EN Official Journal of the European Union C 55/41

COUNCIL OPINION

of 14 February 2006

on the updated convergence programme of Latvia, 2005-2008

(2006/C 55/11)

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 14 February 2006 the Council examined the updated convergence programme of Latvia, which covers the period 2005 to 2008.

(2) Over the last decade, annual real GDP growth in Latvia has averaged over 6 %. This growth performance has been characterised by strong productivity developments and more recently also by employment growth. However, high external imbalances have left Latvia reliant on capital inflows, and the foreign debt-to-GDP ratio has risen. Inflation has picked up since mid-2003 and remains above 6 %, eroding the external competitiveness of the economy and posing a threat to growth. The macroeconomic scenario underlying the programme envisages that real GDP growth will ease from 8,4 % in 2005 to 7,2 % on average over the rest of the programme period. Assessed against currently available information, this scenario appears to be based on plausible growth assumptions. The programme's projections for inflation and the current account deficit appear to be on the low side.

(3) The programme broadly follows the model structure for stability and convergence programmes specified in the new code of conduct (2).

(4) The estimated general government deficit for 2005 in the present update is 1,5 % of GDP based on GDP growth of 8,4 %. This means a slightly lower deficit and a significantly better growth performance than foreseen in the previous programme (deficit of 1,6 % of GDP, growth of 6,7 %). The Commission services' autumn forecast estimated a deficit of 1,2 % of GDP based on GDP growth of 9,1 %. However, recent data on the execution of the government budget on a cash basis indicate that the outcome will be even better than put forward in the update and the Commission services' autumn forecast.

(5) The Council Opinion on the previous update adopted on 8 March 2005 contained no policy invitations. However, it stated that the assessment of the consolidation path and of the appropriateness of the fiscal position was conditional on the favourable development of the external balance, on demand pressures in the economy, and on the moderation in inflation from its then recent peak.

(6) The updated programme aims at a modest reduction of the general government deficit. The update foresees a general government deficit of 1,5 % in 2005, 1,5 % in 2006, 1,4 % in 2007 and 1,3 % in the final year, 2008. The primary balance is set to decrease by 0,1 of a percentage point over the same period. Both revenue and expenditure to GDP ratios are planned to increase over the programme period (by 2,1 p.p. and 1,9 p.p. respectively). Public investment and not separately identified ‘other’ expenditure increase the most (from 2,3 % of GDP in 2005 to 3,3 % of GDP in 2008 and from 12,3 % of GDP to 13,8 % of GDP in 2008, respectively) and social transfers other than in kind decrease the most (from 9,3 % of GDP in 2005 to 8,9 % of GDP in 2008). Compared with the previous update, the November 2005 update broadly confirms the planned adjustment, although the growth outlook is considerably stronger.

(7) Based on Commission services' calculations on the basis of the programme according to the commonly agreed methodology, the structural balance, i.e. the cyclically-adjusted budget balance net of one-off and other temporary measures, is planned to improve only slightly over the programme period (by about of a percentage point of GDP). The planned fiscal effort is back-loaded and concentrated in years in which the output gap is estimated to be negative. The update identifies a medium-term objective (MTO) for the budgetary position, as meant in the Stability and Growth Pact, of a structural deficit of ‘around 1 % of GDP’, and aims at achieving this position in the final year of the programme period. As the programme's MTO is more demanding than the minimum benchmark (estimated at a deficit of around 2 % of GDP), its achievement should fulfil the aim of providing a safety margin against the occurrence of an excessive deficit. The programme's MTO lies within the range indicated for euro area and ERM II Member States in the Stability and Growth Pact and the code of conduct and adequately reflects the debt ratio and average potential output growth in the long term. However, taking into account the risks to sustainable economic convergence highlighted above, more ambitious budgetary positions than currently planned would seem appropriate.

