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### Context and recent developments
- Latvia rebounded from the crisis after undertaking a sustained internal devaluation anchored to a peg to the euro, achieved through sharp fiscal consolidation and a restoration of competitiveness via declining unit labor costs.
- December 2012: Latvia issued a US dollar bond and publicly announced its intention to repay all outstanding obligations to the Fund ahead of schedule.
- The country appears well placed to meet the Maastricht criteria for euro adoption.

### Strong recovery continued through 2012 — growth and labor market
- Real GDP growth:
  - 2011: 5½ percent.
  - First three quarters of 2012: 5.7 percent year-on-year (the fastest rate of growth in the European Union).
- Demand and output composition:
  - Exports (nominal): grew by 12 percent in January-September 2012 versus same period in 2011.
  - Private consumption and gross fixed capital formation: expanded rapidly due to pent-up demand.
  - Growth drivers: intensive and extensive margins in exports; diversification into electrical equipment and machinery.
- Labor market:
  - Unemployment rate: decreased to 13.5 percent in the third quarter of 2012 from 16.2 percent on average in the first half of 2012.
  - Employment growth: 2¾ percent (y-on-y) in the first three quarters of 2012; 3.4 percent in the third quarter.
  - Labor force participation: almost 2 percentage points higher in the third quarter of 2012 than a year ago.
  - Long-term unemployed: about half of total unemployed.
  - Staff estimate of remaining unemployment gap: about 2¾ percentage points.
  - Real wage growth: about 1½ percent per annum.

### Box 1 — Program summary and lessons (Ex-Post Evaluation)
- Pre-crisis dynamics: post-2004 boom driven by large private inflows, rising inflation, real estate bubble, large current account deficit; crisis followed in early 2008 after capital flow reversal and bank liquidity run.
- IMF SBA details:
  - SBA approved on December 23, 2008 with exceptional access of 1,200 percent of quota (SDR 1.5 billion or approximately €1.7 billion) for 27 months, extended to 36 months.
  - International financing package: total financing of €7.5 billion; only €4.5 billion drawn from original €7.5 billion package.
- Program objectives: arrest liquidity crisis, ensure long-term external stability, maintain exchange rate peg, stabilize financial sector, facilitate debt restructuring, foster real depreciation via income policies, adjust fiscal policy, create space for contingent financial sector liabilities; explicit exit strategy: euro adoption.
- Outcomes:
  - Immediate objectives met; financial conditions improved after first review.
  - Loss of reserves and deposit drains stemmed by third quarter 2009.
  - Growth resumed by end-2009 earlier than expected.
  - Contraction and unemployment larger than initially projected; rapid current account turnaround.
- Key lessons:
  - Strong ownership and credible exit strategy critical.
  - International community support and private sector engagement instrumental.
  - Real-financial linkages can amplify shocks; initial underestimation of these linkages affected projections.
  - Flexibility in program design important; fiscal program adapted to sharper-than-projected output collapse.

### Inflation and fiscal developments
- Inflation:
  - Mid-2011 peak: about 4¾ percent (year on year).
  - End-November 2012: 1.5 percent.
  - Core inflation: receded from 3¼ percent to almost zero over same period.
  - Energy price inflation: 5.6 percent (less than half the rate observed a year ago).
- Fiscal balances and 2012 outcomes:
  - 2011: fiscal deficit 3.4 percent of GDP (ESA 95 definition).
  - Original 2012 budget: further adjustment of 1.1 percent of GDP.
  - Mid-year: statutory VAT rate cut by 1 percentage point.
  - Upward revision to tax revenue: 1.3 percent of GDP due to cyclical and broad based revenue over-performance.
  - Mid-year supplementary budget increased spending by 1 percent of GDP on basic health care, road maintenance and pensions, plus higher EC budget contributions and financing for loss-making hospitals.
  - Staff expects headline deficit for 2012: 1.8 percent of GDP.

### Banking sector performance and credit conditions
- Profitability and capital:
  - Banks returned to profitability in 2011.
  - Average return on equity: around 10 percent in the first 9 months of 2012.
  - System-wide capital adequacy ratio: 17.4 percent (regulatory minimum 8 percent).
- Asset quality and provisioning:
  - Non-performing loans (NPLs): decreased from mid-2010 peak of about 19½ percent to 12½ percent.
  - Loan loss provisions: more than ¾ of NPLs.
  - NPLs by sector: corporate loans about 11 percent; household loans 16 percent.
- Credit and deleveraging:
  - Banking sector total assets decreased by about L3½ billion (15 percent) since end-2008.
  - Nominal stock of loans to residents: about 30 percent lower since pre-crisis peak.
  - Loans to residents contracted by 2 percent year-on-year by end-September 2012 (leveling-off from 6 percent contraction at end-2011), excluding removals of Parex Bank and Latvijas Krajbanka.
  - Volume of new loans to residents in first three quarters of 2012: 28 percent higher than same period in 2011; less than 18 percent of these new loans were to households.
- Deleveraging by foreign-owned banks:
  - Subsidiaries reduced liabilities to parent banks by about L3.5 billion since end-2008; L3.2 billion correspond to Nordic banks.
  - Loan-to-deposit ratio (subsidiaries of foreign banks): dropped from almost 260 percent to 176 percent.
  - Liabilities to parent banks decreased by 26 percent from end-2010 to end-2011, and by roughly the same rate in the first three quarters of 2012.
  - Outstanding liabilities to foreign parent banks declined to about 40 percent of their peak-levels.
- Non-resident deposits (NRDs):
  - NRDs increased by 19.7 percent in the year to end-September 2012 (15.7 percent if exchange rate effects excluded).
  - Resident private deposits grew by 1.3 percent over the same period.
  - NRDs now exceed deposits of private residents.
- Specific recapitalization:
  - A mid-size bank specializing in non-resident clients was undercapitalized; a strategic private investor contributed L8.2 million in fresh capital (negotiations ongoing).

### Outlook and risks — staff baseline and medium-term projections
- Short-term (staff baseline for 2013):
  - Growth: projected to decline to about 3¾ percent in 2013 (from above 5 percent in 2012).
  - Exports: growth remains strong but will decline; modest widening of current account deficit expected.
  - Private sector credit: projected to resume gradually; credit to households likely to keep shrinking due to excess housing supply.
  - Employment: projected average growth 1.4 percent in 2013 (down from 2.5 percent in 2012).
  - Unemployment: expected to decrease to about 13.7 percent in 2013 (staff estimate of natural unemployment rate around 12 percent).
  - Inflation: projected consumer price growth 2.2 percent in 2013.
- Medium term:
  - Baseline assumes euro adoption in 2014 (authorities’ target).
  - Output gap: expected to close by 2015–16.
  - Real GDP growth: projected about 4.2 percent in 2014–15; about 4 percent per year from 2016 onwards.
  - Inflation: expected to level off at about 2–2½ percent.
  - Current account: modest widening to about 3½ percent of GDP deficit in the medium term.
  - Financing: expected from gradual reduction in deleveraging pace by foreign banks and conservative pickup in FDI.
  - Constraint: projected productivity improvements partially offset by a stagnant labor force due to demographic trends.

### Risk Assessment Matrix — key risks and impacts
- Overall: Risks are skewed to the downside; adverse developments in the euro area could raise Latvia’s borrowing costs and slow the recovery. Latvia’s high external debt is a significant vulnerability.
- Selected risks, likelihood and impact:
  - Strong intensification of the euro area crisis
    - Relative Likelihood: Medium
    - Impact if Realized: High
  - Protracted period of slow European growth
    - Relative Likelihood: Medium
    - Impact if Realized: Medium
  - Renewed bank deleveraging and/or NRD flight
    - Relative Likelihood: Medium
    - Impact if Realized: Medium
  - Global oil price shock
    - Relative Likelihood: Low
    - Impact if Realized: Low

### Path to euro adoption — prospects and staff views
- Authorities:
  - Strongly committed to euro adoption in 2014; intend to request EC and ECB assessments in spring 2013.
  - Maintain the peg to the euro and participate in ERM-2; not open to alternative exchange rate regimes.
- Staff view on benefits:
  - Eliminate risk of speculative attacks and reduce contagion risk.
  - Address vulnerabilities from foreign currency exposures given high euroization.
  - Reduce sovereign borrowing costs by removing exchange rate premia.
  - Enhance financial sector stability via access to ECB emergency liquidity.
- Maastricht criteria and uncertainties:
  - Latvia appears on track to meet all Maastricht criteria, subject to uncertainties on inflation and interest rate reference values.
  - Harmonized long-term interest rate fell to 3½ percent in October.
  - Outcome depends on treatment of outlier comparator countries.

### International reserves, external financing needs, and bond repayment
- Reserve adequacy:
  - Projected reserve level of €5.4 billion at end-2012 is above three months’ import cover.
  - Reserves as a share of short-term external debt projected at about 50 percent in 2012.
  - 2008 experience: 40 percent of international reserves dissipated due to fall in NRDs.
- Public sector borrowing and repayments:
  - To repay public external obligations over 2013–15 without further eroding reserve adequacy, the public sector needs to borrow €3 billion (about 14 percent of 2012 GDP) during 2013–15 in international markets.
  - Repayments to the European Commission of €2.2 billion are due in 2014–15.
- Bond issue and Fund repayment:
  - December 2012: issued a US dollar bond that raised $1.25 billion at a yield of 2.9 percent.
  - Part of proceeds announced to be used to repay outstanding obligations to the Fund of about SDR 603 million; early repayment would conclude Post-Program Monitoring.

