Republic of Latvia: 2019 Article IV Consultation—Press Release; and Staff Report

2019 Article IV Consultation-Press Release; and Staff Report

Abstract

2019 Article IV Consultation-Press Release; and Staff Report

Context

1. Ten years after the crisis, the Latvian economy continues to strengthen. Growth has averaged 3½ percent and accelerated above 4 percent in 2017–18; the current account has been balanced on average, and external debt has declined by more than a quarter since its post-crisis peak. Credit to GDP has almost halved, and balance sheets have improved significantly. Latvia is in a much stronger position to face adverse shocks and weather an economic downturn than it was before 2008.

2. However, structural constraints create obstacles to a more robust and equitable long-term growth. A tight labor market and a rapidly declining population create binding capacity constraints and limit potential growth. Investment and capital accumulation—once EU funds taper off—will peter if credit growth remains anemic. Low technological diffusion constrains the acceleration of productivity growth. As poverty and inequality remain high, especially among the elderly, Latvia’s aging population is bound to put pressure on fiscal resources and create difficult policy choices about the most efficient use of limited public money.

3. Reputational risks still mar the financial system. Latvia’s third largest bank, ABLV, is undergoing self-administered liquidation after its closure in 2018 due to alleged money laundering (ML). An assessment by MONEYVAL1 raised concerns about Latvia’s anti-money laundering and combating the financing of terrorism (AML/CFT) regime. The number of low ratings that this entailed put the country at risk of being designated (grey-listed) as a jurisdiction with strategic AML/CFT deficiencies. The business model refocusing of Latvia’s banks servicing foreign clients (BSFC) remains untested and could result in greater risk-taking in an over-banked sector.

4. The 2018 Article IV recommendations have been broadly reflected in Latvia’s policies. The new five-party government coalition, which took office in January 2019, has demonstrated strong cohesion and commitment to addressing the challenges the economy faces. The 2019 budget and medium-term stability plan reverse last year’s procyclicality and commit to fiscal prudence, in line with staff recommendations. The authorities have taken actions to reduce exposure to risky banking operations, including through efforts to address MONEYVAL’s recommendations and by overseeing new business plans of BSFCs. The reforms of the insolvency regime and labor markets—vocational education and training, active labor market policies, and access to housing— have progressed.

Recent Economic Ddevelopments

5. Real GDP growth continued to surprise on the upside. It reached 4.8 percent in 2018, significantly exceeding staff’s expectations, with growth in the last quarter generating a strong momentum for 2019. Construction, driven by private investment and rapid utilization of EU structural funds, was the main sector behind this performance. The IT and communication sectors also showed very strong growth, fully offsetting the weak performance of financial services due to the downsizing of BSFCs (Figure 1).

uA01fig01

Gross Value Added of Selected Sectors

(Year-on-year percent change)

Citation: IMF Staff Country Reports 2019, 264; 10.5089/9781513509983.002.A001

Sources: CentralStatistical Bureau of Latvia; Haver Analytics;and IMF staff calculations.

6. Fiscal policy was expansionary despite revenue overperformance. Total cash revenues exceeded staff projections by about 0.3 percent of GDP, thanks to a substantial increase in non-tax revenues2 and buoyant corporate income tax and social security contribution collections supported by better than expected profits and strong wage growth and employment. Expenditure was driven by EU-funded investments and an increase in health and defense spending. The 2018 deficit of 1 percent of GDP was broadly in line with staff projections and implied a fiscal stimulus of about 0.4 percent of GDP (Figure 2).

7. Inflationary pressures eased somewhat in 2018. Average headline inflation decelerated to 2.6 percent in 2018, driven by a decline in global food prices and a VAT reduction for fruits and vegetables, but picked up at the beginning of 2019 reflecting a delayed adjustment in administered gas and electricity prices in response to the energy price increase in 2018 (Figure 3). Average core inflation, at about 2 percent, was 0.6 percentage points lower than in 2017, but accelerated at the end of 2018 following an increase in excise taxes. Energy prices contributed near 1 percentage point to headline HICP and the delayed passthrough to transport and housing accounted for about 0.3 percentage point of core inflation.

uA01fig02

HICP Inflation

(Yoy percent change)

Citation: IMF Staff Country Reports 2019, 264; 10.5089/9781513509983.002.A001

Sources: Central Statistical Bureau of Latvia; and IMF staff calculations.

8. Wages increased significantly, as the labor market continued to tighten. A labor shortage and the increase in minimum wages at the beginning of 2018 pushed real wage growth to 5.7 percent, with private and public sector wages seeing equivalent increases (Figure 4). The highest wage growth was in the health sector (16 percent), following the health care reform that provided higher salaries for medical workers. Unemployment declined significantly to 7.4 percent at end-2018, while labor force participation reached an all-time high of 78 percent. At its lowest level in 10 years, net migration continues to put pressure on the labor market, but at a slower pace.

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Migration Trends

(In thousands)

Citation: IMF Staff Country Reports 2019, 264; 10.5089/9781513509983.002.A001

Sources: Central Statistical Bureau of Latvia; and IMf staff calculations.

