Republic of Latvia
First Review and Financing Assurances Review Under the Stand By Arrangement, Requests for Waivers of Nonobservance of Performance Criteria, and Rephasing of Purchases Under the Arrangement
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The Latvian authorities have strengthened their intervention capacity, financial supervision, and monitoring framework, and have taken steps to contain risks in Parex Bank. The staff report reviews the Republic of Latvia’s economic developments and policies. Substantial progress has been achieved in stabilizing the financial sector. The collapse in output has revealed significant underlying fiscal weaknesses that risk leading to unsustainable deficits in the absence of strong corrective measures. The deeper downturn is also in part explained by the much worse-than-projected international environment.

Abstract

The Latvian authorities have strengthened their intervention capacity, financial supervision, and monitoring framework, and have taken steps to contain risks in Parex Bank. The staff report reviews the Republic of Latvia’s economic developments and policies. Substantial progress has been achieved in stabilizing the financial sector. The collapse in output has revealed significant underlying fiscal weaknesses that risk leading to unsustainable deficits in the absence of strong corrective measures. The deeper downturn is also in part explained by the much worse-than-projected international environment.

I. Introduction and Summary

1. The economic situation has deteriorated markedly since the launch of the program reflecting the collapse of domestic demand, the unwinding of the credit and real estate bubble, and the much worse than expected international environment. These developments have led to a rapid correction in the current account. They have also eroded government revenues, opening a large fiscal gap, and have increased losses in the financial sector. As a result, Latvia’s exchange rate peg has faced waves of heavy pressure.

2. The political and economic outlook remains extremely difficult:

  • Staff and the authorities project that GDP will fall 18 percent this year, with a slow recovery to take hold only in the second half of next year. Much of this output loss will be permanent, though the still-large negative output gap implies significant deflationary pressures for the next year or two.

  • Public discontent is a concern. The coalition parties did poorly at the municipal and European elections on June 6, and lost control of Riga city council. The coalition also faces deep internal divisions. All coalition parties signed the Letter of Intent, notwithstanding earlier questions by some of them on the need for a Fund arrangement. Opposition to spending cuts has been subdued since January’s demonstrations, but could pick up during the winter when unemployment benefits run out for many, and the heating season begins.

3. Against this backdrop, substantial progress has been achieved in stabilizing the financial sector. Since the financial and balance of payments crisis last year when the program was launched, the authorities have strengthened their intervention capacity, financial supervision and monitoring framework, and have taken steps to contain risks in Parex bank.

4. However, the collapse in output has revealed significant underlying fiscal weaknesses that risk leading to unsustainable deficits in the absence of strong corrective measures. Discussions therefore centered on defining a sustainable and structurally sound strategy for fiscal reform, consistent with the Latvian authorities’ strategy to maintain the pegged exchange rate, while minimizing further pressure on economic activity and protecting the most vulnerable at a time of painful dislocation.

II. Background

5. The downturn has proven much deeper than anticipated at the launch of the program (Figures 12, Table 1). Real GDP fell by 18 percent year-on-year in the first quarter of 2009 (13½ percent quarter-on-quarter, seasonally adjusted), compared with the program projection of a 5 percent decline for 2009 as whole. The main causes are the bursting of the credit and real estate bubble, and a collapse in domestic demand:

Figure 1.
Figure 1.

Latvia: Real Sector, 2006-09

Citation: IMF Staff Country Reports 2009, 297; 10.5089/9781451824629.002.A001

Sources: Latvian Central Statistical Bureau, Haver, Fund Staff Calculations
Figure 2.
Figure 2.

Latvia: Labor Markets and Inflation, 2006-09

Citation: IMF Staff Country Reports 2009, 297; 10.5089/9781451824629.002.A001

Sources: Eurostat, Haver, Latvian Central Statistical Bureau, Fund Staff Calculations.1/ HICP at constant tax rates is estimated as HICP, excluding the influence of indirect taxes (excise, VAT and car registration) on consumer prices. It assumes immediate and complete pass-through, and so likely overestimates the effect of taxes on HICP.
Table 1.

Latvia: Selected Economic Indicators, 2007–10

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

Year-average.

National definition. Includes economy-wide EU grants in revenue and expenditure. Program scenario.

Gross external debt liabilities minus gross external debt assets and international reserves.

  • Retail sales fell 25 percent year-on-year in the first quarter of 2009, reflecting declines in household incomes and consumer confidence. Construction and consumer durables spending have fallen even faster (car sales down 80 percent in the first quarter), in part reflecting the credit crunch. Although the level of retail sales seems to have stabilized in the second quarter, year-on-year declines remain substantial.

