP inflation
Period average0.00.70.20.12.92.72.42.42.42.32.3
End-period-0.40.30.42.12.22.72.42.42.42.32.3
Labor market
Unemployment rate (LFS, percent)11.910.89.99.68.78.28.18.07.97.87.8
Employment (period average, percent)2.1-1.01.3-0.30.20.20.00.00.00.00.0
Real gross wages4.66.16.64.94.85.14.34.03.73.43.0
(Percent of GDP)
Consolidated general government 1/
Total revenue36.736.136.236.435.836.636.036.335.835.635.2
Total expenditure37.337.837.836.836.737.837.036.936.336.135.7
ESA balance-1.2-1.5-1.40.1-0.5-0.9-1.0-0.8-0.4-0.4-0.4
ESA structural balance-1.5-1.4-1.40.5-0.9-1.4-1.4-1.0-0.5-0.4-0.4
General government gross debt 5/35.838.534.937.436.335.034.233.132.031.030.0
Saving and investment
Gross national saving21.620.921.821.020.720.821.021.321.121.221.3
Private18.118.118.517.617.017.417.717.717.417.517.6
Public 2/3.52.83.23.33.73.43.33.63.73.73.8
Foreign saving 3/2.71.70.5-1.40.82.42.62.63.13.33.4
Gross capital formation24.322.722.219.621.523.123.623.824.224.524.8
Private20.519.018.516.917.919.620.420.821.221.521.8
Public3.83.73.82.73.63.53.23.03.03.03.0
External sector
Current account balance-2.7-1.7-0.51.4-0.8-2.4-2.6-2.6-3.1-3.3-3.4
Net IIP-66.5-66.1-63.9-58.9-56.5-55.7-54.5-53.4-53.0-52.7-52.3
Gross external debt133.9144.1143.6148.8140.8136.6136.8137.0132.3131.5130.8
Net external debt 4/36.633.729.328.824.430.131.632.534.136.137.7
Memorandum items:
Nominal GDP (billions of euros)22.823.624.324.926.928.930.632.334.135.937.8
Output gap (percent)1.11.00.2-1.21.01.21.00.50.20.00.0
Potential output growth (percent)1.61.93.83.62.33.53.63.63.23.23.0
Terms of trade (annual percentage change)0.6-1.20.72.80.71.60.60.30.10.00.0
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.

Gross public debt of the general government consistent with the cash deficit.

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.

Gross public debt of the general government consistent with the cash deficit.

Table 3.Latvia: General Government Operations, 2013–231
20132014201520162017201820192020202120222023
Projections
(percent of GDP)
Total revenue and grants36.736.136.236.435.836.636.036.335.835.635.2
Tax revenue28.228.328.829.829.829.629.129.729.729.729.8
Direct Taxes16.916.516.717.217.416.716.116.316.316.316.3
Corporate Income Tax1.61.51.61.71.60.80.81.11.11.11.1
Personal Income Tax5.85.95.96.16.36.05.45.35.25.25.2
Social Security Contributions8.78.48.48.48.48.88.88.98.98.98.9
Real Estate and Property Taxes0.80.80.80.90.80.80.80.80.80.80.8
Indirect Taxes11.311.712.112.512.512.913.113.413.413.413.5
VAT7.37.67.88.18.18.48.58.78.88.88.8
Excises3.23.23.33.53.43.53.63.73.73.73.7
Other indirect taxes0.80.91.01.01.00.90.90.90.90.91.0
Non Tax, self-earned and other revenue3.63.33.33.63.33.23.02.82.72.52.4
EU and miscellaneous funds4.94.54.13.02.73.83.83.93.43.33.0
Total expenditure 2/37.337.837.836.836.737.837.036.936.336.135.7
Current expenditure33.534.134.034.133.134.333.833.933.333.132.7
Remuneration7.77.98.28.48.58.68.48.38.28.07.9
Wages and Salaries6.06.16.36.56.56.66.46.46.36.26.1
Goods and Services4.94.84.84.84.95.35.25.25.15.05.0
Subsidies and Transfers18.218.718.218.617.718.518.318.418.118.118.0
Subsidies to companies and institutions7.58.27.47.67.17.57.27.36.96.96.8
Social Support10.510.410.610.810.510.810.911.011.011.011.0
Pensions8.07.77.57.57.27.37.47.57.57.57.5
Other2.62.73.13.43.33.53.53.53.53.53.5
International cooperation0.20.20.20.10.10.20.10.10.10.10.1
Payments to EU budget1.21.21.01.00.81.01.11.11.11.11.1
Oher0.00.00.00.00.00.00.00.00.00.00.0
Interest1.41.51.81.21.11.00.91.00.90.80.8
Capital expenditure3.83.73.82.73.63.53.23.03.03.03.0
Fiscal balance-1.2-1.7-1.5-0.4-0.8-1.2-1.0-0.6-0.6-0.5-0.5
Financing (net)1.21.71.50.40.81.21.00.60.60.50.5
Domestic financing2.4-5.46.5-2.91.41.2-1.9-2.03.0-0.7-0.8
External financing-1.27.1-4.93.3-0.60.02.92.6-2.51.21.3
Errors and omissions0.00.00.00.00.00.00.00.00.00.00.0
Memorandum items
ESA balance-1.2-1.5-1.40.1-0.5-0.9-1.0-0.8-0.4-0.4-0.4
ESA structural balance 3/-1.5-1.4-1.40.5-0.9-1.4-1.4-1.0-0.5-0.4-0.4
General government debt 4/35.838.534.937.436.335.034.233.132.031.030.0
Nominal GDP (billions of euros)22.823.624.324.926.928.930.632.334.135.937.8
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.