9. The current account swung to a deficit. Despite a moderate terms-of-trade improvement, the current account turned into a deficit of 1 percent of GDP in 2018 (Figure 5). Export volume growth decelerated to 1.8 percent amid a moderation in external demand, poor food and agricultural production, partly due to adverse weather conditions, and a decline in exports of financial services on the back of shrinking non-resident deposits. Import volumes grew by 5.1 percent amid strong investment and robust household consumption. Rising real wages pushed unit labor costs to above their pre-crisis peak, and the CPI-based REER continued to appreciate. REER measures accounting for Latvia’s share in global supply chains show a larger appreciation, signaling a faster erosion of competitiveness compared to standard REER measures.3 Yet, profitability in key export-oriented sectors is still very strong. The external sector position is assessed to be moderately stronger than implied by fundamentals and desirable policies. The current account gap is largely attributed to policy gaps, mainly low public health spending and a meager credit growth, only partially offset by a higher-than-desirable fiscal deficit (Annex I).

uA01fig04

Conventional, Value-added REER and ULC

(Index, 2010=100)

Citation: IMF Staff Country Reports 2019, 264; 10.5089/9781513509983.002.A001

Sources: Bems and Johnson (2017); Timmeret al (2015); and IMF staff calculations.
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Enterprise Profitability vs. ULC in Manufacturing

(Index, 2010=100)

Citation: IMF Staff Country Reports 2019, 264; 10.5089/9781513509983.002.A001

*2018 is an estimated average of 2018Q1-Q4.Sources: Central Statistical Bureau of Latvia; Haver Analytics; and IMF staff calculations.

10. The banking system is solvent, profitable, and liquid, but credit growth remains elusive. Capital levels about 40 percent higher than the euro area average suggest ample capital buffers. With average liquidity coverage four times the regulatory minimum, the banking system has the highest share of excess reserves (about 20 percent of total assets) in the euro area. While profitability has slightly decreased since 2016, it remains solid, as slow credit growth has helped stabilize net interest margins amid lower lending rates. Asset quality continues to improve, with NPLs of retail and NFC lending further declining to almost 3 percent—far below the euro area average. The de-risking4 and deleveraging of the BSFC sector further dampened already weak credit growth. While the government-sponsored mortgage program contributed to a slight recovery of household (HH) credit in 2018Q4, SME lending programs have been less successful. Total HH credit declined by 5.4 percent and credit to non-financial corporations declined by 5.8 percent (Figure 7).

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Banking Sector Indicators (Q4 2018)

(Percent)

Citation: IMF Staff Country Reports 2019, 264; 10.5089/9781513509983.002.A001

Note: BSDC = banks servicing domestic clients, BSFC = banks servicing foreign clients, CET1 = Common Equity Tier 1, CIR = cost-to-income ratio, LCR = liquidity coverage ratio, RHS = right hand side; 1/ Data based on consolidated (solo) reporting from 8 (3) banks; 2/ All significant banks (110) directly supervised by the ECB at the highest level of consolidation for which common reporting (COREP) and financial reporting (FINREP); 3/ For SSM: RoE and RoA are computed by dividing "net profit/loss" by, respectively, "equity" and "total assets" at the end of the corresponding reference period. Sources: ECB; FCMC; and staff calculations.

11. Public and external debt remain firmly on a downward path. Latvia’s investment-grade rating was reaffirmed, helping maintain stable market access at very low spreads. These favorable conditions have allowed the authorities to lengthen public debt maturities, recently launching a successful 30-year Eurobond. Prudent fiscal deficits and favorable macroeconomic conditions have helped reduce the public debt burden to 37 percent of GDP in 2018. The sharp decline in nonresident deposits led to a reduction of external debt by a whopping 20 percentage points in 2018 (Annex II and III).

Outlook and Risks

12. Growth is expected to decelerate in 2019. A slower pace of EU fund absorption and wage growth will moderate domestic demand, bringing GDP growth to just above 3 percent. Export growth is expected to recover slightly as one-off adverse weather effects wear off, but will remain sluggish in line with a slowdown in trading partners’ growth and weak service export growth. While the domestic demand slowdown is projected to impact imports, a trade balance deterioration will further widen the current account. Over the medium term, GDP growth is projected to gradually converge to its potential of 3 percent, as EU funds taper off, and capacity constraints become more binding.

Medium-Term Outlook

(percent change)

article image
Sources: Central Statistical Bureau of Latvia and IMF Staff calculations.

13. Wage pressures will keep inflation above 2 percent. With unemployment below its natural rate—estimated near 8 percent—the labor market will continue to pose constraints and keep wage growth above 4 percent before decelerating in line with productivity.5 Inflation is projected to gradually ease and settle at slightly above 2 percent, reflecting catch-up effects relative to the euro area.

14. Risks to the baseline are tilted to the downside, with external factors becoming more prominent. Being a small open economy and relatively well integrated in global supply chains, Latvia could suffer from weaker than expected external growth, especially in the euro area, a sharp tightening of global financial conditions, and rising protectionism. Staff estimates that weak external demand due to a slowdown in the euro area could adversely impact growth by about ½ percentage point.6 Escalation of trade tensions could reduce growth by up to ¼ percentage point.7 A sharp downturn combining the above shocks with a severe confidence shock could reduce growth significantly more.

15. Domestic risks stem from AML/CFT concerns. A failure to improve the AML/CFT regime in line with MONEYVAL’s main recommendations could trigger a grey-listing by the FATF in February 2020 and severely damage confidence in Latvia’s financial sector and its oversight. While the growth impact of ABLV’s closure has so far been negligible, AML/CFT deficiencies in screening claims of non-insured creditors could raise reputational risks. Similarly, failure to refocus the BSFC sector towards a viable business model could put financial sector stability at risk. AML/CFT concerns could have a significant impact on Latvia’s sovereign risk premium and credit conditions (Annex IV) if they result in additional failures in the BSFC sector and/or trigger further withdrawal of parent support of large foreign-owned banks that provide significant domestic lending. Upside risks stem from a faster than projected recovery in credit growth due to effective insolvency administration reforms.

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Balance of Risks

Citation: IMF Staff Country Reports 2019, 264; 10.5089/9781513509983.002.A001

Authorities’ Views

16. Despite slight differences in near-term growth projections, the authorities broadly agreed with staff’s views on the outlook and risks. They expressed a concern that if wages continue to grow near their current pace as the economy moves into a slower gear, profit margins might decrease with gradually worsening cost competitiveness. However, they agreed that signs are inconclusive yet, as wage and producer price growth is decelerating, and consumer price inflation remains at a healthy level. While they emphasized that external risks are greater than domestic, they concurred that risks in the financial sector need to be promptly addressed.