  • Registered unemployment increased to 11½ percent by end-June, up from 7 percent at the end of last year. Labor force survey estimates put unemployment at 14 percent in the first quarter, above the peak projected for the program period.

6. The deeper downturn is also in part explained by the much worse than projected international environment (Figure 3). Instead of increasing by 1½ percent (the October 2008 WEO projection), output in Latvia’s main trading partners is now projected to decline by 5 percent. Partner country currencies have also depreciated sharply, so that—despite rapidly falling domestic inflation—Latvia’s real effective exchange rate has appreciated by 3 percent since the start of the program. This has complicated the original program strategy of internal devaluation through wage and price declines, driven by the authorities’ determination to keep the fixed exchange rate.1

Figure 3.
Figure 3.

Latvia: Competitiveness and the Global Outlook, 2004-09

Citation: IMF Staff Country Reports 2009, 297; 10.5089/9781451824629.002.A001

Sources: INS, World Economic Outlook, IMF Staff Calculations.1/ Dates denote different vintages.2/ Calculated as average of trading partner growth rates, using INS trade weights.3/ Projected.

7. Prices and wages have started to fall. Excluding increases in VAT and excises, since December monthly inflation has been close to zero or slightly negative. Headline inflation has fallen from a peak of 18 percent year on year in mid-2008 to around 3 percent in June. Official data show wages fell 2 percent (quarter on quarter) in the first three months of this year. But the true decline is likely much deeper, since private employers are sharply reducing undeclared cash bonuses. A tripartite committee to promote wage restraint was established in January (structural benchmark), but its effectiveness is uncertain.

8. Credit contraction has exacerbated the downturn, while the demand for lats has fallen (Figure 4):

Figure 4.
Figure 4.

Latvia: Bank Credit, 2006-09

Citation: IMF Staff Country Reports 2009, 297; 10.5089/9781451824629.002.A001

Source: Latvian Authorities, Fund Staff Calculations.
  • After funding a credit boom from 2004 to 2007, some foreign-owned banks are scaling back. An increase in their exposure in late 2008 was reversed in the first quarter, when they repaid €0.8 billion, or just under 10 percent, of their liabilities to their parent institutions. This included a €0.4 billion reversal of extraordinary short-term credit extended in late 2008. Lending standards and margins have tightened, so that overall credit has fallen 3 percent since December.

  • While euro loan and deposit rates have fallen in line with ECB rates, interest rates on lats loans and deposits have increased sharply (Figure 5), reflecting the credit crunch but also uncertainty over the exchange rate. Despite the widening rate differential, lats deposits have fallen 15 percent since the end of last year, while euro deposits have increased 15 percent. Total resident deposits were stable for most of the year, though fell around 2 percent in July.

  • Base money has fallen by one quarter since the end of last year, both currency in circulation (in part reflecting collapsing economic activity) and bank reserves (due to lower reserve requirements and declining non-resident deposits, on which banks must hold lats reserves). Net reserves have fallen even faster, as NDA rose as the Treasury drew down international financial assistance (Figure 6). However, NDA is well below program projections, because the program included a buffer in case of capital outflows or if large-scale support to the banking system were needed (Tables 23).

Figure 5.
Figure 5.

Latvia: Interest Rates and Euroization, 2006-09

Citation: IMF Staff Country Reports 2009, 297; 10.5089/9781451824629.002.A001

Source: Bank of Latvia
Figure 6.
Figure 6.

Latvia: Base Money and BoL’s Net Domestic Assets, 2008-09

Citation: IMF Staff Country Reports 2009, 297; 10.5089/9781451824629.002.A001

Source: Latvian Authorities, Fund Staff Calculations.1/ A broad measure of base money that adds outstandings on the deposit facility to the Bank of Latvia’s definition of base money (lats in circulation, banks’ required and excess reserves, and liabilities to other financial institutions).2/ Adjusted for Parex-related transactions.

9. Fiscal deficits have risen above program targets reflecting both the sharper-than-expected downturn and weak program implementation (Figure 7):

Figure 7.
Figure 7.

Latvia: Fiscal Sector, 2005-09

Citation: IMF Staff Country Reports 2009, 297; 10.5089/9781451824629.002.A001

Source: Fund Staff estimates and calculations.1/ 2006 is based on a different budget classification than the more recent years.
Table 2.

