Describes the preliminary findings of IMF staff at the conclusion of certain missions (official staff visits, in most cases to member countries). Missions are undertaken as part of regular (usually annual) consultations under Article IV of the IMF's Articles of Agreement, in the context of a request to use IMF resources (borrow from the IMF), as part of discussions of staff monitored programs, and as part of other staff reviews of economic developments.

International Monetary Fund
Republic of Latvia - 2006 Article IV Consultation Mission
Preliminary Conclusions
June 6, 2006

A. Overview

1. The Latvian economy has made remarkable strides since the mid-1990s, but sustaining convergence now requires a moderation in the pace of growth. Substantial catchup opportunities, together with deft policymaking, have underpinned the rapid growth and macroeconomic stability of the past decade; relative to the EU15, Latvia's per capita income in purchasing power (PPP) terms has climbed an impressive 16 percentage points. This has reflected strong growth in factor productivity, supplemented in recent years by rapid investment and solid growth in employment. But at only 43 percent, relative per capita income in PPP terms remains the lowest in the EU. Notwithstanding, further improvements cannot be achieved through breakneck growth that compromises macroeconomic and financial stability, and undercuts the prospects of sustainable convergence.

2. Latvia's economy is indeed at a troubling crossroads, rather than being firmly on the path to euro adoption. Since 2004, the economy has been riding the wave of an EU integration-related boom that has undermined the country's record of macroeconomic stability, giving rise to real, external, and financial vulnerabilities. With both private and public demand pushing the economy above its supply capacity, domestic drivers of inflation-including excessively rapid wage growth-are becoming entrenched and the current account deficit has failed to moderate, adding to the economy's already high external debt burden. Households, corporates, and banks have wrongly interpreted the repegging of the lats as a green light to take on large euro exposures, even though exchange rate risk will remain a fact of life in the period leading up to euro adoption. Strong demand, falling interest rates, and speculative activity have fuelled an acceleration in house prices. There are now genuine concerns that a bubble is being created. Labor emigration, the rapid decline in unemployment, and unrealistic expectations of a quick income catchup to EU levels, are amplifying risks that a wage-price spiral is in the offing.

3. Steering the economy away from its overheated path is now the key challenge, which is made all the more difficult by the dearth of effective monetary policy tools and by the excessively optimistic expectations that appear to abound. The urgency of addressing the overheating issue arises from the possibility that foreign investors could reevaluate their exposures to Latvia, causing capital inflows to slow or even reverse, risk premia to rise, and the exchange rate to come under pressure. While the openness of the economy and the exchange rate regime limit policy options, restraining private and public sector demand is essential to contain overheating and the buildup of imbalances, to preserve external competitiveness, and to limit vulnerabilities ahead of euro adoption.

4. While overheating is the prime concern at present, there is also a strong need to focus policies on areas that will allow Latvia's export performance to remain favorable in the future in order to service the country's external liabilities. As evidenced by the solid growth in export volumes in recent years, the current exchange rate parity has provided an adequate level of competitiveness. However, a sizable share of exports remains in low-tech, low-skill goods that are in direct competition with low-wage emerging market suppliers. While other new EU members have moved up the value-added chain, Latvia has been slow to adjust owing to the cushion provided by ready access to low-cost foreign capital, the transit trade with CIS countries, and energy prices that have been below world market levels. But as Latvia's wage gap with the EU closes, preserving competitiveness under a fixed exchange rate (whether inside or outside the euro) will require moving up the technology ladder.
B. Background and Outlook

5. Rapid economic growth-which reached 10¼ percent last year-has opened up a sizable positive output gap. As a result, core inflation has ratcheted up to over 5 percent, the current account deficit relative to GDP remains stuck above 12 percent (notwithstanding the good performance of exports), and net external liabilities have now swelled to close to 60 percent of GDP. While these pressures have stemmed primarily from the demand side, supply side factors have also played a role.

6. In the near term and absent a change in policies, very rapid growth is likely to persist. Domestic demand will continue to drive growth as bank credit and net EU inflows quicken. However, net exports will drag down growth owing to a weakening of competitiveness and a narrowing of food price differentials with other EU members. Overall, we expect GDP growth to moderate only slightly to 9 percent in 2006. With output already above capacity and the likelihood of further labor emigration, overheating pressures in the product and labor markets will intensify in some sectors and become more broad based. The mission therefore expects neither the current account deficit nor core inflation to moderate this year. However, headline inflation will likely decline modestly as world energy prices are expected to increase more slowly.

