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Statement by Mr. Benny Andersen, Executive Director for Latvia and Mr. Gundars Davidsons, Advisor to Executive Director July 11, 2012

Author(s):
International Monetary Fund
Published Date:
July 2012
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1. The economy is rebounding from the recession

Latvia’s economy is recovering strongly, though recent trends, shaped by external demand dynamics, suggest a gradual slowdown. The current government, led by the same Prime Minister who started off the process of consolidation, can now reap the harvest sown in 2009. All through 2011, the GDP, government revenues and export figures continued to surprise on the upside. After a 5.5 percent GDP growth in 2011, a 6.9 percent growth number in the first quarter of 2012 kept the economy at the top of the list of EU growth performance. The conservative end-2011 projections did not materialize and the export sector demonstrated a remarkable resilience through the first months of 2012. The recent trends in exports figures, however, point to a slowdown in the second half of 2012. Due to a rebound in investment, the net export has become negative, but a significant widening of the current account is not expected. Ongoing deleveraging and subdued real estate sector will make it difficult to re-run the 2004–2007 experience in the foreseeable future.

The roots of the strong recovery can be tracked down to the frontloaded fiscal adjustment in 2009. The Latvian authorities believe that the speed of adjustment was the key reason behind the success of Latvia’s Stand-By Arrangement. The decisive actions taken in the summer of 2009, when the authorities chose to follow a more frontloaded fiscal adjustment path than the “program scenario” suggested in the First Review report, pulled the Latvian economy out of a tailspin. Some sectors of the economy, like manufacturing exports, returned to growth already at the end of 2009 and continued to grow at impressive rates over the next two years. However, weak confidence, nourished by the doomsday scenarios prophesied by influential economic pundits and investment bank analysts delayed the rebound in investment and domestic demand. Presently, the economy is experiencing a belated revival of those GDP components, finally contributing to the output growth.

The Latvian authorities believe that their experience could help to better understand the process of adjustment under a fixed exchange rate. It seems that at the outset of the program, neither the economic nor political dynamics of adjustment under a fixed exchange were sufficiently understood. The authorities believe that the quality of future programs would benefit from more in-depth studies of the assumptions and models behind the sizable forecast errors of many parties making projections or just commenting on Latvia’s economy in 2009 and 2010. We are pleased to note that the recent joint IMF/Bank of Latvia conference reviewing Latvia’s experience has been successful in provoking some discussion of those issues.

2. Euro adoption on January 1, 2014 remains the authorities’ strategic goal

The authorities expect to meet the Maastricht fiscal deficit criterion confidently. The 2011 fiscal deficit figures came in considerably below the previously set target. For 2012, both the authorities and staff forecast a deficit figure of 2 percent, well below the 3 percent Maastricht criterion, though strong revenue performance in the first half of the year indicates that the final deficit figure could be even lower.

The authorities are taking steps to establish a framework safeguarding fiscal sustainability. In May, the EU Fiscal Compact was ratified by parliament. The authorities are on their way to make the Fiscal Responsibility Law (FRL), incorporating key features of the Fiscal Compact, operational by the end of October 2012. This will ensure that starting from the 2014 – 2016 period the budget Framework Law will be drafted in accordance with the FRL rules.

In line with their obligations under the EU Fiscal Compact, the Latvian authorities intend to reduce the structural deficit by 0.5 percent of GDP annually. Mindful of the fiscal effect of the cuts in personal income tax (PIT) the Latvian authorities have already identified some offsetting measures; first, real estate property reform, which is expected to be completed in 2013 and, as suggested by staff, will include a substantial improvement of property valuation; and second, excise taxes on tobacco will be raised and brought in line with EU minimal requirements. The government is committed to initiate additional measures, if necessary, to ensure that the fiscal deficit remains in line with the planned path of the structural deficit. With regards to the PIT cuts, we note staff’s preference for raising the PIT allowance threshold. The authorities have always carefully considered the equity dimension of their decisions, which is also reflected in the fact that the Gini coefficient has improved during the crisis.1 Nevertheless, the final choice was strongly advocated by members of the business community who believed that cutting the PIT rate would allow them to attract and retain better-qualified employees.