Policy Discussions: Preparing for the Slowdown

Policy discussions focused on the medium and long-term growth outlook and policy options to boost productivity. Higher productivity growth is needed to offset the large projected growth impact of demographic headwinds and ensure robust long-term potential growth and rapid convergence with the average euro area per capita income. The fiscal stance is appropriate, and fiscal space is available to face adverse shocks. The focus of fiscal policy should turn to the long-term policy mix needed to support productivity improvements and address poverty and inequality. Concerted efforts are needed to address AML/CFT concerns, repair the reputation of the financial system, and ensure that it supports the credit needs of the real economy.

A. Macro-structural Policies: Raising Productivity

17. Medium-term growth is projected to remain strong. GDP growth is expected to decelerate in 2019 and converge to its potential of 3 percent by 2022 (Annex V). Demographic projections suggest that the working age population will reverse its upward trend observed in the recent past and become a significant drag on GDP growth. Supported by ongoing tax and structural reforms, which are expected to underpin a gradual recovery of credit growth and encourage private investment, capital accumulation will remain a steady contributor to potential growth even in the face of tapering EU investment funds. The contribution of TFP growth is assumed to remain in line with its long-term historical average of 1.5 percent.

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Potential Growth Projection in the Baseline Scenario

(In percent)

Citation: IMF Staff Country Reports 2019, 264; 10.5089/9781513509983.002.A001

Sources: Central Statistical Bureau of Latvia; Haver Analytics; and IMF staff calculations.
uA01fig09

Long-Term Potential Growth

(Annual, in percent)

Citation: IMF Staff Country Reports 2019, 264; 10.5089/9781513509983.002.A001

Sources: UN WPP, ILO; and IMF staff calculations.

18. However, the long-term outlook for potential growth is very challenging.8 The working age population is projected to decline by about 31 percent in the next thirty years, implying an average reduction in annual average potential growth of 1¼ percentage points. Furthermore, labor force aging—with the share of workers above the age of 55 increasing by about 3.6 percentage points—is projected to dampen productivity. The adverse effect of the aging workforce on TFP implies an additional dent on potential growth of about ¼ percentage points by 2050. In the very long run, potential growth is thus likely to average around 1½ percent. With 2050 output level lower by a third than if growth were to remain at 3 percent, income convergence will continue, but at a much lower pace.9

19. Reforms that ease labor market constraints could partially offset the negative impact of adverse demographics trends. Measures that improve access to housing, reform vocational education and training, encourage lifelong learning and increase participation in active labor market policies (ALMPs) would promote better skill matching and help reduce structural unemployment. This would also strengthen competitiveness and prevent wages from eroding profitability in the medium term. Policies that help increase participation rates of targeted groups—youth, women, and older workers could increase labor supply in the long run. However, except for policies that stem emigration and encourage permanent immigrant labor, labor reforms would fall significantly short of offsetting the longer-term impact of demographic trends.10 Appropriate costs of tertiary education and incentives for those completing it—residents and nonresidents—to work in Latvia could stem net emigration of skilled workers. Most importantly, increasing productivity growth would allow more rapid wage growth and thus help narrow the income gap between Latvia and the euro area, reducing outward migration and supporting potential growth.

20. Productivity is being held back by impediments to investment and lack of diffusion of new technologies. TFP growth has increased steadily since the crisis, but on average remains well below its high pre-crisis levels due to the very slow transformation of human and physical capital. Latvia’s capital stock is largely composed of buildings and structures. The share of technological equipment and intellectual property in total fixed assets—about 2 percent—has increased only marginally since its pre-crisis level and remains the lowest among European peers. Gross R&D spending—at 0.5 percent of GDP—is only a quarter of the EU average. The share of innovative companies—only 6.3 percent of total—is also very low compared to an EU average of 14 percent.

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Fixed Assets: Technology and Intellectual Property, 2016

(In percent)

Citation: IMF Staff Country Reports 2019, 264; 10.5089/9781513509983.002.A001

Sources: Eurostat; and IMF staff calculations.
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R&D Spending and Innovation, 2017

(In percent; percent of GDP)

Citation: IMF Staff Country Reports 2019, 264; 10.5089/9781513509983.002.A001

Source: Eurostat; OECD Science, Technology and Industry Scoreboard 2017; and IMF staff calculations.

21. Structural reforms supporting TFP growth will thus be critical to mitigate the demographic impact on potential growth. Maintaining potential growth at 3 percent in the long run would require an improvement in TFP growth of near ½ percentage point. There are several avenues to achieve this improvement:

  • Investment in new technologies. Evidence points to a positive impact of intangible assets on productivity growth.11 The ability of firms to invest in new technologies hinges on reforms addressing obstacles to the provision of credit and other measures boosting investment. The 2017 income tax reform may encourage reinvestment of profits, once it is fully effective. Specific tax incentives—replacing tax incentives that expired in 2018—could encourage R&D investment, but need to be carefully designed to improve uptake and prevent misuse.

  • Access to finance. Staff’s analysis shows that Latvia’s companies with access to finance tend to have higher productivity growth. An increase in debt financing (as measured by debt-to-asset ratio) by 10 percentage points tends to be associated with higher productivity growth by about 0.5 percentage point. Increasing access to finance, especially for small productive firms, could thus have large efficiency gains.

  • Better resource allocation. Staff also finds that an excess debt burden hurts productivity growth, and financially distressed firms negatively impact the productivity growth of other firms in the same sector, possibly by holding up productive resources and reducing their ability to borrow. To achieve higher TFP growth, resources need to be allocated among healthy firms, while insolvent companies need to be liquidated or restructured under more efficient procedures (see financial sector section).

