OREANDA-NEWS. Latvia has made rapid strides since the economic crisis, as illustrated by its successful entry to the euro area this year. The unemployment rate has fallen to 10.6 percent from 11.3 percent at end-2013 and over 20 percent at the height of the crisis. Real wages are rising rapidly after several years of wage restraint. The current account deficit has come down to sustainable levels and inflation is low. The Fiscal Discipline Law (FDL) has anchored the budgetary process within a prudent medium-term framework.

But economic growth has slowed recently due to weak investment and an unfavorable external environment. Growth in 2014 is likely to be below 3 percent, down from about 4 percent last year. The direct impact of heightened geopolitical tensions, including sanctions and counter-sanctions, has been relatively small. However the conflict—together with the tepid nature of the euro area recovery—has likely dampened confidence and held back investment.

The medium-term outlook is favorable provided geopolitical tensions subside and the euro area emerges from its prolonged weakness. Growth should pick-up next year as trading partners recover and a large steelmaker, Liepajas Metalurgs, resumes production. Investment is expected to rebound as the external climate improves. Risks are tilted to the downside. In particular, secular stagnation in the euro area could significantly impede medium-term growth prospects, while an intensification of geopolitical tensions could adversely affect the economy through both real and financial channels.

A sustainable investment recovery would require a reversal of the multi-year trend of bank deleveraging. In this context, recent amendments to the insolvency law limiting the liability of mortgage borrowers to collateral should be reconsidered. The amendments may have the unintended consequence of raising down-payments and restricting credit to households, especially low-income and young households.

Preliminary discussions suggest that the 2015 budget is broadly appropriate. The draft budget maintains fiscal responsibility by targeting a structural deficit of around 1% of GDP, in line with the FDL. Automatic stabilizers should be allowed to operate if growth in 2015 is weaker than forecast. Planned measures to reduce inequality over the medium term are welcome, but more could be done.

The new government should press ahead with implementing structural reforms to preserve Latvia’s competitiveness within the currency union. Judicial reforms are needed to speed up debt resolution procedures, while educational reforms would help reduce skills mismatches and thereby bring down the high structural rate of unemployment. Infrastructure development—including ports reforms in line with the World Bank’s recommendations—should also be prioritized.

Latvia’s three largest banks easily passed the ECB’s recent comprehensive assessment. The banking system is sound and liquid. But non-resident deposits (NRDs)—which account for about half of all deposits in the banking system—should continue to be subject to vigilant supervision, especially in light of ongoing regional tensions. Minimum capital and liquidity requirements on NRD-specialized banks are already higher than for others.