Republic of Latvia and the IMF
News Brief: IMF Completes First and Second Review of Latvia Under Stand-By Arrangement
Country's Policy Intentions Documents
Republic of Latvia—Letter
of Intent, Supplementary Memorandum of Economic Policies
Mr. Horst Köhler
Dear Mr. Köhler:
The attached Supplementary Memorandum of Economic Policies (SMEP), adopted by the Cabinet of Ministers, describes the policies the Government and the Bank of Latvia intend to follow for the remainder of the program period under the stand-by arrangement approved by the IMF Executive Board on April 20, 2001. The program is based on our Memorandum of Economic Policies, dated March 21, 2001, and has been discussed and updated with the staff of the IMF during the first and second reviews of economic developments and policies under the stand-by arrangement. As stated before, we do not intend to make any purchases under the stand-by arrangement, but would do so if circumstances warrant.
Despite our best efforts, the performance criterion on the general government fiscal deficit for end-December 2001 was not observed, because of higher-than-expected spending by local governments. We regret that we could not observe this target and wish to request a waiver, and we want to reassure you that we are currently addressing this issue with local governments. We request the completion of the first and second reviews under the stand-by arrangement, in support of our policy program detailed in the attached SMEP.
Our economy has performed very well over the past two years. To sustain strong growth and safeguard our external position, the cornerstone of our economic program remains a return to a balanced budget over the medium term, combined with policies aimed at enhancing the efficiency of the public sector. In addition, our structural reform program is directed at completing the transition to a full-fledged market economy. These policies are also an integral part of our EU accession strategy.
We believe that the policies described in the attached memorandum are adequate to meet the objectives of our economic program, but we will take additional measures to meet these goals should the need arise. Progress in program implementation will continue to be monitored through performance criteria and structural benchmarks (Table 1), which have been set through end-September 2002, the end of the program.
1. The Latvian economy has experienced high and robust growth in a low-inflation environment over the last two years. Real GDP grew by 7½ percent in 2001 despite the slowdown in external demand in the second half of the year. Growth continued to be broad-based and was the highest among EU accession candidate countries. At the same time, inflation has remained subdued, with the twelve-month inflation rate at 3¼ percent in March 2002. Latvia has made considerable progress in its EU accession negotiations, with 27 of the 31 chapters of the acquis communautaire closed to date. Given Latvia's moderate external debt indicators, vulnerability to external shocks remains low, notwithstanding a significant widening of the current account deficit and lower-than-expected FDI inflows in 2001. We also successfully placed our second Eurobond in November 2001.
2. We have reduced the fiscal deficit to 1.9 percent of GDP in 2001, an improvement of about 1½ percentage points over 2000. Nonetheless, the general government fiscal deficit target for end-December 2001 was exceeded by 0.2 percent of GDP because of a budget overrun by the City of Riga. We believe that the deviation from the deficit target did not interfere with program objectives. Moreover, the government has made progress toward implementation of the public sector reform measures under the program. The 2002 budget law sets a higher deficit as compared to 2001, which mainly reflects our spending priorities related to EU and NATO accession and domestic priorities such as education and health, as well as an acceleration of our public investment program. We have, however, shown prudence in the execution of the budget and have observed the indicative end-March 2002 deficit target, specified in the letter to the IMF mission chief dated November 21, 2001, with a comfortable margin.
3. Monetary conditions during 2001 were sufficiently tight to support the Bank of Latvia's (BoL) exchange rate objective. As a result, all end-December 2001 monetary performance criteria under the program were observed. In addition, the BoL discontinued new issues of long-term foreign exchange swaps in December 2001, ahead of schedule. Finally, the BoL began managing liquidity primarily through repo operations, while limiting short-term foreign exchange swaps to monetary fine-tuning. Despite strong credit growth, the financial position of the banking system remains strong.
4. We have fully aligned our prudential framework with international standards through the adoption of amendments to the Law on Credit Institutions (LCI). In addition, Parliament is expected to pass legislative amendments aimed at enhancing our anti-money laundering framework, including combating terrorist financing.
5. Latvia has made steady progress in the area of structural reforms. The privatization process has gained momentum, with the privatization of Latvijas Gaze completed and the divestiture of the Latvian Shipping Company (LASCO) well underway. Significant steps have also been taken in other areas. In particular, the new commercial law became effective in January 2002. Additionally, our efforts have focused on improving the business climate, enhancing competition in the energy and telecommunications sectors, and combating corruption. Our liberal trade regime continues to be in line with EU requirements and our WTO obligations.
