Journal Issue
Share
Article

Republic of Latvia

Author(s):
International Monetary Fund
Published Date:
June 2011
Share
  • ShareShare
Show Summary Details

I. Recent Developments

1. Latvia’s economy continues to recover. After a sharp contraction in 2008-09, real GDP started to increase at the end of 2009. However, because of base effects, year-average growth for 2010 remained slightly negative at -0.3 percent (Figure 1). Recovery was led by restocking and strong export growth, which benefited from competitiveness gains and improving macroeconomic conditions in Latvia’s main trading partners. Domestic demand lagged behind but only because of base effects: during the year retail sales increased 9 percent and new car registrations more than 40 percent. Industrial production grew 15 percent in 2010, before slowing at the end of the year.

Figure 1.Latvia: Real Sector, 2006-11

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

2. After falling in the first year of the program, prices started to rise in 2010 due to world supply shocks (Figure 2). Like other Baltic countries (which have high shares of food and energy in the CPI basket), headline inflation jumped to 4.1 percent in March, with food and energy prices growing 9 and 15 percent. However, core inflation has remained flat due to weak domestic demand and high unemployment. VAT and excise tax increases, introduced at the beginning of 2011, have also raised prices. Wages have started to pick up, but only moderately, and remain 9 percent below their pre-crisis peak.

Figure 2.Latvia: Inflation and the Labor Market, 2006-11

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

1/Weight of each component in 2011 HICP as percentage is indicated on the graph.

3. Though the current account remains in surplus, much of the sharp improvement in 2009 has proved transitory as the investment income account has worsened with the recovery in bank profits (Figure 3).1 The current account slipped briefly into deficit at the end of 2010 for the first time since the crisis, with imports and exports both rising rapidly. Exports grew by around 19 percent after falling 16 percent in 2009, led by wood and steel exports which grew 140 and 48 percent respectively.

Figure 3.Latvia: Balance of Payments, 2006-11

Sources: Bank of Latvia; and IMF staff calculations.

1/ Other is the sum of other investment and portfolio investment and derivatives.

4. Domestic and external market conditions have improved significantly (Figures 5 and 7). Five-year CDS spreads have declined to around 200 basis points (from more than 1100 in early 2009), well below most other Central European countries which have had programs and crisis countries in the euro area, and in line with those of neighboring Lithuania which managed to maintain access to international capital markets. In March, Fitch raised Latvia’s credit rating to investment grade (in line with Moody’s). Treasury rates remain close to all-time lows due to low domestic issuance and increased confidence in the fiscal outlook (Figure 4), and 10-year lats bonds were issued in February. Domestic interbank rates have recently fallen below those in the euro area due to continued excess liquidity and higher interest rates in the euro area. The exchange rate appreciated in January as the Treasury started selling program foreign exchange directly to the market. Once the sales stopped, the exchange rate fell back to the weaker end of the band. Reserves have declined gradually (13 percent since end-October 2010), consistent with the use of program funds for budget support. The financial and corporate sectors have repaid foreign liabilities, although reserves remain at relatively comfortable levels (6 months import coverage in 2011).

Figure 4.Latvia: Fiscal Sector, 2007-16

Sources: Ministry of Finance; and IMF staff calculations.

Figure 5.Latvia: International Reserves and FX Market Developments, 2009-11

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

Figure 6.Latvia: Banking Sector Developments, 2007-11

Sources: FCMC; Bank of Latvia; Latvian Central Statistical Bureau; and IMF staff calculations.

Figure 7.Latvia: Interest Rates and Euroization, 2007-11

Source: Bank of Latvia.

5. The financial sector returned to profitability in early-2011. Improving credit conditions have allowed banks to start releasing provisions built up in 2009 and 2010, and non-performing loans have stabilized (but at high levels) (Figure 6). Tax increases and high food and fuel prices have reduced incomes, leading to an increase in overdue loans in recent months, but most banks have excess capital to deal with any resulting credit losses. Banks have resumed lending, but credit growth remains negative due to amortizations and loan write-offs. Future profitability will depend on banks’ ability to convert deposits into new lending rather than low-yielding deposits at the BoL (which exceed €1 billion or 5 percent of GDP). Despite low interest rates, resident and non-resident deposits increased more than 16 percent in 2010 reflecting increased confidence in the financial system, and are now above pre-crisis levels.

6. October’s elections returned Prime Minister Dombrovskis to office. A coalition government of the Prime Minister’s Unity bloc and the various parties within the Greens and Farmers grouping holds 55 of the 100 seats in Parliament. Despite having a parliamentary majority and fewer coalition partners, garnering political support for further fiscal adjustment (even though much smaller than in previous years) has become increasingly challenging.

II. Policy Discussions

7. With the economy now recovering, discussions focused on fiscal policies that would help Latvia move toward euro adoption, and implementing long-delayed state bank reforms:

  • Fiscal discussions focused on securing a strong 2011 budget so that in 2012 the Maastricht criterion can be met convincingly and the program’s exit strategy of euro adoption in 2014 might be realized.
  • Financial sector talks centered on restarting long stalled efforts to restructure MLB (including to stem losses in the bank) and implementation of the Parex/Citadele restructuring and sales plans.

A. Macroeconomic Framework

8. The macroeconomic framework agreed with the authorities assumes modest and steady recovery. Real GDP is expected to grow 3.3 percent in 2011, and 4 percent from 2012 onwards. Higher food and energy prices and the authorities’ reliance on higher taxes (instead of expenditure cuts) for this year’s fiscal consolidation will hold back private consumption. However, improving confidence and the need for investment (especially in the export sector which is recovering strongly but is becoming capacity-constrained) should support domestic demand. Unemployment is projected to average around 17 percent in 2011 and has fallen somewhat more quickly than staff previously anticipated, but due primarily to emigration and declining labor force participation rather than new jobs. Unemployment will likely take time to return to pre-crisis levels, since re-orienting construction workers to the traded-sector and re-hiring the long-term unemployed or those close to retirement age will be difficult (Box 1).

Box 1:Box 1: Labor Market Trends in Latvia, 2005—10

Despite a decline in the official unemployment rate from 20 to 18 percent between Q1 and Q4 2010, the labor market remains a cause for concern. Job creation has been sluggish: At the current rate it will take around 9 years for employment to return to pre-crisis levels, and around 6 years to return to pre-boom 2005 levels. As a result, long-term unemployment, and the number of discouraged workers, is increasing rapidly. At the same time, the opening up of the German labor market in May to the new EU member states is likely to further increase migration.

Average numbers of workers - full-time equivalent

(thousands, seasonally adjusted)

Emigration

(thousands)

Source: Latvian Central Statistical Bureau and IMF staff estimates.

9. Higher food and energy prices and tax increases are expected to raise inflation this year, but temporarily. Inflation is expected to average 3.2 percent in 2011, as Latvia’s HICP has a higher weight of food and fuel prices than other EU countries. However, these same factors could push Latvia’s inflation rate back down in 2012, provided world food and energy prices do not increase again. With the continuing negative output gap holding down domestic inflation, the Maastricht inflation criterion should be attainable, although the margin is small. Staff noted that while the fixed exchange rate should help anchor medium-term inflation, it makes short-term inflation (and thus meeting the Maastricht reference value) hard to control. The BoL acknowledged the importance of controlling inflation: under the fixed exchange rate this needs to be a joint responsibility with the Ministry of Finance (MoF), for example in avoiding increases in excises and indirect taxes, and in ensuring continued fiscal consolidation. The MoF is considering options for limiting price inflation, including wage restraint. However, Latvia’s success with such arrangements has been limited; promotion of more competitive product markets (strengthening the Competition Authority, opening up public procurement contracts, improving state enterprise cost reduction, and price regulation) might prove more effective, though harder to implement.

Inflation rate

1/ Reference rate is calculated as the average inflation rate of the three EU countries with the lowest projected inflation, plus 1.5 percentage points.

Sources: Eurostat and IMF staff estimates

10. Recovering domestic demand and normalization of the banking sector will lead to a moderate deterioration in the current account over the medium term. Imports are expected to continue rising due to the large import content of exports. However, in the short-term, higher commodity prices will worsen the terms of trade and the trade balance. With wood exports in particular running into capacity constraints, export growth may fall. The income account is projected to turn more negative as banks return to health and reinvested earnings and repatriation of profits to foreign parent banks resume.

11. Continued competitiveness improvements will be essential for the medium-term success of Latvia’s euro adoption strategy. While internal devaluation and higher productivity have produced significant competitiveness gains (the CPI-based real effective exchange rate has depreciated by around 10 percent, ULC-based by 15 percent), improvements have leveled off recently. As discussed in the 2010 Article IV consultation, quantitative assessment of the real exchange rate is complicated by the rapid pace of structural change but, most likely, a moderate competitiveness gap remains. With its nominal exchange rate fixed to most of its main trading partners, Latvia needs to control labor costs and implement structural reforms (Box 2).

Box 2.Structural Reforms to Improve Competitiveness

Structural reforms and wage restraint will be essential to ensure medium-term competitiveness under the fixed exchange rate regime. Although internal devaluation and productivity improvements have led to significant competitiveness gains, these slowed significantly in 2010 as unit labor costs and nominal wages stabilized. As a result, the moderate competitiveness gap that staff estimated in the 2010 Article IV consultation most likely remains.

The authorities pointed to a substantial improvement in exports as evidence of improving competitiveness. After falling 16 percent in 2009, exports have rebounded strongly, growing by around 19 percent in 2010. Latvia’s market share in countries such as Finland, Poland, and Russia has been increasing steadily. Rising hourly productivity in key sectors suggests much of the competitiveness improvement has come from higher productivity rather than deflation. In the boom, unit labor costs rose exceptionally fast by regional standards, but they have since fallen faster than costs in both Lithuania and Estonia. Productivity measured as output per person fell sharply in the run-up to the crisis, but is up 9 percent from its early 2009 trough (compared to 8 percent in Estonia, 5 percent in Lithuania, and 3½ percent in the euro area).

The authorities are considering steps that could limit price and wage growth, and boost productivity. Fiscal consolidation in the 2012 budget will focus primarily on spending cuts and tax increases that do not affect inflation, coupled with continued public wage restraint. Building on efforts early in the program, the authorities will also encourage the private sector to keep wage increases in line with productivity.

Under the EC and Fund-supported program, the authorities are implementing structural reforms to boost productivity and competitiveness. These include preparing a strategy to improve management and efficiency of SOEs (end-October structural benchmark). The authorities are working with the EC on amendments to sector-specific legislation to improve competition in service sectors such as tourism, construction, retail, and private education (see EC SMoU).

Consistent with the Europe 2020 growth strategy, the authorities recognize the need to strengthen the quality of education and to promote R&D. The authorities intend to develop plans for education system reform (in particular vocational training), and are considering ways to boost private investment to raise the capital-labor ratio, and to facilitate technology transfer from more advanced EU economies.

Latvia: Productivity, Wages, and Export Market Shares, 2004-10

Sources: Bank of Latvia; ECB; and Haver.

