## cr17194 - Selected IMF staff report excerpts on the Republic of Latvia

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### Recent economic developments
- Real GDP growth: 2016 = 2.0 percent; Q1 2017 = 4.0 percent year-on-year.
- Components (2016): Private consumption = 3.4 percent; Public consumption = 2.7 percent; Gross fixed capital formation = -11.7 percent.
- Investment: Gross fixed capital formation contracted by 11.7 percent in 2016 due to lower-than-expected absorption of EU funds.
- External and price indicators:
  - Current account balance: 2016 = 1.5 percent of GDP (moved to a surplus in 2016 as terms of trade improved by 4.7 percent).
  - Terms of trade (annual percentage change): 2016 = 4.7; 2017 = -1.0; 2018 = -0.2.
  - HICP inflation: period average 2016 = 0.1 percent; headline inflation = 3.3 percent in April 2017; core inflation 2016 = 1.3 percent.
- Labor market and wages:
  - Unemployment rate (LFS; period average) 2016 = 9.6 percent; long-term share ~41 percent of unemployment in 2016.
  - Real gross wages rose 2016 = 4.9 percent; real wage growth decelerated slightly to 4.6 percent in 2016 but exceeded productivity growth by about 2.6 percentage points.
- Credit and money:
  - Credit to the non-financial private sector grew by 2.3 percent y-o-y in March 2017 (corporates +5.1 percent; households -1.1 percent).
  - Credit to private sector (annual percentage change): 2016 = 3.5; 2017 = 6.2; 2018 = 5.5.
  - Broad money (annual percentage change): 2016 = 6.6; 2017 = 7.3; 2018 = 6.7.
- Output per head and saving:
  - GDP per capita (thousands of euros): 2016 = 12.7; 2017 = 13.6; 2018 = 14.4.
  - Gross national saving (percent of GDP): 2016 = 21.4; 2017 = 20.8; 2018 = 20.7.
- Nominal GDP (billions of euros): 2016 = 25.0; projections: 2017 = 26.6; 2018 = 28.0.

### Outlook and key risks
- Short-term growth projection:
  - Growth expected to rebound to around 3.2 percent in 2017 supported by accelerated EU fund disbursement and robust private credit growth.
  - Real GDP projections (selected): 2016 = 2.0; 2017 = 3.2; 2018 = 3.2.
- Inflation outlook:
  - Headline HICP inflation projected to rise to 3 percent on average in 2017.
  - Core inflation projected to increase to 2 percent in 2017; core inflation accounts for about 75 percent of overall inflation.
- External and fiscal trajectory:
  - Current account projected to return to deficit: Current account balance (percent of GDP): 2016 = 1.5; 2017 = -0.4; 2018 = -1.4.
  - General government gross debt (percent of GDP): 2016 = 37.2; 2017 = 35.9; 2018 = 34.5.
- Key downside risks:
  - Slower-than-expected absorption and inefficient use of EU funds could constrain investment and growth.
  - Continued rapid real wage growth outpacing productivity could harm competitiveness, profitability, and investment.
  - External risks: structurally weak growth in advanced economies; retreat from cross-border integration; intensification of security dislocation in Europe; regional financial instability.
- Balance of risks: more balanced but still tilted to the downside.

### Fiscal developments and stance
- 2016 fiscal outturn:
  - General government basic deficit (cash basis) narrowed to -0.4 percent of GDP; structural surplus of 0.2 percent of GDP (ESA definition) versus 2016 deficit target of 0.9 percent of GDP.
  - Total revenues (excluding foreign assistance) overperformed by about 0.4 percent of GDP.
  - Expenditure under-execution: investment-related under-execution by about 0.8 percent of GDP; other current spending under-executed by about 0.2 percent of GDP.
  - Measures contributing to revenue overperformance: introduction of the solidarity tax, increase in excise duties, and base-broadening and compliance measures.
- 2017 stance and medium-term guidance:
  - 2017 fiscal stance described as expansionary; with fiscal space due to modest gross financing needs and low public debt.
  - Guidance: efficiently use EU investment funds; boost revenue share to offset phasing out of EU funds (average of 3 percent of GDP over the next 4 years) and finance stronger social safety nets; move toward fiscal neutrality over the medium term to avoid procyclicality.
  - Fiscal indicators (selected): Consolidated general government total revenue (percent of GDP): 2016 = 36.2; 2017 = 37.3; 2018 = 37.6. Consolidated general government total expenditure (percent of GDP): 2016 = 36.7; 2017 = 38.2; 2018 = 38.1.
  - Basic fiscal balance (percent of GDP): 2016 = -0.4; 2017 = -0.8; 2018 = -0.5. ESA balance (percent of GDP): 2016 = 0.0; 2017 = -0.7; 2018 = -0.7.

### Tax reform: proposals, fiscal impact, and considerations
- Objectives: support growth, increase equity, and boost revenues; reform underpinned by review of tax structure and rates, improved tax administration, and steps to reduce the shadow economy.
- Proposed measures (selected):
  - Labor taxes: phased out tax-free allowance system, lower PIT rate for lower incomes and higher PIT rate for high incomes, eliminate the “solidarity tax”, and a 13% increase in the minimum monthly wage (authors also reference a 2.7 percent minimum wage increase in 2017 elsewhere).
  - Corporate tax (CIT): tax reinvested profits at 0% and raise the rate on distributed profits to 20%.
  - Revenue-raising offsets: reductions in VAT registration thresholds, gradual increase in excise taxes, higher ceiling on social security contributions.
  - Tax administration: introduction of single accounts, improved services; measures to combat shadow economy (reverse VAT in problematic sectors, online trade transactions register).
- Fiscal impact estimates:
  - Authorities’ direct fiscal cost estimates: increase in the deficit of about 0.7 percent, 0.5 percent and 0.3 percent of GDP from 2018 through 2020.
  - Largest direct revenue losses estimated: progressive PIT regime and differentiated non-taxable minimums = 1 percent of GDP; change in the CIT regime = 0.6 percent of GDP.
  - Staff concern: draft package could entail a fiscal cost of about 1.5 percent of GDP over the first three years of implementation (noting uncertainty about indirect growth offsets).
- Policy recommendations for reform sequencing:
  - Finalize plans swiftly to reduce uncertainty.
  - Carefully manage macro impact to avoid procyclical policy and undermining competitiveness.
  - Ensure the final package sustainably boosts the revenue share (options: property, environmental, or consumption taxes; reduction in exemptions).
  - Offset short-term fiscal impulse by targeting a neutral fiscal stance over the medium term; account for small fiscal multipliers and assumed unwinding of stimulus.

### Financial system, credit growth, and AML/CFT
- Banking sector soundness and liquidity:
  - Capital adequacy ratio 2016 = 21.1 percent.
  - Share of liquid assets in total assets 2016 = 33.8 percent.
  - Latvijas Banka stress tests: banks’ capacity to absorb potential liquidity shocks is adequate.
  - Profitability: banks remain profitable with wide lending-deposit spreads.
- Deposits and non-resident dynamics:
  - Resident deposits grew by 12.2 percent y-o-y through 2016; system-wide deposits declined by 7.4 percent, driven by a 26.5 percent decline in non-resident deposits (NRDs).
  - USD clearing declined by 39 percent over 2016.
  - Drivers: stronger AML/CFT enforcement, sanctions against Russia, and loss of European-based correspondent banking relationships.
- Banks servicing foreign clients (BSFCs):
  - BSFCs: 13 banks cater predominantly to foreign clients; domestically active banks: 7 branches and 3 subsidiaries.
  - BSFCs account for around 12 percent of lending to residents.
  - BSFCs remain broadly sound with strong capital and liquidity buffers; FCMC applies more stringent liquidity and capital requirements to BSFCs and conducts stress testing for NRD outflows.
  - Business-model adjustments observed: switching from transactional to investment models, broadening client base beyond CIS, increasing domestic presence.
- Credit and asset quality:
  - Credit to the non-financial private sector grew by 2.3 percent y-o-y in March 2017 (corporates +5.1 percent; households -1.1 percent).
  - Share of loans past due over 90 days:
    - Households: end-March 2017 = 4.9 percent (from 7.6 percent in 2015).
    - Corporates: end-March 2017 = 2.9 percent (from 4 percent in 2015).
- Policy recommendations to support credit while preserving stability:
  - Promote programs to facilitate SME access to credit (e.g., Altum and EIB guarantees; European Fund for Strategic Investments programs).
  - Continue insolvency reforms: promote rescue of viable businesses, strengthen oversight of insolvency administrators, develop efficiency assessment of insolvency framework.
  - Maintain vigilant supervision and enforcement, including AML/CFT.
  - Ensure appropriate macro-prudential policy settings and monitor financial interconnectedness with Nordic-Baltic parent banks.
  - Shift shadow economy segments into the formal sector to increase financial inclusion and credit access.