Gross public debt of the general government consistent with the cash deficit.

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.

Gross public debt of the general government consistent with the cash deficit.

Table 4.Latvia: Medium-Term Balance of Payments, 2013–23
20132014201520162017201820192020202120222023
Projections
(Percent of GDP, unless otherwise indicated)
Current account-2.7-1.7-0.51.4-0.8-2.4-2.6-2.6-3.1-3.3-3.4
Goods and services (fob)-3.7-1.4-0.50.9-1.3-2.7-3.1-3.5-4.0-4.5-5.0
Goods (fob)-11.5-10.1-9.1-7.7-9.7-10.9-11.1-11.3-11.6-11.8-12.1
Exports43.143.442.541.742.342.541.841.040.539.738.9
Imports-54.5-53.4-51.6-49.4-51.9-53.4-52.9-52.3-52.0-51.5-51.0
Services7.88.68.58.68.48.28.07.87.67.37.1
Credit17.117.417.918.418.218.318.017.717.417.116.8
Debit-9.3-8.7-9.4-9.8-9.8-10.1-10.0-9.9-9.9-9.8-9.7
Primary Income-0.3-0.4-0.6-0.2-0.7-0.9-0.6-0.2-0.10.20.7
Compensation of employees2.32.82.52.21.91.81.81.81.81.81.8
Investment income-3.8-3.8-3.9-3.7-3.6-3.6-3.3-3.0-2.9-2.5-2.0
Secondary Income1.30.10.60.71.21.11.11.11.01.00.8
Capital and financial account1.50.43.4-0.80.02.42.62.63.13.33.4
Capital account2.53.22.81.00.81.21.21.11.11.01.0
Financial account-1.0-2.80.6-1.8-0.71.21.41.52.02.32.4
Direct investment1.61.22.60.02.10.80.71.20.80.70.8
Portfolio investment and financial derivatives0.1-0.5-9.5-4.5-6.5-4.32.51.6-3.30.10.2
of which: general government net issuance-0.36.9-0.63.90.10.34.92.7-2.41.41.3
Other investment-1.0-4.18.83.27.04.7-1.7-1.34.61.51.5
Reserve assets-1.70.5-1.3-0.5-3.30.00.00.00.00.00.0
Errors and omissions1.21.3-2.9-0.60.70.00.00.00.00.00.0
(Percent change, unless otherwise indicated)
Goods and Services
Export value (fob)2.24.62.41.98.58.34.23.64.03.33.1
Import value (fob)0.90.90.9-0.512.610.65.04.34.94.34.1
Export volume1.16.03.04.14.83.23.13.03.03.03.0
Import volume0.41.22.14.59.57.14.54.04.04.04.0
Gross reserves (billions of euros)5.82.73.23.33.93.93.93.93.93.93.9
Gross external debt (billions of euros)30.534.034.937.137.839.441.944.345.147.249.3
Medium- and long-term (billions of euros)18.018.717.218.218.018.219.220.219.620.321.1
Short term (billions of euros)112.515.317.718.919.921.322.624.025.426.828.2
Net external debt (billions of euros)28.38.07.17.26.68.69.410.111.212.513.8
Gross external debt (percent of GDP)133.9144.1143.6148.8140.8136.6136.8136.9132.2131.4130.7
Medium and long term (percent of GDP)78.879.470.973.166.962.962.862.657.656.655.9
Short term (percent of GDP)155.164.772.775.773.973.674.074.374.674.874.8
Net external debt (percent of GDP)236.633.729.328.824.429.730.831.432.834.836.7
Memo items
Nominal GDP (billions of euros)22.823.624.324.926.928.930.632.334.135.937.8
U.S. dollar per euro (period average)1.331.331.111.11
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, 2007–17
20072008200920102011201220132014201520162017
Commercial banks
Capital Adequacy
Regulatory capital to risk-weighted assets 1/11.111.8014.614.617.417.6018.921.022.821.521.4
Regulatory Tier I capital to risk-weighted assets 1/9.810.5011.511.514.215.2017.318.319.818.219.0
Capital and reserves to assets7.97.307.47.37.59.369.99.910.410.111.1
Asset Quality
Annual growth of bank loans37.211.2-7.0-7.1-8.1-10.9-6.5-6.10.13.1-4.6
Annual growth of bank loans to residents30.315.867.2-8.7-8.3-10.5-6.2-7.6-1.53.1-2.8
Annual growth of bank loans to companies36.316.9-6.5-8.0-7.6-9.0-5.6-9.6-1.61.6-7.6
Sectoral distribution of loans (in % of total loans, stock)100.0100.0100.0100.0100.0100.0100.0100.0100.0100.0100.0
Agriculture, hunting and related service activities1.61.71.61.62.02.43.22.82.82.82.8
Construction and real estate activities18.819.620.820.420.018.618.117.917.317.917.3
Industry and trade21.623.122.322.022.024.324.222.723.322.723.3
Financial intermediation6.06.04.53.22.82.73.64.75.14.75.1
Households40.038.439.339.840.039.138.437.836.237.836.2
Non-residents12.111.211.413.113.212.912.614.015.414.015.4
Loans past due over 90 days0.83.616.419.017.211.18.36.96.04.44.1
Loans to households4.716.818.419.315.212.09.57.65.33.5
Loans to corporations2.818.520.816.29.77.05.94.42.73.1
Earnings and Profitability
ROA (after tax)2.00.3-3.5-1.6-0.90.60.91.11.31.50.9
ROE (after tax)24.34.6-41.6-20.4-11.25.68.711.112.514.37.6
Liquidity
Liquid assets to total assets25.021.621.127.327.432.336.539.940.233.837.4
Liquid assets to short term liabilities55.752.862.867.963.959.864.463.166.761.959.5
Customers deposits to (non-interbank) loans68.258.861.977.584.1106.3124.9151.3158.5141.2140.3
Sensitivity to Market Risk
FX deposits to total deposits 2/70.769.474.572.673.576.275.940.343.134.229.1
FX loans to total loans 2/81.885.087.188.986.384.588.513.013.812.58.4
Memorandum Items
Share of non-resident deposits to total deposits41.744.038.041.647.248.947.351.753.442.839.7
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

