In the period from 2003 – 2007 the economy of Latvia had tremendous growth, with gross domestic product (GDP) increasing by 10.3% and 12.2% in 2007 and 2006, respectively. However, there were several factors that led the economy to overheating:

1) Credit grew at an annualized rate of more than 50%, even though the stock of credit (70% of GDP at end-2005) had risen to close to the EU average. Real estate prices jumped more than 60% in both 2005 and 2006.

2) Domestic demand grew excessively, especially private consumption and real estate investment, so that the current account deficit peaked in late 2006 at more than 25% of GDP.

3) Wage and price inflation accelerated in early 2007, with core inflation rising to almost 10% by mid-2007. The CPI-based real effective exchange rate appreciated by 15% from EU accession to end-2007. Substantial wage increases and low productivity growth eroded competitiveness of Latvia significantly.

As a result of overheating, the economy of Latvia has accumulated external vulnerabilities that exacerbate the effects of global financial turmoil:

1) Gross external debt has risen above 130% of GDP, the highest among EU new member states.

2) External debt with original maturity below 1 year (including non-resident deposits at call) exceeds 50% of GDP. An additional 12% of GDP in medium- and long-term external liabilities matures in 2009. Latvia is thus very exposed to the risk of a sudden capital stop.

3) Solvency concerns relate primarily to the private sector, which has net external debt of 70% of GDP. The public sector is currently a net external creditor, though there is a risk that it will have to assume some private sector liabilities.

4) Banks’ reported short-term liquid external assets are substantial (45% of GDP) and provide some buffer against external outflows. However, the market value of these assets and the ability to realize these quickly in the current international financial environment has come into question.

GDP started to level off from Q4 of 2007, and is projected to have fallen by 4.6% in 2008. The main cause is a slowdown in lending that started in early 2007, driven by concerns among foreign banks about their overexposure to the Baltics.

As a consequence, consumption and investment fell. While the overheated non-tradables sector needed to slow down, manufacturing output also dropped sharply due to weaker export demand and the lagged effects of the past deterioration in competitiveness. Wage growth has started to decelerate and employment to decline.

In 2009, the expected drop in GDP is 12%; hence, the economy of Latvia has entered a correction phase from huge imbalances accumulated during the years of overheating. This correction should boost competitiveness and create preconditions for sustainable economic growth in the future:

1) A slowdown in inflation due to lower domestic demand takes place. Even though annual inflation in 2008 was 15.4%, it has reached a single-digit figure in the beginning of 2009. With further wage cuts and low commodity prices, Latvia might face inflation as low as 3.3% in 2009;

2) Due to a slowdown in economic growth, unemployment in January 2009 has increased to 7.6% from 7% at the end of December 2008. It is expected to reach 12.7% by the end of 2009;

3) As a part of the correction, real wages have started decreasing significantly in all the sectors of the economy (by 25% in public sector, and private sector is expected to follow). This is essential for enhanced competitiveness, with the ultimate goal for growth in real wages to reflect gains in productivity;

4) Current account deficit has decreased substantially from 23.8% of GDP in 2007 to 13.8% in 2008, and it is expected to reach 7.3% in 2009. This is because export has grown by 8.7% in 2008, while import has decelerated by 4.1%. Hence, in 2008 the negative external trade balance has decreased by 18% and, consequently, Latvia has decreased the rate of borrowing abroad significantly;

5) The main reason for a decrease in imports: due to the uncertainty in regard to consequences that the global credit crunch and deterioration in asset prices could have in the future, the banks in Latvia have adopted tighter lending policies, which has resulted in a rather substantial decrease in domestic consumption and private investment in Latvia.

6) Current account deficit of Latvia is financed by long-term capital;

7) Central government debt has increased substantially – from 7.4% of GDP in 2007 to 17.3% of GDP in 2008, which is still well below the EU average (general government debt of 18.1% of GDP is way below the Maastricht criterion of 60% of GDP);

8) In recent years, the government of Latvia has run a small budget deficit of 0.8%, 0.5%, and 1.3% of GDP in years 2005, 2006, and 2007, respectively. In 2008, however, budget deficit reached 3.5% due to deteriorating macroeconomic indicators, which has resulted in lower tax revenues.

From September to December 2008, the Bank of Latvia made interventions to buy the Latvian lat in amount of EUR 1.158 bln (around 20% of total reserves). However, the financial system has stabilized, and in 2009 interventions have been negligible.