### Potential growth, productivity drivers, and structural reform priorities
- Staff estimates and historical context:
  - Staff revised medium-term potential growth to 3 percent.
  - Potential growth decline: pre-crisis (2003–07) about 6.9 percent; recent (2012–16) about 2.2 percent; 2016 about 2.5 percent.
  - Output gap 2016 estimated at -0.5 percent.
  - Pre-crisis average growth (2003–07) = 9.9 percent; post-crisis average growth (2012–16) = about 2.7 percent.
- Contributions to decline in potential growth:
  - TFP contribution: dropped from 50 percent (2003–07) to about 3 percent (2012–16).
  - Capital accumulation contribution: about 48 percent (2003–07) and about 54 percent (2012–16).
  - Largest factor: total factor productivity (TFP).
- Convergence implications:
  - Latvia’s GDP per capita (PPS) was about 62 percent of the EU-15 average in 2015.
  - Staff simulations: a 1 percentage point decrease in potential growth could delay closure of the income gap with the EU-15 by about 12 years.
- Policy priorities to raise potential growth:
  - Improve institutional quality: protection of property rights; upgrade legal systems including insolvency and judicial reforms.
  - Increase access to finance, especially for small but productive firms; improve corporate governance of state-owned enterprises.
  - Reduce regulatory and administrative burdens; promote technology diffusion.
  - Raise investment and capacity utilization: modernize capital stock (Latvia has the lowest capital-output ratio in the EU-28); higher public investment in infrastructure (EU electric network connectivity, transport, ports); rapid and efficient absorption of EU funds; attract FDI.
  - Strengthen labor market: active labor market policies; tax and benefit reform to improve incentives (e.g., in-work tax credits, tapering benefits); reduce skill mismatches via vocational education and employer links; attract high-skilled foreign workers; avoid wages outstripping productivity including prudent minimum wage increases.
  - Additional benefits: reforms that boost potential can reduce incentives for informal activity and raise tax compliance and financial inclusion.

### External sector assessment (Annex I)
- External positions and NIIP:
  - NIIP: end-2016 around -58 percent of GDP; projected to continue declining to about -35 percent of GDP over the medium term.
  - Gross assets 2016 = 134 percent of GDP; gross liabilities 2016 = 192 percent of GDP.
  - Debt securities comprised 15 percent of liabilities. Net external debt end-2016 = 29 percent of GDP.
- Current account:
  - Current account 2011–15 average = -2.4 percent of GDP; 2016 moved to a surplus of 1.5 percent of GDP.
  - Counterfactual: assuming 2016 trade volumes at 2015 prices, current account would be -1.3 percent.
  - Projected to swing back into modest deficits in 2017 and 2018 as investment and consumption pick up.
- Real exchange rate and assessment:
  - REER appreciated by about 1 percent between 2015 and 2016.
  - CA regression: suggests an undervaluation of 5–15 percent using standard trade elasticities.
  - EBA-lite REER model: small overvaluation of around 1 percent.
  - Overall external position in 2016 assessed as stronger than implied by medium-term fundamentals, reflecting temporary factors (terms of trade, weak investment, lower fiscal deficit).
- Capital and financial accounts:
  - Capital account dominated by EU structural fund inflows (slowed in 2016; expected to increase in 2017–18).
  - FDI inflows slowed; portfolio and other investment flows main drivers of financial account.
  - High foreign holdings of government bonds and regional banking linkages indicate potential vulnerabilities.
- FX intervention and reserves:
  - Euro is a global reserve currency; reserves in euro area economies typically low by some metrics; currency is free floating.

### Public debt sustainability (Annex III) — key indicators and scenarios
- Nominal gross public debt (2015–2022): 27.5, 34.8, 37.2, 35.8, 34.1, 32.9, 31.5, 30.1, 29.0.
- Public gross financing needs (2015–2022, percent of GDP): 2.0, 10.7, 1.7, 6.1, 4.6, 5.5, 5.4, 4.8, 1.9.
- Real GDP growth (2015–2022): 1.7, 2.7, 2.0, 3.2, 3.2, 3.1, 3.0, 3.0, 3.0.
- Effective interest rate (2015–2022): 4.9, 4.8, 3.6, 3.1, 2.1, 2.2, 2.2, 2.2, 2.3.
- Baseline assumptions (2017–2022):
  - Real GDP growth: 2017 = 3.2; 2018 = 3.2; 2019 = 3.1; 2020 = 3.0; 2021 = 3.0; 2022 = 3.0.
  - Inflation: 2017 = 2.9; 2018 = 2.3; 2019 = 2.3; 2020 = 2.3; 2021 = 2.2; 2022 = 2.2.
  - Primary Balance (2017–2022): 0.1, 0.4, 0.2, 0.6, 0.4, 0.4.
  - Effective interest rate (2017–2022): 3.1, 2.1, 2.2, 2.2, 2.2, 2.3.
- Alternative scenarios:
  - Historical scenario: large pro-debt deviations (Real GDP growth 2018–22 = 0.8 each year; Primary Balance = -1.4 each year).
  - Constant Primary Balance scenario: Primary Balance maintained at 0.1 each year 2017–2022.
- External debt (baseline, 2012–2022 percent of GDP): 138.2, 133.9, 143.0, 141.6, 147.3, 140.2, 134.8, 132.7, 129.7, 123.8, 122.3.
- Stress tests and shocks:
  - Interest rate, growth, current account, and combined shocks (including a 30 percent one-time real depreciation) materially raise external debt ratios in stress scenarios (examples cited: combined shock values 147; 30% depreciation combined shock 142).
  - Individual shocks are permanent one-half standard deviation shocks; combined shock includes permanent 1/4 standard deviation shocks to real interest rate, growth rate, and current account, plus a one-time 30 percent real depreciation in 2017.

### Executive Board / Staff assessment and authorities’ views
- Executive Directors endorsed staff appraisal: Latvia has made great strides since the crisis; macro conditions sound but post-crisis growth pace more modest.
- Staff view: determined policy action can raise growth despite lower potential; priorities include institutional quality, access to financial services, higher investment, capacity utilization, and labor market improvements.
- Authorities broadly agreed with staff’s assessment and emphasized importance of effective tax reform complementing structural reforms.
- Authorities’ fiscal stance: agree on prudent policies, see tax reform as necessary to support growth, equity, and revenues; expect reform to stimulate growth and over time increase revenues but acknowledge short-term revenue costs and need to avoid procyclical policy.
- Authorities concurred credit cycle has turned and that resumption of credit is key to boosting investment and growth; stress preserving financial stability and strengthening AML/CFT.