12. Though the projected recovery is modest, unlike in the pre-crisis years it should be largely self-sustaining. Upside risks include higher partner country growth (which has proven stronger than anticipated) and improved investor confidence and foreign direct investment if, as seems likely, Latvia were to win investment grade ratings from all three major ratings agencies. Against this, financial stability risks or fiscal consolidation in the euro area could weaken Latvia’s exports, and high unemployment, a private debt overhang, and negative or weak credit growth could weigh on domestic demand. High inflation could lead to increasing wage demands, reducing recent competitiveness gains and putting the Maastricht criteria at risk. For the medium-term, challenges include the need to sustain structural reform to boost medium-term growth, and securing euro adoption (which would likely yield significant payoffs to growth and employment).

B. Fiscal Policy

13. For 2010, strong spending discipline enabled Latvia to comfortably meet its fiscal targets. Wage restraint coupled with controls on subsidies and transfers, and tight investment financing rules more than offset the need for additional spending in areas such as health, where structural reforms yield savings only slowly. Tax revenues improved mildly across the board with the better macroeconomic environment. The ESA deficit is estimated at 7.7 percent of GDP, well below the 8.5 percent program target. Excluding bank restructuring costs (which have been largely front-loaded and should be much smaller from now on), the deficit is considerably lower, only 5.5 percent of GDP—within striking distance of the Maastricht 3 percent reference value.

14. The authorities estimate that last December’s and this April’s supplementary budget combined include about L370 million in adjustment measures (full-year effect) (LOI ¶13). Both the original and supplementary budgets rely mainly on tax increases, abolition of tax exemptions, and introduction of new fees. Expenditure measures are few and some may not be sustainable, and there is greater emphasis on fighting the grey economy (though the revenue gains are difficult to quantify). The supplementary budget keeps the MoF’s discretionary power to increase spending without parliamentary approval, but reduces it from 0.4 to 0.2 percent of GDP (LOI ¶17).

15. In staff’s view, while this year’s fiscal effort is significant, some of the budget measures appear likely to be either temporary, difficult to sustain, or have adverse economic side-effects:

  • Temporary measures (L60 million, 0.4 percent of GDP). The authorities’ decision not to gradually restore second pillar pension contributions to pre-crisis levels, but to leave them at 2 percent, will provide a temporary revenue flow, but these do not really represent fiscal adjustment. Long-term sustainability is not improved, as the higher first pillar contributions will increase the build-up of notional defined-contribution accounts, but without any corresponding savings to pay for them. Also, while staff strongly supports the authorities’ efforts to fight the grey economy, the expected yields are either temporary (tax amnesty) or highly uncertain.
  • Measures that may be difficult to sustain (L62 million, 0.5 percent of GDP). Planned health cuts may be optimistic, given end-year spending increases in previous years, hospital arrears, the slow pace of structural reform, and need for increased out-patient spending to compensate for reduced hospital beds. Higher energy prices, as well as increases in VAT, excises, and the minimum wage will increase spending pressures, while the potential unwinding of emergency safety net measures will increase demands for other social assistance such as guaranteed minimum income (which is 50 percent paid by municipalities). Though included in the 2011 budget with L11 million in savings, a reform of family state benefits still has not been agreed upon, and some of the proposals risk hurting the poor. Some of the 2011 spending cuts have been made possible by prepayments and increased spending at the end of 2010, and so do not constitute a permanent adjustment. Raising the SOE dividend payout ratio to 90 percent also does not seem sustainable.
  • Problematic policies (L18 million, 0.1 percent of GDP). The 10 percent minimum wage increase runs counter to the strategy of internal devaluation, and may prove binding in poorer areas, thus raising unemployment or promoting the grey economy. Introduction of an investment tax credit (with fiscal effect starting from 2013) will erode the tax base even further and is unnecessary given Latvia’s already attractive corporate income tax system (low rates but accelerated depreciation). Demand for public works jobs and related programs is likely to be higher than the authorities have budgeted, potentially increasing social hardship.
Fiscal Adjustment in 2011 Original and Supplementary Budgets(in millions of lats)
Full-year impact
A Revenue Measures
Value added taxRaise statutory rate from 21 to 22 percent38
Raise reduced rates from 10 to 12 percent15
Abolish reduced rates on electricity, natural gas and medical equipment21
New mechanism for taxation of foreclosures7
Excise dutiesRaise rates on soft drinks, fuel, alcoholic beverages and tobacco23
Abolish reduced rates on ethanol fuel, natural gas and diesel fuel for22
agricultural farming
Car taxFlat tax on privately used company cars12
Increase in annual car tax, introduce differentiated rates5
Real estate taxDouble rates (previously 0.1-0.3 percent of cadastral value)6
Personal income taxCut statutory rate by 1 percentage point; increase personal and-54
dependents’ allowances
Social contributions (incl. for pensions)Leave second pillar pension contributions at 2 percent, instead of increasing to 4 percent45
Increase social contributions rate by 2 percentage points70
Non-tax revenueIncrease SOE payout ratio to 90 percent and apply to consolidated profits, increase payments for the use of state capital17
Introduce financial stability duty and license fee for providing consumer loan services7
Minimum wageRaise minimum wage from L180 to L200 (net impact)11
Grey economyVarious measures to reduce grey economy15
OtherIncreases in natural resource tax, state duties, lottery and gambling tax6
Total (revenue)265
B. Expenditure measures
RemunerationCuts in judges’ salaries, reduction of staff in public administration10
Goods and servicesVarious cuts across line ministries37
Subsidies and grantsCuts in grants for public railway services3
Reduce general education subsidies and financing for study places3
Social benefitsReform of family state benefits22
Cuts in public works jobs program 1/12
Additional appropriation for guaranteed minimum income-5
Health spendingCut in health spending12
Local governmentsLocal government spending cuts (net effect from a reduction in PIT rate, increase in the local governments’ share and an introduction of a new transfer rule for the poorest municipalities)10
Prepaid expenditureVarious expenditures prepaid at the end of 201014
OtherInfrastructure maintenance, redirection of sworn bailiffs accounts etc.1
Total (expenditure)107
Total adjustment372

Financed from European Social Fund (ESF), not counted as a consolidation measure. 4.9 million lats extra financing is expected to be reallocated from other ESF programs towards public works.

Source: IMF staff calculations based on data provided by the Ministry of Finance.

Financed from European Social Fund (ESF), not counted as a consolidation measure. 4.9 million lats extra financing is expected to be reallocated from other ESF programs towards public works.

Source: IMF staff calculations based on data provided by the Ministry of Finance.

16. The authorities believe their measures will reduce the 2011 deficit to below 4.5 percent of GDP (ESA terms, excluding bank restructuring costs). However, given the risks to spending highlighted above, plus the uncertain yield of measures to combat the grey economy, staff believes the outturn could be slightly higher (4.9 percent of GDP), unless strong spending controls are maintained. Even this would be considerably better than the initial program path of 6 percent of GDP.

17. For 2012, the authorities agreed to aim for a 2.5 percent deficit, well below the 3 percent of GDP Maastricht criterion, so as not to take chances with euro adoption. Provided that the government keeps the 2011 deficit to 4.5 percent of GDP, preliminary estimates suggest a 2012 adjustment need of L150 to 180 million (1.1 to 1.3 percent of GDP) (LOI ¶18). Although still sizable, the full-year effect of 2011 measures, improving macroeconomic projections and lower expected future bank restructuring costs mean the adjustment amount is much lower than estimated at previous reviews. The authorities are optimistic that economic recovery and their fight against the grey economy (LOI ¶15) will lower this adjustment amount further, which they will reassess together with staff in August.

18. However, difficulties finding measures for the 2011 budget hinted at challenges for the 2012 adjustment. While the authorities had prepared a broad menu of options for 2011 fiscal adjustment, this was mainly a listing of ideas from outside (in particular from Fund and Bank TA suggestions, or from Latvia’s Reform Management Group), with little political ownership. For 2012, the government’s preliminary plans foresee further local government adjustment and lower social safety net spending, with further cuts in civil service remuneration and subsidies and grants also under consideration. Staff encouraged the authorities to keep all options on the table, including sensitive areas such as pensions (so far ruled out politically) where spending rose rapidly during the boom years from 6 to 10 percent of GDP (LOI ¶18).

19. Reflecting their commitment to fiscal discipline, the authorities are also taking measures that will yield savings in 2013 and beyond. Pension indexation has been suspended through 2013, supplementary pensions (which were unfunded) will be suspended for new retirees starting 2012, and the Ministry of Welfare is proposing to raise the retirement age and qualification period starting 2016. The government has attempted to extend caps on benefits for high-earners (for those receiving above L11.51 per day, benefits increase 50 percent with income rather than one for one), though this has been suspended while opposition parties seek to overturn this by referendum. The negative effect on revenue of a new VAT repayment system designed to resolve unpaid refunds inherited from the past should gradually peter out.

20. Although recovery is under way, the authorities should extend the emergency social safety net or integrate it into the welfare system. The government plans to phase out the public works program by end-2011 and to cut emergency social safety net spending from L65 million this year to L12.5 million in 2012 (though they may raise this to L47.5 million if needs are higher). The current unemployment insurance system fails to protect the long-term unemployed (benefits taper off quickly and expire after 9 months; the authorities plan to cut this to 6 months), with only 25 percent of the registered unemployed receiving unemployment benefits. Staff encouraged the authorities to ensure adequate safety net spending, to maintain (or even increase) their co-financing of guaranteed minimum income payments (municipalities administer and pay 50 percent of these), and, in line with World Bank recommendations, to support spending on outpatient health care (LOI ¶14).

21. The authorities are developing a framework to anchor fiscal policy once the Maastricht criteria are met and the program expires. Guided by staff advice, they are refining a draft fiscal responsibility law that should limit deficits while providing scope for counter-cyclical policy. To give this law greater legal standing over the budget law and other laws, the authorities believe a constitutional amendment is necessary. Working with opposition parties in parliamentary committee, they hope to build support for this and submit a draft amendment to Parliament by end-November. This would be complemented by a medium-term budget framework law to guide multi-year budgeting by setting binding spending ceilings, in keeping with the proposed strengthening of EU economic governance (LOI ¶17).

C. Financial Sector Policies

22. The health of the financial sector should continue to improve in line with the economic recovery, although a number of challenges remain. To that end, discussions focused on restructuring state-owned banks and measures to strengthen market-based debt restructuring.

23. Restructuring of the state-owned Mortgage and Land Bank (MLB) is long overdue. Despite repeated commitments under the program (most recently an end-September 2010 structural benchmark, itself deferred), progress in restructuring MLB (a hybrid commercial and development bank) has been slow due to lack of political will. In 2010, the bank lost L63 million (0.5 percent of GDP). Although the bank successfully repaid a syndicated loan in March 2011, it did so in part by raising interest rates above average market rates to increase deposits. Staff argued that MLB needed to be restructured without delay.

24. The authorities finally submitted their MLB restructuring plan to the EC on April 15. The plan—developed by an independent consultant and which (despite some technical concerns) drew support from both the EC and IMF—envisages the sale of most of the commercial assets and liabilities of MLB later this year. Non-performing assets and other assets in which there is little market interest could possibly be transferred to Parex Bank for a more gradual workout. The development part of the bank would be merged with other development institutions in Latvia. Staff cautiously applauded the plan’s adoption, but noted that the lack of political consensus on the need to recognize possible losses in MLB meant implementation would be a challenge. Staff also stressed the need to maintain depositor confidence. The authorities agreed on an ambitious set of targets (LOI ¶6, 27) to monitor implementation, linked to disbursements from blocked program funds (mostly EC) for financial restructuring. They will quickly hire a qualified and independent sales consultant to assist with the sales strategy, and recruit a head of restructuring for MLB with international experience from similar restructurings. This should facilitate sale of the bank’s commercial part by mid-December 2011.

