## _cr12171

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### I. Context and recent performance
- Fiscal consolidation of more than 15 percent of GDP reduced the budget deficit to 3.5 percent of GDP (ESA95) in 2011.
- Current account deficit declined from 22 percent of GDP before the crisis to 1.2 percent of GDP in 2011.
- Financial sector: destabilized by the collapse of Parex Bank in late-2008 and deteriorating asset quality, but now well-capitalized and returned to profitability.
- Return to international capital markets and progress toward meeting the Maastricht criteria noted.

### Real sector, labor market, and prices
- Growth and output:
  - Economy grew by 5.5 percent in 2011.
  - Q1 2012: expanded by 6.9 percent year-on-year and 1.1 percent quarter-on-quarter (seasonally adjusted).
  - Industrial production and retail sales in Q1 2012 were 1.7 and 3.5 percent higher than Q4 2011 (seasonally adjusted).
  - Net export contribution turned increasingly negative in 2011 due to high import content of exports and investment.
- Labor market:
  - Employment increased by 30,000 in 2011 after falling by 160,000 in 2009–10.
  - Unemployment rate decreased to 16.4 percent; more than half of the unemployed have been out of work for more than a year.
  - Wages have started to increase in the private sector, but mainly for the higher-skilled.
- Inflation:
  - Inflation jumped to 4.2 percent in 2011.
  - Inflation fell steadily since mid-2011, reaching 2.3 percent at end-May.
  - Core inflation currently around 1.4 percent.
  - Staff projection: inflation is set to fall to 2.4 percent in 2012 and decline further in 2013 as the temporary effect of higher global oil prices is offset by the 1 percentage point cut in VAT.

### Fiscal performance, market confidence, and medium-term outlook
- 2011 fiscal outcomes:
  - 2011 deficit estimated at 3.5 percent of GDP (ESA95).
  - Factors supporting improvement: higher direct taxes and dividends from public enterprises, slow EU funds absorption, savings on unemployment benefits.
  - Offsetting pressures: higher local government spending, cost of bailing out airBaltic (0.4 percent of GDP), and selling the commercial part of Mortgage and Land Bank (MLB).
- Q1 2012 fiscal note:
  - Revenue collections exceeded projections by around L46 million (staff estimates that approximately L26 million is a permanent increase).
- Market access and reserves:
  - Since mid-2011 Latvia issued one 5 and one 10-year dollar-denominated Eurobond with combined face value of $1.5 billion, at an average yield only slightly above 5 percent.
  - International reserves stand at €5.4 billion or 4.5 months of imports.
  - Following an S&P upgrade, all three major rating agencies rate Latvia at investment grade.
  - CDS spreads fell back to around 250 basis points in April before rising with renewed Euro Area tensions.
- Medium-term fiscal challenge:
  - Without further consolidation, fiscal deficit likely to remain above 2 percent of GDP (ESA95) until 2015 given additional spending needs and removal of crisis-related consolidation measures.
  - Authorities committed to deliver a 0.5 percent of GDP structural improvement in the fiscal balance in 2013.

### Euro adoption: benefits, risks, and required reforms
- Staff view: Euro adoption remains highly beneficial—would remove exchange rate risk, reduce currency-mismatch vulnerabilities, lower interest rates, and enhance financial sector stability versus the fixed exchange rate.
- Program strategy: Euro adoption has been the exit strategy of the program; applying is a political decision and a treaty requirement.
- Required reforms to thrive in a currency union:
  - Further improvements in competitiveness to limit external imbalances.
  - Labour and product market reforms to ensure sufficient relative price flexibility.
- Maastricht criteria considerations:
  - Current projections suggest Latvia’s inflation rate would fall below the reference rate by end-Q1 2013, ahead of the EC and ECB convergence assessment in May.
  - Margin is tight and forecast uncertainty is high.
  - Selection of outliers in reference-value calculations is judgment-based, creating uncertainty for authorities.

### External vulnerabilities, debt repayment needs, and market financing strategy
- Repayment needs and external debt:
  - Over next four years Latvia needs to issue external debt to repay €3.9 billion—75 percent of reserves—to official creditors and Eurobond holders.
  - External debt to GDP ratio is more than 140 percent of GDP.
  - Reserves as a share of maturing external debt plus current account deficit stand at about 38 percent.
- Repayment schedule:
  - Repayments to the Fund total €1.1 billion concentrated in 2012–13 (around 7–9 percent of reserves each year).
  - EC repayments total €2.2 billion due in 2014–15 (around 18–23 percent of reserves each year).
  - A €400 million Eurobond comes due in 2014.
  - Latvia plans to issue around €3.8 billion in 2013-4 (in addition to the €1.1 billion issued since mid-last year).
- Risks and staff recommendations:
  - Risks: strong intensification of the Euro Area crisis, Nordic parent bank deleveraging, declines in non-resident deposits, and slower trading-partner growth.
  - Staff recommends: bring forward Eurobond issuance (subject to market conditions), work closely with Nordic supervisory authorities to pace deleveraging, and prepare options to deepen capital markets.

### Banking sector and non-resident deposit considerations
- Profitability and capitalization:
  - Excluding Parex and Latvijas Krajbanka, bank profits increased to L97.5 million in 2011 versus a loss of L228.7 million in 2010.
  - System CAR stands at 18.1 percent (14.9 percent tier 1).
- Liquidity and lending:
  - Liquidity is gradually declining but remains adequate.
  - Credit to private sector: annual changes—2009: -8.4; 2010: -5.6; 2011: -7.4; Mar-12 observation: -10.1 percent.
- External funding and exposures:
  - Banks account for more than half of external debt; some banks rely heavily on potentially unstable non-resident deposits.
  - Non-resident deposits volatility example: fell nearly 30 percent (more than €1.8 billion or about 40 percent of international reserves) in the 12 months following August 2008.
- Prudential responses:
  - Since mid-2011 authorities required banks reliant on non-resident business to maintain additional capital.
  - Authorities anticipate Basel III tools (liquidity-coverage-ratio and capital add-on for systemic risk) will better capture non-resident bank risks.
  - FCMC strengthened examination of correspondent accounts as part of on-site inspections.

