Public Information Notice No. 00/48

Public Information Notice: IMF Concludes Article IV Consultation with Latvia

July 11, 2000

On June 30, 2000, the Executive Board concluded the Article IV consultation with Latvia.¹

Background

The economy turned around in mid-1999 and grew by 3 percent in the fourth quarter of 1999 compared with the same quarter of 1998. Indications are that the economic recovery has accelerated in early 2000: industrial output and tax revenues rose by about 4 percent year-on-year during the first quarter of 2000, while credit to the private sector has expanded by about 11 percent in the first four months of the year. The recovery appears to be driven by a rebound in exports and transport and transit services, as well as a rise in consumer spending. The unemployment rate fell to 8.8 percent in mid-May 2000, more than 1 1/2 percentage points below its peak in April 1999, while inflation continues to be subdued at about 3 1/2 percent.

These positive developments notwithstanding, the persistently large external current account deficit, coupled with a decline of foreign direct investment poses a potential risk to Latvia's external sustainability. After having doubled to about 10 percent in 1998, the current account deficit declined only marginally to 9 1/2 percent of GDP in 1999, but current indications point to a further narrowing in the external current account deficit in 2000 and a further pick-up in foreign direct investment. Despite the continued appreciation of the real effective exchange rate vis-à-vis EU trading partners, other indicators, including the recent robust export performance-in the first quarter of 2000, exports grew by 12 percent overall and by 17 percent to the EU compared with the first quarter of 1999—and a marked slowdown in wage growth, indicate a continued competitiveness margin. Important steps have been taken to further liberalize Latvia's already very open trade regime, in line with Latvia's commitments under the World Trade Organization.

While the fiscal position weakened in the wake of the Russian crisis, the return to a path of prudent fiscal policies since mid-1999 was instrumental in narrowing the external current account deficit. The general government deficit in 1999 was limited to 4.2 percent of GDP, primarily by restraining expenditure below the budget appropriations, as tax receipts were broadly as planned and non-tax revenue fell short of expectations. During the first quarter of 2000, the general government fiscal deficit fell to about 1.2 percent of GDP as tax revenue strengthened across the board, while expenditures were held to about 92 percent of their planned levels. In addition, the November 1999 amendments to the pension law have had a positive impact on the fiscal balance of the Social Fund.

The exchange rate peg to the SDR has served Latvia well and remains appropriate, given that Latvia has maintained adequate external competitiveness. Appropriate monetary policy has supported the Bank of Latvia's exchange rate objectives in the aftermath of the Russian crisis. Monetary conditions loosened somewhat in late 1999 to accommodate banks' demands for lats to guard against potential Y2K-related problems, but this liquidity injection was reversed during the first quarter of 2000. Considerable progress has been made in restoring the soundness of the banking system, and the Bank of Latvia's prudential standards are now largely in line with international norms. The authorities are also on track in their preparatory work to create a Unified Financial Sector Supervisory Agency.

Latvia's precautionary stand-by arrangement with the Fund was approved on December 10, 1999 (for more details see IMF Press Release No. 99/58 and the Memorandum of Economic Policies posted at www.imf.org). The program is (i) centered around fiscal consolidation, with the government aiming to achieve a fiscal deficit of about 2 percent of GDP in 2000 and approximate fiscal balance over the medium-term; (ii) anchored by the exchange rate peg to the SDR, which could be maintained until EU accession; and (iii) enhanced by a wide array of structural reforms, such as pension reform, completion of the privatization of the remaining large public enterprises, and targeted measures to improve the business climate.

Executive Board Assessment

Executive Directors noted that the recession triggered by the Russian crisis had come to an end. Latvia had weathered this external shock, owing largely to the appropriate economic policies pursued by the authorities during the transition years in general, and in the wake of the crisis in particular. A long-standing commitment to macroeconomic stability had enabled Latvia to survive the economic downturn without a serious challenge to its exchange rate regime. Furthermore, earlier structural reforms had largely succeeded in creating a flexible market economy, allowing a relatively quick economic recovery.

Directors emphasized that Latvia's growth prospects over the medium term were promising, provided the authorities continue to pursue appropriately tight financial policies, improve further the efficiency of the public sector, and remove the remaining impediments to private sector activity. This approach would also help produce a reduction in the persistently large external current account deficit, which, together with the decline in foreign direct investment in the wake of the Russian crisis, posed a potential risk to Latvia's external sustainability.

Directors commended the authorities for their tighter fiscal stance, noting the authorities' commitment to maintaining the fiscal deficit at or below 2 percent of GDP in 2000, and 1 percent of GDP in 2001. Directors viewed these deficits as ceilings rather than targets, and supported strongly the authorities' intention to return to a balanced budget at faster pace than now targeted, if external developments were to prove worse than expected. They welcomed the identification of contingency spending measures to help achieve this objective. They also encouraged the authorities to continue their prudent budget execution, and to implement measures intended to improve tax administration and enhance the efficiency and effectiveness of public spending. They welcomed the authorities' decision to transfer privatization receipts directly to the Treasury, rather than allowing the privatization agency to spend them.

Directors commended the authorities for the progress made in pension reform and for putting the finances of the Pension Fund on a more solid footing. They also commended the authorities for the recent adoption of the second, fully-funded pension pillar and the emergence of private pension funds as the third pension pillar, which, taken together, should help ensure adequate retirement income and encourage private savings.

Directors generally agreed that the current exchange rate regime remained appropriate in present circumstances. They emphasized, however, that this was predicated on structural reforms and the maintenance of sufficiently tight financial policies, and should be carefully weighed against a potential erosion in Latvia's competitiveness that could result from a continued appreciation of the lats against the Euro. Directors observed that the Bank of Latvia's monetary policy had been appropriate in supporting its exchange rate objective. Some Directors expressed reservations about the recently-introduced long-term foreign exchange swaps, which carry inherent risks, and were concerned that these, together with the purchase by the Bank of Latvia of Treasury bonds, could complicate the task of monetary policy.

Directors commended the authorities for their determination in restoring the soundness of the banking system, but emphasized that there was no reason for complacency. In particular, Directors stressed the need to monitor carefully credit expansion by banks so as to ensure that loan quality, the extent of loan loss provisioning, and banks' risk management remained adequate. In the same vein, Directors encouraged the Latvian authorities to continue to monitor carefully the large inflows of deposits from non-residents. They welcomed the considerable progress made in bringing the prudential framework closer to full compliance with the Basel Core Principles of Effective Banking Supervision. Directors stressed that, with the improvement in banking supervision, more emphasis needed to be placed on enhancing the regulatory framework and the supervision of nonbank financial institutions. The forthcoming Unified Financial Sector Supervision Agency would need to maintain the high quality standards set by the Bank of Latvia.

Directors welcomed the government's intention to complete the privatization of the remaining large public enterprises by end-March 2001, establish an adequate regulatory framework for utilities, and remove the remaining impediments to private sector activity so as to create an enabling business climate. While some delays had occurred in these areas, Directors considered the recent steps as appropriate in providing new impetus to completing the restructuring of the Latvian economy. They commended Latvia for its open trade regime, and welcomed the authorities' ongoing trade liberalization efforts.