IMF Executive Board Concludes 2015 Article IV Consultation with the Republic of Latvia

Latvia has made remarkable economic progress since the crisis:

Abstract

Latvia has made remarkable economic progress since the crisis:

On April 24, 2015, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation1 with the Republic of Latvia, and considered and endorsed the staff appraisal without a meeting.2

Latvia’s strong recovery has recently slowed in the face of sluggish growth in the euro area and deteriorating economic conditions in Russia amid rising geopolitical tensions. GDP growth decelerated to 2.4 percent in 2014 reflecting weak demand and the prolonged closure of a steel manufacturer (Liepajas Metalurgs). Low food and energy prices held consumer price inflation around 0.7 percent despite rising real wages.

The 2014 general government deficit of about 1.4 percent of GDP was higher than expected due mainly to a one-off payment related to the sale of Citadele bank. The negative budgetary impact of the economic slowdown was largely offset by revenue gains from improved tax compliance and higher wages.

Bank balance sheets continued to strengthen. Profitability increased and the ratio of non-performing loans declined. But credit continued to contract. Growth of non-resident deposits (NRDs) in the banking system was stable.

In 2015, the weak external environment, particularly the sharp slowdown in Russia, will continue to weigh on exports and investment. This is expected to be mitigated, but not fully offset, by higher disposable income due to lower oil prices and robust real wages, the reopening of the steel manufacturer, and the accommodative monetary stance of the ECB. Over time, growth would rise to around 4 percent.

Executive Board Assessment

In concluding the 2015 Article IV consultation with the Republic of Latvia, Executive Directors endorsed staff’s appraisal, as follows:

Latvia’s economic slowdown is expected to persist this year. GDP growth is estimated to have decelerated to about 2.4 percent in 2014, reflecting the prolonged closure of steel manufacturer Liepajas Metalurgs, and weak economic performance in the euro area and Russia amid rising geopolitical tensions. In 2015 the anemic external environment—particularly the sharp recession in Russia—will continue to weigh on exports and investment. This is expected to be somewhat mitigated by higher disposable income due to lower oil prices and robust real wages, the reopening of LM, and the accommodative monetary stance of the ECB.

Faster medium-term growth will be necessary if Latvia is to close the income gap with the rest of the euro area, but this cannot be taken for granted. Medium-term growth of around 4 percent should be feasible. But adverse demographic trends will exert a downward pull on the growth trajectory, so robust growth depends on reforms to reduce still-high structural unemployment, and on boosting capital accumulation and labor productivity. Moreover, the near-term forecast is subject to several downside risks, most importantly a prolonged slowdown in important trading partners such as Russia and the euro area.

While the 2015 budget is broadly appropriate, fiscal space needs to be built-up over the medium-term. Automatic stabilizers should be allowed to operate fully this year, given the weak and uncertain external environment. Over the medium-term, various factors, such as planned reductions to the personal income tax (PIT) rate, could constrain the budget’s capacity for necessary capital and social expenditure. The authorities should explore ways to increase the revenue envelope, for example by reconsidering future PIT rate cuts, greater land taxation in conjunction with cadastre reform, the removal of the cap on social security contributions, and better targeting of a number of tax allowances. Such measures would complement the welcome focus on shrinking the grey economy through better tax compliance.

The continuing contraction of bank credit is increasingly likely to constrain investment. Staff supports recent public sector initiatives to catalyze SME lending, including by providing loan guarantees, taking subordinated positions and encouraging the development of credit bureaus. Reforms to insolvency procedures and the court system are needed to encourage writedowns and accelerate the reduction in private sector debt. This would provide a spur to new lending from both the demand and supply side.

So far there have been no significant disruptions to NRD flows arising from geopolitical tensions. But the Russia-Ukraine conflict highlights the need for maintaining vigilant supervision of NRD banks, which account for almost half of all deposits in the banking system. In this context, the authorities are encouraged to continue their efforts to strengthen and effectively implement the AML/CFT framework. Appropriately, the Financial Intelligence Unit responsible for combating money laundering and financial terrorism has been strengthened. Minimum capital and liquidity requirements are higher for NRD banks, in line with previous staff advice; and the authorities plan to impose on NRDs proportionately higher contributions to the deposit guarantee fund.

Latvia’s most important medium-term challenge is to maintain competitiveness within the euro area currency union. Future increases to the minimum wage should not exceed productivity growth. In order for Latvia to consistently exceed average euro area growth and thereby close the income gap with core economies, productivity growth must be supported by appropriate structural policies. Reforms are needed in a number of areas such as labor markets, higher and vocational education, infrastructure, and SOE management.

Republic of Latvia: Selected Economic Indicators, 2008–15

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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.

Latest data as of March 2015.

Refers to the European Central Bank money market rate from 2014 onwards.

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.

2

The Executive Board takes decisions under its lapse-of-time procedure when the Board agrees that a proposal can be considered without convening formal discussions.

Republic of Latvia: Staff Report for the 2015 Article IV Consultation
Author: International Monetary Fund. European Dept.