For more information, see Republic of Latvia and the IMF
November 10, 1999Dear Mr. Camdessus:
The attached Memorandum of Economic Policies describes the policies the Government and the Bank of Latvia intend to follow for the remainder of 1999 and 2000. These polices are aimed at paving the way for a return to robust economic growth, while maintaining the sustainability of our external position. In this context, we view as central to our economic program a reduction in the fiscal deficit as well a steps to streamline, and enhance the effectiveness of, the public sector over the medium term. In parallel, we are committed to continuing implementation of those structural reforms required to lay the basis for sustainable growth, and to move toward EU accession. In support of these policies, we are requesting a 16-month stand-by arrangement in the amount of SDR 33 million. While we do not intend to make any purchases under the arrangement, we would do so should circumstances warrant.
We believe that the policies described in the attached memorandum are adequate to achieve the objectives of our economic program, but will take additional measures to meet these goals 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. Further, we will conduct with the Fund two reviews of economic developments and policies under the program, the first by mid-June 2000, and the second by mid-December 2000. In addition to a comprehensive evaluation of economic performance under the program, the first review will focus on progress in privatization of the remaining large public enterprises as well as public sector reform. The program will also be evaluated on the basis of a number of quarterly performance criteria and structural benchmarks (enumerated in the attached Table of the Memorandum of Economic Policies). Performance criteria for end-September 2000 and end-December 2000 will be specified at the time of the first review.
1. Since regaining independence, Latvia has succeeded in establishing macroeconomic stability, and has made substantial progress in implementing those structural reforms necessary for sustainable economic growth and eventual EU accession. This solid economic foundation has proved invaluable in allowing us to weather the effects of the economic crisis in Russia. However, the resulting fiscal and external imbalances will continue to present challenges during the remainder of this year and next. In this context, our goal is to pursue economic policies aimed at maintaining a sustainable external position while paving the way for a return to robust economic growth. We believe that a program to achieve such objectives must be centered on a return of the fiscal stance to its historically restrained path, combined with steps to streamline, and enhance the efficiency of, the public sector over the medium term. In parallel, we will need to continue implementing structural reforms and to address any remaining weakness in the banking system revealed by the Russia crisis. Renewed support by the International Monetary Fund will enhance the domestic and external credibility of our economic program for 1999–2000, described below.
2. Economic developments have been dominated since the third quarter of 1998 by the negative spillover of the Russian crisis on the financial and trade sectors. As a result, real GDP declined by about 2 percent on an annual basis in the first half of 1999 after having contracted by 1.9 percent in the fourth quarter of 1998. Inflation has continued to decline, with the CPI rising by just 2.1 percent in the twelve months through August. The collapse in the CIS export market led to a sharp rise in the external current account deficit in the latter part of 1998, contributing to a deficit of 9˝ percent of GDP for the year. However, in the first quarter of 1999, the external current account deficit improved to about 6˝ percent of GDP, as imports began to respond to the economic contraction, and a sharp drop in exports to the CIS was partly offset by a rise in exports to the rest of the world.
3. The fiscal outcome for first half of 1999 was affected adversely by the impact of slower economic growth on revenue, as well as by the higher pension and unemployment benefits and wage increases granted in late 1998, although the delay in the passage of the 1999 budget limited other spending in the first quarter of the year. As a result, the consolidated general government deficit reached 3.6 percent of GDP for the first half of 1999. In order to address the fiscal imbalance, parliament approved in August a negative supplementary budget for the remainder of 1999, which included spending cuts of some LVL 64 million (1.5 percent of GDP) as well as increases in excise tax rates on cigarettes, alcohol and fuel oil. Amendments to the pension law have been approved as well, aimed at raising gradually the retirement age and limiting pensions for working pensioners, but implementation of these changes has been delayed by legal challenges.
4. Monetary developments continue to show signs of a return to stability. Reserve money and broad money grew by some 4 percent and 5 percent, respectively, in the first half of 1999 and nongovernment credit rose at a similar rate, while deposit and lending rates declined. Since July, interventions by the Bank of Latvia (BoL) in the foreign exchange market have led to a temporary tightening of monetary conditions, and a modest rise in interest rates. Following the sharp ruble depreciation and default on Russian sovereign debt last year, several Latvian banks came under significant pressure. Since then, two small banks have been closed, and the operations of two other banks, including Rígas Komerc Banka (RKB), the country's fifth largest bank, were suspended earlier this year. The government and the BoL have responded to the banking sector difficulties with a three-pronged approach. First, temporary liquidity support was provided to the banking system. Second, banking supervision and the prudential regime continued to be enhanced and are now close to full compliance with the Basle Core Principles of Effective Bank Supervision (BCP) and the relevant EU directives. Third, RKB was recapitalized, and the bank was reopened in October.