### MLB (Parex) sale, bank resolution lessons, and airBaltic
- MLB sale and restructuring:
  - Adverse market conditions produced lower-than-expected bids for the commercial part of MLB; a significant share may transfer to the Latvian Privatization Agency (LPA) for gradual workout.
  - Government expected to approve the deal in mid-June 2012 with final settlement likely toward year-end.
  - Staff recommends selling all commercial assets unless bids are clearly well-below market value and then merging the remaining part with other institutions to create a single development institution and remove MLB’s banking license.
- Lessons from Latvijas Krajbanka:
  - Independent audit and FCMC investigation did not reveal discrepancies suggesting correspondent-account assets were unduly encumbered in other banks.
  - Staff recommendation: proactively identify potential problem banks, intensively monitor them, and prepare (including asset valuation) prior to intervention.
- airBaltic:
  - airBaltic reported a loss of L54 million or 0.4 percent of GDP in 2011 and an expected L39 million in 2012.
  - State provided L58 million in equity-like instruments (0.4 percent of GDP) and will make a further L25 million loan later this year.
  - New business plan aims to return to profitability by 2014; authorities searching for a strategic investor.
  - Staff view: economic case for continued subsidies is difficult after large fiscal adjustment; risks to attracting investors include litigation by the former private shareholder and possible DG Competition state-aid investigation.

### Structural reform priorities and fiscal institutions
- Competitiveness and reform priorities:
  - CPI-based and ULC-based REER depreciated by 8 and 23 percent respectively since late-2008; competitiveness improvement slowed since mid-2010.
  - Staff estimates the structural current account deficit around 5 percent of GDP.
  - Priorities to boost labor productivity and competitiveness:
    - Higher education reform (concentrate resources, open professorships to foreign academics, allow more foreign-language instruction, improve student tuition targeting).
    - Improve vocational education-employer matching and facilitate apprenticeships.
    - Strengthen governance: boost State Revenue Service capacity to combat grey economy, improve judicial efficiency, and improve SOE governance and transparency.
    - Increase product market competition: appoint new competition council head and ensure vigorous enforcement.
- Fiscal Responsibility Law (FRL) and fiscal council:
  - Changes made to comply with the Fiscal Compact; introduction of a structural fiscal balance rule welcomed.
  - Staff noted operational challenges estimating potential output and structural balances.
  - Staff recommended appointing a fiscal council with independence and an expanded mandate (independent macro forecasts, costing of measures, ex-ante budget assessment) and consulting it ahead of VAT and PIT cuts.
- Social assistance and pensions:
  - Authorities considering splitting GMI into a municipally-financed subsistence benefit and an activation benefit co-financed by the state budget; staff and World Bank cautioned decentralization could reduce spending where need is greatest and urged postponement until World Bank/DG Employment study is completed.
  - Decision to gradually increase retirement age from 62 to 65 starting in 2014 welcomed; World Bank simulations suggest related measures will reduce fiscal deficit by 0.5–1.5 percent of GDP per year between 2020 and 2030.
  - Staff advised not to continue the early retirement option into 2013.

### Key projections, indicators, and vulnerabilities (selected figures preserved exactly)
- Real GDP growth:
  - 2011: 5.5 percent
  - 2012 (staff projection): 3.5 percent
  - Medium-term projections: 2013: 3.6 percent; 2014: 4.2 percent; 2015: 4.2 percent; 2016: 4.0 percent; 2017: 4.0 percent
- GDP per capita (thousands of euros): 2010: 10.0; 2011: 8.2; 2012: 8.0; 2013: 8.8; 2014: 9.1; 2015: 9.2; 2016: 9.5
- HICP inflation (period average): 2011: 3.3 percent (table); narrative headline projection for 2012: 2.4 percent
- Unemployment rate (LFS period average): 2011: 16.4 percent; 2012 (projected): 15.3 percent (table) / 15.4 percent (other table)
- Fiscal balances:
  - 2011 ESA balance: -3.5 percent of GDP
  - 2012 ESA balance (Proj): -2.0 percent of GDP (authorities and staff forecast a deficit figure of 2 percent for 2012)
  - Basic fiscal balance: 2011: -3.1 percent of GDP; 2012 (projection): -1.2 percent of GDP (Table 3 shows -1.2)
- General government gross debt:
  - 2009: 39.9 percent of GDP (some table entries differ by definition)
  - 2010: 37.8 percent of GDP
  - 2011: 38.7 percent of GDP (Table 6 baseline shows 38.7 for 2012; multiple table entries reflect different definitions/projections)
- External sector:
  - Current account balance: 2011: -1.2 percent of GDP; 2012 (Proj): -2.2 percent of GDP
  - Gross external debt: 2010: 165.6 percent of GDP; 2011: 144.8 percent of GDP; 2012 (Proj): 140.7 percent of GDP
  - Net external debt: 2011: 44.8 percent of GDP; 2012 (Proj): 39.0 percent of GDP
  - Gross official reserves (billions of euros): 2010: 5.8; 2011: 4.9; 2012 (Proj): 5.3 (other table entries: 2009: 4.8; 2010: 5.8; 2011: 4.9; 2012 Proj: 5.1)
- Banking sector (latest observations Mar-12):
  - Regulatory capital to risk-weighted assets: 18.1 percent
  - Regulatory Tier I capital to risk-weighted assets: 14.9 percent
  - Loans past due over 90 days: 13.7 percent
  - Loan loss provisions to total loans: 10.6 percent
  - ROA (after tax): 0.8 percent
  - ROE (after tax): 9.5 percent
  - Residents' FX deposits (percent of total resident deposits): 74.6 percent
  - FX loans to residents (percent of total loans to residents): 86.6 percent
- Credit to private sector (percentage change): 2009: -6.9; 2010: -8.4; 2011: -7.4; 2012 (Proj): -3.8

### Staff recommendations and policy priorities
- Fiscal policy:
  - Save the bulk of current revenue overperformance given still-negative structural balance and strong domestic demand.
  - Avoid introducing major tax-code changes or spending increases mid-year; prefer annual budget stage for full consideration.
  - If fiscal space exists, allow modest additional targeted spending in health, road maintenance, infrastructure, and targeted public-sector wage increases to retain qualified staff.
- Tax policy design:
  - Prefer raising the tax-free threshold rather than cutting the headline PIT rate.
  - Introduce a progressive personal income tax and tax credits for net new hires (especially the long-term unemployed).
  - Finance these measures with higher consumption and real estate taxes combined with a more accurate property register.
- External financing and reserves:
  - Bring forward Eurobond issuance, subject to market conditions, to smooth borrowing profile and bolster reserves.
  - Work closely with Nordic supervisory authorities to ensure gradual deleveraging by parent banks.
  - Prepare options to deepen capital markets to offset declines in bank financing.
- Financial supervision:
  - Make full use of Basel III liquidity-coverage-ratio and consider increasing capital add-on for banks concentrating on non-resident deposits.
  - Strengthen supervision of correspondent accounts and proactively identify and monitor problem banks.
- Structural reforms:
  - Implement productivity-enhancing reforms in education, vocational training, judicial efficiency, SOE governance, and product market competition.
  - Draw up a short list of critical reforms with clear responsibilities for implementation.
- Social policy sequencing:
  - Postpone large-scale social assistance decentralization until completion of World Bank and DG Employment study of long-term unemployment.
  - Avoid continuing the early retirement option into 2013.

