Republic of Latvia: Staff Report for the 2014 Article IV Consultation
Author: International Monetary Fund. European Dept.
Publication Date:
08 May 2014
eISBN:
9781484376294
Language:
English
Keywords:
ISCR; CR; euro; Latvia; structural unemployment; balance of payments; deficit; GDP; requirement; output gap; banking system; capital formation; current account; Commercial banks; property tax
Download PDF (2.1 MB)

Latvia entered the euro area in January 2014 with the fastest rate of growth in Europe. The 2014 Article IV Consultation highlights that a slowdown in investment and exports was partly compensated by robust consumption demand, supported by rising real wages, bringing GDP growth in 2013 to 4.1 percent. Strong job creation reduced the unemployment rate to 11.3 percent by end-2013, close to its structural level. Consumer price inflation fell to an average of about zero in 2013, mainly owing to weakening energy prices. The 2013 general government deficit outturn of 1.0 percent of GDP was below the target of 1.4 percent.

Abstract

Latvia entered the euro area in January 2014 with the fastest rate of growth in Europe. The 2014 Article IV Consultation highlights that a slowdown in investment and exports was partly compensated by robust consumption demand, supported by rising real wages, bringing GDP growth in 2013 to 4.1 percent. Strong job creation reduced the unemployment rate to 11.3 percent by end-2013, close to its structural level. Consumer price inflation fell to an average of about zero in 2013, mainly owing to weakening energy prices. The 2013 general government deficit outturn of 1.0 percent of GDP was below the target of 1.4 percent.

Context

1. Latvia adopted the euro on January 1, 2014, fulfilling a long-desired policy goal. The country has taken rapid strides since the crisis, undertaking a large internal devaluation and addressing severe macroeconomic imbalances. Over the last three years Latvia has achieved strong economic growth and a substantial fall in unemployment. Market confidence has soared; a 1 billion euro seven year government bond issued in January was heavily oversubscribed.

2. The 2012 Article IV consultation supported euro adoption and broadly commended macroeconomic policies. The staff appraisal recommended continued fiscal consolidation at a gradual pace; adoption of a medium-term framework to anchor the budgetary process; strengthening the social safety net; and close supervision of non-resident deposits (NRDs) in the banking system. Policy making has been in line with these recommendations to a considerable extent. The 2014 budget cements past fiscal gains while introducing some measures to protect vulnerable sections of society. The Fiscal Discipline Law (FDL) has been adopted and monitoring and supervision of NRD-specialized banks further strengthened.

Recent Economic Developments

3. Latvia enters the euro area with the fastest rate of growth in Europe, despite some leveling-off in the pace of expansion. Growth has moderated from an average of 5.3 percent in 2011-12 to 4.1 percent in 2013. The output gap is now largely closed and remaining unemployment is largely structural.

A01ufig01

GDP Growth and Contributions

(Real, annual percent)

Citation: IMF Staff Country Reports 2014, 115; 10.5089/9781484376294.002.A001

4. In 2013 robust consumption growth partly compensated for an investment slowdown and unexpected supply shocks in the metal industry. Consumption grew at 5.0 percent y-on-y, buoyed by rising real wages as labor market conditions tightened. On the other hand gross fixed investment declined by 4.3 percent, partly driven by negative developments in the metal industry, but also possibly reflecting increasingly binding credit constraints, and a wait-and-see attitude by investors in the run-up to euro adoption. In the middle of the year the steelmaker Liepajas Metalurgs—accounting for about 2 percent of GDP and 4 percent of exports—ceased production, following a debt default that triggered a government guarantee (Appendix I). Anemic growth in trade partners and the shuttering of Liepajas Metalurgs contributed to the weakness of exports. However, import growth was even slower—consistent with the investment slowdown—resulting in an improvement of the trade balance.

