Latvia
Selected Issues and Statistical Appendix
Author: International Monetary Fund
Publication Date:
17 Aug 2000
eISBN:
9781451824490
Language:
English
Keywords:
ISCR; CR; gross domestic product; local government; central government; private sector; broad money; capital formation; economic development; balance of payments; insolvent company
Download PDF (2.9 MB)

Developments and prospects of nonbank financial institutions of Latvia have been presented in this paper. Foreign direct investment (FDI) inflows to Latvia have declined compared with their earlier levels. This poses an important policy challenge owing to benefits of FDI in terms of financing the current account deficit, contributing to capital formation, productivity, and exports. This paper also discusses the role of the Latvian Privatization Agency (LPA) in the privatization of Latvia's public enterprises and property, along with statistical data on economic indices of Latvia.

Abstract

Developments and prospects of nonbank financial institutions of Latvia have been presented in this paper. Foreign direct investment (FDI) inflows to Latvia have declined compared with their earlier levels. This poses an important policy challenge owing to benefits of FDI in terms of financing the current account deficit, contributing to capital formation, productivity, and exports. This paper also discusses the role of the Latvian Privatization Agency (LPA) in the privatization of Latvia's public enterprises and property, along with statistical data on economic indices of Latvia.

Latvia: Basic Data

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Sources: Latvian authorities; and Fund staff estimates.

I. Introduction

1. The past year has seen Latvia emerge from a recession brought on by the Russian crisis of August 1998. Following three consecutive quarters of negative growth, the Latvian economy grew by 3 percent in the fourth quarter of 1999 and appears to have picked up steam in the first half of 2000.1 Exports have rebounded sharply from their depressed level following the dramatic depreciation of the ruble in late 1998 and the subsequent collapse in import demand in the CIS. In the first quarter of 2000, total merchandise exports rose by 14 percent over the same period of the previous year and—despite the weakness in the euro—exports to the EU increased by 17 percent. Private sector credit growth has recovered as well, growing by a healthy 14 percent in the fourth quarter of 1999 and the first quarter of 2000. Aided by the incipient economic recovery, and consequent improved revenue performance, the fiscal deficit was contained to just over 1 percent of GDP in the first quarter of the year.

2. The ability of the Latvian economy to weather the impact of this large external shock reflects the sound economic policies that have been pursued throughout the transition period. In particular, the long-standing commitment to macroeconomic stability enabled it to survive the economic downturn without a serious challenge to its exchange rate regime. Further, a thorough program of structural reform had largely succeeded in creating a flexible market economy in Latvia, allowing a relatively shallow recession and quick economic recovery.

3. At the same time, however, the Russian crisis brought into focus several remaining weaknesses in the Latvian economy. In particular, the substantial exposure of the banking system to Russia led, in the aftermath of the crisis, to the closure of three small banks, the suspension of operations of the fifth largest bank (which has since resumed operations under foreign ownership), and a significant reduction in financial intermediation. While the Bank of Latvia (BoL) has subsequently taken appropriate action to strengthen banking sector oversight and bring the prudential framework closely in line with international norms, the health of the financial sector remains a subject for continued close monitoring.

4. In addition, the disappointing export performance in 1999—which contributed importantly to the large current account deficit of nearly 10 percent of GDP—points to the importance of completing the structural reform program. In particular, difficulties encountered in diversifying export products and markets to compensate for diminished opportunities in the CIS suggest that further restructuring on the level of both the economy and individual enterprises may well be required. At the same time, the decline in the last two years in FDI flows, from the very high level of 1997, underlines the need to privatize the remaining large state-owned enterprises and continue efforts to enhance the business climate.

5. In this context, the following chapters examine several of the key policy issues facing Latvia:

  • Chapter II reviews developments in the nonbank financial sector and examines potential policy issues. While the BoL’s prudential standards for banking sector regulation are now largely in line with international standards, oversight of nonbank financial institutions is far less developed. This will likely become an increasingly important issue, in particular as private pension plans develop in the context of ongoing pension reform,2 and as Latvia moves toward unified financial sector supervision, scheduled to begin in mid-2001.

  • Chapter III describes trends in foreign direct investment (FDI) over the transition period, examines its impact on the Latvian economy, and discusses prospects for future FDI. While FDI in Latvia has been quite strong overall, and has had a positive impact on economic performance, the level of FDI has declined in the last two years; in 1999, FDI financed about 60 percent of the current account deficit compared with 180 percent in 1997. Given the sizable current account deficits expected over the next several years, it is imperative that Latvia takes measures to ensure that it continues to attract substantial FDI. In that context, the authorities aim inter alia to complete privatization and remove unnecessary impediments to investment.

  • Chapter IV reviews the process of privatization to date and, in particular, the role of the Latvian Privatization Agency (LPA). It is argued that privatization has been generally successful and the process efficient and transparent, although the LPA has engaged in certain activities that would have been better left for budgetary institutions or the private sector. It is particularly important, as Latvia moves now to privatizing the large public utilities, that the process remains efficient and transparent to ensure public support and to generate the largest possible gains for the country.

II. Developments and Prospects of Nonbank Financial Institutions

A. Introduction

6. While much attention has been devoted in recent years to the Latvian banking system, other players in Latvia’s financial sector have received little attention. This was largely due to the fact that non-bank financial institutions (NBFIs) have only recently begun to play a more important role in mobilizing and intermediating savings, thereby complementing, and at times competing with, the role played by commercial banks and forcing them to be more efficient and responsive to market demands.

7. While there is no uniformly accepted definition of NBFIs, their common characteristic is that they mobilize savings and facilitate the financing of different activities, but do not accept deposits from the public at large. NBFIs, therefore, are often defined to comprise insurance companies, leasing companies, private pension funds, and nonbank credit institutions, with the latter usually only accepting deposits from their members. Their relative importance and development is often assessed against financial intermediation by commercial banks and the state of development of capital markets.

8. The slow emergence of NBFIs in Latvia since the mid-1990s is largely in line with international experience in that NBFIs usually only emerge to a noticeable extent once the financial system has reached a certain degree of development and maturity. In fact, the state of development of NBFIs is often used as an indicator for the state of development of the financial system as a whole. In the case of Latvia, the emergence of NBFIs has been somewhat delayed compared to other transition economies in Central and Eastern Europe, in particular neighboring Estonia, as two major banking crises in 1995 and 1998 may have impaired the public’s acceptance of these new forms of financial intermediation. But the impact of the Russian crisis was also quite noticeable and slowed the growth of NBFIs in the second half of 1998 and the first half of 1999.

