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The following item is a Letter of Intent of the government of Latvia, which describes the policies that Latvia intends to implement in the context of its request for financial support from the IMF. The document, which is the property of Latvia, is being made available on the IMF website by agreement with the member as a service to users of the IMF website.
 

September 8, 1997

Mr. Michel Camdessus
Managing Director
International Monetary Fund
Washington, D.C. 20431

Dear Mr. Camdessus:

The attached Memorandum of Economic Policy contains a description of the policies the Government and the Bank of Latvia intend to follow during the period September 1, 1997 through March 1, 1999. The objectives of these policies are to reinforce the macroeconomic stability Latvia has achieved and to promote sustainable economic growth over the medium-term. In this context, structural reforms, in particular the continued expansion of the role of the private sector in the economy and the strengthening of the effectiveness of the public sector, remain key goals. Our long-term goal is to fully integrate Latvia's economy into Europe's, and ultimately gain membership in the European Union. In support of these policies, we hereby request an 18-month standby arrangement in the amount of SDR 33 million. While we do not intend to make any purchases under the stand-by arrangement, we would do so should circumstances warrant.

We believe that the policies described in the attached memorandum are adequate to achieve the objective of the stabilization and structural reform program, and to allow sustained economic growth, but will take additional measures should the need arise. During the period of the arrangement, we will consult with the Fund on the adoption of any such measures that may be appropriate in accordance with the Fund's policies on such consultations. In addition, we will complete with the Fund two reviews of economic developments and policies under the program, the first by mid-March 1998, and the second by mid-November 1998. In addition to a comprehensive evaluation of the program, the first review will focus on progress in privatization of enterprises and apartments, and public sector reform. The program will also be evaluated on the basis of a number of quarterly performance criteria (enumerated in the attached Table of the Memorandum of Economic Policies). Performance criteria for end-June 1998, end-September 1998, and end-December 1998 will be specified at the time of the first review.

Sincerely,

/s/ /s/
Roberts Zile
Minister of Finance
Ministry of Finance
Einars Repse
Governor
Bank of Latvia

Attachment

 

Memorandum of Economic Policies

I.  Introduction

1.  Since Latvia regained its independence in the fall of 1991, the government has made a determined effort to achieve macroeconomic stability and to undertake the structural reforms necessary to create an efficient market-based economy, laying the foundations for sustained non-inflationary economic growth. Following the banking crisis and fiscal slippage of 1995, the government has made major strides in tightening fiscal policy, enhancing the soundness of the banking system, and moving forward the program of structural reform, notably in the areas of privatization, tax administration, banking supervision, and trade policy. Largely as a result, economic growth has resumed and inflation has declined. We recognize, however, that prospects for sustained economic growth over the medium term hinge on the mobilization of savings and an acceleration of structural reforms, in particular in the privatization of large enterprises, the strengthening and extension of private property rights, and improvements in the legal system, which will firmly establish Latvia as a market economy, encourage corporate restructuring, and stimulate domestic and foreign investment. In addition, while the banking sector has greatly improved its soundness following the banking crisis of 1995, we recognize the need to sustain and consolidate gains made to date, as well as to significantly restructure the enterprise sector, given the strong links between the two sectors. Finally, we have continued to improve the quality of our economic data, which will contribute to our ability to formulate appropriate macroeconomic policies. These various "second generation" reforms will, in addition, help pave the way for future accession to the European Union. Continued support by the International Monetary Fund will enhance the domestic and external credibility of our economic program for 1997–98, described below.

II.  Background and Recent Developments

2.  Latvia has completed the first phase of transition, as macroeconomic conditions have stabilized and economic growth has resumed. Real GDP rose by 2.8 percent in 1996, somewhat faster than anticipated. At the same time, inflation has declined more rapidly than anticipated, falling to about 7.5 percent on an annual basis through June. All quantitative performance criteria and indicative targets under the stand-by arrangement through end-June were observed, and the arrangement remained precautionary, as expected.

