Numbers & Statistics

IMF Executive Board Concludes 2019 Article IV Consultation with the Republic of Latvia

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Via IMF (Den Internationale Valutafond)

On August 6, 2019, the Executive Board of the
International Monetary Fund (IMF) concluded the Article IV consultation

[1]

with the Republic of Latvia and considered and
endorsed the staff appraisal without a meeting.


Real GDP growth reached 4.8 percent in 2018, led by a pick-up of
private investment along with a boom in EU-funded construction and
strong growth in IT and communications. Wage growth accelerated to 5.7
percent as the labor market continued to tighten. Unemployment declined
to an all-time low rate of 7.4 percent, while core inflation slowed to
2 percent in 2018. The current account swung into a deficit of 1
percent of GDP as export volumes decelerated, while total external debt
declined significantly by 20 percentage points due to a sharp decline
in non-resident deposits. Growth is expected to decelerate in 2019 to
just above 3 percent, as a slower pace of EU funds
absorption and wage growth moderates domestic demand.

Despite revenue overperformance, fiscal policy was expansionary in
2018, driven by fast absorption of EU investment funds and a
substantial increase in public sector wages. The 2018 general
government deficit reached 1 percent of GDP, implying a fiscal stimulus
of about 0.4 percent of GDP. Still, public debt remains firmly on a
downward path amid favorable financing conditions.

The financial system remains stable despite a significant balance sheet
restructuring of banks servicing foreign clients. Banks remains well
capitalized and liquid, with capital levels
about 40 percent higher than the euro area average and average
liquidity coverage four times the regulatory minimum. Still, credit
growth remains elusive; while the government-sponsored mortgage program
contributed to a slight recovery of household credit by end-2018, total
household credit declined by 5.4 percent and credit to non-financial
corporations declined by 5.8 percent.

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Executive Board Assessment

[2]

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

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.

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.

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.

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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.

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.

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.

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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 re-orientation 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.



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