*Source: STAFF REPORT FOR THE 2017 ARTICLE IV CONSULTATION, Republic of Latvia (IMF).*

### 1.5 percent in 2016 as the terms of trade, driven largely by falling energy prices, improved by

### cr17194 - 1.5 percent in 2016 as the terms of trade, driven largely by falling energy prices, improved by

### Recent economic developments
- Real GDP growth slowed to 2.0 percent in 2016, driven primarily by consumption; gross fixed capital formation contracted by 11.7 percent in 2016 due to lower-than-expected absorption of EU funds.
- Q1 2017 growth accelerated to 4.0 percent year-on-year, driven by strong consumption and exports, and a pick up in investment.
- The current account moved to a surplus of 1.5 percent in 2016 as the terms of trade improved by over 4.7 percent—the largest improvement in 10 years.
- HICP inflation: period average in 2016 was 0.1 percent; headline inflation rose to 3.3 percent in April 2017 due to increasing international energy prices and strong base effects. Core inflation increased moderately to 1.3 percent in 2016.
- Credit to the non-financial private sector grew by 2.3 percent year-on-year in March 2017 (corporates +5.1 percent; households -1.1 percent).
- Unemployment rate (LFS; period average) fell modestly to 9.6 percent in 2016; about 41 percent of total unemployment in 2016 was long-term.
- Real gross wages rose by 4.9 percent in 2016; real wage growth decelerated slightly to 4.6 percent in 2016 but exceeded productivity growth by about 2.6 percentage points.
- Nominal GDP: 2016 = 25.0 (billions of euros); projections: 2017 = 26.6, 2018 = 28.0.
- Selected table figures (2016 actual; 2017–18 projections where shown):
  - Real GDP: 2016 = 2.0; 2017 = 3.2; 2018 = 3.2
  - Private consumption: 2016 = 3.4; 2017 = 3.3; 2018 = 3.2
  - Public consumption: 2016 = 2.7; 2017 = 3.5; 2018 = 3.4
  - Gross fixed capital formation: 2016 = -11.7; 2017 = 8.0; 2018 = 7.5
  - Exports of goods and services: 2016 = 2.8; 2017 = 3.1; 2018 = 3.3
  - Imports of goods and services: 2016 = 4.6; 2017 = 4.8; 2018 = 5.0
  - GDP per capita (thousands of euros): 2016 = 12.7; 2017 = 13.6; 2018 = 14.4
  - Gross national saving (percent of GDP): 2016 = 21.4; 2017 = 20.8; 2018 = 20.7
  - Gross capital formation (percent of GDP): 2016 = 19.9; 2017 = 21.3; 2018 = 22.1
  - Credit to private sector (annual percentage change): 2016 = 3.5; 2017 = 6.2; 2018 = 5.5
  - Broad money (annual percentage change): 2016 = 6.6; 2017 = 7.3; 2018 = 6.7
  - Current account balance (percent of GDP): 2016 = 1.5; 2017 = -0.4; 2018 = -1.4
  - General government gross debt (percent of GDP): 2016 = 37.2; 2017 = 35.9; 2018 = 34.5
  - Consolidated general government total revenue (percent of GDP): 2016 = 36.2; 2017 = 37.3; 2018 = 37.6
  - Consolidated general government total expenditure (percent of GDP): 2016 = 36.7; 2017 = 38.2; 2018 = 38.1
  - Basic fiscal balance (percent of GDP): 2016 = -0.4; 2017 = -0.8; 2018 = -0.5
  - ESA balance (percent of GDP): 2016 = 0.0; 2017 = -0.7; 2018 = -0.7
  - Terms of trade (annual percentage change): 2016 = 4.7; 2017 = -1.0; 2018 = -0.2

### Outlook and risks
- Short-term outlook: Growth is expected to rebound to around 3.2 percent in 2017 supported by an accelerated pace of disbursement of EU funds and continued robust private credit growth.
- Medium-term concerns: Staff estimate that post-crisis medium-term potential growth is lower than previously thought; raising potential growth will require addressing crisis legacies and demographic headwinds.
- Key risks:
  - Slower-than-expected absorption and inefficient use of EU funds could constrain investment and growth.
  - Continued rapid real wage growth outpacing productivity could harm competitiveness, profitability, and investment.

### Policy recommendations and priorities
- Raise potential growth by boosting productivity (TFP), raising investment and capital utilization, and strengthening the labor market.
  - Structural and institutional reforms to boost TFP: protection of property rights, improving the legal system, increasing access to finance, and reducing regulatory and administrative burdens.
  - Raise investment and capacity utilization: efficient use of EU funds, improved energy and transportation networks, and attracting FDI.
  - Improve labor market policies: active labor market policies, tax and benefit reform to improve incentives, and efforts to reduce skills and regional mismatches.
- Fiscal policy:
  - Make efficient use of large inflows of EU investment funds and allocate resources to growth-enhancing investments.
  - Boost the revenue share to compensate for the future loss of EU funds and finance stronger social safety nets.
  - Move fiscal policy toward neutrality over the medium term to avoid procyclical risks.
- Tax reform:
  - The initiative to reform the tax system is welcome; goals are supporting growth, increasing equity, and boosting revenues.
  - Authorities should: i) finalize plans swiftly to reduce uncertainty; ii) carefully manage the macro impact to avoid procyclical policy and undermining competitiveness; and iii) sustainably boost the revenue share to secure public finances after EU funds phase out.
- Shadow economy and business environment:
  - Continued efforts to address the shadow economy by improving the business environment, reducing regulatory and administrative barriers, and improving transparency to increase tax compliance, revenues, and financial inclusion.
- Financial sector and credit growth:
  - Address market failures from the crisis; promote programs to facilitate SME access to credit; continue implementation of insolvency reforms.
  - Maintain vigilant supervision and enforcement to safeguard financial stability and underpin sustainable credit growth.
  - Continue strengthening implementation of AML/CFT measures.

### Executive Board / Staff assessment
- Executive Directors endorsed the staff appraisal: Latvia has made great strides since the crisis; with sound macro conditions but a more modest post-crisis growth pace.
- Determined policy action can raise growth despite a lower potential; priority areas are institutional quality, access to financial services, higher investment, capacity utilization, and labor market improvements.
- The authorities broadly agreed with staff’s assessment and the importance of effective tax reform complementing structural reforms.

*Source: STAFF REPORT FOR THE 2017 ARTICLE IV CONSULTATION, Republic of Latvia (IMF).*

### 10.      The general government deficit narrowed significantly in 2016. The general government

### 10.      The general government deficit narrowed significantly in 2016. The general government

### Fiscal developments (2016)
- The general government basic deficit (on a cash basis) narrowed to -0.4 percent of GDP, an improvement of more than 1 percent of GDP from 2015.
- This translated into a structural surplus of 0.2 percent of GDP (ESA definition) compared to the 2016 deficit target of 0.9 percent of GDP.
- Total revenues (excluding foreign assistance) overperformed by about 0.4 percent of GDP, following measures adopted by the authorities.
- Expenditures were under executed:
  - Investment-related under-execution driven by lower than projected disbursement of EU investment Funds by about 0.8 percent of GDP.
  - Other current spending under-executed by about 0.2 percent of GDP.
- Measures contributing to revenue overperformance included the introduction of the so-called solidarity tax, an increase in excise duties, and measures to broaden the tax base and improve tax compliance.

### Financial system: capitalization, liquidity, and deposits
- Capital adequacy ratio: 21.1 percent in 2016, exceeding the regulatory minimum.
- Share of liquid assets in total assets: 33.8 percent in 2016.
- Latvijas Banka’s stress tests: banks’ capacity to absorb potential liquidity shocks is adequate.
- Profitability: banks remain profitable, maintaining a wide spread between lending and deposit rates.
- Deposits:
  - Resident deposits grew by 12.2 percent y-o-y through 2016.
  - System-wide deposits declined by 7.4 percent, led by a decline of 26.5 percent of non-resident deposits (NRDs).
- Drivers of NRD decline: ongoing strengthening of enforcement of AML/CFT requirements and sanction regimes, financial sanctions against Russia, and loss of European-based correspondent banking relationships.
- Banks servicing foreign clients are actively exploring options to maintain or re-establish US dollar clearance for their clients.
- Financial stability: despite pressures on BSFCs and the changing landscape, financial stability has not been impaired to date.

