Latvia
Recent Economic Developments
Author:
International Monetary Fund
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Publication Date:
19 Dec 1995
eISBN:
9781451824391
Language:
English
Keywords:
ISCR; CR; U.S. dollar; central bank; balance of payments; broad money; central government; economic activity; foreign direct investment; second quarter; secondary market; foreign exchange; credit line
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This paper reviews economic developments in Latvia during 1993–94. During 1994, Latvia began to enjoy the fruits of its steadfast efforts to achieve macroeconomic stabilization and the transformation to a market economy. GDP grew by 2 percent, after three years of economic decline in which output is estimated to have fallen by about 50 percent. Real wages also increased in 1994, after sharp declines in earlier years. Although the unemployment rate increased to about 6½ percent of the labor force, it remained well below expectations and also below unemployment rates in Western Europe.

Abstract

This paper reviews economic developments in Latvia during 1993–94. During 1994, Latvia began to enjoy the fruits of its steadfast efforts to achieve macroeconomic stabilization and the transformation to a market economy. GDP grew by 2 percent, after three years of economic decline in which output is estimated to have fallen by about 50 percent. Real wages also increased in 1994, after sharp declines in earlier years. Although the unemployment rate increased to about 6½ percent of the labor force, it remained well below expectations and also below unemployment rates in Western Europe.

I. Overview

During 1994 Latvia began to enjoy the fruits of its steadfast efforts to achieve macroeconomic stabilization and the transformation to a market economy. GDP grew by 2 percent, after three years of economic decline in which output is estimated to have fallen by around 50 percent. Real wages also increased in 1994, after sharp declines in earlier years. While the unemployment rate increased to around 6 ½ percent of the labor force, it remained well below expectations and also below unemployment rates in Western Europe.

The rate of inflation continued to fall, to 26 percent in the year to December 1994, the lowest in the three Baltic countries. The current account moved into deficit as imports grew sharply and the economy began to absorb foreign resources. The reorientation of trade continued, and exports to the West grew strongly. Capital inflows more than offset the current account deficit, resulting in a further build-up of reserves at the Bank of Latvia, to around 4 ½ months of imports and goods and services at year-end. After more than a year of gradual nominal appreciation, the exchange rate of the lats was pegged to the SDR in February 1994 and has remained fixed since then. The remonetization of the economy continued and interest rates gradually fell.

Owing primarily to a sharp increase in the on lending of foreign resources, a fiscal deficit was recorded in 1994, in contrast to the surplus in the previous year. While the 1994 financial deficit, was held below the budgeted figure of 2 percent of GDP, lending to the enterprise sector—notably energy companies—caused a sharp worsening in the broader fiscal balance. The problems in the energy sector were symptomatic of the slower progress in the structural area, where reform has been lagging behind stabilization efforts. Privatization of medium- and large-scale enterprises accelerated in 1994, albeit at a slower pace than expected. The relatively slow progress in areas such as enterprise restructuring (due in part to the absence of an adequate bankruptcy law) and the registration of private land have become bottlenecks in the transformation of the economy and in the development of financial markets and institutions, thus compromising the effectiveness of stabilization policies. Protectionist pressures led to high agricultural tariffs.

Some of these problems contributed to the difficulties experienced in the first half of 1995. The financial deficit in this period was larger than budgeted as tax administration weakened and revenues were insufficient to cover large expenditure increases, especially on wages and pensions. Fiscal problems were exacerbated by a weakening economy, due in part to a banking crisis which emerged in the second quarter. Three of the ten largest banks failed, and the collapse of the country's largest bank (Bank Baltija) resulted in losses of around 8 percent of GDP. The failure of this bank can be attributed to a combination of bad banking, weak enforcement of prudential regulations, and reported malfeasance. Deposit withdrawals occurred in other banks as confidence in the banking system was shaken, but there were no major bank runs and confidence has been restored. Foreign exchange outflows also occurred as foreign investors and residents lost confidence, but the exchange rate peg held firm and stability returned to the foreign exchange market.

II. Developments in the Domestic Economy

Due to the still relatively poor quality of statistics, data on the real economy in Latvia need to be interpreted with care. Although the transition from the Soviet national accounting system based on “net material product” to an accounting system incorporating the output of all sectors, including the services sector, is now complete, national accounts data in Latvia continue to suffer from a poor coverage of the emerging private sector. This leads to an understatement of the level of GDP in official national accounts data. Similarly, the decomposition of nominal growth rates into unit value and volume changes, although improving, still suffers from a lack of reliable price deflators for different sectors.

1. Aggregate demand

After a cumulative decline of nearly 50 percent between 1990 and 1993, due to the large terms of trade shocks and the collapse of the Eastern markets in the early phases of the transition period, real GDP is estimated to have increased by 2 percent in 1994. The quarterly GDP path suggests that after the steep decline in output during the first half of 1992, the decline in GDP decelerated considerably during 1993, and the trough in output was reached in the first quarter of 1994 (Chart 1). GDP growth became positive in the second quarter of 1994 and accelerated in the fourth quarter of 1994. The strong growth carried over into the first quarter of 1995. Since then, economic activity has weakened considerably, largely on account of the banking crisis.

CHART 1
CHART 1

LATVIA: MACROECONOMIC INDICATORS

Citation: IMF Staff Country Reports 1995, 125; 10.5089/9781451824391.002.A001

Sources: Data provided by the Latvian authorities: and staff estimates.

The turnaround in economic activity in 1994 in Latvia is concurrent with similar developments in the two other Baltic countries; Lithuania's GDP is estimated to have increased by 2 percent in real terms, Estonia's by 3 percent. Most countries in the former Soviet Union, however, continued to record substantial declines in economic activity. The weighted real growth rate in 1994 for the 12 CIS countries was -13 percent, which suggests that the early and strong reforms undertaken by Latvia and the other Baltic countries, which initially caused larger and earlier output declines, are beginning to bear fruit.