### Banking sector vulnerabilities — NRDs, supervision, and regulatory responses
- NRD characteristics and risks:
  - NRDs have short maturity and higher volatility; fell by 30 percent in the 12 months following August 2008.
  - Sudden reversal could cause contagion to resident deposits and pressure international reserves and create contingent fiscal liability via deposit insurance.
  - Quality and availability of some foreign assets harder to verify (example: Latvijas Krajbanka insolvency linked to €140 million encumbered assets).
  - AML/CFT reputational risks higher with non-resident activity (MONEYVAL report).
- Regulatory and supervisory measures:
  - Since mid-2011, FCMC requires banks with non-resident loans >5 percent of total assets or non-resident deposits >20 percent of total assets to hold additional capital (extra capital requirement ranges from 0.5 to 9 percent of risk weighted assets).
  - Plan to keep higher capital requirements for non-resident banking when adopting Basel III—within Pillar II or as Pillar I add-on.
  - FCMC to start monitoring Liquidity Coverage Ratio (LCR) from January 2013; may apply higher run-off factors for NRDs.
  - Discussion on charging NRDs a higher contribution to the Deposit Guarantee Fund (DGF); authorities argue effective premium is higher for NRDs because average deposit size is larger.
  - FCMC amended off-site and on-site inspection frameworks to focus on non-resident exposures and periodic liquidity stress-tests.
- Banking sector restructuring and asset recovery:
  - Sale of commercial part of Mortgage and Land Bank (MLB): assets accounting for almost 60 percent of MLB’s commercial activities by book value have been sold; remaining commercial assets sale planned by 2013Q1 or transfer to Latvian Privatization Agency.
  - Strategy to create a single development institution (SDI) progressing; merger envisaged.
  - Sale process for Citadele postponed; restructuring plan to EC aims to facilitate sale and maximize taxpayer recovery.
  - Latvijas Krajbanka asset recovery: KPMG sold assets and repaid about L90 million to the DGF; sale of loan portfolio (book value ~ L160 million) underway with final offers by end-January and expected conclusion by Q1 2013.
    - DGF payments to depositors about L340 million exceed recovered amounts; legal action to recover missing assets in correspondent accounts amounting to about L130 million recommended.
  - DGF replenishment: deposit insurance premia have been raised by 50 percent; proposal to extend period of increased contributions under consideration.

### Fiscal sustainability — 2013 budget and medium-term challenges
- 2013 budget:
  - Taking account of a 2 percentage point redirection of state social contributions to the second pillar, the budget is projected to achieve a structural improvement of 0.5 percent of GDP, complying with Maastricht criteria and SGP conditions.
  - Budget includes a one percentage point PIT cut already legislated for 2013, increases tax allowances for dependents, and extends residential property tax rates from 0.2 to 1.5 percent while giving local governments more flexibility.
  - Priority spending targets health care bottlenecks, reform lower-end teachers’ salaries, and support demographics.
  - Budget incorporates agreement to lower maximum Guaranteed Minimum Income (GMI) and decentralize its financing, against IMF, World Bank and EC advice.
- Social protection concerns:
  - Staff urged reconsideration of GMI changes: social exclusion benefits already among the lowest in Europe and should not be cut further.
  - Risk that decentralized financing could leave income-constrained local governments unable to provide reduced benefits, causing regional disparities.
  - Staff recommended broader reform of social assistance programs following a World Bank study due in Spring 2013.
- Medium-term fiscal pressures:
  - Headwinds include preapproved PIT cuts totaling 5 percentage points over 2013–15; restored indexation of paid-out pensions as of 2014; gradual reduction in SOE payout ratios from current 90 percent; second-pillar pension contributions increasing over 2015–16 until they reach 6 percent; increasing social insurance benefits for high-earners while restoring ceiling on social contributions.
  - Compensatory measures will be needed to ensure continued reduction in structural fiscal balances in line with the SGP.

### Planned PIT cuts and labor tax policy
- Staff urged reconsideration of the planned PIT cuts, at least from 2014 onwards, due to large cumulative fiscal cost and need for compensatory measures.
- Policy alternatives and trade-offs:
  - Untargeted statutory PIT cuts are not first-best for efficiency or equity.
  - Options include:
    - Introduce a two-tier PIT system (example: two rates—25 percent (the current rate in 2012), and 15 percent for lower income taxpayers—with threshold chosen so the measure is revenue enhancing compared to the current plan).
    - Increase the minimum non-taxable allowance.
    - In conjunction with social assistance reform, introduce an earned income tax credit program.
- Authorities’ stance: view tax cuts as essential for improving work incentives and addressing the informal economy; prefer to focus on other compensatory measures to ensure fiscal sustainability.

### Revenue and expenditure reforms to build fiscal space
- Revenue options:
  - Reform cadastre to enable fair property valuations; increase lower bound for property tax rates while ensuring progressivity.
  - Reduce tax exemptions for dependents alongside reforming state family benefits.
  - Other options: reduce tax allowance for pensions; eliminate indirect tax exemptions (e.g., diesel exemption for farmers); increase environmental taxes.
- Expenditure options:
  - Focus on spending reforms that improve economic incentives.
  - Reduce public transport subsidies while designing targeted cash transfers to protect the poor.
  - Better targeting of family and child benefits and non-contributory supplemental pensions.
  - Reduce duration of parental, maternity and paternity benefits while supporting child care.
- Structural fiscal reforms underway:
  - Law on Budget and Financial Management sets binding ceilings on central government spending for 3 years; approved with 2013 budget.
  - Fiscal Discipline Law (FDL) and related constitutional amendments: priority for passage; FDL pending in parliament and could be passed as early as January 2013.
  - State Revenue Service measures: terminate fictitious companies; restrict activities of persons involved; limit cash transactions; eliminate tax avoidance transactions; medium-term strategy to increase audit coverage.

### Structural reforms, competitiveness, and labor market incentives
- Competitiveness:
  - Staff assess exchange rate broadly in line with fundamentals (Box 3).
  - Staff calculations suggest a modest remaining competitiveness gap of about 4.6 percent, subject to wide uncertainty.
  - REER developments: ULC-based REER depreciated by over 9 percent since end-2009 by Q2 2012; PPI- and CPI-based REERs depreciated by over 6 percent to July and September 2012, respectively.
- Labor market measures:
  - GMI phases out one-for-one with income, creating a high tax wedge; consider reducing benefit more gradually.
  - Shift active labor market policies towards in-work tax credits and benefits to increase employment of lower skilled workers.
  - Reduce duration of family benefits while enhancing formal child care.
- Bottleneck reforms:
  - Judicial reform: address delays in civil courts; retain single “cash-flow” insolvency test and improve implementation.
  - SOEs: propose a new partially centralized institution for SOE governance; legislation pending.
  - Education: improve higher and vocational education quality and resource concentration.

### External stability, debt, reserves, and debt sustainability
- Real sector projections (selected Real GDP growth rates, percent):
  - 2012: 5.2
  - 2013: 3.7
  - 2014: 4.2
  - 2015: 4.2
  - 2016: 4.0
  - 2017: 4.0
- Key national accounts (selected 2012 figures):
  - Real GDP 2012: 5.2 (percentage change)
  - Private consumption 2012: 4.8
  - Gross fixed capital formation 2012: 27.9
  - Exports of goods and services 2012: 11.6
  - Imports of goods and services 2012: 11.4
  - Nominal GDP 2012 (billions of lats): 15.3
  - Nominal GDP 2012 (billions of euros): 21.8
  - GDP per capita 2012 (thousands of euros): 9.9
- Inflation and labor market projections:
  - HICP inflation (period average) 2012: 2.4; end-period HICP 2012: 2.2.
  - Unemployment rate (LFS, period average, percent): 2012: 15.0; projected 2013: 13.7; 2014: 12.3; 2015: 11.1; 2016: 10.1; 2017: 9.4.
  - Employment (period average, percent change) 2012: 2.5; projected 2013: 1.4; 2014: 1.2.
- Public finances and debt dynamics (selected):
  - Consolidated general government 2012:
    - Total revenue: 38.0 percent of GDP
    - Total expenditure: 37.1 percent of GDP
    - Basic fiscal balance 2012: -0.7 percent of GDP
    - ESA balance 2012: -1.8 percent of GDP
    - General government gross debt 2012: 37.6 percent of GDP
  - Baseline public sector gross debt (percent of GDP):
    - 2012: 37.6
    - 2013: 42.2
    - 2014: 37.7
    - 2015: 34.1
    - 2016: 34.1
    - 2017: 33.0
  - Primary deficit (selected): 2012: -0.9; 2013: -0.4; 2014: -0.5; 2015: 0.1.
  - Gross financing need (memoranda):
    - 2012 (percent of GDP): 7.9
    - 2012 (USD billions): 2.2
- International reserves and external sector (selected):
  - Gross official reserves 2012: 6.7 (billions of euros).
  - Reserve projections (billions of euros): 2013: 6.2; 2014: 5.9; 2015: 6.3; 2016: 6.3; 2017: 6.4.
  - Reserve coverage (months of prospective imports) 2012: 5.0.
  - Current account (millions of euros): 2012: -483; 2013: -794; 2014: -858.
  - Current account (percent of GDP): 2012: -2.2; 2013: -3.4; 2014: -3.5.
- External debt:
  - Gross external debt 2012: 143.9 percent of GDP; in euros: 30.2 (billions).
  - Gross external debt projections (percent of GDP): 2012: 143.9; 2013: 138.3; 2014: 137.2; 2015: 127.3; 2016: 119.3; 2017: 115.2.
- Debt sustainability and stress tests:
  - Baseline public sector debt rises to 42.2 in 2013 then declines to 33.0 by 2017.
  - Stress tests include growth shock, primary balance shock, interest rate shock, combined shock, contingent liabilities shock (30 percent depreciation and 10 percent of GDP contingent liabilities).

### Financial sector indicators and stability monitoring
- Financial soundness indicators (selected, Sep-12):
  - Regulatory capital to risk-weighted assets: 17.7 (percent)
  - Return on assets (after tax): 0.8 (percent)
  - Return on equity (after tax): 7.6 (percent)
  - Loans past due over 90 days: 12.5 (percent of loans)
  - Loan loss provisions to loans past due over 90 days: 76.0 (percent)
  - Liquid assets to total assets: 29.7 (percent)
  - Liquid assets to short term liabilities: 59.3 (percent)
  - FX assets to total assets: 80.8 (percent)
  - FX deposits to total deposits: 76.5 (percent)
  - Private sector credit (annual percentage change): 2012: -9.0; 2013 projection: 1.2
- System liquidity and market rates:
  - Excess bank deposits at Bank of Latvia and low money market rates indicate banking system liquidity; Rigibor overnight low.