25. The authorities are committed to implementing Citadele’s sales and Parex’s resolution strategies (LOI ¶24). Repayment of the final tranche of Parex’s syndicated loan on May 3 closes a chapter for a bank that helped cause Latvia’s financial crisis. To maximize recoveries for the state, the sales strategy for Citadele envisages sale of the whole bank in a public auction later this year, while Parex’s resolution strategy recommends a combination of quick sale and gradual asset realization depending on the expected future return of individual assets. Staff welcomed the authorities’ commitment to keep the sales processes for Parex assets and for Citadele separate, and to exclude insiders and related parties. Staff commended the authorities’ commitment to pursue Parex’s former majority shareholders and senior managers in the courts to recover losses they caused to Parex Bank and the state.

26. The authorities have made progress toward strengthening private debt restructuring. They have introduced regulations to reduce tax disincentives for debt write-downs, streamlined foreclosure auction requirements, and introduced a new personal insolvency law. To address mounting debts to utility companies (which may be too small to be worthwhile pursuing in court and difficult to enforce in multi-unit dwellings), the authorities have submitted amendments to the Civil Procedures Law. These amendments would retroactively grant priority status to unsecured claims of utility companies in foreclosure proceedings. Staff voiced concern that the amendments would undermine secured creditors—possibly inhibiting future lending and legal predictability—and were not the best way to address the problem of unpaid utility bills. The authorities agreed to consult with staff on ways to address the problem more directly (improved small claims procedures, a more comprehensive credit registry, better metering, heating assistance for the poor) and to submit amendments to the original proposal by end-July (structural benchmark).

27. The authorities have strengthened financial sector supervision of large exposures, remuneration and stress-testing, in accordance with EU practice. Consistent with current EU regulations, a recent amendment to the Law on Credit Institutions allows the Financial and Capital Market Commission (FCMC) to waive minimum capital adequacy and large exposure requirements in certain limited cases. Staff agreed that the safeguards in the amendment (limitations on new lending and deposit taking on potential beneficiaries) meant that they were likely to be used only in exceptional circumstances, but cautioned against the risk of any regulatory forbearance.

D. Monetary Policy

28. Latvia’s fixed (narrow band) exchange rate regime continues to anchor monetary policy. Since mid-2010, the BoL reduced its official overnight deposit rate from 0.5 to 0.25 percent (currently 25 bps below the ECB’s deposit rate). Staff expressed concern that banks’ holdings of excess lats deposits at the BoL (around €1.1 billion) and tighter liquidity in the euro area (evidenced by the ECB’s recent decision to raise policy rates and the increase in euro area interbank rates) could put pressure on reserves. Since October, the 10 percent decline in reserves coupled with the depreciation of the exchange rate back toward the weaker end of the band, suggest these pressures may already be building. Given strict limits on banks’ net foreign exchange open positions, the authorities saw little risk of banks converting their excess liquidity into foreign currency, although they accepted that demand for foreign exchange from corporates in Latvia had increased. Staff expressed concern at the cuts in official interest rates, especially now that the ECB seems to have started a tightening cycle. To guard against any further build-up of risks, the BoL committed to adjust its policy stance if necessary to ensure that liquidity conditions remained consistent with the fixed exchange rate regime.

Latvian and Euro Area Interest Rates, 2010-11

Sources: Bank of Latvia and European Central Bank.

29. In January 2011, Treasury began converting foreign exchange program funds directly on-market, rather than off-market at the BoL. The authorities argued that such sales would help contain the build-up of banks’ excess deposits at the BoL and facilitate liquidity management. To address staff concerns that such sales would be perceived as foreign exchange market intervention, Treasury agreed to conduct the sales in pre-announced auctions for fiscal financing needs. Sales in early January far exceeded financing needs, prompting the exchange rate to appreciate toward the middle of the band. The private sector took advantage of this (temporary) lats appreciation to repay foreign debt, causing reserves to decline and the exchange rate to fall back to the depreciated end of the band. Treasury argued that these large sales were necessary to build an initial lats deposit buffer to deal with intra-month spending needs; from now on sales would be more closely linked to financing needs.

III. Program Issues

30. Latvia met all quantitative performance criteria for end-September and end-December 2010 and most structural benchmarks. Fiscal targets were met by comfortable margins in September and December 2010, as were NIR and NDA targets, although by a smaller margin than at previous reviews (LOI Table 1). March 2011 indicative targets for NIR and NDA were also met. Most 2010 structural benchmarks were met although some were delayed (LOI Table 3). Staff encouraged the authorities to take more time to improve the draft fiscal responsibility law before submission, and new benchmarks have been set accordingly (LOI Table 4). The SOE strategy has also been delayed and the structural benchmark reset. Staff support the authorities’ request for a waiver of nonobservance of a continuous performance criterion due to their decision at end-2010 to keep an exchange restriction related to deposits in Parex Bank, which was approved by the Board in 2011.

Table 1.Latvia: Selected Economic Indicators, 2008-12
20082009201020112012
Third Rev.ActualProj.Proj.
National accounts(percentage change, unless otherwise indicated)
Real GDP-4.2-18.0-3.5-0.33.34.0
Private consumption-5.2-24.1-9.0-0.13.03.7
Public consumption1.5-9.2-10.0-11.0-2.00.0
Gross fixed investment-13.6-37.3-10.0-19.58.08.5
Stockbuilding (contribution to growth)-4.1-1.51.55.80.00.0
Exports of goods and services2.0-14.15.010.39.57.5
Imports of goods and services-11.2-33.5-6.28.69.07.6
Nominal GDP (billions of lats)16.213.112.212.713.414.2
Nominal GDP (billions of euros)23.018.617.418.119.120.1
GDP per capita (thousands of euros)10.18.27.78.18.59.0
Savngs and Investment
Gross national savings (percent of GDP)18.128.930.224.224.023.6
Gross capital formation (percent of GDP)31.220.318.920.722.223.1
Private investment (percent of GDP)26.416.014.416.816.017.6
HICP inflation
Period average15.33.3-2.0-1.23.21.8
End-period10.4-1.4-0.52.42.02.3
Labor market
Unemployment rate (LFS definition; period average, percent)7.817.321.019.017.215.5
Real gross wages4.4-6.8-7.9-2.3-1.60.5
Consolidated general government 1/(percent of GDP, unless otherwise indicated)
Revenue35.436.239.636.238.136.3
Expenditure and net lending38.743.347.842.642.638.6
Basic fiscal balance-3.3-7.1-8.1-6.4-4.4-2.3
ESA balance less bank restructuring-4.2-8.6-8.5-5.5-4.5-2.5
General government gross debt17.132.843.439.943.043.5
Money and credit
Credit to private sector (percentage change)11.0-6.9-5.5-8.4-1.70.2
Broad money (percentage change)-3.9-1.921.29.85.48.1
Residents’ FX deposits (percent of total deposits)48.655.651.750.353.856.0
Treasury Bill rate (365 days, eop, percent)11.010.31.81.8 2/
Money market rate (one month, eop, percent)13.32.70.60.6 2/
Balance of payments
Gross official reserves (billions of euros)3.74.85.35.85.25.2
(In months of prospective imports)5.46.07.86.15.04.6
(percent of broad money and non-resident deposits)31.141.637.443.537.835.4
Current account balance-13.18.68.23.61.70.5
Trade balance-17.7-7.1-3.3-6.4-7.6-8.1
Exports of goods and services41.843.248.452.958.860.4
Imports of goods and services55.544.244.453.159.361.8
Gross external debt128.7156.3161.1165.2145.4135.1
Net external debt 3/56.858.843.053.834.428.1
Exchange rates
Lats per euro (average) /40.700.700.700.70 2/
Lats per U.S. dollar (average)0.480.480.530.49 2/
REER (average; CPI based, 2000=100)104.5110.3103.6
Sources: Latvian authorities, Eurostat, and IMF staff estimates.

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

Actual rate as of April 18, 2011.

Gross external debt minus gross external debt assets.

Lat is pegged to the euro at a 1 EUR = 0.702804 LVL rate, with ±1 percent band.

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

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

Actual rate as of April 18, 2011.

Gross external debt minus gross external debt assets.

Lat is pegged to the euro at a 1 EUR = 0.702804 LVL rate, with ±1 percent band.

Table 2.Latvia. Macroeconomic Framework, 2008-16
200820092010201120122013201420152016
Projections
(percentage change, unless otherwise indicated)
National accounts
Real GDP-4.2-18.0-0.33.34.04.04.04.04.0
Consumption-4.1-21.5-2.22.13.13.53.73.83.9
Private consumption-5.2-24.1-0.13.03.74.04.14.24.3
Public consumption1.5-9.2-11.0-2.00.01.01.52.02.0
Gross fixed capital formation-13.6-37.3-19.58.08.57.57.06.56.0
Exports of goods and services2.0-14.110.39.57.56.96.56.46.2
Imports of goods and services-11.2-33.58.69.07.67.37.06.96.7
Contributions to growth
Domestic demand-12.5-32.2-0.93.34.24.44.54.54.5
Net exports8.214.20.60.0-0.2-0.4-0.5-0.5-0.5
HICP inflation
Period average15.33.3-1.23.21.81.71.81.91.9
End-period10.4-1.42.42.02.31.12.11.91.8
Labor market
Unemployment rate (LFS definition; period average, percent)7.817.319.017.215.514.113.112.011.0
Employment (period average, percent change)0.1-11.4-3.61.51.00.70.60.60.6
Real gross wages4.4-6.8-2.3-1.60.50.50.60.50.5
(percent of GDP)
Consolidated general government
Revenues35.436.236.238.136.334.533.632.932.1
Expenditure38.743.342.642.638.636.235.034.733.6
Basic Balance-3.3-7.1-6.4-4.4-2.3-1.8-1.4-1.8-1.5
Balance (including bank restructuring costs)-7.5-7.8-7.8-5.6-2.3-1.8-1.4-1.8-1.5
Gross debt17.132.839.943.043.546.549.745.042.4
Savng and investment
Domestic saving18.128.924.224.023.623.022.722.723.0
Private14.930.526.221.719.918.217.317.417.2
Public 1/3.2-1.6-2.02.33.74.85.45.35.8
Foreign saving 2/13.1-8.6-3.6-1.7-0.50.81.72.12.2
Investment31.220.320.722.223.123.824.424.825.2
Private26.416.016.816.017.618.519.119.319.4
Public4.74.33.96.25.55.35.25.55.8
External sector
Current account balance-13.18.63.61.70.5-0.8-1.7-2.1-2.2
Net IIP-78.6-82.6-81.4-72.5-60.4-56.6-53.8-51.6-49.7
Gross external debt128.7156.3165.2145.4135.1129.9125.6116.1109.2
Net external debt 3/56.858.853.834.428.123.519.917.014.3
Memorandum items:
Gross official reserves (billions of euros)3.74.85.85.25.25.86.45.85.7
Nominal GDP (billions of lats)16.213.112.713.414.215.015.816.717.7
Nominal GDP (billions of euros)23.018.618.119.120.121.322.523.825.1
Sources: Latvian Authorities and IMF staff estimates.

