Latvia has a relatively fast growing economy but faces challenges for future growth. Latvia is a small Baltic country which has transitioned from a Soviet era planned economy to a free market open economy, and is a member of the European Union. After independence in 1991, Latvia has had some of the highest economic growth among european countries. However the long term economic growth for Latvia is clouded by the emigration of skilled workers, corruption, high unemployment rate (primarily structural), lack of foreign investment and high income inequality. Approximately 25% of the population lives below the poverty line. Future growth will also be limited by the current low birth rate and decreasing population.
According to the Central Statistical Bureau of Latvia, over a five year span Latvia had the fastest growing economy among the Baltic countries. Real Gross Domestic Product (GDP) growth rate in 2017 was 4.5 percent and much of this growth is attributed to an increase in both investment and private consumption. Approximately half of Latvia’s GDP come from exports. The countries main exports are wood and timber, machinery and equipment, textiles, and iron and steel. Latvia’s economy in real terms (adjusted for inflation) has recently returned to its pre recession levels of 2008. The Latvian government has maintained small budget deficits and the country had a -0.5% budget deficit in 2017.
Latvia's labor market policies have focused on the issue of structural unemployment through updating and improving their vocational training programs. Unemployment is largely structural rather than cyclical, meaning that there is a mismatch between the skills demanded for a job and the skills offered by the citizens. Government has taken steps to improve the economy and address income inequality. For example, the government has increased the minimum monthly wage levels in the previous two years and plans and raising it an additional €50 this year.
A major challenge to the Latvian economy is the loss of skilled workers in conjunction low birth rate. Latvia has experienced a high level emigration of skilled workers to other European countries. Although Latvia is a small country with a population of 1.95 million people, a recent study indicates that 100,000 skilled workers (residents who have obtained higher education) emigrated from Latvia during 2000-2016. The loss of the educated workforce poses a significant challenge to Latvia’s productivity. Latvia's low birth rate also poses a challenge to long term productivity. In 2017, the Latvian birth rate was 9.7 births per 1000 population. Their population growth rate was -1.08% in 2017.
There is a discrepancy between rural and urban unemployment in Latvia. Regional unemployment is much more pronounced than both the unemployment rate in Latvia as a country and the unemployment rate in their capital city, Riga (Refer to Figure 1). This is due to a lack of jobs opportunities in the countryside and limited domestic labor mobility.
Since 2010 wage and productivity growth have been on an upward trend but wage growth has drastically exceeded productivity growth and is expected to continue to do so in the near future (Figure 2). This discrepancy may reduce the competitiveness of the Latvian economy as wage costs have risen faster than productivity. Other emerging European Union (EU) economies also tend to have higher wage growth compared to productivity, as shown in Figure 3.
The lack of foreign investment in Latvia has been partially attributed to the corruption. Corruption continues to be a major challenge to business operations. According to GAN Integrity Solutions, high levels of corruption in Latvia is a major competitive disadvantage for the economy. While the country does have anti-corruption laws on the books, they are not effectively enforced. Bribes, conflicts of interest and irregular payments pose a significant problem to companies doing business in Latvia. This level of corruption makes Latvia a less attractive place to do business. According to the Global Corruption Perceptions Index created by Transparency International, Latvia is the most corrupt country in the Baltic region. However, Latvia ranks as the 40th least corrupt countries out of 180 countries measured. A large portion of the bank deposits made in Latvia are from non-residents. According to SGI (Sustainable Governance Indicators) this poses a “systemic risk to the financial system”.
Recommendations to improve Latvian Economy
The Latvian government should consider implementing more progressive tax policies in order to improve the economic climate, accelerate long term growth, reduce high income inequality and high unemployment. The government has already taken some positive steps in this direction such as transforming the income tax from a flat tax to a progressive tax system and increasing expenditure on vocational training programs. Prior to 2018, the country had one of the lowest tax rates in the EU that disproportionately affected the low wage earners. Recent tax reforms have now shifted the burden to higher income earners. Significant tax reforms were instituted as of January 1st, 2018 that changed their flat personal income tax to a progressive one. The progressive income tax begins at 20% for the minimum amount of income and up to 31.4% for annual income exceeding €55,000.
The loss of educated and skilled workers via emigration from Latvia continues to be a major issue for the economy. Government should consider programs such as investments in technology industries in order to provide incentives for skilled workers to remain in the country. Investments in technology areas such as solar and alternative energy could provide additional high paying jobs as well as provide societal benefits. The government could provide low-interest rate loans for qualified individuals for education and startup industries. The government could make living in Latvia more appealing by allocating more resources for social programs such as health care, and housing. Such spending would have a greater impact on the lower and middle social classes than the top wage earners, and would help to reduce the inequalities in health and income which currently hamper the overall economic productivity. Minimum income support programs have already been implemented for low wage earners in Latvia, and government should consider evaluating and expanding this program in the future to further reduce income inequality. To further address the high level of structural unemployment, the government should provide additional affordable housing and increase the access of education through grants and student loans. The World Economic Forum (WEF) found that it is not only the access to education, but the quality of education in Latvia that needs to be addressed. The WEF Global Competitiveness Index shows that the quality of education in Latvia is significantly worse than its neighboring countries.
The Latvian government should continue its efforts to reduce corruption as a top priority item to increase foreign investment. Latvia should continue to implement stricter banking regulations. Latvia joined the Organization for Economic Cooperation and Development (OECD) in 2016 and has improved banking regulations. Latvian banks have recently improved their efforts to prevent money laundering and fraud. These efforts appear to have had an effect on the share of non-resident deposits to total deposits. The ratio of these types of deposits is in a downward trend which helps to reduce the systemic risk. For example, the ratio of these deposits reduced from 53.4% in 2015 to 42.8% in 2016. The OECD has recognized Latvia’s efforts to reduce money-laundering and limiting the portion of non-resident bank accounts. Decreased corruption would attract additional foreign investment, and as a result would have a very substantial positive impact on the Latvian economy.
A significant portion of Latvian exports goes to the Russian Federation, however instability in Russia or other neighboring countries poses geopolitical risks that could limit economic growth. Political instability could severely limit exports and foreign investment The Latvian government could mitigate this risk by strengthening relationships with other EU countries and the United States. Additionally, they should focus on increasing exports to countries outside of the Russian Federation.
Lastly, the Latvian government should take proactive measures to improve the countries low birth rate. Government should consider policies such as additional paid maternity leave and additional child care support. Taxation policy could be modified to encourage childbearing by giving large tax breaks to couples with new born children.
Latvia has experienced great economic growth following their independence from the Soviet Union, but faces significant challenges to their long term growth prospects. These challenges include the emigration of skilled workers, lack of foreign investment, high structural unemployment, high income inequality, low birth rate, and corruption. These challenges could be diminished through the implementation of various government policies. Specifically, the implementation of more progressive tax policies will help to reduce income inequality. Minimum income support is needed to reduce the numbers of citizens living below the poverty line. Government regulations are required to reduce the high levels of corruption and encourage foreign investment. Measures should be taken to encourage entrepreneurship and human capital improvement through low interest rate loans. More high paying jobs in technology and industry will reduce the outflow of highly skilled workers from Latvia. Increasing the quality and access to education is another key to the future success of the Latvian economy. While Latvia faces significant challenges, long term economic growth can be likely achieved provided that these steps are implemented.