1. Foreign assets and liabilities. The NIIP has improved gradually and stood at around -56 percent of GDP by end 2017, compared to -58 percent at end-2016; it is projected to continue declining to about -48 percent of GDP over the medium term. Gross assets stood at 133 percent of GDP in 2017, while gross liabilities stood at 189 percent. Debt securities comprised only 24 percent of these liabilities. At the same time, net external debt stood at 24 percent of GDP at the end of 2017.

2. Current account. The current account moved to a deficit of 0.8 percent of GDP in 2017, driven by a notable uptick in goods imports, as investment and consumption growth accelerated. The current account is projected to further deteriorate in 2018 and 2019 as investment and consumption continue to be strong. The EBA-lite CA model results suggest a CA gap of around 2.5 percent of GDP in 2017, of which about 1.5 percentage points can be attributed to the policy gap. This in turn mostly reflects the average fiscal stance of the rest of the world, which is assessed overly accommodative at this juncture. The remainder of the CA gap is unexplained by the model and may represent other distortions that affect the external sector, including exchange rate misalignment. Overall, the current account position is assessed stronger than implied by fundamentals and desirable policies.

ESA Summary Table
EBA-lite CA model
CA-Actual-0.8%
CA-Norm-3.3%
CA-Gap2.5%
o/w Policy gap1.5%
Elasticity-0.45
Implied REER Gap-5.6%
CA-Fitted-1.9%
Residual1.1%
EBA-lite Index REER model
ln(REER)-Actual4.61
ln(REER)-Norm4.62
REER-Gap-0.8%
o/w policy gap-0.8%

3. Real exchange rate. The REER appreciated by about 0.8 percent between 2016 and 2017. The EBA-lite CA model suggests an undervaluation of 5.6 percent using standard trade elasticities. As Latvia is still a catching-up economy, continued strong investment and consumption should bring down the balance without the need for an exchange rate adjustment. The EBA-lite Index REER model finds a small undervaluation.

4. Capital and financial accounts. The capital account is dominated by EU structural fund inflows, which slowed in 2017, as funds are primarily aimed at supporting current expenditure on structural measures. FDI inflows, at 3.7 percent of GDP in 2017, rebounded to their highest level since the GFC, portfolio and other investment flows remain 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.

5. 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.

6. The external position in 2017 was stronger than implied by medium-term fundamentals and desirable policies. A widening of the current account deficit from 2018 onwards is expected, on the back of a pick-up in investment and unwinding of terms-of-trade gains.

Annex II. Recent Developments in the BSFC Sector

1. Foreign authorities have alleged that Latvian BSFCs have been involved in money laundering. On February 13, the Financial Crimes Enforcement Network of the U.S. Department of the Treasury (FinCEN) named Latvia’s ABLV Bank an institution of primary money laundering concern. FinCEN issued a proposal under the U.S. Patriot Act, seeking to prohibit ABLV from engaging in dollar transactions with correspondent banks. FinCEN’s report found that the bank orchestrated money laundering schemes, obstructed regulatory enforcement, engaged in bribery, and conducted illicit activities linked to North Korea, Russia, and Ukraine. In 2017, Rietumu Bank, also one of Latvia’s largest banks, was fined €80 million for being involved in a tax avoidance scheme in France; Rietumu is currently appealing the French court ruling.

