Mission Concluding Statement 

Latvia: Staff Concluding Statement of an IMF Staff Visit

December 9, 2016

The Latvian economy remains sound, but is facing headwinds. Unemployment continues its downward path, the current account has strengthened, and credit growth is picking up. Nevertheless, weak investment (largely associated with a delay in EU-funds absorption), geopolitical tensions, and low external demand have dampened growth this year. The Brexit decision added to an already uncertain climate, although direct effects have been minimal. Despite picking up, inflation continues to be below the Euro Area target.

Growth is expected to accelerate in 2017. While weaknesses could persist, the gradual resumption of EU-funds, improving bank credit, and strengthening external conditions should help the economy accelerate in the coming year. Consequently, after reaching just around 1¼ percent in 2016, growth is expected to pick up to some 3 percent in 2017.

The medium-term outlook is favorable, but it is not immune to risks. Specifically, weaker growth in the euro area and emerging economies would undermine growth prospects, as could protracted uncertainty associated with post-Brexit arrangements. In such an environment, continued vigilance, adequate buffers, and prudent policy making are essential.

The financial system remains stable. The banking system continues to be well capitalized and liquid. The continued strengthening of Anti-Money Laundering regulations, along with their implementation, is welcome. In light of the loss of correspondent banking relationships for a number of non-resident deposit (NRD) banks, ongoing vigilance is needed. NRD outflows, as well as any potential long-term implications for the financial sector, should be monitored closely. Furthermore, while there are no immediate risks to financial stability, the largely Nordic-dominated banking sector is exposed to developments in Nordic countries, where household sector risks persist.

The 2017 budget is broadly appropriate and is well balanced. The budget is broadly compliant with European Union fiscal commitments and is in line with the Latvian fiscal discipline law, thereby ensuring prudent fiscal management and buffers, and sustainable debt. The fiscal stance is modestly expansionary: appropriately so, in view of an almost closed, yet still negative, output gap. Measures to support education and health reforms are welcome, but ongoing efforts to improve tax compliance and shrink the shadow economy are needed. Furthermore, the authorities should focus on developing a strategic plan to bring tax revenue up to the Government’s target of one third of GDP by 2020, reduce income inequality, and promote work incentives.

Maintaining competitiveness remains a key priority. Even though wage pressures have eased somewhat, additional efforts are needed to boost competitiveness. In addition, the government should press ahead with reforms in education, health, the legal system, promoting credit, and addressing the shadow economy, which are crucial to raising potential growth.

The IMF team is grateful for the generous hospitality of the Latvian authorities and would like to thank all interlocutors in government, the Bank of Latvia, and the private sector, for constructive and fruitful discussions.