COMMISSION STAFF WORKING DOCUMENT TECHNICAL ANNEX Accompanying the document REPORT FROM THE COMMISSION CONVERGENCE REPORT 2013 (prepared in accordance with Article 140(1) TFUE at the request of Latvia)
Date: 2013-06-05
Institutions: European Commission
Subjects: Latvia, approximation of laws, balance of payments, budgetary equilibrium, economic statistics, exchange rate, inflation, interest, monetary union

EUROPEAN 
COMMISSION 

Brussels, 5.6.2013  
SWD(2013) 196 final 

COMMISSION STAFF WORKING DOCUMENT 

TECHNICAL ANNEX 

Accompanying the document 

REPORT FROM THE COMMISSION 

CONVERGENCE REPORT 2013 

(prepared in accordance with Article 140(1) TFUE at the request of Latvia) 

{COM(2013) 341 final} 

EN 

   EN 

 
 
 
 
  
 
 
European Commission 

Directorate-General for Economic and Financial Affairs 

Convergence Report 2013 

EUROPEAN ECONOMY 

xxx/2013 

2 

 
 
 
 
ABBREVIATIONS 

LV 
EA 
EU-27 
EU-25 
EU-15 

EUR 
ECU 
LVL 
USD 
SDR 

AMR 
BoL 
BoP 
CAR 
CEE 
CIS 
CPI 
CR5 

EC 
ECB 
EDP 
EMI 
EMS 
EMU 
ERM II   
ESA95   
ESCB 
EU 

Eurostat  
FCMC 
FDL 
FDI 
FSAP 
GDP 
HICP 
HICP-CT 
IMF 
MFI 
MIP 
MTO 
NCBs 
NEER 
NPL 
OJ 
OJL 
PIT 
PPS 
PPP 
R&D 
REER 

Latvia 
Euro area 
European Union, 27 Member States 
European Union, 25 Member States before 2007 (i.e. EU-27 excl. BG and RO) 
European Union, 15 Member States before 2004 

Euro 
European currency unit 
Latvian lats 
US dollar 
Special Drawing Rights 

Alert Mechanism Report 
Bank of Latvia 
Balance of Payments 
Capital adequacy ratio 
Central and Eastern Europe 
Commonwealth of Independent States 
Consumer price index 
Concentration ratio (aggregated market share of five banks with largest market share) 

European Community 
European Central Bank 
Excessive Deficit Procedure 
European Monetary Institute 
European Monetary System 
Economic and monetary union 
Exchange rate mechanism II 
European System of Accounts 
European System of Central Banks 
European Union 

Statistical Office of the European Union 
Financial Capital Market Commission 
Fiscal Discipline Law 
Foreign direct investment 
Financial Sector Action Plan 
Gross domestic product 
Harmonised index of consumer prices 
HICP at constant taxes 
International Monetary Fund 
Monetary Financial Institution 
Macroeconomic Imbalance Procedure 
Medium-term objective 
National central banks 
Nominal effective exchange rate 
Non-performing loans 
Official Journal 
Official Journal Lex 
Personal Income Tax 
Purchasing Power Standard 
Purchasing Power Percentage 
Research and development 
Real effective exchange rate 

3 

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
SITC 
SME 
TEC 
TFEU 
ULC  
VAT 

Standard International Trade Classification 
Small and medium entreprises 
Treaty establishing the European Community 
Treaty on the Functioning of the European Union 
Unit labour costs 
Value added tax 

4 

 
 
 
 
 
 
 
 
ACKNOWLEDGEMENTS 

The Convergence Report and its Technical Annex were prepared in the Directorate-General for Economic 
and Financial Affairs. The main contributors were Balazs Forgo, Radoslav Krastev and Ingrid Toming. 

Other contributors were Benjamin Angel, Gatis Eglitis, Christine Frayne, Nikolay Gertchev, Isabel Grilo, 
Henriette Keller, Federico Lucidi, Filip Keereman, Matteo Salto, Ruediger Voss and Christian Weise. 

Statistical assistance was provided by Gerda Symens and André Verbanck.  

The  report  was  coordinated  by  Balazs  Forgo  under  the  supervision  of  Paul  Kutos,  Head  of  Unit  and 
approved  by  Sean  Berrigan,  Director,  Maarten  Verwey,  Deputy  Director  General,  and  Marco  Buti, 
Director General. 

Questions and comments may be referred to Balazs Forgo (balazs.forgo@ece.europa.eu) 

v 

 
 
 
 
 
CONTENTS 

Convergence Report 2013 

Convergence Report 2013 - Technical annex 

1. 

Introduction 

1.1.  ROLE OF THE REPORT 

1.2.  APPLICATION OF THE CRITERIA 

1.2.1.  Compatibility of legislation 

1.2.2.  Price stability 

1.2.3.  Public finances 

1.2.4.  Exchange rate stability 

1.2.5.  Long-term interest rates 

1.2.6.  Additional factors 

2. 

Latvia 

2.1. 

LEGAL COMPATIBILITY 

2.1.1. 

Introduction 

2.1.2.  Objectives 

2.1.3.  Central bank independence 

2.1.4.  Prohibition of monetary financing and privileged access 

2.1.5. 

Integration in the ESCB 

2.1.6.  Assessment of compatibility 

2.2.  PRICE STABILITY 

2.2.1.  Respect of the reference value 

2.2.2.  Recent inflation developments 

2.2.3.  Underlying factors and sustainability of inflation 

2.3.  PUBLIC FINANCES 

2.3.1.  The excessive deficit procedure for Latvia 

2.3.2.  Recent fiscal developments 

2.3.3.  Outlook for public finances 

2.4.  EXCHANGE RATE STABILITY 

2.5. 

LONG-TERM INTEREST RATES 

2.6.  ADDITIONAL FACTORS 

2.6.1.  Developments of the balance of payments 

2.6.2.  Product market integration 

2.6.3.  Financial market integration 

2.7. 

SUSTAINABILITY OF CONVERGENCE 

LIST OF TABLES 

2.1. 

2.2. 

2.3. 

2.4. 

2.5. 

Latvia - Components of inflation 

Latvia - Other inflation and cost indicators 

Latvia - Budgetary developments and projections 

Latvia - Balance of payments 

Latvia - Product market integration 

1 

3 

5 

5 

6 

7 

7 

12 

12 

14 

14 

17 

17 

17 

17 

17 

17 

17 

18 

18 

18 

18 

19 

22 

22 

23 

24 

24 

26 

27 

28 

29 

31 

34 

18 

20 

23 

28 

30 

vii 

 
 
 
LIST OF GRAPHS 

2.1. 

2.2. 

2.3. 

2.4. 

Latvia - Inflation criterion since 2007 

Latvia - HICP inflation 

Latvia - Inflation, productivity and wage trends 

LVL - Spread vs central rate 

2.5.  Exchange rates - LVL/EUR 

2.6. 

2.7. 

2.8. 

2.9. 

Latvia - 3-M Rigibor spread to 3-M Euribor 

Latvia - Long-term interest rate criterion 

Latvia - Long-term interest rates 

Latvia - Saving and investment 

2.10.  Latvia - Effective exchange rates 

2.11.  Latvia - Foreign ownership and concentration in the banking sector 

2.12.  Latvia - selected banking sector soundness indicators relatively to the euro area 

2.13.  Latvia - Non-resident deposits (NRD) 

2.14.  Latvia - Recent development of the financial system relatively to the euro area 

LIST OF BOXES 

1.1.  Article 140 of the Treaty 

1.2.  Assessment of price stability and the reference value 

1.3.  Excessive deficit procedure 

1.4.  Data for the interest rate convergence 

1.5. 

The Macroeconomic Imbalance Procedure (MIP) 

18 

19 

21 

25 

25 

26 

26 

27 

29 

29 

32 

32 

33 

33 

6 

8 

10 

13 

15 

viii 

 
 
 
 
 
 
Convergence Report 2013 

(prepared in accordance with Article 140(1) of the Treaty) 

 
 
Report 

 
 
Convergence Report 2013 

Technical annex 

 
 
1. 

INTRODUCTION 

1.1. 

ROLE OF THE REPORT 

The  euro  was  introduced  on  1  January  1999  by 
eleven  Member  States.  The  decision (1)  by  the 
Council (meeting in the composition of the Heads 
of  State  or  Government)  on  3  May  1998  in 
Brussels  on  the  eleven  Member  States  deemed 
ready  to  participate  in  the  single  currency  had,  in 
accordance  with 
(Article  121(4) 
the  Treaty 
TEC) (2), been prepared by the Ecofin Council on 
a  recommendation  from  the  Commission.  The 
decision  was  based  on  the  two  Convergence 
Reports  made  by  the  Commission (3)  and  the 
(EMI), 
European 
Monetary 
respectively (4).  These 
in 
accordance with Article 121(1) TEC (5), examined 
the 
whether 
convergence 
legal 
requirements. 

the  Member  States 

reports,  prepared 

satisfied 
the 

and  met 

Institute 

criteria 

Since 
then,  Greece  (2001),  Slovenia  (2007), 
Cyprus  and  Malta  (2008),  Slovakia  (2009)  and 
Estonia (2011) have joined the euro. 

Those  Member  States  which  are  assessed  as  not 
fulfilling the necessary conditions for the adoption 
of the euro are referred to as "Member States with 
a derogation". Article 140 of the Treaty lays down 
provisions  and  procedures  for  examining  the 
situation of Member States with a derogation (Box 
1.1).  At  least  once  every  two  years,  or  at  the 
request  of  a  Member  State  with  a  derogation,  the 
Commission  and  the  European  Central  Bank 
(ECB)  prepare  Convergence  Reports  on  such 
Member States. Denmark and the United Kingdom 
the 
negotiated  opt-out  arrangements  before 
adoption  of  the  Maastricht  Treaty (6)  and  do  not 

(1)  OJ L 139, 11.5.1998, pp. 30-35 
(2)  The  numbering  of  Treaty  articles  cited  in  this  report 
corresponds to the one of the Treaty on the Functioning of 
the  European  Union  (TFEU)  except  when  explicitly 
mentioned. Article 121(4) TEC does no longer exist in the 
TFEU,  as  it  refers  to  the  first  countries  deemed  ready  to 
adopt the euro on 1 January 1999. 

participate  in  the  third  stage  of  EMU.  Until  these 
Member  States 
to 
participate in the third stage and join the euro, they 
are not the subject of an assessment as to whether 
they fulfil the necessary conditions.  

they  wish 

indicate 

that 

In  2012,  the  Commission  and  the  ECB  adopted 
their latest regular Convergence Reports (7). None 
of the Member States assessed in those reports was 
deemed  to  meet  the  necessary  conditions  for 
adopting the euro. 

On 5 March 2013 Latvia submitted a request for a 
convergence  assessment.  This  Commission  Staff 
Working  Document  is  a  Technical  Annex  to  the 
Convergence Report 2013 on Latvia and includes a 
detailed 
the  progress  with 
convergence. 

assessment  of 

The  financial  and  economic  crisis,  along  with  the 
recent  euro-area  debt  crisis, 
in  general,  has 
exposed gaps  in  the  current  economic  governance 
system  of  the  Economic  and  Monetary  Union 
(EMU)  and  showed  that  its  existing  instruments 
need  to  be  used  more  fully.  With  the  aim  of 
ensuring  a  sustainable  functioning  of  EMU,  an 
overall  strengthening  of  economic  governance  in 
the  Union  was  undertaken  over  the  past  three 
this  Commission  Staff 
years.  Accordingly, 
Working  Document  makes 
references  where 
appropriate  to  procedures  that  help  to  strengthen 
the assessment of the convergence process and its 
incorporates 
sustainability. 
references  to  the  strengthened  surveillance  of 
macroeconomic imbalances (see section 1.2.6.). 

In  particular, 

it 

(3)  Report 

on 

progress 

and 
recommendation  with  a  view  to  the  transition  to  the  third 
stage  of  economic  and  monetary  union,  COM(1998)1999 
final, 25 March 1998. 

convergence 

towards 

(4)  European  Monetary  Institute,  Convergence  Report,  March 

1998. 

(5)  The content of this article is now included in Article 140(1) 

TFEU. 

(6)  Protocol  (No  16)  on  certain  provisions  relating 

to 
Denmark,  Protocol  (No  15)  on  certain  provisions  relating 

to  the  United  Kingdom  of  Great  Britain  and  Northern 
Ireland. 

(7)  European  Commission,  Convergence  Report  2012, 
COM(2012)  257  final,  30  May  2012;  European  Central 
Bank, Convergence Report 2012, May 2012. 

5 

 
                                                           
                                                                                   
Convergence Report 2013 - Technical annex 

Chapter 1 - Introduction 

Box 1.1: Article 140 of the Treaty

"1. At least once every two years, or at the request of a Member State with a derogation, the Commission 
and the European Central Bank shall report to the Council on the progress made by the Member States with 
a  derogation  in  fulfilling  their  obligations  regarding  the  achievement  of  economic  and  monetary  union. 
These reports shall include an examination of the compatibility between the national legislation of each of 
these Member States, including the statutes of its national central bank, and Articles 130 and 131 and the 
Statute of the ESCB and of the ECB. The reports shall also examine the achievement of a high degree of 
sustainable convergence by reference to the fulfilment by each Member State of the following criteria: 

— the achievement of a high degree of price stability; this will be apparent from a rate of inflation which is 
close to that of, at most, the three best performing Member States in terms of price stability, 

—  the  sustainability  of  the  government  financial  position;  this  will  be  apparent  from  having  achieved  a 
government budgetary position without a deficit that is excessive as determined in accordance with Article 
126(6), 

—  the observance  of  the normal  fluctuation  margins  provided  for  by  the  exchange-rate  mechanism  of  the 
European Monetary System, for at least two years, without devaluing against the euro, 

— the durability of convergence achieved by the Member State with a derogation and of its participation in 
the exchange-rate mechanism being reflected in the long-term interest-rate levels. 

The four criteria mentioned in this paragraph and the relevant periods over which they are to be respected 
are  developed  further  in  a  Protocol  annexed  to  the  Treaties.  The  reports  of  the  Commission  and  the 
European Central Bank shall also take account of the results of the integration of markets, the situation and 
development of the balances of payments on current account and an examination of the development of unit 
labour costs and other price indices. 

2. After consulting the European Parliament and after discussion in the European Council, the Council shall, 
on  a  proposal  from  the  Commission,  decide  which  Member  States  with  a  derogation  fulfil  the  necessary 
conditions on the basis of the criteria set out in paragraph 1, and abrogate the derogations of the Member 
States concerned. 

The Council shall act having received a recommendation of a qualified majority of those among its members 
representing Member States whose currency is the euro. These members shall act within six months of the 
Council receiving the Commission's proposal. 

The qualified majority of the said members, as referred to in the second subparagraph, shall be defined in 
accordance with Article 238(3)(a). 

3.  If  it  is  decided,  in  accordance  with  the  procedure  set  out  in  paragraph  2,  to  abrogate  a  derogation,  the 
Council shall, acting with the unanimity of the Member States whose currency is the euro and the Member 
State  concerned,  on  a  proposal  from  the  Commission  and  after  consulting  the  European  Central  Bank, 
irrevocably  fix  the  rate  at  which  the  euro  shall  be  substituted  for  the  currency  of  the  Member  State 
concerned, and take the other measures necessary for the introduction of the euro as the single currency in 
the Member State concerned." 

The  remainder  of  the  first  chapter  presents  the 
methodology  used  for  the  application  of  the 
assessment  criteria.  Chapter  2  examines 
the 
fulfilment  of  the  convergence  criteria  and  other 
requirements in the order as they appear in Article 
140(1)  (see  Box  1.1).  The  cut-off  date  for  the 
statistical  data 
this  Convergence 
included 
Report was 16 May 2013. 

in 

1.2.  APPLICATION OF THE CRITERIA 

In  accordance  with  Article  140(1)  of  the  Treaty, 
the 
the  Convergence  Reports  shall  examine 
compatibility  of  national  legislation  with  Articles 
130  and  131  of  the  Treaty  and  the  Statute  of  the 
European System of Central Banks (ESCB) and of 
the European Central Bank. The reports shall also 
examine  the  achievement  of  a  high  degree  of 
sustainable  convergence  by  reference 
the 
fulfilment of the four convergence criteria dealing 

to 

6 

 
 
 
 
 
 
with price stability, public finances, exchange rate 
stability  and  long  term  interest  rates  as  well  as 
some  additional  factors.  The  four  convergence 
criteria  are  developed  further 
in  a  Protocol 
annexed  to  the  Treaty  (Protocol  No  13  on  the 
convergence criteria).  

1.2.1.  Compatibility of legislation 

In  accordance  with  Article  140(1)  of  the  Treaty, 
the  legal  examination  includes  an  assessment  of 
compatibility 
a  Member  State’s 
legislation,  including  the  statute  of  its  national 
central  bank,  and  Articles  130  and  131  of  the 
Treaty. This assessment mainly covers three areas.  

between 

•  First,  the  independence  of  the  national  central 
bank  and  of  the  members  of  its  decision-
making  bodies,  as  laid  down  in  Article  130, 
must  be  assessed.  This  assessment  covers  all 
issues  linked  to  a  national  central  bank's 
institutional  financial  independence  and  to  the 
personal  independence  of  the  members  of  its 
decision-making bodies.  

financing 

•  Second,  in  accordance  with  Articles  123  and 
124  of  the  Treaty,  the  compliance  of  the 
national  legislation  is  verified  against  the 
prohibition  of  monetary 
and 
privileged access. The prohibition of monetary 
financing is laid down in Article 123(1) of the 
Treaty,  which  prohibits  overdraft  facilities  or 
any  other  type  of  credit  facility  with  the  ECB 
or the central banks of Member States in favour 
of  Union 
institutions,  bodies,  offices  or 
agencies,  central  governments,  regional,  local 
or  other  public  authorities,  other  bodies 
governed by public law, or public undertakings 
of  Member  States;  and  the  purchase  directly 
from these public sector entities by the ECB or 
central  banks  of  debt  instruments.  As  regards 
the prohibition on privileged access, the central 
banks,  as  public  authorities,  may  not  take 
measures  granting  privileged  access  by  the 
public  sector  to  financial  institutions  if  such 
measures  are  not  based  on  prudential 
considerations.  

•  Third,  the  integration  of  the  national  central 
bank  into  the  ESCB  has  to  be  examined,  in 
order to ensure that at the latest by the moment 
of euro adoption, the objectives of the national 
central bank are compatible with the objectives 
of the ESCB as formulated in Article 127 of the 
Treaty.  What  is  more,  the  provisions  on  tasks 

Convergence Report 2013 - Technical annex 

Chapter 1 - Introduction 

in  national  central  banks  laws  are  assessed 
against  the  relevant  provisions  of  the  Treaty 
and the ESCB/ECB Statute.  

1.2.2.  Price stability 

The  price  stability  criterion  is  defined  in  the  first 
indent  of  Article  140(1)  of  the  Treaty:  “the 
achievement of a high degree of price stability […] 
will  be  apparent  from  a  rate  of  inflation  which  is 
close to that of, at most, the three best performing 
Member States in terms of price stability”. 