Bank of Latvia Balance Sheet 2005-10

(End-period; at program exchange rates, in millions of lats unless otherwise stated)

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Source: Bank of Latvia and IMF staff estimates and projections.

Excludes banks’ deposits at deposit facility.

Table 3.

Latvia: Monetary Survey, 2006-10

(End-period; in millions of lats unless otherwise stated)

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Source: Bank of Latvia and IMF staff estimates and projections.
  • The government missed the end-December 2008 performance criterion for the adjusted fiscal deficit by ½ percent of GDP, the end-March by ¼ percent of GDP, and the end-June indicative target by an estimated 1 percent of GDP. This reflects the adverse economic conditions and overruns in the central government deficit. Local governments on the other hand abstained from expected expenditure increases ahead of the municipal elections.

  • The program’s fiscal measures were only partly implemented. Although all the December budget tax increases (about 2½ percent of GDP) were introduced, only around one third of the 4½ percent of GDP in expenditure cuts appear to have been implemented. Significant cuts were instead made on mandated expenditure including EU-financed spending and transfers to local governments, which will later need to be reversed. Pension expenditure was also underestimated.

  • Public wages were, in general, only slightly reduced (although bonuses were removed), while monthly wages below L360 (€500) per month (the bulk of local government wages) were protected by law from wage cuts. As a result, indicative wage-bill targets for end-December, end-March and end-June were also missed.

  • Across-the-board cuts have created arrears, leading to nonobservance of a continuous performance criterion. The authorities also newly disclosed the existence of two extra-budgetary funds (one subsequently liquidated; the other suspended for the duration of the program), which breached a statement at the start of the program that no such funds existed.

  • The structural performance criterion on submitting a fully-fledged supplementary budget to parliament by end-March was not met, though in part this delay reflected the fall in February of the previous government.

10. Reflecting the output collapse, tax revenues have fallen sharply since the beginning of 2009. VAT receipts fell 30 percent year on year in the first half of the year, despite the increase in the VAT rate from 18 to 21 percent and the removal of most exemptions, because of the collapse in domestic demand and drawdown of a large overhang of VAT refunds accumulated during the boom years (2–4 percentage points of GDP). Compliance has also deteriorated. Direct taxes have been more robust, which may reflect lower than projected declines in officially recorded wages and the tendency of corporate income tax payments to lag corporate profits.

11. General government expenditure remains broadly in line with program projections, with slippages in the central government offset by temporary restraint by local governments:

  • Pension spending increased 32 percent year on year in the first half; it will rise from 6 percent of GDP in 2005 to a projected 9 percent of GDP this year.

  • The public sector wage bill remains high: it fell almost 5 percent in the first half of the year, whereas the program had assumed a 35 percent contraction.

  • The authorities recapitalized the state-owned Mortgage and Land Bank in January, creating unbudgeted above-the-line costs of ¼ percent of GDP, and (subject to EC approval) intend to convert EU funds deposited in the bank (a further ¼ percent of GDP) to further increase equity.

  • Spending in the first half of the year was temporarily depressed by a ban—since lifted—on local governments signing project contracts that extend into 2010.

12. Because of the downturn (and despite the appreciation of the real exchange rate) the current account has moved into surplus (Figure 8). Exports have fallen because of the decline in world demand. But this has been more than offset by a collapse in imports, which fell nearly 40 percent year-on-year in the first quarter of 2009. In addition, Latvia’s income account has returned to surplus as the profits of foreign-owned firms evaporated. As a result, the current account ran a €370 million (2 percent of annual GDP) surplus through May.

Figure 8.
Figure 8.

Latvia: Balance of Payments, 2008-09

Citation: IMF Staff Country Reports 2009, 297; 10.5089/9781451824629.002.A001

Source: Bank of Latvia and staff calculations.

13. However, the capital account has weakened considerably:

  • Domestically owned banks have made larger loan repayments than expected. As part of the restructuring of €775 million of syndicated loans, Parex’s external creditors were paid €232 million in March.

  • The maturity extension (only to 2011) with expected full repayment implies a lower rollover rate than assumed over the program period. Other local banks have been unable to roll over syndicated loans, even though the government was ready, in some cases, to offer guarantees on new liabilities, implying considerably larger outflows than under the program (which had assumed 40 percent rollover).

  • Some foreign banks have lowered exposure to their Latvian subsidiaries (see paragraph 8).

  • Nonresident deposit outflows have continued, on the whole at a much slower pace than the crisis last November-December, though rapid at times.

