# EUR-Lex - 52013SC0196 - EN

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# 52013SC0196

**COMMISSION STAFF WORKING DOCUMENT TECHNICAL ANNEX Accompanying the document REPORT FROM THE COMMISSION CONVERGENCE REPORT 2013 (prepared in accordance with Article 140(1) TFUE at the request of Latvia) /* SWD/2013/0196 final */**

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European Commission

Directorate-General
for Economic and Financial Affairs

Convergence
Report 2013

EUROPEAN ECONOMY                                                                                                   xxx/2013

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

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

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 (balazs.forgo@ece.europa.eu)

Convergence
Report 2013  1

Convergence Report 2013 - Technical annex  3

1.     Introduction  5

1.1.     ROLE OF THE REPORT  5

1.2.     APPLICATION OF THE CRITERIA  6

1.2.1.    Compatibility of legislation  7

1.2.2.    Price stability  7

1.2.3.    Public finances 12

1.2.4.    Exchange rate stability  12

1.2.5.    Long-term interest rates 14

1.2.6.    Additional factors 14

2.     Latvia  17

2.1.     Legal compatibility  17

2.1.1.    Introduction  17

2.1.2.    Objectives 17

2.1.3.    Central bank independence  17

2.1.4.    Prohibition of monetary financing and
privileged access 17

2.1.5.    Integration in the ESCB  17

2.1.6.    Assessment of compatibility  18

2.2.     Price stability  18

2.2.1.    Respect of the reference value  18

2.2.2.    Recent inflation developments 18

2.2.3.    Underlying factors and sustainability of
inflation  19

2.3.     Public finances  22

2.3.1.    The excessive deficit procedure for Latvia   22

2.3.2.    Recent fiscal developments 23

2.3.3.    Outlook for public finances 24

2.4.     EXCHANGE RATE STABILITY  24

2.5.     Long-term interest rates  26

2.6.     Additional factors  27

2.6.1.    Developments of the balance of payments 28

2.6.2.    Product market integration  29

2.6.3.    Financial market integration  31

2.7.     Sustainability of convergence  34

LIST OF Tables

2.1.     Latvia - Components of inflation  18

2.2.     Latvia - Other inflation and cost indicators 20

2.3.     Latvia - Budgetary developments and projections 23

2.4.     Latvia - Balance of payments 28

2.5.     Latvia - Product market integration  30

LIST OF Graphs

2.1.     Latvia - Inflation criterion since 2007  18

2.2.     Latvia - HICP inflation  19

2.3.     Latvia - Inflation, productivity and wage trends 21

2.4.     LVL - Spread vs central rate  25

2.5.     Exchange rates - LVL/EUR  25

2.6.     Latvia - 3-M Rigibor spread to 3-M Euribor 26

2.7.     Latvia - Long-term interest rate criterion  26

2.8.     Latvia - Long-term interest rates 27

2.9.     Latvia - Saving and investment 29

2.10.   Latvia - Effective exchange rates 29

2.11.   Latvia - Foreign ownership and concentration in
the banking sector 32

2.12.   Latvia - selected banking sector soundness
indicators relatively to the euro area   32

2.13.   Latvia - Non-resident deposits (NRD) 33

2.14.   Latvia - Recent development of the financial
system relatively to the euro area   33

LIST OF Boxes

1.1.     Article 140 of the Treaty  6

1.2.     Assessment of price stability and the reference
value  8

1.3.     Excessive deficit procedure  10

1.4.     Data for the interest rate convergence  13

1.5.     The Macroeconomic Imbalance Procedure (MIP) 15

Report

1.1.      ROLE
OF THE REPORT

The euro was introduced on 1 January 1999
by eleven Member States. The decision ([1]) by the Council (meeting in the composition of the Heads of State
or Government) on 3 May 1998 in Brussels on the eleven Member States deemed
ready to participate in the single currency had, in accordance with the Treaty
(Article 121(4) TEC) ([2]), been prepared by the Ecofin Council on a recommendation from the
Commission. The decision was based on the two Convergence Reports made by the
Commission ([3]) and the European Monetary Institute (EMI), respectively ([4]). These reports, prepared in accordance with Article 121(1) TEC ([5]), examined whether the Member States satisfied the convergence
criteria and met the legal requirements.

Since then, Greece (2001), Slovenia (2007), Cyprus and Malta (2008), Slovakia (2009) and Estonia (2011) have joined the euro.

Those Member States which are assessed as
not fulfilling the necessary conditions for the adoption of the euro are
referred to as "Member States with a derogation". Article 140 of the
Treaty lays down provisions and procedures for examining the situation of
Member States with a derogation (Box 1.1). At least once every two years, or at
the request of a Member State with a derogation, the Commission and the
European Central Bank (ECB) prepare Convergence Reports on such Member States. Denmark and the United Kingdom negotiated opt-out arrangements before the adoption of the Maastricht
Treaty ([6]) and do not participate in the third stage of EMU. Until these
Member States indicate that they wish to participate in the third stage and
join the euro, they are not the subject of an assessment as to whether they
fulfil the necessary conditions.

In 2012, the Commission and the ECB adopted
their latest regular Convergence Reports ([7]). None of the Member States assessed in those reports was deemed to
meet the necessary conditions for adopting the euro.

On 5 March 2013 Latvia submitted a request
for a convergence assessment. This Commission Staff Working Document is a
Technical Annex to the Convergence Report 2013 on Latvia and includes a
detailed assessment of the progress with convergence.

The financial and economic crisis, along
with the recent euro-area debt crisis, in general, has exposed gaps in the
current economic governance system of the Economic and Monetary Union (EMU) and
showed that its existing instruments need to be used more fully. With the aim
of ensuring a sustainable functioning of EMU, an overall strengthening of
economic governance in the Union was undertaken over the past three years.
Accordingly, this Commission Staff Working Document makes references where
appropriate to procedures that help to strengthen the assessment of the
convergence process and its sustainability. In particular, it incorporates
references to the strengthened surveillance of macroeconomic imbalances (see
section 1.2.6.).

The remainder of the first chapter presents
the methodology used for the application of the assessment criteria. Chapter 2
examines the fulfilment of the convergence criteria and other requirements in
the order as they appear in Article 140(1) (see Box 1.1). The cut-off date for
the statistical data included in this Convergence Report was 16 May 2013.

1.2.      APPLICATION
OF THE CRITERIA

In accordance with Article 140(1) of the
Treaty, the Convergence Reports shall examine the compatibility of national
legislation with Articles 130 and 131 of the Treaty and the Statute of the
European System of Central Banks (ESCB) and of the European Central Bank. The
reports shall also examine the achievement of a high degree of sustainable
convergence by reference to the fulfilment of the four convergence criteria
dealing with price stability, public finances, exchange rate stability and long
term interest rates as well as some additional factors. The four convergence
criteria are developed further in a Protocol annexed to the Treaty (Protocol No
13 on the convergence criteria).

1.2.1.   Compatibility
of legislation

In accordance with Article 140(1) of the
Treaty, the legal examination includes an assessment of compatibility between a
  Member State’s legislation, including the statute of its national central
bank, and Articles 130 and 131 of the Treaty. This assessment mainly covers
three areas.

· First, the independence of the national central bank and of the
members of its decision-making bodies, as laid down in Article 130, must be
assessed. This assessment covers all issues linked to a national central bank's
institutional financial independence and to the personal independence of the
members of its decision-making bodies.

· Second, in accordance with Articles 123 and 124 of the Treaty, the
compliance of the national legislation is verified against the prohibition of
monetary financing and privileged access. The prohibition of monetary financing
is laid down in Article 123(1) of the Treaty, which prohibits overdraft
facilities or any other type of credit facility with the ECB or the central
banks of Member States in favour of Union institutions, bodies, offices or
agencies, central governments, regional, local or other public authorities,
other bodies governed by public law, or public undertakings of Member States;
and the purchase directly from these public sector entities by the ECB or
central banks of debt instruments. As regards the prohibition on privileged
access, the central banks, as public authorities, may not take measures
granting privileged access by the public sector to financial institutions if
such measures are not based on prudential considerations.

· Third, the integration of the national central bank into the ESCB
has to be examined, in order to ensure that at the latest by the moment of euro
adoption, the objectives of the national central bank are compatible with the
objectives of the ESCB as formulated in Article 127 of the Treaty. What is
more, the provisions on tasks in national central banks laws are assessed
against the relevant provisions of the Treaty and the ESCB/ECB Statute.

1.2.2.   Price
stability

The price stability criterion is defined in
the first indent of Article 140(1) of the Treaty: “the achievement of a high
degree of price stability [...] will be apparent from a rate of inflation which
is close to that of, at most, the three best performing Member States in terms
of price stability”.

Article 1 of the Protocol on the
convergence criteria further stipulates that “the criterion on price stability
[...] shall mean that a Member State has a price performance that is sustainable
and an average rate of inflation, observed over a period of one year before the
examination, that does not exceed by more than 1.5 percentage points that of,
at most, the three best performing Member States in terms of price stability.
Inflation shall be measured by means of the consumer price index on a
comparable basis, taking into account differences in national definitions”.

Since national consumer price indices
(CPIs) diverge substantially in terms of concepts, methods and practices, they
do not constitute the appropriate means to meet the Treaty requirement that
inflation must be measured on a comparable basis. To this end, the Council
adopted on 23 October 1995 a framework regulation ([8]) setting the legal basis for the establishment of a harmonised
methodology for compiling consumer price indices in the Member States. This
process resulted in the production of the Harmonised Indices of Consumer Prices
(HICPs), which are used for assessing the fulfilment of the price stability
criterion. Until December 2005, HICP series had been based on 1996 as the
reference period. A Commission Regulation (EC) No 1708/2005 ([9]) provided the basis for a change of the HICP index base reference
period from 1996=100 to 2005=100.

(Continued on the next page)

Box (continued)

As has been the case in past convergence
reports, a Member State’s average rate of inflation is measured by the
percentage change in the arithmetic average of the last 12 monthly indices
relative to the arithmetic average of the 12 monthly indices of the previous
period. The reference value is calculated as the arithmetic average of the
average rate of inflation of the three best-performing Member States in terms
of price stability plus 1.5 percentage points.

Over the 12-month period covering May
2012-April 2013, the three best-performing Member States in terms of price
stability were Sweden (0.8%), Latvia (1.3%) and Ireland (1.6%), yielding a
reference value of 2.7%. Greece was excluded from among the best performers, as
its inflation rate and profile deviate by a wide margin from the euro area
average, mainly reflecting the severe adjustment needs and exceptional
situation of the Greek economy (see Box 1.2).

