Latvia's debt: how did we get it and do we want to see it even larger?
In 2020, Latvia's consolidated general government debt reached 43.5% of GDP. Now and then, we would hear public discussions of whether the level of debt should perhaps be increased to, for example, 60% of GDP. Therefore, this article is an attempt to take a bit closer look at how Latvia arrived at its current level of debt (particularly, at the Covid-19 implications for debt) and how it compares to the levels of other EU countries.
Latvia's debt has almost quadrupled over two decades
In 2020, Latvia's debt per capita reached 6680 euro. Moreover, this takes into account everybody, be it the working population, pensioners or even infants. The level of debt per employed was already almost 15 000 euro. Moreover, given the current demographic trends in Latvia, the money borrowed today will have to be repaid by generations with an even more shrinking number of employed. Consequently, the debt per capita and debt per working person will continue to grow even if the borrowed amount remains broadly the same.
Looking at the evolution of Latvia's debt since 2000 (see Chart 1), it is obvious that it has lingered at slightly above 10% of GDP for some time, but has currently quadrupled. This is a clear illustration of "you never know" when speaking about debt and that debt can swell significantly even from a relatively low level at certain conditions. Impacted by the financial crisis, Latvia's debt jumped to 47.9% of GDP in 2010. This was a result of both the plunging GDP growth and higher government spending during the crisis, triggering the need to borrow.
In the following years, the level of debt stabilised and edged down only slightly, as, despite the growing GDP, the government budget ran a deficit virtually every year. A considerable increase in spending to reduce the fallout from the Covid-19 pandemic over the last two years pushed the debt up again, although not as much as during the previous crisis. But the effects are still continuing, and they are likely to take the debt up to 50% of GDP by 2022.
The level of debt has risen in all EU countries
Latvia, like other EU countries, provided various types of support to population and businesses to help those affected by business restrictions and falling incomes through the pandemic. These measures were financed from various sources – the existing budget as well as international loans on particularly favourable borrowing conditions. Spending to reduce the fallout from the Covid-19 pandemic was sizeable in Latvia and all other EU countries alike.
Various types of pandemic-related expenditures in all EU countries range broadly from 3.2% of GDP in Romania to as much as 20.1% of GDP in Greece (8.7% of the year 2020 GDP in Latvia; see Chart 2). Moreover, many countries have considerable amounts of contingent liabilities in the form of guarantees and other liquidity supporting measures. That does not really affect the level of debt as yet, but if, for example, the government guarantees for the private sector loans are exercised, this could have implications for the future debt (see more detail in an article on "the invisible part of the debt" by Baiba Brusbārde).
Mainly due to the crisis response expenditure, last year saw an increase in government debt in Latvia as well as all the other EU countries (see Chart 3). The debt grew by 12.6 percentage points on average, with the most significant rise observed in countries with pre-existing high levels of indebtedness. This was dependent on the gravity of the pandemic effects for each of those countries, but also on the availability of own resources for crisis response measures and on the price at which the countries could borrow (for example, the yields on the issued Greek government securities were higher than the euro area average). Latvia's debt grew by 6.5 percentage points or 1.5 billion euro in a year.
Although debt has increased in all EU countries (and quite considerably), currently, financing is available at very low interest rates. Nevertheless, the central banks cannot continue forever with their accommodative monetary policies. As soon as the major central banks decide on changing their monetary policy stance, interest rates are expected to rise. If the government debt continues growing, the "old and cheap" liabilities will have to be refinanced by "new and expensive" ones to cover the swelling government expenditure. This will increase the debt servicing costs even at a potentially constant level of debt. With the period of the temporary departure from the fiscal rules allowed by the EC during the pandemic expiring, the government deficit will again have to be kept within certain limits. This could require boosting the revenue (for example, through tax raises) or cutting the spending in some other areas, as larger amounts will have to be paid in interest. The government does need to support its population and businesses during the crisis, but the spending has to moderate when the crisis is over.
Optimum? Not optimum? Optimum? ...
The maximum debt-to-GDP ratio of 60%, which is very often mentioned when speaking about debt, was initially set by the Treaty of Maastricht agreeing on the fundamental principles of the European Union . In Latvia's case, it is also stipulated by the Fiscal Discipline Law . Currently, however, the general escape clause has been activated with regard to the fiscal rules, enabling the euro area member states to exceed the spending limits set by the Maastricht criteria, but the fiscal rules are expected to be tightened again when the crisis is over. The fact that certain euro area countries have already exceeded the debt limit raises a question of what would be the "optimum" limit for debt and whether it is the 60% stipulated under the Treaty or perhaps a different one? The answer is not a straight-forward one and depends on both the assumptions used to evaluate the optimum limit and a country's stage of development. For example, developing countries are advised not to exceed the limit of 40% of GDP in the long term . At the same time, highly developed countries enjoying unchallenged access to borrowing are quite capable of steadily sustaining a higher level of debt in the long term. For example, Japan's debt reached 225% of GDP in 2020. The sustainability of its debt is supported by the country's reputation as well as the fact that the debt is mostly long-term and consists of domestic borrowing. Latvia is in a different position.
Although the optimum limit of debt for each specific country might be a subject for discussion, an excessively large debt can weigh on economic growth , jeopardise investors' trust and deteriorate the borrowing conditions. Moreover, whether the borrowed money is squandered on short-term needs or invested in, for example, know-how and infrastructural development involving a potential future benefit is also important. Surely, development should indeed be supported, yet the funding absorption capacity and cost-effectiveness should also be considered. For example, it is impossible to build and renovate roads across the entire territory of Latvia at once, as we do not have enough companies for the work. Moreover, good roads in all Latvia alone would not guarantee rapid development, as the overall infrastructure is equally important. The questions of "how much" and "what" should be developed need to be addressed constantly.
