Republic of Latvia: Staff Concluding Statement of the 2024 Article IV Mission
IMF News, June 18, 2024
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- Published: June 18, 2024
Economic situation — recent performance and vulnerabilities
- Growth and inflation
- Real GDP growth contracted by 0.3 percent in 2023.
- Real GDP growth for Q1 2024 was 0.9 percent year-on-year.
- Headline inflation declined to 0.0 percent y/y in May 2024, compared to 0.9 percent in December 2023.
- Core inflation stood at 3.1 percent in April 2024, down from 4 percent in December 2023.
- Strong nominal wage growth of 11 percent y/y in Q1 2024 is sustaining persistent service inflation.
- External and fiscal balances
- The current account deficit narrowed to 4 percent of GDP in 2023 from 4.8 percent in 2022, driven by import contraction and lower energy prices.
- Fiscal performance in 2023 was stronger than expected due to revenue buoyancy linked to inflation and less need for energy support measures.
- Structural headwinds
- Russia’s war in Ukraine and related geoeconomic fragmentation are depressing private investment and productivity, compounding long-standing challenges to productivity, investment, and labor supply.
- Productivity growth has failed to match real wage increases, weighing on competitiveness.
Outlook and risks
- Growth projections
- Real GDP growth is projected to increase from -0.3 percent in 2023 to 1.7 and 2.4 percent in 2024 and 2025, respectively.
- Medium-term growth is projected to continue at an average of around 2.5 percent, supported by public investment and reforms, including those in the National Recovery and Resilience Plan (NRRP).
- Inflation projections
- Headline inflation (annual average) is projected to decline from 9.1 percent in 2023 to 2.0 percent in 2024.
- A slight rise in headline inflation is expected in 2025, reflecting higher projected energy prices.
- Core inflation (annual average) is projected to slow from 9.8 percent in 2023 to 3.3 percent in 2024 and is expected to remain above headline inflation in 2024 and 2025.
- Both headline and core inflation are expected to approach the ECB’s 2 percent target after 2026.
- Key downside and systemic risks
- Rising geopolitical tensions and deeper geoeconomic fragmentation could trigger another surge in energy prices and renewed monetary tightening.
- Credit risks from prevalence of variable-rate loans and high interest costs may weaken consumption and investment.
- Weaker-than-expected external demand would adversely affect Latvia.
- High recent wage growth poses risks to competitiveness.
- Delays in public investment and structural reforms could weigh on potential growth and delay the green transition.
Fiscal policy — stance, recommendations, and structural measures
- Near-term stance
- Considering the improving outlook, a less expansionary, neutral fiscal stance for 2024 is warranted.
- The cyclically adjusted fiscal deficit is projected to increase by 0.5 percentage points to 2.4 percent of potential GDP in 2024.
- Keeping the 2024 cyclically adjusted deficit broadly unchanged relative to 2023 would require an adjustment of 0.5 percentage points of GDP.
- 2025 and medium-term guidance
- The 2025 budget should aim to reduce the cyclically adjusted deficit to about 2 percent of potential GDP, implying an adjustment of about ½ percent of potential GDP.
- Fiscal policy should remain flexible and evolve if risks materialize.
- Policy options to create fiscal space and protect priorities
- Reduce tax exemptions.
- Raise revenue from property taxation by updating cadaster values with market prices.
- Strengthen tax enforcement.
- Improve investment spending efficiency.
- Protect the most vulnerable while better targeting social support.
- Structural fiscal consolidation options
- (i) Broadening the bases of corporate income tax (CIT) and personal income tax (PIT), including by reducing the shadow economy.
- (ii) Broadening the base of property taxes.
- (iii) Reducing tax exemptions and fossil fuel subsidies.
- (iv) Rationalizing spending on goods and services.
- Public investment management and long-term spending pressures
- Significant planned investments in green and digital transitions, healthcare, education, and affordable housing create fiscal pressures.
- Large cost overrun in Rail Baltica: originally estimated at 4.6 percent and now at about 22.6 percent of 2024 GDP—urgent improvement in public investment management is warranted.
- Recent reforms: minimum contribution period for a pension raised from 15 years to 20 years effective January 2025; retirement age to increase by three months annually until it reaches 65 years in 2025.
- Recommendation to link both the official and early retirement ages to future life expectancy gains to encourage longer work lives after reaching 65.
- Latvia should swiftly implement NRRP investments and balance fossil fuel subsidies, pricing/carbon taxes, and norms to achieve climate goals efficiently while supporting sustainability.
Financial sector policies and macrofinancial oversight
- Resilience and vulnerabilities
- Banking sector remained well capitalized and liquid, with a low NPL ratio.
- Bank profitability was boosted by the rise in interest rates on loans.
