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Republic of Latvia and the IMF

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Finance & Development
A quarterly magazine of the IMF
June 2001, Volume 38, Number 2

Latvia on the Way to the European Union
Roberts Zile and Inna Steinbuka

Having met most of the criteria for membership in the European Union, Latvia is addressing a few remaining challenges. These include closing the income gap and achieving structural, fiscal, and monetary convergence.

As it enters the third millennium, Latvia is poised to become a member of the European Union (EU). In mid-December 1999, the Helsinki summit approved Latvia as a candidate for membership, and detailed negotiations for its entry are under way. Latvia's first decade of transition was marked by a substantial reorientation of its economic and institutional focus toward Western Europe; in the coming decade, formal accession to the European Union is likely to be a significant milestone.

Topping Latvia's political and economic agenda, EU accession has become one of the driving forces behind the country's adjustment and reform efforts. To achieve European integration, Latvia must meet specific conditions and implement specific policies. EU accession has also served as a primary goal, helping to break political deadlocks and counterbalance the destructive activities of lobbies. For instance, Latvia was the first Baltic country that, despite tough opposition, adopted anti-money-laundering legislation and set up a disclosure office.

The European Union is not the only "outside anchor" for domestic policies in Latvia. Economic policy programs and loan arrangements with the IMF, as well as lending programs with the World Bank, continue to serve as external anchors. Also, the goal of joining the World Trade Organization (Latvia became a member in February 1999) unquestionably influenced policymaking because the conditions associated with membership provided targets that helped policymakers reach consensus on launching and sustaining politically difficult reforms designed to liberalize the economy and trade.

The European Commission (EC) has determined that Latvia largely meets the general, so-called Copenhagen criteria for EU membership. These provide broad guiding principles in the political, economic, legal, and institutional arenas. They require, for example, the existence of a well-functioning market economy and the ability to compete in Western European markets. According to the latest EC progress report, Latvia has broadly met this requirement.

By anchoring its economic, political, and institutional structures to those of advanced Western European nations, Latvia is likely to be viewed as a more secure place for doing business. Such a perception should help reduce the risk premiums associated with the Baltic countries and foster further investment, stronger trade flows, and other forms of convergence. However, it will take decades to close the income gap between Latvia and the rest of the European Union. An adequate policy mix should continue to be implemented to accelerate convergence of incomes.

The three most important issues facing the Latvian authorities in designing adequate policies are

  • how and when the income gap between Latvia and the European Union can be closed;
  • how to stay on track to achieve fiscal and monetary convergence; and
  • how to accelerate structural convergence and create a fully competitive market economy.

Real convergence

Achieving real convergence is the most difficult task Latvia faces. Per capita GDP is one of the main indicators used for measuring real convergence and involves comparisons over time and between regions. In Latvia, per capita GDP measured according to purchasing power parity ($5,893 in 1999, according to the IMF's World Economic Outlook, October 2000) is lower than in European Union member countries. Given that output statistics in transition economies are deficient in several ways, however, growth might be understated. In Latvia, where these deficiencies are due not to the weakness of statistical methods used for drawing up the national accounts but to the large informal sector in the economy, the official data exaggerate GDP decline and show recovery occurring more slowly (Åslund, 2001).

Even taking into account the underestimation of GDP, it will be difficult, over the medium term, to close the large income gap between Latvia and the European Union. Factors that will enhance growth should help reduce this gap: the expansion of capital, macroeconomic stability, liberalization, and other macro policies, as well as established property rights, institution building, the rule of law, and the prevention of corruption. Real convergence in terms of per capita GDP is an outcome of, rather than a precondition for, EU membership. Lessons from the enlargement of the euro area—in particular, as demonstrated by Greece, Ireland, and Portugal—have shown that rapid real convergence can take place after a country has joined the European Union.

Nominal convergence

The Maastricht criteria, which specify the measures of macroeconomic convergence required for membership in European Economic and Monetary Union (EMU), could be used to assess the nominal convergence of EU accession countries. These criteria set quantitative limits on inflation, long-term interest rates, the general government budget deficit, gross government debt, and exchange rates. In general, countries joining the European Union must be able to meet the fiscal and monetary convergence criteria relatively soon after joining if they also want to become part of EMU. With respect to convergence with the Maastricht criteria, Latvia has made clear progress (see table). The inflation rate has dropped below 3 percent, the exchange rate peg is credible, the budget deficit is under control, and public debt is very low.