(8) The budgetary outcome could be worse than projected in the programme. Even though the growth forecasts and assumed tax elasticities underlying past budgets have usually proved cautious, the latter is no longer necessarily the case in the current programme as its assumed tax elasticities seem favourable. Furthermore, the programme refers to several (proposed) social policy measures which would increase such expenditure rather than decrease it, as projected in the programme.

(9) In view of this risk assessment, the budgetary stance in the programme may not be sufficient to achieve a budgetary position in structural terms that can be considered as appropriate under the Pact by the end of the programme period. Also, as stated above, a more ambitious strategy than that set out in the programme would be desirable. The pace of the adjustment towards the programme's MTO implied by the programme is slower than the annual improvement of the structural balance of 0,5 % of GDP as a benchmark (higher in good economic times) as specified in the Stability and Growth Pact. In particular, a possible deterioration in the structural balance in 2006, implied by maintaining the 2006 target if the 2005 outcome is significantly stronger than expected, would correspond to significant fiscal easing in a context of continuing very high-demand pressures and relevant stability risks.

(10) According to the Stability and Growth Pact, ‘major structural reforms’ with a verifiable impact on the long-term sustainability of the public finances should be taken into account when defining the adjustment path to the programme's MTO or for allowing a temporary deviation from the programme's MTO. The programme notes that the ongoing pension reform and introduction of a second pillar, in particular, will gradually reduce social security contributions in the general government balance compared to the 2004 level. The net cost of the pension reform is estimated in the programme at 0,25 % of GDP in 2005, rising progressively to 1,25 % of GDP in 2008. This could allow a temporary deviation from the required yearly adjustment path of 0,5 % of GDP towards the programme's MTO because the structural reforms on which it is based are sufficiently detailed in the programme and have a significant beneficial impact on the long-term sustainability of the public finances. However, for 2006 the adjustment, also taking into account the structural reforms, is not fully in line with the Stability and Growth Pact. Nevertheless the safety margin against breaching the 3 % of GDP deficit reference value is ensured in all years of the programme. The suggestion above for a more demanding pace of adjustment towards the programme's MTO than implied by the programme seems feasible given that in the early programme years the estimated net cost of the pension reform is modest.

(11) The debt ratio is estimated at 14,9 % of GDP in 2005, well below the 60 % of GDP Treaty reference value. The debt ratio is projected to decrease very slightly over the programme period, to 14,7 % of GDP in 2008, with the effects of persistent deficits substantially dampened by high nominal GDP growth.

(12) With regard to the sustainability of public finances, Latvia appears to be at low risk on grounds of the projected budgetary costs of ageing populations (3). The currently very low level of gross debt is projected to remain below the 60 % reference value throughout the 2005-2050 projection period. Latvia is implementing a pension reform launched in 1996 which contributes significantly to contain the budgetary impact of ageing populations.

(13) The envisaged measures in the area of public finances are broadly consistent with the broad economic policy guidelines included in the integrated guidelines for the period 2005-2008. In particular, the convergence programme outlines measures to support jobs and growth by changes in the revenue and expenditure structure (especially a shift of the tax burden from direct to indirect taxation and a cut in transfers) and by making public investment a spending priority. Nonetheless, greater focus is needed on delivering the key objectives, such as containing inflation, addressing the external account imbalance and increasing activity rates by promoting an inclusive labour market.

(14) The National Reform Programme of Latvia, submitted on 21 October 2005 in the context of the renewed Lisbon strategy for growth and jobs, identifies securing macroeconomic stability as the main challenge with implications for public finances, and to that end strengthening of fiscal discipline and budgetary planning procedures are to play the major role. The budgetary implications of the limited number of concrete reform measures specified in the National Reform Programme are reflected in the budgetary projections of the convergence programme. The public finance measures envisaged in the convergence programme are in line with the actions foreseen in the National Reform Programme. As mentioned above, the convergence programme outlines measures to support growth and employment by changes in the revenue and expenditure structure (especially a shift of the tax burden from direct to indirect taxation and a cut in transfers) and by making public investment a spending priority.