Article  1  of  the  Protocol  on  the  convergence 
criteria  further  stipulates  that  “the  criterion  on 
price stability […] shall mean that a Member State 
has a price performance that is sustainable and an 
average rate of inflation, observed over a period of 
one  year  before  the  examination,  that  does  not 
exceed by more than 1.5 percentage points that of, 
at  most,  the  three  best  performing  Member  States 
in  terms  of  price  stability.  Inflation  shall  be 
measured by means of the consumer price index on 
a comparable basis, taking into account differences 
in national definitions”.  

legal  basis  for 

they  do  not  constitute 

Since  national  consumer  price  indices  (CPIs) 
diverge substantially in terms of concepts, methods 
and  practices, 
the 
appropriate means to meet the Treaty requirement 
that  inflation  must  be  measured  on  a  comparable 
basis.  To  this  end,  the  Council  adopted  on  23 
October  1995  a  framework  regulation (8)  setting 
the 
the  establishment  of  a 
harmonised  methodology  for  compiling  consumer 
price  indices  in  the  Member  States.  This  process 
resulted  in  the  production  of  the  Harmonised 
Indices  of  Consumer  Prices  (HICPs),  which  are 
used  for  assessing  the  fulfilment  of  the  price 
stability  criterion.  Until  December  2005,  HICP 
series  had  been  based  on  1996  as  the  reference 
period.  A  Commission  Regulation  (EC)  No 
1708/2005 (9)  provided  the  basis  for  a  change  of 
the  HICP  index  base  reference  period  from 
1996=100 to 2005=100. 

(8)  Council  Regulation  (EC)  No  2494/95  of  23  October  1995 
concerning  harmonised  indices  of  consumer  prices  (OJ  L 
257,  27.10.1995,  pp.  1-4),  amended  Regulations  (EC)  No 
1882/2003 and No 596/2009 of the European Parliament of 
the Council. 

(9)  Commission Regulation (EC) No 1708/2005 of 19 October 
2005 laying down detailed rules for the implementation of 
Council  Regulation  (EC)  No  2494/95  as  regards  the 
common  index  reference  period  for  the  harmonised  index 
of  consumer  prices,  and  amending  Regulation  (EC)  No 
2214/96. 

7 

 
                                                           
Convergence Report 2013 - Technical annex 

Chapter 1 - Introduction 

Box 1.2: Assessment of price stability and the reference value

The numerical part of the price stability criterion implies a comparison between a Member State's average 
price performance and a reference value.  

A  Member  State’s  average  rate  of  inflation  is  measured  by  the  percentage  change  in  the  unweighted 
average of the last 12 monthly indices relative to the unweighted average of the 12 monthly indices of the 
previous period, rounded to one decimal. This measure captures inflation trends over a period of one year as 
requested  by  the  provisions  of  the  Treaty.  Using  the  commonly  used  inflation  rate  –  calculated  as  the 
percentage change in the consumer price index of the latest month over the index for the equivalent month 
of  the  previous  year  –  would  not  meet  the  one  year  requirement.  The  latter  measure  may  also  vary 
importantly from month to month because of exceptional factors.  

The reference value is calculated as the unweighted average of the average rates of inflation of, at most, the 
three best-performing Member States in terms of price stability plus 1.5 percentage points. The outcome is 
rounded to one decimal. While in principle the reference value could also be calculated on the basis of the 
price performance of only one or two best performing Member States in terms of price stability, it has been 
existing  practice  to  select  the  three  best  performers.  Defining  the  reference  value  in  a  relative  way  (as 
opposed to a fixed reference value) allows to take into account the effects of a common shock that affects 
inflation rates across all Member States.  

As Article 140(1) of the Treaty refers to 'Member States' and does not make a distinction between euro area 
and other Member States, the Convergence Reports select the three best performers from all Member States 
– EU-15 for the Convergence Reports before 2004, EU-25 for the reports between 2004 and 2006 and EU-
27 for reports as of 2007.  

The notion of 'best performer' is not defined explicitly in the Treaty. It is appropriate to interpret this notion 
in a non-mechanical manner, taking into account the state of the economic environment at the time of the 
assessment. In previous Convergence Reports, when all Member States had a positive rate of inflation, the 
group of best performers in terms of price stability naturally consisted of those Member States which had the 
lowest  positive  average  rate  of  inflation.  In  the  2004  report,  Lithuania  was  not  taken  into  account  in  the 
calculation of the reference value because its negative rate of inflation, which was due to country-specific 
economic  circumstances,  was  significantly  diverging  from  that  of  the  other  Member  States,  making 
Lithuania  a  de  facto  outlier  that  could  not  be  considered  as  'best  performer'  in  terms  of  price  stability 
(Lithuania's average 12-month inflation was at that time 2.3 percentage points below the euro area average 
12-month inflation). In 2010, in an environment characterised by exceptionally large  common shocks (the 
global economic and financial crisis and the associated sharp fall in commodity prices), a significant number 
of countries faced episodes of negative inflation rates (the euro area  average inflation rate in March 2010 
was only slightly positive, at 0.3%). In this context, Ireland was excluded from the best performers, i.e. the 
only Member State whose average inflation rate deviated by a wide margin from that of the euro area and 
other  Member  States,  mainly  due  to  the  severe  economic  downturn  in  that  country  (Ireland's  average  12-
month  inflation  was  at  that  time  -2.3%  and  that  of  the  euro  area  0.3%).  At  the  current  juncture,  it  is 
warranted  to  exclude  Greece  from  the  best  performers,  as  its  inflation  rate  and  profile  deviate  by  a  wide 
margin from the euro area average, mainly reflecting the severe adjustment needs and exceptional situation 
of the Greek economy, and including it would unduly affect the reference value and thus the fairness of the 
criterion. In April 2013, the 12-month average inflation rate of Greece was 0.4% and that of the euro area 
2.2%,  with  the  gap  between  the  two  forecast  to  increase  further  in  the  months  ahead.  Table  1.1  lists  the 
reference value in the Convergence Reports issued since 1998. 

(Continued on the next page) 

8 

 
 
 
 
 
 
 
Convergence Report 2013 - Technical annex 

Chapter 1 - Introduction 

Box (continued) 

Table 1:

Inflation reference value in previous and current Convergence Reports

Convergence Report

Cut-off month

adoption date

1998

2000

2002

2004

2006 May 

2006 December

2007

2008

2010

2012

2013

January 1998

March 2000

April 2002

August 2004

March 2006

October 2006

March 2007

March 2008

March 2010

March 2012

April 2013

Three best
performers 1) 2)

Austria, France, Ireland

Sweden, France, Austria
United Kingdom, France, Luxembourg 5)
Finland, Denmark, Sweden

Sweden, Finland, Poland

Poland, Finland, Sweden

Finland, Poland, Sweden

Malta, Netherlands, Denmark

Portugal, Estonia, Belgium 

 Sweden, Ireland, Slovenia

 Sweden, Latvia, Ireland

Reference
value 3)

Euro area average
inflation rate 4)

2.7

2.4

3.3

2.4

2.6

2.8

3.0

3.2

1.0

3.1

2.7

1.5

1.4

2.4

2.1

2.3

2.2

2.1

2.5

0.3

2.8

2.2

1) EU15 until April 2004; EU25 between May 2004 and December 2006; EU27 from January 2007 onwards.

2) In case of equal rounded average inflation for several potential best performers, the ranking is determined on the basis of unrounded da

3) Reference values are only computed at the time of Convergence Reports. All calculations of the reference value

    between the Convergence Reports are purely illustrative.

4) Measured by the percentage change in the arthmetic average of the latest 12 monthly indices relative to the 

    arithmetic average of the 12 monthly indices of the previous period.

5) Based on revised data, Germany would replace Luxembourg as one of the three Member States with the lowest

    12 month average inflation in April 2002. This change would not affect the price and long-term interest rate reference values in April 2002

in 

inflation 

the  percentage  change 

As has been the case in past convergence reports, a 
Member  State’s  average  rate  of 
is 
the 
measured  by 
arithmetic  average  of  the  last  12  monthly  indices 
relative to the arithmetic average of the 12 monthly 
indices of the previous period. The reference value 
is  calculated  as  the  arithmetic  average  of  the 
average  rate  of 
three  best-
inflation  of 
performing  Member  States  in  terms  of  price 
stability plus 1.5 percentage points. 

the 

Over  the  12-month  period  covering  May  2012-
April  2013,  the  three  best-performing  Member 
States  in  terms  of  price  stability  were  Sweden 
(0.8%), Latvia (1.3%) and Ireland (1.6%), yielding 
a  reference  value  of  2.7%.  Greece  was  excluded 
from  among  the  best  performers,  as  its  inflation 
rate and profile deviate by a wide margin from the 
euro  area  average,  mainly  reflecting  the  severe 
adjustment  needs  and  exceptional  situation  of  the 
Greek economy (see Box 1.2).  

The Protocol on the convergence criteria not only 
requires  Member  States  to  have  achieved  a  high 
degree  of  price  stability  but  also  calls  for  a  price 
performance  that  is  sustainable.  The  requirement 
of sustainability aims at ensuring that the degree of 
price  stability  and  inflation  convergence  achieved 
in previous years will be maintained after adoption 
of  the  euro.  This  deserves  particular  attention  in 

the  current  juncture  as  the  financial  turmoil 
exposed unsustainable price developments in many 
EU Member States, including euro area countries, 
in the pre-crisis period. 

than  reflecting 

Inflation sustainability implies that the satisfactory 
inflation  performance  must  essentially  be  due  to 
the  adequate  behaviour  of  input  costs  and  other 
in  a 
factors 
influencing  price  developments 
structural  manner,  rather 
the 
influence  of  temporary  factors.  Therefore,  this 
Technical  Annex  examines  also  the  role  of  the 
macroeconomic  situation  and  policy  stance  in 
inflation performance, developments in unit labour 
costs  as  a  result  of  trends  in  labour  productivity 
and nominal compensation per head, developments 
in  import  prices  to  assess  how  external  price 
developments  have 
impacted  on  domestic 
inflation.  Similarly,  the  impact  of  administered 
prices  and  indirect  taxes  on  headline  inflation  is 
also considered.  

9 

 
 
 
 
 
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Chapter 1 - Introduction 

Box 1.3: Excessive deficit procedure

The  excessive  deficit  procedure  is  specified  in  Article  126  of  the  Treaty,  the  associated  Protocol  on  the 
excessive  deficit  procedure  and  Council  Regulation  (EC)  No  1467/97  on  speeding  up  and  clarifying  the 
implementation  of  the  excessive  deficit  procedure (1),  which  is  the  “corrective  arm”  of  the  Stability  and 
Growth Pact. Together, they determine the steps to be followed to reach a Council decision on the existence 
of  an  excessive  deficit,  which  forms  the  basis  for  the  assessment  of  compliance  with  the  convergence 
criterion on the government budgetary position. As part of an overall strengthening of economic governance 
in  the  Union,  Council  Regulation  (EC)  No  1467/97  was  amended  in  2011.  In  particular,  a  numerical 
benchmark was introduced for operationalising the debt criterion in Article 126(2) of the Treaty.  

Article  126(1)  states  that  Member  States  are  to  avoid  excessive  government  deficits.  The  Commission  is 
required to monitor the development of the budgetary situation and of the stock of government debt in the 
Member  States  with  a  view  to  identifying  gross  errors  (Article  126(2)).  In  particular,  compliance  with 
budgetary discipline is to be examined by the Commission on the basis of the following two criteria: 

“(a)  whether  the  ratio  of  the  planned  or  actual  government  deficit  to  gross  domestic  product  exceeds  a 
reference value [specified in the Protocol as 3 percent], unless: 
•  either the ratio has declined substantially and continuously and reached a level that comes close to the 

reference value; 

•  or,  alternatively,  the  excess  over  the  reference  value  is  only  exceptional  and  temporary  and  the  ratio 

remains close to the reference value; 

(b) whether the ratio of government debt to gross domestic product exceeds a reference value [specified in 
the Protocol as 60 percent], unless the ratio is sufficiently diminishing and approaching the reference value 
at a satisfactory pace”. 

According to the Protocol on the excessive deficit procedure, the Commission provides the statistical data 
for the implementation of the procedure. As part of the application of this Protocol, Member States have to 
notify data on government deficits, government debt, nominal GDP and other associated variables twice a 
year, before 1 April and before 1 October (2). After each reporting date, Eurostat examines whether the data 
are in conformity with ESA95 (3) rules and related Eurostat decisions and, if they are, validates them. 

The Commission is required to prepare a report if a Member State does not fulfil the requirements under one 
or  both  of  the  criteria  given  above  (Article  126(3)).  The  report  also  has  to  take  into  account  whether  the 
government deficit exceeds government investment expenditure and all other relevant factors. These include 
developments  in  the  medium-term  economic  position (4)  the  medium-term  budgetary  position  of  the 
Member State (5), in the medium-term government debt position (6), as well as any other factors which, in 
the opinion of the Member State concerned, are relevant and which the Member State has put forward to the 
Council  and  the  Commission.  In  that  context,  particular  consideration  shall  be  given  to  financial 
contributions  to  fostering  international  solidarity  and  achieving  the  policy  goals  of  the  Union,  the  debt 
incurred  in  the  form  of  bilateral  and  multilateral  support  between  Member  States  in  the  context  of 
safeguarding  financial  stability,  and  the  debt  related  to  financial  stabilisation  operations  during  major 
financial disturbances.  

(1)  OJ L 209, 2.8.1997, p. 6. Regulation as amended by Regulation (EC) No 1056/2005 (OJ L 174, 7.7.2005, p. 5). 
(2)  Council Regulation  (EC)  No  479/2009  on the application  of  the  Protocol  on  the  excessive  deficit  procedure  (OJ  L 

145, 10.06.2009, p1). 

(3)  European System of National and Regional Accounts, adopted by Council Regulation (EC) No 2223/96 (OJ L 310, 
30.11.1996, p. 1). Regulation as last amended by Regulation (EC) No 400/2009 of the European Parliament and of 
the Council (OJ L 126, 21.5.2009, p. 11). 

(4)  In particular, potential growth, including the various contributions, cyclical developments, and the private sector net 

savings position. 

(5)  In particular, the record of adjustment towards the medium-term budgetary objective, the level of the primary balance 
and  developments  in  primary  expenditure,  the  implementation  of  policies  in  the  context  of  the  prevention  and 
correction of excessive macroeconomic imbalances and in the context of the common growth strategy of the Union, 
as well as the overall quality of public finances, in particular the effectiveness of national budgetary frameworks. 
(6)  In  particular,  its  dynamics  and  sustainability,  including,  risk  factors  including  the  maturity  structure  and  currency 
denomination of the debt, stock-flow adjustment and its composition, accumulated reserves and other financial assets, 
guarantees, in particular those linked to the financial sector, and any implicit liabilities related to ageing and private 
debt, to the extent that it may represent a contingent implicit liability for the government.

(Continued on the next page) 

10 

 
 
 
 
                                                           
 
 
Convergence Report 2013 - Technical annex 

Chapter 1 - Introduction 

Box (continued) 

The Council and the Commission shall make a balanced overall assessment of all the relevant factors. Those 
factors shall be taken into account in the steps leading to the decision on the existence of an excessive deficit 
when assessing compliance on the basis of the debt criterion. When assessing compliance on the basis of the 
deficit criterion in a country with a debt ratio exceeding the reference value, those factors shall be taken into 
account  in  the  steps  leading  to  the  decision  on  the  existence  of  an  excessive  deficit  subject  to  the  double 
condition that the deficit is close to the reference value and its excess over it is temporary. Due consideration 
is foreseen for pension reforms introducing a multi-pillar system including a mandatory, fully-funded pillar 
and the net cost of the publicly managed pillar. (7) 

The next step in the procedure is the formulation by the Economic and Financial Committee of an opinion 
on this report, which according to the Stability and Growth Pact must occur within two weeks of its adoption 
by  the  Commission  (Article  126(4)).  If  it  considers  that  an  excessive  deficit  exists  or  may  occur,  the 
Commission  addresses  an  opinion  to  the  Council  (Article  126(5)).  Then,  on  the  basis  of  a  Commission 
proposal,  the  Council  decides,  after  an  overall  assessment,  including  any  observation  that  the  concerned 
Member State may have, whether an excessive deficit exists (Article 126(6)). The Stability and Growth Pact 
prescribes that any  such decision has to be adopted as a rule  within four months of the reporting dates (1 
April, 1 October). 

At  the  same  time  as  deciding  on  the  existence  of  an  excessive  deficit,  the  Council  has  to  issue  a 
recommendation to the Member  State concerned with a  view to  bringing that situation to an end within a 
given period, on the basis of a Commission recommendation (Article 126(7)). According to the Stability and 
Growth Pact, the Council recommendation has to specify when the correction of the excessive deficit should 
be  completed,  the  annual  budgetary  targets  that  the  Member  State  concerned  has  to  achieve,  and  has  to 
include  a  maximum  deadline  of  six  months  at  most  for  effective  action  to  be  taken  by  the  Member  State 
concerned.  Within this deadline, the Member State concerned shall report to the Council on action taken. 
The report shall include targets for government expenditure and revenue and for the discretionary measures 
consistent with the Council's recommendation, as well as information on the measures taken and the nature 
of those envisaged to achieve the targets.  

If effective action has been taken in compliance with a recommendation under Article 126(7) and, compared 
with  the  economic  forecasts  in  this  recommendation,  unexpected  adverse  economic  events  with  major 
unfavourable  consequences  for  government  finances  occur  subsequent  to  its  adoption,  the  Council  may 
decide,  on  a  recommendation  from  the  Commission,  to  adopt  a  revised  recommendation  under  the  same 
article, which may notably extend the deadline for the correction of the excessive deficit by one year. In the 
case of severe economic downturn for the euro area or the EU as a whole, the Council may also decide, on 
recommendation by the Commission, to adopt a revised recommendation under Article 126(7), provided that 
this does not endanger fiscal sustainability in the medium term. 

Where it establishes that there has been no effective action in response to its recommendations, the Council 
adopts a decision under Article 126(8) on the basis of a Commission recommendation immediately after the 
expiry of the deadline for taking action (or at any time thereafter when monitoring of the action taken by the 
Member State indicates that action is not being implemented or is proving to be inadequate). The provisions 
of  Article  126(9  and  11),  on  enhanced  Council  surveillance  and  ultimately  sanctions  in  case  of  non-
compliance, as well as the new enforcement mechanisms introduced in 2011, are not applicable to Member 
States with a derogation (that is, those that have not yet adopted the euro), which is the case of the Member 
State  considered  in  this  report.  Following  a  Council  decision  establishing,  under  Article  126(8),  that  the 
Member State did not take effective action in response to a Council recommendation under Article 126(7), 
the Council, on recommendation by the Commission, addresses to Member States with a derogation a new 
recommendation under Article 126(7).  

(7)  Where the excess of the deficit over the reference value reflects the implementation of a pension reform introducing a 
multi-pillar system that includes a mandatory, fully funded pillar, the Council and the Commission shall also consider 
the  cost  of  the  reform  when  deciding  on  the  existence  of  an  excessive  deficit,  as  long  as  the  deficit  does  not 
significantly exceed a level that can be considered close to the reference value, and the debt ratio does not exceed the 
reference value, provided that overall fiscal sustainability is maintained.

(Continued on the next page) 

11 

 
 
 
                                                           
 
 
Convergence Report 2013 - Technical annex 

Chapter 1 - Introduction 

Box (continued) 

When, in the view of the Council, the excessive deficit in the Member State concerned has been corrected, 
the  Council  abrogates  its  decision  on  the  existence  of  an  excessive  deficit,  again  on  the  basis  of  a 
Commission recommendation (Article 126(12)). 

From  a  forward-looking  inflation  perspective,  the 
report  includes  an  assessment  of  medium-term 
prospects  for  price  developments.  The  analysis  of 
factors that have an impact on the inflation outlook 
– cyclical conditions, labour market developments 
and  credit  growth  –  is  complemented  by  a 
reference to the most recent Commission services' 
forecast 
can 
inflation.  That 
of 
the 
subsequently  be  used 
Member State is likely to meet the reference value 
the  months  ahead (10).  Medium-term 
also 
inflation  prospects  are  also  assessed  by  reference 
to  the  economies'  key  structural  characteristics, 
including the functioning of the labour and product 
markets. 

to  assess  whether 

forecast 

in 

1.2.3.  Public finances 

The  convergence  criterion  dealing  with 
the 
government  budgetary  position  is  defined  in  the 
second  indent  of  Article  140(1)  of  the  Treaty  as 
“the  sustainability  of  the  government  financial 
position: 
this  will  be  apparent  from  having 
achieved a government budgetary position without 
a  deficit  that  is  excessive  as  determined  in 
accordance  with  Article  126(6)”.  Furthermore, 
Article  2  of  the  Protocol  on  the  convergence 
criteria states that this criterion means that “at the 
time  of  the  examination  the  Member  State  is  not 
the  subject  of  a  Council  decision  under  Article 
126(6) of the said Treaty that an excessive deficit 
exists”. 