Latvia: Key economic indicators

  1998 1999 2000 2001

  Percent over the previous year
GDP 3.9 1.1 6.6 6.0
Consumer price index 4.7 2.4 2.6 3.0
  Percent of GDP
General government budget fiscal balance -0.9 -4.2 -2.71 -1.7
Current account balance -10.6 -9.6 -6.8 -7.0
Exchange rate (Latvian lats per U.S. dollar) 0.590 0.585 0.606 0.60
Unemployment (percent, at end of year) 9.2 9.1 7.8 7.0

Source: Republic of Latvia, Ministry of Economy, 2001, Macroeconomic Review, No. 1 (6).

Inflation, as measured by the consumer price index, was 2.6 percent in 2000. It is projected to be maintained at a similarly low level over the medium term, although it may slightly outpace Western European levels for several more years as Latvia adjusts domestic prices to the level of international prices. This is a general problem for all transition and accession countries. Although there is scope for price adjustments in the nontradable sectors, particularly transport services, housing, and energy, rapid convergence achieved exclusively through tough deflationary measures would seriously restrict Latvia's growth and depress employment levels.

Latvia's fiscal deficit exceeded 3 percent in 1994 (owing to increases in net lending), in 1995 (owing to the banking crisis), and in 1999 and 2000 (owing to the Russian crisis). Under Latvia's fixed-peg exchange rate regime, the fiscal system is the main line of defense against a negative external shock; given the large current account deficit, fiscal policy should be prudent and needs to be tightened over the medium term. Some potential sources of pressure on the fiscal position also need to be recognized. External pressures have arisen as Latvia has begun to adopt the environmental and other standards of the European Union. Some experts have estimated that extra spending required for EU accession could be as high as 5 percent of GDP for a number of years in all candidate countries, which may also incur costs in complying with the requirements of the North Atlantic Treaty Organization (NATO). Ongoing reforms of the health, education, and pension systems have created domestic pressures. A medium-term fiscal framework is absolutely essential and will highlight the difficult trade-offs Latvia faces between the need for fiscal discipline and the need for extra spending. However, it would not be appropriate at this stage for Latvia to tie its fiscal policy to an inflexible (Maastricht) target.

At the end of 1999, Latvia's government debt amounted to 13.1 percent of GDP. It will be maintained at a reasonably low level in the years to come. Interest rates and exchange rates are harder to evaluate. For example, it is difficult to apply the Maastricht interest rate criterion to accession countries because their markets for long-term debt are not well developed. The criterion for exchange rates, strictly speaking, does not apply to these countries because they do not share a regional exchange rate arrangement.

We believe that the degree of nominal convergence necessary for Latvia to accede to the EMU should not be overemphasized prior to EU accession. Once Latvia becomes an EU member, the prospect of subsequent currency integration through EMU provides another anchor both for monetary policies and for ongoing structural and institutional reforms.

Structural policy convergence

Latvia liberalized its economy quickly, freeing prices at the beginning of its transition. The economy was opened to the world, allowing not only goods and services to flow freely over its borders but also capital, implying full currency convertibility for most current and capital account transactions.

Latvia's privatization scheme got off to a slow start for at least two reasons. First, the manufacturing sector was dominated by large producers of specialized goods (electronics, for example) destined for the countries of the former Soviet Union. Large companies are more difficult to privatize than small and medium-size firms. Second, the country's tight fiscal policy represented a serious impediment to privatization, with restructuring implying fiscally costly layoffs of redundant labor.

According to an assessment by the World Bank, with gradual privatization and slow bank restructuring, Latvia had completed about 80 percent of structural reforms by 1995. Only four transition countries—the Czech Republic, Estonia, Hungary, and Poland—did better, completing about 90 percent of structural reforms by 1995. Currently, almost all large companies in Latvia have been privatized, and about two-thirds of GDP is produced by the private sector. Latvia has implemented some of the most stringent banking regulations in Eastern Europe, and a sound and profitable financial sector is beginning to emerge.