5. Inflation fell sharply. Headline inflation in 2013 was zero, compared with 2.3 percent the previous year, continuing a sustained decline since the peak of early-2011. The main cause for the decline was a 1.7 percent fall in energy prices, which has a large weight in the Latvian economy, partly due to the importance of the transportation sector. Excluding energy, food and non-alcoholic beverage components, CPI inflation was about 0.6 percent in 2013. Inflation has picked up in the early months of 2014, with y-on-y CPI rising to 0.6 percent in February, and core CPI to 1.2 percent.

6. Unemployment, while still high, is falling rapidly. By end-2013, the unemployment rate had declined to 11.3 percent, relative to 13.9 percent at end-2012, continuing the steep fall from a crisis peak of about 20 percent in 2010. The improvement is underpinned by strong job creation: over the same period, employment increased by 2.1 percent, while the participation rate held steady. Tightening labor market conditions are reflected in rising wages: real wages increased by about 4.2 percent in 2013, a significant acceleration from the muted pace of earlier wage growth (1.3 percent in 2012). This is in line with staff analysis suggesting that the cyclical component of unemployment has largely been eliminated at this juncture; remaining unemployment is mainly structural in nature.1

7. Bank balance sheets are improving, but net credit growth has yet to resume. Banks’ return on equity improved to 9.7 percent in 2013 from 8.8 percent the previous year. With the pace of write-offs accelerating, the NPL ratio for non-financial corporate loans declined to 7.9 percent in September 2013 from 10.9 percent a year previously, while that of household loans declined from 15.9 percent to 13.4 percent. But the amortization of existing loans continued to exceed the issuance of new loans, and domestic credit contracted by 5.7 percent in 2013.

8. Nordic parent banks continue to deleverage from their Latvian subsidiaries. Liabilities to parent banks declined to 4.2 billion euros by end-2013 from 5.2 billion euros a year ago, bringing loan-to-deposit ratios to 134 percent from 160 percent a year earlier. Banks report that they are now generally comfortable with the level of loan-to-deposit ratios, and stand ready to expand their balance sheets, but that credit growth is restrained by a combination of weak demand and tighter lending standards. Meanwhile non-resident deposits (NRDs) in the banking system continued to grow, albeit at a slower pace.2 NRDs grew by 11.1 percent in 2013 compared to 17.1 percent in 2012, belying concerns of a surge of deposit inflows in the wake of the Cyprus banking crisis.

9. The 2013 budget target was met despite a large unanticipated government payment on behalf of the steel firm. The general government deficit outturn of 1.3 percent of GDP was slightly below the target of 1.4 percent.3 Improved tax administration and reforms to tackle underreporting yielded substantial revenue gains. This more than compensated for higher than planned expenditures caused by the guarantee call on Liepajas Metalurgs (about 0.3 percent of GDP), and the indexation of small pensions (below 285 euros) from September onwards. Adjusting for revenue transfers from the government to the privately managed pension pillar (the second pillar), the 2013 outturn implied a fiscal consolidation of about 0.8 percent of GDP. Separately, the passage of the Fiscal Discipline Law (FDL)—which constrains the structurally adjusted fiscal deficit to 0.5 percent of GDP or less—ensures that future budgets will be grounded in a medium-term framework that seeks to avoid pro-cyclicality.

10. Since the crisis external stability has improved notably, but there are lingering concerns (Appendix II). From a substantially overvalued pre-crisis starting point, staff estimate that the real effective exchange rate is now broadly in line with fundamentals. External debt has fallen substantially but remains high at about 131 percent of GDP at end-2013. While external debt is projected to decrease by a further 10 percentage points of GDP over the medium term in the baseline, large shocks to growth and the non-interest current account could impede the adjustment. Moreover, NRDs are subject to sudden stops in the face of a sufficiently large financial shock, although the risk is mitigated by the accumulation of liquid foreign assets by and higher prudential requirements for NRD-specialized banks.