The increase in real GDP in 1994 was led by strong investment growth, primarily in the construction and services sectors. The share of gross capital formation in GDP is estimated to have grown significantly in 1994 (Table 1). Private and public consumption also grew, driven by the increases in real wages. Reflecting the strong growth in investment, the current account balance swung from a surplus of 6.7 percent of GDP in 1993 to a deficit of 2.5 percent in 1994. This shift is the result of an increase in imports of Almost 30 percent in real terms, combined with growth in aggregate real exports of only 1 percent. 1/ In addition, foreign direct investment increased in 1994, reflecting increased confidence by foreign investors on account of successful stabilization and the low level of external debt. Private domestic savings decreased as a percentage of GDP while public savings became negative for the first time (to the tune of 1 percent of GDP), following large wage and pension increases in late 1993 and in the second half of 1994. The increase in investment occurred primarily in the private sector; public investment remained very low, at one percent of GDP.

Table 1.

Latvia: Savings–Investment Balance 1/

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Sources: Latvian authorities; and staff estimates.

Columns may not sum due to rounding.

External current account deficit (+).

Government current balance.

Derived as residual.

Preliminary estimates suggest that the economy grew strongly through the first quarter of 1995, but since then has weakened considerably. The main reason for this slowdown in economic activity lies in the emergence of a banking crisis which was precipitated by the collapse of the largest bank in Latvia (Bank Baltija) at the end of May 1995. The closure of Bank Baltija and the earlier failure of several smaller banks led to the freezing of more than 30 percent of private sector deposits in the Latvian banking system.

2. Supply

Data for the sectoral composition of GDP show that the performance of different sectors varied widely during 1994 (Table 2). Two of the major sectors, construction and services, grew in real terms. Services account for close to 60 percent of nominal GDP, underlining Latvia's comparative advantage in transit trade. Energy production stabilized in real terms. Production in manufacturing and, especially, in agriculture continued to decline, and now combined account for less then 30 percent of nominal GDP.

Table 2.

Latvia: Sectoral Output

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Source: Central Statistical Bureau.

a. Agriculture

Agricultural output declined further in 1994 to just under 9 percent of GDP, down from 15 percent in 1993 and over 20 percent in 1990. In real terms, agricultural production fell by almost 30 percent in 1994, after declines of 14 percent and 29 percent in the two previous years. Whereas the collapse from 1990 onwards can largely be attributed to the erosion of markets for agricultural goods in the former Soviet Union, the recent weakness primarily reflects continuing difficulties in developing new markets because of quality problems, lack of marketing experience (packaging, etc.), small farm sizes, lack of equipment in most private farms and, consequently, low productivity.

Nevertheless, privatization of the agricultural sector has continued at a relatively fast pace in 1994. Private farms in 1994 produced 68 percent of all meat, 72 percent of all cereals and almost 100 percent of all potatoes, after only accounting for, respectively, 27 percent, 7 percent, and 62 percent in 1992. Private farms now represent 75 percent of all sown area and produce 73 percent of all agricultural products (Table 3). The production gains of private farms have been, however, due to their increasing number, rather than improvements in productivity. Data on productivity per agricultural employee are still not available, but a comparison of the yields per hectare of several crops suggests that private farms are only slightly more productive than state-owned farms and that their productivity has actually decreased since 1990. For example, yields of cereals for private farms are only 6. percent higher than yields for state-owned farms and for most other product groups yields are about the same for state-owned and private farms.

Table 3.

Latvia: Agricultural Production

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Sources: Central Statistical Bureau; and staff calculations.

The reason for this development might lie in the often inefficiently small farm size (the average size of a private farm was 20 hectares in 1994) and widespread lack of equipment. On average, only every fifth private farm has a tractor and only every tenth private farm has a tractor-pulled plough. When farms are privatized, the former cooperative generally retains ownership of most machinery and other capital assets. In addition, farmers have limited access to credit, partly because of their inability to pledge land as collateral. As of end-July 1995, only 6 percent of all land in Latvia had been measured and registered.

b. Manufacturing

After substantial falls in the production of manufactured goods in the previous two years, official statistics recorded a modest decline of 4 percent in 1994. This is also reflected in the small decrease in the share of manufacturing in nominal GDP from 22 percent to 21 percent. Manufacturing appears to have turned the corner, with positive growth in real terms in the second half of 1994 and in the first quarter of 1995. Data on volume changes in industrial production are unreliable due to the incomplete coverage of new and newly privatized companies, as well as the poor quality of price deflators. Nonetheless, the data suggest that the growth in manufacturing was led by the production of textiles, paper and paper products, and chemicals, especially plastics. The turnaround in manufacturing is also evident in the developments in energy consumption, which in 1994 declined only slightly, despite higher prices and some improvements in energy efficiency.

c. Energy

The production of energy stabilized in real terms in 1994. It appears that the main power plants in Latvia were able to make some progress in improving energy efficiency in 1994, since an equal amount of energy was produced using fewer inputs of primary energy (Table 4). The consumption of coal and gas (natural and liquified) both declined by around 40 percent, while the consumption of heavy fuel oil increased by 24 percent.

Table 4.

Latvia: Energy Consumption

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Source: Latvian authorities.

d. Construction

Construction recovered substantially in 1994 and was, besides services, the engine of the moderate growth that the Latvian economy enjoyed in 1994. The share of the construction sector in nominal GDP increased by more than 2 percentage points and real growth of more than 20 percent was recorded, despite the low level of public investment. Hence, the growth in construction appears to be entirely based on private sector activities, especially the construction of private residences and tourist facilities, with only minor investments in infrastructure.

e. Services

As in previous years, the share of services in nominal GDP increased in 1994. For the first time, however, output in services also increased in real terms, by more than 8 percent. Services can be subdivided into four broad categories. First, many services which were previously discouraged, such as tourism and some forms of entertainment, are likely to have continued to increase in 1994. Second, services which have grown disproportionately in line with the transition from a centrally planned to a market economy, such as financial services, continued to show positive growth through 1994, but can be expected to slow in 1995. Third, services which are closely related to real output, such as retailing and transportation, contributed moderately to the overall increase in services in 1994, and can be expected to gain additional importance over the medium term. Finally, services provided by the Government, such as education and health care, can be expected to shrink further as these services are provided more efficiently.

III. Labor Market, Wages, and Prices

1. Labor market and wages

The slow upward trend in unemployment continued through 1994. Average unemployment increased from 4.9 percent in 1993 to 6.4 percent in 1994 (Table 5). In the first six months of 1995, unemployment remained broadly unchanged.

