## 1. Asset Composition of Pension Plans

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### A. System architecture and rules
- Latvia has a three-pillar pension system: two mandatory and one voluntary pillar.
- Pillar I: state compulsory, pay-as-you-go (PAYG), notional defined-contribution (NDC) system with nearly universal coverage; pensions indexed to inflation plus 50-80 percent of real wage growth.
- Pillar II: mandatory fully-funded defined contribution (FDC) pension scheme; persons born after July 1, 1971, and at least 15 years old are automatically registered; funded part is state administered (record keeping public, investment privately managed).
- Pillar III: voluntary private pension scheme (launched July 1998); payouts from age 55.
- Participation and contribution rules:
  - Covers most employees and self-employed.
  - Self-employed persons with income lower than the minimum wage contribute 10 percent of their income (compared to the 20 percent rate for employees).
  - The self-employed having income at least at the minimum wage or exceeds it, contribute for the old age pension the 20 percent from a freely chosen object, which is not smaller than the amount of the minimum wage, and 10 percent from the difference of the income and the freely chosen object (OECD, 2023).
  - Social insurance contribution rate for state old-age pensions (NDC + FDC) is 20 percent of the gross wage: employees pay 7.5 percent and employers pay 12.5 percent.
  - Of the 20 percent, 15 percent is allocated to the PAYG system (pillar I) and 5 percent to the funded mandatory system (pillar II).
- Minimum insurance period: increased to 20 years effective 1 January 2025. Minimum pensions are granted to people who fulfill the 20-year contribution condition for regular pensions.
- Retirement age: effective January 2025, the retirement age for both men and women is 65 years. Since 1 January 2014 the retirement age has been increasing by three months every year and is 65 years effective 1 January 2025.

### B. Asset volumes, composition, and returns
- Aggregate asset volumes:
  - Second pillar pension assets: almost EUR 8.8 billion (21.9 percent of GDP or 51 percent of the total assets of the nonbank financial sector) (Bank of Latvia, 2025).
  - Third pillar assets: almost EUR 1 billion (2.5 percent of GDP or 5.7 percent of the total assets of the nonbank financial sector) (Bank of Latvia, 2025).
- Returns:
  - Nominal average annual return on pension assets over the last 10 years: around 2 percent.
  - Staff analysis: the low rate of return is a key factor behind the projected decline in replacement rates.
- Recent asset composition indicators (2024Q4):
  - State funded pension scheme asset composition:
    - Other, 2%
    - Claims on credit institutions, 17%
    - Debt securities and other fixed-income securities, 2%
    - Shares and other variable-yield securities, 79%
    - Investment certificates of investment funds and similar securities, 0.01%
  - Private pension plans asset composition:
    - Other, 4%
    - Claims on credit institutions, 27%
    - Debt securities and other fixed-income securities, 1%
    - Shares and other variable-yield securities, 68%
    - Investment certificates of investment funds and similar securities, 0.19%
- Bank of Latvia measure to reduce management fees charged by pension fund managers resulted in savings of 0.2 percent of GDP. The measure differentiates traditional from alternative investments and could incentivize increased allocations for longer-term investments.

### C. Current fiscal and adequacy indicators
- Government pension spending as a share of GDP over the last 5 years: 7.9–8.7 percent for most years, except 2023 when it increased to 10 percent of GDP due to high inflation.
- In the 2025 budget, contributions equivalent to 1 percent of GDP from pillar II were diverted to the unfunded public system (pillar I).
- Replacement rate definition: the ratio of the first pension of those who retire each year over an economy-wide average wage at retirement.
- EC’s 2024 Ageing Report projection for Latvia (pillar I replacement rate): decline from 56 percent to 24 percent during 2022-2050 (largest decline among EU states per the report).
- Old-age dependency ratio (defined as the ratio of persons aged 65 and older to persons aged 20-64): projected to increase from 36 to 61 percent over 2022-2070.
- Population projection: population is projected to continue shrinking by a third between 2022 and 2070.

### D. Adequacy challenges, poverty, and distributional concerns
- Main risks:
  - Latvia’s current low and declining benefit ratio risks inadequate retirement income and higher old-age poverty, particularly among those older than 75 years and among women.
- Poverty indicators:
  - Latvia’s 65+ at-risk-of-poverty rate: in line with Estonia but above Lithuania and the euro area average over the last decade; in 2024, Latvia had the highest 65+ at-risk-of-poverty rate in the EU (Eurostat, EU-SILC dataset).
- Recent reforms and their effects:
  - Recent pension reforms aimed at addressing poverty have improved or maintained pensions’ role in protecting against poverty for some groups, but most reforms will result in lower replacement rates in the future, reducing pension entitlements from public pension schemes.
- Demographic drivers exacerbating adequacy challenges:
  - Population aging driven by low fertility and high emigration of young people.
  - Life expectancy is low (second lowest in Europe after Lithuania).
  - Cumulative net migration in 2019-2070 is projected to be negative for Latvia (EC, 2021).