9. Nevertheless, there is no doubt that the nonbank financial sector has taken off in Latvia, and there are clear indications that NBFIs will undergo a similarly rapid development as in neighboring Estonia, where especially leasing operations have expanded buoyantly. It should be noted though that the Latvian insurance market is already outpacing the Estonian one. The challenge for the Latvian authorities is to ensure that (i) the growth of NBFIs develops in an orderly fashion; (ii) an appropriate legal and regulatory framework is put in place to reduce potential vulnerabilities; and (iii) possible obstacles to their development and their ability to play a useful role in fostering financial intermediation and resource allocation be removed.

10. This chapter focuses on the role of NBFIs in Latvia over the last few years, with a view to assessing their development, relative importance, and prospects in the run-up to EU accession, as well as the legal and regulatory framework governing their business conduct and supervision. The latter is important with respect to the implications on the creation and setup of the Unified Financial Sector Supervision Agency, which is to become operational in July 2001. While existing vulnerabilities will be mentioned, it should be noted that this chapter is only intended to provide a preliminary overview of the nonbank financial sector, and the analysis will be fine-tuned and deepened in the context of the Financial System Stability Assessment (FSSA) for Latvia, which is currently planned for early 2001.

B. Development of Nonbank Financial Institutions—An Overview

11. The growth of NBFIs has outpaced the growth of commercial banks over the last two years, albeit starting from a very low base. Notwithstanding the economic slowdown and crisis in the banking system triggered by the Russian crisis, combined assets of the nonbank financial sector rose by more than two-thirds from below 4 percent of GDP at end-1997 to 6½ percent of GDP at end-1999 (Table 1). This compares to growth in the banking system’s domestic assets by about one third, from 22½ percent of GDP at end-1997 to 30 percent of GDP at end-1999, which is still quite rapid given the circumstances.3 4 In general, most players in the NBFI markets are either affiliated with major commercial banks or foreign-owned and -managed. It should be noted that NBFIs taken together have surpassed the stock market capitalization at the Riga Stock Exchange (RSE) at end-1999. Overall, their rapid growth notwithstanding, NBFIs are still too small to create significant vulnerabilities for their owners or the economy at large, but it is nevertheless important to ensure that such vulnerabilities do not arise in the future.

Table 1.

Latvia: Growth of the Nonbank Financial Sector

(In percent of GDP)

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Sources: Bank of Latvia; Latvian Leasing Association, Insurance Supervision Inspectorate, Riga Stock Exchange; and Fund staff estimates.

12. Leasing companies have expanded their market share particularly rapidly, with a more than doubling of their assets within only two years. Based on evidence from more advanced leasing markets in other transition economies (such as Estonia), their exponential growth can be expected to continue unabated for several years before slowing to more sustainable growth rates once the stock adjustment effect dissipates. By contrast, insurance companies’ premia have risen relatively slowly, as the concept of life insurance has not yet taken off in Latvia, which is similar to the experience of other transition economies. This likely reflects the attitude of a large share of the public that private insurance is not needed for something that the state provides for through the public pension system, namely adequate retirement income and support of surviving widows and orphans. The prospects for life insurance policies are likely to be further impaired by the rapidly emerging private pension funds which since their formalization in late 1998 have grown quite impressively; the potential for further expansion by the latter is promising in that they are assigned a crucial role under the pension reform being undertaken in Latvia.5 Finally, credit unions, while quintupling their assets within the last five years, are still of marginal importance in Latvia, and although they play a pivotal role in providing financing to their members in markets currently underserved by commercial banks, their overall size will remain relatively small.

Leasing

13. While the leasing market in Latvia has expanded rapidly over the last few years, its size relative to the Estonian leasing market is still quite small, lagging its development by two or three years. In addition, the market has been marked by a noticeable consolidation, with the number of companies reporting to the Latvian Leasing Association (which covers companies accounting for more than 90 percent of all assets) having fallen from 17 at end-1997 to 11 at end-1999. Most players are affiliated with a commercial bank, accounting for more than 95 percent of the leasing market, with the two largest leasing companies owned by two major banks having a market share of 74 percent. To the extent that commercial banks own leasing companies, the BoL supervises them as a result of the recent introduction of supervision of banks on a consolidated basis. Other leasing companies—with a market share of less than 5 percent—are not subject to any direct supervision by government authorities but are subject to the standard laws underlying private contracts.

14. The leasing industry is marked by very stable customer relationships, with many leasing companies working with a set circle of partners, which also translates into a high degree of specialization. About 90 percent of leasing companies’ assets are related to contracts with corporate customers, while households account for the remainder, mainly for consumption articles, such as cars. Concentration in terms of leased products is high, which could lead to increased vulnerability in the event the economy slows, defaults rise, and seized assets prove difficult to recover and sell: as of end-1999, about 45 percent of the leasing portfolio was for vehicles, 18 percent for machinery and equipment, and 12 percent for real estate, while factoring—the assignment of accounts receivable from customers—accounted for about 13 percent. The term structure of leasing contracts is focussed on medium-term maturities, in line with the term structure on bank loans: 19 percent of contracts are up to one year, 40 percent between 1 and 3 years, 25 percent between 3 to 5 years, and the remainder for long-term leases with maturities exceeding 5 years.

Insurance Companies

15. The insurance density (insurance premia in percent of GDP) in Latvia, at about 2½ percent of GDP at end-1999, is still significantly below the level of EU countries (where it generally ranges between 5 and 7 percent of GDP) but above the level observed in other transition economies of similar income, such as Estonia and Lithuania. Based on premia collected, life insurance companies account for only about one-tenth of the insurance market, with a slightly declining trend, indicating that this form of insurance has not yet achieved a high level of acceptance by the Latvian public. At end-1999, there were eight life insurance companies and 19 non-life insurance companies operating in Latvia, down from nine and 21 companies, respectively, at end-1998, as three licenses were withdrawn during the year. This decline is part of an overall trend of consolidation which has been going on in the insurance market—contrary to the banking sector—and led to the reduction in the number of insurance companies from 42 in 1995 to 27 at end-1999. All such companies are privately owned, with 19 of them having major foreign ownership, mostly from Scandinavia, Germany, Switzerland, and the U.S., and accounting for about 40 percent of the capital of Latvian insurance companies at end-1999. Concentration in the market is relatively high, with the five largest players representing about three-fifths of the non-life insurance premia in 1999, although with a declining trend (1997: 66 percent), which is a sign of the increasingly competitive market environment.