The Protocol on the convergence criteria
not only requires Member States to have achieved a high degree of price
stability but also calls for a price performance that is sustainable. The
requirement of sustainability aims at ensuring that the degree of price
stability and inflation convergence achieved in previous years will be
maintained after adoption of the euro. This deserves particular attention in
the current juncture as the financial turmoil exposed unsustainable price
developments in many EU Member States, including euro area countries, in the
pre-crisis period.

Inflation sustainability implies that the
satisfactory inflation performance must essentially be due to the adequate
behaviour of input costs and other factors influencing price developments in a
structural manner, rather than reflecting the influence of temporary factors.
Therefore, this Technical Annex examines also the role of the macroeconomic
situation and policy stance in inflation performance, developments in unit
labour costs as a result of trends in labour productivity and nominal
compensation per head, developments in import prices to assess how external
price developments have impacted on domestic inflation. Similarly, the impact
of administered prices and indirect taxes on headline inflation is also considered.

(Continued on the next page)

Box (continued)

(Continued on the next page)

Box (continued)

From a forward-looking inflation
perspective, the report includes an assessment of medium-term prospects for
price developments. The analysis of factors that have an impact on the
inflation outlook – cyclical conditions, labour market developments and credit
growth – is complemented by a reference to the most recent Commission services'
forecast of inflation. That forecast can subsequently be used to assess whether
the Member State is likely to meet the reference value also in the months ahead ([10]). Medium-term inflation prospects are also assessed by reference to
the economies' key structural characteristics, including the functioning of the
labour and product markets.

1.2.3.   Public
finances

The convergence criterion dealing with the
government budgetary position is defined in the second indent of Article 140(1)
of the Treaty as “the sustainability of the government financial position: this
will be apparent from having achieved a government budgetary position without a
deficit that is excessive as determined in accordance with Article 126(6)”.
Furthermore, Article 2 of the Protocol on the convergence criteria states that
this criterion means that “at the time of the examination the Member State is not the subject of a Council decision under Article 126(6) of the said Treaty
that an excessive deficit exists”.

The convergence assessment in the budgetary
area is thus directly linked to the excessive deficit procedure which is
specified in Article 126 of the Treaty and further clarified in the Stability
and Growth Pact (see Box 1.3 for further information on the excessive deficit
procedure as strengthened by the 2011 reform of the Stability and Growth Pact).
The existence of an excessive deficit is determined by Regulation 1467/97 as
amended in 2005 and 2011 (most recently under the "Six-Pack") which
sets out the way in which government deficit and debt levels are used to assess
whether an excessive deficit exists, under article 126 of TFEU. The
convergence  assessment in the budgetary area is therefore judged by whether a
Council decision under 126(6) exists, and the Member State needs to comply with
the deficit and debt requirements elaborated in regulation 1467/97 to ensure
that it is not subject to such a decision ([11]).

The issue of sustainability deserves
particular attention at a time when the financial crisis has significantly
impacted on the fiscal positions in many Member States. Related to this,
economic governance in the EMU was substantially strengthened in 2011. This
included, inter alia, the operationalisation of the debt criterion in the
Excessive Deficit Procedure ([12]).

1.2.4.   Exchange
rate stability

The Treaty refers to the exchange rate
criterion in the third indent of Article 140(1) as “the observance of the
normal fluctuation margins provided for by the exchange-rate mechanism of the
European Monetary System, for at least two years, without devaluing against the
euro”.

Article 3 of the Protocol on the
convergence criteria stipulates: “The criterion on participation in the
exchange rate mechanism of the European Monetary System (...) shall mean that a
Member State has respected the normal fluctuation margins provided for by the
exchange-rate mechanism of the European Monetary System without severe tensions
for at least the last two years before the examination. In particular, the
Member State shall not have devalued its currency’s bilateral central rate
against the euro on its own initiative for the same period” ([13]). Based on the Council Resolution on the establishment of the ERM
II ([14]), the European Monetary System has been replaced by the Exchange
Rate Mechanism II upon the introduction of the euro, and the euro has become
the centre of the mechanism.

In its assessment of the exchange rate
stability criterion, the Commission takes into account developments in
auxiliary indicators such as foreign reserve developments and short-term
interest rates, as well as the role of policy measures, including foreign
exchange interventions, in maintaining exchange rate stability.

Latvia was still under an international
balance-of-payments assistance programme during the first part of the assessment
period for this report. In order to determine whether this constitutes evidence
that a country has faced severe tensions in its exchange rate, the Commission
examines the role played by official external financing during the assessment
period.

As in previous reports, the assessment of
this criterion verifies the participation in ERM II and examines exchange rate
behaviour within the mechanism. The relevant period for assessing exchange rate
stability in this Technical Annex is 17 May 2011 to 16 May 2013.

1.2.5.   Long-term
interest rates

The fourth indent of Article 140(1) of the
Treaty requires “the durability of convergence achieved by the Member State
with a derogation and of its participation in the exchange rate mechanism being
reflected in the long-term interest rate levels”. Article 4 of the Protocol on
the convergence criteria further stipulates that “the criterion on the
convergence of interest rates (...) shall mean that, observed over a period of
one year before the examination, a Member State has had an average nominal
long-term interest rate that does not exceed by more than two percentage points
that of, at most, the three best performing Member States in terms of price
stability. Interest rates shall be measured on the basis of long-term
government bonds or comparable securities, taking into account differences in
national definitions” (see Box 1.4).

In the 2012 Convergence Report, the
long-term interest rate of Ireland, one of the three best-performing Member
States in terms of price stability also at that time, was not included in the
calculation of the reference value for the long-term interest rate criterion
due to the severe distortions in its sovereign bond market ([15]). However, supported by the successful implementation of its
financial assistance programme, the long-term interest rate of Ireland has
converged significantly closer to that of other euro area Member States since
then and Ireland's bond market access improved considerably ([16]). This suggests that the long-term interest rate of Ireland became
an economically meaningful benchmark, which would not distort the reference
value any more.

For the assessment of the criterion on the
convergence of interest rates, yields on benchmark 10-year bonds have been
taken, using an average rate over the latest 12 months. The reference value is
calculated as the simple average of the average long-term interest rates of the
three best-performing Member States in terms of price stability plus 2
percentage points. In April 2013, the reference value, derived from the average
interest rate in Sweden (1.6%), Latvia (3.8%) and Ireland (5.1%), was 5.5%.

1.2.6.   Additional
factors

The Treaty in Article 140 also calls for an
examination of other factors relevant to economic integration and convergence.
These additional factors include financial and product market integration and
the development of the balance of payments. The examination of the development
of unit labour costs and other price indices, which is also prescribed by
Article 140 of the Treaty, is covered in the subchapter on price stability.

The assessment of additional factors is an
important indication of whether the integration of a Member State into the euro
area would proceed without difficulties. As regards the balance of payments,
the focus is on the situation and development of the external balance ([17]). Integration of product markets is assessed through trade, foreign
direct investment and a smooth functioning of the internal market. Finally,
progress in financial integration is examined, together with the impact of the
financial crisis, the main characteristics, structures and trends of the
financial sector and compliance with the acquis of the Union in this area.

Starting with the 2012 Convergence Report,
the convergence assessment is aligned with the broader "European
semester" approach which takes an integrated and upstream look at the economic
policy challenges facing the EMU in ensuring fiscal sustainability,
competitiveness, financial market stability and economic growth. The section on
additional factors makes reference to the surveillance of macroeconomic
imbalances under the Macro-economic Imbalance Procedure, which was adopted in
December 2011 as one of the key elements of the legislative package (the "Six-Pack")
to enhance the governance structures in EMU, and integrates its results into
the assessment.

2.1.      Legal
compatibility

2.1.1.   Introduction

The Bank of Latvia (Latvijas Banka) was
founded in 1922 and re-instated in 1991, under the Law on the Bank of Latvia
(hereinafter: BoL Law).

Following the assessment of the Convergence
Report from 2012, the Latvian Government, in cooperation with Latvijas Banka,
prepared amendments to the BoL Law, which the Latvian Parliament (Saeima)
adopted on 10 January 2013. The last amendment of the BoL Law prior to the
changes in 2013 dates back to 2009.

The Council of Latvijas Banka is the
decision making body of the Bank and consists of the Governor, the Deputy
Governor and six other Council members. The Governor is appointed by the Saeima
upon recommendation of at least ten of its members. The Deputy Governor and the
other members of the Council of Latvijas Banka are appointed by the Saeima upon
the proposal of the Governor. The Governor, the Deputy Governor and the other
members of the Council of Latvijas Banka hold office for six years.

2.1.2.   Objectives

The objectives of Latvijas Banka are
compatible with the TFEU.

An imperfection under the former BoL Law
(2009) regarding the objective of Latvijas Banka has been remedied. In line
with Article 127(1) of the TFEU, Article 3 of the new BoL Law now clearly
states that the primary objective of the Bank is to maintain price stability.

2.1.3.   Central
bank independence

No incompatibilities or imperfections with
the TFEU and the ECB/ESCB Statute exist in this respect given that the
incompatibilities and imperfections of the former BoL Law with regard to the
independence of the Central Bank as enshrined in the TFEU and the ESCB/ECB
Statute have been remedied.

A provision of the BoL Law (2009) under
which the Saeima by means of a resolution could liquidate Latvijas Banka and
thereby breach the financial and institutional independence of the Bank has
been repealed.

Articles 22 and 28 of the new BoL Law have
brought the rules on resignation, absence and dismissal of the Governor
including the right of judicial review of dismissal before the Court of Justice
of the EU in line with the provisions of the TFEU and the ECB/ESCB Statute on
the Central Bank independence.

Pursuant to the new Article 13 of the BoL
Law, the prohibition of Latvijas Banka to seek or take instructions from the
Government or any other institution explicitly includes also the prohibition to
seek or take instructions from Union institutions, bodies, offices or agencies
as referred to in Article 130 of the TFEU and Article 7 of the ESCB/EC Statute.

With regard to the financial independence
of Latvijas Banka, the new Article 181 of the BoL Law now provides
that parts of the profits and payments for the usage of state capital shall be
transferred to the state general budget only after accumulated losses in the
previous years, if any, have been covered.

2.1.4.   Prohibition
of monetary financing and privileged access

Following the changes introduced by the new
BoL Law there is no longer any incompatibility with regard to the prohibition
of monetary financing under Article 123 of the TFEU.

The new Article 36 of the BoL Law has
clarified the scope of the public sector entities falling within the ambit of
the prohibition under Article 123 TFEU. Now Article 36 of the BoL Law states
clearly that Latvijas Banka shall not be entitled to grant any type of credit
facilities and purchase debt instruments in accordance with Article 123 of the
TFEU and Article 21 of the ECB/ESCB Statute.