Outlook and Risks

11. Under staff’s baseline scenario, economic growth will ease slightly in 2014. Consumption is expected to level off from the rapid pace of last year, but should remain robust, supported by the continuing tightness of labor markets and a rise in the minimum wage from 280 to 325 euros per month. A rebound in investment and imports is predicated on improved business sentiment and the release of pent-up investment demand in the wake of euro adoption. Stronger growth in the euro area and other trade partners should enable more rapid export growth. However, the downward revision of baseline growth in Russia will have a moderating impact on the rebound in investment and exports. Inflation should pick up as the downward pressure from commodity prices recedes and wages continue to rise. The forecast is rather sensitive to the extent of the investment recovery, which in turn is tied to the prospects of resuscitating credit. Looking further ahead, with continuing reform efforts and prudent macroeconomic management, growth of about 4 percent per annum—well above the euro area average—should be attainable during the convergence process.4

12. There are risks to this broadly favorable outlook (RAM). A prolonged slowdown in European partner countries would dampen Latvia’s recovery and increase its current account deficit, while a surge in global financial volatility could affect bank funding. Ongoing events in Ukraine could generate real and external spillovers. While trade links with Ukraine are minor, Russia accounts for about 11 percent of exports. A deeper slowdown in Russia would adversely affect trade prospects, especially if there were broader regional spillovers. As noted by the authorities, ruble depreciation could depress export margins even if trade volumes held steady. Moreover, the flow of non-resident deposits (NRDs) to the Latvian banking system from CIS countries could be subject to volatility. On the domestic front, slow progress on important structural reforms could cause an erosion of hard-won gains in competitiveness, a resurfacing of imbalances and upward pressure on external debt ratios. That said, Latvia does have upside potential if it can generate higher levels of investment, including through additional foreign direct investment, and rapidly implement reforms aimed at enhancing productivity and improving the business environment.

Policy Discussions

13. Discussions centered on maintaining competitiveness in the euro area; reviving bank credit to support investment; ensuring fiscal sustainability over the medium term while strengthening the social safety net; and the need for vigilant financial sector supervision. Taken together, this set of policies would promote external stability going forward, while preserving internal balance and laying the foundations for robust growth.

A. Maintaining Competitiveness in the Euro Area

14. Latvia’s medium-term macroeconomic challenge—maintaining competitiveness under a fixed exchange rate regime—remains unaltered by euro accession. The chief source of past competitiveness gains was a combination of productivity growth and wage restraint. The resulting turnaround in the real effective exchange rate enabled an export-driven recovery. But with the output gap near zero and the labor market tightening correspondingly, wages are inevitably on the rise. Productivity gains should therefore be the chief driver of competitiveness gains going forward. The authorities agreed on the importance of structural reforms across a broad range of areas, aimed at improving productivity, lowering structural unemployment and enhancing competitiveness.

15. Upgrading public infrastructure could provide an important spur to competitiveness. As noted in the Baltic Cluster Report (BCR), infrastructure improvements would enhance productivity, while helping to attract FDI and associated technological knowhow. Staff urged implementation of the recommendations of the World Bank’s recent comprehensive assessment of Latvian ports: enhancing connectivity to land transport, and improving governance and accountability. Reforms to liberalize the electricity sector and deregulate tariffs would encourage new suppliers to enter the market, over time increasing supply and reducing prices. On a different front, centralizing SOE management while divesting non-core activities—in line with long-planned reforms—would improve efficiency and accountability, contributing to an improvement in the business environment. The authorities agreed with the thrust of recommended reforms in each of these areas. The World Bank recommendations were being studied with a view to develop an actionable plan. Tariff liberalization in the electricity sector—initially planned for April—had been postponed in order to develop better safeguards for low-income households, who would be negatively affected by a rise in tariffs. Legal amendments establishing centralized management of SOEs are pending in parliament.

16. Progress on education and training reforms could help Latvia reduce structural unemployment and move up the product value chain. As highlighted in the Cluster Report, reforms to higher education—including an independent quality-based accreditation of study fields, better targeting of public funding to universities, consolidation of higher education institutions and promoting the use of EU foreign languages in teaching—would build a more skilled workforce. Reforms to vocational training—including apprenticeship programs and better alignment of training with employers’ needs—could help reduce skills mismatches and hence alleviate structural unemployment in the medium-term. The authorities agreed with the need for wide-ranging reforms, and pointed to progress in a number of areas. A project has been launched with the World Bank to study a new financing model for higher education. Institutes of higher education are being encouraged to shift resources from the social sciences towards STEM fields, and to collaborate with municipalities and the private sector in anticipating the skills demanded by the market. A pilot project has been launched with technical assistance from Germany under which students from 6 vocational education and training (VET) institutions apprentice at firms with international links. The program will be studied and potentially expanded.

