Latvia: Raising investment to support growth and increase living standards

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By Enes Sunel and Robert Grundke

Investment in Latvia has slowed since the global financial crisis, in contrast to its Baltic neighbours, Estonia and Lithuania. This has weighed on potential growth and slowed the convergence of living standards towards the OECD average. High risk aversion of banks, weak competition in the financial sector, and shallow capital markets have limited access to finance for firms. At the same time, investment demand has been low as high informality, weak competition and skilled labour shortages have weighed on business dynamism, innovation and productivity.

How can Latvia raise investment to support growth and increase living standards? The 2024 Economic Survey of Latvia  identifies five priorities:

1. Improve bank credit provision. Banks have been reluctant to lend, despite strong deposit growth (Figure 1). A history of low asset recovery and money laundering cases made banks more risk averse. Recent reforms, including the establishment of a specialised Economic Court, have significantly improved insolvency procedures and strengthened the fight against money laundering and corruption. However, the cost of credit, lending standards and collateral requirements still remain high compared to other Euro Area countries. Increasing competition in the banking sector by reducing barriers to customer mobility and strengthening the legal and investigative powers of the Competition Council to monitor anti-competitive behaviour in financial markets could help to lower borrowing costs. Improving banks’ management of anti-money laundering risks could also help raise access to credit. Providing continuous training to compliance officers in the financial sector could help to lower the administrative burden for clients and avoid unwarranted de-risking.

Figure 1. Bank lending has decreased despite rising deposits

Source: Bank of Latvia

2. Deepen capital markets to foster alternative sources of credit. Latvia’s stock market is the second smallest in the euro area, while none of the large state-owned enterprises (SOEs) are listed. Listing minority stakes in SOEs could help attract foreign investors, deepen capital markets and improve the corporate governance of SOEs. Corporate bond issuance is another source of non-bank finance and also needs to improve. Further reducing the administrative costs of bond issuance, improving the financial literacy of smaller firms, and facilitating greater investment of domestic institutional investors, such as second-pillar pension funds, in domestic securities would help deepen capital markets and improve access to non-bank finance.

3. Reduce informality to foster business dynamism and innovation. The shadow economy accounts for more than a quarter of economic activity and has not decreased since 2012. Widespread informality hampers access to finance for firms, restricts training opportunities for workers and distorts the level playing field, reducing business dynamism and innovation. Strengthening tax enforcement by improving data infrastructure and analysis as well as the human resources of the State Revenue Service, raising the quality of public services and continuing the fight against corruption to raise trust in institutions and the tax morale would help lower informality. Moreover, social security contributions for low-wage earners are much higher in Latvia than in other OECD countries, reducing incentives to formalise work (Figure 2). Lowering social security contributions for lower incomes, while maintaining social security benefit levels, would help to reduce informality and could be financed from general tax revenue, for example by raising revenue from property and corporate income taxes or increasing the progressivity of personal income taxes for higher incomes.

Figure 2. Reducing high labour taxes for low-wage earners would raise incentives to formalise work

Average tax wedge decomposition, % labour costs, 2022

Note: The tax wedge is the sum of personal income tax, employee plus employer social security contributions, minus social benefits as a percentage of labour costs. The tax wedge is shown for a single individual without children. Panel B and C show the tax wedge by income level measured in percent of the income of the average worker (AW).
Source: OECD Taxing Wages database.

4. Improve competition enforcement. Low competitive pressures for incumbents reduce their incentives to innovate and become more productive. Barriers to market entry and competition are high, particularly in many services sectors where the presence of state-owned enterprises is high (Figure 3). Although there has been some improvement since 2018, Latvia still ranks below the OECD average in the competition assessment of regulation. To strengthen competition enforcement, the Competition Council should receive the power to start investigations and challenge administrative decisions and regulations that restrict competition, as is the case in Italy or Spain. Moreover, the strong presence of state-owned enterprises (SOEs) in many markets may introduce entry and growth barriers for private firms. To enforce competitive neutrality of SOEs, it is key to increase the power of the Competition Council to conduct market investigations and initiate evaluations of state ownership rationales of SOEs.

Figure 3. Reducing high entry barriers in services sectors and improving competition assessment of regulation would help fostering business dynamism and innovation

OECD Indicators of Product Market Regulation (PMR), index scale of 0-6 from least to most restrictive (higher values indicate worse performance)

Note: OECD average for 2023 includes all OECD countries, apart from Belgium, Hungary, Mexico, the Netherlands, and the United States for which data collection is still ongoing. PMR values for Estonia and Lithuania for 2023 will only be released in Summer 2024.
Source: OECD (2023), Product Market Regulation Database (forthcoming).

5. Addressing skilled labour shortages by stepping up training. The low level of digital and management skills hinders the adoption of digital technologies by Latvian firms and reduces their productivity and competitiveness. Nevertheless, Latvian firms invest little in training (Figure 4). This is related to the large number of small firms, which lack resources to provide training. Moreover, severe skilled labour shortages and weak coordination among firms, as only about half of firms are members of an employer organisation, exacerbate the problem of poaching of skilled employees by other firms, further reducing incentives to invest in training of employees. To strengthen training provision in small firms and reduce concerns about employee poaching, sectoral training funds could be established to improve cooperation between firms and training providers in training design and delivery.

Figure 4. Firms need to step up training

Spending for continuing vocational training (CVT) courses, % of total labour cost of all enterprises, 2020

Source: Eurostat, Continuing vocational training survey (CVTS) 2020.

Reference:
OECD (2024), OECD Economic Surveys: Latvia 2024, OECD Publishing, Paris, https://doi.org/10.1787/dfeae75b-en