16. Insurance premium growth, at about 8½ percent in 1999, slowed markedly compared to the 31 percent growth in 1998, reflecting both the impact of the economic recession but also a certain degree of market satisfaction. At the same time, claims have increased substantially, by close to 50 percent in 1999, and equaled about one-third of insurance companies’ investments.

17. Investments by insurance companies reached LVL 70 million in 1999 (1.9 percent of GDP), of which about one-third came from life insurance companies. The share of investment undertaken in Latvia rose from about 70 percent at end-1998 to about 85 percent at end-1999, which is surprisingly high in view of the very lenient restrictions on investment abroad, compared to the restrictions applying to private pension funds (see below).6 However, the losses related to the holdings of securities from Russia and other CIS countries—such securities represented about 10 percent of all investments prior to the onset of the crisis—may have contributed on this renewed focus on investment in Latvia. At end-1999, about two-fifths of all investment consisted of bank deposits and cash, also surprisingly high by international standards, while Latvian stocks accounted for 22 percent of the investments of life-insurance companies and only 12 percent of non-life insurance companies, with Latvian bonds representing 23 percent and 17 percent of investments, respectively. It should be noted, however, that the shares of investment in the Latvian securities market have been increasing noticeably lately.

18. The Laws on Insurance Companies and their Supervision and on Insurance Contract, which were adopted in September 1998, strengthened the legal foundation of the Insurance Supervision Inspectorate (ISI) in charge of supervision of all insurance companies and private pension funds. Both laws also removed most of the major areas of non-compliance with EU directives, which was also confirmed by an outside evaluation by the EU. Nevertheless, some remaining obstacles still need to be addressed, most importantly the current restriction on foreign insurance companies establishing branches in Latvia; foreign insurers can currently provide services in Latvia only through the establishment of a joint-stock company.

Private Pension Funds

19. Following the enactment of the Law on Pension Funds in July 1998, Latvia has begun to move toward a three-tier pension system that will comprise (i) the pay-as-you-go pension; (ii) the newly created mandatory, fully-funded second pension pillar; and, (iii) as a third pillar, the voluntary pension funds. As of end-May 2000, licenses to operate four private pension funds have been granted, two of which are majority-owned by private banks and one by a major insurance company. The fourth private pension fund is a closed fund managed by an Estonian brokerage company for the employees of Lattelekom, the Latvian telecommunications company. While these private pension funds only started operations in mid-1999, their assets have already reached about one-third the level of life insurance company premia (Table 1).

20. Private pension funds are licensed and supervised by the ISI. The Law on Pension Funds currently imposes a limit of 15 percent for investments abroad—much tighter than the limits on insurance companies. This was intended to help foster the development of Latvian capital markets but may prove overly restrictive over time, with an undesirable impact on returns and risk of pension investments, in particular if the funds continue to grow much more rapidly than the Latvian capital markets. Management of the investment of the capital accumulated in the pension fund can only be assigned to banks, life insurance companies, investment companies, and brokerage houses licensed by the Securities Markets Commission (SMC) to perform brokerage activities in the securities markets.

Credit Unions

21. Credit unions in Latvia differ from banks in that they are only entitled to take deposits from their members. They are also subject to less lenient regulatory and supervisory standards. The principal goal of credit union activities is to satisfy the economic and household needs of the credit union members by issuing credit and taking deposits. Currently, eleven credit unions are operating in Latvia, with eight of them conducting business in rural areas (Table 2). While their total assets have more than quintupled over the last three years or so, they are still quite small relative to the size of the economy. Concentration is quite high: the assets of the biggest credit union alone account for three-fourth of the total assets of all credit unions.

Table 2.

Latvia: Credit Unions, 1996-2000

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Source: Bank of Latvia

22. Credit unions are supervised by the Bank of Latvia, based on the Law on Credit Institutions and the Law on Cooperative Societies which govern the foundation, operations, organisation, and liquidation of credit unions. The former law stipulates that credit unions may be established by natural persons that live in the same civil parish or city or are employees of companies and institutions located in the administrative territory of the same municipality. The minimum foundation capital of credit unions is LVL 2000.

C. Regulatory and Other Issues

23. The Latvian financial sector has been evolving quickly over the last few years, and the vulnerability of its largest component, the banking sector, was displayed during the banking crisis triggered by the Russian crisis. While these problems have been appropriately addressed by the Latvian authorities by enhancing banking supervision and bringing the prudential framework in line with international standards,7 the authorities are only beginning to set an adequate framework for the rapidly growing non-bank financial sector. While the expansion of NBFIs has, admittedly, been from a low base, there are two main areas of vulnerabilities that need to be addressed: (i) the regulation and supervision of NBFIs’activities; and (ii) the stability of their funding and investment decisions, which is increasingly becoming foreign and could be a drag on Latvia’s capital account and increase its volatility.8

Regulatory and Supervisory Framework

24. As stated above, regulation and supervision of activities of NBFIs has been spread between two different institutions: (i) the Bank of Latvia, which supervises credit unions and is also in charge of leasing companies owned by commercial banks; and (ii) the ISI, which is in charge of supervising insurance companies and the newly emerging private pension funds. In addition, the SMC, whose main task is the supervision of brokerage firms, investment companies, and other securities market professional specialists and intermediaries, is involved in monitoring the activities of NBFIs to the extent that such activities do have an impact on Latvia’s securities markets. Finally, some very small players in the rapidly growing leasing market are not subject to any specific supervision of their activities by government institutions, but are subject to the laws underlying private contracts.

25. This segmentation of supervision, which is compounded by the limited scope for exchanging information between the various supervisory bodies due to existing restrictive secrecy laws, may lead to the emergence of financial instruments or activities that are intended to take advantage of these regulatory gaps or deficiencies. Further, the recent considerable strengthening of banking sector regulation may contribute to the growth of NBFIs, as financial intermediaries seek ways to undertake more risky activities.

