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Latvia -- 2002 Article IV Consultation, Concluding Statement of the IMF Mission
December 18, 2002
Recent developments and outlook
1. Latvia has enjoyed strong growth in a low-inflation environment over the last few years, making it a frontrunner among EU accession countries. Despite weak external demand, economic activity has remained strong. We expect growth of 5¼ percent this year, taking into account the strong third quarter growth rate of 7.4 percent, and of 5½ percent in 2003. Inflation has remained subdued and should be about 2 percent in 2002 and 3 percent next year. Latvia is poised for even stronger growth over the medium term, as it accedes to the EU and NATO and reaps the benefits of a decade of generally prudent macroeconomic policies and far-reaching structural reforms.
2. The persistently large external current account deficit is the main risk to sustaining Latvia's strong economic performance. We project this deficit to be 8¾ percent of GDP this year; after accounting for recent improvements in statistical methods, this represents an underlying worsening in Latvia's external position relative to last year. While much of the current account deficit has so far been financed by foreign direct investment, thus keeping Latvia's external debt at moderate levels, this situation could change if investor sentiment toward Latvia were to change. It is thus crucial that the current prudent macroeconomic policy mix be extended to 2003 and beyond. Fiscal policy is accorded a special responsibility in this regard under Latvia's successful fixed exchange rate regime.
3. The recent prudent macroeconomic policy mix is also reflected in the overall successful implementation of Latvia's economic program under the current stand-by arrangement, which expires this December. This holds particularly true for the fiscal performance so far this year, which bodes well for achieving the annual fiscal deficit target of 1.8 percent of GDP.
Fiscal policy
4. Building on Latvia's fiscal consolidation of the last two years, the mission urges the authorities to continue their move toward a balanced budget over the medium term. This strategy would be consistent with the projected continuation of high growth and an only marginal improvement of the external balance. It would also allow Latvia to limit the public sector's call on national savings, help maintain low levels of interest rates, and reduce vulnerability to contagion from other emerging market crises—and thereby promote strong private sector activity. Adhering to the balanced-budget strategy would also ensure fiscal flexibility and avoid a situation in which Latvia might be forced to undertake a procyclical fiscal consolidation upon EU accession to meet, within a short period, the criteria under the Maastricht treaty and the Stability and Growth Pact.
5. Against this background, we recommend that the general government fiscal deficit for 2003 be held to 1.8 percent of GDP, the expected 2002 outcome. We believe that such an outcome can be achieved in the current budgetary deliberations. However, strong political will is needed and some painful decisions are required to limit expenditure growth, especially with respect to the wage bill and social spending.
6. The strong pressure to limit expenditure growth could be alleviated if all or part of the reductions in the corporate income and social tax rates were delayed to the later part of 2003 or to 2004. The tax rate reductions, currently scheduled to take effect in January 2003, will cause a revenue loss of about 1 percent of GDP. While we generally support the objective of lowering the tax burden, especially regarding the social tax, the tax rate reductions taken together may not be affordable at present. A postponement would give the new government an opportunity to consider its medium-term tax reform plans and to possibly combine these tax rate reductions with changes in the property tax currently scheduled for 2004, which will generate additional revenues for local governments. The latter would help to balance the revenue impact for the central government of any reductions in the corporate income and social tax rates if, for example, the central government's share of the personal income tax was raised or its contribution to the local government Equalization Fund lowered.
7. A general reconsideration of Latvia's corporate income tax regime is needed. If Latvia proceeds with lowering its tax rate to 15 percent in 2004, it will have the second lowest corporate tax rate among EU member and accession states and the lowest combined corporate/resident shareholder tax burden among all these countries. In addition, a wide array of costly and distortionary tax exemptions exist. Although taxes are important, they are not the most important factor in investment decisions: macroeconomic stability, adequate infrastructure, a trained labor force, and clean government are generally considered more important. In addition, Latvia has been very successful in attracting business, and foreign direct investment has grown rapidly in recent years. The upcoming entry into the EU and NATO will make Latvia an even more attractive business location. The business environment is thus better served in the current circumstances through a sound fiscal policy and macroeconomic stability, rather than a lowering of corporate tax rates or an expansion of tax incentives.
