Blog

Source: IMF – News in Russian

June 8, 2025

Washington, DC – June 9, 2025

Latvia’s economy is navigating a complex global environment while addressing structural challenges at home. Geoeconomic fragmentation, geopolitical tensions, higher trade barriers and trade policy uncertainty, and labor and skills shortages are adding to challenges to productivity growth. Meanwhile, Latvia faces significant medium- and long-term spending pressures driven by population aging, defense needs, and investments for energy security. To address these spending needs, staff recommends the mobilization of additional revenue and the acceleration of structural fiscal reforms. Improving pension adequacy requires strengthening the second and third pillars of the pension system. The authorities should continue to monitor risks in the financial sector, including banks’ exposure to the commercial real estate sector, and reassess the solidarity contribution on banks. To strengthen resilience and growth—which will also support public finances—the authorities should consider measures to boost productivity. These include increasing the quantity and quality of corporate investment (e.g., by improving firms’ access to finance), supporting the reallocation of labor and capital toward higher value-added products and services, and enhancing digital technology adoption in traditional sectors.

Outlook and Risks

Growth is projected to rebound in 2025. Real GDP growth is projected to recover to about 1 percent in 2025, underpinned mainly by higher public investment, but also a recovery in private consumption and a gradual recovery of external demand. Headline inflation is projected to increase to about 3 percent in 2025, reflecting higher energy prices in the early months of 2025 and higher food prices, and core inflation is expected to moderate but remain above headline reflecting persistent services inflation.

Risks to the outlook are tilted to the downside. Rising geopolitical tensions, and higher tariffs and trade policy uncertainty may dampen the recovery. Although direct trade and financial exposures to the United States are small, weaker demand in key European trading partners and lower consumer and business confidence could affect economic and financial stability through financial contagion. Other downside risks to growth include a further slowdown of growth in Latvia’s trading partners, delays in the absorption of EU funds, new increases in global energy and food prices, and an increase in electricity prices. At the same time, a strong economic recovery in Latvia’s main trading partners, a boost in confidence from improved security, a faster-than-expected disbursement of EU funds, and a swift implementation of structural reforms may contribute to higher-than-expected economic growth. Latvia has a strong track record, solid commitment to fiscal discipline, and strong fiscal institutions. Despite that, the fiscal balance is subject to downside risks from higher spending in defense, contingent liabilities with state-owned enterprisesthat could be in excess of the Fiscal Safety Reserve, and higher capital expenditure with large infrastructure projects.

Fiscal Policy: Addressing Public Spending Pressures

The moderately expansionary budget in 2025 is appropriate, given the currently negative output gap. The headline fiscal deficit is projected to increase to about 3 percent of GDP in 2025, because of higher defense and investment spending needs. At the same time, the 2025 budget includes tax reforms to simplify the personal income tax that will generate minimal revenue gains.

Latvia’s government faces significant medium- and long-term spending pressures.These include rising costs for pensions and health care, increased defense spending, and investments for energy security. The government has recently committed to increasing defense spending to 5 percent of GDP from 2026 onwards. In the absence of measures to raise fiscal revenues and reprioritize government spending, Latvia’s structural fiscal deficit (including one-off expenses) is projected to average about 3 percent of GDP in the medium-term. This would raise public debt close to 50 percent of GDP in 2030, eroding fiscal space and limiting the authorities’ ability to address large adverse shocks in the future.

Going forward, the authorities should proactively preserve fiscal buffers. Staff estimates that bringing public debt to its pre-Covid level of 40 percent of GDP in 2030 requires a fiscal consolidation of about ½ percent of GDP per year between 2026 and 2030.

The government should therefore mobilize additional revenue. Revenue measures could include (i) strengthening tax compliance; (ii) broadening the bases of corporate and personal income taxes (e.g., by reducing the shadow economy); (iii) continuing to improve VAT collection efficiency through further narrowing the compliance gap; (iv) reducing tax exemptions and fossil fuel subsidies; and (v) raising property tax revenue. The government should also consider improving the efficiency of public spending by further improving procurement, eradicating rent-seeking activities, simplifying regulation, reducing bureaucracy, and increasing the efficiency of public administration and public investment management.