### Appendix I — The Non-Resident Banking Sector (overview and metrics)
- Structure:
  - 20 commercial banks—including 8 subsidiaries of foreign banks—and 8 foreign bank branches in Latvia.
  - FCMC classifies a bank as specialized in non-resident clients if NRDs represent more than 20 percent of its assets.
- NRDs scale and origin:
  - NRDs across the banking system are about L5.5 billion or 51 percent of total deposits (end-September 2012).
  - Deposit origin composition (end-September 2012): about 1/3 from EU countries; 12 percent from CIS countries (70 percent of them from Russia); 55 percent from other non-EU jurisdictions.
  - Additional: 58 percent of EU deposits from the U.K.; 25 percent from Cyprus.
  - Estimated ultimate origin: 80 to 90 percent of NRDs estimated to come from CIS countries.
- Drivers of NRD flows (12 months to end-September 2012):
  - NRDs increased by 19.7 percent (15.7 percent excluding exchange rate effects).
  - Drivers: relocation of CIS depositors from banks under stress (mainly Cyprus); Latvia’s EU residency permit program played a minor role (only about L50 million of L290 million in claimed investment in banking sector).
- Assets and exposures:
  - Share of foreign assets in NR banks’ total assets: about 55 percent (vs. 12 percent for banks dealing with residents).
  - Geographic distribution of foreign assets: EEA 62 percent; CIS 18 percent; U.S. and Canada 13 percent.
  - Foreign asset composition: almost half are claims on foreign MFIs; foreign loans about 1/4 (70 percent of these to CIS clients); foreign securities about 1/4 (almost half government securities—93 percent issued by U.S., Canada or EEA).
- Portfolio shifts 2008–2012:
  - NRDs in banks dealing with non-resident clients increased by almost L1.4 billion between 2008 and 2012.
  - NR banks’ foreign assets expanded by L1.2 billion, mostly invested in liquid assets (claims on foreign MFIs with maturity up to 30 days and government securities account for more than 90 percent of accumulated foreign assets).
  - Domestic assets held by NR banks decreased by L0.5 billion between 2008 and 2012; loans to residents by NR banks decreased by almost L1 billion.
- Capital adequacy and regulation:
  - Capital adequacy (2007→2011): banks dealing with residents increased from about 10 percent to close to 20 percent; banks dealing with non-residents increased from slightly above 10 percent to about 15 percent.
  - FCMC extra capital requirements since mid-2011 range from 0.5 to 9 percent of risk weighted assets depending on non-resident exposure.

### Appendix II — Latvia’s Demographic Challenge
- Population decline:
  - During 2000–11, population declined by about 14 percent (340 thousand people).
  - Emigration responsible for about ⅔ of decline; natural change due to low fertility accounted for remainder.
  - Estimated 200–215 thousand people emigrated during 2000-11 (roughly 9 percent of the population).
  - Natural decline: about 125–140 thousand people (5 percent of population).
  - Number of births halved since early 1990s—from around 40,000 annual births to around 20,000.
- Emigration dynamics:
  - Largest episodes during Russian crisis early 2000s and global financial crisis 2008–10.
  - Net emigration in 2008–10 about four times larger than during 2005–07 boom.
  - Preferred destinations in 2011 for over ⅘ of emigrants: EU countries (Germany, the UK, Ireland).
  - Net emigration declined sharply in 2011; surveys indicate 20 percent of emigrants plan to return within 5 years.
- Policy implications and recommendations:
  - Pro-growth policies favoring income convergence most traction to discourage emigration.
  - Policies to increase birth rates: Draft NDP 2014–20 aims for “a stable basis for demographic growth”; 2013 budget includes family-related health, tax, and social support measures.
  - Evidence: availability of formal childcare has unambiguously positive effect on fertility; parental leave effects ambiguous; financial transfers have small and usually temporary effects.
  - Recommendation: prioritize child care policies and means-test child allowances; in-work tax credits could promote low-skilled employment and help mitigate fertility decline.

### Bank Work, Executive Board conclusions, and staff statements
- Program activities and reports:
  - Evaluations: “Assessment of Post-Crisis Policy Options”; Competitiveness Report; Ports Competitiveness and Governance Review.
  - Staff visit: May 2013; 2013 Article IV Consultation: October/November 2013.
- Executive Board conclusions (January 23, 2013; PIN No. 13/11):
  - Macroeconomic performance: Real GDP growth 5.5 percent in 2011 and 5.7 percent in first three quarters of 2012.
  - Unemployment remains high at about 15 percent; half of unemployed out of work >1 year.
  - Consumer price inflation averaging [2.4] percent in 2012.
  - Return to international markets; government aims to adopt euro in 2014 and well-positioned to meet Maastricht criteria in 2013.
  - Fiscal consolidation reduced general government deficit from nearly 10 percent of GDP in 2009 to 3.4 percent in 2011; 2012 deficit below 2 percent despite VAT cut and supplementary spending.
  - Financial sector: banking system profitable and well capitalized; NRDs expanding rapidly matched by accumulation of liquid foreign assets.
- Board recommendations and concerns:
  - Continue strong policies to safeguard financial stability, tackle structural unemployment, and strengthen potential growth.
  - Build fiscal space; keep GMI lowering and decentralization under close review.
  - Mixed views on PIT cuts; need for compensatory measures and equity considerations.
  - Timely passage and implementation of Fiscal Discipline Law critical.
  - Vigilance on NRD increase; welcome higher capital requirements and recommend intensive supervision.
  - Completion of banking sector restructuring and new FSAP useful to assess post-crisis transformation.
  - Structural reform priorities: judicial system, SOE governance and transparency, higher and vocational education.
- Staff and authorities statements (January 23, 2013):
  - Latvia repaid all outstanding obligations to the Fund on December 20, 2012: repurchase amounted to SDR 603.038 million (about €714.3 million).
  - Authorities broadly agree with staff views; determined to implement PIT cuts and committed to euro adoption and measures to reduce unemployment and support reforms.

*Source: Republic of Latvia: Ex-Post Evaluation of Latvia’s Stand-By Arrangement; IMF staff report excerpts (content unit _cr1328).*

### 1. Ex-Post Evaluation of Latvia's Stand-By Arrangement: A Summary ______________________________5

### 1. Ex-Post Evaluation of Latvia's Stand-By Arrangement: A Summary

### Context and recent developments
- Latvia rebounded from the crisis after undertaking a sustained internal devaluation anchored to a peg to the euro, achieved through sharp fiscal consolidation and a restoration of competitiveness via declining unit labor costs.
- December 2012: Latvia issued a US dollar bond and publicly announced its intention to repay all outstanding obligations to the Fund ahead of schedule.
- The country appears well placed to meet the Maastricht criteria for euro adoption.

### Strong recovery continued through 2012
- Real GDP growth:
  - 2011: 5½ percent.
  - First three quarters of 2012: 5.7 percent year-on-year (the fastest rate of growth in the European Union).
- Demand composition:
  - Exports (nominal): grew by 12 percent in January-September 2012 versus same period in 2011.
  - Private consumption and gross fixed capital formation: expanded rapidly due to pent-up demand.
- Labor market:
  - Unemployment rate: decreased to 13.5 percent in the third quarter of 2012 from 16.2 percent on average in the first half of 2012.
  - Employment growth: 2¾ percent (y-on-y) in the first three quarters of 2012; 3.4 percent in the third quarter.
  - Labor force participation: almost 2 percentage points higher in the third quarter of 2012 than a year ago.
  - Long-term unemployed: about half of total unemployed.
  - Staff estimates a remaining unemployment gap of about 2¾ percentage points.
  - Real wage growth: about 1½ percent per annum.

### Box 1 — Program summary and lessons (Ex-Post Evaluation)
- Pre-crisis dynamics: post-2004 boom driven by large private inflows, rising inflation, real estate bubble, large current account deficit; crisis followed in early 2008 after capital flow reversal and bank liquidity run.
- IMF SBA approved on December 23, 2008 with exceptional access of 1,200 percent of quota (SDR 1.5 billion or approximately €1.7 billion) for 27 months, extended to 36 months.
- International financing package: total financing of €7.5 billion (co-financed and coordinated with EU, EBRD, World Bank, Nordic countries, and neighbors); only €4.5 billion drawn from original €7.5 billion package.
- Program objectives: arrest liquidity crisis, ensure long-term external stability, maintain exchange rate peg, stabilize financial sector, facilitate debt restructuring, foster real depreciation via income policies, adjust fiscal policy to limit financing needs, create space for potential contingent financial sector liabilities; explicit exit strategy: euro adoption.
- Outcomes:
  - Immediate objectives met; financial conditions improved relative to program projections after first review.
  - Loss of reserves and deposit drains stemmed by third quarter 2009.
  - Growth resumed by end-2009 earlier than expected.
  - Economic contraction and unemployment larger than initially projected.
  - Turnaround in current account significant and rapid.
- Key lessons:
  - Strong ownership critical and rooted in public acceptance of austerity measures.
  - Explicit and credible exit strategy (euro adoption) helps boost confidence and anchor objectives.
  - International community support and private sector engagement were instrumental; parent banks maintained exposure and recapitalized subsidiaries.
  - Specific Latvian conditions aiding internal adjustment are not easily replicable: low initial public debt, strong ownership, credible exit strategy, large upfront current account adjustment (mainly autonomous).
  - Real-financial linkages can amplify shocks; underestimation of these linkages led to underestimation of crisis impact on real activity.
  - Flexibility in program design important; fiscal program adapted to a sharper-than-projected output collapse.

### Inflation and fiscal developments
- Inflation:
  - Mid-2011 peak: about 4¾ percent (year on year).
  - End-November 2012: 1.5 percent.
  - Core inflation: receded from 3¼ percent to almost zero over same period.
  - Energy price inflation: 5.6 percent (less than half the rate observed a year ago).
- Fiscal balance:
  - 2011: fiscal deficit 3.4 percent of GDP (ESA 95 definition).
  - Original 2012 budget: further adjustment of 1.1 percent of GDP.
  - Mid-year: statutory VAT rate cut by 1 percentage point.
  - Upward revision to tax revenue: 1.3 percent of GDP due to cyclical and broad based revenue over-performance.
  - Mid-year supplementary budget increased spending by 1 percent of GDP on basic health care, road maintenance and pensions, plus higher EC budget contributions and financing for loss-making hospitals.
  - Staff expects headline deficit for 2012: 1.8 percent of GDP (below Maastricht criterion of 3 percent of GDP).

