Republic of Latvia: Staff Report for the 2004 Article IV Consultation
Author: International Monetary Fund
Publication Date:
16 Aug 2004
eISBN:
9781451824520
Language:
English
Keywords:
ISCR; CR; deficit; fiscal policy; EU accession; Latvia; procedure; current account; GDP deflator; broad money; Baltics
Download PDF (541.7 KB)

This 2004 Article IV Consultation highlights that since the last Article IV consultation discussions, economic activity in Latvia has maintained its momentum. GDP grew 7½ percent in 2003 and 8¾ percent year over year in the first quarter of 2004; however, inflation climbed to 6.1 percent at end-June, from 3.6 percent at end-2003. Fiscal performance has improved appreciably, and public debt remains low. The general budget deficit, at 1.6 percent of GDP in 2003, narrowed by nearly 1 percentage point from 2002, reflecting lower-than-budgeted expenditures, unexpectedly high tax revenues, and lower net lending.

Abstract

This 2004 Article IV Consultation highlights that since the last Article IV consultation discussions, economic activity in Latvia has maintained its momentum. GDP grew 7½ percent in 2003 and 8¾ percent year over year in the first quarter of 2004; however, inflation climbed to 6.1 percent at end-June, from 3.6 percent at end-2003. Fiscal performance has improved appreciably, and public debt remains low. The general budget deficit, at 1.6 percent of GDP in 2003, narrowed by nearly 1 percentage point from 2002, reflecting lower-than-budgeted expenditures, unexpectedly high tax revenues, and lower net lending.

I. Background

A. A Glance at the Past

1. Latvia’s transition, culminating in EU accession in May 2004, has been a success story, but achieving real convergence with European standards of living remains a long-term objective. With an average annual rate of about 6 percent since 1996, GDP growth has been the highest among the new EU member countries (see chart). The narrow band around the SDR-lats exchange rate peg—introduced in 1994—together with responsible fiscal and monetary policies have fostered macroeconomic stability, while structural reforms have nurtured the development of a thriving private sector. Despite a very fractured political setup (eleven governments since independence) and institutional weaknesses, Latvia’s strong economic growth and reform efforts garnered invitations to join the EU and the NATO. These developments also helped attract large inflows of foreign direct investments (FDI), which, in turn, contributed to the financing of Latvia’s large current account deficit. However, per capita income is still below that of other acceding countries and stands at only one-third of the EU-15 average in PPP terms, suggesting that it may take several decades for Latvia to catch up with its richer neighbors.

uA01fig01

GDP per capita and Real GDP Growth

Citation: IMF Staff Country Reports 2004, 260; 10.5089/9781451824520.002.A001

Sources: Country authorities and International Financial Statisitcs, IMF.

2. The consistency between the Fund’s recommendations and the authorities’ views has been high. Following 7 Standby arrangements—with the last one expiring in December 2002—Latvia has been cited as an example of highly effective prolonged assistance by the Fund.1 Consultations have been constructive, and the quality of the policy dialogue with the Fund has been high. The authorities have, in particular, appreciated the Fund’s contribution to capacity building in the early transition years and its role in managing the banking crisis of 1995. The Fund’s advice has been followed in most instances, in particular in the development of a stable exchange rate regime and an effective banking supervisory framework, which led to the creation of the Financial and Capital Market Commission (FCMC) in 2000. Fiscal policy has also mostly been in line with the Fund’s recommendations, although recently, in the context of repeated political changes, the authorities on occasion have favored a looser stance than recommended by staff.

B. Recent Developments

3. Strong economic activity is maintaining its momentum. Led by robust domestic demand, real growth reached 7½ percent in 2003 and 8¾ percent (year-on-year) in the first quarter of 2004. Despite sluggish activity in its European trading partners, Latvia’s exports boomed in 2003. Leading indicators such as industrial production, retail trade, and investment spending suggest that strong growth has continued into the second quarter of 2004.

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Contributions to GDP Growth, 2002-03

Citation: IMF Staff Country Reports 2004, 260; 10.5089/9781451824520.002.A001

Sources: Latvia authorities and Fund staff estimates.

