Republic of Latvia 2010 Article IV Consultation
Staff Report; Public Information Notice on the Executive Board Discussion; and Statement by the Executive Director for the Republic of Latvia
Author: International Monetary Fund
Publication Date:
09 Dec 2010
eISBN:
9781455212798
Language:
English
Keywords:
ISCR; CR; end-June performance criteria; compromise proposal; proposal; debt; deficit rule; year-on-year inflation; current account; private sector; broad money; labor market; personal income; fiscal policy
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Policy efforts in Latvia have supported stabilization. Immediate risks are much lower, but medium-term challenges remain. The government should focus on durable spending cuts, but revenue measures may also be required. Efforts to strengthen regulation and supervision to improve financial stability, including reducing reliance on wholesale external funding, is commended. With monetary and fiscal policy constrained by the fixed exchange rate and the need to reduce the deficit, growth depends on structural reform. While economic and financial conditions are much improved, risks remain significant.

Abstract

Policy efforts in Latvia have supported stabilization. Immediate risks are much lower, but medium-term challenges remain. The government should focus on durable spending cuts, but revenue measures may also be required. Efforts to strengthen regulation and supervision to improve financial stability, including reducing reliance on wholesale external funding, is commended. With monetary and fiscal policy constrained by the fixed exchange rate and the need to reduce the deficit, growth depends on structural reform. While economic and financial conditions are much improved, risks remain significant.

I. Background

A. From Boom to Bust1

1. During the 2000s Latvia’s economy grew extremely rapidly, helped by capital inflows and expansionary macroeconomic policies. Growth averaged 7.5 percent in the first part of the decade, driven by structural reforms ahead of European Union (EU) accession. Following EU membership in 2004, growth accelerated into double digits (Figure 1). Increased confidence in the peg caused interest rates to fall, leading to a boom typical of exchange rate based stabilizations. Substantial inflows from Nordic parent banks into Latvia’s small economy fuelled rapid credit expansion, largely foreign currency-denominated, which financed increasing current account deficits. Investment primarily in non-tradables contributed to a dramatic real estate bubble. Though strong revenue growth pushed the budget into small surplus by 2007, between 2001 and 2007 government spending doubled in real terms.

Figure 1.
Figure 1.

Latvia: Accelerating Growth and Boom Years, 2000-08

Citation: IMF Staff Country Reports 2010, 356; 10.5089/9781455212798.002.A001

Sources: Latvian authorities; and IMF staff calculations.

2. The boom proved unsustainable. Inflation increased, worsening competitiveness and turning real interest rates negative, which increased domestic demand, further fuelling the boom (Figure 2). Fund advice to tighten fiscal policy was largely ignored (Box 1). The Bank of Latvia (BoL) raised its refinancing rate largely in line with European Central Bank (ECB) changes, and increased reserve requirements in 2004 and 2005, but annual credit growth remained high. Latvia’s non-financial private sector debt rose rapidly from 35 percent of GDP in 2000 to 116 percent in 2007—in Europe an increase matched only by Iceland and Spain—and was a key source of vulnerability. The current account deficit rose to more than 20 percent of GDP in 2006 and 2007, increasing Latvia’s net external debt to 50 percent of GDP. Foreign banks, overexposed to the Baltics, started to slow lending in early 2007. By end-2007 GDP had started to fall, and then global prospects worsened.

Figure 2.
Figure 2.

Latvia: Deteriorating Competitiveness During the Boom, 2000-10

Citation: IMF Staff Country Reports 2010, 356; 10.5089/9781455212798.002.A001

Sources: Latvian authorities; and IMF staff calculations.

