## _cr0903

## Source details

**Canonical URL:** [_cr0903](https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2009/_cr0903.pdf)

## Other formats

- [Markdown version](/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2009/_cr0903.pdf.md)
- [Structured JSON version](/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2009/_cr0903.pdf.json)

---

### Introduction and crisis context
- Years of unsustainably high growth and large current account deficits have coalesced into a financial and balance of payments crisis.
- Since end-August, private sector deposits have fallen by 10 percent; Parex Bank lost more than a quarter of its deposits.
- From end-August to end-November, official reserves fell by almost 20 percent to €3.4 billion, one third of short-term external debt and just over 100 percent of base money (from 127 percent in September), as the central bank sold foreign currency to defend the peg.
- Despite substantial intervention, since early October the exchange rate has remained at its upper (depreciated) band, while interbank spreads have spiked.
- Authorities sought Fund assistance under emergency financing procedures and support from the European Union’s balance of payments facility, partner countries and other international organizations.
- Program centerpieces: (i) immediate measures to stem the loss of bank deposits and international reserves; (ii) steps to restore confidence in the banking system in the medium-term; (iii) fiscal measures to limit the substantial widening in the budget deficit, and prepare for early fulfillment of the Maastricht criteria; and (iv) incomes policies and structural reforms to rebuild competitiveness under the fixed exchange rate regime.

### Macroeconomic outlook and targets (2009–2011)
- Growth and inflation projections (staff baseline):
  - Real GDP: drop by 5 percent in 2009 and a further 3 percent in 2010, before growing in 2011.
  - Year average inflation in 2009 drops to just under 6 percent; December year on year inflation falls to just above 3 percent; headline inflation expected to fall to 2 percent by end-2010.
- External sector:
  - Current account deficit projected to decline from 14¾ percent of GDP in 2008 to 7¼ percent in 2009, and to -5.5 percent of GDP in 2010 (Box 7 table).
  - Capital and financial account: from a €2.2 billion surplus in 2008 to a €2.2 billion deficit in 2009; FDI declines considerably; trade credit contracts; net short-term capital outflows rise sharply as non-resident deposits are withdrawn.
- Bank and corporate rollover assumptions:
  - Bank rollover: 80 percent for foreign-owned banks and their subsidiaries; 40 percent for state-owned and domestic banks without a foreign affiliation.
  - Corporates: ability to rollover only 40 percent of their external debt, with supporting assumptions: 75 percent rollover for non-bank financial institutions to foreign parents; 50 percent for loans of public companies; considerably lower rollover for real estate and construction firms.
- Medium-term recovery narrative: gradual moderate recovery as global deleveraging eases, banks recapitalized, external financing and domestic lending resume, EU grants boost investment, and wage/price slowdowns improve competitiveness; positive output growth should resume from 2011 but remain below Latvia’s long-term potential.

### Financial sector strains, Parex Bank, and crisis response
- Banking vulnerabilities and exposures:
  - Two-thirds of bank loans are backed by real estate.
  - Real estate prices have fallen by a third since the peak of the boom.
  - Overdue loans have picked up; many will probably turn non-performing.
  - Almost 60 percent of the banking system is owned by banks from Sweden and other Nordic countries; loans from parent institutions are main financing source with 80 percent maturity greater than one year.
  - Domestically owned banks rely on short-term syndicated loans and non-resident deposits.
  - Reported liquidity and capital adequacy ratios suggest capacity to withstand a gradual deterioration; solvency indicators were boosted in October by reclassification of securities as “held to maturity” under a new IFRS regulation.
- Crisis developments and BoL support:
  - From end-August to end-November, system-wide deposits fell by 10 percent (excluding valuation effects); non-resident deposits fell 13 percent since end-August.
  - The BoL provided LVL 555m (€780 million, 3½ percent of GDP) in additional banking system liquidity since end-August: LVL 195 million (€279 million) attributed to operations backed by Treasury bills for Parex; earlier LVL 200 million from lowering reserve requirements; further cuts released LVL 380 million.
  - Since end-August the BoL sold around €900m in foreign currency: just under a quarter of official reserves.
  - Latvian banks need to rollover €1.4 billion of syndicated loans (roughly 5 percent of their liabilities) in the coming year.
- Parex Bank specific actions and risks:
  - Initial voluntary government agreement to take over 51 percent failed to stop outflows; authorities increased liquidity support—LVL 350 million (€500 million or more than 2 percent of GDP) from the Treasury and a net LVL 200 million (1¼ percent of GDP) from the BoL.
  - On December 1, authorities imposed a partial freeze limiting withdrawal amounts from large non-commercial private deposits (an exchange restriction subject to Fund approval).
  - Parex has €775 million (3½ percent of GDP) of syndicated loans maturing in February and June 2009, plus a €200 million Eurobond which is potentially callable—risks could lead to a €1 billion capital outflow.
  - On December 5 the government completed takeover of 85 percent of Parex shares and appointed new professional management; emergency legislation submitted to permit government intervention and full takeovers where needed.
  - Staff recommendation: once the government has full ownership, err on the side of overcapitalizing Parex by raising capital adequacy to at least 12 percent (provided due diligence suggests positive going-concern value); develop clear strategy to return bank to private sector rapidly; consider EBRD participation; partial deposit freeze to be lifted once outflow pressures ease.

### Private debt restructuring and insolvency reform
- Private debt restructuring critical given large external private debt and domestic on-lending by foreign parents.
- Authorities committed to developing a comprehensive private debt restructuring strategy by end-April 2009.
- Likely elements of strategy:
  - Amend insolvency law to facilitate workouts between viable enterprises and their creditors by end-June 2009; distinguish viable firms for rehabilitation from non-viable for liquidation; expedite court approval and grant priority status to new financing.
  - Improve personal bankruptcy framework: streamlined procedures, debt counseling, timely creditor participation; encourage loan modifications given substantial decline in real estate prices.
  - Strengthen banks to restructure debts: parent banks expected to absorb loan losses in subsidiaries; consider debt-equity swaps, bank recapitalization, transfer of bad assets to independent asset management company; assess case-by-case vs. broader approaches.

### Fiscal consolidation, measures, and structural reforms
- Initial fiscal context:
  - Without policy change, 2009 fiscal deficit was set to reach double digits.
  - 2008 deficit now expected to be 3 percent of GDP (compared to earlier assumed budget balance).
  - 2009 budget passed in November targeted a 1 percent of GDP surplus originally; revised target was budget balance but weakness in tax revenues led to expected deficit around 3 percent of GDP.
- Supplementary budget and program targets:
  - On December 11 Parliament adopted a revised budget with 7 percent of GDP in measures, to target a 4.9 percent of GDP deficit.
  - Composition of adjustment: roughly ⅓ from revenue measures and ⅔ from cutting expenditure (reducing public sector nominal wages and a 25 percent real cut for most current spending).
  - Revenue measures include: increase standard VAT by 3 percentage points to 21 percent and reduced rate from 5 percent to 10 percent from 2009; increased excises; PIT rate reduced by 2 percentage points to 23 percent but partially reverse increases in non-taxable allowances; from 2010 introduce 10 percent tax on all capital income and increase real estate/property taxes.
  - Expenditure measures: cap 2009 expenditures at just below 40 percent of GDP; require cuts of 4½ percent of GDP over and above originally adopted central government budget; approximately 15 percent cuts in compensation of all public sector employees from January 1, 2009; pension freeze; rationalize subsidies; protect productive government investment and social spending.
  - Social spending: increase from 21 to 25 percent of the budget; total social spending will increase by 1½ percent of GDP between 2008 and 2009; supplementary budget maintains increases to small pensions, minimum wage, personal income tax allowances, unemployment benefits and State Employment Agency funds.
- Medium-term fiscal aims:
  - Lower deficit to Maastricht level of 3 percent of GDP "as soon as reasonably feasible", with structural adjustment of 6 percentage points of GDP from 2008 to 2011.
  - Adopt fiscal rules, medium-term budget framework, strengthen public financial management; prepare fiscal responsibility law in first semester of 2009.
  - Additional consolidation measures through 2011 may include further VAT increases, additional public employment and wage reductions, and indexing pensions only to inflation from 2010.

### Exchange rate policy, alternative regimes, and strategy choice
- Macroeconomic framework centered on maintaining Latvia’s quasi-currency board at the current exchange rate parity (LOI ¶19–20); authorities and EU institutions strongly oppose change in the peg.
- Key risks of changing the peg:
  - Balance sheet effects: some 70 percent of bank deposits and nearly 90 percent of loans are foreign currency denominated; private sector net foreign currency debt around 70 percent of GDP.
  - Devaluation could shrink the current account deficit but increase external debt to GDP ratio sharply and may not improve private sector roll-over rates.
  - Spillovers to emerging European economies and Nordic parent banks.
- Alternative regimes considered (Box 1):
  - Widening exchange rate band to ±15 percent (ERM2 permitted): could improve competitiveness faster and reduce current account deficit, but produce larger initial output decline due to adverse balance sheet effects; a 15 percent devaluation would increase private sector net foreign currency exposure by 11 percent of GDP (two thirds corporate, one third household), private consumption fall by around 6 percentage points, and private investment fall by 5 percentage points.
  - Accelerated euro adoption at a depreciated exchange rate: would deliver many benefits and avoid speculative parity setting, possibly easing ECB facility access for solvent banks, but would not resolve solvency concerns; EU authorities ruled out immediate euro adoption as inconsistent with the Maastricht Treaty.

### External financing package, Fund Stand-By Arrangement (SBA) and phasing
- Balance of payments needs through early-2011:
  - With current account deficit projected at 7¼ percent of GDP in 2009, gross external financing requirements close to €15 billion through early-2011, net financing gap around €7.5 billion.
- External commitments expected to fill bulk of the gap:
  - The European Union: €3.1 billion over the program period, including €2.2 billion over the next 6 months.
  - The Nordic Countries: up to €1.8 billion, expect to disburse from early 2010.
  - The Czech Republic, Poland and Estonia: €0.2 billion, €0.1 billion and €0.1 billion, respectively.
  - The World Bank and the EBRD: €0.4 and €0.1 billion, respectively.
- IMF exceptional access under SBA:
  - Amount: SDR 1.521626 billion (1200.02 percent of quota, or approximately €1.7 billion).
  - Proposed initial purchase: up to SDR 0.54 billion (SDR 535.344 million upon approval).
  - Arrangement length: 27 months (December 2008 to March 2011).
  - Phasing (Box 7 and TMU timetable):
    - December 23, 2008: 535.344 SDRs — Approval.
    - February 15, 2009: 178.448 SDRs — First review/end-Dec-2008 targets.
    - May 15, 2009: 178.448 SDRs — Second review/end-Mar-2009 targets.
    - Subsequent tranches: 89.224 SDRs (Aug-09, Nov-09, Feb-10, May-10, Aug-10, Nov-10) and final 94.042 SDRs on Feb-15-2011; Total: 1521.626 SDRs (1200.0 percent of quota).
  - Purchases from February 2009 onward depend on quarterly reviews.
- SBA conditionality and prior actions (selected):
  - Prior actions: submit Parex resolution plan to FCMC; Parliament adopt 2009 supplementary budget capping general government deficit below 5 percent of GDP; government sign protocol stipulating 15 percent reduction in local government employees’ average compensation.
  - Quantitative performance criteria and indicators: floors on net international reserves of the BoL; ceiling on net domestic assets of the BoL; floor on adjusted general government cash balance; continuous criteria on non-accumulation of domestic and external debt arrears; indicative ceiling on general government wage bill.
  - Structural benchmarks include: adopt operational guidelines for emergency liquidity assistance by December 31, 2008; establish Committee to Promote Wage Restraint by January 31, 2009; complete focused examination of banking system by March 31, 2009; develop comprehensive debt restructuring strategy by April 30, 2009; amend banking and insolvency laws by end-June 2009; submit second supplementary budget by March 31, 2009.

### Risks, downside scenarios, and staff assessment
- Main risks to program and repayment capacity:
  - Correcting currency misalignment without nominal depreciation is extremely difficult; requires large external support and sustained wage and fiscal discipline.
  - Maintaining the peg requires substantial political commitment; risk of weakening execution if commitment falters.
  - Local governments account for one-third of government spending; their commitment is critical and past off-balance-sheet local projects may create contingent risk.
  - Financial sector stabilization is essential; new bank liquidity problems or higher-than-expected non-resident deposit withdrawals could widen financing gap.
  - Success in rebalancing toward tradables via structural reform is required to preserve repayment capacity.
  - Regaining access to international capital markets, particularly medium- and long-term borrowing after the program ends, is key.
- Stress-test and scenario findings (Box 6):
  - Baseline gross external debt around 134 percent of GDP, projected to rise before declining rapidly after 2011.
  - Real depreciation shock (30 percent one-time) raises external debt to GDP outcome to 198 (figure labels).
  - Combined shock outcome: 147 (figure labels).
- Fiscal costs and contingent liabilities of bank restructuring (preliminary staff estimates):
  - Total fiscal costs of bank restructuring may fall between 15-20 percent of GDP through 2010, increasing public sector gross debt above 40 percent of GDP.
  - Public sector contingent liabilities related to the banking sector could reach 20 to 30 percent of GDP during the period.
  - Direct fiscal costs table (millions of lats and percent of GDP): Direct fiscal costs (2008, 2009, 2010, Total): 356, 1,868, 253, 2,477 — 2.3, 12.4, 1.7, 16.4 (percent of GDP).
  - Contingent liabilities: 4,449, 4,553, 3,422 — ... 29.1, 30.2, 23.0 (percent of GDP).
  - Footnotes preserved: 1/ Excluding capital injections by foreign shareholders, estimated at 9.7% of GDP over 2009-2010. 2/ Assuming a realization rate of 5%, over 2009-2010, on guarantees over deposits and of 50% on potential guarantees in 2009. 3/ Medium-term deposits in Parex are projected at 356 millions lats. Short-term deposits may reach 211 millions lats in 2008 and be rolled over onto 2009.
- Risks to the Fund from SBA (assessment excerpt):
  - Outstanding use of Fund resources would reach 422.2 percent of quota upon approval and 1,200 percent by February 2011.
  - If drawn in full, Latvia’s outstanding use of Fund resources will represent 8 percent of GDP by 2011; from first purchase outstanding use would be 2.8 percent of GDP.
  - Projected Fund GRA credit outstanding to Latvia (SDR millions): 2008: 535.3; 2009: 1,070.7; 2010: 1,427.6; 2011: 1,521.6; service peaks in 2013 at SDR 634.7 (Table 6 projections preserved).

