# EUR-Lex - 52013DC0341 - EN

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# 52013DC0341

**REPORT FROM THE COMMISSION TO THE EUROPEAN PARLIAMENT AND THE COUNCIL Convergence Report 2013 on Latvia (Prepared in accordance with Article 140(1) of the Treaty on the functioning of the European Union at the request of Latvia) /* COM/2013/0341 final */**

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REPORT FROM THE COMMISSION TO THE
EUROPEAN PARLIAMENT AND THE COUNCIL

Convergence Report 2013 on Latvia
(Prepared in accordance with Article 140(1) of the Treaty on the functioning of
the European Union at the request of Latvia)

1.           Purpose of the report

Article 140(1) of the Treaty on the Functioning
of the European Union (hereafter TFEU) requires the Commission and the ECB to
report to the Council, at least once every two years, or at the request of a
Member State with a derogation[1],
on the progress made by the Member States in fulfilling their obligations
regarding the achievement of economic and monetary union. The latest Commission
and ECB Convergence Reports, relating to all Member State with a derogation,
were adopted in May 2012.

This report has been prepared in response to a
request of Latvia, submitted on 5 March 2013. A more detailed assessment
of the state of convergence in Latvia is provided in a Technical Annex to this
report (SWD(2013) 196).

The content of the reports prepared by the
Commission and the ECB is governed by Article 140(1) of the TFEU. This Article
requires the reports to include an examination of the compatibility of national
legislation, including the statutes of the national central bank, with Articles
130 and 131 of the TFEU and the Statute of the European System of Central Banks
and of the European Central Bank (hereafter ESCB/ECB Statute). The reports must
also examine whether a high degree of sustainable convergence has been achieved
in the Member State concerned by reference to the fulfilment of the convergence
criteria (price stability, public finances, exchange rate stability, long-term
interest rates), and by taking account of other factors mentioned in the final
sub-paragraph of Article 140(1) of the TFEU. The four convergence criteria are
developed in a Protocol annexed to the Treaties (Protocol No 13 on the
convergence criteria).

The economic and financial crisis has, in
general, exposed gaps in the current economic governance of the Economic and
Monetary Union (EMU) and showed that its existing instruments need to be used
more fully. The present examination takes place within a context of the reform
of EMU governance, which was undertaken over the past three years with the aim
of ensuring a sustainable functioning of EMU. The assessment of convergence is
thus aligned with the broader "European semester" approach which
takes an integrated and upstream look at the economic policy challenges in
ensuring fiscal sustainability, competitiveness, financial market stability and
economic growth. The key innovations in the area of governance reform,
reinforcing the assessment of each Member States' convergence process and its
sustainability, include inter alia the strengthening of the excessive
deficit procedure by the 2011 reform of the Stability and Growth Pact and new
instruments in the area of surveillance of macroeconomic imbalances. In
particular, this report takes into account the assessment of the 2013 update of
  Latvia's Convergence Programme[2]
and the findings under the Alert Mechanism Report of the Macroeconomic
Imbalances Procedure[3].

Convergence criteria

The examination of the compatibility of
national legislation, including the statutes of the national central bank,
with Article 130 and with the compliance duty under Article 131 of the TFEU
encompasses an assessment of observance of the prohibition of monetary
financing (Article 123) and the prohibition of privileged access (Article 124);
consistency with the ESCB's objectives (Article 127(1)) and tasks (Article
127(2)) and other aspects relating to the integration of the national central
bank into the ESCB at the moment of the euro adoption.

The price stability criterion is defined
in the first indent of Article 140(1) of the TFEU: “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”[4]. The requirement of sustainability
implies that the satisfactory inflation performance must essentially be
attributable to the behaviour of input costs and other factors influencing
price developments in a structural manner, rather than the influence of
temporary factors. Therefore, the convergence examination includes an
assessment of the factors that have an impact on the inflation outlook and is
complemented by a reference to the most recent Commission services' forecast of
inflation[5].
Related to this, the report also assesses whether the country is likely to meet
the reference value in the months ahead.

