## 1lvaea2019001

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### Overview and context
- The Latvian economy continued to strengthen ten years after the crisis, with growth averaging 3½ percent and accelerating above 4 percent in 2017–18.
- Growth reached 4.8 percent in 2018, driven mainly by construction and strong IT and communication sector performance, offsetting weak financial services.
- The current account has been balanced on average, and external debt has declined by more than a quarter since its post-crisis peak.
- Credit to GDP has almost halved and private sector balance sheets have improved significantly.

### Fiscal developments, stance, and long-term priorities
- 2018 fiscal outcome: deficit of 1 percent of GDP.
- Fiscal stimulus implied in 2018: about 0.4 percent of GDP.
- 2019 overall balance is expected to improve by 0.4 percent of GDP.
- Drivers of the 2019 balance:
  - Higher spending of 0.6 percent of GDP on wage increases for health and judiciary workers (0.2 percent of GDP), one-off special benefits of ministry of interior employees, and public investment.
  - Offsetting measures and revenues of about 0.6 percent of GDP from an increase in social security contributions, new measures to boost tax compliance, and exceptional revenues from SOE dividend payments and sale of CO2 allowances.
  - The exceptional SOE dividend is excluded from the 2019 ESA balance.
  - The emission sales took place in 2018, but revenues are recorded on accrual basis in 2019.
- Structural effort with a closing output gap: about 0.4 percent of GDP.
- Medium-term fiscal outlook:
  - Authorities’ 2019 Stability Program would help achieve a small consolidation of about 0.3 percent of GDP over the medium term.
  - Public debt and gross financing needs are projected to be on a declining path under the baseline and stress scenarios.
  - Scenario note: An expansionary fiscal policy scenario referenced assumes an expansionary fiscal policy of 2 percent of GDP over 2 years.
- Fiscal guidance:
  - Avoid public sector wage increases not aligned with productivity in the short run.
  - Carefully assess potential fiscal costs of new spending initiatives and identify financing sources.
  - Allow automatic stabilizers to operate fully if negative shocks occur; consider temporary high-quality measures in a severe downturn.
- Long-term fiscal priorities:
  - Accommodate demographic and social spending costs; identify new stable revenue sources.
  - Support productivity-boosting reforms and focus capital spending on projects that catalyze private investment and have high social impact.
  - Improve adequacy and targeting of existing social programs to address poverty and inequality.
  - Strengthen transparency and governance of local authorities and state-owned enterprises.
- Revenue and tax policy options noted:
  - Simplify VAT rate structure and reduce noncompliance to increase VAT revenue.
  - Increase intake from property taxes; revise methodology for estimating cadastral values.
  - Align effective taxation of CO2 emissions and other pollutants across fuels and uses.
  - Monitor microenterprise regime amendments to prevent tax optimization and avoid hindering innovative firms.
- Public administration reform:
  - Territorial reform seeks to reduce the large number of municipalities (110 municipalities and 9 cities; proposal to reduce number by about 2⁄3 within two years).
  - Local authorities account for about 60 percent of general government employments and 30 percent of expenditures; salaries constitute 45 percent of their expense.

### Financial system stability, AML/CFT, and banking-sector adjustment
- Banking-system resilience:
  - Capital levels about 40 percent higher than the euro area average.
  - Average liquidity coverage four times the regulatory minimum.
  - Banking system has the highest share of excess reserves (about 20 percent of total assets) in the euro area.
  - Profitability: ROA (after tax) 2018: 1.3; ROE (after tax) 2018: 10.1.
  - Asset quality: NPLs of retail and NFC lending declined to almost 3 percent.
- Money-laundering and reputational risks:
  - ABLV placed in self-liquidation since June 2018 after alleged institutionalized money laundering; ECB determined the institution was “likely to fail.”
  - ABLV’s limited role in the domestic economy meant implications were primarily reputational; IMF Country Report No. 18/266 estimated the direct impact of ABLV on growth at 0.5 percentage points.
  - MONEYVAL’s assessment found significant deficiencies in Latvia’s AML/CFT regime which, if unaddressed, could lead to grey-listing by FATF.
  - Risk: AML/CFT concerns could trigger grey-listing by the FATF in February 2020 if MONEYVAL’s main recommendations are not met.
- BSFCs (banks servicing foreign clients):
  - Non-resident deposits declined by more than 60 percent since end-2017; share declined to about 20 percent of total deposits.
  - BSFCs have less than 6 percent of their total lending involving domestic clients.
  - FCMC assessed BSFCs’ new business models under SREP; sustainability remains untested.
- Policy recommendations to restore confidence and support financial intermediation:
  - Strengthen AML/CFT effectiveness: enhance risk-based supervision, financial intelligence quality and use, preventive measures, investigation and prosecution, and coordination among authorities.
  - Ensure accurate beneficial ownership information and focus AML/CFT supervision on proper identification of beneficial ownership.
  - Improve AML/CFT preventive measures and suspicious transaction reporting quality and level.
  - Enhance AML/CFT enforcement: recruit and train staff, apply IT solutions, strengthen investigative and prosecutorial bodies, and develop sentencing guidelines.
  - Intensive regional cooperation across Nordic-Baltic countries; consider EU-level institution for AML/CFT supervision to facilitate consistent cross-border supervision and convergence.
  - Upgrade supervisory powers for bank liquidation: enable mandatory out-of-court administrative liquidation (administrator appointed by the FCMC) to reduce legal uncertainty and limit contingent liabilities, consistent with EU harmonization.
  - Oversee BSFCs’ re-orientation; limit voluntary liquidation to assessed cases and require independent asset sufficiency audits before liquidation.
  - Encourage de-risking and consolidation of the banking sector to align bank activities with real-economy financing needs.
  - Improve access to state loan guarantee programs to spur SME lending.
  - Complete insolvency reforms to raise recovery rates and lower lending costs.
  - Strengthen revenue administration to combat the shadow economy.

### Credit growth, insolvency, shadow economy, and non-bank finance
- Credit dynamics:
  - Total household credit declined by 5.4 percent in 2018.
  - Credit to non-financial corporations declined by 5.8 percent in 2018.
  - Credit to private sector (annual percentage change): 2018: -5.6.
  - Credit to private sector remains anemic despite record-low borrowing costs and rising demand.
- Supply-side constraints:
  - Deposit-rate stickiness: weighted average deposit rate 1.13 percent at end-February 2019; household deposit rate 1.17 percent; NFC deposit rate 0.79 percent.
  - Net interest margins compressed; banks prefer preserving capital and liquidity buffers.
  - Riskiness of corporate lending high (credit risk-weights of many banks exceeding 80 percent).
- Insolvency administration:
  - Recovery rates low by international comparison; proceedings can be excessively long and complicated.
  - Recommendations: improve licensing, selection, specialization, compensation, legal protection, and allow administrators to conclude cases; consider administrative liquidation frameworks for bank resolution.
- Shadow economy and demand effects:
  - Shadow economy estimated at more than 20 percent of GDP; more than 10 percent of working age population carries out undeclared activities.
  - Underreporting and “envelope” wages exclude many potential borrowers from bank lending.
- Non-bank finance (shadow banking):
  - MUNFI was 66 percent of GDP; non-bank lending about 20 percent of total lending at end-2018 (up from 10 percent at end-2013).
  - Leasing companies provided about 8 percent of GDP at end-2018, mostly to NFCs (about three-quarters).
  - Non-bank lending has grown consistently by more than 10 percent year-on-year since 2016.
- Policy recommendations to revive credit growth:
  - Ensure high standards for insolvency administration to raise creditors’ expected recovery rates.
  - Strengthen revenue administration to reduce informality and improve borrower transparency.
  - Pursue banking-sector consolidation to improve operational efficiency and ease lending constraints.
  - Make state loan guarantee programs more accessible and transparent to spur SME lending.
  - Extend macroprudential measures to leasing companies to prevent regulatory arbitrage.

### Macroprudential policy and housing market risks
- Housing market indicators:
  - Real house prices increased by more than 7 percent per year over the last three years despite a shrinking population.
  - House price index still about 20 percent below its pre-crisis peak in 2008.
  - Outstanding mortgage loans below 20 percent of GDP at end-2018 (euro area average about 38 percent of GDP).
- Macroprudential recommendations:
  - Lower the current LTV ratio limit of 90 percent to 80 percent for residential mortgage lending.
  - Impose restrictions on home refinancing.
  - Introduce a debt service-to-income (DSTI) limit.
  - Limit the maximum maturity of mortgages and consumer loans.
  - Apply higher provisions for loans with LTV ratios above the limit and conduct regular assessments of collateral valuation standards.
  - Extend measures to leasing companies.
- Authorities’ planned measures: introduce DSTI, DTI, and credit maturity caps, in addition to the existing LTV cap.

### Growth, labor market, structural constraints, and productivity reforms
- Short-term challenges:
  - Labor market tightness; labor force participation reached an all-time high of 78 percent.
  - Expected deceleration of EU investment funds; anemic credit growth; lingering AML/CFT reputational risks.
- Labor market and wages:
  - Real wage growth: 2018: 5.7 percent (driven by labor shortage and minimum wage increase).
  - Highest wage growth in health sector: 16 percent.
  - Unemployment declined to 7.4 percent at end-2018.
  - Net migration at its lowest level in 10 years but still puts pressure on the labor market.
- Long-term constraints:
  - Rapidly declining population; working age population projected to decline by about 31 percent in the next thirty years.
  - Low technological diffusion; high poverty and inequality, especially among the elderly.
  - Production-function estimates: without reforms, long-run potential growth could average around 1½ percent.
  - To maintain potential growth at 3 percent in the long run would require an improvement in TFP growth of near ½ percentage point.
- Staff structural reform priorities:
  - Ease labor market constraints: reduce structural and long-term unemployment; increase labor force participation of targeted groups; encourage return of Latvian emigrants; allow entry of skilled immigrants.
  - Promote better skill matching, improve vocational education and training, and expand active labor market policies.
  - Increase investment in new technologies and R&D; consider tax incentives for R&D carefully designed to improve uptake and prevent misuse.
  - Improve firms’ access to finance and attract foreign direct investment; address red tape, perceived corruption, informality, and public sector inefficiencies.
  - Improve access to housing to support labor mobility.
- Staff and authorities’ views:
  - Authorities agreed on focusing on easing labor market constraints and improving skill matching; skeptical about differentiating minimum wages across regions due to administrative complexity.
  - Authorities emphasized encouraging inward and discouraging outward migration and attracting high-skilled immigrant labor.

### Outlook, risks, and staff scenario analysis
- Growth projections and outlook:
  - Growth reached 4.8 percent in 2018.
  - Growth projected to decelerate: 2019: 3.2; 2020: 3.1; medium term converge to 3.0.
  - Drivers: slower EU fund absorption and moderating wage growth; export growth expected to recover slightly.
- Inflation and labor dynamics:
  - With unemployment below natural rate (estimated near 8 percent), wage growth expected above 4 percent before decelerating in line with productivity.
  - Inflation projected to ease and settle at slightly above 2 percent.
- External and domestic downside risks:
  - Staff estimate weak external demand due to a slowdown in the euro area could adversely impact growth by about ½ percentage point.
  - Escalation of trade tensions could reduce growth by up to ¼ percentage point.
  - AML/CFT concerns could, if unaddressed, trigger grey-listing by FATF and severely damage financial sector confidence, sovereign risk premium, and credit conditions.
  - Failure to refocus BSFCs towards viable business models could put financial stability at risk.
- Risk Assessment Matrix (selected entries):
  - Rising protectionism and retreat from multilateralism: Likelihood: High; impact for Latvia: could reduce growth by up to ¼ percentage point; recommended: diversify export markets and strengthen competitiveness.
  - Weaker-than-expected global growth: Likelihood: High; impact for Latvia: about ½ percentage point adverse growth impact; recommended: allow automatic stabilizers and coordinate at European level.
  - Sharp tightening of global financial conditions: Likelihood: High/Medium; mitigation: prudent debt management and issuance of long-term sovereign debt.
  - Delays in AML/CFT reforms: Likelihood: High; impact: possible grey-listing, damaged confidence; recommended: promptly address MONEYVAL recommendations and ensure proper liquidation of ABLV with screening of non-insured creditor claims.
- Simulation scenarios (GIMF model) and results:
  - AML/CFT Mild Adverse Scenario [1a]: GBPREM initial increase of 56 bps decaying by 50 percent each year; XFP shock of 131 bps; perfect pass-through to bank lending rates.
  - AML/CFT Severe Adverse Scenario [1b]: GBPREM and XFP shocks doubled relative to 1a; short-term equity risk premium shock of about 6.5 percent (equivalent to ~2 percent equity market drop).
    - Severe adverse scenario reduces real GDP growth by 4.5 percent on average over the medium term; real GDP declines by up to 1.5 percent and real investment by up to 11.5 percent at peak.
  - Insolvency Regime, Benign Scenario [2a]: bankruptcy costs decline permanently by 15 percent (phased over three years); recovery rate increase of 9.6 percent; lifts real GDP growth by 3.4 percent on average over the medium term; real GDP and investment increase by 1.1 percent and 9.0 percent after two years.
  - Insolvency Regime, Less Benign Scenario [2b]: bankruptcy costs fall by 5 percent phased over 5 years; recovery increases 3.2 percentage points; smaller gains for GDP and investment.
- Staff policy mix recommendation:
  - Redouble efforts on AML/CFT, insolvency reforms, and oversight of banks’ de-risking.
  - Use fiscal space prudently; allow automatic stabilizers to operate and deploy temporary high-quality measures if needed.
  - Long-term fiscal policies should address demographic costs, target social programs, and focus capital spending on high-return projects.
  - Introduce preemptive macroprudential measures to support sound lending standards amid rising property prices.

