Latvia -- 2004 Article IV Consultation, Concluding Statement of the IMF Mission

April 29, 2004

Describes the preliminary findings of IMF staff at the conclusion of certain missions (official staff visits, in most cases to member countries). Missions are undertaken as part of regular (usually annual) consultations under Article IV of the IMF's Articles of Agreement, in the context of a request to use IMF resources (borrow from the IMF), as part of discussions of staff monitored programs, and as part of other staff reviews of economic developments.

1. Latvia's successful transition, accompanied by strong growth and far-reaching reforms, is culminating in EU accession on May 1. In recent years, GDP has, on average, grown faster than any other accession country and inflation has been moderate—supported by responsible monetary and fiscal policies, and a successful exchange rate peg . Despite repeated political changes and institutional weaknesses, reform efforts have created a business-friendly economic environment and helped attract large inflows of foreign direct investments.

2. However, the potential risks of overheating and a widening external current account deficit represent a challenge to Latvia's economy in the medium term. The current account deficit is expected to worsen further next year: it poses a risk to continued strong performance. Latvia is generally well-placed for ERM2 entry and euro adoption, but the risks of overheating are likely to increase in the run-up to EMU as capital inflows increase and interest rate differentials narrow. These risks call for continued fiscal consolidation-as monetary policy increasingly becomes ineffective as a demand management tool-and a strengthening of prudential controls. Structural reforms should continue to focus on further improving the business environment, fighting corruption, and fostering real convergence for successful performance in EMU.

Recent developments

3. Economic activity is buoyant, while inflation has edged up somewhat recently. Real GDP growth in 2003 reached 7½ percent, supported by strong consumption and exports and indicators suggest that activity remained strong in the first quarter of 2004. The current account deficit widened further to 9 percent of GDP in 2003, but the exchange rate has remained within the 1 percent band without major interventions on the part of the BoL.

4. At present, the evidence concerning overheating remains mixed. GDP growth is above potential, the downward trend in inflation has been reversed, and the unemployment rate has continued to fall. In addition, real wage growth has accelerated, apartment prices in Riga have risen sharply for the last two years, and credit to the private sector has grown on average 40 percent in the last 3 years. Mortgages and consumer loans account for an increasing share of banks' portfolio, while consumption growth exceeded GDP growth. There are, however, a number of mitigating factors and the banking sector remains fundamentally healthy. First, part of the observed increase in inflation was due to one-time changes in administered prices (rents and utilities) and wage growth has been below productivity growth over the past five years. Second, data on real estate prices, although limited and unreliable, indicate that the rapid growth (at least for apartment prices) may have subsided in the second half of 2003. Third, while the rapid pace of credit growth could be a problem, the ratio of bank credit to the private sector to GDP is still low in Latvia-below 50 percent of the average in euro area countries. Finally, the banking system's financial soundness indicators remain favorable.

Economic Outlook and EU Accession

5. We project real GDP to grow by 6¼ percent in 2004, driven by continued strong domestic demand. While Latvia's end-2003 performance was broadly consistent with the quantitative Maastricht criteria, some risks remain in meeting the inflation criterion. After the psychological effects of EU accession subside, we expect inflation to hover at about 4 percent, reflecting the necessary harmonization of administered prices and tax rates with EU standards. The current account deficit is projected to increase further owing to higher EU-related imports and to remain rather high for the next few years.

6. Latvia's accession could provoke large capital inflows and intensify the credit boom. Latvia is already experiencing a large and sustained growth in credit to the private sector. We urge the authorities to monitor wage and credit developments closely, tighten prudential guidelines for the financial sector, and be alert to overvaluation in real estate markets. Fiscal policy needs to be sufficiently restrictive to curb domestic demand, given the fixed exchange rate regime; and structural reforms need to be deepened to increase the economy's flexibility. Over the longer term, the elimination of exchange rate variability should boost exports to the EU, and reduce risk premia and interest rates, thus deepening financial integration. The loss of monetary policy should not have a major impact, given the success with the hard peg of the past ten years. The labor market should remain flexible: its role as a shock absorber is paramount for a successful ERM2 and euro adoption.

ERM2 and Monetary-Financial Policies

7. We support the authorities' plans to enter ERM2 in January 2005 and introduce the euro in January 2008. The different entry path relative to Latvia's Baltic neighbors is justified, given the need to repeg the lats to the euro and related adjustments in the financial system. While we support the plan to adopt the market lats/euro exchange rate prevailing immediately prior to ERM2 accession given the absence of any indication of a major exchange rate misalignment, this plan will have to be assessed carefully taking into account the prevailing circumstances at the time of entry. It is also important to take necessary measures to guarantee a smooth repegging of the lats and facilitate the adjustment that commercial banks, enterprises, and especially individuals will have to undergo.