The inflation reference value was calculated to
be 2.7% in April 2013, with Sweden, Latvia and Ireland as the three
best-performing Member States[6].

It is warranted to exclude from the best
performers countries whose inflation rates could not be seen as a meaningful
benchmark for other Member States. Such outliers were in the past identified in
the 2004 and 2010 Convergence Reports[7],
as their inflation rates differed by a wide margin from the euro area average.
At the current juncture, it is warranted to exclude Greece from 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, and including it would unduly affect the
reference value and thus the fairness of the criterion[8]. Greece is replaced by Ireland among the best performers.

The convergence criterion dealing with
public finances is defined in the second indent of Article 140(1) of the
TFEU 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”. As part of an overall
strengthening of economic governance in EMU, the secondary legislation related
to public finances was enhanced in 2011, including the new regulations amending
the Stability and Growth Pact[9].

The TFEU 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”[10].

The relevant two-year period for assessing
exchange rate stability in this report is 17 May 2011 to 16 May 2013. 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. The analysis also takes into account the impact of external
official financing arrangements wherever relevant, including their size, the
amount and profile of assistance flows and the possible policy conditionality.

The fourth indent of Article 140(1) of the TFEU
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 2 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”.

The interest rate reference value was
calculated to be 5.5% in April 2013. The reference value is based on the
long-term interest rates in Sweden, Latvia and Ireland[11].

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, 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. However, 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, suggesting that the long-term interest rate of Ireland has become a meaningful benchmark again.

Article 140(1) of the TFEU also requires an
examination of other factors relevant to economic integration and convergence.
These additional factors include financial and product market integration, the
development of the balance of payments on current account and the development
of unit labour costs and other price indices. The latter are covered within the
assessment of price stability. The additional factors are important indicators
that the integration of a Member State into the euro area would proceed without
difficulties and broadens the view on sustainability of convergence.

2.           Legal compatibility

In the 2012 Convergence Report, the assessment
on legal convergence concluded that legislation in Latvia, in particular the
Law on the Latvijas Banka (Bank of Latvia, BoL), was not fully compatible with
the compliance duty under Article 131 of the TFEU. Incompatibilities notably
concerned the independence of the central bank, the prohibition of monetary
financing and central bank integration into the ESCB at the time of euro
adoption with regard to the ESCB tasks laid down in Article 127(2) of the TFEU
and Article 3 of the ESCB/ECB Statute.

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 adopted on 10
January 2013. The Law on the Bank of Latvia as amended is fully compatible with
Articles 130 and 131 of the TFEU.

3.           Price stability

In Latvia, the 12-month average inflation rate
was above the reference value at the time of the last convergence assessment in
2012. The average inflation rate in Latvia during the 12 months to April 2013
was 1.3%, i.e. well below the reference value of 2.7%. It is projected to
remain below the reference value in the months ahead.

After a peak of annual HICP inflation at 15.3%
in 2008, significant nominal wage adjustment and a correction in import prices
led to a period of negative headline inflation in 2009 and 2010. As the cycle
turned and a rising global commodity price trend set in, average inflation rose
from -1.2% in 2010 to 4.2% in 2011, boosted also by indirect tax increases. As
these temporary effects faded, inflation moderated to 2.3% in 2012 and by April
2013 annual inflation fell to -0.4%.

Annual HICP inflation is expected to be 1.4% on
average in 2013, according to the Commission services' Spring 2013 Forecast,
due i.a. to falling energy prices and a 1 percentage point reduction in the
standard VAT rate as of July 2012. It is projected to pick up in 2014 to 2.1%
on average, in the context of improving domestic demand and liberalisation of
the electricity market. The price level in Latvia (around 71% of the euro area
average in 2011) suggests potential for further price level convergence over
the long term.

Sustainable convergence implies that the respect
of the reference value reflects underlying fundamentals rather than temporary
factors. In the case of Latvia, the VAT reduction of July 2012 has contributed
to the current low level of 12-month average inflation. However, the analysis
of underlying fundamentals 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.