### Credit growth and asset quality
- Credit to the non-financial private sector grew by 2.3 percent y-o-y in March 2017.
  - Growth composition: 5.1 percent to corporates and -1.1 percent to households.
- Household loan demand: improved as credit institutions eased credit standards somewhat, and on the back of steadily rising disposable income.
- Household loan portfolios: shrinking at an increasingly slow pace, but the annual rate of change remains negative.
- Loan quality improved:
  - Share of loans past due over 90 days:
    - Households: 4.9 percent by end-March 2017 (from 7.6 percent in 2015).
    - Corporates: 2.9 percent by end-March 2017 (from 4 percent in 2015).

### Outlook and risks (short and medium term)
- Growth and current account:
  - Growth is expected to pick up to 3.2 percent in 2017.
  - The current account is projected to return to deficit and widen in the medium term.
- Drivers of near-term growth: accelerated disbursement of EU funds in 2017 boosting investment and public consumption; robust private consumption supported by slowing but continued wage growth, credit recovery, and improving sentiment.
- Fiscal outlook: general government deficit projected to increase to accommodate EU-funded investment projects but expected to remain within its structural deficit target of 1 percent of GDP.
- Inflation:
  - Headline HICP inflation projected to rise to 3 percent on average in 2017 due to rising energy prices and stronger external price pressures.
  - Core inflation projected to increase moderately to 2 percent in 2017; core inflation accounts for about 75 percent of overall inflation.
- Risks to inflation: second-round effects from energy price pass-through and continued real wage growth could affect core inflation; higher EU fund absorption and an increase in minimum wages by 2.7 percent in 2017 could add further demand pressures.
- External position: currently assessed to be stronger than implied by medium term fundamentals.
- Balance of risks:
  - Risks to the baseline are more balanced but still tilted to the downside.
  - Downside risks include slower than projected absorption of EU funds and/or failure of credit to resume, which would hold back domestic demand and future growth.
  - Upside or adverse inflation risk: headline inflation could remain above 3 percent or rise further should energy prices continue to increase.
  - External risks: structurally weak growth in advanced economies, retreat from cross-border integration, intensification of security dislocation in Europe, and risks of regional financial instability.

### Potential growth, drivers, and policy challenges
- Short- and medium-term outlook:
  - Staff revised medium-term potential growth down to 3 percent.
  - Potential growth has declined: from about 6.9 percent in the pre-crisis period (2003–07) to about 2.2 percent more recently (2012–16); about 2.5 percent in 2016.
  - Output gap in 2016 estimated at -0.5 percent, suggesting the economy is operating close to its potential.
- Historical growth context:
  - Pre-crisis average growth: 9.9 percent over 2003–07.
  - Post-crisis average growth: about 2.7 percent over 2012–16.
- Contributions to decline in potential growth:
  - TFP contribution dropped from 50 percent (2003–07) to about 3 percent (2012–16).
  - Capital accumulation contributed about 48 percent (2003–07) and about 54 percent (2012–16).
  - Largest factor for the decline: total factor productivity (TFP).
- Implications for convergence:
  - Latvia’s GDP per capita (in purchasing power standards) was about 62 percent of the EU-15 average in 2015.
  - Staff simulations suggest that a 1 percentage point decrease in potential growth could delay the closure of the income gap with the EU-15 by about 12 years.
- Constraints on medium-term acceleration: slow TFP growth, low investment, persistent demographic drag, and crisis legacies undermining productive capacity.

### Policy recommendations to raise potential growth and productivity
- Priority areas (drawing on cross-country and Latvia-specific analysis):
  - Structural and institutional reforms to improve allocation and efficient use of resources:
    - Improve quality of institutions (protection of property rights, upgrading legal systems including insolvency and judicial reforms).
    - Increase access to financial services, especially for small but productive firms.
    - Reduce regulatory and administrative burdens on businesses.
    - Improve corporate governance of state-owned enterprises.
    - Promote greater technology diffusion.
    - Fiscal structural reforms to improve efficiency in the tax system and reduce resource misallocation.
  - Higher investment rates and improved capacity utilization:
    - Latvia has the lowest capital-output ratio in the EU-28; modernizing capital stock could lift potential growth.
    - Higher public investment in infrastructure (connectivity to the EU electric network, transport infrastructure, port efficiency) may induce greater private investment if high-return projects are undertaken and compatible with fiscal space.
    - Rapid and efficient absorption of EU structural funds is important.
    - Attracting more foreign investment could provide additional avenues.
    - Increasing capacity utilization would provide further, yet limited, scope for higher medium-term growth.
  - Strengthening labor market policies to offset negative demographic dynamics and preserve competitiveness:
    - Active labor market policies, and tax and benefit reform to improve incentives for work (e.g., in-work tax credits, improvements in tapering of benefits to reduce the high labor tax wedge especially for low-income earners).
    - Reduce skill mismatches by strengthening vocational education and improving links with employers, and attract high-skilled foreign workers.
    - Avoid wages outstripping productivity gains, including by prudent increases in the minimum wage.
- Additional effects:
  - Structural reforms designed to boost potential can also reduce incentives to participate in the shadow economy (by reducing regulatory burden and improving government service quality).
  - Minimizing skills mismatches would improve incentives to participate in the formal economy and lower structural unemployment.

*Source: Republic of Latvia — IMF Country Report (selected chapter content).*

### 24.      The authorities broadly shared staff’s analysis of the drivers of potential growth and

### 24.      The authorities broadly shared staff’s analysis of the drivers of potential growth and

### Drivers of potential growth and structural reform
- Authorities broadly shared staff’s analysis of drivers of potential growth and agreed on need to continue reforms to raise it.
- Key frictions and dynamics:
  - Heightened risk aversion lingers post-crisis but could slowly unwind as the external environment improves.
  - The turning of the credit cycle could lift potential growth as investment picks up.
  - Scope for increases in the labor force through immigration is limited.
- Ongoing broad structural reform agenda to boost TFP includes:
  - education and health reforms;
  - an action plan to combat the shadow economy;
  - gas market liberalization;
  - work to improve the insolvency regime.
- Tax and benefit reform along with active labor market policies have a role to play in raising labor force participation.