The convergence assessment in the budgetary area 
is  thus  directly  linked  to  the  excessive  deficit 
procedure which is specified in Article 126 of the 
Treaty  and  further  clarified  in  the  Stability  and 
Growth  Pact  (see  Box  1.3  for  further  information 

(10)  According  to  the  Commission  services'  Spring  2013 
Forecast, the inflation reference value is forecast to stand at 
2.4%  in  December  2013,  with  Portugal,  Sweden  and 
Cyprus  as  best  performers  in  terms  of  price  stability. 
Greece  has  been  excluded  from  the  best  performers  in 
December 2013 as its average inflation rate is forecasted to 
deviate from the euro area average by a wide margin. The 
forecast  of  the  reference  value  is  subject  to  significant 
uncertainties  given  that  it  is  calculated  on  the  basis  of  the 
inflation forecasts for the three Member States projected to 
be  the  best  performers  in  terms  of  price  stability  in  the 
forecast  period,  thereby  increasing  the  possible  margin  of 
error. 

12 

the  way 

on the excessive deficit procedure as strengthened 
by  the  2011  reform  of  the  Stability  and  Growth 
Pact).  The  existence  of  an  excessive  deficit  is 
determined  by  Regulation  1467/97  as  amended  in 
2005  and  2011  (most  recently  under  the  "Six-
Pack")  which  sets  out 
in  which 
government  deficit  and  debt  levels  are  used  to 
assess  whether  an  excessive  deficit  exists,  under 
article 126 of TFEU. The convergence  assessment 
in  the  budgetary  area  is  therefore  judged  by 
whether  a  Council  decision  under  126(6)  exists, 
and  the  Member  State  needs  to  comply  with  the 
in 
deficit  and  debt 
regulation  1467/97  to  ensure  that  it  is  not  subject 
to such a decision (11).  

requirements  elaborated 

The  issue  of  sustainability  deserves  particular 
attention  at  a  time  when  the  financial  crisis  has 
significantly  impacted  on  the  fiscal  positions  in 
many  Member  States.  Related  to  this,  economic 
the  EMU  was  substantially 
governance 
strengthened in 2011. This included, inter alia, the 
operationalisation  of  the  debt  criterion  in  the 
Excessive Deficit Procedure (12). 

in 

1.2.4.  Exchange rate stability 

(11)  The  definition  of  the  general  government  deficit  used  in 
this  report  is  in  accordance  with  the  excessive  deficit 
procedure, as was the case in previous convergence reports. 
In particular, interest expenditure, total expenditure and the 
overall balance include net streams of interest expenditure 
resulting  from  swaps  arrangements  and  forward  rate 
agreements.  Government  debt  is  general  government 
consolidated  gross  debt  at  nominal  value  (Council 
Regulation 479/2009). Information regarding the excessive 
deficit  procedure  and  its  application  to  different  Member 
States 
at: 
http://ec.europa.eu/economy_finance/economic_governanc
e/sgp/deficit/index_en.htm. 

found 

since 

2002 

can 

be 

and 

two 

new 

regulations 

surveillance 

frameworks, 

the  Stability 

three 
and  Growth  Pact 

(12)  A  directive  on  minimum  requirements  for  national 
on 
budgetary 
regulations 
macroeconomic 
and 
amending 
complementing  it  with  new  enforcement  mechanisms  for 
euro  area  Member  States  entered  into  force  on  13 
December 2011. Besides the operationalisation of the debt 
criterion  in  the  Excessive  Deficit  Procedure  mentioned  in 
introduced  a  number  of 
Box  1.3, 
important  novelties  in  the  Stability  and  Growth  Pact,  in 
particular  an  expenditure  benchmark  to  complement  the 
assessment  of  progress 
the  country-specific 
medium-term budgetary objective. 

the  amendments 

towards 

 
                                                           
                                                           
 
 
 
 
Convergence Report 2013 - Technical annex 

Chapter 1 - Introduction 

Box 1.4: Data for the interest rate convergence

The  fourth  indent  of  Article  140(l)  of  the  Treaty  requires  that  the  durability  of  nominal  convergence  and 
exchange rate stability in Member States should be assessed by reference to long-term interest rates. Article 
4 of the Protocol on the convergence criteria adds that these “Interest rates shall be measured on the basis of 
long-term  government  bonds  or  comparable  securities,  taking  into  account  differences  in  national 
definitions”. 

Article  5  of  the  Protocol  requires  that  the  Commission  should  provide  the  statistical  data  used  for  the 
application of the convergence criteria. However, in the context of the interest rate criterion, the ECB has 
developed the criteria for harmonising the series of yields on benchmark 10 year bonds on behalf of Eurostat 
and collects the data from the central banks. The selection of bonds for inclusion in this series is based on 
the following criteria: 

• 

issued by central government; 

•  a residual maturity as close as possible to 10 years; 

•  adequate liquidity, which is the main selection criterion; the choice between a single benchmark or the 

simple average of a sample is based on this requirement; 

• 

fixed coupon; 

•  yield gross of tax. 

The representative interest rates  used in this report (for Latvia, Sweden and Ireland) are  calculated on the 
basis  of  secondary  market  rates,  using  single  benchmark  bonds.  For  Latvia  and  Sweden,  the  residual 
maturity of the benchmark bond is close to 10 years, while for Ireland it is close to 7½ years. 

Data  used  in  this  Report  can  be  found  on  Eurostat  ("Maastricht  criterion  bond  yields  (mcby):  EMU 
convergence  criterion  bond  yields",  code:  tec00097).  The  same  series  is  also  published  by  the  ECB's 
Statistical Data Warehouse (code IRS.M.Country Code.U2.L.L40.CI.0000.EUR.N.Z). 

third 

The Treaty refers to the exchange rate criterion in 
the 
indent  of  Article  140(1)  as  “the 
observance  of  the  normal  fluctuation  margins 
provided  for  by  the  exchange-rate  mechanism  of 
the  European  Monetary  System,  for  at  least  two 
years, without devaluing against the euro”.  

Article  3  of  the  Protocol  on  the  convergence 
criteria  stipulates:  “The  criterion  on  participation 
in  the  exchange  rate  mechanism  of  the  European 
Monetary  System  (…)  shall  mean  that  a  Member 
State has respected the normal fluctuation margins 
provided  for  by  the  exchange-rate  mechanism  of 
the  European  Monetary  System  without  severe 
tensions  for  at  least  the  last  two  years  before  the 
examination. In particular, the Member State shall 
not  have  devalued  its  currency’s  bilateral  central 
rate  against  the  euro  on  its  own  initiative  for  the 
same period” (13). Based on the Council Resolution 

on  the  establishment  of  the  ERM  II (14),  the 
European  Monetary  System  has  been  replaced  by 
the  Exchange  Rate  Mechanism  II  upon 
the 
introduction of the euro, and the euro has become 
the centre of the mechanism.  

in  auxiliary 

In  its  assessment  of  the  exchange  rate  stability 
criterion,  the  Commission  takes  into  account 
developments 
indicators  such  as 
foreign  reserve  developments  and  short-term 
interest  rates,  as  well  as  the  role  of  policy 
exchange 
measures, 
interventions, 
rate 
stability.  

in  maintaining  exchange 

including 

foreign 

Latvia  was still  under  an  international  balance-of-
payments  assistance  programme  during  the  first 
part  of  the  assessment  period  for  this  report.  In 
order 
this  constitutes 
evidence  that  a  country  has  faced  severe  tensions 

to  determine  whether 

(13)  In  assessing  compliance  with  the  exchange  rate  criterion, 
the  Commission  examines  whether  the  exchange  rate  has 
remained  close  to  the  ERM  II  central  rate,  while  reasons 
for  an  appreciation  may  be  taken  into  account,  in 
accordance  with  the  Common  Statement  on  Acceding 

Countries  and  ERM2  by  the  Informal  ECOFIN  Council, 
Athens, 5 April 2003. 

(14)  97/C 236/03 of 16 June 1997, OJ C 236, 2.8.1997, p.5. 

13 

 
                                                           
                                                                                   
 
 
 
 
 
Convergence Report 2013 - Technical annex 

Chapter 1 - Introduction 

in its exchange rate, the Commission examines the 
role  played  by  official  external  financing  during 
the assessment period.  

economically  meaningful  benchmark,  which 
would not distort the reference value any more. 

As  in  previous  reports,  the  assessment  of  this 
criterion  verifies  the  participation  in  ERM  II  and 
examines  exchange  rate  behaviour  within  the 
mechanism.  The  relevant  period  for  assessing 
exchange  rate  stability  in  this  Technical  Annex  is 
17 May 2011 to 16 May 2013. 

1.2.5.  Long-term interest rates 

the  Protocol  on 

The  fourth  indent  of  Article  140(1)  of  the  Treaty 
requires  “the  durability  of  convergence  achieved 
by  the  Member  State  with  a  derogation  and  of  its 
participation  in  the  exchange  rate  mechanism 
being  reflected  in  the  long-term  interest  rate 
levels”.  Article  4  of 
the 
convergence  criteria  further  stipulates  that  “the 
criterion  on  the  convergence  of  interest  rates  (…) 
shall mean that, observed over a period of one year 
before the examination, a Member State has had an 
average  nominal  long-term  interest  rate  that  does 
not  exceed  by  more  than  two  percentage  points 
that of, at most, the three best performing Member 
States in terms of price stability. Interest rates shall 
be measured on the basis of long-term government 
bonds  or  comparable  securities, 
into 
account  differences  in  national  definitions”  (see 
Box 1.4). 

taking 

In  the  2012  Convergence  Report,  the  long-term 
interest  rate  of  Ireland,  one  of  the  three  best-
performing  Member  States  in  terms  of  price 
stability  also  at  that  time,  was  not  included  in  the 
calculation of the reference value for the long-term 
interest  rate  criterion  due  to  the  severe  distortions 
in  its  sovereign  bond  market  (15).  However, 
supported  by  the  successful  implementation  of  its 
financial  assistance  programme,  the  long-term 
interest rate of Ireland has converged significantly 
closer  to  that  of  other  euro  area  Member  States 
since  then  and  Ireland's  bond  market  access 
improved  considerably (16).  This  suggests  that  the 
long-term  interest  rate  of  Ireland  became  an 

(15)  In  March  2012,  the  12-month  average  long-term  interest 
rate  in  Ireland  was  9.1%.  Ireland  has  been  the beneficiary 
of  an  EU/IMF  financial  assistance  programme  since 
December 2010 and it had practically no market access. 
(16)  Disruptions  were  still  present  in  Ireland's  sovereign  debt 
market  during  the  reference  period,  but  were  gradually 
diminishing  with  the  successful  implementation  of  its 
EU/IMF  financial  assistance  programme.  In  March  2013 
Ireland issued a 10-year bond of EUR 5 billion with a yield 
of 4.15%. 

14 

the  criterion  on 

the  assessment  of 

For 
the 
convergence of interest rates, yields on benchmark 
10-year  bonds  have  been  taken,  using  an  average 
rate over the latest 12 months. The reference value 
is  calculated  as  the  simple  average  of  the average 
long-term 
three  best-
rates  of 
performing  Member  States  in  terms  of  price 
stability  plus  2  percentage  points.  In  April  2013, 
the  reference  value,  derived  from  the  average 
interest rate in Sweden (1.6%), Latvia (3.8%) and 
Ireland (5.1%), was 5.5%. 

interest 

the 

1.2.6.  Additional factors 

The  Treaty  in  Article  140  also  calls  for  an 
examination  of  other  factors relevant  to  economic 
integration  and  convergence.  These  additional 
factors 
include  financial  and  product  market 
integration and the development of the balance of 
payments. The examination of the development of 
unit labour costs and other price indices, which is 
also  prescribed  by  Article  140  of  the  Treaty,  is 
covered in the subchapter on price stability. 

of 

the 

is  an 
The  assessment  of  additional  factors 
important indication of whether the integration of a 
Member  State  into  the  euro  area  would  proceed 
without  difficulties.  As  regards  the  balance  of 
payments,  the  focus  is  on  the  situation  and 
balance (17). 
development 
Integration of product markets is assessed through 
trade,  foreign  direct  investment  and  a  smooth 
internal  market.  Finally, 
functioning  of 
progress  in  financial  integration  is  examined, 
together with the impact of the financial crisis, the 
main  characteristics,  structures  and  trends  of  the 
financial sector and compliance with the acquis of 
the Union in this area. 

external 

the 

(17)  The  external  balance  is  defined  as  the  combined  current 
and  capital  account  (net  lending/borrowing  vis-à-vis  the 
rest of the world). This concept permits in particular to take 
full  account  of  external  transfers  (including  EU  transfers), 
which  are  partly  recorded  in  the  capital  account.  It  is  the 
concept closest to the current account as defined when the 
Maastricht Treaty was drafted. 

 
                                                           
                                                           
Convergence Report 2013 - Technical annex 

Chapter 1 - Introduction 

Box 1.5: The Macroeconomic Imbalance Procedure (MIP)

The Macroeconomic Imbalance Procedure (MIP): key elements  

A  key  lesson  from  the  economic  and  financial  crisis  has  been  that  the  economic  governance  framework 
underpinning EMU needed to be further strengthened to address the issue of unsustainable macroeconomic 
trends.  The  new  procedure  on  prevention  and  correction  of  macroeconomic  imbalances  –  the 
Macroeconomic Imbalance Procedure (MIP) – responds to this need and was one of the key elements of the 
legislative package (the "6-pack") to enhance the governance structures in EMU.  

A two-step approach with a preventive and a corrective arm  

The overall design of the MIP includes a "preventive" arm and a stronger "corrective" arm for more serious 
cases. For euro area countries, the corrective arm is supplemented by an enforcement mechanism including 
the  possibility  of  financial  sanctions.  The  procedure  relies  on  a  two-step  approach  where  the  first  step 
consists  of  an  alert  mechanism  that  aims  to  identify  Member  States  with  potentially  emerging 
macroeconomic  imbalances  and  which  require  more  in-depth  investigation.  If,  on the  basis of  such  an  in-
depth  analysis,  the  situation  is  considered  unproblematic  no  further  steps  are  taken.  If  the  Commission 
however  considers  that  macroeconomic  imbalances  exist,  it  may  come  forward  with  proposals  for  policy 
recommendations  for  the  Member  State  concerned  (which  will  be  –  in  the  preventive  arm  –  part  of  the 
integrated package of recommendations under the European semester). In case the in-depth review points to 
severe imbalances in a Member  State, the Council would declare the existence of an excessive imbalance 
and  adopt  a  recommendation  asking  the  Member  State  to  present  a  Corrective  Action  Plan  (CAP).  After 
submission of the CAP by the Member State, the Council would assess the CAP which either can be deemed 
sufficient or insufficient; if found insufficient, the Member State should present a new CAP. If the new CAP 
is again found insufficient, a fine can be imposed (0.1% of GDP), though just for euro area Member States 
(1). When a sufficient CAP is in place, the Council will assess whether or not the Member State concerned 
has  taken  the  recommended  actions  according  to  the  set  deadlines.    For  euro  area  Member  States  a  first 
assessment of non-compliance would lead to an interesting-bearing deposit (0.1% of GDP). After a second 
decision by the Council declaring non-compliance, the Council can take the decision to convert the deposit 
into an annual fine. If the Council considers that the Member State has taken the recommended corrective 
action,  but  imbalances  are  not  yet  corrected,  the  procedure  will  be  placed  in  abeyance.  If  the  Council 
considers  that  the  Member  State  concerned  has  taken  the  appropriate  action  and  the  Member  State  is  no 
longer experiencing excessive imbalances, the procedure will be closed.  

The alert mechanism scoreboard: design and rationale 

The scoreboard is an element of the alert mechanism and is intended to facilitate the identification of trends 
of imbalances that are under the scope of the MIP and require closer examination. In line with the different 
challenges  facing the Member States, it comprises indicators of the external position (current account and 
net  international  investment  position),  competitiveness  developments  (real  effective  exchange  rates,  unit 
labour  cost,  export  market  shares)  and  indicators  of  internal  imbalances  (private  sector  and  general 
government debt, private sector credit flow, house prices and the unemployment rate). The scoreboard thus 
encompasses variables where both the economic literature and recent experiences suggest associations with 
economic crises, while indicative alert thresholds were identified for each indicator.  

The 2013 Alert Mechanism Report (AMR)  

As the first step of the MIP process of 2013, the Commission published its second Alert Mechanism Report 
in November 2012. The AMR made an economic reading of the scoreboard as foreseen by the legislation 
and on this basis, similarly to the conclusion of the 2012 AMR,  Latvia  was not identified for  an  in-depth 
review related to possible imbalances. 

(1)  These decisions are taken with so called "reversed qualified majority voting" (RQMV), which implies that there needs
to be a majority against taking the step (as opposed to the normal approach where a decision needs the backing of a
qualified majority).

Starting  with  the  2012  Convergence  Report,  the 
convergence  assessment 
the 
broader  "European  semester"  approach  which 

is  aligned  with 

takes  an  integrated  and  upstream  look  at  the 
economic  policy  challenges  facing  the  EMU  in 
ensuring  fiscal  sustainability,  competitiveness, 

15 

 
 
 
                                                           
 
 
 
Convergence Report 2013 - Technical annex 

Chapter 1 - Introduction 

financial  market  stability  and  economic  growth. 
The  section  on  additional  factors  makes  reference 
to  the  surveillance  of  macroeconomic  imbalances 
under  the  Macro-economic  Imbalance  Procedure, 
which  was  adopted  in  December  2011  as  one  of 
the  key  elements  of  the  legislative  package  (the 
"Six-Pack")  to  enhance  the  governance  structures 
in  EMU,  and  integrates  its  results  into  the 
assessment. 

16 

 
2. 

LATVIA 

2.1. 

LEGAL COMPATIBILITY 

2.1.1.  Introduction 

The Bank of Latvia (Latvijas Banka) was founded 
in 1922 and re-instated in 1991, under the Law on 
the Bank of Latvia (hereinafter: BoL Law).  

Following  the  assessment  of  the  Convergence 
Report  from  2012,  the  Latvian  Government,  in 
cooperation  with  Latvijas  Banka,  prepared 
amendments  to  the  BoL  Law,  which  the  Latvian 
Parliament (Saeima) adopted on 10 January 2013. 
The  last  amendment  of  the  BoL  Law  prior  to  the 
changes in 2013 dates back to 2009. 

The  Council  of  Latvijas  Banka  is  the  decision 
making  body  of  the  Bank  and  consists  of  the 
Governor,  the  Deputy  Governor  and  six  other 
Council  members.  The  Governor  is  appointed  by 
the Saeima upon recommendation of at least ten of 
its  members.  The  Deputy  Governor  and  the  other 
members  of  the  Council  of  Latvijas  Banka  are 
appointed by the Saeima upon the proposal of the 
Governor.  The  Governor,  the  Deputy  Governor 
and  the  other  members  of  the  Council  of  Latvijas 
Banka hold office for six years. 

2.1.2.  Objectives 

The  objectives  of  Latvijas  Banka  are  compatible 
with the TFEU. 

