A. Introduction

1. When Latvia regained independence in 1991, the government embarked on a comprehensive program of transformation, from a centrally-planned to a market-based economy. The authorities moved ahead quickly in liberalizing the economy: domestic prices were almost completely freed; external trade and the exchange system were virtually fully liberalized; and small- and medium-scale privatization proceeded rapidly. The first phase of the transformation is now largely complete; market forces determine prices and external trade, and a relatively stable macroeconomic environment has been achieved. Real GDP is estimated to have declined by some 50 percent between 1990 and 1993, caused by the incipient restructuring of the economy, the loss of export markets following the breakdown of COMECON, and large relative price changes. At the same time, price deregulation, adjustment of administered prices, and elimination of the monetary overhang contributed to a surge in inflation, which reached some 960 percent (12-month basis) in December 1992. The external current account registered surpluses in the early independence years, reflecting weak domestic demand and the external financing constraint.

2. Since 1994, the economy has been recovering from the initial shock at the beginning of the decade, although a deteriorating fiscal situation and a banking crisis undermined public confidence and led to a temporary pause in 1995. Inflation has, however, continued to decelerate. The current account has moved into increasing deficits, but large capital inflows (except in the period surrounding the banking crisis), have resulted in balance of payments surpluses and a build-up of gross foreign exchange reserves. Recently, the pace of structural reform has lagged being the progress achieved in macroeconomic stabilization. However, the new government is firmly committed to completing the second phase of the structural reform agenda, in particular accelerating large-scale privatization, reforming the legal framework, and simplifying and strengthening enforcement laws and regulations.

3. The rest of this chapter reviews economic developments and policies in Latvia in 1995–96; developments during this period have been dominated by the after-effects of the fiscal slippage in 1994 and the banking crisis in 1995, although there are signs of a recovery from these adverse episodes.¹ The subsequent chapters provide more in-depth analysis of selected economic issues facing Latvia: Chapter II analyzes the environment for private-sector development; Chapter III reviews interest rate developments, focussing in particular on the treasury bill market; and Chapter IV discusses interlinkages between inflation, external competitiveness, and the credibility of the authorities’ anti-inflation policies. Statistical tables are included in Appendix I.

B. Domestic Economy

4. Real GDP was unchanged from 1994 to 1995. The stagnation in economic growth was due to the effects on private consumption and investment from a loss of confidence caused by the banking crisis, as well as by a weaker external position. While growth in domestic demand stood at 2½ percent in 1995, a worsening of the external balance—caused mainly by strong import growth—withdrew 2½ percentage points from GDP growth. The strongest sectoral growth rates in 1995 were registered in services and construction.

5. Indications are that the economic recovery has resumed in late 1995. Real GDP in the first two quarters of 1996 was 1½ percent higher than in the corresponding period of 1995. Domestic demand has remained weak, as the confidence effects of the banking crisis continue to have an impact on private consumption and investment. On the other hand, net foreign demand has turned around, reflecting an improvement in volume terms in the external accounts. The upturn in economic activity in 1996 has been concentrated in the services sectors, and in particular in transit trade.

6. In the period since the lats was pegged to the SDR in February 1994, the rate of inflation has continued to decline, albeit at a more modest pace than before. Inflation (12-month rate) declined from 26 percent in December 1994 to 23 percent in December 1995, and further to 16 percent in October 1996. Indications are that inflation in the period of the SDR peg has reflected in part the continuing adjustment of Latvia’s price level toward that of its western trading partners. In addition, in 1995 inflation was spurred by a surge in liquidity (stemming from balance of payments surpluses in late 1994) and large public sector wage increases. Adjustments in administered prices and in excise taxes also added to inflation in 1995 and 1996.

7. In the period up to 1994, as real GDP declined, Latvia experienced a considerable increase in open unemployment. Since then, however, the rate of open unemployment has changed little. The key reasons that registered unemployment has remained broadly unchanged are that the decline in economic activity has stopped, that the unemployment benefits are limited in amounts and stringent eligibility criteria apply, and that some public works programs have been implemented. However, given the extensive job creation in the parallel economy, the official data might overstate the extent of unemployment.