2.1.5.   Integration
in the ESCB

There are no incompatibilities or
imperfections as to the integration of the BoL into the ESCB.

Following the amendments to Articles 4, 5,
7, 9, 15, 26, 34 to 38 and 43 of the BoL Law, the incompatibilities and
imperfections described in the Convergence Report from 2012 with regard to the
ESCB/ECB tasks have been remedied.

2.1.6.   Assessment
of compatibility

The Law on the Bank of Latvia as amended is
fully compatible with Articles 130 and 131 of the TFEU.

2.2.      Price
stability

2.2.1.   Respect
of the reference value

The 12-month average inflation rate for
Latvia, which is used for the convergence assessment, was above the reference
value at the time of the last convergence assessment in 2012. Since then,
average annual inflation declined from above 4% to well below 2%. In April
2013, the reference value was 2.7%, calculated as the average of the 12-month
average inflation rates in Sweden, Latvia and Ireland plus 1.5 percentage
points. The average inflation rate in Latvia during the 12 months to April 2013
was 1.3%, i.e. 1.4 percentage points below the reference value. It is projected
to remain below the reference value in the months ahead.

2.2.2.   Recent
inflation developments

In previous years, Latvia's inflation rate
moved in quite a wide range mainly as a consequence of volatile commodity price
movements and a very intense business cycle. These factors were amplified by
the composition of the consumer basket, which includes a relatively high share
of food and energy products and significant taxation changes.

HICP inflation ([18]) peaked at over 17% in 2008, with price dynamics turning around
sharply after the intra-year collapse of demand. Significant nominal wage
adjustment and a correction in import prices led to almost a year of negative
headline inflation from October 2009. Inflation however rose from -2.8% in
April 2010 to 4.8% by May 2011, as the cycle turned and a new global commodity
price shock set in, exacerbated by the impact of a regional drought and the
effect of indirect tax increases. From that local peak, annual inflation fell
to -0.4% by April 2013, helped mainly by a continuing wage restraint in the
Latvian economy, a decreasing contribution from food and energy prices and the
cut of the standard VAT rate by 1 percentage point as of July 2012. Average
HICP inflation slowed from 4.2% in 2011 to 2.3% in 2012.

Core inflation (measured as HICP inflation
excluding energy and unprocessed food) has been well below headline inflation
in recent years, highlighting the strong effect that rising commodity prices
had on inflation. However, the gap closed in early 2013, as energy inflation fell
below zero and core inflation stood at -0.4% in April 2013. In mid-2011,
processed food prices temporarily lifted core inflation to over 3%, but it has
declined since then as underlying price and cost pressures from the real
economy remained subdued. In contrast to Latvia's EU-neighbours, non-energy
industrial goods prices continued to fall in April 2013, which may partly be
explained by increasing competition on the Latvian retail market. Services
prices started to edge up from 2010, but this trend reversed in July 2012
despite the continuing strong recovery of domestic demand, due inter alia to
the impact of taxes, energy prices and still moderate wage growth. In addition,
the price of telecommunication services declined very significantly in
late-2012, contributing to an overall services price inflation of -0.4% in
April 2013. Producer price inflation declined in 2012 and remained low in early
2013, indicating that there is no short-term cost pressure from the domestic
industry.

2.2.3.   Underlying
factors and sustainability of inflation

Macroeconomic policy-mix and cyclical stance

Real GDP growth was above 10% on average
between 2005 and 2007, but fell to around -7% in 2008-2010. As credit flows
abruptly reversed, Latvia required an EU/IMF led international financial
assistance programme and ambitious fiscal consolidation began. The reallocation
of resources to the tradable sector created the basis for an export-driven
recovery. Domestic demand revived only slowly under the burden of financial
deleveraging and fiscal consolidation, but from 2011 it was supported by
favourable labour market developments. The positive trends continued in 2012
and while growth shifted more towards domestic demand, it remained broadly
balanced. Real GDP growth reached 5.5% in 2011 and 5.6% in 2012, helped also by
an exceptionally good harvest. Growth is projected by the Commission services'
2013 Spring Forecast to slow to 3.8% in 2013, and to recover to 4.1% in 2014
with the expected improvement in the external environment. Commission services
estimate that the Latvian economy will operate slightly above its potential
output in 2013-2014.

The fiscal stance, as measured by changes
in the structural balance, deteriorated until 2008, as pro-cyclical fiscal
policy contributed to the boom and failed to prepare for the crisis. Fiscal
policy turned restrictive in 2009, when a huge adjustment was imposed by the
crisis and implemented in the framework of the EU-IMF assistance programme. As
a result of the large fiscal adjustment, the structural deficit improved to
-0.3% by 2012. According to the Commission services' Spring 2013 Forecast, the
structural balance is projected to deteriorate to -1.4% in 2013 and to -1.5% in
2014 under the assumption of unchanged policy, including due to the increase in
state contributions to the fully funded private pension scheme.

The narrow fluctuation band to the euro,
the high degree of euroisation and integration with the European financial
system constrain the scope and effectiveness of domestic monetary policy.
Nevertheless, the Bank of Latvia continued to loosen monetary conditions with
the aim to stimulate the channelling of abundant lats liquidity to economic
development. In 2012, the Bank of Latvia cut its refinancing rate in two steps
from 3.5% to 2.5% and lowered its marginal lending facility rates in three steps.
The reserve requirement was set at 3% for bank liabilities above two years and
5% for all other liabilities included in the reserve base from November 2008
until January 2012, when both were lowered by 1 percentage point.  By September
2012, the Bank of Latvia reduced the interest rate on its 7-day deposit
facility to 0.075% and on its overnight deposit facility to 0.05%. On the
macro-level, the deleveraging of the Latvian economy appears to have abated by
early 2013, as new lending nearly counterbalanced the amortisation of the
outstanding loan stock, after correction for bank insolvencies (Parex,
Krajbanka) and write-offs.

Wages and labour costs

A considerable wage adjustment took place
in Latvia over 2009 and 2010, with compensation per employee falling by a
cumulative 19% in two years, supported by policies implemented under the EU-IMF
assistance programme. Employment declined at a high rate, especially in the
private sector, as jobs were shed heavily in construction and manufacturing.
The unemployment rate started to decline from around 20% in early 2010, due
mainly to employment growth, and fell below 15% by 2012, while the
participation rate increased significantly. The economic recovery led to a
moderate increase in private sector wages in 2011 and 2012 amid some tightening
of the labour market. Nominal unit labour costs (ULC) rebounded somewhat in
2011, but the pace of ULC growth slowed in 2012 to a sustainable level. Labour
productivity growth is expected to be low over the next two years, partly
reflecting more cautious business investment ([19]).

The Latvian labour market demonstrated
substantial flexibility during the crisis, underpinned by a decentralised
wage-setting system. That said, large public sector wage cuts indirectly
supported nominal wage reduction in the private sector in 2009 and 2010. Public
sector wages picked up somewhat earlier in 2011 and increased somewhat faster
than those of the private sector in 2012, partly reflecting a correction of
earlier excessive cuts in some fields. In 2013-2014, wages are projected by the
Commission services' 2013 Spring Forecast to grow broadly in line with
productivity, although the labour market is tightening and structural problems,
in particular regional differences and skills mismatches on specific labour
market segments could lead to some pressures, if not addressed.

External factors

Over the past three years, consumer prices
were largely driven by global commodity prices and a regional food price shock
in 2010. Latvia's small and open economy is in general highly sensitive to
external impulses, but the composition of the consumer basket and the
relatively high share of material inputs in production costs also aggravate the
impact of volatile commodity prices. After supporting disinflation in 2009,
import prices, measured by the imports of goods deflator in the national
accounts, rose sharply in the second half of 2010 and early 2011, reflecting
increasing world energy and food prices. The subsequent broad stabilisation in
the Brent oil price (in euro terms), coupled with a good regional harvest in
2011, led to a moderation in the growth of import prices. The rate of import
price growth fell further in 2012, despite a temporary spike in oil prices (in
euro terms) around March of that year. The contribution of energy prices to
HICP inflation remained high in 2012, with 1.4 percentage points on average.

The nominal effective exchange rate of the
lats, measured against a group of 35 trading partners, remained broadly stable
since the beginning of 2010. Between late 2008 and early 2010, there was a
period when the nominal effective exchange rate was somewhat stronger, as the
currencies of many of Latvia's trading partners depreciated against the euro
during this phase of the financial crisis. From May 2010, the currencies of
some of Latvia's major trading partners in Central and Eastern Europe depreciated
against the euro usually when the euro depreciated to the dollar, which
resulted in a broadly stable lats nominal effective exchange rate. Towards the
end of 2011, the lats appreciated by 2%, i.e. from the weak to the strong side
of its fluctuation band to the euro, which resulted in a temporary nominal
effective exchange rate appreciation in late 2011. However, these gains were
eroded in 2012, as the euro weakened versus currencies of other trading
partners.

Administered prices and taxes

Changes in administered prices and indirect
taxes significantly influenced inflation over the past three years, although
the extent of the contribution fluctuated both in size and direction ([20]). Administered prices, which account for about 14% of the HICP
basket, to a large extent reflected the impact of volatile global energy
prices, transmitting their generally rising price trend. Indirect tax changes
raised inflation in 2010-2011, as the government relied partly on revenue-side
measures in stabilising public finances. On the other hand, the July 2012 VAT
rate reduction reinforced the strong disinflationary trend that was already
evident since mid-2011.

The annual average increase of
administrative prices fell from 19% in 2009 to 2.3% in 2010, before picking up
again to 7.3% in 2011 and 7.4% in 2012, largely reflecting the delayed impact
of changes in the international price of oil. In particular, tariffs for heat
energy rose significantly in the first half of 2010 and in January 2012, those
of natural gas in the summer of 2010 and 2011 and those of electricity in the
first half of 2011. Administered price growth demonstrated a declining profile
in 2012 and early 2013, dropping from 10.7% in March 2012 to -0.7% by April
2013. Rather unusually, administered prices fell (month-on-month) in January
and February 2013. This was due mainly to a drop in the wholesale natural gas
price of Latvia with automatic effects on heating prices

The indirect tax changes over 2009-2011
were motivated mainly by the need for rapid fiscal consolidation and a strategy
to rebalance taxation across bases, as the process of accession-related excise
tax harmonisation with EU legal requirements has been completed. In January
2009, the standard VAT rate was increased by 3 percentage points and the reduced
VAT rate by 5 percentage points. In January 2011, there was a further VAT
increase (of 1 percentage point for the standard rate and 2 percentage points
for the reduced rate) and a further broadening of the tax base under the
standard VAT rate. In addition, excise taxes on alcohol, tobacco and fuel were
raised in mid-2011. In July 2012, the standard VAT rate was reduced by 1
percentage point to 21%, based on an unexpected proposal by the Ministry of
Finance in late-April 2012. Annual constant-tax inflation (HICP-CT) was on
average 2.4% in 2012, i.e. about 0.1 percentage points above headline inflation
([21]). Assuming full and immediate pass-through ([22]), the average impact of the VAT reduction during the reference
period is estimated at around 0.5 percentage point. Adding this to the annual
average inflation of Latvia during the reference period would produce a figure
of 1.8% that is still below the reference value.

