Introduction
Latvia re-established its independence in September 1991, and joined the World Bank on August 11, 1992. An economic report entitled "Latvia - The Transition to a Market Economy" (Report No. 11233-LV) was issued in green cover for discussion with the Government and was distributed to the Board in draft in October 1992. Government discussions took place in mid-November 1992. The report provides an overview of Latvia's economic situation, policies, and prospects and presents detailed discussions of individual sectors. An economic update is planned for early 1993. Following the approval of a stand-by arrangement with the IMF, the Executive Directors approved, on October 22, 1992, the first loan to Latvia, a Rehabilitation Loan (President's Report No. P-5848-LV) for $45 million equivalent, which became effective on October 23.
Background
Latvia has an area of about 25,000 square miles; a little less than half the country is arable; woodlands cover about 40 percent of the territory and are an important source of timber. Industry accounts for nearly 50 percent of GDP and 30 percent of employment. Agriculture accounts for about 18 percent of GDP and 16 percent of employment. Latvia has a population of about 2.7 million, of which 1 million live in Riga.
Latvia's annexation by the Soviet Union after World War II led to a radical transformation of its economy. Its comparatively well-developed infrastructure and skilled work force motivated Soviet central planners to establish some relatively sophisticated industries in the republic. As a result of the comparably higher efficiency of its economy, Latvia enjoyed one of the highest standards of living among the republics of the former Soviet Union, as indicated by a per capita income that was 30 percent above the Union average. However, as occurred elsewhere in the former Soviet Union, real economic growth steadily declined over the years. The abandonment of central planning by the Soviet authorities in the second half of the 1980s did not reverse this economic decline. Instead, the increasing economic and political turmoil aggravated macroeconomic imbalances and led the entire Soviet economy into crisis.
The increased economic autonomy in the late 1980s allowed Latvia to abandon Soviet pricing policies and initiate a comprehensive price reform in 1991, about one year before similar reforms were introduced in most parts of the former Soviet Union (FSU). Price reform continued in several stages, and by early 1992 less than 8 percent of goods and services in the consumer price index remained subject to controls. Some indirect price controls in the form of controls on profit margins may still exist.
The price reform had several important, but temporary, effects on the economy in 1991. First, the faster pace of price reform in Latvia relative to its main trade partners resulted in a significant improvement in Latvia's terms of trade and a sudden shift in the trade balance, from a deficit of 6.8 percent of GDP in 1990 to a surplus of 3.4 percent of GDP in 1991. Second, the price reform contributed to an improvement in the financial position of Latvian enterprises, as they were able to adjust their output prices substantially while still buying imported inputs at relatively low prices. Third, it contributed to the sharp reduction in subsidies from 13.7 percent of GDP in 1990 to 4.3 percent in 1991 and allowed improvement in the government budget surplus from 2 percent of GDP in 1990 to 8 percent of GDP in 1991.
The improvement in the budget and in the financial situation of enterprises occurred despite the severe contraction of economic activity: real GDP fell by 3.5 percent in 1990 and 8 percent in 1991. During this period, the decline in output was offset by the terms of trade gains and the policy of not indexing wages (real wages fell by 29 percent in 1991), allowing enterprises to retain their workforce despite operating at low levels of capacity. As a result, the overall level of employment in 1991 remained at the previous year's level.
The severe contraction of output was essentially due to the collapse of trade relations with the former Soviet republics, particularly Russia. Such trade disruptions were caused by: attempts by the republics to limit exports and avoid internal shortages, reluctance to accept rubles for payments, and deficiencies in the payments mechanisms. The extent of the collapse of trade was indicated by the sharp decline in the ratio of imports to GDP from 47 percent in 1990 to 27 percent in 1991. Although negotiations has continued, trade relations has not been normalized.
Recent Economic Developments
The macroeconomic situation worsened further during the first half of 1992. The depressing effect of trade disruptions on output was aggravated by the depleting stocks of raw materials, and the sharp reversal of Latvia's terms of trade, resulting from the acceleration of price reforms in Russia and the other former Soviet republics. Industrial output declined by 30 percent, compared to the first half of 1991, and agricultural output collapsed due to a severe drought in mid-1992. As a result, real GDP is expected to fall by about 30 percent in 1992. The worsening of terms of trade not only depressed activity further but also reversed the gains generated in 1991. The financial situation of enterprises worsened and unemployment, which was still negligible (0.2 percent) at the beginning of the year, started to rise. The adverse developments also had a negative impact on the public finances, with the emergence of a budget deficit equivalent to about 3 percent of GDP in the first half of 1992. Inflationary pressures also increased in the first quarter of 1992 with consumer prices rising by an average of 48 percent a month before dropping to 13 percent a month in the second quarter.