In view of the above assessment, and in the light of the need to ensure sustainable convergence, including by reducing the external imbalance and containing inflation, the Council invites Latvia to pursue more ambitious budgetary positions than currently planned, including for 2006, notably by bringing forward the attainment of the MTO set in the programme, maintaining it during the programme period and avoiding pro-cyclical fiscal policies in ‘good times’.

Comparison of key macroeconomic and budgetary projections

2004 2005 2006 2007 2008 Real GDP (% change) CP Nov 2005 8,5 8,4 7,5 7,0 7,0 COM Nov 2005 8,3 9,1 7,7 7,1 n.a. CP Dec 2004 8,1 6,7 6,5 6,5 n.a. HICP inflation (%) CP Nov2005 6,2 6,9 5,6 4,3 3,5 COM Nov 2005 6,2 6,8 6,0 4,8 n.a. CP Dec 2004 6,2 4,3 3,0 3,0 n.a. Output gap (% of potential GDP) CP Nov 2005 (6) 0,5 0,8 0,4 – 0,5 – 1,1 COM Nov 2005 (8) 0,1 0,8 0,3 – 0,7 n.a. CP Dec. 2004 (6) 1,6 0,9 0,0 – 0,5 n.a. General government balance (4) (% of GDP) CP Nov. 2005 – 1,0 – 1,5 – 1,5 – 1,4 – 1,3 COM Nov 2005 – 1,0 – 1,2 – 1,5 – 1,5 n.a. CP Dec.2004 – 1,7 – 1,6 – 1,5 – 1,4 n.a. Primary balance (% of GDP) CP Nov 2005 – 0,2 – 0,7 – 0,8 – 0,6 – 0,6 COM Nov 2005 – 0,2 – 0,5 – 0,8 – 0,8 n.a. CP Dec 2004 – 0,9 – 0,8 – 0,8 – 0,7 n.a. Cyclically-adjusted balance= Structural balance (5) (% of GDP) CP Nov. 2005 (6) – 1,1 – 1,7 – 1,6 – 1,3 – 1,0 COM Nov 2005 (7) – 1,0 – 1,5 – 1,6 – 1,3 n.a. CP Dec 2004 n.a. n.a. n.a. n.a. n.a. Government gross debt (% of GDP) CP Nov 2005 13,1 14,9 13,6 13,7 14,7 COM Nov 2005 14,7 12,8 13,0 13,2 n.a. CP Dec 2004 14,2 1,5 15,8 15,0 n.a. Convergence programme (CP); Commission services' autumn 2005 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://europa.eu.int/comm/economy_finance/about/activities/sgp/main_en.htm

(2) The programme has gaps in the optional data prescribed by the new code of conduct (in particular, data are not given for labour productivity per hours worked).

(3) Details on long-term sustainability are provided in the technical assessment of the programme by the Commission services

(http://europa.eu.int/comm/economy_finance/about/activities/sgp/main_en.htm).

(4) The net costs of the ongoing pension reform (introduction of a second pillar) are included in the deficit. The costs are estimated at 0,27 % of GDP in 2005, 0,37 % of GDP in 2006, 0,62 % of GDP in 2007 and 1,32 % of GDP in 2008.

(5) Cyclically-adjusted balance (as in the previous rows) excluding one-off and other temporary measures. The year-on-year improvement in the cyclically-adjusted balance foreseen in the programme, adjusting for the impact of the phased implementation of the pension reform, would be 0,2 % of GDP in 2006, 0,6 % in 2007 and 1,0 % in 2008, an average of 0,6 % in the period 2006-2008. Since there are no other one-off and temporary measures specified in the programme, the cyclically-adjusted balance and the structural balance are identical.

(6) Commission services' calculations on the basis of the information in the programme.

(7) There are no one-off and other temporary measures in the Commission services' forecast.

(8) Based on estimated potential growth of 7,9 %, 8,3 %, 8,3 % and 8,2 % respectively in the period 2004-2007.

Source:

Convergence programme (CP); Commission services' autumn 2005 economic forecasts (COM); Commission services' calculations.