Table 5.

Latvia: Labor Market Indicators

(In thousands)

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Source: Central Statistical Bureau.

Defined as the full time work equivalent of working time that is reported lost due to enforced reduced hours and unpaid leave.

The proportion of long-term unemployed has continued to increase from 39 percent of all unemployed in June 1994 to over 50 percent in June 1995. This points to a steady segmentation of the labor market, in which it becomes increasingly difficult for parts of the population to find jobs. The segmentation is underlined by the large regional differences in unemployment rates. The southeastern part of Latvia near the Russian border reports unemployment rates of around 24 percent, with unemployment in individual towns of up to 40 percent, due to the closing of several large enterprises and the continuing decline in agricultural production. Unemployment in Riga, on the other hand, did not exceed 2 percent during 1994.

The proportion of the unemployed receiving unemployment benefits has remained low, at 44 percent in June 1995. The low proportion of benefit recipients is related to the relatively stringent eligibility requirements, and to the low level of benefits, which are defined as 90 percent of the minimum wage. 1/ While the minimum wage was raised in October 1994 from LVL 22.5 to LVL 28, unemployment benefits in mid-1995 were only around 25 percent of the average wage in the state sector (Table 6).

Table 6.

Latvia: Average Wages

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Sources: Latvian authorities; and staff calculations.

To be eligible for unemployment benefits an applicant must be a permanent resident of Latvia, must prove that he/she is actively looking for a job by reporting once a month to the employment office, and must have worked for six months in the previous year, with all social taxes paid. Benefits are paid by the former employer for one month, followed by six months of state-funded payments. Since January of 1994, municipalities can apply for an extension of the period in which unemployed benefits are paid from six months to twelve months, which has been granted to 105 municipalities under the condition that the unemployed participate in unpaid public works programs during the extension period. When the eligibility for unemployment benefits ends, those individuals still unemployed are eligible to receive social assistance. It is likely that the extension of the benefits period to twelve months contributed to the increase in measured long-term unemployment.

In step with the increased proportion of long-term unemployed, the public works program was extended. In 1994, 21,000 unemployed participated in the social works program for an average period of 2.5 months. In addition, retraining programs continue to be an important part of the labor market policy of the Government. During 1994, 13 percent of the recipients of unemployment benefits participated in such programs, which offer computer, accounting and other business related courses, as well as training in many trades and crafts.

Real wages underwent a prolonged period of decline in 1990-92, falling by more than 35 percent, in line with the decline in output. By mid-1995, real wages had recovered to more than 80 percent of their 1990 level (Table 6). 2/

2. Price developments

The liberalization of most prices in Latvia was completed at the end of 1992; only a few administered prices remain, including in the transport and energy sectors, as well as rents for residential apartments. Prices are administered by several different agencies. Heating prices, for example, are set by local Governments, while prices of transportation and mail services are set by the Ministry of Economy. Any time the administering agency proposes a price increase of more than 5 percent, the agency has to submit its justifications to the Anti-Monopoly Committee, whose approval is required. The Committee's decision is based on cost calculations submitted by enterprises, the ability of consumers to pay, and the level of profit of the enterprise.

Energy, i.e., electricity, gas, and heating, is the most important group of products for which prices are still administered. Prices for gas, used for purposes other than heating, appear to be based on actual costs after the 33 percent increase in April 1995. On the other hand, electricity prices, tariffs for heating and hot water, as well as tariffs for heating gas, do not make adequate provision for capital costs.

Following a sharp fall during the first two years of the stabilization program, the decline in the rate of inflation has slowed. After inflation of around 950 percent in 1992, prices rose by only 36 percent in 1993 (Chart 2, Table 7). Inflation surged in the fourth quarter of 1993, when the standard VAT rate was increased from 12 percent to 18 percent, and remained high in the first quarter of 1994. Price pressures eased during the summer months, largely on account of seasonal factors. However, inflation accelerated in the fall of 1994 and remained high through the first quarter of 1995, due to the general wage increase in budgetary organizations (granted in October), the imposition of higher import tariffs on agricultural goods, and the surge in domestic liquidity stemming from the balance of payments surplus. For 1994 as a whole, prices increased by 26 percent. Price pressures eased in mid-1995 amid the banking crisis, and the rate of inflation fell to 23 percent in the year to August 1995.

CHART 2
CHART 2

LATVIA: INFLATION IN CONSUMER PRICES

Citation: IMF Staff Country Reports 1995, 125; 10.5089/9781451824391.002.A001

Source Data provided by the latvian authorities
Table 7.

Latvia: Inflation in Consumer Prices

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Sources: Latvian authorities; and staff calculations.

Increases in administered prices, which were generally at an extremely low level at the beginning of the transition process, have contributed to recent inflation outcomes. Prices of administered goods have a weight of approximately 20 percent in the CPI and increased by about 50 percent during 1994, far above the average price growth for all other goods (less than 20 percent). Developments have been quite similar in the first six months of 1995. Administered prices grew by about 20 percent in the six months to June 1995, while prices for all other goods increased by less than 12 percent.

An additional reason for the persistence of relatively high measured inflation could be that the CPI may be a somewhat imperfect measure of inflation in a rapidly changing economy. In particular, at times of large quality improvements, the CP1 will overstate inflation, since goods would no longer be strictly homogeneous. The producer price index, which may be less affected by quality changes, lends support to the notion that underlying inflation may be somewhat lower than suggested by the CPI; this index increased by 11 percent in the year to June 1995. 1/

Table 8 shows price increases of sub-groups of goods and services, which are divided into categories which might be thought of as tradable and nontradable. These data suggest that prices of nontradables have recently risen at a substantially more rapid pace than those of tradables. A large part of recent inflation may therefore be due to the continuing adjustment of the relative price of nontradables, due to their low starting point. If productivity growth in the tradable sector exceeds that in the nontradable sector, prices in Latvia can be expected to continue to rise faster than in Latvia's major trading partners for some time to come. 2/

Table 8.

Latvia: Price Changes of Tradables and Nontradables

(Percent change)

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Sources: Latvian authorities; and staff calculations.