An imperfection under the former BoL Law (2009) 
regarding the objective of Latvijas Banka has been 
remedied. In line with Article 127(1) of the TFEU, 
Article  3  of  the  new  BoL  Law  now  clearly  states 
that  the  primary  objective  of  the  Bank  is  to 
maintain price stability. 

2.1.3.  Central bank independence 

that 

No  incompatibilities  or  imperfections  with  the 
TFEU  and  the  ECB/ESCB  Statute  exist  in  this 
respect  given 
incompatibilities  and 
the 
imperfections of the former BoL Law with regard 
to  the  independence  of  the  Central  Bank  as 
enshrined in the TFEU and the ESCB/ECB Statute 
have been remedied.  

A  provision  of  the  BoL  Law  (2009)  under  which 
the  Saeima  by  means  of  a  resolution  could 
liquidate  Latvijas  Banka  and  thereby  breach  the 
financial  and  institutional  independence  of  the 
Bank has been repealed. 

Articles  22  and  28  of  the  new  BoL  Law  have 
brought  the  rules  on  resignation,  absence  and 
dismissal  of  the  Governor  including  the  right  of 
judicial  review  of  dismissal  before  the  Court  of 
Justice of the EU in line with the provisions of the 
TFEU  and  the  ECB/ESCB  Statute  on  the  Central 
Bank independence. 

Pursuant to the new Article 13 of the BoL Law, the 
prohibition  of  Latvijas  Banka  to  seek  or  take 
instructions  from  the  Government  or  any  other 
institution  explicitly  includes  also  the  prohibition 
to 
from  Union 
institutions, bodies, offices or agencies as referred 
to in Article 130 of the TFEU and Article 7 of the 
ESCB/EC Statute. 

instructions 

seek  or 

take 

With  regard  to  the  financial  independence  of 
Latvijas  Banka,  the  new  Article  181  of  the  BoL 
Law  now  provides  that  parts  of  the  profits  and 
payments  for  the  usage  of  state  capital  shall  be 
transferred  to  the  state  general  budget  only  after 
accumulated  losses  in  the  previous  years,  if  any, 
have been covered. 

2.1.4.  Prohibition  of  monetary  financing  and 

privileged access 

Following the changes introduced by the new BoL 
Law  there  is  no  longer  any  incompatibility  with 
regard  to  the  prohibition  of  monetary  financing 
under Article 123 of the TFEU. 

The  new  Article  36  of  the  BoL  Law  has  clarified 
the scope of the public sector entities falling within 
the  ambit  of  the  prohibition  under  Article  123 
TFEU.  Now  Article  36  of  the  BoL  Law  states 
clearly that Latvijas Banka shall not be entitled to 
grant any type of credit facilities and purchase debt 
instruments  in  accordance  with  Article  123  of  the 
TFEU and Article 21 of the ECB/ESCB Statute. 

2.1.5.  Integration in the ESCB 

There  are no  incompatibilities  or  imperfections  as 
to the integration of the BoL into the ESCB. 

17 

 
Convergence Report 2013 - Technical annex 

Chapter 2 - Latvia 

Table 2.1:

Latvia - Components of inflation

(percentage change)1)

weights  

in total   

2007

2008

2009

2010

2011

2012

Apr-13

HICP

Non-energy industrial goods

Energy

Unprocessed food 

Processed food

Services

HICP excl. energy and unproc. food

HICP at constant taxes

Administered prices HICP

10.1

3.3

10.4

12.3

14.4

12.9

9.7

9.8

16.6

15.3

2.7

27.3

13.7

27.4

15.4

13.8

13.6

31.8

3.3

0.0

4.0

0.4

6.8

4.7

3.5

-1.9

17.6

-1.2

-3.5

5.4

-0.1

1.0

-4.5

-2.7

-1.4

2.1

4.2

-1.0

13.5

3.8

9.1

0.5

2.4

2.7

7.3

2.3

-1.5

8.7

2.2

2.5

1.7

0.9

2.4

7.4

1.3

-1.4

4.3

3.3

1.2

1.2

0.4

1.7

4.2

2013

1000

237

159

103

207

293

738

1000

142

1) Measured by the arithmetic average of the latest 12 monthly indices relative to the arithmetic average of the 12 monthly indices

   in the previous period.

Sources: Eurostat, Commission services.

Following  the  amendments  to  Articles  4,  5,  7,  9, 
15,  26,  34  to  38  and  43  of  the  BoL  Law,  the 
incompatibilities  and  imperfections  described  in 
the Convergence Report from 2012 with regard to 
the ESCB/ECB tasks have been remedied. 

2.1.6.  Assessment of compatibility 

The Law on the Bank of Latvia as amended is fully 
compatible  with  Articles  130  and  131  of  the 
TFEU. 

2.2. 

PRICE STABILITY 

2.2.1.  Respect of the reference value 

The  12-month  average  inflation  rate  for  Latvia, 
which is used for the convergence assessment, was 
above  the  reference  value  at  the  time  of  the  last 
convergence  assessment  in  2012.  Since  then, 
average  annual  inflation  declined  from  above  4% 
to  well  below  2%.  In  April  2013,  the  reference 
value  was  2.7%,  calculated  as  the  average  of  the 
12-month average inflation rates in Sweden, Latvia 
and  Ireland  plus  1.5  percentage  points.  The 
average  inflation  rate  in  Latvia  during  the  12 
months to April 2013 was 1.3%, i.e. 1.4 percentage 
points below the reference value. It is projected to 
remain  below  the  reference  value  in  the  months 
ahead. 

Graph 2.1:Latvia - Inflation criterion since 2007

(percent, 12-month moving average)

16

12

8

4

0

-4
Jan-07

Jan-08

Jan-09

Jan-10

Jan-11

Jan-12

Jan-13

Latvia

Reference value

Note: The dots  in December 2013 show the projected 
reference value and 12-month average inflation in the country.
Sources: Eurostat, Commission services' Spring 2013 Forecast.

2.2.2.  Recent inflation developments 

In previous years, Latvia's inflation rate moved in 
quite  a  wide  range  mainly  as  a  consequence  of 
volatile  commodity  price  movements  and  a  very 
factors  were 
intense  business  cycle.  These 
amplified  by  the  composition  of  the  consumer 
basket,  which  includes  a  relatively  high  share  of 
food  and  energy  products  and  significant  taxation 
changes. 

18 

 
 
 
 
 
 
HICP  inflation  (18)  peaked  at  over  17%  in  2008, 
with  price  dynamics  turning  around  sharply  after 
the  intra-year  collapse  of  demand.  Significant 
nominal  wage  adjustment  and  a  correction  in 
import  prices  led  to  almost  a  year  of  negative 
headline  inflation  from  October  2009.  Inflation 
however rose from -2.8% in April 2010 to 4.8% by 
May  2011,  as  the  cycle  turned  and  a  new  global 
commodity  price  shock  set  in,  exacerbated  by  the 
impact  of  a  regional  drought  and  the  effect  of 
indirect tax increases. From that local peak, annual 
inflation  fell  to  -0.4%  by  April  2013,  helped 
mainly  by  a  continuing  wage  restraint  in  the 
Latvian  economy,  a  decreasing  contribution  from 
food and energy prices and the cut of the standard 
VAT  rate  by  1  percentage  point  as  of  July  2012. 
Average HICP inflation slowed from 4.2% in 2011 
to 2.3% in 2012. 

Graph 2.2:Latvia - HICP inflation

(y-o-y percentage change)

20

15

10

5

0

-5

2007

2008

2009

2010

2011

2012

2013

Source: Eurostat.

Latvia

Euro area

the 

inflation  (measured  as  HICP 

Core 
inflation 
excluding  energy  and unprocessed food) has  been 
well  below  headline  inflation  in  recent  years, 
highlighting 
rising 
commodity  prices  had  on  inflation.  However,  the 
gap  closed  in  early  2013,  as  energy  inflation  fell 
below  zero  and  core  inflation  stood  at  -0.4%  in 
April  2013.  In  mid-2011,  processed  food  prices 
temporarily lifted core inflation to over 3%, but it 

strong 

effect 

that 

that 

indices.  Eurostat  considers 

(18)  Eurostat has been reviewing the statistical practices used to 
compile the HICP in Latvia against HICP methodology and 
other  guidelines  and  good  practices  in  the  field  of 
consumer  price 
the 
methods  used  for  producing  the  Latvian  HICP  are  of  a 
good  standard.  Eurostat's  recommendations  have  been 
followed and the quality of the consumer price statistics for 
Latvia  improved  during  recent  years.  The  representativity 
of the Latvian HICP in terms of accuracy and reliability is 
adequate.  There  were  no  apparent  instances  of  non-
compliance with the HICP methodology. The Latvian data 
pass all standard HICP validation tests – they are internally 
consistent.  Latvian  HICP  data  should 
therefore  be 
considered comparable to the HICPs of other EU countries. 
The full report will be published in the relevant section on 
Eurostat's website. 

Convergence Report 2013 - Technical annex 

Chapter 2 - Latvia 

has  declined  since  then  as  underlying  price  and 
cost  pressures  from  the  real  economy  remained 
subdued.  In  contrast  to  Latvia's  EU-neighbours, 
non-energy  industrial  goods  prices  continued  to 
fall in April 2013, which may partly be explained 
by  increasing  competition  on  the  Latvian  retail 
market.  Services  prices  started  to  edge  up  from 
2010,  but  this  trend  reversed  in  July  2012  despite 
the  continuing  strong 
recovery  of  domestic 
demand,  due  inter  alia  to  the  impact  of  taxes, 
energy  prices  and  still  moderate  wage  growth.  In 
addition,  the  price  of  telecommunication  services 
declined 
late-2012, 
significantly 
contributing  to  an  overall  services  price  inflation 
of  -0.4%  in  April  2013.  Producer  price  inflation 
declined in 2012 and remained low in early 2013, 
indicating that there is no short-term cost pressure 
from the domestic industry. 

very 

in 

2.2.3.  Underlying  factors  and  sustainability  of 

inflation 

Macroeconomic  policy-mix  and  cyclical 
stance 

led 

Real  GDP  growth  was  above  10%  on  average 
between 2005 and 2007, but fell to around -7% in 
2008-2010.  As  credit  flows  abruptly  reversed, 
Latvia  required  an  EU/IMF 
international 
financial  assistance  programme  and  ambitious 
fiscal  consolidation  began.  The  reallocation  of 
resources  to  the  tradable  sector  created  the  basis 
for  an  export-driven  recovery.  Domestic  demand 
revived  only  slowly  under  the  burden  of  financial 
deleveraging  and  fiscal  consolidation,  but  from 
2011 it was supported by favourable labour market 
developments.  The  positive  trends  continued  in 
2012  and  while  growth  shifted  more  towards 
domestic  demand,  it  remained  broadly  balanced. 
Real GDP growth reached 5.5% in 2011 and 5.6% 
in  2012,  helped  also  by  an  exceptionally  good 
harvest.  Growth  is  projected  by  the  Commission 
services' 2013 Spring Forecast to slow to 3.8% in 
2013,  and  to  recover  to  4.1%  in  2014  with  the 
external 
expected 
environment.  Commission  services  estimate  that 
the Latvian economy will operate slightly above its 
potential output in 2013-2014. 

improvement 

the 

in 

The  fiscal  stance,  as  measured  by  changes  in  the 
structural  balance, deteriorated until  2008, as  pro-
cyclical  fiscal  policy  contributed  to  the  boom  and 
failed to prepare for the crisis. Fiscal policy turned 
restrictive  in  2009,  when  a  huge  adjustment  was 
imposed  by  the  crisis  and  implemented  in  the 

19 

 
 
                                                           
Convergence Report 2013 - Technical annex 

Chapter 2 - Latvia 

Table 2.2:

Latvia - Other inflation and cost indicators

2007

2008

2009

2010

2011

(annual percentage change)

20121)

20132)

20142)

HICP inflation

Latvia 

Euro area

10.1

2.1

Private consumption deflator

Latvia 

Euro area

9.9

2.2

Nominal compensation per employee

Latvia 

Euro area

Labour productivity

Latvia 

Euro area

Nominal unit labour costs

Latvia 

Euro area

Imports of goods deflator

Latvia 

Euro area

35.1

2.6

5.8

1.3

27.7

1.3

5.7

1.0

15.3

3.3

16.2

2.6

15.7

3.5

-4.2

-0.3

20.7

3.8

9.7

4.2

1) 2012 data (except HICP inflation) are estimates. 

2) Commission services' Spring 2013 Forecast.

Source: Eurostat, Commission services.

3.3

0.3

3.2

-0.4

-12.7

1.8

-5.3

-2.4

-7.9

4.3

-6.7

-8.1

-1.2

1.6

-1.8

1.7

-6.7

2.0

4.0

2.6

-10.4

-0.7

7.6

5.7

4.2

2.7

5.0

2.5

17.2

2.2

14.8

1.2

2.1

0.9

6.1

6.6

2.3

2.5

3.0

2.1

3.9

1.8

2.9

0.3

1.0

1.4

7.7

2.6

1.4

1.6

1.9

1.6

3.1

1.8

1.9

0.3

1.2

1.4

2.0

0.6

2.1

1.5

2.3

1.7

3.8

1.8

1.9

0.9

1.9

0.8

2.1

1.2

framework  of  the  EU-IMF  assistance  programme. 
As  a  result  of  the  large  fiscal  adjustment,  the 
structural  deficit  improved  to  -0.3%  by  2012. 
According  to  the  Commission  services'  Spring 
2013  Forecast,  the  structural  balance  is  projected 
to  deteriorate  to  -1.4%  in  2013  and  to  -1.5%  in 
2014  under  the  assumption  of  unchanged  policy, 
including due to the increase in state contributions 
to the fully funded private pension scheme. 

The  narrow  fluctuation  band  to  the  euro,  the  high 
degree  of  euroisation  and  integration  with  the 
European financial system constrain the scope and 
effectiveness  of  domestic  monetary  policy. 
Nevertheless,  the  Bank  of  Latvia  continued  to 
loosen  monetary  conditions  with  the  aim  to 
stimulate the channelling of abundant lats liquidity 
to  economic  development.  In  2012,  the  Bank  of 
Latvia  cut  its  refinancing  rate  in  two  steps  from 
3.5%  to  2.5%  and  lowered  its  marginal  lending 
facility 
reserve 
requirement  was  set  at  3%  for  bank  liabilities 
above  two  years  and  5%  for  all  other  liabilities 
included in the reserve base from November 2008 
until January 2012, when both were lowered by 1 
percentage point.  By September 2012, the Bank of 
Latvia reduced the interest rate on its 7-day deposit 
facility  to  0.075%  and  on  its  overnight  deposit 
the 
facility 

the  macro-level, 

to  0.05%.  On 

steps.  The 

three 

rates 

in 

20 

deleveraging  of  the  Latvian  economy  appears  to 
have  abated by  early  2013, as  new  lending nearly 
counterbalanced 
the 
outstanding  loan  stock,  after  correction  for  bank 
insolvencies (Parex, Krajbanka) and write-offs. 

amortisation 

the 

of 

Wages and labour costs 

A  considerable  wage  adjustment  took  place  in 
Latvia over 2009 and 2010, with compensation per 
employee  falling  by  a  cumulative  19%  in  two 
years,  supported  by  policies  implemented  under 
the  EU-IMF  assistance  programme.  Employment 
declined  at  a  high  rate,  especially  in  the  private 
sector,  as  jobs  were  shed  heavily  in  construction 
and manufacturing. The unemployment rate started 
to  decline  from  around  20%  in  early  2010,  due 
mainly to employment growth, and fell below 15% 
by  2012,  while  the  participation  rate  increased 
significantly.  The  economic  recovery  led  to  a 
moderate increase in private sector wages in 2011 
and  2012  amid  some  tightening  of  the  labour 
(ULC) 
market.  Nominal  unit 
rebounded somewhat in 2011, but the pace of ULC 
growth  slowed  in  2012  to  a  sustainable  level. 
Labour  productivity  growth  is  expected  to  be  low 

labour  costs 

 
 
 
 
 
Convergence Report 2013 - Technical annex 

Chapter 2 - Latvia 

coupled with a good regional harvest in 2011, led 
to a moderation in the growth of import prices. The 
rate  of  import  price  growth  fell  further  in  2012, 
despite  a  temporary  spike  in  oil  prices  (in  euro 
terms) around March of that year. The contribution 
of  energy  prices  to  HICP  inflation  remained  high 
in 2012, with 1.4 percentage points on average. 

The  nominal  effective  exchange  rate  of  the  lats, 
measured  against  a  group  of  35  trading  partners, 
remained  broadly  stable  since  the  beginning  of 
2010. Between late 2008 and early 2010, there was 
a period when the nominal effective exchange rate 
was somewhat stronger, as the currencies of many 
of Latvia's trading partners depreciated against the 
euro during this phase of the financial crisis. From 
May  2010,  the  currencies  of  some  of  Latvia's 
major  trading  partners  in  Central  and  Eastern 
Europe  depreciated  against  the  euro  usually  when 
the  euro  depreciated  to  the  dollar,  which  resulted 
in a broadly stable lats nominal effective exchange 
rate. Towards the end of 2011, the lats appreciated 
by 2%, i.e. from the weak to the strong side of its 
fluctuation  band  to  the  euro,  which  resulted  in  a 
temporary  nominal  effective  exchange 
rate 
appreciation  in  late  2011.  However,  these  gains 
were eroded in 2012, as the euro weakened versus 
currencies of other trading partners. 

over  the  next  two  years,  partly  reflecting  more 
cautious business investment (19). 

flexibility 

labour  market 
during 

demonstrated 
The  Latvian 
substantial 
crisis, 
the 
underpinned  by  a  decentralised  wage-setting 
system.  That  said,  large  public  sector  wage  cuts 
indirectly supported nominal wage reduction in the 
private  sector  in  2009  and  2010.  Public  sector 
wages  picked  up  somewhat  earlier  in  2011  and 
increased somewhat faster than those of the private 
sector  in  2012,  partly  reflecting  a  correction  of 
earlier excessive cuts in some fields. In 2013-2014, 
wages  are  projected  by  the  Commission  services' 
2013 Spring Forecast to grow broadly in line with 
is 
productivity,  although 
tightening  and  structural  problems,  in  particular 
regional  differences  and  skills  mismatches  on 
specific  labour  market  segments  could  lead  to 
some pressures, if not addressed. 

labour  market 

the 

Graph 2.3:Latvia - Inflation, productivity and wage trends

(y-o-y % change)

40

30

20

10

0

-10

-20

2007

2008

2009

2010

2011

2012

2013

2014

Administered prices and taxes 

Productivity (real GDP per person employed)

Nominal compensation per employee

Nominal unit labour costs

HICP inflation

Source: Eurostat, Commission services' Spring 2013 Forecast.

External factors 

Over  the  past  three  years,  consumer  prices  were 
largely  driven  by  global  commodity  prices  and  a 
regional  food  price  shock  in  2010.  Latvia's  small 
and open economy is in general highly sensitive to 
external  impulses,  but  the  composition  of  the 
consumer  basket  and  the  relatively  high  share  of 
material  inputs  in  production  costs  also  aggravate 
the  impact  of  volatile  commodity  prices.  After 
supporting  disinflation  in  2009,  import  prices, 
measured  by  the  imports  of  goods  deflator  in  the 
national  accounts,  rose  sharply  in  the  second  half 
of 2010 and early 2011, reflecting increasing world 
energy  and  food  prices.  The  subsequent  broad 
stabilisation in the Brent oil price (in euro terms), 

in 

Changes  in  administered  prices  and  indirect  taxes 
significantly  influenced  inflation  over  the  past 
three years, although the extent of the contribution 
size  and  direction (20). 
fluctuated  both 
Administered prices, which account for about 14% 
of the HICP basket, to a large extent reflected the 
impact  of  volatile  global 
energy  prices, 
transmitting  their  generally  rising  price  trend. 
Indirect tax changes raised inflation in 2010-2011, 
as  the  government  relied  partly  on  revenue-side 
measures  in  stabilising  public  finances.  On  the 
other  hand,  the  July  2012  VAT  rate  reduction 
reinforced the strong disinflationary trend that was 
already evident since mid-2011. 