  • FDI inflows. Despite having some of the least restrictive FDI rules in the EU,12 Latvia’s FDI inflows have been relatively weak, especially in the non-service sector. This is in part because of deterrents, such as red tape, perceived corruption, informality, and public sector inefficiencies.13 Addressing these deterrents and encouraging FDI inflows, especially majority-stake acquisitions, could also help raise productivity growth.14 In this regard, the OECD estimates significant long-term growth benefit of SOE stake sales and strengthening competition in Latvia.15

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FDI Stock by Industry

(Inward; in percent of GDP)

Citation: IMF Staff Country Reports 2019, 264; 10.5089/9781513509983.002.A001

Note: Value of foreign investors’ equity in and net loans received by enterprises of a specific industry resident in the reporting economy. Sources: Euroslat; Haver Analytics; and IMF staff calculations.

Authorities’ Views

22. The authorities agreed that easing labor market constraints would support competitiveness in the short and medium term. They reiterated their skepticism about differentiating minimum wages across regions due to administrative complexities but emphasized their efforts to reduce structural unemployment by improving skill matching, upskilling, and ALMP uptake. Regarding migration policies, they agreed that the focus should be on encouraging inward and discouraging outward migration and were open to policies that would attract high-skilled immigrant labor. The authorities consider productivity-enhancing reforms as critical to mitigating the negative impact of adverse demographic trends on long-term growth. Improving the business environment is necessary to attract foreign and domestic investment, while capital market development could help unlock financing for large firms and redirect bank financing to medium and small enterprises. They also noted that cost pressures from labor shortages are creating incentives for companies to invest in new technologies, but policies are nonetheless needed to improve R&D spending.

B. Fiscal Policy: Supporting Growth

23. Fiscal policy in 2019 is projected to be slightly contractionary. With a lower revenue intake, as the full impact of the tax reform kicks in, and limited new spending initiatives, the 2019 overall balance is expected to improve by 0.4 percent of GDP. Higher spending (0.6 percent of GDP) on wage increases for health and judiciary workers (0.2 percent of GDP), one-off special benefits of ministry of interior employees,16 and public investment are compensated with an increase in social security contributions, new measures to boost tax compliance, and exceptional revenues from SOE dividend payments and sale of CO2 allowances (about 0.6 percent of GDP).17 With a closing output gap, the structural effort amounts to about 0.4 percent of GDP.

24. Under current policies, the fiscal stance is expected to be broadly neutral over the medium term. The authorities’ medium-term objectives outlined in the 2019 Stability Program, suggest there are no immediate risks of fiscal imbalances. These objectives would help achieve a small consolidation of about 0.3 percent of GDP over the medium term, enough to keep public debt relatively low, declining, and manageable (Annex III). However, new measures currently under discussion, including further wage increases, tax adjustments, and a territorial reform could entail fiscal costs that need to be carefully assessed and for which financing sources need to be identified in future budgets. While recent increases to the minimum wage and wages in specific sectors have not undermined fiscal stability, it has put pressure on the overall wages in the economy, particularly in the service sector. Further increases, if not aligned with productivity growth, could undermine competitiveness and should thus be avoided.

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Structural Balance and the Business Cycle

(In percent of GDP)

Citation: IMF Staff Country Reports 2019, 264; 10.5089/9781513509983.002.A001

Sources: Ministry of Finance; and IMF staff calculations.

25. The targeted fiscal path suggests Latvia has some fiscal space to react to shocks. Fiscal space is underpinned by solid access to financing under favorable terms and relatively low debt burden and gross financing needs, both of which are projected to be on a declining path under the baseline and stress scenarios. Furthermore, public debt and the fiscal stance seem resilient even under a temporary expansionary fiscal policy scenario.18 Given the closing of the output gap and existing uncertainties related to ongoing and planned reforms, the authorities’ fiscal path is appropriate. Should negative shocks materialize, the authorities should let automatic stabilizers operate fully. In the event of a severe economic downturn, expansionary fiscal policy through temporary, high-quality measures could be considered.

26. Room for policy maneuvering could be limited over the long term. Spending needs could increase if social and fiscal pressures to address relatively high poverty and inequality levels and a rapidly aging population increase.19 Due to a significant decline in replacement rates to about 16 percent by 2050 under the existing retirement benefit rules, long-term pension spending costs are projected to fall, offsetting the rise in health and other long-term care spending. The existing pension system thus ensures fiscal sustainability, but raises questions of its social sustainability, especially considering already high poverty rates among the elderly. Balancing social and fiscal sustainability may require policies to expand fiscal space over the long term. Raising replacement rates to the recommended ILO minimum of 40 percent could increase costs by almost 4 percentage points of GDP over the next ten years.20

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Poverty Rate Relative to EU Income Level, 2016

(In percent)

Citation: IMF Staff Country Reports 2019, 264; 10.5089/9781513509983.002.A001

Source: OECD (2019), Poverty rate (indicator). doi: 10.1787/0fe1315d-en (Accessed on 07 May 2019)
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Age-related Spending Projections

(In percent of GDP)

Citation: IMF Staff Country Reports 2019, 264; 10.5089/9781513509983.002.A001

Source: IMF staff calculations.

27. The long-term fiscal policy mix thus needs to remain focused on securing resources to accommodate demographic and other social spending costs and boosting productivity and potential growth:

  • Identifying new growth-friendly revenue sources. VAT revenue could increase without unduly increasing the tax burden, for example by simplifying the rate structure and reducing noncompliance. Latvia’s large persistent VAT gap relative to EU peers suggests that improvements in tax administration and combating the shadow economy could yield significant revenue benefits. Efforts to increase Latvia’s intake from property taxes—significantly below the euro area average—could also provide a sustainable source of revenue. The government’ proposal to revise the methodology for estimating cadastral values is a welcome step.