8. Following a precipitous real wage decline in the early part of transition, some real wage recovery has taken place since. Wages were increased sharply in late 1994, but subsequently nominal wages have changed little, and real wages have been eroded by the continuing inflation. Nominal wages in the state sector increased by 27½ percent in 1995, corresponding to a real increase of 2 percent. In 1996 (through September), wages have increased by 12 percent in nominal terms and declined by 6 percent in real terms.

C. Balance of Payments

9. The current account deficit widened to 3½ percent of GDP in 1995 from 2½ percent of GDP in 1994. Exports continued to grow strongly in 1995, but were outpaced by a surge in imports. Preliminary data for the first half of 1996 indicate that, mainly as a result of a terms of trade loss due to a sharp drop in prices of wood exports and a continued increase in imports, the current account deficit reached almost 3 percent of annual GDP. Indications are that the strong import growth in 1995–96 to a large extent reflected purchases of capital goods. While the trade balance has been moving further into deficit in 1995–96, this-has been offset in part by a stronger balance on nonfactor services. The trade balance registered deficits of US$580 million (12 percent of GDP) in 1995 and US$418 million (8 percent of annual GDP) in the first half of 1996. At the same time, the services balance (including the income and transfers balance) recorded surpluses of US$414 million in 1995 and US$268 million in the first half of 1996. Net transport revenues—mainly of shipping and railroad enterprises—generated almost all of the recorded surpluses in services.

10. The banking crisis led to large capital outflows beginning in the spring of 1995. Gross international reserves declined from the equivalent of 4½ months of imports at end-1994 to about 2½ months in mid-1995. However, as it became evident that measures were being taken to address the banking problems (see section F below) and interest rates were allowed to increase, capital flows turned around; for 1995 as a whole, there was a net capital inflow. At the end of 1995, gross international reserves of the Bank of Latvia stood at about three months of imports of goods and nonfactor services. In the first half of 1996, capital inflows more than offset the current account deficit, resulting in an overall balance of payments surplus and a further increase in official international reserves, maintaining the coverage of three months of imports. While there is a lack of firm data on capital flows, indications are that the capital inflows in 1996 were related to: (i) residents’ draw-down of savings held abroad; (ii) repatriation of capital to increase commercial banks’ capital base; (iii) portfolio investments by foreigners; and (iv) increased direct investment. Given the initial starting point and limited recourse to external borrowing, external debt disbursed and outstanding stood at US$423 million, or 9 percent of GDP, at end-1995, and increased to US$435 million, or 9 percent of GDP, at end-June 1996. External debt service increased from 3 percent of exports of goods and nonfactor services in 1995 to 5 percent in the first half of 1996.

11. The ongoing restructuring of the export sector, in particular in the wood product, textile, and chemical industries, has led to continued strong growth in Latvia’s exports to the West. The share of exports to countries outside the Baltics, Russia, and other countries of the former Soviet Union increased from 50 percent in 1994 to 62 percent in 1995. In the first half of 1996, however, mainly because of the sharp decline in the price of wood exports, the share of exports to countries outside the Baltics, Russia, and other countries of the former Soviet Union declined to 56 percent. Germany, Sweden, the United Kingdom, and Finland are Latvia’s largest export markets in Europe. The share of exports to Germany in relation to total Latvian exports to countries outside the Baltics, Russia and other countries of the former Soviet Union, increased from 18½ percent in 1994 to 25½ percent in the first half of 1996. In the same period, the share of exports to Sweden increased from 12 percent to 17½ percent. Compared to 1994, the distribution of Latvia’s exports to the Baltics, Russia and other countries of the former Soviet Union in 1995 and in the first half of 1996 changed in favor of the other Baltic countries. The share of Russia declined from 55 percent of exports in 1994 to 51 percent in the first half of 1996. The main suppliers of imports to Latvia outside the Baltics, Russia, and other countries of the former Soviet Union are Germany, Finland, and Sweden, while among the Baltics, Russia, and the former Soviet Union, Russia remains the dominant supplier.