### Fiscal Policy: Addressing Fiscal Headwinds
- 2017 budget alignment and measures:
  - The 2017 budget is in line with Latvia’s Fiscal Discipline Law and its European commitments.
  - Expenditure measures: increase in funding for education and social protection, growing defense spending, and an increase of about 2.7 percent in the average monthly minimum wage.
  - Surge of EU investment funds expected in 2017 with a corresponding increase in project investment foreseen.
  - Revenue measures: increase in excise and natural resource taxes and a reduction of some tax exemptions.
  - Comprehensive expenditure review produced prioritization and expenditure savings, including tightening eligibility for receiving unemployment benefits.
  - Budget uses national and EU-permitted flexibility for financing structural reforms in the healthcare and pension systems.
- Short-term fiscal stance and sustainability:
  - Considering the smaller-than-budgeted deficit in 2016, the 2017 fiscal stance is expansionary.
  - With no financing constraints, modest gross financing needs and low public debt there is fiscal space to accommodate such a stance without threatening fiscal or debt sustainability.
  - Small, yet still negative, output gap—fiscal stance can boost investment and growth without overheating concerns.
  - Little evidence of a wage-price spiral: real wage growth expected to be more muted than previous years and broadly in line with productivity growth.
- Medium-term risks and projections:
  - Fiscal policy over the medium term is consistent with fiscal sustainability, but fiscal headwinds are on the horizon.
  - Based on medium term objectives in the 2017–20 Stability Program—under a no tax reform scenario—the fiscal stance is expected to become broadly neutral over the medium term as the economy reaches its potential, and public debt is expected to remain at low levels, and on a downward path.
  - Phasing out of EU funds (which account for an average of 3 percent of GDP over the next 4 years) would pose a challenge for meeting medium-term growth objectives; authorities need to prepare well in advance to find revenue-enhancing measures.
- Policy guidance and recommendations:
  - Mind policy constraints within the currency union; fiscal stimulus in 2017 should be followed by a more neutral stance over the medium term, especially if inflation continues to rise.
  - Quality of spending is key: ensure spending is directed to investments that help reduce economic slack in 2017 and support medium term growth; efficient allocation of EU funds to high-return areas (e.g., upgrading infrastructure) is important.
  - If growth disappoints, allow automatic stabilizers to operate fully.
  - Efforts to develop a tax strategy are welcome: draft proposals aim to adopt measures to raise growth, improve equity, and gradually raise tax revenues to around 1/3 of GDP. Key principles: i) improving work incentives; ii) increasing tax compliance (including addressing the shadow economy); iii) adopting revenue-enhancing policies.
  - Fiscal impact of the final tax package needs careful assessment: current formulation estimated to entail a fiscal cost of about 1.5% of GDP over the first three years of implementation. While indirect positive impacts may mitigate some cost, the extent needs careful assessment.
  - Potential conflicts and risks in tax measures:
    - A system based on taxation of distributed earnings has attractive features (e.g. neutrality towards investment) but may lead corporates to lock in cash and forgo profitable investment opportunities.
    - Proposed increase in the minimum wage could have negative employment or competitiveness impacts on low wage sectors and regions.
    - The draft tax reform package, while likely bringing some growth and equity benefits, is estimated to entail a short-term revenue loss, complicating the objective of raising tax revenues to 1/3 of GDP. The final package should include measures to sustainably achieve this goal—options include property, environmental, or consumption taxes, and/or a reduction in exemptions.
  - Combating the shadow economy in tandem with tax reform:
    - Measures that can boost revenues and reduce the shadow economy include increased tax compliance for high-net-worth taxpayers; mandatory use of certified invoicing programs for SMEs; cross-checking VAT declarations with merchant point-of-sale transactions.
    - Strengthening revenue administration and improving capacity to address compliance risks is important.
    - Combining “sticks” and “carrots” can be effective in curtailing the shadow economy and boosting revenues.

### Authorities’ View (on fiscal and growth stance)
- Authorities agree on importance of maintaining prudent fiscal policies and compliance with fiscal rules.
- They view proposed tax reform as necessary to address economic challenges, with priorities to support growth, increase equity, and boost revenues.
- Acknowledge revenue costs of some measures but expect reform will stimulate growth and over time revenues.
- Over the medium term they expect improved incentives for labor participation and investment, together with efforts to reduce the shadow economy, to underlie revenue gains.
- See minimum wage increase as necessary to reduce income inequality and see little effect on competitiveness, partly given relatively higher wages in the tradable sector; nonetheless they stress avoiding procyclical policy and keeping wage increases aligned with productivity growth.

### Financial Sector: Unlocking Credit Growth while Maintaining Financial Stability
- Credit cycle and macrofinancial conditions:
  - Latvia’s protracted period of credit stagnation is ending; indicators suggest the credit cycle has turned.
  - Households and non-financial corporates have been deleveraging since the crisis; debt servicing capacity has strengthened.
  - NPL ratios for households and corporates continue to shrink.
  - Credit growth has returned at the aggregate level and across most segments, though the household sector is lagging.
  - The credit gap—on some measures—calculated as the percentage deviation of credit to GDP from its long-run trend, has turned slightly positive.
  - These indicators suggest Latvia is in the very early stage of the expansion phase of the credit cycle.
- Constraints on credit growth:
  - Credit growth remains constrained by both demand and supply factors.
  - Demand factors tend to matter more for larger firms; supply constraints tend to matter more for SMEs and households.
  - ECB survey: credit standards have been eased slightly by credit institutions in Latvia but remain conservative when lending to NFCs—reasons include insufficient equity, lack of positive credit history, shortcomings of the legal framework, and the shadow economy.
  - NFC credit demand may be constrained by postponed investment plans due to economic and geopolitical uncertainty; pickup in EU structural funds investment may alleviate this constraint.
  - Household loan demand has been aided by the state guaranteed mortgage loan program, which has helped push housing prices slightly upwards; but relatively low income and savings constrain household credit demand.
- Policy recommendations to boost credit while preserving stability:
  - Turning weak lending around, particularly for SMEs, is key to boosting investment and growth.
  - Implementation of European Fund for Strategic Investments programs would help; more SMEs could be eligible for guarantees from Development Finance Institution Altum and the European Investment Bank—improving access for SMEs that lack credit history.
  - Measures to shift firms and individuals out of the shadow economy, diminish regulatory burden, and promote an investment-friendly environment could boost credit to the private sector.
  - Closer monitoring of financial interconnectedness is appropriate: banks in the Nordic-Baltic region are highly interconnected via group structures and have common exposures at firm and property levels; reliance of Latvian subsidiaries on parent bank financing has decreased considerably but supervisory collaboration and cross-border crisis preparedness and management remain important.
  - Continued strengthening of supervision and enforcement, including AML/CFT, can safeguard financial stability, underpin sustainable credit growth, and support Latvia’s role as a regional financial center.
    - For banks servicing domestic clients, strong capital and funding positions and ample liquidity provide foundations to expand credit portfolios.
    - For BSFCs, recent decline in sector size may reduce vulnerabilities; ongoing strengthening of AML/CFT supervision and banks’ internal compliance should bolster the sector amid dwindling business, withdrawal of correspondent banking relationships, and continued deposit reduction.
    - Close monitoring of financial innovations such as crowdfunding and virtual currencies is encouraged.
  - Shifting segments of the shadow economy into the formal sector would increase financial inclusion and boost credit by providing proof of income and assets needed to apply for credit.

### Authorities’ View (on financial sector)
- Authorities concurred that the credit cycle has turned and resumption of credit is key to boosting investment and growth.
- They agree both supply and demand factors constrain credit growth variably for corporates and households.
- Emphasize that measures to boost credit should not compromise financial stability; prudential standards should be maintained.
- Support shifting segments of the shadow economy to the formal sector to support financial inclusion.
- Stress importance of close monitoring of regional financial interconnectedness and cooperation with Baltic and Nordic neighbors.
- Underscore continued vigilant supervision and regulation of the banking sector and ongoing efforts to strengthen AML/CFT implementation and enforcement.