3.  Despite continued growth in exports and the tightening of fiscal policy, the current account deficit reached 6.6 percent of GDP in 1996, reflecting in part one-time increases in fuel imports in advance of pre-announced excise tax increases and adverse external conditions for wood exports. However, despite the fact that the government did not draw the first tranche of the World Bank SAL as expected, capital inflows were large and resulted in a balance of payments surplus, in contrast to the previous year. In the first quarter of this year, the current account deficit was some 7 percent of GDP and export growth strengthened further, led by a turnaround in wood exports. At end-June 1997, international reserves of the Bank of Latvia stood at US$800 million, equivalent to about 3 months of imports.

4.  Fiscal policy was tightened considerably in 1996, with a fiscal deficit of 1.2 percent of GDP, compared with 3.3 percent of GDP in 1995, and continued to be quite cautious during the first half of 1997. Including capital spending of LVL 15 million (0.5 percent of GDP), the central government main budget recorded a fiscal deficit of LVL 23 million (0.8 percent of GDP) in 1996, compared with LVL 112 million (4.5 percent of GDP) the previous year. Through the first half of 1997, a fiscal surplus of LVL 13 million was accumulated, reflecting higher-than-anticipated revenues from most taxes, lower interest payments, and spending restraint, including in capital spending. We consider the tax rates already in place, in particular on labor, as relatively high, and therefore have continued to focus our revenue efforts on measures to improve tax administration, including an expansion of the large taxpayers unit, and the completion of the assignment of taxpayer identification numbers. Tax arrears have been declining steadily over the last three quarters, as a result of improved auditing and collections. Expenditure management has been enhanced as well, including through improved control of local government borrowing and the incorporation within the treasury of all extrabudgetary accounts.

5.  Monetary developments during the first half of 1997 suggest that the trend toward gradual remonetization has continued, driven by increased confidence in economic policies and the banking system. The stronger demand for reserve money has been satisfied primarily through the Bank of Latvia's foreign exchange operations, and net international reserves of the Bank of Latvia have exceeded program projections. Interest rates have fallen sharply since the beginning of the year, reflecting fiscal tightening, continued falling inflation, and the favorable international credit rating given to Latvia in January 1997. Treasury bill rates for 28-day bills have declined from a peak of about 45 percent in mid-1995 to below 4 percent since the beginning of 1997, while bids continue to exceed supply by at least 2:1. Credit to the private sector has picked up considerably since end-December 1996, but remains at a relatively low level of about 7 percent of GDP. This still-low level of lending to the private sector likely reflects structural weaknesses, which we are attempting to address, including the overall weak financial position of the enterprise sector, difficulties of pledging collateral, lax enterprise accounting procedures, and limited experience of the banking sector in evaluating enterprises, as reflected in the continued high lending rates. The development of capital markets in Latvia has accelerated in recent months: the interbank market has sharply increased its activity, the government began to issue two-year treasury notes in April, and a Securities and Exchange Commission began effective functioning in June.

6.  Banking supervision was strengthened significantly following the banking crisis of 1995, with the adoption of more stringent prudential regulations, and increased monitoring and enforcement. Latvia now has some of the most stringent regulations of all transition economies, and most regulations conform closely to or exceed EU standards. The soundness of the banking system has improved considerably, although several problem banks remain. The number of banks has declined from 51 in June 1995 to 32 at present, while the number of "core banks" in full compliance with all prudential regulations, and therefore permitted to accept household deposits, has risen from 12 to 19 this year. In addition, bank profits have continued to increase, bank capital is rising, and non-performing loans are declining, in relative terms, in banks' portfolios. The Latvian Savings Bank, one of only two majority publicly owned bank (along with the much smaller Mortgage and Land Bank), has been merged with a smaller bank as an initial step in the privatization process, and a public offering involving some 22 percent of the Savings Bank's shares was completed in May, bringing total shares held by the private sector to nearly 50 percent.

