Latvia: Risk Assessment
Country Risk Rating
Business Climate Rating
- Membership of the euro zone (2014) and the OECD (2016)
- Financial system dominated by Swedish banks (85% of domestic credit)
- Reform of insolvency law and legal system
- Transit point between the European Union and Russia (coastline and its ports)
- Advanced digitization of the country
- Decline in the workforce (low birth rate, emigration); high rate of structural unemployment
- Technological lag (R&D = 0.6% of GDP, EU average = 2%)
- Inadequate land links with the rest of the European Union
- Concentration of wealth in the capital; high income inequalities
- Heavy taxation of labour which hits those on low wages and encourages under-declaration
- Problem of corruption
- Declining competitiveness and profitability: wage increases above productivity gains
- Importance of non-residents’ bank deposits (half of the total)
Growth Buoyed by Internal Demand
Stronger growth is expected in 2018, sustained by internal factors. Private consumption will likely also help underpin activity, thanks to a rise in the minimum wage (up from EUR 380 to EUR 430 a month in 2018), as well as lower taxes on the less wealthy and gradually falling unemployment. However, any increase in disposable income will probably be limited by continuing high inflation. In addition, the shortage of labor due to the emigration of young skilled workers, as well as the mismatch of higher education and vocational training to needs, will continue to limit the reduction in unemployment.
Exports, particularly of food products, timber and furniture, telephones and screens, will benefit from stronger economic performance in the country’s main markets: Germany, Poland, and the other Baltic countries. However, exports towards Russia will still be constrained by continuing Russian countersanctions. Sales of dairy products, fish, and beverages have been hit especially hard. The construction sector will benefit in turn from industrial momentum, as well as from the upswing in private and public investment, with the latter being boosted itself by increased European funds enabling the funding of numerous infrastructure projects, principally in the transport sector. Private investment will also be buoyant, though still constrained by worries over Russia. International road and rail transport, as well as warehousing, will depend on their use by Russia, which wants to foster its own ports.
A Satisfactory Fiscal Position
The public accounts are set to be in balance in 2018. Higher spending on defense (from 1.4% of GDP in 2014 to 2% in 2018), infrastructure, education, and healthcare should be offset by higher incomes generated by stronger revenues, which result from combating tax evasion associated with the informal economy (24% GDP). Moreover, a wide-ranging fiscal reform was adopted by the parliament in August 2017 and will be implemented from 2018 onwards. It comprises, in particular, greater income tax progressivity (with the creation of tax brackets rather than a single 23% tranche) and higher corporation tax (rising from 15% to 20%) – although companies who reinvest their profits are fully exempt. The public debt burden, already moderate, will likely continue to ease in 2018, after peaking temporarily in 2016 in connection with the early refinancing of a repayment due in early 2017. Although mostly contracted with non-residents and denominated in euros, there is no exchange rate risk.
Contained current account deficit and substantial non-resident bank deposits
The current account deficit will widen because of a worsening goods balance. This is because imports, fueled by the growth in domestic demand and poor diversification of production, will grow faster than exports. The services surplus, related to tourism and the transit of goods (to and from Russia) and remittances from expatriate workers, will largely offset this deficit. The current account balance is funded by European funds and foreign investment, which is unaffected by the worsening relations with Russia. Gross external debt, although steadily declining, is still substantial (140% of GDP, but only 26% as net debt). A third is owed by Swedish bank subsidiaries to their parent companies, and this proportion is shrinking as local deposits increase. Another third corresponds to non-resident deposits, mostly Russian, in specialized banks.
Ministerial Instability and Fragmentation of the Political Scene
The October 2014 elections returned the traditional center-right coalition – made up of the Unity Party, the Alliance of Greens and Farmers and the National Alliance Party – who now hold 61 out of 100 seats in the Assembly. However, disagreements between the coalition members and ministerial instability are rife: Maris Kucinsskis is the third Prime Minister during this parliamentary term. The upcoming parliamentary elections, scheduled for October 2018, could result in a change to the current coalition. This is because the Unity Party (22% of the votes cast in 2014) is not expected to achieve the 5% needed to get into Parliament, according to polls conducted in 2017. The collapse in popularity is accompanied by more intense competition at the center, with two new parties since 2014, including the Movement For!, which is pro-European. The country’s main political force remains the National Harmony Party, which is nonetheless expected to remain in opposition. This center-left party (currently with 24 seats), which draws support from the Russian-speaking minority (27% of the population), is still unable to form a coalition because of the ethnic vote reinforced by the cooling of relations with Russia.