Council opinion

of 27 March 2007

on the updated convergence programme of Latvia, 2006-2009

(2007/C 89/05)

THE COUNCIL OF THE EUROPEAN UNION,

Having regard to the Treaty establishing the European Community,

Having regard to Council Regulation (EC) No 1466/97 of 7 July 1997 on the strengthening of the surveillance of budgetary positions and the surveillance and coordination of economic policies [1], and in particular Article 9(3) thereof,

Having regard to the recommendation of the Commission,

After consulting the Economic and Financial Committee,

HAS DELIVERED THIS OPINION:

(1) On 27 March 2007 the Council examined the updated convergence programme of Latvia, which covers the period 2006 to 2009 [2]. On 6 March 2007, the Latvian government announced a plan aiming at combating inflation. This includes a revision of the budgetary targets, with a balanced budget in 2007 and 2008 and a surplus from 2009 onwards. However, this Council opinion is based on the convergence programme.

(2) The macroeconomic scenario underlying the programme envisages a soft-landing of the economy, with real GDP growth slowing from 11,5 % in 2006 to 8,0 % on average over the rest of the programme period. Assessed against currently available information, this scenario appears to be based on plausible growth assumptions. Nevertheless, there are significant risks of less favourable macroeconomic developments in view of large external imbalances, high inflation and increasing signs of overheating of the Latvian economy. The programme's projections for inflation appear to be slightly optimistic.

(3) For 2006, the Commission services' autumn 2006 forecast estimated the general government deficit at 1,0 % of GDP, against a target of 1,5 % of GDP set in the previous update of the convergence programme. The updated programme presents a deficit estimate of 0,4 % of GDP, which is plausible in view of the higher than expected revenues and despite the impact of budgetary amendments adopted in October 2006, which increased expenditures by an estimated 1,5 % of GDP.

(4) The main goal of the medium-term budgetary strategy is to gradually improve the fiscal outlook and achieve a balanced budget by 2010. This goal will require a considerable consolidation effort after the deterioration in 2006 and 2007 by almost 112 percentage point of GDP. The envisaged adjustment in 2008 and 2009 is identical in the headline and in the primary balance, respectively 0,4 and 0,5 percentage points of GDP. Compared to the previous update, the planned budgetary targets are more stringent, but the adjustment remains back-loaded against a more favourable macroeconomic scenario. After the significant loosening of the expenditure-to-GDP ratio in 2007, the programme envisages consolidating the budget during 2008-2009 by increasing the revenue-to-GDP ratio by 0,4 percentage points each year, while keeping broadly constant the expenditure-to-GDP ratio. The revenue-to-GDP ratio is planned to increase mainly due to higher "other "revenues, which represents an increased inflow of EU funds. Accordingly, the expenditure ratio for the gross fixed capital formation component is increasing, broadly offset after 2007 by a decline in "other "expenditures (which in the programme includes part of consumption expenditure) by 34 percentage points in 2008 and in social transfers by 12 percentage points in 2009.

(5) The structural balance (i.e. the cyclically-adjusted balance net of one-off and other temporary measures) calculated according to the commonly agreed methodology is planned to deteriorate from a deficit of 1 % of GDP in 2006 to a deficit of 134 % of GDP in 2007 and to improve to a surplus of 14 % by 2009. The medium-term objective (MTO) for the budgetary position presented in the programme is a structural deficit of 1 % of GDP, which the programme aims to achieve around 2008, as in the previous update. As the MTO is more demanding than the minimum benchmark (estimated at a deficit of around 2 % of GDP), achieving it should fulfil the aim of providing a safety margin against the occurrence of an excessive deficit. The MTO lies within the range indicated for euro-area and ERM II Member States in the Stability and Growth Pact and the code of conduct and adequately reflects the debt ratio and average potential output growth in the long term.

(6) The risks to the budgetary projections in the programme appear broadly balanced for 2007, but the budgetary outcomes could be worse than projected in the programme from 2008, due to risks to the macroeconomic scenario. The budgetary strategy relies on an increase in the revenue-to-GDP ratio and on declines in the ratios to GDP of social transfers and "other expenditure "(which in the programme includes part of consumption expenditure), which could have been better substantiated, taking into account that according to the update a formal medium-term framework for the planning and control of public finances is planned to be introduced from 2008 onwards.

