Republic of Latvia -- Aide-Mémoire, IMF Staff Visit to the Republic of Latvia
December 2, 2005
The rapid pace of economic growth in Latvia has quickened income convergence, but has also brought unwelcome side effects. The growth acceleration has its roots in the deepening of real and financial integration following Latvia's accession to the European Union (EU) in mid-2004, which fully liberalized access to EU markets, even as declining risk premia brought lower domestic interest rates and a concomitant boost to domestic demand. However, current growth is outpacing the economy's capacity to generate goods and services and, with activity now somewhat above potential, price and wage inflation have increased and the external current account deficit has widened. Inflation, moreover, is likely to remain above the Maastricht threshold for some time, implying that euro adoption will be delayed beyond the original target date of early 2008.
Bursts of very high growth will frustrate, rather than support, Latvia's goal of sustained income convergence. Rapid wage and price increases that are not backed by productivity improvements will erode external competitiveness and further widen the current account deficit. Credit that serves to boost consumption and real estate will not expand the economy's long-term potential or generate the resources to repay debt. Credit quality is often procyclical—strong in good times but falling when the economy slows—suggesting that a lending boom could be followed by a credit squeeze. Moreover, developments in real estate and other asset prices often coincide with credit cycles, creating the potential for wide price swings.
With these risks in mind, it is important to take early action to contain overheating pressures and ensure the resilience of the financial system. Steps are needed to dampen demand to a rate that is more in line with the economy's supply potential, and to slow the speed of credit to prevent the accumulation of financial sector vulnerabilities.
A. Background and Outlook
Domestic demand is expected to continue to be the main driver of GDP and to further tighten the labor market in the period ahead. Rapidly expanding bank credit and inflows of EU grants (on the order of 4 percent of GDP) will continue to boost consumption and public and private investment next year, while deteriorating external competitiveness from rising unit labor costs is expected to weaken the contribution of external demand. Together, we expect GDP growth to moderate from about 10 percent this year to near 9 percent in 2006, still well in excess of our estimate of potential. As a result, overheating pressures built up this year will continue to mount while the current account deficit is unlikely to narrow below this year's expected deficit of 11 percent of GDP. Job-rich growth and very heavy outward migration—aided by the lifting of several countries' restrictions on labor inflows from new EU members—have sharply reduced the unemployment rate to 8¾ percent. Labor shortages that are apparent in several sectors are expected to intensify next year.
While some reduction in headline inflation is possible in the event of favorable external price shocks, little moderation in underlying inflation is expected. Rising world energy prices, repegging from the SDR to the euro at the end of 2004 when the U.S. dollar was relatively weak, and ongoing convergence of food and natural gas prices to world levels are among the causes of Latvia's current high inflation. However, these supply-side factors occurred against robust domestic demand conditions, allowing firms to pass rising costs through to prices, while preserving or increasing profit margins. That the pickup in Latvia's inflation is apparent across a broad range of CPI categories also suggests that robust domestic demand has played a significant role. For 2005, we expect end-year headline inflation of about 7 percent, some 1½ percentage points higher than core inflation (excluding energy and seasonal food). For 2006, core inflation is expected to remain broadly unchanged, as growing demand and wage pressures offset the impact of the nominal effective depreciation in late-2004. Forecasts for headline inflation are much less certain, and depend on adjustments in regulated prices and developments in world energy prices.
The longer demand pressures persist, the more protracted and costly will be the disinflation process. Recent surveys find that Latvian residents expect inflation to continue at current levels over the coming year, underpinning future price and wage setting behavior, which in turn would validate these expectations. Widespread indexation of wages to past inflation will also put a floor under inflation, potentially feeding a wage-price spiral.
