Republic of Latvia: Staff Concluding Statement of an IMF Article IV Consultation

July 2, 2018

Growth is projected to moderate and fundamentals remain mostly sound, with fiscal and current account deficits and public debt at prudent levels and the financial system stable. Still, with output above potential and real wages rising sharply, the policy mix needs to be calibrated to smoothly navigate the ongoing cyclical upswing and place the economy on a path of sustainable long-term growth.

The authorities should seize this opportunity to redouble reform efforts, focusing on addressing labor market challenges, increasing labor productivity, and supporting investment growth.

Financial sector stability should be bolstered by further strengthening the enforcement of AML/CFT regulations and carefully handling the ongoing refocusing of the business model of banks servicing foreign clients.

Developments, Outlook, and Risks

Latvia’s economy has continued to recover since the crisis. Consumption growth, private investment and utilization of EU structural funds, and a favorable external environment allowed the economy to reach a growth peak of 4.5 percent in 2017. Gross wages increased significantly, by 7.8 percent, and inflation has picked up, with average inflation reaching 2.9 percent in 2017. Nevertheless, competitiveness has held up so far, as evidenced by continued robust profitability of export-oriented sectors.

Economic fundamentals are mostly sound, but risks have emerged. Fiscal and current account deficits and public debt remain at prudent levels, and private sector debt is on a declining path. However, the labor market has continued to tighten, and fiscal policy has become procyclical, as EU investment inflows have picked up and the upfront costs of the tax reform have dampened revenues.

Growth should moderate in the medium term amid increasingly binding capacity constraints . Real GDP growth is projected to reach 3.7 percent in 2018, supported by EU structural funds and rising wages, while external demand is projected to moderate. Over the medium term, growth should gradually converge to its potential rate of 3 percent, as EU investment funds level off and capacity constraints become increasingly binding.

Risks to the baseline are tilted to the downside. On the domestic front, more rapid labor market tightening and a deepening of fiscal pro-cyclicality could trigger an accumulation of imbalances and overheating pressures, and growth could be slower if structural reforms do not further advance. Financial sector stability could be at risk if enforcement of AML/CFT regulations falters or banks servicing foreign clients fail to refocus their business models, which could undermine confidence in the banking system. Externally, growing protectionism and weaker growth in advanced economies could become a drag on export growth, while an abrupt reversal of risk appetite in Europe and/or tighter global financial conditions could raise the cost of public debt financing.

A prudent policy mix is needed to mitigate these risks and ensure the economy stays on a path of sustainable long-term growth . The authorities should keep the reform momentum, focusing on supporting labor market participation, reducing structural unemployment, raising labor productivity, and increasing investment. Fiscal policies should aim to reverse procyclicality, improve the growth-friendliness of fiscal policies, and increase fiscal buffers to be able to respond to future shocks. Strengthening enforcement of AML/CFT regulations, enhancing regulatory tools, and refocusing the business model of banks servicing foreign clients are key to minimize risks for financial sector stability.

Preserving Strong Growth

Labor market constraints pose significant challenges to medium- and long-term growth. Emigration continues to deplete the country of needed skills, a shrinking labor force is driving up wages and eroding competitiveness, while labor force aging is likely to dampen productivity in the long-run. Reforms should focus on easing labor market constraints by encouraging greater labor force participation of targeted groups and reducing structural unemployment. These reforms include greater use of skill-matching and skill-building policies, better access to housing, revisiting the minimum wage structure, and encouraging labor immigration. Productivity-enhancing reforms will also be critical for the economy to cope with demographic headwinds to long-term growth.

More Inclusive and Growth-Friendly Fiscal Policies

A stronger fiscal position is warranted to reverse procyclicality and build adequate fiscal buffers. The authorities aim to achieve these objectives over the medium term, which will require upfront savings, not least to offset the costs associated with the recent tax reform package. Raising permanent revenue and safeguarding growth-enhancing spending would help strengthen fiscal sustainability without compromising social sustainability.

Improving the growth friendliness and inclusiveness of the fiscal policy mix has long-term benefits. Despite the impact on revenue, the recently adopted income tax reform is a step in the direction of reducing the high tax wedge, improving the progressivity of the tax system, and encouraging corporate investment. Reallocating government spending toward investment would help the economy weather the leveling off of EU structural funds in the medium term. More efficient health and education spending and better-targeted social protection programs would help build human capital, improve labor productivity, and address Latvia’s high poverty and inequality rates.

Ensuring Efficient Financial Sector Intermediation

The financial system needs to become more supportive of investment. Despite favorable macroeconomic conditions, credit growth remains subdued. In the medium and long term, more credit will be needed to fuel investment and raise Latvia’s capital-output ratio. The financial system could become more supportive of investment as reforms address risks stemming from the shadow economy and inadequate implementation of the insolvency framework. Completing the reform of the insolvency regime and the licensing of insolvency administrators would help improve creditors’ recovery rates, while efforts to encourage voluntary income and asset disclosure would help reduce credit risk.

The banking system is stable, liquid, and well capitalized, but steadfast actions are necessary to restore its reputation following the suspension of activities of ABLV. While the actions against ABLV, which followed money-laundering allegations, accelerated foreign-client deposit outflows, wider spillover effects have so far been limited. Effective enforcement of AML/CFT regulations should focus on mitigating risks from foreign depositors and opaque companies. Changes in the banking legislation, alongside harmonization at the EU level, are needed to provide more adequate tools to liquidate banks deemed failing or likely to fail. Careful oversight of the refocusing of activities of banks servicing foreign clients, and continued vigilant application of fit and proper rules and assessment of the reputation of bank owners and managers, would help improve their business models and governance. These actions will be key to minimize risks for financial sector stability.

The IMF team is grateful for the generous hospitality of the Latvian authorities, and would like to thank, once again, all interlocutors in government, the Bank of Latvia, and the private sector for constructive and fruitful discussions.