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© 2005 International Monetary Fund
August 2005
IMF Country Report No. 05/282
Republic of Latvia: 2005 Article IV Consultation—Staff Report; Staff Statement; Public Information Notice on the Executive Board Discussion; and Statement by the Executive Director for Republic of Latvia
Under Article IV of the IMF’s Articles of Agreement, the IMF holds bilateral discussions with members, usually every year. In the context of the 2005 Article IV consultation with Republic of Latvia, the following documents have been released and are included in this package:
the staff report for the 2005 Article IV consultation, prepared by a staff team of the IMF, following discussions that ended on April 26, 2005, with the officials of Republic of Latvia on economic developments and policies. Based on information available at the time of these discussions, the staff report was completed on July 14, 2005. The views expressed in the staff report are those of the staff team and do not necessarily reflect the views of the Executive Board of the IMF.
a staff statement of July 27, 2005 updating information on recent developments.
a Public Information Notice (PIN) summarizing the views of the Executive Board as expressed during its July 27, 2005 discussion of the staff report that concluded the Article IV consultation.
a statement by the Executive Director for Rebublic of Latvia.
The document listed below has been or will be separately released.
Selected Issues Paper
The policy of publication of staff reports and other documents allows for the deletion of market-sensitive information.
To assist the IMF in evaluating the publication policy, reader comments are invited and may be sent by e-mail to publicationpolicy@imf.org.
Copies of this report are available to the public from
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INTERNATIONAL MONETARY FUND
REPUBLIC OF LATVIA
Staff Report for the 2005 Article IV Consultation
Prepared by Staff Representatives for the 2005 Consultation with the Republic of Latvia
Approved by Alessandro Leipold and Carlos Muñiz
July 14, 2005
The 2005 Article IV consultation discussions were held in Riga during April 13–26, 2005. The team comprised Ms. van Elkan (head), and Messrs. Luna and Stavrev (all EUR). Ms. Zubkova (Advisor, OED) and Mr. Rosenberg (Regional Representative) attended several meetings. The mission met with Bank of Latvia (BoL) Governor Rimšēvičs, Finance Minister Spurdziņš, and senior officials, academics, and representatives of financial institutions, foreign investors, and NGOs.
Latvia acceded to the European Union (EU) on May 1, 2004 and entered ERM2 on April 29, 2005. A four-party center-right coalition government took office in December 2004. Notwithstanding the short tenure of governments, macroeconomic policy has been anchored to meet the preconditions for EU accession and euro adoption. The next general election is due in 2006. The authorities are aiming to adopt the euro at the beginning of 2008.
Latvia has accepted the obligations of Article VIII, section 2, 3, and 4, and maintains no restrictions on the making of payments and transfers for current international transactions, except for those imposed in compliance with applicable UN Security Council resolutions. All such restrictions have been notified to the Fund pursuant to Decision No. 144 (52/51).
Latvia has subscribed to the Special Data Dissemination Standard. Coverage, periodicity, and timeliness of the data are adequate for surveillance.
The authorities released the mission’s concluding statement (http://www.imf.org/external/np/ms/2005/042505.htm) and have expressed their intention to publish the staff report.
Contents
Executive Summary
I. Background
II. Report on the Discussions
A. Economic Outlook and Medium-Term Risks
B. Fiscal Policy
C. Inflation, Credit Growth, and ERM2/Euro Adoption Issues
D. Financial Sector Issues
E. Structural and Other Issues
III. Staff Appraisal
Tables
1. Selected Economic Indicators
2. Balance of Payments, 2001–06
3. Selected Vulnerability Indicators, 2000–05
4. Consolidated General Government, 2001–05
5. Vulnerability Indicators for Emerging Market Economies, 2004
6. Macroeconomic Framework, 2000–10
7. External Sustainability Framework, 2001–10
8. Selected Banking Indicators by Type of Bank, 2002–04
Figures
1. The Baltics: Macroeconomic Performance, 1997–2004
2. External Sector, 1998–20056
3. Gross Extrenal Debt by Borrower and Long-Term Debt by Creditor, 1999–2004
4. Credit Developments, 2000–05
5. Real Effective Exchange Rates and Export Penetration, 1995–2004
6. Monetary and Financial Indicators
Boxes
1. Impact of One-Off Factors in 2004: A Moderate Effect
2. Article IV Policy Recommendations and Implementation
3. Estimating the Fiscal Stance in Latvia
4. Macroeconomic Effects of Latvia’s Credit Boom
5. Balance Sheet Approach to Macroprudential Vulnerabilities in Latvia
Appendices
I. Fund Relations
II. Financial Soundness Indicators and Financial System Structure, end-2004
III. Follow-up on Key Recommendations of the 2001 FSAP
IV. Statistical Issues
V. Public Information Notice
Executive Summary
Background: Growth increased to 8¼ percent in 2004 on very strong consumption and investment, while inflation and the current account deficit jumped sharply—only partly related to temporary factors. Booming bank credit added to demand pressures and also increased macroprudential risks. Gross external debt reached 93 percent of GDP, although net debt is a more modest 30 percent. Nonresident deposits—an important funding source for banks—point to growing mismatch risks. Latvia joined ERM2 in April 2005 at the prevailing parity and plans to adopt the euro in 2008.
Outlook: Booming demand is set to continue, fuelled by ongoing credit expansion, real wage growth, and sharply higher net EU grants. Average inflation is expected to remain at 6¼ percent—well above the Maastricht limit—while the current account deficit should narrow on account of larger net EU grants.
Policy issues and discussions
Access to substantial EU funds poses a difficult tradeoff for fiscal policy. With the currency peg preventing further effective tightening of monetary policy, fiscal policy remains the primary demand management tool. While EU-financed investment would raise growth potential over the medium term, it adds to near-term cyclical pressures. With output slightly above potential, the mission stressed the need for a firmer fiscal stance than planned. This would also slow external debt accumulation and help prefinance pension reform costs.
Moderating credit growth was viewed as essential to containing inflationary pressures. While credit growth has been driven by availability of new financial instruments and lower real interest rates, it continues to contribute to demand pressures. The authorities are considering taxing multiple mortgage loans to moderate credit growth. Staff called for eliminating distortions in the tax system that were fuelling the mortgage boom, including generous treatment of capital gains on real estate.
Maintaining competitiveness in ERM2 will depend on bringing down inflation and containing wage growth. The mission stressed the importance of demand management for dampening inflation and labor market flexibility to limit wage growth, although there was recognition on both sides that sustained productivity gains augured well for the maintenance of competitiveness going forward.
Vulnerabilities from the credit boom put a premium on strong supervision and prudential safeguards. Recent improvements in financial sector monitoring are welcome but the loosening of some prudential regulations may exacerbate risks. The mission highlighted the need for strengthened supervision of banks with significant nonresident deposits. Recent amendments to AML laws and the authorities’ request for an AML/CFT ROSC are welcome.
Sustaining vigorous growth remains contingent on expanding and efficiently allocating capital and employment. Reducing corruption, transparently allocating EU funds for infrastructure, encouraging greater labor force participation, and better matching skill acquisition with skills demanded in the labor market will help to avoid bottlenecks to medium-term growth.
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July 27, 2005
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July 27, 2005
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Public Information Notice (PIN) No. 05/109
FOR IMMEDIATE RELEASE
August 10, 2005
International Monetary Fund
700 19th Street, NW
Washington, D. C. 20431 USA
On July 27, 2005, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with the Republic of Latvia.1
