Republic of Latvia: Staff Report for the 2005 Article IV Consultation
Author: International Monetary Fund
Publication Date:
10 Aug 2005
eISBN:
9781451824575
Language:
English
Keywords:
ISCR; CR; staff appraisal; IMF staff representative; fiscal policy; Finance; statement; EU grant; foreign currency; private sector; GDP deflator; minimum wage; Inflation
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The staff report for the 2005 Article IV Consultation on the Republic of Latvia highlights the economic outlook and mid-term risks. A sound policy framework and far-reaching structural reforms supported this performance, including a prudent fiscal policy that underpinned the exchange rate peg. The ongoing credit boom and faster real wage growth are expected to support private domestic demand while a sharp increase in net European Union (EU) grants would also boost public spending. Efficiently allocating EU funds for infrastructure was seen as a key element of a framework for promoting efficient resource allocation.

Abstract

The staff report for the 2005 Article IV Consultation on the Republic of Latvia highlights the economic outlook and mid-term risks. A sound policy framework and far-reaching structural reforms supported this performance, including a prudent fiscal policy that underpinned the exchange rate peg. The ongoing credit boom and faster real wage growth are expected to support private domestic demand while a sharp increase in net European Union (EU) grants would also boost public spending. Efficiently allocating EU funds for infrastructure was seen as a key element of a framework for promoting efficient resource allocation.

I. Background

1. During much of the past decade, Latvia’s growth performance has outstripped other new EU member countries while broad macroeconomic stability has been maintained. A sound policy framework and far-reaching structural reforms supported this performance, including a prudent fiscal policy that underpinned the exchange rate peg, and fundamental reforms of the business and wage-setting environments. These efforts promoted enhancements in factor productivity and investment—including substantial FDI—that have expanded productive capacity and narrowed the per capita income gap with Western Europe. However, at 40 percent of the EU-15 average (PPP basis) in 2004, per capita income still remains the lowest in the EU.

uA01fig01

Average GDP Growth, 1996-2003

(In percent)

Citation: IMF Staff Country Reports 2005, 282; 10.5089/9781451824575.002.A001

Source: WEO.
uA01fig02

Average Inflation, 1996-2003

(In percent)

Citation: IMF Staff Country Reports 2005, 282; 10.5089/9781451824575.002.A001

Source: WEO.

2. Rapid economic growth under Latvia’s open trade and capital account regime contributed to relatively large current account deficits and rising external debt (Figure 1). Despite strong growth of exports, current account deficits averaged 7¼ percent of GDP during 1996–2003, consistent with Latvia’s low initial income and high growth potential. FDI has covered about half the cumulative deficit, but with privatization slowing, nonresident deposits (NRDs) and borrowing from parent banks have played an increasing financing role (Figure 2). As a result, total gross external debt has risen sharply to 93 percent of GDP in 2004, even though net external debt remains a more modest 30 percent of GDP (Figure 3).

Figure 1.
Figure 1.

The Baltics: Macroeconomic Performance, 1997-2004

Citation: IMF Staff Country Reports 2005, 282; 10.5089/9781451824575.002.A001

Sources: Country authorities and Fund staff estimates.
Figure 2.
Figure 2.

Latvia: External Sector, 1998-2005

(In percent of GDP)

Current Accout

Citation: IMF Staff Country Reports 2005, 282; 10.5089/9781451824575.002.A001

Sources: Country authorities; and Fund staff estimates.
Figure 3.
Figure 3.

Latvia: Gross External Debt by Borrower and Long-term Debt by Creditor, 1999-2004

Citation: IMF Staff Country Reports 2005, 282; 10.5089/9781451824575.002.A001

Source: Bank of Latvia.

3. Domestic demand picked up sharply in 2004, pushing economic growth well above the 1996-2003 average. A strong increase in investment and consumption—driven by expectations of sustained income convergence and declining real interest rates—pushed GDP growth up to 8½ percent, from 7½ percent in 2003 (Table 1). The external sector remained a net drag on growth even as export volume growth increased. Private sector credit—particularly to households—continued to expand rapidly, growing by more than 35 percent for the fifth consecutive year to reach 57 percent of GDP, second highest among new EU members (Figure 4). Unemployment declined steadily to below 10 percent in Q1 2005—of which long-term unemployment is less than half—even as economy-wide wages continued to rise well above inflation.

