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.
On behalf of our Latvian authorities, we thank staff for the analysis provided in the staff report for the 2014 Article IV Consultation with the Republic of Latvia, the first since the euro adoption. The report properly reflects the fruitful discussions with the authorities on different policy options in the context of both the Article IV and Baltic Cluster Report missions, and the challenges that the Latvian economy is facing. The Latvian authorities have always given careful consideration to policy recommendations coming from the Fund. In our recent experience, policy discussions and Fund advice have provided meaningful input to shaping the authorities’ strategy for a prudent fiscal policy and ambitious structural reforms, which implemented in a frontloaded fashion, routed the economy out of the recession and on a sustainable growth path.
After the years of the crisis, the report describes a largely calm period of an economy in equilibrium. While GDP growth remains among the fastest in Europe, the output gap is largely closed, the current account stays close to balance, and the fiscal position is credibly anchored within the recently enacted medium-term fiscal framework. The real exchange rate is broadly in line with fundamentals and the inflation rate, that had been temporarily pushed into a very low territory by easing commodity and energy prices, is gradually picking up to more normal levels.
In this overall heartening outlook characterized by harmony between staff and the authorities on most issues, our authorities would like to provide more detailed remarks on the following subjects: first, on the outlook for 2014 and 2015 in light of the events in Ukraine; second, on fiscal and tax policies, in particular, with regards to addressing the high level of inequality; and third, on the risks associated with non-resident deposits (NRDs).
Outlook for 2014 and 2015
The recent events in Ukraine and Russia have obviously introduced new downward risks and increased the uncertainty surrounding the projections. For the time being, the effect is difficult to gauge, but the authorities’ calculations suggest that no severe downturn could be expected even in case of material disruptions of economic ties. Both the Ukrainian hryvnia and the Russian ruble have depreciated significantly, but monthly exports data do not show any effect yet; February figures still post robust annual and monthly growth.
However, a growth slowdown may not be ruled out against weaker external demand and if a further escalation leads to trade restrictions and heightened uncertainty. Anecdotal evidence points to a profound impact on businesses working in Ukraine (in particular, fish processing seems to have been harmed the most). A more diverse, but equally uncertain picture is observable in the case of exports to Russia with some enterprises even planning expansion, but most worried about the possible effect of a future escalation of tensions. Significant effects on business confidence and businesses postponing investment or expansion decisions in Latvia cannot be excluded, though very little of this is currently evident. On the upside, should the situation in Ukraine remain contained, a stronger-than-expected euro area recovery may very well provide an additional impetus to the Latvian economy.
Fiscal policy and measures addressing high level of inequality
Despite the unanticipated loan repayment on behalf of Liepajas Metalurgs1, the 2013 fiscal deficit outturn was better than expected, at 1.0 percent of GDP. Staff rightly points to the challenges related to the planned cut in PIT in the coming years. The authorities are fully aware that, if implemented without compensatory measures, it may excessively constrain much-needed public expenditure in priority areas. While it is obvious that an adequate response to this prospect will be necessary, most likely along the lines suggested by staff, it is doubtful that details of possible measures averting the revenue squeeze will be clearer before the October elections. Building on the past success, the authorities are also fully committed to continued efforts to reduce the grey economy that would further increase revenue envelope.
In line with the authorities’ priorities, the 2014 budget included several measures addressing the high level of inequality, such as indexation of small pensions and an increase in the minimum income tax threshold. After a careful analysis of the potential impact on employment, a decision was taken to increase the minimum wage. Job search requirements for unemployed have already been strengthened in 2013. An increase in the minimum income levels used to calculate last resort benefits (GMI), the introduction of gradual phasing out of this benefit with an aim to encourage return to the labor market, as well as a possible return to co-financing and a review of eligibility criteria, are being considered and discussed with municipalities and other stakeholders.
Mitigating the risks pertaining to NRDs
While recognizing the risks related to the NRDs, the authorities do not agree that “the level of non-resident deposits in Latvia’s banking system represents a key vulnerability to the economy”. The authorities closely monitor banks focused on NRDs. Those banks are subject to additional, much stricter, prudential capital and liquidity requirements (within Pillar II)—based on pre-defined quantitative criteria, taking into account both the share of non-resident deposits and loans to non-residents in bank’s balance sheet, as well as their growth rate. Currently, NRD banks’ capital adequacy ratio exceeds the minimum regulatory requirement on average about two times (reaching 17.7 percent at the end of 2013), whereas their average liquidity ratio was 78.3 percent in February 2014 (minimum regulatory requirement is 30percent). Liquidity stress test results show that each Latvian bank would be able to withstand an outflow of up to 60 percent of its non-resident deposits without recourse to other sources of financing to replenish the outflows.
The financial regulator (FCMC) will continue to enhance the risk-oriented approach to supervision and maintain Pillar II tools to adequately capture the risks inherent in banking activities, especially those of the NRD-specialized banks. Capital add-on and individual liquidity ratios for NRD-specialized banks are re-assessed annually or can be re-set more frequently, in case of material changes in banks’ strategy or risk profile. The supervisory toolkit is supplemented by macroprudential instruments that can be activated to address system-wide risks and increase resilience of banks, if mandated by external or internal developments. The new Law on Resolution and Recovery (tentatively by end 2014 or Q1 2015) will, inter alia, introduce a bail-in provision for banks’ creditors, thus effectively alleviating the potential burden of resolution costs on tax-payers.
Latvia continues to strengthen the AML framework. Significant progress has been made in the implementation of the Moneyval recommended action plan. Supervision of AML risks and bank compliance practices remains intense, recently broadening the focus, so as to also encompass non-bank payment services providers given the notable development of this segment.
On a different but related issue, the report leaves the impression that external debt, at 130.6 percent of GDP, is a significant source of concern. This concern is a long-lasting feature of Latvia’s Article IV reports. Nonetheless, it should be noted that this high level of external debt is linked to high level of NRDs, 82 percent of which, as noted in the report, are invested abroad in liquid assets, mitigating the risks of an outflow. Therefore, gross external debt is expected to remain high so long as there is a well-supervised non-resident element in the banking system. In our authorities’ view, the net debt, firmly on a declining trend (expected at 33.1 percent in 2014), would probably be more informative when it comes to the associated risks to the domestic economy.
Since the issue of the guarantee on Liepajas Metalurgs an array of enhancements to the sovereign guarantee system of Latvia has been introduced, the most intrinsic of them being improvement of guarantee planning procedure, strengthening involvement of line ministries into the planning and monitoring process and straitening the target applicant scope. These reforms render relevant grounds to avoid similar cases and fiscal impact in the future.