Republic of Latvia
Fifth Review Under the Stand-By Arrangement and Financing Assurances Review, Request for Waiver of Nonobservance of a Performance Criterion, and Proposal for Post-program Monitoring

Latvia’s economy continues to recover, but the worsening global outlook is likely to hurt growth. Implementation of the program has made the economy more robust to shocks, but risks remain that could derail the recovery and the goal of euro adoption. Spillovers from the euro area crisis could increase—reducing growth and increasing capital outflows—and complicate plans to tap international capital markets. The authorities’ macroeconomic strategy has centered on substantial wage and price cuts and productivity growth to improve competitiveness and reduce external imbalances.

Abstract

Latvia’s economy continues to recover, but the worsening global outlook is likely to hurt growth. Implementation of the program has made the economy more robust to shocks, but risks remain that could derail the recovery and the goal of euro adoption. Spillovers from the euro area crisis could increase—reducing growth and increasing capital outflows—and complicate plans to tap international capital markets. The authorities’ macroeconomic strategy has centered on substantial wage and price cuts and productivity growth to improve competitiveness and reduce external imbalances.

I. Introduction and Program Achievements

1. Latvia’s program has delivered on many of its main objectives, although a number of vulnerabilities remain (Figure 1):

  • The exchange rate peg to the euro has held despite significant pressures early on in the program. Although international reserves fell by around 37 percent between September 2008 and June 2009 as customers withdrew their bank deposits and converted them into foreign currency, they have since risen above pre-crisis levels. The rebuilding of reserves reflects substantial financial assistance from the IMF and other donors, and also an improved current account and the successful return to international capital markets in June this year. While banks’ deleveraging means that outflows are persisting, these no longer threaten the peg.

  • Deposits are now above pre-crisis levels. Private deposits had declined by 19 percent between end-August 2008 and end-September 2009—much of these were non-resident deposits in the now-restructured Parex Bank—but prudential indicators show the banking system has since strengthened significantly (Table 11). Emergency liquidity assistance provided by the BoL to meet these deposit withdrawals was repaid in full in August 2010.

  • The authorities have implemented substantial fiscal consolidation over the program period. Fiscal adjustment measures of around 15 percent of GDP—the bulk taken in 2009—have reduced the fiscal deficit from 9.7 percent of GDP (ESA95) in 2009 to a projected 4 percent of GDP in 2011. The fiscal consolidation has brought Latvia close to meeting the Maastricht fiscal criterion and reduced financing risks.

  • The authorities’ macroeconomic strategy has centered on substantial wage and price cuts and productivity growth to improve competitiveness and reduce external imbalances. Domestic price inflation has been low, while wages fell by 13.6 percent from the end of 2008 through early 2010. This has contributed to a 10 percent depreciation of the CPI-based real effective exchange rate from its 2009 peak, while the ULC-based rate has depreciated 22 percent. The current account deficit—which peaked at 22.5 percent in 2007—moved to a surplus of more than 8 percent of GDP in 2010, but is now falling back toward balance.

  • However, these competitiveness improvements have come at the cost of substantial declines in economic activity and job losses. GDP fell 21 percent from 2007 to 2010 and remains well-below pre-crisis levels, while unemployment rose to 20.7 percent (labor force survey) though has now fallen to 14.6 percent. Latvia’s poverty rates remain among the highest in Europe, making the program’s emergency social safety net critical. According to Eurostat data, severely materially deprived people accounted for 27.4 percent of the population in 2010.

  • Moreover, a number of vulnerabilities remain unresolved. Disbursement of program funds has resulted in an increase in the external debt to GDP ratio (though in line with original program projections and now declining); much of this debt will need to be repaid in 2014-15. Short-term external debt has also increased as a result of large inflows of non-resident deposits. And while the banking sector has returned to profitability, slow court and insolvency procedures mean that the share of non-performing loans remains high at around 18 percent of total loans, constraining credit availability and domestic demand.

Table 1.

Latvia: Selected Economic Indicators, 2008–12

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

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

Actual rate as of December 6, 2011.

Gross external debt minus gross external debt assets.

Lat is pegged to the euro at 1 EUR = 0.702804 LVL rate, with ±1 percent band.

Table 2.

Latvia: Macroeconomic Framework, 2010-16

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Sources: Latvian authorities; and IMF staff estimates.

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

Includes 2nd pillar contributions and privatization receipts, excludes bank restructuring costs.

Current account deficit (+ indicates a surplus)

Gross external debt minus gross external debt assets.

Table 3.

Latvia: General Government Operations, 2010-13

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Sources: Latvian authorities; and IMF staff estimates.

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

Includes budgetary contingency reserves and estimated structural spending needs.

Excludes one-off and unsustainable measures and a (negative) ESA correction buffer for unforeseen events.

The bank restructuring costs are calculated in accordance with ESA 95 definitions.

Table 4.

Latvia: Fiscal Balances and Debt, 2006-12

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Sources: Latvian authorities; and IMF staff estimates.

Definition used at First Review.

2011 excludes non-bank restructuring costs.

Table 5.

Latvia: Public Sector Debt Sustainability Framework, 2006-16

(In percent of GDP, unless otherwise indicated)

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Source: IMF staff estimates.

The coverage refers to the general government; gross debt is used throughout.

Derived as [(r - π(1+g) - g + ε(1+r)]/(1+g+α+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(l+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, 2010–16

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Sources: Latvian authorities; and IMF staff estimates.

Gross reserves in percent of banks’ short-term liabilities and amortization minus the current account surplus.

Gross external debt minus gross external debt assets.