### External position, external debt, and public debt sustainability
- Current account and external debt:
  - Current account balance: 2018: -1.0 percent of GDP.
  - Current account (percent of GDP): 2015: -0.5; 2016: 1.6; 2017: 0.7; 2018: -1.0; 2019: -1.5; 2020: -1.6.
  - Gross external debt (percent of GDP): 2018: 121.0; 2019: 117.4; 2020: 114.4; 2024: 106.2.
  - Net external debt (percent of GDP): 2018: 21.2; 2019: 23.7; 2020: 22.7.
  - NIIP improved to -49 percent of GDP in 2018, from -56 percent of GDP in 2017; expected to improve to -43 percent of GDP over the medium term.
  - Short-term liabilities of monetary and financial institutions decreased by 5.2 billion euros (55 percent) reflecting withdrawal of foreign deposits.
  - Gross reserves (billions of euros): 2018: 3.8; 2019–2024: 3.8.
- External Debt Sustainability Assessment:
  - Baseline gross external debt projected to decline to 106 percent of GDP in 2024.
  - Debt-stabilizing non-interest current account: -4.7 (percent of GDP).
  - Identified external debt-creating flows (selected): 2018: -13.5; 2019: -3.7; 2020: -3.0.
  - Resilience: under all shocks, Latvia’s external debt-to-GDP ratio would be either below or only marginally higher than its 2018 level by 2024.
- Public sector debt sustainability (Annex III):
  - General government gross debt (percent of GDP): 2018: 35.9; 2019: 36.1; 2020: 34.4; 2024: 31.7 (table variation shows projection for 2024: 30.6 in a header).
  - Change in gross public sector debt (annual): 2018: -0.3; 2019: -4.0; 2020: -1.3; cumulative: -5.3.
  - Primary deficit (percent of GDP): 2018: -0.1; 2019: -0.1; 2020: 0.0.
  - Effective interest rate (percent): 2018: 2.9; 2019: 2.6; 2020: 2.5; 2021–2024: 2.9/3.2/3.2/3.2.
  - Public gross financing needs (percent of GDP): 2018: 4.9; 2019: 3.8; 2020: 5.2; 2024: 2.3.
- Debt-composition and scenario notes:
  - Baseline and alternative scenarios (historical, contingent liability) analyzed; contingent liability shock example shows a large primary balance deterioration in 2020 of -5.5 percent of GDP and negative real GDP growth in 2020–2021 of -3.0 percent in that scenario.

### Key statistics and projections (selected figures as reported)
- Real GDP growth (percent change): 2015: 3.0; 2016: 2.1; 2017: 4.6; 2018: 4.8; 2019: 3.2; 2020: 3.1
- Private consumption (percent change): 2015: 2.5; 2016: 1.4; 2017: 4.1; 2018: 4.5; 2019: 3.5; 2020: 3.2
- Gross fixed capital formation (percent change): 2015: -0.5; 2016: -8.4; 2017: 13.1; 2018: 16.4; 2019: 6.0; 2020: 5.0
- Nominal GDP (billions of euros): 2015: 24.3; 2016: 25.0; 2017: 27.0; 2018: 29.5; 2019: 31.4; 2020: 33.1
- GDP per capita (thousands of euros): 2015: 12.2; 2016: 12.7; 2017: 13.9; 2018: 15.3; 2019: 16.3; 2020: 17.2
- Gross national saving (percent of GDP): 2015: 21.8; 2016: 22.3; 2017: 22.9; 2018: 23.2; 2019: 23.0; 2020: 23.0
- Gross capital formation (percent of GDP): 2015: 22.2; 2016: 20.7; 2017: 22.2; 2018: 24.2; 2019: 24.4; 2020: 24.7
- HICP inflation (period average, percent): 2015: 0.2; 2016: 0.1; 2017: 2.9; 2018: 2.6; 2019: 2.7; 2020: 2.4
- Unemployment rate (LFS; period average, percent): 2015: 9.9; 2016: 9.6; 2017: 8.7; 2018: 7.4; 2019: 6.7; 2020: 6.9
- Real gross wages (percent): 2015: 6.6; 2016: 4.9; 2017: 4.8; 2018: 5.7; 2019: 4.5; 2020: 4.5
- Consolidated general government total revenue (percent of GDP): 2015: 36.2; 2016: 36.2; 2017: 35.6; 2018: 36.9; 2019: 35.7; 2020: 35.7
- Consolidated general government total expenditure (percent of GDP): 2015: 37.8; 2016: 36.6; 2017: 36.4; 2018: 37.6; 2019: 36.4; 2020: 36.1
- Basic fiscal balance (percent of GDP): 2015: -1.5; 2016: -0.4; 2017: -0.8; 2018: -0.7; 2019: -0.7; 2020: -0.4
- ESA balance (percent of GDP): 2015: -1.4; 2016: 0.1; 2017: -0.6; 2018: -1.0; 2019: -0.5; 2020: -0.4
- General government gross debt (percent of GDP): 2015: 36.8; 2016: 40.3; 2017: 40.0; 2018: 35.9; 2019: 36.1; 2020: 34.4
- Credit to private sector (annual percentage change): 2015: -2.3; 2016: 3.5; 2017: -1.0; 2018: -5.6
- Current account balance (percent of GDP): 2015: -0.5; 2016: 1.6; 2017: 0.7; 2018: -1.0; 2019: -1.5; 2020: -1.6
- Gross external debt (percent of GDP): 2015: 143.7; 2016: 148.9; 2017: 140.5; 2018: 121.0; 2019: 117.4; 2020: 114.4
- Net external debt (percent of GDP): 2015: 30.7; 2016: 29.2; 2017: 25.5; 2018: 21.2; 2019: 23.7; 2020: 22.7
- Exchange rate: U.S. dollar per euro (period average): 2015: 1.11; 2016: 1.11; 2017: 1.13; 2018: 1.18

### Government-supported credit programs and program design findings
- State mortgage guarantee program: effective in lifting mortgage credit demand but raised average LTV significantly.
- Lending programs for SMEs and student and academic loans: underused.
- Design notes:
  - State loan guarantee for down payment between 10 and 20 percent for families with children and young professionals exists; Latvia does not provide direct subsidies for house purchase.
  - Recommendation: review and calibrate mortgage guarantee design to mitigate increases in average LTV while preserving access; enhance transparency and operational efficiency of SME and student loan programs.

*Source: Republic of Latvia — Staff Report for the 2019 Article IV Consultation (IMF).*

### 0.4 percent of GDP. Still, public debt remains firmly on a downward path amid favorable

### 1lvaea2019001 - 0.4 percent of GDP. Still, public debt remains firmly on a downward path amid favorable

### Overview and context
- The Latvian economy continued to strengthen ten years after the crisis, with growth averaging 3½ percent and accelerating above 4 percent in 2017–18.
- Growth reached 4.8 percent in 2018, driven mainly by construction and strong IT and communication sector performance, offsetting weak financial services.
- The current account has been balanced on average, and external debt has declined by more than a quarter since its post-crisis peak.
- Credit to GDP has almost halved and private sector balance sheets have improved significantly.

### Fiscal developments and public debt
- 2018 fiscal outcome: deficit of 1 percent of GDP, broadly in line with staff projections.
- Fiscal stimulus implied in 2018: about 0.4 percent of GDP.
- Authorities' planned fiscal stance: reverses past procyclicality and is judged appropriate given expected economic deceleration.
- Fiscal policy guidance:
  - Avoid public sector wage increases not aligned with productivity in the short run.
  - Carefully assess potential fiscal costs of new spending initiatives to preserve fiscal space.
  - Allow automatic stabilizers to operate fully if negative shocks occur.
  - Consider temporary high-quality measures in a severe downturn.
- Long-term fiscal policy priorities:
  - Accommodate demographic and social spending costs.
  - Support productivity-boosting reforms.
  - Identify new stable revenue sources to cover growing age-related budget demands.
  - Focus capital spending on projects that catalyze private investment and have high social impact.
  - Improve adequacy and targeting of existing social programs to address poverty and inequality.
  - Strengthen transparency and governance of local authorities and state-owned enterprises.

### Financial system stability and risks
- The financial system remains stable despite significant balance sheet restructuring of banks servicing foreign clients (BSFCs).
- Bank resilience metrics:
  - Capital levels about 40 percent higher than the euro area average.
  - Average liquidity coverage four times the regulatory minimum.
- Financial integrity and reputational risks:
  - ABLV is undergoing self-administered liquidation after its closure in 2018 due to alleged money laundering.
  - MONEYVAL assessment raised concerns about Latvia’s AML/CFT regime, risking grey-listing for strategic deficiencies.
  - BSFCs’ business-model refocusing remains untested and could increase risk-taking in an over-banked sector.
- Policy recommendations to restore confidence and support financial intermediation:
  - Strengthen effectiveness of the AML/CFT regime by enhancing risk-based supervision, financial intelligence quality and use, preventive measures, investigation and prosecution, and coordination among authorities.
  - Upgrade supervisory powers for bank liquidation to include mandatory out-of-court administrative liquidation to reduce legal uncertainty and limit contingent liabilities, consistent with EU harmonization.
  - Oversee BSFCs’ new business plans and reduce exposure to risky banking operations.
  - Encourage de-risking and consolidation of the banking sector to align bank activities with real-economy financing needs.
  - Improve access to state loan guarantee programs to spur SME lending.
  - Complete insolvency reforms to lower lending costs.
  - Strengthen revenue administration to more effectively combat the shadow economy.
  - Introduce new preemptive macroprudential measures to support sound lending standards and mitigate medium-term vulnerabilities amid persistently rising property prices.

### Growth, labor market, and structural challenges
- Short-term challenges: labor market tightness, expected deceleration of EU investment funds, anemic credit growth, and lingering integrity and reputational risks in the financial sector.
- Long-term constraints: rapidly declining population, low technological diffusion, and high poverty and inequality (especially among the elderly).
- Growth projection: growth is projected to decelerate in the medium term and converge to 3 percent.
- Structural reform priorities to raise productivity and labor supply:
  - Ease labor market constraints by reducing structural unemployment and long-term unemployment.
  - Increase labor force participation of targeted groups and encourage return of Latvian emigrants.
  - Allow entry of skilled immigrants.
  - Promote better skill matching.
  - Increase investment in new technologies and R&D.
  - Improve firms’ access to finance and attract foreign direct investment.
  - Improve vocational education and training, active labor market policies, and access to housing.

### Staff views and recommended policy mix
- Structural reforms: focus on easing labor market constraints, boosting investment, improving access to finance, and increasing FDI to raise productivity.
- Fiscal stance: the planned fiscal stance is appropriate and provides space to face downside risks; use automatic stabilizers and high-quality measures if necessary.
- Financial sector policies: strengthen AML/CFT framework effectiveness, upgrade bank resolution powers, de-risk and consolidate banks, complete insolvency reforms, combat the shadow economy, improve SMEs’ access to finance, and introduce tailored macroprudential measures.