7.  We recognize that the enterprise privatization program plays a key role in attracting foreign and domestic investment, promoting restructuring, and stimulating private sector development. In this context, the government has made a major effort to accelerate the privatization process. Over 200 enterprises were privatized in 1996, and an additional 147 purchase agreements have been completed thus far this year; approximately 60 percent of GDP is now generated in the private sector. The privatization of large enterprises has progressed more slowly than initially expected, largely reflecting underlying structural problems, including difficulties in conducting audits, the sizable customer arrears for utility companies, and the challenge of ensuring a competitive energy sector following privatization. However, in recent months, the privatization process for the four largest state enterprises has begun to move quickly forward, and important progress has been made in eliminating structural impediments to privatization in the energy sector. In addition, the process of apartment privatization has accelerated.

8.  The government has made considerable progress during 1996–97, in further liberalizing its trade regime. The adoption of the Baltic Free Trade Agreement and the conclusion of multilateral and bilateral free trade agreements with most of Latvia's major trading partners have significantly reduced external protection. In addition, amendments to the customs tariff schedule, effective July 1, 1997, converted remaining specific import tariffs to ad valorem tariffs; eliminated all remaining quantitative restrictions; and reduced agricultural tariffs, as monitored under the program, to 47 percent. The average production-weighted tariff for all agricultural products now stands at 34 percent. Restructuring of the agricultural sector has advanced substantially, with many tax preferences eliminated, subsidies both transparent and modest, and domestic product prices liberalized.

III.  The Government's Program for 1997–98

Macroeconomic setting

9.  Our broad economic strategy remains unchanged. We believe that the exchange rate peg to the SDR, underpinned by fiscal and monetary restraint, has served Latvia well, and it remains the centerpiece of our macroeconomic policy. At the same time, we are accelerating our program of structural reforms in order to create the conditions for sustained economic growth. The government recognizes that until a number of important impediments to the efficient allocation of resources are removed, economic growth in Latvia will be unable to reach its full potential. In this context, we are placing particular emphasis on the areas of privatization and property rights, which will establish Latvia more firmly as a market-based economy, encourage corporate restructuring, and stimulate domestic and foreign investment. Moving ahead on privatization will, in turn, require that a number of underlying structural difficulties be addressed, such as in energy arrears and pricing, and ensuring competition in the energy sector following privatization. In addition, care should be taken to sustain and consolidate improvements in the health of the banking sector. Finally, improving the effectiveness of public spending and continuing progress made in tax administration would provide the basis for an efficient and effective public sector.

10.  Our program objectives for 1997 of 4 percent growth in real GDP, and inflation of 9 percent (12-month rate) by end-year remain well within reach, despite increases in administered prices, including the doubling of rent ceilings. It is anticipated that the current account deficit will decline to 6.1 percent of GDP, with exports, in particular of wood and wood products, expected to show strong growth. Gross international reserves are expected to be maintained at the equivalent of about three months of imports. For 1998 and over the medium term, increased national savings and higher investment, including in basic public infrastructure, and enhanced efficiency of resource use arising from structural reforms and foreign investment, are expected to raise real GDP growth to at least 5 percent. Inflation will be targeted at 7 percent for 1998, and it is expected to decline further over the medium term. To ensure this favorable medium-term outlook, we are committed to completing our program of enterprise, land, and apartment privatization, ensuring a sound banking sector, strengthening of property rights, liberalization of all trade, and improving the effectiveness of the public sector, by increasing efficiency in spending and continuing progress made in tax administration.

Fiscal policy and public sector reforms

11.  The economic program for 1997 provides for a zero financial deficit (i.e., excluding net lending) in the basic and social budgets. To allow for necessary public investment, a deficit of up to LVL 18 million (1/2 percent of GDP) was budgeted for local governments, to be financed completely by the treasury, and subject to rules meant to ensure both a high social rate of return on investment projects and ability to repay. Including net lending of LVL 12 million, a general government fiscal deficit of LVL 30 million (0.9 percent of GDP) was programmed. Reflecting the improved outlook for revenue, in particular for own revenues of budgetary institutions, a supplementary budget passed in June allowed for additional spending of approximately LVL 47 million. However, the government remains committed to its fiscal targets, and will take compensatory measures if and when it becomes clear that the envisaged revenues are not forthcoming.