12. The commodity composition of Latvian exports shifted in 1995 away from rail/tram vehicles and parts, base metals, and base metal products toward wood products and food processing. The share of wood products in total exports rose from 20 percent in 1994 to 26½ percent in 1995. However, due to the sharp decline in prices of wood exports in the first half of 1996, the share of exports of wood and wood products declined by 2 percentage points compared to 1995. As a result of increased investment in the food and drink industries, the share of food drink, and tobacco exports increased from 9 percent in 1994 to 13 percent in the first half of 1996. Latvia’s main imports are energy (mineral products) and machinery and electrical equipment.

D. Fiscal Policy

13. In the initial years of transition, fiscal policy was tightened gradually. Indeed, the general government fiscal balance ² recorded a surplus of ½ percent of GDP in 1993. This tightening was helped by the fact that Latvia was able to avoid the precipitous government revenue decline observed in many other transition economies. Indirect taxes (VAT and excise taxes) stand for a large share of total tax revenue, as does the social tax collected by the Social Insurance Fund. The expenditure side of the budget is dominated by current spending, of which wages and salaries (10 percent of GDP in 1995) and transfers to households (16 percent of GDP) are important components; investment spending has remained fairly low. Latvia has made good progress in establishing the institutions needed for fiscal management in a market economy; important among these are a well-functioning treasury system that has been set up for central government operations, a Public Investment Program (which is being overseen by the Ministry of Economy), and a tax system geared toward the needs of a market-based economy.³

14. Fiscal policy turned expansionary in 1994, with the fiscal balance moving to a deficit of 4 percent of GDP, reflecting increases in net lending and other expenditure; a major share of the increased net lending was directed to the energy sector. The financial deficit turned from a surplus in 1993 to a deficit of 1.7 percent of GDP in 1994. In 1995, the fiscal problems were exacerbated by the banking crisis, which had both a direct and indirect effects on revenue collection. Total revenue fell by about 1 percentage point of GDP to 35½ percent of GDP in 1995, and the financial deficit widened further to 2.7 percent of GDP. Meanwhile, expenditure excluding net lending remained at about 38 percent of GDP. Nevertheless, as a result of a major compression of net lending, the overall fiscal deficit was reduced by ½ percent of GDP to 3½ percent in 1995.

15. The 1996 budget aimed to reign in fiscal policy through a major revenue mobilization effort combined with expenditure restraint; the fiscal deficit was targeted at 2 percent of GDP. In the first half of 1996, budgetary developments were in line with the annual targets set out in the budget. Indeed, at 35½ percent of GDP, revenue exceeded the target, notwithstanding some increase in recorded tax arrears (this increase was caused in part by better tax inspections which revealed additional tax liabilities). Expenditure was compressed to 37½ percent of GDP in the first half of 1996, reflecting lower spending on maintenance and investment. Overall, the financial deficit was reduced to 1½ percent of GDP and the fiscal deficit to 2 percent of GDP in January-June 1996.

16. The banking crisis in 1995 and the fiscal slippage in 1994 have had lingering effects on the financing of the government deficit. Specifically, from 1994 to 1995, the share of the domestic borrowing requirement covered by banks increased from 75 percent to 82 percent. To an important extent, this reflected a temporary increase in central bank lending to the government. In the first half of 1996, in contrast, the share of bank financing fell to 55 percent, reflecting increased reliance on the treasury bill market.

E. Monetary and Exchange Rate Policy

17. Since the introduction of the national currency, the lats, in 1993, the Bank of Latvia has maintained a restrained monetary policy stance. During 1993, the lats was floating, and was allowed to appreciate in nominal terms. Since the lats was pegged to the SDR in February 1994, monetary policy—including interest rate policy—has been geared toward maintaining the exchange rate peg and safeguarding the balance of payments position. The Bank of Latvia has a range of monetary policy instruments at its disposal. These instruments include reserve requirements for commercial banks, repurchase auctions, a refinance facility for overnight loans, and auctions of central bank deposits. Also, the treasury bill market offers scope for open market operations. In practice, the Bank of Latvia has made limited use of these instruments, and monetary developments since February 1994 have reflected mainly balance of payments movements. The money market in Latvia remains underdeveloped, in part because of the wide differences in individual banks’ financial condition, which acts to hamper normal interbank transactions and therefore the pass-through of monetary policy operations. As a result, the key interest rate at the central bank—the repurchase rate—functions primarily as a signal rate. However, in 1996 activity in the money market has increased appreciably; the daily average turnover in the market increased five fold between the beginning of the year and September.