7. Looking ahead, while a benign scenario with a gradual unwinding of the recent economic excesses is still likely, the possibility of a distinctly more disruptive outcome will increase the longer imbalances go unchecked. Rising household debt, the high level of house prices, and weakening external competitiveness could facilitate an orderly slowdown in demand that would help to cool the economy. However, there is no guarantee that this "natural" adjustment will materialize, particularly as negative real interest rates and substantial EU-financed spending are likely to add further to the current account deficit under unchanged policies. With large unhedged private-sector currency exposures, moreover, allowing these imbalances to go unchecked would be highly risky. The appropriate weight to attach to a disorderly scenario is difficult to assess, but the cross-country evidence strongly suggests that if it were to play out, the costs to Latvia would be large. In particular, it would force a sharp contraction in credit, domestic demand, the current account, asset prices and employment. Our firm view is therefore that a redirection of policies to reduce the risks of a disruptive scenario is urgently needed, and that the price of somewhat slower growth in the short term is well worth paying to lay a stronger foundation for sustainable medium-run growth, stability, and euro accession.
C. Policy Assessment and Recommendations

8. No magic bullet is available to reduce the risks of a disruptive scenario, but a broad range of measures could in our view generate significant results when pursued as a coherent, and clearly-communicated policy package. In the context of rapid credit growth, macroeconomic and financial stability concerns are inherently interrelated, calling for a combination of demand management and prudential measures. Reining-in credit growth, unwinding the fiscal stimulus, and restraining excessive wage growth will be key elements in a policy package to reduce inflation. A communications strategy that fosters realistic expectations about income prospects and sets a feasible-though ambitious-revised target date for euro adoption will help boost the credibility of the package.

Monetary and credit policies

9. Monetary policy appropriately continues to lean against the wind of strong demand and credit growth, but its effectiveness is limited by open capital markets, Latvia's long-standing commitment to euro adoption, and the narrow band currency peg. The recent broadening of the reserve requirement base to encompass long-term liabilities is a welcome step. However, raising the minimum liquidity ratio or further increasing the reserve requirement rate is unlikely to appreciably slow credit owing to still sizable margins on bank loans, the availability of additional liquid assets from parent banks, and the shifting of borrowing to nonbanks and offshore.

10. Against the background of the limited effectiveness of traditional monetary policy tools, a variety of measures are needed to moderate the expansion of mortgage credit. Generous tax treatment of real estate and uneven compliance is helping to fuel speculative activity in land and housing, and contributing to overly rapid mortgage borrowing. To address these trends, several mutually reinforcing measures are needed. Realized capital gains on personal real estate holdings should be treated as income under the personal income tax unless the property is the individual's primary residence and has been owned for more than three years. More accurate reporting of the transaction price in the land register also needs to be enforced at the time of purchase in order to correctly measure capital gains and assess the base for the real estate transfer tax. In the event that the purchase price deviates substantially from market prices for comparable properties, an assessment by an independent licensed appraiser should form the basis for entries in the land register.

Fiscal policy

11. With significant signs of overheating, every effort must be made to ensure that fiscal policy does not add to the already considerable demand pressures emanating from the private sector. Government decisions influence demand through own revenue and expenditure measures, and through authorizations of EU-financed projects implemented by the private sector. In addition, the fiscal authorities can influence private demand through the signaling effect of public sector wage increases and the overall stance of fiscal policy. While cash-based general government deficits have remained moderate in recent years, these mask significant demand injections through spending financed with EU funds (which, for this purpose, should be considered a financing item). The 2006 budget implies a further large stimulus not only due to increased absorption of EU funds by the public and private sectors, but also on account of a significant impulse from self-financed activities. Our strong recommendation is to secure a broadly neutral fiscal stance until overheating subsides (and certainly over the next two years), which will necessitate reversing the substantial stimulus injected in recent years.

12. To achieve this goal and underpin market confidence, a sizable front-loaded fiscal adjustment is needed. As an immediate step, any overperformance of revenues should be saved and supplementary spending authorizations for the rest of the current budget year should be matched by spending cuts elsewhere. Beyond this, starting with next year's budget, a much more ambitious, front-loaded improvement in the fiscal balance will be needed, building on the very modest adjustment envisaged in the 2005 Convergence Program. More specifically, we recommend freezing in 2007 and 2008 the level of spending adjusted for inflation. On our calculations, this would shift the headline cash balance-where revenues increase strongly owing to rapid growth in EU grants-to a surplus of more than 2½ percent of GDP in 2008. To realize this target, self-financed spending should be strictly rationalized. In addition, EU-funded projects should be sequenced to ensure that only the highest-priority projects are implemented first, while those likely to exacerbate bottlenecks (e.g., in construction) should be deferred to the extent possible under EU rules. And third, the proposed phased reduction in the personal income tax rate from 25 to 15 percent beginning in 2007-which would boost households' purchasing power at a time of already very buoyant demand-should be put on hold until overheating pressures have dissipated.

