Council opinion of  14 February 2006  on the updated convergence programme of Latvia, 2005-2008
Date: 2006-02-14
Institutions: Council of the European Union
Subjects: Latvia, stability programme

7.3.2006

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Official Journal of the European Union

C 55/41

COUNCIL OPINION

of 14 February 2006

on the updated convergence programme of Latvia, 2005-2008

(2006/C 55/11)

THE COUNCIL OF THE EUROPEAN UNION,

Having regard to the Treaty establishing the European Community,

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

Having regard to the recommendation of the Commission,

After consulting the Economic and Financial Committee,

HAS DELIVERED THIS OPINION:

(1)

(2)

(3)

(4)

(5)

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

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

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

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

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

(1) OJ L 209, 2.8.1997, p. 1. Regulation as amended by Regulation (EC) No 1055/2005 (OJ L 174, 7.7.2005, p. 1). The

documents referred to in this text can be found at the following website:
http://europa.eu.int/comm/economy_finance/about/activities/sgp/main_en.htm

(2) The programme has gaps in the optional data prescribed by the new code of conduct (in particular, data are not

given for labour productivity per hours worked).

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(6)

(7)

(8)

(9)

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

Based on Commission services' calculations on the basis of the programme according to the
commonly agreed methodology, the structural balance, i.e. the cyclically-adjusted budget balance net
of one-off and other temporary measures, is planned to improve only slightly over the programme
period (by about ¾ of a percentage point of GDP). The planned fiscal effort is back-loaded and
concentrated in years in which the output gap is estimated to be negative. The update identifies a
medium-term objective (MTO) for the budgetary position, as meant in the Stability and Growth
Pact, of a structural deficit of ‘around 1 % of GDP’, and aims at achieving this position in the final
year of the programme period. As the programme's MTO is more demanding than the minimum
benchmark (estimated at a deficit of around 2 % of GDP), its achievement should fulfil the aim of
providing a safety margin against the occurrence of an excessive deficit. The programme's MTO lies
within the range indicated for euro area and ERM II Member States in the Stability and Growth Pact
and the code of conduct and adequately reflects the debt ratio and average potential output growth
in the long term. However, taking into account the risks to sustainable economic convergence high-
lighted above, more ambitious budgetary positions than currently planned would seem appropriate.

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

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

(10) According to the Stability and Growth Pact, ‘major structural reforms’ with a verifiable impact on
the long-term sustainability of the public finances should be taken into account when defining the
adjustment path to the programme's MTO or for allowing a temporary deviation from the program-
me's MTO. The programme notes that the ongoing pension reform and introduction of a second
pillar, in particular, will gradually reduce social security contributions in the general government
balance compared to the 2004 level. The net cost of the pension reform is estimated in the
programme at 0,25 % of GDP in 2005, rising progressively to 1,25 % of GDP in 2008. This could
allow a temporary deviation from the required yearly adjustment path of 0,5 % of GDP towards the
programme's MTO because the structural reforms on which it is based are sufficiently detailed in the
programme and have a significant beneficial impact on the long-term sustainability of the public

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finances. However, for 2006 the adjustment, also taking into account the structural reforms, is not
fully in line with the Stability and Growth Pact. Nevertheless the safety margin against breaching the
3 % of GDP deficit reference value is ensured in all years of the programme. The suggestion above
for a more demanding pace of adjustment towards the programme's MTO than implied by the
programme seems feasible given that in the early programme years the estimated net cost of the
pension reform is modest.

(11)

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

(12) With regard to the sustainability of public finances, Latvia appears to be at low risk on grounds of
the projected budgetary costs of ageing populations (1). The currently very low level of gross debt is
projected to remain below the 60 % reference value throughout the 2005-2050 projection period.
Latvia is implementing a pension reform launched in 1996 which contributes significantly to
contain the budgetary impact of ageing populations.

(13)

(14)

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

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

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

Comparison of key macroeconomic and budgetary projections

Real GDP
(% change)

CP Nov 2005

COM Nov 2005

CP Dec 2004

2004

2005

2006

2007

2008

8,5

8,3

8,1

8,4

9,1

6,7

7,5

7,7

6,5

7,0

7,1

6,5

7,0

n.a.

n.a.

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

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

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HICP inflation
(%)

Output gap
(% of potential GDP)

General government
balance (1)
(% of GDP)

Primary balance
(% of GDP)

Cyclically-adjusted
balance= Structural
balance (2)
(% of GDP)

Government gross debt
(% of GDP)

CP Nov2005

COM Nov 2005

CP Dec 2004

CP Nov 2005 (3)

COM Nov 2005 (5)

CP Dec. 2004 (3)

CP Nov. 2005

COM Nov 2005

CP Dec.2004

CP Nov 2005

COM Nov 2005

CP Dec 2004

CP Nov. 2005 (3)

COM Nov 2005 (4)

CP Dec 2004

CP Nov 2005

COM Nov 2005

CP Dec 2004

2004

2005

2006

2007

2008

6,2

6,2

6,2

0,5

0,1

1,6

– 1,0

– 1,0

– 1,7

– 0,2

– 0,2

– 0,9

– 1,1

– 1,0

n.a.

13,1

14,7

14,2

6,9

6,8

4,3

0,8

0,8

0,9

– 1,5

– 1,2

– 1,6

– 0,7

– 0,5

– 0,8

– 1,7

– 1,5

n.a.

14,9

12,8

1,5

5,6

6,0

3,0

0,4

0,3

0,0

– 1,5

– 1,5

– 1,5

– 0,8

– 0,8

– 0,8

– 1,6

– 1,6

n.a.

13,6

13,0

15,8

4,3

4,8

3,0

– 0,5

– 0,7

– 0,5

– 1,4

– 1,5

– 1,4

– 0,6

– 0,8

– 0,7

– 1,3

– 1,3

n.a.

13,7

13,2

15,0

3,5

n.a.

n.a.

– 1,1

n.a.

n.a.

– 1,3

n.a.

n.a.

– 0,6

n.a.

n.a.

– 1,0

n.a.

n.a.

14,7

n.a.

n.a.

Notes:
(1) The net costs of the ongoing pension reform (introduction of a second pillar) are included in the deficit. The costs are estimated at

0,27 % of GDP in 2005, 0,37 % of GDP in 2006, 0,62 % of GDP in 2007 and 1,32 % of GDP in 2008.

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

(3) Commission services' calculations on the basis of the information in the programme.
(4) There are no one-off and other temporary measures in the Commission services' forecast.
(5) Based on estimated potential growth of 7,9 %, 8,3 %, 8,3 % and 8,2 % respectively in the period 2004-2007.

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