Mission Concluding Statement 

Latvia's economy grew strongly during the past decade, supported by prudent monetary and fiscal policies and fundamental structural reforms. More recently, accelerating growth has been accompanied by a resurgence of inflation and a further widening of the current account deficit. Limiting macroeconomic imbalances will be critical to fostering conditions for sustained economic expansion and for moving forward on the path to euro adoption. At the current juncture, policies should be geared toward containing demand pressures and mitigating financial sector risks.

Economic activity accelerated in the first half of 2004, growing by a vigorous 8¼ percent. Underpinning the pick-up was sharply higher investment, as well as an acceleration in consumption and exports. Stronger import growth nonetheless widened the current account deficit to 13½ percent of GDP in the first six months of the year. Inflation also picked up, peaking at 7¾ percent in recent months. EU-related price increases contributed to the rise in inflation and to domestic demand by encouraging the public to bring forward their spending. Other transitory factors were also at play. But more durable demand pressures are apparent, with underlying inflation (excluding volatile prices and the effects of major one-offs) rising rapidly this year. Moreover, capacity constraints are beginning to bind, with wages in construction—the sector most affected by EU-related spending and mortgage—financed home building—having picked up sharply in recent months. For 2005, we expect rapid credit expansion to contribute to maintaining GDP growth at about 7 percent, presuming fiscal policy injects only a very modest stimulus.

Strong demand and emerging capacity constraints, together with expectations of speedy income convergence fostered by EU accession, increase the likelihood that the recent surge in inflation will become entrenched. To mitigate this risk, macroeconomic policies should avoid intensifying demand pressures. With monetary policy largely constrained by the fixed exchange rate peg in the context of fully liberalized capital flows, raising domestic policy interest rates would likely encourage a switch in borrowing from lats to foreign currency, with no slowing in credit, and could even induce additional capital inflows. The burden of macroeconomic management must therefore fall primarily on fiscal policy.

The main challenge for fiscal policy in the next few years will be to reconcile medium-term public investment needs with the constraints of the economy's cyclical position. Balancing these objectives will require avoiding a procyclical easing of policy when demand is strong. We therefore consider appropriate the strong overperformance of the budget (a surplus of ½ percent of GDP on an annualized basis) during the first nine months of 2004, reflecting higher than forecast tax revenues due to buoyant GDP growth. But for the year as a whole, the general government balance is expected to swing to a deficit of 1¾ percent of GDP as most of the revenue windfall is spent under a supplementary spending bill. While this deficit is lower than the 2.1 percent of GDP approved in the supplementary budget—in itself a welcome outcome—we view an even smaller deficit outturn for this year as desirable, and feasible, provided that discretionary spending is held close to levels contained in the original budget.

The budget proposal for 2005 implies a further large stimulus to demand. While the general government deficit would be capped at 2 percent of GDP, the proposal assumes a substantial increase in spending that would be financed largely by EU grants. In all, EU grants and related expenditures would total some 7 percent of GDP, an increase relative to 2004 (net of contributions to the EU) of 4½ percentage points. These EU-financed expenditures do not widen the measured deficit, nonetheless they represent a sizable increase in claims on available resources that would add to pressures on inflation and imports. An increase in spending of this magnitude in any single year would likely trigger severe overheating pressures. We would therefore urge that line ministries' expenditure plans for 2005 not be executed in full next year, but spread out more smoothly over several years. But even if scaled back, EU-related spending would—under an approximately unchanged deficit—produce a fiscal stimulus of a broadly similar magnitude. To eliminate this cyclically-undesirable stimulus, offsetting reductions in non-priority spending would need to be found.

C. ERM2 and exchange rate issues

The mission continues to support the authorities' euro adoption strategy, but success will depend on implementing policies consistent with cyclical conditions. ERM2 will entail little change in Latvia's monetary policy framework since the Bank of Latvia intends to continue its unilateral commitment to a narrow (±1 percent) exchange rate band. Therefore, fiscal policy will continue to assume primary responsibility for demand management and for preserving external competitiveness within ERM2 and following euro adoption. Repegging the lats from the SDR to the euro—scheduled for the beginning of 2005—should over the longer term help bring inflation more into line with average eurozone inflation by limiting the potential for bilateral exchange rate changes. A shift in the foreign currency denomination of new bank loans from U.S. dollars to euros has already taken place in anticipation of the repegging.

ERM2 entry requires full confidence in the appropriateness of the exchange rate parity, which was last set in early 1994 when the currency peg was established. Since then, growth has been rapid, exports have been reoriented toward the EU, and disinflation has been achieved. Moreover, the exchange rate peg has been resilient enough to withstand the Russia crisis, with output and employment recovering quickly from the shock, underscoring the considerable flexibility in Latvia's factor markets and in nominal wages and prices. Latvia's current account deficit has been consistently large, averaging 8 percent of GDP during 2000-03, but foreign direct investment has provided significant coverage. We see these developments as reflecting Latvia's strong investment and catch-up potential in view of the country's low per capita income and low labor costs. Indeed, external competitiveness measured in terms of relative unit labor cost has improved strongly in recent years (and only part of this reflects U.S. dollar depreciation), export volumes continue to expand, and the export share in EU-15 imports remains on a rising path. These trends have continued in 2004. The mission therefore considers that the current real exchange rate falls well within the equilibrium range. Nonetheless, we are concerned that future competitiveness could be undermined by sustained wage and price pressures unless fiscal policy adopts a countercyclical stance.

D. Financial sector policies

Exceptionally rapid credit growth—an annualized rate of over 50 percent through August 2004—is helping to fuel private demand and could, if left unchecked, weaken the stability of the banking sector. At present, bank profitability is strong, nonperforming loans are low, and capital exceeds minimum requirements, while private sector indebtedness relative to GDP remains below EU levels. But moving too quickly to EU debt levels risks generating overheating pressures and could impair banks' ability to accurately screen credit risk. With most new loans used for mortgage financing or other real estate activities, banks are increasingly exposed to the real property market. Furthermore, with half of all loans extended in foreign currency, banks face large indirect exchange rate risks though their unhedged clients. These conditions call for vigilant supervision and measures to slow credit growth.

We therefore support the Bank of Latvia's decision in July 2004 to raise reserve requirements on deposits from 3 percent to 4 percent in order to place upward pressure on banks' lending rates. Nonetheless, credit growth has remained strong, in part because banks are increasingly funding loan creation through foreign borrowing. To foster a further increase in bank lending rates, the mission recommends extending reserve requirements to all bank liabilities (excluding domestic interbank liabilities). This measure would also eliminate differences in funding costs across banks with diverse liability structures.

The mission sees the timing of the proposed reduction in banks' statutory minimum capital adequacy ratio (CAR) from 10 percent to 8 percent as likely to exacerbate prevailing overheating and credit risks. While introducing the lower rate (which prevails in the EU-15 and in most other accession countries) has the advantage of leveling the playing field between domestic banks (most are foreign bank subsidiaries) and foreign bank branches (which are subject to home-country regulations), it is also likely to induce a further pickup in the already rapid rate of credit expansion, and weaken prudential safeguards in an environment where banks' capacity to evaluate credit risk may be under strain. Thus, while a worthy medium-term objective, the mission recommends postponing the reduction in the minimum CAR until such time as overheating risks have receded and very rapid credit growth has subsided.

*******

We wish the authorities success in the coming months as they advance further on the path to euro adoption. Maintaining prudent macroeconomic policies will support this goal and enhance Latvia's medium-term prospects for income convergence with its new EU partners.