Latvia's stay in the ruble zone did not contribute to resolving its economic difficulties during 1991 and early 1992. Instead, it resulted in payments bottlenecks due to the interruption of regular deliveries of ruble notes from the Russian central bank. These bottlenecks prompted the Latvian government to issue an interim currency, the Latvian ruble, and accelerate plans to introduce the new national currency, the Lats. Since July 20, 1992 the government has declared the Latvian ruble as the only legal tender in Latvia. This status will remain until the Lats is printed and put in circulation in 1993. The Latvian ruble was initially pegged to the Russian ruble at a ratio of one to one, but since July 20, 1992 it has been allowed to float, having appreciated substantially vis-a-vis the Russian ruble. The government's intention is to stabilize the exchange rate for the Latvian ruble before circulating the Lats.
The Stabilization Program
Latvia's departure from the ruble zone has fulfilled some of the necessary conditions for the pursuit of an independent monetary policy and the successful implementation of a stabilization program. The objectives of this program, which was supported by an IMF standby arrangement approved by the IMF Board on September 14, are to sharply reduce the rate of inflation to 3 percent a month by end 1992 and further to 1 1/2 percent by June 1993 and to increase gross official reserves and maintain stability in the external accounts. To achieve these objectives, the Government aims to limit the deficit in the general Government budget to less than 2 percent of GDP through: eliminating almost all consumer subsidies; curtailing subsidies and transfers to agriculture; capping the overall level of employment in the public sector combined with implementing a tax-based incomes policy to help restrain the wage bill; imposing a flat rate import duty of 15 percent on all imports; reducing the number of exemptions from the value added tax and profits tax; and strengthening tax administration and improving cash management of the budget.
In the area of monetary policy, increases in the refinancing rate of the Bank of Latvia (from 50 percent to 80 percent) and the reserve requirement ratio (from 15 to 20 percent) are envisaged. Moreover, deposit rates in the branches of the Bank of Latvia will be liberalized and interest rate subsidies through the banking system will be eliminated. As far as external policies are concerned, a flexible exchange rate policy will be pursued and all export quotas and licensing requirements and the bulk of export taxes will be eliminated.
Available information for the first three months of the program indicate that economic policies have been broadly implemented and the stabilization program is beginning to take hold. Inflation is on a downward trend and the exchange rate of the Latvian ruble has stabilized against the U.S. dollar.
The Structural Reform Measures
Progress has been mixed in the area of privatization and private sector development. Relatively large advances in ownership change have been achieved in the agricultural sector by breaking up collective and state farms, transforming them into share holding companies, and distributing shares to employees. Some progress has also been achieved in privatizing small enterprises. However, progress in privatizing medium and large enterprises has been slow. The main reasons have been a lack of clear policy on citizenship issues and on the restitution of property to previous owners as well as the lack of a coherent privatization strategy. Parliament has adopted a resolution to provide an overall framework for the privatization program. Other measures have also been taken recently which will speed up the privatization process, including a change in the existing law on methods for privatization which will allow both domestic and foreign investors to participate in privatization and to make payment in Latvian rubles instead of hard currency. However, major efforts are still needed for implementing privatization of medium and large enterprises. Branch ministries need to identify the enterprises to be privatized, submit the privatization plans for these enterprises, and embark on a more extensive privatization of large enterprises as soon as possible.
Progress in reforming the financial sector has been slow. There has been some initial progress in restructuring the Bank of Latvia (BOL), which performs central banking and commercial banking functions and dominates the Latvian financial system. Parliament approved two important pieces of legislation designed to separate the two functions and establish a two-tier banking system. However, the restructuring plan for commercial branches still needs to be designed and should involve identifyinghealthy banks for immediate privatization and the restructuring of the rest. The restructuring of the Savings Bank could be implemented at a much faster pace, as its financial situation is fully known. Other financial reform measures that need to be implemented include the introduction of international accounting and auditing standards, the improvement of the payments system, stricter prudential standards, and the development of on-site and off-site bank supervision.
Progress in reforming the social safety net has also been slow. A number of important measures have been introduced, such as the provision of unemployment benefits and allowances to poor families. However, the existing social safety net system cannot meet the needs of the growing number of unemployed workers. Therefore, local employment offices must be strengthened with additional resources, training and retraining programs must be improved, and the system of unemployment benefits must be streamlined in order to allow a growing number of dismissed workers to be covered. That can be achieved by eliminating benefits to new entrants in the labor force and restricting access of voluntary job leavers to unemployment benefits. An appropriate social assistance system also needs to be established. The main actions required in this area are the determination of a poverty line, the periodic adjustment of the poverty line against rises in the prices of a relevant basket of goods, and the establishment of a network of social assistance offices at the local level to help the most vulnerable groups.
