EN Official Journal of the European Union C 73/18

COUNCIL OPINION

of 4 March 2008

on the updated convergence programme of Latvia, 2007-2010

(2008/C 73/05)

THE COUNCIL OF THE EUROPEAN UNION,

Having regard to the Treaty establishing the European Community,

Having regard to Council Regulation (EC) No 1466/97 of 7 July 1997 on the strengthening of the surveillance of budgetary positions and the surveillance and coordination of economic policies (1), and in particular Article 9(3) thereof,

Having regard to the recommendation of the Commission,

After consulting the Economic and Financial Committee,

HAS DELIVERED THIS OPINION:

(1) On 4 March 2008, the Council examined the updated convergence programme of Latvia, which covers the period 2007 to 2010.

(2) Following a sustained period of high growth since the mid-nineties, Latvia's real GDP increased at double-digit rates in 2005-2007. Growth has primarily been driven by a powerful credit boom boosting private consumption and real estate investment, with net external borrowing surpassing 20 % of GDP since 2006. Monetary conditions have been accommodative, given a high degree of euroisation in the framework of a narrowly pegged exchange rate within ERM II. Adding to the overheating from the demand side, labour shortages have contributed to the emergence of a wage-price spiral, with very high wage growth outstripping productivity, leading to the highest inflation in the EU and rapidly worsening cost competitiveness. Helped by a set of measures adopted by the authorities in spring 2007 some slowdown has become visible in the housing market and in domestic consumption, but further steps in this direction are necessary to achieve a smooth adjustment towards a sustainable growth path. In this context fiscal policy has insufficiently tackled the emerging vulnerabilities. Key to addressing internal and external imbalances will be a more ambitious fiscal stance; adherence to an appropriate medium-term budgetary framework; prioritizing public expenditure and re-examining taxation instruments to avoid demand stimulus in sectors which do not significantly strengthen the economy's medium- and long-term supply potential; and a more responsible public sector wage growth. To foster the catching-up process, structural reforms and removal of bottlenecks directed towards strengthening the supply side of the economy are needed.

(3) The macroeconomic scenario underlying the programme envisages a soft landing with real GDP growth gradually decreasing from 10,5 % in 2007 to 6,8 % by 2010. According to the programme, domestic demand will remain the main growth contribution, although it is expected to slow significantly from 2007 to 2008. Assessed against currently available information (2), this scenario appears to be based on plausible growth assumptions. However, the envisaged deceleration of domestic demand is far from assured, and the programme's economic scenario is attended by very high risks to macroeconomic stability, including continued overheating with a substantial risk of an abrupt slowdown at a later stage. Furthermore, without a larger adjustment of aggregate demand and supply than depicted in the programme, the country's external position would not be sustainable in the longer run. The programme's projections for inflation, which appear to be plausible, show that Latvia will be moving further away from nominal convergence at least until 2008. Moreover, uncertainties remain large due — inter alia — to ongoing volatility in energy and other commodity prices and to how the current wage-price spiral may evolve. Restraining public sector compensation is critically important for achieving a reduction in whole-economy wage growth which would be necessary to break the current cost-price dynamics and rapidly worsening cost competitiveness.

(4) For 2007, the previous programme initially targeted a budget deficit of 1,3 % of GDP, while the new update estimated a 0,3 % of GDP budget surplus. The autumn forecast projected a budget surplus of 0,9 % of GDP for 2007, which is very close to the provisional result of a 0,8 % of GDP fiscal surplus. The structural deficit, calculated according to the commonly agreed methodology, is estimated to have decreased from 1 % of GDP in 2006 to 0,5 % in 2007. The difference between the autumn forecast headline figure and the previous programme's target reflects higher revenues, which however were partly offset by higher-than-budgeted expenditure growth. Even based on a surplus close to 0,8 % of GDP, the budgetary policy in 2007 was only partly in line with the invitation in the Council opinion of 27 March 2007 on the previous update of the convergence programme (3), as the background of continuing high demand and risks to stability shows that fiscal policy remained short of that required. Nevertheless, there has been some progress in limiting the previously usual surge in end-of-year spending by public institutions, following guidelines to this end adopted by the government in November 2007.