### Key statistics and projections (selected figures as reported)
- Real GDP growth: 2015: 3.0; 2016: 2.1; 2017: 4.6; 2018: 4.8; 2019: 3.2; 2020: 3.1 (percent change)
- Private consumption: 2015: 2.5; 2016: 1.4; 2017: 4.1; 2018: 4.5; 2019: 3.5; 2020: 3.2 (percent change)
- Gross fixed capital formation: 2015: -0.5; 2016: -8.4; 2017: 13.1; 2018: 16.4; 2019: 6.0; 2020: 5.0 (percent change)
- Nominal GDP: 2015: 24.3; 2016: 25.0; 2017: 27.0; 2018: 29.5; 2019: 31.4; 2020: 33.1 (billions of euros)
- GDP per capita: 2015: 12.2; 2016: 12.7; 2017: 13.9; 2018: 15.3; 2019: 16.3; 2020: 17.2 (thousands of euros)
- Gross national saving (percent of GDP): 2015: 21.8; 2016: 22.3; 2017: 22.9; 2018: 23.2; 2019: 23.0; 2020: 23.0
- Gross capital formation (percent of GDP): 2015: 22.2; 2016: 20.7; 2017: 22.2; 2018: 24.2; 2019: 24.4; 2020: 24.7
- HICP inflation (period average): 2015: 0.2; 2016: 0.1; 2017: 2.9; 2018: 2.6; 2019: 2.7; 2020: 2.4 (percent)
- Unemployment rate (LFS; period average): 2015: 9.9; 2016: 9.6; 2017: 8.7; 2018: 7.4; 2019: 6.7; 2020: 6.9 (percent)
- Real gross wages: 2015: 6.6; 2016: 4.9; 2017: 4.8; 2018: 5.7; 2019: 4.5; 2020: 4.5 (percent)
- Consolidated general government total revenue (percent of GDP): 2015: 36.2; 2016: 36.2; 2017: 35.6; 2018: 36.9; 2019: 35.7; 2020: 35.7
- Consolidated general government total expenditure (percent of GDP): 2015: 37.8; 2016: 36.6; 2017: 36.4; 2018: 37.6; 2019: 36.4; 2020: 36.1
- Basic fiscal balance (percent of GDP): 2015: -1.5; 2016: -0.4; 2017: -0.8; 2018: -0.7; 2019: -0.7; 2020: -0.4
- ESA balance (percent of GDP): 2015: -1.4; 2016: 0.1; 2017: -0.6; 2018: -1.0; 2019: -0.5; 2020: -0.4
- General government gross debt (percent of GDP): 2015: 36.8; 2016: 40.3; 2017: 40.0; 2018: 35.9; 2019: 36.1; 2020: 34.4
- Credit to private sector (annual percentage change): 2015: -2.3; 2016: 3.5; 2017: -1.0; 2018: -5.6
- Current account balance (percent of GDP): 2015: -0.5; 2016: 1.6; 2017: 0.7; 2018: -1.0; 2019: -1.5; 2020: -1.6
- Gross external debt (percent of GDP): 2015: 143.7; 2016: 148.9; 2017: 140.5; 2018: 121.0; 2019: 117.4; 2020: 114.4
- Net external debt (percent of GDP): 2015: 30.7; 2016: 29.2; 2017: 25.5; 2018: 21.2; 2019: 23.7; 2020: 22.7

*Source: Republic of Latvia — Staff Report for the 2019 Article IV Consultation (IMF).*

### 8.      Wages increased significantly, as the labor market continued to tighten. A labor shortage

### 8.      Wages increased significantly, as the labor market continued to tighten. A labor shortage

### Labor market and wages
- Real wage growth reached 5.7 percent following a labor shortage and the increase in minimum wages at the beginning of 2018.
- Private and public sector wages saw equivalent increases.
- Highest wage growth was in the health sector: 16 percent, following health care reform that provided higher salaries for medical workers.
- Unemployment declined to 7.4 percent at end-2018.
- Labor force participation reached an all-time high of 78 percent.
- Net migration is at its lowest level in 10 years and continues to put pressure on the labor market, but at a slower pace.

### Current account and external competitiveness
- The current account turned into a deficit of 1 percent of GDP in 2018.
- Export volume growth decelerated to 1.8 percent in 2018 due to moderation in external demand, poor food and agricultural production (partly adverse weather), and a decline in exports of financial services linked to shrinking non-resident deposits.
- Import volumes grew by 5.1 percent amid strong investment and robust household consumption.
- Rising real wages pushed unit labor costs (ULC) above their pre-crisis peak.
- CPI-based REER continued to appreciate; REER measures accounting for Latvia’s share in global supply chains show a larger appreciation, signaling faster erosion of competitiveness compared to standard REER measures.
- Staff estimates: a 10 percent increase in value added based REER is associated with about 0.2 percentage point decline in growth. (Staff estimate note contained in source.)

### Banking system, credit, and asset quality
- Banking system: solvent, profitable, and liquid.
- Capital levels about 40 percent higher than the euro area average.
- Average liquidity coverage is four times the regulatory minimum.
- Banking system has the highest share of excess reserves (about 20 percent of total assets) in the euro area.
- Profitability has slightly decreased since 2016 but remains solid.
- Asset quality improved: NPLs of retail and NFC lending declined to almost 3 percent—far below the euro area average.
- De-risking and deleveraging of the BSFC sector further dampened credit growth.
- Government-sponsored mortgage program contributed to a slight recovery of household (HH) credit in 2018Q4; SME lending programs have been less successful.
- Total HH credit declined by 5.4 percent in 2018.
- Credit to non-financial corporations declined by 5.8 percent in 2018.

### Public and external debt
- Public debt reduced to 37 percent of GDP in 2018 due to prudent fiscal deficits and favorable macroeconomic conditions.
- Sharp decline in non-resident deposits led to a reduction of external debt by 20 percentage points in 2018.
- Latvia’s investment-grade rating was reaffirmed, supporting stable market access at very low spreads.
- Authorities lengthened public debt maturities and launched a successful 30-year Eurobond.

### Outlook and risks
- Growth projection: GDP growth expected to decelerate in 2019 to just above 3 percent.
- Medium-term projections (percent change):
  - Real GDP: 2018 = 4.8, 2019 = 3.2, 2020 = 3.1, 2024 = 3.0
  - Consumption: 2018 = 4.4, 2019 = 3.4, 2020 = 3.2, 2024 = 3.1
  - Gross investment: 2018 = 15.1, 2019 = 6.0, 2020 = 5.0, 2024 = 5.0
  - Exports: 2018 = 1.8, 2019 = 2.2, 2020 = 2.3, 2024 = 2.2
  - Imports: 2018 = 5.1, 2019 = 3.2, 2020 = 3.2, 2024 = 3.1
- Drivers: slower EU fund absorption and wage growth moderating domestic demand; export growth expected to recover slightly as one-off adverse weather effects wear off but remain sluggish.
- Over the medium term, GDP growth projected to converge to potential of 3 percent as EU funds taper and capacity constraints bind.
- Wage and inflation dynamics:
  - With unemployment below its natural rate—estimated near 8 percent—labor market constraints will keep wage growth above 4 percent before decelerating in line with productivity.
  - Inflation projected to ease and settle at slightly above 2 percent.
- External downside risks:
  - Staff estimates that weak external demand due to a slowdown in the euro area could adversely impact growth by about ½ percentage point.
  - Escalation of trade tensions could reduce growth by up to ¼ percentage point.
- Domestic risks:
  - AML/CFT concerns could trigger grey-listing by the FATF in February 2020 if MONEYVAL’s main recommendations are not met, severely damaging confidence in Latvia’s financial sector and oversight.
  - AML/CFT deficiencies in screening claims of non-insured creditors could raise reputational risks.
  - Failure to refocus the BSFC sector towards a viable business model could put financial sector stability at risk.
  - AML/CFT concerns could significantly impact Latvia’s sovereign risk premium and credit conditions if they result in additional failures in the BSFC sector and/or trigger further withdrawal of parent support of large foreign-owned banks.
- Upside risk: faster than projected recovery in credit growth due to effective insolvency administration reforms.

### Policy discussions and recommendations
- Fiscal stance: appropriate; fiscal space available to face adverse shocks. Focus fiscal policy on long-term policy mix to support productivity improvements and address poverty and inequality.
- Priority: concerted efforts to address AML/CFT concerns, repair financial system reputation, and ensure it supports credit needs of the real economy.
- Macro-structural policies to raise productivity:
  - Productivity challenge: working age population projected to decline by about 31 percent in the next thirty years, implying an average reduction in annual average potential growth of 1¼ percentage points.
  - Labor force aging: share of workers above age 55 increasing by about 3.6 percentage points; adverse effect on TFP implies additional dent on potential growth of about ¼ percentage points by 2050.
  - Long-run potential growth could average around 1½ percent without reforms.
  - To maintain potential growth at 3 percent in the long run would require an improvement in TFP growth of near ½ percentage point.
- Specific reform avenues:
  - Investment in new technologies: increase intangible assets; 2017 income tax reform may encourage reinvestment of profits once fully effective; consider specific tax incentives to encourage R&D investment, carefully designed to improve uptake and prevent misuse.
  - Access to finance: analysis shows companies with access to finance tend to have higher productivity growth; an increase in debt financing by 10 percentage points tends to be associated with higher productivity growth by about 0.5 percentage point. Increase access to finance, especially for small productive firms.
  - Better resource allocation: excess debt burdens hurt productivity growth; financially distressed firms negatively impact productivity growth of other firms in the same sector. Resources should be allocated to healthy firms; insolvent companies need liquidation or restructuring under more efficient procedures.
  - FDI inflows: despite relatively unrestricted FDI rules, FDI inflows are weak, especially in non-service sector, due to deterrents such as red tape, perceived corruption, informality, and public sector inefficiencies. Addressing these deterrents and encouraging majority-stake acquisitions could help raise productivity growth.
- Authorities’ views:
  - Agreed easing labor market constraints supports competitiveness. Skeptical about differentiating minimum wages across regions due to administrative complexities.
  - Emphasized efforts to reduce structural unemployment via improving skill matching, upskilling, and ALMP uptake.
  - Focus on encouraging inward and discouraging outward migration; open to attracting high-skilled immigrant labor.
  - Consider productivity-enhancing reforms critical to mitigate demographic impacts; improving business environment and capital market development necessary to attract investment and unlock financing for firms.
  - Noted cost pressures from labor shortages create incentives for companies to invest in new technologies; policies needed to improve R&D spending.

*International Monetary Fund — Republic of Latvia: Chapter content provided in the source document.*

### 23.      Fiscal policy in 2019 is projected to be slightly contractionary. With a lower revenue

### 23.      Fiscal policy in 2019 is projected to be slightly contractionary. With a lower revenue 

### Fiscal stance and 2019 projections
- 2019 overall balance is expected to improve by 0.4 percent of GDP.
- Drivers of the 2019 balance:
  - Higher spending of 0.6 percent of GDP on wage increases for health and judiciary workers (0.2 percent of GDP), one-off special benefits of ministry of interior employees, and public investment.
  - Offsetting measures and revenues of about 0.6 percent of GDP from an increase in social security contributions, new measures to boost tax compliance, and exceptional revenues from SOE dividend payments and sale of CO2 allowances.
  - The exceptional SOE dividend is excluded from the 2019 ESA balance.
  - The emission sales took place in 2018, but revenues are recorded on accrual basis in 2019.
- With a closing output gap, the structural effort amounts to about 0.4 percent of GDP.

### Medium-term fiscal outlook and risks
- Under current policies, the fiscal stance is expected to be broadly neutral over the medium term.
- The authorities’ medium-term objectives outlined in the 2019 Stability Program would help achieve a small consolidation of about 0.3 percent of GDP over the medium term.
- Public debt and gross financing needs are projected to be on a declining path under the baseline and stress scenarios.
- Scenario note: An expansionary fiscal policy scenario referenced assumes an expansionary fiscal policy of 2 percent of GDP over 2 years.
- Risks and potential fiscal costs:
  - New measures under discussion (further wage increases, tax adjustments, territorial reform) could entail fiscal costs that need careful assessment and identified financing sources.
  - Further minimum wage and sectoral wage increases, if not aligned with productivity growth, could undermine competitiveness and should be avoided.

### Fiscal space and shock response
- Latvia has some fiscal space to react to shocks under the targeted fiscal path, supported by solid access to financing under favorable terms and relatively low debt burden.
- Guidance:
  - Should negative shocks materialize, the authorities should let automatic stabilizers operate fully.
  - In a severe economic downturn, expansionary fiscal policy through temporary, high-quality measures could be considered.