5. Generally good progress continues to be made in implementing structural reforms. Privatization was largely completed by mid-1998, but sales of the three remaining large enterprises have been stalled. Apartment privatization has moved ahead, property rights have been strengthened, and the business climate has been improved. Progress also continues in trade policy and in February 1999, Latvia formally joined the WTO.
6. 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 remains appropriate. At the same time, we are accelerating our program of structural reforms, including the privatization of the three remaining large enterprises and improvements in the framework for private sector activity, in order to continue to attract foreign direct investment, increase productivity and exports, and generate economic growth. We will continue to strengthen the financial system as well, so as to enhance its intermediation role and limit its vulnerability to changes in the economic environment.
7. The negative impact of the Russian crisis on the Latvian economy has been deeper and more prolonged than originally anticipated. While an economic recovery appears to be in its early stage, real growth for the year as a whole is now expected at only around 1 percent, rising to 4 percent in 2000 and 6 percent over the medium-term. Inflation is projected at about 2 percent in 1999 and 3 percent in 2000 and over the medium-term.
8. Fiscal policies over the remainder of 1999 and 2000 will be focused on supporting economic growth while ensuring that significant external vulnerabilities do not develop. We plan, in this regard, to substantially tighten the fiscal stance during the program period, and take significant steps to improve tax administration and increase the efficiency and effectiveness of the public sector, which would allow us to return to near fiscal balance over the medium term.
9. For 1999, we are targeting a consolidated general government fiscal deficit of less than 4 percent of GDP. Such an outcome would, we believe, represent a considerable achievement, in light of the rather large external shock absorbed by the economy from the Russian crisis, as well as the sizable increases in wages and social benefits granted in the second half of 1998. We aim to intensify the fiscal adjustment effort next year and, in this context, are targeting a consolidated general government deficit of less than 2 percent of GDP. Given the already high tax rates in Latvia, we are focusing our efforts on placing stringent limits on expenditure. In particular, a freeze on the overall wage bill of the public sector and tight control over other current spending will contribute to a sharp decline in the ratio of expenditure to GDP of about 3 percentage points of GDP next year. Further, should central government revenue exceed the level we have conservatively projected for this year and next, the additional revenue would be dedicated fully to further deficit reduction; this commitment is formally incorporated in the quantitative performance criteria for the program (Table 1).
10. The economic program incorporates strong measures to address the solvency of the Pension Fund. While these steps are expected to have a significant impact on the financial health of the pension system next year, their full impact will be felt only over the medium-term. Amendments to the pension law passed in August would, inter alia, increase the pension age, and eliminate benefits for working pensioners receiving pensions above 60 lats per month. Should these amendments be overturned by the planned public referendum, the government would implement other measures to generate comparable savings for the Pension Fund. In addition, we will forego any further indexation of pension benefits until November 2000, and continue with CPI-based indexation until at least 2002. Finally, we intend to continue our ongoing reform of the pension system, by passing the necessary legislation for introducing the second pillar of the pension system by end-March 2000. We anticipate that the second pillar will begin operation by January 2001, contingent on the Pension Fund achieving medium-term financial viability.