(7) In view of this risk assessment, the budgetary stance in the programme may not be sufficient to ensure that the MTO is achieved by 2008, as envisaged in the programme. However, it seems to provide a sufficient safety margin against breaching the 3 % of GDP deficit threshold with normal macroeconomic fluctuations throughout the programme period. Except for 2007, the pace of the adjustment towards the MTO implied by the programme is broadly in line with the Stability and Growth Pact, which specifies that the adjustment should be higher in good economic times and could be lower in bad economic times. Nevertheless, 2007 is clearly a year of moving away from the MTO in economic good times, which is not in line with the Stability and Growth Pact. A stronger structural adjustment path frontloaded during the programme period would be appropriate to support a stable macroeconomic convergence process and the mitigation of risks of imbalanced economic growth.

(8) According to the Stability and Growth Pact, "major structural reforms "with a verifiable impact on the long-term sustainability of the public finances should be taken into account when defining the adjustment path to the MTO. The medium-term budgetary strategy outlined in the programme embodies a temporary deviation from the adjustment path towards the MTO in 2007. The programme notes that the ongoing pension reform will gradually reduce social security contributions in the general government balance and that the contribution to the second-pillar pension scheme will increase from 0,4 % of GDP in 2006 to 1,7 % of GDP by 2009. The deterioration of the structural balance foreseen in the programme, adjusting for the impact of the phased implementation of the pension reform, would be of 12 % of GDP in 2007 followed by improvements of 112 % in 2008 and 114 % in 2009. While the net costs of the pension reform can be taken into account when assessing the adjustment path towards the MTO, the adjustment in 2007, even taking into account such costs, is not in line with the Pact. On the other hand, the healthcare reform and public investment projects mentioned in the programme do not qualify as structural reforms on which a temporary deviation can be based, as these measures are insufficiently detailed and the significant beneficial impact on the long-term sustainability of the public finances is not demonstrated in the programme.

(9) Government gross debt is estimated to have reached 10,7 % of GDP in 2006, well below the 60 % of GDP Treaty reference value. The programme projects the debt ratio to decline by 1,3 percentage points over the programme period to reach 9,4 % of GDP by 2009.

(10) The long-term budgetary impact of ageing in Latvia is lower than the EU average, with age-related expenditure projected to fall as a share of GDP over the coming decades, influenced by the expenditure-reducing impact of the reform of the pension system. The current level of gross debt is very low in Latvia and improving the structural budgetary position as planned in the convergence programme update would contribute to contain the risks to the long-term sustainability of public finances. Overall, Latvia appears to be at low risk with regard to the sustainability of public finances.

(11) The convergence programme contains a qualitative assessment of the overall impact of the October 2006 implementation report of the national reform programme within the medium-term fiscal strategy. In addition, it provides some information on the direct budgetary costs or savings of the main reforms envisaged in the national reform programme and its budgetary projections explicitly take into account the public finance implications of the actions outlined in the national reform programme. The measures in the area of public finances envisaged in the convergence programme seem consistent with those foreseen in the national reform programme. In particular, both programmes envisage significant increase in public investment and the convergence programme further expands on measures to be implemented in order to improve the institutional features of the public finances, including the introduction of the multi-annual budgetary framework.

(12) The budgetary strategy in the programme is only partly consistent with the broad economic policy guidelines included in the integrated guidelines for the period 2005-2008. In particular, the projected fiscal stance does not contribute adequately to promoting greater sustainability of the external account.

(13) As regards the data requirements specified in the code of conduct for stability and convergence programmes, the programme provides all required and most of the optional data [3]. However, some inconsistencies exist with regards to standard Table 2.

The Council considers that the worsening of the budgetary position in 2007 is not in line with a prudent fiscal policy aimed at ensuring sustainable convergence, including by reducing the external imbalance and containing inflation. In the subsequent years, the programme envisages progress towards the MTO in a context of strong growth prospects, but the budgetary targets are not ambitious and there are risks to their achievement from 2008 onwards.

In view of the above assessment, the Council invites Latvia to:

(i) reduce the risks of macroeconomic instability by implementing vigorously measures to achieve a significantly better budgetary target for 2007 than foreseen in the programme, as part of a broader reform strategy. Building further on this, measures to enhance consolidation beyond the MTO in subsequent years should also be implemented as soon as possible;

(ii) establish a clearer and more binding medium-term framework for the planning and control of public finances.

The plan announced on 6 March 2007 would, if fully implemented, represent an important step in the right direction.

