Background

Latvia has enjoyed continued strong economic performance since the last Article IV consultation in January 2002. Real GDP growth was 7.9 percent in 2001 and 6.1 percent in 2002; growth has been led by investment and, more recently, consumption. Real per capita GDP now stands some 50 percent above its 1995 level. Inflation remains low and was under 1½ percent in 2002. The current account deficit rose to nearly 10 percent of GDP in 2001, partly reflecting stagnant external demand and one-time factors, while a deficit of below 8 percent of GDP was recorded in 2002. This apparent improvement, however, was due to improved coverage of certain exports and private transfers, masking a deterioration in the underlying external position. Nevertheless, Latvian exporters have demonstrated resiliency in the face of the slowdown in western Europe, quickly reorienting toward other export markets. Inflows of Foreign Direct Investment were strong in 2002, covering about three-fifths of the current account deficit and helping to keep external debt levels moderate. Financial market sentiment towards Latvia remains favorable, as evidenced by relatively low yield spreads on Latvia’s Eurobonds.

This performance owes much to past macroeconomic policy but fiscal control lapsed significantly in late 2002. While the general government fiscal deficit declined by 1 percentage point to 2.2 percent of GDP in 2001 and was kept to 0.7 percent of GDP during the first nine months of 2002, the fiscal position loosened abruptly in the last quarter of the year and the annual deficit rose to 2.7 percent of GDP. This mainly reflected a surge in spending late in the year, while tax and non-tax receipts continued to be buoyant. This spending surge led to reversal of the expenditure tightening that had been accomplished since 1999.

Supported by appropriate monetary policies, the exchange rate peg of the lats to the SDR has contributed to price stability and a stable macroeconomic framework. The growth of credit to the private sector remained high in 2002, but household borrowing taking on increased importance relative to enterprise borrowing; along with the strong wage growth, this contributed to higher rates of consumption. Latvia has continued to improve its financial sector infrastructure under the Financial and Capital Markets Commission, established in July 2001, and is actively aligning its legal and regulatory frameworks for anti-money laundering (AML) and combating the financing of terrorism (CFT) to international standards.

Together with its largely successful macroeconomic policies, political, institutional, and structural reforms underpinned the invitations Latvia received in late 2002 to join the European Union and North Atlantic Treaty Organization. EU membership is scheduled for May 2004.

In July 2002, the IMF Executive Board completed the first and second reviews under Latvia’s 20-month Stand-By Arrangement. The Stand-By Arrangement expired in December 2002.

Executive Board Assessment

Executive Directors noted that Latvia’s growth and inflation performance in 2002 was among the best of the EU accession countries, and that the economy has demonstrated resiliency in the face of relatively slow growth among its major trading partners. However, Directors expressed concern about the magnitude and persistence of unemployment and the external current account deficit, recognizing this deficit both as a sign of Latvia’s transition and as its key vulnerability.

Directors noted that Latvia has completed an impressive decade of transition during its first 10 years of IMF membership, embracing sound fiscal and monetary policies at an early stage and setting the stage for the pursuit of structural reforms and for a remarkable growth and inflation performance. Real per capita GDP has risen more than 50 percent since 1995 and inflation has remained at or below 3 percent since 1998. Together with political and institutional reforms, the transition to a market economy has helped Latvia garner an invitation for EU membership. The IMF has supported Latvia’s transition through a series of Stand-By Arrangements, which have been treated as precautionary since 1995, with the last one expiring on December 19,2002.

Looking ahead, Directors observed that Latvia is poised for continued strong growth in 2003 and over the medium term, provided the authorities maintain prudent macroeconomic policies and forcefully implement the remaining structural reform agenda. The authorities will need to be watchful of the persistent current account deficit. Latvia’s economy appears to be competitive, and further diversification of exports and deeper trade integration with the EU will help contribute to strong economic growth over the medium term. With strong policy resolve, Latvia should be in a position to generate the productivity growth necessary to gradually close the income gap with the EU.