4. Overheating is potentially a serious concern in the run-up to euro adoption (see Section II), although at present the evidence is not fully conclusive. Credit continues to grow rapidly—over 40 percent annually at end-May 2004—mainly driven by mortgage and consumption loans. Consumption grew faster than GDP in real terms in 2003, but with rapid import growth and a weakening current account deficit, it contributed little to domestic resource constraints. Above-trend growth in 2003 may have created a positive output gap, but capacity utilization in manufacturing has remained unchanged at 74 percent over the past twelve months. Inflation surged to 6.2 percent at end-May 2004, from 3.6 percent at end-2003, but so far it has largely reflected exogenous one-off factors—estimated to have contributed about 4 percentage points to inflation (Box 1 and Selected Issues papers). Although unemployment is significantly lower than two years ago, it has recently increased somewhat—albeit largely owing to an increase in labor force participation; accordingly real wage growth, which exceeded growth in labor productivity in much of 2002 and 2003, has slowed down in 2004 (see chart). House prices have increased rapidly, with apartment prices in Riga more than doubling in the past three years, but they seem to have stabilized recently and, adjusted for per capita income, are not high by international standards. In addition, the surge in housing construction could herald price weakening.

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Labor Market and Productivity Growth,1999-2004

(In percent)

Citation: IMF Staff Country Reports 2004, 260; 10.5089/9781451824520.002.A001

Sources: Latvia authorities and Fund staff estimates.
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Average Price per Square Meter of Typical Apartment in Riga

(In US dollars)

Citation: IMF Staff Country Reports 2004, 260; 10.5089/9781451824520.002.A001

Source: www.latio.lv.

Recent Developments in Inflation

Inflation in Latvia has been on the rise in recent months, surging to 6.2 percent at end-May from an average of about 3 percent in previous years. This box suggests that the acceleration of inflation is largely accounted for by one-off events and the depreciation of the Lats vis-à-vis the euro, rather than the rapid credit growth. Furthermore, similar price movements have recently been observed in other new EU member countries.

One-off events have affected recent inflation

  • World food prices have risen 20 percent from a year earlier. In addition, for new EU members, exports from other EU countries will no longer qualify for subsidies, and there is evidence of price speculations in food markets in the run up to accession.

  • Changes in regulated rent and utility prices accounted for slightly more than one percentage point in the overall inflation.

  • To meet EU requirements certain taxes were introduced, including excise taxes on fuel, and VAT on pharmaceutical products.

  • The surge in world oil prices in the first half of 2004 caused fuel prices to rise.

  • The depreciation against the euro contributed to inflation over the past year. This is supported by the fact that annual inflation in the other Baltic countries, which maintain currency board arrangements vis-à-vis the euro, is lower, despite facing similar shocks otherwise.

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For now credit growth does not appear to be contributing to higher inflation

  • The aforementioned exogenous factors likely contributed about 4 percentage points to inflation in May (see table), which leaves little room for credit growth in explaining recent inflation.

  • Credit growth, while increasing vulnerability, is largely the result of catching up and reflects the response to rising demand for credit in the economy. The ratio of credit to the private sector to GDP, and the ratios of household debt to GDP and to disposable income, are all significantly below European comparators and the equilibrium levels suggested by Latvia’s per capital income, the degree of financial liberalization and the level of legal/regulatory/corporate culture (see Cottarelli, Carlo, Giovanni Dell’Ariccia and Ivanna Vladkova-Hollar, “Early birds, late risers, and sleeping beauties: bank credit growth to the private sector in Central and eastern Europe and the Balkans,” IMF Working Paper/03/213).

The main risk to the inflation outlook is that price increases could become persistent if strong demand continues to drive output above potential and causes credit growth to feed into inflation.

5. The rapid credit growth has increased risks, but at present it appears consistent with Latvia’s stage of development. Credit growth, by increasing private sector’s—and in particular households’—indebtedness, has made the economy more vulnerable to exogenous shocks. Furthermore, while it does not appear to have been responsible for the recent rise in inflation, credit growth has likely accommodated the increase in the current account deficit. Nevertheless, credit growth is largely a reflection of strong economic activity (rather than irresponsible monetary policy or inappropriate lending practices) and appears justified by the very low starting point and developmental/institutional factors (see Box 1).2 In addition, the increase in credit has been funded by sustainable sources—deposit growth, bond flotation on the euro market, and internal funding arrangements by foreign banks with subsidiaries in Latvia.