*Source: IMF staff report content provided in the chapter "Selected Economic Indicators, 2008–12" and related excerpts from the referenced document.*

### 1.   Selected Economic Indicators, 2008–12 ............................................................................2

### _cr12171 - 1.   Selected Economic Indicators, 2008–12

### I. Context and recent performance
- Latvia’s economy emerged from the crisis more resilient and within reach of the Maastricht criteria for euro adoption.
- Fiscal consolidation of more than 15 percent of GDP reduced the budget deficit to 3.5 percent of GDP (ESA95) in 2011.
- The current account deficit, which reached 22 percent of GDP before the crisis, declined to 1.2 percent of GDP in 2011.
- Financial sector stabilization: destabilized by the collapse of Parex Bank in late-2008 and deteriorating asset quality, but is now well-capitalized and has returned to profitability.
- Return to international capital markets and progress toward meeting the Maastricht criteria noted.

### Real sector, labor market, and prices
- Growth and output
  - Economy grew by 5.5 percent in 2011 (third fastest in the EU).
  - Q1 2012: expanded by 6.9 percent year-on-year and 1.1 percent quarter-on-quarter (seasonally adjusted).
  - Industrial production and retail sales in Q1 2012 were 1.7 and 3.5 percent higher than Q4 2011 (seasonally adjusted).
  - Net export contribution turned increasingly negative in 2011 due to high import content of exports and investment.
- Labor market
  - Employment increased by 30,000 in 2011 after falling by 160,000 in 2009–10.
  - Unemployment rate decreased to 16.4 percent; more than half of the unemployed have been out of work for more than a year.
  - Wages have started to increase in the private sector, but mainly for the higher-skilled.
- Inflation
  - Inflation jumped to 4.2 percent in 2011 due to higher commodity prices.
  - Inflation fell steadily since mid-2011, reaching 2.3 percent at end-May.
  - Core inflation currently around 1.4 percent.
  - Negative output gap and high unemployment expected to keep core inflation low and contribute to gradual decline in headline inflation.

### Fiscal performance and market confidence
- Fiscal outcomes
  - 2011 deficit estimated at 3.5 percent of GDP (ESA95), well below program targets.
  - Factors supporting fiscal improvement: higher direct taxes and dividends from public enterprises, slow EU funds absorption, savings on unemployment benefits.
  - Offsetting pressures included higher local government spending, cost of bailing out airBaltic (0.4 percent of GDP), and selling the commercial part of Mortgage and Land Bank (MLB).
  - Q1 2012: revenue collections exceeded projections by around L46 million (staff estimates that approximately L26 million of this is a permanent increase in revenues); interest and social benefit payments lower than expected.
- Market access and reserves
  - Since mid-2011 Latvia issued one 5 and one 10-year dollar-denominated Eurobond with combined face value of $1.5 billion, at an average yield only slightly above 5 percent.
  - International reserves stand at €5.4 billion or 4.5 months of imports.
  - Following an S&P upgrade, all three major rating agencies rate Latvia at investment grade.
  - CDS spreads fell back to around 250 basis points in April before rising with renewed Euro Area tensions.

### Banking sector and external vulnerabilities
- Profitability and capitalization
  - Excluding Parex and Latvijas Krajbanka, bank profits increased to L97.5 million in 2011, compared to a loss of L228.7 million in 2010.
  - System CAR now stands at 18.1 percent (14.9 percent tier 1), well above the 8 percent regulatory minimum.
- Liquidity and lending
  - Liquidity is gradually declining but remains adequate.
  - Banks are reluctant to expand lending; credit demand expected to recover gradually as confidence improves.
  - Foreign banks continue to delever to reduce loan-to-deposit ratio (above 175 percent at end-2011), with some repatriating funds as Latvian loans are repaid rather than making new loans.
- External funding and exposures
  - Banks account for more than half of external debt; some banks rely heavily on potentially unstable non-resident deposits.
  - Parent funding and non-resident deposits have exhibited divergent trends; Nordic banks deleveraging quickly while non-resident deposits increase in other banks.
  - Banks are holding more FX liquid assets than before the crisis.

### Key challenges and vulnerabilities
- Strong domestic demand relative to trading partners likely to worsen the trade balance; capital outflows likely to persist due to deleveraging and global risk aversion.
- Need to repay the international support package will put pressure on international reserves.
- Potential skill shortages and lack of internal labour mobility could constrain growth and put pressure on wages unless long-term unemployed reenter the labor market.
- Reliance on bank lending as opposed to other financing could limit investment if deleveraging continues.
- Fundamental challenge: fostering inclusive growth to sustain decreases in inequality and poverty; social protection reforms have not been a political priority so far.

### II. Policy discussions — Macroeconomic outlook and program exit considerations
- Growth projections and risks
  - Staff projection: economy will grow by 3.5 percent in 2012, one percentage point higher than projected at the Fifth Review (strong base effects and robust Q1 data).
  - Authorities believe growth in 2012 likely to end up at around 4 percent and broadly agree with the balance of risks.
  - Recovery drivers: improving consumer sentiment, strong retail sales supporting private consumption; offsetting factors: expected slowdown in private investment due to slower credit growth and still-negative fiscal impulse.
  - Downside risk: intensification of the Euro Area crisis could dampen demand for Latvian exports.
- Employment and social policy
  - Employment growth expected to slow in 2012 with the unemployment rate stabilizing, given slower growth, emerging skill shortages, and limited internal mobility.
  - World Bank and Ministry of Welfare conducting a study of long-term unemployment and associated tax, benefit and employment policies (first draft due November); staff urged authorities not to introduce social assistance reform (including making local authorities responsible for financing benefits) until the study is completed.
- Inflation and external accounts
  - Inflation is set to fall to 2.4 percent in 2012 and decline further in 2013 as the temporary effect of higher global oil prices is offset by the 1 percentage point cut in VAT.
  - Main inflation risk: higher world commodity prices.
  - Current account deficit expected to increase to 2.2 percent of GDP, driven by imports related to domestic investment and increasing foreign bank profitability (which worsens the income account).
  - If growth continues to surprise on the upside, or trading partners decelerate more than expected, the current account deficit could widen further; past rapid growth episodes in Latvia have led to current account deterioration.

