EUROPEAN COMMISSION Brussels, 27.2.2019 SWD(2019) 1013 final COMMISSION STAFF WORKING DOCUMENT Country Report Latvia 2019 Accompanying the document COMMUNICATION FROM THE COMMISSION TO THE EUROPEAN PARLIAMENT, THE EUROPEAN COUNCIL, THE COUNCIL, THE EUROPEAN CENTRAL BANK AND THE EUROGROUP 2019 European Semester: Assessment of progress on structural reforms, prevention and correction of macroeconomic imbalances, and results of in-depth reviews under Regulation (EU) No 1176/2011 {COM(2019) 150 final}



Contents Executive summary 1.Economic situation and outlook 2.Progress with country-specific recommendations 3.Reform priorities 3.1.Public finances and taxation 3.2.Financial sector 3.3.Labour market, education, and social policies 3.4. Competitiveness reforms and investment Annex A: Overview table Annex B: Commission Debt Sustainability Analysis and fiscal risks Annex C: Standard Tables Annex D: Investment Guidance on Cohesion Policy Funding 2021-2027 for Latvia References LIST OF Tables Table 1.1:Key economic, financial and social indicators Table 2.1:Summary table of 2018 CSR assessment Table 3.2.1:Financial soundness indicators

Table C.1:Financial market indicators Table C.2:Headline Social Scoreboard indicators Table C.3:Labour market and education indicators Table C.4:Social inclusion and health indicators Table C.5:Product market performance and policy indicators Table C.6:Green growth LIST OF Graphs Graph 1.1: GDP growth and components' contributions Graph 1.2: Investment growth and contributions, % Graph 1.3: HICP inflation and contributions, % y-o-y change Graph 1.4: Selected labour market indicators Graph 1.5: Population change and its drivers, % Graph 1.6: Selected social inclusion indicators Graph 1.7: Current account and its components, % of GDP Graph 2.1: Multiannual implementation of 2012-2018 country-specific recommendations to date Graph 3.1.1: The fiscal stance and the economic cycle Graph 3.1.2: Expenditure growth and the discretionary fiscal effort Graph 3.1.3: Government primary expenditure by function Graph 3.1.4: Tax revenue and implicit tax rates (2016)

Graph 3.1.5: Property tax revenue and cadastral values in 2012 and 2018 Graph 3.1.6: Estimates of Latvia’s shadow of economy Graph 3.2.1: Credit growth, y-o-y % change Graph 3.2.2: Price to income ratio, index 2010=100 Graph 3.2.3: Newly constructed dwelling space, m2 per 1000 people Graph 3.3.1: Job vacancies and labour shortage indicators Graph 3.3.2: At-risk-of-poverty or social exclusion rate by age groups Graph 3.4.1: Productivity annual change, % Graph 3.4.2: Average annual growth 2010 - 2017, % Graph 3.4.3: Real investment, index 2010=100 Graph 3.4.4: Real investment by asset type, million EUR in 2010 prices Graph 3.4.5: Wage growth compared to wage benchmarks, % change Graph 3.4.6: Productivity and unit labour costs, annual rate of change % Graph 3.4.7: Export market shares, index 2010=100 Graph 3.4.8: Research and development expenditure, % of GDP Graph 4.4.1: Europe's Digital progress report (EDPR), 2018 Map 3.4.4.1: GDP per head in Latvian regions, index EU=100 Map 3.4.4.2: Population change in Latvian regions, 2010-2016, % LIST OF Boxes

Box 2.1: EU funds and programmes contribute to addressing structural challenges and to fostering growth and competitiveness in in Latvia Box 3.3.1: Monitoring performance in light of the European Pillar of Social Rights Box 3.4.1: Investment challenges and reforms in Latvia Executive summary Latvia remains among the countries whose economy is catching up fastest with the EU average, but addressing population decline and ensuring that economic growth benefits all of society continue to be important challenges. Latvia’s economic and labour market performance has been solid in recent years and government borrowing has remained broadly sound. However, growth has not been fully inclusive, as inequality has remained high and growth in peripheral regions has lagged behind the Riga region. Latvia’s main challenge over the coming decades will be to ensure that its economy continues to catch up with the EU average while coping with a falling population. Therefore it will need to invest in innovation, regional development and human capital to improve its social, health and public governance policies ( ). A strong rise in investment and solid consumer spending carried economic growth to 4.7 % in 2018. Consumer optimism and the inflow of EU funds have fuelled domestic demand for the past 2 years and are expected to support GDP growth. However, economic growth is set to slow down in 2019 and 2020 as investment gradually loses its dynamism. Moreover, weakening external demand is expected to weigh on Latvia’s export performance. At the same time, consumer optimism remains high thanks to strong wage increases, which are expected to continue feeding consumer spending in 2019 and 2020. Strong economic growth helped increase employment for the first time in 3 years. The unemployment rate fell to 7.4 % in 2018 as employment growth is forecast to have reached 1.5 %. The strong economy drew more people into the labour market and therefore helped temporarily to offset the continuous decline in the working-age population. However, demographic trends will make it increasingly difficult to increase the number of people employed. Wages are growing rapidly in Latvia, (by nearly 9% in 2017, 7 % in 2018 according to Commission forecast) driven by the tightening of the labour market. Latvia’s population is projected to shrink on average by nearly 1 % annually over the next 20 years. That is roughly the same pace as what has been observed since the early 1990s. However, whereas until now emigration has been the primary driver of population decline, in the future natural population change will take the lead role. Moreover, the rate of decline in the working-age population is set to accelerate over the next 20 years compared with the previous two decades. This will mean that the ratio of non-working population to working population is set to increase at a faster pace than before, which puts an increasing burden on pension policy. Furthermore, a declining population tends to make the economy less efficient as the cost of infrastructure is borne by fewer people. Growth in the cost of labour in Latvia has been among the fastest in the EU over the past few years. Due to the increasing shortage of workers, real wage growth (i.e. taking inflation into account) has exceeded productivity growth for a number of years already. This has not had a significant impact on Latvia’s export performance so far, but if the current wage and productivity trend continues, the competitiveness of Latvia’s exports could suffer in the longer term. On the other hand, inflation remains broadly in check, the economy’s current account is in surplus and credit growth is low, thus significantly reducing the likelihood of the economy overheating. Inequality remains high due to low redistribution through the tax and benefit system. The 2017 tax reform made income taxation slightly more favourable to those on lower incomes, but overall the tax cuts were only partly targeted at this group. Moreover, the overall tax cut has meant less funding is available for social benefits. Public spending on social protection and healthcare remains low and is less effective at reducing poverty and inequality than in other EU countries. Social dialogue between employers and trade unions in the private sector also remains limited. Latvia is catching up fast with average EU living standards, but with great disparities across its regions. Riga and its vicinity account for more than half of Latvia’s GDP and are the country’s economic engine. Regions further away from Riga are both poorer and have had slower growth. The average wage is 40 % higher in Riga than in Latvia’s poorest region, Latgale. The most pronounced differences, however, lie in employment opportunities. In the greater Riga area, employment has increased by 12 % since 2010, while in the rest of the country it has declined by 2 %. These disparities have also had an impact on emigration; the population decline in Riga and its vicinity has been significantly smaller than in the rest of the country. The budget deficit is set to increase slightly in 2019 and 2020 as a result of the tax reform. The 2018 budget balance was better than expected due to strong economic growth. However, the 2019 budget balance is expected to deteriorate somewhat due to the high growth in public wages, and the tax reform still weighing on government revenue. Latvia's performance on the indicators of the Social Scoreboard supporting the European Pillar of Social Rights is mixed. There are notable improvements in Latvia’s labour market: the employment rate is high for both men and women, unemployment is decreasing and there are fewer young people not in employment, education or training. However, not everyone is benefiting from the improved economic situation, and high income inequality remains a challenge. The proportion of people at risk of poverty is decreasing but remains high, especially among vulnerable groups. Moreover, the impact of social benefits on reducing poverty is relatively limited. Access to healthcare remains a significant concern, given the high number of cases where people, especially in the lowest income group, are unable to receive necessary health services. Latvia can boost its long-term growth potential by focusing private and public investments on innovation, human capital and regional development. Latvia remains a catching-up economy and its main national development focus is on increasing its GDP per capita. As evidenced by falling productivity growth rates, the easy gains of the early catch-up stage have been exhausted. This means that productivity growth will have to increasingly rely on knowledge-intensive activities. Latvia’s weakest point has been innovation, which requires investments in research and development, in developing people’s knowledge and skills, and in other intangible assets. Latvia would also benefit from boosting the economic potential of its peripheral regions - increasing their accessibility, and promoting energy efficiency, employment and investment opportunities. Finally, investments in social inclusion and healthcare are needed in order to tackle high inequality and uneven access to employment and public services. Additionally, investment in resource efficiency is also needed in order to speed up Latvia's energy transition. Annex D identifies key priorities for support by the European Regional Development Fund, the European Social Fund Plus and the Cohesion Fund for the 2021-2027 period in Latvia, building on the analysis of investment needs and challenges outlined in this report. Latvia has made limited progress in addressing the 2018 country-specific recommendations. There has been some progress in the following areas: ·Improving governance: this has been achieved notably by passing the whistleblower protection law and by following up on recommendations by the country’s Judicial Council to improve the insolvency process. ·Improving accessibility, quality and cost-effectiveness of the health system.

