Republic of Latvia
Second Review and Financing Assurances Review Under the Stand-By Arrangement, Request for Extension of the Arrangement and Rephasing of Purchases Under the Arrangement and Request for Waiver of Nonobservance and Applicability of Performance Criteria
Author: International Monetary Fund
Publication Date:
15 Mar 2010
eISBN:
9781451977165
Language:
English
Keywords:
ISCR; CR; GDP; government liquidity support; end-December performance criterion; financial market condition; Latvia; current account; output gap; GDP deflator; short term; fiscal policy; foreign currency
Download PDF (1.2 MB)

This paper discusses key findings of the Second Review and Financing Assurances Review Under the Stand-By Arrangement for Latvia. The sharp economic downturn is starting to bottom out, although recovery has not yet begun. The authorities have implemented the June 2009 supplementary budget, and met with a wide margin the end-September performance criterion on the adjusted primary balance. The continuous performance criterion on external payments arrears was missed by a small amount, which the authorities expect to resolve soon.

Abstract

This paper discusses key findings of the Second Review and Financing Assurances Review Under the Stand-By Arrangement for Latvia. The sharp economic downturn is starting to bottom out, although recovery has not yet begun. The authorities have implemented the June 2009 supplementary budget, and met with a wide margin the end-September performance criterion on the adjusted primary balance. The continuous performance criterion on external payments arrears was missed by a small amount, which the authorities expect to resolve soon.

I. Introduction and Summary

1. The authorities have improved their program implementation, especially with respect to fiscal policy. The authorities have realized substantial savings by implementing the June 2009 supplementary budget almost in full, and in December they adopted a strong budget for 2010 with a further 4.2 percent of GDP fiscal adjustment. However, a recent Constitutional Court ruling has overturned last June’s pension reductions, and this will add 1½ percent of GDP to the 2010 deficit. All quantitative performance criteria (PCs) for end-September and end-December 2009 were met by large margins (data for the end-December performance criteria on the fiscal balance and public guarantees are not available but seem likely to be met, and for the fiscal balance by a similarly large margin). For the monetary performance criteria these reflect the substantial buffers that were included earlier, but the fiscal adjustment has been considerably stronger than anticipated or allowed for under the program. The authorities are working to clear small amounts of external payments arrears that resulted in nonobservance of a continuous PC. They have also fulfilled most of the structural benchmarks (though some with slight delay), although one was met only partially (assessment of the wage grid) and one has been reset (fiscal responsibility law).

2. Strong efforts to implement the program and the global recovery have strengthened confidence and reduced financial market risks. Since the First Review, pressure on the exchange rate has subsided, reserves have grown, and CDS spreads and domestic interest rates have fallen steadily. This has enabled the State Treasury to extend maturities and lower its borrowing costs in the domestic market.

3. Even so, the difficult economic situation and coming elections pose considerable risks to future reforms. Falling output and rising unemployment have increased social strains, raising the risk of a populist backlash to fiscal adjustment and an inability to plan new structural reforms ahead of the fall 2010 parliamentary election. The banking sector also remains vulnerable, as non-performing loans (NPLs) are rising and funding sources—especially from abroad—have come under strain, putting pressure on capital and liquidity and discouraging banks from resuming lending. Progress in restructuring the main state-owned banks has been slow. Tensions within the government persist, with the largest coalition party publicly questioning parts of the current Letter of Intent.

4. Recognizing the need to sustain fiscal adjustment to achieve the program’s exit strategy of euro adoption, the authorities have requested an extension of the program until December 22, 2011. This extension would include the first full year of the next parliamentary term, including preparation of the 2012 budget, which is expected to aim for a general government deficit below 3 percent of GDP (ESA definition) to meet the Maastricht deficit criterion.

II. Background

5. The economy is contracting much more slowly (Figure 1, Tables 1–2). Seasonally adjusted GDP fell by an estimated 4 percent quarter-on-quarter in the third quarter (19 percent year-on-year), down from a more than 11 percent decline in the first quarter:

Figure 1.
Figure 1.

Latvia: Real Sector, 2006-09

Citation: IMF Staff Country Reports 2010, 065; 10.5089/9781451977165.002.A001

Sources: Latvian Central Statistical Bureau, Haver, Fund Staff Calculations
Table 1.

Latvia: Selected Economic Indicators, 2007-10

article image
Sources: Latvian authorities, Eurostat, and IMF staff estimates.

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

Gross external debt minus gross external debt assets.

Table 2.

Latvia. Macroeconomic Framework, 2007-14

article image
Sources: Latvian Authorities and IMF staff estimates.

