Latvia country assessment

• To make growth more sustainable the government will need to persevere with its competitiveness agenda. The programme appropriately emphasises education, skills and an improved investment environment. This agenda is particularly important given the mobility of Latvia’s skilled labour force within the integrated European labour market.
  
• Non-bank finance, such as private equity and mezzanine capital is needed. The development of these products would encourage growth of the small and medium-sized enterprise (SME) sector.
  
• Support to energy security and efficiency is critical. Further energy market integration within the Baltic region and with 
other neighbours is needed. Investment into private energy generation could facilitate the production of electricity from renewable sources.

The economy has emerged from recession. Latvia suffered one of the sharpest economic downturns of any emerging market in 2009. However, the country showed steady growth quarter-on-quarter throughout 2010, though for the year as a whole, the economy still showed a slight contraction, as a strong rebound in exports was more than off-set by weakness in government consumption and investment. In the first half of 2011 exports of goods grew by 37 per cent in value terms compared to the first half of 2010, and growth in the export market share confirms Latvia’s continued potential. The economy is likely to grow at around 3.9 per cent in 2011.
 

Fiscal performance has strengthened in the final year of the EU/IMF programme. A further stage in the programme was completed in spring 2011 based on additional fiscal measures in the 2011 budget, which brought the overall sum of fiscal adjustment to 16.6 per cent of gross domestic product (GDP) over the period 2008-11. Following these further fiscal corrections, the authorities will seek to comply with the Maastricht criteria for euro adoption, although inflation, which reached 4.7 per cent in August 2011, remains a key risk. These fiscal developments underpinned a more positive assessment by sovereign rating agencies and, in June 2011, Latvia returned to the international bond markets with the issuance of a US dollar bond.
 

The recovery remains fragile, with export demand still having to stimulate more broad-based growth. The initial recovery was largely based on inventories and exports to dynamic markets such as Germany and Sweden. A more durable growth in productive capacity and, subsequently, in domestic demand is yet to come. The lack of business investment is a concern, given that a number of manufacturing sectors, in particular wood-processing, clothing and metals, have now reached capacity utilisation levels close to those seen before the crisis, thus limiting their future growth potential. Hence, the inability to revive credit to the corporate sector represents the key threat to sustaining growth. The stock of bank loans to the private sector contracted by 6.7 per cent in 2010, with all banks continuing to tighten lending standards and primarily focusing on a small subset of customers with very safe cash flows. Credit growth is also being hampered by the still very high levels of debt of key enterprises as well as a high level of non-performing loans (NPLs), about 18.2 per cent in August 2011.

Latvia has completed a substantial range of structural reforms under the EU/IMF programme. The deep recession of 2008-09 stimulated some wide-ranging reforms in the tax system, large expenditure cuts and a streamlining of public administration. In the education and health care sectors, savings were achieved through layoffs and closing under-used facilities. While these reforms were painful and motivated by the immediate need to contain public sector financing requirements, many were needed to put public finances back on a sustainable footing. Recent revenue measures have helped, but the overall tax burden remains relatively high, particularly on labour.
 

Reforms in the financial sector will further bolster a well-functioning banking sector, though weaknesses of certain banks still need to be fully addressed. The government has already significantly strengthened the powers of the Financial and Capital Market Commission, primarily through seeking stronger coordination with other authorities in the home countries of foreign bank subsidiaries, (Latvia is a signatory of the joint banking sector crisis resolution framework for the Nordic region introduced in August 2010). A core element in returning the financial sector to health was the restructuring of Parex Bank, and the subsequent creation of a recapitalised “good” bank (Citadele) that now has the capacity to generate fresh lending, and for which the return into full private ownership is progressing as planned. The government indicated that Citadele is to be sold at auction. With regard to the Mortgage and Land Bank, Latvia’s eighth-largest bank, which is also in state ownership, a transformation plan was submitted to the European Commission in April 2011, though this plan still needs to be implemented.
 

The authorities have undertaken wide-ranging reforms to facilitate market-based household and corporate debt restructuring. These reforms reduce the likely need for injection of public funds into distressed institutions, and they should free up lending capacity. Incentives for debt relief or speedy out-of-court restructuring were strengthened in July 2010, through tax benefits, and the corporate and personal insolvency regimes were reformed. To address mounting debt to utility companies the authorities have submitted amendments to the Civil Procedures Law, which in particular seeks to safeguard the status of secured creditors.
 

Reforms in the power market have advanced significantly. In part this was motivated by the closure of the Ignalina nuclear power plant in Lithuania in 2009, which underlined the need to develop alternative and more secure energy sources. There is still a relatively limited private sector participation, mainly in the generation segment of the market where state-owned companies are still dominant. The legal and functional unbundling of the vertically integrated state-owned power utility Latvenergo is currently under way with both the distribution and transmission assets being transferred to a fully owned subsidiary. Latvenergo’s privatisation, however, is not being contemplated, as private ownership is prohibited by legislation. Efforts to upgrade the existing power facilities, such as the recent modernisation of Latvenergo’s plant in Riga, are improving generation efficiency. The feed-in-tariff mechanism introduced in 2009 is valid for 10 years, following which there will be a reduced rate. Companies are only eligible for the tariff if they sell their energy to the public electricity supplier, Latvenergo. This framework is, however, being revised and a support scheme for renewable energy is expected to be in place by the end of 2011.
 

A programme for competitiveness is being implemented. Recent government announcements underline the clear intention to restructure the economy in support of a more sustainable growth model. The government is pursuing a “competitiveness agenda” through a study that will make specific recommendations on appropriate workforce skills, and will seek to improve the business environment by targeting a number of indicators. Priority sectors are export-oriented manufacturing, logistics and infrastructure and energy efficiency investments.

• The government’s immediate priority is to adhere to a stringent fiscal consolidation policy, and competitiveness. Against this background, it is important that the authorities dismantle the remaining barriers to private sector growth by implementing measures under the new business environment action plan, and improve governance and transparency in state-owned enterprises.
  
• Accelerating the development of projects in the sustainable energy sector is a key priority. The focus should be on removing the remaining institutional barriers to investments in energy efficiency, mainly in the municipal, household and SME sectors.
  
• In the banking sector, the priorities include improving access of SMEs to finance, which would be helped by steps to facilitate debt restructuring, more efficient absorption of EU funds and the restructuring and privatisation of the remaining state-owned banks. Additionally, the further facilitation of non-bank funding sources, including venture capital funds, could help to increase investment in technology-intensive enterprises.