  • Residents have also begun to accumulate assets abroad—rebuilding buffers dented at the height of the crisis, though also reflecting some loss of confidence in the lats.

14. Amid all these uncertainties—the deeper downturn, loss of confidence in the lats, growing fiscal deficit—Latvia’s exchange rate peg has faced waves of heavy pressure (Figure 9).

Figure 9:
Figure 9:

Latvia: Net international reserves and FX market developments

Citation: IMF Staff Country Reports 2009, 297; 10.5089/9781451824629.002.A001

Source: Bank of Latvia.
  • Since end-December, gross international reserves have fallen more than 25 percent to €2.9 billion; net international reserves have fallen by €1.6 billion.

  • In part these outflows were caused by December’s reduction in reserve requirements, and Treasury’s sale of foreign exchange to finance the deficit. Responding to Fund staff advice to tighten monetary policy and better manage liquidity, from March the Treasury began treasury bill sales—in part financing the deficit—and this helped slow the reserve loss.

  • But the outflows also have more fundamental causes: the deteriorating economic outlook, repayment of loans from foreign parent banks, and increased demand for foreign currency deposits (and lower demand for lats deposits and base money).

  • Numerous shocks have also caused instability, including political uncertainty (February’s collapse of the Godmanis government; June local elections), press reports of possible devaluation (most notably, statements by a former Riksbank governor and senior Latvian politicians), and the shock effect of a failed treasury bill auction in May (which was caused more by simple lack of lats liquidity than devaluation risk).

  • As a result of these shocks, by end-May interest rates had increased sharply—rates on BoL instruments reached close to 80 percent—and the peg was successfully defended.

  • Following the announcement in June of an imminent €1.2 billion European Union disbursement, pressures eased considerably. The lats appreciated within the band and the central bank started to buy foreign exchange. However, forward foreign exchange rates remain high, as do CDS spreads, implying concerns over the stability of the peg as well as sustainability of the government debt.

15. The banking sector is suffering strains caused by the downturn, lower real estate prices and global deleveraging (Figure 10, Table 4):

Figure 10.
Figure 10.

Banking Sector Profitability and Solvency, 2006-09

Citation: IMF Staff Country Reports 2009, 297; 10.5089/9781451824629.002.A001

Sources: FCMC, Bank of Latvia, Latio real estate broker, Arco, Oberhaus and Fund Staff Calculations.1/ Banks (mainly foreign owned) dealing primarily with Latvian residents.2/ Banks dealing primarily with non-residents of Latvia.
Table 4.

Latvia: Financial Soundness Indicators, 2007-09

(In percent, unless otherwise indicated)

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Source: CSB, BoL, FCMC, Latvian Leasing Association, staff calculations

Banks dealing with residents (non-residents) are defined as banks in which non-resident non-MFI deposits are below (above) 20 percent of their assets.

Including euro-denominated positions.

Data for 2008 is not annualized and not comparable to yearly figures due to different sample (for 6 and 9 months respectively); ROE for 2008 based on quarterly data sample, not annualized

Interest payments only.

Prices of typical serial apartments in Riga. Source: Real estate company Latio.

Loans to residents only to total loans (including loans to non-residents).

Preliminary data.

Excluding Parex Bank.

  • A large proportion of household mortgages have negative equity (more than 50 percent of the portfolio of the largest bank) and the share of loans reported to be at least 90 days overdue has risen above 10 percent. The need to provision for bad loans has caused system-wide losses at an annualized rate exceeding 2 percent of GDP.

  • However, the FCMC reports that the banking system is adequately capitalized at present, with a system-wide capital-adequacy ratio (CAR) of 13 percent in May. Earlier this year the FCMC sought written undertakings from the parents of the major foreign banks that they will maintain adequate capitalization and liquidity of subsidiaries. Focused examination of the banking sector by external auditors has been completed at the end of March (structural benchmark) suggesting no immediate solvency issues.

  • The legal framework for bank intervention and deposit insurance has been significantly strengthened in line with requirements of the end-June structural benchmark.

III. Policy Discussions

16. The program needs to be readjusted to the changed economic conditions. In responding to these challenges, the Latvian authorities have stressed the need to respect their EU and ERM2 membership commitments. Discussions focused on:

  • Revising the macroeconomic outlook, in light of the much deeper downturn.

  • Reassessing the fiscal deficit projections for 2009 and the medium-term, evaluating the size of adjustment needed to safeguard debt sustainability, and developing specific measures that would generate this adjustment.

