Latvia will enter the eurozone in 2014. It's already blasting its economy forward with new tax laws and encouraging investment. But some say this could be dangerous and the country risks becoming "the new Cyprus."
Latvia is now actively gearing up for the introduction of the euro after EU finance ministers recently announced the country's entry into the eurozone for January 1, 2014. Although Latvia has convincingly fulfilled all of Maastricht's criteria, some fear that existing tax benefits for holding companies in Latvia will make it into the new tax haven of the eurozone; what some have termed "the new Cyprus."
And in some corners of this Baltic nation, a casual observer could be forgiven for thinking that the country is indeed trying to emulate that southern island. Every summer the glitz and glamour of show business makes tourists flock to Jurmala, a seaside resort about half an hour's drive from the capital Riga. For 12 years, the town has also hosted a song competition, "New Wave," whose participants include many aspiring singers from Russia and the former Soviet republics.
The competition has become an informal meeting place for the wealthy and the powerful of Russia. Russian Oligarchs like Mikhail Fridman and Roman Abramovich have been known to attend.
"The New Wave boosts Latvia, and Jurmala's popularity. Of course, [such events] help us to sell real estate," said Andrey Shcherbakov, head of the real estate department at "Rietumu Banka," a private Latvian bank for affluent individuals mainly from Russia, Belarus, Ukraine, Kazakhstan and other former Soviet countries.
The parliament passed a bill in 2010 which made it possible for non-residents who bought properties in Latvia worth more than 140,000 euros ($183,000) to receive five-year residency permits for Latvia and the EU. Since that law was passed, non-residents have invested more than 377 million euros ($494 million)in Latvian real estate.
"We have noticed an increase in bank clients and we are opening many new bank accounts," Shcherbakov told DW. He added that the biggest influx of new buyers in Latvia has taken place after the recent crisis in Cyprus - which suggests that the money that was in Cyprus is flowing northwards to the Baltic region.
"These are clients who use Latvian banks as a financial center, and we can see a diversification of assets," Shcherbakov said. "People don't simply put their resources into one new bank, they also buy properties and invest in Latvia."
Following in Cypriot footsteps?
Other changes have happened this year as well. Since January 2013, significant modifications to corporate income tax have taken effect, making Latvia an attractive location for establishing holding companies. Sven Giegold, a German politician and member of the European Parliament, in a recent interview with the German magazine "Der Spiegel" named Latvia "the new tax haven of the eurozone."
The new tax law has benefits for those paying income tax, allowing an exemption for dividends paid out by residents to non-residents, and vice-versa. In addition, as of 2014, Latvian holding companies will no longer be taxed on interest and royalties paid to foreign companies. This will make the country ever more attractive to foreign investors who set up holding companies in Latvia. And anyway, any leftover liability owed by corporations is taxed at 15 percent, one of the lowest rates in the EU.
"Basically, there's a desire to develop a banking sector in Latvia that would service non-residents - along the lines of the Cypriot business model," said economist Janis Oslejs, who shares Giegold's view.
Oslejs is also concerned that Latvia is trying to attract Russian money and capital by selling property to Russian and other nationals through third countries. "If Latvia doesn't find a way to achieve fast industrial growth in its basic industries, and provide a stronger foundation for its economy, then we are heading for the kind of unstable pyramid we saw in Cyprus," said Oslejs.
Bridge between east and west
The Prime Minister of Latvia, Valdis Dombrovskis, spearheaded Latvia's attempts to join the eurozone and is confident though that Latvia will not become the new Cyprus. He said to DW that the new tax laws were long debated by politicians, officials and business people over a long period of time in Latvia, with a lot of consultancy taking place. According to Dombrovskis, the Latvian Finance Ministry doesn't predict any negative fiscal effects from its tax policy.
"Speaking of these taxes in general, at the time when we implemented the fiscal consolidation laws, our taxes were also significantly increased," said Dombrovskis. Value added tax was 18 percent before the crisis and is now 21 percent; the rate for state mandatory social insurance payments was 33 percent before, and now is 35 percent. "Excise duty, as well as real estate tax, has been raised. Also, there are now taxes on income from capital and on capital growth," he said.
Natalya Tkachenko, deputy board chair at the Baltic International Bank in Riga - which specializes in serving non-residents in Russia, Ukraine and England - appears to bear Dombrokskis' calm out. Her figures suggest that there has been no a sudden rush on Latvian banks or significant increases in foreign resident's deposits. She told DW that there were around 313 million euros ($410 million) deposited in the bank at the end of February, and that now there are 322 million euros ($421 million). "That is an increase of 3 percent and that's completely normal," she said.
Though Tkachenko explained that there hasn't been any significant influx of investment in the bank since the crisis in Cyprus, she added that she has noted an increasing interest in the possibility of setting up holding companies in Latvia - particularly from Russia, Belarus and Ukraine.
People from the Commonwealth of Independent States "really want to move their business to Latvia," said Tkachenko. "Keep in mind that we have a very attractive geographical location between east and west and our transit business is very developed too."
Mirror, mirror on the wall ...
Though the European Central Bank and the European Commission have raised concerns in their convergence reports over the significant amount of non-resident deposits, Prime Minister Dombrovskis stressed that Latvia has a relatively small banking sector compared to the whole of the EU. "For instance, if banking sector assets were hovering between 700 and 800 percent of GDP in Cyprus; and in the EU, you'll find levels of between 360 and 370 percent; in Latvia, the kinds of assets to GDP ratio is less than 130 percent of our GDP."
There is a lot of potential for non-resident deposits to flood the country under the new rules - but according to data published by the market commission, the proportion of non-resident deposits in Latvia was at 49 percent in 2012. That might sound high, but for the sake of comparison, in 2002 it was at more than 54 percent, and had dropped to 38 percent in 2009 when Latvia suffered the deepest recession in the EU.
"We primarily watch whether all the requirements are taken into account when every dollar, euro or any other currency is invested," said Kristaps Zakulis, head of the Commission. "We examine every investment, where did it come from and whether it has a legal origin. The banks have to fulfil a set of requirements regarding the prevention of money laundering."
Zakulis said that 13 out of 29 banks work mainly with non-resident clients, and they have to follow stricter requirements like insuring higher capital adequacy and liquidity than banks who work with resident deposits.
But not everyone agrees with this assessment. Markus Meinzer, based in Germany, is a senior analyst with the Tax Justice Network, which promotes transparency in international finance. He told DW that Latvia is preparing "dangerous tax laws."
"It's indeed a failure that one allows this kind of low tax rates and tax exemptions in Latvia -combined with very strict bank secrecy and with failures when it comes to fighting money laundering," said Meinzer. "But we shouldn't forget that some countries should take a good look in the mirror - that applies to Germany and the Netherlands and others as well."
Meinzer told DW that it would be wrong to single out any individual states and to demand new members adhere to standards that no one is politically willing to implement within the eurozone or the EU. Being the newest member, the spotlight is now on Latvia - but analysts like Meinzer think that it would be far better for the EU to get its own house in order regarding corporation tax rates and investment opportunities right across the board.
As the Latvian government has been keen to emphasize, the Latvian economy is just a drop in the ocean for now. The question is whether that drop will turn in to a flood as other countries already within the EU tighten up financially, and new entries seek to boost their economies with quick, easy investment and trade.