Medium-term inflation prospects will hinge notably
on wages growing in line with productivity which will mostly depend on
continued labour market flexibility. 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 an outcome are
reduced by Latvia's policy responses to the 2008-2009 crisis, while the
combination of 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 in the foreseeable future.
Improvements in the business environment, progress in attracting new
investment, addressing remaining bottlenecks in the labour market and competitive
price formation in product markets will be key to maintain price stability in
the medium term. Price developments will also depend on maintaining a prudent
fiscal policy, including cautious wage setting in the public sector, to keep
domestic demand in line with fundamentals and help anchor inflation
expectations.

Latvia fulfils the
criterion on price stability.

4.           public finances

Latvia is at present
subject of a Council Decision on the existence of an excessive deficit (Council
Decision of 7 July 2009). The Council recommended Latvia to correct the
excessive deficit by 2012. The general government deficit in Latvia reached 8.1% of GDP in 2010, but decreased to 1.2% of GDP in 2012, due in particular
to a considerable consolidation effort. The Commission services' Spring 2013
Forecast projects the deficit-to-GDP ratio at 1.2% in 2013 and 0.9% in 2014
under a no-policy-change assumption. The ratio of gross public debt to GDP fell
to 40.7% in 2012 and it is projected to fall further to 40.1% of GDP by
end-2014.

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, Parliament approved the Fiscal Discipline
Law (FDL) in the final reading. The law establishes the principle of budgetary
targeting throughout the cycle, with a 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 compliance
with the set of fiscal rules. Thorough implementation of the FDL will be
crucial to counter the risks related to pressure to loosen fiscal policy after
the successful adjustment programme.

In view of these developments and the
Commission services' Spring 2013 Forecast, the Commission considers that the
excessive deficit has been corrected with a credible and sustainable reduction
of the budget deficit below 3% of GDP in 2012, which was the deadline
recommended by the Council. The Commission has therefore recommended that the
Council abrogate the decision on the existence of an excessive deficit for Latvia (SEC(2013) XYZ).

If the Council decides to abrogate the
excessive deficit decision for Latvia, Latvia will fulfil the criterion on
public finances.

5.           Exchange rate stability

The Latvian lats has participated in ERM II
since 2 May 2005, i.e. for more than eight years at the time of adoption of
this report. Upon ERM II entry, the authorities unilaterally committed to keep
the lats within a ±1% fluctuation margin around the central rate. During the
two years preceding this assessment, the lats exchange rate did not deviate
from its central rate by more than ±1% and it did not experience tensions. The
lats traded mostly on the strong side of the unilateral band, as the Latvian
Treasury converted its ample foreign currency funds on the market. The lats
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
expectations regarding euro adoption. Additional indicators, such as
developments in foreign exchange reserves and short-term interest rates do not
reveal pressures on the exchange rate. The last disbursements by the IMF and
the EU under the financial assistance programme took place in August and
October 2010, respectively. In June 2011, Latvia successfully returned to the
international bond market with USD issuance, followed by further transactions,
signalling good market access.

Latvia fulfils the
exchange rate criterion.

6.           Long-term interest rates

The average long-term interest rate in Latvia in the year to April 2013 was 3.8%, below the reference value of 5.5%. The average
long-term interest rate in Latvia had been at the reference value at the 2012
convergence assessment (5.8%) and it gradually declined further since then. Latvia's long-term spreads to euro area long-term benchmark bonds narrowed significantly in
2010, as confidence in the currency peg was regained, fiscal consolidation
yielded results and the conversion of assistance programme funds created ample
lats liquidity. After a pause in 2011, the spread compression continued in
2012, as market confidence in Latvia improved further. The Treasury returned to
the 10-year domestic bond market with several smaller issues during the first
half of 2011. 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 USD-denominated
issuances.

Latvia fulfils the
criterion on the convergence of long-term interest rates.