### Key quantitative targets and monitoring (selected exact figures from TMU and program)
- Net international reserves (floors, million euros): Dec-08 2,103 ; Mar-09 737 ; Jun-09 -507 ; Sep-09 -1,128 ; Dec-09 -1,531.
- Net domestic assets of the BoL (ceilings, million lats): Dec-08 951 ; Mar-09 1,434 ; Jun-09 2,501 ; Sep-09 2,656 ; Dec-09 2,928.
- Adjusted cash fiscal balance (floors, million lats): Dec-08 -894 ; Mar-09 -305 ; Jun-09 -649 ; Sep-09 -893 ; Dec-09 -1,282.
- General government wage bill (ceilings, million lats): Dec-08 1,248 ; Mar-09 214 ; Jun-09 490 ; Sep-09 660 ; Dec-09 884.
- TMU program exchange rates (as of November 28, 2008): LVL 0.702804 = €1 ; LVL 0.544 = $1 ; LVL 0.00571 = 1 JPY.
- Outstanding stock as of November 30, 2008:
  - Net international reserves: 3,368 (million euros).
  - Foreign reserve assets: 3,618 (million euros).
  - Foreign reserve liabilities: 250 (million euros).
  - Net foreign assets of BoL: 2,367 million lats (as of November 30, 2008).
  - Net domestic assets of BoL: -99 (million lats).
  - Base money as of November 30, 2008: 2,268 million lats.

### Staff appraisal and policy conclusions (summary)
- Latvia faces intense liquidity pressures and needs steps to address external debt sustainability concerns, triggered by global financial turmoil and domestic vulnerabilities from the post-EU-accession boom.
- Strategy centers on maintaining the existing exchange rate peg, relying on a prolonged period of factor price compression including reductions in real and nominal wages.
- Exceptional access is proposed because of large capital-account pressures, a low public debt starting position providing room to absorb private liabilities if necessary, and prospects of regaining market access by 2011.
- Policy requirements: exceptionally strong domestic policies—ambitious fiscal consolidation, incomes policies to reduce nominal wages, comprehensive financial sector reforms, private debt restructuring, and sustained structural reforms to improve competitiveness.
- Program safeguards: external financing assurances, targeted conditionality (including passage of supplementary 2009 budget as a prior action), quarterly reviews, and substantial technical assistance.

*Source: IMF staff report excerpts and Technical Memorandum of Understanding (December 2008) as provided in the supplied content.*

### 1. Alternative Exchange Rate Options .............................................................................26

### 1. Alternative Exchange Rate Options

### Introduction: crisis context and program focus
- Years of unsustainably high growth and large current account deficits have coalesced into a financial and balance of payments crisis.
- Since end-August, private sector deposits have fallen by 10 percent, led by a run on Parex Bank which lost more than a quarter of its deposits.
- From end-August to end-November, official reserves fell by almost 20 percent to €3.4 billion, one third of short-term external debt and just over 100 percent of base money (from 127 percent in September), as the central bank sold foreign currency to defend the peg.
- Despite substantial intervention, since early October the exchange rate has remained at its upper (depreciated) band, while interbank spreads have spiked.
- The authorities are seeking Fund assistance under the emergency financing procedures and support from the European Union’s balance of payments facility (consistent with commitments under Article 119 of the European Community treaty), partner countries and other international organizations.
- The proposed Fund-supported program is part of a coordinated international effort with participation from the European Commission, ECB (in line with Latvia’s ERM2 membership), Sweden and other Nordic countries, and financial assistance and expertise from the World Bank and EBRD.
- Program centerpieces: (i) immediate measures to stem the loss of bank deposits and international reserves; (ii) steps to restore confidence in the banking system in the medium-term; (iii) fiscal measures to limit the substantial widening in the budget deficit, and prepare for early fulfillment of the Maastricht criteria; and (iv) incomes policies and structural reforms to rebuild competitiveness under the fixed exchange rate regime.

### Economic developments — background and overheating
- Growth and income:
  - From 2000 to 2007, GDP expanded at an average annual rate of 9 percent.
  - Per capita income rose from 37 percent to just under 60 percent of the EU27 average.
- Overheating indicators by mid-2006:
  - Credit grew at an annualized rate of more than 50 percent.
  - Stock of credit was 70 percent of GDP at end-2005.
  - Real estate prices jumped more than 60 percent in both 2005 and 2006.
  - Current account deficit peaked in late 2006 at more than 25 percent of GDP.
  - Core inflation rose to almost 10 percent year on year by mid-2007.
  - CPI-based real effective exchange rate appreciated by 15 percent from EU accession to end-2007.
  - Staff estimates a cumulative fiscal stimulus of more than 6 percent of GDP through end-2007, while output exceeded potential by 9 percent.
- Procyclical fiscal policy: real expenditure grew by 80 percent between 2003 and 2007.

### Recent developments (late 2007–2008): slowdown and external adjustment
- Growth and activity:
  - GDP started to level off from Q4 2007; projected to fall by 2 percent in the current year.
  - Slowdown driven by lending slowdown that started in early 2007; consumption and investment fell; manufacturing output dropped sharply.
- Fiscal outcomes:
  - Original government objective of a 1 percent surplus was abandoned; revised target was budget balance but weakness in tax revenues has led to an expected deficit of around 3 percent of GDP.
- External sector:
  - Current account deficit narrowed by more than 10 percentage points in the last year, to 13 percent of GDP in Q3 2008.
  - Contribution to adjustment: rise in trade balance of 7.8 percentage points (falling imports) and increase in income balance of 1.2 percentage points (falling profits and reduced earnings of direct investment).
- External vulnerabilities (Tables 3 and 4):
  - Gross external debt has risen above 130 percent of GDP.
  - External debt with original maturity below one year (including non-resident deposits at call) exceeds 50 percent of GDP.
  - An additional 12 percent of GDP in medium- and long-term external liabilities matures in the next year.
  - Private sector net external debt of 70 percent of GDP.
  - Public sector is currently a net external creditor but may have to assume private sector liabilities.
  - Banks’ reported short-term liquid external assets are 45 percent of GDP.

### Financial sector strains and banking structure
- Asset quality and loan exposures:
  - Two-thirds of bank loans are backed by real estate.
  - Real estate prices have fallen by a third since the peak of the boom.
  - Overdue loans have picked up; many will probably turn non-performing.
- Ownership and funding structures:
  - Almost 60 percent of the banking system is owned by banks from Sweden and other Nordic countries.
  - Loans from parent institutions are these banks’ main source of financing; 80 percent of these loans have maturity greater than one year.
  - Foreign bank ownership in Latvia is lower than in Estonia and Lithuania (97 and 85 percent foreign bank shares).
  - Domestically owned banks rely on short-term syndicated loans and non-resident deposits.
- Reported solvency and liquidity:
  - Reported liquidity and capital adequacy ratios suggest capacity to withstand a gradual deterioration, but solvency indicators were boosted in October by reclassification of securities as “held to maturity” under a new IFRS regulation.

### The current crisis (late 2008): market reaction and liquidity drains
- Market sentiment:
  - All three ratings agencies have recently downgraded Latvia; Fitch and S&P assigning lowest investment grade ratings, both with negative outlook.
  - Eurobond spread increased to around 600 basis points; CDS spread has flirted with the 1,000 basis point level.
- Deposit and reserve developments:
  - From end-August to end-November, system-wide deposits fell by 10 percent (excluding valuation effects).
  - Non-resident deposits (almost half total deposits, overwhelmingly in Latvian-owned banks) have fallen 13 percent since end-August.
  - Parex Bank lost one quarter of its deposits since end-August.
  - The BoL provided LVL 555m (€780 million, 3½ percent of GDP) in additional banking system liquidity since end-August.
    - Of this, LVL 195 million (€279 million) attributed to operations backed by Treasury bills issued specifically for liquidity support of Parex Bank.
    - Earlier in the year the BoL released LVL 200 million by lowering reserve requirements; further cuts in November and December released an additional LVL 380 million.
  - Since end-August the BoL has sold around €900m in foreign currency: just under a quarter of official reserves.
  - Latvian banks need to rollover €1.4 billion of syndicated loans (roughly 5 percent of their liabilities) in the coming year.
- Parex Bank specific risks:
  - Initial voluntary government agreement to take over 51 percent (allowing former shareholders to retain significant influence and right to buy back shares one year later) failed to stop outflows.
  - Authorities increased liquidity support—LVL 350 million (€500 million or more than 2 percent of GDP) from the Treasury and a net LVL 200 million (1¼ percent of GDP) from the BoL.
  - On December 1, authorities imposed a partial freeze limiting withdrawal amounts from large non-commercial private deposits.
  - Parex has €775 million (3½ percent of GDP) of syndicated loans maturing in February and June 2009, plus a €200 million Eurobond which is potentially callable—risks could lead to a €1 billion capital outflow.

### The authorities’ program: objectives and strategy
- Immediate objective:
  - Stabilize the financial sector, restore depositor confidence, and avoid disorderly adjustment that would follow abandoning the exchange rate peg.
  - Program includes measures to ringfence and resolve immediate problems in Parex Bank.
  - Draw on substantial outside international financial assistance to meet foreign exchange demand.
- Medium-term objective:
  - Promote economic adjustment and strengthen the peg by restoring confidence in the broader financial system and halting external liquidity drain.
  - Substantial fiscal policy tightening to reduce financing needs, foster real depreciation, and make room for potentially large contingent financial sector liabilities.
  - Aim to meet the Maastricht deficit criteria to facilitate adoption of the euro.
  - Strong incomes policies to reduce inflation and improve competitiveness, structural policies to boost productivity and shift activity from non-tradables to tradables, and likely need for private sector debt restructuring.
- Strategy choice:
  - The authorities’ unequivocal commitment to the exchange rate peg determined the choice of program strategy.
  - Recognition that maintaining the peg brings difficult consequences, including the need for fiscal tightening and the possibility that recession could be protracted relative to alternative strategies.

*Source: IMF staff report excerpt (section and figures/tables referenced in the source PDF).*

### 19.      The macroeconomic framework is centered on maintaining Latvia’s quasi-

### _cr0903 - 19. The macroeconomic framework is centered on maintaining Latvia’s quasi-currency board at the current exchange rate parity

### Exchange rate policy and risks
- The macroeconomic framework is centered on maintaining Latvia’s quasi-currency board at the current exchange rate parity (LOI ¶19–20).
- Key risks of a change in the peg:
  - A change in the peg is strongly opposed by the Latvian authorities and by the EU institutions and would undermine program ownership; the quasi-currency board has been an anchor of macroeconomic stability for more than 15 years and commands popular and political support.
  - Balance sheet effects: some 70 percent of bank deposits and nearly 90 percent of loans are foreign currency denominated; private sector net foreign currency debt of around 70 percent of GDP would cause an immediate deterioration in private sector net worth with any nominal exchange rate change.
  - External financing needs might not be significantly reduced: devaluation would shrink the current account deficit but external debt to GDP ratio would increase sharply and private sector roll-over rates might not improve.
  - Spillover risks to emerging European economies, especially the Baltics and South-Eastern Europe; loan losses in Nordic banks could hurt market confidence in those banks.
- Alternative regimes considered:
  - Widening the exchange rate band to ±15 percent (permitted under ERM2; currently Latvia has unilaterally adopted a ±1 percent band) would produce a larger initial output decline due to adverse balance sheet effects, but would improve competitiveness more quickly and reduce the current account deficit (Box 1).
  - Changing the parity would be more attractive if accompanied by immediate euro adoption, but the EU authorities have ruled out immediate euro adoption as inconsistent with the Maastricht Treaty.

### Macroeconomic outlook and targets (2009–2011)
- Under the peg, real exchange rate overvaluation needs to be addressed through a prolonged process of factor price adjustment, likely requiring a recession in the short run and slow growth for several years (LOI ¶21).
- The authorities’ program assumes cautious macroeconomic targets for 2009-2010 (Table 8; LOI ¶8-9) in response to global weakness and liquidity strains:
  - Real GDP is expected to drop by 5 percent in 2009 and a further 3 percent in 2010, before growing in 2011.
  - Inflation: year average inflation in 2009 drops to just under 6 percent; December year on year inflation falls to just above 3 percent; Latvia should come close to meeting the Maastricht inflation criterion by end-2010.
  - Current account deficit: projected to decline from 14¾ percent of GDP in 2008 to 7¼ percent in 2009, mainly due to a continuing fall in imports as lending and output contract.
  - Capital and financial account: from a €2.2 billion surplus in 2008 to a €2.2 billion deficit in 2009; FDI declines considerably, trade credit contracts, and net short-term capital outflows rise sharply as non-resident deposits are withdrawn.
  - Bank and corporate rollover assumptions:
    - Bank rollover: 80 percent for foreign-owned banks and their subsidiaries; 40 percent for state-owned and domestic banks without a foreign affiliation.
    - Corporates: assumed ability to rollover only 40 percent of their external debt, with supporting assumptions: 75 percent rollover for non-bank financial institutions to foreign parents; 50 percent for loans of public companies; considerably lower rollover for real estate and construction firms.
- Medium-term recovery:
  - Gradual but moderate economic recovery projected (LOI ¶10) as global deleveraging eases, banks are recapitalized, external financing and domestic lending resume, EU grants boost investment, and wage/price slowdowns improve competitiveness. Positive output growth should resume from 2011 but below Latvia’s long-term potential.

