27 November 2012

Republic of Latvia: 2012 Article IV and Second Post-Programme Monitoring Discussions - Concluding Statement of the IMF Mission

On the basis of fiscal outturns so far this year and the 2013 budget approved by parliament, the general government deficit and debt for 2012–13 would be well below their respective Maastricht reference values. As a result of present and past efforts, euro adoption in 2014 appears within reach.

Latvia’s economy continues to recover strongly. Following real GDP growth of 5.5 per cent in 2011, growth is expected to exceed 5 per cent again this year despite recession in the euro area. Labour market conditions are improving. The unemployment rate fell from 16.3 per cent at the beginning of the year to 13.5 per cent at the end of the third quarter, despite an increase in participation rates. Real wage growth remains restrained. Consumer price inflation has declined sharply, easing to 1.6 per cent at end-October after peaking at 4¾ per cent in mid-2011. Robust export growth is expected to keep the current account deficit at about 2 per cent despite recovering import demand.

As a result of present and past efforts, euro adoption in 2014 appears within reach. Inflation and interest rates have declined to low levels, although the reference values for these criteria are yet to be determined by the European institutions. The Latvian authorities’ policy record to date—including the difficult adjustment effort over the past few years—provides assurances for continued stability-orientated policies. Latvia’s accession to the euro area would remove residual currency risk and, by addressing vulnerabilities stemming from foreign-currency exposures, enhance the stability of the already highly euro-ised financial system.

Fiscal Sustainability

With the 2012 budget deficit coming in at under 2 per cent of GDP, the 2013 budget further cements past fiscal gains. Taking into account a 2-percentage point redirection of state social contributions to the second pillar, the budget should achieve an underlying structural improvement of about 0.5 per cent of GDP, thus complying with both the Maastricht deficit criterion and the Stability and Growth Pact (SGP). Additional priority spending is well distributed, addressing some of the bottlenecks in health and reforming lower-end teachers’ salaries. However, some elements of the budget could have been better targeted, such as the one-percentage point cut in the personal income tax (PIT) already legislated. The cuts to and decentralisation of the guaranteed minimum benefit (GMI) could adversely affect the most vulnerable segment of society. This measure should be reconsidered following the study being prepared by the World Bank, and replaced with benefit reforms consistent both with improving incentives to work and ensuring adequate safety net coverage.

Over the medium term, the authorities should take advantage of the ongoing economic recovery to continue building fiscal space. The planned cumulative PIT cuts of 5 percentage points over 2013–15 should be reconsidered, at least for 2014 and beyond: better options could include a two-tier system or an increase in the minimum non-taxable allowance. Compensatory structural reforms would be needed under unchanged PIT policies and in any case to offset numerous other headwinds, such as restored indexation of paid-out pensions, partial restoration of second pillar pension contributions, and the gradual lowering of required dividend ratios for state-owned enterprises (SOEs). Offsetting measures could include, inter alia, strengthened property taxation, the elimination of some wasteful subsidies, and more careful targeting of social insurance and tax exemptions.

Maintaining the momentum on structural fiscal reforms will be crucial for medium-term fiscal sustainability. The Fiscal Discipline Law (FDL) pending in parliament should be passed expeditiously. Its passage would allow the Medium-Term Budgetary Framework (MTBF) to set binding expenditure ceilings for three years, reducing the risk of budgetary slippages, and helping the country stay on the path towards its Medium Term Objective (MTO). Containing fiscal risks from the SOE sector should remain high on the agenda and requires longer-term solutions to improve the management and transparency of public corporations. Pending legislation will establish a partially centralised ownership agency and require regular publication of financial information; its passage should be a priority.

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