In a report on Latvia’s fiscal plans, the European Union executive said the Baltic country seemed to be underestimating the risks to its economy from high inflation, overheating domestic demand and external imbalances.
“The programme’s economic scenario is attended by extremely high risks for macroeconomic stability, with a harder landing being a distinct possibility,” the report said.
“Latvia is invited to aim for more ambitious budgetary targets than foreseen in the programme in order to contain overheating pressures and macroeconomic risks as well as to ensure sustainable convergence,” EU Monetary Affairs Commissioner Joaquin Almunia said in a statement.
Reports on Bulgaria and Estonia, other fast-growing EU newcomers with currencies pegged to the euro, took a more upbeat stance on those countries’ economic future thanks to their tighter fiscal stance. But the two also faced some risks.
The three countries were in the third batch of EU member states to be assessed by the Commission in an annual exercise.
Latvia, which joined the EU in 2004, saw its economy grow by double digits in 2005-07 thanks mainly to a credit boom that boosted private consumption and real estate investment.
But the country’s inflation has shot to the highest in the EU, 14.1 percent year-on-year in December. The current account deficit has widened to about 20 percent of gross domestic product, one of the biggest such shortfalls in the world.
The imbalances have resulted mainly from a lax monetary policy, the lat currency’s peg to the euro, and a wage-price spiral fuelled partly by labour shortages as many Latvians sought jobs abroad after their country joined the EU.
Economic imbalances, also in neighbouring Estonia and Lithuania, renewed financial market speculation last month that currency devaluation was a real risk in one or more of the three Baltic states. High inflation has also delayed its planned adoption of the euro to 2012-13.
The Latvian government has said its anti-inflation programme, aimed at running a budget surplus of one percent of GDP, would ensure a soft landing for the economy. But the Commission was not convinced.
The Latvian programme assumes its GDP growth will slow to 7.5 percent this year and seven percent in 2009 while inflation falls to 12.5 percent and 7.2 percent respectively.
The Commission’s opinions on Bulgaria and Estonia suggested those countries’ economic outlook carried much less risk thanks to more austere fiscal policies.
On risks to Estonia, the report said: “A tighter fiscal stance could have done more to counter the overheating tendencies of the economy and to correct macroeconomic imbalances. These imbalances are expected to moderate only gradually in coming years.”
In Bulgaria, which joined the EU in 2007, “strong economic growth has been with signs of overheating … If this trend were to continue, it could lead to an erosion of competitiveness and question the sustainability of high growth.”
Bulgaria plans to run a budget surplus of three percent of GDP this year.