B. The Government's Program for 2002
Program Objectives and Macroeconomic Framework
6. Notwithstanding the strong economic performance during 2001 and the largely successful implementation of the program, the widening of the external current account deficit, combined with a decline in its financing through FDI inflows, runs counter to our objective to limit Latvia's vulnerability to exogenous shocks. Against this background, recognizing the pivotal role of fiscal policy as our key macroeconomic policy instrument, we will redouble our efforts to implement a tight fiscal policy in 2002 and, over the medium term, move toward a balanced budget. Furthermore, we will proceed with our structural reform agenda so as to foster strong FDI inflows and create an environment conducive to private sector activity. These efforts will be underpinned by maintaining our successful exchange rate peg to the SDR. With a view to preserving our competitiveness, we will postpone the consideration of a minimum wage increase. We recognize the need to closely monitor external developments, and stand ready to further tighten policies as needed to maintain external sustainability.
7. While the slowdown in external demand appears to have led to a temporary moderation of growth in Latvia, we expect that economic activity will rebound quickly and be buoyant and sustained over the medium term. Our main macroeconomic objectives for 2002 and beyond are as follows: (i) real GDP growth at 5 percent in 2002 and 6 percent annually thereafter; (ii) inflation at about 3 percent per year; and (iii) containing the external current account deficit at about 8½ percent of GDP in 2002, with a declining trend thereafter. We also anticipate strong FDI inflows so that about two-thirds of the current account deficit will be financed through these flows, thereby keeping our external debt indicators at low levels.
8. Our fiscal policy aims at achieving a balanced budget over the medium term. While the 2002 budget law envisages a fiscal deficit of 2¾ percent of GDP (including the costs of pension reform), we recognize that under Latvia's present economic circumstances a deficit of 1.8 percent of GDP would be more appropriate. To this end, we will observe the end-June 2002 indicative fiscal deficit target set forth in our letter to the IMF mission chief dated November 21, 2001, as well as the fiscal deficit targets for end-September and end-December 2002 specified in Table 1a attached to this memorandum. We envisage further fiscal adjustment for next year.
9. We expect to achieve these targets through both a strong revenue performance and expenditure restraint. Tax and nontax collections during the first four months of the year have been buoyant and, if sustained as a result of the strengthening economy and improved tax administration, could lead to higher total revenue than budgeted. Based on actual data through April, we will keep spending below the ceilings under the 2002 budget law by 0.7 percent of GDP. Most importantly, we anticipate some delays in the implementation of our public investment program because of the time-consuming appraisal and tender procedures for individual investment projects. In addition, while a recent constitutional court ruling will lead to unanticipated spending of some LVL 5 million on pensions to working pensioners, we nevertheless expect that the financial position of the social fund will be better than budgeted. We will not adopt a supplementary budget during the program period. Furthermore, we will refrain from adopting any Cabinet decisions authorizing the spending of privatization receipts outside of the budget, unless related to unforeseen court decissions.
10. To improve budget discipline at the local government level, we have submitted to Parliament amendments to the Law on Local Government Budgets; we expect these amendments to be adopted by end-June 2002. The amendments will clarify that local government borrowing requires the approval of the Minister of Finance and is subject to the overall local government borrowing limit under the annual budget law. We will not increase the 2002 local government borrowing limit above the ceiling of LVL 11.5 million set in the budget law. In addition, the Ministry of Finance has enhanced its monitoring of local government budgets, including by the monthly monitoring of the budgets of each local government.
11. To shore up our revenue base, we will refrain from reducing the tax rate for social insurance contributions during the course of the year and from introducing any new tax exemptions beyond those currently in force. We will, by end-September 2002, complete the review of all current tax exemptions under the corporate income tax law, in conjunction with the FAD tax policy mission (structural benchmark). In order to enhance excise and VAT collections, we have submitted to Parliament amendments to two laws: (i) amendments to the Law on Taxes and Fees that would give greater enforcement power, including for the collection of tax arrears, to the State Revenue Service and would streamline the appeals procedure; and (ii) amendments to the Law on the Excise Tax for Oil Products that would align the payment period for excise taxes on oil products that enter customs warehouses to the payment period for other taxes, reducing this period from 45 to 10 days. In addition, we are preparing amendments to the Law on the Excise Tax on Alcohol Products to broaden the definition of alcohol products and align it with EU Directives.
12. We continue to implement our public sector reform agenda to raise the effectiveness and efficiency of our public sector. A Coordination Council of senior civil servants is overseeing the implementation of the Public Administration Reform Strategy according to the action plan adopted by the Cabinet in December 2001. The final set of regulations under the Law on Public Agencies is expected to receive Cabinet approval by end-June 2002. Improvements in medium-term budget planning are continuing with the completion of the Ministry of Agriculture's Strategic Planning Pilot Project, which has reviewed the delivery of goods and services provided by all programs under the Ministry's responsibility and is leading to the establishment of performance-based measures under these programs. By end-September 2002, the Cabinet will decide on a framework for extending strategic planning reviews to other line ministries (structural benchmark).