### Banking sector and credit conditions
- Banking sector performance:
  - Banks returned to profitability in 2011.
  - Average return on equity: around 10 percent in the first 9 months of 2012.
  - Non-performing loans (NPLs): decreased from mid-2010 peak of about 19½ percent to 12½ percent.
  - Loan loss provisions: more than ¾ of NPLs.
  - NPLs by sector: corporate loans about 11 percent; household loans 16 percent.
  - System-wide capital adequacy ratio: 17.4 percent (regulatory minimum 8 percent).
- Credit dynamics:
  - Banking sector total assets decreased by about L3½ billion (15 percent) since end-2008.
  - Nominal stock of loans to residents: about 30 percent lower since pre-crisis peak.
  - Loans to residents contracted by 2 percent year-on-year by end-September 2012 (leveling-off from 6 percent contraction at end-2011), excluding removals of Parex Bank and Latvijas Krajbanka from statistics.
  - Volume of new loans to residents in first three quarters of 2012: 28 percent higher than same period in 2011; less than 18 percent of these new loans were to households.
- Deleveraging by foreign-owned banks:
  - Subsidiaries reduced liabilities to parent banks by about L3.5 billion since end-2008; L3.2 billion correspond to Nordic banks.
  - Loan-to-deposit ratio (subsidiaries of foreign banks): dropped from almost 260 percent to 176 percent.
  - Liabilities to parent banks decreased by 26 percent from end-2010 to end-2011, and by roughly the same rate in the first three quarters of 2012.
  - Outstanding liabilities to foreign parent banks declined to about 40 percent of their peak-levels.
  - Recent deleveraging driven mainly by household deleveraging and weak corporate credit demand; tighter lending standards may also play a role.
- Non-resident deposits (NRDs):
  - NRDs increased by 19.7 percent in the year to end-September 2012 (15.7 percent if exchange rate effects excluded).
  - Resident private deposits grew by 1.3 percent over the same period.
  - NRDs now exceed deposits of private residents.
  - Rise in NRDs associated with accumulation of foreign assets, mostly liquid assets such as government securities and claims on MFIs.
- Specific bank recapitalization:
  - A mid-size bank specializing in non-resident clients was found significantly undercapitalized by FCMC; a strategic private investor contributed L8.2 million in fresh capital (negotiations ongoing).

### Outlook and risks
- Short-term (staff baseline for 2013):
  - Growth: projected to decline to about 3¾ percent in 2013 (from above 5 percent in 2012) as base effects phase out and export growth moderates.
  - Exports: growth remains strong but will decline; modest widening of current account deficit expected.
  - Private sector credit: projected to resume gradually; credit to households likely to keep shrinking due to excess housing supply.
  - Employment: projected average growth 1.4 percent in 2013 (down from 2.5 percent in 2012).
  - Unemployment: expected to decrease to about 13.7 percent in 2013 (staff estimate of natural unemployment rate around 12 percent).
  - Inflation: projected consumer price growth 2.2 percent in 2013.
- Medium term:
  - Baseline assumes euro adoption in 2014 (authorities’ target).
  - Output gap: expected to close by 2015–16.
  - Real GDP growth: projected about 4.2 percent in 2014–15; about 4 percent per year from 2016 onwards.
  - Drivers: catch-up in business investment; continued consumption recovery supported by cumulative labor market improvements and planned reductions in personal income tax (PIT) rate over 2013–15; gradual increase in exports as global conditions improve.
  - Inflation: expected to level off at about 2–2½ percent.
  - Current account: modest widening to about 3½ percent of GDP deficit in the medium term.
  - Financing: expected to come from gradual reduction in deleveraging pace by foreign banks and a conservative pickup in FDI.
  - Constraints: projected productivity improvements partially offset by a stagnant labor force due to demographic trends (Appendix II).

*Source: Republic of Latvia: Ex-Post Evaluation of Latvia’s Stand-By Arrangement (summary content provided).*

### 14.      Risks are skewed to the downside. Adverse developments in the euro area could raise

### 14.      Risks are skewed to the downside. Adverse developments in the euro area could raise

### Risk Assessment Matrix — key risks and impacts
- Overall assessment: Risks are skewed to the downside; adverse developments in the euro area could raise Latvia’s borrowing costs and slow the recovery. Latvia’s high external debt is a significant vulnerability; external DSA shocks to growth and/or the current account could substantially delay debt reduction. Upside potential exists if stronger-than-expected FDI and faster job creation occur, aided by full implementation of microeconomic reforms.
- Selected risks, relative likelihood and impact if realized:
  - Strong intensification of the euro area crisis
    - Relative Likelihood: Medium
    - Impact if Realized: High
    - Notes: Several possible triggers at the European sovereign or area-wide levels; financial stresses could escalate as bank-sovereign-real economy links re-intensify; uncertainty could raise borrowing costs given substantial external repayment obligations; Nordic parent banks could deleverage more quickly.
  - Protracted period of slow European growth
    - Relative Likelihood: Medium
    - Impact if Realized: Medium
    - Notes: Potential output damage may be deeper than expected; deleveraging may have a more severe impact; spillovers might be mitigated if Russia and Sweden are less affected.
  - Renewed bank deleveraging and/or non-resident deposit (NRD) flight
    - Relative Likelihood: Medium
    - Impact if Realized: Medium
    - Notes: Nordic parents seem healthy but NRD activities are susceptible to quick reversals; could pressure international reserves if NRD reversals cannot be covered.
  - Global oil price shock
    - Relative Likelihood: Low
    - Impact if Realized: Low
    - Notes: Geopolitical tensions in the Middle East could trigger an oil price shock; weak global demand could instead soften prices; risk to meeting Maastricht inflation criterion is mitigated by the backward-looking nature of the criterion.

### Path to euro adoption — prospects and staff views
- Authorities’ stance and timetable:
  - Authorities strongly committed to euro adoption in 2014; intend to request EC and ECB assessments of convergence, to be prepared in spring 2013.
  - Pending adoption, Latvia will maintain the peg to the euro and participate in ERM-2; authorities are not open to alternative exchange rate regimes.
- Staff view on benefits of euro adoption:
  - Eliminate risk of speculative attacks against Latvia’s exchange rate and reduce contagion risk to other CEE pegged countries.
  - Address vulnerabilities from foreign currency exposures given the financial system is already very highly euroized.
  - Reduce sovereign borrowing costs durably by removing exchange rate premia, while noting sovereign risk within the union remains.
  - Enhance financial sector stability by giving Latvian banks access to the ECB’s emergency liquidity.
- Maastricht criteria and uncertainties:
  - Latvia appears on track to meet all Maastricht criteria, subject to uncertainties on inflation and interest rate reference values (dependent on EU institution determinations).
  - Current inflation is below the Maastricht reference value and should remain under projected reference rate at the time of EC/ECB assessments (based on IMF staff projections of the 3 EU countries with the lowest twelve month inflation rate in March 2013).
  - Harmonized long-term interest rate fell to 3½ percent in October, suggesting good prospects for meeting the interest-rate criterion in early 2013.
  - Outcome remains uncertain due to possible treatment of outlier comparator countries (e.g., Sweden or Germany).

### International reserves — adequacy, pressures, and debt repayments
- Reserve adequacy and maturity profile:
  - Projected reserve level of €5.4 billion at end-2012 is above the standard rule-of-thumb of three months’ import cover.
  - Measures that account for large short-term external debt are low, primarily due to the denominator effect from large NRD deposits.
  - Reserves as a share of short-term external debt are projected at about 50 percent in 2012.
  - Given 2008 experience where 40 percent of international reserves dissipated due to a substantial fall in NRDs, a prudent and vigilant stance is needed.
- External public borrowing needs and repayments:
  - To repay public external obligations over 2013–15 without further eroding reserve adequacy, the public sector needs to borrow €3 billion (about 14 percent of 2012 GDP) during 2013–15 in international markets.
  - Repayments to the European Commission of €2.2 billion are due in 2014–15, with additional repayments scheduled in 2014 related to Eurobond debt.
- Bond issue and Fund repayment:
  - In December 2012 Latvia issued an international US dollar bond that raised $1.25 billion at a yield of 2.9 percent, following ratings upgrades from Fitch and S&P.
  - Part of the proceeds announced to be used to repay outstanding obligations to the Fund of about SDR 603 million; this early repayment would conclude the Post-Program Monitoring.

### Banking sector vulnerabilities — non-resident deposits, supervision, and regulatory responses
- NRDs and liquidity/reputational risks:
  - NRDs have short maturity and higher volatility; they fell by 30 percent in the 12 months following August 2008.
  - A sudden reversal of NRD flows could cause contagion to resident deposits (largely in foreign currency), threaten international reserves, and create a contingent fiscal liability via sovereign backing for deposit insurance.
  - Banks specializing in non-resident clients allocate a significant share of portfolios to liquid foreign assets, but quality and availability of some assets are harder to verify (e.g., Latvijas Krajbanka insolvency triggered by discovery that €140 million of assets were encumbered).
  - Higher reputational risk from non-resident activity: more difficult to ensure AML/CFT compliance; an incident could spill over to the whole banking system despite amelioration of previous deficiencies (MONEYVAL report).
- Regulatory and supervisory measures:
  - Since mid-2011, FCMC requires banks with non-resident loans >5 percent of total assets or non-resident deposits >20 percent of total assets to hold additional capital.
    - Extra capital requirement ranges from 0.5 to 9 percent of risk weighted assets and depends on level and growth of non-resident exposure.
  - Authorities plan to keep higher capital requirements for non-resident banking when adopting Basel III—either within Pillar II or by applying a capital add-on within Pillar I.
  - FCMC will start monitoring Liquidity Coverage Ratio (LCR) from January 2013 and plans to deviate from baseline specification as needed, applying higher run-off factors for NRDs.
  - Given large contingent fiscal liability (45 percent of insured deposits comprise NRDs), staff discussed charging NRDs a higher contribution to the Deposit Guarantee Fund (DGF); authorities argued effective premium is higher for NRDs because average deposit size is larger, though insured amount is restricted to 100,000 euros.
  - FCMC has amended off-site and on-site inspection frameworks to focus on dynamics and quality of non-resident assets, more active use of Pillar II to set minimum requirements for maturity mismatches, and requiring periodic liquidity stress-tests based on FCMC scenarios.
- Banking sector restructuring and asset recovery:
  - Sale of commercial part of Mortgage and Land Bank (MLB): assets accounting for almost 60 percent of MLB’s commercial activities by book value have been sold; remaining commercial assets sale planned by 2013Q1 or transfer to Latvian Privatization Agency if offers unsatisfactory.
  - Strategy to create a single development institution (SDI) progressing; merger of MLB’s non-commercial part with other development institutions envisaged; debate over shareholder ministry is delaying progress.
  - Sale process for Citadele postponed due to weak market conditions; new restructuring plan to EC aims to facilitate sale and maximize taxpayer recovery, including postponing sale dates and allowing partial sales to attract smaller investors.
  - Latvijas Krajbanka asset recovery: KPMG sold assets and repaid about L90 million to the DGF; sale of loan portfolio (book value ~ L160 million) underway with final offers by end-January and expected conclusion by Q1 2013.
    - DGF payments to depositors about L340 million exceed recovered amounts; legal action to recover missing assets in correspondent accounts amounting to about L130 million recommended.
  - DGF replenishment: deposit insurance premia have been raised by 50 percent; proposal to extend period of increased contributions is being considered (current legislation allows higher contributions only for one year after DGF covers deposits).