Although Latvia has successfully completed many structural reforms, many challenges remain. The economy still needs substantial adjustments in product, capital, and labor markets. There is also a need to continue strengthening the institutions that support market activities. Key policy priorities include modernizing the civil service, streamlining the role of subnational governments, and completing pension reform.

Foreign assistance for transition

Foreign assistance to Latvia has gradually increased, keeping pace with the country's transition. In the mid-1990s, the European Commission extended to Latvia a special assistance program for advanced transition countries (PHARE). The international financial institutions (the IMF and the World Bank, the European Investment Bank, the European Bank for Reconstruction and Development, and others) also became major actors in assisting Latvia in its accession to the European Union.

Latvia has benefited significantly from this assistance. First, financing for, and investments in, different industrial and infrastructure projects and human development were crucial in the initial stage of transition, when domestic resources were limited. The grant element in assistance, particularly for investments and training, provided a strong impetus to healthy growth. Second, EU assistance accelerated Latvia's progress toward integration. Third, conditionality for the loans extended by the international financial institutions strengthened the continuity, consistency, and credibility of reforms.

Turning to some problems associated with assistance, we would emphasize that the different international institutions lacked coordination and consistency in establishing programs and setting conditions for various lending and assistance agreements. Often, coordination among the donors and creditors was fundamentally impossible because of the different and even conflicting mandates and interests of their institutions. While donor coordination is beyond Latvia's control, the goal of the current system for coordinating foreign assistance programs in Latvia is to increase efficiency in using foreign financing in line with political, economic, and social priorities.

As the transition in Latvia nears completion, we are convinced that private investment will gradually replace official multilateral and bilateral help. In other words, as Latvia becomes a "normal" market economy, assistance will gradually decrease until it is no longer needed. However, at this stage, international assistance remains important.

The IMF has been and will continue to be the main controlling agency in the field of macroeconomic stabilization while helping to implement "transition packages" of structural reforms. Latvia's new economic program (the Memorandum of Economic Policies was approved by the authorities on March 13, 2001), supported by a Precautionary Stand-By Arrangement, is fully consistent with its EU accession strategy. As an integral part of this strategy, the program provides a credible framework that will enable Latvia to meet the economic criteria for EU membership. The program is designed to reduce external imbalances by administering "strong medicine" comprising tight fiscal policies and structural reforms, especially public sector reforms. The government's core challenge is to achieve two rather controversial goals simultaneously: (1) maintaining a broadly balanced fiscal position over the medium term, and (2) supporting substantial fiscal costs related to accession to the European Union and NATO. To meet these goals, Latvia must improve the way it prioritizes and manages public spending.

The involvement of the IMF will decrease over the medium term, and the European Union will provide key foreign assistance. During 2000-2006, the EU's PHARE program will be supported by two other financial instruments, which will have a sectoral focus—one concentrating on building transport and environmental infrastructure and the other on investment in agriculture and rural development—while PHARE will generally continue to provide broad support for accession across all sectors.

Aid prior to accession can reach 4 percent of GDP, and its effectiveness is contingent on Latvia's ability to identify its true priorities. In the years to come, EU cofinancing, in addition to projected national and private funds, will be guided by the medium-term National Development Plan. The availability and potential benefits of EU funding are difficult to quantify at this stage because it is unclear when Latvia will be invited to join the European Union and whether it will be included in the first or second wave of enlargement. However, under any scenario, aid prior to accession will give new impetus to growth through investment in economic sectors and regions, including in training, and reduce the income gap between Latvia and the European Union.

This article is based on two publications: Inna Steinbuka, 2000, "Alignments of Latvian Economy in the Context of European Integration," Journal of Baltic Studies, Vol. 31, pp. 193-203; and Roberts Zile, Inna Steinbuka, Remigijs Pocs, Juris Krumins, Helmuts Ancans, and Uldis Cerps, 2000, Latvia Entering the XXI Century: Economy, Finances, Integration (Riga: Nacionalais Medicinas Apgads).

Anders Åslund, 2001, "The Myth of Output Collapse After Communism," CEIP Working Paper No. 18 (Washington: Carnegie Endowment for International Peace).

Roberts Zile is Latvia's Special Minister for Cooperation with International Financial Institutions.

Inna Steinbuka is Advisor to the Executive Director, Nordic-Baltic Office, IMF and Professor of Macroeconomics at the University of Latvia.