The credit cycle is spurring a real estate boom. With bank credit to the nonfinancial private sector expanding at an annualized rate of 55 percent (85 percent for households—mostly mortgages), the private sector credit to GDP ratio is set to exceed 60 percent this year, against 20 percent only three years ago. Analysts expect credit growth to continue unabated for several years as banks strive to gain market share in a still very profitable market (average annual return on equity close to 30 percent). While prudential indicators of the banking sector remain sound, capital adequacy and liquidity ratios have slipped closer to statutory minima. Nonbank credit (including leasing) is reportedly also expanding very rapidly, although no comprehensive statistics are available. Booming mortgage lending has helped push up house prices by more than 50 percent in 2005 and, with construction costs about half market prices, residential construction activity has grown by 70 percent over the past year.
B. Policy Assessment and Recommendations
In the current setting, policies should aim at securing a durable reduction in inflation while halting the buildup of risks in financial and related sectors. Achieving these goals is critical to protecting Latvia's external competitiveness and to sustaining real income convergence, while also helping to meet the euro adoption criteria. Under conditions of rapid credit growth, macroeconomic and financial stability concerns are interrelated and reinforcing, underscoring the need for a combination of macroeconomic and prudential measures. Reining-in the fiscal stimulus and credit growth will be important elements of a credible policy package that can support lower inflationary expectations. Setting a realistic target date for euro adoption in combination with such a policy package would serve to anchor market expectations, while also allowing the private sector to better prepare for the eventual changeover.
Latvia's deepening integration into the European financial system limits the effectiveness of traditional monetary policy tools in containing credit growth. With a further shift in the currency composition of bank credit toward euros following Latvia's repegging and entry into ERM2 earlier this year, monetary policy has little autonomous leeway. The BoL therefore has few options for influencing the pace of credit or domestic demand. While credit-to-GDP ratios still have some way to go to reach EU-average levels, cross-country experience shows that credit growth has tended to be correlated with inflation, current account deficits, house price bubbles, and financial sector risks. We therefore see a need to moderate the current pace of credit and resulting convergence to long-run credit-to-GDP ratios.
As one of the BoL's few available instruments, reserve requirements have been increased substantially over the past 18 months—but with limited effect. Reflecting the increase, banks' reserves on deposit at the central bank stood at 5 percent of GDP in October 2005 (and are expected to rise to 6⅔ percent at year end when the latest increase comes into effect), compared with just 3 percent of GDP at end 2004. However, the effectiveness of these measures in raising banks' lending rates or slowing credit growth has been limited by diversion of banks' funding toward foreign liabilities with maturities above two years (which are not subject to the requirement). Moreover, wide spreads between interest rates on credits and banks' funding costs imply that lending remains very profitable for banks. Growing nonbank lending—which is exempt from reserve requirements and less closely supervised—as well as greater targeting by banks of riskier, higher-yielding borrowers may also undercut the effectiveness of tighter reserve requirements looking forward.
With no magic bullet to slow credit growth, the authorities should look to a range of possible measures. These include: discouraging speculative borrowing by closing the capital gains tax loophole on personal real estate holdings to exempt only an individual's primary residence provided the property has been in the individual's ownership for more than three years; a temporary tax on some categories of borrowing—levied either on the loan principal or on interest payments; and a further broadening of reserve requirements to eliminate remaining loopholes in the current arrangements.
The limited effectiveness of monetary policy in demand management puts even greater onus on fiscal policy. We continue to see a broadly neutral fiscal stance as providing the appropriate balance between the benefits for infrastructure development from spending some time-bound EU grants and the need to contain demand pressures. Moreover, achieving a neutral stance would better position the budget to absorb a slowdown in economic growth.
Notwithstanding a smaller-than-budgeted deficit this year, a procyclical fiscal stance is in prospect. While the actual deficit is projected to reach 0.5 percent of GDP, well below the targeted level on account of over-performance of tax revenues, fiscal policy is nonetheless expected to add about 1½ percent of GDP to demand pressures in 2005, after controlling for buoyant cyclical conditions and the large increase in net EU grants (which, for this purpose, should be considered a financing item). The ramping-up of spending in the second half of this year by more than 2 percent of GDP—as approved in the supplementary budget—was primarily responsible for generating the procyclical stance.