11. We recognize that restructuring public expenditure and improving the financial control and accountability of public sector agencies remain key challenges. In particular, given the already high tax rates and the significant additional spending that would be required over the medium term by the planned EU and NATO accessions, it is particularly important that we take steps now to streamline government and reduce less productive expenditure. Reflecting the high priority we assign to these matters, we have, for the first time, named a minister in charge of public sector reform. Further, we intend to complete the ongoing study of public sector wage policy by end-October 1999 and to adopt a new Civil Service Law and public sector wage scale, consistent with the recommendations of this study and in line with budgetary requirements for 2000 and beyond, by end-June 2000. Our efforts to identify duplication of functions and other potential inefficiencies, and to reduce the overall size of the public sector, will rely in part on the expansion of functional reviews of government ministries and agencies. Such a review has been completed for the Ministry of Agriculture, and the resulting action plan for reorganization of the ministry has begun to be implemented. We intend to complete similar reviews for two other ministries by end-1999 and for a third ministry by end-March 2000, and to utilize their findings to generate additional savings during 2000 and in the context of the 2001 budget process. We will, in addition, move to increase public sector transparency and enhance expenditure control, by the submission to Parliament by June 30, 2000 of a Law on Public Sector Agencies, aimed at limiting the proliferation of new agencies and increasing their transparency and accountability. Beginning with the 2000 budget, we will also enhance the ability of the central government to monitor and control expenditure by bringing into the basic budget the gambling tax and a number of duties, fees and charges of special funds as well as the spending associated with these revenues. Further, we intend to bring most special funds into the basic budget and eliminate all earmarked taxes, with the exception of the social tax, beginning with the 2001 budget.
12. A crucial element of our program to improve the efficiency and effectiveness of the public sector is to enhance the functioning of local governments. The Law on Administrative Territorial Reform, passed in 1998, addresses the issue of the large number of very small and economically nonviable towns and pagasts, by providing incentives for voluntary consolidation of local governments and by amalgamating rajons into nine self-governing regions. To date, pilot projects have led to four such cases of consolidation. To speed the process, we intend to move forward the date by which this voluntary process is to be replaced by mandatory consolidation of nonviable governments from end-December 2003 to end-March, 2001. A study identifying those local governments to be consolidated is already underway.
13. The government will continue its efforts to improve tax administration through the ongoing institutional reform of the State Revenue Service (SRS), including the strengthening of customs administration, and the information technology project being carried out with World Bank assistance. The reorganization of the SRS is expected to improve taxpayer services by providing this function at the local level, while the regional level would focus on control, audit and methodology development. Enhanced computerization will contribute to the efforts of the SRS to upgrade significantly its audit function. The Customs Board aims to increase its control over local offices and expand its program of post-importation audits, to ensure that declared import prices are not too low. As part of our effort to maintain a tax system that is simple and broad-based, we will by end-March 2000 make the necessary changes in legislation to clarify and unify tax benefits in special economic zones and free ports and eliminate benefits which are not consistent with EU regulations.
External sector policies and prospects
14. We believe that the external current account deficit remains sustainable. Although we expect the current account deficit to reach approximately 9 percent for 1999, it is expected that about two-thirds of the deficit will be financed by foreign direct investment. Total external debt remains quite manageable, at about 20 percent of GDP in 1999, while public sector debt service is projected at about 4 percent of exports of goods and nonfactor services. Foreign official reserves are targeted to remain at or above 3 months of imports during the course of the program. The yield on the 75 million Eurobond issued in September stood at about 225 basis points above the German five-year bond compared to 330 basis points at issuance of the first 150million Eurobond in May; this, together with the reconfirmation of investment ratings by key rating agencies, indicates that Latvia retains the confidence of the international community.
15. While these indicators appear favorable, we recognize that there is no room for complacency. We are well aware, in particular, that the sustainability of the current account is closely tied to a return to prudent fiscal policies and an acceleration of progress in those structural reforms needed to attract continued FDI, and bring about further productivity gains and strong export growth. Further, we stand ready to tighten financial policies as needed to avoid pressure in the exchange market and maintain the sustainability of the external position. Finally, we are cognizant of the importance of maintaining our debt burden at a cautious level and, in this context, we will carefully assess the need for, and timing of, any further Eurobond issue.
Monetary and exchange rate policies
16. The BoL intends to maintain its current exchange rate peg to the SDR for the program period. A number of key indicators, including growth in export market shares, dollar wages, and unit labor costs, suggest that Latvia has maintained its external competitiveness, despite a gradual appreciation of the real exchange rate. In support of the exchange rate peg and to meet inflation targets, the BoL will undertake foreign exchange transactions and conduct open market operations as necessary.
17. We have formulated a quarterly monetary program including ceilings for net domestic assets of the BoL, taking into account the expected path for growth, inflation, and the balance of payments. The program assumes a gradual increase in money demand and a modest rise in the money multiplier, reflecting expected cautious gains in confidence in the economy and banking system. Reserve money is projected to increase by about 6 percent and broad money by 12 percent in 1999, with increases of 15 and 16 percent, respectively, next year. Private sector credit growth is expected to pick up moderately toward the end of the year and in 2000, in line with the anticipated resumption of economic growth; nevertheless, banks are expected to remain prudent in their lending behavior and adjust their credit operations in response to the enhanced prudential requirements.
