Council opinion of 27 March 2007 on the updated convergence programme of Latvia, 2006-2009
Date: 2007-03-27
Institutions: Council of the European Union
Subjects: Latvia, budget estimate, economic convergence, economic forecasting, public finance, stability programme

24.4.2007

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Official Journal of the European Union

C 89/15

COUNCIL OPINION

of 27 March 2007

on the updated convergence programme of Latvia, 2006-2009

(2007/C 89/05)

THE COUNCIL OF THE EUROPEAN UNION,

Having regard to the Treaty establishing the European Community,

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

Having regard to the recommendation of the Commission,

After consulting the Economic and Financial Committee,

HAS DELIVERED THIS OPINION:

(1)

(2)

(3)

(4)

On 27 March 2007 the Council examined the updated convergence programme of Latvia, which
covers the period 2006 to 2009 (2). On 6 March 2007, the Latvian government announced a plan
aiming at combating inflation. This includes a revision of the budgetary targets, with a balanced
budget in 2007 and 2008 and a surplus from 2009 onwards. However, this Council opinion is based
on the convergence programme.

The macroeconomic scenario underlying the programme envisages a soft-landing of the economy,
with real GDP growth slowing from 11,5 % in 2006 to 8,0 % on average over the rest of the
programme period. Assessed against currently available information, this scenario appears to be
based on plausible growth assumptions. Nevertheless, there are significant risks of less favourable
macroeconomic developments in view of large external imbalances, high inflation and increasing
signs of overheating of the Latvian economy. The programme's projections for inflation appear to be
slightly optimistic.

For 2006, the Commission services' autumn 2006 forecast estimated the general government deficit
at 1,0 % of GDP, against a target of 1,5 % of GDP set in the previous update of the convergence
programme. The updated programme presents a deficit estimate of 0,4 % of GDP, which is plausible
in view of the higher than expected revenues and despite the impact of budgetary amendments
adopted in October 2006, which increased expenditures by an estimated 1,5 % of GDP.

The main goal of the medium-term budgetary strategy is to gradually improve the fiscal outlook and
achieve a balanced budget by 2010. This goal will require a considerable consolidation effort after the
deterioration in 2006 and 2007 by almost 1½ percentage point of GDP. The envisaged adjustment in
2008 and 2009 is identical in the headline and in the primary balance, respectively 0,4 and 0,5
percentage points of GDP. Compared to the previous update, the planned budgetary targets are more
stringent, but
the adjustment remains back-loaded against a more favourable macroeconomic
scenario. After the significant loosening of the expenditure-to-GDP ratio in 2007, the programme
envisages consolidating the budget during 2008-2009 by increasing the revenue-to-GDP ratio by 0,4
percentage points each year, while keeping broadly constant the expenditure-to-GDP ratio. The
revenue-to-GDP ratio is planned to increase mainly due to higher ‘other’ revenues, which represents
an increased inflow of EU funds. Accordingly, the expenditure ratio for the gross fixed capital forma-
tion component is increasing, broadly offset after 2007 by a decline in ‘other’ expenditures (which in
the programme includes part of consumption expenditure) by ¾ percentage points in 2008 and in
social transfers by ½ percentage points in 2009.

(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) Following the formation of a new government in November 2006, after a general election in October, the update was

submitted six weeks beyond the 1 December deadline set in the code of conduct.

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Official Journal of the European Union

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(5)

(6)

(7)

(8)

the cyclically-adjusted balance net of one-off and other temporary
The structural balance (i.e.
measures) calculated according to the commonly agreed methodology is planned to deteriorate from
a deficit of 1 % of GDP in 2006 to a deficit of 1¾ % of GDP in 2007 and to improve to a surplus of
¼ % by 2009. The medium-term objective (MTO) for the budgetary position presented in the
programme is a structural deficit of 1 % of GDP, which the programme aims to achieve around
2008, as in the previous update. As the MTO is more demanding than the minimum benchmark
(estimated at a deficit of around 2 % of GDP), achieving it should fulfil the aim of providing a safety
margin against the occurrence of an excessive deficit. The 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.