The approved budget for 2006 suggests, moreover, that a further demand impulse is in prospect for next year. Three considerations are behind this assessment: (i) the headline deficit is budgeted to widen by about 1 percentage point of GDP; (ii) the projected strong increase in spending is underpinned by very optimistic growth of tax revenues that could be difficult to realize; and (iii) financing provided by EU grants is budgeted to increase substantially relative to the actual 2005 level. Moreover, the Finance Ministry's November 2005 Convergence Program predicts almost no reduction in the headline deficit during 2006-08. As a result, fiscal policy will therefore, in our view, continue to compound the already evident overheating pressures. In view of the fiscal stimulus last year, achieving a neutral position during 2005-06 will require trimming some 3 percentage points of GDP from government spending plans in 2006, and avoiding further recourse to expansionary supplementary budgets.
Other inflation-reducing measures
Several structural factors that stand to block progress with disinflation should also be addressed. Preventing a wage-price spiral will require decoupling wages from past inflation and linking them instead to forward-looking inflation within the context of a credible disinflation plan, including the fiscal and credit measures discussed above. Uncompetitive behavior by firms in key sectors could also tend to push up inflation. Attention should therefore be given in some sectors to correcting anomalies between domestic and international prices including, where feasible, by broadening the number of suppliers of imported commodities.
Relying on cosmetic measures to hold down inflation should be avoided. Such measures, including reductions in indirect taxes and freezing administered prices, will not slow the momentum of underlying inflation and wage dynamics. Moreover, capping administered prices would entrench the current distorted price structure, reduce investment in affected sectors, and could also generate quasi-fiscal costs.
Prudential and supervisory policies
Perceptions of Latvia's macroprudential risks have been slow to adjust to changing circumstances. This likely reflects the long duration of the current expansionary cycle, the fact that interest rates have been on a persistent downward path, and that no new EU member has seen significant problems from rapid financial deepening. An additional factor is that exposure of foreign banks' subsidiaries or branches to Latvia represents only a very small share of their total portfolios, while profits derived from this business constitute a far greater fraction of their consolidated profit. This could induce foreign banks to assume greater risk than is beneficial from the Latvian perspective. The BoL's Financial Stability Reports (FSRs) are an important innovation and provide the appropriate vehicle for highlighting financial sector risks. However, FSR stress tests, which currently consider only a very modest decline in credit quality, should include more realistic scenarios based on historical episodes of other countries that experienced banking crises, and strengthen modeling of household credit risks. In addition, stress tests should attempt to simulate the impact of changes in interest and exchange rates on unhedged borrowers and the feedback onto loan performance and banks' capital cushions.
To preserve credit quality and ensure adequate resilience to adverse shocks, prudential and supervisory measures should be reinforced. We therefore welcome the authorities' decision to undertake a Financial Sector Assessment Program update with the IMF and World Bank in mid-2007. In the meantime, there is a need to remain vigilant to slippages in credit standards, including by carefully monitoring banks' internal risk management and control systems, and coordinating closely with home-country supervisors of foreign banks. Proposals to transform the existing bad-debtor credit registry into a comprehensive database covering all borrowers should also be implemented. In addition, we recommend strengthening prudential protections by establishing maximum loan-to-value (LTVs) rules for mortgages with significantly lower ceilings for multiple mortgage holders, and increasing the risk weighting of some classes of assets (e.g., residential mortgages) in the calculation of banks' capital adequacy. There may also be benefits from coordinating the prudential framework with neighboring countries to prevent "regulatory arbitrage" across countries by foreign banks.
We wish the authorities every success in their efforts to successfully steer the economy toward euro adoption, and thank our interlocutors for their generous cooperation and stimulating discussions.