12.  Fiscal policy for the remainder of 1997 and 1998 will continue to be aimed at supporting macroeconomic stabilization and growth, further improving tax administration, enhancing the efficiency and equity of public spending through adequate public investment, in particular for core infrastructure in transportation and communication, reform of the civil service, pensions, and education and health spending, and continuing the progress made in expenditure management. Given the need for increased public investment in support of private sector activity and one-time costs associated with structural reforms, including those required for EU accession, a small fiscal deficit of 0.5 percent of GDP is targeted for 1998. Revenue is conservatively projected to remain approximately constant as a share of GDP, at 40 percent of GDP. While capital expenditures and spending on other structural reforms will be increased, total spending (including net lending) is expected to decline slightly, to 40.5 percent of GDP.

13.  With respect to tax administration, we will seek to continue to reduce the stock of arrears through improved collections and auditing procedures, as well as capitalization of tax debts of companies to be privatized. In this context, we will reduce the maximum time period for tax deferrals for new tax obligations to three months, or one year in the case of an ongoing audit. We have implemented a debt collection pilot project in three local offices, with good results, and plan to expand the procedures employed to all tax collection offices by January 1998. Over the medium term, increased computerization will play a crucial role in improving tax administration, including by allowing the State Revenue Service (SRS) and customs to select audits on objective risk criteria, and increasing the use of cross-checking between customs and other tax data. We anticipate that, with sufficient financing (we are currently discussing a World Bank loan in part for this purpose) the new computer system for customs will be completed by the first quarter of next year, with final completion of the proposed computerization project by end-1998. Auditing will be further enhanced through the full reporting of all border taxes paid by large taxpayers (including import duties, and VAT and excise taxes on imports) to the large taxpayers unit, bringing the coverage of the unit to about 50 percent of total tax payments. The collection of the social tax will be moved from the Social Fund to the SRS on January 1, 1998 and, by January 1998, necessary changes in tax laws and forms will be made to allow the joint collection of income and social tax. In the area of customs, we have adopted a new Customs Law, consistent with WTO and EU rules, effective on July 1.This law provides for customs valuation (beginning September 1) on the basis of transaction price, in accordance with the requirements of the 1994 GATT. Our anti-smuggling efforts have been enhanced through our cooperation with Crown Agents, including training of customs personnel, and we will continue our joint efforts in this area.

14.  We believe that as tax administration continues to improve and expenditure policy is made more efficient, there will be scope for reductions in tax rates over the medium term, in particular the high payroll tax rates, which tend to discourage employment. The maintenance of a broad tax base with a minimum of exemptions will be crucial for allowing a decline in tax rates, as well as for increasing transparency in government activities. We plan to merge the personal and corporate income taxes in 1998, eliminating in the process several tax exemptions, including for agriculture. Also, in this context, we will limit the introduction of tax-free economic zones to those already established for Riga, Ventspils and Liepaja, which we project will reduce tax collections by some LVL 20 million next year. In addition, we will refrain from introducing any new VAT exemptions and from earmarking tax revenue for special funds.

15.  We maintain as a high priority the rationalization of public expenditure, in particular a better balance between capital and current spending and the provision of adequate resources for operations and maintenance. The public sector wage bill, currently some 9 percent of GDP, places a heavy burden on the budget, while the lack of a general wage increase over the last two years has eroded the ability of the government to recruit and retain skilled staff. We will address these problems through a program of civil service reform, which will be carried out in the context of an overall public sector restructuring. We have taken important initial steps toward this end (with the aid of the World Bank), with the formation of a State Reform Council, composed of seven ministers and headed by the Deputy Prime Minister, to adopt broad guidelines for reform, and a Bureau of Public Sector Reform to implement the proposed changes. The civil service census and review of the activities of each ministry has begun, and is expected to be completed by September 1997. Specific recommendations are expected by end-year as to areas in which duplication across ministries can be eliminated, activities that might better be carried out in the private sector, and the potential for the wage structure to be made more transparent and competitive with the private sector; we intend to give authority to the Council and the Bureau to implement these recommendations. While staffing will likely need to be increased in certain areas, including to meet EU requirements, we anticipate that the implementation of the recommendations of the study will allow a significant net reduction in the overall size of the public sector. With respect to social spending, we are committed to continue our reform efforts, in conjunction with the World Bank, including the establishment of a health insurance reimbursement system with cost controls, and allowing competition among providers.