*Source: IMF staff report content provided in the chapter "Selected Economic Indicators, 2008–12" of the referenced document.*

### 11.      Staff and the authorities agreed that, despite recent tensions in the Euro Area,

### _cr12171 - 11.      Staff and the authorities agreed that, despite recent tensions in the Euro Area,

### Euro adoption: benefits, risks, and required reforms
- Staff view: Euro adoption remains highly beneficial for Latvia—would remove exchange rate risk, reduce vulnerabilities from currency mismatches, lower interest rates, and enhance financial sector stability compared to the fixed exchange rate (where the BoL’s ability to provide liquidity is more constrained).
- Political decision: Applying for Euro adoption is a political decision for the Latvian authorities; adoption is also a treaty requirement.
- Program strategy: Euro adoption has been the exit strategy of the program.
- Required reforms to thrive within a currency union:
  - Further improvements in competitiveness to limit external imbalances.
  - Labour and product market reforms to ensure relative prices are sufficiently flexible to allow the economy to adjust to shocks.
- Authorities’ response: Agreed and pointed to an action plan to implement recommendations of the recently-completed Competitiveness Report.

### Fiscal outlook, 2012 performance, and 2013 policy intentions
- 2012 fiscal deficit:
  - The 2012 ESA fiscal deficit is expected to fall to about 2 percent of GDP, better than budget projections and well below the 3 percent Maastricht criterion.
  - Revenue projections for the year have been increased by L88 million (0.6 percent of GDP) due to higher-than-expected GDP growth and first-quarter revenue overperformance; social benefit spending estimates are lower.
- 2012 spending pressures:
  - Additional L10 million for health spending in the first quarter with further needs expected.
  - Road maintenance underfunded in 2012 budget and much of the program.
  - Higher-than-expected pension outlays due to continuation of the early retirement option.
  - Additional spending by local governments (e.g., in Riga City).
- 2013 structural fiscal commitment:
  - Authorities committed to deliver a 0.5 percent of GDP structural improvement in the fiscal balance in 2013, consistent with the SGP and the Fiscal Compact.
  - The 2013 budget is the first test of budget discipline outside the international support program.
- Authorities’ tentative measures to achieve the 0.5 percent of GDP structural improvement:
  - Nominal freezes on wages and goods and services spending.
  - Eliminating social health and transport components of the social safety net.
  - Further health spending cuts.
  - No new investment projects.
  - Increase in real estate taxes.
- Staff caution:
  - Except for increasing real estate taxes, the proposed policies could exaggerate structural bottlenecks and worsen growth and inequality.
  - Given the still-negative structural balance and strong domestic demand, staff recommended saving the bulk of current revenue overperformance and argued against major tax-code changes or spending increases mid-year.
  - Such changes would be better introduced at the annual budget stage for full consideration of spending pressures and tax policy reforms.
  - Staff supported modest additional spending in underfunded areas (health, road maintenance, infrastructure) and targeted public-sector wage increases to retain qualified staff—consistent with the Fifth Review assessment.

### Tax changes enacted and fiscal cost estimates
- VAT and PIT changes:
  - Authorities will reduce VAT by 1 percentage point from end-June 2012.
  - Authorities signaled personal income tax (PIT) cuts of 5 percentage points by 2015; after the mission the government passed legislation to cut the PIT rate by 1 percentage point to 24 percent in 2013, with further 2 percentage point cuts in both 2014 and 2015.
- Fiscal cost estimates:
  - The full year VAT cost is around 0.3 percent of GDP.
  - The planned 5 percentage point cut in PIT would cost 1.1 percent of GDP.
- Staff recommendations on tax design to promote inclusion and employment:
  - Raise the tax-free threshold rather than cutting the headline PIT rate.
  - Introduce a progressive personal income tax.
  - Introduce tax credits for net new hires, especially the long-term unemployed.
  - Finance these measures with higher consumption and real estate taxes combined with a more accurate property register.
- Impact of tax cuts:
  - The government’s decision to cut taxes (present and future) would reduce room for modest spending increases and limit scope for reducing the tax wedge on low-income workers (which is very high compared to the rest of the EU).

### Medium-term fiscal challenges and compliance with the Fiscal Compact
- Medium-term pressures:
  - Additional spending needs in underfunded areas and removal of crisis-related consolidation measures (restoration of second pillar pension contributions, removal of pensions freeze, reduction in SOE payout ratios, higher interest payments as support is replaced by market financing) suggest that, without further consolidation, the fiscal deficit will remain above 2 percent of GDP (ESA95) until 2015.
  - Passage of legislation in May cutting PIT rates by 5 percentage points by 2015, without specifying offsets, will add to pressures.
- Authorities’ stance: Recognize challenges and reiterated commitment to identify additional measures as needed to fulfill the fiscal compact and meet the medium-term objective of structural budget balance.

### Maastricht convergence criteria: inflation and interest rate considerations
- Authorities’ belief: They are on track to meeting the Maastricht inflation and interest rate criteria, but significant uncertainties remain.
- Inflation timing:
  - Current projections for other EU countries suggest Latvia’s inflation rate would fall below the reference rate by the end of the first quarter of 2013, just ahead of the EC and ECB’s convergence assessment expected in May.
  - The margin is tight and forecast uncertainty is high (for Latvia and especially for other EU-27 countries).
- Exchange rate anchor effect:
  - The fixed exchange rate provides a stable medium-term anchor but makes short-term inflation harder to control; commodity price rises could increase Latvia’s inflation more than the reference rate given relatively high weight of commodities in Latvia’s basket.
- Determination of reference values and outliers:
  - Maastricht reference values are calculated using inflation and long-term interest rates in the three ‘best performers’ in the EU in terms of price stability—interpreted as the three countries with the lowest inflation rates—but outliers are sometimes excluded.
  - Selection of outliers does not follow a precise rule, making it difficult for authorities to predict the exact reference value to be used.
  - Example: In 2010 Ireland was excluded as an outlier for inflation assessment when Estonia applied; in 2012 Ireland is included for inflation but excluded from the interest rate criterion due to market access difficulties.
  - Authorities’ concern: Treatment of outliers could make criteria difficult to meet if, under plausible scenarios, two of the ‘best performers’ could be program countries with deflation but without market access and thus dropped from interest rate reference calculations, lowering reference values.
  - EC and ECB representatives: Criteria would be applied fairly based on economic judgment; strong policy implementation is the best way to ensure Maastricht criteria are met sustainably.