  • Further steps to stabilize the financial system, including strengthening Parex, developing a new business model for the state-owned Mortgage and Land Bank, and promoting recapitalization more generally.

  • Within the constraints posed by the peg, the case for using monetary policy to reduce volatility in lats liquidity.

Staff from the World Bank, Swedish authorities, European Central Bank and, especially, the European Commission, played an active role in the discussions.

A. Macroeconomic Framework

17. Latvia is experiencing a severe contraction in output, comparable to the transition recession of the early 1990s (LOI ¶7–9, Table 5):

Table 5.

Latvia. Macroeconomic Framework, 2007–14

(Percentage change, unless otherwise indicated)

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Sources: Latvian Authorities, Fund Staff Calculations.

Program scenario.

Includes 2nd pillar contributions. Accrual basis.

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

Gross external debt liabilities minus gross external debt assets and international reserves.

  • Staff and the authorities project an 18 percent fall in GDP this year. This decline is among the most severe in the world, and the cumulative output decline exceeds that of the Asian countries in 1998–99. Although some indicators suggest a milder decline in the second quarter, activity is projected to fall further in the second half of the year given expected spending cuts and tax increases in the supplementary budget.

  • The downturn is projected to continue until the second half of next year. Additional measures needed to reduce the 2010 fiscal deficit, lagged effects of real appreciation and continued deleveraging by foreign banks will likely cause continued demand weakness through early 2010. The economy is expected to stabilize in the third quarter, as the major European economies recover. Nevertheless, due to the base effects of declines in late 2009, GDP is still projected to fall on average by 4 percent in 2010 (in line with the consensus forecast). From peak-to-trough, the level of output is projected to fall by close to 30 percent.

uA01fig01
1/ Based on IMF Staff forecasts for seasonally adjusted quarterly GDP from 2007 Q4 to 2010 Q3.Sources: Central Statistial Bureau, Haver, IMF Staff Forecasts.
  • Recovery is likely to be slow. Declines in real estate, financial services, and other non-tradable activities are likely to be permanent, consistent with a fall in the level of potential output (Box 1). It will take time before Latvia becomes cost competitive enough to attract investors into manufacturing and other tradable sectors. The authorities argued that the staff’s medium-term projections were overly pessimistic, especially if the global economy were to recover more strongly than anticipated. In contrast, while accepting the staff projections, EC officials noted the downside risks to output due to fiscal restraint through 2012.

  • The projected downturn has raised unemployment substantially (straining Latvia’s social safety net) and will likely lead to continued deflation. More than 10 percent of employees, including 20–30 percent of those in central government administration, are expected to lose their jobs through 2011. Unemployment is forecast to peak in 2010 at around 18 percent (labor force survey), but could exceed this if the European recession is prolonged and migration opportunities dry up. The slack labor market, nominal wage cuts, and a large negative output gap are expected to cause mild but prolonged deflation: consumer prices are forecast to fall by a cumulative 8 percent through 2011, though an even sharper fall is possible (Box 2).

  • Macroeconomic projections are subject to greater than usual uncertainty, given the extent of the downturn, and alternative possibilities of continued downturn (as fiscal adjustment and credit reduction feed upon themselves) or a more robust recovery if the world economy, especially the EU, were to turn around. However, under either scenario, the decline in output is likely to be permanent and substantial.

18. The current account surplus is expected to widen to 4½ percent of GDP in 2009 and remain in surplus (Table 6). This is a large deviation from the original program projection of a 7 percent of GDP deficit for 2009, followed by moderate deficits. Imports have been lowered in line with the sharp falls in domestic demand—despite the widening of the budget deficit—and some projected improvement in competitiveness in later years. The income account moves into surplus in 2009–10 due to losses at foreign-owned banks and real estate companies, but returns to deficit from 2011 as interest rates increase and the foreign-owned sector makes profits again.

Table 6.

Latvia: Medium Term Balance of Payments, 2007−14

(In millions of euros)

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Sources: Latvian authorities and IMF staff estimates and projections.

2008 official financing includes short term central bank bridge loan. This bridge loan was set at EUR 500 million, though the authorities only drew EUR 360 million. Since this is short term, it is netted out of 2009 official financing as it is repaid.

Table 6.

Latvia: Medium Term Balance of Payments, 2007−14 (Concluded)

(In millions of euros)

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Sources: Latvian authorities and IMF staff estimates and projections.