Latvia’s Guarded Peg Protectors
Baltic markets stretched their winning streak as restored investment grade borrower Latvia repaid the IMF’s 2008 crisis lifeline early with proceeds from a December dollar bond, and Russian depositors transferred accounts from Cyprus now in the process of seeking its own rescue. GDP growth last year at 5.5 percent was the EU’s best, on “remarkable” export performance in the Fund’s view on new market and product forays. Unemployment dipped below 15 percent but is still long-term structural in nature with a large informal economy and skill gaps. Consumer price inflation which spurted on tax increases subsided to 1.5 percent, and the fiscal deficit is below the 3 percent Maastricht criterion with euro entry on track by mid-decade. Banks’ return on equity was 10 percent through the last quarter with NPLs at 12 percent concentrated in the household sector. After the liquidation of two institutions overall credit is contracting as Scandinavian parents continue to pare subsidiary lines. The loan-deposit ratio fell 85 percent from its peak to 175 percent, and non-resident now exceeds private resident deposit size with recent 20 percent “historic” expansion from CIS relocation away from “stressed” centers. Although capital adequacy is double the Basel 8 percent minimum, the regulator recently found deficiencies in a mid-size offshore money specialist. The economy, which shrank 25 percent over 2009-10, will slow modestly on a current account gap of 3.5 percent of GDP this year, according to the organization. FDI should advance, but high external debt remains a “significant” risk. Single-currency adoption could begin in 2014 and erase the chance of a speculative attack as spread throughout Central Europe five years ago. The benchmark interest rate could fall further from the current 3 percent as banks gain access to ECB liquidity. International reserves at EUR 5.5 billion satisfy import cover but a heavy medium-term external repayment schedule requires over half that amount. The Fund advocates “vigilance” in light of 2008’s 40 percent reserve depletion when Russian accountholders fled. It also cites vulnerability from “reputation risk” associated with anti-money laundering weakness, and regulators have promised to address these issues while strengthening foreign-directed prudential norms generally.
On the restructuring front sales for Citadele and the Mortgage and Land Bank have been attempted and assets recovered from Krajbanka. State development units will be merged and the successor institution will not compete commercially. Pension and tax reforms will phase out toward 2015 and must be modified longer-range, and family and transport subsidies should be better targeted, the agency believes. A fiscal discipline law enshrined in the constitution is a top priority, and double-taxation treaties await clarification. Work incentives are lacking in the labor market, and insolvency court “abuse” is a problem in the absence of a cash flow test. Central governance and reporting for state-owned firms despite intentions must be established with a legislative peg, the report adds.
