Washington, DC (June 15, 2021)—After a relatively mild first wave of COVID-19, Latvia experienced a stronger and deadlier second wave. A robust recovery is expected, assuming mass vaccination gains momentum and containment measures are phased out. Policies should remain supportive in the near term and should be adjusted flexibly to the evolving conditions. As the recovery becomes entrenched, policies should shift toward facilitating reallocation and securing smarter, greener, and more inclusive growth.
The COVID-19 Crisis and the Policy Responses
After a relatively mild first wave of COVID-19, Latvia experienced a stronger and deadlier second wave. Supported by an extensive testing program and a proactive government response, Latvia faced a relatively mild spread of infections during the first wave. By mid-2020, as infections eased, containment measures were gradually lifted, only to be reimposed late in the year as the second wave hit, amid periodic increases in cases and hospitalizations. Vaccination efforts are progressing, but the share of the population with at least one shot lags the EU average.
The policy response to the pandemic was sizable and broad-based. The government announced several support packages, amounting in total to about 12 percent of GDP. Most of the measures focused on supporting businesses with guarantees and loans, expanding social assistance through transfers and unemployment benefits, and preserving jobs through wage subsidies. About one-third of the announced fiscal measures were disbursed in 2020. Substantial support was also provided through bank payment moratoria that helped relieve pressure on borrowers. In parallel, the ECB and Latvia’s financial sector supervisor (FCMC) extended forbearance measures that allowed banks to use capital and liquidity buffers to absorb shocks to businesses and households.
These policy responses have helped mitigate the economic and social impact of the crisis. The unemployment benefits and wage subsidies, whose initially modest take-up subsequently expanded, prevented a much more severe downturn in the labor market. Tax relief and equity injection measures had a relatively high take-up and contributed to the mitigation of the COVID-19 crisis in the corporate sector. Together with the loan moratoria, they helped avoid a wave of bankruptcies and safeguarded financial stability. Social assistance measures alleviated the impact of the crisis on the most vulnerable. The relatively large size of the announced package positively influenced expectations and supported economic confidence. Overall, Latvia experienced a relatively milder recession in 2020 than most other European countries.
Economic Outlook and Risks
A strong recovery is expected, assuming mass vaccination gains momentum and containment measures are phased out, but risks remain. Output is projected to grow by 3.6 percent in 2021 and 5.2 percent in 2022, driven by a rebound in consumption owing to pent up demand and the drawing down of precautionary savings. Inflation is assumed to pick up in 2021 before stabilizing at around 2 percent over the medium term. An acceleration of capital spending supported by EU funds, including Recovery and Resilience Facility (RRF) grants, is expected to support medium-term growth. Uncertainty is unusually high with upside and downside surprises possible, depending on the pace of vaccinations and the virus mutations.
Fiscal Policy: Sustainably Supporting the Recovery
The budget for 2021 appropriately maintains support to fight the COVID-19 crisis. In addition to the fiscal support of 4.5 percent of GDP provided in 2020, further temporary support measures of about 9 percent of GDP are planned in response to the surge of COVID-19 infections in early-2021 and to address still-high unemployment. Spending priorities focus on continuing support to the health sector, expanding work and unemployment benefits, and providing business support. All pandemic-related transactions should be reported transparently and audited independently.
Fiscal policy should remain supportive until a sustained recovery emerges. As the epidemiological situation evolves, the adequacy of measures should be assessed, and adjustments made where necessary; effective targeting will remain key to use fiscal space efficiently. With a very uncertain outlook, fiscal support needs to remain available until the recovery is well-established. Should the recovery falter, fiscal stimulus should be further extended.
Medium-term fiscal policy should support a structural transformation of the economy. In this regard, we support the investment plan financed by EU funds. However, execution risks should be mitigated through strong public investment planning and management. Notably, investment decisions should be underpinned by robust selection criteria, and project management supported by a transparent procurement system and effective oversight. Close coordination with the private sector will help mitigate capacity utilization bottlenecks. The credibility of the medium-term fiscal framework (MTFF) should continue to be underpinned by fiscal rules that support a gradual rebuilding of fiscal space once the recovery is firmly entrenched.
Financial Sector Policy: Safeguarding Financial Stability and Reviving Credit Growth
The financial sector entered the crisis in a solid position and risks have been contained so far. Overall, the financial sector has so far appeared resilient, given its comfortable liquidity and capital positions. However, the impact of the COVID-19 may not yet be fully reflected in bank portfolios because of the extensive government support measures. Nevertheless, non-performing loans (NPL) in the hardest hit sectors have begun to rise, although the share of these sectors in banks’ portfolios is contained. The crisis has exacerbated the declining trend of corporate lending since the global financial crisis and has raised concerns regarding bank profitability.