13. Implementing a medium-term budgetary framework would make it easier for the authorities to secure these goals. Welcome progress has been achieved with the decision in 2006 that all line ministries should produce three-year strategic plans, and by folding the separate "special budgets" into the central government's basic budget since 2004. We would underscore the need for further progress, including by formally linking the revenue and expenditure forecasts with the macroeconomic projections within a single document, which could strengthen the credibility of medium-term fiscal projections, ensure that EU-funds are put to their best use to raise the economy's growth potential, and help to enhance spending efficiency by allowing some carryover of unused allocations to the next calendar year.

Prudential measures for banks

14. We remain concerned that banks are continuing to take on sizable credit and market risk despite the level of external imbalances and the delay in euro adoption. Mortgage lending is seen by banks as safe and profitable in view of rapidly growing household incomes and real estate prices. Appetite for risk by large foreign banks is particularly strong given the modest exposure of their portfolios to the Latvian market and the very high returns on equity invested there. However, international experience shows that perceptions of loan quality are notoriously procylical-positive during economic upswings, but deteriorating rapidly when conditions turn less favorable.

15. Efforts to strengthen the regulatory and supervisory framework are needed to help restrain the buildup of financial sector risks, including on account of weakening credit standards. Growing currency mismatches and the revision in the euro adoption timetable suggest the need to treat banks' euro exposures in much the same manner as other foreign currency exposures in terms of assessing both capital charges and setting limits on net open positions. With the introduction of the Basel 2 capital accord, the supervisory authority-in coordination with relevant foreign supervisors where required-should thoroughly assess banks' internal credit-risk models and ensure that banks maintain sufficient capital to adequately cover direct and indirect risks in their portfolios. In determining eligibility for all foreign currency-denominated loans, banks should ensure that loan size is smaller in the case of unhedged borrowers and strictly scrutinize income and cash-flow data provided by potential borrowers. Further refinements to the central bank's stress-testing exercises should include scenario simulations that internalize feedback relationships among macroeconomic variables, borrower solvency, and the level of bank capital. It would be helpful to calibrate scenarios on historical episodes of banking distress in other countries, augmented with informed judgments regarding Latvia-specific conditions, including the proportion of unhedged households and small- and medium-size enterprises. In addition, the consumer protection authorities should better educate borrowers of the risks involved in credit taking. In assessing risks and devising prudential measures, close cooperation with parent banks' supervisors will be crucial.

Labor market and structural policies

16. Labor market bottlenecks need to be addressed to ensure that wage growth does not run ahead of productivity improvements. The labor market is currently very tight across a broad range of skill types and economic sectors. Overheating, emigration of low-skilled workers, and a deficiency of graduates over the past decade with scientific and technical skills are contributing to shortages. Some relief would be provided by slowing domestic demand, improving productivity in the public sector, and further increasing labor force participation by raising the minimum personal income tax exemption. Temporary inward immigration may also assist. However, the growing prevalence of indexing wages to inflation-either explicitly or implicitly-and the spread of sectoral collective bargaining is acting to cement the existing wage structure, further blunting the role of price signals in individuals' decisions about skill acquisition and employment. Ongoing public sector wage reform, which will have an important signaling effect for the private sector, should therefore ensure that future wage growth is better linked to productivity gains and forward-looking inflation expectations, guided by a credible disinflation plan.

17. Boosting export performance while transitioning from a low- to a moderate-wage country requires Latvia to scale the technology ladder. Reducing the size of the gray economy-including by screening firms' financial plans under EU grant applications-will ease restructuring by giving workers a legitimate employment history that allows them to more easily switch jobs in response to demand shifts. But to move up the value chain will also require building human capital, absorbing domestic and foreign technologies, and integrating into multinational production chains. Reducing "red tape," improving infrastructure in areas outside Riga, and maintaining competitiveness through a credible commitment to macroeconomic stability should help attract long-term foreign direct investment into export sectors. EU funds can play a powerful catalytic role if projects are selected on the basis of delivering the highest societal benefits, including by improving education outcomes, increasing business scientific know-how, and expanding infrastructure for viable sectors. In their efforts, the authorities should concentrate on laying a foundation for sustainable growth, while refraining from picking "winners."

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It remains for us to thank our many interlocutors, in both the public and private sectors, for their generous hospitality and stimulating discussions during our visit to Riga.



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