OREANDA-NEWS. July 26, 2012. The Executive Board of the International Monetary Fund (IMF) concluded the First Post-Program Monitoring Discussions with the Republic of Latvia.1

Background

Latvia’s economy has been recovering strongly since 2010, following the deep downturn in 2008–09. Real GDP growth of 5.5 percent in 2011 was underpinned by export growth and a recovery in domestic demand. The growth momentum has continued into 2012 despite deteriorating external conditions, and the economy is expected to expand by 3.5 percent this year. The unemployment rate has receded from its peak of more than 20 percent in 2010, but remains high at more than 16 percent. Half of the unemployed have been out of work for more than a year. Higher commodity prices pushed headline inflation to 4.2 percent in 2011, but core inflation remains low and headline inflation is projected to decline to 2.4 percent in 2012. The current account balance, which swung from a pre-crisis deficit of more than 20 percent of GDP to significant surplus in 2009, was contained to a deficit of 1.2 percent of GDP in 2011. Gross external debt declined to 145 percent of GDP in 2011 from its peak of 165 percent in 2010, while net external debt stands at 45 percent of GDP.

Latvia successfully completed its EU-IMF-supported program in December 2011. As part of the program, Latvia implemented fiscal consolidation measures of more than 15 percent of GDP. As a result, the general government deficit has declined from nearly 10 percent of GDP in 2009 to 3.5 percent of GDP in 2011. This year, strong revenue growth is expected to reduce the fiscal deficit to around 2 percent of GDP, while general government debt is expected to stabilize around 40 percent of GDP. Although the Latvian parliament approved a one percentage point cut in VAT effective July and cuts in personal income tax rates for 2013–15, the approval of the Fiscal Compact is evidence of the authorities’ continued commitment to budget discipline.

Strong program implementation has facilitated a return to market financing, with Latvia issuing USD 1.5 billion in benchmark international bonds since mid-2011. All three major rating agencies now rate Latvia as investment grade.

The financial sector is well capitalized and has returned to profitability, but foreign-owned banks continue to deleverage. The authorities have made progress with the sale of the commercial part of Mortgage and Loan Bank (MLB) and have taken steps to strengthen financial sector supervision in the wake of the November 2011 failure of Latvijas Krajbanka.

Executive Board Assessment

Executive Directors welcomed Latvia’s economic recovery since the crisis. Growth has been strong, inflation is low, the budget deficit has declined steadily, and the foreign reserves position has strengthened. The authorities’ determined policy implementation has facilitated Latvia’s successful return to international capital markets and enabled it to move closer to euro adoption. Given the still existing challenges and vulnerabilities, Directors urged continued commitment to sound policies and implementation of structural reforms in order to boost productivity, enhance competitiveness, and reduce unemployment and poverty.

Directors commended the remarkable fiscal consolidation and emphasized the need for continued prudence to maintain fiscal and debt sustainability. They welcomed ratification of the EU Fiscal Compact, which demonstrates the authorities’ commitment to long-term fiscal stability. Directors generally concurred that the recently adopted legislation to cut the personal income tax and VAT rates might be hard to reconcile with the need for modest spending increases and will have an impact on the current account deficit. They stressed that any major changes to tax code or spending increases should be consistent with the Fiscal Compact and the medium-term framework, and should be introduced at the time of the annual budget. Directors also encouraged the authorities to identify offsetting measures and recommended raising the tax-free income threshold and introducing tax credits for new hires.

Directors underscored the need to tackle Latvia’s high unemployment rate. They urged the authorities to build a strong social safety net, while strengthening incentives to return to work, and to improve education to reduce skill mismatches. Directors cautioned that further decentralizing funding of social assistance and cuts in social expenditure could worsen inequality and undermine growth. They saw merit in postponing changes to social assistance until the joint Ministry of Welfare and World Bank study of long-term unemployment is completed.

Directors noted that the financial sector is well capitalized and has returned to profitability. They welcomed the additional capital requirements for banks reliant on non-resident business and the decision to strengthen supervision of correspondent accounts. Directors encouraged the supervisory authorities to work closely with their Nordic counterparts to ensure deleveraging proceeds gradually. Issuing international bonds ahead of time could also help guard against external risks.

Directors encouraged the authorities to meet the Maastricht criteria sustainably and to introduce well-prioritized structural reforms. They stressed that measures to boost productivity will be critical to ensure that Latvia remains competitive under its fixed exchange rate regime and later with the euro. The focus should be on increasing product market competition, improving governance, including in state-owned enterprises, and strengthening the legal system to encourage investment.