Summary: KEY ISSUES Context: Latvia’s economy continues to recover strongly as it joins the euro area. The output gap is now largely closed, and labor market conditions are tightening despite still high unemployment. The current account is close to balance, while inflation has fallen to near zero due mainly to declining energy prices. Bank balance sheets are improving but credit continues to contract. The growth of non-resident deposits (NRDs) in the banking system decelerated in 2013. Challenges: Latvia’s broadly favorable medium-term outlook faces several external risks. Prolonged weakness in euro area trade partners, or a new episode of global financial volatility could set back the recovery. Ongoing events in Ukraine and Russia could affect the economy through both trade and financial channels, especially if there are broader regional spillovers. Maintaining competitiveness within the euro area will require sustained reform efforts across a number of areas, such as infrastructure, education, labor markets and the judicial system. Staff views: The 2014 budget appropriately continues fiscal consolidation at a gradual pace, and introduces some welcome measures to strengthen the social safety net, but recent changes to the Guaranteed Minimum Income (GMI) benefit should be reconsidered. Medium-term fiscal sustainability has been underpinned by the adoption of the Fiscal Discipline Law (FDL). Efforts to revive bank credit should focus on reducing the private sector’s debt overhang, by improving the efficiency and speed of resolution procedures. The large size of NRDs in the banking system is a source of vulnerability and warrants continued vigilant supervision. Authorities’ views: The authorities largely concurred with staff’s assessment, notwithstanding some differences on tax and benefit policies. They agreed on the importance of structural reforms to preserve competitiveness within the single currency and on the need to maintain higher prudential standards and close supervision of NRD- specialized banks.

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