IV. Public Finance

l. Introduction

The sharp decline in the Latvian economy in the period from 1991 to 1993 created major problems for fiscal policy. However, through prudent policies, the authorities recorded balanced fiscal positions in 1992 and 1993. Indeed, the revenue to GDP ratio—at around 36 percent—has remained among the highest in the Baltic and CIS countries. As a result, Latvia has avoided large scale central-bank credit creation, which has occurred in many CIS countries. More recently, revenue growth has been insufficient to cover large real expenditure increases, especially on wages and pensions, and as a result, deficits have been recorded.

The primary focus in Latvia is on the government “financial deficit”, defined as revenues less expenditures. A broader measure of government financial transactions is given by the “fiscal deficit” which also includes net lending, defined as lending by the Government to the non-government sector less repayments. This broader measure includes the onlending of foreign loans contracted by the central government. Privatization receipts, which have been fairly small, are also included in net lending.

The finances of the general government in Latvia consist of the central government “basic” budget, the social budget, the local government budgets (Box 1), and a number of smaller special funds and special budgets. While the 1995 budget law included for the first time all levels of government in the calculation of a general government balance, in practice there is significant decentralization of fiscal policy. For example, in the first half of 1995, the basic budget controlled by the Ministry of Finance accounted for only 43 percent of revenues and 49 percent of expenditures at the general government level.

Local government Financing

Latvia is administratively divided into 26 regions and 7 cities. The regions are subdivided into around 560 municipalities, typically with populations of 1000 to 5000 people, with significant scope for consolidation to reduce administrative costs and improve economies of scale in service provision. In 1995, local government revenues come from three major sources: (i) revenues from taxes collected on their behalf by the central government, most notably the personal income tax; (ii) transfers from central government, mainly through the Local Budget Equalization Fund (LBEF); and (iii) own revenues from local taxes and fees. Transfers from the central government were reduced in 1995, but local governments received the entire amount of personal income tax, as opposed to around 50 percent in 1994. According to the 1995 budget, the LBEF will receive around LVL 63 million from the central government, and around LVL 12 million from the income tax revenues of the wealthier municipalities and towns. Transfers from the LBEF are based on expenditure needs reflecting factors such as the number of children and pensioners in the population of each area. Unlike in earlier years, transfers in 1995 are largely on an untied basis, with the exception of the requirement of a certain level of per capita health expenditures.

The largest of the special or extrabudgetary funds is the social budget which is managed by the Social Insurance Fund operating under the authority of the Ministry of Welfare, Labor and Health, and which accounted in the first half of 1995 for around 30 percent of general government transactions. The social budget consists of revenues from the social (or payroll) tax and expenditures on old-age pensions and other transfers including sick leave and unemployment benefits. The social budget was independent of the basic budget in 1991 and 1992, but these budgets were consolidated in 1993 and 1994, before being separated again at the start of 1995. The recent separation appears to have favored the social budget at the expense of the basic budget and permitted the social budget to increase pensions during 1995 at times when the basic budget was subject to expenditure controls. Other funds, including the road and forest funds, also receive earmarked revenues from various taxes, fees and fines.

The Treasury Department within the Ministry of Finance has now taken over all the basic functions of controlling the cash execution of the central government basic budget and all reporting and accounting responsibilities. Significant progress has also been made in the area of budgeting. Some medium-term analysis has begun, and the first steps in the preparation of the 1996 budget began earlier than in previous years. However, given the significant volatility of revenues and the limited financing capacity of the government, budget implementation is focussed on controlling expenditures to fit within available cash resources (Chart 3).

CHART 3
CHART 3

LATVIA: FISCAL DEVELOPMENTS

Citation: IMF Staff Country Reports 1995, 125; 10.5089/9781451824391.002.A001

Sources: Date provided by the Latvian authorities and staff estimates.

A Public Investment Program (PIP), managed by the Ministry of Economy, was established in late 1994 with World Bank and EU/Phare assistance. Projects eligible for the PIP include both general government projects and investments by state enterprises that are suitable for government-guaranteed official foreign financing. Expenditure on the PIP in 1995 from both domestic and foreign resources was budgeted at around 2 ½ percent of GDP, predominantly in energy, transport and the environment. Actual implementation in the first half of the year was significantly below budget.

2. Fiscal developments

a. 1994 outcome

The 1994 budget provided for a general government financial deficit of LVL 40 million, or around 2 percent of GDP, following a surplus of around 1 percent of GDP in 1993. This deficit was expected to occur entirely at the central government level; local government budgets and extrabudgetary funds were projected to be balanced. The shift into deficit reflected large increases in wages in budgetary organizations (around 25 percent), old-age pensions (around 50 percent) and other social benefits in November 1993. These higher expenditures were partly offset by increased revenues from the VAT and from the introduction of new excises on gasoline, diesel, and automobiles in November 1993. 1/

With the exception of a hiccup in the second quarter, when temporary tax deferrals were granted to some taxpayers, deficit outcomes in the first three quarters of 1994 were below budgeted levels. As a result, supplementary budgets were adopted in April and October that allowed for pension increases of around 8 ½ percent in Hay and 12 percent in November. Wages in budgetary organizations were also increased by around 24 percent in November after significant upward drift through 1994, and the minimum monthly wage was raised from LVL 15 to LVL 22.5 in April and to LVL 28 in October. The net effect of the growth in old-age pensions in late 1993 and through 1994 was that pensions rose by over 25 percent in real terms on a year-average basis in 1994. Average wages in budgetary organizations grew in real terms by around 10 percent.

The second supplementary budget provided for expenditure increases of LVL 45 million and led to fiscal pressures in the fourth quarter of 1994. However, with tight control over discretionary expenditures, the general government financial deficit was limited to LVL 15 million (2 ½ percent of quarterly GDP) in the fourth quarter, and to LVL 32 million (1 ¾ percent of GDP) for 1994 as a whole (Table 9). The central government outcome was slightly better than projected, while local governments ran a small deficit, reflecting a bank loan taken out by Riga City Council to make heating payments (Tables 10 and 11).

Table 9.

Latvia: Summary of General Government Operations

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Sources: Latvian authorities; and staff estimates.

