August 27, 2009
My authorities express gratitude to staff and management for the timely assistance to Latvia during the current economic problems. The authorities also thank staff for the constructive policy dialogue since the approval of the Stand-by-Arrangement (SBA). The discussion with staff was fruitful and helped to improve policy decisions taken by the authorities.
Latvia has been hit by adverse economic developments much harder than initially expected. Both the sharply worsening financing conditions and the collapse of global trade have played an important role in a stronger than expected downslide of economic activity. The fall in GDP by 18 percent year-on-year in the first quarter of 2009 and a further decrease to -19.6 percent in the second quarter were broadly based, with both domestic absorption and exports contracting significantly.
The bursting of the credit and real estate bubbles and the respective economic contraction were considerably amplified by strong repercussions from global financial distress. Two main factors have played an important role in sharper than expected adjustment. First, much worse financing conditions and increased uncertainty had a significant downward impact on credit flow, washing away any signs of stabilization experienced throughout 2008. Second, significantly decreasing export as a result of the global trade collapse was pushing the economy even deeper into recession.
While strong contraction and growing unemployment are taking a toll on the economy, adjustment of past imbalances is under way. The current account deficit was well in double digits as a fraction of GDP a year ago but has been in surplus this year. Trade in goods and services has become positive, reflecting both a sharp adjustment of domestic demand and a shift away from imports as the bursting real estate bubble and tighter financing conditions have decreased the previously excessive demand for mostly imported durable goods.
Price and wage correction has begun, narrowing the gap between wages and productivity opened during boom years. Headline inflation fell to 2.5 percent in July 2009 and inflation expectations have stabilized at close to zero. Excluding VAT and excise tax increases, monthly inflation has been close to zero or even negative for eight months already. Responding to the considerable easing of the labor market and the building up of unemployment, the decline in seasonally adjusted nominal wages started in late 2008 already, reaching a decline of 2 percent quarter-on-quarter in the first quarter of 2009. Leading indicators suggest an ongoing wage correction in the second quarter. Falling costs have already shown up in relative price measures with the real effective exchange rate being on a depreciation path since spring 2009.
Nevertheless, the economic situation remains difficult. Further output losses are likely before mid-2010 when economic activity is expected to bottom out. Despite some green shoots observed during the recent months—e.g., a positive manufacturing output (3 percent seasonally adjusted quarter-on-quarter increase in the second quarter of 2009, for the first time since early 2008), and improved confidence and employment expectations—the agreed macroeconomic scenario based on the GDP decline of 18 percent in 2009 and of 4 percent in 2010 remains valid with a broadly balanced profile of risks. However, the economy has responded rapidly to the changed conditions through much faster reduction of past imbalances and, given the progress attained so far and the expected continuation of the internal adjustment, my authorities believe that a faster than expected recovery in 2011 and beyond is likely, should assumptions about global developments remain valid.
Fiscal policy and structural reforms
Much stronger than expected GDP contraction has significantly widened the fiscal gap requiring additional measures to be undertaken to ensure fiscal sustainability. In response to the new economic realities, the Latvian Parliament adopted the second 2009 Supplementary Budget Law, which entails fiscal consolidation amounting to LVL 500 million (around EUR 700 million or 4 percnet of GDP). In particular, this includes LVL 710 million expenditure reducing measures, and LVL 290 million expenditure increasing measures to account for a higher automatic expenditure due to a weaker economy, rising debt burden and increasing appropriations for the EU funded projects. In addition, revenue increasing measures amount to LVL 80 million.
The supplementary budget is based on the agreed macroeconomic scenario and revised revenue forecasts. Recent trends indicate that the budget deficit target of 10 percent of GDP on an accrual basis in 2009 is realistic. During seven months in 2009, the general government budget recorded a deficit (on cash basis) of only 3.3 percent of annual GDP, and budget execution is regularly monitored in order to avoid the risk of exceeding the committed fiscal targets.
Though part of the expenditure cuts are across-the-board, as correctly noted by staff, they provide a binding framework for line ministries to implement reforms and improve spending efficiency. Between 2004 and 2008, public expenditure had increased more than two times, building significant inefficiencies in the expenditure base. Consequently, there is room for optimizing expenditure. The authorities agree that there are implementation risks; however, most line ministries have already agreed and specified expenditure cuts for 2009 and the issue is open only in the health care sector.