18. Monetary developments in 1995 were dominated by the erosion of confidence caused by the banking crisis. Reflecting the closure of several banks, broad money declined by almost 20 percent in 1995, or by 35 percent in real terms, and domestic bank credit fell by 33 percent, or 45 percent in real terms. The banking problems, together with the fiscal slippage, contributed to a sharp temporary increase in interest rates. Interest rates on treasury bills increased from about 20 percent in March 1995 to a peak of about 40 percent in October 1995. Subsequently, there was a steep drop to about 12 percent in April 1996. Since then, treasury bill rates have continued on a downward trend.

19. Monetary developments in 1996 have reflected the slow restoration of confidence in the banking system, as well as large capital inflows. Reserve money grew by 24 percent in the 12-month period ended September 1996, most of which was due to unsterilized central bank intervention in the foreign exchange market. Net international reserves of the Bank of Latvia rose by some US$135 million during the first nine months of 1996. However, the strong expansion in reserve money did not lead to a concomitant increase in commercial bank credit and deposits. There were two key reasons for this. First, the public continued to hold a large share of their monetary assets in the form of currency rather than deposits. Second, the banks did not utilize their increased holdings of reserves (which have been well in excess of the required bank reserves) to extend credit.⁴ In effect, bank credit to the nongovernment sector fell by 6 percent in nominal terms over the first nine months of 1996. There are several factors explaining the weakness in bank credit. First, stricter prudential standards and their enforcement have made banks more reluctant to lend. Second, the legal and institutional foundations for a well-functioning credit market are still being developed; these foundations include bankruptcy legislation, registers for land and other collateral, and transparent business regulations. Taking into account the decline in inflation and the balance of payments surplus, as well as the low demand for credit, the Bank of Latvia lowered its refinance rate in several steps, from 24 percent at end-1995 to 10 percent in October 1996; meanwhile, bank lending and deposit rates fell correspondingly.

F. Banking Sector

20. The Latvian banking system is recovering from the crisis in 1995, which erupted with the closure of several banks, including the largest single bank. The Bank of Latvia has acted decisively to deal with the banking problems, through the following measures: (i) adoption of tighter prudential standards;⁵ (ii) stepped-up monitoring of banks through on-site inspections and increased use of external auditors; (iii) closing of banks that are not in compliance with prudential standards; (iv) restriction of the right to accept household deposits to so-called “core banks” subject to enhanced scrutiny; and (v) adoption of international accounting standards and quarterly reporting of accounts by all banks. The restructuring of the two banks in which the government retains ownership interests, the State Savings Bank and Unibank, has moved forward. The State Savings Bank is carrying out a program to cut costs and rationalize operations (including through closure of branches). Options for privatization of the State Savings Bank are under consideration within the government. Unibank has received capital injection from the EBRD and Swedfund as strategic investors, and is now 67 percent privately owned.

21. Overall, indications are that the authorities’ efforts have helped strengthen the banking system. Although confidence is seemingly being restored only slowly, there are several positive signs. First, bank capital increased somewhat (by 15 percent) from end-1995 to mid-1996. Second, total bank assets is recovering, and by mid-1996 had almost reached the pre- crisis level. Third, banks’ lending practices have become more cautious, in light of the recent experience as well as the stricter prudential regulations. Fourth, the number of banks in operation fell from 51 in June 1995 to 36 in June 1996; of the commercial banks in operation in June 1996, 12 were classified as “core banks.”⁶ Fifth, the number of “problem banks” (kept under special watch) declined from 38 in June 1995 to 27 in June 1996. Finally, as of June 1996, all banks except 5 were in compliance with the minimum capital requirement and all but 4 with the capital adequacy ratio.