17. The Latvian labor market is very flexible, as documented in the BCR, but work incentives could be further improved. In particular, a more gradual phasing-out of the guaranteed minimum income (GMI) benefit—which currently phases out one-for-one with income—would reduce the tax wedge for GMI recipients entering employment. More generally, the BCR finds that labor taxation is high across the Baltics relative to comparator countries, so measures to reduce the tax wedge could yield high dividends in reducing structural unemployment. In Latvia, a system of in-work tax credits and benefits should be considered; empirical evidence suggests that these have proven particularly effective in increasing employment of lower skilled workers. The authorities agreed that reducing taxes on labor could help improve work incentives and reduce structural unemployment - and pointed to the lowering of social contributions by 1 percentage point in the 2014 budget. Moreover, the Ministry of Welfare noted that it is working on a proposal to allow GMI recipients to continue to collect the GMI benefit for a period of four months after entering employment.

A01ufig02

Productivity Growth and Real Wage Growth

(Percent)

Citation: IMF Staff Country Reports 2014, 115; 10.5089/9781484376294.002.A001

B. Reviving Bank Credit

18. The continuing contraction of credit is a concern, especially when coupled with the investment downturn. For several years following the trough of the crisis, productivity growth remained well above wage growth, allowing firms to finance investment using retained profits. But the sharp contraction in gross fixed investment in 2013 suggests that the limits to internal financing of investment may have been reached; with the tightening of the labor market, real wages are now rising more quickly and profit margins are being squeezed.

19. Latvia’s creditless recovery is in line with historical experience, but its lengthy duration makes it an outlier. The Baltic Cluster report finds that sharp boom-bust cycles are often followed by creditless recoveries, especially if the cycle is accompanied by a banking crisis, as in Latvia’s case. However, even among the sample of emerging economies that experienced creditless recoveries in the past, positive credit growth has usually resumed by this stage in the cycle. Staff analysis suggests that a combination of demand and supply factors is likely responsible for weak credit: private agents remain burdened with legacy debts, while banks have significantly tightened lending standards since the crisis. The authorities broadly concurred with the assessment, pointing to the need to ensure that credit supply to firms is not restricted to only large corporations.

20. Measures to further reduce the private sector’s debt overhang could help resuscitate the demand for credit, lower perceptions of credit risk, and underpin a rebound in investment. While earlier legal amendments have already strengthened the insolvency regime, its administration and implementation could be strengthened.5 Staff recommended reforms to the judicial system to speed up the often cumbersome process of debt resolution. A recent measure allowing the presiding officer of a court to transfer cases to less burdened jurisdictions is helping to better distribute the backlog of cases, and the number of courts has been increased. The authorities noted that legal amendments are in train to provide more efficient alternatives to the regular court system. The system of arbitration courts—which is currently unwieldy and of uneven quality—will be consolidated and standardized, to increase public confidence in arbitration and encourage its use. The Law of Mediation is being amended to allow courts to order parties to seek mediation (replacing the current purely voluntary nature of mediation). Separately, amendments to the Civil Procedure Law aim at strengthening the role of administrators in authenticating liabilities.

21. Staff warned against the hasty passage of recent legislative proposals that could act as a drag on new lending. Proposed amendments to the Personal Insolvency Law—currently with Parliament—would limit the liability of mortgage borrowers and their guarantors to the value of collateral.6 The authorities confirmed that they will not support the measure, which is likely to drive down the supply and raise the cost of new mortgage lending if enacted. They are confident that in any case the amendment will not be retroactive (which could lead to large-scale write-downs of banks’ mortgage books).