    Furthermore, a relatively low effective tax rate on CO2 emissions provides scope for raising energy tax revenue by aligning the effective taxation of CO2 emissions and other pollutants across different fuels and uses, while also meeting Latvia’s commitments under the Paris Agreement. 21 Finally, while recent amendments to the microenterprise regime aim to reduce tax expenditures, their impact should be monitored closely to ensure the regime is not used solely for tax optimization purposes and does not hinder the growth of innovative firms.

  • Maximizing investment returns. Despite a recent surge, total public and private investment in the economy would decline as EU funds taper off. While the level of public investment is in line with the EU average, Latvia’s investment needs are large and the quality of infrastructure— particularly roads, railway and energy connectivity—lags neighboring countries. This is an obstacle to labor mobility, regional economic development, and FDI inflows. Structural policies that increase public capital spending could help induce private investment, thus giving a push to productivity and GDP growth.22 As EU funds taper off, the authorities should maximize their benefit by supporting investment projects that have a high return, catalyze private investment, and could be frontloaded should the economy need support in a downturn.

  • Reforming the public administration. Adjusting the level and composition of public sector employment could facilitate more effective service delivery and ease the existing labor market tightness.23 The ongoing public administration reform seeks to address these issues, but needs to include the broader public sector to achieve meaningful efficiency gains. The current territorial reform proposal¸ seeking to further reduce the large number of municipalities (119)24 by about 2/3 within the next two years, is an opportunity to right size the public administration and the provision of services to a declining and aging population. Local authorities account for about 60 percent of general government employments and 30 percent of expenditures (above the 23 percent EU average); salaries constitute 45 percent of their expense (significantly above the 32 percent EU average). International experience on the success of municipal consolidation is mixed; however, consolidating municipalities could yield benefits through economies of scales and synergies in public service provision. Strengthening public procurement transparency and efficiency and local authorities’ and SOEs’ governance and reporting would help improve the allocation of resources and prevent misuse of public funds.

  • Improving the adequacy and targeting of social programs. Better results in addressing poverty can be achieved by redesigning existing programs, linking eligibility requirements to socio-economic indicators, introducing uniform standards across municipalities, and completing the guaranteed minimum income reform.25 Funding a larger social housing stock would also have an impact on poverty outcomes due to its potential to improve regional labor mobility and lower structural unemployment (Figure 6).

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VAT Gap

(In percent)

Citation: IMF Staff Country Reports 2019, 264; 10.5089/9781513509983.002.A001

Note: The VAT gap is the difference between the expected VAT revenue and the amount collected and measures the effectiveness of tax compliance measures.Source: Nerudova and Dobranschi, 2019.
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Investment by Sector

(In percent of GDP)

Citation: IMF Staff Country Reports 2019, 264; 10.5089/9781513509983.002.A001

Sources: Central Statistical Bureau of Latvia; and IMF staff calculations.
uA01fig18

Capital Stock and Infrastructure Quality, Latest Value Available

Citation: IMF Staff Country Reports 2019, 264; 10.5089/9781513509983.002.A001

Sources: IMF FAD Expenditure Assessment Tool (EAT); World Economic Outlook; World Development Indicators; IMF Investment and Capital Stock Dataset; and World Economic Forum.

Authorities’ Views

28. The authorities agreed with staff’s views that, as new policy initiatives are being considered, their fiscal impact and ultimate benefit need to be carefully assessed to prevent unduly eroding fiscal space. They also concurred that the long-term fiscal policy mix needs to focus on securing growth-friendly revenue sources to make room for age-related and social spending and to support policies that can boost potential growth. However, the authorities were skeptical about the prospects of raising sufficient revenues to support a significant increase in pension replacement rates in the long run, and therefore considered that raising productivity would be key in balancing fiscal and social sustainability outcomes.

C. Macro-Financial Policies: Restoring Confidence in the Financial System and Reviving Credit Growth

Completing AML/CFT Risk Management and Compliance Reforms

29. Money laundering concerns related to BSFCs continue to weigh on Latvia’s financial sector. Significant gaps in implementation of the AML/CFT framework hampered its effectiveness, exacerbating money laundering and terrorist financing (ML/TF) risks in the banking system, contributing to a withdrawal of global correspondent banks from Latvia and a decline of external funding. The country’s third largest bank, ABLV, has been in self-liquidation since June 2018 after allegations of institutionalized money laundering accelerated deposit outflows, triggering the ECB to determine that the institution was “likely to fail.” Given ABLV’s limited role in the domestic economy, the implications for the economy and the financial system have been primarily reputational.26

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Assessment Ratings of Effectiveness

Citation: IMF Staff Country Reports 2019, 264; 10.5089/9781513509983.002.A001

Note: Includes only European countries for which assessments under the 2013 FATF Methodology are available. Based on MONEYVAL assessments for ALB, CZE, HUN, LVA, LTU, SRB, SVN, and UKR; FATF assessments for AUT, BEL, CHE, DNK, ESP, GBR, IRE, ISL, NOR, PRT, and SWE; and IMF/FATF assessment for ITA. Ratings reflect the extent to which a country’s measures are effective. The assessments are conducted on the basis of 11 immediate outcomes, which represent key goals that an effective AML/CFT system should achieve.Source: Financial Action Task Force (FATF), Consolidated Assessment Ratings, April 17, 2019.

30. MONEYVAL’s assessment of Latvia’s AML/CFT regime found significant deficiencies which, if unaddressed, could lead to Latvia being grey-listed by FATF. Failing to address Latvia’s AML/CFT deficiencies could expose the financial system and the economy to significant further financial integrity and reputational risks and undermine its competitiveness. Notwithstanding the authorities’ significant efforts in this area27, the task ahead is challenging due to the need to demonstrate effectiveness of the AML/CFT regime—including long-term institutional reforms— through progress in several key areas:

  • Strengthening AML/CFT supervision. Supervisory authorities need to improve their understanding and analysis of ML/TF threats and vulnerabilities and strengthen risk-based supervision. They should also aid financial institutions in developing their own risk assessments, mitigation measures, and internal controls.