8. The government needs to enhance its medium-term budget planning and its ability to effectively handle EU funds. Medium-term budget planning will help the authorities in prioritizing spending and identifying worthwhile projects in light of limited available resources, thus facilitating the move toward a balanced budget over the medium term. Finally, the recently adopted amendments to the Law on Local Government Budgets do not appear to be effective in curbing excessive local government borrowing; ensuring that such borrowing stays within the limits stipulated in the annual budget law will be key to achieving a sensible general government fiscal deficit.
Monetary and exchange rate policies
9. The exchange rate peg to the SDR has served Latvia well in maintaining low inflation, supporting confidence, maintaining external competitiveness, and fostering financial sector development. We agree with the Bank of Latvia's current thinking to seek membership in the ERMII mechanism upon EU accession and, ultimately, adopt the euro. The Bank of Latvia is on track in preparing for this step, including by bringing its monetary policy instruments in line with those of the ECB.
10. We recommend that the Bank of Latvia move carefully regarding interest rates. The strong domestic demand—which puts Latvia in a different cyclical position than Western countries—and the rapid credit growth do not warrant further reductions in interest rates anytime soon.
Financial sector
11. Latvia's financial system is sound, and financial sector supervision through the Financial and Capital Markets Commission (FCMC) is of high standards. These achievements need to be protected through vigilance and close cooperation with banks and other financial sector participants. We agree with the Bank of Latvia and the FCMC on the need to closely monitor the rapid credit growth, in particular the sectoral concentration of credits, as well as the funding of such credits. Non-resident deposits have in recent months begun to be intermediated domestically, which increases financial sector vulnerabilities.
12. We welcome the Latvian authorities' efforts to enhance their anti-money laundering (AML) and combating the financing of terrorism (CFT) frameworks. Latvia has a relatively comprehensive system of laws, regulations, and institutions to address both issues, and has in place mechanisms for the international exchange of information in this area. The authorities are continuing to refine this system, for example, through recent and planned amendments to legislation to strengthen CFT provisions, refinement of the indicators of unusual financial activity, and an increase in the resources made available to the Financial Intelligence Unit.
Structural reforms
13. Latvia's transition to a market economy is largely complete. Nevertheless, continued structural reforms are key to further modernizing the economy, promoting private sector activity, and attracting foreign investors. One excellent example of how cooperation between the private and public sector can generate an environment conducive to high growth is the Action Plan to Improve the Business Environment, designed with the input of foreign investors. We encourage the Latvian authorities to maintain the reform momentum.
14. In particular, we commend the authorities' commitment to forcefully battle corruption. We expect that the new anti-corruption office (KNAB) will play an important and constructive role in this regard. We believe that noticeable successes in the fight against and prevention of corruption will signal to the Latvian public and foreign investors that one of the biggest obstacles to sustained private sector activity is sincerely being tackled.
15. Latvia's flexible labor market, skilled labor force, and competitive wages are advantageous and should not be compromised. Nevertheless, unemployment—especially in rural areas—is still high. While it can be expected that sustained growth will ultimately reach all segments of the population, well-targeted active labor market policies to enhance skills could accelerate the integration of the unemployed into the labor force. In addition, raising the minimum wage frequently and in large increments may undermine Latvia's competitive edge vis-à-vis other countries.
16. Latvia's free and open trade system has been key to strong economic performance. The authorities should avoid favoring certain sectors or enterprises through any forms of tax incentives and state guarantees, which could introduce market distortions, lead to abuse, and give rise to large contingent liabilities for the public sector.
Epilogue
17. Latvia joined the IMF in May 1992 and over the last decade has cooperated with the IMF in the framework of successive programs. Latvia's macroeconomic performance under these programs has been remarkable. Upon expiration of the current arrangement, the policy dialogue with the Latvian authorities will shift to a surveillance mode, and IMF staff will continue to cooperate closely with the Latvian authorities through, among other things, Article IV missions and other staff visits.
18. The mission congratulates Latvia on last week's invitation to join the European Union in 2004. This invitation is also a reward for Latvia's successful macroeconomic and structural policies over the last decade.
19. The mission is grateful for the close cooperation and hospitality received in Riga.
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