IMF Survey : Latvia’s Recovery Continues As It Eyes Euro Adoption

IMF News, January 28, 2013

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GDP growth is projected to have exceeded 5 percent for the second year in a row in 2012; Latvia grew at about 5 percent in 2011.
Outlook for 2013 is for continued recovery, but at a somewhat slower pace.
Inflation is low at 1.7 percent and is expected to decline further.
Latvia repaid last December the outstanding amount of its IMF loan; under the original schedule, the final repayment would have taken place in 2015.
Despite the euro-area recession, problems in the euro area have not derailed Latvia’s progress, though risks remain (e.g., increased borrowing costs if financial market stresses resurface; prolonged weak euro-area growth).

Unemployment rate fell from over 16 percent in the first half of 2012 to 13½ percent in the third quarter.
Higher employment has driven increased household disposable income, supporting consumption.
Structural unemployment is estimated at about 12 percent.
Challenges include long-term unemployment, skill erosion, mismatches between jobs and skills, and a large informal economy.

Growth has been well balanced between domestic demand and external demand.
Robust domestic demand driven by both consumption and investment; profit margins for firms have been good, raising investment demand.
Exports have thrived despite weak euro-area demand because:
- Major export partners include countries outside the euro area: Russia, Sweden, and Lithuania.
- Success in seeking non-traditional export markets.
- An extraordinary harvest boosted agricultural exports.

Deep-rooted reforms are needed to lower structural unemployment and improve competitiveness, attract more foreign direct investment, and improve the business environment.
Priority reform areas include:
- Reforms to the judicial system to address court system delays and curb abuses of the insolvency process.
- Strengthening the governance and structure of state-owned enterprises.
- Improving the quality of higher and vocational education.
Maintain reform momentum under more benign conditions to ensure sustainable convergence and competitiveness improvements.

Authorities recently scaled back the GMI benefit from 40 lats per month to 35 lats per month and devolved full funding responsibility to local governments.
IMF concerns:
- Scaling down assistance could hit the most vulnerable hardest and exacerbate poverty and inequality.
- Some cash-strapped local governments may be unable to provide even the reduced benefit.
- The IMF believes the program should be centrally funded, though local governments are better placed to deliver the benefit and monitor eligibility.
Policy options to improve work incentives:
- Phase out the GMI benefit more gradually to increase the incentive to find employment.
- Consider an in-work tax credit.
The IMF is optimistic that authorities will reconsider GMI changes when the World Bank releases its forthcoming study on Latvian unemployment and benefit programs.

Latvia is considering adopting the euro next year and aims to adopt the euro in 2014.
In terms of the fiscal deficit and public debt, Latvia should be comfortably within the Maastricht criteria thresholds.
Technical uncertainties relate to the inflation and interest rate targets:
- Interest rates are low at about 3 ½ percent.
- European institutions will compare Latvia’s inflation and interest rates with those of a reference group of three European countries; uncertainty exists about which countries will comprise that reference group.
- The European Commission has assured Latvia of fair treatment when assessing the inflation and interest rate criteria.
The European institutions will assess whether convergence is sustainable (a forward-looking assessment); maintaining structural reform momentum will best support a positive assessment.
On economic grounds the IMF believes Latvia is better off—and less vulnerable—inside the euro area given its fixed exchange rate, and supports the government’s goal of euro adoption while noting the euro will not eliminate other policy challenges.

This was Latvia’s last post-program monitoring discussion with the IMF.
The Fund will remain engaged as a consulting partner and stand ready to provide technical assistance as and when needed.
Every 12 months a full-fledged policy consultation (the Article IV) will be conducted to take stock of macroeconomic developments, gather views from government, social partners, and NGOs, propose strategies, and summarize findings in a report discussed by the IMF’s Executive Board.
The IMF provides such consultations and assistance to all of the IMF’s 188 member countries.

IMF Survey, January 28, 2013