Exchange Rate, Monetary, and Financial Sector Policies
13. Our monetary policy anchor, the exchange rate peg to the SDR, remains key to maintaining low inflation and supporting confidence, and we intend to retain this peg until EU accession. The BoL's monetary policy will continue to be geared at supporting the peg and sustaining financial sector stability.
14. We anticipate further monetization of our economy and strong confidence in our financial system. Therefore, our monetary program for the remainder of 2002 is based on the assumption of an increase in money demand and the money multiplier. We will contain the growth of reserve money to 12 percent in 2002, by relying primarily on open market operations. Private sector credit growth is expected to moderate to 26 percent in 2002. While we believe that the rate of credit expansion has passed its peak, we are nonetheless carefully monitoring credit developments. The Financial and Capital Market Commission (FCMC) is already scrutinizing banks' credit policy and risk strategies. In addition, if deemed necessary, the BoL will not hesitate to tighten monetary policy to contain credit expansion.
15. The FCMC has made substantial progress in implementing the recommendations set forth in the joint World Bank/IMF Financial Sector Assessment Program (FSAP). Following the re-approval of existing financial sector regulations, the FCMC will harmonize all sector-specific legislation, regulations, and supervisory methods across sectors by end-December 2002 to reap the full benefits of unified supervision. Risk profiles for financial institutions have been prepared and the FCMC will consider introducing a rating system for financial institutions to enhance the effectiveness of its oversight function at a later date. In addition, the FCMC will update its examination manual to effectively cover all branches of the financial sector. Finally, the FCMC will continue to enhance risk-based supervision in all sectors and to promote the introduction of key consumer protection measures for the financial sector.
16. While we have made considerable progress in aligning our anti-money laundering and combating the financing of terrorism frameworks with international practice, we recognize the need to further refine these frameworks and step up our enforcement capacity. To this end, we will, by end-December 2002, submit to Parliament amendments to the Law on the Prevention of Laundering of Proceeds derived from Criminal Activity. The revised law will be in full compliance with FATF, UN, and EU requirements. In addition, a newly established unit under the Financial Police will vigorously pursue reports of suspicious activity identified by our Financial Intelligence Unit (FIU). We will also create a second unit under the Economics Crime Police and ensure that it is fully operational by end-December 2002. Finally, we are committed to increase staffing in our FIU to more effectively process reports of suspicious transactions.
Structural and Trade Policies
17. Our structural reform program is directed at attracting foreign investment and sustaining growth. The focus of our structural reform agenda will be to (i) implement measures identified as catalysts to improve the business climate; (ii) foster competition in the energy and telecommunications sectors; (iii) complete the privatization of large-scale public enterprises; and (iv) combat corruption.
18. We have implemented 68 of the 77 suggested measures in our Action Plan to Improve the Business Environment. We expect that the Cabinet of Ministers will adopt a new Action Plan by mid-2002 based on input from both foreign investors and the domestic business community.
19. We recognize that the foundation of an efficient energy and telecommunications sector is competition and sound regulation. To this end, and in line with the strategy paper and work program of the Public Utilities Commission (PUC), we envisage a transition from regulated monopolies to regulatory frameworks for competitive markets. Key steps in this direction include the completion of the restructuring program of Latvenergo by end-2002 and the implementation of the recently adopted principles for tariff setting, which will be applied across sectors.
20. As already noted, the divestiture of our remaining state enterprises has gained momentum. Following our guidelines for the privatization of LASCO, we will complete the divesture of a majority share to strategic and financial investors by mid-2002 and of the remaining shares by end-2002. Based on the recommendations of our financial advisors, we will strive to sell our minority share in Ventspils Nafta during the second half of 2002. In addition, we will dispose of the remaining state shares in Krajbanka no later than the first quarter of 2003. The divestiture of the state share in Lattelekom still hinges on the resolution of the legal dispute related to the WTO obligation to relinquish the monopoly rights by 2003.
21. The fight against corruption remains one of our key priorities. To this end, the new Law on Prevention of Conflict of Interest has been passed, and the Law on the Establishment of the Office for the Prevention of and Fight against Corruption (OPFC) came into effect May 1, 2002. A head of the office will be appointed and the office will begin all its operations no later than August 1, 2002. By end-December, 2002, the Executive Secretariat of the Crime and Corruption Prevention Council will prepare the 2003 Corruption Prevention Program, which will include well-defined tasks, responsibilities, and timetables.
22. We are committed to maintaining our liberal trade regime and remain in line with EU requirements and our WTO obligations. The MFN rate of 0.5 percent, applied to some industrial goods, has been eliminated and the simple average MFN tariff has been reduced to about 5 percent. Furthermore, we will refrain from raising tariffs.
23. We believe that these policies will bolster Latvia's medium-term growth prospects and facilitate our accession to the EU. We are prepared to implement any additional measures deemed necessary to meet these goals.