### External vulnerabilities, debt repayment needs, and market financing strategy
- External debt and reserve metrics:
  - Over the next four years Latvia needs to issue external debt to repay €3.9 billion—75 percent of reserves—to official creditors and Eurobond holders.
  - External debt to GDP ratio is more than 140 percent of GDP; reserves as a share of maturing external debt plus current account deficit stand at about 38 percent.
- Repayment schedule and borrowing plans:
  - Repayments to the Fund total €1.1 billion concentrated in 2012–13 (around 7–9 percent of reserves each year).
  - EC repayments total €2.2 billion due in 2014–15 (around 18–23 percent of reserves each year).
  - A €400 million Eurobond comes due in 2014.
  - Latvia plans to issue around €3.8 billion in 2013-4 (in addition to the €1.1 billion issued since mid-last year) to meet repayments and bolster reserves.
  - Assessment: Plan is ambitious by emerging market standards but feasible given strong demand for Eurobonds issued since mid-2011, low public debt (around 40 percent of GDP), and improving credit ratings—provided market conditions are not extreme.
- Risks to repayment capacity:
  - Strong intensification of the Euro Area crisis or rising international capital market tensions could complicate borrowing and prompt Nordic parent banks to accelerate deleveraging.
  - A decline in confidence in the Latvian banking system could slow or reverse non-resident deposit inflows; non-resident deposits are volatile but authorities expect continued growth due to political uncertainty in the CIS, problems in competing financial centers, and EU membership.
  - Slower growth in trading partners could worsen the current account and pressure reserves.
- Staff recommendations:
  - Bring forward Eurobond issuance, subject to market conditions, to smooth the borrowing profile and provide a reserve cushion.
  - Work closely with Nordic supervisory authorities to ensure deleveraging by parent banks proceeds gradually to allow development of alternative external financing and protect the balance of payments.
  - Prepare options to deepen capital markets to offset declines in bank financing.
- Nature of external debt and banking-sector liabilities:
  - Gross external debt has increased compared to before the crisis—largely due to borrowing from the Fund and the EC—and is projected to remain above 100 percent of GDP over the medium-term.
  - More than half of gross external debt is banking system liabilities, including debt to Nordic parent banks and non-resident deposits.
  - Net external debt has fallen from 57 to 45 percent of GDP in the past three years, but the large stock of external debt leaves Latvia vulnerable to swings in confidence.
- Non-resident deposits:
  - Non-resident deposits are a significant source of foreign exchange but are a short-term liability and an important source of vulnerability.
  - Example: In the 12 months following August 2008, non-resident deposits fell nearly 30 percent (more than €1.8 billion or about 40 percent of international reserves), prompting the authorities to seek Fund and EC emergency support.
  - Asset-quality concerns: Banks report significant external assets, but their quality is harder to verify—case in point: failure of Latvijas Krajbanka triggered by discovery that €140 million of assets in correspondent accounts were encumbered.
- Prudential responses and market development:
  - Since mid-2011 authorities required banks reliant on non-resident business to maintain additional capital.
  - Authorities anticipate new Basel III prudential tools (liquidity-coverage-ratio and capital add-on for systemic risk) will better capture risks in non-resident banks.
  - Authorities preparing a strategy paper incorporating World Bank FSAP recommendations but are skeptical about sufficient demand for a corporate bond market or vibrant equity market in Latvia; lack of transparency among domestic firms deters listings and outside investors.

### Structural reform, fiscal institutions, and pensions
- Fiscal Responsibility Law (FRL) changes:
  - Authorities made significant changes to the FRL to comply with the Fiscal Compact.
  - Staff welcomed the introduction of a rule based on the structural fiscal balance but noted challenges operationalizing it—requires a clear methodology for estimating potential output and structural fiscal balances.
  - Staff welcomed the intention to appoint a fiscal council and emphasized respecting its independence.
  - Suggested expanding the council’s mandate to cover ex ante tasks: independent macroeconomic forecasts, costing of new measures, and assessment of consistency with budget targets.
  - Recommendation: An effective fiscal council should be consulted ahead of VAT and PIT cuts and compliance should be monitored two times a year (coinciding with budget preparation and the European Semester) to facilitate ex-ante control.
- Social assistance reform timing:
  - Authorities considering splitting the GMI into: (i) a subsistence benefit (financed by municipalities) and (ii) an activation benefit (co-financed by the state budget) conditional on participation in reintegration programs.
  - Staff and World Bank cautioned that decentralizing funding would likely reduce spending on the needy in poorest municipalities with highest demand, and limited implementation capacity would exacerbate differences.
  - Given lack of information on current benefit system and employment programs, staff urged postponing large-scale reforms until after World Bank and DG Employment evaluation of long-term unemployment and associated policies.
- Pensions and retirement age:
  - Decision to gradually increase the retirement age from 62 to 65 starting in 2014 is welcomed.
  - World Bank simulations suggest this and related measures (increasing minimum required insurance period and eliminating supplementary pensions for new pensioners) will reduce the fiscal deficit by 0.5–1.5 percent of GDP per year between 2020 and 2030.
  - Concern: The decision to extend the early retirement option for another year will increase budgetary outlays and could reduce labour force participation—staff advise not to continue the early retirement option into 2013.

*Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2012/_cr12171.pdf*

### 25.      airBaltic continues to lose money (L54 million or 0.4 percent of GDP in 2011 and

### _cr12171 - 25.      airBaltic continues to lose money (L54 million or 0.4 percent of GDP in 2011 and

### airBaltic: losses, state support, and investor prospects
- airBaltic reported a loss of L54 million or 0.4 percent of GDP in 2011 and an expected L39 million in 2012.
- The state took over the airline in late-2011 and has provided L58 million in equity-like instruments (0.4 percent of GDP); a further L25 million loan will be made later this year.
- Management is implementing a new business plan that aims to return to profitability by 2014, and authorities are actively seeking a strategic investor.
- Risks to attracting investors:
  - Litigation by the former private shareholder.
  - The possibility of a state-aid investigation by DG Competition.
- Authorities’ view: DG Competition is likely to view the government injection favorably because it was originally designed as a joint investment with the private investor, who later was in an unsustainable financial position.
- Staff view: aside from state aid issues, the economic case for continued subsidies is difficult to make after a period of unprecedented fiscal adjustment.

### Financial sector supervision and lessons from Latvijas Krajbanka
- Authorities have strengthened financial sector supervision following Latvijas Krajbanka’s failure.
- Findings from reviews:
  - An independent audit of correspondent accounts and an investigation by the FCMC did not reveal discrepancies suggesting assets in these accounts are unduly encumbered or unavailable.
  - Authorities are confident that the fraudulent activities in Latvijas Krajbanka are not present in other banks.
- Supervisory actions:
  - The FCMC has strengthened examination of correspondent accounts as part of on-site inspections.
- Bank resolution lessons:
  - The decision to liquidate Latvijas Krajbanka, rather than transfer assets and liabilities to an acquirer, exposed challenges in implementing the bank resolution framework under the program.
  - Market conditions in late-2011 made it difficult to find an acquiring bank; discovery of fraud required potential acquirers to verify asset quality.
  - Staff recommendation: regulators should proactively identify potential problem banks, monitor them intensively once identified, and prepare (including asset valuation) prior to intervention.