2. ABLV’s Failure. FinCEN’s report triggered a rapid deterioration of ABLV’s liquidity situation. Deposit withdrawals amounted to nearly a quarter of ABLV’s total deposits (2 percent of GDP) within two days of FinCEN’s announcement. In response, the FCMC—upon ECB’s instructions—imposed restrictions on payments made by ABLV until the bank’s liquidity situation was stabilized. As ABLV was unable to secure sufficient liquidity to withstand stressed outflows within the set deadline, the ECB determined ABLV, and its Luxembourg subsidiary, to be “failing or likely to fail”.

3. Liquidation process. The Single Resolution Board (SRB) established that resolution of ABLV and its subsidiary was not in the public interest, as the banks did not provide critical functions in the economy and the financial system, and their failure was not expected to have a significant adverse impact on financial stability. The banks’ liquidation was thus expected to take place under national legislation; however, the Luxembourg court found the local subsidiary to be solvent and refused the request for its liquidation. Moreover, the FCMC did not find legal grounds for a compulsory liquidation of the bank in Latvia, or to revoke its license.1 A voluntary liquidation plan submitted by ABLV’s shareholders was subsequently approved by the FCMC. The shareholders have also filed a case against the ECB and SRB’s decision with the Court of Justice of the European Union.

4. Deposit insurance. On March 3, payouts commenced to about 23,000 insured depositors in ABLV. The payouts are expected to be fully backed by ABLV’s funds without the use of the additional funds of Latvia’s Deposit Guarantee Fund. By end-April, about 25 percent of ABLV’s €480 million insured deposits were paid out. Of concern is the potential disregard for provisions of the Deposit Guarantee Law that prohibit payouts to depositors who have not been identified as required under the provisions of the Money Laundering Prevention Law.

5. Regulatory response. On April 26, parliament approved a bill limiting banks’ activities with customers deemed to be of high-risk. This bill aims to reduce the engagement between Latvian banks and shell companies, while also enhancing the information exchange between financial institutions and law enforcement agencies. However, it does not improve the oversight by all relevant authorities involved in company registration and formation, or bolster the ability of authorities to access ownership information, so as to enhance the transparency of legal persons established in Latvia.

6. Impact on the financial system. These events and the measures taken by FCMC have resulted in a significant drop in deposits. Since the FinCEN report, deposits in the BSFC sector have declined by more than a third. Spillovers to banks servicing domestic clients have so far been limited, with their deposits growing slightly since February. Gross value added of financial services declined by 27 percent y/y during the first quarter of 2018 but was fully offset by growth in other sectors. This limited impact could be in part due to the relatively little engagement of BSFCs with the domestic economy, with only 10–12 percent of their total deposits and loans targeting domestic clients. Furthermore, the BSFC sector has been consolidating since end-2015, after the withdrawal of U.S. correspondent banks from the Latvian market and strengthening of the AML/CFT regulations. Non-resident deposits declined by about 35 percent in 2015–17. Correspondent banking relations have not been affected negatively. In early 2018, Citadele bank restored correspondent banking relations in US dollar transactions.

7. Risks to the outlook. The failure of ABLV and the ongoing efforts to strengthen implementation of AML/CFT regulations may result in a fast consolidation of the BSFC sector. The extent and speed at which it will consolidate is yet unclear, but it could have a tangible impact on the economy. The market exit of ABLV alone could reduce growth by 0.5 percentage points. Under the extreme assumption that the BSFC would be fully consolidated, the loss of value added could reduce growth by about 1 percentage point. Second round effects are difficult to quantify, but given the limited role of the BSFC sector in the domestic economy, they are expected to be much smaller, unless they result in significant deterioration in confidence.

Annex III. Impediments to Credit

1. Despite Latvia’s ongoing economic recovery and record low interest rates, credit growth has remained anemic. Credit growth slowed sharply during the crisis and turned negative in 2009. In the years that followed, credit continued to contract even as the economy emerged from a recession and accommodative monetary policy lowered the cost of borrowing. With the economy now in its eighth year of expansion and borrowing costs at record lows, credit has recovered only slowly. The decline in lending to households has leveled off, while credit to non-financial corporations (NFCs) began to grow modestly in 2017 before turning negative again in 2018.1 Although the credit cycle has turned, the credit-to-GDP gap remains deeply negative.

Credit Growth

(Percent year on year)

Source: Bank of Latvia.

1/Corrected for one-off structural changes in the Latvian banking sector.

Interest Rates on New Loans

(Percent)

Sources: European Central Bank and Haver Analytics.

2. Creditless recoveries are not rare, representing about one-fifth of all recoveries.2 They are likely to occur when an unsustainable credit boom unwinds, resulting in a recession and a banking crisis, as was the case in Latvia. Creditless recoveries are typically weaker than recoveries with credit, with output growth about a third lower on average. Investment tends to have a smaller contribution to growth in creditless recoveries, although consumption is also affected. A recovery can be creditless because credit is not available (lack of supply) or because it is not needed (lack of demand). While it is difficult to pinpoint with certainty, the main drivers behind the lack of credit growth in Latvia, evidence suggests that both supply and demand factors are at play.

Contributions to Real GDP Growth

(Percent)

Sources: Latvian Central Statistical Bureal; and IMF staff calculations.