Inflation remains on a downward path, in line with the authorities’ plans. The peg has helped to keep the inflation rate low, and with the headline inflation at 2.2 percent and core inflation at 1.1 (May figures), the Maastricht criterion seems to be within reach. We agree with staff that there is some uncertainty surrounding the choice of the Maastricht inflation and interest rate reference values. Nevertheless, since the authorities are confident that the European Commission and the ECB will apply Maastricht criteria in an economically meaningful manner, they also believe that Latvia’s prospects of meeting the criteria are good.

3. Strengthening of the financial supervision is underway

The Financial and Capital Market Commission is taking measures to minimize the risks associated with the non-resident banking business model. While recognizing the problem, the authorities believe that the risk is not as significant as perceived by staff. After the demise of Parex, the non-resident banking sector is largely isolated from the rest of the economy. Their usual business model involves a bank, not active in the domestic market, attracting deposits from non-residents and mostly investing in high quality and high liquidity assets abroad. Recognizing that the quality of those assets is difficult and time-consuming to verify, the authorities are introducing measures to limit the risks. They have already introduced additional capital requirements for banks focused on non-residents. The New Liquidity Framework, in particular the Liquidity Coverage Ratio (LCR), will impose strengthened requirements for liquidity positions of banks by preventing excessive maturity mismatches and encouraging the diversification of funding. Close monitoring of LCR including in each significant currency, and monitoring of the Net Stable Funding Ratio (NSFR) will begin in 2013.

In order to ensure that the process of deleveraging proceeds in an orderly manner, the authorities intend to cooperate closely with the Nordic supervisory authorities. As staff, we expect the deleveraging process to continue. The framework of supervisory colleges as well as other Nordic Baltic cooperation structures will be instrumental in facilitating the process of cooperation.

The authorities are pleased to have successfully found buyers for a large share of the Mortgage and Land Bank commercial assets. The authorities do not intend to sell the remaining assets at prices significantly below market value, and if no reasonably priced offer is received, the assets will be transferred to the Latvian Privatization Agency for a more gradual workout.

4. Looking forward, tackling the high unemployment rate and improving competitiveness are authorities’ key priorities

A significant reduction in the level of unemployment can only be achieved with the help of properly targeted labor market measures. The unemployment rate remains high. Paradoxically, the rate of employment is also high, exceeding pre-bubble figures before 2003.2 The bubble has induced a permanent rise in the participation rate and presently the economy is struggling to absorb this surplus labor, which has been activated and consequently released by the trade and real estate related sectors. The Latvian authorities are currently looking into policy options to stimulate employment, and the joint diagnostic report by the World Bank and Ministry of Welfare is expected to provide the necessary analytical underpinning for future decisions.

We concur with staff that future competitiveness improvements will depend on productivity-enhancing reforms. The authorities do not expect the near 7 percent output growth rates to last. Deceleration in export markets will inevitably slow output growth. Continued deleveraging and sluggish credit growth will continue to weigh on domestic demand, leaving productivity improvements in tradable industries as the key source of growth.

Education and governance reforms, increasing product market competition, and strengthening the legal system will be essential to keep the economy competitive. Staff’s suggestions on productivity-enhancing reforms are very much in line with the authorities’ views. Some necessary, though probably not sufficient, steps in reforming those areas have already been made. An outside evaluation of the higher education study programs and science performance is already ongoing. With regards to the product market competition, the authorities have strengthened the Competition Council: a new head of the Council was recently appointed and it seems that the increased payroll has helped to slow staff turnover. Improving the management of state owned enterprises is another priority. It is expected that a new system of management of State-owned-enterprises will become operational in the beginning of 2013. Those reforms are the first steps in building a more dynamic and competitive economy.

1Source: Eurostat
2Source: Eurostat

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