The Latvian lat is fixed to the euro and the Bank of Latvia possesses sufficient reserves to ensure that fluctuations in the LVL/EUR exchange rate do not exceed 1%. The aim of the government of Latvia is to introduce the Euro in no later than 2012.

The banking sector in Latvia is strongly integrated in the European banking system, with the European Union banks accounting for 61% of all assets and 70% of the total loan portfolio.

The amount of guaranteed deposits has been increased to EUR 50’000.

Major sources of bank financing are liabilities to banks (42% of total assets), mainly to the parent banks (31% of total assets), and deposits (42% of total assets).

The ability and willingness of foreign parent banks to finance their subsidiaries and banks in Latvia arise no doubts. In 2008, the amount of funding attracted from parent banks increased by 21% or 1.2 billion lats compared to 2007.

Despite economic downturn, the main performance ratios of commercial banks have remained satisfactory in 2008:

1) assets have increased by 6%;

2) the loan portfolio has increased by 11.2%, with an increase for households by 7% and for enterprises by 13.1% (in previous 5 years loan portfolio grew by 37-59% annually; from 2003-2006 loan growth rate for households outpaced that for businesses by 25-42%);

3) deposits have decreased slightly in 2008 - by 4% (resident deposits have increased by 8,7%, while those of non-residents plummeted by 19.2%; the former constitute 61% of total deposits compared to 54% a year earlier);

4) the liquidity indicator of the banking sector decreased slightly during 2008 - to 52.8% compared to 55.7% at the end of 2007 (minimum requirement – 30%);

5) the average capital adequacy ratio of the banking sector at the end 2008 was 11.8% (12.6% at the beginning of 2008), which is well-above the minimum requirement of 8%.

Due to an increase in expenses related to provisions and costs of funding, profitability of banks has plummeted considerably – by 79%. In total, 16 banks and 1 branch of a foreign bank ended the reporting year with profit, while remaining 5 banks and 4 branches of foreign banks reported loss.

The regulator of Latvian financial markets (Financial and Capital Market Commission) monitors the market and checks performance of all the commercial banks on daily basis. In order to avert the situation that loan loss provisions for some banks could be insufficient, the regulator recurrently inspects banks and, if needed, requires increasing the amount of provisions.

The government of Latvia has acquired majority stake (84.83%) in JSC “Parex banka” in order to ensure stability in the financial system of Latvia. The decision followed a sharp drop in deposits of the bank, and rapid deterioration in liquidity and capital adequacy ratios.

Currently the situation in the bank has stabilized; the number of deposits has increased in January.

The government has supported the provision of State guarantee for the roll-over repayment of Parex banka’s syndicated loans. Guarantee will be effective provided that the banking syndicates agree to the restructuring and the extension of the term of the loans.

Parex banka’s proposal to the syndicated lenders envisages the following loan repayment schedule: 20% of the principal amount are scheduled for repayment by March 2009 with the remaining sum to be split in two payments – 50% in February 2010 followed by 30% in January 2012.

In the three up-coming years a loan amounting to EUR 7.5 billion (LVL 5.27 billion) is to be available to Latvia from international financial donors.

The action program of the government of Latvia aims to stem the current liquidity crisis and then ensure long-term external stability, while maintaining the exchange rate peg:

– The immediate objective is to stabilize the financial sector, restore depositor confidence, and avoid the disorderly adjustment that would follow if the exchange rate peg were abandoned.

– For the medium-term, the program includes measures to promote economic adjustment and strengthen the peg.

– The program:
o includes measures to restore confidence in the broader financial system. Substantial fiscal policy tightening will reduce financing needs;
o aims at meeting the Maastricht deficit criteria to facilitate adoption of the Euro by 2012;
o includes strong income policies to reduce inflation and improve competitiveness;
o includes structural policies that should boost productivity growth and help generate the needed shift from non-tradables to tradables production.

Information sources:
- International Monetary Fund;
- Central Statistical Bureau of Latvia;
- Bank of Latvia;
- Ministry of Finance;
- The Treasury (Ministry of Finance);
- The Financial and Capital Market Commission.

The Latvian Institute (Latvijas institūts) was established by the Latvian state to provide a wide range of information about Latvia, its society, culture and history.