Mission Concluding Statement 

Latvia: Staff Concluding Statement of an IMF Article IV Consultation

May 31, 2017

Economic fundamentals are sound, though a continued prudent and balanced policy mix will be needed to maintain sustainable growth, and to preserve past competitiveness gains.

While the economy is gaining momentum, ongoing reforms will be needed to address crisis scars, and to combat economic headwinds, e.g., demographic challenges, in the years ahead.

The financial sector has a key role to play in supporting growth and maintaining stability; while efforts to address the shadow economy can bring multiple benefits.

Developments, Outlook, and Risks

Macroeconomic conditions remain broadly sound. Fiscal and current accounts are at prudent levels, public debt is low, and unemployment continues to fall. Inflation remained below the ECB's 2 percent target for the euro zone in 2016, on the back of energy and food price developments, but began to pick up later in the year as these reversed. For the first time in 5 years, credit growth to the private sector was positive, and indicators suggest that the credit cycle has turned.

The economy is gaining momentum. Following a growth deceleration last year, related to the slow absorption of EU funds and the associated investment contraction, growth is now accelerating, and is forecast to pick up to around 3¼ percent in 2017. This pick up will be driven by a rebound in investment, continued solid private consumption, and support from net exports as the global economy expands.

Risks are more balanced, but are still tilted to the downside . A prolonged slowdown in key trading partners, notably the Euro Area, would act as a drag on growth; geopolitical tensions, or financial market disruptions, could adversely affect the real and financial sectors; and failure of credit growth to be sustained, or of structural reforms to continue advancing, could undermine medium-term growth prospects. Conversely, growth would be buoyed by a faster than anticipated pick up in investment, stronger consumption growth, or greater support from net exports.

Against this background, continued sound policy making is vital. A balanced policy mix, ambitious reform efforts, and continued vigilant financial sector regulation and supervision are vital to mitigate risks and lay the groundwork for future growth. Prudent macro policies are even more important in an environment of rising price pressures, that have been driven partly by supply factors, where it is necessary to safeguard competitiveness within the currency union.

Efforts to address the shadow economy can bring multiple benefits. The shadow economy hinders economic development and complicates policy making. The authorities’ action plan is already beginning to deliver results. Efforts to improve the business environment, reduce regulatory and administrative barriers, and improve transparency, will not only strengthen incentives to operate in the formal economy, but will also support growth. Reducing the share of the shadow economy is also associated with greater tax compliance and higher revenues. In parallel, such efforts can support credit growth by increasing financial inclusion, and improving the transparency of corporate and household balance sheets.

Potential Growth

“Crisis scars” and economic headwinds could constrain growth in the years ahead. Actual and potential growth rates appear to have settled at more moderate levels since the global financial crisis. So-called “crisis scars”—such as elevated uncertainty, weak corporate balance sheets and tighter credit conditions for SMEs, and high structural unemployment—have been common across many countries. These, along with economic headwinds such as demographic challenges, are likely to mean that, in the absence of meaningful structural reforms, the underlying medium-term potential growth rate of the economy is around 3 percent per year.

Determined policy action could raise potential growth and support faster convergence. Policy actions could include the following: structural and institutional reforms to support productivity growth (including protection of property rights, legal and insolvency reforms, and increasing access to financial services); higher public investment in infrastructure and human capital; and active labor market policies aimed at lowering structural unemployment to help offset negative demographics. Care will also be needed to avoid having wage increases outstrip productivity growth.

Fiscal policy

Current fiscal policy is broadly sound. The general government balance (ESA definition) narrowed to around zero in 2016, consistent with both Latvian and EU fiscal rules. The 2017 budget, which targets a deficit of 0.8 percent of GDP, is broadly appropriate considering Latvia’s low gross financing needs, modest debt, and a still negative output gap. In the short term, policy makers will need to make best use of the pick-up in EU investment funds and allocate these resources to growth-enhancing investments. Looking forward, fiscal policy should become more neutral over the medium term, to avoid risks of procyclical policy.

The Tax Policy Guidelines offer an important opportunity, but the final policy package needs to be clarified, and implemented prudently. While the final details of the “tax strategy” are still to be determined, the stated goals are welcome: namely to support growth, increase equity, and boost revenues. There are three key challenges to ensure that these can be achieved: i) finalizing plans swiftly to reduce uncertainty for households and firms, ii) carefully managing the macro impact to avoid procyclical policy and undermining future competitiveness, and iii) sustainably boosting the revenue share to ensure robust public finances even after EU funds diminish.

Financial Sector

The banking system remains well capitalized, liquid and profitable, and Latvia’s protracted period of credit stagnation is over. In the sector serving domestic clients, balance sheet repair has continued and credit growth has finally resumed, although households still lag non-financial corporates. Banks servicing foreign clients face a changing landscape, with pressures on correspondent banking relationships, dwindling business, and a continued reduction of deposits. However, additional buffer requirements for this sector, and low interconnectedness with the rest of the financial system, limit its potential impact on financial stability, on which there has been no effect to date. Further actions to strengthen the AML/CFT frameworks and their enforcement will be helpful in this regard. Continued vigilant supervision is needed to mitigate real and reputational risks, as is close monitoring of regional financial interconnectedness.

Credit is essential to support medium term growth; and prudential standards should be maintained. Continued and sustainable credit growth will be needed to support investment and boost long term growth. The authorities should pursue policies to address market failures still lingering from the crisis, both supply and demand elements, for example through programs that facilitate SMEs’ access to credit, and continuing the implementation of insolvency reforms.

The IMF team is grateful for the generous hospitality of the Latvian authorities, and would like to thank, once again, all interlocutors in Government, the Bank of Latvia, and the private sector, for constructive and fruitful discussions.