IMF Executive Board Concludes 2006 Article IV Consultation with the Republic of Latvia

On October 4, 2006, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with the Republic of Latvia.¹

Background

The Latvian economy has made remarkable strides since the mid 1990s combining, for the most part, macroeconomic stability with rapid income convergence. Relative to the 15 original European Union members, per capita income in purchasing power parity terms has climbed 16 percentage points, among the fastest of the eight new Eastern European member states (EU8). Inflation performance was also commendable until recently. While current account deficits were larger than for most other EU8, they were broadly consistent with Latvia's income and growth potential. Nonetheless, reliance on foreign savings over an extended period has caused net foreign liabilities to approach 60 percent of GDP in 2005.

Since 2004, the economy has experienced an integration-related boom. Deepening European integration brought lower nominal interest rates, large disbursements of EU grants and external inflows to domestic banks. As a result, GDP growth increased to record levels, and a positive output gap emerged. Consumption and capital formation have been the main drivers of demand while, on the production side, growth has been particularly strong in construction and domestic trade. These patterns reflect the very rapid increase in household credit and sizable spending on EU-related projects and transfers, which nearly doubled in the first full year of EU membership in 2005. Unemployment has fallen sharply, due to extensive outward migration of labor as well as the strength of the growth, reaching 7¾ percent. Headline inflation has remained in excess of 6¼ percent (year-on-year), reflecting higher core inflation as well as rising world energy prices and the harmonization of food prices. The current account deficit has remained above 12 percent of GDP.

Rapid financial deepening has continued, increasing bank exposures to credit and market risk. Credit to private sector residents grew nearly 65 percent in 2005, and the loan to GDP ratio reached 70 percent. While banks' financial soundness indicators remain strong, the real estate sector now accounts for nearly half of total loans. Direct and indirect euro exposures have risen sharply, reflecting both the lifting of limits on open euro positions following the repeg of the lats to the euro and the rapid expansion in euro-denominated loans to mostly-unhedged households. As a result, balance sheet mismatches have widened over the past year.

Notwithstanding a modest headline balance, fiscal policy has been expansionary. Monetary policy continues to lean against the wind of strong demand and credit growth, but its effectiveness is limited by fully open capital markets and the narrow-band exchange rate peg. With little autonomous leeway to influence the pace of economic activity, the Bank of Latvia (BoL) has relied on a significant increase in the burden of reserve requirements-raising the rate and broadening the base in recent years.

Strong growth is expected to continue in 2006. The ongoing credit boom and faster real wage growth are expected to support private domestic demand, while increasing net EU grants will boost public spending. Growth is projected to rise to 11 percent, and output will remain above potential. The current account deficit is projected to widen to 14 percent owing to rapid import growth, as well as rising profits of foreign investment, particularly in the banking sector. Core inflation is likely to remain stuck at around 5¾ percent, although headline inflation may moderate on account of smaller increases in world energy prices.

Executive Board Assessment

Executive Directors praised the authorities for their sound macroeconomic management and far-reaching structural reforms over the past decade, which have fostered rapid economic growth and helped deliver impressive gains in Latvia's living standards since the mid-1990s. However, Directors were concerned that the current exuberant economic expansion, while underpinned by the process of EU integration, is tilted excessively toward domestic demand, bringing with it substantial risks that could disrupt future progress with income convergence. In particular, Directors observed that the economy is now operating above its supply capacity, with high price and wage inflation weakening Latvia's international competitiveness advantage, even as the private sector is taking on sizable foreign-currency denominated liabilities.

Directors considered that the key policy challenge is to steer the economy away from its overheated path and to moderate vulnerabilities. Restraining private and public demand in the near term was seen as crucial to limiting the buildup of external and financial sector vulnerabilities. A front-loaded adjustment was also seen as bringing forward compliance with the Maastricht criteria for euro adoption, thereby limiting the duration of exposure to risks inherent to remaining outside the euro area.