### Long-term pressures and demographic considerations
- Spending needs could increase if social and fiscal pressures to address relatively high poverty and inequality levels and a rapidly aging population increase.
- Projection: Due to a significant decline in replacement rates to about 16 percent by 2050 under existing retirement benefit rules, long-term pension spending costs are projected to fall, offsetting the rise in health and other long-term care spending.
- Trade-off highlighted: The existing pension system ensures fiscal sustainability but raises questions of social sustainability given already high poverty rates among the elderly.
- Estimate: Raising replacement rates to the recommended ILO minimum of 40 percent could increase costs by almost 4 percentage points of GDP over the next ten years.

### Long-term policy mix and recommendations
- Identifying new growth-friendly revenue sources:
  - VAT revenue could increase by simplifying the rate structure and reducing noncompliance; Latvia’s large persistent VAT gap relative to EU peers suggests scope for revenue gains.
  - Efforts to increase intake from property taxes could provide a sustainable revenue source; the government’s proposal to revise the methodology for estimating cadastral values is noted positively.
  - A relatively low effective tax rate on CO2 emissions provides scope for raising energy tax revenue by aligning effective taxation of CO2 emissions and other pollutants across different fuels and uses.
  - Monitor recent amendments to the microenterprise regime to ensure the regime is not used solely for tax optimization and does not hinder growth of innovative firms.
- Maximizing investment returns:
  - While public investment recently surged, total public and private investment would decline as EU funds taper off.
  - Latvia’s investment needs are large and the quality of infrastructure—particularly roads, railway and energy connectivity—lags neighboring countries, impeding labor mobility, regional development, and FDI inflows.
  - Recommendation: Support investment projects with high returns that catalyze private investment and could be frontloaded if the economy needs support in a downturn.
  - Staff simulation: A permanent increase in capital expenditure of 0.5 percent of GDP per year could increase real GDP growth by about 0.2 percent per annum over the medium term.
- Reforming public administration:
  - Adjust level and composition of public sector employment to ease labor market tightness.
  - Territorial reform proposal seeks to reduce the large number of municipalities (119) by about 2⁄3 within the next two years; strictly speaking it is 110 municipalities and 9 cities.
  - Local authorities account for about 60 percent of general government employments and 30 percent of expenditures (above the 23 percent EU average); salaries constitute 45 percent of their expense (significantly above the 32 percent EU average).
  - Actions: Strengthen public procurement transparency and efficiency and local authorities’ and SOEs’ governance and reporting.
- Improving adequacy and targeting of social programs:
  - Redesign existing programs, link eligibility to socio-economic indicators, introduce uniform standards across municipalities, and complete the guaranteed minimum income reform.
  - Funding a larger social housing stock could improve regional labor mobility and lower structural unemployment.

### Authorities’ views
- The authorities agreed that new policy initiatives’ fiscal impacts and benefits need careful assessment to avoid eroding fiscal space.
- They concurred that the long-term fiscal policy mix needs to focus on securing growth-friendly revenue sources to accommodate age-related and social spending and to boost potential growth.
- The authorities were skeptical about raising sufficient revenues to support a significant increase in pension replacement rates in the long run and considered raising productivity key to balancing fiscal and social sustainability outcomes.

### Macro-financial policies: AML/CFT and banking sector resilience
- Money laundering concerns related to BSFCs continue to weigh on Latvia’s financial sector, contributing to withdrawal of global correspondent banks and a decline of external funding.
- ABLV placed in self-liquidation since June 2018 after allegations of institutionalized money laundering accelerated deposit outflows; the ECB determined the institution was “likely to fail.”
  - ABLV’s limited role in the domestic economy meant implications were primarily reputational.
  - IMF Country Report No. 18/266 estimated the direct impact of ABLV on growth at 0.5 percentage points.
  - BSFCs have less than 6 percent of their total lending involving domestic clients.
- MONEYVAL’s assessment found significant deficiencies in Latvia’s AML/CFT regime which, if unaddressed, could lead to grey-listing by FATF.
- Key AML/CFT reform areas and recommendations:
  - Strengthen AML/CFT supervision: improve understanding and analysis of ML/TF threats and vulnerabilities and strengthen risk-based supervision; assist financial institutions in developing risk assessments and internal controls.
  - Ensure accurate beneficial ownership information: monitor effectiveness of amendments to the Law on the Prevention of Money Laundering and Terrorism Financing; focus AML/CFT supervision on proper identification of beneficial ownership.
  - Improve AML/CFT preventive measures and reporting: raise quality and level of suspicious transaction reporting; clarify reporting requirements; focus on higher risk entities such as BSFCs and targeted financial sanctions.
  - Enhance AML/CFT enforcement: improve cooperation across supervisory, financial intelligence, tax administration, and law enforcement authorities; recruit and train additional staff; apply adequate IT solutions; strengthen investigative and prosecutorial bodies; develop sentencing guidelines.
- Regional and EU-level coordination:
  - Intensive regional cooperation needed across Nordic-Baltic countries to identify ML risks and spillovers.
  - Consideration at the EU level for establishing a European-level institution responsible for AML/CFT supervision to facilitate consistent cross-border supervision and convergence.
- Upgrading resolution regime and de-risking banking sector:
  - ABLV’s protracted liquidation reveals deficiencies in regulatory framework and prudential oversight; legal gaps and fragmented resolution regime for euro area banks deemed less significant persist.
  - Recommendations:
    - Address lingering AML/CFT concerns during liquidation processes; strengthen supervisory and enforcement capacity and operational coordination.
    - Upgrade supervisory powers for bank liquidation: while amendments to the Credit Institutions Law allow mandatory liquidation of banks whose license is withdrawn due to AML/CFT breaches, the FCMC cannot impose timely liquidation of solvent banks deemed “failing or likely to fail” (FOLF) by the ECB but not resolved by the SRB.
    - An amendment enabling mandatory out-of-court administrative liquidation (with an administrator appointed by the FCMC) in such cases would reduce legal uncertainty about wind-downs and potential contingent liabilities to the government.

*Source: Republic of Latvia — IMF staff report excerpt.*

### 33.      Refocusing BSFCs’ business models and aligning them with the financing needs of the

### 33.      Refocusing BSFCs’ business models and aligning them with the financing needs of the

### Banking-sector adjustment and BSFCs
- ABLV’s closure and the subsequent pressure to de-risk BSFCs (including terminating activities with some shell companies) has led to a reduction of non-resident deposits by more than 60 percent since end-2017, with their share declining to about 20 percent of total deposits.
- Higher prudential requirements on banks with a significant share of foreign deposits have forced BSFCs to seek new business models with a greater focus on domestic activities where much larger, foreign banks already play a dominant role.
- The FCMC has assessed these business models under the Supervisory Review and Evaluation Process (SREP)—considering future business strategies and risk impact—but their sustainability is yet to be proven.
- Recommendations and supervisory approach:
  - Monitor closely BSFCs with a focus on continued de-risking, prudent lending practices, and enhanced operational efficiency to ensure new activities do not increase financial stability risks or create contingent liabilities for the government.
  - Conduct a risk-based business model review involving opaque entities using a harmonized SREP methodology for less significant institutions (LSIs) to limit supervisory capture.
  - Voluntary liquidation should be limited to cases when the license has not been revoked and only after an assessment by independent audit that available assets are sufficient to reimburse investors. (Footnote text present in source.)

### Supporting Credit Growth
- Despite record-low borrowing costs and rising demand, lending to both households and non-financial corporations (NFCs) remains timid.
- Contributing factors to credit bottlenecks:
  - Some lending headroom of larger banks is being displaced by the absorption of legacy portfolios of banks exiting the Latvian market.
  - Tightening lending standards and declining loan-to-deposit ratios signal cautious lending policies due to concerns about the effectiveness of the insolvency regime and widespread informality.
  - The riskiness of corporate lending remains one of the highest in the euro area (with credit risk-weights of many banks exceeding 80 percent).
  - Despite reforms strengthening insolvency administration, asset recovery rates remain low by international comparison.
  - Evidence on loan demand is mixed; a high share of self-financing and low business confidence weigh on willingness to borrow.
  - Non-bank lending is picking up, outpacing bank lending, but it still represents only about 20 percent of total lending.
- Policy recommendations to revive credit growth:
  - Ensure high standards for insolvency administration to raise creditors’ expected recovery rates and lower the cost of lending.
  - Continue efforts to strengthen the revenue administration to reduce the informal sector and improve borrowers’ transparency.
  - Pursue consolidation of the banking sector aiming to improve operational efficiency and prevent unsustainable business models to ease lending constraints for profitable banks.
  - Make the system of state loan guarantee programs more accessible and transparent to spur SME lending.
- Data note from source footnote:
  - The deposit base funding domestic lending has been unaffected by the liquidation of ABLV Bank. As of end-March 2019, only 0.5 percent of total domestic bank loans were funded by foreign deposits, of which about 7 percent are foreign currency-denominated.

### Preempting buildup of macro-financial vulnerabilities
- Housing market developments:
  - Real house prices have increased by more than 7 percent per year over the last three years despite a shrinking population, driven by a surge in construction costs and prices of new dwellings.
  - Current valuation indicators (price-to-income and price-to-rent ratios and deviations from long-term fundamentals) signal potential vulnerability to overvaluation of housing prices over the medium term.
  - There are no acute financial imbalances: the house price index is still about 20 percent below its pre-crisis peak in 2008, and aggregate house price developments have not been spurred by credit growth.
  - Outstanding mortgage loans have dropped below 20 percent of GDP at end-2018, far below the euro area average of about 38 percent of GDP.
- Macroprudential recommendations:
  - Lower the current LTV ratio limit of 90 percent to 80 percent for residential mortgage lending.
  - Impose restrictions on home refinancing.
  - Introduce a debt service-to-income (DSTI) limit.
  - Limit the maximum maturity of mortgages and consumer loans.
  - Apply higher provisions for loans with LTV ratios above the limit and conduct regular assessments of collateral valuation standards.
  - Extend macroprudential measures to leasing companies to prevent potential regulatory arbitrage between them and banks.
- Comparative context from source figures:
  - Latvia’s macroprudential measures are relatively lenient compared to those in other EU countries; the source includes comparative charts showing LTV and DSTI limits across selected EU countries and mentions a DSTI Ratio (planned).

### Authorities’ views
- The authorities broadly agreed with staff’s views and emphasized:
  - Important legislative changes have been introduced to reduce AML/CFT concerns and international sanctions risks and address MONEYVAL’s recommendations.
  - Demonstrating effectiveness will take time and requires considerable efforts, including the timely liquidation of ABLV under a transparent review process to mitigate reputational risks.
  - Expanding supervisory powers for mandatory liquidation would be welcome but should be considered once the ongoing review of the EU banking resolution regime is completed.
  - Preemptive macroprudential measures would be appropriate to safeguard prudent bank lending amid persistently rising housing prices.
  - Authorities already plan to introduce pre-emptively DSTI, DTI, and credit maturity caps, in addition to the existing LTV cap, to ensure sound lending standards through the cycle.

### Staff appraisal: macroeconomic and financial system assessment
- Positive assessments and projections:
  - The Latvian economy has become considerably more resilient since the global financial crisis, and economic prospects remain favorable.
  - There are no significant economic imbalances; external and government debt are on declining paths; and private sector balance sheets continue to improve.
  - Inflation has been moderate, and competitiveness has held up.
  - The external position is assessed to be moderately stronger than implied by medium-term fundamentals and desirable policies.
  - Growth has been strong, and while it is projected to decelerate in the medium term, it is expected to converge to a still robust rate of 3 percent.
- Risks and challenges:
  - Latvia’s population continues to decline, straining the labor market and posing a long-term growth challenge.
  - Weaker than expected external growth, especially in the euro area, and rising protectionism could significantly weigh on exports.
  - The financial system still confronts financial integrity risks; failure to strengthen AML/CFT effectiveness and refocus BSFCs could undermine financial stability and its ability to support the economy.
- Policy priorities and recommendations:
  - Redouble efforts to ease labor market constraints: promote better skill matching, reduce long-term unemployment, increase labor participation of targeted groups, encourage the return of Latvian emigrants, and allow entry of skilled immigrants.
  - Raise productivity growth to allow more rapid wage growth sustainably and help slow emigration.
  - Implement reforms to improve firms’ access to finance, encourage investment in research and development, and attract foreign direct investment.
  - In the short run, avoid public sector wage increases not aligned with productivity and carefully assess potential fiscal costs of new spending initiatives to preserve fiscal space.
  - If negative shocks occur, allow automatic stabilizers to operate fully and consider temporary high-quality measures to support the economy in the event of a severe downturn.
  - Long-term fiscal policies should address demographic and social spending costs, focus capital spending on projects that catalyze private investment and have high social impact, and improve the adequacy and targeting of social programs.
  - Strengthen transparency and governance of local authorities and state-owned enterprises to improve the use of public resources and prevent misuse.
  - Strengthen the effectiveness of the AML/CFT regime by enhancing risk-based supervision, the quality and use of financial intelligence, the application of preventive measures, investigation and prosecution, and coordination among relevant national and regional authorities.
  - Upgrade supervisory powers for bank liquidation to include mandatory out-of-court administrative liquidation to reduce legal uncertainty and limit potential contingent liabilities, consistent with EU harmonization efforts.
  - Complete ongoing insolvency reforms to lower lending costs, strengthen revenue administration to combat the shadow economy, carefully oversee banks’ de-risking and business model re-orientation towards the real economy to encourage consolidation and ease lending constraints, and improve access to the state loan guarantee system to spur SME lending.
  - Introduce new preemptive macroprudential measures to support sound lending standards and mitigate medium-term financial sector vulnerabilities amid persistently rising property prices.