Inflation outlook

HICP inflation is expected to pick up from
its current very low level in the context of strengthening domestic demand and
some one-off factors. The crisis-related freeze of pension indexation is to end
in 2014 and the PIT rate is scheduled to be reduced further by 2 percentage
points in 2014 and 2015. The forthcoming liberalisation of the retail
electricity market is expected to result in a one-off electricity price
increase. The excise tax on tobacco is to rise in January 2014. On the other
hand, economic activity will remain constrained by a weak external environment,
while tight credit conditions and a prudent fiscal policy are expected to
restrain demand pressures on prices. The available data indicate that despite
an increase in early 2013, inflation expectations remained relatively
well-anchored, in the context of declining headline inflation and slowing
economic growth. The Commission services' Spring 2013 Forecast projects the
average HICP inflation rate to fall to 1.4% in 2013 and to 2.1% in 2014,
compared to 2.3% in 2012.

Risks to the inflation outlook are broadly
balanced. Upside risks are mainly related to a possible rise of commodity
prices, to which Latvia is particularly exposed, and to the difficulty of
controlling wage growth with the tightening of the labour market which will
gradually strengthen the bargaining position of employees. Stronger output
growth could lead to more upward pressure on wages. Downside risks to the
inflation outlook could emerge with a weaker-than-expected growth in Latvia or
abroad. Downward effects may also emerge from on-going energy efficiency
projects in district heating networks that are expected to reduce sales prices.
Uncertainty around the short-term inflation forecast is heightened by the
rather unclear price impact of the upcoming retail electricity market
liberalisation; however, a significant upward effect is already factored in the
forecast.

2.3.      Public
finances

2.3.1.   The
excessive deficit procedure for Latvia

On 7 July 2009, based on a recommendation
by the Commission, the Council decided in accordance with Article 104(6) TEC
that an excessive deficit existed in Latvia and addressed recommendations to
Latvia in accordance with Article 104(7) TEC with a view to bringing an end to
the situation of an excessive government deficit. The Council recommended that
Latvia puts an end to the excessive deficit situation as rapidly as possible
and at the latest by 2012, by ensuring an average annual fiscal effort of at
least 23⁄4% of GDP over the period 2010-2012. In its recommendation, the Council
established a deadline of 7 January 2010 for the Latvian government to take
effective action. On 16 February 2010, the Council concluded that Latvia had
taken action representing adequate progress towards the correction of the
excessive deficit within the time limits set by the Council and that no further
action under the excessive deficit procedure was necessary, thereby putting the
procedure in abeyance ([23]).

According to the data provided by the
Commission (Eurostat), Latvia's general government deficit was 1.2% of GDP in
2012, while the general government debt stood at 40.7% of GDP at the end of
2012. In view of this data and taking into account the Commission's spring 2013
forecast, the Commission considers that the excessive deficit has been
corrected with a credible and sustainable reduction of the deficit below 3% of
GDP. The Commission is therefore recommending to the Council to abrogate the
decision on the existence of an excessive deficit in Latvia.

2.3.2.   Recent
fiscal developments

In 2009-2011 Latvia benefited from a
medium-term financial assistance programme with the EU, which was provided in
conjunction with an IMF Stand-by agreement and was also financed by the World
Bank, the European Bank for Reconstruction and Development, with an involvement
of several EU countries and Norway. This assistance was subject to a number of
policy conditions including fiscal consolidation and structural reforms which
were consistent with the Council recommendations under the EDP. The
comprehensive fiscal consolidation implemented in the course of these years put
Latvia's public finances on a sustainable path, with the structural deficit
declining from its peak of 51⁄2% of GDP in 2008 to 11⁄2% in 2011, while the nominal
balance improved from a deficit of 9.8% of GDP in 2009 to a deficit of 3.6% in
2011. Main consolidation measures implemented during these years included
increases in several tax rates (notably the VAT rate was increased from 18% to
22%) and a wide-ranging reduction in government expenditure, as wages and
employment in the public sector were adjusted downwards and the structure of
public spending improved in several areas. In addition, several social benefits
were partly reduced and partly temporarily capped, and some indexation
mechanisms were suspended. The improvement in the underlying government
budgetary position, however, remained partly obscured by revenue shortfalls in
2009-2011.

Following the finalisation of the
international financial assistance programme, the public finances continued
their improvement trend in 2012. Reflecting past consolidation efforts and
supported by the robust economic recovery, the nominal general government
deficit declined to 1.2% of GDP in that year. At the same time, the structural
balance improved by 11⁄4 pp. and reached a structural deficit of 1⁄4% of GDP, which
is better than Latvia's medium-term objective of ‑0.5% of GDP set in the
2012 and 2013 Convergence Programmes. This improvement in the structural
budgetary position reflects consolidation measures contained in the 2012 budget
law, although the improvement was partly scaled back through the mid-year
supplementary budget and the VAT rate reduction by 1 pp. to 21% from July 2012.
The decline of both the nominal and structural deficit was also supported by a
notable improvement in tax efficiency, helped by considerable policy efforts
that have been put in place in recent years in this area.

The debt-to-GDP ratio increased steeply in
2009 and 2010, reflecting borrowing under the international financial
assistance programme, but stabilised in 2011 and declined in 2012 to a level of
40.7% of GDP. Since June 2011, Latvia has regained full access to financial
markets and is currently enjoying very favourable financing conditions. This allowed
an early repayment of Latvia's outstanding obligations towards the IMF in late
2012, replacing this part of official debt by market financing.

2.3.3.   Outlook
for public finances

The budget for 2013 was adopted by
Parliament on 15 November 2012. At the time of its adoption, the budget law
targeted a general government deficit of 1.4% of GDP; however, due to the
better-than-expected outcome of 2012 it is likely that this target will be
over-achieved in the absence of new policy measures. On the revenue side, the
budget reflects (i) the first step of the three-year strategy to lower the
personal income tax rate from 25% to 20%, with the rate being lowered to 24%
from January 2013; (ii) the impact of the 1 pp. VAT rate reduction from July
2012 and (iii) the lower share of social security contributions which the
government retains, whereas the share of contributions to the second pillar
pension scheme correspondingly increases. On the expenditure side, the increase
in the public sector wage bill is limited and targeted, while pension
indexation remains frozen and some social benefits are capped, implying a
diminishing ratio of government expenditure to GDP. Overall, the general
government deficit is expected to remain at the level of 1.2% of GDP in 2013.
The structural deficit is expected to increase by some 1 pp. of GDP, including
on account of the increasing cost of the systemic pension reform described
above.

Under the no-policy change assumption, the
deficit is expected to slightly improve in nominal terms to 0.9% of GDP in
2014, with the structural deficit remaining broadly unchanged. In particular,
the further decrease in the personal income tax rate offsets the positive
impact of economic growth on tax revenue, while some restrictions on the
increase of social benefits are maintained and the statutory retirement age is
gradually increased, implying a further decline in the share of public
expenditure in GDP. The general government debt-to-GDP ratio is expected to
rise again in 2013, reaching 43.2% as the authorities accumulate assets for
future repayments of debt, and to decline to around 40% of GDP by the end of
2014 as these repayments take effect.

A further planned personal income tax rate
cut in 2015 and restoring the long-term level of state contributions to private
pension funds by 2016 will affect the public finances in coming years, whereas
potential gains in terms of tax efficiency also remain ample. The possibility
of further substantial tax efficiency gains, in response to recent measures to
reduce the share of the informal economy, represents the main upside risk to
the medium-term budgetary outlook. Some of the social benefit restraints
implemented during the years of fiscal adjustment are yet to be lifted; at the
same time the on-going reforms in the area of public expenditure – including
the gradual increase in statutory pension age – could provide an offsetting
effect. At the same time, some of the fiscal risks might materialise, in
particular those that stem from publicly owned companies, of which some are in
on-going restructuring processes. Moreover, the state could face assumption of
debt it has guaranteed in relation to an industrial company in difficulties,
amounting up to 0.3 pp. of GDP if the debt is assumed in full, and possibly
other costs related to this company in 2013 or 2014. Nevertheless, overall
risks to the medium-term outlook are considered to be balanced.

2.4.      EXCHANGE
RATE STABILITY

The Latvian lats entered ERM II on 2 May
2005, i.e. it has spent more than eight years in ERM II at the time of the
adoption of this report. The central rate was set at the parity at which the
lats had been re-pegged from the SDR to the euro on 1 January 2005 (LVL
0.702804 per EUR 1), with a standard fluctuation band of ±15%. Upon ERM II
entry, the authorities unilaterally committed to maintain a tighter fluctuation
margin of ±1% around the central rate. During the two years preceding this
assessment, the official EUR/LVL exchange rate did not deviate from its central
rate by more than ±1%, in line with the Latvian authorities' unilateral
commitment. The evolution of additional indicators also suggest that the
EUR/LVL exchange rate was not subject to severe tensions over the past two
years, though Latvia's international financial assistance programme was in
place until January 2012.

In 2007-2008, the nominal exchange rate of
the lats was relatively volatile within the narrow fluctuation band, influenced
by currency devaluation rumours, in the context of large macro-imbalances.
Initial failure to stabilise the situation in the banking sector in late 2008
led to capital outflows that forced the Bank of Latvia to intervene heavily to
protect the value of the lats. The December 2008 agreement on an international
financial assistance package helped to calm markets. However, market stress
returned in spring 2009, as it became evident that the fiscal situation was
worse than expected and political uncertainty hindered an appropriate policy
response. Market tensions peaked in June 2009, when speculation about an
imminent lats devaluation drove short-term interest rates to over 30%. More
than a third of Bank of Latvia's foreign assets was sold during the financial
turmoil between February and end-June to sustain the peg. Following the Latvian
authorities' supplementary budget in mid-June and the disbursement of the EU's
large second loan tranche in July, financial market conditions rapidly
improved.

