OREANDA-NEWS. Latvia continues to make progress in closing the per capita income gap relative to the European average, but faces short- and longer-term risks and challenges. While growth has slowed recently, reflecting a weak external environment and economic uncertainty, fundamentals are sound: the fiscal and current account deficits are at sustainable levels; the output gap is almost closed; and unemployment continues to fall. Looking forward, growth is forecast to slow slightly in 2016 before picking up next year, led by exports and investment. The outlook is, however, subject to significant risks. Looking further ahead, higher productivity growth and robust competitiveness, along with a resumption of credit growth, will be needed to maintain the pace of convergence over the long-term. Continued reform will be key.

Outlook and Risks

Despite the current slowdown, growth is expected to pick up, but the timing is uncertain. Growth is expected to slow slightly to 2? percent in 2016 due to delays in the absorption of EU funds and continued geopolitical tensions and economic uncertainties. Following the strong construction-driven slowdown observed at the end of the last quarter of 2015, and in the preliminary data releases for the beginning of 2016, growth is expected to pick up later this year and into 2017, as EU funds come on line and the global economy strengthens. However, exactly when this pickup will occur, and how strong it will be, is uncertain.

Sustaining stronger growth will require continued progress with ongoing reforms. Raising and sustaining growth over the medium term is feasible but will require further progress in structural reforms to promote investment, productivity growth, and continued strong competitiveness in the face of adverse demographics.

Actions to address the grey economy will also be crucial. The pervasive grey economy is preventing Latvia from fulfilling its potential, by hindering the efficient allocation of resources, including access to capital, creating an unfair playing field, and curtailing revenues that are necessary to develop the country to everyone’s benefit. Measureable improvements in public services can help motivate a reduction in the grey economy.

The outlook is subject to significant risks: a prolonged slowdown in key trading partners, including the Euro Area and Russia, would act as a drag on growth, geopolitical tensions could adversely affect the real and financial sectors, and failure of credit to resume, or of structural reforms to be advanced, could undermine growth prospects. Prudent policy making, ambitious reform efforts and continued financial sector vigilance are therefore vital.

Productivity

Productivity gains have been the key driver of past income convergence. With a declining labor force due to demographics and emigration, productivity gains will need to be maintained, and will be dependent on investment and growth of total factor productivity.

Future productivity growth will not be simple to achieve, as easy gains have been exhausted. The post crisis productivity gains were mainly made by the least productive firms “catching up” with their domestic technology frontiers. Future gains will require Latvia to close the significant productivity gap that exists with technology leaders in other countries. This will require a strong push towards structural reform. The ambitious Government Action Plan is a welcome step in this regard. Particular attention should be paid to improving the business environment; reducing the grey economy; enhancing public infrastructure; boosting the efficiency of SOEs; enhancing human capital; and increasing the efficiency and effectiveness of the operation of the judicial system and insolvency regime. Sustaining growth over the longer term will require further structural transformation, with an emphasis on high connectivity centers and diversified and higher value exports.

Labor Competitiveness

Post-crisis competitiveness gains were significant, and hard won. The combination of national wage restraint and strong productivity gains after the crisis gave Latvia a vital boost to competitiveness, laying the ground for recovery and a return to the convergence path.

As labor market conditions tighten, care is needed to avoid losing past gains. Falling unemployment, a period of rising average wages, and evidence of skills mismatches point to tightening labor market conditions. While recent wage growth is broadly consistent with accumulated productivity gains, care will be needed to ensure that future wage growth moves hand-in-hand with productivity. In this context, the recent decision to put on hold planned hikes in the minimum wage was appropriate, and future increases should proceed in line with productivity growth over the medium term. At the same time, complementary policies should be employed to address inequality concerns. Ongoing efforts to reform the education system to reduce skills mismatches are welcome.

Financial Sector

The banking system is well capitalized, liquid, and profitable, yet credit growth remains elusive. Balance sheet repair is well advanced, and the credit cycle may be reaching a turning point.

Credit flows need to resume to support investment and growth, but constraints are multifaceted. The crisis continues to cast a shadow, with banks cautious given past losses and bad experiences trying to recover collateral, and some not eager to take on new clients with whom they do not have a positive history. For larger firms with stronger balance sheets and track records, demand appears to be the main constraint (e.g., due to uncertainties around EU-funds and economic prospects), while for smaller firms and households supply factors are likely to play a bigger role (e.g., due to lack of collateral or documentable income). Given the multiple factors at play, a broad-based response is needed to address impediments to credit growth, while at the same time ensuring financial stability. Firm implementation of the recent reforms to the courts and to insolvency procedures is vital, and the authorities should regularly monitor and report on progress made. Furthermore, the Latvian prudential authorities are urged to use the results of the benchmarking exercise of banks’ risk models conducted with their European partners to ensure they appropriately capture risk, and that crisis legacies and associated risk aversion do not unduly constrain lending. Existing credit guarantee programs and public sector initiatives to catalyze SME lending have been well received and expansion could be considered. Other international experience could be explored, for example adequate transparency in processing loan applications or scope for a credit mediation function.

Continued vigilant supervision is required to mitigate real and reputational risks, especially for NRD banks. Recent actions to strengthen AML/CFT regulations and to ensure implementation of appropriate procedures are commendable. Going forward, focusing on implementation of the enhanced regulations, as well as ensuring that sufficient resources are allocated to AML supervision activities, will be key to strengthening the reputation of the Latvian financial sector.

Fiscal Policy

Fiscal policy is broadly sound. Outturns for 2015 indicate that performance was consistent with both Latvian and EU fiscal rules. The 2016 budget is broadly appropriate, balancing concerns about the sluggish economic environment and the need to stay within fiscal rules. Given the risks to the outlook careful management will be needed to maintain compliance.

Future fiscal space is needed to strengthen the social safety net and boost productive public spending. The authorities’ ambitious plan to bring tax revenue up to a third of GDP is commendable, and will require sustained efforts to improve tax compliance and public services. The authorities’ ongoing broad review of tax policy is an opportunity to consider reforms to improve incentives, recalibrate the tax burden equitably, and explore options for opening fiscal space. In particular, the tax burden should be shifted towards more efficient and growth friendly taxation, including property taxation. In this context, staff welcomes the recent cadastral reforms and looks forward to their implementation. The ongoing expenditure review is welcome in order to reprioritize and cut unnecessary spending.

The IMF team is grateful for the generous hospitality of the Latvian authorities, and would like to thank all interlocutors in Government, the Bank of Latvia, the private sector, and other non-government stakeholders, for constructive and fruitful discussions.