The  annual  average  increase  of  administrative 
prices  fell  from  19%  in  2009  to  2.3%  in  2010, 
before picking up again to 7.3% in 2011 and 7.4% 
in  2012,  largely  reflecting  the  delayed  impact  of 
changes  in  the  international  price  of  oil.  In 

(19)  The  2011  compensation  per  employee  and  productivity 
data  presented  in  Table  2.2  is  distorted  by  the  currently 
incomplete  consideration  of  the  2011  Census  results. 
Consistent, revised time series for these variables are set to 
be published only after the cut-off date of this report. 

(20)  According to the Eurostat definition, administered prices in 
Latvia  include  inter  alia  electricity,  gas,  heat  energy, 
hospital  services,  public  transport  and  postal  services.  For 
details, 
see  http://epp.eurostat.ec.europa.eu/portal/page/ 
portal/hicp/methodology/administered_prices 

21 

 
 
                                                           
                                                           
Convergence Report 2013 - Technical annex 

Chapter 2 - Latvia 

particular, tariffs for heat energy rose significantly 
in the first half of 2010 and in January 2012, those 
of natural gas in the summer of 2010 and 2011 and 
those  of  electricity  in  the  first  half  of  2011. 
Administered  price  growth  demonstrated  a 
declining profile in 2012 and early 2013, dropping 
from  10.7%  in  March  2012  to  -0.7%  by  April 
2013.  Rather  unusually,  administered  prices  fell 
(month-on-month)  in  January  and  February  2013. 
This  was  due  mainly  to  a  drop  in  the  wholesale 
natural  gas  price  of  Latvia  with  automatic  effects 
on heating prices 

The  indirect  tax  changes  over  2009-2011  were 
motivated  mainly  by  the  need  for  rapid  fiscal 
consolidation  and  a  strategy  to  rebalance  taxation 
across  bases,  as  the  process  of  accession-related 
excise 
legal 
tax  harmonisation  with  EU 
requirements has been completed. In January 2009, 
the  standard  VAT  rate  was  increased  by  3 
percentage  points  and  the  reduced  VAT  rate  by  5 
percentage  points.  In  January  2011,  there  was  a 
further VAT increase (of 1 percentage point for the 
standard  rate  and  2  percentage  points  for  the 
reduced  rate)  and  a  further  broadening  of  the  tax 
base  under  the  standard  VAT  rate.  In  addition, 
excise  taxes  on  alcohol,  tobacco  and  fuel  were 
raised  in  mid-2011.  In  July  2012,  the  standard 
VAT  rate  was  reduced  by  1  percentage  point  to 
21%,  based  on  an  unexpected  proposal  by  the 
Ministry  of  Finance  in  late-April  2012.  Annual 
constant-tax  inflation  (HICP-CT)  was  on  average 
2.4%  in  2012,  i.e.  about  0.1  percentage  points 
above  headline  inflation  (21).  Assuming  full  and 
immediate pass-through (22), the average impact of 
the  VAT  reduction  during  the  reference  period  is 
estimated  at  around  0.5  percentage  point.  Adding 
this  to  the  annual  average  inflation  of  Latvia 
during the reference period would produce a figure 
of 1.8% that is still below the reference value.  

points 
in  2014  and  2015.  The  forthcoming 
liberalisation  of  the  retail  electricity  market  is 
expected  to  result  in  a  one-off  electricity  price 
increase.  The  excise  tax  on  tobacco  is  to  rise  in 
January  2014.  On  the  other  hand,  economic 
activity will remain constrained by a weak external 
environment,  while  tight  credit  conditions  and  a 
prudent  fiscal  policy  are  expected  to  restrain 
demand  pressures  on  prices.  The  available  data 
indicate  that  despite  an  increase  in  early  2013, 
inflation  expectations  remained  relatively  well-
anchored,  in  the  context  of  declining  headline 
inflation  and  slowing  economic  growth.  The 
Commission  services'  Spring  2013  Forecast 
projects  the  average  HICP  inflation  rate  to  fall  to 
1.4%  in  2013  and  to  2.1%  in  2014,  compared  to 
2.3% in 2012.  

Risks to the inflation outlook are broadly balanced. 
Upside risks are mainly related to a possible rise of 
commodity  prices,  to  which  Latvia  is  particularly 
exposed,  and  to  the  difficulty  of  controlling  wage 
growth  with  the  tightening  of  the  labour  market 
which  will  gradually  strengthen  the  bargaining 
position  of  employees.  Stronger  output  growth 
could  lead  to  more  upward  pressure  on  wages. 
Downside  risks  to  the  inflation  outlook  could 
emerge  with  a  weaker-than-expected  growth  in 
Latvia  or  abroad.  Downward  effects  may  also 
emerge  from  on-going  energy  efficiency  projects 
in  district  heating  networks  that  are  expected  to 
reduce  sales  prices.  Uncertainty  around  the  short-
term  inflation  forecast  is  heightened  by  the  rather 
unclear  price  impact  of  the  upcoming  retail 
electricity  market 
liberalisation;  however,  a 
significant upward effect is already factored in the 
forecast. 

2.3. 

PUBLIC FINANCES 

Inflation outlook 

2.3.1.  The  excessive  deficit  procedure 

for 

low 

HICP  inflation  is  expected  to  pick  up  from  its 
the  context  of 
level 
current  very 
strengthening  domestic  demand  and  some  one-off 
factors.  The  crisis-related  freeze  of  pension 
indexation  is  to  end  in  2014  and  the  PIT  rate  is 
scheduled  to  be  reduced  further  by  2  percentage 

in 

(21)  In the first semester of 2012, HICP-CT was well below the 
headline due to the excise tax increases of mid-2011, but in 
the second semester HICP-CT rose well above the headline 
due to the July 2012 VAT cut. 

(22)  Resulting in a hypothetical direct impact on headline HICP 
of around 2/3 percentage point between July 2012 and June 
2013. 

22 

Latvia 

On 7 July 2009, based on a recommendation by the 
Commission,  the  Council  decided  in  accordance 
with  Article  104(6)  TEC  that  an  excessive  deficit 
existed  in  Latvia  and  addressed  recommendations 
to  Latvia  in  accordance  with  Article  104(7)  TEC 
with  a  view  to  bringing  an  end  to  the  situation  of 
an  excessive  government  deficit.  The  Council 
recommended  that  Latvia  puts  an  end  to  the 
excessive  deficit  situation  as  rapidly  as  possible 
and  at  the  latest  by  2012,  by  ensuring  an  average 
annual  fiscal  effort  of  at  least  2¾%  of  GDP  over 

 
                                                           
Convergence Report 2013 - Technical annex 

Chapter 2 - Latvia 

2009

2010

2011

2012

2013

2014

(as % of GDP unless indicated otherwise)

Table 2.3:

Latvia - Budgetary developments and projections
Outturn and forecast 1)

2007

2008

General government balance

- Total revenues

- Total expenditure

   of which: 
- Interest expenditure

p.m.: Tax burden

Primary balance

Cyclically-adjusted balance

One-off and temporary measures
Structural balance 2)
Government gross debt

p.m: Real GDP growth (%)

p.m: Output gap

Convergence programme
General government balance
Structural balance 2) 3)
Government gross debt

p.m. Real GDP (% change)

-0.4

35.6

36.0

0.4

30.8

0.0

-3.9

0.0
-3.9

9.0

9.6

11.5

-4.2

34.9

39.1

0.6

29.7

-3.6

-5.6

0.0
-5.6

19.8

-3.3

4.4

-9.8

34.0

43.8

1.5

27.0

-8.3

-5.9

-0.3
-5.5

36.9

-17.7

-12.6

-8.1

35.3

43.4

1.4

27.4

-6.7

-4.6

-1.7
-2.9

44.4

-0.9

-11.4

-3.6

34.9

38.4

1.5

27.7

-2.1

-1.8

-0.2
-1.6

41.9

5.5

-5.7

-1.2

35.2

36.4

1.3

28.1

0.1

-0.8

-0.5
-0.3

40.7

5.6

-1.2

-1.2

34.3

35.5

1.5

27.3

0.3

-1.4

0.0
-1.4

43.2

3.8

0.6

2013
-1.1

-1.5

44.5

4.0

-0.9

33.8

34.7

1.6

27.0

0.6

-1.5

0.0
-1.5

40.1

4.1

1.7

2014
-0.9

-1.7

41.0

4.0

2015
-0.9
-2.1

36.4

4.0

2016
-0.9
-2.3

34.6

4.0

1) Commission services’ Spring 2013 Forecast.

2) Cyclically-adjusted balance excluding one-off and other temporary measures.

3) Commission services’ calculations on the basis of the information in the programme. 

There are no one-off and other temporary measures in the programme for the period 2013-2016.

Sources: Commission services and 2013 Convergence Programme of Latvia.

that  Latvia 

the  period  2010-2012.  In  its  recommendation,  the 
Council  established  a  deadline  of  7  January  2010 
for  the  Latvian  government  to  take  effective 
the  Council 
action.  On  16  February  2010, 
action 
concluded 
representing  adequate  progress 
the 
correction  of  the  excessive  deficit  within  the  time 
limits set by the Council and that no further action 
the  excessive  deficit  procedure  was 
under 
necessary, 
in 
abeyance (23). 

taken 
towards 

thereby  putting 

the  procedure 

had 

in  2012,  while 

According to the data provided by the Commission 
(Eurostat), Latvia's general government deficit was 
1.2%  of  GDP 
the  general 
government debt stood at 40.7% of GDP at the end 
of  2012.  In  view  of  this  data  and  taking  into 
account  the  Commission's  spring  2013  forecast, 
the  Commission  considers  that  the  excessive 
deficit  has  been  corrected  with  a  credible  and 
sustainable  reduction  of  the  deficit  below  3%  of 
GDP. The Commission is therefore recommending 
to  the  Council  to  abrogate  the  decision  on  the 
existence of an excessive deficit in Latvia. 

(23)  An  overview  of  all  on-going  excessive  deficit  procedures 
can  be  found  at:  http://ec.europa.eu/economy_finance/ 
economic_governance/sgp/deficit/index_en.htm 

2.3.2.  Recent fiscal developments 

the  European  Bank 
and  Development,  with 

In  2009-2011  Latvia  benefited  from  a  medium-
term financial assistance programme with the EU, 
which  was  provided  in  conjunction  with  an  IMF 
Stand-by  agreement  and  was  also  financed  by  the 
for 
World  Bank, 
Reconstruction 
an 
involvement of several EU countries and Norway. 
This assistance was subject to a number of policy 
conditions 
including  fiscal  consolidation  and 
structural  reforms  which  were  consistent  with  the 
Council  recommendations  under  the  EDP.  The 
comprehensive  fiscal  consolidation  implemented 
in  the  course  of  these  years  put  Latvia's  public 
finances  on  a  sustainable  path,  with  the  structural 
deficit declining from its peak of 5½% of GDP in 
2008  to  1½%  in  2011,  while  the  nominal  balance 
improved  from  a  deficit  of  9.8%  of  GDP  in  2009 
to  a  deficit  of  3.6%  in  2011.  Main  consolidation 
measures implemented during these years included 
increases in several tax rates (notably the VAT rate 
was  increased  from  18%  to  22%)  and  a  wide-
ranging  reduction  in  government  expenditure,  as 
wages  and  employment  in  the  public  sector  were 
adjusted  downwards  and  the  structure  of  public 
spending  improved  in  several  areas.  In  addition, 
several  social  benefits  were  partly  reduced  and 

23 

 
                                                           
 
 
 
 
Convergence Report 2013 - Technical annex 

Chapter 2 - Latvia 

the 

social 

retains,  whereas 

security  contributions  which 

the 
of 
government 
share  of 
contributions  to  the  second  pillar  pension  scheme 
correspondingly  increases.  On  the  expenditure 
side,  the  increase  in  the  public  sector  wage  bill  is 
limited  and  targeted,  while  pension  indexation 
remains  frozen  and  some  social  benefits  are 
capped, 
ratio  of 
government  expenditure  to  GDP.  Overall,  the 
general government deficit is expected to remain at 
the  level  of  1.2%  of  GDP  in  2013.  The  structural 
deficit  is  expected  to  increase  by  some  1  pp.  of 
GDP,  including  on  account  of  the  increasing  cost 
of the systemic pension reform described above. 

a  diminishing 

implying 

Under the no-policy change assumption, the deficit 
is expected to slightly improve in nominal terms to 
0.9%  of  GDP  in  2014,  with  the  structural  deficit 
remaining  broadly  unchanged.  In  particular,  the 
further  decrease  in  the  personal  income  tax  rate 
offsets the positive impact of economic growth on 
tax  revenue,  while  some  restrictions  on 
the 
increase  of  social  benefits  are  maintained  and  the 
statutory  retirement  age  is  gradually  increased, 
implying  a  further  decline  in  the  share  of  public 
expenditure  in  GDP.  The  general  government 
debt-to-GDP  ratio  is  expected  to  rise  again  in 
authorities 
2013, 
accumulate  assets  for  future  repayments  of  debt, 
and  to decline  to  around  40%  of  GDP by  the  end 
of 2014 as these repayments take effect.  

reaching  43.2% 

the 

as 

A  further  planned  personal  income  tax  rate  cut  in 
2015  and  restoring  the  long-term  level  of  state 
contributions to private pension funds by 2016 will 
affect the public finances in coming years, whereas 
potential  gains  in  terms  of  tax  efficiency  also 
remain ample. The possibility of further substantial 
tax efficiency gains, in response to recent measures 
to  reduce  the  share  of  the  informal  economy, 
represents  the  main  upside  risk  to  the  medium-
term budgetary outlook. Some of the social benefit 
restraints  implemented  during  the  years  of  fiscal 
adjustment are yet to be lifted; at the same time the 
on-going reforms in the area of public expenditure 
–  including  the  gradual  increase  in  statutory 
pension  age  –  could  provide  an  offsetting  effect. 
At  the  same  time,  some  of  the  fiscal  risks  might 
materialise,  in  particular  those  that  stem  from 
publicly  owned  companies,  of  which  some  are  in 
on-going  restructuring  processes.  Moreover,  the 
state  could  face  assumption  of  debt 
it  has 
guaranteed in relation to an industrial company in 
difficulties, amounting up to 0.3 pp. of GDP if the 
debt  is  assumed  in  full,  and  possibly  other  costs 

partly  temporarily  capped,  and  some  indexation 
mechanisms were suspended. The improvement in 
the  underlying  government  budgetary  position, 
however,  remained  partly  obscured  by  revenue 
shortfalls in 2009-2011. 

Following  the  finalisation  of  the  international 
financial  assistance  programme, 
the  public 
finances  continued  their  improvement  trend  in 
2012.  Reflecting  past  consolidation  efforts  and 
supported  by  the  robust  economic  recovery,  the 
nominal  general  government  deficit  declined  to 
1.2%  of  GDP  in  that  year.  At  the  same  time,  the 
structural balance improved by 1¼ pp. and reached 
a structural deficit of ¼% of GDP, which is better 
than  Latvia's  medium-term  objective  of  -0.5%  of 
GDP  set  in  the  2012  and  2013  Convergence 
Programmes.  This  improvement  in  the  structural 
budgetary position reflects consolidation measures 
contained  in  the  2012  budget  law,  although  the 
improvement  was  partly  scaled  back  through  the 
mid-year  supplementary  budget  and  the VAT  rate 
reduction  by  1  pp.  to  21%  from  July  2012.  The 
decline  of  both  the  nominal  and  structural  deficit 
was  also  supported  by  a  notable  improvement  in 
tax  efficiency,  helped  by  considerable  policy 
efforts  that  have been  put  in  place  in recent  years 
in this area. 

reflecting  borrowing  under 

The  debt-to-GDP  ratio  increased  steeply  in  2009 
and  2010, 
the 
international  financial  assistance  programme,  but 
stabilised  in  2011  and  declined  in  2012  to  a  level 
of  40.7%  of  GDP.  Since  June  2011,  Latvia  has 
regained  full  access  to  financial  markets  and  is 
currently  enjoying  very  favourable  financing 
conditions.  This  allowed  an  early  repayment  of 
Latvia's  outstanding  obligations  towards  the  IMF 
in late 2012, replacing this part of official debt by 
market financing. 

2.3.3.  Outlook for public finances 

The budget for 2013 was adopted by Parliament on 
15 November 2012. At the time of its adoption, the 
budget  law  targeted  a  general  government  deficit 
of 1.4% of GDP; however, due to the better-than-
expected  outcome  of  2012  it  is  likely  that  this 
target will be over-achieved in the absence of new 
policy  measures.  On  the  revenue  side,  the  budget 
reflects  (i)  the  first  step  of  the  three-year  strategy 
to lower the personal income tax rate from 25% to 
20%,  with  the  rate  being  lowered  to  24%  from 
January 2013; (ii) the impact of the 1 pp. VAT rate 
reduction from July 2012 and (iii) the lower share 

24 

 
to 

this  company 

related 
in  2013  or  2014. 
Nevertheless,  overall  risks  to  the  medium-term 
outlook are considered to be balanced. 

2.4. 

EXCHANGE RATE STABILITY 

The  Latvian  lats  entered  ERM  II  on  2  May  2005, 
i.e. it has spent more than eight years in ERM II at 
the time of the adoption of this report. The central 
rate was set at the parity at which the lats had been 
re-pegged from the SDR to the euro on 1 January 
2005 (LVL 0.702804 per EUR 1), with a standard 
fluctuation band of ±15%. Upon ERM II entry, the 
authorities  unilaterally  committed  to  maintain  a 
tighter  fluctuation  margin  of  ±1%  around  the 
central  rate.  During  the  two  years  preceding  this 
assessment,  the  official  EUR/LVL  exchange  rate 
did  not  deviate  from  its  central  rate  by  more  than 
±1%, in line with the Latvian authorities' unilateral 
of 
commitment.  The 
additional 
indicators  also  suggest 
the  EUR/LVL 
exchange  rate  was  not  subject  to  severe  tensions 
though  Latvia's 
two  years, 
over 
international  financial  assistance  programme  was 
in place until January 2012. 

evolution 
that 

the  past 

Graph 2.4:LVL - Spread vs central rate

(as percent, daily values)

1.5

1.0

0.5

0.0

-0.5

-1.0

-1.5

Jan-07

Jan-08

Jan-09

Jan-10

Jan-11

Jan-12

Jan-13

Source: Commission services, ECB, Reuters EcoWin.

by 

band, 

influenced 

In  2007-2008,  the  nominal  exchange  rate  of  the 
lats  was  relatively  volatile  within  the  narrow 
fluctuation 
currency 
devaluation  rumours,  in  the  context  of  large 
macro-imbalances.  Initial  failure  to  stabilise  the 
situation  in  the  banking  sector  in  late  2008  led  to 
capital  outflows  that  forced  the  Bank  of  Latvia  to 
intervene  heavily  to  protect  the  value  of  the  lats. 
The December 2008 agreement on an international 
financial  assistance  package  helped 
to  calm 
markets. However, market stress returned in spring 
2009, as it became evident that the fiscal situation 
was worse  than  expected  and political  uncertainty 
hindered  an  appropriate  policy  response.  Market 
tensions  peaked  in  June  2009,  when  speculation 

Convergence Report 2013 - Technical annex 

Chapter 2 - Latvia 

about  an  imminent  lats  devaluation  drove  short-
term interest rates to over 30%. More than a third 
of Bank of Latvia's foreign assets was sold during 
the  financial  turmoil  between  February  and  end-
June  to  sustain  the  peg.  Following  the  Latvian 
authorities' supplementary budget in mid-June and 
the  disbursement  of  the  EU's  large  second  loan 
tranche in July, financial market conditions rapidly 
improved.  

regularly 

pre-announced 

The  exchange  rate  peg  did  not  come  under 
significant  pressure  over  the  past  two  years.  The 
lats remained within its fluctuation band during the 
assessment  period  and  the  Bank  of  Latvia  had  to 
intervene  mostly  on  the  strong  side  of  the  narrow 
band.  From  the  beginning  of  2011,  the  Treasury 
changed its financial assistance programme-related 
practice  of  converting  foreign  currency  with  the 
Bank  of  Latvia  and  started  to  buy  lats  on  the 
market  (as  it  had  done  before  mid-2009).  The 
Treasury 
these 
transactions  to  make  the  exchange  rate  impact 
predictable  for  market  participants.  Nevertheless, 
these  transactions  may  have  served  as  intra-band 
interventions  by  selling  foreign  exchange  from 
official reserves in exchange for lats. In early and 
late 2011, large (relative to the size of the Latvian 
lats 
market)  Treasury 
exchange rate to the strong side of the fluctuation 
band.  The  lats  stayed  on  the  strong  side  in  2012, 
but  it  depreciated  towards  the  middle  of  the  band 
the 
late  2012  and  early  2013,  against 
in 
background  of  lower  foreign  currency  supply  by 
the  Treasury  and  market  anticipation  regarding 
euro adoption. 

transactions  drove 

the 

Graph 2.5:Exchange rates - LVL/EUR
(monthly averages)

0.8

0.7

0.6

0.5

2007

2009
Source: ECB, Reuters EcoWin.

2008

2010

2011

2012

2013

The  international  reserve  position  of  the  central 
bank  has  been  quite  strong  as  it  covered  around 
150%  of  base  money  and  around  60%  of  M3  in 
early  2013.  The  credibility  of  the  peg  gradually 
improved  from  mid-2009,  as  indicated  by  a 

25 

 
 
 
Convergence Report 2013 - Technical annex 

Chapter 2 - Latvia 

overnight  euro  deposits  in  the  Bank  of  Latvia  (at 
zero interest). 