22. Over the medium-term, encouraging non-bank sources of finance may help reduce vulnerability to bank-led credit crunches. As detailed in the Baltic Cluster Report, the small scale of Latvia’s domestic market constrains development of its own capital market. Staff encouraged the authorities to pursue integration into regional markets in order to access a larger investment pool. Latvia’s stock market—like those of the other Baltic countries—is already fully integrated with the Nordic exchanges (within the Nasdaq OMX group), sharing a common trading platform and supervisory standards. But smaller companies could be encouraged to list on alternative exchanges such as First North, while regional ratings agencies or credit guarantee schemes—subject to strict supervision and risk management standards—could be explored to alleviate financing constraints for SMEs. The authorities pointed to the formation of the Single Development Institute (Appendix I) as a vehicle for encouraging alternative sources of financing for SMEs. But they noted that government schemes need to be very carefully designed to avoid moral hazard and market distortions.

C. Maintaining a Prudent Fiscal Policy

23. The 2014 budget continues with fiscal consolidation at a measured pace, appropriate to the economy’s cyclical position and moderate government debt. It targets a general government deficit of 0.9 percent of GDP, a gradual narrowing from the 1.3 percent deficit in 2013. The budget is the first to be governed by the new Fiscal Discipline Law (FDL), whose adoption is in line with Fund advice. After adjusting for transfers from government revenue to the privately managed pension pillar (the second pillar), the budget is compatible with the FDL’s medium-term objective of a structural deficit no greater than 0.5 percent.

24. The budget appropriately “unfreezes” some expenditure areas that have been under tight control since the crisis, while rearranging some revenue streams. Small pensions were indexed in September 2013, and the minimum wage has been increased from 285 euros to 320 euros per month. The authorities noted that these measures should be viewed in the context of substantial wage cuts in 2009-10 and only limited increases in 2011-13. On the revenue side, the earlier schedule of reductions in the personal income tax rate has been delayed, in line with staff advice, and replaced instead by a 1 percentage point reduction in social security contributions. To reduce the tax burden on low-income workers and families, the non-taxable threshold for workers and dependents has been increased.

25. While the budget goes some distance to address high levels of inequality, more is needed. In particular, staff urged reversal of the 2013 cuts to Latvia’s Guaranteed Minimum Income (GMI) benefit, and a re-centralization of the scheme’s financing, in line with the recommendations of a comprehensive World Bank study on employment. Social exclusion benefits in Latvia are among the lowest in Europe (Appendix III), while regional disparities mean that some income-constrained local governments may be unable to provide even the reduced benefit levels in full. The authorities argued, however, that higher GMI benefits and centralized financing were only introduced as a crisis measure, and have been appropriately reversed now that the economy is recovering. They also pointed out that local governments had not faced any constraints in financing the benefit scheme in 2013.

26. Budgetary planning will need to contend with several potential fiscal headwinds over the medium-term. Future planned declines in the PIT rate and in SOEs’ payout ratios will act as a drag on revenue, reducing revenue as a percentage of GDP by about 4 percentage points between 2013 and 2016, and thus requiring corresponding reductions in spending to meet medium-term deficit targets.7 Staff argued that such large reductions could impede adequate public expenditure on investment, especially in priority areas like infrastructure. Several options could be considered to ensure that the fiscal envelope remains adequate. First, the PIT cut should be reconsidered. While the authorities view this as a measure to improve work incentives, untargeted cuts in the PIT rate are not first-best from an efficiency or equity perspective.8 Second, revenues from property taxes could be expanded, in conjunction with cadastre reform. Property taxes are generally non-distortionary compared with other forms of taxation, and currently amount to only about 0.7 percent in Latvia, low by international standards.9 The authorities agreed that this could be a promising source of revenue, but suggested that political consensus—likely to develop only after the October election—would be required to move forward. Third, measures to broaden the tax base by combating the grey economy should continue to be pursued vigorously. The authorities pointed to significant progress in this area as a result of improved tax administration, a crackdown on fictitious companies and more frequent audits. Various indicators suggest that there has been a reduction in the number of unregistered businesses and “envelope salaries”, an increase in the number of taxpayers, and an increase in the rate of recovered tax arrears.

