IMF Concludes 2022 Article IV Consultation with Republic of Latvia

Washington, DC : The Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation [1] with the Republic of Latvia and endorsed the staff appraisal without a meeting.

Latvia managed the COVID-19 shock relatively well overall. With the improved health conditions, real GDP rebounded by 4.5 percent in 2021, thus exceeding its pre-crisis level, thanks to strong consumption and investment supported by significant fiscal support. Economic activity continued to be resilient during the first quarter of 2022, surprising on the upside (6.7 percent year-on-year), as households drew down savings accumulated during the pandemic to finance private consumption.

Latvia’s economy is vulnerable to the fallout from the war, although its exposures have weakened appreciably in recent years. Vulnerabilities come mainly from trade exposure to Russia, notably Latvia’s high dependence on imported Russian gas until recently. International sanctions imposed on Russia and Belarus create additional uncertainty. The spillover effects from the war are already manifested in spikes in energy and food prices, supply disruptions, refugee inflows, and increased budgetary pressures. The government has also provided crucial support (including access to social benefits, education, housing, and language training) for the almost 33,000 Ukrainian refugees in Latvia. Although the refugee influx has fiscal costs, it could benefit Latvia’s economy by increasing labor supply.

Growth is projected to slow to 2.5 percent, or about 1½ percentage points lower than the forecast before the war, as the negative confidence shock reduces private investment and trade, and high inflation weighs on private consumption growth. In the medium-term private sector confidence is expected to be lifted, causing a recovery in economic growth. Economic activity is not expected to be affected by interrupted gas supplies, as the government has secured gas reserves. Inflation is forecasted to remain elevated at 14.5 percent in 2022 (period average) due to high energy and food prices and continued supply bottlenecks. Price pressures are expected to ease in the medium term as oil, gas, and food prices decline. The balance of risks is tilted to the downside. Further intensification of the war in Ukraine and stricter sanctions against Russia could lead to yet more prolonged disruptions in Latvia’s trade and finance, as well as a disruption of gas supplies. Inflation could remain elevated for longer if energy and food price shocks and supply constraints persist. An upward pressure on wages could trigger a wage-price spiral and lead to a further deterioration in external competitiveness. On the upside, faster economic recovery could be supported by a quick resolution to the war, easing of supply bottlenecks, and swift implementation of structural reforms.

Executive Board Assessment [2]

The economy fared relatively well during the pandemic. With the improved health conditions, real GDP rebounded in 2021, exceeding its pre-crisis level thanks to strong consumption and investment, as well as significant fiscal support.

However, the war in Ukraine is having major repercussions for Latvia’s economy. Vulnerabilities come mainly from trade exposure to Russia, notably Latvia’s high dependence on imported Russian gas until recently. The spillover effects from the war are already manifested in spikes in energy and food prices, supply disruptions, refugee inflows, and increased budgetary pressures.

The war in Ukraine constitutes the dominant downside risk to Latvia’s economic outlook. Growth is projected to slow in 2022, as high inflation starts to weigh on private consumption and the negative confidence shock reduces private investment. Inflation is forecasted to remain elevated due to continued high energy and food prices and lingering supply bottlenecks. Average inflation is projected to peak this year before declining in 2023. In the medium term, output is projected to rebound somewhat, supported by higher domestic demand and an increase in EU-financed capital spending. Key downside risks include disruptions of gas supplies and a further surge in energy and food prices, which would hurt output and intensify inflationary pressures.

Fiscal policy should be flexible and stand ready to respond to the changing circumstances. Given the unusually high uncertainty, fiscal policy must be flexible in the short term. Notably, automatic stabilizers should provide a first line of defense, while fiscal policy remains attuned to short-term developments. Any revenue overperformance owing to higher inflation should be saved under the baseline scenario. If the economic environment worsens, high-quality discretionary spending should be used to provide fiscal stimulus and protect the vulnerable. Contingency plans are advisable in case the crisis is more prolonged and the need for policy response is larger than envisaged.

Fiscal support to alleviate the impact of high energy prices should be well-targeted. A large portion of the support already provided was not targeted. Scarce public resources should be used to target energy support measures to the most vulnerable. Broad-based measures not only reduce available resources that could otherwise be used to support the most vulnerable groups, but also add to inflationary pressures and discourage conservation efforts. Over the medium term, it is advisable to allow the pass-through of international energy prices to domestic consumers and adjust utility prices in line with the change in costs: higher prices will encourage necessary innovation and investment to boost energy efficiency.

Although the financial sector has so far been resilient to the pandemic, the spillovers of the war warrant close monitoring. The banking sector entered the crisis with comfortable capital and liquidity positions. However, with the war in Ukraine, the real-financial feedback loop requires close monitoring. Supervisors should take a risk-based approach, conduct relevant stress tests, and prepare contingency plans.

Corporate recapitalization and an improved insolvency regime could help revive bank credit. The authorities should focus on assessing the size of the corporate equity gap and developing policy options to support SMEs and micro firms. The implementation of EU Restructuring Directive needs to be expedited.

Macroprudential policy should stand ready to respond to changing housing market conditions. Given the new risks caused by the war, the frequent reviews of macroprudential measures should continue to ensure the right balance between financial stability and the need for credit in the economy.

The authorities should continue to build on their commendable progress in strengthening their AML/CFT framework. They rightly placed a renewed emphasis on emerging risks (including sanctions evasion) and enhanced risk-based supervision of banks. The FCMC should expedite the refocusing of the business models of the banks formerly servicing foreign clients.

The highly uncertain environment calls for strengthened management of the RRP. The more protracted disruptions to global supply chains and the rising costs of materials will likely complicate the execution of the RRP. The government should, therefore, devise strong contingency plans. Latvia’s structural transformation hinges on the timely achievement of the RRP’s milestones and targets.

Measures to enhance energy security should be compatible with Latvia’s green transition goals. In the near term, stepping up crisis preparedness and contingency planning should be a top priority. The authorities have already implemented measures to ensure uninterrupted gas supplies in the near term. In the medium term, diversification of supplies, and boosting investment in clean energy would significantly enhance energy security. The authorities should avail themselves of the support available under NGEU and RePowerEU to facilitate this process.

Adverse demographic developments and skill mismatches call for a comprehensive response. The declining population and shortages of qualified workforce are viewed as the main constraints to long-term growth. The use of targeted labor market policies should be combined with the reforms of the business environment. Over time, the focus should gradually shift to facilitating the reallocation of workers to new jobs.

Efforts to reduce inequality and promote social inclusion should continue. The authorities are taking a range of measures to improve outcomes, along with reforms and investments to improve education and infrastructure in the regions, with support from the RRF. Adjustments to the pension system should be accompanied by increased investment in the health sector. In this regard, forceful implementation of the new health care strategy could help.

Pressing ahead with the digitalization agenda is key to boosting productivity and innovation. Efforts should be targeted at improving the digital infrastructure, building human capacity, and creating an environment through regulations and incentives.