10 March 2014

IMF: Republic of Latvia - Concluding statement of the 2014 Article IV Mission

Latvia enters the euro area with the fastest rate of growth in the currency union, despite a slowdown from the pace of recent years. Over the medium term, fiscal policy will need to contend with several potential headwinds.

The following sections have been abridged

Latvia enters the euro area with the fastest rate of growth in the currency union, despite a slowdown from the pace of recent years. 

The outlook for 2014 is broadly favourable. Growth is projected at around 4 per cent, underpinned by an investment recovery due to the positive sentiment associated with euro adoption... A prolonged slowdown in European partner countries would dampen Latvia’s recovery and increase its current account deficit, while a surge in global financial volatility—for example due to exit from unconventional monetary policy in the US—could affect bank funding.

Over the medium term, economic growth well above the euro area average should be attainable, as Latvian incomes converge towards the regional norm. But to realise this goal, a series of inter-linked policy actions are needed. Maintaining competitiveness within the common currency area will require continual productivity gains, underpinned by sustained progress on structural reforms. Reviving bank credit—which continues to contract well into the recovery—will be necessary to ensure that credit constraints do not hold back investment. Fiscal policy will need to contend with several medium-term headwinds, while helping to strengthen the social safety net. And vigilant supervision of non-resident deposits (NRDs) in the banking system will need to be maintained to guard against external shocks.

Maintaining Competitiveness in the Euro Area

• Latvia’s basic medium-term macroeconomic challenge—maintaining competitiveness under a fixed exchange rate regime—remains unaltered by euro accession... Productivity gains will need to be the chief driver of competitiveness going forward.
• Progress on a broad range of structural reforms will be needed to improve the business climate and yield the desired productivity improvements. 
• Upgrading Latvia’s infrastructure will be necessary to attract foreign direct investment (FDI) and facilitate export growth. 
• Labour market reforms to improve work incentives and lower structural unemployment should be implemented.

Resuscitating Bank Credit

Latvia’s creditless recovery is in line with international experience, but has now continued for longer than the historical norm. Going forward, the continuing contraction of credit in Latvia might constrain investment. Cross-country evidence indicates that sharp boom-bust cycles are often followed by creditless recoveries, especially if the cycle is accompanied by a banking crisis, as in Latvia’s case. However, even among the sample of emerging economies that experienced creditless recoveries in the past, positive credit growth has usually resumed by this stage in the cycle. A combination of supply factors (such as the tightening of credit standards) and demand factors are likely holding back credit in Latvia, and policies should be geared accordingly.

Reforms to further reduce the private sector’s debt overhang could help resuscitate the demand for credit, lower perceptions of credit risk and underpin a rebound in investment. Measures to improve the application of the insolvency law, and more generally, to strengthen the judicial system, would facilitate balance sheet repair.

Recent legislative proposals that could act as a drag on future lending should be reconsidered. 

Maintaining a Prudent Fiscal Policy

• The 2014 budget is broadly appropriate, consolidating the fiscal position at a measured pace.
• While the budget goes some distance in helping to address high levels of inequality, more is needed. 
• Over the medium-term fiscal policy will need to contend with several potential headwinds. 

Vigilant Financial Sector Supervision

The growth of non-resident deposits (NRDs) has decelerated in recent months, but NRDs comprise nearly half of all deposits in the banking system. While the expansion of NRDs is associated with an accumulation of liquid foreign assets (which decreases the risks of domestic spillovers), the increasing size of the sector represents a source of vulnerability to external shocks. The supervision of NRD-specialised banks should continue to be sufficiently intensive and frequent given their relatively higher risks and susceptibility to sudden surges and stops. Appropriately, minimum capital requirements and liquidity ratios on NRD-specialised banks are already higher than for others.

Full press release

See also: Andris Vilks and Klaus Regling hail Latvia’s accession to-ESM, 3.3.14

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