6. In addition, there are no signs of deterioration in overall credit quality. The banking system’s financial soundness indicators remain favorable (see table below).3

7. Although the external current account deficit widened further in 2003 (to 8.6 percent of GDP), competitiveness does not appear to be a problem (Box 2 and Selected Issues papers). At end-2003, the real effective exchange rate was below the early-1999 levels. Latvia’s export penetration ratio has grown steadily since 1999, despite unfavorable market conditions for its main export (wood and wood products), and has surpassed the level reached before the Russia crisis in 1998. Furthermore, export growth over the last 5 years has been accompanied by increasing profit margins. Latvia’s competitiveness ranking by the World Economic Forum has also improved.

Latvia: Selected Financial Indicators, 2000–04

(In percent unless otherwise indicated)

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Sources: Bank of Latvia and Financial and Capital Market Commission (FCMC).

GDP is calculated using annualized quarterly data.

Liquidity test is defined as: (cash + claims on the central bank + claims on other credit institutions + fixed-income government bonds–liabilities to the central bank – liabilities to other credit institutions)/deposits.

End-December values based on audited financial statements; otherwise, as reported by banks.

Return on equity is defined as the ratio of profits to the value of bank-issued equity.

Net foreign asset position vis-à-vis foreign credit institutions, in LVL millions.

Commercial bank lending-deposit spreads for 3-month average of 3–6 months’ maturities.

Dow Jones Riga stock exchange index, end-of-period data.

As of January 2004, the Bank of Latvia has introduced new interest rate reports with respect to domestic deposits and loans, interest rate spreads for 3–6 months’ maturities not available.

8. Despite a significant reduction in net FDI, external debt has increased only moderately and poses no immediate concern. Net FDI coverage of the current account deficit, at 34 percent in 2003 was well below the average observed in the last three years—nearly 60 percent. But this reflected two specific factors. First, Lattelekom’s capital was reduced and in part returned to Teliasonera—the Finnish partner company. Second, a significant part of the loans extended by parent companies to Latvian enterprises matured in 2003 and were repaid rather than rolled over. Net FDI is expected to increase in 2004 and beyond. Gross external debt is about 80 percent of GDP, but more than half of this is due to non-resident deposits (see Table 6). These deposits are in large part dollar denominated and officially come from the USA, even though, according to the BoL, they include funds repatriated by Latvian citizens and funds that originate in CIS countries. The latter are mostly for import-export operations or for safe keeping—as in the case of deposits from Ukraine and Russia. Non-resident deposits are largely redeposited in foreign banks or placed in other liquid foreign assets in OECD countries, closely matching the currencies of the deposits.4 In light of these features and in line with the Board paper on Debt-and-Reserve-Related Indicators of External Vulnerability (www.imf.org), the notion of net external debt appears to be a more appropriate measure to assess Latvia’s external vulnerability. Net debt is only 25 percent of GDP.

Table 1.

Latvia: Selected Economic Indicators, 2000–04

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Sources: Latvian authorities; and staff estimates.

Figures for 2002 and 2003 are based on a new definition of economically active population (aged from 15 years to the retirement age instead of aged 15 years and over). The authorites have not revised the data for earlier years.

Excluding government guaranteed debt.

Table 2.

Latvia: Balance of Payments, 2000–08

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Sources: Latvian authorities and staff estimates.

Estimates of private transfers received were increased substantially following the introduction of a new survey methodology in 2002.

The large swings in portfolio investment reflect to a large extent a planned Eurobond issue of 400 million and related amortization of 225 million in 2004.

Methodological changes in the recording of textile exports in 2002 account for 2.6 percentage points of total export growth.

Without LASCO’s import of three ships in 2001, the FDI coverage of the current account deficit would be 28 percent, and 51 percent if a loan repayment from a leasing subsidiary to its foreign parent (resulting from a restructuring of the concern) in December 2001 is also excluded.

Table 3.

Latvia: Consolidated General Government, 2001–05

(In millions of lats, unless stated otherwise)

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Sources: Ministry of Finance; and Fund staff estimates.

Revenues exclude receipts from privatization.

Excluding social tax revenue channeled to the second pension pillar.

“Other expenditure” consists of spending by the Latvian Privatization Agency (LPA) as directed by Government decree that is effected through the Treasury and not recorded in the fiscal accounts.

Figures for 2004 budget are based on the original GDP assumption.

