Fiscal council: economic development remains rapid but new, significant risks to negative change have emerged  15 February 2019

Fiscal council: economic development remains rapid but new, significant risks to negative change have emerged

The Fiscal Discipline Council (Council) approved the Ministry of Finance's (MoF) Latvian macroeconomic forecasts for 2020-2022, which are used as the basis for medium-term budget framework. Overall, the projections are realistic, but there are concerns about risks in the area of international trade and the reputation of the banking sector.

Approving the inflation forecast, the Council notes that no changes have been made in the inflation forecast since October 2018. However, the pressure on wage growth in the labour market remains high, which may lead to higher inflation level than the MoF currently is forecasting.

"The Latvian labour market continues to heat up - unemployment is falling, participation rates in the labour market are already 70%, and the saturation of the Latvian labour market continues to grow. Consequently, pressures on wages and inflation are expected to continue in the coming years, which may increase inflation measures in the long term," says Inna Šteinbuka, member of the Council.

Approving the forecast of real GDP growth, the Council notes that, compared to the previous forecast in October 2018, the Ministry of Finance has increased the real GDP growth rate by 0.2 percentage points – from 3.0% to 3.2%, but without changes in the coming years.

"However, it should be taken into account that global risks have emerged and in a result foreign trade and external demand have declined. This could lead to the scenario that real GDP growth will not accelerate in 2019, but remain at the previously forecasted 3.0%," highlights I. Šteinbuka.

According to the Council, the performance of the financial and transport sectors was better than expected in 2018, confidence indicators and investment levels also improved, especially in the construction sector supported by European funds. However, in addition to wage growth driven by low unemployment, risks in foreign trade and external demand have intensified in Latvia, including the risk of failing to make the necessary progress in the fight against money laundering, in line with MONEYVAL recommendations.

Approving the macroeconomic forecasts prepared by the Ministry of Finance for 2020-2022, the Council underlines that the favourable conditions for economic growth are continuing to grow above the potential. The Council also notes that the government is not sufficiently implementing policy regarding to the economic cycle to be prepared for a less favourable phase of development.

"Until now, favourable conditions for external trade and more rapid activity in implementing measures with support from the EU funds have stimulated economic growth. In addition, the government stimulates economic development by fiscal easing," says Jānis Platais, Chairman of the Council.

In the context of the 2018 and 2019 budget, Latvia contrasts with Lithuania and Estonia, where the budget is created and executed with a surplus while Latvia has a budget deficit, emphasises J. Platais. All this is also resulting in the fastest economic growth indicators, which are positively influenced by the budget balance in the short term.

"The budget balance has worsened because of Latvia's request to the European Commission to allow a deviation from the budget balance target for the health care reform which is still in place until the end of 2019 as well as the tax reform adopted in 2017, which reduces the tax wedge and increases net income. Such conditions lead to a more rapid increase in expenditure compared to what is allowed, and do not allow to increase expenditures on other priorities," says J.Platais.

The Council disapproves of the government's decision to cover the negative fiscal space in the 2019 budget by re-estimating expenditure on pensions and benefits, taking into account the number of beneficiaries and the average amount of benefits.

"Such expenditures may decrease in the short-term period because of rapid economic growth, as unemployment may be lower and there is more motivation to work than to receive social benefits. By contrast, at the economic downturn period there will be a pressure on the social budget and the government will have to look for other ways to reduce expenditure," says J.Platais.

The Council advises the government to follow closely the development of the economic cycle and to make responsible decisions in the budget so that, as the economic situation worsens, it should not simultaneously reduce public support and raise taxes as it was during the previous crisis.

The Council approves the forecasted indicators by the Ministry of Finance – the real and nominal GDP growth, potential GDP growth and output gap, inflation and GDP deflator.

Council opinion, press presentation and video available here.