IMF Ends 2023 Article IV Review with Latvia

Washington, DC: The Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation[1]with the Republic of Latvia.

Latvia is facing an inflation shock, slow growth, and geopolitical challenges. After averaging 17.2 percent in 2022, headline inflation remained elevated at 12.3 percent y/y in May, largely driven by high energy and food price increases. Core inflation also accelerated to 12.4 percent y/y in May, as the second-round effects of energy prices were broad-based and much stronger than anticipated. The tight labor markets will continue to push up wages, thereby adding to inflationary pressures. Real GDP growth slowed to 2.8 percent in 2022 from 4.3 percent in 2021, largely reflecting lower increase in inventories and slower fixed investment growth. The government will have to continue to deal with the spillovers in the Baltic region from the Russian invasion of Ukraine and the impact of sanctions imposed on Russia and Belarus, the cost-of-living crisis, and energy security.

These short-term concerns are adding to the long-term policy challenge of sustaining the income convergence process. Latvia's income convergence has already been lagging the other Baltic countries. The geopolitical situation and high inflation will likely depress investment and productivity, with serious implications for future prosperity. To secure high long-term growth in a low inflation environment, Latvia needs to lift productivity, increase investment, and overcome skilled labor shortages.

Amid high uncertainty, the outlook is for lower growth, and the balance of risks is tilted to the downside. Real GDP growth is projected to slow to 0.9 percent in 2023, as high inflation weighs on consumption and external demand declines. Headline inflation is projected to decline to 10.4 percent in 2023 but will likely remain elevated for some time. The main risks stem from an escalation of the war and associated sanctions, which could result in renewed increases in energy prices, energy supply disruptions in Europe, and weaker external demand. Global financial conditions could further tighten, with spillovers to Latvian banks and domestic credit growth. Over the medium term, growth is projected to rebound, underpinned by reforms, a rebound in consumption, and public investment.

Executive Board Assessment[2]

Executive Directors welcomed Latvia's economic resilience and notable progress in energy security in the face of unprecedented shocks. They noted that Latvia is facing a difficult environment with high inflation, slow growth and labor shortages, and geopolitical headwinds. In that context, Directors emphasized the need to lower inflation in the near term, while sustaining the income convergence with European peers and paving the way for the green transition and digital transformation.

Directors concurred that fiscal policy should help contain inflationary pressures and create fiscal space to increase spending in social sectors and support public investment over the medium term. They recommended pursuing a tighter fiscal stance in 2023, including by better targeting energy support measures. Such efforts would help to reduce the cash deficit, while allowing the full pass-through of international fuel prices to domestic consumers. Looking ahead, fiscal policy should remain flexible and adapt if adverse risks materialize.

Directors agreed that fiscal reforms should focus on growth-enhancing tax measures, coupled with policies to improve public investment management and to safeguard the sustainability of the pension system. Carbon tax reforms for emissions not covered by the EU Emissions Trading System could also be considered to mitigate climate change and generate revenues.

While welcoming the financial sector's resilience, Directors underscored that tighter financial conditions warrant close monitoring and contingency plans. They encouraged vigilance of risks stemming from the housing market and urged the authorities to continue regular risk-based monitoring of banks' asset quality and liquidity. Directors welcomed the authorities' decision to gradually raise the countercyclical capital buffer rate. Noting Latvia's significant progress with the AML/CFT framework, they encouraged the authorities to keep the momentum and pursue further improvements. Implementing the newly adopted Anti-Corruption Plan and National Strategy is also important.

Directors encouraged the authorities to accelerate structural reforms to build resilience and lift long-term growth, including by implementing the National Recovery and Resilience Plan. Further enhancing energy security, boosting investment in clean energy, and facilitating the transition to renewable energy would be important. Directors also encouraged advancing reforms to mitigate the impact of an aging population, address skill mismatches, and boost high-skilled labor supply. They also emphasized the need to strengthen Latvia's digital transformation to help reduce labor shortages and support productivity.