### Financial sector reform and crisis response
- Parex Bank stabilization (LOI ¶12):
  - On December 5th the government completed the takeover of 85 percent of the shares of Parex Bank and appointed new professional management to negotiate with loan syndicates and major depositors.
  - Emergency legislation submitted to Parliament permitting government intervention and full bank takeover where needed for system stability and payments system operation.
  - Staff recommendation: once the government has full ownership of Parex, err on the side of overcapitalizing the bank by raising its capital adequacy ratio to at least 12 percent (provided due diligence suggests positive going-concern value), given reliance on short-term external funding.
  - After stabilization, management to develop a clear strategy to return the bank to the private sector as quickly as possible; EBRD participation might help; lengthen maturity of liabilities; partial deposit freeze to be lifted once outflow pressures ease.
- System-wide measures:
  - FCMC to supervise a targeted examination by independent auditors focusing on domestic banks relying on short-term external funding (three such banks hold 13 percent of banking system assets and close to 20 percent of deposits).
  - Based on analysis, government and FCMC to work with viable banks to ensure sufficient capital, including design of a public capital support scheme if necessary and consultation with staff before using public funds for recapitalization.
  - Review and, if necessary, revise regulations on liquidity support.
  - Medium-term regulatory changes for banks dealing primarily with non-residents: reduce maturity mismatches, hold sufficient and liquid foreign assets, enhance FCMC monitoring, and be proactive in requesting additional capital.
- Foreign bank commitments and monitoring:
  - Swedish (and other Nordic country) parent banks issued public statements committing to support investments in the Latvian banking system and to make strong efforts to maintain credit activities; intend to at least maintain existing capital adequacy of subsidiaries and recapitalize where necessary; adherence to commitments to be monitored under the program.
- Crisis response capacity:
  - FCMC to enhance monitoring of individual banks and improve information sharing with the BoL and home supervisors.
  - With bolstered reserves from international financial support, including a new €500 million swap line with the Swedish and Danish central banks, the BoL should be ready to lend to illiquid banks against an expanded range of appropriate collateral provided the bank is solvent.
  - Strengthening the Deposit Guarantee Fund and ensuring adequate funding to make reimbursement of insured deposits faster and automatic (through an agent bank).

### Private debt restructuring
- Private debt restructuring identified as important to mitigate solvency risks (LOI ¶16–18); much external debt has a domestic counterpart via foreign parent banks on-lending to households and corporations.
- Authorities committed to developing a comprehensive private debt restructuring strategy by end-April 2009.
- Likely main elements of the strategy:
  - Amending the insolvency law to facilitate workouts between viable enterprises and their creditors by end-June 2009; differentiate non-viable firms (liquidate) from viable firms (rehabilitate); expedite court approval of rehabilitation plans and grant priority status to new financing.
  - Improving the personal bankruptcy framework to support household debtor rehabilitation: streamlined procedures, debt counseling, timely creditor participation, and exploring reforms that encourage loan modifications given the substantial decline in real estate prices; amendments to the insolvency law due by end-June will be part of this reform.
  - Strengthening banks so they can restructure debts: parent banks expected to absorb loan losses in Latvian subsidiaries; insolvency procedures to handle non-viable domestic banks; creditors of viable banks could support recapitalization through debt-equity swaps possibly facilitated by tax and regulatory incentives; bank recapitalization and transfer of bad assets and NPLs to an independent asset management company could enhance restructuring capacity.
  - Consideration of whether a case-by-case approach suffices or whether more comprehensive approaches (for instance, creation of an asset management company) will be needed.

### Fiscal policy: adjustment and structural reforms
- Initial fiscal outlook and need for consolidation:
  - Without policy change, 2009 fiscal deficit was set to reach double digits. The 2009 budget passed in November targeted a 1 percent of GDP fiscal deficit but was based on overly optimistic assumptions.
  - 2008 deficit now expected to be 3 percent of GDP (compared to the earlier assumed budget balance).
  - With unchanged policy the 2009 budget would have resulted in a 12 percent of GDP fiscal deficit.
- Program measures and targets:
  - On December 11 Parliament adopted a revised budget with 7 percent of GDP in measures, to target a 4.9 percent of GDP deficit.
  - Composition of the adjustment: roughly ⅓ from revenue measures (increases in VAT and excises) and ⅔ from cutting expenditure (reducing public sector nominal wages and a 25 percent real cut for most current spending).
  - The fiscal consolidation protects productive government investment and social spending, while making larger cuts in the wage bill; EU-related expenditures remain rigid to secure future EU transfers.
- Expected effects and design features:
  - Revenue measures build on 2008 tax system improvements and rely on base broadening and simplifications: Latvia will shift about 4 percent of GDP from direct to indirect taxes between 2008 and 2011, while broadening the direct tax base for capital gains and real estate taxes in 2010; tax collection will also improve.
  - Expenditure measures are selective and supported by institutional changes: December’s initial 2009 supplementary budget includes clear overall spending targets to be backed by a more detailed supplementary budget in Q1 2009; social spending and capital outlays protected; cuts concentrated in wages.
  - Major structural reforms to support consolidation include reforms of health care, unemployment benefits, pensions (pensions indexation frozen in 2009 and to be reformed), comprehensive reforms of state and local administrations, education system, and civil service.
- Macroeconomic effects:
  - Over the medium term, positive macroeconomic impacts should dominate: rationalized expenditures and higher taxes reduce aggregate demand, improve the external current account, create a more sustainable debt burden, and lower the risk premium.
  - Short-term contractionary effects should remain moderate: cuts in productive government investment are protected; reliance on consumption tax increases helps mitigate GDP contraction; however, the quasi-currency board prevents monetary policy from offsetting fiscal tightening and households’ inability to smooth consumption through credit implies fiscal multipliers should remain positive in the short run.

*Source: Excerpt from the IMF staff report chapter on Latvia’s macroeconomic framework and program measures.*

### 38.      Local governments will play an important role in the consolidation. Key issues

### _cr0903 - 38.      Local governments will play an important role in the consolidation. Key issues

### Local governments: roles, measures, and constraints
- Key issues: clarification of expenditure responsibilities and revenue assignments of sub-national governments, and coordination of fiscal policy between levels.
- On December 10, the government signed a protocol with local governments specifying consolidation measures, including nominal wage cuts in line with those in the central administration.
- Local government budget constraints and fiscal rules:
  - A golden rule preventing current spending from being covered by borrowing.
  - A global ceiling on local government borrowing of 0.3 percent of GDP in 2009, limited to EU projects.
- The revenue-sharing agreement with municipalities will be revisited in the first semester of 2009 as part of the reform of local administration.

### Institutional reforms to strengthen fiscal policy
- Program components:
  - Adopting fiscal rules, especially with embedded expenditure targets.
  - Introducing a medium-term budget framework.
  - Strengthening public financial management systems.
- Government intentions:
  - Prepare a fiscal responsibility law in the first semester of 2009, focusing on increasing transparency and accountability and strengthening budget systems.
  - Guiding fiscal policy objective: meet the 3 percent of GDP Maastricht criterion "as soon as reasonably feasible" (LOI ¶28).
- Technical assistance and advice:
  - Authorities requested technical assistance from FAD to strengthen public financial management systems.
  - Likely to seek World Bank advice on structural reform and improving the efficiency of public expenditure (LOI ¶27).

### Fiscal risks from bank restructuring: estimates and composition
- Staff preliminary estimates: total fiscal costs of bank restructuring may fall between 15-20 percent of GDP through 2010, which would increase public sector gross debt above 40 percent of GDP.
- Components included in the estimate: capital injections, liquidity support to troubled banks, and losses on guaranteed deposits.
- Comparative context:
  - Fiscal cost would be twice as large as during the 1990s Baltic banking crises.
  - May eventually fall close to the median cost of banking crises worldwide since 1970.
- Public sector contingent liabilities related to the banking sector could reach 20 to 30 percent of GDP during the period.
- Table excerpts (in millions of lats and in percent of GDP) — major items preserved as presented:
  - Direct fiscal costs (2008, 2009, 2010 Total): 356, 1,868, 253, 2,477 — 2.3, 12.4, 1.7, 16.4 (percent of GDP).
  - Capital injection 1/...: 560, 100, 660 — ... 3.7, 0.7, 4.4 (percent of GDP).
  - Guarantees 2/...: 425, 153, 578 — ... 2.8, 1.0, 3.8 (percent of GDP).
  - Other 3/: 356, 883, ... 1,239 — 2.3, 5.9, ... 8.2 (percent of GDP).
  - Contingent liabilities: 4,449, 4,553, 3,422 — ... 29.1, 30.2, 23.0 (percent of GDP).
  - Deposits in Parex 3/: 565, 109, 2, ... — ... 3.7, 7.2, ...
  - Uncovered liabilities of deposit insurance: 3,340, 3,062, 2,934 — ... 21.9, 20.3, 19.7 (percent of GDP).
  - Potential guarantees: 544, 399, 488 — ... 3.6, 2.6, 3.3 (percent of GDP).
- Footnotes (verbatim):
  - 1/ Excluding capital injections by foreign shareholders, estimated at 9.7% of GDP over 2009-2010.
  - 2/ Assuming a realization rate of 5%, over 2009-2010, on guarantees over deposits and of 50% on potential guarantees in 2009.
  - 3/ Medium-term deposits in Parex are projected at 356 millions lats. Short-term deposits may reach 211 millions lats in 2008 and be rolled over onto 2009.

### Structural reform and incomes policy
- Constraint: fixed exchange rate; adjustment depends on structural reforms to improve competitiveness and expand the tradable sector (LOI ¶29–30).
- Assessment:
  - Latvia made considerable progress since independence in liberalizing its economy and improving its business environment, but comparisons with other European countries show room for improvement.
  - Easy availability of external financing in recent years may have led to reform complacency; government focus on facilitating real estate investment neglected other sectors.
  - Business licensing can be cumbersome, particularly at the local level; Latvia has not been as proactive as others in attracting flagship investment projects.
- Program steps and commitments:
  - Implementation of the National Lisbon Program to boost competitiveness and productivity as part of EU commitments; European Commission will monitor these reforms.
- Incomes policy measures:
  - Authorities are cutting wages and bonuses in the public sector by 25 percent in 2009 compared to 2008.
  - Intent to extend wage reductions to state-owned enterprises and, by reducing transfers, to local governments.
  - Demonstration effects and slowing economy expected to lead to substantial nominal wage cuts in the private sector.
  - Authorities and social partners are establishing a joint committee to promote wage restraint and strengthen competitiveness, including publishing monthly progress reports with specific recommendations.
- Medium-term wage-setting reforms:
  - Creation of a committee within the existing National TriPartite Council to monitor implementation of public sector wage cuts and issue recommendations to bring private-sector compensation back to levels required to restore competitiveness.
  - Objective: promote transparency in wage setting, increase efficiency of decentralized wage bargaining, and help protect the fixed exchange rate.

### Program modalities — access and financing package
- Balance of payments needs through early-2011:
  - With the current account deficit projected to decline to 7¼ percent of GDP in 2009, gross external financing requirements are close to €15 billion through early-2011, and the net financing gap around €7.5 billion.
- External commitments expected to fill bulk of the gap:
  - The European Union: €3.1 billion over the program period, including €2.2 billion over the next 6 months.
  - The Nordic Countries (Sweden, Denmark, Norway and Finland): up to €1.8 billion, expect to disburse from early 2010.
  - The Czech Republic, Poland and Estonia: €0.2 billion, €0.1 billion and €0.1 billion, respectively.
  - The World Bank and the EBRD: €0.4 and €0.1 billion, respectively, in conjunction with support to the financial sector.
- Exceptional access from the Fund:
  - Amount: SDR 1.521626 billion (1200.02 percent of quota, or approximately €1.7 billion).
  - Proposed initial purchase under the Fund arrangement: up to SDR 0.54 billion.
  - Swedish Riksbank and other Nordic central banks opened a €0.5 billion swap line to bridge to this purchase.
  - Staff proposes exceptional access on credit tranche terms with a 27-month arrangement (December 2008 to March 2011).

### Capacity to repay the Fund and program risks
- Capacity to repay:
  - By the end of the arrangement, Fund exposure is projected to be just below 8 percent of GDP, about 30 percent of gross reserves (Table 11).
  - Public debt increases somewhat over the program; external debt to GDP ratio rises to around 150 percent before falling steadily from 2011 onwards (Tables 13-14; Box 6).
- Key program risks:
  - Correcting currency misalignment without nominal depreciation is extremely difficult; requires large external support and sustained wage and fiscal discipline.
  - Maintaining the peg requires substantial political commitment; risk of weakening execution of necessary policies if commitment falters. Revised 2009 budget was passed by a 57-21 majority despite exceptional fiscal tightening.
  - Local governments account for one-third of government spending; their commitment is critical. Past off-balance-sheet local projects may create additional contingent fiscal risk.
  - Financial sector stabilization is essential; new bank liquidity problems or higher-than-expected non-resident deposit withdrawals could widen the financing gap.
  - Success in rebalancing the economy toward tradable production via sustained structural reform is required to preserve repayment capacity.
  - Regaining access to international capital markets, particularly medium- and long-term borrowing after the program ends, is key.

### Risk mitigation, monitoring, and conditionality
- Program design to mitigate risks:
  - Program duration through March 2011 covers macro framework and budget for 2011, and the 2010 general elections.
  - Up-front actions include December’s passage of budget amendments with fiscal measures of around 7 percent of GDP, and decision to take full government control of Parex.
  - Measures: fiscal restraint, incomes policy, financial sector reforms, institutional improvements, and technical assistance.
- Monitoring and conditionality:
  - SBA expected to run 27 months from December 2008 to March 2011 (Box 7).
  - Disbursements sized and timed to restore confidence in the banking system and support economic policies during global deleveraging.
  - Quarterly reviews: first review mid-February 2009 (based on end-December 2008 targets); second review mid-May 2009 (based on end-March 2009 targets).
  - Purchases under the SBA will be subject to financial assurances reviews; Lending into Arrears policy applies while external arrears remain; each purchase subject to a financing assurances review assessing good faith efforts to facilitate settlement of depositors claims.
  - A safeguards assessment will be completed by the First Review.
- Quantitative performance criteria and indicators:
  - Performance criteria for end-December and end-March (and indicative targets for the rest of 2009) on:
    - (i) a floor on net international reserves of the BoL;
    - (ii) a ceiling on net domestic assets of the BoL;
    - (iii) a floor on the adjusted general government cash balance;
    - (iv) a continuous performance criterion on the nonaccumulation of domestic debt arrears by the general government;
    - (v) a continuous performance criterion on non accumulation of external debt arrears by the general government.
  - Indicative ceiling on the general government wage bill.
  - Structural conditionality focused on stabilizing the financial sector, delivering fiscal adjustment, and establishing a wage-setting mechanism consistent with the fixed exchange rate regime.