The exchange rate peg did not come under
significant pressure over the past two years. The lats remained within its
fluctuation band during the assessment period and the Bank of Latvia had to
intervene mostly on the strong side of the narrow band. From the beginning of
2011, the Treasury changed its financial assistance programme-related practice
of converting foreign currency with the Bank of Latvia and started to buy lats
on the market (as it had done before mid-2009). The Treasury regularly
pre-announced these transactions to make the exchange rate impact predictable
for market participants. Nevertheless, these transactions may have served as
intra-band interventions by selling foreign exchange from official reserves in
exchange for lats. In early and late 2011, large (relative to the size of the
Latvian market) Treasury transactions drove the lats exchange rate to the
strong side of the fluctuation band. The lats stayed on the strong side in
2012, but it depreciated towards the middle of the band in late 2012 and early
2013, against the background of lower foreign currency supply by the Treasury
and market anticipation regarding euro adoption.

The international reserve position of the
central bank has been quite strong as it covered around 150% of base money and
around 60% of M3 in early 2013. The credibility of the peg gradually improved
from mid-2009, as indicated by a reversal of deposit euroisation and the return
of non-resident deposits to the Latvian banking system. The share of
euro-denominated deposits in total resident deposits started to increase in
2012, presumably in expectation of Latvia's future euro adoption. The last
disbursements from the IMF and the EU under the programme took place in August
2010 and October 2010, respectively. After that, Latvia opted not to ask for
further funds committed by the EU and the IMF under the international Balance
of Payments assistance ([24]). In June 2011, Latvia successfully returned to the international
bond market by issuing a 10-year USD 500 million bond, with the achieved yield
of 5.491% signalling good market access. That was followed by a 5-year USD 1
billion issuance in February 2012 with yield of 5.375%. In December 2012,
Latvia issued a 7-year USD 1.25 billion bond at a historical low yield of 2.89%
and used part of the proceeds to repay its remaining programme-related
liability to the IMF.

Financial market conditions in Latvia
improved significantly since 2010, also including strengthened supervision (see
section 2.6.3), demonstrating resilience to political uncertainty ahead of the
October 2010 and September 2011 parliamentary elections. Major credit rating
agencies assessed the results of Latvia's economic stabilisation programme
positively and raised their ratings for Latvia over the past two years([25]).

Over the past two years, the policy rates
of the Bank of Latvia were broadly aligned with those of the ECB, with the
overnight deposit rate at 0.05% since September 2012. Abundant lats liquidity
that was created by the off-market conversion of international programme funds
before 2011 and got locked by the limits on banks' open foreign currency
position kept interbank rates low, at times even below those of the euro area,
although the interbank market remained illiquid beyond the very short term.
There was some limited tension in the Latvian money market during the Krajbanka
insolvency case in late 2011, but the situation calmed down by early 2012.
Since then, the 3-months RIGIBOR moved broadly in parallel with the 3-months
EURIBOR. As an increasing tendency since mid-2012, some banks keep overnight
euro deposits in the Bank of Latvia (at zero interest).

2.5.      Long-term
interest rates

For Latvia, the development of long-term
interest rates over the current reference period is assessed on the basis of
secondary market yields on a single benchmark government bond with a residual
maturity of close to, but below 10 years.

The Latvian 12-month moving average
long-term interest rate relevant for the assessment of the Treaty criterion was
at the reference value at the 2012 convergence assessment. It declined further
from 5.8% then to well below 5% by end-2012. In April 2013, the last month for
which data are available, the reference value, given by the average of
long-term interest rates in Sweden, Latvia and Ireland plus 2 percentage
points, stood at 5.5%. In that month, the 12-month moving average of the yield
on the Latvian benchmark bond stood at 3.8%, i.e. below the reference value.

Long-term interest rate spreads vis-à-vis
the euro area were gradually rising from their lows in 2006 until late 2008,
when they spiked in reaction to fears of a lats devaluation and Latvia's
deteriorating fiscal outlook, peaking in late 2009. Spreads compressed in 2010,
as confidence in the currency peg was regained, fiscal consolidation yielded
results and conversion of assistance programme funds created ample lats
liquidity. Against this background, the Treasury returned to the 10-year
domestic bond market with several smaller issues in the first half of 2011,
thereby extending the maturity profile of lats-denominated government papers. The
favourable market trend broke in July 2011, as international financial markets
came under renewed pressure and the issuance of 10-year bonds was temporarily
suspended. After some pausing in 2011, the spread-compression continued in
2012, as market confidence in Latvia improved further. In 2012, the Treasury
launched a new series of benchmark 10-year bonds, but issued only a relatively
limited amount, benefitting from its favourable liquidity position, due partly
to its successful dollar issuances. The 10-year yields fell
rapidly in 2012, both on the primary and on the secondary market. Spreads against the German benchmark bond stood around 200 basis
points in April 2013 ([26]).

2.6.      Additional
factors

The Treaty (Article 140 TFEU) calls for an
examination of other factors relevant to economic integration and convergence
to be taken into account in the assessment. These additional factors –
including balance of payments developments, product and financial market
integration – are important indicators that the integration of a Member State
into the euro area would proceed without difficulties.

2.6.1.   Developments
of the balance of payments

The external balance (i.e. the combined
current and capital account) moved from a very large deficit in the boom period
before mid-2008 to a surplus of about 11% in 2009. As the economic recovery
gained speed, the surplus in the external balance contracted to about 1% in
2012. The merchandise trade deficit declined substantially since 2008 while the
surplus in trade with services kept improving. Nevertheless, the overall
balance of trade with goods and services posted a deficit of about 3% of GDP in
2012 which is a substantial contraction from the record-high deficit of about
21% of GDP in 2006-2007. The income account swung into surplus in 2009,
reflecting the huge loan loss provisions made by foreign-owned banks and it
returned to a deficit in 2011-2012 when most of the banks regained
profitability. Current transfers and the capital account were consistently
posting surpluses in the past years on the basis of net inflows from EU funds.

According to the Commission services' 2013
Spring Forecast, the external balance is projected to remain in a small surplus
in 2013 and to decline towards balance in 2014 as domestic demand, especially
for investment goods, is set to rise at strong pace.

The large savings-investment gap during the
boom years was closed abruptly in 2009, with the sudden reversal of capital
flows during the international financial crisis. Gross savings peaked in 2009,
amid high uncertainty regarding the future prospects for the economy. In
2011-2012, investments exceeded savings by a small margin reflecting negative
saving rates in the household sector. In contrast, both the government and the
corporate sector reported positive saving rates. Following the steep fall in
2008- 2009, albeit from very high level, investment activity rebounded
substantially in 2011-2012 but remained below the pre-crisis level.

External cost competitiveness has improved
markedly since 2008, as labour cost has dropped substantially and consequently
labour productivity has increased. The major improvement took place in 2009-2010
when the real effective exchange rate depreciated substantially, deflated by
both HICP and ULC. The indicator appreciated somewhat in 2011 as the abrupt
wage correction from the previous two years was reversed but the depreciation
resumed again in 2012 when economic growth outpaced labour costs ([27]). The overall real exchange rate correction is even larger when the
ULC of the manufacturing sector is used as a deflator. Latvia’s export market
shares in both world and EU trade increased markedly in 2010-2012 paced mainly
by large market gains in merchandise trade. The growth in export market share
was also supported by non-price competitiveness improvements, such as quality
upgrades, product and market differentiation ([28]).

The balance of payments assistance granted
to Latvia under the EU-IMF programme of late 2008 was successfully concluded by
early 2012. Latvia borrowed altogether about EUR 4.5 billion out of the total
EUR 7.5 billion available under the programme. Also with a view to its regained
market access, Latvia has not requested a follow-up programme. Moreover, by the
end of 2012 Latvia has repaid all liabilities (EUR 1.1 billion) to the IMF,
with nearly 60% of them being serviced ahead of schedule.

The financial account (without reserves)
recorded net outflows in the period of 2008-2011 amid on-going deleveraging in
the banking sector and substantial decline in real estate and portfolio equity
investments. However, the financial account moved to a positive territory in
2012 due mainly to the government bond issues partly aimed at accumulating cash
reserves for financing large repayments to the EU due in 2014-2015.

Non-resident banking, in particular the
stock of non-resident deposits, recovered strongly after the retreat in 2009.
However, most of the related inflow was offset by investments of non-resident
banks in foreign short-term securities so that the overall net contribution of
the sector to the financial account and foreign reserves was limited.

The net FDI balance has improved
considerably after the collapse in 2009 and peaked at 4.9% of GDP in 2011,
helped by better financial results in the banking sector. However, net FDI
subsided to 2.8% of GDP in 2012 as the external environment deteriorated. Gross
external debt to GDP remained on a steady downward path reaching 136% of GDP at
the end of 2012 as compared to 165% at the end of 2010, supported by strong GDP
growth and by further repayment of inter-company bank funding. Net external
debt also fell substantially to 38% of GDP at the end of 2012 from 54% at the
end of 2010. The improvement in the net international investment position was
less pronounced and its negative net position remained substantial. However,
about 50% of the net international investment position is generated by its FDI
component, which significantly offsets external liquidity and solvency risks.

2.6.2.   Product
market integration

Latvia is well integrated into the EU
economy through trade and investment linkages. The country is a small open
economy with strong gains in export markets and increasing trade openness since
its EU accession (except for a set-back during the crisis of 2008-2009).
However the share of exports of goods and services to GDP is still lower than
for the Baltic neighbours. In 2009, the global crisis resulted in a temporary
contraction of trade openness, as external demand faltered and financial flows
reversed. Trade integration with the EU is progressing at a fast pace but
exports to Russia, including tourists services, are also expanding rapidly in
the past years. The main trading partners within EU 27 were Lithuania, Estonia
and Germany, while Russia remained the main trading partner outside EU 27. The
geographical differentiation of Latvia's exports is also improving as exports
to fast growing Asian economies have surged recently.

Latvia still has a predominant
specialisation in medium-to-low technology products, although there are
developments pointing to an improvement of the trade structure toward
medium-to-high technology products. The shares of exports in machinery,
electrical, optical and transport equipment have increased recently, showing
favourable structural shifts towards higher value-added production. However,
intermediate goods and raw materials retain high importance in the country's
export portfolio while the overall weight of export products with high
technology and innovation costs remains relatively low. Nevertheless, trade
data show that export quality, including product differentiation, market
positioning and other sales factors, is steadily improving ([29]).

After its accession to the EU in 2004,
Latvia has witnessed a substantial inflow of foreign investments driven by
convergence prospects, privatisation deals, and large inflows to the real
estate market. In the boom years prior to 2008, a large share of the
investments has been directed to the real estate market and has partly
contributed to the overheating of the economy. However, the structure of new
foreign investments has changed recently and it is now skewed towards the
tradable sector and contributes in a more sustainable way to the country's
export-oriented growth model. The FDI stock at the end of 2012 was 45% of GDP,
lower than the EU average of 60% (47% when Luxembourg is excluded). FDI inflows
mainly originate in the EU, with Sweden being by far the largest investor with
a share of 24% of the FDI stock at end-2012. The overwhelming majority of the
outstanding FDI stock was channelled into the service sector, while the share
of manufacturing was only around 12%. The main competitive advantages in
attracting FDI inflows in the medium term include lower labour cost vis-à-vis
the EU average, relatively low income taxes and a flexible labour market.