·Making vocational education and training more relevant to labour market; reforms have picked up pace in this area and work based learning is being rolled-out. Plans to develop a comprehensive skills strategy are ongoing. There has been limited progress in the following areas: ·Improving the accountability and the efficiency of public administration. ·Improving taxation: some efforts have been made to improve tax compliance, but the tax burden on labour remains relatively high. There has been no progress in the following areas: ·Improving the adequacy of minimum income benefits: plans to improve minimum income in 2019 have been proposed but funding has yet to be allocated for them. Regarding progress towards its national targets under the Europe 2020 strategy, Latvia has attained its employment rate target. It already met its targets on preventing early school leaving, tertiary education attainment and on reducing poverty in 2016, and is performing well on renewable energy, energy efficiency and reducing greenhouse gas emissions. However, it is far from its public research and development investment target, which it is unlikely to meet by 2020. The main findings of the analysis in this report, and the related policy challenges, are as follows: ·The share of capital taxation is set to decline, while the tax burden on low wages remains high after the tax reform. The cuts in taxes on capital and on labour income have been costly, with significant benefits going to the richest households while limiting resources for redistributive policies. The tax burden on labour has been reduced overall, but remains high for low-wage earners relative to the EU average. Moreover, the freezing of the values used to calculate land and property taxes will reduce the revenue share of recurrent property taxation in GDP over time. ·Despite a sharp reduction in bank deposits by non-residents, improvements in Latvia’s anti-money laundering strategy are warranted, to control the remaining banking risks. In the wake of the closure of Latvia’s third largest bank ABLV due to allegations of money laundering, Latvia banned its banks from servicing ‘shell companies’ and asked them to come up with new business models that would considerably reduce the exposure to money laundering risk. While the non-resident banking sector has now shed more than 60 % of non-resident deposits, Latvia’s anti-money laundering framework still needs substantial improvements. An international expert report highlighted the need to strengthen the quality and capacity of Latvia’s supervisory, control and law enforcement bodies and its international cooperation. ·The education system faces a challenge to consolidate resources while improving quality and efficiency. While Latvia’s education system performs well in terms of learning achievement, access to quality education remains dependent on the place of residence and type of school. In addition, a disproportionate share of resources is used for the maintenance of the large school network rather than for teaching and learning. The higher education system is fragmented and while tertiary education attainment rates are high, the proportion of science, technology, engineering and mathematics graduates is low. Vocational education and training is being modernised, but the share of students in this type of education and their employability are below the EU average, as is participation in adult learning. The low level of digital skills among the labour force limits the use of digital technologies by businesses and the potential for innovation. ·Latvia's labour market performance is positive overall but employment conditions differ across regions and skill levels. Unemployment is significantly higher in regions furthest away from the capital, and moving for work remains a challenge. Older people with outdated skills also encounter more difficulties. Participation and spending in schemes which help the unemployed find work are still lagging behind. Efforts have been made to reach vulnerable groups outside the labour market, but this remains a complex task. ·The adequacy of social benefits remains low. Benefits rose only marginally and do not contribute a lot to alleviating the high levels of poverty and inequality. Ambitious government plans to raise the minimum income level have been shelved due to a lack of funding. The large share of low-wage earners and widespread under-reporting of wages mean that a sizeable part of the population has only minimal social coverage. Despite some increases in the lowest pensions, ensuring their adequacy remains a challenge, while the proportion of the elderly at risk of poverty and social exclusion are increasing. Moreover, the social protection of people with disabilities remains weak. Social housing is scarce and not always fit for living. ·Low public spending for healthcare, and unhealthy lifestyle choices, are the main reasons for the population’s poor health. Additional public financing has resulted in tangible improvements in the availability of health services and reduced waiting times in some areas. However, public spending plans for 2020 remain well below the EU average. Reforms to boost efficiency and quality in healthcare are progressing but are in an early phase. If the new health insurance system comes into effect, it risks reducing access to care for those who cannot afford to make voluntary health contributions. ·Latvia invests very little in research and development. In 2017, the share of expenditure on research and development was 0.51 % of GDP (against 2.1 % in the EU average). This level was among the lowest in the EU and rather stable over the last decade. Moreover, research funding relies almost entirely on EU funds. Latvia is a moderate innovator with some strong points like its information, communications and technology infrastructure, but its performance is lagging behind in human resources, in public-private sector cooperation, and in investment in intellectual property. Latvia’s innovation performance could benefit from the more active involvement of its largest state-owned companies, which have the resources to afford substantive investment capacity. ·Better internal labour mobility is crucial to economic growth outside Riga. Moving for work to places outside the capital region is made difficult by a lack of rental housing. This has often led people who cannot find work where they live to move abroad rather than to move within Latvia. Despite the lack of adequate and affordable housing, investment in housing in places outside Riga has been low due to the population’s low purchasing power and the lack of long-term financing. Investment in housing has also been hampered by lengthy construction processes and poor protection of landlords’ interests in the case of rental housing. ·Latvia is close to meeting its renewable energy target for 2020, but more efforts are needed to improve energy efficiency. A comprehensive programme for improving the energy efficiency of dwellings has helped but energy consumption trend in the residential and transport sectors is growing. Latvia is also on track to achieve its 2020 target for the share of energy produced from renewable sources, although the support scheme has proved expensive. ·Latvia's recycling rate is low and there is little progress in recent years. Latvia still landfills most of its municipal waste. Poor coordination of policies and lack of financial incentives are the main reasons behind its struggle to increase the share of recycling. ·Latvia has slightly improved its score on the corruption perception index, but corruption remains a concern. The recent adoption of the whistleblower law marks a positive step. The country’s anti-corruption body has also gathered momentum recently thanks to it uncovering a number of high profile corruption cases. Nevertheless, government decision-making is still perceived to be influenced by favouritism and the procurement process as susceptible to corruption. Delays in the implementation of the anti-corruption strategy and the lack of verification of the officials’ assets declarations still raise concerns. 1. Economic situation and outlook

GDP growth Strong GDP growth continued in 2018 as investments and private consumption pushed it above 4% for the second year in a row. Consumer optimism and EU fund inflows have determined the growth conditions for the past 2 years and are expected to positively influence GDP growth going forward. Exports performed relatively well, considering the expected slowdown from financial services and transit services. Government consumption increased at a solid pace too and employment growth picked up in 2018 after several years of stagnation supported by strong growth in construction activity. At 2.6% growth, inflation remained about the same as the year before. Graph 1.1:GDP growth and components' contributions Source: European Commission The Commission's Winter Forecast projects growth to slow down to 3.1% in 2019 and to 2.6% in 2020. The core growth drivers – above average consumer optimism and the favourable investment dynamic – are expected to remain present over the forecast horizon. However a number of other factors will mean that growth will slow compared with 2017 and 2018. Most important among them, investment growth is expected to slow to single-digit pace as the EU fund inflows peak. Furthermore, less dynamic external demand and limited fiscal space are set to slow exports and government consumption relative to the previous 2 years. Consumption Solid private consumption is set to remain the core of economic growth over the forecast horizon. In 2018, household consumption is forecast to have grown by 4.5%, surpassing the previous year's growth as it received a boost from strong employment growth. Consumption was further aided by rapid investment growth which led to a steady increase in durable goods consumption. Optimism remains well above the long-term average and is expected to carry private consumption growth at a healthy pace going forward. However, weak employment growth will slow it down somewhat. Investment The inflow of EU funds and office space construction are driving investment growth in Latvia. In 2018, investment is forecast to have grown by 11.2%, slightly down from 13.1% the year before. Office space and EU-funded non-residential construction were the biggest contributors to investment growth. At the same time, investment in intellectual property was stagnant in 2018. As inflows of EU-funds peak, infrastructure investment is set to slow but pent-up demand for office space and housing should ensure investment growth of around 2-3% over the forecast horizon (Graph 1.2). Graph 1.2:Investment growth and contributions, % Source: European Commission Trade Export performed strongly in 2018, but weakening foreign demand and a structural decline in some of Latvia’s services exports suggest a slowdown. Exports is forecast to have grown by 3.6% in 2018, delivering a positive surprise given that the decline in exports of financial services and transport services was expected to weigh heavily on Latvia's overall export performance. Financial service exports which amounted to around 1% of GDP in 2017 are expected to have declined significantly following the government’s decision to drastically reduce the banking sector’s exposure to non-EU clients by banning banks from serving shell companies. Transport exports, are in a long term structural decline due to Russia’s decision to divert most of its cargo to its own ports. Besides these developments, the exports are forecast to perform well despite expected slowdown in external demand. Inflation Energy and services prices are expected to dominate the inflation dynamics over 2019 and 2020. The 2018 inflation figures of 2.6% was driven by increases in energy and services prices. This is slightly less than 2.9% in 2017 when substantial one-off increase in food prices created up-tick in inflation. Wage growth in Latvia has been among the fastest in the EU – it increased by 7.9% in 2017 and continued growing at around the same pace in the first half of 2018. The rapid wage growth has gradually pushed the services price inflation up, but otherwise it has been slow to translate into wider inflation. In 2019, energy price increases, recovering food price growth and a continued push from services prices are expected to lift inflation to 2.7%, before slowing down in 2020 as the energy price increase halts. Graph 1.3:HICP inflation and contributions, % y-o-y change Source: European Commission Productivity and unit labour costs Over the