### Staff appraisal and policy conclusions
- Main assessments:
  - Latvia faces intense liquidity pressures and needs steps to address external debt sustainability concerns, triggered by global financial turmoil and the domestic build-up of vulnerabilities from the post-EU-accession boom.
  - Risks of contagion to neighboring countries if pressures are unaddressed; potential unhinging of the fixed exchange rate against the euro.
- Strategy:
  - Authorities’ program centers on maintaining the existing exchange rate peg, relying on a prolonged period of factor price compression including reductions in real and nominal wages.
  - Alternative accelerated euro adoption at a depreciated exchange rate is not consistent with EU rules.
- Policy requirements and rationale:
  - Exceptionally strong domestic policies are required: ambitious fiscal and incomes policies, comprehensive financial sector reforms, and structural reforms to improve competitiveness.
  - Large and sustained fiscal adjustment envisaged: sizeable improvement in the structural balance between 2008 and 2011; bulk of adjustment from expenditure cuts supported by institutional and structural reforms.
  - Rationale: experience suggests expenditure-led consolidations supported by institutional reforms are more likely to succeed than strategies based primarily on revenue or one-off measures.

*Source: IMF staff report (excerpts provided in the supplied content).*

### 61.      Expenditure cuts are necessary but should be structured to support long-term

### Expenditure cuts are necessary but should be structured to support long-term

### Expenditure strategy and social objectives
- Expenditure cuts are necessary but should be structured to support long-term growth and respect social objectives.
- Authorities are right to protect expenditures that cofinance EU-funded projects given substantial capital investment needs.
- Staff supports protection of social spending embedded in the program in view of likely increases in social hardship as unemployment rises and personal incomes decline.
- Box 4: Social spending under the program
  - Social spending will increase from 21 to 25 percent of the budget.
  - Total social spending will increase by 1½ percent of GDP between 2008 and 2009.
  - Social insurance benefits dominate social transfers; old-age pensions represent ⅔ of total social transfers for the poorest quintile.
  - Supplementary budget maintains additional social measures: increases to small pensions, the minimum wage, and personal income tax allowances in 2009; additional funds for unemployment benefits and the State Employment Agency.
  - Social safety net spending is about ½ percent of GDP below the European average; targeting could be improved and should be addressed in the second supplementary budget for 2009.

### Immediate financial sector priorities: Parex Bank
- First step to solving the immediate liquidity crisis is to address problems in Parex Bank (the second-largest in Latvia).
- A successful resolution of Parex is a pre-requisite for restoring confidence in the system as a whole.
- Authorities have taken control of the bank and installed new management after initial missteps.
- A clear exit strategy that minimizes losses to the state and protects depositors needs urgent development and implementation.
- The imposition of a partial deposit freeze by the government on Parex gives rise to an exchange restriction subject to Fund approval under Article VIII, Section 2(a).
  - New management is actively engaging depositors affected by the exchange control to settle claims.
  - Authorities have taken some steps as described in paragraph 24 and will implement additional measures to resolve the liquidity crisis and restore confidence, supporting intention to remove the deposit freeze as conditions stabilize and clearance of private external arrears arising from this exchange control.
  - Staff supports the authorities' request for temporary Fund approval of the exchange restriction in line with Fund policy, on the basis that it has been imposed for balance of payments reasons, it is temporary and is nondiscriminatory.

### Comprehensive financial sector reforms
- The crisis unveiled weaknesses in the banking system and supervision.
- Recommended immediate actions for the Financial and Capital Market Commission (FCMC):
  - Launch a focused examination of the banking sector.
  - Where appropriate, require banks to increase capital.
  - Strengthen crisis management capacities by:
    - Enhancing the FCMC’s ability to monitor the financial system.
    - Clarifying procedures for providing emergency liquidity assistance.
    - Introducing legislation to allow quicker reaction to systemic crises.
- Taken together, these measures should significantly lower financial sector risk.

### External debt burden and debt resolution
- Authorities need to develop a strategy to address the substantial external debt burden to secure long-term growth and reduce vulnerabilities.
- Much of this debt is rooted in banks’ past excessive domestic lending and the related build-up of domestic debt by households and corporates.
- Debt overhang entirely involves the private sector and will be difficult to address.
- First-step recommendations:
  - Improve insolvency laws.
  - Establish other mechanisms for debt resolution, which are poorly developed in Latvia.

### Competitiveness, wages, and medium-term adjustment
- Longer-term success hinges on policies that improve competitiveness.
- Authorities should:
  - Use legislative and persuasive tools to ensure substantial wage cuts in budget institutions are matched by local governments and state-owned enterprises.
  - Engage with the private sector to encourage similar wage restraint.
  - Develop institutional structures to moderate future wage growth.
- Wage bargaining is decentralized; success is not guaranteed but prior episodes (e.g., the 1998 Russian crisis) provide some confidence in adjustment capacity while maintaining the peg.

### Program risks, safeguards, and implementation requirements
- Considerable risks:
  - Lack of a supportive external environment compared to previous crisis recoveries.
  - Possible fading political momentum for reforms.
  - Competitiveness may not improve decisively.
  - Financial market confidence may not return quickly.
- Program safeguards:
  - External financing assurances to provide additional buffers.
  - Targeted conditionality, including passage of the ambitious supplementary 2009 budget as a prior action.
  - Close monitoring via quarterly reviews.
  - Substantial technical assistance to relieve institutional constraints to program implementation.
- Close engagement by the Fund is deemed crucial despite resource implications.

### Fund support: Stand-By Arrangement
- Staff supports the Latvian authorities’ request for a 27-month Stand-By Arrangement amounting to SDR 1.521626 billion.

### Box 1 — Alternative exchange rate options (summary)
- Options considered in addition to maintaining the existing fixed (narrow-band) exchange rate included:
  - Widening current exchange rate bands to the full 15 percent range permitted under ERM2.
  - Accelerated euro adoption at a depreciated exchange rate.
- Widening the bands:
  - Potential benefit: could deliver a faster economic recovery with a likely V-shaped recovery starting in 2010 due to faster improvement in competitiveness as high pass-through is dampened by the negative output gap.
  - Main channel: faster reduction in the current account deficit mainly via import compression; exports likely to respond slowly.
  - Major costs from balance-sheet effects: Latvia’s private sector net foreign currency exposure is around 70 percent of GDP (corporate sector’s foreign currency open position roughly double household sector’s).
    - A 15 percent devaluation against the euro would increase private sector net foreign currency exposure by 11 percent of GDP, two thirds in the corporate sector and one third in the household sector.
    - Private consumption would fall by around 6 percentage points due to negative wealth effects.
    - Devaluation of this magnitude would lead to a 5 percentage point decline in private sector investment.
  - Widening bands would carry significant, front-loaded risks: deeper fall in output, bank restructuring costs, reduced bank capital from loan defaults, new lending collapse, possible sudden stop in capital flows, regional contagion, undermining of the long-standing peg and confidence.
- Accelerated euro adoption at a depreciated exchange rate:
  - Would deliver most benefits of widening bands but with fewer drawbacks; new euro-entry parity would not be subject to speculation.
  - Could help address liquidity strains if Latvian banks could access ECB facilities (solvent banks with adequate collateral could access liquidity).
  - Would not address solvency concerns and has been ruled out by the European authorities; immediate deterioration in private-sector solvency with large upfront devaluation could require private-sector debt restructuring.
  - EU strongly objects to accelerated euro adoption as inconsistent with treaty obligations, making this option infeasible.

### Box 2 — Cross-country evidence on real exchange rate adjustments (summary)
- Historical episodes exist where countries with currency pegs achieved real depreciations of 15 percent or more while preserving pegs.
- Real depreciations often occurred with help from outside forces (e.g., high inflation in trading partners).
- Table lists episodes (1980-2007) of REER changes ≥ 15 percent among countries maintaining pegged regimes; associated indicators include previous year current account (% of GDP), lowest real GDP growth, and change in current account (% of GDP).

### Box 3 — Latvia’s fiscal adjustment in historical perspective (summary)
- Latvia’s consolidation is relatively large: general government’s structural primary balance improving by 14 percent of GDP between 2009 (constant policy scenario) and 2012.
- Latvia’s consolidation ranks among the largest consolidation episodes in comparable countries over past two decades.
- Consolidation is front-loaded: three quarters of the structural adjustment occurs in the first year versus 40 percent on average in comparable countries.
- Consolidation expected to last three to five years (medium-term objective of meeting Euro adoption criteria), with major structural reform savings materializing progressively over 2010-2013.
- Composition:
  - Expenditure-heavy: 60 percent of adjustment from expenditure cuts; nevertheless, described as more balanced than the average.
  - Expenditure-based consolidations tend to be associated with deeper structural reforms and higher eventual success.

### Box 5 — Exceptional access criteria (summary)
- Proposed total access under the SBA: SDR 1.521626 billion (1200.02 percent of quota, or approximately €1.7 billion).
- Exceptional access framework evaluation concluded requirements are, on balance, satisfied:
  - Exceptional balance of payments pressure in the capital account: significant nonresident deposit outflows, loss of confidence in banking sector, global deleveraging, few prospects for external finance.
  - Sustainable debt position: public debt is very low and expected to remain sustainable; while public debt increases in near-term due to program borrowing, it is projected to decrease rapidly by 2013.
    - Much heavier external debt burden concentrated in the private sector with a significant share (40 percent of total external liabilities, see Box 6) owed to affiliated banks and companies of foreign enterprises operating in Latvia.
    - External debt to GDP increases marginally over next two years but declines by end of program as public external debt is repaid; stress tests and alternative scenarios show external debt remains vulnerable but program policies will mitigate risks.
    - Low public debt provides room for government to absorb some private liabilities if unavoidable without threatening fiscal sustainability.
  - Good prospects of regaining access to private capital markets: access likely to be restored, particularly if international financial markets normalize or Latvia joins the Euro area; program assumes market access will be restored in 2011.
- Program provides a reasonably strong prospect of success focused on: maintenance of the exchange rate peg; macroeconomic stability; and eventual euro adoption.
- Program has support at the highest political level with cross-party support for maintaining the peg, though implementation risks remain.

*Source: IMF Staff report (content as provided).*

### Box 6. External Debt Sustainability 1/

### Box 6. External Debt Sustainability 1/

### Overview
- Latvia’s external debt ratio is high at around 130 percent of GDP.
- Under the staff’s baseline projection it is set to rise further before declining rapidly after 2011 as the economy starts to recover.
- Much of Latvia’s external debt reflects borrowing by and from banks:
  - Domestic financial institutions owe ⅔ of the external debt, corporations another 30 percent.
  - More than half the foreign debt is owed to banks.
  - One-third of the external debt consists of foreign banks’ loans to their subsidiaries or branches in Latvia.
  - About 20 percent represents cross-border loans by unaffiliated foreign banks to Latvian banks.
  - Non-resident deposits represent the third largest financing source, also about 20 percent of Latvia’s external debt.

### External debt by creditor (Table 1: Jun-2008) — exact figures
- Affiliated Banks 1/: 6,508 (In millions of Lats); 14,559 (In million of USD); 43.6 (In percent of GDP); 32.5 (In percent of total)
- Unaffiliated Banks: 4,324; 9,673; 29.0; 21.6
- Non-Resident Deposits: 4,207; 9,412; 28.2; 21.0
- Affiliated Corporates 2/: 1,523; 3,406; 10.2; 7.6
- Unaffiliated Corporates: 613; 1,371; 4.1; 3.1
- Trade Credits received by corporates: 861; 1,926; 5.8; 4.3
- Official Creditors 3/: 540; 1,208; 3.6; 2.7
- International Capital Markets: 844; 1,889; 5.7; 4.2
- Other: 584; 1,307; 3.9; 2.9
- Total external debt: 20,004; 44,752; 134.0; 100

Notes:
- 1/ Loans from foreign banks to their Latvian subsidiaries/branches
- 2/ Loans from foreign enterprises to their majority-owned Latvian subsidiaries
- 3/ Multilateral official creditors constitute almost all the official credit (99 percent)
- Source: Latvian Authorities, Fund Staff Calculations

### Currency denomination and maturity risks
- Most of the external debt is foreign-currency denominated and one-third is short term.
- This exposes Latvia to high currency and rollover risk in case of sudden shifts in confidence.
- Most of the short term external debt is concentrated in the banking sector, mainly non-resident deposits and foreign bank loans.
- Concentration of short term debt is not uniform:
  - Banks that rely on non-resident deposits are most exposed to rollover risk.
  - Subsidiaries and branches of foreign owned banks are less exposed to this form of risk.

### Domestic private debt and vulnerabilities
- Domestic private debt is also high.
- Bank credit to the private sector has grown rapidly during the last 5 years to reach 95 percent of GDP.
- Loans to households, mainly mortgages, represent 38 percent of total bank loans.
- Construction loans make up more than a quarter of corporate loans.
- Around 90 percent of loans are foreign currency denominated, creating mismatch vulnerabilities.

### Debt sustainability projections and scenario findings
- Using the standard debt sustainability analysis, external debt is projected to increase in the near-term before falling rapidly after 2011:
  - The current account improves significantly as domestic demand falls and the economy enters recession. However, the fall in output means that the external debt to GDP ratio increases at first, before falling sharply in the out years as the economy recovers (Figure 10).
  - Historical scenario: if the economy were to perform based on 10-year historical averages, the debt to GDP ratio would fall steadily over the medium-term, to just over 110 percent by 2013. This demonstrates the important role that the projected growth slowdown has on external sustainability.
  - Shocks: standard shocks result in a deteriorating external debt position. In particular, a real depreciation shock would increase external debt to GDP significantly.

### Limitations of standard debt sustainability analysis and additional considerations
- Standard debt sustainability analysis may not capture all of Latvia’s characteristics, given its dependence on foreign bank borrowing for credit intermediation and its role as an offshore financial centre.
- Latvia’s net foreign debt is much lower (around 70 percent of GDP), as it reinvests many of the non-resident deposits in assets overseas. The value and liquidity of these assets then becomes key.
- Much of its foreign borrowing is backed by domestic assets. Thus external debt sustainability will depend on whether these assets recover value and will be able to generate future returns to service the debt.