### Sale and restructuring of MLB (Parex)
- Progress and market conditions:
  - Adverse market conditions resulted in lower-than-expected bids for the commercial part of MLB.
  - Weaker bids mean a significant share of the balance sheet may be transferred to the Latvian Privatization Agency (LPA) and managed by Parex for a more gradual workout.
- Timeline expectations:
  - Government expected to approve the deal in mid-June 2012, with final settlement likely toward the end of this year.
- Staff recommendations:
  - Sell all commercial assets rather than transfer them to the LPA unless bids are clearly well-below market value.
  - Once commercial part is sold, move quickly to merge the remaining part with other institutions to create a single development institution and remove MLB’s banking license.
  - The strategy for consolidation of development finance institutions is scheduled to be completed by end-August; authorities are considering all options, including whether the development institution should have a banking license.

### Competitiveness and structural reform priorities
- Recent competitiveness developments:
  - Wage restraint and deflation produced significant competitiveness improvements since late-2008.
  - CPI-based and ULC-based REER depreciated by 8 and 23 percent respectively.
  - Since mid-2010, competitiveness improvement has slowed.
  - Staff estimates the structural current account deficit is around 5 percent of GDP.
  - Latvia’s price level still seems high for its level of income; unemployment remains a significant problem.
- Required focus: further reorientation toward the tradable sector to remain competitive under a fixed exchange rate and to thrive in the Euro Area.
- Staff-recommended structural reform priorities:
  - Increase labour productivity by improving the quality of education:
    - Consider higher education reform including concentrating resources in fewer institutions, opening professorships to foreign academics, making it easier for classes to be taught in foreign languages, and improving targeting of student tuition financing.
    - Investigate better matching of vocational education to employers’ needs and facilitating apprenticeships for people receiving vocational training.
  - Strengthen the investment climate by improving governance:
    - Ensure the State Revenue Service (SRS) has resources and institutional capacity to combat the grey economy; recent plans to hire more auditors are welcome but will require higher salaries.
    - Develop a strategy to improve judicial system efficiency.
    - Improve governance of state-owned enterprises (SOEs), including partial centralization of ownership, requiring SOEs to publish quarterly financial information, and increasing transparency.
  - Increase product market competition:
    - Quickly appoint a new head of the competition council and ensure vigorous enforcement of existing antitrust legislation.
    - Note difficulty in attracting qualified personnel to the competition council due to low public sector pay.

### Staff appraisal — macro outlook, fiscal policy, and vulnerabilities
- Growth and inflation:
  - Economy recovering strongly despite Euro Area headwinds.
  - Domestic demand recovery resulted in 5.5 percent growth last year (the third fastest in the EU).
  - Strong first quarter data suggests growth this year could reach 3.5 percent or even higher, provided no strong intensification of the Euro Area crisis.
  - Unemployment is unlikely to fall rapidly due to possible skill shortages and limited internal labour mobility.
  - Inflation is set to fall to 2.4 percent as the impact of recent global oil price increases recedes.
- Fiscal outlook and recommendations:
  - Strong revenue performance likely to deliver a budget deficit of about 2 percent of GDP (ESA95) in 2012, well-below the Maastricht deficit criterion.
  - There is pressure for additional spending in areas that adjusted most; tax cuts have likely reduced fiscal space.
  - If fiscal space exists, modest additional spending could be justified in health, road maintenance, and to retain highly qualified government staff — but any increases should be limited and well targeted.
  - Concerns about tax cuts:
    - The decision to cut the VAT and personal income tax (from 2013) could weaken the current account and make it harder to achieve targeted improvements in the structural fiscal balance and to meet fiscal compact commitments.
    - Cutting taxes and loosening fiscal policy is judged premature given strong domestic demand recovery and a still-negative structural balance.
    - Pre-announcing large tax cuts outside the annual budget process and without specifying offsets is imprudent and raises consistency concerns with the fiscal compact.
    - To minimize fiscal costs, labour tax cuts could be targeted at the long-term unemployed or new hires; raising the personal income tax threshold would have been of greater benefit to low-income workers than cutting the headline rate.
  - Fiscal framework reforms:
    - Changes to the Fiscal Responsibility Law to align with the Fiscal Compact (including a structural fiscal balance rule and a ‘fiscal council’) are welcome.
    - More work needed to operationalize the fiscal rule; ensure the fiscal council's independence and a sufficiently broad mandate for ex-ante and ex-post budget control.
    - Planned changes to social assistance should avoid further decentralizing funding given lack of resources in poorer municipalities and should await the World Bank and DG Employment study into long-term unemployment due later this year.
- Euro adoption criteria and external risks:
  - Authorities should focus on meeting the Maastricht inflation and interest rate criteria in a sustainable manner.
  - Uncertainty arises from future global commodity prices, possible deflation in some Euro Area countries, and treatment of outliers when measuring criteria.
  - Bringing forward external bond issuance could help insure against an unexpected worsening of Latvia’s external position, provided terms are reasonable.
  - Latvia’s capacity to repay the Fund remains adequate but risks include further bank outflows, a strong intensification of the Euro Area crisis, and possible current account deterioration.
- Banking sector and non-resident risks:
  - The strength of Latvia’s external position depends critically on the pace of deleveraging by Nordic parent banks.
  - Pace of deleveraging expected to decline this year as Nordic banks approach target loan-to-deposit ratios and credit demand recovers; if not, reserve adequacy could deteriorate.
  - Latvian supervisory authorities should stay in close contact with Nordic counterparts to ensure deleveraging proceeds gradually.
  - FCMC actions and recommendations:
    - Additional capital requirements for banks reliant on non-resident business are welcome but insufficient to stem inflows of short-term non-resident deposits.
    - Increasing size of the non-resident banking system could pose risks and be a potential drain on international reserves unless short-term liabilities are matched by equally liquid foreign assets.
    - The FCMC should make full use of the Basel III liquidity-coverage-ratio and consider increasing the capital add-on for banks concentrating on non-resident deposits.
    - Strengthening supervision of correspondent accounts should help contain risk in the non-resident banking system and prevent recurrence of problems that led to Latvijas Krajbanka’s failure.
- MLB sale and development finance institution consolidation:
  - Authorities close to completing sale of the commercial part of MLB.
  - Staff reiteration: proceed with sale of all asset bundles unless bids are clearly well-below market value; remove MLB’s banking license and merge to create a single development finance institution once sale is completed.
- Final policy emphasis:
  - To be competitive in the Euro Area, implement productivity-enhancing structural reforms and improve competitiveness.
  - Staff suggests drawing up a short list of critical reforms with clear responsibilities for implementation.