7.           Additional factors

Additional factors have also been examined,
including balance of payments developments and integration of labour, product
and financial markets. The external balance reversed in 2008-2009 from large
deficits during the boom years to a surplus of around 11% of GDP in 2009, which
contracted to around 1% of GDP in 2012. The trade deficit declined
substantially from 2008, but deteriorated somewhat with the recovery since
2010. However, the significant correction of the real effective exchange rate
in 2009-2010 has remained broadly preserved and Latvia has continued to gain export
market shares. 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 when most banks regained profitability. The FDI balance
gradually improved from 2009, but it declined somewhat in 2012. The EU-IMF
balance of payments assistance programme granted to Latvia in late 2008 was
successfully concluded in January 2012. Latvia borrowed altogether about EUR
4.5 billion out of the total EUR 7.5 billion that was available under the
programme. Reflecting confidence in its policies and its regained market
access, Latvia has not requested a follow-up programme. By December 2012, Latvia fully repaid its programme-related liabilities to the IMF, while repayments to the
European Commission will fall due between 2014 and 2025.

Latvia's economy is
well integrated within the EU economy through trade and FDI linkages while the
labour market has demonstrated a high degree of mobility within the EU market
and substantial flexibility although structural unemployment is high. On the
basis of selected business environment indicators, Latvia performs broadly in
line with the average of euro area Member States. 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. In the
context of the international financial assistance programme, financial
supervision has been strengthened considerably. Cooperation with home country supervisors
has been further enhanced.

Latvia has a long
tradition and several competitive advantages in servicing non-resident banking
clients, mainly corporates from CIS countries. The supervision of the
non-resident banking business poses additional challenges, inter alia, due to
the cross-border nature of transactions. The national supervising authority has
implemented several measures to reduce the specific risks of this business
activity; banks with a non-resident business model have to keep a high share of
liquid assets and are subject to additional capital requirements. 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.

***

In the light of its assessment on legal
compatibility and on the fulfilment of the convergence criteria, taking into
account the additional factors, and provided that the Council will follow the
Commission's recommendation for the abrogation of the excessive deficit
procedure, the Commission considers that Latvia fulfils the conditions for the
adoption of the euro.

[1]               The Member States that have not yet fulfilled the
necessary conditions for the adoption of the euro are referred to as
"Member States with a derogation". Denmark and the United Kingdom negotiated opt-out arrangements before the adoption of the Maastricht Treaty
and do not participate in the third stage of EMU.

[2]               Available at          
http://ec.europa.eu/economy_finance/economic_governance/sgp/convergence/programmes/2013_en.htm

[3]               The Commission published its first Alert Mechanism
Report (AMR) in February 2012 and the second AMR (under the cycle for 2013) in
November 2012. Based on the conclusions of the two reports, Latvia was not subject to an in-depth review in the context of the Macroeconomic Imbalance
Procedure.

[4]               For the purpose of the criterion on price stability,
inflation is measured by the Harmonised Index of Consumer Prices (HICP) defined
in Council Regulation (EC) No 2494/95.

[5]               All forecasts for inflation and other variables in
the current report are from the Commission services' Spring 2013 Forecast. The
Commission services' forecasts are based on a set of common assumptions for
external variables and on a no-policy change assumption while taking into
consideration measures that are known in sufficient detail. 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.

[6]               The cut-off date for the data used in this report is
16 May 2013.

[7]               Lithuania and Ireland, respectively.

[8]               In April 2013, the 12-month average inflation rate of
  Greece was 0.4% and that of the euro area 2.2%, with the gap between the two
forecast to increase further in the months ahead.

[9]               A directive on minimum requirements for national
budgetary frameworks, two new regulations on macroeconomic surveillance and
three regulations amending the Stability and Growth Pact (SGP) entered into
force on 13 December 2011 (one out of two new regulations on macroeconomic
surveillance and one out of three regulations amending the SGP include new
enforcement mechanisms for euro area Member States). Besides the operationalisation
of the debt criterion in the Excessive Deficit Procedure, 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.

[10]             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.

[11]             The reference value for April 2013 is calculated as the
simple average of the average long-term interest rates in Sweden (1.6%), Latvia (3.8%) and Ireland (5.1%).