Indeed, GDP expansion achieved the highest quarterly rate ever recorded in Latvia in the second quarter, and the fact that this pace continued in the third quarter surmounts the wildest expectations. There is evidence that momentum was maintained in the fourth quarter, signifying that our current growth estimate for 2005 (9.8%) sits at the lower end of the target range. This remarkable acceleration is staggering—and cause for real concern at the same time.

Important features distinguish the Latvian boom from the rebounds seen elsewhere in the region, and show that the Latvian economy is clearly overheating at present. While external demand was very important for the growth recovery in many central European countries, it played only a minor role for the Latvian economy in 2005, as service sectors—particularly domestic trade, transport, and communications—as well as construction, were the key driving forces in Latvia during the first three quarters. This shows that domestic demand, spurred by a credit boom that took the private sector's credit-to-GDP ratio from around 20% in 2003 to a likely 60% in 2006, was predominant. It should be noted, though, that private consumption growth hit a snag in the second quarter, but investment more than compensated.

Inflation averaged 6.7% for 2005 as a whole, pushing down real interest rates. Moreover, keeping the massive current-account deficit in mind (which we estimate at 11.1% of GDP in 2005), it is questionable whether the current surge will continue infinitely. Even though financing the huge gap seems still rather safe, it is about time to examine the consequences of the economic boom and calculate likely adjustment costs—just imagine what happens if the surge terminates precipitously. Without doubt, the biggest risk emanates from a credit-based boom in consumption and investment, especially construction, although it is difficult to see at present what kind of event could interrupt it any time soon. Indeed, even the International Monetary Fund (IMF) expects Latvia’s economic boom to be maintained in the short-to-medium term, while acknowledging growing macroeconomic imbalances and associated risks for stability.

The root cause for the demand surge, besides rising real incomes, has been a rapid credit expansion, itself facilitated by declining real interest rates and the introduction of new credit instruments on the Latvian financial market. As a result, household debt and, even more so, foreign debt have quickly grown in recent years. European Union accession, the perspective of Eurozone membership, and, of course, the fixed euro exchange rate that Latvia adopted in January 2005, followed by European exchange rate mechanism (ERM 2) membership in April, play a key role here. Euro-based credits are much cheaper than borrowing in local currency, virtually excluding exchange-rate risk—at least in the minds of the borrowers.

The mortgage segment has been growing most vigorously, and in the same vein, banks’ vulnerabilities have increased as well. Indebted households, which borrowed in euro, still face exchange-rate risk until the euro is finally adopted in Latvia. Banks are confronted with a likely shortfall of liquid foreign assets against rising short-term liabilities, particularly if house price volatility remains high. A postponement of the current euro adoption target date (2008, according to the government schedule) will aggravate the situation, as the remaining "risk period" is extended. Indeed, inflation has remained stubbornly high in 2005 and is highly unlikely to decrease soon enough for the Maastricht criterion to be met. As a consequence, we have pushed back our assumption in this respect, now expecting euro adoption not earlier than 2009.

The asset-price bubble, most visible perhaps in Riga’s real estate market, is fairly concerning from this point of view, and a strict stance against growing credit risk is necessary to avoid an implosion of the current asset boom in the medium term. Moreover, the tax system has been facilitating mortgage loans by tax exemptions, and the IMF strongly recommended in its recent country report that Latvia amends legislation in this respect. Latvia’s highly uneven geographical economic structure is also an important feature and a likely source of risk, as almost half of the entire population is concentrated in Riga and the surrounding region—the powerhouse of the economy—where asset prices soar, while the rest of the country is left far behind.

As such, reining in demand is thus imperative for Latvian policymakers. Unfortunately, in the face of the ERM 2 membership, the Bank of Latvia’s room for policy maneuvering is much too restricted to effectively proceed against overheating demand. Nevertheless, Latvian authorities are well-advised to closely monitor credit quality indicators and strictly enforce prudential measures to reduce credit risk exposure in the banking sector.

The fiscal stance in general has been too pro-cyclical as well, although higher-than-expected revenues resulted in a fiscal deficit that was much lower than projected in the budget plan. In some way, the government is facing a trade-off, because the inflow of EU transfers and related co-financing from the public budget are pushing the pro-cyclical stance of the budget. However, spending in other areas would have to be cut back in order to compensate for the transfers-induced increase in public expenditures, a move the government has so far largely.