OREANDA-NEWS. February 1, 2013. On January 23, 2013, the Executive Board of the International Monetary Fund (IMF) concluded the 2012 Article IV consultationand the Second Post-Program Monitoring Discussions, and the Ex-Post Evaluation of Exceptional Access Under the 2008 Stand-By Arrangement with the Republic of Latvia.

Background

Latvia continues to rebound vigorously from the deep downturn in 2008–09, despite recession in the euro area. Real GDP growth of 5.5 percent in 2011 and 5.7 percent in the first three quarters of 2012 was underpinned by both external and domestic demand. Strong job creation has resulted in falling unemployment, but the unemployment rate remains high at about

15 percent, and half of the unemployed have been out of work for more than a year. Consumer price inflation has declined sharply from its peak, averaging [2.4] percent in 2012. Robust export growth is expected to keep the current account deficit at about 2 percent despite recovering import demand. Latvia has successfully returned to international markets.

As a result of fiscal consolidation measures over the last 4 years, Latvia reduced its general government deficit from nearly 10 percent of GDP in 2009 (ESA 95 definition) to 3.4 percent of GDP in 2011. Despite a 1 percentage point mid-year reduction in the statutory VAT rate and a supplementary budget containing additional expenditures, revenue over performance helped reduce the deficit to below 2 percent of GDP in 2012. The 2013 budget further cements past fiscal gains and should be consistent with both the Maastricht deficit criterion and the Stability and Growth Pact.

The banking system returned to profitability in 2011 and is well capitalized. Credit to residents has contracted substantially since the onset of the crisis, but the rate of contraction has been declining and is likely to level off soon. Non-resident deposits (NRDs) in the banking system—a potential source of vulnerability to international reserves—have been expanding rapidly, but to a large extent this process has been matched by an accumulation of liquid foreign assets.

The government aims at euro adoption in 2014. The country is well-positioned to meet all the Maastricht criteria in 2013. Joining the euro would remove residual currency risk, adding stability to the Latvian economy.

Executive Board Assessment

Executive Directors agreed with the thrust of the staff appraisal. They welcomed Latvia’s early repayment of all outstanding obligations to the Fund following the successful international bond issuance, which reflects renewed confidence in the economy and the authorities’ policies. The economy continues to recover strongly, inflation has fallen sharply, and the current account deficit is modest. While the medium-term economic outlook is favorable, risks are tilted to the downside because of the uncertain external environment. Directors emphasized the need for continued strong policies to safeguard financial stability, tackle persistently high structural unemployment, and strengthen potential growth.

Directors commended the authorities’ remarkable fiscal adjustment and welcomed that the 2013 budget appropriately consolidates the fiscal gains, holding the budget deficit well below the Maastricht criterion. They called for sustaining measures to build fiscal space and avoid the resurgence of imbalances. Directors urged the authorities to keep the lowering of the Guaranteed Minimum Benefit and the decentralization of its financing under close review to ensure that the system continues to provide adequate support to the most vulnerable and avoids deepening regional disparities. They welcomed the authorities’ readiness to reconsider the issue in light of the upcoming World Bank report. While some Directors saw merit in the planned cuts to the personal income tax in order to improve work incentives, others urged caution given concerns about equity and fiscal space, and highlighted the need for compensatory measures. Directors agreed that structural fiscal reforms, including timely passage and effective implementation of the Fiscal Discipline Law, will be crucial to strengthening fiscal sustainability.

Directors noted that the banking system continues to recover. However, the rapid increase of non-resident deposits (NRDs) warrants vigilance, given that it represents a source of vulnerability to international reserves and a contingent fiscal liability. Directors welcomed higher minimum capital requirements for NRD-specialized banks, and recommended continued intensive and frequent supervision. Directors looked forward to completion of the banking sector restructuring, and noted that a new FSAP would be useful to take stock of the transformation since the crisis.

Directors welcomed the authorities’ strong commitment to euro adoption and commended the progress towards meeting the Maastricht criteria. They noted however that continued strong implementation of structural reforms will be necessary to address high structural unemployment and enhance competitiveness. Priorities for action are reforms to the judicial system, the governance structure and transparency of state-owned enterprises, and the quality of higher and vocational education.

Directors agreed with the conclusions of the ex post evaluation. They concurred that the immediate program objectives were achieved and that important progress was made in meeting longer-term objectives. Key supporting elements included strong ownership by the authorities, significant support by the international community, including a large financing package, effective engagement by the private sector, an explicit and credible exit strategy, and a flexible program design. Directors also agreed that the case of Latvia shows the importance of adequately accounting for real-financial linkages in estimating the impact of financial stress on real activity and in program design.

Ex-Post Evaluation

The economic boom in Latvia that began in 2000 and accelerated following accession to the European Union in 2004 proved unsustainable. Large private sector inflows fueled rapid economic growth driven mainly by domestic demand in the nontradeable sector. Inflation accelerated, a real estate bubble developed, and a large current account deficit opened. The accompanying increase in foreign indebtedness, which financed domestic credit expansion, led to the buildup of vulnerabilities particularly in the banking sector and heightened financial account risks.

By early 2008, the fast growth was leveling off but severe vulnerabilities turned the slowdown into a crisis. Capital flows came to a sudden stop as global liquidity tightened. Uncertainty regarding the financial condition of the largest domestically-owned bank led to a run on its deposits and a severe system-wide liquidity shortage. These pressures were compounded by concerns over the sustainability of the currency peg. In November, the authorities turned to the IMF and the European Commission for financial support to avert a systemic bank failure, prevent further decline in international reserves that could threaten the sustainability of the peg, and address the deterioration in the fiscal position in the face of the decline in economic activity. The Stand-By Arrangement (SBA) was approved in December 2008 with an exceptional access of SDR 1.52 billion, equivalent to 1,200 percent of quota—one of the largest in Fund history at the time, with significant co-financing from other partners including the European Union and regional partners.