While respecting staff estimates, we clearly see that notable buffers have been built into the 2010 budget baseline and consequently the program scenario, especially on the expenditure side, that my authorities feel were not sufficiently discussed. According to our calculations, which are supported by the European Commission estimates, the agreed consolidation measures amounting to 4 percent of GDP on top of the carry-over effects from 2009, should be sufficient to reach our deficit target of 8.5 percent of GDP on an accrual basis in 2010.
Consolidation measures for 2010 are aimed at both increasing revenue and decreasing budget expenditure. On the revenue side, a comprehensive plan to broaden the base of the personal income tax and of the real estate tax and to increase the real estate tax rate is under preparation. On the expenditure side, the authorities will carry out a broad public service reform and, based on a series of functional audits, undertake a number of structural reforms in many areas already identified, including agriculture, defense, foreign affairs, transport, culture, social security and others.
Should the above mentioned measures prove insufficient to ensure a lower fiscal deficit in 2010 compared to this year, additional measures amounting to 2.5 percent of GDP have been identified as feasible. They include an increase in headline VAT rate from 21 to 23 percent, the introduction of a more progressive personal income tax system where the average effective tax rate would be raised to around 25 percent for earnings in excess of LVL 500 per month, and additional expenditure cuts during the budgeting process, including fundamental revisions of line ministries’ budget bases. However, as already stated above, the agreed consolidation measures amounting to 4 percent of GDP are likely to be sufficient to further reduce the budget deficit beyond 2009, even if additional spending on social safety nets were included. While my authorities are fully committed to taking the additionally identified measures, they are likely to be necessary should the authorities fail to deliver the above mentioned structurally grounded expenditure cuts.
In these challenging times, the authorities are taking due care of the most vulnerable part of society by instituting emergency social safety net measures. These measures include, but are not limited to, compensating costs for medication and patient co-payments in hospitals, increasing the guaranteed minimum income and housing support, ensuring transportation for pupils in the areas where schools are being closed down, creating emergency social employment in municipalities. Emergency social safety net measures are being elaborated in cooperation with World Bank experts in order to mitigate the adverse effects of economic contraction and structural reforms on the least protected part of the population.
A remarkable difference of the 2010 budgeting process is the substantial involvement of social partners and the society in the budget preparation already at an early stage, increasing credibility of the much needed consolidation measures. The considerably broadened involvement of all stakeholders shall significantly increase the reform ownership, thus pushing up the probability of a successful budget reform for the coming year.
All political parties that form the government are fully aware of the recent and future challenges and this is well confirmed by the fact that the July 2009 Letter of Intent was signed not only by the Prime Minister, Minister of Finance, Chairwoman of the Financial and Capital Market Commission and Governor of the Bank of Latvia, but also by all coalition parties forming the government. The schedule for preparing the 2010 budget has been adopted by the government and authorities clearly understand the importance of passing the 2010 Budget Law by the agreed deadlines.
The government and the responsible public administration institutions are strongly committed to carrying out all necessary steps to fulfill Maastricht criteria, which would ensure introduction of the euro as soon as possible. According to the present forecasts, 2014 seems a viable euro introduction target date and the authorities are committed to doing whatever it takes to reach this target.
Monetary and financial sector policies
Monetary policy responded to the sharply falling economic activity and strains aggravating in the financial system in late 2008. The decision to lower reserve requirements in late 2008 was taken in the middle of November, amidst mounting financial stability concerns following the Parex takeover. Inter alia, it helped to address the squeezing liquidity conditions of the banking sector, thereby providing a much needed alleviation for the financial system at a very turbulent time. As significant buffers had been accumulated during boom years, it allowed providing support to the banking sector without compromising the sustainability of the fixed exchange rate.
The resulting liquidity surplus by itself was not undermining the stability of the exchange rate. This was evident from the relatively calm situation in the currency market at the very beginning of the year. Similarly, in the absence of FX pressures, surplus liquidity conditions have coincided with a stable exchange rate in the middle of the allowed fluctuations corridor during the past two months.