### Staff Appraisal: outlook and policy priorities
- Short-term outlook and growth projection:
  - After modest slowing in 2013–16, growth is expected to rebound in the short term to around 3.2 percent on the back of resumption of EU funds, recovery of domestic credit, and a favorable external environment.
  - Post-crisis growth has settled at a more modest pace than the rapid pace immediately post-crisis; low-hanging productivity gains have been exhausted.
- Policy priorities to raise potential growth (focus on boosting productivity):
  - Structural and institutional reforms to boost TFP: protection of property rights, improving the legal system, increasing access to finance, reducing regulatory and administrative burdens.
  - Raising investment and capacity utilization: efficient use of EU funds, improved energy and transportation networks, attracting FDI.
  - Improved labor market policies: active labor market policies, tax and benefit reform to improve incentives, and efforts to reduce skills and regional mismatches.
  - Many of these reforms would also help reduce incentives to participate in the shadow economy.
- Fiscal policy guidance:
  - Fiscal policy, if properly calibrated, can support medium term growth but needs to become more neutral over the medium term.
  - Short-term challenge: make efficient use of large inflow of EU investment funds and allocate resources to growth-enhancing investments.
  - Action needed to boost the revenue share to compensate for future loss of EU funds and to finance stronger social safety nets.
  - Fiscal policy should become more neutral over the medium term to avoid risks of procyclical policy.
- Tax reform appraisal and immediate challenges:
  - Initiative to reform the tax system is welcome; goals of supporting growth, increasing equity, and boosting revenues are appropriate.
  - Authorities face three immediate challenges: i) finalize plans swiftly to reduce uncertainty for households and firms; ii) carefully manage macro impact to avoid procyclical policy and undermining future competitiveness; iii) sustainably boost the revenue share to ensure robust public finances even after EU funds phase out.
- Shadow economy and broader benefits:
  - Continued efforts to address the shadow economy can bring multiple benefits: strengthening incentives to operate in the formal economy, supporting growth, increasing tax compliance and revenues, boosting credit growth via greater financial inclusion, and improving transparency of corporate and household balance sheets.

*Source: IMF staff report excerpt (cr17194).*

### 37.      Financial stability is the necessary foundation for sustainable credit growth to boost

### 37.      Financial stability is the necessary foundation for sustainable credit growth to boost

### Financial stability and credit growth: findings
- Recent financial indicators suggest that the credit cycle in Latvia has turned, yet credit growth remains somewhat constrained by demand and supply factors.
- Continued and sustainable credit growth will be needed to support investment and boost long term growth.
- Continued strengthening implementation of AML/CFT measures will support financial stability and underpin sustainable credit growth.
- Vigilant supervision and enforcement are needed to safeguard financial stability and underpin sustainable credit growth.

### Policy recommendations to support credit growth and financial stability
- Pursue policies to address lingering market failures from the crisis, including:
  - Promoting programs that facilitate SMEs access to credit.
  - Continuing the implementation of insolvency reforms, for example:
    - Promoting the rescue of viable businesses.
    - Strengthening the oversight and supervision of insolvency administrators.
    - Developing a system to assess the efficiency of the insolvency framework.
- Ensure appropriate macro-prudential policy settings.
- Continue strengthening risk-based implementation of the AML/CFT framework.
- Participate in coordinated policy response at the European level where relevant.

### Risk Assessment Matrix: key risks, impacts, and policy responses
- High likelihood / High impact: Retreat from cross-border integration (protectionism, economic isolationism)  
  - Impact: As a small open economy, Latvia could be significantly impacted mainly through trade channels.
  - Policy recommendations: Pursue structural policies that enhance productivity; continue to diversify product and export markets; participate in coordinated policy response at the European level.
- High/Medium likelihood / High impact: Structurally weak growth in key advanced and emerging economies  
  - Impact: The Euro Area remains Latvia’s single largest trade partner; a protracted slowdown would directly reduce exports and erode business and consumer confidence.
  - Policy recommendations: Participate in coordinated policy response at the European level; allow automatic stabilizers to operate; consider discretionary fiscal action if the shock is of sufficient magnitude.
- Financial conditions (High/Medium likelihood; varying impact):  
  - Risks noted: Significant further strengthening of the US dollar and/or higher rates; investors reassessing policy fundamentals; term premia decompression; more rapid Fed normalization; European bank distress (Medium); reduced financial services by correspondent banks—"de-risking" (High).  
  - Impact: Could lower funding for Nordic parent banks reliant on wholesale funding, raising financing costs and hindering credit growth; non-resident deposits (NRDs) could be susceptible to sudden stops if access to USD clearing services is constrained.
  - Policy/mitigation: Euro area monetary policy is first line of defense against liquidity stress, supported if needed by activation of backstops and resolution mechanism; risks from correspondent banks' retreat are mitigated by separation between BSFC and the domestic economy, with BSFC not playing a material role in domestic lending or attracting domestic deposits; continue strengthening risk-based implementation of AML/CFT framework.
- Medium/Low likelihood / Medium impact: Failure of credit growth to pick up in a sustained manner  
  - Impact: Persistently weak bank credit growth would constrain investment and growth.
  - Policy recommendations: Pursue policy to address market failures, and ensure appropriate macro-prudential policy settings.
- Medium/Low likelihood / High impact: Failure to continue advancing on structural reforms  
  - Impact: In the absence of structural reforms, productivity growth and the business environment would suffer, harming competitiveness and employment.
  - Policy recommendations: Seek to build base for support to continue with the reform agenda focusing on improving the business environment, labor markets, infrastructure, and human capital.

### Proposed Tax Reform: objectives, key measures, and fiscal impact
- Objectives of reform:
  - Support growth, increase equity, and boost revenues.
  - Reform underpinned by: i) a review of tax structure and rates; ii) efforts to improve tax administration; and iii) steps to reduce the shadow economy.
- Proposed changes to tax structure:
  - Labor tax system: introduction of a phased out tax-free allowance system, a lower PIT rate for lower incomes and a higher tax rate for people with high incomes, eliminating the “solidarity tax”, and a 13% increase in the minimum monthly wage.
  - CIT system: tax reinvested profits at 0% and raise the rate on distributed profits to 20%.
  - Equalize PIT rates for various types of income.
  - Reform the regime for micro-enterprises and small or “lifestyle” businesses.
  - Revenue-raising measures to compensate for losses: reductions in VAT registration thresholds, a gradual increase in excise taxes, and a higher ceiling on social security contributions.
- Tax administration and shadow economy measures:
  - Improve efficiency of tax administration activities, including introduction of single accounts, and improving the accessibility and quality of services.
  - Combat the shadow economy by expanding the application of the “reverse” VAT payment in key “problematic sectors”, reducing VAT thresholds, and introducing an online trade transactions register.
- Assessment and fiscal impact:
  - Some elements move in the right direction for objectives, but an overall assessment is not yet possible.
  - Concerns: elimination of the solidarity tax is revenue losing and moves against improving equity; increasing the PIT rate for capital gains alongside the proposed CIT reform could create incentives for tax planning.
  - Direct fiscal costs (authorities’ estimates): the direct fiscal impact of the tax reform could imply an increase in the deficit of about 0.7 percent, 0.5 percent and 0.3 percent of GDP from 2018 through 2020.
  - Largest revenue losses estimated: introduction of the progressive PIT regime and differentiated non-taxable minimums estimated at 1 percent of GDP; the change in the CIT regime estimated at 0.6 percent of GDP.
  - The authorities estimate an indirect positive impact via behavioral responses leading to higher growth that could over the medium term partly offset the initial negative impact on public finances, but the magnitude of such growth benefits is uncertain and needs careful assessment.

*REPUBLIC OF LATVIA — INTERNATIONAL MONETARY FUND*

### Box 2. Proposed Tax Reform (concluded)

### Box 2. Proposed Tax Reform (concluded)

### Fiscal impulse and macro impact
- A tax package "along these lines" would impart a fiscal impulse into the economy in the first year.
- Considering only the direct impact of the fiscal measures, the stimulus implied by the tax reform is estimated to have a limited impact on GDP given Latvia’s likely small fiscal multipliers and the assumed subsequent unwinding of the fiscal stimulus.
- Risks of procyclical policy from the initial fiscal impulse will need to be offset by targeting a neutral fiscal stance over the medium term.

### Policy considerations and implications
- Offset short-term procyclicality by aiming for a neutral fiscal stance over the medium term.
- Account for likely small fiscal multipliers when assessing the GDP impact of tax measures.
- Plan for the assumed unwinding of the fiscal stimulus when designing the overall fiscal path.