26. Against this background, the Latvian authorities decided to adopt an integrated approach to supervision encompassing the entire scope of the financial and capital markets by merging the existing three supervisory bodies into a consolidated supervisory agency. The law to create the Unified Financial Sector Supervisory Agency was adopted in early June 2000 and the agency is to become operational by July 1, 2001. Apart from enhancing the quality of all supervisory staff to the standards currently set by BoL staff and reaping cost savings as a result of economies of scale, the unified agency is expected to reduce the current regulatory loopholes and facilitate the supervision of financial conglomerates (which operate diverse groups of financial institutions, such as banking, securities, and insurance) with a view to deriving an overall risk assessment of the supervised institutions on a consolidated basis.9

27. However, in spite of the authorities’ laudable efforts, a few vulnerabilities remain. Some NBFIs, mainly independent leasing companies, will continue to fall “in between the cracks” and not be subject to any supervision, although their market share is currently negligible. In addition, given the high concentration of leasing contracts on specific sectors (such as cars and machinery), leasing companies could be particularly vulnerable to a slowdown of the economy as default rates may rise and seized assets may be difficult to sell, which may affect the financial well-being of the parent company, usually a bank. As to insurance companies, the withdrawal of several licenses in 1999 points to some problems in the sector that require the authorities’ heightened attention. The same holds true for the surge in insurance claims in 1999, which together with the high investment in low-yielding bank deposits and the high operating costs, is not conducive to a strengthening of the financial situation of the sector.

28. Overall, the speed with which the market for NBFIs has been expanding over the last two or three years, coupled with the few remaining regulatory deficiencies and the authorities’ current preoccupation with reorganizing the supervisory institutional setup, translate into a heightened vulnerability which needs to be carefully monitored, especially in the near future. Nevertheless, as pointed out at the outset, the nonbank financial sector is still small relative to the size of the economy, and any difficulties that may arise should only have a limited impact on the parent company and the economy at large.

Impact on Capital Account

29. The nonbank financial sector has also, as of yet, had only a limited impact on the balance of payments, or specifically the capital account. However, it can be expected that—with NBFIs beginning to play an increasingly large role in the mobilization of savings and the provision of financing in the years to come—such impact could become more noticeable.

30. This holds particularly true for private pension funds and insurance companies, where a significant unused market potential is evident if measured against their prevalence in the EU. A particularly large catch-up can be expected in the case of private pension funds, with the pension reform undertaken by the Latvian authorities expected to provide additional impetus. While the expected strong growth rates for private pension funds may initially undermine the growth potential of life insurance companies, their growth may, over time, boost the marketing of life insurance contracts as well by helping overcome the engrained mindset that the public pension system will sufficiently provide for an adequate standard of living during retirement or to the survivors of an insured person.

31. These developments would make the Latvian market for insurances and private pension funds even more interesting for foreign investors—which by that time will be likely to also benefit from the EU-mandated removal of the currently still existing barriers of entry—tending to increase foreign direct investment. On the other hand, the rising insurance premia and contributions to private pension funds will increase the search for profitable investment opportunities, which—given the still limited size of Latvian capital markets—may lead to a rising outflow of capital and a rising exposure to market developments abroad.

32. Finally, the currently very restrictive limits for private pension funds on investing abroad may overstretch the availability of investment options in Latvia if growth of private pension funds continues at the current pace—or even accelerates. A loosening of the current investment restrictions may then become necessary and lead to increased investments abroad.

III. Foreign Direct Investment in Latvia

A. Introduction

33. Foreign direct investment (FDI) in Latvia has been large relative to CIS and emerging markets, and has played a crucial role in financing the current account deficit, enhancing productivity, and promoting exports to new markets. The main challenge facing Latvia now is to continue to attract a high level of FDI independent of the privatization process, which is expected to be largely completed within the next year or so. While macroeconomic stability, a highly skilled labor force, a stable tax system, and overall progress in economic reform and in the EU accession process provide a great potential for FDI in Latvia, there remain important obstacles that continue to pose a challenge.

B. Trends in FDI in Latvia

Overall Trends in FDI10

34. Latvia’s performance with regard to FDI has been excellent, although annual FDI has declined from the unusually high level reached in 1997. In that year, FDI inflows reached about US$520 million, more than double their level two years earlier and about 40 percent higher than their levels in 1999 (Table 3). In per capita terms, FDI in Latvia in 1997 was the highest among the Baltic, CIS and Central European states (Table 4). Accumulated FDI in per capita terms in Latvia was fourth in size within this group of countries through 1998, outperformed only by Hungary, the Czech Republic, and Estonia. As a percent of GDP, FDI in Latvia was almost double that in any other country in the group in 1997, and was outperformed only by Estonia and Lithuania in 1998.

Table 3.

Latvia: Foreign Direct Investment, 1995-99

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Source: Balance of Payments of Latvia, Quarterly Bulletin, Central Statistical Bureau of Latvia; and Fund staff estimates.
Table 4.

Latvia: FDI Inflow Per Capita and as a Percentage of GDP in Selected East European, Baltic and European CIS Countries, 1997-98

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Source: Economic Commission for Europe, Economic Survey of Europe, 1999 No. 1, United Nations, New York and Geneva 1999.

35. As in most other countries in transition, large inflows of FDI were associated with the privatization of large state-owned companies.11 This was particularly the case in 1997 and 1998, when receipts of the Latvian Privatization Agency (LPA) reached about US$100 million per year, or some 20-30 percent of total FDI.12 Overall, for the period 1994-98, foreign investors purchased some US$150 million in privatized enterprises and properties from the LPA, and took over approximately an additional US$250 million in liabilities; the sum of these is equal to about one-fourth of total FDI during that period. Despite the importance of privatization for FDI, Latvia has been able more recently to sustain still sizable amounts of FDI in the absence of large privatizations, including through FDI to previously privatized enterprises. In this regard, it is worth noting that foreign investors in privatized firms had, through 1998, committed themselves to about $135 million in subsequent investment.

Structure of FDI by Sector

36. Those sectors attracting the largest share of FDI have changed over time, reflecting both the evolution of the economy away from a focus on agriculture and toward the services sector, and the impact of the privatization process. In 1992-93, FDI was largely directed to agriculture, food processing, construction and retail trade. By the mid-1990s more than 40 percent of accumulated FDI had flowed into the transport and communication sector, due in a large part to the privatization of Lattelekom, and another approximately 20 percent each into financial sector and manufacturing, including textiles, chemicals, and metals (Table 5 and Figure 1). Over the last several years, the most rapidly growing sectors in terms of FDI have been retail trade and real estate. For the transition period as a whole, the transport and communication sector has attracted the most FDI, about 25 percent of the total, followed by the financial sector (19 percent), manufacturing (17 percent), and retail trade (16 percent).