- Domestic credit growth moderated in 2023 due to slowdown and higher borrowing costs.
- Prevalent share of variable-interest-rate loans: 87 and 94 percent of outstanding loans for households and non-financial corporations, respectively.
- Housing prices remain high by historical standards, though housing price-to-wage ratios suggest a slight improvement in affordability in 2023.
- Policy recommendations and monitoring
- Continued monitoring of macro-financial vulnerabilities and spillovers is warranted, including regular risk-based monitoring of banks’ asset quality and tailored stress testing.
- Staff welcomes authorities’ enhanced climate risk oversight and continued efforts to mitigate cybersecurity risk, including participation in ECB 2024 cyber resilience stress tests.
- The current macroprudential policy stance is broadly appropriate; staff welcomes the decision to gradually raise the countercyclical capital buffer requirement from zero to a positive neutral rate.
- Consumer support and fiscal measures affecting financial transmission
- Households’ financial distress related to variable-interest-rate mortgage loans should be addressed through the consumer bankruptcy framework; social protection can provide additional targeted support.
- The new untargeted interest subsidy scheme for variable-rate mortgage loans, financed by the mortgage borrower protection fee (MBPF), is budget-neutral but may hamper monetary policy transmission and affect banks’ profitability and capital adequacy; discretionary fiscal measures of this type should not be renewed at the expiration of the current law in 2024.
- Authorities should refrain from further fiscal initiatives to increase taxes on bank profits; a 20 percent corporate income tax advance payment for credit institutions was implemented based on last year’s earnings instead of distributed profits—further tax increases may undermine banks’ capacity to extend credit, reduce capital headroom, and weaken financial stability.
Structural policies to enhance productivity, investment, and labor supply
- (i) Corporate reforms to boost investment
- Insolvency reforms (transposition of EU Directive 2019/1023) can facilitate exit of unproductive firms and reallocation of resources.
- Access to finance is a major obstacle: the share of firms considering availability of finance a major obstacle is among the highest in the EU.
- Recapitalization of firms with negative equity and development of domestic capital markets could improve access to finance.
- Listing of SOEs could improve corporate governance and productivity.
- (ii) Labor and product market reforms, and digitalization
- Address skilled labor shortages from aging and emigration; net migration was positive in 2023.
- Promote training and internal labor mobility toward priority sectors (green transition, digitalization, health), adopt technology (including AI), enhance migration processes, reduce employment protection, and improve labor force participation for women aged 25-44.
- Streamline product and service market regulations to boost competition and innovation; reduce entry barriers where state-owned enterprise presence is high.
- Construction sector: approval of construction documentation takes longer in Latvia than in Estonia and Lithuania; expedite spatial planning and construction regulation and implement the “Green Channel” initiative to attract green and high-value-added FDI.
- Implement measures to promote digital transformation: (i) enhance connectivity, increase adoption and use of digital technologies, and unleash digital innovation; (ii) implement NRRP measures focusing on digitalization.
- (iii) Climate change policy and energy security
- Latvia’s greenhouse gas emissions have increased since 2000, against the EU trend.
- Climate law and the National Energy and Climate Plan (NECP) are expected to be adopted by the end of the year to ensure policy predictability and certainty.
- NECP measures include: tax for combustion installations outside the EU ETS, phasing out fossil fuel subsidies, increasing investments in renewable energy (mainly wind), energy efficiency, investing in grid connections and interconnections, and supporting electrification of transport.
- NRRP aims to enhance energy efficiency in private and public buildings and modernize and green electricity networks.
- Recommendations on policy mix and specifics:
- Aim for a robust balance between fiscal support, carbon pricing or taxation, and norms, while addressing distributional concerns.
- Design measures to extend carbon pricing to emissions not covered by the EU ETS and enhance carbon taxation effectiveness in transport and agriculture; at 20 percent, the share of Latvia’s emissions covered by the EU ETS is the lowest in EU.
- Remove implicit fossil fuel subsidies, notably favorable tax treatment of diesel for vehicle use.
- Set a more ambitious target for renewable energy share than the current target of 57 percent of gross final energy consumption by 2030 and specify measures to achieve it.
- Continue work on climate adaptation: integrate adaptation into long-term planning, invest in adaptation with large positive externalities, and update adaptation strategy in coordination with municipalities.
Mission logistics
- An IMF team conducted meetings in Riga during June 4–17, 2024.
- The mission was led by Mr. Bernardin Akitoby and comprised Nina Budina, Bingjie Hu, and Keyra Primus (all EUR).
- Carlos Acosta (LEG) participated virtually; Inese Allika (OED) participated in meetings.
Republic of Latvia: Staff Concluding Statement of the 2024 Article IV Mission, June 18, 2024.