Public Information Notice No. 04/85

Public Information Notice: IMF Concludes 2004 Article IV Consultation with the Republic of Latvia

August 6, 2004

On August 4, 2004, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with the Republic of Latvia.¹

Background

Latvia's successful transition culminated in EU accession on May 1. Impressive economic performance—an average real GDP growth of 6 per cent per annum since 1998, the highest among accession countries—has been fostered by responsible fiscal and monetary policies and bold structural reforms. However, per capita income is still below that of the other acceding countries and stands at a little more than one third of the EU-15 average, suggesting that real convergence remains a long-term objective.

Since the last Article IV consultation discussions, economic activity has maintained its momentum, as GDP grew 7½ percent in 2003 and 8¾ percent year-on-year in the first quarter of 2004; however, inflation climbed to 6.1 percent at end-June from 3.6 percent at end-2003. Exogenous factors (in particular the hike in oil prices and tax rate increases resulting from EU tax harmonization) were largely responsible for this bout of inflation. Several elements suggest that overheating could be a potential concern in the run-up to euro adoption, but the evidence is at present mixed. In particular, while above-trend growth may have created a positive output gap, capacity utilization in manufacturing has remained unchanged over the past 12 months. In addition, unemployment, which is significantly lower than two years ago, has recently increased somewhat (in large part owing to increased participation), and real wage growth has slowed in 2004. House price inflation also appears to have decelerated.

Latvia's external position has worsened: the current account deficit reached 8.6 percent of GDP in 2003, as consumption spilled over into imports, and foreign direct investment coverage of the deficit declined (to 34 percent from an average of about 60 percent in the last few years). However, the latter development is likely temporary, and, furthermore, competitiveness does not appear to have weakened. Latvia's export penetration continues to expand despite unfavorable market conditions for its main export and has been accompanied by increasing profit margins.

Credit continues to grow rapidly (about 40 percent per annum in the last three years), driven by mortgage and consumption loans, although it does not appear to have contributed to higher inflation. The credit growth is, however, increasing the vulnerability of the economy to external shocks that may feed into inflation or weaken household balance sheets.

Fiscal performance has improved appreciably, and public debt remains low. The general budget deficit, at 1.6 percent of GDP in 2003, narrowed by nearly 1 percentage point from 2002, reflecting lower-than-budgeted expenditures, unexpectedly high tax revenues, and lower net lending. Lower expenditures were helped by the adoption of restraining mechanisms on advance payments. On the revenue side, the collection of personal income tax, social tax, VAT, and excise tax was particularly good due to buoyant growth and the implementation of several tax administration measures. The strong revenue performance has continued in 2004, resulting in a small surplus as of May, despite interruptions to VAT and excise collections following EU accession.

The fight against corruption and state capture continues. The Corruption Prevention and Combating Bureau (KNAB) established a National Program for Combating and Preventing Corruption and began investigating cases of corruption involving high officials in 2003. The Parliament (Saeima) elected a new director for the bureau after a long process, complicated by political interference. The recently approved amendments to the law on AML/CFT put legislation in line with international standards, but enforcement needs to be strengthened.

Executive Board Assessment

Executive Directors welcomed Latvia's accession to the European Union and agreed that, following the successful transition of the past decade, Latvia is now in a strong position to reap the maximum benefits of EU membership and the prospect of euro adoption. Directors commended the authorities for the impressive growth performance in 2003, which continued to be among the best in the EU accession countries, and for the better-than-expected fiscal outcome—a result of both revenue and expenditure efforts.

Directors observed that the growth outlook remains favorable, driven by strong domestic demand and ongoing recovery in Europe. The widening external current account deficit and rapid credit growth—though consistent with Latvia's development needs—will, however, require a prudent fiscal path and vigilant bank supervision. Over the longer term, Directors stressed that, to achieve real convergence with European standards of living, Latvia will need to maintain macroeconomic stability and a flexible labor market, and pursue further structural reforms aimed at boosting the country's growth potential and safeguarding its competitiveness.

Directors agreed that Latvia's immediate challenge is to secure a smooth ERM2 entry. They supported the authorities' overall strategy for repegging the currency from the SDR to the euro, and pursuing an entry path that is slower than Latvia's Baltic neighbors. While the market exchange rate does not appear misaligned, Directors recommended that the authorities reassess the ERM2 parity choice prior to entry. They also suggested that the ERM2 period should be used to further improve monetary management and develop instruments for liquidity management based on open market operations.

Directors considered that the recent rise in inflation—though largely due to one-off factors—together with the rapid credit growth, could increase the vulnerability to external shocks. They underscored the increased role that fiscal policy should play as the principal tool of demand management, including by increasing the flexibility of fiscal policy over the course of the business cycle. To ward off potential overheating risks in a timely manner, Directors urged the authorities to use the opportunity of the favorable macroeconomic environment to aim for a tighter fiscal policy stance than currently envisaged, even though they recognized Latvia's significant infrastructure needs. In this context, they expressed concern that the supplementary budget for 2004 could result in an overall increase in expenditure, and urged the authorities to use revenues in excess of the original budget to lower the deficit. Efforts to broaden the tax base should also be sustained.

Looking ahead, Directors underscored the importance of moving toward fiscal balance over the medium term, consistent with EU membership. While Latvia's low level of public debt and fiscal deficit path do not pose direct fiscal sustainability problems, Directors saw a further strengthening of fiscal policy as key to addressing external sustainability concerns that could arise from continuing rapid credit growth. In this context, they urged the authorities to work toward developing a medium-term budgetary framework to improve the quality of fiscal policy and the credibility of medium-term objectives. Such a framework would also help plan expenditure out of EU funds and enhance the role of fiscal policy in stabilizing the economy.

Directors noted that Latvia's banking system is well-capitalized, profitable, and liquid, and appears resilient to a wide range of shocks. Nevertheless, the rapid expansion of credit, the potential volatility of nonresident deposits, and the possibility of increased short-term capital inflows following Latvia's integration into the EU all require close monitoring. Directors therefore welcomed the steps being taken to tighten liquidity, and strengthen bank supervision and prudential guidelines, although it was recognized that the impact of prudential tightening on overall credit growth may be limited. They stressed that particular attention should be given to preventing balance sheet problems for borrowers, and minimizing possible leakages to the domestic market from the sizeable nonresident deposits. In addition to strict rules on banks' open positions, it will be important to ensure that banks maintain matching and high-quality liquid assets.

Directors looked forward to continuing progress on promoting private sector activity, attracting foreign direct investment, and reducing the still high unemployment level. They welcomed the authorities' resolute commitment to improve the business environment, and encouraged them to sustain their efforts to enhance export diversification, raise labor productivity, and remove remaining administrative barriers and other obstacles to business. In particular, Directors highlighted the importance of amendments to the insolvency law to improve creditors' rights and making public procurement procedures more transparent. They encouraged the authorities to press ahead with the reorganization and eventual privatization of the remaining public concerns.

Directors commended the authorities' progress on fighting corruption, while underscoring the importance of ensuring that the Corruption Prevention and Combating Bureau remains independent from political pressure and maintains its strong enforcement efforts. They welcomed the recent amendments to the AML/CFT legislation in line with international standards, and urged the authorities to ensure its strict enforcement.