OREANDA-NEWS. Latvia enters the euro area with the fastest rate of growth in the currency union, despite a slowdown from the pace of recent years. The country has made rapid strides since the crisis. The unemployment rate fell to 11.3% at end-2013 from 13.9% a year ago, and the output gap is now largely closed. And market confidence is high, as shown by the successful sovereign bond issue in January. A recent slowdown in investment and exports was partly compensated by robust consumption demand, supported by rising real wages. The passage of the Fiscal Discipline Law (FDL) has anchored the budgetary process within a prudent medium-term framework.

The outlook for 2014 is broadly favorable. Growth is projected at around 4%, underpinned by an investment recovery due to the positive sentiment associated with euro adoption. Exports should be bolstered by higher growth in trade partners. Inflation should increase from close to zero in 2013 to about 1? %, boosted by an increase in the minimum wage and tighter labor market conditions. The main risks to this outlook are external. Export prospects could be adversely affected by the impact on the Russian economy of the ongoing events in Ukraine, especially if there were broader regional spillovers. A prolonged slowdown in European partner countries would dampen Latvia's recovery and increase its current account deficit, while a surge in global financial volatility-for example due to exit from unconventional monetary policy in the US-could affect bank funding.

Over the medium-term economic growth well above the euro area average should be attainable, as Latvian incomes converge towards the regional norm. But to realize this goal, a series of inter-linked policy actions are needed. Maintaining competitiveness within the common currency area will require continual productivity gains, underpinned by sustained progress on structural reforms. Reviving bank credit-which continues to contract well into the recovery-will be necessary to ensure that credit constraints do not hold back investment. Fiscal policy will need to contend with several medium-term headwinds, while helping to strengthen the social safety net. And vigilant supervision of non-resident deposits (NRDs) in the banking system will need to be maintained to guard against external shocks.

Maintaining Competitiveness in the Euro Area

Latvia's basic medium-term macroeconomic challenge-maintaining competitiveness under a fixed exchange rate regime-remains unaltered by euro accession. Since the crisis a combination of productivity growth and wage restraint have enhanced competitiveness. From an overvalued pre-crisis starting point, the real effective exchange rate is now broadly in line with fundamentals. This turnaround has enabled an export-driven economic recovery. But with the closing of the output gap, wages are rising. Therefore, productivity gains will need to be the chief driver of competitiveness going forward.

Progress on a broad range of structural reforms will be needed to improve the business climate and yield the desired productivity improvements. Reforms in higher and vocational education could help reduce skills mismatches and hence alleviate structural unemployment in the medium-term. Centralizing the management of state-owned enterprises while divesting non-core activities-in line with long-planned reforms-would improve efficiency and accountability.

Upgrading Latvia's infrastructure will be necessary to attract foreign direct investment (FDI) and facilitate export growth. The World Bank's recent comprehensive assessment of Latvian ports made several specific suggestions to enhance connectivity to land transport, while improving governance and accountability; these recommendations should be implemented as soon as possible. Plans to liberalize tariffs and introduce greater competition in the electricity sector should be expedited. And regional initiatives could be explored to improve the gas infrastructure.

Labor market reforms to improve work incentives and lower structural unemployment should be implemented. In particular, a more gradual phasing-out of the guaranteed minimum income (GMI) benefit-which currently phases out one-for-one with income-would reduce the tax wedge for GMI recipients entering employment. A system of in-work tax credits and benefits could also be considered because empirical evidence suggests that these have proven effective in increasing employment of lower skilled workers.

Resuscitating Bank Credit

Latvia's creditless recovery is in line with international experience, but has now continued for longer than the historical norm. Going forward, the continuing contraction of credit in Latvia might constrain investment. Cross-country evidence indicates that sharp boom-bust cycles are often followed by creditless recoveries, especially if the cycle is accompanied by a banking crisis, as in Latvia's case. However, even among the sample of emerging economies that experienced creditless recoveries in the past, positive credit growth has usually resumed by this stage in the cycle. A combination of supply factors (such as the tightening of credit standards) and demand factors are likely holding back credit in Latvia, and policies should be geared accordingly.

Reforms to further reduce the private sector's debt overhang could help resuscitate the demand for credit, lower perceptions of credit risk and underpin a rebound in investment. Measures to improve the application of the insolvency law, and more generally, to strengthen the judicial system, would facilitate balance sheet repair. Legal amendments to strengthen the arbitration courts should be expedited; these would increase public confidence in the system and help reduce the caseload on regular courts.

Recent legislative proposals that could act as a drag on future lending should be reconsidered. A legal amendment currently being considered by parliament would limit the liability of mortgage borrowers-and their guarantors-to the value of collateral. This could have the effect of significantly curtailing mortgage lending and raising mortgage rates. Applied retroactively, the measures could cause balance sheet distress at banks facing large-scale write-downs.

Maintaining a Prudent Fiscal Policy

The 2014 budget is broadly appropriate, consolidating the fiscal position at a measured pace. The rise in the minimum wage should be seen in the context of substantial public wage bill cuts during the crisis and only limited increases since. The increase in the non-taxable income tax threshold for workers and dependents will reduce the burden on low-income families.

While the budget goes some distance in helping to address high levels of inequality, more is needed. The cuts to Latvia's Guaranteed Minimum Income (GMI) benefit in 2013, and the de-centralization of the scheme's financing should be reversed. Social assistance benefits in Latvia are among the lowest in Europe, while regional disparities mean that some income-constrained local governments may be unable to provide even the reduced benefit levels in full in a downturn.

Over the medium-term fiscal policy will need to contend with several potential headwinds. The passage of the Fiscal Discipline Law (FDL) is welcome, and should ensure that budgeting is anchored in a framework designed to avoid pro-cyclicality. It will be important to maintain investment expenditures in crucial areas such as infrastructure, but planned declines in the PIT rate and a gradual reduction in SOEs' payout ratios from the current 90 percent level will act as a drag on revenue. Continuing efforts to reduce the scale of the grey economy-which have already yielded results-could increase the revenue envelope. Several other measures could also be considered. Efforts could be made to improve revenues from land taxation. Reductions in the PIT rate could be reconsidered; a further increase in the non-taxable threshold would be preferable.

Vigilant Financial Sector Supervision

The growth of non-resident deposits (NRDs) has decelerated in recent months, but NRDs comprise nearly half of all deposits in the banking system. While the expansion of NRDs is associated with an accumulation of liquid foreign assets (which decreases the risks of domestic spillovers), the increasing size of the sector represents a source of vulnerability to external shocks. The supervision of NRD-specialized banks should continue to be sufficiently intensive and frequent given their relatively higher risks and susceptibility to sudden surges and stops. Appropriately, minimum capital requirements and liquidity ratios on NRD-specialized banks are already higher than for others.