*IMF Staff report excerpt.*

### Box 1. Risk Assessment Matrix

### Box 1. Risk Assessment Matrix

### Risk assessment summary
- The Risk Assessment Matrix (RAM) shows events that could materially alter the baseline path (the scenario most likely to materialize in the view of IMF staff).
- The relative likelihood is the staff’s subjective assessment of the risks surrounding the baseline (“low” is meant to indicate a probability below 10 percent, “medium” a probability between 10 and 30 percent, and “high” a probability between 30 and 50 percent).
- The RAM reflects staff views on the source of risks and overall level of concern as of the time of discussions with the authorities. Non-mutually exclusive risks may interact and materialize jointly.

### Major risks, impacts, and recommended policy responses

- Rising protectionism and retreat from multilateralism
  - Likelihood: High
  - Impact if realized:
    - Escalating and sustained trade actions threaten the global trade system, regional integration, as well as global and regional collaboration.
    - Additional barriers and the threat of new actions reduce growth directly and through adverse confidence effects.
    - Geopolitical competition and fraying consensus about the benefits of globalization lead to economic fragmentation with adverse effects on growth and stability.
    - For Latvia: As a small open economy and relatively well integrated in global supply chains, Latvia could be impacted through trade channels. Staff estimate that escalation of trade tensions could reduce growth by up to ¼ percentage point.
  - Policy recommendations:
    - Continue to diversify product and export markets.
    - Pursue structural policies that enhance productivity and strengthen competitiveness.
    - Participate in coordinated policy response at the European level.

- Weaker-than-expected global growth
  - Likelihood: High
  - Impact if realized:
    - Synchronized growth slowdown as weakening outlooks in the U.S., Europe and China feed off each other.
    - Weak foreign demand makes euro area businesses delay investment, faltering confidence reduces private consumption, debt sustainability concerns further dampen growth.
    - A disorderly Brexit could cause market disruption with negative spillovers.
    - Disregard for common fiscal rules and rising sovereign yields for high-debt countries undermines medium term growth.
    - For Latvia: The euro area remains Latvia’s single largest trade partner. A protracted slowdown would have a direct impact on exports while also eroding business and consumer confidence. Staff estimates that a weak external demand due to a slow-down in the euro area could adversely impact growth by about ½ percentage point.
  - Policy recommendations:
    - Participate in coordinated policy response at the European level.
    - Allow automatic stabilizers to operate.
    - In the event of a severe economic downturn, fiscal policy through temporary, high-quality measures, should be considered.

- Sharp tightening of global financial conditions
  - Likelihood: High/Medium
  - Impact if realized:
    - Could arise from market expectation of tighter U.S. monetary policy or sustained rise in risk premium in reaction to concerns about debt levels in some euro area countries; a disorderly Brexit; or idiosyncratic policy missteps in large emerging markets.
    - Would cause higher debt service and refinancing risks; stress on leveraged firms, households, and vulnerable sovereigns; capital account pressures; and a broad-based downturn.
    - Domestic effects: Could raise the public cost of debt financing. Sharp increases of the interest rate could further hinder credit growth. The impact could be high if the shock is combined with one or more of the above shocks, impacting growth significantly.
  - Mitigation/Response:
    - Perception of Latvia as a safe asset and the issuance of long-term sovereign debt are mitigating factors.
    - Continue implementing prudent debt management policies and build buffers.

- Delays in the implementation of AML/CFT reforms
  - Likelihood: High
  - Impact if realized:
    - Failure to refocus the BSFC sector towards a viable business model.
    - Could trigger a grey-listing by the FATF and severely damage confidence in the financial sector and its oversight and have an impact on the sovereign risk premium and credit conditions.
    - Could undermine confidence in the financial sector, put its stability at risk, and hinder credit growth.
  - Policy recommendations and mitigation/response:
    - Promptly address recommendations in the MONEYVAL report, ensure the proper liquidation of ABLV, including by implementing a careful screening of claims of non-insured creditors and AML/CFT controls.
    - Closely monitor the re-orientation of banks to ensure their new activities do not increase financial stability risks or create contingent liabilities for the government.

*Source: Box 1. Risk Assessment Matrix, IMF staff.*

### 2.5 percent ≤ x <5percent

### 2.5 percent ≤ x <5percent

### Macroprudential Indicators for Latvia and Selected Euro Area countries (as of end-2018)
- Household Loan-to-Value Ratio (In percent): chart shown (countries listed: S VNPOLLTUS VKHUNESTLVA).
- Indicators presented (In percent or percent-point changes, with footnotes: 1/ two-year average change; 2/ three-year average change; 3/ in percentage points).
- Selected country values (extracted as contiguous strings from table):
  - Latvia: -5.5 -0.1 -18.9 -22.8 -0.6 7.1 2.3 -0.3
  - Lithuania: -1.0 7.6 -4.3 0.1 0.1 4.3 1.3 0.2
  - Estonia: -3.4 1.3 3.3 -11.1 -0.3 3.6 -1.0 -0.3
  - Portugal: -7.1 -2.1 -40.1 -51.6 -1.3 8.0 5.3 -0.1
  - Italy: -2.1 0.0 -12.2 -17.4 -0.4 -1.6 -2.3 0.2
  - Spain: -6.2 -2.4 -40.3 -51.8 -0.9 4.7 4.0 -0.2
  - Germany: 0.1 2.8 -1.9 -1.2 0.1 5.6 2.7 -0.1
  - France: 2.8 2.1 2.3 3.9 0.3 1.1 0.7 0.0
  - Netherlands: -5.3 -0.3 -25.3 -22.9 -0.8 6.8 5.7 0.8

### Table 1. Latvia: Selected Economic Indicators, 2015–20
- Real GDP (annual percent change): 2015: 3.0; 2016: 2.1; 2017: 4.6; 2018: 4.8; 2019: 3.2; 2020: 3.1
- Private consumption: 2015: 2.5; 2016: 1.4; 2017: 4.1; 2018: 4.5; 2019: 3.5; 2020: 3.2
- Public consumption: 2015: 1.9; 2016: 3.9; 2017: 4.1; 2018: 4.0; 2019: 3.0; 2020: 3.0
- Gross capital formation: 2015: 2.4; 2016: 2.5; 2017: 14.0; 2018: 15.1; 2019: 6.0; 2020: 5.0
- Gross fixed capital formation: 2015: -0.5; 2016: -8.4; 2017: 13.1; 2018: 16.4; 2019: 6.0; 2020: 5.0
- Exports of goods and services: 2015: 3.1; 2016: 4.4; 2017: 6.2; 2018: 1.8; 2019: 2.2; 2020: 2.3
- Imports of goods and services: 2015: 2.1; 2016: 4.4; 2017: 8.9; 2018: 5.1; 2019: 3.2; 2020: 3.2
- Nominal GDP (billions of euros): 2015: 24.3; 2016: 25.0; 2017: 27.0; 2018: 29.5; 2019: 31.4; 2020: 33.1
- GDP per capita (thousands of euros): 2015: 12.2; 2016: 12.7; 2017: 13.9; 2018: 15.3; 2019: 16.3; 2020: 17.2
- Gross national saving (percent of GDP): 2015: 21.8; 2016: 22.3; 2017: 22.9; 2018: 23.2; 2019: 23.0; 2020: 23.0
- Gross capital formation (percent of GDP): 2015: 22.2; 2016: 20.7; 2017: 22.2; 2018: 24.2; 2019: 24.4; 2020: 24.7
- HICP Inflation (period average): 2015: 0.2; 2016: 0.1; 2017: 2.9; 2018: 2.6; 2019: 2.7; 2020: 2.4
- Unemployment rate (LFS; period average, percent): 2015: 9.9; 2016: 9.6; 2017: 8.7; 2018: 7.4; 2019: 6.7; 2020: 6.9
- Real gross wages: 2015: 6.6; 2016: 4.9; 2017: 4.8; 2018: 5.7; 2019: 4.5; 2020: 4.5
- Consolidated general government: Total revenue (percent of GDP) 2015: 36.2; 2016: 36.2; 2017: 35.6; 2018: 36.9; 2019: 35.7; 2020: 35.7
- Total expenditure (percent of GDP): 2015: 37.8; 2016: 36.6; 2017: 36.4; 2018: 37.6; 2019: 36.4; 2020: 36.1
- Basic fiscal balance: 2015: -1.5; 2016: -0.4; 2017: -0.8; 2018: -0.7; 2019: -0.7; 2020: -0.4
- ESA balance: 2015: -1.4; 2016: 0.1; 2017: -0.6; 2018: -1.0; 2019: -0.5; 2020: -0.4
- General government gross debt (percent of GDP): 2015: 36.8; 2016: 40.3; 2017: 40.0; 2018: 35.9; 2019: 36.1; 2020: 34.4
- Credit to private sector (annual percentage change): 2015: -2.3; 2016: 3.5; 2017: -1.0; 2018: -5.6
- Current account balance (percent of GDP): 2015: -0.5; 2016: 1.6; 2017: 0.7; 2018: -1.0; 2019: -1.5; 2020: -1.6
- Gross external debt (percent of GDP): 2015: 143.7; 2016: 148.9; 2017: 140.5; 2018: 121.0; 2019: 117.4; 2020: 114.4
- Net external debt (percent of GDP): 2015: 30.7; 2016: 29.2; 2017: 25.5; 2018: 21.2; 2019: 23.7; 2020: 22.7
- Exchange rate: U.S. dollar per euro (period average) 2015: 1.11; 2016: 1.11; 2017: 1.13; 2018: 1.18

### Table 2. Latvia: Macroeconomic Framework, 2015–24 (estimates and projections)
- Real GDP (percent change): 2015: 3.0; 2016: 2.1; 2017: 4.6; 2018: 4.8; 2019: 3.2; 2020: 3.1; 2021: 3.1; 2022: 3.0; 2023: 3.0; 2024: 3.0
- HICP inflation (period average): 2015: 0.2; 2016: 0.1; 2017: 2.9; 2018: 2.6; 2019: 2.7; 2020: 2.4; 2021: 2.3; 2022: 2.2; 2023: 2.1; 2024: 2.1
- Unemployment rate (LFS, percent): 2015: 9.9; 2016: 9.6; 2017: 8.7; 2018: 7.4; 2019: 6.7; 2020: 6.9; 2021: 7.0; 2022: 7.2; 2023: 7.3; 2024: 7.3
- Consolidated general government: ESA balance (percent of GDP): 2015: -1.4; 2016: 0.1; 2017: -0.6; 2018: -1.0; 2019: -0.5; 2020: -0.4; 2021: -0.4; 2022: -0.2; 2023: -0.4; 2024: -0.3
- General government gross debt (percent of GDP): 2015: 36.8; 2016: 40.3; 2017: 40.0; 2018: 35.9; 2019: 36.1; 2020: 34.4; 2021: 33.4; 2022: 33.8; 2023: 32.3; 2024: 31.3
- Current account balance (percent of GDP): 2015: -0.5; 2016: 1.6; 2017: 0.7; 2018: -1.0; 2019: -1.5; 2020: -1.6; 2021: -2.1; 2022: -2.5; 2023: -2.8; 2024: -3.3
- Net IIP (percent of GDP): 2015: -63.5; 2016: -58.4; 2017: -56.3; 2018: -49.1; 2019: -48.4; 2020: -46.2; 2021: -44.8; 2022: -44.0; 2023: -43.7; 2024: -43.9
- Nominal GDP (billions of euros, memorandum): 2015: 24.3; 2016: 25.0; 2017: 27.0; 2018: 29.5; 2019: 31.4; 2020: 33.1; 2021: 34.9; 2022: 36.7; 2023: 38.6; 2024: 40.5