Graph 2.6:Latvia - 3-M Rigibor spread to 3-M Euribor

(basis points, monthly values)

2000

1500

1000

500

0

-500

2007

2008

2009

2010

2011

2012

2013

Source: Eurostat.

2.5. 

LONG-TERM INTEREST RATES 

For  Latvia,  the  development  of  long-term  interest 
rates  over  the  current  reference  period  is  assessed 
on the basis of secondary market yields on a single 
benchmark  government  bond  with  a  residual 
maturity of close to, but below 10 years. 

Graph 2.7:Latvia - Long-term interest rate criterion

(percent, 12-month moving average)

14

12

10

8

6

4

2

0
Jan-07

Jan-08

Jan-09

Jan-10

Jan-11

Jan-12

Jan-13

Source: Commission services.

Latvia

Reference value

The  Latvian  12-month  moving  average  long-term 
interest  rate  relevant  for  the  assessment  of  the 
Treaty  criterion  was  at  the  reference  value  at  the 
2012  convergence  assessment.  It  declined  further 
from 5.8% then to well below 5% by end-2012. In 
April  2013,  the  last  month  for  which  data  are 
available, the reference value, given by the average 
of  long-term  interest  rates  in  Sweden,  Latvia  and 
Ireland plus 2 percentage points, stood at 5.5%. In 
that  month,  the  12-month  moving  average  of  the 
yield  on  the  Latvian  benchmark  bond  stood  at 
3.8%, i.e. below the reference value. 

reversal  of  deposit  euroisation  and  the  return  of 
non-resident  deposits  to  the  Latvian  banking 
system. The share of euro-denominated deposits in 
total  resident  deposits  started  to  increase  in  2012, 
presumably  in  expectation  of  Latvia's  future  euro 
adoption. The last disbursements from the IMF and 
the EU under the programme took place in August 
2010  and  October  2010,  respectively.  After  that, 
Latvia opted not to ask for further funds committed 
by  the  EU  and  the  IMF  under  the  international 
Balance of Payments assistance (24). In June 2011, 
Latvia  successfully  returned  to  the  international 
bond market by issuing a 10-year USD 500 million 
bond, with the achieved yield of 5.491% signalling 
good market access. That was followed by a 5-year 
USD  1  billion  issuance  in  February  2012  with 
yield of 5.375%. In December 2012, Latvia issued 
a 7-year USD 1.25 billion bond at a historical low 
yield  of  2.89%  and  used  part  of  the  proceeds  to 
repay  its  remaining programme-related  liability  to 
the IMF. 

also 

since 

2010, 

Financial  market  conditions  in  Latvia  improved 
including 
significantly 
strengthened  supervision 
(see  section  2.6.3), 
demonstrating  resilience  to  political  uncertainty 
ahead  of  the  October  2010  and  September  2011 
rating 
parliamentary  elections.  Major  credit 
agencies assessed the results of Latvia's economic 
stabilisation programme positively and raised their 
ratings for Latvia over the past two years(25).  

Over  the  past  two  years,  the  policy  rates  of  the 
Bank of Latvia were broadly aligned with those of 
the ECB, with the overnight deposit rate at 0.05% 
since September 2012. Abundant lats liquidity that 
was  created  by  the  off-market  conversion  of 
international  programme  funds  before  2011  and 
got  locked  by  the  limits  on  banks'  open  foreign 
currency position kept interbank rates low, at times 
even  below  those  of  the  euro  area,  although  the 
interbank  market  remained  illiquid  beyond  the 
very short term. There was some limited tension in 
the  Latvian  money  market  during  the  Krajbanka 
insolvency  case  in  late  2011,  but  the  situation 
calmed  down  by  early  2012.  Since  then,  the  3-
months  RIGIBOR  moved  broadly  in  parallel  with 
the  3-months  EURIBOR.  As  an 
increasing 
tendency  since  mid-2012,  some  banks  keep 

(24)  In  December  2011  Latvia  drew  the  second  development 
policy  loan  of  the  World  Bank's  Safety  Net  and  Social 
Sector Reform Program for an amount of EUR 100 million 
(0.5% of GDP). 

(25)  The  long-term  foreign-currency  rating  was  raised  from 
BB+ (Fitch, Standard&Poor's) / Baa3 (Moody's) in 2010 to 
BBB (Fitch, Standard&Poor's) / Baa2 (Moody's) in 2013. 

26 

 
                                                           
 
 
Graph 2.8:Latvia - Long-term interest rates

(percent, monthly values)

16

14

12

10

8

6

4

2

0

2007

2008

2009

2010

2011

2012

2013

Latvia

Germany

Source: Eurostat.

Long-term  interest  rate  spreads  vis-à-vis  the  euro 
area were gradually rising from their lows in 2006 
until  late  2008,  when  they  spiked  in  reaction  to 
fears  of  a 
lats  devaluation  and  Latvia's 
deteriorating  fiscal  outlook,  peaking  in  late  2009. 
Spreads compressed in 2010, as confidence in the 
currency  peg  was  regained,  fiscal  consolidation 
yielded  results  and  conversion  of  assistance 
programme  funds  created  ample  lats  liquidity. 
Against  this  background,  the  Treasury  returned  to 
the  10-year  domestic  bond  market  with  several 
smaller  issues  in  the  first  half  of  2011,  thereby 
extending the maturity profile of lats-denominated 
government  papers.  The  favourable  market  trend 
broke  in  July  2011,  as  international  financial 
markets  came  under  renewed  pressure  and  the 
issuance  of  10-year  bonds  was 
temporarily 
suspended.  After  some  pausing  in  2011,  the 
spread-compression  continued  in  2012,  as  market 
confidence  in  Latvia  improved  further.  In  2012, 
the  Treasury  launched  a  new  series  of  benchmark 
10-year bonds, but issued only a relatively limited 
amount,  benefitting  from  its  favourable  liquidity 
position,  due  partly 
its  successful  dollar 
to 
issuances. The 10-year yields fell rapidly in 2012, 
both on the primary and on the secondary market. 
Spreads against the German benchmark bond stood 
around 200 basis points in April 2013 (26). 

2.6.  ADDITIONAL FACTORS 

The  Treaty  (Article  140  TFEU)  calls  for  an 
examination  of  other  factors relevant  to  economic 
integration  and  convergence  to  be  taken  into 
account in the assessment. These additional factors 
–  including  balance  of  payments  developments, 
product  and  financial  market  integration  –  are 

(26)  The  reference  to  the  German  benchmark  bond  is  included 
for illustrative purposes, as a  proxy of the euro area long-
term AAA yield. 

Convergence Report 2013 - Technical annex 

Chapter 2 - Latvia 

important  indicators  that  the  integration  of  a 
Member  State  into  the  euro  area  would  proceed 
without difficulties.  

27 

 
 
                                                           
Convergence Report 2013 - Technical annex 

Chapter 2 - Latvia 

Table 2.4:

Latvia - Balance of payments

Current account

of which: Balance of trade in goods

                 Balance of trade in services

                 Income balance 

                 Balance of current transfers

Capital account
External balance 1)
Financial account

of which: Net FDI

                Net portfolio inflows
                Net other inflows 2)
                Of which International financial assistance

                Change in reserves (+ is a decrease)

Financial account without reserves

Errors and omissions

Gross capital formation

Gross saving

External debt

International investment position

2007

-22.4

-24.0

3.5

-3.2

1.3

2.0

-20.4

21.2

6.8

-2.4

20.2

-3.4

24.7

-0.8

40.0

17.6

128.1

-75.1

2008

-13.2

-17.8

4.0

-1.6

2.2

1.5

-11.7

13.5

3.1

1.1

7.3

4.2

2.0

11.5

-1.8

31.2

18.1

130.0

-78.4

2009

2010

8.6

-7.1

6.0

6.3

3.4

2.4

11.1

-11.8

0.6

0.7

-8.1

12.5

-5.0

-6.8

0.8

20.5

29.1

156.5

-82.3

2.9

-7.0

6.1

0.2

3.6

1.9

4.9

-6.1

1.5

-1.7

-1.9

6.1

-4.0

-2.1

1.2

19.8

22.8

164.8

-80.2

(percentage of GDP)

2011

-2.1

-10.8

6.5

-0.9

3.1

2.1

0.0

0.4

4.9

-2.2

-6.8

0.5

4.5

-4.1

-0.4

25.3

23.0

145.0

-74.0

2012

-1.7

-9.8

6.8

-1.5

2.9

3.0

1.3

-1.4

2.8

4.5

-5.1

-5.2

-3.6

2.2

0.1

25.9

24.2

136.2

-65.0

towards  balance  in  2014  as  domestic  demand, 
especially  for  investment  goods,  is  set  to  rise  at 
strong pace. 

the 

regarding 

The large savings-investment gap during the boom 
years was closed abruptly in 2009, with the sudden 
reversal  of  capital  flows  during  the  international 
financial  crisis.  Gross  savings  peaked  in  2009, 
amid  high  uncertainty 
future 
prospects 
In  2011-2012, 
the  economy. 
for 
investments  exceeded  savings  by  a  small  margin 
reflecting  negative  saving  rates  in  the  household 
sector.  In  contrast,  both  the  government  and  the 
corporate  sector  reported  positive  saving  rates. 
Following the steep fall in 2008- 2009, albeit from 
very  high  level,  investment  activity  rebounded 
substantially in 2011-2012 but remained below the 
pre-crisis level. 

1) The combined current and capital account.

2) Including financial derivatives.

Sources: Eurostat, Commission services, Bank of Latvia.

2.6.1.  Developments  of 

the  balance  of 

payments 

The  external  balance  (i.e.  the  combined  current 
and  capital  account)  moved  from  a  very  large 
deficit  in  the  boom  period  before  mid-2008  to  a 
surplus  of  about  11%  in  2009.  As  the  economic 
recovery  gained  speed,  the  surplus  in  the  external 
balance  contracted  to  about  1%  in  2012.  The 
merchandise  trade  deficit  declined  substantially 
since 2008 while the surplus in trade with services 
kept  improving.  Nevertheless,  the  overall  balance 
of trade with goods and services posted a deficit of 
about  3%  of  GDP  in  2012  which  is  a  substantial 
contraction  from  the  record-high  deficit  of  about 
21%  of  GDP  in  2006-2007.  The  income  account 
swung  into  surplus  in  2009,  reflecting  the  huge 
loan loss provisions made by foreign-owned banks 
and  it  returned  to  a  deficit  in  2011-2012  when 
most  of  the  banks  regained  profitability.  Current 
transfers and the capital account were consistently 
posting surpluses in the past years on the basis of 
net inflows from EU funds. 

According  to  the  Commission  services'  2013 
Spring  Forecast,  the  external  balance  is  projected 
to remain in a small surplus in 2013 and to decline 

28 

 
 
 
 
 
Graph 2.9:Latvia - Saving and investment
(in percent of GDP at market prices)

50

40

30

20

10

0

2007

2008

2009

2010

2011

2012

Gross national saving

Gross capital formation at current prices; total economy

Source: Eurostat, Commission services.

two  years  was 

External  cost  competitiveness  has 
improved 
markedly  since  2008,  as  labour  cost  has  dropped 
substantially and consequently labour productivity 
has increased. The major improvement took place 
in 2009-2010 when the real effective exchange rate 
depreciated  substantially,  deflated  by  both  HICP 
and  ULC.  The  indicator  appreciated  somewhat  in 
2011  as  the  abrupt  wage  correction  from  the 
previous 
the 
depreciation 
in  2012  when 
economic  growth  outpaced  labour  costs (27).  The 
overall real exchange rate correction is even larger 
when the ULC of the manufacturing sector is used 
as a deflator. Latvia’s export market shares in both 
world  and  EU  trade  increased  markedly  in  2010-
2012  paced  mainly  by  large  market  gains  in 
merchandise  trade.  The  growth  in  export  market 
share  was 
non-price 
competitiveness  improvements,  such  as  quality 
upgrades, product and market differentiation (28). 

resumed  again 

reversed  but 

supported 

also 

by 

Graph 2.10:Latvia - Effective exchange rates

(vs. 35 trading partners;  monthly averages;
index numbers, 2007 = 100)

140

120

100

80

2007

2008

NEER

2009
REER, HICP deflated

2010

2011

2012
REER, ULC deflated

Source: Commission services.

(27)  The  reference  group  of  36  trade  partners  used  in  the 
calculation  of  effective  exchange  rates  does  not  include 
Russia, which results into slight underestimation of Latvia's 
competitiveness indicators. 

(28)  Non-price competitiveness indicators are analysed in more 
detail  in  the  Occasional  Paper  issued  by  the  European 
for  Economic  and 
Commission,  Directorate-General 
Financial Affairs: "EU Balance-of-Payments assistance for 
Latvia: 
-- 
http://ec.europa.eu/economy_finance/publications/occasion
al_paper/2012/op120_en.htm 

Foundations 

success" 

of 

Convergence Report 2013 - Technical annex 

Chapter 2 - Latvia 

The  balance  of  payments  assistance  granted  to 
Latvia under the EU-IMF programme of late 2008 
was  successfully  concluded  by  early  2012.  Latvia 
borrowed  altogether  about  EUR  4.5  billion  out  of 
the  total  EUR  7.5  billion  available  under  the 
programme.  Also  with  a  view  to  its  regained 
market  access,  Latvia  has  not  requested  a  follow-
up  programme.  Moreover,  by  the  end  of  2012 
Latvia has repaid all liabilities (EUR 1.1 billion) to 
the  IMF, with nearly 60% of  them  being  serviced 
ahead of schedule. 

The  financial  account  (without  reserves)  recorded 
net outflows in the period of 2008-2011 amid on-
going  deleveraging  in  the  banking  sector  and 
substantial  decline  in  real  estate  and  portfolio 
equity investments. However, the financial account 
moved to a positive territory in 2012 due mainly to 
the  government  bond  issues  partly  aimed  at 
accumulating  cash  reserves  for  financing  large 
repayments to the EU due in 2014-2015.  

Non-resident  banking,  in  particular  the  stock  of 
non-resident deposits,  recovered  strongly  after  the 
retreat  in  2009.  However,  most  of  the  related 
inflow  was  offset  by  investments  of  non-resident 
banks  in  foreign  short-term  securities  so  that  the 
overall  net  contribution  of  the  sector  to  the 
financial account and foreign reserves was limited. 

 The  net  FDI  balance  has  improved  considerably 
after  the  collapse  in  2009  and  peaked  at  4.9%  of 
GDP in 2011, helped by better financial results in 
the banking sector. However, net FDI subsided to 
2.8% of GDP in 2012 as the external environment 
deteriorated. Gross external debt to GDP remained 
on a steady downward path reaching 136% of GDP 
at the end of 2012 as compared to 165% at the end 
of 2010, supported by strong GDP growth and by 
further repayment of inter-company bank funding. 
Net external debt also fell substantially to 38% of 
GDP  at  the  end  of  2012  from  54%  at  the  end  of 
2010.  The  improvement  in  the  net  international 
investment  position  was  less  pronounced  and  its 
substantial. 
negative  net  position 
However,  about  50%  of  the  net  international 
investment  position  is  generated  by  its  FDI 
component,  which  significantly  offsets  external 
liquidity and solvency risks. 

remained 

2.6.2.  Product market integration 

Latvia  is  well  integrated  into  the  EU  economy 
through 
linkages.  The 
country is a small open economy with strong gains 

investment 

trade  and 

29 

 
 
 
                                                           
Convergence Report 2013 - Technical annex 

Chapter 2 - Latvia 

in  export  markets  and  increasing  trade  openness 
since  its  EU  accession  (except  for  a  set-back 
during the crisis of 2008-2009). However the share 
of  exports  of  goods  and  services  to  GDP  is  still 
lower than for the Baltic neighbours. In 2009, the 
global crisis resulted in a temporary contraction of 
trade  openness,  as  external  demand  faltered  and 
financial flows reversed. Trade integration with the 
EU  is  progressing  at  a  fast  pace  but  exports  to 
Russia, 
tourists  services,  are  also 
expanding  rapidly  in  the  past  years.  The  main 
trading  partners  within  EU  27  were  Lithuania, 
Estonia  and  Germany,  while  Russia  remained  the 
main 
trading  partner  outside  EU  27.  The 
geographical  differentiation  of  Latvia's  exports  is 
also  improving  as  exports  to  fast  growing  Asian 
economies have surged recently. 

including 

pointing 

trade  structure 

developments 
the 

Latvia  still  has  a  predominant  specialisation  in 
technology  products,  although 
medium-to-low 
to 
there 
an 
are 
improvement  of 
toward 
medium-to-high  technology  products.  The  shares 
of  exports  in  machinery,  electrical,  optical  and 
increased  recently, 
transport  equipment  have 
showing 
towards 
higher 
production.  However, 
intermediate  goods  and  raw  materials  retain  high 
importance  in  the  country's  export  portfolio  while 
the  overall  weight  of  export  products  with  high 
technology and innovation costs remains relatively 
low.  Nevertheless,  trade  data  show  that  export 
quality,  including  product  differentiation,  market 
positioning  and  other  sales  factors,  is  steadily 
improving (29). 

favourable  structural  shifts 
value-added 

(29)  More details on export competitiveness are provided in the 
Occasional  Paper  issued  by  the  European  Commission, 
Directorate-General  for  Economic  and  Financial  Affairs: 
for  Latvia: 
"EU  Balance-of-Payments 
Foundations 
-- 
http://ec.europa.eu/economy_finance/publications/occasion
al_paper/2012/op120_en.htm 

assistance 

success" 

of 

30 

 
                                                           
Convergence Report 2013 - Technical annex 

Chapter 2 - Latvia 

Table 2.5:

Latvia - Product market integration

Trade openness 1) (%)
Intra-EU trade in goods GDP ratio 2) (%)
Intra-EU trade in services GDP ratio 3) (%)
Extra-EU trade in goods GDP ratio 4) (%)
Export in high technology 5) (%)
Technological balance 6) (%)
Total FDI inflows GDP ratio 7) (%)
Intra-EU FDI inflows GDP ratio 8) (%)
FDI intensity 9)
Internal Market Directives 10) (%)
Value of tenders in the EU Official Journal 11)
Time to start up a new company 12)
Real house price index 13)
Residential investment 14) (%)
Building permits index 15)

2006

2007

2008

2009

2010

2011

55.8

33.1

6.3

11.0

4.2

-3.0

8.4

6.1

3.1

0.5

96.7

16.0

168.5

3.4

132.3

52.6

31.0

6.1

10.0

4.6

-2.4

8.1

7.0

3.8

0.6

62.1

16.0

208.9

4.7

139.1

50.0

28.4

6.2

10.6

4.6

-2.0

3.8

3.0

1.7

0.5

59.8

16.0

181.7

4.6

54.2

44.7

24.4

6.3

9.5

5.3

-1.1

0.4

-2.3

-1.1

0.4

42.5

16.0

110.3

3.2

32.4

54.2

32.0

6.3

12.4

4.8

-1.8

1.6

1.1

0.5

0.4

55.7

16.0

100.0

1.7

27.7

61.2

37.9

6.5

14.4

6.7

-1.7

5.2

4.2

2.1

0.5

87.2

16.0

104.7

1.7

26.3

 1) (Imports + Exports of goods and services / (2 x GDP at current market prices)) x 100 (Foreign Trade Statistics, Balance of Payments).