past couple of years Latvia's productivity growth has accelerated, which dampened the high unit labour cost growth. Productivity growth reached 4.7% in 2017, putting Latvia among the countries with the highest productivity growth in the EU. This is also up from the 2.4% average growth of the preceding 3 years. The productivity growth is broad-based across all main economic activities like industry, trade and the public sector. As a result, the unit labour cost growth slowed to 3.2% in 2017, compared with an average growth of around 5% since 2012. However, over 3 years its growth rate of 14.7% remains among the highest in the EU. Looking forward, productivity growth is set to slow along with overall GDP growth, but is expected to remain robust. The unit labour cost growth is not expected to abate significantly over the forecast horizon as the falling labour supply is set to remain a permanent factor. But the cooling off of the investment growth may ease the labour demand pressure somewhat. Labour market Latvia’s economy raised the labour market activity rate and employment but a further decline of the labour force seems inevitable. In 2018, the rapid growth in construction and trade drove an increase in employment. At the same time, the labour force continued to decline, albeit at a slower pace than in previous years as the strong economy helped increased the activity rate among 20-64-year-olds, which stood at 83.5 % in 3rd quarter of 2018, exceeding its previous peak in 2008. The unemployment rate continued to fall and was 7.1% in 3rd quarter of 2018, well below its historical average, but slightly above the EU average. As a result of the tight labour market, wage growth continued at a rapid pace spurred in part by a significant increase in the minimum wage. Looking forward, wage growth is expected to remain elevated although it should ease somewhat as the pressure from the construction sector eases. Graph 1.4:Selected labour market indicators Source: European Commission Since 2010, there has been a steady improvement in most labour market indicators. The long-term unemployed rate continued its downward path in 2018 and stood at 3.0 % in 3rd quarter of 2018, close to the EU average. Young people also benefit from the improvement in the labour market, with this group’s unemployment rate falling to 9.8 % in 2nd quarter of 2018 (below the EU average of 15.2 %), down from 36.2 % in 2010. The share of young people not in employment, education or training (NEET) also decreased by 0.9 pp (year-on-year) to 10.3 % in 2017 (close to the EU average level of 10.9 %)

Demographic developments Latvia’s population is projected to continue declining by around 1% annually, but the decline in the working age population is set to intensify. Latvia's population has been declining since 1991 at an average rate of slightly above 1% annually. Emigration has accounted for roughly two thirds of the depopulation, while natural change has accounted for the remaining third. The average pace of the population decline over the next 20 years is expected to be about the same as it has been over the past three decades – just above 1% annually. However, migration is projected to gradually balance, while natural change is expected to worsen. Also, the decline in working age population is set to intensify. Whereas since 1990, the working age population has decreased on average at the same rate as the total population, the rate of decline is set to increase. Over the next 20 years the average annual pace of working age population decline is projected at 1.6%, while the average total population decline is projected at 0.9% annually. The decreasing share of the working age population means the old-age dependency ratio is set to increase faster than before. The ratio of over 65 year olds to those between ages 20 and 64 was about 0.2 in 1990, is 0.33 now and is projected to increase to about 0.57 by 2040. The population decline and increasing dependency ratio bring important policy challenges in a number of areas: fiscal sustainability (see Section 3.1.4), labour supply (see Section 3.3.1), healthcare (see Section 3.3.3), education (see Section 3.3.4), productivity, energy and public administration (see European Commission, 2018h). Graph 1.5:Population change and its drivers, % Source: European Commission Social developments Overall poverty and social exclusion have decreased to pre-crisis levels, but vulnerable groups are being left behind. In line with the gradual improvement in the labour market, the share of people living in very low-work intensity households has been falling since 2010 and reached 7.6 % in 2018, down from the peak of 12.6 % recorded in 2010-2011( ). Moreover, severe material deprivation has been steadily decreasing since 2011 and has fallen below pre-crisis levels (9.5 % in 2018 as compared to 24 % in 2007). However, the at-risk-of-poverty rate, a measure of relative poverty, is still above pre-crisis levels (23.3 % in 2018 as compared to 21.2 % in 2007). More broadly, the risk of poverty or social exclusion has decreased steadily since 2012 and was at historically low of 28.4% in 2018. However, the risk of poverty or social exclusion has been increasing for the elderly, the unemployed and persons with disabilities (Section 3.3.2). The at-risk-of-poverty rate is higher in rural areas, and in 2017 the median income of rural dwellers was only 76% that of urban dwellers, against an EU average of 84%. Graph 1.6:Selected social inclusion indicators Source: European Commission Income inequality remains well above the EU average. In 2018, the income of the richest 20 % of the Latvian population was 6.8 times higher than that of the poorest 20 %; a significantly more uneven distribution than in the EU as a whole (5.1 times in 2017). The redistribution through taxes and social transfers in Latvia has a lower impact on income inequality than in other Member States, due to the limited adequacy of social protection system and the limited progressivity of tax system (Section 3.1.3. on taxation and Section 3.3.2 on social policies). Wealth inequality in Latvia is among the highest in the EU. With a Gini coefficient for distribution of wealth ( ) of 78.5, the wealth inequality in Latvia is among the highest of Member States. Around half of the wealth reflects ownership of the main residence and a quarter reflects ownership of other real estate, which is similar to the EU average. Share of wealth as financial assets is somewhat lower in Latvia, but it is mostly owned by the richest households, as in the rest of the EU. The high wealth inequality in Latvia persists despite low levels of housing-related debt and a high rate of home ownership in the general population (81.5 %), including among the population who are at-risk-of-poverty (74.2%). Unequal opportunities persist in access to education and healthcare. Income poverty between children of low-skilled parents and those of high-skilled parents has been gradually narrowing since 2009: in 2018, it stood at 52.1 pps, below the EU average of 53.9 pps in 2017. Likewise, the difference in 2015 students’ performance in science in the OECD Programme for International Student Assessment that could be explained by students’ socio-economic status was among the lowest in the EU. However, when looking at how affordable education is for the different income groups, Latvia fares worse than the EU average, with Latvians reporting more difficulty overall in affording education ( ). In addition, there is a clear gap in labour market participation between ethnic minorities and ethnic Latvians. Moreover, access to healthcare is unequal among income groups — the low income groups report a much higher level of unmet needs for medical services than the high income groups (Section 3.3.3). Regional perspective Economic development and employment opportunities differ considerably among Latvian regions. In 2015, GDP per capita in Riga stood at 167% of the national average, while in the other regions it was below the national average with the poorest region – Latgale – producing only 56% of the national average. However, the GDP per capita figures are influenced by the large amount of commuters coming to Riga and by the fact that all of the largest state-owned enterprises are registered in Riga, while producing economic output all over Latvia. Therefore, the differences in wages arguably provide a fairer view of regional disparities. Workers in Riga earn 113% of national average, while workers in Latgale receive 69% of the national average. Furthermore, the difference in GDP per capita and wages with Riga has narrowed for most regions, the exception being Latvia's western region – Kurzeme – where the growth of GDP per capita and the wages has been slowest in Latvia over the past 15 years or so. However, whereas wages and GDP per capita have risen in all regions (albeit much faster in Riga), employment opportunities have diverged – the Riga metropolitan region's share of total employment has increased from 52% in 2008 to 55% in 2017. Latgale and Kurzeme have fared the worst. Contrary to the rest of the country employment in these regions has shrunk compared to 2010, the year the economy hit its lowest point during the crisis. External position The current account has remained balanced despite accelerating GDP growth. In 2018, the current account is forecast to have been balanced, slightly lower than the 0.7% of GDP surplus in 2017. The current account has remained roughly balanced since 2014, largely due to a better trade balance. From the investment-savings perspective, higher households' net savings rate has been the main contributor to balancing the current account compared to 2010 – 2014. As a result, the net international investment position (NIIP) also continued to improve and stood at minus 50% of GDP at the end of 2018. While still relatively high, the associated economic risks are limited, because the NIIP is mostly composed of foreign direct investment, while the investment position excluding equity was close to balance at the end of 2018. Graph 1.7:Current account and its components, % of GDP Source: European Commission Public finances The general government balance remains negative despite strong GDP growth. The general government recorded a deficit of 0.7% of GDP in 2018 as a sizeable tax cut and increase in defence and healthcare spending drove the slight surplus of 2016 back into deficit. The government balance is set to deteriorate further in 2019 before improving somewhat in 2020. The Commission estimated that the output gap remains substantially positive, making the current deficits contribute to pro-cyclical fiscal policy stance. Table 1.1:Key economic, financial and social indicators (3) The tax-to-GDP indicator includes imputed social contributions and hence differs from the tax-to-GDP indicator used in the section on taxation Source: Eurostat and ECB as of 31-1-2019, where available; European Commission for forecast figures (Winter forecast 2019 for real GDP and HICP, Autumn forecast 2018 otherwise) 2. Progress with country-specific recommendations

