Country Report Latvia
Following a period of strict fiscal consolidation and economic rebalancing, Latvia joined the euro area in 2014. Its economy continues to rebound strongly from a very deep recession in 2009 despite tight local credit conditions and weak external demand.
Strengths (+) and weaknesses (-)
(+) Flexible economy
Compared to its euro area peers, Latvia’s economy benefits from considerable flexibility, which helped it to adjust swiftly in the aftermath of its very deep recession in 2009 by means of internal devaluation. Cautious economic and fiscal policies are generally supported by the public.
(+) Commitment to prudent fiscal policies
Latvia’s political elite is committed to a conservative approach to budgetary planning, as lax fiscal policies contributed to the overheating of the economy in 2006/07. In spite of the end of an IMF standby-agreement and recent euro introduction, continued fiscal prudence can be expected.
Given its very small size, Latvia’s economy is heavily dependent on exports to the EU and Russia, which exposes the economy to external shocks.
(-) High levels of external debt and foreign bank funding
In spite of considerable deleveraging efforts in recent years, (foreign) debt levels remain very high. Non-resident deposits constitute about 50% of the well-capitalized banking sector’s total deposit funding, exposing it to increased risks of deposit flight in case of deteriorating investor confidence.
1. Solid economic recovery amid external headwinds
Latvia’s economic growth once more outperformed its EU-peers in 2013, even as weak external demand depressed both exports and corporate investments. Consequently, economic growth slowed from 5% in 2012 to 4% last year. Given external headwinds, growth in 2013 was mainly driven by private and public consumption, reflecting improving employment figures, rising real wages and less stringent fiscal austerity measures. In contrast to Latvia’s pre-crisis boom years, the gradual recovery of household consumption was not credit-driven, as loan growth remains strongly negative amid ongoing deleveraging efforts. As this trend is likely to continue due to efforts by the mainly Scandinavian-owned banking sector to restore a healthy balance between resident deposits and loans, real wage gains and corporate profits will finance private consumption and corporate investments in the near future. In spite of restricted access to credit, Latvia’s economy is expected to expand by about 4.5% in both 2014 and 2015.
2. Latvia joined the euro area on January 1st 2014
Having met all convergence criteria, Latvia became the 18th member of the euro area on January 1st, 2014. Notwithstanding the decent shape of Latvia’s public finances – given a budget deficit of 1.4% of GDP and public debt of 43% of GDP – its accession was not without controversy amid lingering concerns about the suspected presence of substantial Russian deposits in Latvia’s banking system. While Latvian public support for the introduction of the euro remained lukewarm at best, the country will benefit in various ways from joining the euro area. As its currency, the lat, was not overvalued ahead of the changeover, Latvia’s regained price competitiveness is unlikely to suffer. Meanwhile, exchange rate risks related to Latvia’s still considerable euro-denominated external debt load have been eliminated. Furthermore, Latvia’s banks gain access to the ECB’s liquidity facilities, which should partly mitigate funding risks arising from the current reliance on non-resident deposits. While the euro introduction could boost Latvia’s appeal among investors from the former Soviet Union, the quality of financial supervision is likely to improve, as Latvia has to implement European standards. On balance, in spite of a one-off EUR 325m contribution to the ESM rescue fund, Latvia’s public finances should also benefit from the changeover to the euro, as the availability of emergency ESM support and the possibility to issue public debt in euros without exchange rate risks should lead to declining risk premia. Notwithstanding these advantages, the re-emergence of a credit spree similar to Latvia’s pre-crisis boom period is unlikely. While ongoing efforts by Scandinavian banks to bring credit provision in line with local funding possibilities will dampen credit growth, last year’s introduction of a Fiscal Responsibility Law targeting a structural budget deficit of less than 0.5% of GDP should ensure prudent fiscal management. Meanwhile, tightened regulation and supervision regarding non-resident deposits (see below) should limit their impact on local credit provision.
3. A caretaker government takes over
Latvia’s longest-serving prime minister Valdis Dombrovskis and his entire cabinet resigned on November 27th, 2013, as he assumed responsibility for the collapse of a supermarket roof that claimed 54 lives. Following a month-long search for a suitable successor, President Andris Bērziņš asked Laimdota Straujuma, the then minister of agriculture, to become the new interim prime minister until general elections are held in October 2014. Ms Straujuma, who joined Mr Dombrovs-kis Unity party on the same day, added the Union of Greens and Farmers to the current coalition, which provides her with a 60% parliamentary majority. Based on current opinion polls, a continu-ation of the current ethnic-Latvian based cabinet beyond the October elections is likely, which augurs well for policy continuity. Still, given the emergence of various new parties that are willing to cooperate with the mainly-Russian left-wing Harmony Centre party, which currently leads in the polls, the continued dominance of politics by ethnic-Latvian parties cannot be taken for granted.
4. New banking sector measures to mitigate risks emerging from rising non-resident deposits
Given Latvia’s traditional role as a Baltic financial centre with close ties to the former Soviet Union, concerns emerged last year that sizeable amounts of non-resident deposits would be transferred from crisis-torn Cyprus to Latvian banks. While available Cypriote and Latvian data (see figure 2) suggest that these concerns were overblown, Latvian authorities took specific measures to address associated risks. Besides applying stricter money laundering measures, banks focusing on non-resident depositors are subject to increased individual capital adequacy and minimum liquidity requirements. In line with these measures, as well as current negative credit growth, relatively volatile non-resident deposits are mainly invested into liquid securities that can be swiftly sold in case of a deposit outflow. While Latvia’s regulatory track record is weak, increased attention for this issue within the European Banking Union can be expected in the aftermath of the Cyprus crisis.
Latvia is a small, open economy in the Baltics with a total population of 2m and a nominal GDP of USD 30bn (2013). Given a nominal GDP per capita at PPP of USD 19,217, the former Soviet Republic ranks among the poorest members of euro area, which it joined on January 1st, 2014. Agriculture, timber products and the manufacturing of machinery generate important goods exports, while services exports are dominated by financial services, tourism and transportation. Latvia’s financial sector predominantly caters to clients from the former Soviet Union. Non-resident deposit account for almost 50% of the sector’s total deposit base. Following the overheating of its economy due to excessive credit growth and lax fiscal spending, Latvia experienced the deepest recession of all European countries in 2009, as real GDP collapsed by 17.7%. Forced to apply for external assistance from the EU and the IMF, Latvia initiated a strict fiscal consolidation course with the aim of internal devaluation in order to restore its competitiveness and consequently embarked on an export-driven economic recovery. As a nominal devaluation of the lat was impossible given a very high euro-denominated external debt load, sizeable wage cuts in both the private and public sector were unavoidable. Fortunately, the local population supported its government’s policy, even as already sizeable emigration increased further. This perseverance has paid off so far, as Latvia’s current strong economic growth is more balanced and public finances rank among the best within the euro area. Still, the harsh austerity measures contributed to increased corruption within the public sector. Latvia’s political situation remains characterized by lingering tensions between ethnic Latvians and a large Russian minority. Political parties are mostly organized along ethnic lines and at times influenced by oligarchs, which contributes to a latent risk of political instability.