### Fiscal sustainability — 2013 budget and medium-term challenges
- 2013 budget assessment:
  - Taking account of a 2 percentage point redirection of state social contributions to the second pillar, the budget is projected to achieve a structural improvement of 0.5 percent of GDP, complying with Maastricht criteria and SGP conditions.
  - The budget includes a one percentage point PIT cut already legislated for 2013, increases tax allowances for dependents, and extends residential property tax rates from 0.2 to 1.5 percent while giving local governments more flexibility.
  - Additional priority spending targets health care bottlenecks, reform lower-end teachers’ salaries, and support demographics.
  - Budget incorporates an agreement to lower the maximum level of the Guaranteed Minimum Income (GMI) and decentralize its financing, against IMF, World Bank and EC advice.
- Social protection concerns and recommendations:
  - Staff urged reconsideration of GMI changes: social exclusion benefits in Latvia are already among the lowest in Europe and should not be cut further.
  - Risk that decentralized financing could leave income-constrained local governments unable to provide reduced benefit levels, causing regional disparities.
  - Staff recommended a broader reform of social assistance programs following recommendations of a World Bank study due in Spring 2013.
- Medium-term fiscal pressures and need for fiscal space:
  - Headwinds include: preapproved PIT cuts totaling 5 percentage points over 2013–15; restored indexation of paid-out pensions as of 2014; gradual reduction in SOE payout ratios from current 90 percent; second-pillar pension contributions increasing over 2015–16 until they reach 6 percent; increasing social insurance benefits for high-earners while restoring the ceiling on social contributions.
  - Compensatory measures will be needed to ensure continued reduction in structural fiscal balances in line with the SGP.

*International Monetary Fund staff report excerpt.*

### 28.      Staff urged reconsideration of the planned PIT cuts, at least from 2014 onwards. The

### _cr1328 - 28.      Staff urged reconsideration of the planned PIT cuts, at least from 2014 onwards. The

### Planned PIT cuts and labor tax policy
- Staff urged reconsideration of the planned PIT cuts, at least from 2014 onwards, because the large cumulative size of the proposed cuts implies an excessive loss of fiscal space and a correspondingly greater need for compensatory measures.
- Policy trade-offs and alternatives noted:
  - Untargeted cuts in the statutory PIT rate are not first-best from an efficiency or equity perspective.
  - Better options include:
    - Introduce a two-tier PIT system (example in footnote: two rates—25 percent (the current rate in 2012), and 15 percent for lower income taxpayers—with the threshold chosen so the measure is revenue enhancing compared to the current plan of an across the board cut).
    - Increase the minimum non-taxable allowance.
    - In conjunction with social assistance reform, introduce an earned income tax credit program.
- Authorities’ stance: regard the tax cuts as essential for improving work incentives and addressing the informal economy, and prefer to focus on other measures to ensure fiscal sustainability.

### Revenue and expenditure reform options to build fiscal space
- Revenue measures:
  - Reform the cadastre of properties to facilitate corrections and ensure fair and consistent valuations across regions, followed by an increase in the lower bound for tax rates on property while ensuring progressivity to protect the poorest.
  - Reduce tax exemptions for dependents in conjunction with reforming state family benefits to increase progressivity of family support programs.
  - Other options: reduce the tax allowance for pensions; eliminate exemptions on indirect taxes such as the diesel exemption for farmers; increase revenue from environmental taxes to correct for negative externalities.
- Expenditure measures:
  - Focus spending reforms on improving economic incentives stemming from public spending programs.
  - Public transport subsidies could be reduced while designing a well-targeted cash transfer to compensate the poor for price increases.
  - Better targeting of family and child benefits and non-contributory supplemental pensions to ensure equality both within and across cohorts.
  - Reduce the duration of parental, maternity and paternity benefits while supporting child care to yield savings and improve labor market efficiency.
- Authorities acknowledged the need to consider a broad range of possible measures without committing to reforms in any specific area.

### Structural fiscal reforms underway
- The Law on Budget and Financial Management sets binding ceilings on central government spending for 3 years; approved with the 2013 budget.
- Passing the Fiscal Discipline Law (FDL) and related constitutional amendments should be highest priority to enhance fiscal sustainability by avoiding pro-cyclical fiscal policies and ensuring consistency of expenditure ceilings with both structural balance and expenditure growth rules.
- Status noted: the FDL is pending in parliament and could be passed as early as January 2013.
- State Revenue Service (SRS) measures: terminate fictitious companies and restrict activities of persons involved; limit cash transactions; eliminate transactions designed to avoid income tax; medium-term strategy to increase audit coverage.

### Structural reforms to enhance competitiveness and labor market incentives
- Competitiveness assessment:
  - Staff assess the exchange rate is broadly in line with fundamentals (Box 3).
  - Latvia continues to gain market share in world imports aided by continued depreciation of the REER.
  - Staff calculations suggest a modest remaining competitiveness gap of about 4.6 percent, subject to wide uncertainty.
  - Authorities concur on need for continuing micro-economic reforms to reduce structural unemployment and enhance competitiveness within a fixed exchange rate regime.
- Labor market measures to promote work incentives:
  - The guaranteed minimum income (GMI) benefit currently phases out one-for-one with income, placing a very high tax wedge on GMI recipients entering employment; consideration should be given to reducing the benefit more gradually with rising income.
  - Shift active labor market policies towards in-work tax credits and benefits to increase employment of lower skilled workers.
  - Reduce duration of family benefits while enhancing formal child care to support labor force participation.
- Specific bottleneck reforms under development:
  - Judicial reform: address delays in the civil court system (videoconferencing for witnesses; publication of anonymized court decisions); retain the single “cash-flow” test for insolvency and improve implementation.
  - State-owned enterprises (SOEs): proposal for a new, partially centralized institution to oversee SOE governance and enhance financial reporting; legislation pending; technical working group reviewing each SOE’s future status.
  - Higher and vocational education: quality lagging, limited resources thinly spread, falling student numbers, vocational programs misaligned with labor market needs; proposals to concentrate resources face stakeholder resistance.

### External stability and real exchange rate (Box 3)
- CGER methodology results (estimates vary by approach):
  - External sustainability: -2.1 percent (undervaluation).
  - Macroeconomic balance: 0 (close to equilibrium).
  - Equilibrium real exchange rate (ERER): 15.8 percent (overvaluation).
  - Average misalignment reported: 4.6 percent.
- Methodological sensitivities highlighted:
  - MB results premised on staff’s baseline assumption of closing the output gap by 2017; a slower recovery could imply greater real overvaluation.
  - ES estimate sensitive to the output gap and the stabilized NFA-to-GDP ratio assumption.
  - ERER estimate extremely sensitive to sample period—changing the sample can swing the misalignment by over 10 percent.
- REER developments:
  - By the second quarter of 2012 the ULC-based REER had depreciated by over 9 percent since end-2009.
  - The PPI- and CPI-based REERs depreciated by over 6 percent to July and September 2012, respectively.
- Export performance and diversification:
  - Rapid export growth driven largely by intensive margin (increasing presence in established markets) and also by extensive margin (new markets and products).
  - Exports have diversified away from wood and apparel into electrical equipment and machinery and other sectors.
  - Relative to Baltic neighbors, Latvia’s export share to traditional European markets has fallen more, while exports to CIS countries and major emerging markets are rising.

### Staff appraisal: growth, euro adoption, risks, and priorities
- Recent macro performance:
  - Latvia’s economy recovering strongly; economic growth is expected to exceed 5 percent in 2012 despite recession in the euro area.
  - Inflation has fallen sharply amid a still negative output gap.
  - Unemployment rate is declining despite increasing labor participation, but the level of unemployment remains unacceptably high and mostly structural.
- Near-term outlook:
  - Economic growth expected to weaken slightly in 2013, then pick up in the medium term.
  - Credit to the private sector projected to resume gradually, with business lending picking up earlier than household lending.
  - Output gap expected to close by 2015–16, with inflation leveling off at about 2–2½ percent.
  - Current account deficit should widen modestly while remaining within sustainable bounds.
  - Risks are skewed to the downside, especially adverse developments in the euro area that could derail the recovery and raise Latvia’s borrowing costs.
- Euro adoption and fiscal position:
  - Euro adoption in 2014 appears within reach, subject to technical uncertainties.
  - On the basis of fiscal outturns so far in the year and the 2013 budget, the general government deficit and debt for 2012–13 would be below their respective Maastricht reference values.
  - Euro adoption would remove residual currency risk and enhance stability of the highly euroized financial system.
- Fiscal recommendations:
  - Take advantage of the recovery to continue building fiscal space over the medium term.
  - Reconsider large planned cumulative cuts in the PIT rate; consider a two-tier system or increase in the minimum non-taxable allowance.
  - Compensatory measures will be needed to maintain fiscal momentum in light of headwinds (restored indexation of pensions, partial restoration of second pillar pension contributions, lowering of required dividend ratios for SOEs).
- Financial sector and external vulnerabilities:
  - Rapid increase of non-resident deposits (NRDs) warrants vigilance; expansion associated with accumulation of foreign assets but represents vulnerability to international reserves and a significant contingent fiscal liability given sovereign backing for the deposit guarantee scheme.
  - FCMC’s current and planned prudential measures to guard against such risks are welcome; supervision of NRD-specialized banks should be sufficiently intensive and frequent.
  - Gross reserves are low in relation to short-term external debt; the maturity profile of external debt is shortening as some banks receive short-term NRDs while others repay long-term loans to parent banks.
  - Recent successful international bond issue is welcome as it extends the maturity profile of external debt and will be used in part to prepay outstanding obligations to the Fund.
- Structural reform priorities:
  - Timely implementation of planned reforms (Fiscal Discipline Law; judicial system; SOE governance and transparency; higher and vocational education) would improve the business environment and prospects for sustainably higher investment, employment, and living standards.

