An expansion of domestic demand, a recovery in investment, and a very favorable external environment have contributed to a strong and broad-based growth.

The recent labor market tightening is a sign of maturing economic cycle and represents a regular economic expansion (with economic growth rates slightly above potential). An absence of a positive financial accelerator effect pushing economy towards an unsustainable growth trajectory is an important difference with the past boom when the Latvian economy experienced severe overheating pressures. Within the current creditless growth cycle the odds are against a sustained build-up of overheating and inflation pressures eventually leading to a progressive loss of cost competitiveness and sharp adjustment of economic activity.

While the inflation rate in Latvia (2.6 percent in July 2018) is slightly above the one observed in the Euro Area, it largely reflects an income convergence process with unit labor cost developments in the tradable and non-tradable sector following a path suggested by the Balassa-Samuelson effect. Moreover, a relatively larger share of food and energy in the consumer basket and the economy’s high openness to trade make domestic prices more susceptible to global commodity price pressures, including relatively stronger direct cost push pressures on core inflation.

The authorities share staff’s view that Latvia’s cost competitiveness has held up relatively well. While there are some signs of weakening export market shares in selected neighboring countries, this largely reflects a changing pattern of re-export flows in the region, and market shares of domestically produced exports are less volatile. A positive development of profitability in the manufacturing sector is another sign pointing to a strong competitive position of Latvia’s tradable sector.

The current economic expansion is an opportune moment to strengthen reform efforts, which could mitigate downside risks and raise medium-term growth potential.

The quality of the labor force has room for improvement, and skill-mismatches must be addressed to reduce persistently high structural unemployment. A focused immigration policy could be a part of the solution, and the authorities would appreciate a more granular view on further policy options to complement the measures already taken in 2017 to soften the rules that employers have to follow in attracting high-skilled workers from outside the EU. However, with broad measure of unemployment pointing at well above 10 percent, the authorities attach higher priority to policies aimed at better utilizing Latvia’s existing labor pool. From a longer-term perspective it is also crucial to improve the outcomes of the healthcare sector, as Latvia’s relatively low healthy life expectancy reduces the scope to stemming ageing pressures by increasing the statutory retirement age.

In the medium term, reaching a higher investment to GDP ratio is crucial to raise potential growth and foster productivity. A number of policy areas to address business environment bottlenecks that hinder lending and investment growth (including efficiency of the insolvency regime and judiciary) are already well identified in the authorities’ agenda. The authorities also agree that the availability of the EU funds supports investment and facilitates economic convergence, and the eventual slowdown of these inflows within the next planning period is a source of concern. However, having hovered around 11 percent of gross fixed capital formation since 2010 on average, the EU funds inflows constitute a small part of investment funding. The authorities would appreciate continued work on the drivers of the post-recession investment slowdown in future Article IV consultations as it is likely that there are additional layers of the problem that need to be identified and addressed.

Latvia’s fiscal position remains sustainable.

The general government deficit was 0.5 percent of GDP in 2017, and it is forecasted to be 0.9 percent of GDP this year. Meanwhile, the general government gross debt is expected to gradually decline to around 35 percent of GDP in 2018. Latvia has introduced an ambitious tax reform in 2018. It aims to provide a stable and predictable tax policy, support economic growth, improve the welfare of the population, reduce the tax wedge (especially for low-wage earners), while providing sufficient and predictable tax revenues for the state and local government budget. A progressive income tax system has been introduced for the first time, the differential non-taxable minimum, the allowance for dependents, and the non-taxable minimum for pensioners has been increased, and the minimum monthly wage has been raised. Changes to the corporate income tax system will allow companies to improve their capitalization, which will facilitate lending and investment, as well as promote better acquisition of EU funds. Additionally, the Latvian authorities remain committed to further improve tax administration and reduce shadow economy.

Crisis legacies in the banking sector have been resolved, and the focus remains on removing impediments to credit growth.

The cleanup process of bank balance sheets has been finalized, and the sector has worked-out a significant stock of bad assets from the previous crisis. The special vehicles are being liquidated, loan loss provisions almost fully cover the NPL amount, and the stock of NPLs and write-offs have decreased significantly.

The authorities broadly share staff’s views on the impediments to credit growth, and the comprehensive analysis of supply and demand factors provided in Annex III is appreciated. The authorities recognize the importance of a sound and operational insolvency regime for both investment climate and credit recovery. The legal framework of insolvency procedures seems to be adequate, modern and comprehensive, while its practical application could be further improved.

The authorities note that the importance of the non-bank sector in lending activities is slightly overstated in the report. A large part of the sector is not involved in lending, while leasing operations are mostly run by companies owned by banking groups. Nevertheless, the authorities recognize the importance of continued monitoring of non-bank credit developments and provide for adequate and modern regulation to facilitate socially and economically responsible lending practices and tackle potential externalities.

The authorities emphasize their commitment to continue efforts to restore the reputation of the banking sector and to proceed with de-risking and overall change in risk tolerance.

The authorities acknowledge the importance of vigilant supervision and the need to mitigate risks in the banks servicing foreign clients (BSFC) sector. Important steps have been taken in this regard, including higher prudential requirements to financial institutions with significant share of foreign deposits. These additional capital and liquidity buffers currently allow banks to fulfil their obligations to customers and meet regulatory requirements while executing changes to their business models – by scaling down, merging, changing the type of business license or choosing to end the provision of this type of business in the Latvian financial sector. The FCMC carefully analyzes the new business strategies submitted by the BSFC banks, to ensure that the amended business models are viable and sustainable, and the new risk profiles are manageable.

During the last months, especially along with the new AML/CFT requirements regarding the riskiest opaque entities, the banking sector has been actively cleaning the customer base. The risky part of the banks’ customers has decreased notably, as banks go beyond the requirements set by the Law and refuse to work with shell entities that are not prohibited but may involve high-risk activities. In July 2018 deposits of the banned type of shell companies constituted 0.03 percent of total deposits.

The authorities note that the legal framework on AML/CFT as well as supervisory capacity of the FCMC has been considerably strengthened over the recent years. The authorities are committed to further enhance information sharing among relevant institutions and increase the effectiveness of the ML/FT prevention activities. The FCMC will continue to strengthen data analytical tools to increase supervision effectiveness as well as focus on preventive measures.

The authorities are closely monitoring and supervising the liquidation process of ABLV bank.

The authorities are ensuring the lawful process and protection of creditors interests in line with additional rigorous control mechanisms for the prevention of money laundering, which are set up for this particular case, including assessing regular performance reports by liquidators, and closely monitoring the fulfillment of the approved liquidation plan. The authorities believe that in the specific case of ABLV, self-liquidation serves purposes of public interest (i.e. no taxpayers money is used) and prudential regulation (i.e. protect interests of creditors) better than compulsory liquidation under the current liquidation regime for credit institutions. The case of ABLV has highlighted the need to update existing national, as well as EU, legislation on bank liquidation to increase legal certainty when a bank is determined as “failing or likely to fail” and is liquidated under national insolvency proceedings.