Table 1.

Latvia: Selected Economic Indicators, 2001-06

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

Refers to first quarter actual data.

Includes economy-wide EU grants in revenue and expenditure.

Includes in revenue and expenditure only EU grants for which the government is the final beneficiary. GFSM2001 concept of general government. For 2005, assumes government is final beneficiary of 60 percent of EU grants.

Excluding government guaranteed debt.

Figure 4.
Figure 4.

Latvia: Credit Developments, 2000-05

Citation: IMF Staff Country Reports 2005, 282; 10.5089/9781451824575.002.A001

Source: Bank of Latvia; Eurostat and Fund staff calculations.1/ GDP is of 2004.
uA01fig03

Contributions to GDP Growth, 1996-2005

(1995 constant price, in percent)

Citation: IMF Staff Country Reports 2005, 282; 10.5089/9781451824575.002.A001

Sources: Eurostat and Fund staff estimates.

4. Emerging imbalances have been evident in a pickup in underlying inflation and a widening of the current account deficit. Headline inflation surged in 2004 to 6¼ percent (year-average basis), and the current account deficit swelled to 12.3 percent of GDP (Table 2). While one-off factors related to EU accession and supply shocks contributed, underlying measures of inflation and the current account deficit also deteriorated (Box 1).

Table 2.

Latvia: Balance of Payments, 2001-06

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Sources: Latvian authorities; and Fund staff estimates.

Impact of One-Off Factors in 2004: A Moderate Effect

One-off factors in 2004 accounted for only part of the increase in inflation and the current account deficit. As in several other NM states, EU accession brought increases in indirect taxes and changes in customs duties, leading to higher prices and some pre-accession hoarding of goods during the early part of the year. However, in Latvia, the direct contribution of these effects is thought to have been small. According to the Bank of Latvia, changes in indirect taxes (both increases and reductions) and administratively regulated prices added 1 percentage point to inflation around mid-year. A pre-accession buildup in stocks boosted imports by about 1¼ percent of GDP early in the year, but these are likely to have been largely drawn down during the second half, with only a small net impact on imports for the year as a whole. Food price equalization within the enlarged EU may also have contributed to rising inflation. However, Latvia’s food prices are already relatively high compared with several other NM states, and not out of line with the range of food-price levels observed among EU-15 countries. Moreover, the contribution to inflation of higher world energy prices and the need to gradually raise Latvia’s gas and electricity prices to world levels was muted on account of energy’s relatively low weight in the CPI basket.

Cost of Living Comparison in NM8 Capital Cities-Food and non-alcoholic beverages, July 2004

(Brussels = 100)

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Source: Eurostat.

Excluding unprocessed food, energy, and regulated items, core inflation peaked in late 2004 and, while moderating to 5 percent by mid-2005, Latvia’s monthly price increases remain among the highest in the group of new member (NM) states. With supply shocks having only a moderate direct impact, the still-high level of core inflation can be attributed to rising inflationary expectations and second-round demand effects, including retailers that used the opportunity of EU accession to raise prices in conditions of strong demand. Excluding large one-off investment imports of about 1½ percent of GDP and some pre-accession stock building, the underlying current account deficit widened by about 2 percentage points of GDP in 2004, reflecting strong import demand and rising income payments on FDI.

uA01fig04

Latvia: Headline Inflation, 2002-05

(12-month growth rate)

Citation: IMF Staff Country Reports 2005, 282; 10.5089/9781451824575.002.A001

Sources: Bank of Latvia and Eurostat.
uA01fig05

Headline Inflation, 2003-05

(Month to month percentage change, seasonally adjusted)

Citation: IMF Staff Country Reports 2005, 282; 10.5089/9781451824575.002.A001

Sources: Eurostat and Fund staff calculations.

5. Notwithstanding the surge in imports in 2004—partly attributable to the fast pace of domestic demand—external competitiveness appears adequate. The labor cost-based real exchange rate—broadly unchanged in 2004 relative to 2003—improved significantly compared with earlier years as rapid productivity growth and a modest depreciation of the SDR-linked currency compensated for strong growth in nominal wages (Figure 5). Exports grew robustly in volume terms and, together with a favorable terms of trade, further increased Latvia’s export share in EU and world markets. Latvia joined ERM2 on April 29, 2005 at the prevailing exchange rate parity, having repegged from the SDR to the euro in January.