Improvements are also needed in building institutional capacity for public sector management and coordination of policy development, including the management of public expenditures and investment, and management and coordination of foreign external assistance including technical assistance. The government also needs to establish mechanisms and processes for reviewing and monitoring the public investment program and for integrating it into the budget.
External Debt and Financing Requirements
As a republic within the former Soviet Union, Latvia was allocated responsibility for over US$1 billion of the external debt of the FSU. However, in mid-March 1992, the chairmen of the Supreme Councils of the three Baltic countries issued an official declaration that their countries are not legal successors to the FSU and therefore cannot take responsibility for servicing the external debt. Since gaining independence, Latvia has undertaken only negligible new debt obligations. However, the Government and enterprises will soon have access to foreign credit, starting with loans from multilateral institutions, and short-term credit lines with export credit agencies. Currently, external aid and resource mobilization is being coordinated by the EC within the G-24 framework and include representatives from the multilateral organizations.
Latvia's current account deficits are projected to reach 7 percent of GDP in 1992 and 12 percent of GDP in 1993. These deficits reflect the deterioration of Latvia's terms of trade, the imports needed to prevent further output declines, and the sharp decline in exports to the FSU. Based on preliminary estimates, which are subject to revision, Latvia will need an estimated $435 million of external resources during 1992-93 to finance its current account deficits and build an adequate level of external reserves. Having only recently regained independence and having no credit record, Latvia will need to establish its creditworthiness in the international financial markets. Since private foreign investment will be limited in the short term, official disbursements will have to be the main source of foreign financing.
The current account deficit is expected to be reduced to around 3-4 percent of GDP during the second half of the 1990s as structural adjustment and reform measures begin to improve economic performance, and to increase Latvia's convertible currency exports. Latvia will be able to increase its imports and thus the pace of economic reform, without increasing its debt service buerden to imprudent levels to the extent that the concessional element of its borrowing can be enhanced.
Perhaps the most positive aspect of the government's stabilization and reform program is its determination to carry out the program even under unfavorable macroeconomic circumstances. However, this process will not be easy and requires socio-political measures that could lead to major uncertainties and serious delays in policy actions. A major challenge facing the authorities is to develop the capacity of staff, particularly in the line ministries, to implement the reform program on a timely manner. The reform program may also get derailed because of policy slippage in the areas of greatest socio-political sensitivity, such as introduction of an incomes policy designed to lower real wages. Other significant uncertainties facing the reform effort are the external economic environment and Latvia's access to the international support it needs.
If there is slippage in the level and timing of the financing, the recovery process will be slowed. However, assuming all possible efforts are made to restore supplies of critical inputs from trading partners in the FSU and elsewhere among the former CMEA countries, to find domestic substitutes for imports, and to shift into production lines that are less import-intensive, Latvia should be able to implement its economic reform policies effectively and restore pre-independence levels of income by the later part of the 1990s, provided that most of the required financing is mobilized as planned.
Objectives and Overview
The Bank's immediate objectives are to assist the government in the early implementation of its economic reform program, while providing import financing to maintain essential services and production. The Bank's medium-term objectives are to continue to support a full transition to a market-based economy (including structural measures to ensure a vigorous supply response to the new incentive system), while financing sound investments in key sectors. More specifically, the Bank's activities would aim to: (a) support the process of economic reform by facilitating the implementation of macroeconomic policies and structural reforms needed to stabilize the economy and stimulate production, while providing quick disbursing support to critical sectors of the economy; (b) strengthen the design and implementation of a social safety net that would protect the most vulnerable groups during the transition period and assist in labor force restructuring; (c) build institutional capacity in economic management to support a market-based economy; and (d) support sector-specific reforms to restructure or expand productive capacity and promote medium-term investments to improve economic efficiency and protect the environment (focussing initially on the critical energy sector).
Summary of the Bank's Assistance Program
The Bank envisions an annual lending program of about US$50 million over the next three years. This would allow one to two operations per year, which would initially focus on support for the implementation of the economic reform program and relieving the scarcity of critical imports. As the economy stabilizes, Bank resources would gradually be channelled to support sector and investment operations. Following the Rehabilitation Loan, several projects are being considered including an energy/environment project, a human resource development project with a focus on public sector management and institutional building, and an agricultural sector project. The energy/environment project would support energy conservation and other investments in energy and municipal infrastructure, some of which would not only result in significant cost savings and improved services, but would also begin to address environmental issues and enhance environmental quality. The proposed lending program is also likely to include an operation which would support the restructuring of the banking and enterprise sectors and private sector development as well as agriculture and human resources operations.
