Fiscal discipline council: measures to overcome Covid-19 crisis must be balanced against budgetary resources in medium term  31 March 2020

Fiscal Discipline Council priorities in a pandemic recession

The impact of the unprecedented crisis caused by the pandemic on the global economy is much stronger than the 2008 crisis. Today, the fundamentals of Latvian economy are more solid compared to 2008 and hence we can hope that, the impact of the Covid-19 crisis on the Latvian economy will be less severe. However, considering that we are a small and open economy, Latvia's economic decline largely depends on what happens in other economies. Currently, the economic downturn forecasts for Latvia varies, but at the same time it is clear that the impact of the coronavirus will be significant, and this year the Latvian economy will shrink.

In Latvia, the COVID-19 crisis highlights the weaknesses of Latvia's economic governance, including the problems of social protection and tax avoidance. High income inequality has been observed in Latvia for decades, which will inevitably increase in times of crisis.

The case of COVID-19 is also special because, at present, it is not a crisis that would require budget consolidation. Countering the economic cycle with fiscal policy is the basic principle of fiscal discipline. Latvia and the rest of the world are advised to expand public spending to stimulate the economy, and protect most vulnerable.

The Council welcomes the targeted action taken by the Latvian government to mitigate the effects of the crisis and considers the government measures currently in place to be a step in the right direction. Under normal circumstances, the primary function of the Latvian Fiscal Discipline Council is to ensure responsible use of budget resources, but extraordinary situations require extraordinary action by the Council. Therefore, the Council's priorities are formulated in the light of current events.

Recommendations of International Organizations and Action of the Government of Latvia

The European Commission has issued a communication on the suspension of fiscal rules to enable governments to respond flexibly to budgetary constraints in times of crisis. EU rules on state aid also allow for financial support to companies. The lines of action highlighted by the EU include support to the healthcare system, providing liquidity to affected businesses, stimulating jobs and income for the population.

The IMF emphasizes the need for coordinated and synchronized global cooperation on fiscal stimulus measures. The IMF's priority directions for tackling the crisis include the direct and indirect expense on the health care system, and monetary and credit policies. The IMF website publishes the actions of all 186 Member States, in particular fiscal and monetary measures.

The OECD, like others, emphasizes the need for immediate action to support the health care system and support citizens and businesses.

The crisis requires that the government’s fiscal measures should be timely, targeted and temporary. The actions of the Latvian government are fully in line with the recommendations of international institutions. In Latvia, the idle time benefit mechanism, which covers a wide range of benefit recipients, is operational on short notice. The companies affected by the crisis already have financial support instruments - credit guarantees, and crisis resolution loans provided by ALTUM, the state development financial institution. Latvia has focused its efforts on tax relief measures, allowed the MoF to borrow, suspended EU fund project selection - to channel the funds to mitigate the effects of the crisis. EUR 8 million has been earmarked for staff remuneration to strengthen the health care system.

Legislation of the Latvian Covid-19 Crisis and Challenges for the Council

Article 27 of the COVID-19 Crisis Management Act contains a provision that allows the implementation of the annual state budget law exceeding the maximum permissible state budget expenditure as defined in the medium-term budget framework.

In addition, the COVID-19 Crisis Management Act provides that expenditure-increasing or revenue-decreasing regulations that worsen the general government structural budget balance do not oblige the Cabinet to provide for compensatory measures to ensure the general government structural budget balance is balanced.

The government measures announced at the moment are adequate, but they should be appropriate in size and target businesses and populations (particularly medical care) most affected by the crisis. However, considering that the law does not have expiration time or review clause the fiscal sustainability may be at risk.

The EC has proposed to activate "general escape clause", which removes fiscal conditions during the crisis period to cushion the effects of the crisis and allow countries to use the tools to mitigate the effects of the crisis. In Latvia, this provision automatically triggers permission to deviate from the balance condition incorporated in Article 12 of the Fiscal disciplinary law (FDL). On the other hand, Article 10 of the law provides that the budget framework law for requires the general government budget balance for each period of the year may not be less than -0.5 percent of the gross domestic product of the relevant year (hereinafter - the minimum planned general government budget structural balance). However, the deviation is allowed only to the extent necessary to overcome the severe economic downturn. The Fiscal Discipline Council needs to substantiate its views on the scope of the deviation, but considering the high uncertainty at this point, the challenge is to properly assess revenue and expenditure dynamics.

In addition, the Council has to give its views - the surveillance report - on the Stability Program, although this program is not intended for short term challenges in times of high uncertainty. But it does reduce program’s importance for medium term measures planning – that would help to exit from the crisis.

The FDP confirmed macroeconomic projections in early February, forecasting GDP growth of 2.2%, which was a rather conservative scenario at the time. Although COVID-19 was still confined at that time to Asian countries and China, the FDP asked the Ministry of Finance to include it in its Stability Program sensitivity analysis.

At the moment, it is understandable that a rapid economic downturn is inevitable and is already happening. Experts from Latvia and the world evaluate the possible scenarios differently. One scenario is a temporary two-quarter "V" crisis, with a rapid recovery thanks to deferred economic activity and consumption. The Bank of Latvia has proposed a similar scenario, forecasting a 6.5% decline in GDP by end of 2020.

However, even in such a short-term crisis scenario, GDP will fall by more than € 2.3 billion, and the debt-to-GDP ratio will automatically increase.

In previous years of economic growth approving a budget with deficit was practiced, which is a pro-cyclical budgeting practice and runs counter to the principles of a good fiscal discipline. At the same time, the debt-to-GDP ratio has been declining in 2018, reflecting strong GDP growth. General government consolidated gross debt decreased to EUR 10.6 billion in 2018, an decrease of EUR 0.2 billion or 1.8% compared to 2017.

Currently, central and local government debt is € 10.3 billion. The general government budget balance is planned at -0.4% of GDP. Fiscal security reserve EUR 33.2 million.

Assuming that GDP may fall by around € 2.3 billion in 2020, the general government balance could worsen to at least -3.7% of GDP, but it should be borne in mind that additional resources will be needed by aviation companies, passenger carrier companies (including Rigas Satiksme) and then the balance may deteriorate to -5% of GDP even in the case of relatively quick recovery in the economy.

At the moment, it cannot be ruled out that the crisis will not be short-lived with very rapid recovery. And even if Latvia's debt level is relatively low, budget resources are not unlimited, access to financial markets cannot be taken for granted and responsible action will be needed to ensure long-term fiscal sustainability.

Council priorities in a period of relaxation of fiscal discipline

The Fiscal Discipline Council will act in accordance with the principle that crisis management measures are necessary, but that they should be balanced against available budget resources and states borrowing capacity, and not lead to fiscal imbalances in the medium and long term.

The Council's priorities are:

1. Understand as precisely as possible the possible fiscal impact of measures already adopted. 

2. Assess whether the government’s fiscal measures are timely, targeted and temporary.

3. Ensure operational "crisis monitoring" and provide the government with regular assessment (at least twice a month) of the fiscal consequences of deviations from fiscal conditions in order not to endanger the fiscal sustainability of the country.

4. Follow that the government does not accept commitments that would not be fulfillable or would lead to unsustainable fiscal liabilities in the event of a larger (than currently expected) economic downturn. 

5. Assist the government on working out an “exit strategy”: timely elaborate on plans for a return to normality to avoid collapse of the economy

6. Inform the crisis management board of its findings.