Table 5.

Latvia: Accumulated Foreign Direct Investment by Kind of Activity, 1995-99

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Source: Investment in Latvia, Quarterly Bulletin, Central Statistical Bureau of Latvia.

FDI by Source Country

37. The sources of FDI to Latvia has changed as well over the transition, with the EU and other Baltic countries playing an increasingly important role, and Russia and the CIS becoming less active. About 70 percent of accumulated FDI in Latvia in 1999 came from the industrial countries, including 59 percent from the EU, up from about 54 percent in 1995 (Table 6 and Figure 1). Within the EU, the largest accumulated investment has come from Denmark and Germany, although FDI from Sweden, the UK, and Finland have grown quite rapidly over the past five years. The share of FDI from the US has remained roughly constant, at about 10 percent of the total. Nearly 6 percent of total FDI came from the other Baltic states, primarily Estonia, in 1999, compared with just ½ percent five years earlier. Meanwhile, the share of Russia in total FDI has declined sharply, from almost 19 percent in 1995 to 7 percent in 1999.

Figure 1.
Figure 1.

Latvia: FDI by Activity and by Country of Origin, 1995-99

Citation: IMF Staff Country Reports 2000, 100; 10.5089/9781451824490.002.A001

Source: Investment in Latvia, Quarterly Bulletin, Central Statistical Bureau of Latvia.
Table 6.

Latvia: Accumulated Foreign Direct Investment by Country of Origin, 1995-99

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Source: Investment in Latvia, Quarterly Bulletin, Central Statistical Bureau of Latvia.

C. Observed Benefits from FDI

Current Account Deficit Financing

38. Foreign direct investment in Latvia has contributed in an extremely important way to external viability in Latvia, financing an average of 95 percent of the current account deficit in the four years since 1996. While FDI typically contributes to higher current account deficits due to the subsequent increased imports of investment goods, high levels of FDI can be regarded as extremely positive not only because FDI is non-debt creating, but also because any increase in imports is likely to be more than compensated for in the future due to the generally high efficiency of FDI projects in generating exports and substituting for imports (see below). In addition, a considerable part of FDI does not lead to more imports, but rather is spent to acquire domestic assets and to pay for domestic investment, wages and other operational costs. The ratio of FDI financing to the current account deficit is therefore an important indicator of external sustainability. This ratio peaked in Latvia at the exceptionally high level of almost 180 percent in 1997, before declining to about 50 percent and 60 percent in 1998 and 1999, respectively, which are broadly in line with other reforming transition economies (Table 7 and Figure 2).

Figure 2.
Figure 2.

FDI as a Percentage of Current Account Deficit in Selected East European and Baltic Countries, 1997-99 1/

Citation: IMF Staff Country Reports 2000, 100; 10.5089/9781451824490.002.A001

Source: International Financial Statistics.1/ Current account is expressed as a positive number.
Table 7.

Latvia: FDI Inflow as a Percentage of Current Account Balance in Selected East European, Baltic and CIS Countries, 1997-99

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Source: International Financial Statistics, IMF.

FDI and Exports

39. Foreign-owned companies in Latvia tend to be more export-oriented than domestic firms, as is generally the case in transition economies.13 In particular, while accounting for 39 percent of total sales, foreign companies were responsible for 53 percent of all Latvian exports in 1998 (Tables 8 and 9). Furthermore, the share of foreign firms in total exports has been on the rise from about 40 percent in 1996. Moreover, the ratio of the share in total exports to the share in total sales has increased for foreign-owned companies over 1996-98, from 1.18 to 1.37, suggesting that the relative export orientation of foreign firms compared with domestic companies has increased over this period.

Table 8.

Latvia: Export Share of FDI Companies by Sector, 1996-99

(In percent)

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Source: Central Statistical Bureau of Latvia.
Table 9.

Latvia: Share of FDI Companies in Total Sales and Employment by Sector, 1996-98

(In percent)

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Source: Central Statistical Bureau of Latvia.

40. The increasing importance of foreign-owned firms in Latvia’s exports appears to reflect both their relative effectiveness in generating such exports as well as the fact that FDI has been attracted precisely to those sectors with the greatest export potential. The increase in foreign firms’ share of exports has been driven mainly by a rise in their share of exports in the dynamic manufacturing industries—including food and beverages, textiles, chemicals, and mining. Meanwhile, the share of foreign enterprises in the exports of machinery as well as agricultural, forestry, and fishing—declining sectors in Latvia—fell during the same period. This provides indirect evidence as well regarding the importance of FDI in the restructuring of the Latvian economy; FDI appears to have helped ensure that resources are reallocated to their most efficient use.

FDI and Productivity

41. The favorable export performance of FDI companies partly reflects their relatively high productivity. While these companies accounted for about 24 percent of total employment in 1998, they were responsible for almost 40 percent of total sales. This productivity difference was consistent across all sectors, with the exception of the financial sector, and was particularly dramatic in transport and communication, where the largest FDI has taken place.

42. On average, labor productivity in FDI companies was double its level in domestic companies (Table 10). Again this difference was consistent across sectors, other than finance, and was especially large in transport and communications. This greater productivity was reflected in the fact that salaries in foreign companies was nearly 60 percent higher than those in domestic companies in1998, and this difference had grown considerably since 1996 (Table 11). The higher labor productivity is consistent with the greater degree of capital intensity in foreign-owned firms; overall fixed assets per worker in the foreign-owned sector were almost double that of domestic enterprises (Table 12). Despite this higher capital intensity, the efficiency of capital is also higher than the domestic sector (Table 13).

Table 10.

Latvia: Labor Productivity by Sector, 1996-98

(In lats per employee)

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Source: Central Statistical Bureau of Latvia.
Table 11.

Latvia: Annual Average Salaries, 1996-98

(In lats)

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Source: Central Statistical Bureau of Latvia.
Table 12.

Latvia: Fixed Assets per Worker, 1996-98

(In lats per employee)

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Source: Central Statistical Bureau of Latvia.
Table 13.

Latvia: Economic Performance Indicators, 1996-98

(In lats per employee, unless otherwise indicated)

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Source: Central Statistical Bureau of Latvia.