*Source: Box 6. External Debt Sustainability, Jun-2008 (Latvian Authorities, Fund Staff Calculations).*

### Box 7. Latvia: Stand-By Arrangement

### Box 7. Latvia: Stand-By Arrangement

### Stand-By Arrangement: size, access, length, and phasing
- Access: SDR 1.521626 billion (1200.02 percent of quota or approximately €1.7 billion).
- Length: 27 months.
- Phasing:
  - SDR 535 million will be made available upon the Board’s approval of the arrangement to address the large balance of payments need in the fourth quarter of 2008 and to replenish reserves.
  - The nine subsequent tranches will equal SDR 986 million.
  - The next two tranches could be made available in February and May 2009, and quarterly thereafter.

### Program conditionality: prior actions, performance criteria, and structural measures
- Prior Actions:
  - Submission of resolution plan to FCMC by Parex management.
  - Parliament to adopt 2009 supplementary budget capping general government fiscal deficit at below 5 percent of GDP.
  - Government to sign protocol stipulating a 15 percent reduction in local government employees’ average compensation.
- Quantitative Performance Criteria:
  - Floor on net international reserves.
  - Ceiling on net domestic assets.
  - Floor on adjusted general government cash balance.
- Continuous Performance Criteria:
  - Non-accumulation of domestic debt arrears by the general government.
  - Non-accumulation of external debt payment arrears by the general government.
- Quantitative Indicative Target:
  - Ceiling on general government wage bill.
- Structural Performance Criterion:
  - Submission to Parliament of a second supplementary budget for 2009 to define spending allocations across ministries and spending agencies, and to identify clear programs that should be rationalized (March 31, 2009).
- Structural Benchmarks and Timetable:
  - Cabinet of Ministers to adopt decision that reforms controls over budget execution (December 31, 2008).
  - Adopt operational guidelines clarifying procedures for provision of emergency liquidity assistance (December 31, 2008).
  - National Tripartite Co-operation Council will establish a Committee to Promote Wage Restraint (January 31, 2009).
  - Review and, if necessary, revise regulations on emergency liquidity support (January 31, 2009).
  - Complete focused examination of the banking system (March 31, 2009).
  - Develop comprehensive debt restructuring strategy (April 30, 2009).
  - Amend banking laws to give FCMC, BoL and Government powers to restore financial stability in case of systemic crisis (June 30, 2009).
  - Adopt an amendment to the Budget and Financial Management law to strengthen financial responsibility, transparency and accountability (June 30, 2009).
  - Amend insolvency law to facilitate orderly and efficient debt restructurings (June 30, 2009).

### Schedule of reviews and purchases (IMF disbursement timetable)
- December 23, 2008: 535.344 SDRs — Approval of arrangement.
- February 15, 2009: 178.448 SDRs — First review and end-December 2008 performance criteria.
- May 15, 2009: 178.448 SDRs — Second review and end-March 2009 performance criteria.
- August 15, 2009: 89.224 SDRs — Third review and end-June 2009 performance criteria.
- November 15, 2009: 89.224 SDRs — Fourth review and end-September 2009 performance criteria.
- February 15, 2010: 89.224 SDRs — Fifth review and end-December 2009 performance criteria.
- May 15, 2010: 89.224 SDRs — Sixth review and end-March 2010 performance criteria.
- August 15, 2010: 89.224 SDRs — Seventh review and end-June 2010 performance criteria.
- November 15, 2010: 89.224 SDRs — Eighth review and end-September 2010 performance criteria.
- February 15, 2011: 94.042 SDRs — Ninth review and end-December 2010 performance criteria.
- Total: 1521.626 SDRs (1200.0 percent of quota).

### Key macroeconomic context, trends, and staff baseline projections
- Output and demand (annual percent change, staff estimate/projection):
  - Real GDP: 2004 8.7; 2005 10.6; 2006 12.2; 2007 10.3; 2008 -2.0; 2009 -5.0; 2010 -3.0.
  - Private consumption: 2004 11.2; 2005 12.2; 2006 13.9; 2007 -6.3; 2008 -7.5; 2009 -6.0.
  - Gross fixed investment: 2004 23.8; 2005 23.6; 2006 16.3; 2007 8.4; 2008 -10.0; 2009 -12.0; 2010 -8.5.
  - Exports of goods and services: 2004 9.4; 2005 20.3; 2006 6.5; 2007 11.1; 2008 4.5; 2009 -3.0; 2010 2.1.
  - Imports of goods and services: 2004 16.6; 2005 14.8; 2006 19.3; 2007 15.0; 2008 -6.1; 2009 -9.5; 2010 -5.2.
- Prices and labor:
  - HICP (average): 2004 6.2; 2005 6.9; 2006 6.6; 2007 10.1; 2008 15.5; 2009 5.9; 2010 2.2.
  - Unemployment rate (LFS definition, year-average): 2004 8.7; 2005 6.8; 2006 6.2; 2007 6.7; 2008 9.0; 2009 11.0.
- Fiscal aggregates (selected, in percent of GDP):
  - Consolidated general government revenue: 2004 35.3; 2005 36.1; 2006 38.4; 2007 38.0; 2008 34.8; 2009 36.6.
  - Consolidated general government expenditure: 2004 36.4; 2005 36.9; 2006 37.7; 2007 41.1; 2008 39.8; 2009 41.4.
  - Basic fiscal balance: 2004 -1.1; 2005 -0.9; 2006 0.7; 2007 -3.0; 2008 -4.9; 2009 -4.9.
  - General government gross debt (in percent of GDP): 2004 14.4; 2005 11.6; 2006 9.9; 2007 8.3; 2008 14.3; 2009 33.7; 2010 46.0.
- Balance of payments and reserves:
  - Current account balance (percent of GDP): 2004 -12.8; 2005 -12.5; 2006 -22.5; 2007 -23.8; 2008 -14.8; 2009 -7.3; 2010 -5.5.
  - Gross official reserves (millions of euros): 2004 1,992; 2005 3,439; 2006 3,966; 2007 3,720; 2008 3,386; 2009 4,741.
  - Net international reserves (millions of euros): 2007 5.7; Nov-08 6.5 (latest observation: Nov-08).

### Financial sector conditions, vulnerabilities, and stress indicators
- Banking sector key features and risks:
  - Credit to nongovernment (percent change): 2005 47.0; 2006 64.3; 2007 58.4; 2008 34.2; 2009 13.0.
  - Loan stock heavily weighted towards real estate; lending overwhelmingly in foreign exchange (e.g., FX loans to residents: Q2 2008 88.2 percent).
  - Residents' FX deposits (millions of euros): 2004 1,279; 2005 1,859; 2006 2,689; 2007 3,659.
  - FX deposits held by residents (percent of total deposits held by residents): Q3, 2008 47.1 percent.
  - Capital adequacy ratio (overall banking sector): Q3, 2008 12.3 percent.
  - NPLs (in percent of total loans): Q3, 2008 0.7 percent; but overdue loans rising.
  - Liquid assets to short-term liabilities: Overall Banking Sector Q1 2008 about mid-50s percent range; non-resident banks show severe liquidity strain.
- Market signals:
  - Eurobond spreads and Latvia CDS reached record levels in 2007–08.
  - Swedish banks have cut back lending sharply to the Baltics; stress visible in parent bank share performance.
- Financial soundness indicators (selected, in percent):
  - ROA (after tax) Q3, 2008 1.2 percent; ROE (after tax) Q3, 2008 14.7 percent.
  - Provisions to NPLs Q3, 2008 119 percent.

### External vulnerabilities, debt dynamics, and stress tests
- External debt and financing metrics:
  - Gross external debt (percent of GDP): 2004 92.5; 2005 99.9; 2006 114.7; 2007 134.1; Q2, 2008 134.0.
  - Short-term external debt (original maturity, percent of total ED): Q2, 2008 35.9 percent.
  - Gross external financing requirement (US$ billion, Q4 2007): 8.8 (gross external financing requirement figure appears in staff tables).
- External debt sustainability stress tests (summary):
  - Baseline external debt (percent of GDP) projection: baseline 134 (figure label), historical 110 (figure label) — scenario boxes show various average projections.
  - Individual shocks (per figure notes): permanent one-half standard deviation shocks to variables; combined shocks and a one-time real depreciation of 30 percent in 2009 are modeled.
  - Scenario outcomes (selected box averages shown in figure):
    - Baseline: 134 (label).
    - Real depreciation shock (30% depreciation): shock outcome 198 (label).
    - Combined shock: 147 (label).
  - Gross financing need under baseline is shown on the right scale in the figure (numeric series presented in charts).
- Public sector debt sustainability:
  - Baseline public sector gross debt (percent of GDP): 2008 14.3; 2009 33.7; 2010 46.0; 2011 50.2; 2012 46.1; 2013 33.5.
  - Change in public sector debt (percent of GDP): 2008 6.1; 2009 19.3; 2010 12.3; 2011 4.3; 2012 -4.2; 2013 -12.6.
  - Identified debt-creating flows in 2009: 17.3 percent of GDP.
  - Debt-stabilizing primary balance (percent of GDP) shown as 0.8 in the header of the table (label).

### Fiscal financing and program financing plan (2008–11)
- Program financing table (Table 9 projection of financing requirements and sources, selected items):
  - Total financing requirements (2008 Q4 through 2010 aggregates): Total financing requirements per row totals (e.g., 2008 total -6,201; 2009 -5,511; 2010 -1,867; medium-term total -16,111 in Table 9 context).
  - Non-resident deposits outflow expectations: 2009 outflows 16.9 percent; 2010 outflows 9.2 percent (memo note).
  - Recapitalization by foreign parent banks (upper bound): amounts cited per quarter and projection sum presenting an upper bound (e.g., 2009 total recapitalization flows in table).
- Indicators of Fund credit (Table 11 summary, in millions of SDR):
  - Proposed Stand-By Arrangement purchases (end-period stock): 2008 535.3; 2009 1,070.7; 2010 1,427.6; 2011 1,521.6; and subsequent stock projections through 2016.
  - Charges and obligations series are presented in millions of SDRs and percent of quota in table.

### Key vulnerability indicators and recent observations (Table 3, selected)
- Real GDP growth (latest observation Q3, 2008): -4.6 percent (Q3, 2008).
- HICP inflation (period average; Oct-08): 13.7 (Oct-08).
- Short-term interbank rate, 1-month RIGIBOR (eop, in percent): 13.9 (15-Dec-08).
- Eurobond secondary market spread (bps, eop): 856 (12-Dec-08).
- Exchange rate regime: Pegged to the euro (+-1% band).
- Current account balance (in percent of GDP): Q3, 2008 -12.9.
- Net FDI inflows (in percent of GDP): Q3, 2008 4.8.
- Gross international reserves (GIR, in US$ billion): Nov-08 4.7.
- Gross external debt (in percent of GDP): Q2, 2008 134.0.
- FX loans to residents (in percent of total loans): Q2, 2008 88.2.
- Credit to private sector (percent change, Nov-08): 14.3.

### Staff-estimated medium-term projections (selected aggregates and narratives)
- Staff projections for nominal GDP (in billions of euros): 2004 11.1; 2005 12.9; 2006 15.9; 2007 19.9; 2008 21.7; 2009 21.5; 2010 21.2.
- Current account (in millions of euros, projected): 2008 -3,217; 2009 -1,566; 2010 -1,161; cumulative prospective official financing lines and Fund role shown in financing tables.
- The program anticipates substantial IMF financing (SDR 1.521626 billion) and other prospective official financing (including EU, Nordic countries, World Bank, and others) to fill financing gaps, alongside conditional recapitalization by foreign parent banks as an upper bound.

*Source: IMF staff report Box 7, “Latvia: Stand-By Arrangement,” extracted from the provided IMF country report content.*

### 1.      Financial market strains in Latvia have intensified in past weeks as events in

### _cr0903 - 1.      Financial market strains in Latvia have intensified in past weeks as events in

### Summary of the request and program scope
- Request for a 27-month Stand-By Arrangement (SBA) in the amount equivalent to SDR1.521626 billion (1,200.02 percent of quota or €1.7 billion) covering the period December 2008 to March 2011.
- Program monitored through quantitative performance criteria and indicative targets, structural performance criteria and structural benchmarks, and quarterly reviews.
  - First review on or after February 15, 2009.
  - Second review on or after May 15, 2009.
- Technical Memorandum of Understanding specifies quarterly targets for:
  - Net international reserves of the Bank of Latvia.
  - Net domestic assets of the Bank of Latvia.
  - The cash fiscal balance of the general government.
  - The general government wage bill.
  - Non-accumulation of domestic and external debt arrears of general government (continuous performance criteria).

### Recent economic performance and macroeconomic outlook (2000–2011)
- Historical performance and vulnerabilities:
  - Growth averaged 9 percent between 2000-07.
  - Current account deficits in excess of 20 percent of GDP in both 2006 and 2007.
  - Gross external debt ratio of 135 percent of GDP.
- Causes of vulnerability:
  - Growth driven by private consumption and investment in real estate and other non-tradable sectors.
  - Rapid public expenditure growth and wage growth above productivity eroded competitiveness and pushed consumer price inflation up.
  - High level of short-term external debt and rising private-sector indebtedness.
- Policy steps taken prior to program:
  - Introduction of an anti-inflation plan in early 2007, including taxation of real estate activity and new bank lending regulations.
  - 2007 budget recorded a surplus.
  - Government took control of Parex Bank, replaced its management.
  - Saeima approved a supplementary budget for 2009 capping the underlying general government fiscal deficit (excluding possible financial system support measures) at below 5 percent of GDP.
- Recent external shock and financing needs:
  - Global financial market turmoil reduced availability of external finance; sovereign downgrades.
  - Significant deposit outflows at Parex since September led to partial nationalization and liquidity support.
  - Expectation of a significant short-term financing requirement.
  - Expected macro path:
    - 5 percent contraction in output in 2009.
    - Further, more moderate decline in output in 2010.
    - Headline inflation expected to fall to 2 percent by end-2010.
    - Current account deficit to narrow to 5 percent by 2010 as imports subside.
    - Anticipated external financing gap of €7.5 billion through 2011, to be filled by IMF, EU, World Bank and bilateral contributions.
    - Moderate positive output growth expected to resume from 2011.

