124 COUNTRY ASSESSMENTS Transition Report 2012

MACROECONOMIC PERFORMANCE has seen a consistent recovery since early 2010, following LATVIA a dramatic 20 per cent drop in GDP in 2008-09. The year 2011 saw one of the highest growth rates in the (at 5.5 per cent) despite the implementation of further fiscal HIGHLIGHTS OF THE PAST YEAR measures. Exports remained on a steady expansion path in spite of the slow-down in the core eurozone economies in the second half of The EU/IMF programme was successfully concluded 2011, with capital and consumption goods performing particularly at the end of 2011. This paves the way for compliance strongly. Industrial production weakened from the second half of last with key Maastricht criteria for public finances, and the year, though still showed growth of about 7 per cent in annual terms government remains committed to euro adoption in 2014. in the first months of 2012. Despite this weakening in the external environment the economy showed one of the strongest quarterly The authorities have delivered a strong policy performance. growth rates of all EU countries in the second quarter, with a 1 per As a result, Latvia has regained its investment grade sovereign cent expansion compared with the previous quarter. Unemployment credit rating and managed to return to international capital continues on a steady downward trend to currently almost 16 per cent. markets with substantial issues at manageable yields. Latvia concluded its three-year financial programme with the European The restructuring of the financial sector has progressed well. Union and IMF in December 2011, and the balance-of-payments This applies particularly with regard to the successor institution position (with a very small current account deficit in 2011) had to Parex, formerly the second largest in the country. The adjusted to the point where the government did not need to draw on a restructuring of Mortgage and Land Bank (MLB) is also under way. substantial share of the available programme funds. The government remains, in principle, committed to eurozone accession in 2014, on which a decision will be taken by mid-2013. Euro membership could KEY PRIORITIES FOR 2013 further reduce the cost of major refinancing needs in the coming years. The government should continue to pursue its Further fiscal measures have already brought the fiscal deficit down competitiveness agenda. Skill mismatches are an to a much better than expected 3.5 per cent of GDP in 2011, and in increasingly prominent constraint on growth. Poor the first half of 2012 the budget has similarly outperformed plans. indicators for private research and development (R&D) and External assessments by the (EC) and the vocational training in comparison with European partners IMF therefore expect that ambitious fiscal targets this year can be underline the need for improvements in these areas. met. The target for inflation (which in July 2012 stood at only 1.7 per cent compared with a year ago) is similarly likely to be met, and The government should implement plans to improve reductions in indirect taxes have helped in this regard. The positive the management and transparency of state-owned policy performance has been reflected in a number of sovereign companies. Important proposals include moving to rating upgrades, which paved the way for Latvia’s return to the capital partially centralised ownership of state-owned enterprises, markets in summer 2011 and again in February 2012. Overall credit and regular publication of financial accounts. to the private sector contracted by 8 per cent in 2011, though in the face of emerging capacity constraints corporate lending has expanded The gradual reinstatement of contributions to private pension modestly. As in the other Baltic economies, foreign-owned bank funds should continue. The substantial assets accumulated in subsidiaries continue to reduce their liabilities to their parents. this process could begin to feed local needs for long-term funds, with prudent portfolio diversification remaining the key priority.

Main macroeconomic indicators (% – unless indicated) 2012 sector transition indicators Sector transition score 2009 2010 2011 2012 estimated projected 4.0 GDP growth -17.7 -0.9 5.5 4.2 3.5 Inflation (end-year) -1.4 2.4 3.9 1.9 3.0 Government balance/GDP -9.8 -8.2 -3.5 -2.0 2.5 Current account balance/GDP 8.7 3.0 -2.2 -2.0 2.0 Net FDI (in million US$) 157 359 1457 1024 1.5 External debt/GDP 164.3 165.0 137.2 na 1.0 Gross reserves/GDP 25.7 31.7 22.5 na 0.5 Credit to private sector/GDP 108.8 104.2 93.9 na 0.0 Agribusiness General industry Real estate Telecommunications Electric power Natural resources Sustainable energy Railways Roads Urban transport Water Banking IAOFS Capital markets PE finance MSME Corporate Energy Infrastructure FI

Source: EBRD. Note: Water – Water and wastewater; IAOFS – Insurance and other financial services; PE – Private equity. COUNTRY ASSESSMENTS 125 Latvia

The short-term outlook is for a substantial weakening in growth as the Integration in the regional energy markets remains a priority. eurozone stagnates. Continuing tight fiscal policy, wage adjustments In August 2012 the government announced measures that in the face of still considerable unemployment and the contraction mandate large enterprises to contract their electricity in the open in credit remain key impediments to Latvia’s growth in the next two market (as opposed to transacting at regulated prices). This is years. There is also an ongoing risk to bank asset quality, with the expected to enhance competition, ultimately also benefiting share of non-performing loans still remaining at around 12.5 per cent. households. The planned nuclear power plant and LNG terminal in could also help to reduce energy costs in Latvia.