Following the steep house price inflation
in the boom years, the real estate market experienced a radical downward
correction in 2009-2010. The house price index dropped by 37.3% in 2009 and 11%
in 2010 and recovered only partially by 9.9% in 2011 and 3.8% in 2012. A more
substantial recovery is reported on the market for new dwellings while the
existing housing stock witnessed only a very modest rebound. Residential
construction was very responsive to house price developments, and increased
from about 1.4% of GDP in 2003 to 4.8% of GDP in 2007, before adjusting rapidly
in the downswing phase to 2% of GDP in 2010. A significant shift of resources
from construction and real estate to manufacturing and transport sectors took
place in 2009-2010. While the construction sector started growing again in
2011-2012, its share in GDP is not likely to reach the pre-crisis peak anytime
soon.

According to the latest edition of the
Internal Market Scoreboard, Latvia is one of the best performing countries in
terms of transposition deficit, registering a 0.4% rate in November 2012
(compared to an EU average of 0.6%). However, a small increase in the backlog
has been registered with respect to May 2012, when the transposition deficit
amounted to 0.1% (best performance in that edition). The share of public
procurement tenders announced in the Official Journal appears significantly
higher than the EU average (67.3% over 2006-11 compared with an EU average of
17.8% over the same period) ([30]).

Concerning the business environment, Latvia
has implemented a series of ambitious reforms in recent years, aimed at
reducing start-up costs, simplifying procedures for property registration,
construction permits and tax collection, and streamlining insolvency
procedures, also by introducing out-of-court settlement of insolvencies. As a
result of these reform efforts, Latvia has significantly closed the gap with
respect to the best regulation practices. The 2012 competitiveness monitoring
report published by the Commission's Directorate General for Enterprise and
Industry ranks Latvia above the EU average in terms of business environment.
Good performance is reported in the areas of market entries and exits, SMEs
lending, and timeliness of government payments. At the same time Latvia is
still lagging behind in terms of enterprise survival rate and to a lesser
extent in terms of time required for starting business and early stage
financing. The report also concludes that Latvia is improving its industrial
competitiveness, especially in terms of specialisation, although its innovation
performance remains weak. In the World Bank's 2013 report on ease of doing
business, covering performance in 2012, Latvia is relatively well positioned at
the 25th place in the ranking, out of 185 countries, and there are only four EA
members that are better ranked than Latvia. In the 2012-2013 Global
Competitiveness Index of the World Economic Forum, Latvia is ranked at the 55th
place out of 144 countries, moving up by 9 positions in comparison with the
previous edition of the ranking. The country is lagging behind 13 euro area
members in the ranking.

2.6.3.   Financial
market integration

Latvia's financial sector is well
integrated into the EU financial system, particularly through its strong
linkages to Nordic financial groups. The relative importance of foreign-owned
credit institutions, as measured by their share in the banking sector's total
assets, has increased considerably since EU accession. Despite the increase of
financial deepening, the relative size of Latvia's financial system is still
small compared to the euro area average. Concentration in the banking sector,
as measured by the market share of the five largest institutions, is above the
euro area average.

Financial intermediation in Latvia is
performed predominantly by commercial banks. Their buoyant expansion resulted
in a classical boom-bust cycle that ended in 2008. Banks were heavily affected
by significant loan losses and stretched liquidity. However, the sector
successfully managed its adaptation to the new economic conditions and has
proved resilient to financial stability shocks. Foreign-owned institutions were
supported by their parents, while domestic banks ensured sufficient
capitalisation on their own.

Overall, the sector's strategy in dealing
with the crisis has been to deleverage the balance sheets in order to keep
liquidity high and to strengthen the quality of assets. From a macro-financial
stability perspective, the strategy has been successful. The aggregate core
Tier 1 ratio has reached 15.3% in January 2013, while the ratio of
non-performing loans has been reduced to 11.1% from its peak level of 19.4% in
September 2010. The sector's liquidity has been strengthened significantly,
with a liquidity ratio of well above 30%. The consolidation of the banking
sector in Latvia has implied, nevertheless, a contraction of bank credit by around
40 percentage points of GDP since its peak. However, the deleveraging is
related to the necessary economic restructuring in the bust phase of the cycle
and does not affect the flow of new credit to viable businesses.

The financial crisis also affected the
business landscape in the banking sector, leading to the nationalisation of
Parex Banka, the second biggest bank in the country at that time. Confidence
gradually returned, in particular after mid-2009, supported by large
disbursements of international financial assistance, fiscal consolidation and
structural reforms. Latvia achieved progress in dealing with Parex Banka by
splitting it into a viable (Citadele) and a resolution bank and initiated the
privatisation of Citadele along with the commercial assets of Mortgage and Land
Bank. The Latvian financial supervisor decided in November 2011 to limit the
operations and subsequently to initiate bankruptcy proceedings against
Krajbanka, a subsidiary of Snoras Bank, after the latter was nationalised by
the Lithuanian government and an insolvency procedure was launched amid
allegations of fraud. Krajbanka had a market share of 3.4% and its depositors
were compensated from the deposit guarantee fund for amounts of up to EUR
100,000. The sector's stability has been enhanced after these successfully
conducted restructuring and resolution experiences.

Latvia has a long tradition and several
competitive advantages in servicing non-resident banking clients, mainly
corporates from CIS countries. While there was a drop in this business during
the financial crisis aggravating Latvia's external funding problem, it has
fully recovered by 2012 and around half of the banking system's total deposits
stems from non-residents. Although this part of banking is a characteristic
element of the Latvian financial market, neither the share of total banking
assets relative to GDP (147% in Latvia versus 367% in the EU on average in
2011) nor the share of non-resident banking within these assets is
extraordinarily high when compared to some other EU Member States.

Although there are several small banks
which deal with non-residents, the activity is concentrated mainly in three
banks. Some recent changes in the administrative environment (selling of
residence permits, double-taxation agreement with Russia from 2013, new law on
holding companies) may favour the further development of this business. To
cater for their specific risks, banks with non-resident business keep a high
share of liquid assets and are subject to additional capital requirements (see
below).

The non-banking part of the Latvian
financial sector remains small compared to the euro area average and has grown
only slowly. The dynamic increase in second pillar pension savings ended in
2009 with the partial redirection of social security contributions to the
budget. The accumulated second-pillar pension savings amounted to around 6.2%
of GDP at the end of 2011. Voluntary private pension fund savings amounted to
less than 1% of GDP at the end of 2012. Assets managed by life and non-life
insurance companies, respectively at around 0.6% and about 2% of GDP, are still
low, even in comparison to other new Member States.

The Riga stock exchange belongs to the
NASDAQ OMX group and uses a single trading platform together with other
exchanges in the Baltic-Nordic region. The stock market plays a marginal role
in the financing of the Latvian economy. The debt securities market remains
dominated by government issuances and represents only a limited source of
funding for private companies.

Regulation and supervision of all financial
institutions is carried out by the Financial and Capital Market Commission
(FCMC). In the context of the international financial assistance programme,
financial supervision has been strengthened considerably. Cooperation with home
country supervisors has been further enhanced.

The supervision of the non-resident banking
business poses additional challenges, inter alia, due to the cross-border
nature of transactions. The FCMC implemented several measures to reduce the
risks of this sector: on top of the capital add-ons (beyond Pillar 1), it
recently introduced additional liquidity requirements. The FCMC also monitors
these banks more actively (including their internal procedures, asset quality
and correspondent accounts).

Latvia achieved full compliance with the
transposition of the Financial Sector Action Plan (FSAP) directives and is on
the way of completing transposition of the post-FSAP directives.

Latvia's legislation largely complies with
international standards in the field of anti-money laundering (AML). However, a
determined and effective implementation of AML rules will remain key. The
Financial Intelligence Unit (FIU) under the supervision of the General
Prosecutor and the Financial and Capital Market Commission (FCMC) are the main
institutions set to fight money laundering. In July 2012, the MONEYVAL
Committee of the Council of Europe published an evaluation report ([31]), which concludes that Latvia's legislation and institutional setup
are largely compliant with the international AML standards. In reference to 40
assessment benchmarks, the country is ranked from partly compliant to compliant
on each of them. The report also points to several loopholes in the overall
money laundering control system, in particular implementation and statistical
reporting. In response, the Council of Ministers approved on 28 March 2013 an
Action Plan for implementing the recommendations of the MONEYVAL report. The
FIU is tasked with monitoring the implementation of the Action Plan and
different measures are assigned to various institutions directly or indirectly
involved in fighting financial crimes. All underlying deadlines will expire by
the end of 2013. As part of the measures, the government is committed to increase
the financing and human resource capacities of the main AML institutions. The
Council of Ministers is expected to review the implementation progress in
September 2013.

2.7.      Sustainability
of convergence

This concluding section draws together
elements that are key for gauging the sustainability of Latvia’s convergence
vis-à-vis the euro area. Such an assessment is appropriate in view of the fact
that Latvia remains in a process of profound economic adjustment, having
recently exited an IMF-EU macro-economic programme which was necessitated by
the unwinding of macro-financial imbalances accumulated in the mid-2000s. To
this end, the analysis reviews sustainability from a number of angles:

First, the sustainability dimension is
inherent in the individual convergence criteria themselves. This holds most
explicitly for the price stability criterion, which includes the requirement of
a “sustainable price performance”. The fiscal criterion (EDP) also involves a
forward-looking aspect, providing a view on the durability of the correction of
fiscal imbalances. While the exchange and interest rate criteria are, by
construction, backward-looking, they aim at capturing an economy’s ability to
operate durably under conditions of macroeconomic stability, hence indicating
whether the conditions for sustainable convergence following euro adoption are
in place.

Second, the assessment of additional
factors (balance of payments, product and financial market integration)
required by the Treaty broadens the view on sustainability of convergence and
allows for a more complete picture, complementing the quantitative criteria. In
particular, a sound external competitiveness position, effectively functioning
markets for goods and services and a robust financial system are key ingredients
to ensure that the convergence process remains smooth and sustainable.

Third, the convergence assessment should be
informed by the results and findings of enhanced policy co-ordination and
surveillance procedures (MIP, fiscal governance). The aim of these new
governance instruments is not to add to the existing requirements for euro
adoption, but to make full use of the more comprehensive analysis undertaken
under the new surveillance tools in assessing sustainability of convergence.
While individual elements drawn from the new governance framework (e.g. related
to AMR scoreboard indicators) are included in the relevant chapters on
convergence above, this  section uses the new framework to provide a more
integrated view of the sustainability dimension.

