IMF Executive Board Concludes 2019 Article IV Consultation with the Republic of Latvia
On August 6, 2019, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation 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.
Executive Board Assessment
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.
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.
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.
Source: International Monetary Fund
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