Supply-side Factors

3. Bank lending to households and NFCs has remained sluggish even though the banking sector is healthy, and private sector balance sheets have improved. Capital and liquidity ratios comfortably exceed required levels. The ratio of non-performing loans has declined considerably from its 2010 peak and is in line with the EU average. Loan-loss provisioning is high and profitability is strong. Stress tests performed by the Bank of Latvia indicate that credit institutions’ capacity to absorb a potential increase in credit risks due to shocks is good and continues to improve, thanks to the improving quality of their loan portfolio and their high level of capitalization. Both NFC and household debt-to-GDP ratios have declined steadily from their post-crisis peaks.

Banking Sector Indicators, Q4 2017
LatviaEU averageMinimum requirement
Tier 1 capital ratio19.016.28
Total capital ratio21.419.011
Liquidity ratio159.530
Liquidity coverage ratio313.3148.5
Leverage ratio9.85.3
Loan-to-deposit ratio71.3116.7
Excluding foreign deposits103.0
NPL ratio4.14.0
NPL coverage ratio93.244.5
Return on equity (percent)7.66.1
Return on assets (percent)0.90.4
Sources: Financial and Capital Market Commission; European Banking Authority.

Liquid assets/current liabilities with maturity up to 30 days.

Sources: Financial and Capital Market Commission; European Banking Authority.

Liquid assets/current liabilities with maturity up to 30 days.

Household Debt

(Percent)

Source: European Central Bank.

Non-Financial Corporation Debt

(Percent)

Source: European Central Bank.

4. Banks’ capital buffers have been increased several times since the crisis. A capital add-on was introduced in 2012 for banks with lending to foreign clients exceeding 5 percent of total assets, and all banks became subject to a capital conservation buffer starting in 2014. The FCMC in 2015 identified six “other systemically important institutions” (O-SIIs), with capital surcharges phased in over 2017–18.

Summary of Macroprudential Measures in Latvia
LTV capEffective June 12, 2007, maximum LTV of 90 percent. Effective September 18, 2014, LTV may reach 95 percent if loans are guaranteed by the State.
Countercyclical capital bufferSet to 0 on February 1, 2016. All credit institutions covered. Rate is reviewed quarterly by the FCMC and has not changed.
Capital conservation bufferEffective May 28, 2014, all credit institutions are required to maintain a capital conservation buffer of Common Equity Tier I capital equal to 2.5 percent of total risk exposure.
Pillar 1 add-onEffective April 30, 2012, banks must maintain additional capital if lending to foreign clients exceeds 5 percent of total assets. Capital add-on depends on the share and growth rate of foreign clients’ loans in bank’s assets.
Capital surcharges for systemically important institutionsOn December 30, 2015, the FCMC identified six institutions as “other systemically important institutions” (O-SIIs). The following capital buffer rates were set on November 7, 2016, with a phase-in period:
Effective June 30, 2017, the capital buffer was set to 1 percent for ABLV Bank, Swedbank, and SEB banka, and to 0.75 percent for Rietumu Banka, Citadele banka, and DNB banka.
Effective June 30, 2018, the capital buffer rises to: 2 percent from 1 percent for ABLV Bank, Swedbank, and SEB banka; to 1.75 percent from 0.75 percent for Rietumu Banka; and to 1.50 percent from 0.75 percent for Citadele banka and DNB banka.
Other measures to mitigate structural systemic riskEffective January 1, 2011, credit institutions were subject to a financial stability levy equal to 0.036 percent of their liabilities, after certain adjustments. The levy was increased to 0.072 percent effective January 1, 2012. The purpose of to levy is to finance measures that may be needed to promote financial stability.

5. Moreover, Swedish banks operating in Latvia have been affected by tighter capital requirements back home. Domestically active banks in Latvia are dominated by branches and subsidiaries of Nordic banks—primarily Swedish banks. The latter have likely reduced their credit supply in Latvia as a result of tighter capital requirements introduced in Sweden in the last five years and applied on a consolidated basis.

Sweden: Capital Requirements, 2013–17(In percent unless otherwise indicated)
20132014201520162017
Capital conservative buffer (CCoB)2.52.52.52.5
Countercyclical capital buffer (CCyB)1.52
Systemic risk buffer (SRB)3.03.03.0
Pillar II capital add-on2.02.02.0
Risk weight floor
Residential1525252525
Commercial100100100100
Source: IMF Country Report No. 17/350
Source: IMF Country Report No. 17/350

6. Lending standards, which were tightened during the crisis, have remained strict amid lingering credit risk concerns. Banks cite insufficient collateral, excessive leverage, insufficient profitability or cash flow, shortcomings in the legal framework; and the shadow economy as reasons for rejecting loan applications. In this context, household credit is directed mainly to high-income households: the highest quintile accounts for 61 percent of outstanding household loans. Businesses report that access to credit is improving, but remains difficult relative to other countries in region.

Cumulative Changes in Lending Standards to NFCs

(Positive values indicate a tightening)

Sources: European Commission and IMF staff calculations.

Ease of Access to Loans

(1=extremely difficult; 7=extremely easy)

Source: World Economic Forum Global Competitiveness Report.