### E. Policy recommendations and reform options
- Fiscal and revenue actions:
  - Increase revenue and reorient and rationalize spending to help finance higher pension spending needed for adequacy.
  - Build fiscal buffers to support medium- and long-term pressures arising from higher pillar I spending.
    - Staff estimates show revenue and spending measures could deliver 3 percent of GDP over 2026-2030; proceeds could relieve current and future spending pressures and ensure fiscal sustainability.
- Pillar-specific measures:
  - Increase contribution rates and the returns to the mandatory defined contribution pension pillar.
  - Strengthen incentives for higher voluntary savings for retirement (pillar III).
  - Improve the governance and investment strategies of pillar II to seek higher long-term returns (including lifecycle default options).
  - Strengthen pillars II and III to improve adequacy and reduce burden on pillar I; increase contribution rates to the mandatory defined contribution pension pillar to raise allocations to pension capital without raising fiscal pressures.
  - Increase returns to pillars II and III by changing the asset composition of retirement savings to include more equity and other long-term investments; a prudent increase in equities and alternative investments would increase returns.
  - Strengthen incentives for higher voluntary (pillar III) savings through a more flexible and accessible system design, including:
    - Providing tax incentives to businesses that offer pillar III to employees.
    - Auto-enrollment into voluntary pension schemes with an opt-out option.
- Labor market and demographic measures:
  - Adopt active labor market policies to increase labor force participation.
  - Incentivize pensioners to work.
  - Link retirement ages to future life expectancy gains.
- Comprehensive approach:
  - Take a comprehensive approach to cushion the effects of population aging while improving pension adequacy.

*Source: Extracted from “ENSURING ADEQUATE AND AFFORDABLE PENSIONS IN LATVIA,” Republic of Latvia, International Monetary Fund, July 31, 2025.*

### 1. Asset Composition of Pension Plans ________________________________________________ 6

### 1. Asset Composition of Pension Plans

### A. System architecture and rules
- Latvia has a three-pillar pension system: two mandatory and one voluntary pillar.
- Pillar I: state compulsory, pay-as-you-go (PAYG), notional defined-contribution (NDC) system with nearly universal coverage; pensions indexed to inflation plus 50-80 percent of real wage growth.
- Pillar II: mandatory fully-funded defined contribution (FDC) pension scheme; persons born after July 1, 1971, and at least 15 years old are automatically registered; funded part is state administered (record keeping public, investment privately managed).
- Pillar III: voluntary private pension scheme (launched July 1998); payouts from age 55.
- Participation: covers most employees and self-employed. Note on self-employed contributions: self-employed persons with income lower than the minimum wage contribute 10 percent of their income (compared to the 20 percent rate for employees). The self-employed having income at least at the minimum wage or exceeds it, contribute for the old age pension the 20 percent from a freely chosen object, which is not smaller than the amount of the minimum wage, and 10 percent from the difference of the income and the freely chosen object (OECD, 2023).
- Social insurance contribution rate for state old-age pensions (NDC + FDC) is 20 percent of the gross wage: employees pay 7.5 percent and employers pay 12.5 percent. Of the 20 percent, 15 percent is allocated to the PAYG system (pillar I) and 5 percent to the funded mandatory system (pillar II).
- Minimum insurance period: increased to 20 years effective 1 January 2025. Minimum pensions are granted to people who fulfill the 20-year contribution condition for regular pensions.
- Retirement age: effective January 2025, the retirement age for both men and women is 65 years. Since 1 January 2014 the retirement age has been increasing by three months every year and is 65 years effective 1 January 2025.