### Table 3. Latvia: General Government Operations, 2015–24 (percent of GDP unless noted)
- Revenue (percent of GDP): 2015: 36.2; 2016: 36.2; 2017: 35.6; 2018: 36.9; 2019: 35.7; 2020: 35.7; 2021: 34.2; 2022: 33.4; 2023: 33.6; 2024: 33.7
- Taxes (percent of GDP): 2015: 20.4; 2016: 21.1; 2017: 21.1; 2018: 20.3; 2019: 19.9; 2020: 20.1; 2021: 20.1; 2022: 20.0; 2023: 20.0; 2024: 20.0
  - Personal Income Tax: 2015: 5.9; 2016: 6.1; 2017: 6.3; 2018: 5.9; 2019: 5.6; 2020: 5.2; 2021: 5.1; 2022: 5.1; 2023: 5.1; 2024: 5.1
  - Corporate Income Tax: 2015: 1.6; 2016: 1.7; 2017: 1.6; 2018: 1.0; 2019: 0.6; 2020: 1.1; 2021: 1.1; 2022: 1.1; 2023: 1.1; 2024: 1.1
  - Value-added tax: 2015: 7.8; 2016: 8.1; 2017: 8.1; 2018: 8.3; 2019: 8.5; 2020: 8.6; 2021: 8.7; 2022: 8.8; 2023: 8.8; 2024: 8.8
- Social Contributions (percent of GDP): 2015: 8.4; 2016: 8.4; 2017: 8.3; 2018: 8.6; 2019: 8.7; 2020: 8.8; 2021–2024: 8.8
- Expenditure (percent of GDP): 2015: 37.8; 2016: 36.6; 2017: 36.4; 2018: 37.6; 2019: 36.4; 2020: 36.1; 2021: 35.5; 2022: 34.8; 2023: 34.0; 2024: 34.0
- Net lending/borrowing (percent of GDP): 2015: -1.5; 2016: -0.4; 2017: -0.8; 2018: -0.7; 2019: -0.7; 2020: -0.4; 2021: -1.3; 2022: -1.4; 2023: -0.4; 2024: -0.3
- ESA structural balance (percent of GDP): 2015: -1.4; 2016: 0.1; 2017: -0.9; 2018: -1.5; 2019: -1.1; 2020: -0.6; 2021: -0.5; 2022: -0.3; 2023: -0.4; 2024: -0.3
- General government debt (percent of GDP): 2015: 36.8; 2016: 40.3; 2017: 40.0; 2018: 35.9; 2019: 36.1; 2020: 34.4; 2021: 34.6; 2022: 33.8; 2023: 32.3; 2024: 31.3
- Nominal GDP (billions of euros, memorandum): same as Table 2 figures.

### Table 4. Latvia: Medium-Term Balance of Payments, 2015–24
- Current account (percent of GDP): 2015: -0.5; 2016: 1.6; 2017: 0.7; 2018: -1.0; 2019: -1.5; 2020: -1.6; 2021: -2.1; 2022: -2.5; 2023: -2.8; 2024: -3.3
- Goods (fob) balance (percent of GDP): 2015: -9.0; 2016: -7.5; 2017: -8.5; 2018: -8.7; 2019: -8.6; 2020: -8.7; 2021: -8.9; 2022: -9.1; 2023: -9.3; 2024: -9.6
- Exports (percent of GDP): 2015: 42.5; 2016: 41.6; 2017: 42.7; 2018: 41.0; 2019: 39.3; 2020: 38.2; 2021: 37.3; 2022: 36.5; 2023: 35.8; 2024: 35.1
- Imports (percent of GDP): 2015: -51.6; 2016: -49.1; 2017: -51.2; 2018: -49.7; 2019: -47.9; 2020: -46.9; 2021: -46.2; 2022: -45.6; 2023: -45.1; 2024: -44.7
- Gross reserves (billions of euros): 2015: 3.2; 2016: 3.3; 2017: 3.9; 2018: 3.8; 2019–2024: 3.8 (constant)
- Gross external debt (billions of euros): 2015: 34.9; 2016: 37.3; 2017: 38.0; 2018: 35.7; 2019: 36.8; 2020: 37.9; 2021: 39.1; 2022: 40.3; 2023: 41.6; 2024: 43.1
- Gross external debt (percent of GDP): 2015: 143.7; 2016: 148.9; 2017: 140.5; 2018: 121.0; 2019: 117.4; 2020: 114.4; 2021: 112.1; 2022: 109.7; 2023: 107.9; 2024: 106.2
- Net external debt (billions of euros): 2015: 7.5; 2016: 7.3; 2017: 6.9; 2018: 6.3; 2019: 7.4; 2020: 7.5; 2021: 7.8; 2022: 8.3; 2023: 9.0; 2024: 9.9
- Net external debt (percent of GDP): 2015: 30.7; 2016: 29.2; 2017: 25.5; 2018: 21.2; 2019: 23.7; 2020: 22.7; 2021: 22.2; 2022: 23.3; 2023: 24.4

### Table 5. Latvia: Financial Soundness Indicators, 2014–18 (commercial banks)
- Capital adequacy:
  - Regulatory capital to risk-weighted assets: 2014: 21.0; 2015: 21.8; 2016: 20.4; 2017: 20.8; 2018: 21.7
  - Regulatory Tier 1 capital to risk-weighted assets: 2014: 18.3; 2015: 19.3; 2016: 17.3; 2017: 18.5; 2018: 19.7
  - Capital and reserves to assets: 2014: 9.9; 2015: 10.1; 2016: 10.1; 2017: 11.1; 2018: 12.9
- Asset quality:
  - Annual growth of bank loans: 2014: -6.1; 2015: 0.1; 2016: 3.1; 2017: -4.6; 2018: -5.6
  - Annual growth of bank loans to residents: 2014: -7.6; 2015: -1.5; 2016: 3.1; 2017: -2.8; 2018: -5.4
  - Loans past due over 90 days (percent): 2014: 6.9; 2015: 4.6; 2016: 6.3; 2017: 5.5; 2018: 5.3
    - Loans to households past due over 90 days: 2014: 9.5; 2015: 7.6; 2016: 5.3; 2017: 3.5; 2018: 3.1
    - Loans to corporations past due over 90 days: 2014: 5.9; 2015: 4.4; 2016: 2.7; 2017: 3.1; 2018: 3.2
- Earnings and profitability:
  - ROA (after tax): 2014: 1.1; 2015: 1.2; 2016: 1.6; 2017: 1.0; 2018: 1.3
  - ROE (after tax): 2014: 11.1; 2015: 12.3; 2016: 16.6; 2017: 9.4; 2018: 10.1
- Liquidity:
  - Liquid assets to total assets: 2014: 39.9; 2015: 35.7; 2016: 30.4; 2017: 34.0; 2018: 30.0
  - Liquid assets to short term liabilities: 2014: 63.1; 2015: 46.5; 2016: 37.5; 2017: 42.1; 2018: 37.2
  - Customer deposits to (non-interbank) loans: 2014: 151.3; 2015: 157.0; 2016: 144.8; 2017: 140.7; 2018: 120.3
- Sensitivity to market risk:
  - FX deposits to total deposits: 2014: 40.3; 2015: 43.1; 2016: 34.2; 2017: 29.1; 2018: 13.7
  - FX loans to total loans: 2014: 13.0; 2015: 13.8; 2016: 12.5; 2017: 8.4

### Annex I. External Sector Assessment — key findings
- Net international investment position (NIIP):
  - Both foreign assets and liabilities declined in 2018.
  - Short-term liabilities of monetary and financial institutions decreased by 5.2 billion euros (55 percent), reflecting the withdrawal of foreign deposits.
  - NIIP improved to -49 percent of GDP in 2018, from -56 percent of GDP in 2017; expected to improve to -43 percent of GDP over the medium term.
  - Gross external debt stood at 121 percent of GDP at end-2018.
- Current account:
  - Current account deficit increased to 1 percent of GDP in 2018.
  - Drivers: slower export growth amid moderation in external demand, poorer agricultural output, and declining exports of financial services.
  - Projected to widen in 2019 and over the medium term as investment continues to be strong.
  - EBA-lite CA model: CA gap of 1.6 percent of GDP in 2018; policy gap amounts to 4.3 percent of GDP.
  - Assessment: current account position is moderately stronger than implied by fundamentals and desirable policies.
- Real exchange rate:
  - REER appreciated by 3.3 percent in 2018.
  - EBA-lite CA model suggests REER undervaluation of 3.8 percent.
  - EBA-lite REER Index model finds undervaluation of 7 percent.
  - Note: REER model is not well suited for Latvia; produces large residual and poor fit.
- Capital and financial accounts:
  - Capital account dominated by EU structural fund inflows, which improved markedly in 2018.
  - FDI inflows declined substantially from 2017.
  - Large outflows in other investment due to withdrawal of foreign deposits, financed partially by decline in banks’ holdings of foreign debt securities.
- FX intervention and reserves:
  - Euro has status of a global reserve currency; reserves held by euro area economies are typically low by standard metrics.
  - Reserves for Latvia: 12.5 percent of GDP as of end-2018; currency is free floating.
- Overall assessment:
  - Latvia’s external position in 2018 is assessed to be moderately stronger than implied by medium-term fundamentals and desirable policies.
  - A widening of the current account deficit from 2019 onwards is expected, on the back of a pick-up in investment.

- ESA Summary table (selected entries):
  - CA-Actual: -1.0%
  - Cyclically adjusted CA: -1.0%
  - Multilaterally Consistent Cyclically adjusted CA Norm: -2.7%
  - CA-Gap: 1.6%
  - of/which Policy gap: 4.3%
  - Elasticity: -0.43
  - Implied REER gap: -3.8%
  - CA-Fitted: 1.2%
  - Residual: -2.2%
  - Ln(REER) Actual: 4.64
  - Ln(REER) Fitted: 4.71
  - Ln(REER) Norm: 4.71
  - Residual: -0.07
  - REER Gap: -7.0%
  - of/which Policy gap: 0.4%

### Annex II. External Debt Sustainability Assessment — key findings and projections
- External debt developments:
  - Gross external debt declined markedly in 2018 to 121 percent of GDP, from 141 percent of GDP in 2017.
  - Decline driven by fall in foreign deposits: foreign deposits declined by 5.2 billion euros in 2018.
  - External debt of nonfinancial corporates and households declined slightly in 2018; foreign debt of non-bank financial institutions increased.
- Baseline projection:
  - Gross external debt is projected to continue to decline to 106 percent of GDP in 2024.
  - Current account balance excluding interest payments projected to deteriorate to a deficit of 1.5 percent of GDP in 2024, still well above debt-stabilizing level (-4.8 percent of GDP).
  - Gross financing needs projected to decline.
- Resilience to shocks:
  - External debt appears broadly resilient across shocks and historical scenarios.
  - Under all shocks, including the combined shock scenario, Latvia’s external debt-to-GDP ratio would be either below or only marginally higher than its 2018 level by 2024.
- Table 1. External Debt Sustainability Framework (selected figures, percent of GDP unless indicated):
  - Baseline gross external debt: 2014: 144.1; 2015: 143.7; 2016: 148.9; 2017: 140.5; 2018: 121.0; 2019: 117.4; 2020: 114.4; 2021: 112.1; 2022: 109.7; 2023: 107.9; 2024: 106.2
  - Debt-stabilizing non-interest current account: -4.7
  - Change in external debt (annual percentage-point change): 2014: 10.2; 2015: -0.4; 2016: 5.2; 2017: -8.4; 2018: -19.5; 2019: -3.7; 2020: -2.9; 2021: -2.4; 2022: -2.3; 2023: -1.9; 2024: -1.6
  - Identified external debt-creating flows (4+8+9): 2014: -4.4; 2015: -4.1; 2016: -5.7; 2017: -13.9; 2018: -13.5; 2019: -3.7; 2020: -3.0; 2021: -2.5; 2022: -2.0; 2023: -1.5; 2024: -1.0
  - Current account deficit, excluding interest payments: 2014: -1.5; 2015: -2.2; 2016: -3.9; 2017: -2.7; 2018: -0.8; 2019: -0.2; 2020: -0.1; 2021: 0.3; 2022: 0.7; 2023: 1.1; 2024: 1.6
  - Net non-debt creating capital inflows (negative): 2014: -1.4; 2015: -2.8; 2016: 0.0; 2017: -2.0; 2018: -2.1; 2019: -1.4; 2020: -1.3; 2021: -1.2; 2022: -1.2; 2023: -1.2; 2024: -1.1
  - Automatic debt dynamics contributions and other decomposition lines presented in table.
- Scenario and bound tests (summary):
  - Bound tests and shock scenarios (interest rate shock; real depreciation shock; current account shock; growth shock; combined shock) are presented with baseline and scenario averages; figures indicate resilience with baseline gross external debt reaching 106 (percent of GDP) by 2024 and scenario averages varying (examples: historical and scenario boxes display values such as 118, 117, 123, 122, 115 depending on scenario).

