Public Information Notice No. 05/109

Public Information Notice: IMF Executive Board Concludes 2005 Article IV Consultation with the Republic of Latvia

August 10, 2005

On July 27, 2005, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with the Republic of Latvia.¹

Background

During much of the past decade, Latvia's growth performance outstripped other new European Union (EU) members while inflation remained subdued. A sound policy framework and far-reaching structural reforms supported this performance, including a prudent fiscal policy that underpinned the exchange rate peg. These achievements were capped by Latvia's accession to the EU last year and, more recently, by ERM2 entry. Nonetheless, per capita GDP—at 40 percent of the EU-15 average in PPP terms—remains the lowest in the EU. Against the backdrop of an open trade and capital account regime, income convergence contributed to relatively large current account deficits, averaging 7¼ percent of GDP during 1996-2003, and sharply rising gross external debt, which reached 93 percent of GDP in 2004, though net debt remains a more modest 30 percent of GDP.

Economic growth picked up sharply in 2004 on very strong domestic demand, accompanied by a jump in underlying inflation and current account deficit. Investment and consumption were buoyed by expectations of sustained income convergence and declining real interest rates that pushed GDP growth to 8½ percent. Unemployment continued to decline gradually, and is below 10 percent. Inflation rose to 6¼ percent and the current account deficit widened to 12⅓ percent of GDP in 2004, partly reflecting one-off factors related to EU accession and other supply shocks; but even excluding these effects, inflation and the current account deficit have increased, pointing to the presence of demand-induced imbalances. Private sector credit—particularly to households—continued to expand strongly, approaching 60 percent of GDP.

Latvia joined ERM2 at end-April 2005 at the prevailing exchange rate parity, having repegged from the IMF's Special Drawing Right (SDR) to the euro in January. Labor cost-based competitiveness was broadly unchanged in 2004 relative to the previous year, and considerably stronger than in earlier years. Rapid wage growth was compensated by strong productivity gains and a modest depreciation of the SDR-linked exchange rate. Exports of goods and services grew robustly in volume terms in 2004 and, together with a favorable terms of trade, further increased Latvia's export market share.

Booming bank credit added to demand pressures and macroprudential risks. With bank profits strong, nonperforming loans low and well provisioned, ready access to foreign financing, and capital adequacy—though moderating in recent years—well above the newly lowered minimum requirement of 8 percent of assets, banks faced few constraints in expanding their balance sheets. Mortgages continued to be the most dynamic segment. With most loans denominated in foreign currency, unhedged borrowers are exposed to exchange rate movements. Nonresident deposits—a significant funding source at many banks—represent more than half of total deposits, raising concerns about the growing shortfall between banks' liquid foreign assets and short-term foreign liabilities, as well as possible links with money laundering.

Macroeconomic policies sought to ease demand pressures in 2004. The general government deficit narrowed by ½ percentage point to 1.1 percent of GDP on stronger-than-budgeted revenues and lower spending than approved in the supplementary budgets. Monetary policy was tightened through an increase in the refinancing rate and a strengthening of mandatory reserve requirements, although real interest rates on lats-denominated bank loans declined. The repeg to the euro and ERM2 entry were effected smoothly and spreads on euro-denominated bonds have narrowed to 20 basis points.

Robust growth is expected to continue in 2005. The ongoing credit boom and faster real wage growth are expected to support private domestic demand while a sharp increase in net EU grants would also boost public spending, with growth reaching 7¾ percent, keeping output somewhat above potential. While inflation (on a 12-month basis) has remained on a downward track through mid-year reflecting the high base in early 2004, strong demand pressures and additional increases in energy prices will likely prevent a further decline in inflation in the second half of the year, with year-average inflation broadly unchanged relative to 2004. The current account deficit is expected to narrow to about 10½ percent of GDP on account of larger net EU transfers and the absence of bulky one-off investments that pushed up imports last year.

Executive Board Assessment

Executive Directors commended the strong performance of the economy, which had culminated in Latvia's admission to ERM2 earlier this year. They cautioned, however, that decisive and timely action to reduce inflation would be crucial to meeting the authorities' euro adoption timetable and, more generally, to preserving external competitiveness. While Directors generally considered rapid financial deepening and persistently large current account deficits to be broadly consistent with Latvia's stage of real convergence, they saw potential risks associated with these developments and welcomed the authorities' commitment to remain vigilant and to address these risks as needed.