*Source: Box 2. Proposed Tax Reform (concluded), cr17194*

### Annex I. External Sector Assessment

### Annex I. External Sector Assessment

### Foreign assets and liabilities
- NIIP stood at around -58 percent of GDP by end 2016 and is projected to continue declining to about -35 percent of GDP over the medium term.
- Gross assets stood at 134 percent of GDP in 2016.
- Gross liabilities stood at 192 percent of GDP in 2016.
- Debt securities comprised only 15 percent of these liabilities.
- Net external debt stood at 29 percent of GDP at the end of 2016.

### Current account
- The current account moved to a surplus of 1.5 percent of GDP in 2016, driven by large terms of trade gains, weak investment growth, and a lower-than-budgeted fiscal deficit.
- This outturn was atypical: the current account had averaged a deficit of -2.4 percent of GDP over 2011–15.
  - Note: Assuming 2016 trade volumes at 2015 prices, i.e. absent any terms of trade effects, the current account deficit would be -1.3 percent.
- The current account is projected to swing back into modest deficit in 2017 and 2018 as investment gathers steam and consumption continues to be strong.
- CA gap estimates are inflated by unusually strong cyclical components and limitations of the CA regression (especially demographic variable coefficients and sensitivity to underlying series), implying uncertainty and suggesting a range for the CA gap of around 2–4 percent of GDP in 2016.

### Real exchange rate (REER)
- The REER appreciated by about 1 percent between 2015 and 2016.
- The CA regression model suggests an undervaluation of 5–15 percent using standard trade elasticities.
- Many factors accounting for the unusually strong current account are expected to unwind, bringing down the balance without a need for exchange rate adjustment.
- The EBA-lite REER model finds a small overvaluation of around 1 percent, largely consistent with the evolution of the REER and rising unit labor costs.

### Capital and financial accounts
- The capital account is dominated by EU structural fund inflows, which slowed in 2016 but are expected to increase in 2017–18.
- FDI inflows slowed in recent years, making portfolio and other investment flows the main drivers of the financial account.
- High foreign holdings of government bonds and cross-border linkages of the banking sector in the region indicate potential vulnerabilities.

### FX intervention and reserves level
- The Euro has the status of a global reserve currency; as such, reserves held by euro area economies are typically low to standard metrics, but the currency is free floating.

### Overall external position assessment
- The external position in 2016 was stronger than implied by medium term fundamentals and desirable policies.
- This is broadly in line with the CA-based REER assessment but largely reflects temporary improvements in the current account driven by improved terms of trade, slowing investment, and a lower-than-budgeted fiscal deficit.
- A widening of the current account deficit from 2017 onwards is expected, on the back of a pick-up in investment and unwinding of terms of trade gains.

### Annex II. Banks Servicing Foreign Clients (BSFCs) in Latvia
- The banking sector has a dual nature:
  - Domestically active banks: 7 branches and 3 subsidiaries, mainly from the Nordic countries, cater predominantly to the Latvian population and are responsible for most lending.
  - Banks servicing foreign clients: 13 banks cater predominantly to foreign clients, with limited participation in the domestic economy and a large share of deposits from foreign clients, mostly from the CIS.
- BSFCs depend on correspondent banking relationships (CBRs) for direct settlements in foreign currencies.
- Developments through 2016:
  - System wide non-resident deposits declined by 26.5 percent y-o-y through 2016.
  - USD clearing declined by 39 percent over the same period.
  - Some BSFCs experienced deposit and turnover declines well in excess of system averages.
  - Declines attributed to withdrawal of global correspondent banks; strengthening AML/CFT requirements and enforcement; financial sanctions and economic downturn in Russia.
- Soundness and buffers:
  - BSFCs remain broadly sound, supported by strong capital and liquidity buffers.
  - Investments are mostly in foreign liquid assets and deposits with Latvijas Banka.
  - Limited linkages between BSFCs and the domestic banking sector mitigate contagion risks.
  - BSFCs account for around only 12 percent of lending to residents.
  - The FCMC applies more stringent liquidity and capital requirements to BSFCs and closely monitors developments, including stress testing for further outflow of non-resident deposits (NRDs).
- AML/CFT and remediation:
  - BSFCs, in dialogue with the FCMC, have undertaken independent audits of their AML/CFT frameworks, procedures, and practices and are working to implement recommendations.
  - Additional resources have been dedicated to AML/CFT supervision.
- Business-model adjustments and risks:
  - Ongoing pressures could lead to further decline in deposits and turnover; some banks have found alternative arrangements to CBRs with global banks.
  - Some banks affected by withdrawal of USD CBRs and experiencing NRD declines are reviewing business models (including switching from transactional to investment models), broadening customer base beyond the CIS region, and increasing presence in the domestic market.
- Policy implications:
  - Continued vigilant supervision is needed to mitigate real and reputational risks.
  - Further strengthening internal controls and addressing AML/CFT shortcomings identified by the 2016 independent audits are central to mitigating risks and ensuring sustainability of BSFCs.

*Source: Annex I. External Sector Assessment (cr17194).*

### Annex III. Public Debt Sustainability Assessment

### Annex III. Public Debt Sustainability Assessment

### Debt Dynamics and Key Indicators (Public sector = general government)
- Nominal gross public debt (2015–2022): 27.5, 34.8, 37.2, 35.8, 34.1, 32.9, 31.5, 30.1, 29.0
- Public gross financing needs (2015–2022, in percent of GDP): 2.0, 10.7, 1.7, 6.1, 4.6, 5.5, 5.4, 4.8, 1.9
- Real GDP growth (in percent, 2015–2022): 1.7, 2.7, 2.0, 3.2, 3.2, 3.1, 3.0, 3.0, 3.0
- Inflation (GDP deflator, in percent, 2015–2022): 5.2, 0.4, 0.7, 2.9, 2.3, 2.3, 2.3, 2.2, 2.2
- Nominal GDP growth (in percent, 2015–2022): 7.5, 3.1, 2.7, 6.2, 5.5, 5.5, 5.3, 5.3, 5.2
- Effective interest rate (in percent, 2015–2022): 4.9, 4.8, 3.6, 3.1, 2.1, 2.2, 2.2, 2.2, 2.3
- Sovereign spreads: EMBIG (bp) 67; 5Y CDS (bp) 58
- Ratings (foreign / local): Moody's A3 / A3; S&Ps A- / A-; Fitch A- / A-

### Contribution to Changes in Gross Public Sector Debt (2015–2022, percent of GDP)
- Change in gross public sector debt (2015–2022, annual then cumulative): 3.2, -3.7, 2.4, -1.4, -1.8, -1.1, -1.4, -1.4, -1.1, cumulative -8.2
- Identified debt-creating flows (2015–2022, annual then cumulative): 1.4, 0.4, -0.9, -1.3, -1.6, -1.3, -1.6, -1.3, -1.2, cumulative -8.2
- Primary deficit (2015–2022, annual then cumulative): 1.6, -0.1, -0.7, -0.1, -0.4, -0.2, -0.6, -0.4, -0.4, cumulative -2.2
- Primary (noninterest) revenue (percent of GDP, 2015–2022 and cumulative): 35.1, 36.0, 36.1, 37.2, 37.4, 36.7, 36.4, 36.1, 35.5, cumulative 219.3
- Primary (noninterest) expenditure (percent of GDP, 2015–2022 and cumulative): 36.8, 35.9, 35.4, 37.0, 37.0, 36.5, 35.8, 35.7, 35.1, cumulative 217.1
- Automatic debt dynamics (2015–2022, annual then cumulative): -0.2, 0.5, -0.3, -1.1, -1.2, -1.1, -1.0, -0.9, -0.8, cumulative -6.0
  - Interest rate/growth differential (2015–2022, annual then cumulative): -0.6, -0.9, -0.6, -1.1, -1.2, -1.1, -1.0, -0.9, -0.8, cumulative -6.0
    - Of which: real interest rate: -0.3, 0.2, 0.1, 0.0, -0.1, -0.1, 0.0, 0.0, 0.0, cumulative -0.1
    - Of which: real GDP growth: -0.3, -1.0, -0.7, -1.1, -1.1, -1.0, -0.9, -0.9, -0.9, cumulative -5.9
  - Exchange rate depreciation (2015–2017): 0.4, 1.3, 0.3
- Other identified debt-creating flows (2015–2022): all 0.0
  - Privatization/Drawdown of Deposits: all 0.0
  - Contingent liabilities: all 0.0
- Residual, including asset changes (2015–2022, annual): 1.7, -4.1, 3.4, -0.2, -0.2, 0.2, 0.2, -0.1, 0.2, 0.0