Since the start of the European Semester in 2011, 85% of all country-specific recommendations addressed to Latvia have recorded at least ‘some progress'. Looking at how Latvia has implemented its CSRs in the years since they first began to be issued, 84% of all the recommendations addressed to Latvia have recorded at least ‘some progress’ (Graph 2.1). Latvia has achieved substantial progress and full implementation by maintaining fiscal discipline, adopting the domestic fiscal framework and by improving macro-prudential supervision of the banking sector. Graph 2.1:Multiannual implementation of 2012-2018 country-specific recommendations to date Source: European Commission Latvia maintains fiscal discipline and has somewhat reduced tax burden on low wages. Fiscal targets are set with a tight margin to the rules-based requirements. A fiscal framework has been set up and implemented. The recommendation since 2012 to shift taxation from low wages to other sources less detrimental to growth was partly addressed by the 2017 tax reform. While the tax wedge on low wages has been reduced, it is still high in Latvia. Moreover, the tax-cutting measures were only partly targeted towards low income groups, while the reform costs limit resources for public services, including for distributional policies. Tax compliance has improved over time as a result of the tax administration’s efforts, but remains a challenge. Social policy reforms have not advanced much, mostly due to their costs. Minimum social benefits remain very low and only a marginal increase has been adopted. Far-reaching minimum income reform has not been introduced, primarily due to its cost. Public expenditure of and participation in activation measures for the unemployed remain limited, while outdated skills and insufficient knowledge of the Latvian language remain obstacles to employment. Updating vocational education and training curricular has been accelerated and work-based learning is introduced. Participation in adult learning although increasing, remains low. Financing for public healthcare is increasing in 2018-2019, but its level is still low relative to other countries and service needs. The public administration reform plan adopted in November 2017 is being slowly rolled out, aiming for streamlining of central government as well as greater efficiency and quality of services, but no such plans have been presented for the local authorities. Streamlining of central government has been launched, aiming for greater efficiency and quality of services, but no such plans have been presented for the local authorities. The fight against corruption has been ramped up under the new leadership of The Corruption Prevention and Combatting Bureau, with investigations launched in several large corruption cases. However, verification of asset declarations of the public officials still raises concerns. The recent adoption of the Whistleblower Protection Law provides an opportunity to increase transparency and the efficiency of the public administration. Overall, Latvia has made limited progress ( ) in addressing the 2018 country-specific recommendations. It made some progress on strengthening the accountability of public administration, notably by passing the Whistleblower Protection Law, by following up on recommendations from its Judicial Council to improve the insolvency process, by increasing the provision of public healthcare services, and by proceeding with the reforms in the vocational education. Only limited progress was made on reducing the tax wedge on low-income earners, on improving the efficiency of public administration. No progress was made on improving the adequacy of minimum social benefits, as the planned increase in minimum income benefits has not been funded. Table 2.1:Summary table of 2018 CSR assessment Source: European Commission Box 2.1: EU funds and programmes contribute to addressing structural challenges and to fostering growth and competitiveness in in Latvia Latvia is one of the countries benefiting most from EU support. The financial allocation from the European Structural and Investment Funds (ESIF) to support Latvia in facing development challenges amounts to EUR 5.63 billion under the current multiannual financial Framework. This is equivalent to around 3% of the country’s GDP annually. As of the end of 2018, some EUR 4.27 billion (around 76% of the total) had already been allocated to specific projects. In addition, Latvia benefits from other EU programmes such as: (i) the Connecting Europe Facility, which allocated EUR 269.4 million to specific strategic transport network projects; and (ii) Horizon 2020, under which 290 participants have received funding of EUR 53 million (including 47 SMEs, accounting for funding of about EUR 10 million). EU funding has helped to address policy challenges identified in the 2018 country-specific recommendations. The European Social Fund is being used to upskill and reskill the labour force— as a result, so far more than 50 000 unemployed people and almost 9 000 employed people have improved their qualifications and skills. The quality of vocational education and training (VET) has improved as VET school network optimisation is completed, curricula reform is ongoing and over 1 000 students have enrolled in work-based learning. The implementation of Latvia’s health reforms is ongoing and ESIFs are contributing to improving the accessibility, quality and cost-effectiveness of the healthcare system. For example, to address regional disparities in access to healthcare, 133 medical practitioners have already been attracted to rural areas and to cities outside Riga. EU funding is contributing to major developments in the Latvian economy by promoting growth and employment via investments in areas such as research, technological development and innovation, business competitiveness, sustainable transport, employment and labour mobility. By 2018, investments driven by the ESIF had already led to the building or modernisation of more than 300 km of roads, both at regional level and in connection with the TEN-T network. Over 40 supported research project supported by the European Regional Development Fund (ERDF) have been commercialised, and support has already been approved for 3 111 businesses, including 382 start-ups, generating 665 new jobs. ESIFs have also contributed to a reduction of greenhouse gas emissions by 8 570 tonnes of CO2. In addition, the Commission can provide tailor-made technical support upon a Member State's request via the Structural Reform Support Programme to help Member States implement growth-sustaining reforms to address challenges identified in the European Semester process or other national reforms. Latvia, for example, is receiving support to improve its tax administration, assess and improve the overall performance of its health and develop its capital markets. The Commission is also assisting the authorities in their efforts to fight money laundering through the implementation of a training programme. In addition, in 2018, work has started on improving the efficiency of the public sector, in the Ministry of Interior in particular. Furthermore, support is being provided to strengthen the coordination and monitoring framework of state-owned enterprises. EU funding contributes to the mobilisation of private investment. ERDF alone mobilises additional private capital by allocating about EUR 130 million in the form of loans, guarantees and equity. This is expected to leverage additional private investment amounting to EUR 440 million. Altogether, 2.85% of the ESIFs allocation was paid in the form of financial instruments. In addition, the overall volume of approved operations by the European Investment Bank with backing from the European Fund for Strategic Investments (EFSI) amounts to EUR 229 million, which is set to trigger a total of EUR 966 million in additional private and public investments (February 2019). Latvia ranks 8th as to the overall volume of approved operations as a share of GDP. 9 projects involving Latvia have so far been approved under the infrastructure and innovation window of EFSI. They amount to EUR 207 million in total financing, which should, in turn, generate EUR 567 million in investments. Under the SME component, 8 agreements with intermediary banks have been approved for a total of EUR 22 million, which should mobilise around EUR 399 million of total investment. 7 298 SMEs and mid-cap companies are expected to benefit from this support. EU action strengthens national, regional and local authorities and the civil society. EUR 101 million have been allocated to strengthen the capacity of public administration at different levels and to enhance cooperation with stakeholders. More information at: https://cohesiondata.ec.europa.eu/countries/LV 3. Reform priorities 3.1.Public finances and taxation

3.1.1.Fiscal policy The government’s fiscal policy has been expansive at the time of cyclical upturn in the economy. The fiscal policy stance appears to have amplified volatility of the economy by the fiscal tightening in 2016, when the economy was temporarily affected by a drop in investment, and by the pro-cyclical expansion in 2017 and 2018 (Graph 3.1.1). Moreover, the fiscal stimuli in 2017 and 2018 added to wage and inflation pressures in the economy, and reduced fiscal capacity to counteract, when the cycle turns. Graph 3.1.1:The fiscal stance and the economic cycle Source: European Commission – Autumn 2018 forecast Government spending has been volatile and has deviated from a prudent expenditure path. As a result of positive revenue surprises and underspending, Latvia achieved a fiscal surplus in 2016 compared to a planned deficit of 1% of GDP. However, rather than safeguarding the improved starting base, the budgets in 2017 and 2018 were marked by strong expenditure growth and the introduction of tax cuts, which exhausted the fiscal space. Government expenditure growth went from 0.2% in 2016 to 10.9% in 2017 and 8.6% in 2018 (Graph 3.1.2), exceeding a prudent expenditure path based on smoothed potential growth over 10 years and actual inflation. In 2019 and 2020, expenditure growth is projected to moderate to around 5%, while the expansionary effect of the adopted tax measures calls for a lower expenditure growth. Graph 3.1.2:Expenditure growth and the discretionary fiscal effort Source: European Commission – Autumn 2018 forecast Latvia spends less on health and social protection than other Member States on average. The government expenditure structure has changed very little between 2014 and 2018, except for an increase in defence spending and lower expenditure on economic affairs (Graph 3.1.3). The national defence spending increased due to the commitment regarding the North Atlantic Treaty Organization to attain the target of 2% of GDP. This is partly offset by a recent decline in the level of subsidies for the energy sector, although these are still higher than in other Member States (see Section 3.4.2 on mandatory procurement of electricity). Public spending on social protection and health services in Latvia has slightly increased, but remains among the lowest in the EU. Such expenditure is a channel for redistributive policies, for which Latvia scores low. Section 3.3 covers social and health expenditure in greater detail. Graph 3.1.3:Government primary expenditure by function Source: European Commission, 2019 Draft Budgetary Plan 3.1.2.Fiscal framework and expenditure review The fiscal framework is broadly followed, but expenditure limits are occasionally disregarded in budget implementation. The budgetary planning is based on the fiscal rules set by the fiscal discipline law and takes into account the allowed deviations for implementing structural reforms. However, applying the national budgetary rules is problematic in two areas. Firstly, the Latvian authorities treat the transitional costs of the tax reform as one-off measures, while they are not recognised as such by the Commission because the adopted measures are deliberate policy actions. Secondly, authorities tend to reallocate expenditure from budgetary positions the fiscal discipline law allows to fluctuate, to expenditure positions fixed through pre-determined limits. The apparent breaches of the fiscal discipline law requirements are flagged by the independent Fiscal Discipline Council ( ), but this has not yet led to policy change. Disregarding the expenditure limits has contributed to the recent rapid expenditure growth and undermines principles of fiscal prudence. The 2018 annual expenditure review has delivered some savings, but it not yet used for the broader public sector reform. The review identified expenditure savings of 0.2% of GDP to be used for re-allocations of other spending priorities for 2019. Notable examples include more cost-efficient management of state-owned real estate and consolidation of information technology (IT) infrastructure which will bring further gains in the medium term. Completion of the pilot project for ‘zero-based’ budgeting for state libraries launched in 2017 has been further postponed to 2019, highlighting difficulties in applying the method across public services. The expenditure review process has not yet fed into public sector reform, intended to streamline public administration and readjust policy priorities. The State Chancellery is expected to lead the process, with administrative support from the Ministry of Finance and other ministries. 