16.  The government implemented the first stage of a pension reform in 1995, which provided for actuarially fair pensions based on work history and retirement age. We are moving ahead with the second phase of this reform by preparing a concept paper, which will serve as the basis for legislation for implementing the planned fully-funded privately-managed tier of the system; the concept paper will be completed by the end of this year. We have recently amended the pension law to establish a minimum guaranteed pension for those choosing early retirement and to modify the benefit calculation for individuals who had been unemployed, and so unable to make contributions, during some portion of their relevant work history; it is estimated that the additional costs associated with these measures will be less than LVL 1 million in 1997. At the same time, we recognize the necessity of taking steps to ensure the long-term financial sustainability of the pension system, in particular given the need to accumulate a surplus to finance the implementation of a fully-funded tier of the pension system. We believe that this need can be met by continued improvements in the administration of the social tax (including through enhanced computerization), and faster economic growth (pensions are indexed to consumer prices rather than to wages until 2000).

17.  We recognize that more effective expenditure policy goes hand-in-hand with improved budgeting and expenditure management. To enhance medium-term planning, the government will submit their first two-year rolling budget, for 1998–99, in October of this year. We are moving forward as well with our plans for improving the incentive structure and equity of the system of revenue-sharing with the local governments, and the reorganization of the local government structure, including the amalgamation of a number of extremely small and non-viable government units. In this context, we have submitted a bill to Parliament which would eliminate the district (rajons) level of local government, to be replaced by intergovernmental councils composed of lower level (town and village) governments. In addition, until January 1999, local governments can voluntarily merge, and several have already done so; beginning in 1999, consolidation of local governments will be determined at the national level.

Monetary and exchange rate policies

18.  The Bank of Latvia intends to maintain its current pegged exchange rate to the SDR. In our view, Latvia has maintained its external competitiveness despite the real exchange rate appreciation as measured by standard indices over the past several years. The trade-weighted real effective exchange rate has appreciated since the pegging to the SDR in February 1994 by about 12 percent, but is virtually unchanged since the third quarter of 1994. In any case, the appreciation has reflected in large part a catch-up of the initial undervaluation as well as productivity gains resulting from economic reform. In addition, wages measured in foreign currency remain competitive, exports are buoyant, and the overall balance of payments position is strong. In support of the exchange rate peg, the Bank of Latvia will continue its interest rate policy of responding flexibly to foreign exchange flows to achieve inflation objectives. Should unexpectedly large inflows emerge, the Bank of Latvia would be prepared to adopt sterilization measures and, if necessary, fiscal tightening, in order to prevent an excessive increase in liquidity; a nominal appreciation would not be contemplated unless the inflows proved large and sustained and jeopardized our inflation objectives.

19.  Despite the generally satisfactory external position, the current account deficit does merit close attention, in particular given the paucity of information regarding the nature and potential volatility of the capital inflows financing this deficit. We expect, however, that the current account deficit will decline from 6.6 percent of GDP in 1996 to 6.1 percent of GDP this year, partly on the strength of a strong export performance, in particular in the wood industry. In the event that adverse balance of payments developments threaten our net international reserves target, we would be prepared to tighten fiscal and monetary policy, notably through interest rate increases. In addition, we recognize the importance of stimulating domestic savings, through structural reform, in order to reduce reliance on foreign financing of investment.

20.  In view of the need for an adequate level of international reserves, the program establishes a floor on net foreign assets, as shown in the attached table; the corresponding definition is given in Annex III. This floor has been set at a level that is lower than projected under the monetary program, given the difficulties in predicting capital flows. In the event of a speculative attack against the currency, the Bank of Latvia will take all necessary measures to defend the peg. We would maintain a trigger for consultation with Fund staff in case of interventions in the foreign exchange market in the amount of US$75 million in any two-week period.

