Download Date: 5/11/2011 - 5:30 PM Current Classification: FOR OFFICIAL USE ONLY 61287 V2 Republic of Latvia—Assessment Letter for the World Bank May 11, 2011 1. Latvia’s economic recovery is strengthening after the sharp contraction in 2008-09. Real GDP started to increase in late 2009, and after a slightly negative outturn in 2010 due to base effects, growth is forecast at 3.3 percent in 2011 and 4 percent in the medium term. Net exports supported the initial recovery, but domestic demand is expected to drive growth from 2011 onwards as improving confidence and investment outweigh continued fiscal consolidation, the weak labor market, and contracting credit. However, unemployment is 17 percent (Labour Force Survey) and could remain in double digits for some time, including because of challenges in shifting those previously employed in construction to other sectors. 2. After a period of deflation (inflation averaged -1.2 percent in 2010), prices started to rise in late 2010 due to world supply shocks. Like other Baltic countries (which have high shares of food and energy in the CPI basket), headline inflation jumped to 4.1 percent in March, with food prices growing 9 percent, and energy prices by 15 percent. VAT and excise tax increases, introduced at the beginning of 2011, have also raised prices. However, core inflation has remained flat due to weak domestic demand and high unemployment, and inflation is projected to fall in 2012. Wages have started to pick up, but only moderately, and remain 9 percent below the pre-crisis peak. 3. The current account remains in surplus, though much of the sharp improvement in 2009 has proved transitory. The investment income account has worsened, but because of the recovery in profits of foreign banks, which reflects the underlying recovery.1 The current account slipped briefly into deficit at the end of 2010 for the first time since the crisis, with imports and exports both rising rapidly. 4. Financial indicators underscore growing confidence. The 5-year CDS for Latvia has fallen to around 200 basis points, and in March Fitch raised Latvia’s credit rating to investment grade status. T-bill rates remain close to historic lows, 10-year lats bonds were issued in February, and bank deposits are above pre-crisis levels. Though repayment of banks’ foreign liabilities has led to some decline in international reserves, they remain at comfortable levels. 5. With the economy recovering, policy efforts should focus on measures to help Latvia move toward euro adoption, and long-delayed state bank reforms. Euro adoption—which the authorities hope to achieve in 2014—would allow a credible exit from the current exchange rate regime, thereby permanently eliminating a key source of risk, and 1 The balance in the income account in early 2009 was artificially high due to the treatment of bank losses. Debt write-downs and other valuation effects were booked as a credit in the income account. Download Date: 5/11/2011 - 5:30 PM Current Classification: FOR OFFICIAL USE ONLY 2 would also lower borrowing costs. To qualify for the euro, Latvia needs to undertake further fiscal adjustment, but also to be mindful of the price stability criterion. Additionally, some adjustments in interest rates could be warranted in line with movements in ECB rates, and Latvia will need to remain vigilant to safeguard competitiveness over the medium term. 6. Strong spending discipline enabled Latvia to comfortably meet its 2010 fiscal targets. The ESA deficit is estimated at 7.7 percent of GDP, well below the 8.5 percent program target. Excluding bank restructuring costs (which have been largely front-loaded and should be much smaller from now on), the deficit is considerably lower, only 5.5 percent of GDP—within striking distance of the Maastricht 3 percent reference value. 7. For 2011, the budget passed in December 2010 and the supplementary budget passed in April 2011 should deliver a fiscal deficit well below the previously agreed program target. Both budgets rely mainly on revenue increases, including greater emphasis on fighting the gray economy (revenue gains in this area are difficult to quantify). Expenditure measures are few and some may not be sustainable. The authorities believe their measures will reduce the 2011 deficit to below 4.5 percent of GDP (ESA terms, excluding bank restructuring costs). Given risks of higher spending, plus the uncertain yield of measures to combat the gray economy, the outturn could be slightly higher (perhaps as high as 4.9 percent of GDP), but even this would be considerably better than the initial program path of 6 percent of GDP. 8. For 2012, the authorities will aim for a 2.5 percent of GDP deficit, well below the 3 percent of GDP Maastricht criterion, to demonstrate their commitment to euro adoption. Preliminary estimates suggest a 2012 adjustment need of L150 to 180 million (1.1 to 1.3 percent of GDP), which is much lower than estimated previously. The authorities are aware that next year’s fiscal consolidation will need to focus on expenditure cuts, rather than tax increases (except in areas such as real estate taxes), so as to contain domestic inflation and maximize the chances of meeting the Maastricht price stability criterion. 9. Significant steps have been taken to stabilize the financial system and maximize the recovery of state aid while reducing government involvement in the banking sector. After long delays, Latvia submitted its restructuring plan for Mortgage and Land Bank to the EC in April, which envisages the sale of most of its commercial assets and liabilities. The development part of the bank would be merged with other development institutions. The government is also implementing its plans for Citadele and Parex banks: selling Citadele as a whole bank in a public auction later this year, and for Parex, combining quick sales with gradual asset realization depending on expected future returns. In addition, the authorities have strengthened financial sector supervision and improved procedures for private debt restructuring. 