3.1.3.Taxation Latvia relies on labour and consumption tax revenue, while capital is less taxed. Latvia’s tax revenue share in GDP is lower than the EU average. Labour and consumption taxes are the main revenue sources, but taxes on capital represent a low share of total revenue, even compared to other Member States (Graph 3.1.4). While cross-border effects are often used as an argument in favour of setting low tax rates, only in few cases lower implicit tax rates ( ) on capital have gained disproportionately larger revenue. For most countries, including Latvia, the relationship between level of tax rates and tax revenue broadly holds. Moreover, a lower tax burden on capital has regressive distributional effects, considering that (i) high-income households hold a larger share of financial and property wealth and earn more income from capital; and (ii) lower capital tax revenue reduces public resources for redistributive policies supporting more low-income households. A growth-friendly and revenue-neutral tax shift would have positive employment and GDP growth effects. Latvia stands out in terms of its high tax wedge on low wages; it is recommended that it shifts this tax burden to capital and property (Section 2). A model simulation shows that a revenue-neutral tax shift from low wages to property would increase employment and GDP growth, while also reducing income inequality (European Commission, 2017). Moreover, as property tax evasion is more difficult than labour tax evasion, it could also benefit tax compliance. Graph 3.1.4:Tax revenue and implicit tax rates (2016) Source: European Commission — Taxation trends in the European Union The tax measures adopted in 2017 are costly, while the tax wedge, while smaller, remains high on low wage. Personal income taxation has become more progressive, but also lower on average. The tax wedge on low income has been reduced as a result, but for a single person earning 50% of the average wage in 2020 it is estimated at 36%, which is still high relative to the EU average of 32.5% in 2017 (European Commission, 2018h). The net costs of the tax cutting and revenue-increasing measures are estimated at a total of 1.1% of GDP over 2018-2020. The richest households and capital owners seem to be the main beneficiaries of the reforms. Notably, reducing the standard personal income tax rate from 23% to 20% costs 0.8% of GDP, of which 60% goes to the richest 30% of tax payers (Ivaškaitė-Tamošiūnė et al., 2018). Transforming the corporate income taxation regime is estimated to cost 0.7% of GDP by 2020. While some of the cost will be transitional, the cut in the effective corporate tax on profits and dividends benefits the richest households (who own most of the financial wealth) (Section 1). Moreover, lower public revenues limit resources for public services on which vulnerable groups rely. The labour tax measures do not significantly reduce income inequality and poverty. The 2017 tax reform only partly targets low-income earners, as the adopted measures are not well suited for reaching the lowest income households, which tend to be unemployed, inactive or include pensioners with low pensions. For low-income earners with dependent children, a large share of their taxable income was already covered by tax-free allowances before the reform; they gain little from the personal income tax reduction and the increases in allowances. One third of pensioners had lower pensions than the allowance for pensioners before the reform, which means they do not benefit from an increase in the allowance. Such pensioners are concentrated in the poorest 20% of households. Therefore, social transfers seem better suited to reaching the poorest households (Section 3.3.2). At a similar cost as the adopted tax reform, increasing minimum social benefits has a potential to significantly reduce poverty and inequality in Latvia (Ivaškaitė-Tamošiūnė et al., 2018). The share of capital taxation is set to decline under the current policies. Revenue from taxes on capital is estimated to decline from 3.6% of GDP in 2017 to around 3% of GDP by 2020. This mostly reflects the costs of the corporate income tax reform, which is somewhat offset by increasing tax rate on interest and capital gains. The share of recurrent property tax revenue is also projected to decline; this is connected to hesitation in updating property values used for taxation to bring them into line with market values. Property taxation is based on outdated values. Recurrent property tax accounts for 0.8% of GDP in 2018, below the EU average of 1.6% of GDP in 2017. Around 60% of property tax revenue comes from land, 10% from housing and 30% from other buildings (Graph 3.1.5). The real estate cadastral values used as a basis for taxation are set to follow the market values. However, updating of cadastral values has been postponed for several years and taxation still reflects market values of 2012/2013. The proposed, but not adopted, update of cadastral values for 2018 based on 2015 market values would have increased total cadastral values by 34%, corresponding to some 0.3% of GDP in property tax revenue. The largest differences between cadastral values and market values are for agricultural land and newly built apartments. Distortions in property taxation lead to unequal treatment of taxpayers. Similar properties can have notably different property tax liabilities. This is linked to freezing of the cadastral values and special tax treatment by some local authorities which set different tax rates ranging from 0.2% to 1.5% and grant tax rebates up to 90%. More affluent municipalities tend to grant more tax rebates and use them as tool for attracting residents, thus gaining their income tax revenue. Property tax expenditure accounted for 0.1% of GDP in 2016 (Ministry of Finance, 2017). While some 40% are socially motivated, a notable share of revenue is foregone for a blanket rebate for residents in the sea-side resort of Jurmala and dedicated rebates for companies in the special economic zones and municipal companies in Riga. Various distortions hinder the uniform application of property tax and equal treatment of all Latvian taxpayers irrespective of their place of residence. Cadastral value freezes and blanket rebates have regressive distributional impacts, as property wealth is concentrated in higher income households. Graph 3.1.5:Property tax revenue and cadastral values in 2012 and 2018 Source: State Land Service of Latvia, Ministry of Finance

Tax evasion has declined, but remains relatively high. The share of the shadow economy appears to have declined over the past years by different estimates (Graph 3.1.6). However, estimates also show a large measurement uncertainty, even pointing in different directions at some points. Nevertheless, the share of under-reported economic activity is higher in Latvia than in other Baltic States. In particular, underreporting of salaries (‘envelope wages’), particularly in the construction sector, accounts for a large share of the shadow economy. Under-reported work could be reduced as a result of: (i) a sectoral wage agreement in the construction sector setting a minimum wage higher than the national minimum (Section 3.3.1); and (ii) electronic registration of working hours on large construction sites. Graph 3.1.6:Estimates of Latvia’s shadow of economy Source: Sauka & Putnins (2018), Schneider (2017), Study and Reports on the VAT Gap in the EU-28 Member States (2018), State Revenue Service (SRS) (2018) Fighting tax crimes remains a priority for the authorities. Several measures to combat the shadow economy came into force in 2018, such as: (i) disclosure of information on employers paying average salaries that are lower than the state minimum wage; and (ii) disclosure of information on employers penalised for paying ‘envelope wages’ and taxpayers not submitting tax returns on time. By the order of the Prosecutor General, chief prosecutors are requested to intensify the prosecution of financial and economic crimes and the previously lenient approach to penalties has been stiffened. However, implementation of some measures faces difficulties, as new ways of tax evasion are being uncovered, e.g. updating cash registers takes more time than planned, as new problems are discovered in already certified cash registers. The tax administration has been strengthened to work more efficient and on more complex cases. The World Bank has launched, with the support of the European Commission, a technical assistance project on tax audit, VAT control and fraud risk assessment, and to review the legal framework for VAT compliance. Specifically, Latvia is advised to: (i) legislate joint and several liability in the case of fraudulent transaction chains; (ii) create a large taxpayers’ unit within the State Revenue Service; and (iii) investigate VAT taxpayers not submitting tax returns instead of applying automatic deregistration ( ). The micro-enterprise tax regime has become more restricted, but is still abused as a tax optimisation tool. The maximum annual turnover for the micro-enterprise tax regime has decreased from EUR 100 000 to EUR 40 000. A higher tax rate is applied for turnover exceeding this amount, but the overall tax wedge remains still more attractive than that under the general labour tax regime. The micro-enterprise tax regime dominates in sectors with a high share of labour input, like taxi drivers, arts and sporting activities. The number of micro-enterprise taxpayers decreased in 2017-2018, but still accounts for some 8% of employees. These taxpayers have lower social contributions and social protection as a result. 3.1.4.Debt sustainability analysis and fiscal risks Under current policies, Latvia faces low fiscal sustainability risks in the medium and long run. The manageable initial debt level and the limited sensitivity to possible macro-fiscal shocks underpin the assessment of low fiscal sustainability risks (Annex B). Under the 2018 Ageing Report’s (European Commission, 2018d) baseline scenario, total ageing-related expenditure is not projected to increase between 2018 and 2070 as a projected fall in pension spending more than offsets increases for other items. If welfare pressures are considered, risks to fiscal sustainability appear higher. Healthcare and long-term care spending is projected to increase by some 3% of GDP by 2070 due to non-demographic cost drivers pushing up costs, under a more adverse scenario in the 2018 Ageing Report. This reflects on the currently low public spending on healthcare (Section 3.3.3) and the expected increase in demand for health services as living standards rise. Moreover, the currently very low pension adequacy is projected to worsen in the long run, which may not be socially and politically sustainable (Section 3.3.2). The average total pension (including both public and private pension income from the mandatory individual schemes) stood at 24% of the average wage in Latvia in 2016, below the EU average ratio of 43.5% ( ). The 2018 Ageing Report projects that the ratio for Latvia will decline to 18.6% by 2070, indicating that income from mandatory individual schemes would not suffice to compensate for lower public pension benefits. The structural fiscal costs involved in maintaining the benefit ratio at its current level would amount to around 2% of GDP. Increasing it to the EU average would entail a cost of 10% of GDP. 3.2. Financial sector Financial stability The Latvian banking sector remains sound despite the challenges over non-resident banks. The total capital ratio is over 22% - in line with the euro area average and well above the 10% that banks are required to keep in order to withstand an adverse shock. The Latvian banking sector’s profitability has until recently been considerably above the euro area average. However, the winding down of the non-resident banking sector activities coupled with more stringent requirements for loan loss provisions has reduced the non-resident banking sector’s profitability. This is, however, expected to be temporary and does not pose a risk to the sector’s stability. Finally, the share of non-performing loans (NPLs) at above 5% is somewhat higher than the euro area average. The NPL share dropped quickly after peaking during the financial crisis in 2010. However, unlike in the other Baltic countries, the figures have stopped improving and have remained broadly unchanged for the past 4 years. This is partly due to negative credit growth during most of that time, but primarily it is due to deteriorating quality of foreign customers’ loan portfolio. While the quality of the domestic loan portfolio has continued to improve with loans past due 90 days standing at around 3.0% in 2018, the quality of the loan portfolio of foreign customers has rapidly deteriorated since 2015, landing at around 12% in 2018 (Bank of Latvia, 2018). The increase in NPLs of foreign customers is linked to the depreciation of the Russian rouble. Table 3.2.1:Financial soundness indicators Source: European Central bank A highly integrated and concentrated Nordic-Baltic banking system warrants close collaboration among financial supervisors. Most large Latvian banks belong to Nordic banking groups, with