Figure 5.
Figure 5.

The Baltics: Real Effective Exchange Rates and Export Penetration, 1995-2004

Citation: IMF Staff Country Reports 2005, 282; 10.5089/9781451824575.002.A001

Sources: Country authorities; Eurostat; Direction of Trade; and International Financial Statistics.1/ Economy wide.

6. Booming bank credit added to demand pressures. With bank profits strong, easy access to foreign financing, nonperforming loans low and well provisioned, and capital adequacy—though moderating in recent years—still considerably higher than the newly lowered minimum requirement,1 banks faced few constraints in expanding their balance sheets (Table 3 and Appendix II). With mortgages the most dynamic segment of the credit market, banks have become increasingly exposed to credit risk from possible house price fluctuations and from a slowdown in economic growth to which bank lending is an important contributor. Since most mortgages are denominated in foreign currency (euros and U.S. dollars), indebted households are exposed to movements in the exchange rate. Nonresident deposits (NRDs)—an important funding source at many banks (including several of the largest banks)—represent more than half of total deposits, raising concerns about the growing shortfall of banks’ liquid foreign assets relative to short-term foreign liabilities, as well as possible links with money laundering.

Table 3.

Latvia: Selected Vulnerability Indicators, 2000-05

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Sources: Latvian authorities; and Fund staff calculations.

Latest observations as indicated in the last column.

Current account deficit plus amortization of external debt.

Public sector covers general government.

Based on averages for the last five years for the relevant variables (i.e., growth, interest rates).

Overall balance plus debt amortization.

ST debt and maturing medium- and long-term debt, domestic and external, excluding external debt to official creditors.

Debt in foreign currency or linked to the exchange rate, domestic and external, excluding external debt on concessional terms.

ST debt and maturing medium- and long-term debt at variable interest rates, domestic and external.

Financial sector includes commercial banks.

7. Despite two supplementary budgets, strong revenue overperformance enabled a better-than-budgeted fiscal outturn in 2004. With conservative revenue forecasts, higher-than-expected GDP growth, and lower spending than approved in the supplementary budgets, the general government deficit on a cash basis was contained to 1.1 percent of GDP,2 one percentage point below target and ½ percentage point below the 2003 outturn, consistent with Executive Directors’ recommendations during the 2004 Article IV consultation (Table 4 and Box 2). Adjusting for cyclical effects on revenue and excluding net EU grants, the fiscal stance is estimated to have been contractionary in 2004 (Box 3).

Table 4.

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.

Article IV Policy Recommendations and Implementation

Latvia has generally heeded the Fund’s advice on macroeconomic and structural policies, as evidenced by a series of stand-by arrangements, the most recent of which expired at end-2002. However, recent years have seen an easing of fiscal control toward year-end on account of a surge in spending, slowing progress toward the authorities’ medium-term goal of budget balance. Monetary policy has generally supported the exchange rate peg, and in preparation for euro adoption, liquidity management has increasingly relied on open market operations.

In the financial area, supervision has been streamlined with the establishment of a unified financial sector supervisor, and the authorities recently approved a package of legislation aimed at eliminating deficiencies in the AML/CFT framework.

In concluding the last Article IV consultation, Directors praised Latvia’s continued strong economic performance (http://www.imf.org/external/pubs/ft/scr/2004/cr04260.pdf). However, they saw as ongoing risks the large current account deficit and rapid credit growth which—though consistent with Latvia’s stage of development—called for a prudent fiscal path and vigilant bank supervision. They also advised that potential overheating risks should be warded off in a timely manner. This advice remains relevant in view of recent macroeconomic developments.