Includes 2nd pillar contributions and privatization receipts, excludes bank restructuring costs.

Current account deficit (+ indicates a surplus)

Gross external debt minus gross external debt assets.

Sources: Latvian Authorities and IMF staff estimates.

Includes 2nd pillar contributions and privatization receipts, excludes bank restructuring costs.

Current account deficit (+ indicates a surplus)

Gross external debt minus gross external debt assets.

Table 3.Latvia: General Government Operations, 2009-13
20092010201120122013
ThirdActualThirdProj.RiskProj.Proj.
ReviewReviewscenario
(millions of lats)
Total revenue and grants4,7354,8424,6074,6235,1195,1385,1365,153
Tax revenue3,5153,3353,4033,3243,7143,6923,8523,912
Direct Taxes2,1662,0422,0742,0022,1532,1492,2282,205
Corporate Income Tax19798112102121116127139
Personal Income Tax729770779775739737764789
Social Security Contributions1,1671,0861,0931,0341,1931,1961,2321,166
Real Estate and Property Taxes738790919999105111
Indirect Taxes1,3491,2941,3291,3221,5611,5431,6241,707
VAT7987958258079729529911,051
Excises504459458475476480515536
Other indirect taxes46404640113111118120
Non Tax, self-earned and other revenue690598604508507496490527
EU and miscellaneous funds530909600791898950794715
Total expenditure 1/5,6625,8365,4245,2905,7155,7885,4665,417
Current expenditure5,2315,3595,0345,2335,0505,1845,0955,061
Primary Current Expenditure5,0815,1494,8554,9894,8244,9534,8104,736
Remuneration1,3371,1821,0871,1821,0681,0741,0831,107
Goods and Services675689691689583587600634
Subsidies and Transfers2,8843,0262,9372,8722,9923,1102,9382,798
Subsidies to companies and institutions1,2241,2131,1781,1401,3751,4661,3161,169
E.U. funds related subsidies668777784704790850725578
Social Support1,6461,7961,7451,7161,6041,6321,6081,615
Pensions1,0821,2351,2521,1951,1641,1641,1661,166
Other564561493521440468442449
International cooperation1317151713131314
Payments to EU budget148140121145130130137145
Net lending and other current expenditure361121810051515151
Interest151210180244227231285325
Capital expenditure430477390477624604551536
E.U. funds related capital expenditure135200141200359350293263
Measures to be identified000-42000-180-180
Possible contingencies 2/000040000
Basic fiscal balance-927-994-817-667-596-650-330-263
Bank restructuring costs9943218221715015000
Fiscal balance-1,026-1,426-999-884-746-800-330-263
Financing (net)1,0261,426999884746800330263
Domestic financing-976425112-4715621040-426
Banking system-1,01042529-4715621040-426
Central Bank-654425313-14756110-60-530
Commercial banks-3560-284100100100100104
Nonbanks3408300000
Privatization and other00000000
External financing1,9701,001827931590590290690
Net borrowing (net)195701192505205205201,040
Exceptional financing1,7759317086817070-230-350
Errors and omissions3206000000
Sources: Latvian authorities and IMF staff estimates.

Total expenditure excludes net acquisition of financial assets and other bank restructuring costs.

Includes the budgetary clause to increase spending without parliamentary approval.

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

(percent of GDP)
Total revenue and grants36.239.636.236.838.138.336.334.5
Tax revenue26.927.326.726.527.727.527.226.2
Direct Taxes16.616.716.315.916.016.015.714.7
Corporate Income Tax1.50.80.90.80.90.90.90.9
Personal Income Tax5.66.36.16.25.55.55.45.3
Social Security Contributions8.98.98.68.28.98.98.77.8
Real Estate and Property Taxes0.60.70.70.70.70.70.70.7
Indirect Taxes10.310.610.410.511.611.511.511.4
VAT6.16.56.56.47.27.17.07.0
Excises3.93.83.63.83.53.63.63.6
Other indirect taxes0.40.30.40.30.80.80.80.8
Non Tax, self-earned and other revenue5.34.94.74.03.83.73.53.5
EU and miscellaneous funds4.07.44.76.36.77.15.64.8
Total expenditure 1/43.347.842.642.142.643.138.636.2
Current expenditure40.043.939.541.737.638.636.033.8
Primary Current Expenditure38.842.238.139.735.936.934.031.7
Remuneration10.29.78.59.48.08.07.77.4
Goods and Services5.25.65.45.54.34.44.24.2
Subsidies and Transfers22.024.823.122.922.323.220.718.7
Subsidies to companies and institutions9.49.99.29.110.210.99.37.8
E.U. funds related subsidies5.16.46.25.65.96.35.13.9
Social Support12.614.713.713.711.912.211.410.8
Pensions8.310.19.89.58.78.78.27.8
Other4.34.63.94.23.33.53.13.0
International cooperation0.10.10.10.10.10.10.10.1
Payments to EU budget1.11.11.01.21.01.01.01.0
Net lending and other current expenditure0.30.90.10.80.40.40.40.3
Interest1.21.71.41.91.71.72.02.2
Capital expenditure3.33.93.13.84.64.53.93.6
E.U. funds related capital expenditure1.01.61.11.62.72.62.11.8
Measures to be identified0.00.00.0-3.30.00.0-1.3-1.2
Possible contingencies 2/0.00.00.00.00.30.00.00.0
Basic fiscal balance-7.1-8.1-6.4-5.3-4.4-4.8-2.3-1.8
Bank restructuring costs0.83.51.41.71.11.10.00.0
Fiscal balance-7.8-11.7-7.8-7.0-5.6-6.0-2.3-1.8
Memorandum items
ESA balance-9.7-8.5-7.7-6.0-4.9-5.3-2.5-2.5
ESA balance less bank restructuring 3/-8.6-8.5-5.5-6.0-4.5-4.9-2.5-2.4
General government debt32.843.439.950.443.043.043.546.5
Primary basic balance-5.9-6.4-5.0-3.4-2.7-3.1-0.30.4
Nominal GDP (In millions of lats)13,08312,21312,73612,56313,42813,42814,16114,955
Sources: Latvian authorities and IMF staff estimates.

Total expenditure excludes net acquisition of financial assets and other bank restructuring costs.

Includes the budgetary clause to increase spending without parliamentary approval.

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

Sources: Latvian authorities and IMF staff estimates.

Total expenditure excludes net acquisition of financial assets and other bank restructuring costs.

Includes the budgetary clause to increase spending without parliamentary approval.

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

Table 4.Latvia: Fiscal Balances and Debt, 2006-12
2006200720082009201020112012
Fiscal balances(percent of GDP)
Basic fiscal balance (excl. bank restructuring)-0.50.6-3.3-7.1-6.4-4.4-2.3
Alternative fiscal balances
(i) Authorities’ definition plus net lending0.00.00.30.10.40.4
Basic fiscal balance, authorities’ definition0.6-3.3-6.8-6.3-4.1-2.0
(ii) Adjustment for 2nd pillar contribution diversion less gain from 2nd pillar contributions < 8%0.00.00.01.21.61.71.7
Fiscal balance, adjusted for pension diversion 1/-0.50.6-3.3-8.3-8.1-6.2-4.0
(iii) Adjustment for EU-related operations less revenues from EU2.33.12.74.04.76.75.6
plus EU-related spending4.13.64.26.17.38.67.2
Non-EU basic balance1.31.1-1.8-5.0-3.9-2.6-0.8
(iv) Primary balance plus interest0.60.30.41.21.41.72.0
Primary basic balance0.11.0-2.9-5.9-5.0-2.7-0.3
(v) Recognition of bank restructuring costs less bank restructuring costs0.00.04.20.81.41.10.0
Overall balance-0.50.6-7.5-7.8-7.8-5.6-2.3
(vi) Program-relevant ESA balance ESA definition less bank restructuring-0.5-0.3-4.2-8.6-5.5-4.5-2.5
(v) ESA deficit (relevant for euro adoption) plus ESA bank restructuring0.00.00.01.12.30.40.0
ESA deficit-0.5-0.3-4.2-9.7-7.7-4.9-2.5
Public debt
Gross debt9.97.817.132.839.943.043.5
of which foreign currency-denominated5.24.49.825.632.635.235.4
Net debt (debt less government deposits)7.44.713.123.032.236.136.6
Net debt if no more bank restructuring7.44.713.123.032.235.035.5
Sources: Latvian authorities and IMF staff estimates.

Definition used at First Review.

Sources: Latvian authorities and IMF staff estimates.

Definition used at First Review.

Table 5.Latvia: Public Sector Debt Sustainability Framework, 2006-16(In percent of GDP, unless otherwise indicated)
ActualProjections
20062007200820092010201120122013201420152016Debt-stabilizing

primary

balance 9/
1Baseline: Public sector debt 1/9.97.817.132.839.943.043.546.549.745.042.4-3.0
o/w foreign-currency denominated5.24.49.825.632.635.235.438.141.336.834.6
2Change in public sector debt-1.9-2.19.315.77.13.10.53.03.2-4.7-2.6
3Identified debt-creating flows (4+7+12)-2.4-3.57.011.011.63.50.1-0.5-1.1-0.9-0.9
4Primary deficit-0.1-1.02.95.95.02.70.3-0.4-1.1-1.2-1.2
5Revenue and grants36.136.235.436.236.238.136.334.533.632.932.1
6Primary (noninterest) expenditure36.035.238.342.141.240.936.634.032.431.730.9
7Automatic debt dynamics 2/-2.2-2.50.04.35.2-0.4-0.2-0.10.00.30.3
8Contribution from interest rate/growth differential 3/-1.7-2.1-0.35.22.3-0.4-0.2-0.10.00.30.3
9Of which contribution from real interest rate-0.5-1.3-0.61.42.20.91.41.51.82.22.0
10Of which contribution from real GDP growth-1.2-0.70.33.80.1-1.3-1.6-1.7-1.8-1.9-1.7
11Contribution from exchange rate depreciation 4/-0.6-0.40.3-0.92.9
12Other identified debt-creating flows-0.1-0.14.10.81.41.10.00.00.00.00.0
13Privatization receipts (negative)-0.1-0.1-0.10.00.00.00.00.00.00.00.0
14Recognition of implicit or contingent liabilities0.00.00.00.00.00.00.00.00.00.00.0
15Other (specify, e.g. bank recapitalization)0.00.04.20.81.41.10.00.00.00.00.0
16Residual, including asset changes (2-3) 5/0.51.42.34.8-4.6-0.40.43.54.3-3.8-1.7
Public sector debt-to-revenue ratio 1/27.321.448.390.7110.3112.7120.0134.9148.1136.7132.0
Gross financing need 6/2.20.38.915.912.69.36.86.09.77.32.1
in billions of U.S. dollars0.40.13.04.33.02.41.91.72.92.30.8
Scenario with key variables at their historical averages 7/43.043.146.450.245.843.8-5.3
Scenario with no policy change (constant primary balance) in 2011-201643.046.052.159.258.659.0-4.2
Key Macroeconomic and Fiscal Assumptions Underlying Baseline
Real GDP growth (in percent)12.210.0-4.2-18.0-0.33.34.04.04.04.04.0
Average nominal interest rate on public debt (in percent) 8/5.94.75.65.44.24.54.95.35.86.46.4
Average real interest rate (nominal rate minus change in GDP deflator, in percent)-4.0-15.6-8.86.96.52.43.53.84.24.74.7
Nominal appreciation (increase in US dollar value of local currency, in percent)11.410.3-6.67.3-9.5
Inflation rate (GDP deflator, in percent)9.920.314.4-1.5-2.32.01.41.51.61.71.7
Growth of real primary spending (deflated by GDP deflator, in percent)12.27.64.2-9.8-2.62.6-6.9-3.2-0.91.71.4
Primary deficit-0.1-1.02.95.95.02.70.3-0.4-1.1-1.2-1.2
Source: IMF staff estimates

Indicate coverage of public sector, e.g., general government or nonfinancial public sector. Also whether net or gross debt is used.