(5) The main goal of the budgetary strategy is to foster macroeconomic stability by continuing to respect the medium-term objective (MTO) of a structural deficit of 1 % of GDP — achieved since 2006 — by a growing margin over the programme period. Compared to the previous programme, which planned to achieve the MTO only from 2008 onwards, the new update broadly confirms the envisaged consolidation path but from a much better budgetary starting position against a broadly unchanged macroeconomic scenario. According to Commission services' calculations on the basis of information in the programme, the structural balance is projected to improve from a deficit of 0,5 % of GDP in 2007 to a surplus of 0,5 % of GDP in 2008 and by 0,5 percentage point per year in 2009-2010. Two-thirds of the rise in the headline surplus by almost 1 percentage point of GDP owes to an increase in the revenue-to-GDP ratio and the remaining third from a fall in the expenditure-to-GDP ratio. On the revenue side, the projected rise in indirect taxes and ‘other revenues’ as a share of GDP more than offsets a projected decline in social contributions due to the ongoing pension reform. Restraint in expenditure on public consumption and compensation of employees relative to GDP (which is not assured by measures described in the programme) is assumed to provide budgetary room for proposed increases in social payments, including in the areas of pensions and parent benefit, and public investment.

(6) The budgetary outcomes could be much worse than projected in the programme. There are significant risks to the overall macroeconomic stability stemming from the wide external imbalance and the currently overheated state of the economy. Were the credit-financed, domestically-driven growth to slow abruptly, the budget could come under strong pressure, as the programme's revenue projections are based on the assumption of continuing high consumption and favourable labour market conditions. The projected reduction in the expenditure ratio seems difficult to achieve in the absence of underpinning measures. As medium-term expenditure ceilings for ministries and public institutions were introduced only in 2007, it is not yet possible to judge their effectiveness. The track record of recent years rather points to overruns as high nominal growth has created the opportunity each year to spend extra revenues in the framework of a supplementary budget. Finally, the programme counts on substantial revenues related to privatization (amounting to a total of 0,5 % of GDP according to the programme), which are surrounded by uncertainties.

(7) In view of this risk assessment, the budgetary stance in the programme seems sufficient to maintain the MTO throughout the programme period, as envisaged in the programme. The fiscal policy stance implied by the programme is in line with the Stability and Growth Pact, but it should be tightened given the size of the economic imbalances and the heightened responsibility of fiscal policy due to the limited scope of monetary policy under a quasi-fixed exchange rate regime within ERM II. The likelihood of a better-than-estimated 2007 outturn should be used to aim for a much higher surplus position in 2008.

(8) Latvia appears to be at low risk with regard to the sustainability of public finances. The long-term budgetary impact of ageing is lower than the EU average, with age-related expenditure projected to fall as a share of GDP over the coming decades, influenced by the expenditure-reducing impact of the reform of the pension system. The current level of gross debt is very low and improving the budgetary position as planned in the convergence programme update would contribute to limiting the risks to the long-term sustainability of public finances.

(9) The convergence programme seems to be consistent with the October 2007 implementation report of the national reform programme. In particular, the implementation report identifies securing macroeconomic stability as the main challenge with implications for public finances and to that end allots a major role to the strengthening of fiscal discipline and budgetary planning procedures. While the programme contains a qualitative assessment of the overall impact of the national reform programme within the medium-term fiscal strategy, it does not provide detailed information on the direct budgetary costs/savings associated with the main reforms envisaged in the national reform programme.

(10) The budgetary strategy in the programme is partly consistent with the country-specific broad economic policy guidelines in the area of budgetary policies issued in the context of the Lisbon strategy. However, the projected fiscal stance does not contribute adequately to countering overheating and promoting economic sustainability.

(11) In terms of progress in implementing its ERM II commitments, the authorities have taken certain steps but more are needed to strengthen the fiscal stance and restrain domestic demand. Some measures have been implemented to curb credit growth but with limited impact. The March 2007 anti-inflation plan was a step in the right direction, albeit with limited immediate effect, but fell short of the stronger measures needed to stabilise the economy and to achieve a sustainable reduction in inflation. Further structural reforms are needed to address the weak supply-side of the economy and worsening competitiveness. The economic stabilization plan currently under consideration by the Latvian authorities is likely to include further fiscal and tax measures, as well as steps to improve the business environment and competitiveness.

(12) As regards the data requirements specified in the code of conduct for stability and convergence programmes, the programme has a small gap in compulsory data and provides most of the optional data (4).

The overall conclusion is that the programme aims to reduce economic imbalances and excessive demand pressure by setting slightly increasing but overall modest surplus target for 2008-2010, in excess of the MTO. However, the risks to the achievement of the budgetary targets are high, primarily due to large macroeconomic uncertainty and a track record of slippages from expenditure plans. Moreover, a considerably tighter stance of fiscal policy is urgently needed to meet the programme's aims in a context of an economy subject to risks to stability — stemming from inflationary pressures, deteriorating cost competitiveness and sharply increasing net foreign liabilities. While medium-term expenditure ceilings have been introduced, they remain to be tested. As regards the long-term sustainability of public finances Latvia is assessed to be at low risk.

