OECD Economic Outlook, Volume 2024 Issue 1

Latvia

Real GDP is projected to grow by 1.8% in 2024 and 2.9% in 2025. Rapidly falling headline inflation and rising nominal wages will boost real incomes and consumption. Public investment will accelerate due to the absorption of EU funds, while lower interest rates will support business and residential investment. Exports will pick up as key export markets recover. Core inflation will remain high due to strong wage growth related to labour shortages and rising minimum and public sector wages. Rising geopolitical risks could adversely affect risk premiums and derail growth.

Fiscal policy should be gradually tightened to reduce high deficits and lower inflationary pressures. Reducing the labour tax wedge for low-income earners and shifting the tax burden towards other income, property, and environmental taxes would help lower high informality. Listing large state-owned enterprises and strengthening competition in the financial sector could help deepen capital markets and raise access to finance. Bolstering competition enforcement and addressing skills shortages by improving training opportunities and facilitating skilled migration would support business dynamism and innovation.

Rising real wages are supporting private consumption

GDP grew by 0.3% in the fourth quarter of 2023, with a strong 11.6% annual increase in gross average monthly wages and falling inflation bolstering private consumption. The absorption of EU funds has supported investment. However, industrial production has been volatile in recent months and was 0.9% lower in February than a year earlier. Annual inflation fell sharply to 1% in March due to declining energy and food prices, but core inflation remains high at 3.8%. The labour market remains tight, with the unemployment rate at 6.8% in March and the vacancy rate at 2.5% in the fourth quarter of 2023, only 0.5 percentage points below its pre‑pandemic level.

Latvia: Inflation and activity indicators

Note: Core inflation refers to the harmonised index of consumer prices excluding food, energy, alcohol and tobacco. Wage refers to average net monthly wages and salaries of employees. The right-hand panel shows the projected allocation of revenue from the Recovery and Resilience Facility funds.

Source: OECD Prices database; Eurostat; Statistical Central Bureau of Latvia; Ministry of Finance of Latvia; OECD Economic Outlook 115 database; and OECD calculations.

Statlink

Latvia: Demand, output and prices

Statlink

Rising geopolitical tensions contributed to a sharp rise in quarterly import prices in the fourth quarter of 2023. In February, merchandise import values increased by 7.8% month-on-month, while export values fell by 9.4%. The number of bankruptcies continues to decline due to the strong energy price support provided in the past, other than in sectors heavily affected by the sanctions against Russia and Belarus. Tighter financial conditions have led to a steady decline in annual house price growth in recent months.

Fiscal policy will remain expansionary

The fiscal stance will ease in 2024 and remain broadly neutral in 2025. According to the 2024 budget, spending for health and education will increase by 0.9% and 0.4% of GDP, respectively, and internal security and defence spending will be raised by 0.5% of GDP. Higher interest payments of 0.5% of GDP by 2025 add to spending pressures. Tax revenue increases of 0.5% of GDP by 2026 will offset part of the increased spending, including a tax on undistributed profits of credit institutions, a gradual increase in reduced VAT rates on fruits and vegetables, and increases in excise tax rates on tobacco and alcoholic beverages. EU Recovery and Resilience Facility grants will finance investment and training measures for small businesses, with average yearly spending of about 1.6% of GDP in 2024‑25. The easing of monetary policy from the second half of 2024 will support firm borrowing, although these effects could be dampened by weak competition in the financial sector.

The recovery will be driven by domestic demand

Real GDP growth will recover to 1.8% in 2024 and rise to 2.9% in 2025. Falling inflation and high wage growth will raise household purchasing power and private consumption over the next two years. Rising unit labour costs and weak export demand will restrain export growth. Business and residential investment activity will pick up as financing conditions gradually ease. Significant inflows of EU funds will boost public infrastructure investment and spending on digitalisation and skills upgrading programmes for small businesses. Wage growth will remain strong due to skills shortages and planned increases in public sector and minimum wages, leading to sticky core inflation. Intensified regional geopolitical risks could significantly increase risk premiums and hamper foreign direct investment flows. On the upside, stronger‑than‑expected growth in the rest of the euro area would boost exports.

Stronger investment is required to support inclusive and sustainable growth

Limited access to finance coupled with high informality, skilled labour shortages and weak competition hamper business dynamism, innovation and investment. To reduce high credit costs, it is key to reduce switching costs for bank customers and strengthen competition enforcement. Listing large state‑owned enterprises could help to deepen capital markets and improve access to non-bank finance. High informality should be tackled by lowering labour taxes for low-wage earners, improving tax enforcement and continuing to fight corruption. Improving the design and delivery of training and encouraging more women to enter occupations with high labour shortages would help to address skills shortages. Strengthening the powers of the Competition Council to enforce competitive neutrality of state‑owned enterprises and challenge regulations that restrict competition would foster business dynamism and innovation. Reducing tax expenditures for fossil fuels would incentivise innovation and investment in green technologies. To address rising spending pressures in defence, health and old age poverty and stabilise public debt, it is key to raise spending efficiency, reallocate spending and increase tax revenue from income and property taxes.