Derived as [(r - π(1+g) - g + αε(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; α = share of foreign-currency denominated debt; and α = nominal exchange rate depreciation (measured by increase in local currency value of U.S. dollar).

The real interest rate contribution is derived from the denom inator in footnote 2/ as r - π (1 +g) and the real growth contribution as -g.

The exchange rate contribution is derived from the numerator in footnote 2/ as αε(1+r).

For projections, this line includes exchange rate changes.

Defined as public sector deficit, plus amortization of medium and long-term public sector debt, plus short-term debt at end of previous period.

The key variables include real GDP growth; real interest rate; and primary balance in percent of GDP.

Derived as nominal interest expenditure divided by previous period debt stock.

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.

Source: IMF staff estimates

Indicate coverage of public sector, e.g., general government or nonfinancial public sector. Also whether net or gross debt is used.

Derived as [(r - π(1+g) - g + αε(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; α = share of foreign-currency denominated debt; and α = nominal exchange rate depreciation (measured by increase in local currency value of U.S. dollar).

The real interest rate contribution is derived from the denom inator in footnote 2/ as r - π (1 +g) and the real growth contribution as -g.

The exchange rate contribution is derived from the numerator in footnote 2/ as αε(1+r).

For projections, this line includes exchange rate changes.

Defined as public sector deficit, plus amortization of medium and long-term public sector debt, plus short-term debt at end of previous period.

The key variables include real GDP growth; real interest rate; and primary balance in percent of GDP.

Derived as nominal interest expenditure divided by previous period debt stock.

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.

Table 6.Latvia: Medium Term Balance of Payments, 2008-16
200820092010201120122013201420152016
Projections
(millions of euros)
Current account-3,0071,60664933399-174-380-508-548
Trade balance (fob)-4,073-1,326-1,168-1,451-1,630-1,825-2,033-2,248-2,487
Exports6,5275,2766,7838,0068,6649,2909,92210,66111,489
Imports10,6006,6027,9519,45710,29511,11511,95512,90813,976
Services9171,1251,1211,3581,3441,4251,5041,6031,714
Credit3,0872,7572,7953,2373,5033,7564,0114,3104,645
Debit2,1711,6321,6751,8792,1592,3312,5072,7072,931
Income-3631,17644-242-303-475-573-649-631
Compensation of employees372392430439476501524546570
Investment income-735784-386-681-778-977-1,096-1,195-1,201
Current transfers512631653667688702722786857
of which: EU (net)34176372395302266225225225
Capital and financial account2,015-3,142-989-1,0422331,2792,1511,202549
Capital account341452353170290307325325326
Financial account1,674-3,593-1,341-1,212-579721,826876222
Direct investment697112251495509528557603653
of which: equity capital286996493419424440466509555
Portfolio investment254124-1416787281,4682,399738-12
of which: general government210-4-27407401,4802,4127500
Financial derivatives-71303-169000000
Other investment795-4,132-1,283-2,385-1,294-1,024-1,130-465-418
Trade credit-40-114248-1191517191821
Ass ets2787-166-160-98-93-94-110-123
Liabilities-67-20241441113111113129144
Loans2,486-2,012-2,527-1,632-1,035-721-791-330-411
Ass ets-187-274691,258346259181136102
Liabilities2,673-1,986-2,996-2,890-1,381-980-972-466-513
Currency and deposits-1,633-2,008977-615-273-320-359-153-29
Ass ets-130-763-1,016-475-553-586-619-393-249
Liabilities-1,503-1,2451,993-139279265260239220
Other-18319-1900000
Errors and omissions-414143-36000000
Overall balance-1,407-1,393-375-7093321,1051,7716941
Financing1,4071,393375709-332-1,105-1,771-694-1
Change in reserve assets (+ denotes decline)456-922-725609-16-631-55259642
IMF (net)5911943000-316-474-219-610
Purchases300000000
Repurchases00-316-474-219-610
Other official financing (net)3602,12080010000-1,000-1,229-43
Disbursements80010000000
Repayments0000-1,000-1,229-43
Sources: Latvian authorities and IMF staff estimates.

2009 estimate of the current account would have been 2.8 percent of GDP if provsioning by foreign banks for their non-performing loans were excluded.

Gross reserves in percent of banks’ short-term liabilities and amortization minus the current account surplus.

Gross external debt minus gross external debt assets.

Memorandum items:(percent of GDP, unless otherwise indicated)
Current account 1/-13.18.63.61.70.5-0.8-1.7-2.1-2.2
Trade balance (fob)-17.7-7.1-6.4-7.6-8.1-8.6-9.0-9.5-9.9
Exports28.428.337.441.943.043.744.144.845.7
Imports46.135.543.949.551.152.253.254.355.6
Services4.06.06.27.16.76.76.76.76.8
Credit13.414.815.416.917.417.617.818.118.5
Debit9.48.89.29.810.711.011.211.411.7
Income-1.66.30.2-1.3-1.5-2.2-2.5-2.7-2.5
Compensation of employees1.62.12.42.32.42.42.32.32.3
Investment income-3.24.2-2.1-3.6-3.9-4.6-4.9-5.0-4.8
Current transfers2.23.43.63.53.43.33.23.33.4
of which: EU (net)0.10.92.12.11.51.31.00.90.9
Net FDI3.00.61.42.62.52.52.52.52.6
Export G&S growth (value, fob, percent change)10.6-16.419.217.48.27.26.87.47.8
Import G&S growth (value, fob, percent change)-1.7-35.516.918.88.98.07.68.08.3
Export G&S price increase (percent change)8.5-3.67.37.20.70.30.31.01.5
Import G&S price increase (percent change)11.7-2.47.19.01.20.70.61.01.5
Gross reserves (billions of euros)3.74.85.85.25.25.86.45.85.7
(in months of prospective imports)5.46.06.15.04.64.84.94.14.0
Reserve Cover 2/23.778.657.951.152.160.458.657.365.4
Short-term debt (percent of official reserves)268.5149.1168.7183.8190.0167.6151.4165.6165.0
Banks’ short term liabilities (billions of euros)7.65.57.77.67.97.87.77.67.4
Total short-term debt (billions of euros)9.97.29.89.59.99.89.79.69.5
Reserves (percent of short-term external debt)37.267.159.354.452.659.766.060.460.6
Gross external debt (billions of euros)29.629.129.927.827.227.628.227.627.4
Medium and long term (billions of euros)19.721.920.218.317.417.918.618.018.0
Short term (billions of euros)9.97.29.89.59.99.89.79.69.5
Net external debt (billions of euros) 3/13.110.99.76.65.75.04.54.03.6
Gross external debt128.7156.3165.2145.4135.1129.9125.6116.1109.2
Medium and long term85.6117.8111.395.686.184.082.775.971.5
Short term43.138.553.949.849.045.943.040.337.7
Net external debt56.858.853.834.428.123.519.917.014.3
Nominal GDP (billions of euros)23.018.618.119.120.121.322.523.825.1
U.S. dollar per euro (period average)1.471.461.32
Lats per euro0.700.700.700.700.700.700.700.700.70
Sources: Latvian authorities and IMF staff estimates.

2009 estimate of the current account would have been 2.8 percent of GDP if provsioning by foreign banks for their non-performing loans were excluded.

Gross reserves in percent of banks’ short-term liabilities and amortization minus the current account surplus.

Gross external debt minus gross external debt assets.

Sources: Latvian authorities and IMF staff estimates.

2009 estimate of the current account would have been 2.8 percent of GDP if provsioning by foreign banks for their non-performing loans were excluded.

Gross reserves in percent of banks’ short-term liabilities and amortization minus the current account surplus.

Gross external debt minus gross external debt assets.

Table 7.Latvia: External Debt Dynamics, 2008-16
200820092010201120122013201420152016
(billions of euros)
Gross external debt29.629.129.927.827.227.628.227.627.4
Public2.54.86.06.97.38.39.58.98.9
Short term0.50.10.10.10.10.10.10.10.1
Long term1.94.65.96.77.28.29.48.88.8
Private27.124.323.920.920.019.418.818.718.5
Banks18.515.515.613.312.411.811.211.110.9
Short term7.65.57.77.67.97.87.77.67.4
Long term10.910.07.85.74.54.03.53.53.5
Corporate6.15.85.95.15.05.05.05.15.1
Short term1.81.51.91.81.91.91.91.91.9
Long term4.34.34.03.33.13.13.13.13.1
Other2.53.12.52.52.52.52.52.62.6
(percent of GDP)
Gross external debt128.7156.3165.2145.4135.1129.9125.6116.1109.2
Public10.825.733.235.936.138.942.137.635.4
Short term2.40.80.70.60.60.60.50.50.5
Long term8.525.032.535.235.538.341.637.134.9
Private117.9130.6132.0109.599.091.083.578.673.8
Banks80.683.285.869.561.655.549.846.643.3
Short term33.129.642.739.839.236.534.131.829.5
Long term47.553.643.129.722.518.915.714.813.8
Corporate26.431.032.326.924.923.622.421.220.3
Short term7.68.210.59.49.28.88.38.07.8
Long term18.822.921.917.515.614.814.013.212.5
Other10.916.413.913.212.511.911.310.810.2
(debt dynamics, change in debt to GDP ratio)
Total Debt to GDP1.027.68.9-19.8-10.3-5.2-4.3-9.5-7.0
Due to change in debt12.1-2.84.7-11.3-2.81.92.7-2.6-0.7
Due to nominal GDP-11.130.44.3-8.5-7.5-7.2-6.9-6.9-6.3
Public Debt to GDP5.714.97.42.70.22.83.2-4.6-2.2
Due to change in debt6.212.36.74.42.14.75.3-2.3-0.2
Due to nominal GDP-0.42.60.7-1.7-1.9-1.9-2.1-2.3-2.0
Private Debt to GDP-4.712.71.5-22.5-10.5-8.0-7.5-4.9-4.8
Due to change in debt6.0-15.1-2.1-15.7-4.9-2.8-2.6-0.4-0.5
Due to nominal GDP-10.727.83.6-6.8-5.7-5.3-4.9-4.6-4.3
Memorandum items:
Nominal GDP (billions of euros)23.018.618.119.120.121.322.523.825.1
Sources: Latvian authorities and IMF staff estimates.
Sources: Latvian authorities and IMF staff estimates.
Table 8.Latvia: External Debt Sustainability Framework, 2006-16(In percent of GDP, unless otherwise indicated)
ActualProjections
20062007200820092010201120122013201420152016Debt-stabilizing