Directors agreed that the exchange rate peg to the Special Drawing Rights and the current value of the lats remain appropriate. The peg should remain the anchor of Latvia’s economic strategy during the period leading to EU entry. Directors considered Latvia well positioned to join ERM II after EU accession as a precursor to the adoption of the euro. They underlined the importance of a good public understanding of the implications of the shift in the exchange rate regime. Directors recognized that the monetary policy conduct of the Bank of Latvia in support of the exchange rate peg has been broadly appropriate, but some cautioned against further cuts in the interest rate. Directors were also concerned with the occasional resort to the use of short-term foreign exchange swaps in amounts deemed excessive.

Directors underscored the importance of a prudent fiscal policy, given Latvia’s large current account deficit, buoyant domestic demand, and expenditure commitments associated with EU and NATO membership. They regretted the resort to an expansionary supplementary budget and the loss of expenditure discipline toward the end of 2002, which had reversed the strong fiscal performance throughout much of the year. These developments stand in contrast with the more positive fiscal developments in the neighboring Baltic countries, which also face expenditure pressures associated with EU and NATO accession.

Against this background, Directors welcomed the authorities’ intention to move toward a balanced budget over the medium term, and underscored the importance of early decisive steps in this direction. They noted the adoption of general government fiscal deficit of about 3 percent of GDP in the 2003 budget law, and regretted that this signaled further fiscal relaxation in the context of strong economic growth. Directors therefore called upon the authorities to quickly resume the path of fiscal consolidation, including by redoubling their efforts to durably reduce non-priority spending, improving medium-term budget planning, and enhancing the efficiency of spending. They also urged the authorities to exercise restraint in further raising wages following the sharp increase in the government wage bill in 2002, and they suggested that the introduction of the new merit-based pay scale in 2004 be combined with efforts to improve the efficiency of the civil service. Enhanced efforts to monitor expenditure commitments and advance payments are also required.

Directors noted that the reductions of the social and corporate income tax rates that took effect in January 2003 provide an unwarranted fiscal stimulus at a time when Latvia is enjoying buoyant growth. They urged that further tax rate reductions be delayed until Latvia’s fiscal performance has improved. Most Directors suggested that at that time, reducing payroll taxes would probably warrant higher priority than reducing corporate taxes-already among the lowest of EU member and accession countries. The authorities should also move aggressively to improve tax collections and curtail tax exemptions.

Noting that the 2002 amendments to the Law on Local Government Budgets had done little to enhance control over subnational fiscal positions, Directors urged the authorities to monitor developments and take steps to enhance local government discipline. Directors felt that according local governments some scope to influence their tax revenues would, by providing flexibility in setting property and personal income tax rates, complement, and perhaps facilitate, steps to tighten control over deficits.

While noting that the banking system is well-supervised and financially sound, Directors welcomed the authorities’ initiatives to strengthen financial sector surveillance. The authorities have brought their regulatory and supervisory framework largely in line with international standards. They have also made progress in monitoring the continued large inflows of nonresident deposits and the rapid growth of credit, particularly foreign-currency credit, such as through their new financial sector stability reports. Directors urged the authorities to remain vigilant to possible risks and emerging financial sector vulnerabilities in these areas, and to be ready to take action as necessary. Directors welcomed the authorities’ steps to strengthen the framework for AML and CFT, in order to bring Latvia into full compliance with international AM L/C FT standards.

Directors stressed that progress against corruption and state capture will be critical for allowing Latvia to improve its business climate and achieve its full growth potential. They welcomed the authorities’ recent steps to reduce corruption, including through the adoption of a national anti-corruption strategy and the opening of an anti-corruption bureau. They also encouraged the authorities to build on the recent divestment of the state gas and shipping companies and to complete the process of large-scale privatization.