In view of the above assessment and given the need to ensure sustainable convergence and a smooth participation in ERM II, Latvia is invited to contribute to reducing overheating pressures and risks to macroeconomic instability by:

(i) aiming for significantly more ambitious budgetary targets in 2008 and beyond than foreseen in the programme, notably by fully saving any revenue overperformance and respecting the expenditure ceilings;

(ii) within the overall public sector expenditure limits set within the medium-term budget planning framework, carefully prioritizing public expenditure and re-examining taxation instruments to avoid demand stimulus in sectors which do not significantly strengthen the economy's medium- and long-term supply potential;

(iii) adopt further policies to contain inflationary pressures, including through a responsible public sector wage-setting, thus contributing to the sharp reduction in whole-economy wage growth necessary to break the current cost-price dynamics and rapidly worsening cost competitiveness.

Comparison of key macroeconomic and budgetary projections

2006 2007 2008 2009 2010 Real GDP (% change) CP Nov 2007 11,9 10,5 7,5 7,0 6,8 COM Nov 2007 11,9 10,5 7,2 6,2 n.a. CP Jan 2007 11,5 9,0 7,5 7,5 n.a. HICP inflation (%) CP Nov 2007 6,6 10,1 12,5 7,2 4,9 COM Nov 2007 6,6 9,6 9,8 6,0 n.a. CP Jan 2007 6,6 6,4 5,2 4,2 n.a. Output gap (5) (% of potential GDP) CP Nov 2007 2,0 2,8 1,3 – 0,3 – 1,7 COM Nov 2007 (6) 2,1 2,7 0,8 – 1,7 n.a. CP Jan 2007 1,8 1,3 – 0,5 – 2,0 n.a. Net lending/borrowing vis-à-vis the rest of the world (% of GDP) CP Nov 2007 – 21,1 – 23,5 – 20,3 – 18,3 – 16,4 COM Nov 2007 – 19,9 – 22,2 – 18,9 – 18,0 n.a. CP Jan 2007 – 17,4 – 17,2 – 16,3 – 15,8 n.a. General government balance (% of GDP) CP Nov 2007 – 0,3 0,3 0,7 1,0 1,2 COM Nov 2007 – 0,3 0,9 0,8 0,5 n.a. CP Jan 2007 – 0,4 – 1,3 – 0,9 – 0,4 n.a. Primary balance (% of GDP) CP Nov 2007 0,2 0,7 1,0 1,2 1,5 COM Nov 2007 0,2 1,3 1,2 0,9 n.a. CP Jan 2007 0,2 – 0,8 – 0,4 0,1 n.a. Cyclically-adjusted balance (5) (% of GDP) CP Nov 2007 – 0,9 – 0,5 0,4 1,1 1,7 COM Nov 2007 – 0,8 0,2 0,5 1,0 n.a. CP Jan 2007 – 0,9 – 1,7 – 0,8 0,2 n.a. Structural balance (7) (% of GDP) CP Nov 2007 – 0,9 – 0,5 0,4 1,1 1,7 COM Nov 2007 – 0,8 0,2 0,5 1,0 n.a. CP Jan 2007 – 0,9 – 1,7 – 0,8 0,2 n.a. Government gross debt (% of GDP) CP Nov 2007 10,6 9,4 8,3 7,2 6,4 COM Nov 2007 10,6 10,2 7,8 6,4 n.a. CP Jan 2007 10,7 10,5 10,6 9,4 n.a. Convergence programme (CP); Commission services' autumn 2007 economic forecasts (COM); Commission services' calculations.

(1) OJ L 209, 2.8.1997, p. 1. Regulation as amended by Regulation (EC) No 1055/2005 (OJ L 174, 7.7.2005, p. 1). The documents referred to in this text can be found at the following website:

http://ec.europa.eu/economy_finance/about/activities/sgp/main_en.htm

(2) The assessment takes into account notably the Commission services' autumn forecast and the Commission assessment of the October 2007 implementation report of the national reform programme.

(3) OJ C 89, 24.4.2007, p. 15.

(4) In particular the data on capital taxes (compulsory data), the subcomponents of the stock-flow adjustment and some elements of the long-term sustainability of public finances table are missing.

(5) Output gaps and cyclically-adjusted balances according to the programmes as recalculated by Commission services on the basis of the information in the programmes.

(6) Based on estimated potential growth of 9,8 %, 9,8 %, 9,3 % and 8,9 % respectively in the period 2006-2009.

(7) Cyclically-adjusted balance excluding one-off and other temporary measures. There are no one-off and other temporary measures according to the most recent programme and the autumn forecast.

Sources:

Convergence programme (CP); Commission services' autumn 2007 economic forecasts (COM); Commission services' calculations.