### B. Asset volumes, composition, and returns
- Second pillar pension assets: almost EUR 8.8 billion (21.9 percent of GDP or 51 percent of the total assets of the nonbank financial sector) (Bank of Latvia, 2025).
- Third pillar assets: almost EUR 1 billion (2.5 percent of GDP or 5.7 percent of the total assets of the nonbank financial sector) (Bank of Latvia, 2025).
- Nominal average annual return on pension assets over the last 10 years: around 2 percent.
- Staff analysis: the low rate of return is a key factor behind the projected decline in replacement rates.
- Recent asset composition indicators (2024Q4):
  - Asset composition of the state funded pension scheme: Other, 2%; Claims on credit institutions, 17%; Debt securities and other fixed-income securities, 2%; Shares and other variable-yield securities, 79%; Investment certificates of investment funds and similar securities, 0.01%.
  - Asset composition of private pension plans: Other, 4%; Claims on credit institutions, 27%; Debt securities and other fixed-income securities, 1%; Shares and other variable-yield securities, 68%; Investment certificates of investment funds and similar securities, 0.19%.
- Bank of Latvia measure to reduce management fees charged by pension fund managers resulted in savings of 0.2 percent of GDP. The measure differentiates traditional from alternative investments and could incentivize increased allocations for longer-term investments.

### C. Current fiscal and adequacy indicators
- Government pension spending as a share of GDP over the last 5 years: 7.9–8.7 percent for most years, except 2023 when it increased to 10 percent of GDP due to high inflation.
- In the 2025 budget, contributions equivalent to 1 percent of GDP from pillar II were diverted to the unfunded public system (pillar I).
- Replacement rate definition: the ratio of the first pension of those who retire each year over an economy-wide average wage at retirement.
- EC’s 2024 Ageing Report projection for Latvia (pillar I replacement rate): decline from 56 percent to 24 percent during 2022-2050 (largest decline among EU states per the report).
- Old-age dependency ratio (defined as the ratio of persons aged 65 and older to persons aged 20-64): projected to increase from 36 to 61 percent over 2022-2070.
- Population projection: population is projected to continue shrinking by a third between 2022 and 2070.

### D. Adequacy challenges, poverty, and distributional concerns
- Latvia’s current low and declining benefit ratio risks inadequate retirement income and higher old-age poverty, particularly among those older than 75 years and among women.
- Latvia’s 65+ at-risk-of-poverty rate: in line with Estonia but above Lithuania and the euro area average over the last decade; in 2024, Latvia had the highest 65+ at-risk-of-poverty rate in the EU (Eurostat, EU-SILC dataset).
- Recent pension reforms aimed at addressing poverty have improved or maintained pensions’ role in protecting against poverty for some groups, but most reforms will result in lower replacement rates in the future, reducing pension entitlements from public pension schemes.
- Demographic drivers: population aging in Latvia is driven by low fertility and high emigration of young people; life expectancy is low (second lowest in Europe after Lithuania); cumulative net migration in 2019-2070 is projected to be negative for Latvia (EC, 2021).

### E. Policy recommendations and reform options
- Increase revenue and reorient and rationalize spending to help finance higher pension spending needed for adequacy.
- Increase contribution rates and the returns to the mandatory defined contribution pension pillar.
- Strengthen incentives for higher voluntary savings for retirement (pillar III).
- Improve the governance and investment strategies of pillar II to seek higher long-term returns (including lifecycle default options).
- Adopt active labor market policies to increase labor force participation.
- Incentivize pensioners to work.
- Link retirement ages to future life expectancy gains.
- Take a comprehensive approach to cushion the effects of population aging while improving pension adequacy.

*Source: Extracted from “ENSURING ADEQUATE AND AFFORDABLE PENSIONS IN LATVIA,” Republic of Latvia, International Monetary Fund, July 31, 2025.*

### 8. Efforts to ensure fiscal sustainability through reduced pension spending often conflict

### 8. Efforts to ensure fiscal sustainability through reduced pension spending often conflict with social sustainability by undermining the financial well‑being of retirees

### Key findings
- Demographics worsen but pension spending is projected to decline due to the declining benefit ratio.
- EC’s 2024 Ageing Report projects a decline in the gross public pension expenditure-to-GDP ratio in Latvia from 7 percent of GDP in 2025 to 5.4 percent of GDP in 2070.
- The decline in the benefit ratio and replacement rate of Latvia’s public (PAYG) pillar is driven by switching part of the public old-age scheme into privately funded schemes; public provision decreases while the private mandatory part increases (Ministry of Welfare of Latvia, 2023).
- The projected drop in public pension expenditure raises concerns about adequacy of pension income for those relying on public pensions and will increase social pressure on the state pension system.