*Source: IMF staff report excerpt (document content provided).*

### 42.      Staff recommends that the next Article IV consultation be held on the standard

### _cr1328 - 42.      Staff recommends that the next Article IV consultation be held on the standard 12-month cycle.

### Real sector: growth and outlook
- Growth remained robust in 2012.
- Real GDP (Table 2 projections):
  - 2012: 5.2
  - 2013: 3.7
  - 2014: 4.2
  - 2015: 4.2
  - 2016: 4.0
  - 2017: 4.0
- Contributions to growth (Table 2):
  - Domestic demand and net exports split shown; net exports contribution projected around -0.5 to -0.7 in later years.
- Key national accounts (Table 1, selected):
  - Real GDP 2012: 5.2 (percentage change)
  - Private consumption 2012: 4.8
  - Gross fixed capital formation 2012: 27.9
  - Exports of goods and services 2012: 11.6
  - Imports of goods and services 2012: 11.4
- Nominal GDP:
  - 2012 (billions of lats): 15.3
  - 2012 (billions of euros): 21.8
  - GDP per capita 2012 (thousands of euros): 9.9

### Inflation and labor market
- HICP inflation (period average, Table 1): 2012: 2.4
- End-period HICP 2012: 2.2
- Consumer price inflation is on a downward path despite still-high oil price inflation (figure caption).
- Labor market (Table 2):
  - Unemployment rate (LFS, period average, percent): 2012: 15.0; projected 2013: 13.7; 2014: 12.3; 2015: 11.1; 2016: 10.1; 2017: 9.4
  - Employment (period average, percent change) 2012: 2.5; projected 2013: 1.4; 2014: 1.2; 2015: 0.9; 2016: 0.7; 2017: 0.4
  - Real gross wages 2012: 1.3; projected modest positive growth thereafter.

### Fiscal developments and projections
- Fiscal recommendation (front matter): Staff recommends next Article IV consultation on standard 12-month cycle.
- 2012 fiscal deficit and Maastricht: The 2012 fiscal deficit should be below 2 percent of GDP (ESA 95), meeting the Maastricht criterion (figure caption).
- Consolidated general government (Table 1):
  - Total revenue 2012: 38.0 percent of GDP
  - Total expenditure 2012: 37.1 percent of GDP
  - Basic fiscal balance 2012: -0.7 percent of GDP
  - ESA balance 2012: -1.8 percent of GDP
  - General government gross debt 2012: 37.6 percent of GDP
- General Government Operations (Table 3, selected 2012 figures, millions of lats):
  - Total revenue and grants 2012: 5,833
  - Tax revenue 2012: 4,256
  - Total expenditure 2012: 5,942
  - Fiscal balance (2012, millions of lats): -101
  - ESA balance (2012, percent of GDP): -1.8 (Table 3 concluded)
- Debt dynamics and sustainability (Table 6, selected):
  - Baseline public sector gross debt:
    - 2012: 37.6 (percent of GDP)
    - 2013: 42.2
    - 2014: 37.7
    - 2015: 34.1
    - 2016: 34.1
    - 2017: 33.0
  - Change in public sector debt 2012→2013: 0.1 (percent of GDP) rising to 4.6 in 2013 (Table 6 line 2 shows 4.6 for 2013)
  - Primary deficit (Table 6 line 4) 2012: -0.9; 2013: -0.4; 2014: -0.5; 2015: 0.1; 2016: 0.0; 2017: -0.2
  - Gross financing need (Table 6 memoranda, percent of GDP and USD values):
    - Gross financing need (percent of GDP) 2012: 7.9
    - Gross financing need (USD billions) 2012: 2.2

### International reserves and external financing
- Gross official reserves (Table 1 and Table 7 memo):
  - 2012 (billions of euros, Table 1): 6.7
  - Table 7 memorandum: Gross reserves (billions of euros) 2012: 6.7; projections: 2013: 6.2; 2014: 5.9; 2015: 6.3; 2016: 6.3; 2017: 6.4
  - Reserve coverage (months of prospective imports) 2012: 5.0 (Table 1)
- Figure notes:
  - Two international bonds issued in 2012 have helped support reserves, but reserves remain below benchmark adequacy level.
- Balance of payments and external sector (Table 7, selected projections, millions of euros):
  - Current account (millions of euros): 2012: -483; 2013: -794; 2014: -858; 2015: -944; 2016: -980; 2017: -1,032
  - Current account (percent of GDP, memorandum): 2012: -2.2; 2013: -3.4; 2014: -3.5; 2015: -3.6; 2016: -3.5; 2017: -3.5
  - Exports (millions of euros) 2012: 9,530; Imports 2012: 12,124
  - Net FDI (percent of GDP, memo): 2012: 3.6; projected 2013: 3.7; 2014: 3.8; 2015: 3.8; 2016: 4.0; 2017: 4.0
- External debt (Table 8 and Table 9):
  - Gross external debt (percent of GDP) 2012: 143.9 (Table 9 baseline series shows 143.9 for 2012 in percent of GDP); Table 8 shows gross external debt in billions of euros 2012: 30.2
  - Gross external debt (projection trend): 2012: 143.9; 2013: 138.3; 2014: 137.2; 2015: 127.3; 2016: 119.3; 2017: 115.2 (percent of GDP, Table 9)

### Banking sector and financial stability
- Banking sector profitability and asset quality (figure captions and Table 12):
  - Despite losses related to Krajbanka and Parex Bank, the banking sector is again profitable (figure caption).
  - Non-performing loans are gradually declining (figure caption).
- Selected Financial Soundness Indicators (Table 12, year-end or latest):
  - Regulatory capital to risk-weighted assets (Sep-12): 17.7 (percent)
  - Return on assets (after tax) Sep-12: 0.8 (percent)
  - Return on equity (after tax) Sep-12: 7.6 (percent)
  - Loans past due over 90 days Sep-12: 12.5 (percent of loans)
  - Loan loss provisions to loans past due over 90 days Sep-12: 76.0 (percent)
  - Liquid assets to total assets Sep-12: 29.7 (percent)
  - Liquid assets to short term liabilities Sep-12: 59.3 (percent)
  - FX assets to total assets Sep-12: 80.8 (percent)
  - FX deposits to total deposits Sep-12: 76.5 (percent)
  - Private sector credit (annual percentage change, Table 1): 2012: -9.0; 2013 projection: 1.2
- System liquidity and market rates (figure captions):
  - Excess bank deposits at Bank of Latvia and low money market rates indicate banking system liquidity; Rigibor overnight low (figure).

### Competitiveness, euro adoption, and Maastricht criteria
- Competitiveness measures:
  - Real Effective Exchange Rates (2006=100) show improvement (figure caption).
- Maastricht criteria and euro adoption (Figure 8):
  - Inflation has recently fallen below the criterion reference rate (figure caption).
  - Harmonized long-term interest rate decreasing and in line with recent reference values (figure caption).
  - Public support for euro adoption affected by the euro area crisis (figure caption).
  - Latvia expected to meet Maastricht fiscal criteria with ease in 2012 (figure caption).
- General government debt relevant for Maastricht:
  - General government gross debt 2013 projection: 42.2 (percent of GDP) (Table 3 concluded / Table 4)

### Debt sustainability and stress tests
- Public debt sustainability (Figure 9 and Table 6):
  - Baseline public sector debt path shows gross debt rising to 42.2 in 2013 then declining to 33.0 by 2017 (Table 6 baseline).
  - Debt-stabilizing primary balance reported as -0.6 (Table 6 last column).
  - Stress test boxes (Figure 9) show average baseline and scenario values; scenarios include growth shock, primary balance shock, interest rate shock, combined shock, contingent liabilities shock (30 percent depreciation and 10 percent of GDP contingent liabilities).
- External debt stress tests (Figure 10 and Table 9):
  - Baseline external debt in percent of GDP 2012: 143.9; tests include interest rate shock, current account shock, growth shock, real depreciation shock (30 percent), and combined shocks.
  - Gross financing need under baseline (Table 9 memo): 2012: 13.3 (billion euros) and in percent of GDP 2012: 68.8 (Table 9 gross financing need lines)

### Policy implications and recommendations (implied by content)
- Maintain fiscal discipline to keep ESA deficit within Maastricht criterion (2012 deficit should be below 2 percent of GDP).
- Continue policies supporting reserve adequacy and manage gross financing needs given projected external amortization and financing (IMF prepayment removes gross financing needs for 2013 but needs remain high in future years, figure caption).
- Monitor banking sector asset quality and non-performing loans while preserving liquidity buffers and FX liquidity, given significant FX exposures and non-resident deposit shares.
- Proceed with euro adoption criteria monitoring given favorable inflation, interest rate, and fiscal positions, while managing public support dynamics.

*Source: REPUBLIC OF LATVIA — IMF staff report content unit _cr1328.*

### Appendix I. The Non-Resident Banking Sector in Latvia

### Appendix I. The Non-Resident Banking Sector in Latvia

### Overview
- Commercial banks’ assets accounted for almost 90 percent of total assets in the financial sector and 150 percent of GDP at end-2001.
- There are 20 commercial banks—including 8 subsidiaries of foreign banks from Sweden, Norway, Austria, Russia and Ukraine—and 8 foreign bank branches in Latvia.
- The banking sector is segmented between banks dealing with domestic clients and banks dealing with non-resident clients (NR banks).
- The FCMC classifies a bank as specialized in non-resident clients if NRDs represent more than 20 percent of its assets.