G. Trade Policy⁷

22. Latvia’s external trade system is virtually fully liberalized. Import tariff rates are generally low, ranging from 1 percent on raw materials and inputs to 20 percent on nonagricultural imports (basic rates) and about one-fourth of imports is covered by free-trade agreements. The main exception to the liberal trade system is that agricultural imports are strongly protected, with an average production-weighted tariff rate of 53 percent. In addition, some minor specific tariffs and import quotas apply to selected imports, import and export tariff quotas are in place (these are consistent with Latvia’s international agreements), and a few selected goods are subject to export taxes.

H. Energy Sector

23. Latvia’s energy needs are still being met by the public sector; electricity is supplied by Latvenergo, gas by Latvija Gaze, and heating and hot water by local government companies. The authorities’ policy to improve the financial operations of the sector has been aimed at measures to enforce payments by energy customers, supplemented by cost-recovery pricing. Payments enforcement has concentrated on cutting off supply to delinquent customers and establishing payment schedules for customers in arrears. These efforts have helped bring about a gradual decline in electricity and gas arrears since early 1995. However, due to a less stringent collection policy by the local governments, payments arrears relating to heating and hot water have continued on an upward trend in absolute terms. Total customer arrears for electricity, gas, and heating/hot water declined from a peak of 8 percent of GDP in March 1995 to 6 percent of GDP in September 1996. Preparations for partial privatization of both Latvenergo and Latvija Gaze are at an advanced stage, and it is expected that increased private ownership will help bring about more fundamental improvements in the energy sector’s operations.

I. Privatization

24. In the early years of transition, Latvia privatized a large proportion of the smaller-scale enterprises through a voucher scheme. Privatization moved to a new stage in 1995–96, due to the adoption of significant changes in the legal framework. In the area of enterprise privatization, the government has approved nearly all enterprises for privatization. Privatization of large strategic enterprises, including energy companies, are now in process. However, the adoption of privatization plans has been held up, primarily by a slow approval process.

25. Apartment privatization has continued to move slowly, due to the time-consuming and complicated privatization process, the problems encountered with restitution conflicts, as well as the fact that rents continue to be artificially low (which makes purchasing flats unattractive). The government has attempted to address some of these problems by streamlining the process through computerization, and the authorities are reviewing incentives for municipalities to part with apartments under their auspices. Finally, the government is streamlining the land purchase and registration process, including through computerization.

J. Legal and Institutional Reform

26. Latvia has moved decisively forward in the area of legal reform in 1995–96. Most of the legal changes have been aimed at facilitating the development of the private sector and making the legal environment more conducive to foreign participation in the transition process. First, the privatization process was effectively opened up to foreign investment through a series of amendments to the privatization law adopted at the beginning of 1996. In particular, foreigners were granted the right to buy privatization vouchers directly, thereby allowing them to participate in most privatization.⁸ Second, many legal restrictions on land ownership have been or are in the process of being removed. Investors from countries which have signed bilateral investment agreements can now buy land under enterprises and agricultural land; currently, approximately 20 countries have such agreements. This right is in the process of being extended to all countries. At the same time, certain strategic sectors, such as wood export products, still have some restrictions on majority share ownership by foreigners. Third, a new bankruptcy law was passed in September 1996 and became effective in November 1996.

K. Role of the International Monetary Fund

27. The IMF has supported Latvia through financial and technical assistance. Financial assistance has been provided in the context of two stand-by arrangements (SBAs). The first SBA was approved in September 1992, was in an amount of SDR 55 million, and was fully disbursed. The second SBA was approved in December 1993, and was in an amount of SDR 23 million of which SDR 9 million has been disbursed. Subsequently, two precautionary SBAs have been approved, the first in April 1995 in an amount of SDR 27 million and the second in April 1996 in an amount of SDR 30 million; no disbursements have taken place under either of these arrangements. Latvia has also made drawings under the Structural Transformation Facility (STF). IMF technical assistance has been provided in a broad range of areas, relating to statistics, monetary policy, prudential supervision of the financial system, government budget management, and legal reforms.