Directors expected robust economic growth to continue in 2005. They attributed the increase in inflation in 2004 to both demand and supply factors. However, with growth remaining somewhat above potential and rising regulated and world energy prices, Directors saw inflation declining only marginally this year.

Given inflation inertia and overheating concerns, Directors called for macroeconomic policies to, at a minimum, avoid adding to demand pressures. In view of the pegged exchange rate, Directors considered fiscal policy to be the primary tool for ensuring macroeconomic stability. Directors also emphasized the need to moderate the recent pace of credit growth in order to subdue private demand and limit the buildup in macroprudential risks.

Directors considered that a broadly neutral fiscal stance for 2005 would balance the need to accommodate supply-enhancing EU-financed investment with that of containing the short-term demand effects of higher public spending. Directors welcomed efforts to contain the execution of the budget in 2004, but expected that the likely fiscal outturn in 2005—although significantly tighter than the approved budget—would add to demand pressures. To avoid a demand stimulus from fiscal policy, Directors urged the authorities to save the projected overperformance in revenue and hold fiscal spending excluding payments to the EU constant relative to GDP. Consistent with this, the size of the supplementary budget under preparation should be strictly limited.

Directors considered that fiscal consolidation over the medium term—beyond what is contemplated in the Convergence Program—was desirable to slow the build up in external debt. They welcomed recent improvements in medium-term budgeting associated with the tapping of EU funds and preparation of Convergence Programs. Notwithstanding the low level of Latvia's public debt, Directors also considered that medium-term fiscal adjustment would help to prefinance the cost of ongoing pension reform. Some Directors noted that some flexibility could be considered in the fiscal consolidation.

Directors, viewing rapid credit growth as adding to demand pressures, commended the Bank of Latvia's decision to raise interest rates and tighten reserve requirements over the past year. However, as Latvia's ERM2 entry further limits the scope for an independent monetary policy, Directors considered that the options for additional tightening had diminished, and they therefore called for other measures to moderate credit growth. In this regard, closing capital gains tax loopholes that could be fuelling the mortgage boom was seen as a priority. Directors also supported the authorities' intention to impose a temporary tax on mortgage borrowing if the pace of credit growth failed to moderate.

Directors considered that Latvia's external competitiveness remained adequate at present, and supported the decision to enter ERM2 at the prevailing euro-lats peg. However, Directors saw the recent acceleration of wages as a risk to future competitiveness. They therefore called for policies to contain wage and price inflation while preserving existing labor market flexibility.

Directors underscored the need for strong supervision and prudential safeguards in the present environment of very rapid credit growth. They welcomed recent improvements in monitoring and stress testing and the ongoing shift to euro-denominated borrowing in response to Latvia's repeg to the euro, but considered that the recent easing of prudential regulations amid the sustained credit boom could well exacerbate financial sector risks. They therefore urged continued close oversight of banks' credit standards and currency exposures, and maintenance of tighter loan conditions in situations of currency mismatch between borrowers' income and debt.

Directors recommended enhanced supervision of banks with substantial nonresident deposits. They considered that the recent outflows from a few small banks because of money laundering concerns attested to the risks associated with these deposits. Directors urged rigorous monitoring of large banks with substantial domestic and nonresident deposits to limit risks of contagion. Owing to the different profile of banks dealing with nonresident deposits, they also called for compiling macroprudential data separately for banks with and without substantial exposure to nonresident deposits.

Directors welcomed the recent antimoney laundering amendments and the authorities' request for an Anti-Money Laundering and Combatting the Financing of Terrorism (AML/CFT) Report on the Observance of Standards and Codes (ROSC). They stressed that strict implementation of the legal framework was critical for successfully combating money laundering. Directors urged that any remaining weaknesses identified by the ROSC be quickly addressed in order to safeguard Latvia's position as a regional financial center.

Directors encouraged the authorities to move ahead with structural measures to sustain vigorous growth. Efficiently allocating EU funds for infrastructure was seen as a key element of a framework for promoting efficient resource allocation, along with the authorities' continued reduction of corruption. Directors also called for removing constraints on effective labor supply by encouraging labor force participation through a narrowing of the tax wedge on low-wage earners, sharpening incentives to find employment, and by ensuring that the education system becomes more responsive to skill needs of employers.