### Scenarios and projections (pillar I only)
- If the benefit ratio remains at the 2024 level:
  - Fiscal deficit increases from 3.7 percent of GDP in 2026 to 4.6 percent of GDP in 2034.
  - Public debt increases from 48.4 percent of GDP to 56.8 percent of GDP over 2026-2034.
- If Latvia’s benefit ratio converges to the average EU benefit ratio:
  - Fiscal deficit increases from 4.1 percent of GDP to 7 percent of GDP over 2026-2034.
  - Public debt increases from 49 percent of GDP to 67.6 percent of GDP over 2026-2034.
- Conclusion: Using a more realistic (higher) benefit ratio will put stronger upward pressure on the fiscal deficit and public debt.

### Impact when pillar II is included
- Including pillar II benefit ratio (illustrative scenario) reduces medium‑term fiscal pressures relative to pillar I only:
  - Fiscal deficit is about 0.4 percent of GDP lower on average in the medium term.
  - Public debt is about 0.9 percent of GDP lower on average in the medium term.
- Despite these gains, pillar II as currently designed is not sufficient to substantially lower medium- and long-term pressures on pension spending in the face of Latvia’s aging population.
- Policy implication: It is essential to further strengthen pillar II by increasing contributions and returns.

### Policy recommendations (short to medium term)
- Keep the Latvian multi-pillar pension system; strengthen pillars II and III to improve adequacy and reduce burden on pillar I.
  - Increase contribution rates to the mandatory defined contribution pension pillar to raise allocations to pension capital without raising fiscal pressures.
  - Increase returns to pillars II and III by changing the asset composition of retirement savings to include more equity and other long-term investments; a prudent increase in equities and alternative investments would increase returns.
  - Strengthen incentives for higher voluntary (pillar III) savings through a more flexible and accessible system design, including:
    - Providing tax incentives to businesses that offer pillar III to employees.
    - Auto-enrollment into voluntary pension schemes with an opt-out option.
- Build fiscal buffers to support medium- and long-term pressures arising from higher pillar I spending.
  - Staff estimates show revenue and spending measures could deliver 3 percent of GDP over 2026-2030; proceeds could relieve current and future spending pressures and ensure fiscal sustainability.
  - Potential revenue measures (illustrative):
    - Continue to improve VAT collection efficiency: VAT revenue-to-GDP ratio was 9.7 percent of GDP in 2024; VAT compliance gap decreased almost 20 percentage points between 2013 and 2022 but preliminary estimates show the gap increased in 2023 and remained high at 8.9 percent (EC, 2024b).
    - Broaden corporate and personal income tax bases by reducing the shadow economy: Latvia’s informal sector was 21.4 percent of GDP in 2024.
    - Reduce tax exemptions and fossil fuel subsidies: tax exemptions are 7.7 percent of GDP in Latvia (compared to Estonia 0.9 percent of GDP, and Lithuania 4.2 percent of GDP).
    - Increase property tax revenue: Latvia collects about 0.6 percent of GDP vs 1.1 percent of GDP in the euro area; options include updating cadaster values with market prices, reducing property tax exemptions, and raising the property tax rate while matching policies to support low-income households.
  - Expenditure-side actions:
    - Reorient and rationalize spending away from lower-priority goods and services.
    - Improve efficiency of public spending via better procurement, eradicating rent-seeking, simplifying regulation, reducing bureaucracy, and increasing public administration efficiency.

### Structural measures to increase pension adequacy and sustainability
- Increase the size and productivity of the workforce to improve pension adequacy while maintaining financial sustainability:
  - Pursue active labor market policies to increase labor force participation: invest in education, promote access to childcare to support higher female labor force participation, and attract qualified workers.
  - Incentivize more pensioners to work after retirement (e.g., enhance education for older persons); healthier aging requires more investment in the health sector to extend health life expectancy and support longer working lives.
  - Link statutory retirement ages to future life expectancy gains to balance sustainability and adequacy and to create incentives to delay retirement; additional reforms could link official and early retirement ages to life expectancy once retirement age reaches 65.
- Foster higher productivity growth and allocative efficiency to reduce pension spending pressure by generating higher economic growth and tax revenues without raising contribution rates or cutting benefits.

### Illustrative fiscal scenarios and assumptions
- Figure 6 baseline note: baseline includes an increase in defense spending from 4 percent of GDP in 2025 to 5 percent of GDP in 2026.
- Scenario definitions (Figure 6):
  - Scenario 1: incorporates revenue and expenditure measures of 0.6 percent of GDP per year (2026-2030).
  - Scenario 2: includes higher public spending due to pensions (assuming a constant benefit ratio).
  - Scenario 3: combines Scenario 1 and Scenario 2 (higher spending on pensions with revenue and expenditure measures).