MAJOR STRUCTURAL REFORM DEVELOPMENTS The financial sector continues to return to health. The liquidation The government has focused on strengthening competitiveness and the in November 2011 of Krajbanka, the subsidiary of Lithuanian Bank investment regime. An action plan of 645 measures in such areas as Snoras, was due to an isolated case of fraud at the parent bank. human capital, innovation and investment promotion was adopted by The supervisor has since confirmed through more in-depth on-site parliament in February 2012. Strengthening education is a key priority; inspections that no similar problems exist in other . This bank for instance, enrolment in vocational education in Latvia remains failure did, however, highlight some remaining inefficiencies in the one of the lowest in the European Union. The action plan comprises coordination of supervisory intervention with other countries in measures on higher education, where infrastructure and equipment the region, even though this coordination is in principle very close, are to be modernised, and legislative changes aimed at enhancing given the contacts built up through the Nordic-Baltic Memorandum flexibility and focusing on study fields more in line with demand of Understanding (MoU). Elsewhere, Citadele Bank, the “good expressed by industry. Private R&D spending remains the lowest in the bank” successor to Parex Bank following its nationalisation in late European Union, though the government is seeking to take steps to 2008, is continuing its restructuring programme, including through accelerate the commercialisation of scientific research, for example, by the sale of various foreign participations in agreement with the establishing competence centres and stimulating knowledge transfer. competition directorate of the EC. This should facilitate the ultimate objective of transferring the bank back into private ownership Latvia remains an attractive location for foreign direct investment. and reviving growth in credit in the domestic credit market. The Inflows accounted for about 5 per cent of GDP in 2011, in line with remaining institution – also named Parex Bank – that took over the other Baltic economies. A recent initiative by the president is to delinquent assets ceased commercial banking operations in March give greater autonomy to regional governments in giving incentives for 2012. Renamed , it continues to manage delinquent assets investment in production facilities. The government remains committed with a view to maximising recoveries. The sale of Mortgage and to strengthening attractiveness to FDI investors in priority sectors, such Land Bank (MLB), Latvia’s eighth largest bank and the remaining as export-oriented manufacturing or energy efficiency investments. state participation in the sector, is progressing and, according to the government, should be concluded by the end of 2012. The governance and anti-competitive conduct of state-owned companies remains a concern for private investors, though the The government is committed to gradually reinstating contributions government is pursuing measures to address these issues. The to private pension funds. During the severe 2009 recession, Latvia government’s intention is to partially centralise ownership of state- reduced contributions to mandatory (second pillar) pension funds from owned enterprises, and to enhance transparency through regular 8 to 2 per cent of gross salaries, similar to measures also adopted by publication of financial accounts. The decision by Latvenergo to have several other countries in central Europe and the Baltics. its long-term bonds quoted on the local exchange and to comply In July 2012 the government approved a gradual increase of with the resulting listing requirements is a step in this direction. The contributions from 2013 to ultimately 6 per cent in 2016, underlining nationalisation of the remaining shares in the state airline, Air Baltic, a commitment to the three-pillar model. These funds, which became necessary following the failure of Lithuanian Bank Snoras, and currently hold assets of about €1.5 billion, could be an important of its Latvian subsidiary. However, the airline remains loss-making and source of local long-term capital, which is increasingly sought by required a substantial cash injection by the government in October large domestic enterprises. The decision to gradually increase the 2011. This may give rise to a state-aid investigation by the EC. retirement age to 65 years, from the current 62 years, along with several other changes in entitlements, should also help to put the finances of the state system on a more sustainable footing.

Real GDP (1989 = 100) Fiscal balance and current account balance ■ Latvia ■ EBRD-33 ■ Fiscal balance (% of GDP) ■ Current account balance (% of GDP)

200 10 180 5 160 140 0 120 -5 100 80 -10 60 -15 40 -20 20

0 -25 2006 2007 2008 2009 2010 2011 2012 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012