The 1995 Budget includes around 20 special funds not previously included in the data. These boost revenues and expenditures by around 1 percent of GDP in 1995.

Excludes extrabudgetary investment in the PIP financed through net lending and other sources.

Table 10.

Latvia: Central Government Operations and Social Security

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Table 11.

Latvia: Local Government Operations

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Sources: Latvian authorities; and staff estimates.

The share of income tax revenues received by local governments was increased in 1995 and transfers from the central government were reduced accordingly.

Problems in the energy sector also contributed to a sharp increase in net lending by the central government. Around half of the total net lending of LVL 48 million (2 ¼ percent of GDP) represented loans by the central government to three public enterprises (the energy and gas companies and the Lats group of agricultural companies). The remainder of net lending included the onlending of foreign resources through the banking system and project lending by international organizations, including the World Bank and the EBRD.

The total fiscal deficit for 1994 was therefore around 4 ¼ percent of GDP, a swing of nearly 5 percent of GDP from 1993. The majority of net lending was financed by foreign loans, while the financial deficit was essentially financed through the banking system, mainly through the sale of Treasury bills. The face value of Treasury bills outstanding rose from LVL 2 million at end-1993 to LVL 30 million at end-1994 (Table 12). The Treasury bills of 28-day maturity accounted for around 30 percent of this amount, while bills of 91-day maturity accounted for the remainder. The discount rate on Treasury bills fell gradually through the year as investor interest grew, largely from banks wishing to reduce excess reserves.

Table 12.

Latvia: Treasury Bill Auctions

(Millions of lats, face value)

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Sources: Ministry of Finance; and staff calculations.

Dates refer to date of auctions rather than settlement.

b. 1995 budget and January-June 1995 outcome

The 1995 budget provided for a central government financial deficit of LVL 40 million (1 ¾ percent of GDP) and balanced budgets in local governments and the special funds. Projections indicated, however, that the achievement of the overall deficit target for the general government would require some shift in revenue and expenditures between the basic and social budgets, or the build-up of a surplus in the social budget to offset a larger deficit in the basic budget.

General government revenues were projected to rise from 36 ¼ percent of GDP in 1994 to 37 ½ percent in 1995, while expenditures were projected to increase from 38 percent of GDP to 39 ¼ percent of GDP in 1995, although these increases largely reflected the inclusion of around 20 special funds that were previously outside the budget process. Consequently, the underlying revenue to GDP ratio was budgeted to remain approximately constant. The continued strength in revenues also reflected: (i) the full-year effect of the increase in the VAT rate on food in June 1994; (ii) growth in wage-related taxes from increases in real wages; and (iii) projected improvements in tax administration in the collection of customs and excises, and the widening of excises on energy products. In the case of expenditures, growth in 1995 largely reflected the full-year effect of wage and pension increases that occurred in the fourth quarter of 1994, along with some new initiatives in priority areas including education and agriculture. A modest increase in investment was budgeted, which, together with planned extrabudgetary investment in the PIP would increase overall public investment to around 2 ½ percent of GDP. Defense expenditures were expected to remain below 1 percent of GDP.

Net lending was projected to fall significantly in 1995, being limited to the onlending of funds under the Public Investment Program to avoid loans to make up for losses in the energy companies as had occurred in 1994. As a result, the overall fiscal deficit was expected to contract from 4 ¼ percent of GDP in 1994 to around 2 ¼ percent of GDP in 1995. Apart from the foreign financing of the PIP, the deficit was expected to be financed by the sale of government securities, with a planned shift into longer maturities than the 28- and 91-day securities that had hitherto been issued.

Revenue performance in the first quarter of 1995 was below projections, resulting in a general government financial deficit of LVL 19 million (3 ½ percent of quarterly GDP), versus the projected deficit of LVL 15 million. However, more significant divergences from the budget projections became apparent early in the second quarter when the expected seasonal pick-up in revenues did not materialize. Tax arrears increased by 20 percent (LVL 31 million, or around 15 percent of actual quarterly revenues) in the second quarter, with increases in arrears on all major taxes, and tax evasion was also reported to have increased. Expenditures on discretionary items, including investment and supplies and maintenance, were cut significantly, but this was insufficient to prevent a further quarterly deficit of around LVL 19 million (3 ¼ percent of GDP). The deficit for the first half of the year, at LVL 38 million, was nearly equal to the budgeted deficit for the whole of 1995.

The weakening in revenues can be attributed primarily to three interrelated factors: (i) the banking crisis; (ii) a weakening in economic activity (Chart 1); and (iii) weak tax administration. Apart from its indirect effects on economic activity, the banking crisis is likely to have affected revenues through three channels: (i) at least LVL 6 million in government deposits were frozen in Bank Baltija and other failed banks; (ii) some taxpayers were—and some claimed to be—unable to pay taxes because of frozen current accounts in the failed banks; and (iii) bank failures have reportedly caused a shift to cash transactions which may have led to lower compliance with tax laws.

Problems in tax administration appear, however, to be the major cause of revenue weakness. There were delays in early 1995 in several planned improvements in administration, including the introduction of a national database of taxpayers with unique tax identification numbers, and the introduction of a specialist unit to monitor and audit tax payments by the largest taxpayers. There have also been personnel problems in the State Revenue Service, as reflected in the resignation of senior officials in April 1995. Administrative problems associated with the introduction of new tax laws may also have affected revenues: the profit tax was replaced by a corporate income tax in April, and a new law on the VAT formally replaced the law on the turnover tax, even though the latter had been administered as a VAT for some time.

The financing of the larger than expected deficit also became a problem in the second quarter as banks reduced their Treasury bill purchases on account of liquidity problems and the lack of flexibility in the cut-off discount rate in weekly securities auctions. Between early March and early July, the face value of the outstanding stock of Treasury bills fell from LVL 58 million to LVL 24 million, with interest in the 91-day and the new 182-day securities virtually disappearing.

Commercial banks partly offset the rundown in their Treasury bill holdings by increasing direct lending to the government in the second quarter. These short maturity loans did not suffer from the perceived lack of liquidity of Treasury bills, which banks attributed to the very limited participation by the Bank of Latvia in the secondary market. In net terms, however, commercial banks significantly reduced their credit to the government, and the government fully drew down its credit line with the Bank of Latvia. 1/ Faced with financing pressure, the government negotiated a LVL 20 million increase in its credit line in May, to be repaid by November 1995.