### Policy objectives and overall strategy (2009–2011)
- Main objectives:
  - Stem immediate liquidity pressures.
  - Restore long-term stability by strengthening the banking sector, correcting fiscal imbalances, and adopting domestic policies to improve competitiveness while maintaining the fixed (narrow-band) exchange rate.
  - Strengthen long-term structural performance and lay groundwork for euro-area entry as soon as possible.
- Exchange rate stance:
  - Fixed (narrow band) exchange rate of the lats will remain the anchor for monetary policy until euro adoption.
  - Commitment to conservative monetary policy: maintain quantitative limits on foreign currency swaps and main refinancing operations; ensure base money remains adequately backed by BoL net international reserves.
- Fiscal strategy:
  - Immediate and sustained fiscal consolidation anchored in a medium-term fiscal framework to lower the deficit to the Maastricht level of 3 percent of GDP by 2011.
  - Structural adjustment of 6 percentage points of GDP from 2008 to 2011.
  - Preserve social safety nets and maintain high investment spending; ringfence EU-financed projects.

### Financial sector policies and crisis measures
- Parex Bank resolution:
  - Partial nationalization and replacement of management; suspension of previous owners from executive roles.
  - New legislation planned to provide legal means for full government control.
  - New management required to develop and submit a resolution plan to the FCMC (prior action).
  - International auditing firm to be hired for a comprehensive audit and due diligence, paving the way to recapitalization and a clear exit strategy to return activities to the private sector.
  - New management to seek firm commitments from external parties to renew Parex’s syndicated funding in the near future.
- Comprehensive bank resolution strategy (key elements):
  - Focused examination of the banking system to assess solvency and liquidity (structural benchmark for end-March 2009); work conducted by international audit firms and submitted to the FCMC.
  - Viable banks needing capital increases to seek private restructuring, mergers, or parent bank support; conditional public financial support per EU state aid rules where necessary.
  - Public support terms and eligibility to be legislated and published; recapitalization plan to be implemented by end-April 2009 and IMF Staff to be consulted prior to equity injections.
  - FCMC to enhance daily liquidity monitoring of foreign banks’ exposure in Latvia and strengthen contacts with home supervisors.
  - Use of Pillar II of Basel II to require additional capital and enhanced liquidity positions where warranted.
  - Commitment to fair and equitable treatment of depositors and creditors; removal of the partial freeze on withdrawal amounts from large non-commercial private deposits in Parex as conditions stabilize.
  - Temporary Fund approval requested for the exchange restriction on balance of payments grounds (temporary and non-discriminatory).
- Crisis management and supervisory strengthening:
  - FCMC to monitor bank-by-bank maturity profiles, deposits, liquid assets, group exposures, interbank transactions, foreign credit lines, debt rollovers, asset quality and bank capital; BoL to share liquidity support information with FCMC.
  - Operational guidelines to clarify procedures for inter-agency coordination, cross-border arrangements and treatment of collateral by end-December 2008 (structural benchmark).
  - Review of emergency liquidity support regulations and adoption of revised regulations if necessary by end-January 2009 (structural benchmark); Fund staff to support.
  - Domestic Standing group to meet regularly to maintain common understanding of financial stability responsibilities among government, BoL and FCMC.
  - FCMC to receive adequate additional resources.
- Legal and insolvency framework reforms:
  - Banking laws to be amended by end-June 2009 to allow timely and effective actions in systemic crises (structural benchmark).
    - Empower emergency liquidity assistance against a wide range of collateral, implement full takeovers (preferably through bridge banks), and guarantee interbank liabilities.
    - Enhance special bank insolvency regime to allow earlier intervention, appointment of temporary administrators without court approval, and tools such as purchase and assumption transactions, sale of part or whole bank, bridge banks, and reduction in value of existing shareholders' equity to absorb losses.
    - Mechanisms to ensure reimbursements under the deposit guarantee fund (DGF) are fast and automatic (through an agent bank) and give DGF temporary powers to increase insurance premia after a payout.

### Private debt restructuring and insolvency reform
- Need for comprehensive strategy to ensure sustainability of private-sector domestic and external debt.
  - Voluntary restructurings to be facilitated; insolvency law tools to play a role in burden-sharing.
  - IMF technical assistance to develop a comprehensive private debt restructuring strategy by end-April 2009 (structural benchmark).
- Banking sector role:
  - Capital injections, including from foreign parents, to maintain solvency.
  - Align tax treatment to facilitate bank creditors maintaining longer-term support of viable banks (e.g., debt-for-equity swaps).
  - Seek international assistance to assess by end-March 2009 merits of establishing an independent asset management entity to take over bad assets and restructure nonperforming loans.
- Insolvency law reforms:
  - Amend Insolvency Law by end-June 2009 to facilitate orderly and efficient restructurings (structural benchmark).
    - Refine corporate insolvency regime: priority status to new financing, clarify class voting by creditors, expedited court approval of rehabilitation plans.
    - Assess personal bankruptcy framework to rehabilitate household debtors by lowering administrative costs and involving creditor participation.
    - Encourage loan modifications to avoid unwarranted foreclosures and address inefficiencies in foreclosure procedures.

*Source: IMF staff summary of the Latvian authorities' program submission (text as provided).*

### 22.      We have already taken a number of measures in support of these goals:

### _cr0903 - 22.      We have already taken a number of measures in support of these goals:

### Fiscal stance and immediate budgetary outcomes
- Controlled budget execution without creating arrears; prioritized essential expenditures, secured tax collection, and pooled available cash.
- Capped the general government deficit (excluding bank restructuring costs) at around 3 percent of GDP in 2008.
- Parliament adopted a supplementary budget for 2009 on December 11 (Prior action) that caps the 2009 general government fiscal deficit at below 5 percent of GDP, implying an adjustment of around 7 percentage points of GDP compared with the budget passed in November.

### Tax revenue measures (main measures included in the supplementary budget law; should raise approximately 2½ percent of GDP)
- From 2009: increase the standard VAT rate by 3 percentage points, to 21 percent, and the reduced rate from 5 percent to 10 percent; the list of items eligible for the reduced rate will be significantly reduced.
- From 2009: increase excise on fuel, alcohol, non-alcoholic beverages, and coffee.
- From 2009: partially reverse recently adopted increases in non-taxable allowances under the personal income tax (PIT) law, but reduce the PIT rate by 2 percentage points to 23 percent.
- From 2010: introduce a 10 percent tax rate on all capital income (interest, dividends, royalties, rental income, realized nominal capital gains on shares, realized nominal capital gains on immovable property). Applicable to all capital gains on real estate transactions unless minimum times of continuous ownership (five years) and residence (one year) are fulfilled.
- From 2010: increase real estate and property taxes by removing exemptions to broaden the tax base.
- Increase non-tax revenues: user fees will be increased; dividend pay-out rates by state owned companies will rise from 27-35 percent at present to 50 percent.
- Improve tax administration with international assistance; no significant improvements in collection rates factored into projections before 2010.

### Expenditure ceilings, consolidation measures, and social protection
- In 2009 cap expenditures at just below 40 percent of GDP.
- Requires cuts of 4½ percent of GDP over and above amounts in the originally adopted central government budget and envisaged local government budgets.
- Main measures to achieve cuts:
  - (i) approximately 15 percent cuts in compensation of all public sector employees with effect from January 1, 2009;
  - (ii) a pension freeze;
  - (iii) rationalizing subsidies (excluding social support), and outlays on goods and services.
- No reductions in social support beyond the impact of the wage reduction (which will lower indexed benefits).
- Intend to improve targeting of all social safety nets within a social spending budget that increases by 1 percentage point of GDP relative to 2008.
- Note: measures to restructure the banking sector including recapitalizing banks, covering the liabilities of the deposit guarantee fund and providing various liquidity instruments, may entail significant additional fiscal costs.

### 2009 budget mechanics and contingency arrangements
- Supplementary budget determines total spending appropriations for the consolidated central government consistent with a targeted fiscal deficit of 4.9 percent of GDP.
- Sets aside 10 percent of state basic budget appropriations (excluding those relating to EU-financed projects, debt service and payments to the EU budget) in a contingency reserve held by central government.
- Will submit to Parliament a second supplementary budget law for 2009 to define allocation of spending appropriations among spending agencies and ministries and identify programs to be rationalized by March 31, 2009 (structural performance criterion).
- The contingency reserve will be reduced to 5 percent of appropriations once the second supplementary budget has been passed.

### Local governments and budget execution controls
- Equivalent measures to ensure local governments match central government belt-tightening:
  - Sign a protocol (prior action) stipulating a 15 percent reduction in local government employees’ compensation.
  - Local governments barred from borrowing except for EU-financed projects and intra-year liquidity needs.
  - Local governments will not receive any central government guarantees for the duration of the program.
  - Implement fully and without delay the State Audit Office recommendations of September 2008 regarding assessment of implementation of the 2007 budget and budgets of local governments.
- Adopt a cabinet decision to reform controls on budget execution by end-December 2008 (structural benchmark). The decision will:
  - Stipulate progressive release of appropriations from the central basic budget contingency reserve subject to meeting performance criteria and benchmarks in the TMU.
  - Require all spending ministries and institutions to submit weekly cash-flow projections and proposals for new commitments; local governments to submit similar reports every fortnight.
  - Establish a committee of finance ministry and Treasury officials to meet weekly and propose recommendations to the Prime Minister on new commitments.
  - If revenue shortfalls occur, commitments will be immediately reduced to cover only obligatory expenditures.
  - Treat privatization receipts and other revenues from asset disposals as financing items to ensure expenditure appropriations represent hard ceilings.

### Structural reforms, fiscal framework, and medium-term consolidation
- Seek assistance from the IMF, EU and bilateral donors in Q1 2009 to strengthen public financial management with goals to:
  - (i) strengthen the budget formulation process;
  - (ii) improve the Ministry of Finance’s spending controls (especially over the wage bill at the general government level);
  - (iii) make the medium-term budget framework operational;
  - (iv) increase transparency and external oversight in the budget, improve fiscal decentralization;
  - (v) adopt a PPP law in accordance with international standards.
- Amend the Budget and Financial Management law (with IMF and EU assistance) to strengthen provisions on financial responsibility, transparency and accountability to:
  - Keep public debt at an appropriate level;
  - Set expenditure ceilings;
  - Avoid procyclicality in fiscal policy; and
  - Ultimately allow automatic stabilizers to operate fully by end-June 2009 (Structural benchmark).
- Approach the World Bank for technical assistance on comprehensive reforms of education, civil service, state administration and healthcare systems to be launched in 2009; completed reforms could eventually deliver annual savings of about 2 percent of GDP, including due to staff savings commencing in 2010.

### Additional consolidation and income policies
- Additional consolidation measures needed to attain deficit target of 3 percent of GDP by 2011: further increasing the VAT rate, additional reductions in public employment and wages, and (from 2010) indexing pensions only to inflation.
- Strong commitment to wage restraint:
  - Cut average compensation (wages and bonuses) in the entire public sector by an additional 15 percent in 2009 (relative to the originally adopted budget), with further reductions in 2010-2011.
  - Secure commitments from boards of all publicly owned enterprises to deliver the same levels of reduction in compensation.
  - Work with the National Tripartite Co-operation Council to encourage private sector follow-through.
- Reform wage-setting mechanisms:
  - National Tripartite Co-operation Council to establish a Committee to Promote Wage Restraint by end-January 2009 (Structural Benchmark) with mandate to (i) monitor implementation of measures to reduce nominal wages (and bonuses) in public and private sectors, and (ii) issue recommendations to correct deterioration in competitiveness and ensure compensation evolves in line with fixed exchange rate constraints.
  - Committee to prepare a monthly report to be discussed by the full National Tripartite Co-operation Council, presented to the Prime Minister and Parliament, and published.

### Growth rebalancing and business environment
- Form a national committee to examine Latvia’s long-term strategic options.
- Press ahead with National Lisbon Program objectives: promote development of new products and technologies, increase labor market flexibility, facilitate regional mobility, strengthen the business environment, reduce administrative burdens on the private sector (particularly those hampering small and medium-sized enterprises).
- Promote exports by streamlining reimbursements of overpaid VAT and increasing availability of risk capital and guarantees by launching a holding fund financed by the European Investment Fund (EIF).

### IMF arrangement, safeguards, and program monitoring
- Commit to policies to maintain the exchange rate peg, macroeconomic stability, and euro adoption; stand ready to take additional measures if required and to consult with the IMF in advance of policy revisions.
- Recognize importance of completing a safeguards assessment by the first review of the SBA; Bank of Latvia to provide information and receive a safeguards mission as necessary.
- All long-term funds provided under the program will be disbursed to the government of Latvia and held in an account at the Bank of Latvia.
- Authorize IMF to publish the Letter of Intent, attachments (including the TMU), and the related staff report.

### Prior actions, performance criteria, and key quantitative targets (selected)
- Prior actions:
  - 1. Management of Parex bank to develop a resolution plan and submit it to the FCMC. Attachment, Para. 12
  - 2. Parliament to adopt a supplementary budget for 2009 with a general government deficit at below 5 percent of GDP. Attachment, Para. 22
  - 3. Government to sign a protocol stipulating a 15 percent reduction in local government employees’ compensation. Attachment, Para. 26

- Quantitative performance criteria and indicative targets (selected values preserved exactly as in source):
  - Floors on the net international reserves of the Bank of Latvia (net of government foreign liabilities resulting from program financing; in million euros): Dec-08 2,103 ; Mar-09 737 ; Jun-09 -507 ; Sep-09 -1,128 ; Dec-09 -1,531
  - Ceilings on the net domestic assets of the Bank of Latvia (including government foreign liabilities resulting from program financing; in million lats): Dec-08 951 ; Mar-09 1,434 ; Jun-09 2,501 ; Sep-09 2,656 ; Dec-09 2,928
  - Floors on the adjusted cash fiscal balance of the general government (in million lats): Dec-08 -894 ; Mar-09 -305 ; Jun-09 -649 ; Sep-09 -893 ; Dec-09 -1,282
  - Ceiling on the general government wage bill (in million lats): Dec-08 1,248 ; Mar-09 214 ; Jun-09 490 ; Sep-09 660 ; Dec-09 884

- Continuous performance criteria:
  - Non-accumulation of domestic arrears by the general government.
  - Non-accumulation of external debt payments arrears by the general government.