non-interest

current account 6/
1Baseline: External debt114.2127.7128.7156.3165.2145.4135.1129.9125.6116.1109.2-5.5
2Change in external debt14.713.51.027.68.9-19.8-10.3-5.2-4.3-9.5-7.0
3Identified external debt-creating flows (4+8+9)-3.4-19.5-7.434.48.1-9.5-8.7-6.9-5.9-5.3-4.9
4Current account deficit, excluding interest paym17.417.811.1-9.9-4.5-4.1-2.6-1.6-0.8-0.2-0.2
5Deficit in balance of goods and services22.320.513.71.10.30.51.41.92.42.73.1
6Exports44.041.441.843.252.958.860.461.362.063.064.2
7Imports66.261.955.544.253.159.361.863.264.365.767.3
8Net non-debt creating capital inflows (negative)-6.5-6.7-1.43.6-1.5-2.7-2.6-2.6-2.6-2.6-2.7
9Automatic debt dynamics 1/-14.4-30.5-17.240.713.8-2.7-3.4-2.7-2.4-2.4-2.0
10Contribution from nominal interest rate5.14.61.91.30.92.42.12.52.52.42.4
11Contribution from real GDP growth-9.8-7.94.630.20.6-5.1-5.5-5.2-5.0-4.8-4.4
12Contribution from price and exchange rate cha-9.7-27.2-23.79.212.3
13Residual, incl. change in gross foreign assets (2-3)18.133.08.5-6.80.8-10.3-1.61.71.6-4.2-2.1
External debt-to-exports ratio (in percent)259.6308.6308.1362.2312.6247.1223.8211.9202.7184.5170.1
Gross external financing need (in billions of U23.229.843.030.824.130.730.531.431.030.430.1
in percent of GDP116.5103.3126.8118.9100.610-Year10-Year117.6111.6109.5103.196.290.7
Scenario with key variables at their historical averages 5/145.4136.6131.5126.7118.2111.7-12.1
HistoricalStandard
Key Macroeconomic Assumptions Underlying BaselineAverageDevation
Real GDP growth (in percent)12.210.0-4.2-18.0-0.34.19.33.34.04.04.04.04.0
GDP deflator in US dollars (change in percent)10.831.322.8-6.7-7.38.512.35.60.60.70.71.20.9
Nominal external interest rate (in percent)6.45.81.80.80.53.62.31.61.51.92.02.02.1
Growth of exports (US dollar terms, in percent)16.235.918.8-20.913.215.715.721.57.36.45.97.06.9
Growth of imports (US dollar terms, in percent)32.434.95.5-39.011.015.222.123.08.07.16.77.57.4
Current account balance, excluding interest payme-17.4-17.8-11.19.94.2-6.68.64.12.61.60.80.20.2
Net non-debt creating capital inflows6.56.71.4-3.61.53.02.92.72.62.62.62.62.7
Source: IMF staff estimates

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

The contribution from price and exchange rate changes is defined as [-ρ(1 +g) + εα(1+r)]/(1+g+ρ+gρ) times prevous period debt stock. p increases with an appreciating domestic currency (ε> 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 keyvariables (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.

Source: IMF staff estimates

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

The contribution from price and exchange rate changes is defined as [-ρ(1 +g) + εα(1+r)]/(1+g+ρ+gρ) times prevous period debt stock. p increases with an appreciating domestic currency (ε> 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 keyvariables (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.

Table 9.Latvia: Bank of Latvia Balance Sheet, 2007-12
200720082009201020112012
ActualsProj.
(Billions of Lats, current exchange rate)
Reserve money2.52.11.92.62.32.3
Currency issued1.01.00.80.91.01.1
Reserves at the BoL1.41.11.11.71.31.2
Required reserves1.41.10.90.80.80.8
Deposit facility0.00.00.30.90.50.4
Net foreign assets 1/2.82.33.34.03.63.6
Foreign assets2.92.73.44.13.63.7
Foreign liabilities0.10.40.10.00.00.0
Net domestic assets-0.3-0.2-1.4-1.4-1.3-1.4
Net credit to government-0.2-0.6-1.3-1.1-0.9-1.0
Net credit to banks (excluding deposit facility)0.00.60.10.00.00.0
Net credit to other sectors0.00.00.0-0.1-0.1-0.1
Other items, net-0.1-0.2-0.3-0.3-0.3-0.3
(Billions of Lats, program exchange rate for actual figures)
Net foreign assets2.33.34.03.6
minus disbursments of program funds0.42.33.03.1
minus SDR allocation0.10.10.1
Program net international reserves1.90.90.80.4
Base money 2/2.11.61.81.9
minus program net international reserves1.90.90.80.4
Program net domestic assets0.20.71.01.4
Memorandum items:
Base money 2/2.52.11.61.81.81.9
Net foreign assets (percent of base money)112.6110.5201.5229.8203.5196.3
Net foreign assets (percent of reserve money)112.6110.4174.3153.6155.6159.4
Net foreign assets (percent of M2)76.567.3112.2112.6101.097.1
Net foreign assets (percent of broad money)45.039.356.963.153.950.0
Broad money multiplier2.52.83.12.42.93.2
Source: Bank of Latvia and IMF staff estimates.

Includes Treasury foreign assets deposited at the BoL

Excludes banks’ deposits at deposit facility

Source: Bank of Latvia and IMF staff estimates.

Includes Treasury foreign assets deposited at the BoL

Excludes banks’ deposits at deposit facility

Table 10.Latvia: Monetary Survey, 2007-12
200720082009201020112012
ActualsProj.
(Billions of Lats)
Broad money6.25.95.86.46.77.3
Lats broad money (M2)3.63.53.03.63.63.7
Currency in circulation0.90.90.70.80.91.0
Lats deposits2.72.62.32.82.72.8
Resident foreign exchange deposits2.52.52.92.83.13.5
Net foreign assets-4.5-5.9-3.0-1.2-0.9-0.5
Bank of Latvia2.82.33.34.03.63.6
Domestic money banks-7.3-8.2-6.3-5.3-4.6-4.2
Net domestic assets10.711.88.87.67.77.8
Domestic credit13.014.312.211.211.211.3
Credit to government, net-0.1-0.4-1.5-1.4-1.2-1.2
Credit to public corporations0.30.40.40.50.50.5
Credit to private sector12.914.313.312.212.012.0
Other items, net-2.4-2.4-3.4-3.6-3.6-3.4
Sources of funds of deposit money banks18.018.216.316.415.114.9
Resident deposits5.35.15.25.65.86.3
Non-resident deposits4.53.53.34.24.14.3
Liabilities to foreign financial institutions7.99.37.46.55.04.2
Other foreign liabilities0.30.40.60.10.10.1
Uses of funds of deposit money banks18.018.216.316.415.114.9
Reserves1.61.21.21.81.41.3
Cash in vault0.10.20.10.10.10.1
Required reserves1.41.10.90.80.80.8
Deposit facility0.00.00.30.90.50.4
Domestic credit13.214.313.412.312.212.3
Foreign assets5.54.94.95.64.74.4
Other items, net-2.2-2.2-3.1-3.3-3.2-3.1
(Annual percentage change)
Broad money12.6-3.9-1.99.85.48.1
Net foreign assets-70.1-31.948.959.624.140.8
Bank of Latvia15.0-16.042.121.7-10.00.3
Domestic money banks-43.8-13.623.217.113.38.0
Net domestic assets31.311.2-25.4-13.90.72.2
Domestic credit31.89.7-14.5-8.10.00.4
Credit to government, net-186.9-323.3-298.52.913.80.0
Credit to public corporations118.352.53.819.92.14.1
Credit to private sector33.011.0-6.9-8.4-1.70.2
(Percent of GDP, unless otherwise indicated)
Memorandum items:
Lats broad money (M2)24.621.422.628.126.826.5
Broad money41.836.644.550.250.151.4
Currency in circulation6.15.45.16.36.66.9
Residents’ foreign exchange deposits (percent of total deposits)48.248.655.650.353.856.0
Domestic credit88.188.293.388.183.579.5
Private sector credit87.088.1101.595.689.184.6
Nominal GDP (billions of lats)14.816.213.112.713.414.2
Source: Bank of Latvia and IMF staff estimates.
Source: Bank of Latvia and IMF staff estimates.
Table 11.Latvia: Financial Soundness Indicators, 2007-11(In percent, unless otherwise indicated)
Dec-07Dec-08Dec-09Dec-10Feb-11
Commercial banks
Capital Adequacy
Regulatory capital to risk-weighted assets11.111.814.614.615.0
Regulatory Tier I capital to risk-weighted assets 1/9.810.511.511.511.8
Capital and reserves to assets7.97.37.47.37.6
Asset Quality
Annual growth of bank loans37.211.2-7.0-7.2-8.1
Loans past due over 90 days0.83.616.419.018.7
Loans past due over 90 days net of loan loss provisions to capital13.667.665.358.6
Loan loss provisions to loans past due over 90 days61.357.461.663.6
Loan loss provisions to total loans2.29.411.711.9
Share of loans in total assets, banks dealing with residents 2/80.482.576.474.775.6
Share of loans in total assets, banks dealing with non-residents 2/48.951.752.446.446.3
Earnings and Profitability
ROA (after tax)2.00.3-3.5-1.60.5
ROE (after tax)24.34.6-41.6-20.46.2
Net interest income to total income32.530.123.319.022.0
Noninterest expenses to total income32.347.5114.593.561.3
Trading income to total income7.85.68.65.411.1
Personnel expenses to noninterest expenses31.521.38.511.917.9
Income from operations with non-residents to total income
Banks dealing with residents 2/13.013.721.025.726.7
Banks dealing with non-residents 2/49.248.044.846.655.0
Liquidity
Liquid assets to total assets25.021.621.127.326.4
Liquid assets to short term liabilities55.752.862.867.966.2
Customers deposits to (non-interbank) loans68.258.861.977.577.0
Sensitivity to Market Risk
Net open positions in FX to capital 3/5.46.34.1*4.2*
Net open positions in EUR to capital3.23.73.0*2.8*
FX assets to total assets79.780.582.780.680.7
FX deposits to total deposits70.769.474.572.672.5
FX liabilities to total liabilities 2/81.781.183.881.681.8
FX loans to total loans 2/81.885.087.188.988.2
Nonfinancial Enterprises 4/
Total debt to equity202.0217.6281.2226.5**
Return on equity31.114.41.78.4**
Earnings to interest expenses496.7225.924.1324.1**
Households
Household debt to GDP42.441.148.146.3
Household debt service to GDP 5/2.52.72.52.0
Real Estate Markets
Real estate prices annual growth rate 6/-7.3-37.1-39.67.65.8
Residential real estate loans to total loans 7/31.630.531.332.132.1
Commercial real estate loans to total loans 7/17.819.519.918.0
Memorandum Items
Number of banks dealing with residents 2/914151515
Number of banks dealing with non-residents 2/1413121414
Assets of banks dealing with residents to total banking system assets 2/60.863.978.466.666.5
Assets of banks dealing with non-residents to total banking system assets 2/39.236.121.633.433.5
Source: Latvian Authorities

Excluding Parex Bank.