Estimating the Fiscal Stance in Latvia

In addition to standard adjustments for cyclical conditions and differences between cash and accrual accounting, estimating the demand effect of fiscal policy requires accounting for EU transfers. EU-financed government spending leaves the fiscal balance unchanged but adds to demand pressures, the timing of which may not fully coincide with the receipt of EU funds owing to advance and ex post payments which are recorded upon arrival of the funds in the national budget presentation. On the other hand, contributions to the EU raise the measured deficit, but do not generate domestic demand. The Latvian budget format (“extended” government) includes in revenues and expenditures EU grants to private sector final beneficiaries (estimated by the mission at 40 percent of EU grants for 2005), even though these are not part of government activity. On the basis of these considerations, the appropriate concept for assessing the fiscal stance is the change in the structural accrual balance excluding net EU grants and transfers to the private sector where the government is the paying authority.

Latvia: Demand Effects of Fiscal Policy, 2004

(In percent of GDP)

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Sources: Ministry of Finance; and Fund staff calculations.

Includes economy-wide EU grants in revenue and expenditure.

Includes in revenue and expenditure only EU grants for which the government is the final beneficiary. GFSM2001 concept of government.

EU VAT procedures increase collection lag on imports by one month.

For extended government concept, includes economy-wide EU receipts. For general government concept, includes only those grants for which government is the final beneficiary.

8. Within the limits of the narrow band exchange-rate peg, the BoL tightened its policy instruments over the past year. A one percentage point increase in the refinancing rate and a tightening of mandatory reserve requirements—including by broadening the base to include banks’short-term foreign liabilities—helped lift nominal interest rates on lats-denominated bank loans (Figure 6). However, the pickup in inflation was even stronger, and real borrowing costs declined, while real deposit rates turned sharply negative. Maintaining the ±1 percent band, the lats was repegged to the euro at the beginning of 2005 and Latvia entered ERM2 at end-April 2005. The authorities are aiming to adopt the euro at the beginning of 2008, which would require satisfying the Maastricht criteria sometime during 2007.

Figure 6.
Figure 6.

Latvia: Monetary and Financial Indicators

Citation: IMF Staff Country Reports 2005, 282; 10.5089/9781451824575.002.A001

Sources: Latvian authorities; ECB; Bloomberg; and Fund staff calculations1/ Owing to changes in reporting tables, data from 2004 is not fully consistent with earlier periods.

II. Report on the Discussions

9. The discussions focused on policies to maintain macroeconomic and financial stability while preserving external competitiveness. The challenge for the near term was seen as dampening overheating pressures in order to qualify for euro adoption without an undue delay that could generate its own risks.3 Over the medium term, the goal is to sustain real income convergence by reducing risks of a boom-bust cycle triggered by eroding competitiveness and a heavy private-sector debt overhang. The discussions also explored the contribution of the financial sector to prevailing macroeconomic conditions, and the extent of vulnerabilities generated by the ongoing credit boom, the size of NRDs, and deficiencies in the AML/CFT framework.

10. While recognizing the importance of fiscal policy as the primary lever to moderate demand, the authorities stressed that access to substantial EU funds posed a difficult tradeoff. Given the constraints of the narrow-band currency peg, the authorities saw clear limits to their ability to influence private domestic demand through further tightening of monetary policy. While there was agreement that reining-in fiscal policy was the main available tool to contain overheating pressures, the authorities and the mission had different perspectives on how to resolve the tradeoff between the medium-term capacity-enhancing benefits of EU-financed spending (including on infrastructure), and the short-term benefits—for macroeconomic stability—of a firmer fiscal stance. This partly also reflected different assessments of the extent of spare capacity and thus prospects for disinflation.

A. Economic Outlook and Medium-Term Risks

11. While the authorities saw strong growth continuing in 2005, they expected inflation and the current account deficit to moderate as temporary supply shocks dissipated. They forecast economic growth at 7½ percent for this year, but estimated that this would leave output below potential until 2006. One-off supply side factors—rather than overheating pressures—were seen by the authorities as primarily responsible for the higher inflation and current account deficit last year. They saw spare capacity in industry (a utilization rate of about 70 percent—though rising) and the recent jump in the investment-to-GDP ratio (with positive effects on growth potential) as consistent with a still-negative output gap. For 2005, the authorities expect the current account deficit to narrow to 10 percent of GDP and inflation to moderate to 5–5½ percent (year-average basis). However, they were concerned about risks of second-round effects from further increases in energy prices scheduled for 2005, which could delay euro adoption.