The planned economic and sector work would provide the analytical underpinning for the Bank's policy discussions with the government and future lending. In close coordination with the IMF and European institutions, the Bank's work will continue to focus on the sectoral and structural elements of the reform program. The CEM in FY93 provided a comprehensive overview of macroeconomic and sectoral issues, constraints and priorities. Periodic economic updates are planned to review fast moving developments in the economy and to reassess overall financing requirements and creditworthiness. Sector work will also be initiated in Enterprise Reform and Financial Restructuring, Agriculture, and Public Sector Management.
Substantial technical assistance (TA) will be required to design and implement structural and sectoral reforms and investment projects. Many systemic or structural reforms are being supported by the Rehabilitation Loan and terms of reference for the related TA have been prepared. The government would understandably prefer to finance this TA with grant resources and the Bank is assisting the government in identifying such sources. As such, the Bank has already made available its preliminary assessment of TA requirements to interested donors and expressed its willingness to help in the drafting of terms of reference for and recruitment of consultants. Future sector operations are also likely to require TA components, particularly for the design and implementation of related policy and institutional reforms.
Other Bank Group Activities
Membership in IFC is expected in the early part of 1993. The IFC expects to support the privatization and modernization process of local enterprises so that they can become internationally competitive, particularly those that can attract foreign technical partners in joint venture undertakings. IFC would assist such firms by providing technical assistance for the privatization process when requested and by providing financial support to privatized enterprises that show promise of becoming internationally competitive. Initial IFC investments in Latvia would be made in relatively small companies that have joint venture partners with access to export markets. Areas that show particular promise at this time are wood products, construction materials and the tourism sector. At the request of the government, FIAS undertook an initial diagnostic assessment of the environment for foreign investment and provided specific recommendations in this area. Once Latvia becomes a member of MIGA, new foreign investments would be eligible for non-commercial risk guarantees, and for specific promotional and advisory services.
Collaboration with other Agencies
Close coordination has been maintained with the IMF, EC, EBRD, and other aid agencies to ensure the efficient use of resources and technical assistance. Various donors have been providing assistance to Latvia for the past year or so and, the G24 coordinates resource mobilization activities. The Nordic countries are involved in a number of sectors already, providing both financial and technical assistance. Other European countries, either bilaterally or through the EC, have initiated programs of assistance, as have the USA and Canada. EBRD has also initiated its program in Latvia, focussing in particular on energy, telecommunications, infrastructure and the financial sector. As the Bank builds up its presence in Latvia, it plans to intensify its aid coordination efforts. Considerable effort has already been devoted to sharing information with donors, both formally and informally, to minimize the risk of duplication of activities. Realizing the full potential of various assistance efforts already under way and/or planned will require strengthened coordination by the government and the establishment of consistent approaches among donors. Establishing appropriate systems and strengthening the central government agencies to fulfill these responsibilities is of the highest priority at this stage of the reform process.
Most aid to Latvia so far has been in the form of grants for food and medical aid. Several lines of credit have been provided bilaterally. Technical assistance is an important aspect of international assistance. Approval of EBRD's first loan to Latvia in the energy sector is expected before the end of this year. The Bank's planned lending in relation to other donors and to total needs is moderate at around $50 million annually. However, the Bank's strength lies in its ability to mobilize large sources of cofinancing such as happened with the expected cofinancing of the Rehabilitation Loan by the Export Import Bank of Japan.
Risks to the Bank's Lending Strategy
Parliamentary and presidential elections are planned for spring 1993. On several occasions, the government assured the Bank that the reform program enjoys strong support among all parties. The program is seen as an economic necessity for Latvia's transition and is not a political issue. The Rehabilitation Loan and the IMF's standby agreements are designed to support the government's economic reform program. The Bank's strategy depends on the success of the government's implementation of its program. There are two risks of slippage in the reform program: (i) difficulties in the adjustment process itself, and the need to support it with a strong and financially rational social safety net; (ii) Latvia's limited implementation capacity; (iii) continued delays in re-establishment of trade relations with the traditional suppliers in the former Soviet Union; and (iv) the availability of external financing. Slippage in the reform program may jeopardize disbursements of the Loan, and the adherence to the economic reform program is understood to be a condition for further Bank assistance. To reduce the risk of considerable slippage, intensive technical assistance is being provided to implement the reform program, including assistance for strengthening of the social safety net to enhance the program's social and political acceptability. Assistance to improve and strengthen institutional capacities will also be provided. On the trade side, Latvia is continuing discussions in an effort to restore relations with its traditional suppliers as well as establishing trade ties with new partners. The Bank participates in aid coordination efforts and encourages the government to take a more active role in resource mobilization.