The FINANCIAL -- On June 10, 2016, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation1 with the Republic of Latvia.
GDP growth picked up to 2.7 percent in 2105, up about 0.25 percent over the previous year, despite a weak external environment. Private consumption grew by 3.3 percent, spurred by gains in employment and real wages, but weak external conditions, combined with lingering geopolitical tensions had a dampening effect. Investment saw a modest turnaround, growing at 2.1 percent following a contraction of almost 5.5 percent over 2013–14. Exports grew by only 1.4 percent, reflecting tepid growth in the euro area and the prolonged recession in Russia, although Latvian businesses proved resilient and able to penetrate alternative markets. Inflation remained well below target, falling to 0.2 percent, driven by the decline in oil and food prices and low inflation in the euro area, according to IMF.
The general government deficit was around 1.3 percent of GDP in 2015, 0.3 percentage points higher than targeted in the budget, but still consistent with domestic and EU fiscal rules. The higher outturn was the result of a previously agreed change of plan from long-term renting to purchasing the newly built offices of the State Revenue Services. Tax revenues were supported by strong wage growth and improved tax compliance.
Bank balance sheets continued to strengthen. Capital adequacy increased and the ratio of non-performing loans declined. Credit continued to shrink, with the stock of bank credit to the private sector declining by 2.2 percent (y-on-y) at end 2015. Non-resident deposits (NRDs) in the banking system were stable. On the regulatory front, the authorities took a series of steps to clamp down in anti-money laundering (AML) cases, including bank closures, fines and personnel actions.
Executive Board Assessment
Executive Directors commended the steady economic progress in Latvia, and the generally favorable macroeconomic conditions despite the current slowdown. They noted that the medium-term outlook is broadly positive; however, higher productivity and additional fiscal space are needed to support inclusive growth and employment.
Directors emphasized the need for continued structural reforms across a wide range of areas to enhance productivity, maintain competitiveness, and improve equity. This would be vital to maintain the pace of income convergence with the rest of Europe. Reforms are needed to improve the investment climate; enhance public infrastructure; strengthen the governance of state-owned enterprises; improve the efficiency and effectiveness of the judicial system and insolvency regime; and encourage innovation. Measures are also needed to improve labor participation and align education and vocational training with market demand. Directors urged the authorities to monitor wage developments and their impact on competitiveness. They generally considered that increases in the minimum wage should not exceed productivity growth over the medium term, while complementary policies should address inequality and poverty.
Directors noted that the gray economy is preventing Latvia from achieving its full potential by hindering the efficient allocation of resources, creating an unfair playing field, and curtailing budget revenues. They called for further efforts to improve participation in the formal economy alongside measures to enhance public services and garner public support.
Directors noted with satisfaction that Latvia’s banking system is well capitalized and profitable. However, they expressed concern that the persisting weakness in bank credit constrains investment and growth. They encouraged the authorities to address the legal and structural constraints hampering lending to SMEs and households, and to use the benchmarking exercise to review banks’ risk models. Directors commended the authorities’ efforts to strengthen AML/CFT regulations and supervision, and urged continued vigilance to mitigate risks, especially those related to non-resident deposits. They urged the authorities to focus on implementation of the enhanced regulations and to continue to align the framework with international standards.
Directors considered the fiscal stance to be broadly appropriate, while noting that vigilance will be needed to ensure adherence to targets and EU rules. They also noted that additional fiscal space is needed over the medium term to strengthen the social safety net, promote social inclusion, and boost productive public spending. They welcomed the authorities’ plan to raise tax revenue, and recommended using the ongoing reviews of tax and expenditures as an opportunity to consider comprehensive reforms to improve incentives and recalibrate the tax burden equitably.