UMTS license receipts of LVL 8 million in 2002, treated as revenues in the authorities’ presentation, here are treated as financing.

Additional LPA spending directed by decrees that is not effected through the Treasury.

Revenues include only first pillar social taxes; expenditures include only transfers to households.

Table 4.

Latvia: Monetary Developments, 2000–04

(In millions of lats)

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Sources: Bank of Latvia and IMF staff estimates.

Assuming an Eurobond issue in the amount of euro 300 million in 2003.

Private sector credit growth in 2001 would have been 40 percent excluding a loan from one bank to its leasing affiliate in the context of a restructuring operation.

Table 5.

Latvia: Medium-Term Macroeconomic Framework, 2001–08

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Sources: Latvian authorities and Fund staff estimates.

Reflects the recent revision in national accounts data, which is due to the rebasing of real GDP at 2000 average prices and minor changes in the components of GDP from the expenditure side (mainly inventories).

External current account deficit.

2001 figures reflect LASCO’s investment in ships which amounts to 1.5 percent of GDP.

Government revenues do not include privatization receipts.

Including change in inventories.

Including net lending.

Table 6.

Latvia: External Sustainability Framework, 1999–2008

(In percent of GDP, unless otherwise indicated)

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One third of total projected FDI is assumed to be debt creating (loans from parent companies).

Derived as [r - g - ρ(1+g) + εα(1+r)]/(1+g+ρ+gρ) times previous 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, e = nominal appreciation (increase in dollar value of domestic currency), and a = share of domestic-currency denominated debt in total external debt.

The contribution from price and exchange rate changes is defined as [-ρ(1+g) + εα(1+r)]/(1+g+ρ+gρ) times previous period debt stock. ρ increases with an appreciating domestic currency (ε > 0) and rising inflation (based on GDP deflator).

This term includes exchange-rate valuation effects, which in 2000 and 2001 may explain 1 - 2 percentage points of the debt increase. The large debt increase in these years does also reflect methodological changes.

Defined as non-interest current account deficit, plus interest and amortization on medium- and long-term debt, plus short-term debt at end of previous period.

Data consistency problems, including methodological changes, prevent use of a longer historic sample. It should be noted, nonetheless, that earlier years did include negative growth and financial instability

Equilibrium Exchange Rate and External Competitiveness

For Latvia, the imminent ERM2 accession requires abandoning the current SDR peg and fixing a new euro peg. Such a peg could serve as the basis for the eventual adoption of the euro. Assessing how close the current exchange rate is to its equilibrium level is a daunting task in an economy undergoing rapid growth and structural change. Some competitiveness indicators can nonetheless guide the analysis.

Latvia’s large external current account deficit may suggest an underlying exchange rate misalignment. However, as argued in IMF Country Report No. 03/331, structural factors, such as an increase in expected income and investment explain most of the deficit during the last decade. Indeed at end-2003, the Unit Labor Cost (ULC-based) Real Effective Exchange Rate (REER), the CPI-based REER and the PPI-based REER were all at or below early 1999 levels. In addition, the market-to-PPP exchange rate ratio—well below unity—is about 10 percent lower than for Lithuania after adjusting for per capita income.

uA01fig05

Latvia: REER

(CPI, ULC and PPI)

Citation: IMF Staff Country Reports 2004, 260; 10.5089/9781451824520.002.A001

Sources: Latvia authorities and Fund staff estimates.

A comprehensive study of the competitiveness in the Baltic states (Special Issues Paper: The Baltics: Competitiveness on the Eve of EU Accession) concluded that the equilibrium exchange rate in Latvia appreciated significantly in the early years of transition prompted by strong productivity growth and large capital inflows. The REER has followed similar dynamics and, since 1999, has remained quite stable. Based on a broad range of indicators, the analysis suggests no clear evidence of exchange rate misalignment in Latvia.

An exchange rate overvaluation could also manifest itself in weak export performance. Latvia’s export penetration, however, has grown steadily since 1999. Market shares in EU and world markets have grown about 25 percent since 1999 and exports to the EU now accounts for nearly 85 percent including the new accession countries. Furthermore, export growth and the successful penetration of international markets have been accompanied by increasing profit margins over the last 5 years. Despite the limitations of the indicator employed—the ratio of wage costs to value added—the figure is at least indicative of a trend.

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