Includes 2nd pillar contributions.

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

Gross external debt minus gross external debt assets.

  • Domestic demand has continued to decline sharply. Retail sales fell by 30 percent year-on-year in the third quarter, partly due to the contractionary effect of the June 2009 supplementary budget. Depressed confidence (notwithstanding recent improvements) and a withdrawal of credit have also led to massive contractions in construction activity (down 37 percent year-on-year in the third quarter), and sales of consumer durables such as new cars (down 74 percent in the third quarter). Real estate prices seem to have bottomed out, but at 30 percent of their peak.

  • After slowing in summer, job cuts have resumed, particularly in the public sector. The registered unemployment rate rose to 15 percent in November (despite outward migration), while the labor force survey measure increased above 20 percent in October, far exceeding the 16 percent year-average projection at the First Review.

  • The domestic downturn has been partly offset by some recovery in the tradables sector. Seasonally adjusted manufacturing output has expanded by more than 10 percent since its February trough, with wood products (one of Latvia’s main exports) growing more than 40 percent. The transport sector, which depends heavily on CIS transit trade, has also held up well: the volume of cargo loaded at Latvia’s ports in the third quarter was unchanged from a year ago, although cargo unloaded was down close to 30 percent.

6. The domestic recession and falling wages have led to deflation (Figure 2). Latvian firms have responded to falling demand by trimming producer prices for goods sold domestically by 11 percent since late 2008. They have also cut wages, which fell 4 percent year-on-year in the third quarter. But the true correction has probably been even greater as these official figures omit sharp cuts in undeclared cash-in-hand wage payments. As a result, consumer prices have fallen for eight consecutive months, and in November were 1¼ percent below their year-earlier level.

Figure 2.
Figure 2.

Latvia: Labor Markets and Inflation, 2006-09

Citation: IMF Staff Country Reports 2010, 065; 10.5089/9781451977165.002.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.

7. Competitiveness is gradually improving and the external economic environment has become more supportive (Figure 3). The CPI-based real exchange rate has depreciated by 6 percent since its peak in March, back to its pre-program level, due to domestic deflation and the reversal of partner country depreciations earlier in the year. However, preliminary Bank of Latvia (BoL) data suggest that the ULC-based measure has depreciated by more. The euro area, Latvia’s largest single trading partner, finally grew in the third quarter (0.4 percent quarter-on-quarter), after five consecutive quarters of recession.

Figure 3.
Figure 3.

Latvia: Competitiveness and the Global Outlook, 2006-09

Citation: IMF Staff Country Reports 2010, 065; 10.5089/9781451977165.002.A001

Sources: World Economic Outlook, Eurostat, Bank of Latvia, IMF Staff Calculations.1/ Dates denote different vintages.

8. The fiscal deficit has been well below the First Review’s increased program targets as expenditure restraint has offset falling tax revenues (Figure 4, Tables 3–4):

Figure 4.
Figure 4.

Latvia: Fiscal Sector, 2005-09

Citation: IMF Staff Country Reports 2010, 065; 10.5089/9781451977165.002.A001

Source: Fund Staff estimates and calculations.
Table 3.

Latvia: General Government Operations, 2008-12

article image
Sources: Latvian authorities and IMF staff estimates.
Table 3.

Latvia: General Government Operations, 2008-12

article image
Sources: Latvian authorities and IMF staff estimates.

Compared to the baseline this includes 4.2 percent of GDP (L500 million) of measures, less 0.7 percent of GDP of additional net lending, 1.5 percent of GDP of additional pension spending, plus 0.3 percent of GDP of temporary cuts, timing effects etc. (see Table 5).

Total expenditure excludes net acquisition of financial assets and other bank restructuring costs.

Basic fiscal balance, in cash, or net government borrowing/lending.

Table 4.

Latvia: Fiscal balances and Debt, 2008-14

article image
Sources: Latvian authorities and IMF staff estimates.

Definition used at First Review.

Statistically adjusted from cash to accrual, less net lending, plus other liabilities (e.g., PPPs).

Table 5.

Latvia: Estimated Impact of the 2010 Budget

(percent of GDP, cash basis)

article image
Sources: Latvian authorities and IMF staff estimates.

Basic fiscal balance, or general government net borrowing requirement excluding bank restructuring costs.

Table 6.

Latvia: Public Sector Debt Sustainability Framework, 2004-2014

(percent of GDP, unless otherwise indicated)

article image

General government.