  • Ensuring accurate beneficial ownership information. Shell entities have been misused in Latvia for ML/TF purposes, especially in BSFC activities. The effectiveness of recent amendments to Law on the Prevention of Money Laundering and Terrorism Financing intended to improve the availability of companies’ beneficial owner information should be carefully monitored. The proper identification of beneficial ownership through the application of preventive measures (e.g., customer due diligence) should be a specific area of focus of AML/CFT supervision.

  • Improving AML/CFT preventive measures and reporting. The quality and level of reporting of suspicious transactions by financial entities needs to improve and the reporting requirements should be clarified. Special focus should be on ensuring effective implementation of preventive measures by higher risk entities, such as BSFCs, including with respect to targeted financial sanctions.

  • Enhancing AML/CFT enforcement. Cooperation across supervisory, financial intelligence, tax administration, and law enforcement authorities, the recruitment and training of additional staff, and the application of adequate IT solutions would help enforcement efforts and improve analytical capabilities. Strengthening investigative and prosecutorial bodies would improve their ability to more effectively lay charges and prove cases of ML/TF, which could contribute to making criminal sanctions more effective, proportionate, and dissuasive. The development of sentencing guidelines would also be helpful in this regard.

31. These reforms would benefit from intensive regional cooperation. The absence of a common EU-wide AML/CFT supervisory framework creates a need for greater cross-border coordination, especially given AML/CFT concerns in several Baltic and Nordic countries. At a regional level, coordination is needed to identify the sources of ML risks and possible spillover effects due to close financial interlinkages across the Nordic-Baltic countries. At an EU level, consideration should be given to establishing a European-level institution responsible for AML/CFT supervision, which will facilitate a consistent approach to cross-border risks and contribute toward supervisory convergence on AML/CFT issues.28

Upgrading the Resolution Regime and De-risking the Banking Sector

32. ABLV’s protracted liquidation reveals deficiencies in the regulatory framework and prudential oversight. Legal gaps and evolving supervisory capacity continue to amplify challenges from the fragmented resolution regime for euro area banks that are deemed less significant or whose failure is not expected to have a destabilizing effect on the financial system and the wider economy. Persistent supervisory weaknesses in ABLV’s liquidation proceedings call for further strengthening the FCMC’s role in bank resolution:

  • Addressing lingering AML/CFT concerns. In July 2018, ABLV’s self-liquidation commenced under a complex coordination structure among liquidators, financial, and law enforcement authorities. The FCMC’s role in this process includes monitoring payouts to mitigate the risk of payments to entities associated with money laundering and ensuring the filing of suspicious transaction reports on creditors’ funds or sales. The long period required to develop a methodology for screening ABLV’s creditors points to the challenges of balancing creditor interests and supervisory and financial stability objectives in an environment of heightened AML/CFT scrutiny. The extensive reliance by the FCMC and FIU on third-party experts in ABLV’s liquidation underscores the need for stronger supervisory and enforcement capacity, better operational coordination, and adequate resources to effectively address AML/CFT compliance breaches in complex cases.

  • Upgrading supervisory powers for bank liquidation. The FCMC recommends court-appointed administrators and supervises the asset management during liquidations. Amendments to the Credit Institutions Law now allow mandatory liquidation of banks whose license is withdrawn due to AML/CFT breaches. However, the FCMC cannot impose timely liquidation of solvent banks that are deemed “failing or likely to fail” (FOLF) by the ECB, but are not resolved by the SRB.29 An amendment of the regulatory framework enabling mandatory out-of-court administrative liquidation (with an administrator appointed by the FCMC) in such cases30 would reduce legal uncertainty about the wind-down of failing banks and about potential contingent liabilities to the government.

33. Refocusing BSFCs’ business models and aligning them with the financing needs of the real economy would help restore confidence in the banking sector. ABLV’s closure and the subsequent pressure to de-risk BSFCs (including terminating activities with some shell companies) has led to a reduction of non-resident deposits by more than 60 percent since end-2017, with their share declining to about 20 percent of total deposits. Higher prudential requirements on banks with a significant share of foreign deposits have also forced BSFCs to seek new business models with a greater focus on domestic activities where much larger, foreign banks already play a dominant role. The FCMC has assessed these business models under the Supervisory Review and Evaluation Process (SREP)— considering future business strategies and risk impact—but their sustainability is yet to be proven. Monitoring closely BSFCs with a focus on continued de-risking, prudent lending practices, and enhanced operational efficiency would ensure that their new activities are carried out in line with appropriate risk mitigation strategies and do not increase financial stability risks or create contingent liabilities for the government. A risk-based business model review involving opaque entities could use a harmonized SREP methodology for less significant institutions (LSIs) to limit supervisory capture.

Supporting Credit Growth

34. Structural gaps and heightened uncertainty in the financial system have exacerbated credit bottlenecks. Despite borrowing costs at record lows and rising demand, lending to both households and non-financial corporations (NFCs) remains timid. Some lending headroom of larger banks is being displaced by the absorption of legacy portfolios of banks exiting the Latvian market. Tightening lending standards and declining loan-to-deposit ratios also signal that banks’ lending policies remain cautious due to concerns about the effectiveness of the insolvency regime and widespread informality.31 The riskiness of corporate lending remains one of the highest in the euro area (with credit risk-weights of many banks exceeding 80 percent). Despite reforms strengthening insolvency administration, asset recovery rates remain low by international comparison. While evidence on loan demand is mixed, a high share of self-financing and low business confidence still weigh on the willingness to borrow. While non-bank lending is picking up, outpacing bank lending, it still represents only about 20 percent of total lending (Annex VI).

uA01fig21

Bank vs. Non-bank Lending

(EUR billions)

Citation: IMF Staff Country Reports 2019, 264; 10.5089/9781513509983.002.A001

Sources: Bank of Latvia; Haver; and IMF staff calculations.

