Latvia: Risk Assessment
Country Risk Rating
Business Climate Rating
- Member of the Eurozone (2014) and the OECD (2016)
- Domestic financial system dominated by Swedish banks (85% of domestic credit)
- Efforts to improve the regulation of the offshore financial system
- Rapid reduction in non-resident bank deposits (from half to 20% of the total since 2017)
- Transit point between the European Union and Russia (coastline and ports)
- High level of digitization
- Declining workforce (low birth rate, emigration) and high structural unemployment
- Technological lag (R&D = 0.5% of GDP, EU average = 2%)
- Declining competitiveness and profitability: wage increases exceed productivity gains
- Poor recovery in the event of default despite reforms to insolvency and justice law
- Weak credit growth
- High labor taxation, which hits people on low wages and encourages under-reporting
- Inadequate land links with the rest of the European Union
- Concentration of wealth in the capital; high income inequalities
Growth driven by private consumption
Growth is expected to continue slowing, but will remain at a decent level in 2020, driven by strong household consumption. The steady decline in the labor force, linked to aging and the emigration of young workers, particularly skilled workers, is leading to a reduction in unemployment and maintaining upward pressure on wages. Combined with controlled inflation, wage increases (also due to a 13% hike in the minimum wage in 2019) will sustain robust household consumption. Nevertheless, the decline in the stock of skilled labor is crippling productivity gains (over the 2009/2016 period, more than 40% of emigrants were skilled), thus affecting the country’s potential growth. Public consumption and investment are set to be less dynamic after the peaks reached in 2018, although they will be supported by European funds (structural and investment funds of the EU), with Latvia receiving €4.79 billion from the 2014/2020 budget. Despite favorable financing conditions, thanks to the ECB’s policy, private investment will suffer from weak credit growth. Growth in lending to the private sector is being held back by the large informal sector (over 20% of GDP), poor recovery in the event of default and ongoing consolidation of the financial system, which is prompting banks to apply strict criteria.
Slow progress in cleaning up a broken financial system
A large number of Latvian banks serve foreign customers, most of them in CIS countries, with a high risk of money laundering. Moneyval’s latest report highlighted the inadequacy of Latvian regulations to combat this problem (the country’s third-largest bank, ABLV, was liquidated due to accusations of institutionalized money laundering), prompting the government to reform the financial system to make it more transparent and to prevent the country from being placed on the FATF’s grey list. Banks serving foreigners are trying to refocus their activity on the domestic market following the reduction in non-resident deposits and the ban on services to shell companies.
Continuing conservative fiscal management
Public accounts are expected to remain in slight deficit, as rising revenues accompany higher expenditure. Tax reforms aimed at making income tax more progressive will continue. Social spending will increase, including on pensions and social benefits. At the same time, according to the multiannual budget plan 2020/2022, the increase in revenue will come mainly from an increase in excise duties. Reducing tax expenditure on micro businesses and scrapping VAT exemptions will increase fiscal room for maneuver. Public debt, which is low, is expected to continue declining. Although it is largely contracted with non-residents, it does not pose an exchange rate risk as it is denominated in euros.
The current account deficit is poised to widen due to a deterioration in the trade balance. Imports of capital goods and food products, driven by strong domestic demand and underdiversified domestic production, will outpace exports (wood, capital goods, food products: 60% of exports in 2018), which will be hurt by slower demand globally, but particularly in the euro area. The services surplus, linked to tourism and the transit of goods (to and from Russia), and expatriate remittances offset much of the trade deficit. The small current account deficit is largely financed by European funds and foreign investment (2.5% of GDP). Gross external debt, one-third of which corresponds to the State’s share, has been slashed since 2017 but remains high (120% of GDP, but 21% net due to foreign assets owned by banks).
A disparate coalition and an ostracised Russian minority
The candidate of the ruling coalition, which comprises the New Conservative Party, the Populist Party (KPV), the Liberal Party (AP!) and the Nationalist Alliance, won the presidential election held in May 2019. The position of President is a largely ceremonial one. The negotiations that led to the formation of the coalition were lengthy, and the pro-Russian Harmony party, which topped the votes in the 2018 parliamentary elections, failed in the end to become a member. The lack of political representation for the large Russian-speaking minority (30% of the population) in successive governments testifies to the exclusion of this group from Latvian society, in a country where language is an important identity issue. Internal divisions within the coalition will complicate the government’s action and may threaten its stability. Political continuity should be ensured, however, as the country has always had a pro-European center-right government since its independence in 1991.
Relations with Russia have grown tense again since the construction of a border fence with Russia, which is officially intended to prevent smuggling and illegal entry of migrants into Latvia, but which is perceived by some Russian media outlets and politicians as a gesture by Riga against Moscow.