*Sources: EC 2024 Ageing Report; IMF staff calculations; Ministry of Welfare of Latvia, 2023.*

### 1.      Latvia’s economy has faced remarkable challenges in recent years. Russia’s war in Ukraine

### Latvia: Firm-Level Drivers of Labor Productivity Growth

### Overview and Context
- Russia’s war in Ukraine led to supply disruptions and a sharp increase in input costs for firms. Despite some moderation in inflation after the initial shock, the level of input costs has remained high for Latvia and the Baltic region and, in conjunction with slow productivity growth, has led to erosion of competitiveness (Armendariz and others 2024).
- The income convergence relative to the average of euro area slowed down in Latvia during the past five years and lags that in the other Baltic economies (see Text Figure 1 in 2025 IMF Latvia Staff Report).
- Aging and defense are increasing public spending needs that must be financed with greater fiscal revenue, which must come to a certain extent from higher economic growth. Therefore, improving productivity growth is critical to restoring competitiveness and maintaining fiscal space.

### Productivity Trends and Diagnostic Findings
- Labor productivity growth has decelerated during the past two decades in Latvia and lags that of the other Baltic economies.
- Resource misallocation has dragged down productivity growth in the last two decades (Armendariz and others 2024).
- There is evidence of rising dispersion in the marginal revenue product of capital, especially for Estonia and Lithuania, indicating capital misallocation.
- Allocative efficiency and business dynamism are important for productivity growth: reallocating capital and labor toward more productive firms, within-firm improvements (innovation and management), and firm entry/exit dynamics all matter for aggregate productivity (Hsieh and Klenow 2009; Olley and Pakes 1996).

### Decomposition Methodology (Labor Productivity Growth)
- The decomposition follows Decker and others (2017) into four components:
  - Sector-level average productivity growth for continuing firms.
  - An allocative efficiency term: covariance of firm-level labor productivity and the share of industry employment accounted by the firm (∆cov(θf, pf)).
  - Contribution by firm entry: θE2 (P_E2 − P_C2).
  - Contribution by firm exit: θX1 (P_C1 − P_X1).
- Notation preserved from the source: ∆PP_i = ∆p̅_i,c + ∆cov_c(θ_f, p_f) + θ_E2(P_E2 − P_C2) + θ_X1(P_C1 − P_X1).
- The first term represents within-firm average productivity growth for continuers; the second term measures allocative efficiency among continuers; the remaining terms represent net entry contributions.
- Decomposition is calculated for each industry each year and aggregated at the country level using sector-level employment shares in the initial year.
- Firms with only one employee are dropped from the sample in the analysis.

### Key Empirical Findings for Latvia
- The contribution of allocative efficiency declined and turned negative during 2016-21, indicating that firms expanding employment tended to be lower-productivity firms and labor reallocation toward higher-productivity firms was stagnant.
- The contribution by firm entry to labor productivity growth is consistently negative throughout the sample periods: entrant firms tend to have lower labor productivity levels than incumbent firms on average.
- Firm exit makes a positive contribution to labor productivity growth, which outweighed the negative contribution by firm entry during 2016-19 in Latvia.
- The net productivity growth contribution by firm entry (net entry) is very limited overall.
- At the industry level, allocative efficiency contributed negatively to labor productivity growth in industries such as agriculture, manufacturing, construction, wholesale, and retail trade.
- Administrative data results are broadly consistent with aggregate findings; Orbis-based results for Latvia cover a limited sample and show some differences (e.g., positive but declining allocative efficiency during 2012-19 that turns negative in 2020).

### Comparative Findings: Estonia and Lithuania
- The contribution of allocative efficiency to labor productivity growth also declined over time in Estonia and Lithuania.
- Estonia: firms with higher productivity were expanding employment during 2001-2015; allocative efficiency worsened after 2010 and turned negative after 2016.
- Lithuania: contribution by allocative efficiency declined and turned negative after 2011.
- In both Estonia and Lithuania, the contribution of firm entry is negative; the contribution by firm exit is positive throughout the sample period and increased after 2015.
- For Lithuanian firms, firm exit failed to compensate for negative firm entry during 2001-15.

### Dynamics of Entrant Firms
- Entrant firms are skewed toward lower labor productivity at time of entry but their productivity improves over time.
- For firms that entered in 2010 across the Baltics, the distribution of labor productivity shifts from the low end toward the center over ten years, with average labor productivity increasing significantly and becoming more evenly distributed.