Derived as [(r -π(1+g) - g + αε(1+r)]/(1+g+gπ)) times preivous period debt ratio, with r = interest rate; π = growth rate of GDP deflator; g = real GDP growth rate; α = share of foreign-currency denominated debt; and ε = nominal exchange rate depreciation (measured by increase in local currency value of U.S. dollar).

The real interest rate contribution is derived from the denominator in footnote 2/ as r -π (1+g) and the real growth contribution as -g.

The exchange rate contribution is derived from the numerator in footnote 2/ as αε(1+r).

For projections, this line includes exchange rate changes.

Defined as public sector deficit, plus amortization of medium and long-term public sector debt, plus short-term debt at end of previous period.

The key variables include real GDP growth; real interest rate; and primary balance in percent of GDP.

Derived as nominal interest expenditure divided by previous period debt stock.

Assumes that key variables (real GDP growth, real interest rate, and other identified debt-creating flows) remain at the level of the last projection year.

  • The authorities met the end-September PC on the adjusted fiscal primary balance by nearly 3 percent of GDP (and are likely to meet the end-December PC too). They also met the indicative target on the public wage bill.

  • For the most part, the authorities have implemented the expenditure cuts in the June supplementary budget although some additional health spending was undertaken late in the year. They have also refrained from using the space for extra social safety net spending provided under the program to respond to the crisis. However, in late December the Constitutional Court ruled that last June’s pension cuts (10 percent across-the-board and 70 percent for working pensioners) were unconstitutional. This will raise the deficit by 1 percent of GDP annually (1½ percent of GDP in 2010, since the 2009 pension cuts have to be reimbursed). While not ruling out the possibility of future pension cuts, the Court held that the government had rushed the pension cuts without considering less harmful alternatives.

  • Tax revenues have been in line with program projections. Through November, the general government deficit (including net lending) is estimated at 4.7 percent of GDP. Staff project an 8 percent of GDP deficit for the year (9.3 percent of GDP excluding second pillar pension contributions, the previous program definition, compared to a ceiling of 13 percent of GDP). This forecast is uncertain given the scale and unpredictability of spending in December.

9. Expenditure has been lowered through structural reforms, and cuts in administration, social spending and the public-sector wage bill:

  • Structural reforms have continued, mainly in health and education. Drawing partly on World Bank advice, the authorities have derived permanent savings by closing underutilized hospitals, and reducing the number of teachers (given low student-teacher ratios).

  • A number of ministries, including defense, education, interior and agriculture, have cut administrative costs by merging agencies, such as a four-way merger to create the new Institute for Food and Environment.

  • However, many of the savings have come from reductions in the quality or scope of public services. These include July’s decision to suspend elective surgery unless the patient pays in full, abolition of university grants for poorer students, and cuts in research spending. However, in October health spending was allowed to increase by L25 million to cover emergency care for the remainder of the year.

  • The public sector wage bill has been reduced. The central government laid off almost 6,000 workers in the third quarter, and applied an 18 percent average wage cut to the remainder. The burden has fallen heavily on teachers, who now earn less than half the public-sector average.

  • The government increased social safety net spending less than the program allowed. It added only L14 million (0.1 percent of GDP) to cover health copayments for the poor and additional transportation for schoolchildren, not the 1 percent of GDP allowed under the program. This increase was more than offset by cuts in local governments’ discretionary benefits, such as free school meals and maternity benefits.

  • Arrears have remained low, although arrears incurred to a foreign supplier (for a L6 million contract, which the authorities expect soon to clear) meant nonobservance of a continuous PC.

10. The recession has contributed to a large current account surplus (Figure 5, Table 7). A collapse in imports coupled with a more modest decline (then stabilization) in exports has led to a very sharp adjustment in the goods and services balance, which recorded a small surplus for the first time in the third quarter (compared with a 3½ percent of GDP deficit last year). The current account surplus reached an annualized 8.7 percent of GDP for the first nine months of 2009, a sizeable reversal compared to deficits of 22 percent of GDP in 2007 and 13 percent in 2008. Excluding foreign banks’ provisioning for non-performing loans (which does not create a reserve inflow but reduces the stock of external debt), the surplus for the whole year is projected to be somewhat less, at around 3 percent of GDP. This represents a dramatic turnaround, and a considerable improvement on earlier projections.

Figure 5.
Figure 5.

Latvia: Balance of Payments, 2008-09

Citation: IMF Staff Country Reports 2010, 065; 10.5089/9781451977165.002.A001

Source: Bank of Latvia and staff calculations.
Table 7.

Latvia: Medium Term Balance of Payments, 2007-14

article image
Sources: Latvian authorities and IMF staff estimates.