In the authorities’ view, the heightened risk aversion rather than the downward pressure of liquidity surplus on domestic interest rates exaggerated the demand for foreign currency and provoked outflows during the spring and early summer of 2009, showing up in sizable central bank interventions. As partly discussed in the staff report, the uncertainty was caused by a series of shocks: political uncertainty after the previous government stepped down, uncertainty surrounding municipal elections, misleading and exaggerated press reports on top of bold statements and speculations regarding the stability of the lats, amplified by the delayed program review and ongoing consultations regarding future policies in response to a much stronger than expected economic contraction.
The reduction in official interest rates, according to the authorities’ view, should be considered together with the spread between the official lats and euro rates, given the exchange rate peg of the lats to the euro. On the backdrop of significant ECB rate cuts since October 2008, even after the Bank of Latvia lowered the refinancing rate from 6 to 4 percent, the spread between the corresponding lats and euro refinancing rates is nearly twice as high as in September 2008, mitigating concerns of falling interest rates from the exchange rate stability point of view.
Authorities share staff’s view that significant program financing inflows on the backdrop of heightened fiscal deficit warrant adjustments of the liquidity management strategy to avoid excess money market volatility, at the same time fully respecting the limitations imposed by a quasi-currency board arrangement. While authorities see this could be well attained within the current operational framework, they would be willing to share the experiences and discuss the issue with IMF staff. Only then the final decision on fine-tuning the current liquidity management strategy could be taken by the Bank of Latvia.
Many other steps have been taken to safeguard the financial system. Intervention capacity has been strengthened by developing a new Law on Bank Takeover, amendments to the Credit Institution Law, the Deposit Guarantee Law and the Law on the Financial and Capital Market Commission. The Financial and Capital Market Commission (FCMC) has improved supervision and monitoring of the sector by enacting new regulations on assessing asset quality and on provisioning, and by issuing supervisory guidance on banks’ internal capital adequacy assessment processes thus shoring up capital buffers; liquidity regulations are also being revised in line with the recent developments in the best international practice. Moreover, the FCMC has stepped up its monitoring of individual banks and enacted new reporting requirements. In the meantime, the IMF has been requested to provide technical assistance to improve the operational aspects of the Deposit Guarantee Fund.
At present, the banking sector is adequately capitalized having a system-wide capital adequacy ratio above 12 percent, and overall banks have sufficient liquidity. With the continuing economic downturn and deteriorating quality of banks’ loan portfolios, capital buffers should be maintained significantly above the regulatory minimum. Several banks have already responded to these developments with new capital injections from their shareholders.
Progress has been made in resolving the problems of Parex, the second-largest Latvian bank. An agreement to reschedule the bank’s syndicated loans was reached in March. In April, the government and the EBRD agreed on the EBRD’s investment of 25 percent of Parex equity and a subordinated loan. In May, the state recapitalized Parex. The FCMC will keep monitoring Parex liquidity, ensuring that its management’s restructuring plans do not entail undue risks. The partial deposit freeze will be removed once conditions stabilize.
The FCMC remains committed to closely monitoring banks, also by using the stress-testing framework more widely. Forward-looking assessments to ensure that banks maintain adequate liquidity and solvency buffers will be completed supplementing top-down stress tests with bottom-up stress tests run by banks on the basis of uniform macroeconomic scenarios and linkage of these scenarios to loan performance. Results will be used to assess potential needs for additional own funds to build up banks’ solvency.
Contingency planning and crisis management capacity are being refined. Building on the progress in the financial sector to date with the finalization of a comprehensive strategy for bank recapitalization and resolution of authorities will ensure a stronger financial sector while having in place strong contingencies in the event of shocks.
On the basis of the information provided herein and in the Staff Report and authorities’ strong commitment to pursue the measures identified in the Letter of Intent, the authorities request the Board’s approval for the completion of the First Review and Financing Assurances Review under the SBA. As the depth of economic contraction has sharply reduced government revenues, it has been impossible to fulfill fiscal targets without exacerbating already painful dislocations. On the basis of the 2009 corrective measures and the authorities’ plans for the future detailed herein and in the Letter of Intent, we request waivers for the non-observance of the end-March 2009 performance criterion on the fiscal deficit, and the continuous performance criterion on non-accumulation of domestic arrears by the general government. Also, in light of the change of the government in March, additional time was needed to prepare the supplementary budget. We are therefore also requesting a waiver for the end-March 2009 structural performance criterion on its submission to parliament.