The Latvian economy continues to be resilient to the fallout of Russia's invasion of Ukraine but growth will slow to 2.5% next year (down 1.5pp from its previous forecast), the Executive Board of the International Monetary Fund (IMF) said at the end of its periodic consultations with Latvia.

The IMF said Latvia has managed the COVID-19 shock relatively well overall. With the improved health conditions, real GDP rebounded by 4.5% in 2021, thus exceeding its pre-crisis level, thanks to strong consumption and investment supported by significant fiscal support, the fund said.

Economic activity continued to be resilient during 1Q of 2022, surprising on the upside, at 6.7% y/y, as households drew down savings accumulated during the pandemic to finance private consumption, it noted.

Latvia’s economy is vulnerable to the fallout from the war, although its exposures have weakened appreciably in recent years, the IMF says.

Vulnerabilities come mainly from trade exposure to Russia, notably Latvia’s high dependence on imported Russian gas until recently. International sanctions imposed on Russia and Belarus create additional uncertainty.

The spillover effects from the war are already manifested in spikes in energy and food prices, supply disruptions, refugee inflows, and increased budgetary pressures.

The government has provided crucial support (including access to social benefits, education, housing, and language training) for the almost 33,000 Ukrainian refugees in Latvia. Although the refugee influx has fiscal costs, it could benefit Latvia’s economy by increasing labour supply, the IMF believes.

Growth is projected to slow to 2.5%, or about 1½ percentage points lower than the forecast before the war, as the negative confidence shock reduces private investment and trade, and high inflation weighs on private consumption growth. In the medium-term private sector confidence is expected to be lifted, causing a recovery in economic growth, the IMF says.

Economic activity is not expected to be affected by interrupted gas supplies, as the government has secured gas reserves, the fund believes.

Inflation is forecast to remain elevated at 14.5% in 2022 (period average) due to high energy and food prices and continued supply bottlenecks. Price pressures are expected to ease in the medium term as oil, gas, and food prices decline, the fund emphasised.

Yet the IMF says that further intensification of the war in Ukraine and stricter sanctions against Russia could lead to yet more prolonged disruptions in Latvia’s trade and finance, as well as a disruption of gas supplies.

Inflation could remain elevated for longer if energy and food price shocks and supply constraints persist. An upward pressure on wages could trigger a wage-price spiral and lead to a further deterioration in external competitiveness.

Amon the pieces of advice given by the IMF were the following: supervisors should take a risk-based approach, conduct relevant stress tests, and prepare contingency plans.  An improved insolvency regime could help revive bank credit.

The authorities should also focus on assessing the size of the corporate equity gap and developing policy options to support SMEs and micro firms, the IMF says.

The implementation of the EU Restructuring Directive needs to be expedited, the Fund advised.

Macroprudential policy should stand ready to respond to changing housing market conditions. Given the new risks caused by the war, the frequent reviews of macroprudential measures should continue to ensure the right balance between financial stability and the need for credit in the economy, it added.

The IMF also underlined that the declining population and shortages of qualified workforce are viewed as the main constraints to long-term growth.

The use of targeted labour market policies should be combined with the reforms of the business environment. Over time, the focus should gradually shift to facilitating the reallocation of workers to new jobs. Efforts to reduce inequality and promote social inclusion should continue. The authorities are taking a range of measures to improve outcomes, along with reforms and investments to improve education and infrastructure in the regions, with support from the EU's Reconstruction and Resilience Fund (RRF), the IMF stressed.