IMF says Latvia’s econ­omy con­tin­ues to re­cover strongly

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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).

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