Directors commended the continued evolution of the Action Plan to Improve the Business Environment, which has helped to remove unnecessary administrative barriers and other obstacles to business. They emphasized the need to maintain Latvia’s flexible labor market institutions and policies while addressing the underlying causes of the high, albeit declining, unemployment rate. In this context, Directors stressed that wage growth needs to be contained to improvements in productivity in order to safeguard Latvia’s external competitiveness.

Republic of Latvia: Selected Economic Indicators

Sources: Latvian authorities and IMF staff estimates.

^1/Excludes government-guaranteed debt.

^2/CPI-based, end-of-period.

Republic of Latvia: Selected Economic Indicators

	1997	1998	1999	2000	2001	2002
		Changes in percent
Real Economy
Real GDP	8.4	4.8	2.8	6.8	7.9	6.1
Unemployment rate (ILO, end of period)	14.4	13.7	14.5	14.6	12.8	11.6
Consumer price index (end of period)	7.0	2.8	3.2	1.8	3.2	1.4
		In percent of GDP
Public Finance
General government balance	0.3	−0.8	−3.9	−3.2	−2.2	−2.7
Total government debt 1/	12.0	10.5	13.0	13.1	15.0	14.6
External government debt 1/	6.7	6.4	9.2	8.2	9.5	8.9
		End-period; changes in percent
Money and credit
Reserve money	31.2	6.7	11.6	7.7	8.8	22.4
Broad money	38.6	6.0	8.0	27.9	20.8	20.9
Domestic credit (non-government)	76.2	58.6	15.3	36.7	50.4	36.5
	In percent of GDP unless stated otherwise
Balance of payments
Trade balance	−15.1	−18.6	−15.4	−14.8	−17.6	−17.2
Current account balance	−6.1	−10.6	−9.7	−6.9	−9.6	−7.8
International reserves	2.5	2.9	2.9	2.6	3.0	2.9
(in months of imports)
Exchange rate
Exchange rate regime	Peg to the SDR
Exchange rate (lats per USS;	0.581	0.590	0.585	0.607	0.628	0.618
period average)
Real effective exchange rate	80.0	91.4	98.8	98.9	97.0	91.8
(2000 = 100) 2/

Sources: Latvian authorities and IMF staff estimates.

^1/Excludes government-guaranteed debt.

^2/CPI-based, end-of-period.

View Table

Republic of Latvia: Selected Economic Indicators

	1997	1998	1999	2000	2001	2002
		Changes in percent
Real Economy
Real GDP	8.4	4.8	2.8	6.8	7.9	6.1
Unemployment rate (ILO, end of period)	14.4	13.7	14.5	14.6	12.8	11.6
Consumer price index (end of period)	7.0	2.8	3.2	1.8	3.2	1.4
		In percent of GDP
Public Finance
General government balance	0.3	−0.8	−3.9	−3.2	−2.2	−2.7
Total government debt 1/	12.0	10.5	13.0	13.1	15.0	14.6
External government debt 1/	6.7	6.4	9.2	8.2	9.5	8.9
		End-period; changes in percent
Money and credit
Reserve money	31.2	6.7	11.6	7.7	8.8	22.4
Broad money	38.6	6.0	8.0	27.9	20.8	20.9
Domestic credit (non-government)	76.2	58.6	15.3	36.7	50.4	36.5
	In percent of GDP unless stated otherwise
Balance of payments
Trade balance	−15.1	−18.6	−15.4	−14.8	−17.6	−17.2
Current account balance	−6.1	−10.6	−9.7	−6.9	−9.6	−7.8
International reserves	2.5	2.9	2.9	2.6	3.0	2.9
(in months of imports)
Exchange rate
Exchange rate regime	Peg to the SDR
Exchange rate (lats per USS;	0.581	0.590	0.585	0.607	0.628	0.618
period average)
Real effective exchange rate	80.0	91.4	98.8	98.9	97.0	91.8
(2000 = 100) 2/

Sources: Latvian authorities and IMF staff estimates.

^1/Excludes government-guaranteed debt.

^2/CPI-based, end-of-period.