7. Concerns about the insolvency system may also be restraining credit growth. According to a study by Deloitte and Touche, creditors lost between €580–750 million as a result of abuses in insolvency proceedings over the period 2008–14. In 2017, five insolvency administrators were placed under criminal arrest and/or suspended by the Latvian Insolvency Administration following allegations of extortion and money laundering. Several of these administrators were implicated in the liquidation proceedings of Trasta Komercbanka. The recovery rate of creditors’ claims on firms in liquidation is low by international standards, and insolvency proceedings can be excessively long and complicated. To address these concerns, the authorities have embarked on wide-ranging reforms to strengthen the insolvency regime.

Recovery Rate of Debt of Insolvent Firms, 2016

(Percent)

Source: OECD.

Box 1.Insolvency Administration Reforms

In 2017, the Latvian authorities issued Insolvency Policy Development Guidelines. The guidelines aim to encourage businesses to use reorganization or restructuring proceedings to restore solvency, maximize the value of recovered assets from insolvency proceedings, ensure that insolvency administrators are well-qualified, and improve the supervision and regulation of insolvency administration.

Progress has been made in enacting regulations and legislative amendments to strengthen insolvency administration. Abuses by insolvency administrators have been a matter of serious concern to the Latvian authorities for several years. In 2017, the Cabinet of Ministers enacted several regulations on training and examination of insolvency administrators, tightening the disciplinary process for insolvency administrators, and improving the record-keeping by insolvency administrators. Parliament also amended the Civil Procedure Law and the Insolvency Law to provide for an electronic insolvency monitoring system that will disseminate public information about insolvency proceedings.

A newly-empowered Insolvency Administration oversees the professionalism of insolvency administrators. In 2017, the Insolvency Administration took over the authority of certifying and terminating insolvency administrators. Nearly 900 cases were filed in court last year to remove insolvency administrators. The Administration terminated 51 administrators’ certificates for reasons including failing to take the professional examination, acting in bad faith, or repeatedly violating regulations.

Ongoing IMF technical assistance is helping to complete a mid-term evaluation of the implementation of the Insolvency Policy Development Guidelines, including the status of the insolvency administration reforms, a review of insolvency administration, and an assessment of the performance monitoring system for measuring the effectiveness of insolvency proceedings.

8. Many would-be borrowers cannot get credit because their official income is inadequate. The size of Latvia’s shadow economy is estimated at more than 20 percent of GDP, which is large compared to other advanced economies and larger than in Estonia and Lithuania. The phenomenon of underreported or “envelope” wages—i.e., formally registered workers receiving part of their income informally—is widespread. Similarly, underreported corporate profits represent a sizeable share of actual corporate profits. Boosting credit growth will therefore require reforms to encourage workers and firms to move from the shadow economy into the formal sector. Informal activity is strongly related to low trust in government and flourishes despite a relatively favorable business environment.

Estimated Size of the Shadow Economy, 2016

(Percent)

Source: OECD.

Trust in Government, 2015

(Percent of respondents who said they had confidence in their government)

Source: OECD.

Demand-side Factors

9. Surveys paint a mixed picture of loan demand. The euro area bank lending survey, conducted by Bank of Latvia in cooperation with the ECB, shows that demand for bank credit has increased since 2015. This has been the case for households, SMEs, and large enterprises, although some decrease in demand from large enterprises was observed in 2017 owing to the use of internal financing.

Source: Euro area bank lending survey.

10. Other surveys, however, indicate that demand for credit has been weak. Nearly three-quarters of SMEs surveyed by the Bank of Latvia in 2016 responded that they had no need for credit, either because they did not have any immediate investment plans or because they had the resources to finance their own investments.3 Over a third said risk aversion explained their reluctance to borrow from banks in the future. Business confidence has remained subdued throughout the economic recovery, which could help explain why many firms do not have plans to expand.

Business Confidence

(Index)

Source: Central Statistical Bureau of Latvia.

11. Another demand-side factor behind the lack of bank credit growth is the growing tendency of borrowers to turn to non-bank financing. The non-bank financial sector (NBFS) in Latvia is small by European standards: in 2016, the assets of the NBFS and other financial intermediaries represented 42 percent of GDP compared to a euro area average of 367 percent4 But the sector is growing, with non-bank lending to both households and NFCs largely outpacing bank lending in recent years. Consequently, the ratio of non-bank loans to bank loans has risen to 20 percent compared to 10 percent in 2013. The bulk of non-bank lending consists of financial leasing loans to NFCs. Non-bank lending to households is smaller, but growing rapidly. In 2017, only a quarter of new house purchases were financed by banks; the rest were financed by non-bank lenders or by the buyers’ own means.5

Non-bank Lending to Households and NFCs

(EUR billions)

Sources: Bank of Latvia; and IMF staff calculations.

Bank and Non-Bank Assets

(Percent of GDP)

Sources: Bank of Latvia; and IMF staff calculations.

1/ Excluding the central bank and holding companies.

Annex IV. Public Debt Sustainability Analysis

Public Sector Debt Sustainability Analysis(DSA)—Baseline Scenario

(In percent of GDP, unless otherwise indicated)

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 – = (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.

