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IMFSurvey Magazine: Interview

Latvia Struggles to Overcome Economic Downturn

Apartment for sale in Riga, Latvia, where bursting real estate bubble has been factor in deep economic slump (photo: Ilmars Znotins/AFP/Getty Images)

EUROPE'S TRANSITIONAL ECONOMIES

Latvia Struggles to Overcome Economic Downturn

IMF Survey online

July 28, 2009

  • Broad agreement reached on policy package to fight economic downturn
  • Fiscal framework allows for higher spending to protect vulnerable groups
  • Fiscal reforms needed to put economy on sustainable path to adopt euro

The IMF and Latvia reached understanding on July 27 on a staff-level agreement that can lead to the completion of the first review under Latvia’s Stand-By Arrangement with the Fund.

The agreement, which has been endorsed by the IMF’s Management, must still be approved by the 24-member Executive Board.

An IMF mission, led by Anne-Marie Gulde and Mark Griffiths, has just returned from Riga after agreeing on a new policy package with the government of Prime Minister Dombrovskis. The package, which will give Latvia access to about €195 million ($278.3 million) in new financing, is designed to fight the deep downturn that has gripped the country, and at the same time bring government finances back on a sustainable footing.

In this interview, Gulde and Griffiths explain the rationale for the policy measures, which will be discussed by the IMF’s Board in early September.

IMF Survey online: The EU (European Union) agreed more than a month ago to provide Latvia with additional financing. Why did the IMF take so long?

Gulde: The Latvian authorities, the IMF, and the EU have had the same goal in mind from the start: to return growth and prosperity to the country. To achieve this, there has always been broad consensus among all parties involved, including the EU, that containing the budget deficit and ensuring medium-term fiscal sustainability are essential goals.

The key concern for the IMF has been to get a fuller picture of the proposed measures and how they will be implemented. The need for more detail was necessary to understand how vulnerable groups in Latvia’s society could best be protected. We also wanted to make sure that any budget reform would be based on sustainable measures aimed at improving the long-term competitiveness of the economy.

Such a rethink of spending requires a lot of work, which is why it has taken us longer than expected to reach agreement. We have carried out this analysis jointly with the EU, which was present at our most recent meetings, and which supports the more detailed measures worked out during this past week.

As a result of our hard work, we now have a more realistic spending framework for 2009 that builds on the government’s supplementary budget agreed in June. The revisions to the 2009 framework reflect additional spending to protect the most vulnerable.

IMF Survey online: When do you expect Latvia’s economy to recover?

Griffiths: The economic downturn has been much deeper than anticipated. Real GDP has fallen by 18 percent year-on-year in the first quarter of 2009. The main reason is the bursting of the credit and real estate bubble and a collapse of domestic demand. And of course, the global economy has been much worse than we expected back in December when the program with Latvia was first agreed. This has made it harder for the country to maintain its exports.

Recovery is likely to be slow. We expect the economy to stabilize next year, as recovery takes hold in Europe. Even so, GDP is still projected to fall by about 4 percent through 2010, and it will take time for Latvia’s industry to regain competitiveness.

IMF Survey online: What does this mean for the budget?

Gulde: The downturn has significantly weakened government finances, causing the fiscal deficit to widen by much more than was originally agreed with the government in January. So even with considerable assistance from the international community, Latvia has a huge budget hole that needs to be plugged.

The fiscal adjustment in Latvia takes place in the context of the country’s desire to adopt the euro as soon as possible. As you know, the EU’s rules require a sustainable budget deficit of 3 percent of GDP for countries wishing to join the euro area. To give you a sense of the challenge, we project that Latvia’s deficit this year will be in the double digits.

The government has proposed a strengthened policy package intended to reduce the fiscal deficit in 2009 and beyond in a sustainable manner. With a deficit of this size, cuts are unfortunately unavoidable, requiring challenging trade-offs among spending priorities. In setting these priorities, we were mindful of ensuring that the public sector can continue to work efficiently and support the overall economic fabric of the country.

Equally, if not more important, is to ensure that any budget cuts protect vulnerable groups in society. With this in mind, our main concern was to limit across-the-board cuts. While such cuts provide a “quick fix” in the short term, they disproportionately hurt the poor. Across-the-board cuts also have a negative influence in the longer run on the quality of government services.

The revised fiscal framework aims to keep the general government deficit in 2009 below 13 percent of GDP and reduce it to the Maastricht limit of 3 percent as soon as possible thereafter, consistent with the government’s desire to adopt the euro at the earliest possible date.

IMF Survey online: What specific measures were taken to protect social spending?

Griffiths: The original IMF-supported program that was agreed with the government back in December 2008 ensured that social spending was fully protected. But, given the gravity of the situation, cuts in all areas have now become unavoidable.

But, as Anne-Marie said, we were particularly concerned that huge across-the-board cuts would impose a disproportionate burden on the poor. Over the past few weeks, we have worked with the authorities and the World Bank to refine the cost-cutting measures to make sure they can deliver the necessary adjustment without putting the most vulnerable groups at a disadvantage.

To give you an example, we have worked with the government and the World Bank on a comprehensive strategy to improve the social satety net. Measures we agreed on include guaranteed minimum income payments covering health copayments for the most vulnerable, increasing funds for emergency housing support, protecting schooling for six-year-olds, and promoting job creation through active labor market policies.

IMF Survey online: Will tax increases be necessary?

Gulde: Adjustment of this magnitude will be easier if both expenditure and revenue measures are included. Latvia has a tradition of very low taxation, which worked well when growth was high. But lower growth will require a tax system that brings revenues more in line with expenditures. As a first step in this direction, measures proposed for this year and next include improvements in tax administration and a broadening of the real estate and personal income tax.

Taking steps to raise revenues now will help avoid further cuts in spending down the line. But we should make sure that tax reform—such as changes to the personal income tax—does not disproportionably fall on the poor. Latvia has had a flat tax in place since 1997. Making it more progressive would bring the country in line with most other countries in the EU and would reduce the tax burden on low-income groups.

IMF Survey online: It seems that maintaining the peg to the euro has come at a high price for Latvia. Wouldn’t it have made more sense to devalue?

Gulde: The authorities have stressed the importance of controlling government debt and deficits and maintaining the peg of the lats to the euro until the country will be able to join the euro area as a full member. The agreed set of policies was designed with those goals in mind.

In deciding to maintain the peg, the authorities have chosen a path that puts a heavy burden on fiscal policy in the short term. But even without the end goal of euro adoption to drive policy decisions, Latvia would have faced a very difficult policy environment and would over time have needed to bring expenditures in line with revenues.

Comments on this article should be sent to imfsurvey@imf.org


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