Macroeconomic performance

Latvia became the 18th member of the eurozone in January 2014. The country replaced its lats with the euro at the same pegged exchange rate that has been in place since 2005. Rapid fiscal consolidation following the deep recession of 2008 and benign inflation trends in its very open economy have enabled Latvia to meet the Maastricht criteria.

Latvia registered the fastest GDP growth in the EU since 2012. The economy expanded more rapidly than expected in 2013, with annual per capita output exceeding its pre-crisis peak for the first time, primarily on the back of stronger domestic demand driven by household expenditures and higher exports. In the first half of 2014 investment growth turned positive at 5 per cent year-on-year after four consecutive quarters of contraction, but it was still private consumption together with increasing exports that contributed most strongly to output growth.

The government continues to unwind austerity measures. After years of post-crisis fiscal consolidation, the government plans to continue loosening spending controls, as a result of abundant tax revenues, while remaining in line with the EU’s Stability and Growth Pact. Following a significant improvement in 2012, the budget deficit reached 1.1 per cent of GDP in 2013. Under the ongoing competitiveness programme, plans are under way to simplify the tax system, reduce the labour tax burden (by decreasing personal income tax rates) and gradually increase the minimum tax threshold.

Financial sector stability has been restored, largely owing to the final sale of the state stake in Citadele, the performing part of the now defunct Parex. Furthermore, adoption of the euro and participation in the banking union should contribute to overall financial stability (the three largest financial institutions will be directly supervised by the European Central Bank (ECB) from the end of 2014). The changeover has resulted in higher credit ratings, which is beneficial for banks. With any remaining exchange rate risk now removed, banks expect a positive impact on loan pricing. Low interest rates set by the ECB and the ECB’s long-term refinancing operation should help to stimulate lending.

Latvia is exposed to the now decelerating Russian economy. Given that 11.6 per cent of exports were directed there in 2013 and Russian entities account for a large share of non-resident deposits in the banking sector, Latvia’s economy is vulnerable. Nevertheless, the short-term outlook for growth remains well above the regional average, and is now projected at 3.2 per cent and 3.7 per cent in 2014 and 2015, respectively.

Major structural reform developments

The government supported household incomes through pension hikes and a rise in the minimum wage. For the first time since the 2008-09 global financial crisis, the lowest level of pensions (below €285 a month) was increased by 4 per cent in September 2013, followed by another 2.7 per cent rise in October 2014. This move affected 85 per cent of pensioners in the country for whom the average monthly pension stood at €270 beforehand. In addition, the monthly minimum wage was increased by 12.5 per cent to €320 in January 2014, and the government is considering a further 10 per cent rise. This rise was justified with a robust increase in workforce productivity (which rose from pre-crisis levels of 54 per cent to 67 per cent of the EU-28 average in 2013) and strong growth figures.

The tax burden has been reduced. The government cut social contributions by 1 percentage point in 2014, to 10.5 per cent paid by employees and 23.6 per cent paid by employers. The personal income tax rate of 24 per cent will be reduced gradually over the coming years until it reaches 22 per cent in 2016. In order to support low-income households, the non-taxable threshold for workers and dependants has been raised by 17 per cent and 45 per cent, respectively.

Parliament approved amendments to the energy law. The new amendments, adopted in March 2014, envisage a gradual opening of the natural gas market by April 2017. Latvijas Gaze, the only vertically integrated company operating in the natural gas market in Latvia, is to be unbundled by April 2017. The government’s ambition is to liberalise the natural gas market in Latvia, thereby encouraging alternative supplies and competition. These modifications are in line with the EU’s third energy package, which stipulates the effective separation of supply and production activities from network operations.

Electricity market liberalisation has been postponed until 2015. Social concerns were among the reasons behind this decision. The government has approved a compensation mechanism for low-income households as well as households with three or more children, as energy prices are expected to increase significantly following the liberalisation. The necessary amendments to the electricity market law regarding this compensation mechanism were adopted in September 2014. The new electricity connection between Estonia and Latvia, already approved by the main grid operators in both countries, will be in operation by 2020 and is likely to enhance competition.

Considerable challenges remain in stimulating innovation and creating value in the economy. As documented recently by the European Commission, Latvia’s exports consist mainly of low value added goods with limited intake of technology. The share of high-tech products stands at 6.3 per cent of total exports, significantly below the EU average of 15.4 per cent. R&D expenditures are the second lowest in the EU, at only 0.7 per cent of GDP, much below the government’s EU 2020 target of 1.5 per cent. On the Innovation Union Scoreboard 2014, Latvia belongs to the group of “modest innovators” and, relative to the rest of the European Union, the country has improved its innovation performance over the last years from 35 per cent in 2006 to 40 per cent of the EU average in 2013. The lack of cooperation between research institutions and businesses is an obstacle to the commercial use of research results.

OECD accession talks started in May 2013. The aim is for Latvia to become a full member by 2016. In May 2014 Latvia took an important step towards accession to the Organisation for Economic Co-operation and Development (OECD) by joining the OECD Anti-Bribery Convention. The country has since undergone the first systematic review on the implementation of its anti-bribery laws. In addition to Latvia’s EU membership, OECD membership should provide incentives to speed up reforms already introduced in areas such as the management of state-owned enterprises (SOEs), insolvency regulations and the professionalisation of SOE board members.

The shadow economy remains significant and may even be increasing. According to the Shadow Economy Index for the Baltic Countries, compiled by the Stockholm School of Economics, the shadow economy in Latvia expanded slightly to 23.8 per cent of GDP in 2013, up from 21.1 per cent in 2012. An increase in corporate tax evasion is seen as the main reason, especially in the recovering construction sector, where it is estimated that 45 per cent of all sector activities occur informally. The Latvian State Revenue Service initiated new measures against tax fraud late in 2014 by systematically targeting a number of industries.