18. In view of the need for an adequate level of international reserves, the program establishes a floor on the net foreign assets of the BoL. This floor has been set at a level that is lower than projected under the monetary program, given the difficulties in accurately predicting capital flows and the potential need for short-run interventions. In the event of pressures in the foreign exchange market, the BoL will take the necessary measures to defend the peg, including by raising interest rates. We will consult with Fund staff in case of interventions in the foreign exchange market exceeding US$75 million in any two-week period.
Financial sector policies
19. The Russian crisis had a significant impact on the Latvian financial sector, in particular the banking industry. In reaction to the crisis, the BoL intensified its oversight of banks with large exposure to Russia, increased the weighting of banks' holdings of non-OECD (Zone B countries) government securities for purposes of calculating risk-weighted capital, and introduced limits on banks' exposure to non-OECD countries. In order to minimize the risk of a systemic crisis, the BoL and the government have contributed to the recapitalization of RKB, which had become insolvent as a consequence of its exposure to Russian assets. The BoL will urge the RKB to seek, without delay, a strategic investor or a merger with another bank. Moreover, the BoL is fully committed to divest its investment in the RKB as soon as market conditions allow and, in any case, by end-September 2000.
20. The BoL has been steadfastly implementing a broad-based plan to further strengthen banking oversight and financial sector supervision and to ensure full compliance with the Basle Core Principles of Effective Bank Supervision and the relevant EU directives. First, banking supervision on a consolidated basis has been largely implemented. Prudential returns of banks are now compiled on a consolidated basis, and the BoL has begun to receive these returns for the first half of 1999. Annual accounts of credit institutions will, beginning with 1999, also have to be prepared and audited on a consolidated basis. Second, regulations and reporting requirements for the comprehensive treatment of country risk and transfer risk were adopted in July 1999 and reporting will become effective October 1, 1999. Third, amendments to existing regulations on loan classification and loan-loss provisioning, aimed at enhancing and simplifying loan classification procedures and ensuring adequate provisioning, including for country and transfer risk, have been approved by the BoL, and are to be implemented effective January 1, 2000. Fourth, we are moving to enhance our prudential regulation to cover market risk. The BoL is preparing regulations on capital charges and reporting requirements for market risk and will approve the prudential coverage of such risk by end-March 2000, for implementation beginning July 1, 2000. Moreover, memoranda of understanding have been signed with supervisory agencies of other countries and the domestic agencies responsible for banking, securities, and insurance supervision, which will facilitate transfer of information and therefore strengthen financial sector oversight. We intend to submit to the cabinet a draft law on the creation of a unified financial sector supervisory agency. In this context, we are fully committed to ensuring adequate safeguards to maintain the political independence of such a regulatory agency, and a high quality of staff. We will also strive to expeditiously introduce rules, in line with EU directives, to cover the reporting on close links and requirements for pre-notification of the BoL in case of a major acquisition or investment by a bank. We will continue to monitor closely the quality of loan portfolios, and stand ready to take rapid action should problems begin to be perceived.
21. Latvia has made significant progress in trade liberalization in the last several years, and is rated among the least trade-restricting countries according to the IMF Index of Trade Restrictiveness. The simple average tariff declined from 5.6 percent to 5.0 percent during 1997-99, and tariff dispersion fell from 10.7 to 9.7 over the same period. With respect to agriculture, the production-weighted MFN tariff for those commodities subject to tariffs of 20 percent or more (mainly cheese, butter, pork products, and grain products) was reduced from 38 percent to 35 percent in February 1999, and virtually all tariff rates for agricultural commodities are now lower than, or equal to, EU rates. Nevertheless, we plan to take steps to further simplify and liberalize our trade regime. Specifically, by end-September 2000, we shall lower all tariff rates above EU levels to EU levels, effective January 1, 2001. In addition, pursuant to our accession agreement with the WTO, we will reduce the production-weighted average tariff on those agricultural commodities mentioned above to about 34 percent, to be effective no later than June 2000. Legislation for a further small reduction will be enacted by end-September 2000, to be effective January 1, 2001. Beyond 2001, these rates will continue to be steadily reduced. We have continued to enhance our legislative framework for trade and to make it consistent with WTO regulations and guidelines. In this regard, in March 1999, Parliament adopted the law on safeguards in compliance with the relevant WTO legislation. An anti-dumping law, based on WTO text and consistent with its regulations, has been passed by parliament in its first reading, and is expected to be enacted before end-1999. Likewise, we aim to have a countervailing duties law consistent with WTO regulations enacted by end-2000. We have introduced a temporary tariff on pork products in line with the WTO safeguards regulations. We expect continued improvements in market conditions, which would allow us to not renew this temporary tariff beyond its expiry date in December 1999. Finally, we shall not, during the program period, introduce any new specific tariffs or export subsidies.