### Interpretations and Possible Mechanisms
- Entrant firms tend to have less capital and thus lower labor productivity (Melitz and Polanec 2015).
- Incumbent firms may have market power and higher intangible investment, leading to competitive advantages (lower marginal costs, higher fixed costs) that act as barriers to entry (De Ridder 2024).
- Incumbents more often invest in incremental R&D using existing technologies, while young firms more often invest in radical R&D with smaller immediate productivity effects (Acemoglu and Cao, 2015).
- Entrant firms in Latvia may face limited access to finance (e.g., lack of collateral) and limited access to skilled labor, contributing to lower initial productivity.

### Policy Implications and Considerations
- Targeted support for displaced workers can mitigate social costs of creative destruction, but broad subsidies to nonviable firms may delay necessary reallocation and lead to productivity stagnation.
- Policies that prevent misallocation of capital and labor—by improving allocative efficiency and easing reallocation toward more productive firms—could boost aggregate productivity.
- During crises, government programs should balance social protection and avoiding subsidies that keep nonviable firms afloat; evidence from Estonia suggests generous job retention schemes can have negative effects on aggregate productivity growth when they prevent within-sector labor reallocation.
- Enhancing access to finance and skilled labor for entrant firms could improve their productivity trajectories and increase the positive productivity contribution of firm entry over time.

*Prepared by Bingjie Hu and Can Ugur; IMF staff calculations and analysis presented in the 2025 IMF Latvia Staff Report chapter.*

### 15.      The employment share of micro firms also increased over time in Latvia and the other

### 15–MODERNIZING LATVIA: FIRM DYNAMICS, PRODUCTIVITY, AND ELECTRICITY SECTOR

### Firm dynamics and productivity findings
- The employment share of micro firms increased over time in Latvia and the other two Baltic economies.
- Labor productivity growth slowed over the same period; if labor is trapped in stagnant micro firms, aggregate growth will be slow.
- Fast-growing young firms take up a bigger share of employment (2-3 percent in the case of Latvia) than slow-growing young firms, but their footprint in the aggregate economy remains small compared with more advanced economies (United States employment share about 6 percent).
- Firm entry rates in Latvia are higher than the EU average and other advanced economies such as the United States, although entry rates for firms with more than 10 employees are lower.
- Despite a remarkable decline by 10 percentage points during the past decade, the share of negative-equity firms is still very high in Latvia (about 30 percent as of 2022).
- Asset recovery rates during insolvency processes have risen to 67 percent in recent years, but collateralization of loans remains very high (160 percent as of 2024).
- A significant percentage of firms in Latvia cite finance availability as a major obstacle; a recent survey (November 2024–January 2025; 750 business owners) found 63 percent of Latvian entrepreneurs rated the business environment as poor and 29 percent found it favorable. Main concerns: limited financial access, labor shortages, administrative burdens, government influence on business, legislative stability, tax burden, and municipal policies.

### Policy implications and recommendations (firm-level and product market)
- Use firm-level productivity data to distinguish temporary low productivity of startups from persistent low productivity of nonviable firms.
- Government programs should target innovative young firms that support long-term economic growth, instead of helping unproductive small firms survive.
- Support high-quality entry:
  - Implement targeted subsidies funding R&D intensive startups with high growth potential.
  - Provide support for skilled workforce training and programs facilitating the adoption of new technologies to accelerate learning processes for high-potential new firms.
- Facilitate efficient exit:
  - Continue reforms to improve access to the formal insolvency process for micro and small firms (e.g., by making it cheaper).
  - Establish an early warning mechanism so firms in financial distress can restructure debt at an early stage.
  - Further improve asset recovery to address issues related to overcollateralization.
- Encourage firm dynamism by reducing regulatory burden:
  - Streamline licensing processes (for example, by adopting “silent consent” principles).
  - Reduce use of retail price controls in certain sectors (e.g., pharmaceuticals).
  - Lower barriers to entry in sectors like legal and notary services to encourage more net entry of firms.
- Improve allocative efficiency of capital and labor:
  - Provide targeted grants or subsidies to innovative firms expected to outperform incumbents or for activities that enhance productivity (e.g., investment in R&D).
  - Facilitate access to finance and skilled talent for high-productivity firms; develop domestic capital markets to support firms lacking tangible collateral.
  - Enhance migration and active labor market policies to allow faster integration of high-skilled migrant workers.
  - Adopt education policies to improve availability of STEM programs and provide incentives for local talents to stay.
  - Make product market regulation more flexible to allow more competition and incentives for innovation.