 2) (Intra-EU-27 Imports + Exports of goods / (2 x GDP at current market prices)) x 100 (Foreign Trade Statistics).

 3) Intra-EU-27 trade in services (average credit and debit in % of GDP at current prices) (Balance of Payments).

 4) (Extra-EU-27 Imports + Exports of goods / (2 x GDP at current market prices)) x 100 (Foreign Trade Statistics).

 5) Taken directly from Eurostat's databases: Exports of high technology products as a share of total exports.

 6) (Exports - imports in high tech) / GDP at current prices x 100, since 2007 the data based upon SITC Rev. 4 (earlier SITC Rev. 3).

 7) Total FDI inflows (in % of GDP at current prices).

 8) Intra-EU-27 FDI inflows (in % of GDP at current prices).

 9) FDI intensity (average intra-EU-27 inflows and outflows in % of GDP at current prices).

10) Percentage of internal market directives not yet communicated as having been transposed, in relation to the total number.

11) Public procurement - Value of public procurement which is openly advertised in the EU Official Journal in total public procurement.

12) Time to start a new company (in days), Doing Business World Bank.

13) Experimental house price index (2005=100), Eurostat.

14) Gross capital formation in residential buildings (in % of GDP), Eurostat.

15) Number of new residential buildings (2005=100), Eurostat. 

Sources: Eurostat, Sectoral Performance Indicators Database (SPI), Commission services.

substantial 

inflow  of 

After  its  accession  to  the  EU  in  2004,  Latvia  has 
foreign 
witnessed  a 
investments  driven  by  convergence  prospects, 
privatisation  deals,  and  large  inflows  to  the  real 
estate  market.  In  the  boom  years  prior  to  2008,  a 
large share of the investments has been directed to 
the real estate market and has partly contributed to 
the  overheating  of  the  economy.  However,  the 
structure  of  new  foreign  investments  has  changed 
recently and it is now skewed towards the tradable 
sector and contributes in a more sustainable way to 
the  country's  export-oriented  growth  model.  The 
FDI  stock  at  the  end  of  2012  was  45%  of  GDP, 
lower  than  the  EU  average  of  60%  (47%  when 
Luxembourg  is  excluded).  FDI  inflows  mainly 
originate in the EU, with Sweden being by far the 
largest  investor  with  a  share  of  24%  of  the  FDI 
stock  at  end-2012.  The  overwhelming  majority  of 
the outstanding FDI stock was channelled into the 
service  sector,  while  the  share  of  manufacturing 
was  only  around  12%.  The  main  competitive 

in  attracting  FDI 

advantages 
the 
medium  term  include  lower  labour  cost  vis-à-vis 
the EU average, relatively low income taxes and a 
flexible labour market. 

inflows 

in 

Following  the  steep  house  price  inflation  in  the 
boom  years,  the  real  estate  market  experienced  a 
radical  downward  correction  in  2009-2010.  The 
house  price  index  dropped  by  37.3%  in  2009  and 
11% in 2010 and recovered only partially by 9.9% 
in  2011  and  3.8%  in  2012.  A  more  substantial 
recovery  is  reported  on  the  market  for  new 
dwellings  while 
the  existing  housing  stock 
witnessed only a very modest rebound. Residential 
construction  was  very  responsive  to  house  price 
developments,  and  increased  from  about  1.4%  of 
GDP  in  2003  to  4.8%  of  GDP  in  2007,  before 
adjusting rapidly in the downswing phase to 2% of 
GDP in 2010. A significant shift of resources from 
construction  and  real  estate  to  manufacturing  and 
transport  sectors  took  place  in  2009-2010.  While 

31 

 
 
 
 
 
Convergence Report 2013 - Technical annex 

Chapter 2 - Latvia 

the  construction  sector  started  growing  again  in 
2011-2012, its share in GDP is not likely to reach 
the pre-crisis peak anytime soon. 

ranking.  The  country  is  lagging  behind  13  euro 
area members in the ranking. 

According  to  the  latest  edition  of  the  Internal 
Market  Scoreboard,  Latvia  is  one  of  the  best 
performing  countries  in  terms  of  transposition 
deficit, registering a 0.4% rate in November 2012 
(compared to an EU average of 0.6%). However, a 
small  increase  in  the  backlog  has  been  registered 
with  respect  to  May  2012,  when  the  transposition 
deficit amounted to 0.1% (best performance in that 
edition).  The  share  of  public  procurement  tenders 
announced 
the  Official  Journal  appears 
significantly  higher  than  the  EU  average  (67.3% 
over  2006-11  compared  with  an  EU  average  of 
17.8% over the same period) (30). 

in 

2.6.3.  Financial market integration 

Latvia's financial sector is well integrated into the 
EU financial system, particularly through its strong 
linkages  to  Nordic  financial  groups.  The  relative 
importance of foreign-owned credit institutions, as 
measured  by  their  share  in  the  banking  sector's 
total  assets,  has  increased  considerably  since  EU 
accession.  Despite 
financial 
deepening,  the  relative  size  of  Latvia's  financial 
system  is  still  small  compared  to  the  euro  area 
average.  Concentration  in  the  banking  sector,  as 
measured  by  the  market  share  of  the  five  largest 
institutions, is above the euro area average. 

increase  of 

the 

the  best 

settlement 

out-of-court 

Concerning  the  business  environment,  Latvia  has 
implemented  a  series  of  ambitious  reforms  in 
recent  years,  aimed  at  reducing  start-up  costs, 
simplifying  procedures  for  property  registration, 
construction  permits  and 
tax  collection,  and 
insolvency  procedures,  also  by 
streamlining 
introducing 
of 
insolvencies.  As  a  result  of  these  reform  efforts, 
Latvia has significantly closed the gap with respect 
regulation  practices.  The  2012 
to 
competitiveness  monitoring  report  published  by 
the  Commission's  Directorate  General 
for 
Enterprise and Industry ranks Latvia above the EU 
average  in  terms  of  business  environment.  Good 
performance  is  reported  in  the  areas  of  market 
entries and exits, SMEs lending, and timeliness of 
government payments. At the same time Latvia is 
still lagging behind in terms of enterprise survival 
rate and to a lesser extent in terms of time required 
for starting business and early stage financing. The 
report  also  concludes  that  Latvia  is  improving  its 
industrial  competitiveness,  especially  in  terms  of 
specialisation, although its innovation performance 
remains weak. In the World Bank's 2013 report on 
ease  of  doing  business,  covering  performance  in 
2012,  Latvia  is  relatively  well  positioned  at  the 
25th place in the ranking, out of 185 countries, and 
there  are  only  four  EA  members  that  are  better 
ranked  than  Latvia.  In  the  2012-2013  Global 
Competitiveness  Index  of  the  World  Economic 
Forum,  Latvia  is  ranked  at  the  55th  place  out  of 
144  countries,  moving  up  by  9  positions  in 
comparison  with  the  previous  edition  of  the 

(30)  The  value  of  tenders  published  in  the  EU  Official  Journal 
may  serves  as  a  proxy  of  the  extent  to  which  national 
public procurement are open to foreign bidders. 

32 

Graph 2.11:Latvia - Foreign ownership and concentration in 
the banking sector

(in percent, weighted averages)

70

60

50

40

30

20

10

0

LV, 2004

LV, 2011

EA, 2004

EA, 2011

Concentration in the banking sector (CR5 ratio)

Share of foreign institutions as % of total assets

Source: ECB, Structural indicators for the EU banking sector, 2 Jan 2013.

Financial  intermediation  in  Latvia  is  performed 
predominantly  by  commercial  banks.  Their 
buoyant  expansion  resulted  in  a  classical  boom-
bust cycle that ended in 2008. Banks were heavily 
affected  by  significant  loan  losses  and  stretched 
successfully 
the 
liquidity.  However, 
managed  its  adaptation  to  the  new  economic 
conditions  and  has  proved  resilient  to  financial 
stability  shocks.  Foreign-owned  institutions  were 
supported  by  their  parents,  while  domestic  banks 
ensured sufficient capitalisation on their own.  

sector 

Overall,  the  sector's  strategy  in  dealing  with  the 
crisis has been to deleverage the balance sheets in 
order  to  keep  liquidity  high  and  to  strengthen  the 
quality  of  assets.  From  a  macro-financial  stability 
perspective,  the  strategy  has  been  successful.  The 
aggregate  core  Tier  1  ratio  has  reached  15.3%  in 
January  2013,  while  the  ratio  of  non-performing 
loans  has  been  reduced  to  11.1%  from  its  peak 
level  of  19.4%  in  September  2010.  The  sector's 
liquidity  has  been  strengthened  significantly,  with 
liquidity  ratio  of  well  above  30%.  The 
a 
consolidation  of  the  banking  sector  in  Latvia  has 
implied, nevertheless, a contraction of bank credit 

 
                                                           
 
Convergence Report 2013 - Technical annex 

Chapter 2 - Latvia 

by  around  40  percentage  points  of  GDP  since  its 
peak.  However,  the  deleveraging  is  related  to  the 
necessary economic restructuring in the bust phase 
of  the  cycle  and  does  not  affect  the  flow  of  new 
credit to viable businesses. 

versus 367% in the EU on average in 2011) nor the 
share of non-resident banking within these assets is 
extraordinarily high when compared to some other 
EU Member States. 

Graph 2.13:Latvia - Non-resident deposits (NRD)

Graph 2.12:Latvia - selected banking sector soundness indicators 
25
relatively to the euro area

%

20

15

10

5

0

LV, 2004

LV, H1-12

EA, 2004

EA, H1-12

Return on equity

Capital adequacy

Non performing loans

Note: For H1-2012, EU-27 non performing loans are a proxy for EA.
Source: ECB, Consolidated banking data, EC calculations.

The  financial  crisis  also  affected  the  business 
landscape  in  the  banking  sector,  leading  to  the 
nationalisation of Parex Banka, the second biggest 
bank  in  the  country  at  that  time.  Confidence 
gradually  returned,  in  particular  after  mid-2009, 
supported  by  large  disbursements  of  international 
financial  assistance, 
fiscal  consolidation  and 
structural  reforms.  Latvia  achieved  progress  in 
dealing  with  Parex  Banka  by  splitting  it  into  a 
viable  (Citadele)  and  a  resolution  bank  and 
initiated  the  privatisation  of  Citadele  along  with 
the  commercial  assets  of  Mortgage  and  Land 
Bank. The Latvian financial supervisor decided in 
the  operations  and 
November  2011  to  limit 
subsequently  to  initiate  bankruptcy  proceedings 
against  Krajbanka,  a  subsidiary  of  Snoras  Bank, 
after  the  latter  was  nationalised  by  the  Lithuanian 
government  and  an  insolvency  procedure  was 
launched amid allegations of fraud. Krajbanka had 
a  market  share  of  3.4%  and  its  depositors  were 
compensated  from  the  deposit  guarantee  fund  for 
amounts  of  up  to  EUR  100,000.  The  sector's 
stability has been enhanced after these successfully 
conducted 
resolution 
experiences. 

restructuring 

and 

(percent, yearly values)

50

40

30

20

10

0

2004

2005

2006

2007

2008

2009

2010

2011

2012

NRD to GDP

NRD to bank assets

Source: FCMC,  Eurostat.

Although there are several small banks which deal 
with  non-residents,  the  activity  is  concentrated 
mainly in three banks. Some recent changes in the 
administrative  environment  (selling  of  residence 
permits,  double-taxation  agreement  with  Russia 
from  2013,  new  law  on  holding  companies)  may 
favour the further development of this business. To 
cater  for  their  specific  risks,  banks  with  non-
resident business keep a high share of liquid assets 
and  are  subject  to  additional  capital  requirements 
(see below).  

Graph 2.14:Latvia - Recent development of the  financial 
system relatively to the euro area

(in percentage of GDP)

200
180
160
140
120
100
80
60
40
20
0

EA, 2012
Note: Debt  Securities other than shares, excluding financial derivatives.

EA, 2004

LV, 2012

LV, 2004

Debt securities

Stock market capitalisation

Credit to non-financial corporations

Credit to households

Source: Eurostat, Bank of Latvia.

Latvia has a long tradition and several competitive 
advantages 
in  servicing  non-resident  banking 
clients,  mainly  corporates  from  CIS  countries. 
While there was a drop in this business during the 
financial  crisis  aggravating  Latvia's  external 
funding  problem,  it  has  fully  recovered  by  2012 
and  around  half  of  the  banking  system's  total 
deposits  stems  from  non-residents.  Although  this 
part  of  banking  is  a  characteristic  element  of  the 
Latvian financial market, neither the share of total 
banking  assets  relative  to  GDP  (147%  in  Latvia 

The  non-banking  part  of  the  Latvian  financial 
sector  remains  small  compared  to  the  euro  area 
average and has grown only slowly. The dynamic 
increase in second pillar pension savings ended in 
2009 with the partial redirection of social security 
contributions  to  the  budget.  The  accumulated 
second-pillar pension savings amounted to around 
6.2% of GDP at the end of 2011. Voluntary private 
pension fund savings amounted to less than 1% of 
GDP  at  the  end  of  2012.  Assets  managed  by  life 

33 

 
 
 
 
Convergence Report 2013 - Technical annex 

Chapter 2 - Latvia 

is 

tasked  with  monitoring 

laundering  control  system, 

compliant  to  compliant  on  each  of  them.  The 
report  also  points  to  several  loopholes  in  the 
in 
overall  money 
particular implementation and statistical reporting. 
In response, the Council of Ministers approved on 
28  March  2013  an  Action  Plan  for  implementing 
the  recommendations  of  the  MONEYVAL  report. 
The  FIU 
the 
implementation  of  the  Action  Plan  and  different 
measures  are  assigned  to  various  institutions 
directly or indirectly involved in fighting financial 
crimes. All underlying deadlines will expire by the 
end  of  2013.  As  part  of  the  measures,  the 
government is committed to increase the financing 
and  human  resource  capacities  of  the  main  AML 
institutions.  The  Council  of  Ministers  is  expected 
to 
in 
the 
review 
September 2013. 

implementation  progress 

2.7. 

SUSTAINABILITY OF CONVERGENCE 

This  concluding  section  draws  together  elements 
that  are  key  for  gauging  the  sustainability  of 
Latvia’s convergence vis-à-vis the euro area. Such 
an  assessment  is  appropriate  in  view  of  the  fact 
that  Latvia  remains  in  a  process  of  profound 
economic  adjustment,  having  recently  exited  an 
IMF-EU  macro-economic  programme  which  was 
necessitated  by  the  unwinding  of  macro-financial 
imbalances accumulated in the mid-2000s. To this 
end,  the  analysis  reviews  sustainability  from  a 
number of angles: 

First, the sustainability dimension is inherent in the 
individual  convergence  criteria  themselves.  This 
holds  most  explicitly  for 
the  price  stability 
criterion,  which  includes  the  requirement  of  a 
“sustainable  price  performance”.  The 
fiscal 
criterion  (EDP)  also  involves  a  forward-looking 
aspect,  providing  a  view  on  the  durability  of  the 
correction  of 
the 
rate  criteria  are,  by 
exchange  and 
construction,  backward-looking, 
they  aim  at 
capturing  an  economy’s  ability  to  operate durably 
under  conditions  of  macroeconomic  stability, 
hence 
the  conditions  for 
sustainable  convergence  following  euro  adoption 
are in place. 

imbalances.  While 

indicating  whether 

fiscal 
interest 

Second, 
the  assessment  of  additional  factors 
(balance  of  payments,  product  and  financial 
the  Treaty 
market 
broadens the view on sustainability of convergence 
for  a  more  complete  picture, 
and  allows 

required  by 

integration) 

and  non-life  insurance  companies,  respectively  at 
around 0.6% and about 2% of GDP, are still low, 
even in comparison to other new Member States. 

The Riga stock exchange belongs to the NASDAQ 
OMX  group  and  uses  a  single  trading  platform 
together with other exchanges in the Baltic-Nordic 
region.  The  stock  market  plays  a  marginal  role  in 
the  financing  of  the  Latvian  economy.  The  debt 
securities  market 
by 
issuances  and  represents  only  a 
government 
limited source of funding for private companies. 

dominated 

remains 

Regulation  and  supervision  of  all 
financial 
institutions  is  carried  out  by  the  Financial  and 
Capital  Market  Commission  (FCMC).  In  the 
context  of  the  international  financial  assistance 
programme, 
supervision  has  been 
strengthened considerably. Cooperation with home 
country supervisors has been further enhanced.  

financial 

The  supervision  of 
the  non-resident  banking 
business poses additional challenges, inter alia, due 
to  the  cross-border  nature  of  transactions.  The 
FCMC  implemented  several  measures  to  reduce 
the  risks  of  this  sector:  on  top  of  the  capital  add-
ons  (beyond  Pillar  1),  it  recently  introduced 
additional liquidity requirements. The FCMC also 
monitors  these  banks  more  actively  (including 
their 
internal  procedures,  asset  quality  and 
correspondent accounts).  

full  compliance  with 

Latvia  achieved 
the 
transposition  of  the  Financial  Sector  Action  Plan 
(FSAP) directives and is on the way of completing 
transposition of the post-FSAP directives. 

largely 

legislation 

Latvia's 
complies  with 
international  standards  in  the  field  of  anti-money 
laundering  (AML).  However,  a  determined  and 
implementation  of  AML  rules  will 
effective 
remain key. The Financial Intelligence Unit (FIU) 
under  the  supervision  of  the  General  Prosecutor 
and the Financial and Capital Market Commission 
(FCMC)  are  the  main  institutions  set  to  fight 
money laundering. In July 2012, the MONEYVAL 
Committee of the Council of Europe published an 
evaluation  report  (31),  which  concludes 
that 
Latvia's  legislation  and  institutional  setup  are 
largely  compliant  with  the  international  AML 
standards. 
assessment 
benchmarks,  the  country  is  ranked  from  partly 

reference 

to  40 

In 

(31)  http://www.coe.int/t/dghl/monitoring/moneyval/ 

Evaluations/round4/LTV4_MER_MONEYVAL(2012)16_
en.pdf 

34 

 
                                                           
the  quantitative  criteria. 

complementing 
In 
particular,  a  sound  external  competitiveness 
position, effectively functioning markets for goods 
and services and a robust financial system are key 
ingredients to ensure that the convergence process 
remains smooth and sustainable. 