D. Promoting FDI

Obstacles to Investment

43. While Latvia has been successful in attracting FDI, important obstacles to continued growth of foreign and domestic investment remain. According to a 1998 study by the Foreign Investment Advisory Service (FIAS) of the World Bank14 and a survey conducted by the LDA in cooperation with EU/Phare in 1999,15 the three major general administrative barriers that hinder business as identified by respondents were corruption, excessive bureaucracy, and difficulty in obtaining long-term credit in LVL at a reasonable interest rate. Four specific barriers that adversely affected the every day management of business as identified by the majority of correspondents were the lack of a customer-oriented approach in government institutions, unpredictable action by government officials, insufficient communication between government agencies and levels of government, and lack of information on procedures. As to the different aspects of conducting business, important problems noted by respondents were inconsistency in customs processing of cargo, the lengthy periods needed to prepare for and process property registration, and the difficult and nontransparent procedures required to process construction permits and obtain work and residence permits.

Policy Recommendations and Action

44. Based on the FIAS report and the LDA/Phare Survey, in May 1999 the Latvian authorities approved an action plan and began to introduce measures to improve the business climate and eliminate barriers to investment. In addition, an LDA/Phare project to improve the business environment was established, working with representative of the different cities and districts of Latvia. Furthermore, a foreign investors council was also created to incorporate the views of these investors. In February 2000, the Government approved the recommendations of that council as a part of a combined action plan to improve the business environment.16

45. Several significant steps have been taken to combat the lack of transparency in government and other barriers to investment, but progress in some areas has proved more difficult than anticipated. A Corruption Prevention Council, comprising a number of key ministers, has been established and a Corruption Prevention Program has been approved by government. Administrative barriers—a potential breeding ground for corruption—are being reduced, including via the simplification of procedures for obtaining work and construction permits; the easing of the registration process for real estate; improvements in, and standardization of, government inspections; and the streamlining of the system of municipal fees. Further, a simplified system of customs declarations is being introduced incrementally. Improvements are also being made gradually to the court system, including through the ongoing training of judges, particularly in tax law. In each of these areas, however, additional measures are needed and their implementation is, in some cases, behind the ambitious schedule presented in the government’s action plan.

E. Prospects for Future FDI

46. While the prospects of continued strong FDI in Latvia appear good, a lot will depend on economic policies, including continued prudent macroeconomic policy and a strengthening of structural reform efforts. Staff has projected conservatively that FDI will decline from about 6 percent of GDP in 2000 to about 5 percent of GDP in 2005. The successful privatization of remaining large public enterprises and utilities is particularly important, not only because it would lead to FDI flows into these enterprises and sectors, but also because it would help improve productivity and competitiveness in the economy; the fact that Latvia is likely to be in the next wave of EU accession is also an important factor that should help attract increased FDI. However, this positive effect is not automatic and is dependent on progress in meeting EU standards, including in labor and environmental areas, implementing measures to improve the business climate, and maintaining economic stability and enhancing competitiveness in general.

47. Latvia also enjoys a strong comparative advantage in some sectors, especially transport, forestry, and related industries. This could open the way for FDI participation in large projects such as the US$900 million pulp mill—with Finnish and Swedish participation—that is now under consideration with implementation tentatively set for 2002-04. Again, success in attracting these investments is importantly conditional on addressing the main administrative difficulties that are currently facing investors.

F. Conclusions

48. While FDI inflows to Latvia remain sizable, they have declined compared to their very high levels in 1996 and 1997. This poses an important policy challenge because of the substantial benefits of FDI in terms of financing the large current account deficit, contributing to capital formation, enhancing productivity, and promoting exports. The prospects for FDI in Latvia should benefit from the EU accession process, the planned completion of privatization, economic stability, a skilled labor, and Latvia’s comparative advantage in important areas. These positive factors, however, are not sufficient and need to be supported by progress in a wide range of structural reforms aiming at improving the business environment in general and addressing specific obstacle identified by the business community in particular. Latvia is already progressing in this direction but important efforts are still needed.

IV. Privatization: Role of the Latvian Privatization Agency

49. This chapter discusses the role of the Latvian Privatization Agency (LPA) in the privatization of Latvia’s public enterprises and property, its contribution to promoting economic development and the use of privatization receipts. Following a brief review of the economic impact of privatization, the paper discusses the privatization process and the role of the LPA, and reviews the non-privatization activities of the LPA. The Chapter concludes with a brief evaluation of the privatization process in Latvia.

A. Introduction

50. The privatization of the state and municipal property and enterprises that commenced in the middle of 1991 is now approaching its completion. By late-1999, over 95 percent of the former state-owned enterprises had been privatized; the percentage of private sector output in the Latvian economy exceeded 70 percent; and almost all small and medium size enterprises were fully in private hands. In construction, trade, and many manufacturing sub-sectors, privately owned companies now account for almost 100 percent of output (Table 14). Reflecting these gains in privatization, employment in the public sector declined from 59 percent of total employment in 1992 to 30 percent of total employment in 1999.17 A small number of large, mostly utility enterprises still remain in public hands.

Table 14.

Latvia: Value Added per Employee, Wages, and Depth of Privatization by Sector, 1994-99

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Source: Economic Development of Latvia Report, 1999, Ministry of Economy, Fund staff estimates.

51. Privatization has led to improvements in asset use and growing productivity per employee. Productivity grew much faster in sectors dominated by private companies—such as manufacturing, mining, construction, and trade—than in those sectors dominated by publicly-owned companies (Table 14).

52. In addition, privatization generated substantial financing for the budget and extrabudgetary operations and privatized assets were used to retire privatization and compensation vouchers issued in the early 1990s. Since its establishment in 1994, privatization managed by the LPA has generated close to LVL 200 million in cash receipts (equivalent to about 7 percent of the average annual GDP during this period), and retired over LVL1 billion (face value) in privatization and compensation vouchers.18 Of the LVL 200 million in cash receipts, over LVL 95 million was transferred to the state budget—i.e., the State Property Privatization Fund—and another LVL 6 million to the local government privatization fund, with the remainder going to LPA administrative expenses (LVL 25 million), social expenditures and investment (LVL 24 million) and purchases of real estate (LVL 3 million) (Tables 15 and 16). Pending privatizations are expected to bring in even larger cash financing in the forthcoming year or two, when the sale of the largest enterprises is completed.