21.  Credit to the private sector has grown significantly during the first half of 1997, and the Bank of Latvia will monitor closely developments to ensure that this expansion does not threaten inflation or reserves targets of the program. However, given the low degree of monetization, private sector credit growth will need to accelerate over the medium term in order to finance private sector activity. To achieve this, we intend to remove impediments to bank lending. In this regard, the government has moved to speed up the registration and titling of land and movable property; this should help address bottlenecks in arranging collateral for loans, as should further apartment privatization. In addition, the completion of the enterprise privatization process and restructuring of the enterprise sector should help stimulate efficient bank lending by establishing more viable commercial entities with appropriate accounting standards.

22.  In April, the Bank of Latvia eliminated the reserve requirement for liabilities to foreign banks. It is hoped that the reduction in the cost of foreign funds will help to enhance access of local banks to longer-term credit, and thereby allow lending to domestic enterprises with longer maturities. The Bank of Latvia will maintain a close watch on developments in banks' foreign borrowing, and stands ready to reimpose this reserve requirement should excessive borrowing endanger our objectives for price stability, and the attainment of the target for net international reserves.

23.  We have formulated a quarterly monetary program including ceilings for net domestic assets of the Bank of Latvia, taking into account the expected path for growth, inflation, and the balance of payments, and assuming a gradual reduction in velocity, reflecting continuing increased confidence in the economy and banking system. The implied monetary stance for the second semester of 1997 is largely unchanged from the existing program, and the program for 1998 implies a stance broadly similar to current policy. The program foresees, for the period June 1997-June 1998, an increase in broad money of 18 percent, and a rise in reserve money of 20 percent. Taking into account the expected government borrowing requirement, this monetary expansion would be consistent with a rise in bank credit to the non-government sector of 25 percent, or about 17 percent in real terms.

Financial sector reform

24.  Banking supervision was strengthened significantly following the banking crisis of 1995, with the adoption of more stringent prudential regulations, and increased monitoring and enforcement, including frequent on-site inspections and quarterly external audits. Largely as a result, the health of the banking system has improved substantially. We recognize, however, that some problem banks remain, and that the gains made to date need to be protected and consolidated. The Bank of Latvia will maintain its policy of withdrawing licenses from banks that do not comply with prudential and other regulations, which has reduced the number of banks from 51 in mid-1995 to 32 at present. In addition, the minimum capital requirements are scheduled to increase to LVL 2 million in April 1998, and it is expected that all operating banks will meet this minimum standard. We intend as well to implement a change in the Capital Adequacy Directive, which is already more stringent than the Basel requirement, to require banks to take account of market risk, including interest and exchange rate risk, in their exposure and increase their capital adequacy ratio accordingly.

25.  Privatization of the Savings Bank is proceeding, as the Latvia Privatization Agency is finalizing a plan to re-capitalize and complete the sale of the remaining government shares by end-1997, and is implementing the safeguards agreed with the World Bank under the SAL. The management of the new merged bank has been almost completely changed, and the soundness of the company is being improved through rationalization of bank operations, including the elimination of unprofitable branches and a significant reduction in the number of employees. In addition, the Savings Bank has taken the initiative to introduce lending with privatization vouchers as collateral, which has also resulted in increased earnings for the Bank. These measures have already resulted in a turnaround in profit in 1997.

26.  A draft deposit insurance scheme has been prepared by the Bank of Latvia, and is expected to be presented to Parliament in November 1997. We believe that the banking system is now sufficiently stable and sound to warrant the introduction of such a scheme. The proposed law would minimize the potential moral hazard problem, as well as the fiscal cost, by maintaining a modest level of protection, limiting the insurance to core banks, and by having the scheme financed primarily by participating banks. The cabinet has also submitted to Parliament an anti-money laundering law. The government considers the further development of Latvia's financial markets to be an important element in creating the conditions for sustained economic growth, by increasing both the level of savings and the efficiency with which it is channeled to investments. The Bank of Latvia will encourage the development of the treasury bill market, and increase its capacity to engage in open market operations. In addition, cooperation between the Ministry of Finance and the Bank of Latvia will be enhanced, to aid in the management of the government's cash flow. A securities and exchange commission was established in June 1997, in order to encourage stock market activity. We also have submitted to Parliament a draft law defining the modalities for the operations of investment funds, are preparing legislation to harmonize with the EU our framework for the regulation of insurance companies, and have drafted implementing legislation for the regulation of private pension funds.