Any assessment of the sustainability of
convergence has limits and must be based on a judgement of the likely future
evolution of the economy. In particular, as experience has shown, the
sustainability and robustness of the convergence process after euro adoption is
to a significant extent endogenous, i.e. it depends on a Member State’s
domestic policy orientations after it has joined the euro area. Therefore,
while the assessment of sustainability is an essential element in determining a
Member State’s readiness to adopt the euro based on  initial conditions and
existing policy frameworks, the outcome of such a sustainability assessment
must  ultimately be  conditional and can only be  validated by the adoption of
appropriate policies over time. In this respect, the on-going strengthening of
governance mechanisms in EMU will have a major part to play in ensuring that
such policies are implemented by the Member State after euro adoption.

The analysis below looks at sustainability
from five different perspectives: price stability; fiscal performance and
governance; macroeconomic imbalances; competitiveness and market functioning;
and financial stability.

Price stability

Latvia’s present inflation rate is well
below the reference value, and  while the inflation rate is projected to rise
from the current unusually low levels, it is expected to remain moderate over
the forecast horizon. Going beyond the headline view, a sustainable price
performance implies that the respect of the reference value reflects underlying
fundamentals rather than temporary factors. In the case of Latvia, it is
evident that the VAT reduction of July 2012 has contributed to the current low
level of 12-month average inflation. However, the VAT reduction has not been
the decisive factor in bringing the inflation rate below the reference value.
Moreover, analysis of underlying fundamentals (e.g. cyclical conditions and
policy stance, wage and productivity developments, imported inflation,
administered prices – see section 2.2) and the fact that the reference value
has been met by a wide margin support a positive assessment on the fulfilment
of the price stability criterion.

In Latvia, the level of final consumption
prices of private households stood at around 71% of the euro area average in
2011. This suggests potential for further price level convergence in the long
term, as income levels (around 54% of the euro-area average in PPS in 2011)
rise towards the euro-area average. To the extent that this is an equilibrium
phenomenon, it does not imply a loss of price and cost competitiveness, but the
process needs to be managed carefully so as to detect and counteract the
emergence of excessive price pressures at an early stage

Longer-term inflation prospects will hinge
on wages growing in line with productivity. As Latvia is still a catching-up
economy, wages are expected to grow at a faster rate than in most advanced euro
area members. However, risks to price stability from catching-up related price
adjustment are limited by the recently demonstrated flexibility of the labour
market and wage-setting mechanisms which should ensure that labour costs are
aligned with productivity. They are also contained by the country's significant
progress in implementing the EU services directive and low market entry costs,
which keep competitive pressures high, as witnessed by the recent new entries
in the retail market. A shortage of well-qualified labour in the medium term
could drive up wages relative to productivity. Addressing the remaining
bottle-necks will be important in limiting any tightening of the labour market.

The productivity growth required to ensure
a smooth catching-up in the price level will largely depend on improvements in
the business environment and progress in attracting new investment. Increased
market competition should also support favourable price developments (and there
is no evidence that Latvia would fare worse in this respect than the euro area
average). Price developments will also depend on maintaining a prudent fiscal
policy stance, including cautious wage setting in the public sector, to keep
domestic demand in line with fundamentals and help anchor inflation
expectations. Finally, if commodity prices rise again in the medium-term,
Latvia would be particularly affected due to the composition of its consumer
basket, low energy efficiency and high material input share in production.

Fiscal performance and governance

The 2013 Convergence Programme covering
the period of 2013-2016 was submitted on 29 April 2013. The budgetary strategy
outlined in the programme is to maintain a structural budgetary position which
is based on the medium-term budgetary objective (MTO), with any deviation from
it limited to the incremental impact of the systemic pension reform (i.e. the
increase in state contributions to the second pillar pension scheme). The MTO
itself is set at the level of ‑0.5% of GDP. In terms of nominal targets,
this strategy implies a headline deficit of 1.1% of GDP in 2013, with the
deficit declining further to 0.9% in 2014 and stabilising at that level in
2015-2016. The headline budgetary targets for 2013 and 2014 are very close to
projections in the Commission's 2013 spring forecast with a deficit of 1.2% of
GDP in 2013 and 0.9% of GDP in 2014.

Further details on the assessment of the
2013 Convergence Programme for Latvia, including the assessment of the
long-term budgetary impact of ageing, can be found in the Commission Staff
Working Paper ([32]). This is accompanied by the Commission recommendation for a
Council Recommendation on the 2013 National Reform Programme of Latvia and
delivering a Council opinion on the 2013 Convergence Programme of Latvia.

Latvia has put in place a number of
governance measures, which demonstrate a longer-term commitment to sound public
finances. In March 2012, Latvia signed the Treaty on Stability, Coordination
and Governance in the EMU, and the respective ratification law was approved by
Parliament in May 2012. This implies an additional commitment to conduct
stability-oriented and sustainable fiscal policies. Moreover, in January 2013,
the Parliament approved the Fiscal Discipline Law (FDL) in the final reading.
The law establishes the principle of budgetary targeting throughout the cycle,
with the benchmark structural deficit of 0.5% of GDP, and will provide a
framework for a rules-based fiscal policy, in particular through limiting
pro-cyclical expenditure increases. The law also contains provisions regarding
the establishment of an independent Fiscal Council, to be set up from 1 January
2014, which will oversee the compliance with the set of fiscal rules.

To ensure a sustainable fiscal position, it
is decisive that the freshly adopted FDL is implemented in a robust way
according to its intentions, in order to pre-empt pressures to soften fiscal
discipline in the future. After the successful exit from  the adjustment
programme and a return to a favourable macroeconomic setting, there is a risk
of popular demands to undo some of the budgetary consolidation achieved during
the crisis, for example to compensate for the loss in real income of some
population groups or to slow down the pace of efficiency-seeking reforms in
public administration. The FDL can help in pursuing a sound and determined
fiscal strategy for the medium term and in reacting to such demands in a
balanced way; however, the new fiscal governance framework is not yet tested.

Macroeconomic imbalances

The assessment of convergence also draws on
the surveillance of macroeconomic imbalances under the Macroeconomic Imbalance
Procedure (MIP - see also Box 1.5), embedded in the broader "European
semester" approach to enhance the governance structures in EMU, and
integrates the MIP results into the analysis. Related to this, following the
adoption of the legislation establishing the new procedure for surveillance and
correction of macroeconomic imbalances (MIP) ([33]), the Commission published its first Alert Mechanism Report (AMR)
in February 2012 ([34]) and the second AMR (under the cycle for 2013) in November 2012.

The related scoreboard update shows that Latvia
breaches the indicative threshold in two out of ten indicators, one in the area
of external imbalances (namely on net international investment position) and
one in the area of internal imbalances (on unemployment). Both indicators are
moving towards the indicative thresholds. Based on the conclusions of the two
reports, Latvia was not subject to an in-depth review in the context of the
MIP.

The AMR from November 2012 notes that after
accumulation of imbalances prior to the crisis in 2008-2009, Latvia's external
competiveness has s improved substantially. The process of internal adjustment
included wage and employment cuts, fiscal consolidation, deleveraging in the
private sector, and growth-enhancing structural reforms.

Competitiveness, labour and product market
functioning

Standard indicators of cost
competitiveness, such as real effective exchange rates (REER) and relative unit
labour costs, are now below the indicative thresholds set under the scoreboard
for monitoring external imbalances under the MIP. In 2008, the REER adjusted
for unit labour costs reached a peak of 64% above the 2000 level. However, the
REER depreciated by about 20% in 2009-2010 and stayed broadly stable
afterwards. This level of the REER is considered sustainable, as the country
has  steadily gained market shares over the past years even when exports are
adjusted for growth of markets. It should be also noted that the REER estimates
do not include Russia, which is one of the major trade partners of Latvia.
Inclusion of Russia would result in an even more favourable assessment of
Latvia's cost competitiveness. As far as non-cost competitiveness indicators
are concerned, ECFIN studies have shown wide-ranging gains in terms of quality,
variety, and product and market differentiation, which have contributed to the
increase in export market shares([35]). Consequently, the latest projections suggest that the current
account deficit will remain below 3% of GDP in 2013-2014 while the overall
external balance (current and capital accounts) will be slightly positive for
the same period.

The Latvian labour market demonstrated a
high degree of flexibility during the crisis. Job seekers also showed high
mobility within the EU as emigration increased substantially in the process of
structural adjustment. More recently, as of 2012, the economic recovery and the
steady pace of job creation not only reduced emigration but raised
significantly the number of immigrants in Latvia. Underpinned by a
decentralised wage-setting system, a considerable wage adjustment took place in
Latvia over 2009 and 2010 and wages moved broadly in line with productivity
afterwards. In 2013-2014, wages are projected by the Commission services' 2013
Spring Forecast to remain consistent with productivity. Vacancy rates remain among
the lowest in the EU indicating that at aggregated level labour supply is
adequate. Nevertheless, regional differences and skills mismatches on specific
labour market segments keep structural unemployment relatively high. However,
the latest statistics show that youth unemployment, though still high, has
moved slightly below the EU average while long-term unemployment remains a
major challenge. All these structural deficiencies on the labour market amount
to a significant loss in potential output and pose risks of excessive wage
adjustments; they need to be properly addressed by active labour market
policies and education reforms, as stipulated in the Commission and Council
country specific recommendations.

Latvia has achieved significant progress in
liberalising its markets and integrating its trade of goods and services within
the Single Market. Much of the structural adjustments related to this process
have been already completed. However, challenges still remain and they are
being addressed in the context of the country's specific recommendations issued
by the Commission and the Council. The recommendations emphasise the importance
of enhancing energy efficiency and energy interconnections with other EU Member
States, reducing the backlog in the judicial system, and modernising the
education and research institutions. The recent opening of the electricity
market to cross-border competition is one of the positive examples in the field
of energy reforms while the gas market is still closed for competition.

The associated process of further
structural adjustment needs to be supported by flexible resource allocation and
functioning markets. Moreover, some social policy indicators are still
significantly below the euro area average, which puts additional risks on the
full completion of the convergence process. However, on balance, the size of
the economic restructuring and convergence progress in the past several years
shows that the country's institutional capacity and market maturity are already
sufficient to address remaining challenges.