- Structural performance criterion:
  - Submit a second supplementary budget law for 2009 to Parliament to define allocation of total spending appropriations among spending agencies and ministries, by end-March 2009. Attachment, Para. 25

- Selected structural benchmarks (deadlines preserved exactly):
  - Initiate a focused examination of the banking system by international audit firms; by end-March 2009. Attachment, Para. 13
  - Adopt operational guidelines for provision of emergency liquidity assistance (ELA); by end-December 2008. Attachment, Para. 14
  - Review regulations on emergency liquidity support and, if necessary, adopt revised regulations; by end-January 2009. Attachment, Para. 14
  - Amend banking laws to allow FCMC, BoL and Ministry of Finance to take timely and effective actions in systemic crises; by end-June 2009. Attachment, Para. 15
  - Develop a comprehensive debt restructuring strategy; by end-April 2009. Attachment, Para. 16
  - Amend the Insolvency Law to facilitate orderly and efficient debt restructurings; by end-June 2009. Attachment, Para. 18
  - Adopt cabinet decision to reform controls on budget execution; by end-December 2008. Attachment, Para. 27
  - Adopt an amendment on fiscal responsibility to the Budget and Financial Management Law; by end-June 2009. Attachment, Para. 28
  - Establish a committee to promote wage restraint; by end-January 2009. Attachment, Para. 31

### Technical Memorandum of Understanding (TMU) highlights
- Program exchange rates (as of November 28, 2008): LVL 0.702804 = €1 ; LVL 0.544 = $1 ; LVL 0.00571 = 1 JPY.
- Net international reserves (NIR) definition: BoL foreign reserve assets minus BoL foreign reserve liabilities, minus Treasury liabilities to IMF, EU and other official creditors participating in the program.
  - Outstanding stock as of November 30, 2008: 3,368 (in million euros).
  - Foreign reserve assets as of November 30, 2008: 3,618 million euro.
  - Foreign reserve liabilities as of November 30, 2008: 250 million euro.
  - Sum of Treasury liabilities to IMF, EU and other official creditors participating in the program as of November 30, 2008: 0 billion euro.
  - Floors on level of NIR (in million euros): December 31, 2008 (performance criterion) 2,103 ; March 31, 2009 (performance criterion) 737 ; June 30, 2009 (indicative target) -507 ; September 30, 2009 (indicative target) -1128 ; December 31, 2009 (indicative target) -1,531
- Net domestic assets (NDA) of the BoL definition and levels:
  - Outstanding stock as of November 30, 2008: -99 (in million lats).
  - Base money as of November 30, 2008: 2,268 million lats.
  - Ceiling on level of NDA (in million lats): December 31, 2008 (performance criterion) 951 ; March 31, 2009 (performance criterion) 1,434 ; June 30, 2009 (indicative target) 2,501 ; September 30, 2009 (indicative target) 2,656 ; December 31, 2009 (indicative target) 2,928

*Source: Letter of Intent and Technical Memorandum of Understanding (December 17, 2008) as provided in the supplied content.*

### 9.      Net foreign assets of the BoL are defined as the difference between the BoL’s foreign

### _cr0903 - 9.      Net foreign assets of the BoL are defined as the difference between the BoL’s foreign

### Net foreign assets of the Bank of Latvia (BoL)
- Net foreign assets are defined as the difference between the BoL’s foreign reserve assets and the BoL’s foreign reserve liabilities as defined in paragraphs 2 and 3, plus those foreign reserve assets of the BoL that were excluded from the definition in paragraph 2.
- As of November 30, 2008, net foreign assets of the BoL amounted to 2,367 million lats.

### NDA ceiling adjustor and reserve assumptions
- Ceilings assume all program related financing will be given to the Latvian government and deposited in the government’s account in the BoL.
- If the reserve requirement ratio and/or the definition of liabilities subject to reserve requirements is changed during the program period, the BoL will consult with IMF staff to modify the limits appropriately.
- Adjustor: The NDA ceiling for end-December 2008 will be adjusted downwards by 200 million lats if the BoL’s recent foreign exchange swaps with foreign central banks are not closed by the end of 2008.

### Floor on the Adjusted Cash Fiscal Balance of the General Government (in million of lats)
- Adjusted cash fiscal balance in 2007: -362
- Cumulative adjusted cash fiscal balance from January 1, 2008:
  - December 31, 2008 (performance criterion): -894
- Cumulative adjusted cash fiscal balance from January 1, 2009:
  - March 31, 2009 (performance criterion): -305
  - June 30, 2009 (indicative target): -649
  - September 30, 2009 (indicative target): -893
  - December 31, 2009 (indicative target): -1,282

### Definition and scope of general government and adjusted cash fiscal balance
- General government includes:
  - (i) central government, including all ministries, agencies and institutions attached thereto, as defined in the basic budget;
  - (ii) the social security fund (first pillar), as described in the special budget;
  - (iii) municipalities, regional governments and their special budgets classified as part of general government in budget documents and included by the BoL in monthly submissions to the IMF of balance sheets and consolidated accounts.
- No off-budgetary funds will be maintained or created.
- The definition includes any new funds or special budgetary and extra-budgetary programs created during the program period to carry out fiscal operations as defined in the IMF’s Manual on Government Finance Statistics 2001; authorities will inform IMF staff immediately of any such creation.
- Adjusted cash fiscal balance is defined as net government lending/borrowing, in cash and excluding bank restructuring costs, plus EU project grants (reimbursements and advances).
- Monitoring and reporting: monthly financing information, reconciled with revenue and expenditure reports within 30 days after the end of each month.

### Treatment of EU-financed expenditure and bank restructuring costs
- EU financed expenditure reported monthly, distinguishing subsidies and transfers versus capital expenditure, and central versus local government; some EU financed expenditure may be reallocated from subsidies (excluding social support) to capital expenditure.
- Cash fiscal balance excludes bank restructuring costs, including:
  - loans to financial institutions and investments in equity of financial institutions (requited recapitalization);
  - unrequited recapitalization;
  - purchase of troubled assets.
- Any general government financial operation to support banks, including emission of guarantees or provision of liquidities, will be immediately reported to IMF staff.
- Consistent with NDA ceilings, the government will deposit all program related financing in its BoL account.
- Adjustor: Quarterly floor for adjusted cash fiscal balance will be adjusted upwards starting in 2009 for interest receipts or capital gains from government deposits or investments in the banking system, including in the BoL, in excess of 15 million lats each quarter.

### Ceiling on the General Government Wage Bill (in million of lats)
- Wages and salaries in 2007: 1,060
- Wages and salaries (ceiling) cumulated from January 1, 2008:
  - December 31, 2008 (indicative target): 1,248
- Wages and salaries (ceiling) cumulated from January 1, 2009:
  - March 31, 2009 (indicative target): 214
  - June 30, 2009 (indicative target): 490
  - September 30, 2009 (indicative target): 660
  - December 31, 2009 (indicative target): 884
- Ceiling includes general government wages and salaries, allowances, and bonuses. No in kind benefits will be increased or created during the program period.

### Continuous performance criteria on arrears
- Domestic arrears:
  - General government domestic arrears, defined as amounts not paid by the contract-specified date or within a normal commercial period for similar transactions, will be kept at zero for the duration of the program. This is a continuous performance criterion.
- External debt payments arrears:
  - The general government will accumulate no new external debt payments arrears during the program period.
  - External debt payment arrear defined as a payment due to nonresidents by the general government, which has not been made within seven days after falling due.
  - This criterion excludes trade credits and nonresident deposits in state-owned banks and applies continuously.
  - Stock of external debt payments arrears will be calculated based on reported schedule of external payment obligations; data will be reconciled with creditors and adjustments incorporated as they occur.

### Monitoring and reporting requirements — key reporting items and periodicity (selected)
- To be provided by the Ministry of Finance:
  - Consolidated central (basic and special budgets), local and general government operations based on the IMF fiscal template: Monthly, within four weeks of the end of each month.
  - Data on EU project grants (reimbursements and advances), capital expenditures and subsidies covered by EU advances or eligible for EU reimbursement on EU-supported projects specifically agreed with the EU: Monthly, within three weeks of the end of each month.
  - Consolidated central and general government bank restructuring operations: Daily, by end of next working day.
  - Privatization receipts received by the general government budget (in lats and foreign exchange, and payments in government bonds): Monthly, within four weeks of the end of each month.
  - Information on debt stocks and flows, domestic and external, guarantees on new debt: Monthly, within four weeks of the end of each month.
  - Data on general government arrears, including to suppliers: Monthly, within four weeks of the end of each month.
  - Data on the stock of the general government system external arrears: Daily, with a seven days lag.
- To be provided by the Bank of Latvia:
  - Balance sheet of the BoL (in both program and actual exchange rates): Monthly, within three working days of the end of each month.
  - Consolidated accounts of the commercial banks: Monthly, within two weeks of the end of each month.
  - Monetary survey: Monthly, within two weeks of the end of each month.
  - Data on components of the NIR of the BoL (in both program and actual exchange rates): Weekly, within one week of the end of each week.
  - Currency operations, including government foreign receipts and payments and breakdown of interbank market operations by currencies (interventions): Daily, by end of next working day.
  - Foreign exchange rate data: Daily, by end of next working day.
  - Volume of foreign exchange lats trades: Monthly (weekly for a sample of large banks), within one week of the end of each week.
  - Projections for external payments of the banking sector falling due in the next four quarters, interest and amortization (for medium and long-term loans): Quarterly, within four weeks of the beginning of the year.
  - The BoL will continue to provide balance of payments data in electronic format: Monthly, within six weeks of the end of each month.
- To be provided by the Financial and Capital Markets Commission:
  - Daily deposit monitoring bank by bank in the agreed format: Daily, by end of next working day.
  - Daily detailed deposit monitoring in Parex Bank in the agreed format: Daily, by end of next working day.
  - Banking system monitoring indicators in the agreed format (liquidity, credit quality, summary capital adequacy, simplified balance sheet and income statements): Monthly, within four weeks of the end of each month.
  - Detailed capital adequacy reporting in the agreed format: Quarterly, within four weeks of the end of each quarter.
  - Commercial banks’ balance sheets (bank-by-bank): Quarterly, within four weeks of the end of each quarter.
  - Commercial banks’ income statements (bank-by-bank): Quarterly, within four weeks of the end of each quarter.

### IMF Stand-By Arrangement (SBA) proposed access and phasing
- Authorities request a 27-month SBA with access of SDR 1.522 billion (1,200 percent of quota).
- Proposed access is front-loaded:
  - SDR 535 million (422 percent of quota) available upon approval.
  - SDR 178 million (141 percent of quota) available in February 2009 and SDR 178 million (141 percent of quota) in May 2009.
  - Remaining access phased in six quarterly purchases of SDR 89 million (70 percent of quota), and a final purchase of SDR 94 million (74 percent of quota) scheduled for February 2011.
- Table 1: Latvia: Proposed SBA–Access and Phasing (Purchases / Percent of quota / Availability Date / 1/SDR mn Purchase Cumulative)
  - 2008 December (Approval): 535.3 / 422.2 / 422.2
  - 2009 February: 178.4 / 140.7 / 562.9
  - 2009 May: 178.4 / 140.7 / 703.7
  - 2009 August: 89.2 / 70.4 / 774.0
  - 2009 November: 89.2 / 70.4 / 844.4
  - 2010 February: 89.2 / 70.4 / 914.8
  - 2010 May: 89.2 / 70.4 / 985.1
  - 2010 August: 89.2 / 70.4 / 1,055.5
  - 2010 November: 89.2 / 70.4 / 1,125.9
  - 2011 February: 94.0 / 74.2 / 1,200.0
  - Total: 1,521.6 / 1,200.0 / 1,200.0
- Note: Starting from February 2009, purchases will depend on the completion of a review.

### Background, risks and external debt statistics
- Latvia had an extensive program relationship with the Fund in the 1990s; last purchases were in 1994; full repayment in 2004.
- Assessment timeframe and documents cited include data as of end-November 2008; note that the supplement uses rounded figures.
- External vulnerabilities and debt:
  - Gross external debt has risen to 130 percent of GDP.
  - The private sector accounts for the bulk of external debt and has net external debt of 70 percent of GDP.
  - The public sector is currently a net external creditor but may have to assume private sector liabilities related to the banking sector.
  - A large proportion of gross external debt is short-term, contributing to a projected total financing requirement of 29 percent of GDP in 2009.
- Table 3. Latvia: External Debt, 2005–2008 (In millions of Euros / In percent of GDP)
  - Total External Debt:
    - 2005: 12,876
    - 2006: 18,230
    - 2007: 26,629
    - 2008 1/: 28,058
  - of which Public:
    - 2005: 855
    - 2006: 916
    - 2007: 1,068
    - 2008 1/: 2,207
  - of which Private:
    - 2005: 12,021
    - 2006: 17,314
    - 2007: 25,562
    - 2008 1/: 25,852
  - Total External Debt (percent of GDP):
    - 2005: 100.0
    - 2006: 114.8
    - 2007: 134.2
    - 2008 1/: 129.2
  - Public (percent of GDP):
    - 2005: 6.6
    - 2006: 5.8
    - 2007: 5.4
    - 2008 1/: 10.2
  - Private (percent of GDP):
    - 2005: 93.3
    - 2006: 109.0
    - 2007: 128.8
    - 2008 1/: 119.0
  - Sources: Latvian authorities and IMF staff estimates.
  - 1/ Projected to end-2008.
- Table 4. Debt Ratios in Past Exceptional Access Cases (In percent of GDP) — selected entries:
  - Earlier arrangements, 2003-05:
    - Argentina (2003): 129.0 / 82.5 / 12.2
    - Brazil (2003): 38.6 / 21.5 / 5.1
    - Turkey (2005): 35.0 / 17.8 / 3.0
    - Uruguay (2005): 82.0 / 60.8 / 13.8
  - Newly approved arrangements (2008):
    - Georgia 2/: 34.6 / 21.0 / 2.8
    - Hungary 3/: 106.4 / 37.6 / 4.2
    - Ukraine 4/: 54.3 / 10.4 / 2.5
    - Iceland 5/: 165.0 / 99.9 / 5.1
    - Pakistan 6/: 31.4 / 29.5 / 3.5
    - Latvia (2008) 7/: 129.2 / 10.2 / 2.8
  - Sources: Board documents and IMF staff estimates.
  - 1/ Ratios for the year indicated in parenthesis. Year in parenthesis corresponds to the year of approval of the last IMF arrangement with each country.
  - 7/ End-2008 projection, assuming first purchase under proposed arrangement.