External sector policies

27.  The government has made considerable progress in liberalizing trade. Excluding agricultural products, Latvia has a very liberal trade regime, with several categories of imports duty-free, and tariff rates on most raw materials and spare parts at only 1 percent. A Baltic Free Trade Agreement has been adopted, and the conclusion of free-trade agreements with most of our trading partners (EU, EFTA, Czech Republic, Slovak Republic, and Slovenia), covering about 65 percent of total trade, has significantly reduced external protection. Several more free trade agreements are expected to be finalized in early 1998. Moreover, following progress achieved in bilateral and multilateral trade negotiations, accession to WTO could take place by end-1997.

28.  The government has passed amendments to the customs tariff schedule which, effective July 1, convert all remaining specific tariffs (with the exception of sugar, confectionaries, alcoholic beverages and tobacco cigarettes) to ad valorem tariffs; reduce agricultural tariffs on products which were well above 100 percent to 75 percent, thereby lowering the average production-weighted basic tariffs for all agricultural products to 34 percent; and significantly lower the basic tariff rates on many other goods, with several rates falling to zero or 1 percent. In addition, in June 1997, all quantitative import restrictions were eliminated. The export tariff on timber has been reduced by 50 percent and will be eliminated by the end of 1998. In addition, steps to restructure the agriculture sector are well advanced; many of the least efficient producers have left the market, several tax exemptions for agriculture have been eliminated, and remaining subsidies are transparent and modest (on the order of 3 percent of the basic budget). Ongoing reforms (under a proposed World Bank rural development project) including land reform, strengthening of the rural financial system, improved extension services, and targeted poverty reduction, should enhance the productivity of the agricultural sector and prepare farmers for a more competitive environment.

29.  We recognize that the reductions in agricultural tariffs, while substantial, fall short of the commitment under the previous program. We believe that our more gradual approach has been justified both by the already low level of effective protection for domestic agriculture brought about by the policies described above, the necessity of protecting poor farmers from additional transitory costs that would have arisen from further tariff reductions, and the slower-than-expected pace of negotiations with the WTO. However, we recognize the importance of a liberal trade policy in agriculture in benefitting consumers and contributing to the continuing restructuring of the economy, and intend to reduce both the level and dispersion of agricultural tariffs over the course of the program. Specifically, by end-June 1998, we intend to submit to Parliament legislation to ensure that the average production-weighted agricultural tariff rate (as defined under the program) is no greater than 30 percent, and convert the few remaining specific import duties except on sugar to ad valorem tariffs. By end-September 1997, the import licensing process will be reduced from 30 days to no more than 10 working days, and fees will be reduced to reflect only associated administrative costs, in line with WTO requirements. Finally, by end-1998, we will eliminate all remaining export duties (excluding those for books more than 50 years old and antiques.)

30.  The government will continue to pursue a prudent policy in contracting external debt, and intend to maintain the public external debt-to-GDP ratio at about 10 percent. We have, in addition, enhanced our monitoring of external debt by merging the Department of External Debt Management in the Ministry of Finance with the State Treasury Department, and by including all foreign loans contracted and guaranteed in the budget law starting with the 1997 budget. Following a favorable investment grade credit rating, opportunities for foreign borrowing by the private sector have increased; for balance of payments purposes, a system to report such borrowing has been put in place. With respect to the EU/G-24 loans, we will make a concerted effort at recovery to the fullest extent possible, and will refrain from on-lending of repayments.

