ISSN 1725-3217 Convergence Report 2013 on Latvia EUROPEAN ECONOMY 3|2013 Economic and Financial Affairs The European Economy series contains important reports and communications from the Commission to the Council and the Parliament on the economic situation and developments, such as the European economic forecasts and the Public finances in EMU report. Unless otherwise indicated the texts are published under the responsibility of the Directorate-General for Economic and Financial Affairs of the European Commission to which enquiries should be addressed. Legal notice Neither the European Commission nor any person acting on its behalf may be held responsible for the use which may be made of the information contained in this publication, or for any errors which, despite careful preparation and checking, may appear. More information on the European Union is available on the Internet (http://europa.eu). ISBN 978-92-79-28535-6 doi: 10.2765/40058 © European Union, 2013 Reproduction is authorised provided the source is acknowledged. European Commission Directorate-General for Economic and Financial Affairs Convergence Report 2013 on Latvia EUROPEAN ECONOMY European Economy N° 3/2013 ABBREVIATIONS LV Latvia EA Euro area EU-27 European Union, 27 Member States EU-25 European Union, 25 Member States before 2007 (i.e. EU-27 excl. BG and RO) EU-15 European Union, 15 Member States before 2004 EUR Euro ECU European currency unit LVL Latvian lats USD US dollar SDR Special Drawing Rights AMR Alert Mechanism Report BoL Bank of Latvia BoP Balance of Payments CAR Capital adequacy ratio CEE Central and Eastern Europe CIS Commonwealth of Independent States CPI Consumer price index CR5 Concentration ratio (aggregated market share of five banks with largest market share) EC European Community ECB European Central Bank EDP Excessive Deficit Procedure EMI European Monetary Institute EMS European Monetary System EMU Economic and monetary union ERM II Exchange rate mechanism II ESA95 European System of Accounts ESCB European System of Central Banks EU European Union Eurostat Statistical Office of the European Union FCMC Financial Capital Market Commission FDL Fiscal Discipline Law FDI Foreign direct investment FSAP Financial Sector Action Plan GDP Gross domestic product HICP Harmonised index of consumer prices HICP-CT HICP at constant taxes IMF International Monetary Fund MFI Monetary Financial Institution MIP Macroeconomic Imbalance Procedure MTO Medium-term objective NCBs National central banks NEER Nominal effective exchange rate NPL Non-performing loans OJ Official Journal OJL Official Journal Lex PIT Personal Income Tax PPS Purchasing Power Standard PPP Purchasing Power Percentage R&D Research and development REER Real effective exchange rate ii SITC Standard International Trade Classification SME Small and medium entreprises TEC Treaty establishing the European Community TFEU Treaty on the Functioning of the European Union ULC Unit labour costs VAT Value added tax iii ACKNOWLEDGEMENTS The Convergence Report and its Technical Annex were prepared in the Directorate-General for Economic and Financial Affairs. The main contributors were Balazs Forgo, Radoslav Krastev and Ingrid Toming. Other contributors were Benjamin Angel, Gatis Eglitis, Christine Frayne, Nikolay Gertchev, Isabel Grilo, Henriette Keller, Federico Lucidi, Filip Keereman, Matteo Salto, Ruediger Voss and Christian Weise. Statistical assistance was provided by Gerda Symens and André Verbanck. The report was coordinated by Balazs Forgo under the supervision of Paul Kutos, Head of Unit and approved by Sean Berrigan, Director, Maarten Verwey, Deputy Director General, and Marco Buti, Director General. Questions and comments may be referred to Balazs Forgo ([email protected]) iv CONTENTS Convergence Report 2013 1 Convergence Report 2013 - Technical annex 11 1. Introduction 13 1.1. ROLE OF THE REPORT 13 1.2. APPLICATION OF THE CRITERIA 14 1.2.1. Compatibility of legislation 15 1.2.2. Price stability 15 1.2.3. Public finances 20 1.2.4. Exchange rate stability 20 1.2.5. Long-term interest rates 22 1.2.6. Additional factors 22 2. Latvia 25 2.1. LEGAL COMPATIBILITY 25 2.1.1. Introduction 25 2.1.2. Objectives 25 2.1.3. Central bank independence 25 2.1.4. Prohibition of monetary financing and privileged access 25 2.1.5. Integration in the ESCB 25 2.1.6. Assessment of compatibility 26 2.2. PRICE STABILITY 26 2.2.1. Respect of the reference value 26 2.2.2. Recent inflation developments 26 2.2.3. Underlying factors and sustainability of inflation 27 2.3. PUBLIC FINANCES 30 2.3.1. The excessive deficit procedure for Latvia 30 2.3.2. Recent fiscal developments 31 2.3.3. Outlook for public finances 32 2.4. EXCHANGE RATE STABILITY 32 2.5. LONG-TERM INTEREST RATES 34 2.6. ADDITIONAL FACTORS 35 2.6.1. Developments of the balance of payments 36 2.6.2. Product market integration 37 2.6.3. Financial market integration 39 2.7. SUSTAINABILITY OF CONVERGENCE 42 LIST OF TABLES 2.1. Latvia - Components of inflation 26 2.2. Latvia - Other inflation and cost indicators 28 2.3. Latvia - Budgetary developments and projections 31 2.4. Latvia - Balance of payments 36 2.5. Latvia - Product market integration 38 v LIST OF GRAPHS 2.1. Latvia - Inflation criterion since 2007 26 2.2. Latvia - HICP inflation 27 2.3. Latvia - Inflation, productivity and wage trends 29 2.4. LVL - Spread vs central rate 33 2.5. Exchange rates - LVL/EUR 33 2.6. Latvia - 3-M Rigibor spread to 3-M Euribor 34 2.7. Latvia - Long-term interest rate criterion 34 2.8. Latvia - Long-term interest rates 35 2.9. Latvia - Saving and investment 37 2.10. Latvia - Effective exchange rates 37 2.11. Latvia - Foreign ownership and concentration in the banking sector 40 2.12. Latvia - selected banking sector soundness indicators relatively to the euro area 40 2.13. Latvia - Non-resident deposits (NRD) 41 2.14. Latvia - Recent development of the financial system relatively to the euro area 41 LIST OF BOXES 1.1. Article 140 of the Treaty 14 1.2. Assessment of price stability and the reference value 16 1.3. Excessive deficit procedure 18 1.4. Data for the interest rate convergence 21 1.5. The Macroeconomic Imbalance Procedure (MIP) 23 vi Convergence Report 2013 on Latvia (prepared in accordance with Article 140(1) of the Treaty) REPORT FROM THE COMMISSION CONVERGENCE REPORT 2013 on Latvia (Prepared in accordance with Article 140(1) of the Treaty on the functioning of the European Union at the request of Latvia) 1. PURPOSE OF THE REPORT Article 140(1) of the Treaty on the Functioning of the European Union (hereafter TFEU) requires the Commission and the ECB to report to the Council, at least once every two years, or at the request of a Member State with a derogation1, on the progress made by the Member States in fulfilling their obligations regarding the achievement of economic and monetary union. The latest Commission and ECB Convergence Reports, relating to all Member State with a derogation, were adopted in May 2012. This report has been prepared in response to a request of Latvia, submitted on 5 March 2013. A more detailed assessment of the state of convergence in Latvia is provided in a Technical Annex to this report (SWD(2013) 196). The content of the reports prepared by the Commission and the ECB is governed by Article 140(1) of the TFEU. This Article requires the reports to include an examination of the compatibility of national legislation, including the statutes of the national central bank, with Articles 130 and 131 of the TFEU and the Statute of the European System of Central Banks and of the European Central Bank (hereafter ESCB/ECB Statute). The reports must also examine whether a high degree of sustainable convergence has been achieved in the Member State concerned by reference to the fulfilment of the convergence criteria (price stability, public finances, exchange rate stability, long-term interest rates), and by taking account of other factors mentioned in the final sub-paragraph of Article 140(1) of the TFEU. The four convergence criteria are developed in a Protocol annexed to the Treaties (Protocol No 13 on the convergence criteria). The economic and financial crisis has, in general, exposed gaps in the current economic governance of the Economic and Monetary Union (EMU) and showed that its existing instruments need to be used more fully. The present examination takes place within a context of the reform of EMU governance, which was undertaken over the past three years with the aim of ensuring a sustainable functioning of EMU. The assessment of convergence is thus aligned with the broader "European Semester" approach which takes an integrated and upstream look at the economic policy challenges in ensuring fiscal sustainability, competitiveness, financial market stability and economic growth. The key innovations in the area of governance 1 The Member States that have not yet fulfilled the necessary conditions for the adoption of the euro are referred to as "Member States with a derogation". Denmark and the United Kingdom negotiated opt-out arrangements before the adoption of the Maastricht Treaty and do not participate in the third stage of EMU. 2 reform, reinforcing the assessment of each Member States' convergence process and its sustainability, include inter alia the strengthening of the excessive deficit procedure by the 2011 reform of the Stability and Growth Pact and new instruments in the area of surveillance of macroeconomic imbalances. In particular, this report takes into account the assessment of the 2013 update of Latvia's Convergence Programme2 and the findings under the Alert Mechanism Report of the Macroeconomic Imbalances Procedure3. Convergence criteria The examination of the compatibility of national legislation, including the statutes of the national central bank, with Article 130 and with the compliance duty under Article 131 of the TFEU encompasses an assessment of observance of the prohibition of monetary financing (Article 123) and the prohibition of privileged access (Article 124); consistency with the ESCB's objectives (Article 127(1)) and tasks (Article 127(2)) and other aspects relating to the integration of the national central bank into the ESCB at the moment of the euro adoption.