Developments Since Transition Upon regaining independence in 1991, the Latvian economy experienced a sharp economic decline as it began its transition to a market economy and lost its economic links with the former Soviet Union (FSU). Real GDP during these years fell by half. The Government quickly realized that a comprehensive reform program was needed and introduced fiscal discipline as well as limits to enterprise subsidies. Thanks to early steps toward liberalization, Latvia became the second country from the FSU to join the World Trade Organization (WTO) in 1999. The country reached the final stages of transition to a market economy in May 2004, having acceded to the European Union (EU). Most markets have been liberalized, privatization is close to completion, and vital strides in legal reform, institutional development, and the social safety net are being implemented. Price liberalization took place in most of the markets early in the transition and restrictions on foreign exchange transactions have been very limited. A clear focus on EU integration has had a strong positive effect on Latvia’s domestic policy by serving as a unifying force supporting political, economic, and social reforms across a broad spectrum. Recent Economic Performance Latvia recorded impressive economic growth after joining the EU, with real GDP growth exceeding 10 percent per year. However, economic growth was driven almost entirely by domestic demand, encouraged by large real wage increases, extremely rapid credit growth, and stimulus from EU funds. The labor market tightened significantly with the unemployment rate declining steadily to 6 percent in 2007, from double digit levels before 2004. Moreover, since Latvia's accession to the EU, labor out-migration increased considerably adding to labor shortages and pushing up wages. These developments led to major external and internal imbalances with significant threats to the stability of the financial system. Both the current account deficit and inflation reached very high levels, the latter seriously undermined the purchasing power of households’ income and international competitiveness. Furthermore, much of the rapid credit expansion was in foreign exchange and banks were taking on increasing exposures to real estate, which brought substantial risks to the banks' asset quality and the financial sector stability. The policy response to these imbalances was insufficient. Given Latvia’s currency peg, the focus was on fiscal policy which tended to be pro-cyclical and expansionary – despite robust economic growth translating into good revenue performance, the fiscal balance remained in deficit in most years (except in 2007 when the budget saw a marginal surplus). After a period of economic overheating, the economy started to slide into recession, which together with the impact of the global financial crisis forced the authorities to seek external support. Risks to financial sector stability have further increased as a result of the global financial turmoil and related liquidity pressures. The currency peg has been under substantial pressure since the end of September and the central bank spent over €1bn to support the currency while foreign reserves fell to €3.4bn at the end of November. In November, the government had to take over the majority stake in the second largest bank, PAREX, as the bank was experiencing a run on deposits, and later in December withdrawals from the bank were restricted while the government further increased its shareholding. In late December, Latvia concluded talks on a large stabilization package, led by the IMF and with support from the EU, Nordic countries, the World Bank and others. The 27 month IMF program is based on preserving the existing exchange rate within the narrow peg and therefore requires exceptionally strong domestic adjustment policies (a very large fiscal adjustment of 7 percent of GDP in 2009) and sizable external financing (€7.5bn). Program implementation has faced significant challenges with delays in preparation of a fully-fledged supplementary budget. This resulted in missing the second tranche of the IMF assistance scheduled for the second quarter 2009. The situation has been further complicated by a rapidly deteriorating growth outlook – the budget for 2009 was based on a projected 5 percent GDP contraction while revised estimates by the Ministry of Finance suggest that GDP will drop 12 percent. As the expected slowdown in Latvia’s main trading partners undermines the outlook for exports, prospects of economic recovery remain bleak, with risks to the process of regaining macroeconomic stability. Challenges Ahead Latvia’s immediate and greatest challenge is to weather the current financial crisis and regain economic stability. A large multilateral stabilization package of €7.5 billion for Latvia is conditional on a set of strong domestic adjustment policies that will help to unwind accumulated imbalances while maintaining the currency peg arrangement. Apart from the near-term focus on the financial sector stabilization, the program focuses primarily on fiscal and income policies. Fiscal consolidation will need to be backed by structural reforms, including strengthening public financial management and comprehensive reforms of the civil service, state administration, education and the healthcare systems Latvia needs to alleviate the impact of the current financial crisis on the most vulnerable social groups. In this context, it will be essential to improve the targeting of social safety nets. Once the thrust of the crisis is over, the primary goal will be to ensure Latvia’s sustainable convergence with the EU, supported with further structural reforms to improve competitiveness and innovation.
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