Republic of Latvia: Staff Concluding Statement of an IMF Article IV Consultation
IMF News, July 2, 2018
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- Published: July 2, 2018
Developments, Outlook, and Risks
- Recent performance and drivers:
- Growth reached a peak of 4.5 percent in 2017.
- Gross wages increased by 7.8 percent in 2017.
- Average inflation reached 2.9 percent in 2017.
- Consumption growth, private investment, utilization of EU structural funds, and a favorable external environment supported the recovery.
- Competitiveness has held up, evidenced by continued robust profitability of export-oriented sectors.
- Economic fundamentals:
- Fiscal and current account deficits and public debt are described as "at prudent levels."
- Private sector debt is on a declining path.
- The labor market has continued to tighten.
- Fiscal policy has become procyclical, as EU investment inflows have picked up and the upfront costs of the tax reform have dampened revenues.
- Projections:
- Real GDP growth is projected to reach 3.7 percent in 2018, supported by EU structural funds and rising wages.
- Over the medium term, growth should gradually converge to its potential rate of 3 percent, as EU investment funds level off and capacity constraints become increasingly binding.
- Risks (tilted to the downside):
- Domestic: more rapid labor market tightening and a deepening of fiscal pro-cyclicality could trigger accumulation of imbalances and overheating pressures.
- Structural: growth could be slower if structural reforms do not further advance.
- Financial sector: faltering enforcement of AML/CFT regulations or failures by banks servicing foreign clients to refocus their business models could undermine confidence in the banking system.
- External: growing protectionism and weaker growth in advanced economies could drag on export growth; an abrupt reversal of risk appetite in Europe and/or tighter global financial conditions could raise the cost of public debt financing.
Policy Guidance: Prudent Policy Mix
- Overarching recommendation:
- Calibrate fiscal and other policies to smoothly navigate the ongoing cyclical upswing and place the economy on a path of sustainable long-term growth.
- Seize the opportunity to redouble reform efforts, focusing on addressing labor market challenges, increasing labor productivity, and supporting investment growth.
- Specific fiscal policy guidance:
- Reverse procyclicality and improve the growth-friendliness of fiscal policies.
- Increase fiscal buffers to be able to respond to future shocks.
- Raise permanent revenue and safeguard growth-enhancing spending to strengthen fiscal sustainability without compromising social sustainability.
- Reallocate government spending toward investment in anticipation of the leveling off of EU structural funds.
- Improve efficiency of health and education spending and better-target social protection programs to build human capital and address high poverty and inequality rates.
- Labor market and productivity reforms:
- Encourage greater labor force participation of targeted groups and reduce structural unemployment.
- Use greater skill-matching and skill-building policies, improve access to housing, revisit the minimum wage structure, and encourage labor immigration.
- Implement productivity-enhancing reforms to cope with demographic headwinds (emigration, shrinking labor force, labor force aging).
- Investment and credit intermediation:
- Make the financial system more supportive of investment; credit growth remains subdued despite favorable macroeconomic conditions.
- Complete the reform of the insolvency regime and the licensing of insolvency administrators to improve creditors’ recovery rates.
- Encourage voluntary income and asset disclosure to help reduce credit risk.
- Financial sector stability and AML/CFT:
- Strengthen enforcement of AML/CFT regulations, focusing on mitigating risks from foreign depositors and opaque companies.
- Enhance regulatory tools and change banking legislation, alongside harmonization at the EU level, to provide more adequate tools to liquidate banks deemed failing or likely to fail.
- Carefully oversee the refocusing of activities of banks servicing foreign clients; continue vigilant application of fit and proper rules and assessment of the reputation of bank owners and managers.
- Restore the banking system’s reputation following the suspension of activities of ABLV; actions against ABLV accelerated foreign-client deposit outflows, but wider spillover effects have so far been limited.
Priorities to Preserve Strong Growth and Inclusion
- Address labor market constraints that threaten medium- and long-term growth:
- Counter emigration and the shrinking labor force that drive up wages and erode competitiveness.
- Address labor force aging that is likely to dampen productivity in the long run.
- Strengthen the inclusiveness and growth-friendliness of fiscal policy:
- The recently adopted income tax reform is viewed as a step toward reducing the high tax wedge, improving progressivity, and encouraging corporate investment, despite revenue impacts.
- Reallocating spending toward investment and improving the targeting and efficiency of social and human capital spending have long-term benefits.
Closing Note
- The IMF team expressed gratitude for the hospitality of the Latvian authorities and thanked interlocutors in government, the Bank of Latvia, and the private sector for constructive and fruitful discussions.
Republic of Latvia: Staff Concluding Statement of an IMF Article IV Consultation — July 2, 2018