### Risks to the Fund from the new SBA
- Latvia’s proposed access would be high and front-loaded.
- Outstanding use of the Fund’s GRA resources would reach 422 percent of quota upon approval and rise to 1,200 percent of quota in February 2011.
- Outstanding use of Fund resources would exceed the 300 percent cumulative access limit until May 2014.
- Relative to quota, peak exposure to Latvia would exceed all recent exceptional access cases except Turkey; proposed access would be the highest among recent cases, exceeding slightly that of Iceland.
- Currency holdings resulting from scheduled purchases under the proposed SBA would be subject to level-based surcharges from the approval of the arrangement until August 2014 (100 basis points over the basic rate of charge, adjusted for burden sharing, on credit outstanding exceeding 200 percent of quota, and 200 basis points on credit outstanding exceeding 300 percent of quota).

*INTERNATIONAL MONETARY FUND—Republic of Latvia—Assessment of the Risks to the Fund and the Fund's Liquidity Position; December 19, 2008.*

### 5.      If the proposed SBA is drawn in full, Latvia’s total outstanding use of Fund

### _cr0903 - 5.      If the proposed SBA is drawn in full, Latvia’s total outstanding use of Fund

### Impact on Latvia — outstanding use and GDP
- If the proposed SBA is drawn in full, Latvia’s total outstanding use of Fund resources will represent 8 percent of GDP by 2011.
- From its first purchase, Latvia’s outstanding use of Fund resources would be 2.8 percent of GDP.
- Latvia’s outstanding use of Fund resources in terms of GDP would reach 7.9 percent by end-2011.

### Impact on Latvia — external debt service burden and debt ratios
- By end-2008, Latvia’s outstanding use of Fund resources would account for 2.1 percent of external debt, rising to 5.3 percent by end-2011.
- Projected service under the proposed SBA would peak in 2013 at SDR 635 million, accounting for:
  - close to 8 percent of external debt service,
  - over 6 percent of exports of goods and services,
  - and 15 percent of gross reserves.
- Table 6 projected time series (selected rows, SDRs and percents preserved exactly as in source):
  - Fund GRA credit outstanding to Latvia (SDR millions): 2008: 535.3; 2009: 1,070.7; 2010: 1,427.6; 2011: 1,521.6; 2012: 1,131.3; 2013: 529.0; 2014: 170.3; 2015: 11.8; 2016: 0.0.
  - Fund GRA credit outstanding to Latvia (percent of quota): 2008: 422.2; 2009: 844.4; 2010: 1,125.9; 2011: 1,200.0; 2012: 892.2; 2013: 417.2; 2014: 134.3; 2015: 9.3; 2016: 0.0.
  - Latvia's GRA credit outstanding (percent of total external debt): 2008: 2.1; 2009: 4.0; 2010: 5.3; 2011: 5.3; 2012: 4.0; 2013: 1.9; 2014: 0.6; 2015: 0.0.
  - Latvia's GRA credit outstanding (percent of GDP): 2008: 2.8; 2009: 5.6; 2010: 7.5; 2011: 7.9; 2012: 5.8; 2013: 2.6; 2014: 0.8; 2015: 0.1.
  - Latvia's GRA credit outstanding (percent of gross international reserves): 2008: 16.1; 2009: 35.4; 2010: 33.8; 2011: 31.4; 2012: 23.4; 2013: 13.0; 2014: 3.6; 2015: 0.2.
  - Latvia's GRA debt service to the Fund (percent of exports of goods and services): 2008: 0.0; 2009: 0.3; 2010: 0.5; 2011: 0.6; 2012: 4.6; 2013: 6.2; 2014: 3.3; 2015: 1.4; 2016: 0.1.
  - Latvia's GRA debt service to the Fund (percent of total external debt service): 2008: 0.1; 2009: 0.8; 2010: 1.4; 2011: 1.1; 2012: 6.7; 2013: 7.7; 2014: 4.6; 2015: 2.9; 2016: 0.2.
  - Projected payment of charges to the Fund on GRA credit outstanding (SDR millions): 2008: 2.7; 2009: 24.8; 2010: 43.2; 2011: 53.9; 2012: 51.0; 2013: 32.5; 2014: 10.2; 2015: 2.1; 2016: 0.1.
  - Projected debt service payments to the Fund on GRA credit outstanding (SDR millions): 2008: 2.7; 2009: 24.8; 2010: 43.2; 2011: 53.9; 2012: 441.4; 2013: 634.7; 2014: 368.9; 2015: 160.7; 2016: 11.9.

### Impact on Fund finances and liquidity
- The proposed SBA would reduce the one-year forward commitment capacity (FCC) by SDR 1.5 billion, about 1.5 percent of the FCC of SDR 99 billion as of mid-December.
- After the first purchase, Latvia’s share of total Fund credit outstanding would be about 3.0 percent.
- The share of total credit extended to the top-five users of Fund resources was 91 percent as of end-November 2008; this concentration would decline slightly to 88 percent following the first purchase under the proposed arrangement.
- Fund GRA credit outstanding to Latvia would be equivalent to 7.7 percent of the Fund’s precautionary balances as of end-April 2008; this exposure would rise to about 22 percent of current precautionary balances if the proposed SBA is fully drawn.
- Projected charges on Latvia’s GRA obligations: SDR 25 million in 2009 and SDR 43 million in 2010.
- Fund’s residual burden-sharing capacity as of end-November 2008: SDR 50 million.

### Prudential and burden-sharing considerations
- If Latvia were to incur arrears on the charges accruing on its GRA obligations, the Fund’s available burden-sharing capacity could be significantly reduced.
- The potential impact on burden-sharing capacity would decline if the Fund’s loan portfolio expands due to purchases made under other recently agreed arrangements or new lending.

### Assessment and risks to program success and repayment
- The proposed arrangement with Latvia entails significant financial risks to the Fund: the level of access is large relative to Latvia’s economy and debt servicing capacity and is well above previous Fund exposure to Latvia.
- The relatively small size of the loan (in SDR terms) in relation to the Fund’s finances helps contain the risks to the Fund.
- Key program risks identified:
  - High external debt coupled with centering the program on maintaining the current exchange rate peg.
  - Correcting a large currency misalignment without nominal depreciation is very difficult based on experience from other currency board and fixed exchange rate cases.
  - Maintaining support for the peg requires prolonged commitment to fiscal consolidation and sustained wage and fiscal discipline by private and public sectors.
  - A high level of external financial support is required; Latvia may not be able to rely upon a supportive external environment.
  - Need for effective mechanisms to restructure private debt to mitigate risks.
  - Regaining access to international capital markets depends substantially on the normalization of those markets.
  - Inadequate program implementation, persistent financial sector instability (domestic or external), and weak structural reforms that fail to improve competitiveness present major downside risks to Latvia’s external position and capacity to repay the Fund.

*Source: IMF staff report text in content unit _cr0903 - 5.      If the proposed SBA is drawn in full, Latvia’s total outstanding use of Fund*

### 13.      Exceptionally strong domestic policy implementation will be required for the

### 13.      Exceptionally strong domestic policy implementation will be required for the

### Program overview and objectives
- Purpose: support Latvia’s strategy to restore confidence, stabilize the economy, and maintain the exchange rate peg to lay the groundwork for entry into the euro area.
- IMF action: approval of a 27-month Stand-By Arrangement of SDR 1.52 billion (about €1.68 billion, or US$2.35 billion).
  - Immediate availability: SDR 535.3 million (about €591.5 million, or US$826.3 million).
  - Remainder disbursed in nine installments subject to quarterly reviews.
  - Arrangement entails exceptional access: about 1,200 percent of Latvia’s quota.
  - Approved under the Fund’s fast-track Emergency Financing Mechanism procedures.
- Program aims (immediate and medium-term):
  - Stabilize the financial sector and restore depositor confidence.
  - Avoid disorderly adjustment that would follow abandonment of the exchange rate peg.
  - Ensure long-term external stability while maintaining the peg.
  - Meet Maastricht deficit criteria to facilitate adoption of the euro.

### Immediate crisis response measures
- Measures to defend the peg and stem deposit and reserve losses:
  - Immediate measures to stem the loss of bank deposits and international reserves.
  - Ring-fence and resolve immediate problems in Parex Bank to prevent systemic contamination.
  - Draw on substantial international financial assistance to meet foreign exchange demand.
- Recent developments informing measures:
  - Since end-August, private sector deposits fell by 10 percent, led by a run on Parex Bank which lost more than a quarter of its deposits.
  - From end-August to end-November, official reserves fell by almost 20 percent to €3.4 billion, one third of short-term external debt and just over 100 percent of base money (from 127 percent in September), as the central bank sold foreign currency to defend the peg.
  - Since early October the exchange rate has remained at its upper (depreciated) band and interbank spreads have spiked.

### Financial sector policies and bank resolution
- Parex Bank actions:
  - Government partially took over Parex Bank; new management installed; previous owners suspended from executive roles.
  - Authorities aim at obtaining full ownership; Bank instructed to offer to minority shareholders.
  - New management to select a lead advisor by January 15, 2009 to attract a strategic investor.
- System-wide banking measures:
  - Develop a comprehensive bank resolution strategy and undertake focused examination of the banking system.
  - Require viable banks needing capital increases to seek private restructuring via outside investors or mergers, or capital support from parent banks.
  - Strengthen crisis management capacity; amend laws to allow FCMC, BoL and the Ministry of Finance to take timely effective actions in systemic crises and enhance the special bank insolvency regime.
  - Support from international community will allow provision of emergency liquidity assistance (ELA) to solvent banks while respecting fair and equitable treatment of depositors and creditors (resident and non-resident).
- Private-sector debt sustainability:
  - Capital injections including from foreign parent banks and amendments to the Insolvency Law to facilitate orderly and efficient debt restructurings.

### Fiscal policy stance and public finance measures
- Fiscal goals and measures:
  - Immediate and sustained fiscal consolidation anchored in a medium-term fiscal framework to lower the deficit to the Maastricht level of 3 percent of GDP by 2011.
  - The parliamentary supplementary budget for 2009 caps next year’s general government fiscal deficit at below 5 percent of GDP.
  - This implies an adjustment of around 7 percentage points of GDP compared with the budget passed in November.
  - Measures include sizable expenditure cuts, maintaining public investment, and protecting social spending.
- Social spending and targeting:
  - Social spending under the program will increase from 21 to 25 percent of the budget, or by 1½ percent of GDP between 2008 and 2009.
  - Additional measures to improve targeting of social benefits to be included in the second supplementary budget for 2009.
- Public debt and IMF quota:
  - Latvia joined the IMF on May 19, 1992; its quota is SDR 126.80 million (about €140.1 million, or US$195.7 million), and has no outstanding use of IMF credits.

### Incomes policies and structural reforms
- Wage and income measures:
  - Authorities committed to wage restraint as key to restoring competitiveness.
  - Cut average compensation in the entire public sector by 15 percent in 2009, with further reductions in 2010-2011.
  - Reform wage-setting mechanisms to align compensation with constraints of a fixed exchange rate.
  - Establish a Committee to Promote Wage Restraint to monitor implementation and issue recommendations for public and private sectors.
- Structural reform agenda:
  - Vigorous measures to rebalance the economy toward tradables and boost productivity.
  - Private sector debt restructuring to be facilitated.
  - Form a national committee to examine long-term strategic options and press ahead with objectives in the National Lisbon Program.
  - Seek World Bank technical assistance on comprehensive reforms of education, civil service, state administration and healthcare systems.
  - Seek assistance from the Fund, EU and bilateral donors to strengthen public financial management and incorporate prudent fiscal rules into national legislation.

### International coordination and financing package
- Program is part of a coordinated international effort:
  - European Commission participated fully in program preparation, along with ECB (in line with Latvia’s ERM2 membership), Sweden and other Nordic countries.
- Financing gap coverage:
  - The Fund’s Stand-By Arrangement will fill just over 20 percent of the country’s 2009-2011 net financing gap.
  - The remainder to be met by the European Union, the European Bank for Reconstruction and Development, the World Bank and other bilateral creditors.
- Commitments from foreign banks:
  - Foreign parent banks operating in Latvia have affirmed commitment to provide their subsidiaries with adequate financing.
- Expected outcomes with substantial international support:
  - Allow the economy to eventually emerge from slow growth with fewer strains on corporate and household balance sheets.
  - Help address Latvia’s immediate balance of payments needs, contain and reverse increase of external debt, improve competitiveness and return Latvia to a sustainable growth path.

### Risks, implementation challenges, and staff assessment
- Implementation imperative:
  - Sustained and forceful implementation and prompt response to changes in underlying conditions and deviations from program assumptions are essential to safeguard Fund resources.
  - Latvia’s track-record of successful adjustment and high level of domestic and regional support provide some confidence that the ambitious policy package will be delivered.
- Economic outlook and trade-offs:
  - A deep recession and a drawn-out recovery appear inevitable given the needed price compression and wage reductions.
  - Fiscal tightening is unavoidable given government borrowing difficulties and probable additional budgetary burden from bank restructuring.
  - The authorities acknowledge the program is ambitious and challenging and stand ready to take additional measures if necessary.

### Key statistics and selected indicators (as reported)
- Stand-By Arrangement: SDR 1.52 billion (about €1.68 billion, or US$2.35 billion); immediate SDR 535.3 million (about €591.5 million, or US$826.3 million).
- Exceptional access: about 1,200 percent of Latvia’s quota.
- Reserve changes: official reserves fell by almost 20 percent to €3.4 billion (from end-August to end-November).
- Deposits: private sector deposits fell by 10 percent since end-August.
- Parex Bank deposit loss: more than a quarter of its deposits.
- Social spending: increases from 21 to 25 percent of the budget, or by 1½ percent of GDP between 2008 and 2009.
- Fiscal targets: general government fiscal deficit capped at below 5 percent of GDP for 2009; target to reach Maastricht deficit of 3 percent of GDP by 2011.
- Quota: SDR 126.8 million (Latvia’s IMF quota).

*Source: Press Release No. 08/345 and associated Executive Board documents, December 23, 2008.*

---


_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2009/_cr0903.pdf_