Council opinion of 4 March 2008 on the updated convergence programme of Latvia, 2007-2010
Date: 2008-03-04
Institutions: Council of the European Union
Subjects: Latvia, budget estimate, economic convergence, economic forecasting, public finance, stability programme

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COUNCIL OPINION

of 4 March 2008

on the updated convergence programme of Latvia, 2007-2010

(2008/C 73/05)

THE COUNCIL OF THE EUROPEAN UNION,

Having regard to the Treaty establishing the European Community,

Having regard to Council Regulation (EC) No 1466/97 of 7 July 1997 on the strengthening of the 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)

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

Following a sustained period of high growth since the mid-nineties, Latvia's real GDP increased at
double-digit rates in 2005-2007. Growth has primarily been driven by a powerful credit boom
boosting private consumption and real estate investment, with net external borrowing surpassing
20 % of GDP since 2006.

Monetary conditions have been accommodative, given a high degree of euroisation in the framework
of a narrowly pegged exchange rate within ERM II. Adding to the overheating from the demand side,
labour shortages have contributed to the emergence of a wage-price spiral, with very high wage
growth outstripping productivity, leading to the highest inflation in the EU and rapidly worsening
cost competitiveness. Helped by a set of measures adopted by the authorities in spring 2007 some
slowdown has become visible in the housing market and in domestic consumption, but further steps
in this direction are necessary to achieve a smooth adjustment towards a sustainable growth path. In
this context fiscal policy has insufficiently tackled the emerging vulnerabilities. Key to addressing
internal and external imbalances will be a more ambitious fiscal stance; adherence to an appropriate
medium-term budgetary framework; prioritizing public expenditure and re-examining taxation instru-
ments to avoid demand stimulus in sectors which do not significantly strengthen the economy's
medium- and long-term supply potential; and a more responsible public sector wage growth. To
foster the catching-up process, structural reforms and removal of bottlenecks directed towards
strengthening the supply side of the economy are needed.

The macroeconomic scenario underlying the programme envisages a soft landing with real GDP
growth gradually decreasing from 10,5 % in 2007 to 6,8 % by 2010. According to the programme,
domestic demand will remain the main growth contribution, although it is expected to slow signifi-
cantly from 2007 to 2008. Assessed against currently available information (2), this scenario appears
to be based on plausible growth assumptions. However, the envisaged deceleration of domestic
demand is far from assured, and the programme's economic scenario is attended by very high risks
to macroeconomic stability,
including continued overheating with a substantial risk of an abrupt
slowdown at a later stage. Furthermore, without a larger adjustment of aggregate demand and supply
than depicted in the programme, the country's external position would not be sustainable in the
longer run.

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

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

(2) The assessment takes into account notably the Commission services' autumn forecast and the Commission assessment of

the October 2007 implementation report of the national reform programme.

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The programme's projections for inflation, which appear to be plausible, show that Latvia will be
moving further away from nominal convergence at least until 2008. Moreover, uncertainties remain
large due — inter alia — to ongoing volatility in energy and other commodity prices and to how the
current wage-price spiral may evolve. Restraining public sector compensation is critically important
for achieving a reduction in whole-economy wage growth which would be necessary to break the
current cost-price dynamics and rapidly worsening cost competitiveness.

(4)

(5)

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

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

(6)

The budgetary outcomes could be much worse than projected in the programme. There are signifi-
cant risks to the overall macroeconomic stability stemming from the wide external imbalance and the
currently overheated state of the economy. Were the credit-financed, domestically-driven growth to
slow abruptly, the budget could come under strong pressure, as the programme's revenue projections
are based on the assumption of continuing high consumption and favourable labour market condi-
tions.

The projected reduction in the expenditure ratio seems difficult to achieve in the absence of underpin-
ning measures. As medium-term expenditure ceilings for ministries and public institutions were intro-
duced only in 2007, it is not yet possible to judge their effectiveness. The track record of recent years
rather points to overruns as high nominal growth has created the opportunity each year to spend
extra revenues in the framework of a supplementary budget. Finally, the programme counts on
substantial revenues related to privatization (amounting to a total of 0,5 % of GDP according to the
programme), which are surrounded by uncertainties.