35. Efforts to revive credit growth could focus on several key areas. Ensuring high standards for insolvency administration would help raise creditors’ expected recovery rates and lower the cost of lending. Ongoing efforts in strengthening the revenue administration would help reduce the informal sector and improve borrowers’ transparency. Consolidation of the banking sector aiming to improve operational efficiency and prevent unsustainable business models would ease lending constraints for profitable banks. Making the system of state loan guarantee programs more accessible and transparent could spur SME lending.

Preempting Buildup of Macro-Financial Vulnerabilities

36. The rapid rise in property prices merits attention. Despite a shrinking population, real house prices have increased by more than 7 percent per year over the last three years due to a surge in construction costs and prices of new dwellings. Current valuation indicators (price-to-income and price-to-rent ratios and deviations from long-term fundamentals) signal potential vulnerability to overvaluation of housing prices over the medium term. Yet, there are no acute financial imbalances, as the house price index is still about 20 percent below its pre-crisis peak in 2008, and aggregate house price developments have not been spurred by credit growth. Outstanding mortgage loans have dropped below 20 percent of GDP at end-2018, far below the euro area average of about 38 percent of GDP.

uA01fig22

Real Average Gross Monthly Wages and Real Property Prices

(Percent, year-on-year)

Citation: IMF Staff Country Reports 2019, 264; 10.5089/9781513509983.002.A001

Sources: Bank of Latvia; Haver Analytics; and IMF staff calculations.

37. Timely adoption of precautionary macroprudential measures can help contain medium-term balance sheet risks. The high share of variable rate mortgages raises the risk to debt service capacity if household leverage increases, while a slowing wage growth could reduce debt affordability. BSFCs’ re-orientation may also result in a deterioration of borrower quality if they loosen credit standards and increase household lending to maintain profitability amid falling margins. Latvia’s macroprudential measures are relatively lenient compared to those in other EU countries and could be preemptively adjusted. Lowering the current LTV ratio limit of 90 percent to 80 percent (closer to other European peers) for residential mortgage lending, imposing restrictions on home refinancing, introducing a debt service-to-income (DSTI) limit, and limiting the maximum maturity of mortgages and consumer loans would mitigate vulnerabilities related to real-estate exposures. Higher provisions for loans with LTV ratios above the limit and regular assessments of collateral valuation standards would prevent excessively risky lending. Finally, macroprudential measures should apply to leasing companies to prevent potential regulatory arbitrage between them and banks.

uA01fig23

Macroprudential Policy: Selected EU Countries with LTV and DTSI Limits

(In percent)

Citation: IMF Staff Country Reports 2019, 264; 10.5089/9781513509983.002.A001

Sources: European Systemic Risk Board; and IMF staff calculations.

Authorities’ Views

38. The authorities broadly agreed with staff’s views. National authorities emphasized that important legislative changes have been introduced to reduce AML/CFT concerns and international sanctions risks and address MONEYVAL’s recommendations. They agreed that demonstrating effectiveness will take time and requires considerable efforts, including the timely liquidation of ABLV under a transparent review process to mitigate reputational risks. They also agreed that expanding supervisory powers for mandatory liquidation would be welcome but should be considered once the ongoing review of the EU banking resolution regime is completed. The authorities agreed that preemptive macroprudential measures would be appropriate to safeguard prudent bank lending amid persistently rising housing prices. They noted that, notwithstanding the low household debt and the sluggish lending, considering the record-low interest rates, they already plan to introduce pre-emptively DSTI, DTI, and credit maturity caps, in addition to the existing LTV cap to ensure sound lending standards through the cycle.

Staff Appraisal

39. The Latvian economy has become considerably more resilient since the global financial crisis, and economic prospects remain favorable. There are no significant economic imbalances; external and government debt are on declining paths; and private sector balance sheets continue to improve. Inflation has been moderate, and competitiveness has held up. The external position is assessed to be moderately stronger than implied by medium-term fundamentals and desirable policies. Growth has been strong, and while it is projected to decelerate in the medium term, it is expected to converge to a still robust rate of 3 percent.

40. However, important challenges and risks may test the economy’s resilience. First, Latvia’s population continues to decline, which strains the labor market and poses a long-term growth challenge. Second, weaker than expected external growth, especially in the euro area, and rising protectionism could significantly weigh on exports. Third, the financial system still confronts financial integrity risks. Failure to strengthen the effectiveness of the AML/CFT regime and refocus BSFCs could undermine the stability of the financial system and its ability to support the economy.

41. Growth-enhancing reforms are aptly considered a priority by the government. Ongoing efforts to ease labor market constraints should be redoubled, including by promoting better skill matching and reducing long-term unemployment, increasing labor participation of targeted groups, encouraging the return of Latvian emigrants and allowing entry of skilled immigrants. Raising productivity growth will allow more rapid wage growth to take place sustainably and help slow emigration. Reforms that improve firms’ access to finance, encourage investment in research and development, and attract foreign direct investment could yield important productivity gains.

42. The authorities’ planned fiscal stance reverses past procyclicality and is appropriate given the expected deceleration of the economy. Given Latvia’s relatively low and declining government debt and favorable financing terms, some fiscal space is available to react to shocks. Nonetheless, in the short run, the authorities should avoid public sector wage increases that are not aligned with productivity and should carefully assess the potential fiscal costs of new spending initiatives, in order to preserve fiscal space. If negative shocks affect the economy, the authorities should allow automatic stabilizers to operate fully and could consider temporary high-quality measures to support the economy in the event of a severe downturn.