Swedish lenders SEB and Swedbank the two leading names in Latvia. The creation of Luminor Bank AS ( ) in 2017 put in place Latvia’s second largest credit institution, with a market share of 15 % in deposits and 25 % in lending. Given the Nordic economies’ financial openness and the relatively large size of their banking system, potential spill-overs from shocks originating in those countries could be significant. Risks mainly relate to the Nordic housing markets and — with the exception of Finland — to the high indebtedness of their households. Risks may materialise in the form of constrained lending activity, short-term deposit volatility and higher financing costs for Latvian banks given the relatively heavy dependence of some Nordic countries on wholesale funding. In this regard, cross-border supervisory cooperation is warranted, to maximise the effectiveness of national macro-prudential policy instruments, ensure a level playing field for all credit institutions and reduce the risk of regulatory arbitrage. Credit growth Credit growth is improving but remains below that of the other Baltic countries. Following the 2009-2010 economic crisis, credit growth to households was negative until 2017. Since then, the annual credit growth has hovered barely above zero, while in the other Baltic countries it had been around 6-8 % over the past 2 years. Credit growth (adjusted for sales and securitisation) to non-financial corporations has been on average 1.4 % over 2018. Since 2010, private sector credit growth rates on average have remained below nominal GDP growth and as a consequence private debt has declined from above 130 % of GDP in 2010 to just above 80 % in 2017. The slow credit recovery is due to both demand and supply factors. High credit risk (bad track records, weak borrower collateral and equity), shortcomings in the legal framework (lengthy insolvency procedures, reluctance over income and asset disclosure) and the shadow economy are considered the most important supply side constraints to corporate lending, especially to SMEs, keeping banks’ lending standards tight. At the same time, credit demand from non-financial corporations is volatile due to the demand for large amounts, as smaller investments are often financed with internal resources. Subdued credit demand among households is linked to the shrinking of the population, the high incidence of undeclared incomes and to the large share of the population that has a bad credit score, a legacy of the financial crisis. Graph 3.2.1:Credit growth, y-o-y % change Source: European Central bank Domestic non-bank lending is much more buoyant than bank lending. Although banks are the main providers of funding to the Latvian economy, the role of non-bank players such as leasing companies (e.g. for the purchase of vehicles) in domestic lending is growing. Latvian non-financial corporations, particularly start-ups, also use risk capital as an alternative source of funding. Crowdfunding services, mainly attracting foreign investors and foreign borrowers, are also increasing at a rapid pace. Anti-money laundering supervision In the wake of the downfall of its third largest bank Latvia has taken swift action to minimise money laundering risks. In early 2018, the United States financial crime enforcement network (FinCen) implicated Latvia's then third biggest bank ABLV to conducting large scale money laundering. Due to the gravity of FinCen’s implications, the European Central bank revoked its licence and the ABLV bank went into self-liquidation. Its case reinvigorated international concern about the money laundering risks inherent to the Latvian non-resident banking sector ( ). In March 2018, the European Commission requested the European Banking Authority (EBA) to investigate whether breaches of EU law were committed by Latvia in relation to the above case. Latvian authorities are cooperating well with the EBA in this enquiry, although there has been some delay in providing the EBA with the requested information. In the aftermath of the ABLV case, the government expressed its firm commitment to significantly reduce the risk of money laundering in the Latvian banking sector. In May 2018 it adopted a regulation banning servicing certain types of shell companies and required the remaining non-resident banks to change their business models away from providing transactions to risky non-resident clients.

Due to the ban on shell company servicing and banks’ business model change, non-resident deposits fell significantly in 2018. In 2018 the non-resident deposits in Latvian banks declined by 60% from 8.2 billion euros (40 % of all deposits) in February to 3.1 billion euros (20% of all deposits) by the end of 2018 ( ). The decline was due to non-resident banks ceasing relationship with the riskiest clients. The remaining deposits are split broadly equally between EU and non-EU clients. Although foreign deposits have declined substantially, they remain above the government’s initial target of 5% of all deposits. Moreover, they have stabilised since August and Latvia’s bank supervisor ( ) believes that they are unlikely to fall further. The money laundering case concerning the ABLV Bank showed that weaknesses in the supervision remain. Although, since 2015, the Finance and Capital Market Commission (FCMC) had carried out several inspections at the ABLV Bank, in the course of which various sanctions and corrective measures had been imposed, apparently these did not ensure the expected results. Moreover, the 2018 Mutual Evaluation Report on Latvia’s AML system by Moneyval ( )found that while all the key risk assessment and control elements were in place, their scope and quality were inadequate relative to the volume of financial flows going through Latvia’s non-resident banks (Council of Europe, 2018). The report was critical of Latvia’s law enforcement’s success in uncovering and prosecuting money laundering-related crime and it pointed out that the sanctions applied to convicted individuals did not appear to be dissuasive. Law enforcement bodies recognize deficiencies and are committed to putting in more effort into fighting the money laundering crime. Finally, the Moneyval’s report called for a more holistic approach and for better international cooperation to fight money laundering-related crime. In response to the Moneyval’s report, Latvia has expressed commitment to review its anti-money laundering strategy. To address the weaknesses identified by the Moneyval’s report, Latvia has come up with a detailed action plan for improving its anti-money laundering/counter terrorist financing strategy. The main priorities listed in the action plan include enhancing risk-based supervision and introducing preventive measures, ensuring the required human resources for the supervisory authorities, effective information exchange among the investigative authorities and IT solutions for timely and efficient data management, among others. The National Risk Assessment of Latvia is also under review. The government plans to strengthen the dialogue between the public and private sectors in order to ensure the necessary information sharing and collaboration. While supervision and control bodies have been strengthened, law enforcement authorities’ capacity also needs to be increased. FCMC’s powers have been recently broadened to issuing regulations on risk assessment in national and international sanctions and its staff was increased. Financial Intelligence Unit’s ( ) staff was also increased to help them oversee the ABLV liquidation and implement Moneyval’s recommendations. However, the law enforcement authorities’ capacity to handle anti-money laundering cases remains low. Police investigators and prosecutors qualified in anti-money laundering are missing, which is one of the causes of the low number of money laundering prosecutions and convictions. Finally, despite improvements, first instance court cases concerning money laundering offences remain lengthy (2019 EU Justice Scoreboard (forthcoming). Housing market House price growth has picked up over the past two years. The house price growth exceeded 8% in 2017 and continued at the same pace in the first half of 2018. By comparison, the average house price growth from 2010 to 2016 was 5.5%. Despite the rapid pace, house price growth has remained broadly in line with income growth. The price to income ratio is now only slightly higher than it was in 2010 and significantly lower than it was at the height of the real estate bubble in 2008 (Graph 3.2.2). The demand for housing has been boosted by a state guarantee programme helping families and young professionals to get a mortgage against lower down payment than banks would normally require. This has also helped the mortgage credit growth turn positive in 2017. The construction of dwellings has also increased slightly, but over a longer time frame it has been anaemic. In stark contrast with the other Baltic countries, the amount of newly constructed dwelling space in Latvia has not increased much since 2010 (Graph 3.2.3). Graph 3.2.2:Price to income ratio, index 2010=100 Source: European Commission Undeclared wages, cumbersome construction regulations and weak protection of landlords hold back investment in housing. Since the financial crisis of 2009, banks in Latvia are taking a much more prudent approach to granting credit against undeclared incomes and they currently identify this as one of the main obstacles to higher mortgage credit growth. Furthermore, investors point to lengthy and cumbersome construction regulations making the process costly and leaving investors less agile to respond to growing demand. Finally, weak protection of landlords discourages more investment into rental housing (European Commission 2018a). The government has prepared a draft rental law that would significantly strengthen the protection of landlords' interests. However, there are concerns that the proposal would shift the balance of protection too much in favour of landlords. Graph 3.2.3:Newly constructed dwelling space, m2 per 1000 people Source: Statistics Estonia, Central Statistical bureau of Latvia, Statistics Lithuania, European Commission calculations Investment in housing is crucial to facilitating better internal mobility and access to quality jobs in the peripheral regions. A large share of owner-occupied buildings means there are few options for people who would like to move for jobs outside of the Riga metro area. Moreover, the population’s low purchasing power makes commercial residential development not viable. This in turn hinders regional growth and encourages emigration. The experience of the city of Valmiera ( ) shows that there is a high demand for affordable rental housing and that it can be a powerful policy tool to attract people to the municipality, providing employees to local businesses. However, it also suggests that residential development is only viable if cheap long-term financing is available. Inspired by Valmiera’s example, the Ministry of the Economy has put forward a state support programme aimed at helping municipalities finance rental housing projects. However, this has yet to be approved by the government. 