Privatization

31.  The government has made a major effort to accelerate the privatization process, and we remain fully committed to our goal of privatizing all remaining enterprises by mid-1998. In this context, we aim to conclude 300 purchase agreements in 1997. Substantial progress has been made on privatizing the largest enterprises. In April 1997, 32.5 percent of the shares of Latvijas Gaze were sold to strategic investors, and following additional sales of shares to employees and the general public, the government will become a minority shareholder by March 1998. A major restructuring of the Latvenergo power company is underway, to be completed by January 1998, with the aim of transforming the company's branches into separate generating, transmission, and distribution enterprises. By end-September, we will decide (in consultation with the World Bank), on an approach to the privatization of Latvenergo, which will ensure a competitive environment following privatization. With respect to the Ventspils Nafta oil terminal, ancillary activities have been divested to the Latvian Privatization Agency, and a merger with a pipeline operator will be completed by September 15. These actions have paved the way for the next stage of privatization, involving sales to strategic investors as well as a public offering; it is expected that the government will become a minority shareholder by end-1997. The privatization of the Latvia Shipping Company was initiated toward the end of 1996, and negotiations have entered their second round with 8 potential strategic investors. A decision will be taken by the end of the year on the precise modalities of the privatization of the company, and the government will become a minority shareholder by end-June 1998.

32.  We plan as well to take specific steps to eliminate the structural problems in the energy sector that have slowed the privatization process to date. This includes resolving the issue of customer arrears and ensuring that tariffs are set to recover economic costs, including for capital. The government's assumption of part of the customer arrears of Latvijas Gaze (as well as a corresponding amount of the company's own arrears) was an important step in that regard, and write-offs against provisions and profits have further reduced the claims of Latvijas Gaze and Latvenergo. The current level of consumer arrears more or less corresponds to outstanding current bills according to the newly established payment schedules of 30 days for electricity bills and 40 days for gas bills. We will reinforce our efforts by establishing settlement schedules for debt not written off, and, in order to limit the accumulation of new arrears, enforcing strictly tariff payment, and cutting off service to customers who do not respect the new settlement schedules. In addition, the government increased electricity rates by about 10 percent on May 1, and has increased rates by more than 80 percent in real terms since July 1995, moving energy prices closer to covering full economic costs. Our energy pricing policies will continue to be based on the principle that tariffs be sufficient to cover economic costs, including the cost of capital.

33.  The government also has begun to quicken the pace of apartment privatization, with some 11 percent of all government-owned apartments sold by end-June. Most of these were privatized through an accelerated procedure, which can be initiated by individual tenants, and which avoids the need for land registration ahead of divestiture. We maintain our goal of privatizing 20 percent of government-owned apartments by end-year and an additional 30 percent in 1998. Amendments to the law on apartment privatization have been passed, allowing the sale of non-residential space for cash, reducing the ability of local governments to slow the privatization process, and allowing the sale of central government-owned apartments. Sales for cash have begun to generate revenues for local governments, which will allow them to implement the privatization program more rapidly. During the remainder of the year, we plan to take a number of additional supporting measures, including reaching agreements with local governments (which own most apartments) on a timetable for further privatization; and a significant increase in rents, now at very low levels, to provide incentive for tenants to privatize their apartments. We intend as well to move ahead with privatization of land and, starting in 1997, lots are being offered for sale in connection with enterprise privatization.

Other structural policies

34.  The government has as a high priority the improvement of governance in the country. We believe that maintaining a broad tax base, continuing to increase transparency in budgeting and expenditure management, including procurement, and eliminating unnecessary regulations and licenses will help to improve the transparency of public decision-making and limit opportunities for discretion by government officials. In addition, we intend to enforce rigorously the anti-corruption law passed last year, and to complete the anti-corruption program initiated this year in collaboration with the World Bank.

35.  We are advancing as well with respect to other structural measures needed to provide the basis for sustainable economic growth, including institutional and legal reforms to improve and extend property rights, increase competition, and further enhance the business climate. New regulations were introduced in November 1996 reducing the number of licenses required for different types of businesses from 165 to 118, and we are planning a substantial further reduction to approximately 70 by end-1997, limited to issues of national security and public safety and for statistical purposes. A law expanding the scope of land divestiture, including to foreigners, was passed during 1996. In addition, we have submitted in August 1997 legislation to establish a register for collateral based on movable property. The process of settling restitution claims and the subsequent land registration is also moving forward; we intend to register about one-third of all land and delineate and assess some 45 percent of all properties by end-1997.