The deficit for 1995 is projected to be higher than budgeted, given the larger-than-expected deficit in the first half of 1995 and the decisions to increase pensions by around 7 percent from July 1 and to begin compensation to depositors of failed banks. Deposit compensation of LVL 500 per depositor was planned, with budget constraints limiting the initial payment in 1995 to LVL 200 per depositor, with a further LVL 100 per year over the next three years. The budgetary cost would be LVL 23 million (1 percent of GDP) in 1995, and would total around LVL 55 million over three years. A supplementary budget providing for deposit compensation was submitted to Parliament in August. The revised deficit would be around LVL 90 million (3 ¾ percent of GDP); including net lending, the fiscal deficit would amount to 4 ½ percent of GDP.

3. Revenue structure

There have been major changes to tax legislation in Latvia in recent years, including the passage of a package of laws and amendments in late 1994 and early 1995 (see Appendix I for a description of the tax system as of June 30, 1995). The aim of this legislation has been the implementation of a tax system appropriate for a market economy and consistent with Latvia's plans for membership in the European Union. The tax package included an umbrella law that authorizes the imposition of taxes and fees, and provides for a broad range of penalties, including significant fines, and the seizure of bank accounts, cash, goods and property. Cash transactions over a certain size are forbidden, and new regulations allow for presumptive taxation, including the power to impose higher taxes based on surveys of businesses. Banks must now transfer tax payments to the state budget within one day or pay high fines.

Taxes on goods and services include the VAT, excise taxes, and customs taxes. With the exception of excise taxes which are shared with the road fund (gasoline) and a special health budget (alcohol), these accrue entirely to the central government budget. VAT revenues were around 9 percent of GDP in the first half of 1995, a significant increase from 5 ½ percent of GDP in 1993 before the increases in VAT rates. The tax base for the VAT is relatively broad by international standards, and now covers the services of public utilities.

Revenues from customs, mainly from import tariffs, were less than 1 percent of GDP in the first half of 1995. Revenues from this source have been essentially flat in nominal terms for about two years and have underperformed budget projections in this period. Latvian borders are reportedly extremely porous, and there is little control over goods in transit. Shortages of equipment, including weighing scales at some border posts, hinder administration.

Excise revenues, which were equivalent to around 2 percent of GDP in the first half of 1995, are primarily from excises on gasoline, diesel and alcohol. The tax bases for excises on gasoline and diesel were recently broadened to cover substitute products. A recent study based on automobile usage suggests tax evasion of around 30-40 percent of potential revenues, primarily due to poor border control. Evasion of excises on alcohol and tobacco is also high, but should be reduced by the recent introduction of tax stamps on these products. The excise on gasoline, at around 17 percent of the pump price (or 8 U.S. cents per liter), has been unchanged for nearly two years and is low compared with Western European rates.

Taxes on income include the corporate and personal income taxes and the social tax. The personal income tax yielded around 5 percent of GDP in the first half of 1995. A flat rate of 25 percent applies to personal income after standard deductions, with a 10 percent surtax on higher incomes. The low yield of this tax by international standards reflects: (i) the relatively low rate structure; (ii) relatively generous deductions for taxpayers and their dependents; and (iii) exemptions for pensions and agricultural income.

The corporate income tax, which replaced the profit tax in 1995, yielded only 2 percent of GDP in the first half of 1995, down from nearly 4 percent of GDP in 1994. The decline of this tax over time may in part reflect the gradual weakening of the links between public enterprises and the central government: tax payments in the past may have had a “negotiated” aspect. Other factors include: (i) increases in real wages which have reduced profits; (ii) falls in the profitability of the re-export of raw materials from Russia and other FSU countries; and (iii) generous tax holidays to businesses with foreign capital which encourage domestic residents to make investments via offshore companies. Such tax holidays have been curtailed under the new corporate income tax law.

Revenues from the social tax were around 11 ¼ percent of GDP in the first half of 1995, a yield similar to that of recent years. While there are different rates for different industries, the standard tax rate of 38 percent (paid mainly by the employer) is higher than in Lithuania and Estonia which have rates of 31 and 33 percent, respectively. Since an individual's pension payments are unrelated to previous social tax payments, there is little incentive for individuals to ensure that the correct social tax payments are made on their behalf, and many employers do not contribute, or pay social taxes only on the minimum wage.

The majority of taxes, including those accruing to the local governments, are collected by the State Revenue Service which was formed in April 1994, following the merger of the State Finance Inspection Board and the Customs Department. Social tax revenues are collected by a separate tax administration in the Social Insurance Fund. As noted above, tax administration appears to have weakened recently. While the new umbrella tax law allows for harsh penalties, there have apparently been few instances of the prosecution of wrongdoers. The collection of identified tax liabilities is also weak, with tax arrears increasing across all major taxes in 1995. Official tax deferrals account for a relatively small proportion of this increase. The majority of large debtors are state enterprises.

4. Expenditure structure

A comparison of the pattern of expenditures in Latvia and other countries suggests a number of noteworthy points (Table 13). In terms of economic classification, expenditures in Latvia are dominated by payments of wages, old-age pensions and other transfer payments. Spending on these categories, which is high by international standards, accounted for around two-thirds of general government expenditure in the first half of 1995 or around 26 percent of GDP, up from around 23 ½ percent of GDP in 1993. Expenditures on investment and interest are lower than in most other countries. At the functional level, expenditures on health, education, and social security and welfare are relatively high by international standards.

Table 13.

Latvia: Government Expenditure for Selected Countries 1/

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Sources: Latvian authorities; “Unproductive Public Expenditures”, Pamphlet No. 48, Fiscal Affairs Department, IMF, 1995; and staff estimates.

For Latvia, includes both central and local government. Data for other countries are for 1983–90. The sums of components do not necessarily equal the totals because some minor components are not shown and because of classification differences.

Weighted average of Australia, Canada, Denmark, Germany, Israel, Luxembourg, United Kingdom, and United States.

Weighted average of Argentina, Chile, Hungary, Panama, Romania, Swaziland, and Zimbabwe.