D. Financial Supervision

27. The level of non-resident deposits in Latvia’s banking system represents a key vulnerability to the economy, albeit one that is mitigated by some factors. At end-2013, NRDs accounted for almost half of the banking sector’s total deposits. A sudden stop or reversal in NRDs could put pressure on the country’s balance of payments, while constituting a significant contingent fiscal liability (via sovereign backing for the deposit insurance system). However, risks to the domestic economy are mitigated by the fact that about 82 percent of such deposits are invested abroad, mostly in liquid instruments.10

28. Despite widespread concerns about a substitution of NRDs from Cyprus to Latvia in early 2013, there is little evidence to date of such an effect. If anything, there has been a recent deceleration in the growth rate of NRDs. But developments so far have occurred against the backdrop of deposit withdrawal restrictions and capital controls in Cyprus. Regulators must remain vigilant to the possibility of large inflows from Cypriot depositors when controls are eased. The evolving situation in Ukraine and Russia could lead to capital flight from those countries and a surge in deposit inflows to Latvia. On the other hand, sanctions targeted against individuals and businesses in the CIS could cause outflows from the Latvian banking system to jurisdictions outside the ambit of sanctions. Some smaller Latvian banks also have considerable asset exposure to Ukraine.

29. The authorities are keenly aware of the need for vigilant supervision of the NRD banking sector. They agreed with staff that spillovers from events in Ukraine will need to be closely monitored, although they did not view as likely any systemic impact. The financial regulator (FCMC) already imposes higher minimum capital and liquidity requirements on NRD-specialized banks, in line with staff advice.11 These differential requirements will be continued under the Basel III framework. The authorities also pointed to several steps that have been taken to strengthen the AML/CFT regime, including more intensive on-site and off-site checks, larger sanctions levied against banks for regulatory infractions, and a further strengthening of customer due diligence rules. The Financial Intelligence Unit (FIU)—responsible for fighting money laundering, tax evasion and other financial crimes—has been strengthened with additional staff and comprehensive training programmes.

30. Bank supervision responsibilities will evolve as the euro area moves towards a banking union. By the end of 2014, the ECB will undertake direct supervision of systemic cross-border banks, including the large Nordic subsidiaries resident in Latvia. But supervision of these banks at a consolidated level would quite likely be separated from the ECB; with Sweden unlikely to “opt-in” to the banking union, and Norway not part of the European Union. Existing colleges of supervisors for large cross-border banks comprise both home and host representation. When the Single Supervisory Mechanism (SSM) comes into effect, modalities should be in place for close consultation between the Latvian host authorities, ECB regulators and the Nordic regulators of the parent banks, both on supervision and on setting regulatory requirements (e.g. capital and liquidity requirements). The authorities concurred with the need for close tripartite communication, noting that agreement had already been reached on expanding the supervisory colleges to include representation from all three parties.

Staff Appraisal

31. As Latvia joins the euro area, its economy continues to recover strongly. Growth in 2013 is estimated at 4.1 percent, and the output gap has largely closed. Unemployment, while still high, has been declining rapidly and is now mainly structural in nature. A slowdown in investment and exports was partly compensated by robust consumption demand, supported by rising real wages.

32. The outlook for 2014 is broadly favorable. Growth is projected at around 3.8 percent, underpinned by an investment recovery due to the positive sentiment associated with euro adoption. Exports should be bolstered by higher growth in key European trade partners. The main risks to this outlook are external. Export prospects could be adversely affected by the impact on the Russian economy of the ongoing events in Ukraine, especially if there were broader regional spillovers. Sustained weakness in European partner countries would dampen Latvia’s recovery and increase its current account deficit, while a surge in global financial volatility could affect bank funding.

33. The 2014 budget consolidates past fiscal gains at a measured pace. It contains some commendable measures to strengthen the social safety net, including a rise in the minimum wage, indexation of small pensions and a rise in the minimum income tax threshold. However, more should be done to strengthen Latvia’s Guaranteed Minimum Income (GMI) benefit.