3. Financial sector vulnerabilities turned the slowdown into crisis (Figure 3, Table 1). Private sector deposits fell almost 10 percent between end-August and end-November. Post-Lehman, at first there were doubts over the health of Swedish banks, but the Swedish government’s announcement in September of a support package restored confidence. Then speculation over Parex Bank’s (the second largest bank, and largest domestically owned) ability to pay its syndicated loans caused a run on the bank: its deposits fell 25 percent creating a severe liquidity shortage, and necessitating a deposit freeze. The initial attempt to partially nationalize Parex was mishandled and deposits fell steeply until agreement on the SBA was announced on December 19. Aside from the turmoil in international markets, Latvian banks’ funding model (relying relatively more than neighboring countries on nonresident deposits and short-term syndicated loans) and lax lending standards during the boom exacerbated its crisis. The BoL cut reserve requirements to increase banks’ liquidity, but customers converted withdrawals into foreign currency, draining international reserves. To prevent international reserve cover of base money from falling below 100 percent (potentially threatening the currency board), ensure sufficient funds to meet depositor withdrawals, and address a rapidly deteriorating fiscal position due to falling revenue and financial sector costs, in November 2008 the authorities approached the Fund and European Commission (EC) for emergency financial support.

Figure 3.
Figure 3.

Latvia: Onset of the Crisis and Stabilization, 2008-10

Citation: IMF Staff Country Reports 2010, 356; 10.5089/9781455212798.002.A001

Sources: Latvian authorities; Bloomberg; and IMF staff calculations.
Table 1.

Latvia: Selected Economic Indicators, 2007–10

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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.

Effectiveness of Past IMF Advice Prior to the Crisis

In 2006, the Fund warned of risks from overheating and recommended a tighter fiscal stance including slower public wage growth, more effective real estate taxation to cool mortgage borrowing and moderate credit growth, strong banking supervision, and efforts to boost productivity and exports. The 2008 Article IV staff report, which was not discussed by the Board, also called for a tighter fiscal stance and steps to strengthen the tradable sector, while emphasizing the need for precautionary financial buffers and contingency planning.

The authorities maintained a stimulative fiscal stance until late in the boom despite double-digit growth and inflation, although in 2007 they did expand real estate taxation and refrain from a generalized personal income tax cut. To slow rapid credit growth and inflation, the authorities in 2007 required banks to grant loans only on the basis of legally reported income, required a 10 percent minimum down payment, and strengthened loan-to-value requirements to slow the rapid credit growth, but later reversed the last two measures. The authorities heeded advice to reinstate limits on banks’ net open position in euros in 2007, but did not follow recommendations to raise the minimum capital adequacy ratio. Most of the recommendations of the 2007 FSAP Update were implemented, except for creating a more favorable environment for out-of-court debt restructuring, and events showed that the authorities’ contingency planning was not sufficient to avoid serious challenges when banks came under pressure.

B. Program Strategy

4. Mindful of the fragile world economy, Fund staff considered a wide range of options to stabilize Latvia and stem the risk of contagion.2 Fund staff were ready to consider exchange rate depreciation, probably through step adjustment of the peg combined with full use of the ±15 percent margins allowed under ERMII (and the prospect of credible ECB intervention if these bands were tested), or through accelerated euro introduction at a depreciated rate, although this latter option was dismissed as inconsistent with the Maastricht Treaty. Depreciation would have boosted exports, allowed lower interest rates, and eased pressures on international reserves, although high pass-through could have led to rapid inflation and limited the competitiveness benefits. However, given the high share of foreign currency borrowing, depreciation would have immediately damaged household and corporate balance sheets. This could have resulted in increased private sector defaults, collapsing domestic demand and a deeper initial recession. The counter-argument is that these balance sheet effects would also happen eventually under internal devaluation, since falling wages and prices and rising unemployment would make it harder to service debts, but the process would take place over time, potentially allowing banks to adjust. Perhaps the strongest—and hardest to quantify—argument against depreciation was the risk it would encourage speculative attacks against other European countries with pegs. Post Lehman Brothers, the outcome of this could have been quite uncertain.

5. Reflecting their view of the potential costs, the authorities insisted on basing the program strategy on maintaining the peg—a pillar of economic stability since 1994. The program is built on fiscal adjustment and internal devaluation—wage and price cuts and productivity boosting reforms—to improve competitiveness and reduce the current account deficit. Given the authorities’ strong preference for this approach, and substantial financial support from the EC and Nordic and other EU countries (Sweden, Denmark, Norway, Finland, Estonia, the Czech Republic, and Poland), the Fund supported the authorities’ adjustment program (the World Bank and EBRD also provided assistance, financial and technical). An international support package of €7.5 billion (€3.1 billion from the EC, €1.7 billion Fund and €1.8 billion Nordics) was assembled and designed to be sufficiently large to convince markets the peg would stay.