Risk-based supervision should continue. Government measures and prudential regulations have temporarily eased the impact of the crisis on the banking sector while supporting borrowers, but risks could re-emerge. Supervisors should ensure that banks are prepared to tackle potential significant increase in NPL levels and should conduct risk-based supervision. Supervision should continue to ensure that non-SSM banks are subject to the same extraordinary monitoring applied to the SSM banks and require banks to continually assess borrowers’ creditworthiness.
The exit strategy from the support measures will require corporate recapitalization and strengthening of the insolvency regime. Latvia’s corporate sector is characterized by the predominance of SMEs and micro firms, including in pandemic-hit sectors. It is important to assess the size of the corporate equity gap and policy options to address it, including potentially equity injections. Grant-based support would be the best suited option for micro enterprises. Recapitalization programs should be based on a “triage” approach (sorting companies into viable, viable with restructuring, and non-viable categories). In the meantime, progress in reforming the insolvency regime should continue in order to facilitate the swift repair of firms’ balance sheets. Latvia has made significant progress in upgrading its insolvency regime, including by strengthening the regulation of insolvency administrators and data collection mechanisms. The ongoing implementation of the EU Restructuring Directive presents an opportunity to address remaining gaps, including upgrading the rehabilitation process and simplifying corporate debt restructuring through out-of-court and hybrid restructuring procedures.
The enhanced macroprudential policy toolkit should help support financial stability. Latvia’s macroprudential policy framework is built on strong foundations, and new borrower-based measures that were introduced on June 1, 2020 have supplemented existing tools and will help to preserve prudent lending in view of future shocks. The augmented macroprudential toolkit will need to be re-calibrated in line with economic conditions if cyclical divergences between Latvia and the euro-area emerge.
Latvia has made significant progress in strengthening its AML/CFT framework. As a result of reforms to the AML/CFT system, Latvia avoided gray listing by the Financial Action Task Force in February 2020, including by increasing the effectiveness of the system (e.g. AML/CFT risk based supervision and availability of beneficial ownership information of legal persons registered in Latvia). Moreover, in December 2019, Moneyval issued a follow-up report, with all FATF Recommendations rated as being sufficient for technical compliance. Building on this progress, the authorities conducted a National ML/FT Risk Assessment (NRA) in 2020 and risk mitigation measures are currently being implemented based on the outcomes of the NRA. Latvia should follow through on its plans to further strengthen the effectiveness of its regime. Regional IMF technical assistance on AML/CFT will help deepen the reform agenda. In parallel, consistent with the needs of the real economy, the Financial and Capital Market Commission (FCMC) should continue to intensively monitor the refocusing of the business models of banks formerly servicing foreign clients.
Macro-Structural Reforms: Building the Foundation for Sustainable, Inclusive, and Greener Growth
Policies to facilitate job creation in newly expanding sectors would minimize the economic and social costs of COVID-19. Labor market policy should remain nimble to be responsive to the shifting demand. In the near term, employment support programs should continue to ensure adequate coverage of vulnerable workers to tackle unemployment. Job-friendly policies should be proactive, including through in-work benefits where cost-effective, hiring incentives, and strengthened active labor market policies. Over time, the focus should gradually shift to facilitating reallocation of workers to new jobs. Measures to improve the business environment and strengthen the social safety net could complement these reforms.
EU funds will help spearhead the authorities’ digitalization agenda. The EU RRF provides an opportunity to accelerate the digital transformation, including through investments in education, while creating an enabling environment through regulations and incentives. Efforts to strengthen the governance framework and raise awareness of the public for digital security should continue. If spent well, the funds under the RRF would help Latvia close digitalization gaps and catalyze private sector investments.
Latvia is moving to deliver on its ambitious climate commitments. The authorities aim to reduce greenhouse gas emissions by 65 percent between 1990 and 2030 and achieve climate neutrality by 2050. Significant progress is being made on reducing emissions, but their intensity is still high in electricity, agriculture, and transportation sectors. A carbon pricing mechanism that covers the key transportation sector could be considered. Leveraging their RRF allocation, the authorities should also follow through on their plans to increase energy efficiency and adaptation to climate change. Continued investment in research and innovation would support Latvia’s green transition.
The IMF team is grateful for the generous hospitality of the Latvian authorities, and would like to thank, once again, all interlocutors in government, the Bank of Latvia, and the private sector for constructive and fruitful discussions.