### Baseline and Alternative Fiscal Scenarios (selected variables)
- Baseline scenario underlying assumptions (2017–2022):
  - Real GDP growth (2017–2022): 3.2, 3.2, 3.1, 3.0, 3.0, 3.0
  - Inflation (2017–2022): 2.9, 2.3, 2.3, 2.3, 2.2, 2.2
  - Primary Balance (2017–2022): 0.1, 0.4, 0.2, 0.6, 0.4, 0.4
  - Effective interest rate (2017–2022): 3.1, 2.1, 2.2, 2.2, 2.2, 2.3
- Historical scenario (2017–2022):
  - Real GDP growth (2017–2022): 3.2, 0.8, 0.8, 0.8, 0.8, 0.8
  - Inflation (2017–2022): 2.9, 2.3, 2.3, 2.3, 2.2, 2.2
  - Primary Balance (2017–2022): 0.1, -1.4, -1.4, -1.4, -1.4, -1.4
  - Effective interest rate (2017–2022): 3.1, 2.1, 2.5, 2.8, 3.0, 3.4
- Constant Primary Balance scenario (2017–2022):
  - Real GDP growth (2017–2022): 3.2, 3.2, 3.1, 3.0, 3.0, 3.0
  - Inflation (2017–2022): 2.9, 2.3, 2.3, 2.3, 2.2, 2.2
  - Primary Balance (2017–2022): 0.1, 0.1, 0.1, 0.1, 0.1, 0.1
  - Effective interest rate (2017–2022): 3.1, 2.1, 2.2, 2.3, 2.2, 2.4

### Composition of Public Debt and Financing Needs
- Gross nominal public debt (projection, composition charts show trends 2015–2022).
- Public gross financing needs (in percent of GDP, projection trends 2015–2022).
- By maturity (2006–2022): medium and long-term versus short-term shares shown in projection charts.
- By currency (2006–2022): local currency-denominated versus foreign currency-denominated shares shown in projection charts.

### External Debt Sustainability (2012–2022, percent of GDP unless indicated)
- External debt (baseline, 2012–2022): 138.2, 133.9, 143.0, 141.6, 147.3, 140.2, 134.8, 132.7, 129.7, 123.8, 122.3
- Debt-stabilizing non-interest current account (long-run): -5.7
- Change in external debt (2012–2022): -6.3, -4.3, 9.1, -1.4, 5.7, -7.1, -5.5, -2.1, -3.0, -5.8, -1.6
- Identified external debt-creating flows (2012–2022): -6.5, -5.8, -4.6, 2.0, -4.8, -6.0, -4.6, -4.1, -3.9, -3.6, -3.2
  - Current account deficit, excluding interest payments (2012–2022): -0.8, -0.6, -1.3, -1.9, -3.8, -2.9, -1.2, -1.0, -1.3, -0.6, 0.0
  - Net non-debt creating capital inflows (negative) (2012–2022): -3.3, -1.8, -1.8, -2.8, 0.3, -1.9, -1.9, -1.8, -1.8, -1.8, -1.8
  - Automatic debt dynamics (2012–2022): -2.4, -3.4, -1.6, 6.7, -1.2, -1.2, -1.5, -1.3, -0.7, -1.2, -1.5
    - Contribution from nominal interest rate (2012–2022): 4.5, 3.3, 3.2, 2.7, 2.4, 3.3, 2.6, 2.6, 3.0, 2.5, 2.1
    - Contribution from real GDP growth (2012–2022): -5.9, -3.4, -2.7, -4.5, -2.7, -4.6, -4.1, -3.9, -3.8, -3.7, -3.5
    - Contribution from price and exchange rate changes (2012–2016 shown): -1.0, -3.3, -2.1, 8.5, -0.9, ...
- Residual, including change in gross foreign assets (2012–2022): 0.1, 1.4, 13.7, -3.4, 10.5, -1.1, -0.9, 2.1, 0.9, -2.2, 1.6
- External debt-to-exports ratio (in percent, 2012–2022): 225.5, 222.5, 240.2, 240.3, 254.0, 240.4, 232.9, 230.2, 226.0, 215.7, 213.2
- Gross external financing need (in billions of US dollars, 2012–2022): 20.1, 22.3, 22.4, 22.7, 20.0, 22.2, 23.3, 24.1, 25.4, 26.2, 25.2
  - In percent of GDP (2012–2022): 71.4, 73.6, 71.3, 84.1, 72.1, 76.4, 75.2, 73.6, 73.6, 72.3, 66.5

### External Debt Stress Tests and Scenarios (summarized)
- Bound tests present alternative scenarios for external debt (percent of GDP):
  - Baseline: 122 (projected average)
  - Historical scenario: 140
  - Interest rate shock: results illustrated with baseline at 122 and shock raising debt (labelled i-rate shock; example box figure shows 131)
  - Non-interest current account shock (CA shock) and combined shocks (including a 30 percent one-time real depreciation) raise external debt ratios (examples: combined shock 147; 30% depreciation combined shock 142)
  - Scenario values and shock descriptions: growth shocks, CA shocks, interest rate shocks, combined shocks, and a 30 percent real depreciation are applied as permanent or one-time shocks as described in the charts and notes.
- Notes on shocks:
  - Individual shocks are permanent one-half standard deviation shocks.
  - Combined shock includes permanent 1/4 standard deviation shocks applied to real interest rate, growth rate, and current account balance; and a one-time real depreciation of 30 percent occurs in 2017 in the real depreciation shock.

### Key Macroeconomic Assumptions Underlying Baseline (historical averages and projections)
- Real GDP growth (historical averages and projections): historical averages and 2017–2022 projections show real GDP growth around 3.0–3.2 in projections; historical volatility noted (examples: 2012–2016 average 2.6, deviation 2.1, etc.).
- GDP deflator in US dollars (change in percent): historical series includes -16.2 for 2015 and projections of modest positive changes (e.g., 2017 2.9, 2018 1.6, later years 2.5, 2.3, 1.9, 1.7).
- Nominal external interest rate (in percent): historical and projected values include 3.0, 2.6, 2.5, 1.6, 1.7, 4.4, with projections 3.0, 2.4, 2.0, 2.1, 2.4, 2.0, 1.8.
- Growth of exports and imports (US dollar terms, in percent): historical variability and projected growth rates are reported (examples: exports projected 5.5, 5.9, 5.2, 4.9, 5.0, 4.7; imports projected 8.3, 7.9, 6.1, 5.5, 5.5, 5.1).
- Current account balance, excluding interest payments (percent of GDP): historical and projected values include 0.8, 0.6, 1.3, 1.9, 3.8, 2.0 with projections 2.9, 1.2, 1.0, 1.3, 0.6, 0.0.
- Net non-debt creating capital inflows (percent of GDP): historical and projected values around 1.9 and 1.8 in projections.

*Source: IMF staff (Annex III. Public Debt Sustainability Assessment, Republic of Latvia staff report materials).*

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_Source: https://www.imf.org/-/media/files/publications/cr/2017/cr17194.pdf_