*Source: IMF staff calculations and Latvian authorities as presented in the PDF content unit.*

### Annex III. Public Sector Debt Sustainability Analysis (DSA)

### Annex III. Public Sector Debt Sustainability Analysis (DSA)

### Baseline scenario — key public debt and financing indicators (as of December 30, 2018)
- Nominal gross public debt (percent of GDP): 2017: 38.2; 2018: 40.0; 2019: 35.9; 2020: 34.6; 2021: 33.2; 2022: 32.9; 2023: 32.8; 2024: 31.7; projection in table for 2024: 30.6.
- Public gross financing needs (percent of GDP): 2017: 9.1; 2018: 4.9; 2019: 3.8; 2020: 5.2; 2021: 5.3; 2022: 6.3; 2023: 3.2; 2024: 2.3; later entry: 4.4 (table formatting).
- Real GDP growth (percent): 2017: -0.2; 2018: 4.6; 2019: 4.8; 2020: 3.2; 2021: 3.1; 2022: 3.1; 2023: 3.0; 2024: 3.0.
- Inflation (GDP deflator, percent): 2017: 1.7; 2018: 3.2; 2019: 4.2; 2020: 2.9; 2021: 2.3; 2022: 2.2; 2023: 2.1; 2024: 2.0.
- Nominal GDP growth (percent): 2017: 1.7; 2018: 8.0; 2019: 9.2; 2020: 6.2; 2021: 5.5; 2022: 5.4; 2023: 5.2; 2024: 5.1.
- Effective interest rate (percent): 2017: 4.0; 2018: 2.9; 2019: 2.6; 2020: 2.5; 2021: 2.9; 2022: 3.2; 2023: 3.2; 2024: 3.2.
- Sovereign spreads: EMBIG (bp) and 5Y CDS (bp) entries shown in table (EMBIG 51; 5Y CDS 58).

### Contribution to changes in public debt (percent of GDP)
- Change in gross public sector debt (annual): 2017: 3.6; 2018: -0.3; 2019: -4.0; 2020: -1.3; 2021: -1.4; 2022: -0.3; 2023: -0.1; 2024: -1.1. Cumulative: -5.3.
- Identified debt-creating flows (annual): 2017: 1.9; 2018: -3.8; 2019: -2.7; 2020: -1.2; 2021: -1.2; 2022: -0.1; 2023: 0.1; 2024: -0.9. Cumulative: -4.3.
- Primary deficit (percent of GDP): 2017: 1.7; 2018: -0.1; 2019: -0.1; 2020: 0.0; 2021: -0.4; 2022: 0.6; 2023: 0.7; 2024: -0.3. Cumulative: -0.3 then 0.3 (table entries across horizon).
- Primary (noninterest) revenue and grants (percent of GDP): 2017: 35.7; 2018: 35.5; 2019: 36.7; 2020: 35.6; 2021: 35.5; 2022: 34.0; 2023: 33.3; 2024: 33.5; cumulative: 33.5; total over projection horizon: 205.4.
- Primary (noninterest) expenditure (percent of GDP): 2017: 37.3; 2018: 35.3; 2019: 36.7; 2020: 35.6; 2021: 35.2; 2022: 34.6; 2023: 33.9; 2024: 33.2; cumulative: 33.2; total over projection horizon: 205.7.

### Automatic debt dynamics and components (percent of GDP)
- Automatic debt dynamics (annual contribution): 2017: 0.2; 2018: -3.7; 2019: -2.7; 2020: -1.2; 2021: -0.8; 2022: -0.7; 2023: -0.6; 2024: -0.6; cumulative: -4.6.
- Interest rate/growth differential (annual): 2017: -0.5; 2018: -2.7; 2019: -3.1; 2020: -1.2; 2021: -0.8; 2022: -0.7; 2023: -0.6; 2024: -0.6; cumulative: -4.6.
  - Of which: real interest rate: 2017: -0.2; 2018: -1.0; 2019: -1.3; 2020: -0.2; 2021: 0.2; 2022: 0.3; 2023: 0.3; 2024: 0.3; cumulative: 1.3.
  - Of which: real GDP growth: 2017: -0.3; 2018: -1.7; 2019: -1.7; 2020: -1.1; 2021: -1.0; 2022: -1.0; 2023: -1.0; 2024: -0.9; cumulative: -5.9.
- Exchange rate depreciation contribution (annual): 2017: 0.7; 2018: -1.0; 2019: 0.4; 2020 onward: not shown (dots).
- Residual, including asset changes (annual): 2017: 1.7; 2018: 3.5; 2019: -1.3; 2020: -0.1; 2021: -0.2; 2022: -0.2; 2023: -0.2; 2024: -0.2; cumulative: -1.0.

### Definitions and modeling notes (as provided)
- Public sector is defined as general government.
- Effective interest rate defined as interest payments divided by debt stock (excluding guarantees) at the end of previous year.
- Automatic debt dynamics derived using formula in footnote 5 with r = interest rate; π = growth rate of GDP deflator; g = real GDP growth rate; a = share of foreign-currency denominated debt; e = nominal exchange rate depreciation (local currency value increase of U.S. dollar).
- Real interest rate contribution derived as r - π (1+g); real growth contribution derived as -g.
- Exchange rate contribution derived as ae(1+r).
- Residual includes asset changes and interest revenues (if any); projections include exchange rate changes during the projection period.
- Debt-stabilizing balance scenario assumes key variables (real GDP growth, real interest rate, and other identified debt-creating flows) remain at the level of the last projection year.

*Source: IMF staff.*

---

### Table 2. Composition of public debt and alternative scenarios

### Underlying assumptions (selected)
- Baseline: Real GDP growth (percent): 2019: 3.2; 2020: 3.1; 2021: 3.1; 2022: 3.0; 2023: 3.0; 2024: 3.0. Inflation (percent): 2019: 2.9; 2020: 2.3; 2021: 2.2; 2022: 2.1; 2023: 2.0; 2024: 2.0. Primary Balance (percent of GDP): 2019: 0.0; 2020: 0.4; 2021: -0.6; 2022: -0.7; 2023: 0.3; 2024: 0.3. Effective interest rate (percent): 2019: 2.5; 2020: 2.9; 2021–2024: 3.2/3.2/3.2/3.2/3.2 (table entries).
- Historical scenario: Real GDP growth (percent) 2019–2024: 3.2; 1.1; 1.1; 1.1; 1.1; 1.1. Inflation mirrors baseline. Primary Balance (percent of GDP) 2019–2024: 0.0; -1.2; -1.2; -1.2; -1.2; -1.2. Effective interest rate higher in projections relative to baseline (e.g., 2019: 2.5; 2020: 2.9; 2021: 3.5; 2022: 3.8; 2023: 3.9; 2024: 4.1).
- Constant Primary Balance Scenario: Primary Balance 2019–2024: 0.0; effective interest rate similar to baseline.
- Contingent Liability Shock: Real GDP growth path includes a negative shock in 2020–2021 (e.g., 2020: -3.0; 2021: -3.0); Inflation lower in early years (2019: 2.9; 2020: 0.8; 2021: 0.7); Primary Balance shows a large deterioration -5.5 in 2020 then -0.6, -0.7, then recovery to 0.3; Effective interest rate elevated (table shows 2019: 2.5; 2020: 3.4; 2021–2024: 3.3/3.3/3.3/3.3).

### Composition and projections (figures summarized)
- Gross nominal public debt and public gross financing needs are presented as projections by year (2017–2024) showing declining gross debt ratios under baseline and varying financing needs over the projection horizon.
- Debt by maturity: breakdown into medium and long-term versus short-term stocks across 2008–2024 projection.
- Debt by currency: local currency-denominated versus foreign currency-denominated shares across 2008–2024 projection.

*Source: IMF staff.*

---

### Annex IV. Modeling the impact of domestic risks to the outlook — scenarios, calibration, and impacts

### Context and motivation
- Refocusing the troubled BSFC sector and reviving credit growth depends on completing AML/CFT and insolvency reforms.
- Renewed money laundering concerns could cause bank failures or withdrawal of parent support for foreign bank subsidiaries/branches; deficiencies in insolvency administration lower recovery rates and raise cost of capital.

### Scenarios simulated (GIMF model)
- AML/CFT Mild Adverse Scenario [1a]:
  - ABLV’s protracted liquidation leads to persistent system-wide AML/CFT concerns for BSFCs.
  - Raises perceived sovereign risk due to implicit contingent liabilities; increases external financing cost of corporate borrowers.
  - Calibration: temporary but persistent nominal shock to short-term government bond premium (GBPREM) with initial increase of 56 bps in the first year, decaying by 50 percent each subsequent year; perfect pass-through to bank lending rates; shock to external finance premium (XFP) by 131 bps.
- AML/CFT Severe Adverse Scenario [1b]:
  - Additional BSFCs fail; banks reduce lending due to constrained parent funding; funding of deposit insurance depleted; contingent liabilities become explicit.
  - Calibration: GBPREM and XFP shocks doubled (relative to 1a); deteriorating investor confidence affects equity market; NFC lending rate shock more persistent (consistent with GBPREM shock).
  - Modeled as short-term shock to equity risk premium of about 6.5 percent (equivalent to a drop in the equity market by about 2 percent).
- Insolvency Regime, Benign Scenario [2a]:
  - Reputational damage contained; insolvency reforms fully effective; asset recovery rates converge to EU average.
  - Calibration: bankruptcy costs decline permanently by 15 percent (phased in over three years), implying an increase in recovery rate of 9.6 percent.
- Insolvency Regime, Less Benign Scenario [2b]:
  - Reforms less effective; muted improvement in recovery rates.
  - Calibration: bankruptcy costs fall by 5 percent phased over 5 years, implying recovery rate increase of 3.2 percentage points (noted elsewhere in the document).

### Calibration basis and historical reference points
- Since end-2017, BSFC deposits dropped from €8 billion to €3.3 billion.
- Corporate lending spread increased to more than 6 percent, remaining elevated by about 1.4 percentage points relative to pre-ABLV level.
- Latvia’s sovereign spread (10-year) to German Bunds widened to about 80 basis points and remains 34 bps higher than pre-ABLV level.
- External finance premium (XFP) defined as difference between corporate lending rate for loans of EUR 1 mln. or less and the 10-year Latvian sovereign yield.
- Long-term average XFP: 3.28 percent (Jan. 2014 to Feb. 2018).
- Government risk premium (GBPREM) defined as difference between 10-year sovereign yields for Latvian and German government bonds; long-term average 0.74 percent (Jan. 2014 to Feb. 2018).

### Simulation results — adverse scenarios (selected outcomes)
- Severe adverse scenario (1b) reduces real GDP growth by 4.5 percent on average over the medium term.
- Under severe scenario, real GDP declines by up to 1.5 percent and real investment declines by up to 11.5 percent at peak.
- Adverse scenarios produce negative effects on REER, primary surplus (percent of GDP), corporate leverage, and other macro variables (figures present time paths t0 to Y10).

### Simulation results — benign insolvency reform scenarios (selected outcomes)
- Under benign insolvency reform (2a), a 15 percent permanent reduction in bankruptcy costs:
  - Increases asset recovery rate by 9.6 percent.
  - Lifts real GDP growth by 3.4 percent on average over the medium term.
  - Real GDP and investment increase by 1.1 percent and 9.0 percent, respectively, after two years.
  - Higher asset recovery (by almost 10 percent) could raise sustainable corporate leverage sufficiently to offset a negative sovereign premium shock equivalent to that in adverse scenarios over the medium term.
- Under less benign scenario (2b), smaller and slower benefits: bankruptcy costs fall by 5 percent over 5 years, recovery increases modestly and impacts on GDP/investment are correspondingly smaller.

*Source: IMF staff calculations.*

---

### Annex V. Estimating potential growth — baseline, key assumptions, and risks

### Staff central estimate
- Staff estimates potential growth to be around 3 percent over the medium term.
- Production function approach baseline assumptions and numbers (selected):
  - Capital: current capital-output ratio of 3; assumed depreciation rate 4 percent; projected investment rate 5 percent; capital growth 4 percent.
  - Labor: contribution of labor to potential growth projected to become negative in the medium term due to demographic trends; 2018 UN projections suggest population and working age population will decline by about 1 percentage point annually.
  - TFP growth: long-term historical average about 1.5 percent; baseline assumes TFP growth settles at about 1.5 percent.