(7)

In view of this risk assessment, the budgetary stance in the programme seems sufficient to maintain
the MTO throughout the programme period, as envisaged in the programme. The fiscal policy stance
implied by the programme is in line with the Stability and Growth Pact, but it should be tightened
given the size of the economic imbalances and the heightened responsibility of fiscal policy due to

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

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(8)

(9)

(10)

(11)

the limited scope of monetary policy under a quasi-fixed exchange rate regime within ERM II. The
likelihood of a better-than-estimated 2007 outturn should be used to aim for a much higher surplus
position in 2008.

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

the national reform programme.

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

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

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

(12) As regards the data requirements specified in the code of conduct for stability and convergence
programmes, the programme has a small gap in compulsory data and provides most of the optional
data (1).

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

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

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

(1) In particular the data on capital taxes (compulsory data), the subcomponents of the stock-flow adjustment and some

elements of the long-term sustainability of public finances table are missing.

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

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

Comparison of key macroeconomic and budgetary projections

Real GDP
(% change)

CP Nov 2007

2006

11,9

2007

10,5

COM Nov 2007

11,9

10,5

CP Jan 2007

11,5

9,0

HICP inflation
(%)

CP Nov 2007

COM Nov 2007

CP Jan 2007

Output gap (1)
(% of potential GDP)

CP Nov 2007

COM Nov 2007 (2)

CP Jan 2007

6,6

6,6

6,6

2,0

2,1

1,8

9,6

6,4

2,8

2,7

1,3

2008

2009

2010

7,5

7,2

7,5

9,8

5,2

1,3

0,8

7,0

6,2

7,5

7,2

6,0

4,2

6,8

n.a.

n.a.

4,9

n.a.

n.a.

– 0,3

– 1,7

– 1,7

– 0,5

– 2,0

10,1

12,5

Net lending/borrowing
vis-à-vis the rest of the
world
(% of GDP)

CP Nov 2007

– 21,1

– 23,5

– 20,3

– 18,3

– 16,4

COM Nov 2007

– 19,9

– 22,2

– 18,9

– 18,0

CP Jan 2007

– 17,4

– 17,2

– 16,3

– 15,8

General government
balance
(% of GDP)

CP Nov 2007

COM Nov 2007

– 0,3

– 0,3

0,3

0,9

0,7

0,8

1,0

0,5

CP Jan 2007

– 0,4

– 1,3

– 0,9

– 0,4

Primary balance
(% of GDP)

CP Nov 2007

COM Nov 2007

CP Jan 2007

0,2

0,2

0,2

0,7

1,3

1,0

1,2

– 0,8

– 0,4

Cyclically-adjusted
balance (1)
(% of GDP)

CP Nov 2007

– 0,9

– 0,5

COM Nov 2007

– 0,8

0,2

0,4

0,5

CP Jan 2007

– 0,9

– 1,7

– 0,8

1,2

0,9

0,1

1,1

1,0

0,2

n.a.

n.a.

n.a.

n.a.

1,2

n.a.

n.a.

1,5

n.a.

n.a.

1,7

n.a.

n.a.

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Structural balance (3)
(% of GDP)

Government gross debt
(% of GDP)

CP Nov 2007

COM Nov 2007

CP Jan 2007

CP Nov 2007

COM Nov 2007

CP Jan 2007

2006

2007

2008

2009

2010

– 0,9

– 0,8

– 0,9

10,6

10,6

10,7

– 0,5

0,2

– 1,7

9,4

10,2

10,5

0,4

0,5

– 0,8

8,3

7,8

10,6

1,1

1,0

0,2

7,2

6,4

9,4

1,7

n.a.

n.a.

6,4

n.a.

n.a.

Notes:
(1) Output gaps and cyclically-adjusted balances according to the programmes as recalculated by Commission services on the basis of the

information in the programmes.

(2) Based on estimated potential growth of 9,8 %, 9,8 %, 9,3 % and 8,9 % respectively in the period 2006-2009.
(3) Cyclically-adjusted balance excluding one-off and other temporary measures. There are no one-off and other temporary measures

according to the most recent programme and the autumn forecast.

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