Annex V. External Debt Sustainability
Latvia: External Debt Sustainability Framework, 2013–23(In percent of GDP, unless otherwise indicated)
ActualProjections
20132014201520162017201820192020202120222023Debt-stabilizing non-interest current account 6/
Baseline: External debt133.9144.1143.6148.8140.9137.0135.2132.2126.3126.9126.9-6.1
Change in external debt-4.310.2-0.55.2-7.9-3.9-1.7-3.1-5.90.60.0
Identified external debt-creating flows (4+8+9)-5.8-4.41.7-4.7-12.8-2.5-2.0-2.2-1.3-1.1-1.3
Current account deficit, excluding interest payments-0.6-1.5-2.2-3.7-1.30.81.10.91.31.81.9
Deficit in balance of goods and services3.71.40.5-0.91.33.13.53.84.24.44.7
Exports60.260.760.460.060.561.660.860.059.558.657.7
Imports63.962.260.959.161.864.764.363.863.663.162.4
Net non-debt creating capital inflows (negative)-1.8-1.4-3.00.1-2.1-0.8-0.7-1.2-0.8-0.7-0.8
Automatic debt dynamics 1/-3.4-1.57.0-1.0-9.4-2.5-2.4-1.9-1.8-2.2-2.4
Contribution from nominal interest rate3.33.22.72.42.11.91.92.01.91.41.2
Contribution from real GDP growth-3.1-2.4-5.0-3.1-6.2-4.4-4.2-3.9-3.7-3.6-3.6
Contribution from price and exchange rate changes 2/-3.6-2.39.2-0.3-5.3
Residual, incl. change in gross foreign assets (2–3) 3/1.414.7-2.39.84.9-1.40.2-0.8-4.61.81.3
External debt-to-exports ratio (in percent)222.5237.2237.7247.8232.9222.5222.3220.2212.4216.4219.8
Grass external financing need (in billions of US dollars) 4/22.322.322.620.022.326.029.332.234.735.237.3
in percent of GDP73.671.183.772.573.510-Year10-Year72.776.678.679.876.376.5
Scenario with key variables at their historical averages 5/137.0141.1144.1142.1147.4152.22.8
Key Macroeconomic Assumptions Underlying BaselineHistorical AverageStandard Deviation
Real GDP growth (in percent)2.41.93.02.24.50.36.13.73.33.13.03.03.0
GDP deflator in US dollars (change in percent)5.01.8-16.50.05.10.311.213.63.83.63.12.92.6
Nominal external interest rate (in percent)2.62.51.61.71.53.52.41.61.51.51.51.11.0
Growth of exports (US dollar terms, in percent)5.64.7-14.51.610.75.214.620.06.05.45.24.64.1
Growth of imports (US dollar terms, in percent)4.21.0-15.8-0.714.92.519.323.36.76.15.85.14.6
Current account balance, excluding interest payments0.61.52.23.71.33.55.4-0.8-1.1-0.9-1.3-1.8-1.9
Net non-debt creating capital inflows1.81.43.0-0.12.12.11.50.80.71.20.80.70.8

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.

Latvia: External Debt Sustainability—Bound Test1,2

(External debt n 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.

Annex VI. Assessing the Impact of the Tax Reform

1. A comprehensive tax reform came into effect in 2018. It encompasses changes to the tax structure and rates, and measures to improve the tax administration, reduce the shadow economy, and address inequality. These changes include: i) moving from a flat to a progressive PIT schedule, gradually increasing—and making more progressive—the non-taxable income threshold, increasing child allowances, and increasing social security contribution (SSC) rates by 1 percent;1 and ii) changing the CIT system from gross to distributed profit taxation, and increasing the tax rate from 15 to 20 percent. To partially compensate for the revenue loss of the reform, a gradual increase of excise rates will take effect during the next three years, and VAT administrative measures will seek to reduce informality and improve revenue collection. The revenue impact of administrative measures is highly uncertain; therefore, staff’s analysis only focuses on the impact of the PIT and CIT reforms.

2. The PIT reform seeks to reduce labor costs and income inequality. The new PIT system reduces the PIT rate for low incomes (up to €20,004 per year) from 23 to 20 percent, taxes middle incomes (up to €55,000 per year) at 23 percent, and higher incomes at 31.5 percent. The estimated post-reform tax wedge declines to below 40 percent—closer to the level in Estonia and Lithuania—which could help improve Latvia’s competitiveness in the region. The largest impact is expected for low-wage earners, especially those with families. However, workers who already have very low wages and do not pay income taxes will be worse off due to the SSC rate increase, which undermines the income progressivity objective of the reform.