12. The mission considered the economy to be somewhat more cyclically advanced, with output marginally above potential since late 2004. The ongoing credit boom and stronger real wage growth were expected to underpin private domestic demand this year, while a sharp increase in spending financed by net EU grants (by 2.4 percentage points to 3.6 percent of GDP) would also boost public spending. Staff thus projected GDP growth of 7¾ percent for 2005, slightly above the authorities’ forecast and above staff’s estimate of short-term growth potential (about 6½ percent). Moreover, actual growth may be exceeding the reported rate owing to very dynamic activity in the grey economy, especially construction. On the cyclical position of the economy, the mission noted that activity was unevenly distributed across economic sectors and geographic regions—with services accounting for nearly four-fifths of the economy and the Riga region generating the bulk of GDP—a pattern reinforced by the recent composition of growth. It pointed to evidence of capacity constraints in construction (the sector most affected by mortgage-financed housing and EU-financed infrastructure spending), where shortages of qualified workers have pushed up wages; and to the very rapid expansion in retail sales that has raised core inflation. While investment would enhance future growth potential, in the short term staff saw the pace of activity as set to further widen the positive output gap.

13. Against this background, the mission saw the risks weighted toward higher core inflation and a wider underlying current account deficit this year. While headline inflation (on a 12-month basis) would remain on a downward track through mid-year reflecting the high base in early 2004, demand pressures would likely turn this trend around in the second half, with the mission projecting year-end inflation at 6¼ percent. While staff saw the current account deficit narrowing to about 10½ percent of GDP this year on the basis of higher net current transfers from the EU4 and the absence of bulky one-off investments that pushed up imports in 2004, adjusting for these one offs, the deficit would be slightly higher in underlying terms than in 2004 due to strong domestic demand and higher energy prices.

Latvia: Underlying Current Account, 2003-05

(In percent of GDP)

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Source: Fund Staff calculations.

Includes imports of ships, turbines (together 1.4 percent of GDP), and some pre-accession stock building not unwound by year-end. Staff estimate.

14. High external imbalances and rising foreign debt—the main risks for the medium term—could weigh on market sentiment, particularly if euro adoption is substantially delayed. With relatively modest official reserve coverage of short-term external financing needs (Table 5), Latvia remains reliant on capital inflows. Under the baseline, staff is projecting external debt climbing by 14 percentage points of GDP over the next six years, reaching 108 percent by 2010. This reflects the impact on the current account deficit of strong domestic demand and faster inflation and productivity-adjusted wage growth relative to trading partners—with the deficit only partly financed by FDI—and the need to maintain adequate reserve coverage for imports (Tables 6–7). This baseline highlights the need for demand restraint to improve the saving-investment balance and slow debt accumulation. Fiscal consolidation would need to contribute significantly to the required adjustment, complemented by higher net private saving from measures to moderate credit growth (see below). The BoL regarded net debt (projected by the mission to reach 50 percent of GDP in 2010) as a more relevant indicator of vulnerability and noted that lending by parent banks to Latvian subsidiaries—which is likely to be continuously rolled over—accounted for 12 percentage points of gross debt. They also considered that external sector risks would greatly diminish once Latvia adopted the euro. The mission cautioned, however, that unless macroeconomic policies were geared to containing demand and inflation, market sentiment could be adversely affected, heightening external risks in the short term.

Table 5.

Latvia: Vulnerability Indicators for Emerging Market Economies, 2004

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Sources: WEO; IFS; and Fund staff estimates.

Current account deficit plus amortization of external debt.

Official reserves and banks’ liquid foreign currency-denominated assets cover about 75 percent of short-term debt at remaining maturity and foreign currency deposits.

Since end-April 2005.

The large negativee value reflects Malaysia’s negative gross external financing requirement (owing to a large current account surplus) and very high level of reserves.

Table 6.

Latvia: Macroeconomic Framework, 2000-10 Baseline and Phased-Adjustment Scenarios

(In percent of GDP, unless otherwise indicated)

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Sources: Latvian authorities; and Fund staff estimates.

Defined as the sum of the current account deficit and the capital account deficit.

Includes 2nd pillar contributions. Accrual basis.

Includes gross official reserves and banks’ liquid foreign-currency assets.

Table 7.

Latvia: External Sustainability Framework, 1999-2010

(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 (in

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

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.