### Non-resident deposits (NRDs): scale and origin
- NRDs across the banking system are about L5.5 billion or 51 percent of total deposits.
- As of end-September 2012, deposit origin composition:
  - about 1/3 of NRDs were from EU countries;
  - 12 percent from CIS countries (70 percent of them from Russia);
  - 55 percent from other non-EU jurisdictions.
- Additional deposit origin details:
  - 58 percent of EU deposits are from the U.K.;
  - 25 percent of EU deposits are from Cyprus.
- Estimated ultimate origin:
  - Overall, 80 to 90 percent of NRDs are estimated to come from CIS countries.
- Concentration among banks:
  - NRDs account for more than 70 percent of deposits for 2/3 of local banks;
  - more than 60 percent of deposits for all non-Nordic subsidiaries;
  - less than 10 percent of deposits for all but one branch of foreign banks and for all Nordic subsidiaries.

### Drivers of recent NRD flows (12 months to end-September 2012)
- NRDs increased by 19.7 percent (15.7 percent if exchange rate effects are excluded).
- Identified drivers:
  - Relocation of CIS depositors from countries with banks under stress in the euro area, mainly Cyprus.
  - Latvia’s EU residency permit program since mid-2010, which grants permits to foreigners investing at least L200,000 in subordinated debt of a credit institution (other eligible investments include real estate or nonfinancial companies). However:
    - only about L50 million in investment (out of L290 million) claimed for obtaining EU residency permits were made in the banking sector, indicating a minor role.

### Asset composition and foreign exposure of NR banks
- Share of foreign assets in NR banks’ total assets: about 55 percent.
- Share of foreign assets in banks dealing with residents: 12 percent.
- Geographic distribution of foreign assets (more than 90 percent issued by counterparts in):
  - EEA: 62 percent;
  - CIS countries: 18 percent;
  - U.S. and Canada: 13 percent.
- Foreign asset breakdown for NR banks:
  - Almost half of total foreign assets are claims on foreign MFIs; 80 percent of these claims are from EEA countries (of which banks from Germany, Austria, the U.K. and Switzerland account for 77 percent).
  - Foreign loans account for about 1/4 of NR banks’ foreign assets:
    - About 70 percent of these foreign loans are granted to clients from CIS countries;
    - 40 percent of total foreign loans are granted directly to clients in CIS countries;
    - the remainder are granted indirectly through jurisdictions such as the U.K., Cyprus, British Virgin Islands and Belize.
  - Foreign securities account for 1/4 of foreign assets of NR banks:
    - Almost half of foreign securities correspond to government securities;
    - Among government securities, 93 percent is issued by the U.S., Canada or EEA countries;
    - These countries also account for 57 percent of non-government securities;
    - 28 percent of non-government securities is issued by corporates from CIS countries.

### Recent accumulation of liquid foreign assets and portfolio shifts (2008–2012)
- NRDs in banks dealing with non-resident clients increased by almost L1.4 billion between 2008 and 2012.
- NR banks’ portfolio of foreign assets expanded by L1.2 billion over the same period, most invested in liquid assets.
- Composition of accumulated foreign assets over the last 4 years:
  - Claims on foreign MFIs (with maturity up to 30 days) and government securities account for more than 90 percent of the foreign assets accumulated.
  - Foreign loans are essentially at the same level as in 2008 (no material increase).
- NR banks have become more detached from the domestic economy:
  - Domestic assets held by NR banks decreased by L0.5 billion between 2008 and 2012 (while total assets increased by L0.7 billion).
  - Loans to residents granted by NR banks decreased by almost L1 billion over the same period.

### Capital adequacy and regulatory measures
- Capital adequacy developments (2007 to 2011):
  - Banks dealing with residents: average capital adequacy ratio increased from about 10 percent in 2007 to close to 20 percent in 2011.
  - Banks dealing with non-residents: capital adequacy ratio increased from slightly above 10 percent to about 15 percent in 2011.
- Regulatory response:
  - Since mid-2011 the FCMC requires NR banks to hold extra capital depending on exposure to the non-resident business and its growth rate, with extra capital requirements ranging from 0.5 to 9 percent of risk weighted assets.

### Structure of the banking sector (end-September 2012) — selected figures from FCMC table
- System totals (selected):
  - Total assets (System): 60.5 (unit context: implied millions of Lats in table);
  - Foreign assets (System): 7.6;
  - Total assets (Banks): 56.9; Foreign (Banks): 8.4.
- By activity (dealing with NR depositors):
  - Total assets: 37.2; Foreign: 15.5.
- By ownership (selected):
  - Domestic banks total assets: 38.4; Foreign: 12.4.
  - Subsidiaries of foreign banks total assets: 71.3; Foreign: 5.3.
  - Nordic parents (subsidiaries) total assets: 77.4; Foreign: 1.3.
  - CIS parents total assets: 28.5; Foreign: 9.7.
- Branches of foreign banks total assets: 85.1; Foreign: 2.3.

*Source: FCMC; Bank of Latvia; and IMF staff calculations.*

### Appendix II. Latvia’s Demographic Challenge

### Appendix II. Latvia’s Demographic Challenge

### Population decline and main drivers
- During 2000–11, the population declined by about 14 percent (340 thousand people).
- Emigration was responsible for about ⅔ of this decline while natural change due to low fertility accounted for the remainder.
- Emigration:
  - An estimated 200–215 thousand people, mainly young people—roughly 9 percent of the population—have left Latvia during 2000-11 (Hazans, 2011; and Central Statistics Bureau).
- Low fertility:
  - The decline of the population for natural reasons was about 125–140 thousand people (5 percent of the population).
  - The number of births has halved since the early 1990s—from around 40,000 annual births to around 20,000—falling below replacement levels.

### Economic and national implications
- Demographic decline is perceived as an important national concern beyond economic considerations.
- Short-term economic effects of emigration may include:
  - Potential welfare enhancement (in expectation) as an alternative to unemployment.
  - Reduced unemployment insurance costs.
  - Increased inflow of remittances.
- Long-term negative economic consequences of emigration and demographic decline include impacts on:
  - Human capital.
  - Public finances.
  - Pension schemes.
- For a small country like Latvia (about 2 million inhabitants), excessive emigration is described as unsustainable.
- Authorities are engaged in reversing incentives to emigrate and encouraging return of expatriates.

### Emigration dynamics and recent trends
- Largest episodes of emigration in the past decade occurred during:
  - The Russian crisis in the early 2000’s.
  - The global financial crisis in 2008–10.
- In 2008–10, net emigration was about four times larger than during the boom in 2005–07.
- Preferred destinations in 2011 for over ⅘ of emigrants were countries inside the European Union, notably Germany, the UK, and Ireland.
- Net emigration declined sharply in 2011 and is likely to fall further as the economy rebounds; whether it will turn negative is unclear.
- Surveys indicate that 20 percent of emigrants plan to return within 5 years (Hazans, 2011).
- Given a large income gap between Latvia and preferred emigration destinations, some component of net emigration is likely structural and less amenable to reversal.

### Policies to discourage emigration
- Policies with most traction:
  - Pro-growth policies favoring income convergence and factor price equalization over time.
- Measures with less political support:
  - Facilitating immigration by other nationalities.
- Public encouragement:
  - Ministers have publicly encouraged expatriate Latvians to return, while recognizing labor mobility within the EU.

### Policies to increase birth rates (demographic focus)
- Draft National Development Plan 2014–20 (NDP) sets “a stable basis for demographic growth” as a strategic objective.
- 2013 budget family-related measures include:
  - Health care: compensation for prescription medicines for mothers and children, extended access to medical services, and compensation for treatment of reproductive health.
  - Tax policy: extended income tax allowance for dependents.
  - Social support: extended cash transfers for children aged 0–1.5 years, higher floor and ceiling for parental benefits, and new cash transfer to families to facilitate access to kindergarten services.

### Evidence on drivers of fertility and policy implications
- General points:
  - Fiscal policy can help families reduce costs of children and influence preferences only when support is sufficiently large, consistent, and appropriately designed.
  - Political pressure for universal rather than means-tested transfers could risk poorly targeted, fiscally costly measures that fall short of objectives.
- Specific evidence:
  - Availability of formal childcare has an unambiguously positive effect on fertility rates (through childcare subsidies and enrollment, part-time employment or control over working time).
  - Duration and payment of parental leave has an ambiguous effect on fertility, conditional on employment; home- or childcare leave benefits that are not earnings related can have positive effects, especially among low-income families (example: Finland).
  - Financial transfers can have a small and positive but usually temporary effect on fertility rates: they may induce earlier childbearing decisions without significantly affecting overall fertility; transfers typically do not affect opportunity costs and cover only a small part of direct costs, but can affect fertility of low-income households.

### Trade-offs and policy recommendations
- Balance to navigate:
  - Boosting fertility.
  - Containing disincentives for labor force participation.
  - Reducing inequalities among beneficiaries.
- Targeting and design:
  - Personal income tax allowances for children can be regressive because unemployed and low-income families may not have enough income to benefit.
  - Similar support could be more effectively provided through child benefits.
  - Family-oriented support in Latvia (both contributory and non-contributory) has been found to be poorly targeted; priority should be given to means-testing all child allowances.
- Labor market and childcare:
  - Empirical evidence suggests high levels and durations of parental benefits can disincentivize work; long paid leaves can result in deteriorating skills.
  - Best options for reconciling family and work incentives lie in policies promoting child care.
  - OECD countries with the highest female employment rates today are also the ones with high fertility rates.
  - Recent literature documents a significant negative elasticity of female labor supply with respect to the cost of child care of around -0.13 to -0.2.
    - Implication: policies to reduce the cost of child care for families could achieve the dual goal of increasing fertility and promoting work incentives.
  - In-work tax credits—desirable for promoting low-skilled employment—could also help mitigate fertility decline if conditioned on the presence of children in the household.

*Source: Appendix II. Latvia’s Demographic Challenge (IMF staff report excerpt).*

### 1. Bank Work

### 1. Bank Work

### Program activities and evaluations
- Evaluation: "Assessment of Post-Crisis Policy Options" — Evaluation of the employment and social protection situation in Latvia coming out of the crisis: “Who is Unemployed, Inactive or Needy? Assessment of Post-Crisis Policy Options” — October 2012; March 2013.
- Competitiveness Report: Peer Review of Industrial Policy — March 2012; June 2013.
- Ports: Competitiveness and Governance Review — January 2013; November 2013.

### Fund work program and timeline
- Staff Visit — May 2013.
- 2013 Article IV Consultation — October 2013; November 2013.