Comparison of key macroeconomic and budgetary projections

Notes:

Source:

Convergence programme (CP); Commission services' autumn 2006 economic forecasts (COM); Commission services' calculations

| 2005 | 2006 | 2007 | 2008 | 2009 |

Real GDP (% change) | CP Jan 2007 | 10,2 | 11,5 | 9,0 | 7,5 | 7,5 |

COM Nov 2006 | 10,2 | 11,0 | 8,9 | 8,0 | n.a. |

CP Nov 2005 | 8,4 | 7,5 | 7,0 | 7,0 | n.a. |

HICP inflation (%) | CP Jan 2007 | 6,9 | 6,6 | 6,4 | 5,2 | 4,2 |

COM Nov 2006 | 6,9 | 6,7 | 5,8 | 5,4 | n.a. |

CP Nov 2005 | 6,9 | 5,6 | 4,3 | 3,5 | n.a. |

Output gap (% of potential GDP) | CP Jan 2007 [4] | 0,0 | 1,8 | 1,3 | ‘�0,5 | ‘�2,0 |

COM Nov 2006 [8] | ‘�0,2 | 1,1 | 0,4 | ‘�1,0 | n.a. |

CP Nov 2005 [4] | 0,8 | 0,4 | ‘�0,5 | ‘�1,1 | n.a. |

General government balance [9] (% of GDP) | CP Jan 2007 | 0,1 | ‘�0,4 | ‘�1,3 | ‘�0,9 | ‘�0,4 |

COM Nov 2006 | 0,1 | ‘�1,0 | ‘�1,2 | ‘�1,2 | n.a. |

CP Nov 2005 | ‘�1,5 | ‘�1,5 | ‘�1,4 | ‘�1,3 | n.a. |

Primary balance [9] (% of GDP) | CP Jan 2007 | 0,7 | 0,2 | ‘�0,8 | ‘�0,4 | 0,1 |

COM Nov 2006 | 0,7 | ‘�0,4 | ‘�0,7 | ‘�0,7 | n.a. |

CP Nov 2005 | ‘�0,7 | ‘�0,8 | ‘�0,6 | ‘�0,6 | n.a. |

Cyclically-adjusted balance [9] (% of GDP) | CP Jan 2007 [5] | 0,1 | ‘�0,9 | ‘�1,7 | ‘�0,8 | 0,2 |

COM Nov 2006 | 0,2 | ‘�1,3 | ‘�1,3 | ‘�0,9 | n.a. |

CP Nov 2005 [4] | ‘�1,7 | ‘�1,6 | ‘�1,3 | ‘�1,0 | n.a. |

Structural balance [5] [9] (% of GDP) | CP Jan 2007 [6] | 0,1 | ‘�0,9 | ‘�1,7 | ‘�0,8 | 0,2 |

COM Nov 2006 [7] | 0,2 | ‘�1,3 | ‘�1,3 | ‘�0,9 | n.a. |

CP Nov 2005 | ‘�1,7 | ‘�1,6 | ‘�1,3 | ‘�1,0 | n.a. |

Government gross debt (% of GDP) | CP Jan 2007 | 12,1 | 10,7 | 10,5 | 10,6 | 9,4 |

COM Nov 2006 | 12,1 | 11,1 | 10,6 | 10,3 | n.a. |

CP Nov 2005 | 13,1 | 14,9 | 13,6 | 14,7 | n.a. |

[1] OJ L 209, 2.8.1997, p. 1. Regulation as amended by Regulation (EC) No 1055/2005 (OJ L 174, 7.7.2005, p. 1). The documents referred to in this text can be found at the following website:http://europa.eu.int/comm/economy_finance/about/activities/sgp/main_en.htm

[2] Following the formation of a new government in November 2006, after a general election in October, the update was submitted six weeks beyond the 1 December deadline set in the code of conduct.

[3] In particular the data on the subcomponents of the stock-flow adjustment and some elements of the long-term sustainability of public finances table are missing.

[4] Commission services calculations on the basis of the information in the programme.

[5] Cyclically-adjusted balance (as in the previous rows) excluding one-off and other temporary measures.

[6] There are no one-off and other temporary measures in the programme

[7] There are no one-off and other temporary measures in the Commission services' autumn 2006 forecast.

[8] Based on estimated potential growth of 9,3 %, 9,6 %, 9,6 % and 9,5 % respectively in the period 2005-2008.

[9] The net costs of the ongoing pension reform (introduction of a second pillar) are included in the deficit. The costs are estimated at 0,3 % of GDP in 2005, 0,4 % of GDP in 2006, 0,6 % of GDP in 2007, 1,3 % of GDP in 2008 and 1,5 % of GDP in 2009. The year-on-year change in the structural balance foreseen in the programme, adjusting for the impact of the phased implementation of the pension reform, would be a worsening of 0,6 % of GDP in 2007, an improvement of 1,6 % in 2008 and 1,2 % in 2009.

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