Directors acknowledged that Latvia's economic setting-with a currency peg and an open capital account-constrains the availability and effectiveness of standard policy options, but considered that a broad range of measures-if pursued as a coherent and clearly-communicated package-could yield significant results. They recommended that this package should focus on reining-in the pace of credit growth, unwinding the fiscal stimulus that has already been injected, and securing an environment in which wage growth is tied to productivity gains. To boost the credibility of the package, several Directors advised that a feasible, though ambitious, revised target date for euro adoption be announced.

Directors counseled that, at a minimum, fiscal policy should avoid adding to the already considerable demand pressure emanating from the private sector. As an immediate step, this would require saving in full all revenue overperformance this year. Directors also urged the authorities to limit the scale of any supplementary spending appropriations and to undertake offsetting expenditure reductions. Beyond this year, they stressed that an ambitious front-loaded adjustment is necessary to reverse the fiscal stimulus added in recent years and to partially offset private demand injections. To achieve this goal, Directors recommended restraining real spending, focusing on own-financed items and those EU-funded projects likely to exacerbate bottlenecks, and postponing the planned reduction in the personal income tax rate until overheating pressures have dissipated. Directors noted that, in the event the envisaged private sector savings do not materialize, fiscal policy would need to shoulder a larger burden of the adjustment. They observed that the authorities' plans to enhance strategic planning and implementation of a medium-term budgeting framework would help to move away from the practice of supplementary budgets.

Directors commended the monetary authorities for instituting policies that lean against the wind of strong demand and credit growth, including the recent broadening of the reserve requirement base, and recommended that domestic policy interest rates continue to track those of the euro area. However, they urged caution with respect to other measures, including raising the minimum liquidity ratio and the reserve requirement rate, that could divert bank lending offshore and to less-regulated nonbanks and promote further currency substitution, while leaving the overall pace of credit growth largely unaffected.

Directors viewed the generous tax treatment of real estate as contributing to the very rapid growth in mortgage credit and house prices. They recommended broadening the base of the personal income tax to include realized capital gains on real estate holdings, excluding on long-term primary residences. Directors also called for more accurate reporting of the transaction price at the time of purchase to correctly measure capital gains and assess the base for the real estate transfer tax.

Directors called for strengthening the supervisory framework and macroprudential analysis in order to constrain the buildup of risks in the financial sector. In view of growing currency mismatches and delayed euro entry, they advised that prudential regulations governing banks be amended to treat the euro as any other foreign currency. Directors emphasized that the introduction of Basel 2 would increase the need for close and effective cooperation with foreign supervisors of banks with Latvian subsidiaries or branches, and to ensure that subsidiaries' credit-risk models are fully appropriate to the Latvian financial market. They also recommended refining stress-testing scenarios to better simulate the effects of macroeconomic shocks, and called for better educating households about the risks associated with borrowing. Directors looked forward to the 2007 Financial Sector Assessment Program update, which they saw as an opportunity to further address issues related to risks in the financial sector. They welcomed the strengthening of the Anti-Money Laundering/Combating Financing of Terrorism framework, but called for continued vigilance to safeguard Latvia's position as a regional financial center.

In the context of the tightening of the labor market, Directors underscored the need to maintain wage discipline and better link compensation to performance, including through the signaling effect of public-sector wages, in order to safeguard external competitiveness and prevent the emergence of a wage-price spiral. They noted that reducing overheating, improving productivity in the public sector, and further increasing labor force participation would mitigate wage pressures. Directorsn also considered that limited inward immigration could relieve growth bottlenecks arising from skilled-labor shortages. To sustainably underpin real income growth while boosting export performance, Directors noted the need for Latvian firms to move up the value-added chain. This would require improving Latvia's attractiveness to long-term investment through a credible commitment to macroeconomic stability, reducing bureaucratic hurdles, and exploiting the potential catalytic role of EU funds to build human capital and facilitate absorption of new technologies.