September 2010.

From 2009, regulatory Tier 1 capital to risk weighted assets is calculated as Tier 1 capital (including deduction) to risk-weighted assets.

Banks dealing with residents (non-residents) are defined as banks in which non-resident non-MFI deposits are below (above) 20 percent of assets.

Including euro-denominated positions.

Data are not annualized and so may not be comparable; From 2010 Q2 the data cover all nonfinancial enterprises.

Interest payments only.

Prices of typical standard apartments in Riga. Source: Real estate company Latio.

Loans to residents as a share of total loans (including loans to non-residents).

Source: Latvian Authorities

Excluding Parex Bank.

September 2010.

From 2009, regulatory Tier 1 capital to risk weighted assets is calculated as Tier 1 capital (including deduction) to risk-weighted assets.

Banks dealing with residents (non-residents) are defined as banks in which non-resident non-MFI deposits are below (above) 20 percent of assets.

Including euro-denominated positions.

Data are not annualized and so may not be comparable; From 2010 Q2 the data cover all nonfinancial enterprises.

Interest payments only.

Prices of typical standard apartments in Riga. Source: Real estate company Latio.

Loans to residents as a share of total loans (including loans to non-residents).

Table 12.Latvia: Selected Vulnerability Indicators, 2006-11
200620072008200920102011 1/Latest Observation
Key economic and market indicators
Real GDP growth (y-o-y, percent)12.210.0-4.2-18.0-0.3Q4, 2010
HICP inflation (period average, percent)6.610.115.33.3-1.24.1Mar-11
Short-term (ST) interbank rate, 1-month RIGIBOR (eop, percent)2.96.813.32.70.60.6May-11
Eurobond secondary market spread (bps, eop)2374648505307152May-11
Exchange rate (lats per U.S. dollar, eop)0.530.480.520.480.530.48Apr-11
Exchange rate (lats per U.S. dollar, period average)0.560.510.480.480.530.49Apr-11
External sector
Exchange rate regimePegged to the euro band)
Current account balance (percent of GDP)-22.5-22.3-13.18.63.6Q4, 2010
Net FDI inflows (percent of GDP)7.56.83.00.61.4Q4, 2010
Exports (percentage change of US$ value)16.235.918.8-17.18.035.0Feb-11
Real effective exchange rate index (2000=100, period average)89.295.1104.5110.3103.6102.9Feb-11
Gross international reserves (GIR, US$ billion)4.55.85.07.07.77.5Mar-11
GIR in percent of ST debt at remaining maturity (RM) excluding non-resident deposits262.9215.9160.7282.9311.8Q4, 2010
GIR in percent of ST debt at RM including banks’ non-resident FX deposits43.034.237.267.083.0Q4, 2010
Net international reserves (NIR, US$ billion)4.45.73.92.01.61.2Mar-11
Total gross external debt (ED, percent of GDP)114.0127.6129.2156.3165.2Q4, 2010
ST external debt (original maturity, percent of total ED)44.143.233.524.632.6Q4, 2010
ED of domestic private sector (percent of total ED)94.896.091.683.579.9Q4, 2010
Total gross external debt (percent of exports)259.6308.6308.1362.2312.6Q4, 2010
Gross external financing requirement (US$ billion) 2/6.68.811.86.314.4Q4, 2010
Public sector (PS) 3/
Basic balance (excluding bank restructuring costs; percent of GDP)-0.50.6-3.3-7.1-6.4Q4, 2010
Primary basic balance (percent of GDP)0.11.0-2.9-5.9-5.0Q4, 2010
Gross PS financing requirement (percent of GDP) 4/2.20.38.915.912.6Q4, 2010
General government gross debt (percent of GDP)9.97.817.132.839.9Q4, 2010
Financial sector (FS) 5/
Capital adequacy ratio (percent)10.211.111.814.614.615.0Feb-11
Overdue loans (percent of total loans) 6/0.50.83.616.419.018.7Feb-11
Provisions (percent of overdue loans)93.364.961.357.461.663.6Feb-11
Return on average assets (percent)2.12.00.3-3.5-1.60.5Feb-11
Return on equity (percent)25.624.24.6-41.6-20.46.2Feb-11
Residents’ FX deposits (percent of total resident deposits)41.248.248.655.650.351.6Feb-11
FX loans to residents (percent of total loans to residents)76.986.388.492.192.291.8Feb-11
Credit to private sector (percent change, year-on-year) 7/33.011.0-6.9-8.4-8.7Feb-11
Memorandum item:
Nominal GDP (billions of U.S. dollars)19.928.833.927.224.0Q4, 2010
Sources: Latvian authorities and IMF staff calculations.

Latest observations as indicated in the last column.

Current account deficit plus amortization of external debt.

Public sector covers general government.

Overall balance plus debt amortization.

Financial sector includes commercial banks.

90-days overdue.

Total loans less loans to the public sector and transit loans, provided to both residents and non-residents.

Sources: Latvian authorities and IMF staff calculations.

Latest observations as indicated in the last column.

Current account deficit plus amortization of external debt.

Public sector covers general government.

Overall balance plus debt amortization.

Financial sector includes commercial banks.

90-days overdue.

Total loans less loans to the public sector and transit loans, provided to both residents and non-residents.

Table 13.Latvia: Proposed Schedule of Reviews and Purchases
Amount of purchase
Date 1/Millions of SDRsPercent of quotaConditions
December 29, 2008535.344376.7Approval of arrangement
August 31, 2009178.448125.6First review, end-March 2009 performance criteria
February 19, 2010178.448125.6Second review and end-September 2009 fiscal performance criteria and end-December 2009 monetary performance criteria
August 12, 201090.00063.3Third review and end-March 2010 fiscal performance criteria and end-June monetary performance criteria
May 15, 2011107.87775.9Fourth review and end-December 2010 performance criteria
November 15, 2011431.509303.7Fifth review and end-August 2011 performance criteria
Total1521.6261070.8
Source: IMF staff estimates.

For past purchases, actual dates are shown. For potential future purchases, the earliest possible dates are shown.

Source: IMF staff estimates.

For past purchases, actual dates are shown. For potential future purchases, the earliest possible dates are shown.

Table 14.Latvia: Program Financing, 2010-11(millions of euros)
201020112010Q1 to
Mar.Jun.Sep.Dec.Mar.Jun. Sep.Dec.2011Q4
ProjectionsProj.
Total financing requirements1,5114714571,2641,4819205826527,338
Amortizing debt1,201822347768067925416175,202
Other sectors-42153-24198104179129208903
Banks1,243669372-1227026144124094,298
of which:
Public3132519023023300783
Subs930644182-1457023814124093,515
Short term liabilities490-2812765392-30-13-64773
Trade credit (net)-14412-113-31623-28-18-128
Resident FX accumulation-36-82-531,187121155811181,492
Total financing sources8174712511,0641,4819205825526,138
Current account35126253-1617614547-35982
Direct investment (net)-148721092198294105214746
Portfolio investment and financial derivatives (net)-30-8820-212-12375-12358400
o/w government eurobond000003700370740
Capital account13863975550454036523
Other1,147-70438869713556183-2333,603
Change in gross reserves (+ denotes decline)-641232-465149472-295220212-115
Financing gap69402062000001001,200
Official financing69402062000001001,200
IMF194010600000300
EU500002000000700
Nordics000000000
World Bank001000000100200
Czech Republic000000000
EBRD000000000
Poland000000000
Memorandum Item
Lines of credit (cumulative stocks)007507507508508501,4001,400
Nordics005505505505505501,1001,100
Czech Republic 1/00100100100200200200200
Poland 1/00100100100100100100100
Source: IMF staff estimates.

Loan agreements not yet signed.

Source: IMF staff estimates.

Loan agreements not yet signed.

Table 15.Latvia: Indicators of Fund Credit, 2009-16(millions of SDR)
20092010201120122013201420152016
Stock, existing 1/713.8982.2982.2692.3257.256.10.00.0
Stock, existing and prospective 1/713.8982.21521.61231.6796.6568.5242.70.0
Obligations, existing11.26.620.2314.6448.6204.256.50.0
Repurchase0.00.00.0290.0435.1201.156.10.0
Charges11.26.620.224.613.53.00.40.0
Obligations, existing and prospective11.26.625.5333.9467.7246.8334.2244.8
Repurchase0.00.00.0290.0435.1228.1325.8242.7
Charges11.26.625.544.032.618.78.52.1
Stock of existing Fund credit
In percent of quota502.3691.2691.2487.2181.039.50.00.0
In percent of GDP4.26.25.93.91.40.30.00.0
In percent of exports of goods and services9.811.810.06.52.30.50.00.0
In percent of gross reserves16.519.521.715.35.11.00.00.0
Stock of existing and prospective Fund credit
In percent of quota502.3691.21070.8866.7560.6400.1170.80.0
In percent of GDP4.26.29.17.04.32.91.20.0
In percent of exports of goods and services9.811.815.511.67.04.71.90.0
In percent of gross reserves16.519.533.627.215.810.44.90.0
Obligations to the Fund from existing Fund drawings
In percent of quota7.84.614.2221.4315.7143.739.70.0
In percent of GDP0.10.00.11.82.41.10.30.0
In percent of exports of goods and services0.20.10.23.04.01.70.40.0
In percent of gross reserves0.30.10.46.98.93.71.10.0
Obligations to the Fund from existing and prospective Fund drawings
In percent of quota7.84.617.9235.0329.1173.7235.2193.1
In percent of GDP0.10.00.21.92.51.31.61.1
In percent of exports of goods and services0.20.10.33.14.12.12.61.8
In percent of gross reserves0.30.10.67.49.34.56.80.0
Source: IMF staff estimates.

End-period. The authorities have indicated their intention of treating the purchases associated with the Fourth and Fifth Reviews as precautionary. “Existing and prospective” assumes that these amounts are drawn.

Source: IMF staff estimates.

End-period. The authorities have indicated their intention of treating the purchases associated with the Fourth and Fifth Reviews as precautionary. “Existing and prospective” assumes that these amounts are drawn.

31. The authorities have requested a rephasing of remaining amounts under the arrangement, making them available subject to one final review, which will focus on the 2012 budget (Table 13). Given delays completing this Fourth Review—due to the October 2010 elections and time needed to identify 2011 fiscal measures—performance criteria would be set for end-August, with indicative targets for end-June and end-September, so that the Fifth and final review can be completed before the program ends on December 22, 2011. The additional amount associated with the Fifth Review (SDR 432 million) would become available only subject to understandings on a strong 2012 budget aimed at bringing the deficit safely below the Maastricht criterion. Given the improving financial position, the authorities intend to treat IMF, EU, and bilateral funds as precautionary, and will only draw EUR 100 million from the World Bank which is expected to be approved shortly (Table 14).