53. The need to privatize even the largest public enterprises has seldom been questioned by the Latvian government; most disagreements have focused on the mode and pace of privatization. Except for the privatization of some parts of the electric power sector, the government and the political majority in the Saeima remain committed to completing the privatization of the utilities sector.19 20 The success of the privatization has owed much not only to the political commitment to the process, but to the institution that was vested with the task of privatizing Latvia’s public assets, the LPA.

54. This chapter argues that privatization has succeeded in Latvia in large part because it was carried out by a single, professionally staffed government agency that was given a clear mandate and resources to accomplish the job, was required to operate in a transparent manner, and, to a large extent, succeeded in shielding itself from outside political influences. However, the chapter also maintains that the LPA’s mandate should have been limited to privatization only, and should not have been extended to promoting of economic development. In this regard, its revenues should not have been used for activities such as the provision of social assistance, financing of bank recapitalization scheme, and more recently, financing of government expenditure on the national census, participation in Hanover’s EXPO 2000, and others. The use of privatization receipts for extrabudgetary fiscal operations may have adversely affected the agency’s efficiency, and certainly had a negative impact on the transparency of Latvia’s fiscal accounts and operations. This last issue is very important especially now, when the forthcoming privatization of last remaining public enterprises is expected to yield relatively large sums of privatization receipts.

B. Managing the Privatization Process

Overview

55. The LPA was established in April 1994, in response to the poor privatization experience during the 1991-93 period when the management of the process was decentralized among different ministries supervising individual enterprises.21 A professional and focused institution was needed to direct the task of privatizing state property in a transparent manner and monitor the implementation of privatization regulations and compliance with provisions provided by purchase agreements for the post-privatization period. The LPA was registered as a non-profit state joint stock company and became the main executor of state-owned enterprise privatization in Latvia.

56. The privatization process accelerated only gradually following the establishment of the LPA. In part, this reflected the fact that privatization remained decentralized until early 1996, when the government decided to accelerate privatization by centralizing it in the hands of the LPA.22 In the first two months of 1996 alone, the cabinet of ministers decided to privatize a total of 318 state enterprises, statutory companies and their structural units, or 50 percent more than for the entire previous year.23 Among these were large companies including Latvijas Savings Bank, Ventspils Nafta, Latvenergo, and state passenger carriage motor transport companies. By the end of 1997, the cabinet of ministers had assigned 861 state-owned companies and 75 companies under liquidation for privatization. In addition, state capital shares in 165 companies and 48 properties were submitted for privatization. However, it was only in 1997, that The LPA was able to begin privatizing major enterprises when it sold 32.5 percent share in the Latvijas Gaze to the German consortium Ruhrgas/Preussen Elektra and Russian gas supply enterprise Gazprom (16.25 percent to each) on April 2, 1997.24

57. During the six years of the LPA’s existence more than 1000 companies and properties have been privatized. In addition, shares of 85 companies have been offered in public offerings, and, as a result, there are over 110,000 shareholders in the new companies. Shares of a number of the privatized enterprises have been listed on the Riga Stock Exchange. The fact that early on in the privatization process the government determined which companies would not be privatized played an important role in ensuring the transparency and credibility of the process.25

Foreign Assistance to the LPA

International advisers to the LPA actively supported Latvia’s privatization effort. The German Government provided technical assistance to the LPA to help prepare enterprises for privatization. In 1997, an EU Phare project, aimed at developing the strategy for restructuring the large state-owned enterprises in order to facilitate their privatization, was competed. The project was also intended to help identify potential foreign investors, as well as to disseminate information about the course of state-owned enterprise privatization process and investment possibilities in Latvia, by way of different communication tools, including the Internet. Another EU Phare technical assistance project was implemented during 1997-99 to provide guidance in the privatization of large enterprises, including Ventspils Nafta and Lattelekom. World Bank consultants also participated in the development and implementation of several LPA projects, including the work on the privatization of LASCO and Lattelekom, launched in 1995. In 2000, the LPA, with advice from the World Bank, began a search for international advisers to accelerate the privatization of LASCO and the restructuring and eventual privatization of Lattelekom.

Modes of Privatization

58. The LPA has used three methods to privatize companies: public offer (auction), international tenders, and sale of shares to employees and pensioners. Public offerings have provided the quickest way to privatization and spread the ownership of assets among the entire population. International tenders were intended to bring in foreign capital from investors that could provide company-specific expertise, and sector-specific link to foreign markets. International tenders are more costly to organize and, therefore, have been limited to the larger companies with an international presence. Sales to employees and pensioners offered the fastest way to dispose of assets that were too small to be offered more broadly and in cases where the revitalization of the privatized units depended more heavily on management and employee incentives than on infusion of significant capital.

59. Since 1995, the LPA has offered the possibility to settle part of payments for state assets, including land, apartments or company shares, with privatization vouchers. By October 1,1999, the government had issued over 100 million privatization certificates, with a face vale of nearly LVL 3 billion. Latvian residents were eligible to receive the certificates for the time lived in Latvia and as a compensation for being subjected to political repression in the Soviet Union. In addition, former property owners and their heirs have been granted property compensation certificates. In the public offering program the privatization certificates are a means of payment and are used at their face value—28 LVL. The deadline for applying privatization vouchers had been initially set for 30 December 1999, but was subsequently extended by one year.

60. Public offering. This program offered to all residents an opportunity to participate in the privatization process and promoted the development of stock market in Latvia by increasing its depth and liquidity. Shares of profitable companies were offered for sale within the public offering program. This program was launched in 1995, and by end of 1999, shares of 85 companies had been sold (Table 17). Most commonly, shares were sold for privatization vouchers at a price determined during the offering. In addition, however, the LPA introduced a second type of public offering—the so called “People’s round”—in which the price was determined in a regular public offering of the company’s shares that had been held previously without restrictions on participation.26 Further, in 1996 a public offering for cash program was launched, and has been successfully used for a number of large enterprises, including Latvijas Unibanka and the Latvian Savings Bank.

61. International Tenders. To attract foreign investment the LPA has organized international tenders for 153 companies, and sold 79 of these companies attracting US$40 million in investments. It is estimated that foreign investors have added about 9,000 jobs in these companies. The first (and so far only) program to issue Global Depository Receipts started in August 1997. GDRs were issued in ratio 1:1 with shares, and later these receipts were offered to institutional investors outside the U.S., with quotation on the London Stock Exchange, and to qualified U.S. investors. At present, the shares are also quoted on the Berlin Stock Exchange. Plans are under way to execute similar programs for other Latvian companies under privatization, including Lattelekom and the Latvian Shipping Company.