34. Over the medium-term fiscal policy will need to contend with several potential headwinds. The passage of the FDL is welcome, and should ensure that budgeting is anchored in a framework designed to avoid pro-cyclicality. It will be important to maintain investment expenditures in crucial areas such as infrastructure, despite planned reductions in the income tax rate. Continuing efforts to reduce the scale of the grey economy—which have already yielded results—could increase the revenue envelope. Reductions in the PIT rate should be reconsidered. Property tax revenues should be expanded in conjunction with cadastral reform.

35. Latvia’s basic medium-term macroeconomic challenge—maintaining competitiveness under a fixed exchange rate regime—remains unaltered by euro accession. With internal devaluation having run its course and labor markets tightening, the focus must shift from wage restraint to productivity gains. Progress on a broad range of structural reforms will be needed to improve the business climate and yield the desired productivity improvements.

36. Priority reforms include measures to upgrade Latvia’s infrastructure, improve the system of higher and vocational education, and improve SOE management. The recommendations of a recent World Bank study of Latvian ports should be implemented as soon as possible. Plans to liberalize tariffs and introduce greater competition in the electricity sector should be expedited. Reforms to align higher education more closely with market demand, and to expand vocational education, would help reduce skills mismatches and hence alleviate structural unemployment in the medium-term. Centralizing the management of state-owned enterprises while divesting non-core activities—in line with long-planned reforms—would improve efficiency and accountability.

37. Labor market reforms to improve work incentives and lower structural unemployment should be implemented. In particular, a more gradual phasing-out of the guaranteed minimum income (GMI) benefit—which currently phases out one-for-one with income—would reduce the tax wedge for GMI recipients entering employment. A system of in-work tax credits and benefits could also be considered to increase employment of lower skilled workers.

38. Bank credit continues to contract well into the recovery in Latvia, and in the other Baltic countries, and could constrain investment going forward. A combination of supply and demand factors are likely holding back credit. Measures to tackle the private sector’s debt overhang could help resuscitate both credit demand and supply, and underpin an investment rebound. Proposed reforms to unclog the backlog of insolvency cases—including legislative amendments to encourage speedier alternatives to the traditional court system, such as arbitration and mediation—are commendable.

39. The growth of non-resident deposits (NRDs) has decelerated in recent months, but NRDs comprise nearly half of all deposits in the banking system. While the expansion of NRDs is associated with an accumulation of liquid foreign assets (which decreases the risks of domestic spillovers), the increasing size of the sector represents a source of vulnerability to external shocks. The supervision of NRD-specialized banks should continue to be sufficiently intensive and frequent, including with regard to AML/CFT, given their relatively higher risks and susceptibility to sudden surges and stops. This is particularly important in the context of elevated risks arising from events in Ukraine. Appropriately, minimum capital requirements and liquidity ratios on NRD-specialized banks are already higher than for others.

40. Staff recommends that the next Article IV consultation be held on the standard 12-month cycle.

Latvia: Risk Assessment Matrix

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Figure 1.

Latvia: Real Sector, 2007-13

Citation: IMF Staff Country Reports 2014, 115; 10.5089/9781484376294.002.A001

Sources: Latvian Central Statistical Bureau; Haver Analytics; and IMF staff calculations.1/ Difference with long-term average.
Figure 2.
Figure 2.

Latvia: Inflation and the Labor Market, 2007-13

Citation: IMF Staff Country Reports 2014, 115; 10.5089/9781484376294.002.A001

Sources: Eurostat; Haver Analytics; Latvian Central Statistical Bureau;and IMF staff calculations.1/ Labor Force Survey. Unemployment data for 2011 was revised in compliance with the population census; official data before 2011 has not yet been revised; revised data is staff estimate based on 2011 correction.
Figure 3.
Figure 3.

Latvia: Fiscal Developments, 2008-14

Citation: IMF Staff Country Reports 2014, 115; 10.5089/9781484376294.002.A001

Sources: Latvian authorities; and IMF staff estimates.
Figure 4.
Figure 4.