Tax Wedges, 2017

(single person at 67% of avg. earnings)

EUROSTAT, OECD (2018), Tax wedge (indicator) (Accessed on 03 May 2018)

MoF and staff estimates

3. The CIT reform aims to stimulate investment growth. Distributed profit taxation could improve companies’ balance sheets, particularly of small ones that do not benefit much from tax exemptions, and provide relief of their effective tax burden. However, the extent to which this translates into productive investment depends on businesses’ behavior, which is difficult to estimate ex-ante. The reform also aims to improve balance sheet transparency, thereby improving companies’ access to bank financing. Experience with this system in Estonia, where it has been in place for over a decade, shows improvement in firms’ capital and liquidity. However, its impact on investment and productivity—albeit positive—remains difficult to quantify as many other factors influence firms’ behavior, including economic conditions, the business environment, access to finance, the structure of the corporate sector, and the strength of corporate management2

4. The reform is likely to have a positive impact on growth. As standard multipliers suggest only a minor direct impact, we simulate the dynamics of the PIT and CIT reforms using the IMF’s Globally Integrated Monetary and Fiscal Model (GIMF).3 This allows a more comprehensive estimate of their medium and long-term growth impact. A Latvia-specific reform scenario is calibrated using the authorities’ estimates of the improvement in the effective tax rates post reform, while the CIT reform is calibrated to simulate similar behavioral dynamics as observed in Estonia. Under a scenario, where corporates’ tax relief gradually translates into productive investment, the combined PIT and CIT reforms could result in higher real GDP over the medium term by almost 1.5 percent. Financing of the reform is also a key factor in estimating its impact. Deficit financing of the reform, will have a large positive upfront impact on growth, which will dissipate quickly. Over the long term, a budget-neutral option delivers the largest benefits, especially one that focuses on revenue rebalancing.

Estimated Medium Term Impact of the Tax Reform

Source: Staff estimates.

5. The tax reform will be costly. With the new introduction of a progressive system, PIT could be permanently lower by up to 1 percent of GDP on average.4 CIT revenues will have an even larger impact—by about half for the first two years of implementation (similar to the pattern observed in Estonia) and gradually converge to below pre-reform levels. While the positive effect on net income of individuals and corporates will likely support consumption and investment, absent any further reforms to find stable revenue sources, the government tax revenue ratio will be permanently lower.

Latvia was allocated €5.63 billion of European Structural and Investment Funds for the period 2014–20, including €1.16 billion for infrastructure, €782 million for environment protection, and €764 million in support of SMEs.

A reduction of Latvenergo’s capital (a public enterprise) was used in lieu of a one-off compensation for the State’s liabilities related to the subsidization of green energy generation.

IMF Country Report 16/151. Each percentage point increase in the minimum wage results in about 0.12–0.17 percentage point increase in firms’ wages.

IMF, 2018, “Regional Economic Outlook Europe”. European Wage Dynamics and Labor Market Integration. The study finds that in Latvia productivity gains are translated into similar real wage increases in the long run.

IMF, 2016, “Emigration and Its Economic Impact on Eastern Europe,” IMF Staff Discussion Note 16/07.

See “Labor Market Challenges,” Republic of Latvia: Selected Issues, International Monetary Fund, 2018.

Estimates for single workers earning 67 percent of the average wage.

See IMF Country Report No. 17/194 and “Demographic Headwinds to Convergence,” Republic of Latvia: Selected Issues, International Monetary Fund, 2018.

See IMF, 2016, “Regional Economic Issues: Central, Eastern and Southeastern Europe,” and IMF Country Report No. 16/172.

See OECD ,2015, “Policy areas for increasing productivity in Latvia,” OECD Economics Department Working Papers, No 1255.

See IMF, 2017, Fiscal Monitor, April.

See “Efficient Government Spending,” Republic of Latvia: Selected Issues, International Monetary Fund, 2018.

See IMF Country Report No. 17/195.

IMF, 2017, Fiscal Monitor, “Tackling Inequality.”

See IMF, 2018, Euro Area—Financial System Stability Assessment.

Pursuant to Article 27 of the Credit Institutions Law, a credit institution’s license may be cancelled if it fails to comply with laws governing the activities of the credit institution, which includes the AML/CFT Law.

NFC credit growth turned negative in 2017 due to structural changes in the banking sector, notably the transfer of Nordea Bank’s loan portfolio to its parent bank in Sweden prior to its merger with DNB. Excluding these one-off effects, however, NFC credit growth remained positive throughout 2017.

See Abiad, A., G. Dell’Ariccia, and B. Li, “Creditless Recoveries,” IMF Working Paper 11/58. A creditless recovery is defined as an episode where real credit growth is negative in the first three years following a recession.

SMEs represent more than 99 percent of all enterprises in Latvia, and their turnover accounts for more than three-quarters of total NFC turnover.

Bank of Latvia, Financial Stability Report 2017.

European Commission, Country Report Latvia 2018.

To be used to increase financing for the healthcare reform.

See “Gross profit taxation versus distributed profit taxation and firm performance: effects of Estonia’s corporate income tax reform,” Eesti Pank Working Paper No 2/2011.

Multipliers range between 0.4–0.6, based on multipliers found in the literature for advanced economies, using the methodology explained in “Fiscal Multipliers: Size, Determinants, and Use in Macroeconomic Projections,” IMF, 2014.

The shortfall compares staff’s current baseline assumptions against PIT revenues pre-reform taking the most recent observable year as a reference point, adjusted for macroeconomic and wage dynamics.

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