Financial stability

The integration of the domestic financial
sector into the EU financial system is substantial, mainly thanks to a high
level of foreign ownership of the banking system. The relative size of Latvia's
financial system is small compared to the euro area average and the economy has
recently gone through a significant deleveraging process. The foreign-owned
segment of the financial sector proved resilient to the recent economic and
financial crisis, benefitting from substantial recapitalisation from parent
banks, while weaknesses in the domestic banking sector contributed to the need
for balance-of-payment support at the outset of the crisis. In the context of
the international financial assistance programme, financial supervision has
been strengthened considerably and domestic banking sector resilience has been
strengthened. Cooperation with home country supervisors has been further
enhanced.

Looking ahead, it is essential that
sustainable convergence is not jeopardised by a re-emergence of a
credit-fuelled expansion in domestic demand and an associated rise in asset
prices – notably in the housing market.  The prospects of such a boom
re-emerging are reduced by Latvia's  policy responses to the 2008-2009 crisis,
which included the establishment of a Credit Register, changes in real estate
taxation (property and transaction taxation) and tightened banking sector
regulation (see section 2.6.3). The combination of other factors that drove
buoyant credit expansion in the past (pent-up credit demand, accelerated
financial deepening and integration, rapid risk spread compression) is not
expected to recur either, as higher property and consumption taxes as well as
tighter credit regulation are providing sufficient safeguards. That said, in
view of the expected price level convergence, real interest rates may ceteris
paribus be lower for Latvia than for the euro area average, which needs to
be counteracted both by a prudent macro stance and appropriate supervisory
practices. An appropriate and timely use of macro-prudential policies will also
be important in limiting any undesirable consequences related to credit growth.

Latvia has a long tradition and several
competitive advantages in servicing non-resident banking clients, mainly
corporates from CIS countries. To cater for their specific risks, banks with a
non-resident business model are required to keep a high share of liquid assets
and are subject to additional capital requirements. The supervision of the
non-resident banking business poses additional challenges, inter alia, due to
the cross-border nature of transactions. As the management of such financial
inflows is key to sustaining economic convergence, the national supervising
authority has implemented several measures to reduce the risks of this business
activity. Going forward, close monitoring of financial stability risks,
readiness to adopt further regulatory measures if needed, and determined
implementation of anti-money laundering rules will remain key.

Conclusion

Overall, a broad-based look at underlying
factors suggests that sufficiently strong conditions are in place for Latvia to
be able to maintain a robust and sustainable convergence path in the medium
term, thus supporting a positive assessment. However, significant challenges
remain, and policy discipline – which has increased during and after the crisis
but has not always been strong in the past – will need to be maintained in a
determined manner to fully exploit the benefits of participation in the euro
area and minimise risks to the convergence path going forward.

([1])  OJ
L 139, 11.5.1998, pp. 30-35

([2])  The
numbering of Treaty articles cited in this report corresponds to the one of the
Treaty on the Functioning of the European Union (TFEU) except when explicitly
mentioned. Article 121(4) TEC does no longer exist in the TFEU, as it refers to
the first countries deemed ready to adopt the euro on 1 January 1999.

([3])  Report
on progress towards convergence and recommendation with a view to the
transition to the third stage of economic and monetary union, COM(1998)1999
final, 25 March 1998.

([4])  European
Monetary Institute, Convergence Report, March 1998.

([5])  The
content of this article is now included in Article 140(1) TFEU.

([6])  Protocol
(No 16) on certain provisions relating to Denmark, Protocol (No 15) on certain
provisions relating to the United Kingdom of Great Britain and Northern Ireland.

([7])  European
Commission, Convergence Report 2012, COM(2012) 257 final, 30 May 2012; European
Central Bank, Convergence Report 2012, May 2012.

([8])  Council
Regulation (EC) No 2494/95 of 23 October 1995 concerning harmonised indices of
consumer prices (OJ L 257, 27.10.1995, pp. 1-4), amended Regulations (EC) No
1882/2003 and No 596/2009 of the European Parliament of the Council.

([9])  Commission
Regulation (EC) No 1708/2005 of 19 October 2005 laying down detailed rules for
the implementation of Council Regulation (EC) No 2494/95 as regards the common
index reference period for the harmonised index of consumer prices, and
amending Regulation (EC) No 2214/96.

([10]) According
to the Commission services' Spring 2013 Forecast, the inflation reference value
is forecast to stand at 2.4% in December 2013, with Portugal, Sweden and Cyprus
as best performers in terms of price stability. Greece has been excluded from
the best performers in December 2013 as its average inflation rate is
forecasted to deviate from the euro area average by a wide margin. The forecast
of the reference value is subject to significant uncertainties given that it is
calculated on the basis of the inflation forecasts for the three Member States
projected to be the best performers in terms of price stability in the forecast
period, thereby increasing the possible margin of error.

([11]) The
definition of the general government deficit used in this report is in
accordance with the excessive deficit procedure, as was the case in previous
convergence reports. In particular, interest expenditure, total expenditure and
the overall balance include net streams of interest expenditure resulting from
swaps arrangements and forward rate agreements. Government debt is general
government consolidated gross debt at nominal value (Council Regulation
479/2009). Information regarding the excessive deficit procedure and its
application to different Member States since 2002 can be found at:
http://ec.europa.eu/economy_finance/economic_governance/sgp/deficit/index_en.htm.

([12]) A
directive on minimum requirements for national budgetary frameworks, two new
regulations on macroeconomic surveillance and three regulations amending the
Stability and Growth Pact and complementing it with new enforcement mechanisms
for euro area Member States entered into force on 13 December 2011. Besides the
operationalisation of the debt criterion in the Excessive Deficit Procedure
mentioned in Box 1.3, the amendments introduced a number of important novelties
in the Stability and Growth Pact, in particular an expenditure benchmark to
complement the assessment of progress towards the country-specific medium-term
budgetary objective.

([13]) In
assessing compliance with the exchange rate criterion, the Commission examines
whether the exchange rate has remained close to the ERM II central rate, while
reasons for an appreciation may be taken into account, in accordance with the
Common Statement on Acceding Countries and ERM2 by the Informal ECOFIN Council,
Athens, 5 April 2003.

([14]) 97/C
236/03 of 16 June 1997, OJ C 236, 2.8.1997, p.5.

([15]) In
March 2012, the 12-month average long-term interest rate in Ireland was 9.1%.
Ireland has been the beneficiary of an EU/IMF financial assistance programme
since December 2010 and it had practically no market access.

([16]) Disruptions
were still present in Ireland's sovereign debt market during the reference
period, but were gradually diminishing with the successful implementation of
its EU/IMF financial assistance programme. In March 2013 Ireland issued a
10-year bond of EUR 5 billion with a yield of 4.15%.

([17]) The
external balance is defined as the combined current and capital account (net
lending/borrowing vis-à-vis the rest of the world). This concept permits in
particular to take full account of external transfers (including EU transfers),
which are partly recorded in the capital account. It is the concept closest to
the current account as defined when the Maastricht Treaty was drafted.

([18]) Eurostat
has been reviewing the statistical practices used to compile the HICP in Latvia
against HICP methodology and other guidelines and good practices in the field
of consumer price indices. Eurostat considers that the methods used for
producing the Latvian HICP are of a good standard. Eurostat's recommendations
have been followed and the quality of the consumer price statistics for Latvia
improved during recent years. The representativity of the Latvian HICP in terms
of accuracy and reliability is adequate. There were no apparent instances of
non-compliance with the HICP methodology. The Latvian data pass all standard
HICP validation tests – they are internally consistent. Latvian HICP data
should therefore be considered comparable to the HICPs of other EU countries.
The full report will be published in the relevant section on Eurostat's
website.

([19]) The
2011 compensation per employee and productivity data presented in Table 2.2 is
distorted by the currently incomplete consideration of the 2011 Census results.
Consistent, revised time series for these variables are set to be published
only after the cut-off date of this report.

([20]) According
to the Eurostat definition, administered prices in Latvia include inter alia
electricity, gas, heat energy, hospital services, public transport and postal
services. For details, see http://epp.eurostat.ec.europa.eu/portal/page/ portal/hicp/methodology/administered_prices

([21]) In
the first semester of 2012, HICP-CT was well below the headline due to the
excise tax increases of mid-2011, but in the second semester HICP-CT rose well
above the headline due to the July 2012 VAT cut.

([22]) Resulting
in a hypothetical direct impact on headline HICP of around 2/3 percentage point
between July 2012 and June 2013.

([23]) An
overview of all on-going excessive deficit procedures can be found at:
http://ec.europa.eu/economy_finance/
economic_governance/sgp/deficit/index_en.htm

([24]) In
December 2011 Latvia drew the second development policy loan of the World
Bank's Safety Net and Social Sector Reform Program for an amount of EUR 100
million (0.5% of GDP).

([25]) The
long-term foreign-currency rating was raised from BB+ (Fitch, Standard&Poor's)
/ Baa3 (Moody's) in 2010 to BBB (Fitch, Standard&Poor's) / Baa2 (Moody's)
in 2013.

([26]) The
reference to the German benchmark bond is included for illustrative purposes,
as a proxy of the euro area long-term AAA yield.

([27]) The
reference group of 36 trade partners used in the calculation of effective
exchange rates does not include Russia, which results into slight
underestimation of Latvia's competitiveness indicators.

([28]) Non-price
competitiveness indicators are analysed in more detail in the Occasional Paper
issued by the European Commission, Directorate-General for Economic and
Financial Affairs: "EU Balance-of-Payments assistance for Latvia:
Foundations of success" -- http://ec.europa.eu/economy_finance/publications/occasional_paper/2012/op120_en.htm

([29]) More
details on export competitiveness are provided in the Occasional Paper issued
by the European Commission, Directorate-General for Economic and Financial
Affairs: "EU Balance-of-Payments assistance for Latvia: Foundations of
success" --
http://ec.europa.eu/economy_finance/publications/occasional_paper/2012/op120_en.htm

([30]) The
value of tenders published in the EU Official Journal may serves as a proxy of
the extent to which national public procurement are open to foreign bidders.

([31]) http://www.coe.int/t/dghl/monitoring/moneyval/
Evaluations/round4/LTV4_MER_MONEYVAL(2012)16_en.pdf

([32]) Available
at: http://ec.europa.eu/economy_finance/
economic_governance/sgp/convergence/index_en.htm

([33]) The
package of six legislative proposals to strengthen the economic governance of
the EU entered into force in December 2011.
http://europa.eu/rapid/pressReleasesAction.do?reference=MEMO/11/898

([34]) http://ec.europa.eu/economy_finance/articles/governance/
2012-02-14-alert_mechanism_report_en.htm

([35]) More
details on export competitiveness are provided in the Occasional Paper issued
by the European Commission, Directorate-General for Economic and Financial
Affairs: "EU Balance-of-Payments assistance for Latvia: Foundations of
success" --
http://ec.europa.eu/economy_finance/publications/occasional_paper/2012/op120_en.htm