Republic of Latvia: Staff Concluding Statement of the 2019 Article IV Mission
IMF News, June 28, 2019
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- Published: June 28, 2019
Overview
- Publication date: June 28, 2019.
- Contact: PRESS OFFICER: Gediminas Vilkas; Phone: +1 202 623-7100; Email: MEDIA@IMF.org
- Summary judgement: Latvia’s economic fundamentals remain broadly sound, with a low and declining debt burden and prudent fiscal and current account deficits. Growth is projected to decelerate to just above 3 percent in 2019 amid a less supportive external environment. A tight labor market and adverse demographic trends create capacity constraints and will limit long-term growth without reforms.
Recent performance and outlook
- Growth and drivers:
- Growth has averaged above 3½ percent in the last 10 years.
- Real GDP grew 4.8 percent in 2018, led by a pick-up of private investment, a boom in EU-funded construction, and strong growth in IT and communications.
- Growth is projected to slow in 2019 to just above 3 percent.
- Over the medium term, growth is projected to converge to a still robust rate of 3 percent.
- Inflation and competitiveness:
- Inflation has been moderate, and competitiveness has held up.
- Public and external finances:
- No significant economic imbalances; external and government debt are on declining paths; private sector balance sheets continue to improve.
Key risks and constraints
- Demographics:
- The population continues to decline on average by 1 percent per year, largely due to ongoing emigration, especially of young and skilled Latvians.
- A shrinking and aging labor force is likely to reduce productivity growth and have a negative impact on long-term growth and living standards.
- In the absence of reforms, long-term growth could fall by half.
- External risks:
- Vulnerability to external demand shocks due to openness and integration in the global economy.
- Weaker than expected global growth, especially in the euro area, and rising protectionism could weigh on GDP growth.
- A sharp decline in confidence and tightening of global financial conditions could increase borrowing costs for the government and the private sector.
- Financial sector reputational risks:
- The 2018 MONEYVAL assessment raised concerns about Latvia’s AML/CFT regime.
- Failure to strengthen AML/CFT effectiveness and to refocus banks servicing foreign clients toward viable business models could significantly undermine financial stability and the sector’s capacity to support investment and GDP growth.
- Credit dynamics:
- Banks are stable, profitable and liquid, but credit growth remains elusive.
- Despite record low borrowing costs, lending standards have tightened amid structural changes and uncertainty.
- Mortgage lending is slowly recovering, supported significantly by the state guarantee program for families with children and young professionals, but other lending programs remain underused.
- Persistently rising property prices pose medium-term vulnerabilities.
Policy recommendations — labor market and productivity
- Priorities to raise productivity and support long-term growth:
- Redouble efforts to ease labor market constraints, including:
- Promoting better skill matching.
- Reducing long-term unemployment.
- Increasing labor participation of targeted groups.
- Encouraging Latvian emigrants to return.
- Allowing skilled immigrants to enter the domestic labor market.
- Address structural and institutional obstacles that inhibit use of new technologies and better resource allocation through:
- Upgrading the insolvency framework.
- Improving access to finance for small and productive firms.
- Encouraging investment in research and development and foreign direct investment.
- Raising productivity growth to allow more rapid wage growth sustainably and help slow emigration.
Policy recommendations — fiscal policy and social sustainability
- Medium-term fiscal stance:
- The authorities’ planned fiscal stance reverses past procyclicality and is appropriate given the expected deceleration of the economy.
- In the short term, avoid further public sector wage increases that are not aligned with productivity growth to protect competitiveness.
- Given relatively low and declining government debt and favorable financing terms, some fiscal space exists to react to shocks.
- Authorities should carefully assess potential fiscal costs of new spending initiatives and identify stable revenue sources to preserve fiscal space.
- If negative shocks occur, accommodate the decline in revenues and rise in spending to protect vulnerable populations; in a severe downturn consider temporary high-quality measures to support the economy.
- Long-term fiscal pressures:
- Fiscal space could be more limited over the long term due to demographic challenges and rising aging and health care costs.
- Public spending is already relatively low; expenditure savings alone are unlikely to cover growing age-related demands.
- Long-term policies should focus on securing new revenue sources and supporting reforms that boost productivity and growth.
- Focus capital spending on projects that can catalyze private investment and have high social impact.
- Address poverty and inequality by improving the adequacy and targeting of existing social programs.
- Improve efficiency of public services and strengthen transparency and governance of local authorities and state-owned enterprises.
Policy recommendations — financial sector integrity and supervision
- Restoring confidence in the financial system:
- Strengthen the effectiveness of the AML/CFT framework and demonstrate results through long-term reforms.
- Reforms should aim at enhancing:
- Risk-based supervision.
- The quality and use of financial intelligence.
- Application of preventive measures.
- Investigation and prosecution.
- Coordination among relevant national and regional authorities.
- Upgrade supervisory powers for bank liquidation to include mandatory out-of-court administrative liquidation to reduce legal uncertainty and limit contingent government liabilities, consistent with EU harmonization efforts.
- Continue efforts to reduce exposure to risky banking operations, address MONEYVAL recommendations through legislative and institutional changes, and oversee new business plans of banks servicing foreign clients.
Policy recommendations — reviving credit growth and financial intermediation
- Measures to support lending and appropriate de-risking:
- Complete insolvency reforms to accelerate rehabilitation of debtors and lower lending costs through improved expected recovery rates.
- Strengthen revenue administration to more effectively combat the shadow economy and improve borrowers’ transparency.
- Carefully oversee banks’ de-risking and business model re-orientation towards the real economy to encourage consolidation and ease lending constraints.
- Improve access to and knowledge about state loan guarantee programs to spur SME lending.
- Apply new preemptive macroprudential measures to both banks and non-banks to support sound lending standards through the cycle.
- Review side effects of state guaranteed mortgage programs to mitigate medium-term financial sector vulnerabilities amid rising property prices.
IMF Staff Concluding Statement, Republic of Latvia: Mission Concluding Statement, June 28, 2019.