Latvia: Financial Markets Developments, 2006-13

Citation: IMF Staff Country Reports 2014, 115; 10.5089/9781484376294.002.A001

Sources: Bank of Latvia; Bank for International Settlements; Bloomberg; and IMF staff calculations.
Figure 5.
Figure 5.

Latvia: Banking Sector Developments, 2007-13

Citation: IMF Staff Country Reports 2014, 115; 10.5089/9781484376294.002.A001

Source: Bank of Latvia; Bloomberg; FCMC; and IMF staff calculations.1/ Data from January 2012 onwards exclude Pa rex Bank, which lost its banking license in March 2012, and Latvijas Krajbanka, which was suspended in November 2011 and lost its banking licence in May 2012.2/ Data from March 2012 onwards exclude Parex Bank and from May 2012 exclude Latvijas Krajbanka.
Figure 6.
Figure 6.

Latvia: Balance of Payments, 2007-13

Citation: IMF Staff Country Reports 2014, 115; 10.5089/9781484376294.002.A001

Sources: Bank of Latvia; ECB; and IMF staff calculations.1/ Other is the sum of other investment and portfolio investment and derivatives. In February 2012, the increase is driven by the issuance of a USD 1 billion benchmark international bond.
Figure 7.
Figure 7.

Latvia: External Debt and Vulnerabilities in the Banking System

Citation: IMF Staff Country Reports 2014, 115; 10.5089/9781484376294.002.A001

Sources: Bank of Latvia; FCMC; and IMF staff calculations.1/ exclude foreign loans and non-resident deposits.
Table 1.

Latvia: Selected Economic Indicators, 2008-14

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

LFS statistics were revised in 2011 in compliance with population census; data before 2011 have not been revised yet.

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

Gross external debt minus gross external debt assets.

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

Table 2.

Latvia: Macroeconomic Framework, 2010-19

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Sources: Latvian authorities; and IMF staff estimates.

LFS statistics were revised in 2011 in compliance with population census; data before 2011 have not been revised yet.

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

Includes bank restructuring costs.

Current account deficit (+ indicates a surplus)

Gross external debt minus gross external debt assets.

Table 3.

Latvia: General Government Operations, 2010-19 1/

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Sources: Latvian authorities; and IMF staff estimates.

Fiscal accounts are on a cash basis as provided by the authorities

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

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

Table 4.

Latvia: Medium-Term Balance of Payments, 2010-19

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Sources: Latvian authorities; and IMF staff estimates.

Gross external debt minus gross external assets.

Table 5.

Latvia: Financial Soundness Indicators, 2008-13

(in percent unless otherwise indicated)

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

Excluding Parex Bank hereinafter (Parex Bank was bailed-out in November 2008; it was excluded from the calculation of net open currency position as of March 2009 as they didn’t comply with the limits on net open currency position set by Minimum Capital Requirements regulation after they have received the state support and several restrictions on their operations were introduced; as of July 2011 banking regulator (FCMC) allowed Parex Bank not to comply with capital adequacy regulation and excluded it from calculaton of other regulatory ratios; banking licence of Parex Bank was cancelled as of March 2012 as it was converted to asset management company “Reverta”)

Excluding Parex Bank and Latvijas Krājbanka hereinafter (operations of Latvijas Krājbanka were suspended as of November 2011 and its banking licence was cancelled as of May 2012)

Regulatory Tier 1 capital to risk weighted assets as from Dec_2009 is calculated as Tier 1 capital (including deduction)/risk-weighted assets

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.

Euro-denominated positions are included in and before 2012, but not in 2013.

Data is not annualized and not comparable to yearly figures due to different sample (for 3, 6, 9 and 12 months respectively); Starting from Q2 2010 data used in calculatons is adjusted to full coverage of the nonfinancial enterprises.

Interest payments only.

Table 6.

Latvia: Indicators of Fund Credit, 2009-16

(millions of SDRs)

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Source: IMF staff estimates.