8. In view of the exceptional pace of credit growth, close monitoring of the financial system is warranted, and we support the authorities' plans to consider tightening guidelines for mortgage lending and other measures of a similar nature. Notwithstanding the current low level of credit compared with the European average, very rapid credit growth carries with it risks of a deterioration of credit quality, which, in many countries, has not been immediately apparent. We welcome the authorities' commitment to monitor the situation closely. At this time, the banking system is resilient, with a very low ratio of nonperforming loans, and an excess of capital over the FCMC's already conservative (10 percent) minimum capital requirement. The regulatory and supervisory system remains sound, while commercial banks are in general aware of the potential risk and are using modern risk management systems and techniques. The volatility of the dollar-euro exchange rate is a source of exchange rate risk mainly for banks' clients who borrow in foreign currency. The currency mismatch in household balance sheets is a potential vulnerability for the system: more needs to be done to inform households of the risk and to advise them on risk management. The banks' own exposure is limited by the legal restrictions on their net open position and some banks operate with even tighter guidelines. Banks also actively manage their liquidity risks, maintaining high levels of liquidity, particularly in view of the greater volatility of their nonresident deposits. The authorities are considering the precautionary measures mentioned above, but should be aware of the limitations to the effectiveness of such controls. For these reasons the main policy instrument remains fiscal policy.

Fiscal Policy

9. We welcome the better-than-expected fiscal performance in 2003 and so far in 2004. The general government budget deficit, at 1.8 percent of GDP, narrowed by almost 1 percentage point compared to 2002 and fell well below the supplementary budget's target of 3.1 percent. This outcome reflected lower-than-budgeted expenditures, and unexpectedly high tax revenues. In particular, we are encouraged by the fact that a repeat of end-2002 spending spree did not materialize, thanks to the recently established restraining mechanisms on advance payments. The strong revenue performance was due to buoyant growth, as well as the implementation of a number of tax administration measures. Revenue performance so far in 2004 has also exceeded expectations.

10. Given the 2003 outturn and the potential risks of overheating, we urge the authorities to explore the possibilities for fiscal tightening in 2004, and, at a minimum, use any additional revenues to lower the deficit. Savings could be made by reducing expenditure on goods and services in the basic budget, which exceeds the 2003 outcome by 25 percent. While risks to revenue performance remain in 2004, because of procedural changes associated with EU accession, we project revenues for the year could be higher by ½ percent of GDP, judging from the higher projected tax base, and tax performance in the first quarter of 2004. While a budget amendment is planned for fall this year to reflect the second biannual adjustment of pensions to inflation and the inclusion of cash flows related to EU cohesion funds, it is crucial that no other increase in spending is permitted, and savings be found elsewhere to make room for these changes.

11. We urge the authorities to move toward a balanced budget in the medium term to help reduce the large current account deficit. This is also essential in view of the need to guarantee an appropriate buffer below the SGP deficit ceiling of 3 percent to allow the automatic fiscal stabilizers to operate. Given the favorable macroeconomic environment, and to mitigate the looming risks of overheating, we advise the government to adopt a deficit target of 1¼ percent of GDP for the 2005 budget. As no further tax cut is planned for 2005, the robust trend in revenues and EU financial support should offer sufficient resources for essential expenditure. However, because of the large co-financing need and the lag in receiving EU funds, the government needs to make some tough decisions in limiting discretionary spending growth. In this context, we also encourage the authorities to move quickly in implementing a medium-term budget framework. This is crucial for strengthening the budgeting of resources and ensuring that the Maastricht fiscal deficit criterion is met.

12. The coordination of the planning of EU funds and the budget formulation process needs to be strengthened. In particular, EU-related spending should be planned and evaluated in a multi-year context to smooth the impact on the budget deficit. This also requires that the budget framework have a medium-term perspective.

Structural and other issues

13. The authorities should accelerate the process of restructuring and privatization of the remaining public concerns. Following the recent settlement of the dispute over Lattelekom, the government should now proceed with the steps necessary to complete the sale of the shares remaining in public hands. The authorities should promptly design and implement the plan for the legal unbundling of Latenergo.

14. The fight against corruption and money laundering must remain among the government's priorities. We welcome the results obtained by KNAB in enforcement; the challenge is now prevention. Politics should not to interfere with the selection process of the director and the independence of the bureau must be guaranteed. The amendments recently approved render Latvia's AML legislation in line with international practice. However, enforcement in this area needs to be strengthened.

15. Although decreasing, unemployment remains high, in part because of the skill mismatch in the labor force. It is crucial to develop plans to improve the quality and effectiveness of the education system. At the same time, labor market flexibility—also in terms of wage determination procedures—should be maintained.

16. The recent data ROSC findings point at the overall high quality of data. We welcome the commitment shown by the CSB, the BoL and the Ministry of Finance to follow the recommendations and improve certain aspects of data collection and the compilation of some statistics.

Finally, we would like to thank the Latvian authorities for the close cooperation with the mission, their hospitality, and for the stimulating discussions.


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