The government should adopt measures to support medium- and long-term pressures arising from higher spending with pensions. The government needs a comprehensive approach to improve pension adequacy while ensuring the financial balance of the pension system. This may include pursuing active labor market policies to increase labor force participation, incentivizing pensioners to work, and linking the retirement ages to future life expectancy gains. The authorities should also strengthen pension adequacy by increasing the contribution rates and the returns to the mandatory defined contribution pension pillar and strengthening incentives for higher voluntary savings for retirement through a more flexible and accessible system design.

Financial Policies: Countering Risks and Building Resilience in the Financial Sector

The authorities should monitor loan exposure to commercial real estate (CRE) and reassess the solidarity contribution on banks. If remaining in place for long, the solidarity contribution could distort bank lending toward less productive uses such as real estate and reduce lending to corporates. This is because banks can spread the increased tax costs over the full term of a mortgage, unlike for corporate loans which have shorter maturities. Considering structural changes in the office CRE segment globally, and given that loans to the CRE sector are around 31 percent of banks’ total corporate loan portfolio, CRE developments should be closely monitored.

The macroprudential policy stance remains broadly appropriate. The implementation of a positive neutral countercyclical capital buffer requirement, which will be raised to 1 percent in June 2025, helps build up releasable macroprudential buffers. However, the looser debt-to-income and debt service-to-income limits implemented in 2024 to promote loans for the purchase of energy-efficient housing should be reconsidered. Latvia has made further progress in strengthening its AML/CFT framework.

Structural Reforms: Policies to Boost Investment and Productivity

Latvia’s low productivity growth is driven by sluggish capital accumulation and an inefficient allocation of productive resources. The low capital stock results from inadequate investment in part driven by financial constraints and low risk-adjusted expected returns. Structural bottlenecks like costly and lengthy insolvency processes (despite improvements) or limited occupational and regional mobility of the labor force have hindered the flow of resources from low- to high-productivity firms. Boosting productivity would help to increase the tax base and sustainably lift incomes, while preserving Latvia’s external competitiveness.

Corporate reforms can improve capital allocation and enhance access to finance. Insolvency reforms with a focus on micro companies and timely initiation of insolvency cases that facilitate the exit of firms that are not economically viable could help to reallocate resources to more viable businesses. Initiatives to develop the capital market could help improve the access to finance by smaller firms. Expanding venture capital and equity financing would improve access to finance, therefore boosting opportunities for startups and allowing young firms to scale up. All these reforms will be more successful if combined with deepening the EU’s single market, which will allow Latvia’s firms to leverage economies of scale and greatly improve access to capital markets.

Addressing labor and skills shortages would sustain investment and productivity growth in Latvia. High-quality education and training systems, and targeted upskilling and reskilling measures are key to reducing the labor and skills shortages, improving competitiveness, and boosting productivity. The facilitation of skilled migration and the use of targeted active labor market policies will also help to enhance participation in the labor market.

Product and service market reforms can enhance competition and productivity. The regulatory framework could be improved by reducing the use of retail price regulation, streamlining spatial planning and construction regulations, and further simplifying administrative procedures and digitalization efforts in the construction sector.

The authorities should enhance support for innovation, technology adoption, and digital transformation, as well as strengthen energy security. Despite a modest rise in the past decade, Latvia’s R&D spending as a share of GDP remains among the lowest in Europe, hampering innovation and productivity growth. The authorities should accelerate the digital transformation by centralizing the governance of digital platforms and systems in the public sector, expanding digital training to public employees, promoting digitalization in businesses and in the education sector, and enhancing the broadband infrastructure. Finally, Latvia should continue to enhance its energy security by increasing the share of renewable energy, including biomass, and improving interconnections to other European power grids.

An IMF team conducted meetings in Riga during May 26–June 6, 2025. The mission was led by Mr. Luis Brandao-Marques and includes Gianluigi Ferrucci, Bingjie Hu, and Keyra Primus (all EUR). Carlos Acosta and Anjum Rosha (all LEG) participated virtually in meetings. Gundars Davidsons (OED) participated in the meetings. The mission would like to thank the authorities for their open collaboration, generous availability, and the candid and constructive discussions.

https://www.imf.org/en/News/Articles/2025/06/06/mcs060925-Latvia-Staff-Concluding-Statement-2025-Article-IV-Mission

MIL OSI