Latvia

Latvia’s fiscal position remains manageable in the short term, but structural pressures are rising. The general government deficit is expected to remain close to 3% of GDP and public debt below 50%, providing a comfortable starting point by regional standards. The key vulnerability lies in medium-term expenditure dynamics. Defense spending is structurally increasing toward roughly 5% of GDP over the coming years, alongside higher security-related costs, infrastructure investment and national co-financing of EU funds. As these commitments accumulate, fiscal buffers narrow and flexibility diminishes, leaving public finances more exposed to adverse shocks, including weaker growth or persistently higher borrowing costs.

Funding conditions have improved thanks to monetary easing, but sovereign financing remains sensitive to broader market developments. Government bond yields and spreads have risen despite policy rate cuts, reflecting elevated issuance across the Eurozone linked to defense and infrastructure needs, as well as heightened regional geopolitical risk. This implies a higher cost of debt over the medium term and may feed through to private-sector borrowing.

The banking sector is stable, well capitalized and liquid, with credit growth recovering and non-performing loans contained. However, the system is highly concentrated and bank-centric, limiting competition and keeping lending margins elevated. Widespread variable-rate borrowing leaves households and firms sensitive to interest-rate cycles, dampening the transmission of monetary easing. Latvia’s shallow capital markets exacerbate these frictions: equity market capitalization — at roughly 1–2% of GDP — is among the lowest in the EU, and venture capital and institutional investor participation remain limited. This financial structure constrains scale-up and innovation, amplifies investment cyclicality and raises vulnerability to credit tightening.

Corporate financial stress remains contained. Business insolvencies declined by around 2% in 2025 and are projected to fall further — by roughly 10% in 2026 — placing Latvia among Europe’s best performers and contrasting with expected increases elsewhere. Resilient domestic demand, labor hoarding and gradually easing financing conditions underpin this improvement. Still, risks persist among SMEs exposed to high financing costs, energy-price swings and weak external demand, leaving the corporate sector sensitive to a turn in the cycle.

Latvia's political environment is characterized by robust democratic institutions and a strong Euro-Atlantic orientation. However, the scheduled parliamentary elections by October 2026 introduce an additional layer of political risk, influenced by domestic coalition dynamics and persistent geopolitical tensions with Russia. The parliament is highly fragmented, with no single party commanding a majority. This could lead to prolonged government bargaining, slowing legislative action and structural reform. 

Geopolitical risk remains a defining feature of Latvia's political landscape. The majority of the Latvian population perceives Russia as the main external threat, with concerns about national security and territorial defense shaping public opinion and political priorities. The war in Ukraine has heightened sensitivities, prompting emphasis on defense spending, border security and resilience measures. Latvia's strategic position on NATO's eastern flank makes it subject to ongoing Russian hybrid tactics. Underlying socio-political tensions persist around minority integration and national identity, particularly regarding the Russian-speaking community.