The risks to the budgetary projections in the programme appear broadly balanced for 2007, but the
budgetary outcomes could be worse than projected in the programme from 2008, due to risks to the
macroeconomic scenario. The budgetary strategy relies on an increase in the revenue-to-GDP ratio
(which in the
and on declines in the ratios to GDP of social transfers and ‘other expenditure’
programme includes part of consumption expenditure), which could have been better substantiated,
taking into account that according to the update a formal medium-term framework for the planning
and control of public finances is planned to be introduced from 2008 onwards.

In view of this risk assessment, the budgetary stance in the programme may not be sufficient to
ensure that the MTO is achieved by 2008, as envisaged in the programme. However, it seems to
provide a sufficient safety margin against breaching the 3 % of GDP deficit threshold with normal
macroeconomic fluctuations throughout the programme period. Except for 2007, the pace of the
adjustment towards the MTO implied by the programme is broadly in line with the Stability and
Growth Pact, which specifies that the adjustment should be higher in good economic times and could
be lower in bad economic times. Nevertheless, 2007 is clearly a year of moving away from the MTO
in economic good times, which is not in line with the Stability and Growth Pact. A stronger structural
adjustment path frontloaded during the programme period would be appropriate to support a stable
macroeconomic convergence process and the mitigation of risks of imbalanced economic growth.

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 adjust-
ment path to the MTO. The medium-term budgetary strategy outlined in the programme embodies a
temporary deviation from the adjustment path towards the MTO in 2007. The programme notes that
the ongoing pension reform will gradually reduce social security contributions in the general govern-
ment balance and that the contribution to the second-pillar pension scheme will increase from 0,4 %
of GDP in 2006 to 1,7 % of GDP by 2009. The deterioration of the structural balance foreseen in
the programme, adjusting for the impact of the phased implementation of the pension reform, would
be of ½ % of GDP in 2007 followed by improvements of 1½ % in 2008 and 1¼ % in 2009. While
the net costs of the pension reform can be taken into account when assessing the adjustment path
towards the MTO, the adjustment in 2007, even taking into account such costs, is not in line with
the Pact. On the other hand, the healthcare reform and public investment projects mentioned in the
programme do not qualify as structural reforms on which a temporary deviation can be based, as
these measures are insufficiently detailed and the significant beneficial
impact on the long-term
sustainability of the public finances is not demonstrated in the programme.

(9)

Government gross debt is estimated to have reached 10,7 % of GDP in 2006, well below the 60 % of
GDP Treaty reference value. The programme projects the debt ratio to decline by 1,3 percentage
points over the programme period to reach 9,4 % of GDP by 2009.

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(10)

(11)

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

The convergence programme contains a qualitative assessment of the overall impact of the October
2006 implementation report of the national reform programme within the medium-term fiscal
strategy. In addition, it provides some information on the direct budgetary costs or savings of the
main reforms envisaged in the national reform programme and its budgetary projections explicitly
take into account the public finance implications of the actions outlined in the national reform
programme. The measures in the area of public finances envisaged in the convergence programme
seem consistent with those foreseen in the national
In particular, both
programmes envisage significant increase in public investment and the convergence programme
further expands on measures to be implemented in order to improve the institutional features of the
public finances, including the introduction of the multi-annual budgetary framework.

reform programme.

(12)

The budgetary strategy in the programme is only partly consistent with the broad economic policy
guidelines included in the integrated guidelines for the period 2005-2008. In particular, the projected
fiscal stance does not contribute adequately to promoting greater sustainability of
the external
account.

(13) As regards the data requirements specified in the code of conduct for stability and convergence
programmes, the programme provides all required and most of the optional data (1). However, some
inconsistencies exist with regards to standard Table 2.

The Council considers that the worsening of the budgetary position in 2007 is not in line with a prudent
fiscal policy aimed at ensuring sustainable convergence, including by reducing the external imbalance and
containing inflation. In the subsequent years, the programme envisages progress towards the MTO in a
context of strong growth prospects, but the budgetary targets are not ambitious and there are risks to their
achievement from 2008 onwards.