*IMF staff report excerpt.*

### 40.      Latvia’s performance under the first six months of post-program monitoring has

### _cr12171 - 40.      Latvia’s performance under the first six months of post-program monitoring has

### Overview
- Latvia’s performance under the first six months of post-program monitoring has been impressive.
- Strong program implementation has allowed Latvia to move closer to the program’s exit strategy of euro adoption.

### Macroeconomic performance and projections
- Real GDP growth:
  - 2011: 5.5 percent
  - 2012 (projection): 3.5 percent
  - Medium-term projections: 2013: 3.6 percent; 2014: 4.2 percent; 2015: 4.2 percent; 2016: 4.0 percent; 2017: 4.0 percent
- GDP per capita (thousands of euros): 2010: 10.0; 2011: 8.2; 2012: 8.0; 2013: 8.8; 2014: 9.1; 2015: 9.2; 2016: 9.5
- HICP inflation:
  - Period average 2011: 3.3 percent
  - Period average 2012 (projected): -1.2 percent (table shows -1.2 for 2009; careful—headline in narrative: headline inflation projected to decline to 2.4 percent in 2012)
  - Narrative projection: headline inflation projected to decline to 2.4 percent in 2012
- Labor market:
  - Unemployment rate (LFS definition; period average): 2011: 16.4 percent; 2012 (projected): 15.3 percent
  - Half of the unemployed have been out of work for more than a year (narrative statement).

### Fiscal outcomes, projections, and balances
- Fiscal consolidation delivered under the EU-IMF-supported program: measures of more than 15 percent of GDP (narrative).
- General government deficit evolution:
  - 2009: nearly 10 percent of GDP (narrative)
  - 2011: ESA balance -3.5 percent of GDP (Table 3 shows ESA balance for 2011 = -3.5)
  - 2012 (projection): ESA balance -2.1 percent of GDP (Table 3, 2012)
- Basic fiscal balance (percent of GDP):
  - 2009: -7.1
  - 2010: -6.4
  - 2011: -3.1
  - 2012 (projection): -1.2
- General government gross debt (percent of GDP):
  - 2009: 39.9
  - 2010: 37.8
  - 2011: 38.7
  - 2012 (projection): 41.4 (Table 6 baseline shows 41.4 for 2012)
  - Table 3 memorandum: General government debt 2010: 39.9; 2011: 37.8; 2012: 38.7 (note: multiple table entries reflect different definitions/projections)
- Fiscal table highlights (2011 actual, percent of GDP):
  - Total revenue: 36.2
  - Total expenditure: 39.0
  - Basic fiscal balance: -3.1
  - Fiscal balance (including restructuring costs): -3.1

### External sector and reserves
- Current account balance:
  - 2009: 8.7 percent of GDP (surplus)
  - 2011: -1.2 percent of GDP (deficit)
  - Narrative: current account balance was contained to a deficit of 1.2 percent of GDP in 2011
- Gross external debt:
  - 2010: 165.6 percent of GDP
  - 2011: 144.8 percent of GDP
  - 2012 (projection): 140.7 percent of GDP
- Net external debt: 2011: 44.8 percent of GDP (Table 2 shows net external debt 2011 = -44.8? Table 1 shows net external debt 2011 = 44.8; narrative: net external debt stands at 45 percent of GDP)
- Gross official reserves (billions of euros):
  - 2010: 5.8
  - 2011: 4.9
  - 2012 (projection): 5.3
- Gross international reserves (GIR, US$ billion) (latest observations):
  - Apr-12: 7.0 (Table 15)
- Reserve coverage indicators:
  - GIR in percent of ST debt at remaining maturity excluding non-resident deposits: Q4, 2011: 65.0
  - GIR in percent of ST debt at RM including banks' non-resident FX deposits: Q4, 2011: 36.2

### Debt sustainability and risks
- Public sector debt-to-GDP (baseline path):
  - 2007: 7.8
  - 2009: 32.9
  - 2010: 39.9
  - 2011: 37.8
  - 2012 (projection): 38.7
  - 2017 (projection): 34.7
- Debt-stabilizing primary balance (Table 6): -0.3 (row shows -0.3 under "Debt-stabilizing primary balance 9/")
- Identified debt-creating flows and automatic dynamics:
  - Automatic debt dynamics contribution (2011): -0.2 (Table 6)
- External debt dynamics:
  - External debt (percent of GDP) baseline: 2010: 165.6; 2011: 144.8; 2012 (projection): 140.7; 2017: 109.4
  - Gross external financing need (US$ billions) example: 2011: 21.7 (Table 9 historical lines)
- Vulnerability tests (figures summarized in charts):
  - Public debt and external debt stress tests presented with scenarios including growth shock, interest-rate shock, real depreciation, current account shock, and combined shocks (figures show baseline and scenario trajectories).

### Financial sector indicators and stability
- Bank soundness (selected indicators, latest observations Mar-12 unless otherwise noted):
  - Regulatory capital to risk-weighted assets: Mar-12: 18.1 percent
  - Regulatory Tier I capital to risk-weighted assets: Mar-12: 14.9 percent
  - Loans past due over 90 days: Mar-12: 13.7 percent
  - Loan loss provisions to total loans: Mar-12: 10.6 percent
  - Return on average assets (ROA, after tax): Mar-12: 0.8 percent
  - Return on equity (ROE, after tax): Mar-12: 9.5 percent
  - Residents' FX deposits (percent of total resident deposits): Mar-12: 74.6 percent
  - FX loans to residents (percent of total loans to residents): Mar-12: 86.6 percent
- Credit to private sector (annual percentage change):
  - 2009: -8.4
  - 2010: -5.6
  - 2011: -7.4
  - Mar-12 observation: -10.1 percent (Table 15 shows -10.1 Mar-12)

### Key narrative findings and policy-relevant conclusions
- The economy has rebounded strongly from its recession in 2008–09, supported by export growth and a recovery in domestic demand.
- The fiscal deficit has improved more than expected following large fiscal consolidation under the EU-IMF-supported program.
- International reserves have been replenished thanks to Latvia’s successful return to international capital markets.
- Important challenges remain, including a still-high unemployment rate (more than 16 percent) and elevated gross external debt, although gross external debt has declined from its 2010 peak.

