Outlook

Despite the difficulties, the Latvian economy is making headway, and doing it in a balanced manner. Against the backdrop of continuing geopolitical tensions and sluggish growth outlook in the EU, the 2.7 percent GDP growth rate posted in 2015 can be considered good news. In particular, since this growth rate was achieved with the current account balance in line with fundamentals, and public and private debt dynamics causing no concern.

Growth slowdown in last two quarters, however, provides some food for thought about the prospects of convergence with Western Europe. Over the last two quarters – the last quarter of 2015 and the first of 2016 – GDP growth has slowed and turned negative. Although this deceleration was mostly due to temporary factors, reflecting a combination of delays in the absorption of EU funds and problems in one large steel manufacturer, staff rightly points out that medium-term growth will hinge on the ability to implement meaningful structural reforms.

An average growth of 4 percent is indeed attainable, but it would require effort on the part of the authorities to set off additional sources of growth. The last time the economy’s growth rates reached or exceeded 4.0 percent was in 2011-2012, rebounding from a more than 20 percent drop during the crisis. In the absence of structural reforms and stronger credit expansion, growth rates of such magnitude seem challenging.

Labor Competitiveness

The authorities share staff’s concerns about rising wage pressures. Some of the increase is indeed offsetting the long period of wage restraint after the crisis. Also, it contains some measurement error due to tax evasion. However, that can only explain part to the rise; the other part points to renewed pressures in the labor market. Minimum wage increases in excess of labor productivity growth could potentially hurt competitiveness and should be avoided in the future.

Further reforms in vocational and higher education remain a core part of our strategy to strengthen competitiveness. In order to improve labor flexibility, work on revising the Guaranteed Minimum Income law, allowing for a gradual tapering of benefits, as advised by staff, is ongoing. Also, the authorities plan to introduce measures aimed at improving regional labor mobility. However, free movement of labor within the EU imposes limits to how much can be achieved by measures containing wage pressures. Against this backdrop, the authorities see measures aimed at building a more skilled workforce – namely improvements in higher and vocational education – as key to guaranteeing future growth.

Financial sector

Overall, the analysis on the reasons for low credit is in line with the authorities’ views – sluggish credit growth is likely hampering growth. Both demand and supply factors are hindering growth, albeit for different groups. While for larger enterprises and more established enterprises demand factors matter, credit supply for SMEs and households remain tight.

Lending by Nordic subsidiaries could indeed be better attuned to Latvian circumstances. The analysis in the Selected Issues paper clearly sets out the reasons for sluggish growth and can serve as a good ground for a discussion. The suggestion to use the benchmarking exercise conducted with their European partners to review banks’ internal risk models is worth considering.

However, the role of other, domestic, factors should not be underestimated. In the report, staff highlights the importance of the insolvency process. It is indeed vital to continue progress in this area; however, the authorities see that a broader approach, focusing not only on the insolvency process, but strengthening the whole legal environment and judiciary system is necessary. Strengthening the authorities’ investigative capacity, combating and preventing corruption, as well as maintaining high standards of ethics and business culture among all stakeholders – particularly state authorities and insolvency administrators – are of paramount importance. As in other policy areas, grey economy remains an important factor holding back credit recovery.

The authorities acknowledge the importance of vigilant supervision and mitigating of risks in the NRD sector. The FCMC has taken important steps to mitigate anti-money laundering and terrorism financing (AML/CFT) risks. In this context, independent reviews of AML/CFT compliance in NRD banks have been carried out by competent US consultancy firms in April and May.

As a minor point, the authorities do not share the view that limited lending of the NRD sector to the domestic economy implies that a large part of the economy has limited access to credit (as Selected Issues, p.27, Paragraph 17 seems to indicate). Given the volatile nature of the main funding sources of NRD banks, their engagement in lending for residents might be unwelcome from the financial stability perspective. It is the resident-servicing banking sector that is essential in this process.

Fiscal policy

The fiscal position remains sustainable. The 2015 fiscal deficit was 1.3 percent and in 2016 it is envisaged at 1.1 percent. Public debt remains low by EU standards and is projected to trend downwards over the medium term.

Additional fiscal space will be needed to support reforms in the education and health sectors and to strengthen the social safety net in the coming years. The authorities’ envisaged review of tax and expenditures provides an opportunity to examine options for opening fiscal space. At the same time, one should be realistic about what can be achieved at the current stage of development. While social spending is among the lowest in EU and should gradually be increased, the EU is a rather high-bar reference group in this respect. As can be inferred from the chart on page 17 of the report, social spending has a tendency to correlate with GDP per capita. Latvia still remains one of the poorest countries in the EU in need of setting the right conditions for catching-up. That said, the authorities are aware of the need to increase targeted social spending, in addition to health care and education reform, and plan to do it in the coming years.

Concerning options for opening fiscal space, the authorities see more potential in combating the grey economy and less in recalibrating the tax burden. The authorities have doubts that some of the measures suggested by staff (like the PIT surtax on high income) would constitute a ‘growth friendly taxation’. High share of grey economy implies that any re-calibration aimed at taxing the higher income share of population would fall disproportionally on the shoulders of remaining non-grey economy high wage earners. Also, it would increase the relative costs (vis-à-vis similar countries) of attracting high-skilled employees. Combating the grey economy remains the authorities’ main priority. Over the last few years, the authorities have been fairly successful in this area and will continue to implement measures strengthening the taxation framework and the capacity of tax authorities. Moreover, the ongoing tax system review will assist the authorities in developing a medium-term tax strategy focusing on policy goals such as maintaining the competitiveness of the tax system, analyzing options to improve equality and identifying options to increase government revenues to finance increased spending needs.