It is like when we are thinking about our personal liabilities. Even though we do not have any "Maastricht criteria" prescribing the percentage of annual income that may be borrowed, there are still some mechanisms holding us back from borrowing and spending infinitely. A lender can evaluate how much a person has already borrowed, look at the previous debt repayment record as well as tailor the conditions and interest rates based on the existing situation. A person is aware that the debt will have to be repaid. It is the same with the government debt. Somebody will have to repay it, and even if it is a long-term debt, it may still limit growth and future resources available.
Debt is a result of the interplay of various factors
Going back to the analysis of the situation in Latvia, with the GDP level growing, the percentage of debt relative to GDP decreases. The real GDP growth has been the main factor limiting the increase in debt over the most recent years, except in 2020, when Latvia's GDP contracted.
At the same time, although from 2012 to 2019 Latvia's budget ran a surplus only once, according to the debt sustainability model of the IMF, the primary balance (i.e. deficit without interest payments; see Chart 4) contributed slightly to the reduction of the overall debt. This was the main driver of the debt evolution in 2020 and most likely also in the medium term (within the period from 2021 to 2026), as the government deficit in those years can be expected to exceed the scheduled interest payments.
At the same time, changes in guarantees, which are included in the debt estimate, as well as changes in real interest rates have had a minor effect. Previously, the changes in debt were also affected by exchange rate movements, but, as Latvia is currently a euro area member state and the share of other currencies in its debt composition is also becoming insignificant, this factor has had no major effect since 2014 nor is going to have it in the future.
Provided that there will be economic growth in the near term and the borrowing conditions remain favourable, the main factor affecting the level of debt in the near term will be the primary deficit. With the deficit growing, the level of debt will also increase. A moderate government deficit or a surplus would be the main tool to be applied also to reduce the debt.
In the circumstances of a persistently high government deficit, debt may reach the limit within a couple of years
Assuming a moderate government deficit over the coming years  and based on the projected paths of GDP, exchange rate and interest rates, the debt can be expected to increase somewhat over the next two years, followed by a moderate contraction to 44.7% in the medium-term by 2026 (see Chart 5). Moreover, for those conditions to materialise, the tight fiscal rules stipulated in the Fiscal Discipline Law have to be complied with.
At the same time, if we continue spending as much as in 2020 (i.e. slightly above the Maastricht criterion of 3% for the government deficit), the government debt would reach 60% of GDP already in 2026. What are the implications? To repay the debt, taxes raises and spending cuts would be required, and that's no picnic. Living "wisely", we can arrive at a 45% of GDP debt in a matter of a couple of years, but spending as much as last year, the debt would quickly hit the 60% of GDP mark.
According to an institutional paper on debt sustainability published by the European Commission , Latvia's short-term risks to the government debt are currently higher, whereas the medium-term risks are low. Short-term risks increased as a result of the borrowing needs in response to the Covid-19 pandemic, whereas in the medium term the uncertainty is decreasing, although interest rates are likely to grow. Latvia will require new borrowing to roll over the existing debt (over 6 billion euro in the period from 2022 to 2026 ). The current borrowing rates are favourable, but no one knows whether the rates will still be low after some time when we need to borrow again. Therefore, the invitation to borrow as much as we can because money is cheap does not really work. Yes, it really is cheap now, but will it still be cheap when the debt matures? Most probably not.
To have something that can be spent on a rainy day, we should build up savings rather than debt on a sunny day
Latvia will have access to sizeable European Union funding for strengthening and supporting economic growth in the near term, yet the level of debt needs to be sufficiently low, so that we can use borrowing opportunities more flexibly, if needed. The objective is to spend wisely rather than to spend the maximum available amount. No doubt, the support provided to the population during the Covid-19 was really vital. Moreover, we cannot be sure of how the situation will evolve this year either, considering the virus mutations and the low uptake of the vaccines. Although the economy has rebounded and businesses have exhibited extraordinary skills of adapting to the new rules, we have the autumn and winter season, traditionally characterised by a higher spread of viruses, ahead of us. Possibly, some additional support mechanisms involving budgetary implications will be required.
Saving for a rainy day is something to be learned by both individuals and the state, i.e. the debt should be reduced when the economic conditions are good, so that borrowing and undertaking more debt can be resorted to when needed. Moreover, we should all learn to distinguish between wishes and needs. "Extra money" could, no doubt, be spent on many worthy causes, but we have to consider whether this is an absolute necessity or just something desirable that can better wait until we are able to earn the money first and only then spend it.
Discussion about this particular issue and other government debt-related topics will continue at this year's economic conference organised by Latvijas Banka.
 Treaty on European Union, adopted on 7 February 1992; https://europa.eu/european-union/sites/default/files/docs/body/treaty_on_european_union_en.pdf
 Fiscal Discipline Law, adopted on 31 January 2013; https://likumi.lv/ta/en/en/id/254896-fiscal-discipline-law
 Pienkowski A. Debt Limits and the Structure of Public Debt. Published on 22 May 2017. https://www.imf.org/en/Publications/WP/Issues/2017/05/22/Debt-Limits-and-the-Structure-of-Public-Debt-44913
 Reinhart C.M., Rogoff K.S. Growth in a time of Debt. American Economic Review: Papers & Proceedings 100 (May 2010): 573–578
 Hereinafter, the fiscal deficit rather than the primary deficit excluding interest payments is analysed.
 Debt Sustainability Monitor 2020, European Commission, published in February 2021. https://ec.europa.eu/info/publications/debt-sustainability-monitor-2020_en
 The Treasury's borrowing plans https://www.kase.gov.lv/en/debt-management/debt-and-cash-management-strategy/borrowing-plans