### Key statistics on firms, finance, and insolvency (preserved exactly)
- Fast-growing young firms employment share in Latvia: 2-3 percent.
- United States corresponding employment share: about 6 percent.
- Decline in share of negative-equity firms over past decade: 10 percentage points.
- Share of negative-equity firms in Latvia as of 2022: about 30 percent.
- Asset recovery rates during insolvency processes (recent years): 67 percent.
- Collateralization of loans (2024): 160 percent.
- Survey of entrepreneurs (November 2024–January 2025; 750 business owners): 63 percent rated business environment as poor; 29 percent found it favorable.

### Electricity sector: background, current status, and implications for integration
- Latvia’s Energy Strategy 2050 aims for greener, more secure, and efficient electricity supply; pursuing autarky would be costly and inefficient—greater integration with neighboring and EU electricity grids is recommended to enhance security, stability, and reduce price volatility.
- Electricity consumption and structure:
  - Latvia’s per capita electricity consumption: 3.7 MWh annually; EU average: 5.7 MWh.
  - Most electricity used in industry and services; services sector is a key driver of consumption growth.
  - Latvia produces about 85 percent of its electricity needs domestically (relative to 60 percent in Lithuania and Estonia).
  - Latvia experiences a production shortfall of approximately 1 TWh annually, covered through imports from neighboring countries.
- Electricity generation mix (2024):
  - Hydroelectric power: about 56 percent of electricity generation in 2024.
  - Natural gas accounted for about a quarter of electricity production in 2024 and serves as a balancing source.
  - Wind, solar, and biomass contribution has increased significantly since 2010 but remains insufficient to cover variability in hydro output.
- Characteristics and challenges:
  - Latvia’s hydro generation is primarily run-of-river, resulting in high seasonal variability (peaks in spring; falls well below monthly consumption for the rest of the year).
  - High reliance on renewables requires balancing mechanisms; natural gas co-generation and electricity imports are key balancing sources.
  - Expanding RES capacity (notably inshore wind farms) requires significant grid upgrades and further integration into the EU market to reap full benefits.
- Electricity prices and volatility:
  - 2015-20 average monthly average electricity price: 40.5 euros/MWh.
  - 2024-25 average monthly average electricity price: 91.8 euros/MWh.
  - Electricity prices surged in 2022 to as much as ten times the pre-shock average; prices have receded but remain well above pre-pandemic levels.
  - Price components for final electricity bill (household and non-household customers): basic energy cost (approximately 50-60 percent of total); transmission costs (20-30 percent); taxes (20 percent).

*Prepared from IMF staff chapter content.*

### 6.      Marginal gas prices have a significant impact on electricity prices in Latvia and the EU.

### 6.      Marginal gas prices have a significant impact on electricity prices in Latvia and the EU.

### A. Marginal gas prices and electricity pricing dynamics
- EU electricity prices are largely based on the marginal spot pricing mechanism, with natural gas prices driving electricity prices for a larger share of time than their share in the power mix.
- Natural gas was the price-setting technology 63 percent of the time in 2022 in the EU, despite accounting for only 20 percent of the electricity mix.
- Strong correlation: when gas prices are low, electricity prices tend to be equally low; when gas prices rise sharply (as during the 2022-23 shock), electricity prices follow suit.
- Gas price volatility has largely subsided, but electricity prices have remained high and volatile, indicating lingering effects from market fragmentation.

### B. Benefits of a more integrated electricity market
- System fragmentation and interconnection:
  - Substantial interconnection capacity has been built across Western Europe, but significant gaps remain and the system remains fragmented with limited network integration.
  - Fragmentation amplifies impacts of unexpected shocks by limiting efficient risk sharing across interconnected markets.
- Price divergence and congestion:
  - Market fragmentation can cause significant price differences across neighboring countries; example: September 2023 exhibited adjacent bidding zones with negative prices in one area and positive prices in another due to bottlenecks.
  - Summer 2024 saw large price gaps between Eastern and Western Europe driven by a surge in demand from Ukraine.
  - In the Northern Europe pricing zone (includes DNK, EST, FIN, LVA, LTU, NOR, SWE), instances of low-price convergence (>10 EUR/MWh difference) rose from approximately 50 percent of the time in 2017 to about 95 percent of the time in 2023.
- Quantified integration benefits:
  - Greater integration within subsets of countries could reduce needed dispatchable generation capacity to meet peak demand by nearly 20 percent and storage capacity by 30 percent (Zachmann and others 2024; Roth and Schill, 2023).
  - Dolphin and others (2024) estimate a significant increase in cross-border electricity trade could boost annual EU GDP by around 0.1 percent in 2030.
- Enumerated system-level benefits from integration:
  - More energy security with fewer backup power plants
  - Lower price volatility
  - Less fuel use and less GHG
  - More RES generation with less investment (through better location)
  - More system flexibility with less storage investments
  - Higher consumer surplus thanks to more competition
- Long-term structural gains:
  - Transition to predominantly renewable and low-carbon energy plus a more fully integrated EU market would lower electricity costs and price volatility and support resilience to shocks.
  - Lower, less volatile electricity prices would foster investor confidence and stimulate corporate investment, including in energy-intensive and innovative sectors (e.g., artificial intelligence, quantum computing, digital services), enhancing firm dynamism and productivity growth.