10. Adjustment of official interest rates may be needed to support the fixed exchange rate, especially now that the ECB appears to be entering a tightening cycle. Download Date: 5/11/2011 - 5:30 PM Current Classification: FOR OFFICIAL USE ONLY 3 Should international reserves continue to decline, there would be a case for raising interest rates, particularly as interbank rates dropped below those in the euro area in April. 11. Continued competitiveness improvements will be essential for the medium-term success of Latvia’s euro adoption strategy. Internal devaluation and higher productivity have produced significant competitiveness gains (relative to their peaks, the CPI-based real effective exchange rate has depreciated by around 10 percent, the ULC-based measure by 15 percent), although improvements have leveled off recently. As discussed in the 2010 Article IV consultation, quantitative assessment of the real exchange rate is complicated by the rapid pace of structural change but, most likely, a moderate competitiveness gap remains. With its nominal exchange rate fixed to most of its main trading partners, Latvia needs to control labor costs and implement productivity-enhancing structural reforms. 12. The IMF’s Executive Board is expected to consider Latvia’s request for completion of the Fourth Review under the Stand-By Arrangement on May 25, 2011. Since July 2010 when the Board approved the Third Review (and concluded the 2010 Article IV Consultation), the authorities have met all September and December 2010 quantitative performance criteria and continued to perform well on macroeconomic indicators in 2011. They met most structural benchmarks, although some with delay, and intend to make progress on a fiscal responsibility law, a strategy for state-owned enterprises, and the divestment of state-owned banks in 2011. The authorities have requested a waiver of nonobservance of a continuous performance criterion due to their decision at end-2010 to extend an exchange restriction related to Parex Bank. The earlier Board approval of that restriction expired at end-2010, and the restriction was unapproved for a short period before the Executive Board granted another temporary approval in April 2011. Download Date: 5/11/2011 - 5:30 PM Current Classification: FOR OFFICIAL USE ONLY 4 Table 1. Latvia: Selected Economic Indicators, 2008–12 2008 2009 2010 2011 2012 Third Rev. Actual Proj. Proj. National accounts (percentage change, unless otherwise indicated) Real GDP -4.2 -18.0 -3.5 -0.3 3.3 4.0 Private consumption -5.2 -24.1 -9.0 -0.1 3.0 3.7 Public consumption 1.5 -9.2 -10.0 -11.0 -2.0 0.0 Gross fixed investment -13.6 -37.3 -10.0 -19.5 8.0 8.5 Stockbuilding (contribution to growth) -4.1 -1.5 1.5 5.8 0.0 0.0 Exports of goods and services 2.0 -14.1 5.0 10.3 9.5 7.5 Imports of goods and services -11.2 -33.5 -6.2 8.6 9.0 7.6 Nominal GDP (billions of lats) 16.2 13.1 12.2 12.7 13.4 14.2 Nominal GDP (billions of euros) 23.0 18.6 17.4 18.1 19.1 20.1 GDP per capita (thousands of euros) 10.1 8.2 7.7 8.1 8.5 9.0 Savings and Investment Gross national savings (percent of GDP) 18.1 28.9 30.2 24.0 24.0 23.6 Gross capital formation (percent of GDP) 31.2 20.3 18.9 20.7 22.2 23.1 Private investment (percent of GDP) 26.4 16.0 14.4 16.8 16.0 17.6 HICP inflation Period average 15.3 3.3 -2.0 -1.2 3.2 1.8 End-period 10.4 -1.4 -0.5 2.4 2.0 2.3 Labor market Unemployment rate (LFS definition; period average, percent) 7.8 17.3 21.0 19.0 17.2 15.5 Real gross wages 4.4 -6.8 -7.9 -2.3 -1.6 0.5 Consolidated general government 1/ (percent of GDP, unless otherwise indicated) Revenue 35.4 36.2 39.6 36.2 38.1 36.3 Expenditure and net lending 38.7 43.3 47.8 42.6 42.6 38.6 Basic fiscal balance -3.3 -7.1 -8.1 -6.4 -4.4 -2.3 ESA balance less bank restructuring -4.2 -8.6 -8.5 -5.5 -4.5 -2.5 General government gross debt 17.1 32.8 43.4 39.9 43.0 43.5 Money and credit Credit to private sector (percentage change) 11.0 -6.9 -5.5 -8.4 -1.7 0.2 Broad money (percentage change) -3.9 -1.9 21.2 9.8 5.4 8.1 Residents' FX deposits (percent of total deposits) 48.6 55.6 51.7 50.3 53.8 56.0 Treasury Bill rate (365 days, eop, percent) 11.0 10.3 ... 1.8 1.8 2/ ... Money market rate (one month, eop, percent) 13.3 2.7 ... 0.6 0.6 2/ ... Balance of payments Gross official reserves (billions of euros) 3.7 4.8 5.3 5.8 5.2 5.2 (In months of prospective imports) 5.4 6.0 7.8 7.2 5.9 5.5 (percent of broad money and non-resident deposits) 31.1 41.6 37.4 43.5 37.8 35.4 Current account balance -13.1 8.6 8.2 3.3 1.7 0.5 Trade balance -17.7 -7.1 -3.3 -6.5 -6.3 -6.8 Exports of goods and services 41.8 43.2 48.4 52.9 50.1 51.4 Imports of goods and services 55.5 44.2 44.4 53.4 50.8 52.4 Gross external debt 128.7 156.3 161.1 165.2 145.4 135.1 Net external debt 3/ 56.8 58.8 43.0 53.8 34.4 28.1 Exchange rates Lats per EUR (average) /4 0.70 0.70 ... 0.70 0.70 2/ ... Lats per U.S. dollar (average) 0.48 0.48 ... 0.53 0.49 2/ ... REER (average; CPI based, 2000=100) 104.5 110.3 ... 103.6 ... ... Sources: Latvian authorities, Eurostat, and IMF staff estimates. 1/ National definition. Includes economy-wide EU grants in revenue and expenditure. 2/ Actual rate as of April 18, 2011. 3/ Gross external debt minus gross external debt assets. 4/ Lat is pegged to the EUR at a 1 EUR = 0.702804 LVL rate, with ±1 percent band.