OECD Economic Outlook, Volume 2023 Issue 2

Latvia

Real GDP is projected to grow by 1.9% in 2024 and 2.7% in 2025 after contracting slightly in 2023. Declining inflation and strong nominal wage growth will bolster private consumption. Tight financing conditions will weigh on housing and business investment, while public investment growth will accelerate as EU funds are absorbed. However, skilled labour shortages and weak capacity in infrastructure planning risk hindering the implementation of investment plans.

To contain inflationary pressures, it is essential to gradually tighten the fiscal stance. Additional spending on health, education and defence should be financed by raising spending efficiency and increasing tax revenue from property, inheritance and capital gains taxes. Skilled labour shortages, including in the public sector, should be addressed by improving access to, and the quality of, training and adult learning, facilitating skilled migration and fostering the adoption of digital technologies. Deepening capital markets by listing large state‑owned enterprises would improve access to finance and support investment.

High inflation and weak exports have weighed on growth

After a technical recession in the first half of 2023, GDP increased by 0.6% in the third quarter of 2023. Strong public investment, helped by the absorption of EU funds, has more than compensated for weak export demand and private consumption. Industrial production increased in recent months, but was still about 3% lower than a year earlier. High interest rates and weak confidence have weighed on private investment and construction. Annual inflation has fallen rapidly to 2.3% in October, due to declining energy and food prices, but core inflation remains high at 5.9%. Average monthly gross wages increased by 12% year‑on‑year in June, resulting in a slight real wage increase of 0.1%. The labour market remains tight with unemployment at 6.5% in October and a vacancy rate of 2.7%, only 0.3 percentage points lower than its pre-pandemic value, indicating strong skilled labour shortages.

Latvia: Inflation and activity indicators

1. Headline inflation refers to the harmonised index of consumer prices, core inflation refers to the harmonised index of consumer prices excluding food, energy, alcohol and tobacco. Wages refer to average monthly wages and salaries of employees. The right-hand panel shows the projected allocation of revenue from the Recovery and Resilience Facility grants.

Source: OECD Prices database; Statistical Central Bureau of Latvia; 2023-26 Stability Programme of Latvia; OECD Economic Outlook 114 database; and OECD calculations.

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Latvia: Demand, output and prices

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Weaker growth in major export markets and falling export and import prices are weighing on foreign trade. Both export and import values have declined since the spring and in September the volume of foreign trade was around 23% lower than a year earlier. The transport sector and the manufacture of wood and metal products have been hit hard by the sanctions against Russia and Belarus. Tight financial conditions are moderating domestic demand. Rising interest rates on new mortgages remain the highest in the Baltic region, outweighing the impact of falling prices for older dwellings and reducing overall housing affordability.

Fiscal policy will face multiple expenditure pressures

Fiscal policy will be broadly neutral in 2024, reflecting announcements to increase spending on health and education, improve cybersecurity and external border infrastructure and maintain support for Ukrainian refugees. Defence spending will increase from around 2.2% of GDP in 2023 to 3% of GDP by 2027. Newly introduced energy policy support measures cost 0.1% of GDP in 2023 and any further support is assumed to be phased out by April 2024. Additional expenditure pressures stem from rising general government interest payments, which are estimated to reach around 1% of GDP by 2025. EU Recovery and Resilience Facility grants will finance capital expenditure as well as training measures for small businesses to foster digital and management skills, with average yearly spending of about 1.3% of GDP in 2024-25. Higher indexation of pension benefits in 2022-23 in response to the cost-of-living crisis and the rapid ageing of the population is expected to reverse the surplus of the social security fund from 0.3% of GDP in 2023 to a deficit of 0.1% of GDP in 2026. The fiscal stance will be tightened in 2025 to ensure a slight decline in the general government gross debt-to-GDP ratio towards the government’s objective of 40% in the medium term.

Domestic demand will lead the recovery

Falling inflation and rising nominal wages will support real incomes and raise private consumption over the next two years. Although tight financial conditions will weigh on investment, the significant inflow of EU funds will boost public infrastructure investment and spending on support measures for digitalisation and upskilling in small businesses, which will help to crowd in private investment. Wage growth will remain strong due to skills shortages and planned increases in public sector and minimum wages, leading to sticky core inflation. Delays in the absorption of EU funds and weaker-than-expected growth in key export destinations are the major downside risks. On the upside, a warm winter would contribute to a rapid decline in energy prices and inflation, further boosting household real disposable income and private consumption.

Supporting investment and inclusive growth

The listing of state-owned enterprises would help improve their governance and attract investors. This could deepen capital markets and raise access to finance for other firms. Improving public procurement and infrastructure planning capacity, particularly at the municipal level, is key for the successful implementation of EU funds and raising productivity. Introducing progressively-increasing social security contributions for low-income earners and stepping up enforcement efforts would help to reduce informality. This also requires raising trust in institutions and continuing the fight against corruption, for example by applying the heavy fines for tax evasion and bribery that current legislation allows. To accelerate the green transition, price signals in household energy consumption should be maintained to create incentives for improving energy efficiency, while supporting vulnerable households with loan subsidies or grants. Strengthening competition enforcement would help to raise business dynamism, innovation and productivity.