### Executive Board summary and assessment
- IMF Executive Board concluded the 2012 Article IV consultation, Second Post-Program Monitoring Discussions, and Ex-Post Evaluation of Exceptional Access Under the 2008 Stand-By Arrangement with the Republic of Latvia — concluded January 23, 2013; Public Information Notice No. 13/11 dated January 28, 2013.
- Macroeconomic performance and outlook:
  - Real GDP growth: 5.5 percent in 2011 and 5.7 percent in the first three quarters of 2012.
  - Unemployment: remains high at about 15 percent; half of the unemployed have been out of work for more than a year.
  - Consumer price inflation: averaging [2.4] percent in 2012.
  - Current account deficit: expected to be about 2 percent in 2012 due to robust export growth.
  - Return to international markets noted; government aims at euro adoption in 2014 and is well-positioned to meet Maastricht criteria in 2013.
- Fiscal outcomes and assessments:
  - General government deficit reduced from nearly 10 percent of GDP in 2009 (ESA 95 definition) to 3.4 percent of GDP in 2011 through fiscal consolidation over 4 years.
  - Revenue over-performance helped reduce the deficit to below 2 percent of GDP in 2012 despite a 1 percentage point mid-year reduction in the statutory VAT rate and a supplementary budget with additional expenditures.
  - The 2013 budget consolidates past fiscal gains and should be consistent with both the Maastricht deficit criterion and the Stability and Growth Pact.
- Financial sector:
  - Banking system returned to profitability in 2011 and is well capitalized.
  - Credit to residents contracted substantially since the crisis onset; the rate of contraction has been declining and is likely to level off soon.
  - Non-resident deposits (NRDs) have been expanding rapidly; this expansion has largely been matched by an accumulation of liquid foreign assets.
- Board recommendations and concerns:
  - Continue strong policies to safeguard financial stability, tackle persistently high structural unemployment, and strengthen potential growth.
  - Sustain measures to build fiscal space and avoid resurgence of imbalances; keep lowering of the Guaranteed Minimum Benefit (GMI) and decentralization of its financing under close review to ensure adequate support to the most vulnerable and to avoid deepening regional disparities.
  - Mixed views on planned personal income tax (PIT) cuts: some Directors see merit for work incentives; others urge caution given equity and fiscal space concerns and highlight need for compensatory measures.
  - Structural fiscal reforms and timely passage and effective implementation of the Fiscal Discipline Law are crucial for fiscal sustainability.
  - Vigilance on rapid increase of NRDs as a source of vulnerability to international reserves and contingent fiscal liability; welcome higher minimum capital requirements for NRD-specialized banks and recommend continued intensive and frequent supervision.
  - Completion of banking sector restructuring and a new FSAP would be useful to assess post-crisis transformation.
  - Priorities for structural reform: judicial system, governance and transparency of state-owned enterprises, and quality of higher and vocational education.
  - Agreement with ex post evaluation conclusions: immediate program objectives were achieved; important progress toward longer-term objectives; noted importance of accounting for real-financial linkages in program design.

### Ex-Post Evaluation (EPE) findings on the 2008 crisis and SBA
- Pre-crisis boom (2000–2008) features:
  - Growth driven mainly by domestic demand in the nontradeable sector, fueled by large private sector inflows.
  - Inflation acceleration, real estate bubble, large current account deficit, and increased foreign indebtedness financing domestic credit expansion.
  - Vulnerabilities built up in the banking sector and financial account risks intensified.
- Crisis dynamics in 2008:
  - Capital flows stopped as global liquidity tightened.
  - Run on deposits at the largest domestically-owned bank led to system-wide liquidity shortage.
  - Concerns over sustainability of the currency peg compounded pressures.
  - Authorities turned to IMF and European Commission for financial support in November 2008 to avert systemic bank failure, protect international reserves and the peg, and address fiscal deterioration.
- Stand-By Arrangement (SBA):
  - SBA approved in December 2008 with exceptional access of SDR 1.52 billion, equivalent to 1,200 percent of quota.
  - Significant co-financing from other partners including the European Union and regional partners.

### Selected economic indicators, 2009–13 (as presented)
- Real Economy
  - Real GDP (percentage change): 2009: -17.7; 2010: -0.9; 2011: 5.5; 2012: 5.2; 2013: 3.7.
  - HICP inflation (percentage change, period average): 2009: 3.3; 2010: -1.2; 2011: 4.2; 2012: 2.4; 2013: 2.2.
  - Unemployment rate (period average, percent) 1/: 2009: 18.2; 2010: 18.7; 2011: 16.2; 2012: 15.0; 2013: 13.7.
  - Nominal GDP (billions of lats): 2009: 13.1; 2010: 12.8; 2011: 14.3; 2012: 15.3; 2013: 16.3.
- Public Finance 2/ (percent of GDP, unless otherwise indicated)
  - Total Revenue: 2009: 36.2; 2010: 36.0; 2011: 35.6; 2012: 38.0; 2013: 35.4.
  - Total Expenditure: 2009: 43.3; 2010: 42.4; 2011: 38.7; 2012: 38.7; 2013: 36.6.
  - Basic fiscal balance: 2009: -7.1; 2010: -6.4; 2011: -3.1; 2012: -0.7; 2013: -1.2.
  - ESA balance: 2009: -9.7; 2010: -8.2; 2011: -3.4; 2012: -1.8; 2013: -1.7.
  - General government gross debt: 2009: 32.9; 2010: 39.7; 2011: 37.5; 2012: 37.6; 2013: 42.2.
- Balance of payments
  - Trade balance (percent of GDP): 2009: -7.1; 2010: -7.0; 2011: -10.7; 2012: -11.9; 2013: -12.3.
  - Current account balance (percent of GDP): 2009: 8.7; 2010: 3.0; 2011: -2.1; 2012: -2.2; 2013: -3.4.
  - Gross official reserves (billions of euros): 2009: 4.8; 2010: 5.8; 2011: 4.9; 2012: 5.4; 2013: 6.7.
  - Gross external debt: 2009: 156.8; 2010: 165.1; 2011: 143.9; 2012: 138.3; 2013: 137.2.
  - Net external debt 3/: 2009: 58.8; 2010: 54.2; 2011: 46.0; 2012: 39.5; 2013: 35.1.
- Exchange rates
  - Lats per U.S. dollar (average): 2009: 0.506; 2010: 0.530; 2011: 0.501.
  - Lats per euro (average): 2009: 0.704; 2010: 0.704; 2011: 0.697.
  - REER (period average; CPI based, 2000=100): 2009: 110.2; 2010: 103.6; 2011: 103.8.
  - REER (percent change, + denotes appreciation): 2009: 5.5; 2010: -6.0; 2011: 0.2.
- Money and Credit
  - Broad money (percentage change): 2009: -1.9; 2010: 9.8; 2011: 1.5; 2012: 2.5; 2013: 6.6.
  - Credit to private sector (percentage change): 2009: -6.9; 2010: -8.4; 2011: -7.4; 2012: -9.0; 2013: 1.2.
  - Treasury Bill rate (365 days, eop, percent): 2009: 10.2; 2010: 1.8; 2011: 1.7.
  - Money market rate (one month, eop, percent, annualized): 2009: 2.7; 2010: 0.6; 2011: 1.1.
- Notes:
  - Sources: Latvian authorities, Eurostat, and IMF staff estimates.
  - 1/ LFS statistics were revised in 2011 in compliance with population census; data before 2011 have not been revised yet.
  - 2/ National definition. Includes economy-wide EU grants in revenue and expenditure.
  - 3/ Gross external debt minus gross external debt assets.

### Staff and authorities statements (January 23, 2013)
- Staff Representative statement:
  - Summary of developments since staff report (EBS/12/167); additional information does not change the staff appraisal thrust.
  - Latvia repaid all outstanding obligations to the Fund on December 20, 2012: repurchase amounted to SDR 603.038 million (about €714.3 million) covering obligations under the 2008-11 SBA; all tables and charts in the staff report incorporate the repayment unless specified otherwise.
- Statement by Messrs. Benny Andersen and Gundars Davidsons (on behalf of Latvian authorities):
  - Authorities broadly agree with views outlined in Article IV/PPM and Ex-Post Evaluation reports; thanked staff for analysis.
  - Economic outlook: authorities project gradual slowdown in 2013, recognizing current growth is a rebound from the crisis.
  - End of 2008 SBA: repayment closes chapter on SBA; repayment financed by a US dollar bond issuance at a yield of 2.9 percent; noted emigration as significant crisis cost and highlighted demographic challenges (Appendix II referenced).
  - On contentious issues:
    - Guaranteed Minimum Income (GMI): authorities view centralization as temporary; favor decentralization to municipalities but acknowledge inequality and poverty concerns; willing to reconsider centralization elements if justified by the upcoming World Bank report “Latvia: Who is Unemployed, Inactive or Needy? Assessing Post-Crisis Policy Options”; 2013 budget law includes transfers to poorest municipalities and government committed to support municipalities if personal income tax revenues fall below planned targets.
    - Personal Income Tax (PIT) cuts: authorities determined to implement PIT cuts as planned to reduce labor costs, lower unemployment, and improve competitiveness; cuts were a difficult compromise supported by business community and stakeholders.
    - Non-resident deposits (NRDs): authorities taking steps to mitigate NRD risks; FCMC set higher capital requirements for banks specialized in non-resident clients and strengthened supervision and liquidity risk management; stand ready to introduce additional measures if NRD-associated risks increase.
  - Road ahead:
    - Unwavering commitment to euro adoption and meeting Maastricht criteria sustainably; reassured by ECB and EC assurances.
    - Continued efforts to reduce unemployment; noted unemployment decline from over 20 percent peak to 13.5 percent in 3rd quarter 2012 (seasonally adjusted 14.1 percent); acknowledged remaining unemployment is largely structural.
    - Policy measures: new targeted grant scheme for companies expanding employment in selected sectors launched in late 2012; measures to facilitate regional mobility; refinement of active labor market measures and training programs; World Bank study expected to provide guidance.
    - Growth-enhancing reforms envisaged in higher and vocational education, judicial system, management of state-owned enterprises, and competition policy; authorities warned of insider resistance to higher education reforms and emphasized sustaining reform momentum.

*Source: _cr1328 - 1. Bank Work (IMF Public Information Notice No. 13/11 and associated statements).*

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2013/_cr1328.pdf_