C. Stabilization and Recovery

6. Though the fixed exchange rate strategy avoided the balance sheet effects of disorderly devaluation, the recession proved far steeper than envisaged at end-2008 (Figure 4). Output fell 18 percent in 2009, the deepest recession in the world. Unemployment increased to 17 percent. These worse than expected outcomes were mirrored around the world, but they were magnified in Latvia (and the other Baltic countries) due to unwinding of the imbalances built up during the preceding boom.

Figure 4.
Figure 4.

Latvia: Real Sector, 2006-10

Citation: IMF Staff Country Reports 2010, 356; 10.5089/9781455212798.002.A001

Sources: Latvian Central Statistical Bureau; Haver; and IMF staff calculations.

Latvia: Key Economic Indicators, 2008-10

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Figures for Latvia correspond to the December 2008 SBA Request (EBS/08/155).

Forecast figures for 2009 correspond to the November 2008 WEO Update.

Forecast figures for 2009 correspond to the October 2008 WEO.

Forecast figures for 2009 correspond to the December 2008 Staff Visit Concluding Statement.

7. The recession caused wage and price deflation:

  • Wages fell 10 percent in 2009, led by the public sector (potentially large declines in undeclared “envelope” wages may mean the private sector wage drop is understated) (Figure 5).

  • Consumer prices fell 1.4 percent during 2009 (end of period); excluding increases in VAT and excises, prices fell 6.5 percent.

  • Lower prices and wages have improved competitiveness. Although nominal depreciations among trading partners meant the CPI based real effective exchange rate did not peak until February 2009, it has since depreciated by around 10 percent (Figures 2 and 6).

Figure 5.
Figure 5.

Latvia: Labor Markets and Inflation, 2006-10

Citation: IMF Staff Country Reports 2010, 356; 10.5089/9781455212798.002.A001

Sources: Eurostat; Haver; Latvian Central Statistical Bureau; and IMF staff calculations.
Figure 6.
Figure 6.

Latvia: Competitiveness, 2001-10

Citation: IMF Staff Country Reports 2010, 356; 10.5089/9781455212798.002.A001

Sources: Bank of Latvia; Eurostat; and IMF staff calculations.

8. The deep recession and improved competitiveness pushed the current account into substantial surplus in 2009 and early 2010 (Figure 7, Table 6). Goods exports fell 21 percent in 2009, in part because of lower export prices, but imports fell even more, by 40 percent, due to collapsing domestic demand. A large part of the 9 percent of GDP current account surplus in 2009 reflects foreign banks writing off losses in Latvia—around 6 percent of GDP—that will likely prove transitory (these losses are recorded as positive for the income account although no funds are actually transferred; the net international investment position improves).

Figure 7.
Figure 7.

Latvia: Balance of Payments, 2008-10

Citation: IMF Staff Country Reports 2010, 356; 10.5089/9781455212798.002.A001

Sources: Bank of Latvia; and IMF staff calculations.1/ Other is the sum of other investment and portfolio investment and derivatives.
Table 2.

Latvia. Macroeconomic Framework, 2008-15

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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.

Table 3.

Latvia: General Government Operations, 2009-12

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Sources: Latvian authorities and IMF staff estimates.

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

The ESA 95 deficit for 2009 is 9.0 percent of GDP due to: (i) unspent greenhouse gas trading revenues (0.7 percent of GDP), (ii) PPPs (0.6 percent of GDP), (iii) broader definition of general government (0.2 percent of GDP), and (iv) accrual adjustments.

Table 4.

Latvia: Fiscal balances and Debt, 2006-15

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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: Public Sector Debt Sustainability Framework, 2005-2015

(Staff projections; In percent of GDP, unless otherwise indicated)

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General government.

Derived as [(r - π(1+g) - g + αε(1+r]/(1+g+π+gπ)) times previous 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.

Table 6.

Latvia: Medium Term Balance of Payments, 2007–15

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Sources: Latvian authorities and IMF staff estimates.