### C. Macroeconomic costs of high electricity prices and firm-level impacts
- Macroeconomic costs of high and volatile electricity prices:
  - Competitiveness: high electricity price disparity disadvantages energy-intensive exporters.
  - Investment: high electricity price volatility hurts investment.
  - Consumption: high energy costs and volatility reduce household consumption.
  - Taxes: high electricity prices are associated with lower excise tax revenue.
- Econometric analysis (Latvian manufacturing firms; Orbis data 2010-2022):
  - Sample for price-level regressions: 49,561 observations (analysis excludes small firms with less than two employees).
  - Electricity prices used exclude taxes and pertain to the category “Consumption from 500 MWh to 1999 MWh – band IC”.
  - Price volatility measured from intraday ENTSO-E prices recorded every 15 minutes (96 data points per day) to compute daily averages; annual standard deviation computed over ~365 daily data points.
- Key empirical findings:
  - Electricity price level elasticity: aggregate elasticity of -0.25 — a 10 percent increase in electricity prices reduces employment in manufacturing by 2.5 percent.
    - Regression aggregate coefficient: Electricity price level = -0.249*** (standard error 0.0925) in Models 1 and 2; other model estimates reported in Annex tables.
  - Electricity price volatility elasticity: aggregate elasticity of -0.066 — a 10 percent increase in electricity price volatility reduces employment in manufacturing by 0.66 percent.
    - Regression aggregate coefficient: Electricity price volatility = -0.0665*** (standard error 0.0223) in Models 1 and 2; other model estimates reported in Annex tables.
  - Heterogeneous impacts across industries: larger employment effects observed in beverages, leather, pharmaceutical, and transport equipment industries.
  - Caveat: job losses in manufacturing could be offset by job creation in less electricity-intensive sectors (e.g., services), but effects may be persistent in presence of labor market frictions.
- Regression sample sizes and fit:
  - Electricity price level regressions: Observations 49,551; R-squared 0.477.
  - Electricity price volatility regressions: Observations 35,073; R-squared 0.475.

### D. Policy implications and recommended actions for Latvia
- Strategic objective: Improve interconnections to other European power grids to unlock benefits of a unified energy market, increase economic activity, and reduce price volatility and energy insecurity.
- Key recommended actions:
  - Closer integration into Europe’s power grid: coordinate policies and investments at the EU and national levels to fully integrate Latvia into Europe’s power grid.
  - Resource pooling: consider pooling resources with neighboring countries to develop grid infrastructures that provide shared benefits across borders.
  - Streamline domestic permitting processes: reduce time and costs associated with building interconnections and more renewables.
- Additional context and timing:
  - The recent synchronization with the Continental Europe Synchronous Area (CESA) electricity grid is an opportunity to modernize Latvia’s electricity infrastructure.
  - On February 8, 2025, the three Baltic countries disconnected their power grids from the Russia, Belarus, Estonia, Latvia, and Lithuania grid (BRELL). The transition resulted in higher electricity prices in the short term; closer integration with the region and the EU would support higher risk sharing, leading to higher energy security, lower volatility, and lower prices in the long run.
- Broader potential macro gains from integration:
  - Estimates range from 0.5 to 3.5 percent level increase in GDP from closer integration, with the average EU country experiencing a 1.5 percent increase in GDP (Arnold and others 2025).

*Source: IMF country report chapter: “6. Marginal gas prices have a significant impact on electricity prices in Latvia and the EU.”*

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_Source: https://www.imf.org/-/media/files/publications/cr/2025/english/1lvaea2025002-source-pdf.pdf_