43. Long-term fiscal policies should aim to accommodate the impact of demographic and social spending costs and support productivity-boosting reforms. New stable revenue sources would be needed to adequately cover growing age-related demands on the budget. Given Latvia’s vast investment needs, the authorities should focus capital spending on projects that have the potential to catalyze private investment and have high social impact. Poverty and inequality concerns could be addressed by improving the adequacy and targeting of existing social programs. Reforms to strengthen the transparency and governance of local authorities and state-owned enterprises can help improve the use of public resources and prevent misuse.

44. The authorities have signaled strong political commitment at the highest level to restore the reputation of the financial system. Efforts to reduce exposure to risky banking operations, address MONEYVAL’s recommendations, and oversee BSFCs’ new business plans are welcome. Long-term reforms need to focus on the effectiveness of the AML/CFT regime by enhancing risk-based supervision, the quality and use of financial intelligence, the application of preventive measures, investigation and prosecution, and coordination among relevant national and regional authorities. Upgrading the supervisory powers for bank liquidation to include mandatory out-of-court administrative liquidation would reduce legal uncertainty and limit potential contingent liabilities, consistent with EU harmonization efforts.

45. The financial system needs to become more supportive of the domestic economy. Efforts to revive credit growth should focus on completing the ongoing insolvency reforms to lower lending costs. Steps are also needed to strengthen the revenue administration to more effectively combat the shadow economy. Careful oversight of banks’ de-risking and business model reorientation towards the real economy should encourage consolidation and ease lending constraints. Improving access to the system of state loan guarantee programs could spur SME lending. New preemptive macroprudential measures should support sound lending standards and mitigate medium-term financial sector vulnerabilities amid persistently rising property prices.

46. The next Article IV Consultation is expected to be completed on the standard 12-month cycle.

Risk Assessment Matrix1

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1\ The Risk Assessment Matrix (RAM) shows events that could materially alter the baseline path (the scenario most likely to materialize in the view of IMF staff). The relative likelihood is the staff’s subjective assessment of the risks surrounding the baseline (“low” is meant to indicate a probability below 10 percent, “medium” a probability between 10 and 30 percent, and “high” a probability between 30 and 50 percent). The RAM reflects staff views on the source of risks and overall level of concern as of the time of discussions with the authorities. Non-mutually exclusive risks may interact and materialize jointly.
Figure 1.
Figure 1.

Latvia: Real Sector

Citation: IMF Staff Country Reports 2019, 264; 10.5089/9781513509983.002.A001

Sources: Eurostat; Haver Analytics; Central Statistical Bureau of Latvia; and IMF staff calculations.
Figure 2.
Figure 2.

Latvia: Fiscal Developments

Citation: IMF Staff Country Reports 2019, 264; 10.5089/9781513509983.002.A001

Sources: Eurostat; Haver Analytics; Central Statistical Bureau of Latvia; and IMF staff calculations.
Figure 3.
Figure 3.

Latvia: Inflation

Citation: IMF Staff Country Reports 2019, 264; 10.5089/9781513509983.002.A001

Sources: Eurostat; Haver Analytics; Central Statistical Bureau of Latvia; and IMF staff calculations.
Figure 4.
Figure 4.

Latvia: Labor Market

Citation: IMF Staff Country Reports 2019, 264; 10.5089/9781513509983.002.A001

Sources: Eurostat; Haver Analytics; Central Statistical Bureau of Latvia; and IMF staff calculations.
Figure 5.
Figure 5.

Latvia: Balance of Payments

Citation: IMF Staff Country Reports 2019, 264; 10.5089/9781513509983.002.A001

Sources: Bank of Latvia; Central Statistical Bureau of Latvia; European Commission; and IMF staff calculations.1/ Real effective exchange rates are based on IC-37 countries for ULC.
Figure 6.
Figure 6.

Latvia: Inequality and Poverty

Citation: IMF Staff Country Reports 2019, 264; 10.5089/9781513509983.002.A001

Sources: Eurostat; Euromod; IMF FAD Expenditure Assessment Tool (EAT); World Economic Outlook; ASPIRE; Haver Analytics; OECD (2019), Poverty rate (indicator). doi: 10.1787/0fe1315d-en (Accessed on 07 May 2019); and IMF staff calculations.1/ Active population aged 25–64.
Figure 7.
Figure 7.

Latvia: Banking Sector Developments

Citation: IMF Staff Country Reports 2019, 264; 10.5089/9781513509983.002.A001

Sources: Bank of Latvia; FCMC; Haver Analytics; and IMF staff calculations.1/ Data from March 2012 onwards exclude Parex Bank and from May 2012 exclude Latvijas Krajbanka.
Figure 8.
Figure 8.

Latvia: Credit Growth Developments

Citation: IMF Staff Country Reports 2019, 264; 10.5089/9781513509983.002.A001

Sources: European Central Bank; Bank of Latvia; and IMF staff calculations.
Figure 9.
Figure 9.

Latvia: Macro-Financial Conditions

Citation: IMF Staff Country Reports 2019, 264; 10.5089/9781513509983.002.A001

Sources: Bank of Latvia; European Central Bank; European Systemic Risk Board; Haver Analytics; and IMF staff calculations.
Table 1.

Latvia: Selected Economic Indicators, 2015–20

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

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

Gross external debt minus gross external assets.

Table 2.

Latvia: Macroeconomic Framework, 2015–24

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Sources: Latvian authorities; and IMF staff calculations.

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

Includes bank restructuring costs.

Current account deficit

Gross external debt minus gross external assets.

Table 3.

Latvia: General Government Operations, 2015–241

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Sources: Latvia 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.

Exclude one-off and unsustainable measures.

Table 4.

Latvia: Medium-Term Balance of Payments, 2015–24

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Sources: Latvian authorities; and IMF staff calculations.

Based on detailed data until 2013. Extrapolated for debt outside the public sectors and MFIs starting 2014.

Gross external debt minus gross external assets.