Weighted average of India, Indonesia, and Malawi.

Includes “other government services”, interest, and unclassified expenditures.

General government employment in Latvia is quite high by international standards. For example, Latvia has around 70 general government employees per 1000 population which is close to the average in OECD countries, but far above the average levels of lower income countries. 1/ Latvia's relatively high level may be explained in part by its high degree of public sector provision in some sectors—e.g., health, education and agriculture—relative to many other countries (Box 2). Wages in budgetary organizations are linked to an official wage scale that was last increased in late 1994. There has, however, been significant drift in budgetary organization wages, due in part to the decision in late 1994 to grant a staggered 41 percent increase to teachers, following strikes to correct perceived problems in wage relativities.

Expenditures on health and education

Due to the high level of budgetary expenditures on wages in Latvia there has been considerable discussion about reform in health and education. Latvia has a very high number of doctors, at around 3.4 doctors per thousand population, compared with an average of 2.5 per thousand in industrial countries. Budget financing provides for relatively low salaries, though actual salaries may be higher through reallocation of expenditures in hospitals and the widespread practice in budgetary organizations of requesting budget wage funding for more positions than there are employees. The number of hospital beds is also very high at around 12 per 1000 population, and the average length of hospital stay is around twice the average for the Nordic countries. These indicators suggest that there is scope for reform in health care. One aspect of this reform is the introduction of patient fees to reduce unnecessary hospitalization and allow closure of institutions. From August 1995, medical establishments are able to charge (and retain) up to 25 percent of the cost of treatment, which in hospitals is estimated at LVL 8-12 per patient-day. Hospital charges had previously been limited to LVL 0.45 per day (LVL 0.05 for pensioners and children) or less than US$1 per day.

Education expenditures are also high by international standards. The central government is responsible for the provision of higher education and vocational training, while local governments provide pre-school to secondary general education. The salaries of teachers in local schools are paid by the central government while local governments finance all other costs of general education. Elementary and secondary education are free, while fees are charged for pre-school education, meals and transportation. Between 1990 and 1993 there were falls in the number of students in all forms of education, from kindergarten to tertiary, as the population declined. In the same period, however, there were increases in the number of both teachers and schools at the comprehensive and tertiary level.

Interest expenditures were around 1 percent of GDP in the first half of 1995. While nominal interest rates are relatively high in Latvia, the stock of debt is still small. This stock includes Treasury bills and credit from the Bank of Latvia, but the major component is around LVL 63 million (2 ½ percent of GDP) of bonds issued, mainly in 1994, in conjunction with the restructuring of the two state-owned banks, the Universal Bank of Latvia and the Latvian Savings Bank. These nontradable bonds carry maturities of up to 7 years.

Expenditures on investment are low, in part because of compression of “discretionary” expenditures in recent years due to the large expenditure increases on wages and transfers. Budgetary investment expenditures were around ¾ percent of GDP in the first half of 1995, down from a little over 1 percent in 1993 and 1994. Indeed, investment expenditures have been below budgeted amounts each year since 1993. Non-budgetary investment under the Public Investment Program will supplement budgetary investment in 1995, but this component is also expected to be below planned amounts. Expenditures on supplies and maintenance have also been cut sharply in 1995 and in recent years.

5. Social security and the social safety net

Social expenditures in Latvia include various types of social security benefits (including old-age, disability and survivors pensions), unemployment and retraining benefits, family benefits (including child-care benefits, family allowances, maternity leave and birth grants) and social assistance for low-income residents (Tables 14 and 15). In total, these cost around 16 percent of GDP in the first half of 1995. With the exception of social assistance, all these benefits are paid by the central government, though in some cases benefits are disbursed by enterprises which withhold a corresponding amount of social taxes.

Table 14.

Latvia: Pension System

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Sources: Ministry of Labor, Welfare and Health; and staff estimates.

Budget estimate; does not include the effect of pension increases in 1995.

From 1995. all pensions except social pension are paid by the social budget rather than by the basic budget.

Heating allowance in 1993 is not included in calculation of average pensions.

Table 15.

Latvia: Family Benefits

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Sources: Ministry of Labor, Welfare and Health; and staff estimates.

Estimate at time of approval of budget.

In 1995, the majority of expenditures are to be paid from the social budget, the exceptions being family allowances, child-care benefits, maternity leave and social pensions (pensions to people with no work history) which are paid by the basic budget. Expenditures on these items by the basic budget was budgeted at around LVL 43 million in 1995. These payments were not considered to be insurance-related and were therefore not transferred to the social budget; this allocation is one reason why the financial situation of the social budget was better than the basic budget in 1995.

The major social expenditure item is the old-age pension. The current old-age pension system provides almost universal coverage from age 55 for women and 60 for men, with earlier retirement ages for certain categories of individuals. The current formula, introduced in late 1993, provides for a base pension of 30 percent of the average wage, with an increase of 0.4 percent of the average wage for each year of work history up to a maximum of 38 years. Actual pensions in mid-1995 were somewhat below what would be implied by the formula because the general budgetary situation has not allowed all indexation increases that the formula would accommodate. Pensions remain untaxed.

The affordability of the current pension system is threatened in the long term by the ageing population and in the short term by weak tax administration. In particular, individual pensions are not linked to social tax payments, so individuals have little incentive to ensure that the correct social tax payment is made on their behalf, and there has been a significant increase in the ratio of pensioners to contributors in recent years. In July 1995, a major package of legislation was introduced into Parliament that would significantly overhaul the social security system including old-age pensions and sickness, disability, maternity, unemployment and funeral benefits (Box 3). The aim of the proposed reforms is to ensure the continued affordability of a social security system and to move toward a funded insurance system that links individual benefits more closely to prior contributions, thus reducing labor market distortions.

Family allowances are the major categorical benefit. These are paid on a per-child basis and were budgeted to cost around 1 ¼ percent of GDP in 1995. The nominal value of these has been held fixed for some time. The elimination of this benefit was planned, but subsequently rejected, at the start of 1994 when tax deductions for children were introduced in the personal income tax law.