In view of the above assessment, the Council invites Latvia to:

(i) reduce the risks of macroeconomic instability by implementing vigorously measures to achieve a signifi-
cantly better budgetary target for 2007 than foreseen in the programme, as part of a broader reform
strategy. Building further on this, measures to enhance consolidation beyond the MTO in subsequent
years should also be implemented as soon as possible;

(ii) establish a clearer and more binding medium-term framework for the planning and control of public

finances.

The plan announced on 6 March 2007 would, if fully implemented, represent an important step in the right
direction.

Comparison of key macroeconomic and budgetary projections

Real GDP
(% change)

CP Jan 2007

2005

10,2

2006

11,5

COM Nov 2006

10,2

11,0

CP Nov 2005

8,4

7,5

2007

2008

2009

9,0

8,9

7,0

7,5

8,0

7,0

7,5

n.a.

n.a.

(1) In particular the data on the subcomponents of the stock-flow adjustment and some elements of the long-term sustain-

ability of public finances table are missing.

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2005

2006

2007

2008

2009

HICP inflation
(%)

Output gap
(% of potential GDP)

General government
balance (6)
(% of GDP)

Primary balance (6)
(% of GDP)

Cyclically-adjusted
balance (6)
(% of GDP)

Structural balance (2) (6)
(% of GDP)

Government gross debt
(% of GDP)

CP Jan 2007

COM Nov 2006

CP Nov 2005

CP Jan 2007 (1)

6,9

6,9

6,9

0,0

COM Nov 2006 (5)

– 0,2

CP Nov 2005 (1)

CP Jan 2007

COM Nov 2006

CP Nov 2005

CP Jan 2007

COM Nov 2006

CP Nov 2005

CP Jan 2007 (2)

COM Nov 2006

CP Nov 2005 (1)

CP Jan 2007 (3)

COM Nov 2006 (4)

CP Nov 2005

CP Jan 2007

COM Nov 2006

CP Nov 2005

0,8

0,1

0,1

– 1,5

0,7

0,7

– 0,7

0,1

0,2

– 1,7

0,1

0,2

– 1,7

12,1

12,1

13,1

6,6

6,7

5,6

1,8

1,1

0,4

– 0,4

– 1,0

– 1,5

0,2

– 0,4

– 0,8

– 0,9

– 1,3

– 1,6

– 0,9

– 1,3

– 1,6

10,7

11,1

14,9

6,4

5,8

4,3

1,3

0,4

– 0,5

– 1,3

– 1,2

– 1,4

– 0,8

– 0,7

– 0,6

– 1,7

– 1,3

– 1,3

– 1,7

– 1,3

– 1,3

10,5

10,6

13,6

5,2

5,4

3,5

– 0,5

– 1,0

– 1,1

– 0,9

– 1,2

– 1,3

– 0,4

– 0,7

– 0,6

– 0,8

– 0,9

– 1,0

– 0,8

– 0,9

– 1,0

10,6

10,3

14,7

4,2

n.a.

n.a.

– 2,0

n.a.

n.a.

– 0,4

n.a.

n.a.

0,1

n.a.

n.a.

0,2

n.a.

n.a.

0,2

n.a.

n.a.

9,4

n.a.

n.a.

Notes:
(1) Commission services calculations on the basis of the information in the programme.
(2) Cyclically-adjusted balance (as in the previous rows) excluding one-off and other temporary measures.
(3) There are no one-off and other temporary measures in the programme
(4) There are no one-off and other temporary measures in the Commission services' autumn 2006 forecast.
(5) Based on estimated potential growth of 9,3 %, 9,6 %, 9,6 % and 9,5 % respectively in the period 2005-2008.
(6) The net costs of the ongoing pension reform (introduction of a second pillar) are included in the deficit. The costs are estimated at
0,3 % of GDP in 2005, 0,4 % of GDP in 2006, 0,6 % of GDP in 2007, 1,3 % of GDP in 2008 and 1,5 % of GDP in 2009. The year-
on-year change in the structural balance foreseen in the programme, adjusting for the impact of the phased implementation of the
pension reform, would be a worsening of 0,6 % of GDP in 2007, an improvement of 1,6 % in 2008 and 1,2 % in 2009.

Source:
Convergence programme (CP); Commission services' autumn 2006 economic forecasts (COM); Commission services' calculations