*Source: IMF staff report and Public Information Notice No. 12/76, July 16, 2012.*

### 3.5 percent of GDP in 2011. This year, strong revenue growth is expected to reduce the fiscal

### 3.5 percent of GDP in 2011.

### Fiscal outlook and euro adoption prospects
- 2011 ESA balance: -3.5 (percent of GDP).
- 2012 ESA balance (Proj): -2.0 (percent of GDP).
- General government gross debt: 37.8 (2011) and 38.7 (2012, Proj) (percent of GDP).
- Total Revenue: 35.9 (2011) and 37.2 (2012, Proj) (percent of GDP).
- Total Expenditure: 39.0 (2011) and 38.6 (2012, Proj) (percent of GDP).
- Basic fiscal balance: -3.1 (2011) and -1.4 (2012, Proj) (percent of GDP).
- Authorities expect to meet the Maastricht fiscal deficit criterion; both authorities and staff forecast a deficit figure of 2 percent for 2012.
- EU Fiscal Compact ratified by parliament; Fiscal Responsibility Law (FRL) to be operational by end-October 2012 to align the 2014–2016 budget Framework Law with FRL rules.
- Authorities intend to reduce the structural deficit by 0.5 percent of GDP annually in line with Fiscal Compact obligations.
- Offsetting measures identified for personal income tax (PIT) cuts: real estate property reform (expected completed in 2013, including improved property valuation) and raising excise taxes on tobacco to meet EU minimal requirements.
- Staff preference noted for raising the PIT allowance threshold; authorities emphasize equity considerations and cite improvement in the Gini coefficient during the crisis.

### Economic recovery and macro performance
- Real GDP growth: -17.7 (2009), -0.3 (2010), 5.5 (2011), 3.5 (2012, Proj) (percentage change).
- HICP inflation (period average): 3.3 (2009), -1.2 (2010), 4.2 (2011), 2.4 (2012, Proj) (percentage change).
- Unemployment rate (period average, LFS definition): 17.3 (2009), 19.0 (2010), 16.4 (2011), 15.4 (2012, Proj) (percent). Note: Revised by +0.8 percentage points in 2011 in compliance with population census; data before 2011 has not been revised yet.
- Nominal GDP (billions of lats): 13.1 (2009), 12.7 (2010), 14.2 (2011), 14.9 (2012, Proj).
- Current account balance: 8.7 (2009), 3.0 (2010), -1.2 (2011), -2.2 (2012, Proj) (percent of GDP).
- Trade balance: -7.1 (2009), -7.1 (2010), -9.8 (2011), -11.4 (2012, Proj) (percent of GDP).
- Gross official reserves (billions of euros): 4.8 (2009), 5.8 (2010), 4.9 (2011), 5.1 (2012, Proj).
- Gross external debt: 156.8 (2009), 165.6 (2010), 144.8 (2011), 140.7 (2012, Proj).
- Net external debt: 58.8 (2009), 53.6 (2010), 44.8 (2011), 39.0 (2012, Proj).
- REER (period average; CPI based, 2000=100): 110.2 (2009), 103.6 (2010), 103.8 (2011) with percent change +5.5 (2009), -6.0 (2010), +0.2 (2011).
- Broad money (percentage change): -1.9 (2009), 9.8 (2010), 1.5 (2011), 7.9 (2012, Proj).
- Credit to private sector (percentage change): -6.9 (2009), -8.4 (2010), -7.4 (2011), -3.8 (2012, Proj).

### Market access and external financing
- Latvia issued $1.5 billion in benchmark international bonds since mid-2011.
- All three major rating agencies now rate Latvia as investment grade.
- Directors noted strengthened foreign reserves position and successful return to international capital markets.
- Directors recommended issuing international bonds "ahead of time" as a guard against external risks.

### Financial sector resilience and supervision
- Financial sector: well capitalized and returned to profitability; foreign-owned banks continue to deleverage.
- Authorities progressed with sale of commercial part of Mortgage and Loan Bank (MLB) and strengthened supervision following November 2011 failure of Latvijas Krajbanka.
- Additional capital requirements introduced for banks focused on non-resident business.
- New Liquidity Framework to include Liquidity Coverage Ratio (LCR); monitoring of LCR in each significant currency and Net Stable Funding Ratio (NSFR) monitoring will begin in 2013.
- Authorities intend close cooperation with Nordic supervisory authorities to ensure orderly deleveraging, using supervisory colleges and Nordic Baltic cooperation structures.
- Authorities found buyers for a large share of Mortgage and Land Bank commercial assets; remaining assets to be transferred to Latvian Privatization Agency if no reasonably priced offer received.

### Structural reforms, labor market, and competitiveness
- Directors urged continued structural reforms to boost productivity, enhance competitiveness, and reduce unemployment and poverty.
- Key reform areas emphasized:
  - Increasing product market competition.
  - Improving governance, including in state-owned enterprises (new management system expected operational beginning of 2013).
  - Strengthening the legal system to encourage investment.
  - Education and governance reforms and outside evaluation of higher education study programs and science performance already ongoing.
- Unemployment: high despite employment rate exceeding pre-bubble figures; participation rate rose permanently post-bubble.
- Directors urged building a strong social safety net while strengthening incentives to return to work and improving education to reduce skill mismatches.
- Recommendation to postpone changes to social assistance until joint Ministry of Welfare and World Bank study of long-term unemployment is completed.
- Staff and authorities agree productivity-enhancing reforms are critical as near 7 percent growth rates are not expected to persist and export market deceleration plus deleveraging will slow output growth.

### Executive Board and Directors' views
- Executive Directors welcomed Latvia’s recovery: strong growth, low inflation, declining budget deficit, strengthened foreign reserves, and successful return to capital markets moving Latvia closer to euro adoption.
- Directors commended fiscal consolidation and ratification of the EU Fiscal Compact as commitment to long-term fiscal stability.
- Directors generally concurred that cuts in personal income tax and VAT may be hard to reconcile with modest spending increases and will affect the current account deficit; any major tax or spending changes should be consistent with the Fiscal Compact and medium-term framework and introduced at the annual budget.
- Directors encouraged identifying offsetting measures, recommended raising the tax-free income threshold and introducing tax credits for new hires.
- Directors cautioned that further decentralizing funding of social assistance and cuts in social expenditure could worsen inequality and undermine growth.

*Source: IMF staff report and Executive Board assessment for the First Post-Program Monitoring Discussions with the Republic of Latvia.*

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2012/_cr12171.pdf_