Expenditures on unemployment benefits and retraining were budgeted at around LVL 19 million in 1995 (¾ percent of GDP). Actual spending will most likely be somewhat lower due to the lower-than-expected number of registered unemployed and the low ratio of these who receive benefits.

Social assistance in Latvia in 1995 is mainly administered by local governments and financed out of own revenues and untied transfers from the central government, as opposed to previous years when the central government provided matching grants. Because of differences in revenue capacity in different areas, there are great differences in both the thresholds for receiving means-tested benefits and the amounts paid in benefits. Social benefits are typically paid in “tied” form rather than in cash, and include heating allowances, assistance in kind, food coupons and free school lunches. The difficulty in assessing the need for such expenditures is exacerbated by the lack of measures of poverty, though differential unemployment rates would suggest large differences in poverty rates. Beginning in August 1995, a new household survey of 8,000 households by the Central Statistical Bureau (with the support of the World Bank and UNDP) is expected to provide information that will assist in the design of an improved social safety net.

V. Monetary Developments

1. Monetary and exchange rate policies

Exchange rate stability has been the main goal of monetary policy in Latvia, with the lats pegged to the SDR since February 1994. Under these circumstances, the behavior of monetary aggregates during 1994 was largely determined by developments in the foreign exchange market; velocity continued the downward trend observed since late 1992, reflecting increased confidence in the lats (Chart 4). After cumulative net purchases of nearly US$300 million in 1993, the Bank of Latvia became a net seller of foreign exchange during the first quarter of 1994 (Chart 5). Large inflows of foreign exchange to the Bank of Latvia resumed in the second half of the year, however, and by end-December gross official reserves had increased by over US$100 million vis-à-vis their end-1993 level, reaching US$626 million.

CHART 4
CHART 4

LATVIA: VELOCITY OF BROAD MONEY 1/

Citation: IMF Staff Country Reports 1995, 125; 10.5089/9781451824391.002.A001

Source: Data provided by the Latvian authorities.1/ Nominal GDP divided by end-of-period broad money (including foreign exchange deposits).
CHART 5
CHART 5

LATVIA: NET PURCHASES OF FOREIGN EXCHANGE BY THE BANK OF LATVIA

(Cumulative, in millions of US$)

Citation: IMF Staff Country Reports 1995, 125; 10.5089/9781451824391.002.A001

Source: Bonk of Latvia.

Social insurance reform

The proposed pension reform calls for the replacement over time of the current “pay as you go” system by a three-tier system that has been designed with World Bank assistance. The first tier would provide a modest level of benefits related in part to contribution history, but with a minimum government-provided pension to protect the lifetime poor. The second tier would be a mandatory, funded system of privately managed savings accounts. The third tier would be a voluntary, funded system for those who wished to save for higher retirement incomes.

The exact nature of the new system will be unclear until the relevant legislation is passed by Parliament. However, it is expected that implementation would begin in 1996 with the first tier. From 1996, social tax payments on behalf of all employees would be credited to individual accounts which will accrue interest in line with average wage growth. Upon retirement, annual pensions would be calculated as the accumulated balance divided by the average post-retirement life expectancy. Benefits would be indexed in line with price (rather than wage) growth. The second tier would not be introduced before 1998, to ensure that capital market development in Latvia has progressed sufficiently so that there will be sufficient assets for the investment of the funded component.

It has been proposed that the social tax rate would be unified for all employees at 38 percent, and that around half the tax payment will be made by the employee. Since the majority of the social tax payment would be attributed to the retirement account of individual employees who may regard it more as savings than as a tax, it is expected that this will lead to a significant reduction in evasion of social tax payments.

The minimum pensionable retirement age would be unchanged for men at 60, but would increase for women from 55 to 56 in 1996, and by half a year each calendar year until it reaches 60. While earlier proposals for a gradual increase in the retirement age to 65 have not been accepted, it is expected that many people will work past the minimum retirement age since the new pension formula will ensure a significantly higher pension for those who work longer: the previous formula had only very small increases with each year of work history and in practice provided no incentive to work past the minimum retirement age. This will have a beneficial effect on the budget, because these workers will continue to pay income tax and because part of the social tax payments are used to fund benefits other than pensions.

The proposed legislation would also reform other benefits. Sick leave benefits would be reformed from the current government-funded system to make the individual responsible for the first day and the employer for the remainder of the first two weeks, at which point the social budget would take over payments, which would be based in part on previous social tax payments. In addition, benefits would be limited to 80 percent of average earnings, rather than 100 percent as before.

Unemployment benefits would also be reformed to provide a greater link to individual contributions. Benefits would shift from a system with benefits set at 70 or 90 percent of the minimum wage to an insurance benefit of 50 percent of the previous wage, with an extra 5 percent for each 5 years of employment history. In addition, to provide an incentive for job search there would be gradual cuts to benefits after three and six months, with their elimination after nine months (at which time social assistance might become available).

In view of the fixed exchange rate policy and its limited use of market-based monetary instruments, the Bank of Latvia did not mop up the liquidity generated through the balance of payments. Having ruled out a nominal appreciation of the lats, the Bank of Latvia's strategy in 1994 was to accommodate higher monetary growth and to continue to run a tight credit policy, both by restricting refinance credits and by keeping credit to the Government within the negotiated amounts under the credit line agreement. In the event, reserve money increased by 20 percent in 1994, which represented a 5 percent decline in real terms (Table 16). Broad money, however, rose by almost 50 percent during the year, or 18 percent in real terms (Table 17). The sharp increase in the multiplier was the result of the build-up of the Treasury-bill market (Box 4), which led to a marked reduction in banks' excess reserves during the year. The reserve/deposit ratio declined from 23 percent in December 1993 to 12 percent in December 1994, due to increased purchases of Treasury bills by commercial banks and, to a lesser extent, to changes in the reserve requirement later in the year (Section 3). The currency/deposit ratio remained high in 1994, at around 45 percent (Chart 6).

CHART 6
CHART 6

LATVIA: MONEY MULTIPLIER AND BANK RESERVES

Citation: IMF Staff Country Reports 1995, 125; 10.5089/9781451824391.002.A001

Sources Bank of latvia and staff calculations.
Table 16.

Latvia: Reserve Money and Net Domestic Assets of the Bank or Latvia

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