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Latvia - Economy

Latvia is on track to join the eurozone on January 1, 2014. In 2009, Latvia almost went bankrupt, but recovered surprisingly quickly. The road to recovery and the euro has been hard work for Latvia. By 2009 Latvia faced the largest economic contraction in the European Union. The country was on its knees, sustained only through emergency loans from the EU and the International Monetary Fund (IMF). In return for the substantial international aid, Latvia had to make stringent cuts - in 2009 alone, wages were reduced by 30 percent and government spending was cut by 20 percent. Unemployment shot up. The program’s goal or exit strategy called for Latvia to reduce the country’s budget deficit to 3% of GDP by 2012 in order to pave the way for euro adoption in 2014. Annual deficit targets were agreed with the European Commission and the IMF to help Latvia achieve its goal.

The IMF and EC were both extremely skeptical that Latvia will be able to reduce its budget deficit to the Maastricht Treaty required level of 3 percent of GDP by 2012 or even 2014. This meant Latvia's adoption of the Euro may be indefinitely delayed. Moreover, there is a widespread perception that corruption is becoming more pervasive. This perception could inhibit foreign investment. The problem of corruption is not an exercise in morals, but in empirical practicality -- with the message the more corruption there is, the more difficult it will be to emerge from the economic crisis.

The Government of Latvia enacted a series of tough fiscal austerity budgets that reduced the deficit by 13% of GDP. Industrial production and exports were both up nearly 25% in the year ending October 2010. The country received a boost when Standard & Poor’s upgraded the country’s sovereign credit rating in early December 2010. Latvia’s GDP growth rate is estimated at around 4.0% for 2011. By 2013 Latvia's growth was expected to reach 5 percent. Latvia had lowered government and public sector spending to 36 percent of gross domestic product (GDP) [in Greece, the equivalent rate is still around 50 percent].

For centuries under Hanseatic and German influence and then during its inter-war independence, Latvia used its geographic location as an important East-West commercial and trading center. Industry served local markets, while timber, paper, and agricultural products supplied Latvia's main exports. The years of Soviet occupation tended to integrate Latvia's economy into the U.S.S.R. in order to serve that empire's large internal industrial needs. Since reestablishing its independence, Latvia has proceeded with market-oriented reforms. Its freely traded currency, the Lat, was introduced in 1993 and has held steady or appreciated against major world currencies.

Before late 2007, Latvia's economic performance was among the best of the EU accession countries. Real per capita GDP had more than doubled compared to its 1995 level; the economy was expanding rapidly, with GDP growth hitting 12.2% in 2006. The next 3 years (2005-2007) brought on average economic growth of nearly 11% per year. As in much of the rest of Europe and the United States, Latvia’s growth during this time was fueled by a credit boom that bolstered domestic demand, drove prices and wages up unsustainably, and resulted in a massive housing bubble. Government spending also rose rapidly during this period, further fueling the price and asset bubbles.

In 2008, however, unwinding domestic imbalances combined with adverse external factors to bring a halt to Latvia's economic growth. Its GDP shrank by 4.6% in 2008 and by a staggering 18.7% (year on year) in the second quarter of 2009. The recession is causing widespread unemployment, especially in Latvia's eastern regions. The harmonized unemployment rate in September 2009 reached 19.7%. Latvia registered some of the highest inflation rates in the EU in recent years, which delayed prospects of introducing the Euro currency. As of November 2009, Latvia was experiencing deflation as a result of rapidly falling demand.

In response to the worsening macroeconomic situation, in late December 2008 Latvia signed a 27-month Stand-by Arrangement with the IMF, the EC, and several other partners for an assistance package totaling approximately EUR 7.5 billion ($10.5 billion). The program is centered on restoring competitiveness through economic adjustment, fiscal prudence, and factor price deflation. At the same time, Latvia's current account balance has improved markedly. From 2006 through 2008, it experienced a deficit ranging from 12.6% to 22.5% of GDP, but since early 2009 Latvia's exports outnumbered its imports.

Independence forced Latvia into a precarious position regarding its energy supply. With the exception of peat and timber, Latvia had no significant domestic energy resources and received 93% of its imported energy from Soviet republics. Latvia has sought ways to diversify its energy sources and to increase energy conservation. In August 2001, the Kegums hydroelectric power plant was reopened, contributing to Latvia's ability to supply 25% of its energy that year. Furthermore, in June 2002 the European Investment Bank loaned Latvenergo, a state-owned energy supply group, 80 million Euros to modernize its generation and distribution of electricity and thermal energy. On May 6, 2009, Latvenergo opened the first reconstructed power unit of the Riga thermal power station No 2. The reconstructed power plant provides 600 megawatts (Mw) electrical and 1,123 Mw thermal capacity. The new power unit (420 Mw) has increased the power efficiency of the plant and is supposed to decrease Latvia's power supply dependency by 30%. The expectations are that the new power unit will reduce the import of electricity by 1,400 gigawatt hours per year on average. Latvia is also looking to regional cooperation arrangements to diversify its energy supplies. With the other Baltic states, it plans to create an electricity network able to operate independently of its Russian counterpart. It is planning major infrastructure projects to provide energy supplies via Scandinavia, and it is working with Estonia, Lithuania and Poland to build a new nuclear power station in Ignalina, Lithuania.

Privatization in Latvia is effectively complete. All of the previously state-owned small and medium enterprises have been privatized, leaving in state hands the electric utility, the Latvian railway company, and the Latvian postal system, as well as state shares in several politically sensitive concerns. Despite the lack of transparency of the early stages of the privatization process and certain difficulties in privatization of some of the largest companies, Latvian privatization efforts have led to the development of a dynamic and prosperous private sector, which accounts for approximately 70% of the country's GDP.

In the last few years, Latvia has implemented many positive reforms in the business sphere (ranking 27th worldwide on the ease of doing business there, according to the World Bank Doing Business 2010 report). Most reforms deal with licensing, taxes, and business closures. In the 2005/2006 period, Latvia made it easier for businesses to comply with building requirements and reduced the number of licenses and permits required. In addition, Latvia launched an electronic tax filing system and improved the regulation of bankruptcy administrators in order to reduce corruption.

In response to the economic crisis, foreign direct investment (FDI) flows are drying up, but FDI stock remains relatively high as a result of a high level of Western and Eastern investment following Latvia's accession to the EU. Representing 4.2% of Latvia's total foreign direct investment, the U.S. FDI stock in Latvia stood at $461 million at the end of the second quarter of 2008, according to the Bank of Latvia's figures. In 2008, U.S. goods and services accounted for 1% of Latvia's total imports, while exports to the United States accounted for 1.6% of Latvia's total exports. Latvia has been a member of the World Trade Organization since 1999. Latvia and the United States have signed treaties on investment, trade, intellectual property protection, and avoidance of double taxation.

In the long term, Latvia's return to economic growth will depend on comprehensive structural reforms, economic adjustment and improvements to the business environment, particularly the drive to reduce corruption and strengthen the rule of law, and on Latvia's ability to use the opportunities presented by EU membership.

Despite little support from the population, Latvia officially became the 18th member of the euro zone at midnight on 01 December 2014. A poll held by Latvia’s SKDS market research and polling company in December shows that 50 percent of respondents oppose the currency switch. Only eight percent of the country’s population fully support euro as the new currency while 16.5 percent “mostly support” it. For the first two weeks after the euro's introduction from January 1, 2014, Latvia’s currency, the lat, will circulate simultaneously with the euro while change from payments in lats will be given in euros.

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Page last modified: 05-01-2014 18:59:21 ZULU