Privatization and other structural reforms
22. We are committed to revitalizing the privatization process and completing it before end-2000. Toward this end, the Cabinet of Ministers approved privatization terms for the Latvian Shipping Company in mid-August. In accordance with these terms, we intend to complete the sale of 44 percent of the company to a strategic investor by January 2000. By end-March 2000, an additional 21 percent of shares will be sold to employees and other domestic residents in return for privatization vouchers, leaving the government as a minority shareholder. We will strive to sell the remainder of shares by end-2000. With regard to Latvenergo, the cabinet will approve the method of privatization and a timetable by end-December 1999. The timetable will include the sale of a substantial share of Latvenergo by end-September 2000, details of which will be discussed at the time of the first review. Privatization of Lattelekom (of which the government still owns 51 percent) will be completed once negotiations are concluded with the current strategic investor to determine compensation for its relinquishing monopoly rights earlier than initially agreed; the government will aim to sell its remaining shares in Lattelekom by end-September 2000. Privatization receipts in excess of budget amounts would be used for debt repayment.
23. Improvements in the regulatory and legal framework for utilities need to move forward in parallel with the privatization process. In the energy sector, regulation will be enhanced to ensure that rate-setting is based on economic criteria and that regulation is aimed at encouraging competition. This will be reflected in the government's new energy sector policy, the formulation of which will be completed by end-September 1999. Moreover, several reforms in energy legislation are required to allow the privatization of Latvenergo to go forward. The energy law will need to be amended to allow the privatization of hydropower stations. A new law on holding companies and subsidiaries (Law on Concerns) will also need to be enacted if privatization of Latvenergo as unbundled units is to remain an option. We will work towards having both legislative measures passed by end-December 1999. Further, a new telecommunications law, aimed at strengthening the independence of the telecommunications regulator, will be submitted to cabinet by end-December 1999, with the aim of ensuring passage by parliament by end-June 2000. At the same time, we are committed to putting in place a single regulatory agency with responsibility for all public utilities by January 2001, and legislation to this effect will be presented to parliament by end-March 2000.
24. We continue to improve the business environment in Latvia, notably by implementing the requirements of the acquis communautaire and the recommendations of the 1998 Foreign Investor Advisory Service (FIAS) report on administrative barriers to foreign investment in Latvia. First, we aim to have a new commercial code, with enhanced protection of creditor interests and minority shareholder rights, enacted by end-March 2000. Minority shareholder rights will also be bolstered by a new Securities Law, which is currently being prepared. Second, to strengthen the capacity of the judicial apparatus to implement new legislation, we will continue efforts to increase judicial training. Third, to facilitate the creation of new companies, the Enterprise Register and the State Revenue Service will put into practice a unified enterprise registration procedure by end-June 2000. Fourth, in the construction sector, we will reduce the time needed to obtain land property rights and register real estate by end-June 2000, and work with municipalities to streamline the process of obtaining permits for commercial construction projects. Finally, to make the application of customs procedures more transparent and consistent, we will take steps to improve the training of customs officials.
25. We have continued to make good progress in other areas of structural reform. By end-July, nearly all land properties had been registered in the cadastre and some 33 percent had been entered into the Land Book. We expect this share to rise to 40 percent by the end of the year, and to 60 percent by end-2000. In addition, two-thirds of government-owned apartments had been privatized by end-August, and we anticipate that this share will rise to 75 percent of all apartments by the end of 1999 and that privatization will be near completion by end-2000.
26. We believe that the policies described above will help ensure that Latvia experiences strong and sustainable economic growth over the medium-term. We stand ready to take additional measures to meet these goals should the need arise.