62. Sales to employees and pensioners. In state stock companies employees and pensioners could acquire up to 20 percent of the company shares using privatization certificates, and 5 percent were reserved for pension funds. For some companies, without debts, the management could acquire up to 25 percent using privatization certificates. For strategically important companies, the government could maintain shares as well.

Dealing with Insolvent Companies

63. Insolvent companies can be liquidated, and sold as a single entity or in parts. In some cases, the LPA has overseen a transformation of public companies into stock companies before they were fully or partially sold. According to the law, the LPA can exchange the outstanding debt with company shares; later the state could sell the shares for certificates or cash. Other adjustments include increasing the company’s equity by adding private capital or investment of the company as a tangible asset into another company. In a number of rehabilitation projects the LPA has required companies to retain a certain number of workers. As a result, about 8,000 jobs have been retained in the purchase agreements signed in 1998.27 To ensure that investors keep their commitments, the LPA has a policy of monitoring companies for three years following privatization, and can withdraw from the contract if the buyer does not meet its contractual obligations.

Transparency of the Privatization Process

64. To ensure transparency of the privatization process the LPA has made a considerable effort to inform the general public how, to whom and on what conditions state property was sold. Announcements on enterprises at different privatization stages are published in the official government information bulletin and in local newspapers, as well as in the most popular daily and weekly periodicals.28 The mass media are regularly informed about all privatization decisions and briefed on the issues addressed during the meetings of the LPA’s Executive and the Supervisory Boards. Every two weeks, LPA’s management, joined by representatives of privatized companies, hold press conferences to discuss current developments and prospects. Also, the LPA provides on a regular basis information to Saeima factions, committees, the cabinet of ministers and the Office of the President of the Republic of Latvia.

C. LPA Involvement in Social Assistance and Economic Development

65. The LPA, in addition to attracting new owners and investments to enterprises, has also been made responsible for finding solutions to specific social problems that affect the employees of state-owned enterprises in privatization, in particular, payment of wage arrears, benefits to laid off employees, and social tax debts. (Tables 16 and 18 present detailed information on LPA’s cash flows and its balance sheet.) Typically, upon taking control of state-owned enterprises in financial distress or in liquidation, the LPA prepares proposals for protecting employees, including those laid off during insolvency with claims for work injuries, wage arrears or social tax debts, in accordance with the requirements of the EU in this area.29 The LPA has also set aside a part of the privatization receipts to fund employees’ claims; in cases when settlement agreement or rehabilitation has been approved, the LPA can ask for the repayment of the compensation amounts from the company. In addition, the cabinet of ministers has issued several orders whereby claims by employees of insolvent enterprises are to be settled directly from the state privatization fund.

66. The significant social role of the LPA is reflected in its spending (Table 16). Social tax payments and salaries of laid-off employees accounted for more than LVL 8 million through 1999. In 1998, for example, the claims of employees of 63 insolvent state-owned enterprises or statutory companies controlled by the state were settled, with a cost to the LPA of almost LVL 3 million.

67. The LPA has also participated in the development of financial markets. To facilitate securities market development in Latvia, in 1995 the LPA participated in establishing the Latvian Central Depository (LCD), in which it still holds a 19 percent stake (see Table 18). In addition, the LPA is one of the founders and shareholders of non-profit Latvijas Tehnologiskais parks (Latvia Technology Park), established in 1996 and dedicated to finding commercial applications for scientific research & development-based production in Latvia. Further, in 1996, the LPA and the LDA jointly established the non-profit Privatizacijas agenturas starptautiska skirejtiesa (LPA International Court of Arbitration) to resolve disputes (including those pertinent to the privatization of state and municipal property) between companies, institutions or persons under the civil law.

68. Finally, the LPA has undertaken certain activities aimed at economic development more broadly. To extend support to enterprises under privatization that were in short-term financial problems, the LPA and LDA founded Insolvency, Rehabilitation, and Bankruptcy. To be eligible for assistance under this program, enterprises had to prove that their long-term sales agreements demonstrated the scope for further development, and, most importantly, that the termination of these enterprises would create serious social problems. Most recently, LPA’s subsidiary Birojs 2000, established in 1998, organized the Annual Meeting of the Board of Governors of the European Bank for Reconstruction and Development in Riga, during May 19-23, 2000. It is estimated that this has accounted for about LVL 3 million in spending in 2000.

D. Conclusions

69. Despite a relatively slow start, Latvia has succeeded in privatizing a large part of its productive assets. Frequent changes of government and the resulting political uncertainty, the banking crisis in 1995, and the economic recession in 1999 have failed to derail the privatization process. Privatization in Latvia succeeded primarily because once the cabinet of ministers decided to privatize particular state enterprises the actual, often protracted, privatization process has been mostly insulated from political influence.

70. The performance of the LPA, however, has not been free of problems. In particular, the LPA has been asked to undertake activities that went beyond their work on privatization, and could probably have been better accomplished by budgetary institutions or the private sector. In addition, privatization receipts should have been spent in a more transparent way; in particular, much of the spending on social assistance and economic development should have been considered within the overall budget process. In the next year or two, Latvia can expect significant privatization receipts from completing the sell-off of the remaining major companies. It is critical that these revenues not be earmarked for out-of-the-budget expenditure, and that Latvia continue strengthening its fiscal management.

Table 15.

Latvia: Revenues and Expenditure of the State Property Privatization Fund, 1993-99 1/

(In thousands of lats)

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Source: Economic Development Report 1999, Ministry of Economy.

Note: Data on expenditure for 1998 and 1999 apply to the first 10 months of the year only.

Table 16.

Latvia: Use of Privatization Revenues by the Latvian Privatization Agency, 1994-2000

(In thousands of lats)

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Source: Latvian Privatization Agency.
Table 17.

Latvia: Summary of Public Offerings, 1995-99

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Source: Economic Development of Latvia Report, 1999, Ministry of Economy; and the Latvian Privatization Agency.
Table 18.

Latvia: Balance Sheet of the Latvian Privatization Agency, 1994-98

(In thousands of lats)

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Source: Latvian Privatization Agency Annual Reports, (1994-1998).

Company formed by the LPA and the Latvian Development Agency to manage insolvent companies.

The LPA invested in URP investment company on behalf of the state. The company has been closed and investment written off in 1997.