32. Staff encouraged the authorities to increase market borrowing to help prepare for full reliance on private financing after the program period:

  • The authorities intend to lengthen maturities—2- and 5-year bonds are being considered after the recent issuance of 10-year bonds—but have generally limited issuance given that they used program funds instead and wished to keep interest rates very low. While program funds originally intended for budget support have been used up, funds set aside for the financial sector (about €650 million) are being released gradually for budgetary use as banking reforms progress and risks fall (LOI ¶6). Even so, staff encouraged more ambitious domestic issuance, noting that banks’ substantial excess liquidity means there is little risk of crowding out.
  • Building on their strong budget performance, lower CDS, and improved credit ratings, the authorities intend to return to international markets soon. Completion of the review may lead to investment grade status from all three major credit rating agencies, and thus more favorable terms.
  • While domestic and international issuances are now expected to push public debt to around 50 percent of GDP in 2014, this includes a build-up in government deposits in preparation for large amortizations (including program funds) coming due in 2014 and 2015, so that net debt will be much lower (Tables 3-5 and Figure 8).

Figure 8.Latvia: Public Debt Sustainability: Bound Tests 1/

(Public debt in percent of GDP)

Source: IMF 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/ Permanent 1/4 standard deviation shocks applied to real interest rate, growth rate, and primary balance.

3/ One-time real depreciation of 30 percent and 10 percent of GDP shock to contingent liabilities occur in 2010, with real depreciation defined as nominal depreciation (measured by percentage fall in dollar value of local currency) minus domestic inflation (based on GDP deflator).

33. Latvia is expected to be in a comfortable position to repay the Fund (Table 15). Outstanding Fund credit is projected to reach about 22 percent of gross reserves in 2011 with repayments peaking in 2013 at 2.4 percent of GDP and 8.9 percent of gross reserves. Gross external debt is projected to fall steadily from its 2010 peak of 165 percent of GDP while net external debt is substantially lower (54 percent of GDP in 2010) and falls over the medium term (Tables 7-8 and Figure 9). Latvia’s capacity to repay would be further enhanced by continued progress toward euro adoption and the resulting ability to tap international markets at lower cost and to be able to economize on the need for international reserves.

Figure 9.Latvia: External Debt Sustainability: Bound Tests 1/

(External debt in percent of GDP)

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

1/ Shaded areas representactual data. Individual shocks are permanentone-half standard deviation shocks. Figures in the boxes representaverage projections for the respective variablesin the baseline and scenario being presented. Ten-year historical average forthe variable is also shown.

2/Permanent1/4 standard deviation shocks applied to real interest rate, growth rate, and current accountbalance.

3/One-time real depreciation of 30 percentoccurs in 2011.

34. Staff encouraged the authorities to begin considering how the Fund might best support Latvia’s efforts beyond program expiration in December. While the program has at times been demanding, the authorities appreciated that the financial and policy support from the IMF, EC, and bilateral partners under the program had contributed to the successful adjustment effort. While post-program monitoring (required since exceptional resources remain outstanding) is the most likely scenario, the authorities will consider whether a short-term precautionary arrangement to support strong policies until the Maastricht criteria are met could be helpful. However, they will not request an arrangement if this would jeopardize euro adoption chances and would consult with the EC beforehand; for example, the ECB has suggested that even a precautionary arrangement could signal that Latvia is not converging sustainably. An ex-post evaluation is expected in 2012.

IV. Risks

35. Overall risks have fallen substantially, with the recovery taking hold and further adjustment having been achieved. The chances of Latvia tipping back into recession or experiencing serious financial pressures are much less at this stage, but risks remain:

  • External environment. Commodity price increases could raise inflation and accelerate the current account deterioration, making it harder to maintain reserves. Uncertainties around Europe’s growth outlook could weigh on external demand and, in an extreme scenario, reduce external liability rollover rates.
  • Politics. Although Prime Minister Dombrovskis’ electoral grouping gained seats in October, the coalition has at times lacked cohesion, though now seems more committed to fiscal discipline. The coming presidential election (elected by members of Parliament) could prove a challenge. However, alternative governments would likely be much less committed to economic reform.
  • Reform fatigue/fiscal slippages. Securing further adjustment in 2012 after 3 years in which 15 percent of GDP in adjustment measures have been taken will not be simple technically (easier savings have already been taken) or politically.
  • Delay in euro adoption would lower confidence, perpetuate exchange rate risk, and make it harder for Latvia to refinance external amortizations at low interest rates. In addition to 2012 fiscal challenges, inflation could also be a risk. Euro area problems might also lead to stricter application of the more subjective elements in the convergence assessment.
  • Financial sector. While risks are greatly diminished, careful handling of the MLB restructuring and the next steps on Citadele/Parex is needed. Bank restructuring costs associated with Citadele/Parex have been recognized in ESA terms upfront. Any possible costs associated with MLB should be recognized in 2011 so as not to complicate attainment of the Maastricht fiscal criterion.
  • Longer-term competitiveness and stability. Challenges in the euro area highlight the need in a currency union for a flexible economy and fiscal discipline to maintain competitiveness and provide scope for counter-cyclical policy. Latvia has demonstrated its ability to execute internal devaluation, but will need to continually enhance productivity and efficiency in the future.
  • That said, compared to previous reviews, the risks are considerably lower and increasingly within the hands of the Latvian authorities to solve.

V. Staff Appraisal

36. The economic recovery is strengthening. Improving confidence and a recovery in private investment are expected to more than offset factors dragging down domestic demand (unemployment, fiscal consolidation, and difficulties accessing credit) and should support a return to growth. Inflation has picked up due to world food and energy prices and tax increases, although core inflation remains contained. However, job creation is still weak and shifting workers formerly employed in construction will be difficult so that, save for migration or declining labor market participation, unemployment could remain in double digits for some time. The authorities may need to augment their active labor market policies with more creative reforms targeted toward the long-term unemployed or other disadvantaged groups.

37. Program performance has been good in terms of macroeconomic targets, less so in terms of structural reform. Despite some spending increases before October’s elections, the authorities met their 2010 fiscal performance criteria and indicative targets by comfortable margins. NIR and NDA performance criteria were also met, and performance remains strong so far in 2011. Although some structural benchmarks were delayed or not completed, the authorities have finally submitted their MLB restructuring plan to the EC, and intend to submit a fiscal responsibility law to Parliament and complete development of their strategy to reform SOEs this year.

38. With the program almost complete, the next key target is to fulfill the euro adoption criteria in a convincing and sustainable way. This means lowering the deficit to well below the 3 percent reference value and demonstrating further deficit reductions in the out years to show EU institutions and member states that the target has been met in a sustainable way. It also means taking steps to improve price competition and to ensure that next year’s fiscal consolidation focuses on expenditure cuts, rather than tax increases, so as to contain domestic inflation. Euro adoption would mark a successful exit from Latvia’s ambitious and difficult program. Conversely, a delay in euro adoption when Latvia is so close would be a tremendous lost opportunity to eliminate exchange rate risk and lower borrowing costs.

39. Though substantial progress has been made in reducing the budget deficit, the authorities should make a final push to reduce the deficit well below 3 percent of GDP in 2012. The authorities’ phenomenal 2009-11 adjustment effort has put the Maastricht deficit criterion solidly within reach although continued strong implementation in 2011 will be necessary. Any revenue over-performance or other savings should be used to achieve a lower deficit (apart from social safety net needs or greater absorption of EU funds). The authorities’ decision to aim at a 2012 deficit of 2.5 percent of GDP should help demonstrate their commitment to meeting the Maastricht criteria in a sustainable way, while not taking risks with meeting the target.

40. To achieve this target, it will be important to keep all options on the table and identify high-quality measures early in the budget cycle. Unfortunately, political considerations complicate a serious discussion of ways to find savings from pensions (which increased massively during the boom and are absorbing an increasing share of GDP, thus forcing higher taxes or spending cuts elsewhere) in a way that guarantees the poorest pensioners are protected. The authorities’ targets for the grey economy are ambitious, but need to be monitored carefully to ensure they are met. With unemployment likely to persist, and few registered unemployed actually receiving benefits, the authorities should be wary of phasing out emergency social safety net programs to find fiscal savings. Instead, they should work closely with the World Bank to integrate these emergency schemes into a robust permanent safety net.

41. Institutional reform could help ensure fiscal sustainability once the program has ended. The authorities already have a draft fiscal responsibility law, but should revise it to ensure it is sufficiently countercyclical and not so tight as to be unrealistic (and overridden) in downturns. Once a reasonable law has been designed, the authorities are aiming for broad political support for the constitutional reform that will likely be needed to make sure it takes precedence over other laws so that it is respected during the budgetary process. Constitutional reform may also be necessary to make the proposed medium-term budget framework law effective.

42. The authorities should prepare reforms to promote price flexibility and price stability. Latvia’s successful adherence to its fixed exchange rate demonstrates its underlying commitment to price stability. However, to minimize the risk that Latvia might miss the Maastricht numerical criterion for price stability, fiscal adjustment in 2012 needs to be based on sustainable measures, such as structural spending cuts and tax increases that would not affect inflation (e.g., real estate taxes). This underlines the importance of reforming the cadastre, implementing structural reforms, introducing greater competition into product markets by enhancing the powers of the Competition Authority, and improving management of SOEs. These reforms should also help sustain competitiveness, including if Latvia were to be admitted to the euro area.

43. Adjustment of official interest rates may be needed to support the fixed exchange rate, especially now that the ECB appears to be entering a tightening cycle. Should international reserves continue to decline, there would be a prima facie case for raising interest rates, particularly as interbank rates are now below those in the euro area. Given its decision to peg the exchange rate, the BoL should as far as possible mimic the behavior of the ECB to maintain the credibility of the peg and to show preparedness for monetary policy being determined by the ECB.

44. The authorities need to implement their long delayed plans for reforming state-owned banks and continue their efforts to promote market-based debt restructuring. Though long overdue, the authorities’ decision to submit their MLB restructuring plan is welcome, but they now need to hire an independent, well-qualified, and experienced sales consultant, and limit further fiscal losses. Similarly, successful implementation of the Parex and Citadele restructuring and sales strategies should maximize the recovery of state-aid while reducing state involvement in the banking sector. The authorities also need to avoid undermining the status of secured creditors and the important progress that has been made in promoting market-based debt restructuring.

45. While the situation in Latvia is much improved, risks to the program and the authorities’ goal of euro adoption remain. These include the possibility that politics and reform fatigue complicate achievement of additional deficit reduction, and that global commodity price increases slow domestic demand and raise inflation. Variability in the Maastricht reference value for price stability introduces additional uncertainty. Efforts should focus on meeting all Maastricht criteria in a sustainable way.

46. Latvia’s program implementation has underpinned the economic recovery now underway. Latvia’s intention to return to international markets and to treat this and potential future purchases as precautionary reflects the marked improvement in external financing conditions. Staff supports the authorities’ request for completing the Fourth Review and financing assurances review on the basis of Latvia’s performance under the arrangement, and the policy commitments specified in the Letter of Intent. Staff also recommends granting a waiver of nonobservance of the continuous performance criterion on imposing or intensifying restrictions on the making of payments and transfers for current international transactions, and approval of the authorities’ request to rephase the remaining purchases under the arrangement.

1The balance in the income account in early 2009 is artificially high due to the treatment of bank losses. Debt write-downs and other valuation effects were booked as a credit in the income account.

Other Resources Citing This Publication