On May 2, 2014, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation1 with the Republic of Latvia.
Latvia entered the euro area in January 2014 with the fastest rate of growth in Europe. 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 due to weakening energy prices. A successful sovereign bond issue in January demonstrated that the country retains market access at favorable rates.
The 2013 general government deficit outturn of 1.0 percent of GDP was below the target of 1.4 percent.2 Improved tax administration yielded substantial revenue gains which more than compensated for a large unanticipated loan repayment on behalf of a bankrupt steel company, and indexation of small pensions from September onwards. Separately, the passage of the Fiscal Discipline Law ensures that future budgets will be grounded in a prudent medium-term framework that seeks to avoid pro-cyclicality.
Bank balance sheets continued to strengthen. Profitability increased and the ratio of non-performing loans declined for both the household and corporate sector. But credit continued to contract, and parent funding of Nordic subsidiary banks declined further. Non-resident deposits (NRDs) in the banking system—which now account for almost half of all deposits and are subject to stricter prudential requirements—continued to grow but at a slower pace.
Executive Directors congratulated the Latvian authorities on fulfilling their goal of joining the euro area. Directors observed that the economic recovery continues to be strong, unemployment has declined rapidly, and the current account position is near balance. However, risks to the broadly favorable medium-term outlook are tilted to the downside, given an uncertain external environment. Directors emphasized the importance of continued fiscal prudence, accelerated reforms to reduce structural unemployment and boost productivity, sustained resumption of bank credit, and vigilant supervision of the financial sector.
Directors agreed with the broad contours of the 2014 budget, which allows fiscal consolidation to continue at a measured pace while strengthening the social safety net. They welcomed the passage of the Fiscal Discipline Law and the authorities’ commitment to the structural deficit targets over the medium term. To this end, Directors encouraged the authorities to reconsider the planned reductions in the personal income tax rate, improve revenue administration, and broaden the tax base by increasing property taxes and reducing the grey economy. Addressing high levels of income inequality and safeguarding investment expenditures in crucial areas remain important objectives.
Directors underscored that progress on a broad range of structural reforms will be needed to maintain competitiveness within the euro area and to reduce structural unemployment. Key priorities include upgrading infrastructure, particularly in the area of ports, liberalizing the electricity sector, and centralizing the management of state-owned enterprises while divesting non-core activities. Directors also recommended aligning higher education and vocational training with market demand to reduce skills mismatches. Broader labor market reforms are also needed to improve work incentives. In this regard, they saw merit in a more gradual phasing-out of the guaranteed minimum income (GMI) benefit to reduce the tax wedge for GMI recipients entering employment.
Directors highlighted the urgency of reviving bank credit to support investment and growth. They welcomed the planned reforms to expedite the resolution of insolvency cases, and urged further efforts to reduce the private sector’s debt overhang and develop non-bank sources of financing, including through further integration with regional markets. Directors noted that the large size of non-resident deposits (NRD) and associated risks warrant continued vigilant supervision. They supported the stricter prudential requirements for NRD-specialized banks, close consultation with home and European supervisors and regulators, and ongoing initiatives to strengthen the framework for anti-money laundering.