Public Information Notice No. 02/5

Public Information Notice: IMF Concludes 2001 Article IV Consultation with the Republic of Latvia

January 25, 2002

On January 18, 2002, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with the Republic of Latvia.¹

Background

Latvia has enjoyed a strong economic performance since the last Article IV consultation in June 2000. Real GDP growth was 6½ percent in 2000 and accelerated to 8¾ percent in the first half of 2001; growth has been led primarily by investment. Inflation has remained low at 3 percent in 2000 and 2001. The current account deficit fell to 7 percent of GDP in 2000, after reaching almost 10 percent of GDP in 1998-99, during the Russian crisis. However, further reduction of the current account deficit in 2001 was halted, due to the combination of continued strong growth in Latvia and a slowdown among Latvia's main trading partners. Nevertheless, robust export growth (9 percent in 2000) appears to have been sustained in 2001, as exporters have quickly reoriented toward other markets. Strong inflows of foreign direct investment have financed about three-fifths of the current account deficit, helping to keep external debt levels moderate. Market sentiment toward Latvia remains favorable, as evidenced by the relatively low yield spread on Latvia's first Eurobond and by the successful issue, in November 2001, of a second Eurobond.

This performance reflects on generally strong macroeconomic and structural policies, apart from a lapse in fiscal control in late 2000. After a moderate decline in 2000, the general government fiscal deficit is likely to have been reduced by about 1½ percentage points in 2001, to 1.7 percent of GDP. Fiscal consolidation has been accomplished mainly through expenditure restraint: the ratio of expenditures to GDP has been reduced by about 6 percent of GDP from the relatively high level reached in 1999 in the wake of the Russian crisis. The ratio of government revenue to GDP fell by about 4 percentage points from 1999 to 2001, reflecting a desire to reduce the tax burden, but also some weaknesses in tax collection.

The exchange rate peg of the lats to the SDR has contributed to price stability. Monetary policies have supported the exchange rate peg, while a relatively rapid expansion of credit to the private sector has helped facilitate investment. Latvia has continued to improve its financial sector framework, which includes the introduction of a unified financial sector supervision under the Financial and Capital Markets Commission in July 2001.

Latvia's generally liberal market economy and its continued pursuit of structural reforms in many areas have helped forge an environment conducive to investment and durable economic growth, which is also reflected in Latvia's prospect of joining the EU in 2004.

The main challenge to Latvia's economy is the persistent current account deficit. Past current account deficits have partly reflected the import content of the investment activity that has underpinned economic growth. Nonetheless, deficits of this magnitude, if sustained, pose a potential risk to Latvia's external sustainability.

The IMF Executive Board approved a 20-month Stand-By Arrangement (SBA) with Latvia in April 2001. The first review under the SBA was not completed at this time, over concerns about the 2002 budget, but may be taken up by the Executive Board at a later date.

Executive Board Assessment

Executive Directors noted that Latvia's economic performance in 2001 had been among the best of the EU accession candidate countries. Strong and broad-based economic growth had been driven by domestic demand, particularly investment, while inflation had remained low. At the same time, Directors expressed concerns about the magnitude and persistence of the external current account deficit and regretted that the first review under the current Stand-By Arrangement was delayed.

Directors were of the view that the economic performance in 2001 reflected Latvia's long-standing commitment to macroeconomic stability and the success of earlier structural reforms in creating a flexible and resilient market economy. In particular, Directors noted that the authorities had successfully implemented their 2001 economic program, including by adhering to macroeconomic policy targets.

Directors agreed that under Latvia's present circumstances the exchange rate peg to the SDR remained appropriate, but cautioned that it needed to be underpinned by the maintenance of sound fiscal and monetary policies. The peg should remain an anchor of Latvia's economic strategy in the period leading to European Union accession. Directors welcomed the Bank of Latvia's decision to discontinue the issuance of long-term foreign exchange swaps ahead of schedule and to limit their use of short-term foreign exchange swaps by relying more on open market operations.

Directors noted Latvia's strong medium-term growth prospects. To meet this potential, the authorities needed to continue pursuing disciplined macroeconomic policies, further improve public sector efficiency, and sustain the momentum of structural reforms. This would help ensure strong economic growth and low inflation in the medium term. For 2002, Directors expected that domestic demand would again underpin significant growth in the Latvian economy, albeit below the pace of 2001. However, the slowdown in the global economy was likely to place additional stress on Latvia's external current account, as had become evident in late 2001. Under the fixed exchange rate regime, fiscal policy remained the primary instrument of macroeconomic management.

Directors supported the government's intention to move toward a balanced budget over the medium term. However, they expressed reservations about the expansionary fiscal policy in the 2002 budget, which could exacerbate pressure on the external current account. Directors recognized the spending needs associated with EU and NATO accession-which are needed to upgrade the delivery of crucial public goods—and supported the authorities' desire to gradually reduce the tax burden on the economy. To make room for these important steps, however, Directors saw as crucial the improved prioritization and containment of public expenditure especially in election year 2002, continued efforts to enhance tax administration, and more determination in bringing public sector reforms to fruition, including at the municipal levels of government. In this context, Directors welcomed the authorities' adoption of fiscal targets for the first half of 2002 that were in line with a modest annual deficit; however, they noted that the budget adopted by Parliament would imply a substantial fiscal loosening in the second half of 2002. They encouraged the authorities to take steps to avoid this loosening of the fiscal stance, which as noted would likely add to pressures on the external current position.

Directors welcomed Latvia's participation in the joint IMF-World Bank Financial Sector Assessment Program, and noted that no major sources of vulnerability had been identified. They observed the smooth transition to unified financial sector supervision under the Financial and Capital Markets Commission. Directors recognized that Latvia had established an adequate money-laundering framework, but urged the authorities to strengthen enforcement capacity and to enhance their monitoring of the large inflows of non-resident deposits. They welcomed Latvia's quick actions to introduce anti-terrorism financing legislation after September 11. Some Directors expressed reservations over the possible introduction of a Financial Services Center in Latvia.

Directors expressed concern with the continued rapid expansion of private sector credit, particularly at very short terms, and urged the authorities to stand ready to tighten monetary conditions if deemed necessary to counter a worsening in the quality of banks' loan portfolios.

Directors welcomed advances in Latvia's agenda for structural reforms as the means to reduce unemployment and external vulnerability. They noted the continued improvements in the environment for investment, and particularly foreign investment. In this regard the process of EU accession was providing a useful impetus to structural and institutional reform, and Directors welcomed Latvia's progress in accession negotiations. Directors urged the authorities to persevere in their privatization of large-scale public enterprises and in their efforts to fight corruption and improve governance. They commended Latvia's maintenance of a very open international trade regime.