Third,  the  convergence  assessment  should  be 
informed  by  the  results  and  findings  of  enhanced 
policy  co-ordination  and  surveillance  procedures 
(MIP,  fiscal  governance).  The  aim  of  these  new 
governance  instruments  is  not  to  add  to  the 
existing  requirements  for  euro  adoption,  but  to 
make full use of the more comprehensive analysis 
undertaken  under  the  new  surveillance  tools  in 
assessing  sustainability  of  convergence.  While 
individual  elements  drawn 
the  new 
governance  framework  (e.g.  related  to  AMR 
scoreboard indicators) are included in the relevant 
chapters  on  convergence  above,  this    section  uses 
the  new  framework  to  provide  a  more  integrated 
view of the sustainability dimension. 

from 

the 

sustainability 

robustness  of 

assessment  of 

sustainability  of 
Any 
convergence  has  limits  and  must  be  based  on  a 
judgement  of  the  likely  future  evolution  of  the 
economy.  In  particular,  as  experience  has  shown, 
the 
and 
the 
convergence  process  after  euro  adoption  is  to  a 
significant extent endogenous, i.e. it depends on a 
Member  State’s  domestic  policy  orientations  after 
it  has  joined  the  euro  area.  Therefore,  while  the 
assessment of sustainability is an essential element 
in  determining  a  Member  State’s  readiness  to 
adopt  the  euro  based  on    initial  conditions  and 
existing policy frameworks, the outcome of such a 
sustainability  assessment  must 
  ultimately  be  
conditional  and  can  only  be    validated  by  the 
adoption  of  appropriate  policies  over  time.  In  this 
respect,  the  on-going  strengthening of  governance 
mechanisms in EMU will have a major part to play 
in ensuring that such policies are implemented by 
the Member State after euro adoption.  

The  analysis  below  looks  at  sustainability  from 
five  different  perspectives:  price  stability;  fiscal 
performance  and  governance;  macroeconomic 
imbalances; 
and  market 
functioning; and financial stability. 

competitiveness 

Price stability 

Latvia’s  present  inflation  rate  is  well  below  the 
reference  value,  and    while  the  inflation  rate  is 
projected  to  rise  from  the  current  unusually  low 

Convergence Report 2013 - Technical annex 

Chapter 2 - Latvia 

levels,  it  is  expected  to  remain  moderate  over  the 
forecast horizon. Going beyond the headline view, 
a  sustainable  price  performance  implies  that  the 
respect  of  the  reference  value  reflects  underlying 
fundamentals rather than temporary factors. In the 
case of Latvia, it is evident that the VAT reduction 
of  July  2012  has  contributed  to  the  current  low 
level of 12-month average inflation. However, the 
VAT reduction has not been the decisive factor in 
bringing  the  inflation  rate  below  the  reference 
underlying 
value.  Moreover, 
fundamentals  (e.g.  cyclical  conditions  and  policy 
stance,  wage  and  productivity  developments, 
imported  inflation,  administered  prices  –  see 
section  2.2)  and  the  fact  that  the  reference  value 
has been met by a wide margin support a positive 
assessment  on  the  fulfilment  of  the  price  stability 
criterion. 

analysis 

of 

In Latvia, the level of final consumption prices of 
private  households  stood  at  around  71%  of  the 
euro area average in 2011. This suggests potential 
for  further  price  level  convergence  in  the  long 
term,  as  income  levels  (around  54%  of  the  euro-
area average in PPS in 2011) rise towards the euro-
area  average.  To  the  extent  that  this  is  an 
equilibrium  phenomenon,  it does  not  imply  a  loss 
of price  and  cost  competitiveness, but  the process 
needs to be managed carefully so as to detect and 
counteract 
the  emergence  of  excessive  price 
pressures at an early stage 

Longer-term  inflation  prospects  will  hinge  on 
wages growing in line with productivity. As Latvia 
is still a catching-up economy, wages are expected 
to grow at a faster rate than in most advanced euro 
area  members.  However,  risks  to  price  stability 
from  catching-up  related  price  adjustment  are 
limited  by  the recently  demonstrated  flexibility  of 
the  labour  market  and  wage-setting  mechanisms 
which  should  ensure  that  labour  costs  are  aligned 
with  productivity.  They  are  also  contained  by  the 
country's  significant  progress  in  implementing  the 
EU  services directive  and low  market  entry  costs, 
which  keep  competitive  pressures  high,  as 
witnessed  by  the  recent  new  entries  in  the  retail 
market. A shortage of well-qualified labour in the 
medium  term  could  drive  up  wages  relative  to 
productivity.  Addressing  the  remaining  bottle-
necks will be important in limiting any tightening 
of the labour market.  

 The  productivity  growth  required  to  ensure  a 
smooth  catching-up  in  the  price  level  will  largely 
the  business 
depend  on 

improvements 

in 

35 

 
environment  and  progress 
in  attracting  new 
investment.  Increased  market  competition  should 
also  support  favourable  price  developments  (and 
there  is  no  evidence  that  Latvia  would  fare  worse 
in  this  respect  than  the  euro  area  average).  Price 
developments  will  also  depend  on  maintaining  a 
prudent  fiscal  policy  stance,  including  cautious 
wage setting in the public sector, to keep domestic 
demand in line with fundamentals and help anchor 
inflation expectations. Finally, if commodity prices 
rise  again  in  the  medium-term,  Latvia  would  be 
particularly  affected  due  to  the  composition  of  its 
consumer  basket,  low  energy  efficiency  and  high 
material input share in production. 

Fiscal performance and governance 

 The  2013  Convergence  Programme  covering  the 
period  of  2013-2016  was  submitted  on  29  April 
2013.  The  budgetary  strategy  outlined  in  the 
programme  is  to  maintain  a  structural  budgetary 
position  which  is  based  on  the  medium-term 
budgetary  objective  (MTO),  with  any  deviation 
from  it  limited  to  the  incremental  impact  of  the 
systemic  pension  reform  (i.e.  the  increase  in  state 
contributions to the second pillar pension scheme). 
The MTO itself is set at the level of -0.5% of GDP. 
In terms of nominal targets, this strategy implies a 
headline deficit of 1.1% of GDP in 2013, with the 
deficit  declining  further  to  0.9%  in  2014  and 
stabilising at that level in 2015-2016. The headline 
budgetary targets for 2013 and 2014 are very close 
to  projections  in  the  Commission's  2013  spring 
forecast with a deficit of 1.2% of GDP in 2013 and 
0.9% of GDP in 2014. 

Further  details  on  the  assessment  of  the  2013 
Convergence Programme for Latvia, including the 
assessment  of  the  long-term  budgetary  impact  of 
ageing,  can  be  found  in  the  Commission  Staff 
Working  Paper  (32).  This  is  accompanied  by  the 
Commission 
for  a  Council 
Recommendation  on  the  2013  National  Reform 
Programme  of  Latvia  and  delivering  a  Council 
opinion  on  the  2013  Convergence  Programme  of 
Latvia. 

recommendation 

Latvia  has  put  in  place  a  number  of  governance 
longer-term 
measures,  which  demonstrate  a 
commitment  to  sound  public  finances.  In  March 
2012,  Latvia  signed  the  Treaty  on  Stability, 
Coordination and Governance in the EMU, and the 
law  was  approved  by 
respective  ratification 

(32)  Available 

at: 

http://ec.europa.eu/economy_finance/ 

Convergence Report 2013 - Technical annex 

Chapter 2 - Latvia 

in  May  2012.  This 

implies  an 
Parliament 
additional  commitment 
to  conduct  stability-
oriented and sustainable fiscal policies. Moreover, 
in  January  2013,  the  Parliament  approved  the 
Fiscal  Discipline  Law  (FDL)  in  the  final  reading. 
The  law  establishes  the  principle  of  budgetary 
targeting throughout the cycle, with the benchmark 
structural deficit of 0.5% of GDP, and will provide 
a  framework  for  a  rules-based  fiscal  policy,  in 
particular 
pro-cyclical 
expenditure  increases.  The  law  also  contains 
provisions  regarding 
the  establishment  of  an 
independent  Fiscal  Council,  to  be  set  up  from  1 
January  2014,  which  will  oversee  the  compliance 
with the set of fiscal rules. 

limiting 

through 

the 

that 

freshly  adopted  FDL 

To  ensure  a  sustainable  fiscal  position,  it  is 
decisive 
is 
implemented  in  a  robust  way  according  to  its 
intentions, in order to pre-empt pressures to soften 
fiscal discipline in the future. After the successful 
exit from  the adjustment programme and a return 
to  a  favourable  macroeconomic  setting,  there  is  a 
risk  of  popular  demands  to  undo  some  of  the 
budgetary consolidation achieved during the crisis, 
for  example  to  compensate  for  the  loss  in  real 
income  of  some  population  groups  or  to  slow 
down  the  pace  of  efficiency-seeking  reforms  in 
public  administration.  The  FDL  can  help  in 
pursuing a sound and determined fiscal strategy for 
the medium term and in reacting to such demands 
in  a  balanced  way;  however,  the  new  fiscal 
governance framework is not yet tested. 

Macroeconomic imbalances 

The assessment of convergence also draws on the 
surveillance  of  macroeconomic  imbalances  under 
the  Macroeconomic  Imbalance  Procedure  (MIP  - 
see  also  Box  1.5),  embedded  in  the  broader 
"European  semester"  approach  to  enhance  the 
governance  structures  in  EMU,  and  integrates  the 
MIP  results  into  the  analysis.  Related  to  this, 
following 
legislation 
adoption  of 
establishing  the  new  procedure  for  surveillance 
and  correction  of  macroeconomic 
imbalances 
(MIP) (33), the Commission published its first Alert 
Mechanism  Report  (AMR)  in  February  2012 (34) 

the 

the 

(33)  The  package  of  six  legislative  proposals  to  strengthen  the 
economic  governance  of  the  EU  entered  into  force  in 
2011. 
December 
http://europa.eu/rapid/pressReleasesAction.do?reference=
MEMO/11/898 

(34)  http://ec.europa.eu/economy_finance/articles/governance/ 

economic_governance/sgp/convergence/index_en.htm  

2012-02-14-alert_mechanism_report_en.htm 

36 

 
                                                           
                                                           
and the second AMR (under the cycle for 2013) in 
November 2012.  

The  related  scoreboard  update  shows  that  Latvia 
breaches the indicative threshold in two out of ten 
indicators,  one  in  the  area  of  external  imbalances 
(namely  on  net  international  investment  position) 
and  one  in  the  area  of  internal  imbalances  (on 
unemployment).  Both 
indicators  are  moving 
towards  the  indicative  thresholds.  Based  on  the 
conclusions  of  the  two  reports,  Latvia  was  not 
subject to an in-depth review in the context of the 
MIP.  

The  AMR  from  November  2012  notes  that  after 
accumulation  of  imbalances  prior  to  the  crisis  in 
2008-2009,  Latvia's  external  competiveness  has  s 
improved  substantially.  The  process  of  internal 
adjustment  included  wage  and  employment  cuts, 
fiscal  consolidation,  deleveraging  in  the  private 
sector, and growth-enhancing structural reforms. 

Competitiveness,  labour  and  product  market 
functioning 

Standard  indicators  of  cost  competitiveness,  such 
as  real  effective  exchange  rates  (REER)  and 
relative  unit  labour  costs,  are  now  below  the 
indicative  thresholds  set  under  the  scoreboard  for 
monitoring external imbalances under the MIP. In 
2008,  the  REER  adjusted  for  unit  labour  costs 
reached  a  peak  of  64%  above  the  2000  level. 
However, the REER depreciated by about 20% in 
2009-2010  and  stayed  broadly  stable  afterwards. 
This  level  of  the  REER  is  considered  sustainable, 
as  the  country  has    steadily  gained  market  shares 
over the past years even when exports are adjusted 
for growth of markets. It should be also noted that 
the  REER  estimates  do  not  include  Russia,  which 
is  one  of  the  major  trade  partners  of  Latvia. 
Inclusion  of  Russia  would  result  in  an  even  more 
cost 
favourable 
competitiveness. 
non-cost 
competitiveness  indicators  are  concerned,  ECFIN 
studies have shown wide-ranging gains in terms of 
quality,  variety, 
and  market 
differentiation,  which  have  contributed  to  the 
increase in export market shares(35). Consequently, 
the  latest  projections  suggest  that  the  current 

Latvia's 
as 

and  product 

assessment 

of 
far 

As 

(35)  More details on export competitiveness are provided in the 
Occasional  Paper  issued  by  the  European  Commission, 
Directorate-General  for  Economic  and  Financial  Affairs: 
for  Latvia: 
"EU  Balance-of-Payments 
Foundations 
-- 
http://ec.europa.eu/economy_finance/publications/occasion
al_paper/2012/op120_en.htm 

assistance 

success" 

of 

Convergence Report 2013 - Technical annex 

Chapter 2 - Latvia 

account  deficit  will  remain  below  3%  of  GDP  in 
2013-2014  while  the  overall  external  balance 
(current  and  capital  accounts)  will  be  slightly 
positive for the same period.  

by 

projected 

The  Latvian  labour  market  demonstrated  a  high 
degree  of  flexibility  during  the  crisis.  Job  seekers 
also  showed  high  mobility  within  the  EU  as 
emigration increased substantially in the process of 
structural  adjustment.  More  recently,  as  of  2012, 
the economic recovery and the steady pace of job 
creation  not  only  reduced  emigration  but  raised 
significantly  the  number  of  immigrants  in  Latvia. 
Underpinned  by  a  decentralised  wage-setting 
system, a considerable wage adjustment took place 
in  Latvia  over  2009  and  2010  and  wages  moved 
broadly  in  line  with  productivity  afterwards.  In 
2013-2014,  wages 
the 
are 
Commission  services'  2013  Spring  Forecast  to 
remain consistent with productivity. Vacancy rates 
remain among the lowest in the EU indicating that 
at  aggregated  level  labour  supply  is  adequate. 
Nevertheless, 
regional  differences  and  skills 
mismatches  on  specific  labour  market  segments 
keep  structural  unemployment  relatively  high. 
However,  the  latest  statistics  show  that  youth 
unemployment,  though  still  high,  has  moved 
slightly  below  the  EU  average  while  long-term 
unemployment  remains  a  major  challenge.  All 
these  structural  deficiencies  on  the  labour  market 
amount to a significant loss in potential output and 
pose  risks  of  excessive  wage  adjustments;  they 
need  to  be  properly  addressed  by  active  labour 
market  policies  and  education 
reforms,  as 
stipulated in the Commission and Council country 
specific recommendations. 

Latvia  has  achieved  significant  progress 
in 
liberalising its markets and integrating its trade of 
goods  and  services  within  the  Single  Market. 
Much  of  the  structural  adjustments  related  to  this 
process  have  been  already  completed.  However, 
challenges  still  remain  and 
they  are  being 
addressed  in  the  context  of  the  country's  specific 
recommendations  issued  by  the  Commission  and 
the  Council.  The  recommendations  emphasise  the 
importance  of  enhancing  energy  efficiency  and 
energy  interconnections  with  other  EU  Member 
States, reducing the backlog in the judicial system, 
and  modernising 
the  education  and  research 
institutions.  The  recent  opening  of  the  electricity 
market  to  cross-border  competition  is  one  of  the 
positive  examples  in  the  field  of  energy  reforms 
while the gas market is still closed for competition.  

37 

 
                                                           
Convergence Report 2013 - Technical annex 

Chapter 2 - Latvia 

paribus be lower for Latvia than for the euro area 
average, which needs to be counteracted both by a 
prudent  macro  stance  and  appropriate  supervisory 
practices. An appropriate and timely use of macro-
prudential  policies  will  also  be  important  in 
limiting  any  undesirable  consequences  related  to 
credit growth. 

Latvia has a long tradition and several competitive 
advantages 
in  servicing  non-resident  banking 
clients,  mainly  corporates  from  CIS  countries.  To 
cater  for  their  specific  risks,  banks  with  a  non-
resident business model are required to keep a high 
share of liquid assets and are subject to additional 
capital  requirements.  The  supervision  of  the  non-
resident  banking  business  poses  additional 
challenges,  inter  alia,  due  to  the  cross-border 
nature of transactions. As the management of such 
financial  inflows  is  key  to  sustaining  economic 
convergence, the national supervising authority has 
implemented  several  measures  to  reduce  the  risks 
of  this  business  activity.  Going  forward,  close 
monitoring of financial stability risks, readiness to 
adopt  further  regulatory  measures  if  needed,  and 
determined 
anti-money 
laundering rules will remain key. 

implementation 

of 

Conclusion  

Overall,  a  broad-based  look  at  underlying  factors 
suggests  that  sufficiently  strong  conditions  are  in 
place for Latvia to be able to maintain a robust and 
sustainable convergence path in the medium term, 
thus  supporting  a  positive  assessment.  However, 
significant challenges remain, and policy discipline 
–  which  has  increased  during  and  after  the  crisis 
but  has  not  always  been  strong  in  the  past  –  will 
need  to  be  maintained  in  a  determined  manner  to 
fully  exploit  the  benefits  of  participation  in  the 
euro  area  and  minimise  risks  to  the  convergence 
path going forward. 

The  associated  process  of  further  structural 
adjustment  needs  to  be  supported  by  flexible 
functioning  markets. 
resource  allocation  and 
Moreover,  some  social  policy  indicators  are  still 
significantly  below  the  euro  area  average,  which 
puts  additional  risks on  the  full  completion  of  the 
convergence  process.  However,  on  balance,  the 
size 
and 
convergence  progress  in  the  past  several  years 
shows  that  the  country's  institutional  capacity  and 
market  maturity  are  already  sufficient  to  address 
remaining challenges. 

restructuring 

economic 

the 

of 

Financial stability 

The  integration  of  the  domestic  financial  sector 
into the EU financial system is substantial, mainly 
thanks to a high level of foreign ownership of the 
banking  system.  The  relative  size  of  Latvia's 
financial system is small compared to the euro area 
average  and  the  economy  has  recently  gone 
through  a  significant  deleveraging  process.  The 
foreign-owned  segment  of  the  financial  sector 
proved  resilient  to  the  recent  economic  and 
substantial 
financial  crisis,  benefitting 
from 
recapitalisation 
banks,  while 
weaknesses 
the  domestic  banking  sector 
in 
contributed  to  the  need  for  balance-of-payment 
support at the outset of the crisis. In the context of 
the  international  financial  assistance  programme, 
financial  supervision  has  been  strengthened 
sector 
considerably 
resilience has been strengthened. Cooperation with 
home  country  supervisors  has  been 
further 
enhanced.  

and  domestic  banking 

parent 

from 

Looking  ahead,  it  is  essential  that  sustainable 
convergence is not jeopardised by a re-emergence 
of  a  credit-fuelled  expansion  in  domestic  demand 
and  an  associated  rise  in  asset  prices  –  notably  in 
the housing market.  The prospects of such a boom 
re-emerging  are  reduced  by  Latvia's 
  policy 
responses to the 2008-2009 crisis, which included 
the  establishment  of  a  Credit  Register,  changes  in 
real  estate  taxation  (property  and  transaction 
taxation)  and  tightened  banking  sector  regulation 
(see  section  2.6.3).  The  combination  of  other 
factors  that  drove  buoyant  credit  expansion  in  the 
past  (pent-up  credit  demand,  accelerated  financial 
deepening  and 
integration,  rapid  risk  spread 
compression)  is  not  expected  to  recur  either,  as 
higher  property  and  consumption  taxes  as  well  as 
tighter  credit  regulation  are  providing  sufficient 
safeguards. That said, in view of the expected price 
level  convergence,  real  interest  rates  may  ceteris 

38