IMF Executive Board Concludes 2010 Article IV Consultation and Third Review of the Stand-By Arrangement with the Republic of Latvia

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.

On July 21, 2010, the Executive Board of the International Monetary Fund (IMF) concluded the 2010 Article IV consultation with the Republic of Latvia and completed the Third Review of the country’s performance under an economic program supported by a Stand-By Arrangement (SBA).1 Completion of the review makes available an amount equivalent to SDR 90 million (about €105.8 million or US$135.6 million), bringing total disbursements under the SBA to SDR 982 million (about €1.15 billion or US$1.48 billion).

Background

Latvia’s economy grew extremely rapidly for a number of years through 2007. Capital inflows, including from foreign parent banks, and expansionary macroeconomic policies pushed up growth, but also fueled unsustainable credit and housing bubbles, as well as a current account deficit above 20 percent of gross domestic product (GDP). The combination of these bubbles unwinding, the global financial crisis, and acute banking pressures in Latvia contributed to a crisis in late 2008 and eventually to an 18 percent output contraction in 2009—the largest in the world. In November 2008, with deposit withdrawals putting pressure on international reserves and the fiscal position deteriorating due to a steep drop in revenue as well as mounting banking costs, Latvia approached the Fund and European Commission for emergency financial support.

Strengthened policy implementation since mid-2009, including sizeable fiscal adjustment, as well as financial and policy support from international program partners have helped stabilize Latvia’s economy and restore a measure of balance after the crisis. Domestic interest rates and external measures of risk have both come down dramatically since 2009. Deposits, which fell sharply early in the crisis, have returned to near pre-crisis levels, which along with a sharp improvement in the current account and international support have boosted foreign exchange reserves and restored confidence in Latvia’s exchange rate peg. While the country’s contraction has been especially steep, falling prices and wages have gone a long way toward addressing previous competitiveness problems. Policy actions in the past year have also helped insulate Latvia to a degree from recent turbulence in Western Europe

Latvia’s economy appears to be bottoming out with positive annual growth expected to return in 2011. However, growth is forecast to remain well below pre-crisis levels in the medium term, and Latvia faces a number of challenges to entrench stability, raise growth, and meet the Maastricht criteria for euro adoption as quickly as possible—a key goal of the government. These challenges include: reducing very high unemployment, including by facilitating a shift toward the tradable sector; undertaking substantial additional fiscal adjustment; ensuring that competitiveness is restored and maintained; and resolving a large private sector debt overhang that will inhibit growth.

Executive Board Assessment

Executive Directors commended the authorities for undertaking difficult fiscal and financial sector reforms, which have helped stabilize the economy and contributed to a rebound after last year’s deep recession. Although near-term vulnerabilities have declined substantially, the recovery is still fragile and significant medium-term challenges remain toward the goal of euro adoption. Directors underscored the importance of sustained fiscal adjustment, restoration of financial sector health, and continued structural reforms aimed at reorienting growth toward the tradable sector, boosting employment and competitiveness, and improving the business environment.

Directors emphasized that considerable fiscal adjustment is still needed, especially on the expenditure side, to preserve debt sustainability and lower the deficit in line with the Maastricht criteria. They encouraged the authorities to focus on high-quality measures and durable spending cuts, including by re-examining areas where spending had increased significantly in the past, and to improve control over state-owned enterprises. Given the required size of the adjustment, Directors welcomed the authorities’ medium-term tax strategy, which identifies possible revenue measures, as well as the plans to tackle the gray economy. They supported efforts to improve budget practices and promote counter-cyclical policies, including through the planned fiscal responsibility law. Strengthening the authority of the Ministry of Finance would help improve policy formulation and implementation. It would also be important to maintain fiscal discipline and avoid further deviation from the consolidation strategy through the coming election period. Preparation of a menu of options would help achieve needed savings in the 2011 budget.

Directors welcomed the substantial improvement in competitiveness since early 2009, attributable in part to the marked decline in unit labor costs. Additional wage and price adjustment, together with structural reforms, would help close any remaining competitiveness gap, further enhance confidence in the quasi-currency board exchange rate regime, and reorient the economy toward the export sector.

Directors commended efforts to address Latvia’s high unemployment rate, notably a successful public works program. They encouraged further reforms to enhance productivity, a lower tax wedge on labor, and measures to address skill shortages and mismatches through training and vocational education.

Directors welcomed the progress in strengthening financial sector regulation and supervision, bank resolution procedures, and credit and liquidity risk management rules. They emphasized the need to ensure that banks fully comply with regulations and maintain adequate provisioning against nonperforming loans. Given high levels of private sector debt, further steps would also be needed to facilitate market-based debt restructuring, streamline insolvency and foreclosure procedures and reduce costs, and address tax disincentives. Directors called for rapid action to restructure the two state-owned banks, including preparation of a restructuring plan for Mortgage and Land Bank.

Public Information Notices (PINs) form part of the IMF’s efforts to promote transparency of the IMF’s views and analysis of economic developments and policies. With the consent of the country (or countries) concerned, PINs are issued after Executive Board discussions of Article IV consultations with member countries, of its surveillance of developments at the regional level, of post-program monitoring, and of ex post assessments of member countries with longer-term program engagements. PINs are also issued after Executive Board discussions of general policy matters, unless otherwise decided by the Executive Board in a particular case.

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.

1

Under Article IV of the IMF’s Articles of Agreement, the IMF holds bilateral discussions with members, usually every year. A staff team visits the country, collects economic and financial information, and discusses with officials the country’s economic developments and policies. On return to headquarters, the staff prepares a report, which forms the basis for discussion by the Executive Board. At the conclusion of the discussion, the Managing Director, as Chairman of the Board, summarizes the views of Executive Directors, and this summary is transmitted to the country’s authorities. An explanation of any qualifiers used in summings up can be found here: http://www.imf.org/external/np/sec/misc/qualifiers.htm.