OREANDA-NEWS. August 18, 2010. The Executive Board of the International Monetary Fund (IMF) concluded the 2010 Article IV consultation with the Republic of Latvia and completed the Third Review of the country’s performance under an economic program supported by a Stand-By Arrangement (SBA).1 Completion of the review makes available an amount equivalent to SDR 90 million (about €105.8 million or USD 135.6 million), bringing total disbursements under the SBA to SDR 982 million (about €1.15 billion or USD 1.48 billion).

Background

Latvia’s economy grew extremely rapidly for a number of years through 2007. Capital inflows, including from foreign parent banks, and expansionary macroeconomic policies pushed up growth, but also fueled unsustainable credit and housing bubbles, as well as a current account deficit above 20 percent of gross domestic product (GDP). The combination of these bubbles unwinding, the global financial crisis, and acute banking pressures in Latvia contributed to a crisis in late 2008 and eventually to an 18 percent output contraction in 2009—the largest in the world. In November 2008, with deposit withdrawals putting pressure on international reserves and the fiscal position deteriorating due to a steep drop in revenue as well as mounting banking costs, Latvia approached the Fund and European Commission for emergency financial support.

Strengthened policy implementation since mid-2009, including sizeable fiscal adjustment, as well as financial and policy support from international program partners have helped stabilize Latvia’s economy and restore a measure of balance after the crisis. Domestic interest rates and external measures of risk have both come down dramatically since 2009. Deposits, which fell sharply early in the crisis, have returned to near pre-crisis levels, which along with a sharp improvement in the current account and international support have boosted foreign exchange reserves and restored confidence in Latvia’s exchange rate peg. While the country’s contraction has been especially steep, falling prices and wages have gone a long way toward addressing previous competitiveness problems. Policy actions in the past year have also helped insulate Latvia to a degree from recent turbulence in Western Europe

Latvia’s economy appears to be bottoming out with positive annual growth expected to return in 2011. However, growth is forecast to remain well below pre-crisis levels in the medium term, and Latvia faces a number of challenges to entrench stability, raise growth, and meet the Maastricht criteria for euro adoption as quickly as possible—a key goal of the government. These challenges include: reducing very high unemployment, including by facilitating a shift toward the tradable sector; undertaking substantial additional fiscal adjustment; ensuring that competitiveness is restored and maintained; and resolving a large private sector debt overhang that will inhibit growth.

Executive Board Assessment

Executive Directors commended the authorities for undertaking difficult fiscal and financial sector reforms, which have helped stabilize the economy and contributed to a rebound after last year’s deep recession. Although near-term vulnerabilities have declined substantially, the recovery is still fragile and significant medium-term challenges remain toward the goal of euro adoption. Directors underscored the importance of sustained fiscal adjustment, restoration of financial sector health, and continued structural reforms aimed at reorienting growth toward the tradable sector, boosting employment and competitiveness, and improving the business environment.

Directors emphasized that considerable fiscal adjustment is still needed, especially on the expenditure side, to preserve debt sustainability and lower the deficit in line with the Maastricht criteria. They encouraged the authorities to focus on high-quality measures and durable spending cuts, including by re-examining areas where spending had increased significantly in the past, and to improve control over state-owned enterprises. Given the required size of the adjustment, Directors welcomed the authorities’ medium-term tax strategy, which identifies possible revenue measures, as well as the plans to tackle the gray economy. They supported efforts to improve budget practices and promote counter-cyclical policies, including through the planned fiscal responsibility law. Strengthening the authority of the Ministry of Finance would help improve policy formulation and implementation. It would also be important to maintain fiscal discipline and avoid further deviation from the consolidation strategy through the coming election period. Preparation of a menu of options would help achieve needed savings in the 2011 budget.

Directors welcomed the substantial improvement in competitiveness since early 2009, attributable in part to the marked decline in unit labor costs. Additional wage and price adjustment, together with structural reforms, would help close any remaining competitiveness gap, further enhance confidence in the quasi-currency board exchange rate regime, and reorient the economy toward the export sector.

Directors commended efforts to address Latvia’s high unemployment rate, notably a successful public works program. They encouraged further reforms to enhance productivity, a lower tax wedge on labor, and measures to address skill shortages and mismatches through training and vocational education.

Directors welcomed the progress in strengthening financial sector regulation and supervision, bank resolution procedures, and credit and liquidity risk management rules. They emphasized the need to ensure that banks fully comply with regulations and maintain adequate provisioning against nonperforming loans. Given high levels of private sector debt, further steps would also be needed to facilitate market-based debt restructuring, streamline insolvency and foreclosure procedures and reduce costs, and address tax disincentives. Directors called for rapid action to restructure the two state-owned banks, including preparation of a restructuring plan for Mortgage and Land Bank.