IMF says Latvia’s economy continues to recover strongly
IMF says Latvia’s economy continues to recover strongly. Following real GDP growth of 5.5 percent in 2011, growth is expected to exceed 5 percent again this year despite recession in the euro area. Labor market conditions are improving. The unemployment rate fell from 16.3 percent at the beginning of the year to 13.5 percent at the end of the third quarter, despite an increase in participation rates. Real wage growth remains restrained. Consumer price inflation has declined sharply, easing to 1.6 percent at end-October after peaking at 4¾ percent in mid-2011. Robust export growth is expected to keep the current account deficit at about 2 percent despite recovering import demand.
As a result of present and past efforts, euro adoption in 2014 appears within reach. On the basis of fiscal outturns so far this year and the 2013 budget approved by parliament, the general government deficit and debt for 2012–13 would be well below their respective Maastricht reference values. Inflation and interest rates have declined to low levels, although the reference values for these criteria are yet to be determined by the European institutions. The Latvian authorities’ policy record to date—including the difficult adjustment effort over the past few years—provides assurances for continued stability-oriented policies. Latvia’s accession to the euro area would remove residual currency risk and, by addressing vulnerabilities stemming from foreign-currency expo- sures, enhance the stability of the already highly euroized financial system.
Despite Latvia’s generally favourable medium-term outlook, risks are tilted to the downside because of the fragile external environment. If adverse developments in the euro area were to cause renewed stress in international financial markets, this could raise Latvia’s borrowing costs in the face of high external debt. A prolonged slowdown in European partner countries would dampen Latvia’s recovery and increase its current account deficit. That said, Latvia does have upside potential if it can attract greater foreign direct investment and create more jobs quickly. Full implementation of the structural reform agenda would make this favourable scenario likelier.
With the 2012 budget deficit coming in at under 2 percent of GDP, the 2013 budget further cements past fiscal gains. Taking into account a 2-percentage point redirection of state social contributions to the second pillar, the budget should achieve an underlying structural improvement of about 0.5 percent of GDP, thus complying with both the Maastricht deficit criterion and the Stability and Growth Pact (SGP). Additional priority spending is well distributed, addressing some of the bottlenecks in health and reforming lower-end teachers’ salaries. However, some elements of the budget could have been better targeted, such as the one-percentage point cut in the personal income tax (PIT) already legislated. The cuts to and decentralization of the guaranteed minimum benefit (GMI) could adversely affect the most vulnerable segment of society. Over the medium term, the authorities should take advantage of the ongoing economic recovery to continue building fiscal space. The planned cumulative PIT cuts of 5 percentage points over 2013–15 should be reconsidered, at least for 2014 and beyond: better options could include a two-tier system or an increase in the minimum nontaxable allowance. Compensatory structural reforms would be needed under unchanged PIT policies and in any case to offset numerous other headwinds, such as restored indexation of paid-out pensions, partial restoration of second-pillar pension contributions, and the gradual lowering of required dividend ratios for state-owned enterprises (SOEs).