### Numerical baseline projections (selected table entries)
- Projected GDP growth: 2024: 3.8; 2025–202? (table shows "Proj. GDP Growth 3.8 3.0 3.0" across columns—retain structure as in source).
- Potential growth contributions (selected):
  - Capital contribution: 2.4; 1.5; 2.3 (table columns reflect historical, recent, and projection values).
  - Capacity utilization: 0.6; 1.0; 0.0.
  - Labor: -0.1; 0.2; -0.7.
  - Average hours worked: -0.6; -0.1; 0.0.
  - TFP growth: 1.5; 0.5; 1.5.
- Long-run potential growth contributions (table):
  - Average growth in 2024: GDP Growth 3.0; Capital 2.3; Labor -0.7; TFP Growth 1.5.
  - Average growth in 2025–50: GDP Growth 1.6; Capital 0.9; Labor -0.6; TFP Growth 1.3.

### Risks to the baseline and alternative outcomes
- Downside scenario:
  - If credit growth remains subdued and capital accumulation weak (as in 2012–18) and/or TFP growth falls to 0.5 percent (recent historical average), potential growth could be 1–2 percentage points lower than baseline.
- Upside scenario:
  - If working age population remains relatively stable and/or credit growth recovers faster (increasing investment by 1½–3 percentage points of GDP and capital contribution by ¼–¾ percentage points), medium-term potential growth could be up to 1½ percentage points higher.
- Very long-term demographic effect:
  - Demographics projected to reduce potential growth by 1.4 percentage points on average in 2020–50 (indirect negative effect from declining labor and balanced growth path implication for capital accumulation).
  - Increased share of workers above age 55 expected to reduce TFP growth by 0.2 percentage points.

*Source: IMF staff calculations.*

### Annex VI. Further Investigation of Credit Constraints

### Annex VI. Further Investigation of Credit Constraints

### Overview
- Despite record low interest rates and solid growth outturns, credit growth in Latvia has remained anemic; bank lending to households and non-financial corporations (NFCs) has been sluggish even though solvency and liquidity conditions in the banking sector remain robust and private sector indebtedness has reached record lows.
- The credit-to-GDP gap remains deeply negative.
- Several supply and demand factors contribute to the ongoing weak credit growth.

### Supply Side Effects
- Deposit-rate stickiness and compressed bank profitability
  - Adoption of negative interest rate policy (NIRP) in June 2014 transmitted efficiently to lower lending rates given the high share of variable rate lending.
  - Even after more than 3½ years of NIRP, the weighted average deposit rate in Latvia still stood at 1.13 percent at end-February 2019.
  - Deposit rates for households and non-financial corporates were 1.17 percent and 0.79 percent, respectively.
  - Net interest margins (NIMs) have compressed as lending rates for new loans declined and existing (variable rate) loans re-priced while deposit rates have not adjusted as quickly.
  - AML/CFT breaches by BSFCs might have introduced an “economic lower bound” of deposit rates (well above zero) to offset diminished depositor confidence and the substantial decline of non-resident deposits due to aggressive de-risking by BSFCs.
  - Given the declining marginal rate of return from lending, most banks seem to prefer preserving high capital and liquidity buffers rather than lending.
  - Banks could temporarily increase lending volumes to offset higher adjustment costs in setting deposit rates at the cost of deviating temporarily from the minimum capital requirement.

- Increased caution on borrower debt-servicing capacity
  - Although lower lending rates eased borrowers’ financial constraints, debt-to-income ratios of both households and NFCs have bottomed out.
  - Potential deterioration in long-term debt affordability would necessitate tightening lending standards to avoid higher asset impairment levels.
  - Lending standards have remained strict since the crisis, and lending conditions for long-term loans have become increasingly stringent as the stock of non-performing loans to NFCs has leveled off.
  - Access to credit remains more difficult in Latvia than elsewhere in the region.

- Insolvency regime and creditor recovery
  - Persistent gaps in the insolvency regime may weigh on investment and restrain credit growth by raising the cost-efficient origination of new loans.
  - The recovery rate of creditors’ claims remains low by international comparison; insolvency proceedings can be excessively long and complicated, raising the cost of bank lending.
  - The riskiness of corporate lending remains one of the highest in the euro area (with credit risk-weights for some larger banks above 80 percent).

### Ensuring High Standards of Insolvency Administrators (policy recommendations and findings from Box 1)
- Strengthened framework to date
  - Insolvency administrators are subject to a comprehensive legal framework covering licensing, appointment and supervision.
  - Following the 2016 Guidelines, the Ministry of Justice introduced new regulations on training and examination, tightened disciplinary processes, and improved record-keeping requirements.
  - Positive effects observed in: (i) licensing and examination procedures; (ii) registration and selection; (iii) reporting duties and professional standards (code of conduct); and (iv) enhanced supervision of administrators.

- Remaining deficiencies and recommended reforms
  - Licensing
    - Criteria for the evaluation of a candidate’s reputation are not well defined; clear and objective rules would increase transparency and help prevent arbitrary decision-making.
    - Frequent re-validation requirements make licensing very burdensome and adversely impact the effectiveness of ongoing insolvency proceedings.
    - The current licensing period of two years should be extended, and administrators should be allowed to conclude cases for which they were validly appointed.
  - Selection process
    - As of January 2019, administrators are randomly selected by the court from a candidate list using a fully automatic and electronic mechanism. This ensures independence and impartiality but does not consider administrators’ area of expertise.
    - Recommendation: grouping administrators in rosters organized by areas and levels of expertise and type of borrower to encourage specialization, especially for large or complex firms.
  - Appointment in bank resolution
    - Under Section 1(34f) of the Credit Institutions Law, administrators are appointed by the court upon recommendation by the FCMC.
    - In liquidation cases following withdrawal of a bank license due to AML/CFT breaches, recent amendments empower the FCMC to appoint administrators and oversee liquidation.
    - Recommendation: for bank liquidation outside AML/CFT cases, consider greater FCMC involvement or an administrative liquidation framework enabling the FCMC to commence and carry out liquidation proceedings.
  - Compensation and legal protection
    - In cases without assets or where recovery values are low, the deposit of two salaries is reportedly used to satisfy expenses, leaving nothing to pay administrators’ remuneration.
    - Recommendation: remedy by limiting expenses to 50 percent of the asset value and/or allocating a prorated amount of the deposit to cover the administrator’s remuneration.
    - For high-value cases, the insurance coverage for potential damages caused by administrators to third parties is too low and should be aligned with the respective asset value.
  - Note on eligibility and examination
    - Only a natural person older than 25 years who has a law degree, is fluent in Latvian, has at least three years of work experience, has passed the insolvency administrator’s exam, and has an impeccable reputation may be licensed as an insolvency administrator.
    - A rigorous examination procedure requires completion of a training course and examination on insolvency law and practice, and periodic recertification.

### Demand Side Effects
- Informal economy and borrower exclusion
  - Recent estimates suggest Latvia’s shadow economy stands at more than 20 percent of GDP—significantly above peer countries.
  - More than 10 percent of the working age population carries out undeclared activities.
  - The use of “envelope” wages is widespread; underreported corporate profits represent a sizeable share of actual corporate profits.
  - Many potential borrowers may be excluded from bank lending on the basis of reported income.

- Investment and corporate financing behavior
  - ECB’s Bank Lending Survey: about a fifth of all reporting banks saw a net increase of loan demand from large corporates and SMEs in 2019Q1.
  - Reforms to the insolvency regime improved the legal environment for debt restructuring, helping increase debt service capacity in rapidly growing sectors (construction and manufacturing).
  - Despite a reversal in the decline of loan demand by large enterprises, the recent pickup in corporate profitability continues to encourage internal financing.
  - Risk aversion among corporates remains high; business confidence is still subdued.
  - NFC’s investment rate at just above 20 percent is   about half of their  profit share.
  - The microenterprise regime may incentivize firms to remain small, holding back investment to grow; the new corporate tax regime encourages the use of internal funding for investment.

### Shadow Banking and Non-Bank Finance
- Growth and size
  - The size of the shadow banking sector has doubled over the last five years.
  - The monitoring universe of non-bank financial intermediation (MUNFI) was 66 percent of GDP (compared to a euro area average of nearly 400 percent).
  - Non-bank lending represented almost 20 percent of total credit at end-2018 (up from 10 percent at end-2013).
  - Non-bank lending has grown consistently by more than 10 percent year-on-year since 2016.

- Composition and borrowers
  - Leasing companies provided the bulk of non-bank finance at about 8 percent of GDP at end-2018, mostly to NFCs (about three-quarters).
  - Non-bank lending to households is smaller but has grown more rapidly.
  - In 2018, a large number of new house purchases were self-financed, reflecting the low household debt-to-GDP ratio of about 20 percent in Latvia.

- Sectoral contribution
  - Other financial institutions (OFIs), including captive financial institutions and money lenders, leasing companies, investment funds, and other credit intermediation, have been the largest contributor to the rise in non-bank lending.

*Source: Annex VI. Further Investigation of Credit Constraints (IMF staff analysis contained in the provided content).*

### 9.      Government supported programs have had mixed success in lifting credit demand. In

### 9.      Government supported programs have had mixed success in lifting credit demand. In

### Effectiveness of government-supported credit programs
- State guarantee program for mortgage loans: effective in lifting credit demand, but "with some negative side effects of significantly raising the average LTV."
- Lending programs for SMEs and student and academic loans: underused.

### Design and targeting details noted
- The Latvian government does not provide direct subsidies for house purchase; however, it is possible to obtain a state loan guarantee for the down payment of between 10 and 20 percent for families with children and young professionals.
- Making the current system more transparent and efficient is identified as a way to improve takeup and broaden access to educational opportunities, with significant productivity gains in the future.

### Data, institutional, and surveillance context relevant to program assessment
- Membership Status: Joined May 19, 1992; Article VIII.
- Quota: 332.30  100.00
- Fund holdings of currency (Exchange Rate): 332.26  99.99
- Reserve Tranche Position: 0.06  0.02
- Net cumulative allocation (SDR Department): 120.82  100.00
- Holdings (SDR Department): 120.82  100.00
- Latest financial arrangements (selected):
  - Stand-By: Date of Arrangement Dec 23, 2008; Expiration Date Dec 22, 2011; Amount Approved (SDR Million) 1,521.63; Amount Drawn (SDR Million) 982.24
  - Stand-By: Date of Arrangement Apr 20, 2001; Expiration Date Dec 19, 2002; Amount Approved (SDR Million) 33.00; Amount Drawn (SDR Million) 0.00
  - Stand-By: Date of Arrangement Dec 10, 1999; Expiration Date Apr 09, 2001; Amount Approved (SDR Million) 33.00; Amount Drawn (SDR Million) 0.00
- Projected Payments to Fund (SDR Million): Principal 2019 0.00  2020 0.00  2021 0.00; Charges/Interest 2019 0.00  2020 0.00  2021 0.00; Total 2019 0.00  2020 0.00  2021 0.00
- Exchange rate arrangement: As of January 1, 2014, the currency of Latvia is the euro, which floats freely and independently against other currencies. On January 1, 2005, the lat was re-pegged to the euro at the rate 1 euro = 0.702804 lats, and on April 29, 2005, Latvia entered ERM II.
- Assessment of Data Adequacy for Surveillance — General: Data provision to the Fund for surveillance purposes is adequate (A).
- Latvia is a subscriber of the Special Data Dissemination Standard (SDDS) Plus since August 2018.

### Findings and policy implications
- Findings:
  - State mortgage guarantee program increased mortgage credit demand but had the adverse effect of raising average loan-to-value (LTV).
  - SME lending and student/academic loan programs are not achieving expected uptake.
  - Greater transparency and efficiency in program design and delivery could increase takeup, expand access to education, and yield future productivity gains.
- Policy implications:
  - Review and calibrate mortgage guarantee design to mitigate increases in average LTV while preserving access.
  - Enhance transparency and operational efficiency of SME and student loan programs to raise utilization.
  - Consider targeted measures to broaden access to educational financing to capture potential productivity gains.

*Prepared By European Department — REPUBLIC OF LATVIA STAFF REPORT FOR THE 2019 ARTICLE IV CONSULTATION—INFORMATIONAL ANNEX (July 22, 2019).*

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_Source: https://www.imf.org/-/media/files/publications/cr/2019/1lvaea2019001.pdf_