1. On July 16, after the issuance of the staff report (SM/99/168, 07/12/99), a new government headed by Mr. Skele (a two-time former prime minister) was approved by the Latvian parliament. The formation of the new government followed the resignation of Prime Minister Kristopans and the collapse of the ruling coalition. The new government, in contrast to the previous one, contains the largest party and controls a large majority in parliament, suggesting that political stability may be enhanced. The composition of the new government gives reason to expect that the general policy direction of fiscal consolidation and progress on structural reform will continue. The government aims to take immediate steps to contain the fiscal deficit in 1999 and to seek further consolidation in 2000 after which a balanced budget will be maintained, to keep inflation in the 2-4 percent range, to continue to ensure the stability of the lats, and to complete privatization within one year. In particular, the new government plans to present a supplementary budget for 1999 to parliament already in the next few weeks, incorporating substantial expenditure cuts, although it is too early to tell if this goes beyond achieving the original target deficit. Furthermore, the government has expressed its clear desire to move as quickly as possible on a successor stand-by arrangement, and a mission has been scheduled for early September. The staff appraisal remains valid.

2. Macroeconomic developments continue to reflect the impact of the Russian crisis. Real GDP contracted by 2.3 percent in the first quarter on an annual basis and data on industrial production suggest that the contraction has continued in the second quarter; should final data confirm this, growth projections would need to be revisited. Consumer price inflation remained unchanged at 1.9 percent (12-month rate) in June compared with May while producer price deflation accelerated to 5.2 percent.

3. Updated balance-of-payments data suggest that the current account deficit amounted to US$87 million or about 5 percent of GDP in the first quarter, some US$50 million larger than preliminary estimates. However, large errors and omissions illustrate the continued difficulties with the balance of payments statistics and the need for further improvement in this area. End-June gross official reserves stood at US$1,007 million or 3 months of imports, some US$30 million less than projected reflecting in part a reevaluation of the price of gold.

4. As to fiscal developments, tax revenues improved marginally in the second quarter; nominal revenues from consumption taxes were 3.9 percent lower than a year earlier, compared with a 9.8 percent decline in the first quarter. On the expenditure side, the category transfers to households (unemployment benefits and pensions) recorded the highest increase compared with the previous year. The government continued to restrain discretionary spending, especially investment and net lending, both of which remained well below budget. As a result, despite the disappointing revenue performance, the authorities were able to limit the consolidated central and local government deficit to about LVL69 million excluding privatization receipts or 3.7 percent of projected six-month GDP.

5. Monetary developments continue to show signs of a return to stability and most monetary aggregates, with the exception of net foreign assets of commercial banks, are now back at their pre-crisis levels. Reserve money and broad money grew by 3.2 percent and 4.6 percent, respectively, in June while nongovernment credit rose by 0.9 percent. The average risk-weighted capital adequacy ratio for the banking system stood at 16 percent at end-June, down from 18 percent at end-March. The rehabilitation plan for the Rigas KomercBanka remains under consideration and medium-sized depositors are now being asked to convert their deposits into capital If the required capital cannot be obtained by mid-August, legal proceedings for liquidating the bank will be initiated.