3.3. Labour market, education, and social policies 3.3.1.Labour market In line with the favourable macroeconomic environment, the labour market performance is overall positive. The employment rate increased on the back of declining unemployment and growing activity rate. The long-term unemployed and young people continue to benefit from the steady improvement in the labour market (Section 1). However, the shrinking pool of the working age population is contributing to increasing labour shortages, in particular in Riga. Population projections suggest a further decrease in the working age population and an increase in the share of the elderly in the population in the medium and long term (Ministry of Economics, 2018). In addition, structural gaps in employment based on skills level, ethnicity and regions persist. Ensuring skills’ supply is one of the main areas where demand for investment remains significant. Emigration is motivated by working and living conditions, and it contributes to skill shortages. Between 2009 and 2016, the outflow of skilled labour (those with at least a medium level of education) amounted to 120 000 people. More than a half of emigrants had tertiary education, equivalent to 17.4% of the high-educated segment (ECE, 2018b). Although the outflows have decreased in recent years, still about half of the country’s population decline is due net emigration (Section 1). Emigration of skilled labour contributes to skills shortages (OECD 2017Z). Emigration is motivated by low wages and financial difficulties in Latvia, as well as dissatisfaction with quality of life and social safety nets (Hazans, 2015). The rapid wage growth (Section 1) in Latvia could discourage emigration and incentivise return migration. The Ministry of Economics (2018) assumes that the steady economic growth and increase of qualitative and well-paid jobs should reverse the net emigration by 2023. Labour shortages are reported across various sectors. Most shortages are in sectors related to science, technology, engineering, and mathematics (STEM fields), including ICT, as well as in the healthcare sector (see Section 3.3.3 on healthcare and Section 3.3.4 on education) (European Commission, 2018a). Labour shortages are also becoming more pronounced in the construction sector following its recent stronger growth (Ministry of Economics, 2018). In 2018, vacancies registered at public employment services doubled, reaching pre-crisis levels, of which nearly 80% in the Riga region. Since February 2018, incentives are provided to employers to recruit highly skilled workers from non-EU countries in occupations where a significant shortage of labour is projected. The education and skills governance systems are also being reformed (Section 3.3.4) Graph 3.3.1:Job vacancies and labour shortage indicators Source: European Commission (Eurostat, Economic Sentiment Indicator) Box 3.3.1: Monitoring performance in light of the European Pillar of Social Rights The European Pillar of Social Rights is designed as a compass for a renewed process of upward convergence towards better working and living conditions in the European Union( I ). It sets out 20 essential principles and rights in the areas of equal opportunities and access to the labour market; fair working conditions; and social protection and inclusion. The analysis in this report has been carried out in light of the Pillar’s principles. Latvia faces challenges on a number of indicators of the Social Scoreboard supporting the European Pillar of Social Rights. Despite the improvements in the labour market, challenges remain on equal opportunities, labour market access, and social protection and inclusion. Disparities in employment across regions and skills levels persist, while participation in adult learning and active labour market policies is lower than in other EU countries. Wages are increasing at a rapid pace and the minimum wage was raised in 2018. However, income inequality remains high, in part due to the low redistributive power of the tax and benefits system. Although the risk of poverty or social exclusion has been decreasing, it remains elevated for people with disabilities, the elderly and the unemployed. Access to affordable healthcare is a challenge. Although self-reported unmet needs for medical care are decreasing, they remain high. In 2017, people in the lowest income quintile reported a much higher level of unmet needs for medical and dental care due to cost (9.9% and 25.5% respectively) than people in the highest income quintile (0.9% and 3.3% respectively). The Youth Guarantee is effectively supporting young people in the labour market. Implementation of the Youth Guarantee in Latvia started in 2014, targeting young people not in employment, education or training aged 15-29 years. The employment offers provided under the scheme are mostly subsidised employment in the regular labour market. The education offers emphasise several vocational tracks, and also include ‘Youth workshops’ which provide training to help young people with their career choices. The Youth Guarantee is implemented using national funds, the European Social Fund and the Youth Employment Initiative. It has helped significantly reduce the rate of young people not in employment, education or training, which in 2017 fell to 10.3%, below the EU average of 10.9%. Employment conditions differ across regions and internal mobility remains a challenge. Uneven regional distribution of jobs and vacancies is one of the key challenges the country is facing (Ministry of Economics, 2018). The employment rate in Riga is higher (73.4%) than in other regions, in particular Latgale (62.2%). This encourages residents of Vidzeme and Zemgale to take advantage of those region’s proximity to the capital region, with the result that 10% and 15% respectively of their employed residents work in Riga. The regional mobility support programme provides commuting or relocation support, but the uptake remains low, as the amount of support (cumulatively EUR 400 for first 4 months) does not sufficiently compensate for relocation expenses and the support is temporary. Lack of affordable and quality rental housing is the key bottleneck for internal mobility in the country (Section 3.2). Gaps in employment based on skills level and ethnicity persist. The employment gap of 15.8 pps between people with high- and medium-educational attainment in Latvia is among the highest in the EU. This is linked to the relatively low employment rate of medium-educated men. More than 35% of registered unemployed have vocational education and training background and half of them are over 50 years old, thus indicating outdated skills. The employment gap between Latvians and citizens from ethnic minorities has narrowed to 3.3 pps, but the ethnic employment gap remains at 6.5 pps and is wider for the older generations. More than 40% of ethnic minorities over 55 year old have no knowledge of the Latvian language or their proficiency is low (Mieriņa et al., 2017). In addition, participation in adult learning for the 55-64 age group is only 3.5% (2017). Further investment in upskilling the older generations and in the Latvian language training could support the labour supply against the backdrop of the negative demographic trends.

The spending on and coverage of active labour market policies remains low, limiting the activation of those furthest away from the labour market. Latvia has made progress on integrating the long-term unemployed into the labour market with long-term unemployment rates at the EU average. However, participation in active labour market policies remains low at 5.8 per 100 persons wanting to work. Low public expenditure on active labour market policies, at only 0.6% of GDP (2016) contributes to this situation ( ). Employment services can also be difficult to access, especially for more disadvantaged workers in rural areas, as the low adequacy of social assistance benefits hampers regular contact between jobseekers and employment offices (OECD, 2016a). Information exchange and coordination between public employment services, social services and educational institutions is insufficient, which results in poor monitoring of school-to-work transitions and success on the labour market. A coordinated approach aimed at long-term activation of people furthest away from the labour market could be improved. The coverage of the active labour market policies and the capacity of the public employment service are linked to funding, therefore the demand for investment will remain significant. The prevalence of occupational diseases is increasing and the fatal accident rate is high. The rapid rise in victims of an occupational disease results in partial or full workability loss and contributes to the increasing rate of persons with disabilities. While the fatal accident rate is among the highest in the EU, the very low rate of non-fatal incidents is explained by the poor accident reporting culture. High prevalence of underreported work contributes to the under-reporting of accidents at work and heightens occupational risks (Section 3.1.3). The State Labour Inspectorate carries out preventive measures, but has limited capacity and high staff turnover. To pursue the Social Pillar principle on a healthy and safe work environment, further investments may contribute to ensure healthier and longer working lives. A sectoral wage agreement in the construction sector is a novelty in Latvia, but it requires a more flexible legal framework. The agreement was reached in 2018, setting a minimum wage for the sector of EUR 780 (higher than the national minimum of EUR 430) and reducing a surcharge for overtime work to 50%. The current legal requirement for a surcharge is 100% of contractual wage. Amendments to the Labour Law allowing for a smaller surcharge for overtime if the minimum wage in a sector is substantially increased were adopted by the Parliament, but were rejected by the President, thus putting on hold the sectoral agreement. This agreement would be a novelty for the Latvian industrial relations system, as so far there have been no collective agreements at sector level in the private sector. Four additional agreements in transportation, wood processing, pharmaceuticals and telecommunications will be facilitated through an EU-funded project, thus strengthening social dialogue at sectoral level. The institutional set-up for social dialogue is well established, but the capacity of social partners is limited. In 2016, membership of trade unions continued to decrease, falling to just 10.7%, while the density of employers’ organisation has been increasing in recent years, reaching a figure of 44% (Eurofound, 2018). The institutional set-up for national level social dialogue is well developed and social partner involvement in policymaking has improved. However, social partners lack financial and human resources and their capacity to participate in the legislative process remains a challenge. In this context, investment in capacity building of social partners is important to ensure the effectiveness of social dialogue. 3.3.2.Social policies Income inequality and poverty remain high and spending on social protection is low. According to the Social Scoreboard (Box 3.3.1), Latvia faces challenges on equal opportunities, social protection and inclusion. In 2016, Latvia spent only 12 % of GDP on social protection, well below the EU average of 19.1 %. Given the low spending on social protection, the impact of social transfers is limited. In 2018, social transfers (excluding pensions) reduced the risk of poverty rate by 19.1% in Latvia vs. 33.2% on average in 2017 in the EU. Likewise, the impact of social transfers on inequality was only 19.3%, among the lowest in the EU and well below the average (of 40.4%). In order to accelerate progress towards inclusive growth, significant investments would be required to foster active inclusion and social integration of people at risk of poverty or social exclusion, including access to integrated social services, food and material aid for the most deprived. The adequacy of social assistance benefits remains low and they contribute little to alleviating high poverty and inequality. From January 2018, the guaranteed minimum income tops up income to EUR 53 (some municipalities voluntarily provide higher benefits). The average housing benefit is less than EUR 15 per person per month, while the calculated poverty threshold for 2017 was EUR 367. The adequacy of the minimum income benefits is below the EU average ( ). According to the national data, out of the first (lowest) income quintile, 68.3% report difficulties making ends meet; however, only 16.2% have received the status of ‘poor person’ giving them access to social assistance and only 6.7% receive guaranteed minimum income. People from quasi-jobless households at risk of poverty face more difficulty accessing certain services in Latvia compared to other EU Member States ( ). The concept paper adopted in 2014 envisaging a significant increase in benefit adequacy has not been implemented and the plan to improve the minimum income support system has not been adopted, although revised and resubmitted to the government multiple times (latest version submitted in May 2018). The minimum income level reform could bring inequality and poverty in Latvia more in line with the EU average. The reform targets low income households and can notably address poverty and inequality concerns. However, simply making benefits more generous could negatively affect the beneficiaries’ incentives to work. The current withdrawal of means-tested benefits at the same rate as work income increases impacts on incentives to take up work. This can be mitigated by a more gradual withdrawal of the means-tested benefits. At a similar cost as the 2017 tax reform, the reform of the minimum income level, with more gradual transition from means-tested benefits to labour income, has the potential to close the gap to the EU average in terms of poverty and inequality while improving incentives to work (Ivaškaitė-Tamošiūnė et al., 2018). A relatively high and increasing share of the elderly are at risk poverty and social exclusion. The at-risk-of-poverty or social exclusion rate for the elderly continued to deteriorate and at 49.0% (2018) was significantly above the EU average of 18.2% (2017). From 2013 to 2018 the rate of poverty and social exclusion among women of 65 years of age and older has increased by 13.6 pps. Mostly, these are pensioners who retired before 1996 under the previous pension law, which produced very low benefit amounts that were further devalued by low indexation. Moreover, the poverty gap, which measures the intensity of poverty (i.e. how poor the poor are), is among the highest in Europe. This is mainly because pensions lag behind the growth in labour incomes while there are no adequate safety nets for the elderly. Graph 3.3.2:At-risk-of-poverty or social exclusion rate by age groups Source: European Commission (Eurostat The adequacy of pensions is low and is projected to remain low in the long run. In 2018, Latvia took some steps to improve situation for pensioners by: (i) increasing pensions for older pensioners; (ii) raising income tax allowances; (iii) making indexation rules more favourable for pensioners with longer service records; and (iv) introducing a time-limited survivor’s pension. In addition, a right to inherit state-funded pension capital if the deceased has not reached pension age will be effective as of 2020. However, the generosity and coverage of the measures are limited. The minimum pension and state social security old-age allowance have not been increased. The minimum pension remains at the 2006 level in a range from EUR 70.43 to EUR 108.85 per month, depending on the length of contributions. The pension adequacy is projected to remain one of the lowest in the EU in the long run (European Commission, 2018c). The unemployed are at high risk of poverty, in particular if the duration of unemployment increases. Unemployment benefits are paid for the first 9 months of unemployment and are gradually reduced in the meantime. Both the replacement rate and the duration of unemployment benefit (for a year-long work record) correspond to the EU average ( ). However, the at-risk of poverty rate of unemployed persons is high at 59.6% and increasing. The low social insurance contributions of employees often result in low unemployment benefits. Moreover, the low social assistance benefits, which support unemployed people experiencing long unemployment spells, contribute to high poverty among the unemployed. The social security system does not cover all people in employment, and the self-employed contribute little to their pensions. Some 8% of Latvian workers are self-employed without employees, as compared to the EU average of 10%. They are not covered by unemployment benefits scheme or insured against accident and occupational injuries. Almost all (90%) self-employed pay social insurance contributions from income that are equal to the minimum wage. The low social contributions will result in very low old-age pensions (European Commission, 2018c). In addition, casual workers are not covered by sickness benefits and seasonal workers are not insured against the majority of social risks. Social protection for persons with disabilities is weak. The share of persons with disabilities at risk of poverty or social exclusion in Latvia is 42.5%, one of the highest in the EU (EU average 30.1%). Latvia has one of the highest gaps in the EU between the at-risk-of poverty rate and social exclusion rate for persons with and without disabilities (20.8 pps vs. the EU average of 9.2 pps). Disability pensions are low and 43% of persons with disabilities receive pensions below EUR 120 per month. The state social security benefit, which serves as a base for calculating the invalidity pension, has not been revised since 2006 and currently stands at EUR 64.03 per month, or EUR 106.72 per month for people who have been living with disabilities since childhood. The transition from institutional to community-based care has started. Institutions for children in out-of-family care and adults with special care needs are costly and have poor social outcomes. Those are set to be replaced by community-based services at local level and family-like care. In 2018, financial support for foster families was increased and a communication campaign to overcome prejudices about adults with mental disabilities was launched. The policy is supported by the EU funds, however, only a part of overall needs for community-based care services is covered and further investment would be needed. In addition, the implementation of EU-funded projects has been delayed for almost 2 years, putting at risk its planned completion by 2023 (State Audit Office, 2018). Access to long-term care is improving but remains weak. Despite progress in the delivery of home care services, unmet needs for homecare services due to financial reasons was 37.9% of households in need in 2016, above the EU average of 32.2%. The municipalities are responsible for services, which are mostly delivered in institutional care centres. Low remuneration of social workers and low population density is a challenge for quality care services in rural regions (ESPN, 2018). Access to childcare facilities is low in the countries’ main centres of economic activity. Availability of affordable (mainly public) kindergartens is a challenge in Riga and other larger cities, where young people tend to migrate (Eurofound, 2018). In 2017, 28.4% of all 0-3 year olds were enrolled in formal childcare, which is below the Barcelona targets of 33% and below the EU average of 34.2% (EU-SILC). Compensation for inability to provide a place in municipal kindergarten does not cover the costs of private child-minding services, which can cause people to choose not to work over accepting low-wage employment. Poor prestige, low remuneration and heavy workload result in high staff rotation and recruitment problems at social service providers. Currently, 38.7% of municipal social services do not comply with the minimum requirement set by law to provide one social work specialist per 1 000 inhabitants. National social care centres face a large staff turnover, especially in jobs directly related to customer care (caregivers, social caregivers, social rehabilitators and social workers). One fifth of carers receive the minimum statutory wage, and many other employees are paid only slightly higher than that. Access to adequate housing, particularly for low-income groups, is a challenge. 15.2% of the population experiences severe housing deprivation, significantly above the EU average of 4.5%. Half of those below the poverty risk threshold live in poor housing conditions ( ). Inhabitants of rural areas, in particular in the Latgale region, live in worse housing conditions than the urban population. While the housing cost overburden rate in Latvia has been declining, still almost one-third (32.9 %) of households report that housing costs impose a heavy burden (CSB 2018a). Social housing is scarce and often not fit for living. In 2016, social housing constituted only 0.4% of social housing stock compared to the EU average of 8%. This is insufficient to respond to demand and currently there are 7 000 people waiting for a home. Local governments, with few exceptions, invest little to improve the technical condition of social housing and as a result, one third of vacant premises are not fit for living. State-funded grants for social housing have not been available since 2009.

There is little data on homelessness and this phenomenon is not addressed at national level. There is no national strategic document addressing homelessness, and the scope of existing policy documents only addresses the provision of night shelter services. According to national data, in 2017, more than 6 800 people used municipal and private shelters. These service providers are mostly located in the largest cities of Latvia and data on homelessness nationwide is lacking. To address the issue of homelessness and improve the provision of social housing, investment would be needed, in particular at municipal level. Social enterprises receive legal backing and financial support, but lack capacity. In April 2018, the Law on Social Enterprises came into force laying down the main principles and working arrangements of social enterprises in Latvia. To foster the creation of social enterprises a grant programme is available and so far 27 of around 220 planned grants have been awarded. Further investment would help to address such challenges as poor managerial and business skills of existing non-governmental organisations and limited access to business incubators (European Commission, 2018g). 3.3.3.Healthcare Poor health outcomes are linked to low public spending on health and to unhealthy lifestyles. Life expectancy is among the lowest in the EU and levels of preventable and amenable mortality are high ( ). Cardiovascular diseases and cancer are the biggest causes of death. Behavioural risk factors are more prominent in Latvia than in the EU on average, with rising obesity rates and alcohol consumption (OECD/EU, 2018). Moreover, the low public financing for health limits access to quality and timely care for all. In response, the authorities have prioritised public spending on health and have initiated a number of reforms fostering the efficiency and quality of health services. Restricted access to publicly funded healthcare leads to unmet needs for care and inequality of opportunities. State-paid health services are limited by a ‘quota’ system, which leads to long waiting times. To overcome this constraint, patients tend to pay out-of-pocket for private services. Additional significant barriers to accessing healthcare stem from: the level of user charges for the public services, co-payments for prescribed medicines and out-of-pocket payments for medicines that are excluded from coverage. In 2016, out-of-pocket payments constituted 44.6% of health spending in Latvia, well above the EU average of 18.2%. This leads to financial hardship for vulnerable groups such as pensioners and low-income households. The incidence of so-called ‘catastrophic’ and impoverishing out-of-pocket payments ( ) for healthcare (13% and 4% of households respectively in 2013) is among the highest in the World Health Organization European Region (WHO 2018a; WHO 2018b). The above mentioned factors contribute to high inequality, with the poorest 20% of households reporting a much higher level of unmet needs for medical and dental care due to cost (9.9% and 25.5%, respectively, in 2017) than the richest 20% of households (0.9% and 3.3%, respectively). Voluntary health insurance for a part of the population risks worsening their health status. A new health insurance system was set to come into effect in January 2019, now postponed to July 2019. For two baskets of health services, it defines a ‘full basket’, and a ‘minimum basket’. The latter is limited to a basic set of healthcare services, such as care provided by general practitioners, preventive checks, emergency services and some other special conditions ( ). Around 30 000 to 53 000 people (mainly seasonal workers and micro-enterprise workers) will have to make voluntarily health insurance payments in order to access the ‘full basket’. Only some 5 000 people had made voluntary payments by early January 2019. The remaining of the affected population faces the risk of financial hardship if certain health problems occur or delaying their treatment until it becomes an emergency covered by the ‘minimum basket’. Health reforms concern a number of areas and are progressing, although they are still at an early phase of implementation. The implementation of the hospital sector reform, more specifically the configuration of new single-speciality, regional and tertiary hospitals and the operational development of local hospitals is supported with financing from the EU funds. There are also plans to further develop the eHealth system and pilot a small number of multi-disciplinary health centres for the primary care reform in 2019. However, plans for reforming primary care, such as setting the number and location of health centres across the country, and the related investments, have not been prepared yet. An action plan to improve patient safety and health system quality has been set in motion. Early measures taken so far include educating healthcare staff in patient safety issues, and better application and a