Public Finance Perspective - Latvia
Dmitri Maslitchenko dmitri@mailroom.com
The Latvian people have lived in the Baltic-shore territory for
more than 4,000 years, with the Latvian language being one of the oldest
living languages of Europe. "Latvia's location at an East-West
crossroads, and her ice-free ports on the Baltic Sea, have made her an
inviting target for expansional powers.".(EIU, 1995). Over the
centuries, Latvia has been occupied by the Teotonic knights of Germany,
the knights of Sweden and Poland, and the tsars of Russia. World War I
and the fall of the Russian tsars provided an opportunity for numerous
Russian colonies to break away. Only Latvia, Lithuania, and Estonia
gained and maintained independence on November 18, 1918, by signing a
treaty with the new Soviet Russian government. Latvia quickly began to
develop a successful economy and joined the League of Nations in 1922.
In 1940, Stalin presented Latvia with an ultimatum, admit Soviet
troops or face annihilation. During the next fifty years, the Soviet
Union ruled over Latvia. Freedom of speech and press were abolished.
Access to western printed materials, radio broadcasts, and other
communications were strictly forbidden, and religious activities were
destroyed. In 1987 large human rights demonstrations began to take
place, with the most notable being the 1989 joining of hands in the
unforgettable Baltic Way from Tallinn through Riga to Vilnius.
On May 4, 1990, the Supreme Council of the Republic adopted the
Declaration on the Renewal of the Independence of the Republic of Latvia.
In a referendum held in March of 1991, the people of Latvia voted
overwhelmingly in favor of democratic and independent statehood for the
Republic of Latvia. "Latvia's declaration of the restoration of
independence in August of 1991 resolved many of the issues prominent
during the transitionary period between occupation by Russian troops and
Latvian independence." (World Bank, 1995). The declaration lays down
that Latvia is "an independent democratic republic, the sovereign power
of which belongs to the people of Latvia, and its statehood is determined
by the 1922 Constitution"(EIU, 1995). On September 17, 1991, the
Republic of Latvia was granted full membership in the UN. On June 5,
1993, the 5th legislature (Saeima) was elected in general and democratic
elections.
An overview of the Latvian Economy
Latvia is rapidly becoming a dynamic market economy, with Estonia
being the only other former Soviet state close to Latvia in the
transformation. However, the transformation has not been without effort,
the IMF reported only a 2% growth in GDP in 1994, following declines in
GDP in 1992 and 1993. The government's monetary policies and reform
programs have kept inflation under 2% a month, encourtaged growth in the
private sector estimated to account for over half the GDP, and encouraged
growth in trade with the West.
"Price reform in Latvia came in several stages, bringing relative
prices more in line with world prices and reducing the excess demand for
goods in Latvia.".(EIU, 1995). By 1992 less than 8% of goods and
services in the consumer price index remained under price controls. The
price reform "increased GDP, contributed to an improvement in the
financial position of Latvian enterprises, and assisted in the
improvement of the government budget"(EIU, 1995).
on the economy were only temporary.
However, the effects
But even the price reforms could not pull Latvia out of a economic
situation that was becoming worse in 1992. "Depleting stocks of raw
materials and energy resources and the continued lack of foreign
financial resources coupled with a reduction in agriculture due to a
severe drought assisted in the reduction of GDP by 30%.".(EIU, 1995).
Unemployment increased to 2%, profit and income tax revenues declined,
and enterprise tax arrears continued to rise. The negative impact of
these events resulted in an increasing fiscal deficit.
Recent reform efforts...
Since Latvia regained independence in 1991, the government of
Latvia has made substantial progress in stabilizing the economy and
structural reforms. "The government has been involved in a large effort
to transform the economy from a centrally planned system to a market
based system.".(EIU, 1995). A comprehensive economic program was
initiated late in 1992 which focused on stabilization. Tight monetary
and fiscal policies maintained an almost balanced budget through 1993 and
reduced the rate of inflation, which declined steadily from over 900% in
1992 to less than 2% in 1995 (World Bank, 1995).
Prices and trading
were liberalized. "Efforts to restructure the banking system, to
privatize the economy, and to demonopolize large state owned enterprises,
encouraged the development of the private sector and allowed
restructuring of domestic production, removed from highly subsidized and
protected markets." (World Bank, 1995).
An important element of the reform efforts was the introduction of
a national currency in 1992 which allowed the Bank of Latvia to pursue an
independent monetary policy. "Tight monetary policy was supported by a
broadly balanced government budget in conjunction with tax-based income
policy." (World Bank, 1995). Since 1993 the country has had a stable
currency, the LAT. "The nominal exchange rate, since introduction, has
continued to remain fairly stable against the dollar.". (EIU, 1995).
The government has also made reform progress in several other areas
which include fiscal policy and the social safety net. "Fiscal reform
measures replaced the Soviet tax system with a modern tax system and
shifted expenditures significantly from subsidies and transfers to
enterprises, to other areas.".(EIU, 1995). The government is still
working in other areas including extrabudgetary funds and tax collection
capacity. A number of reform measures have also been taken to improve
the social safety net, including the introduction of unemployment
benefits and allowances to poor families. However financial resources
for social safety net reform measures continue to decrease as
unemployment and pensions costs continue to increase. "Financing of the
social safety net has been re-examined to address its dependence on the
wage base which has inflated the cost of labor and discouraged
employment.".(EIU, 1995).
Progress has also been made in structural reforms. Prices have
been liberalized, the trading has opened, banking institutions have been
privatized, as have been a number of small businesses and agricultural
land. Latvia also seems to have weathered the banking crisis and the
economy has begun to recover late in 1995 and has since experienced some
growth in 1996. The banking system has moved towards fairly stable and
functioning private banks. Progress has also been made in land
restitution and agricultural privatization. Much of the agriculture has
already been privatized and the government plans to increase the pace of
privatization of state enterprises. Approximately two-thirds of the
enterprises owned by government have been privatized. Privatization of
large enterprises has been at a slower rate, with only 85 of the 200
proposed projects completed by late 1994.(World Bank). With the approval
of laws establishing the Privatization Agency and the State Property
Fund, the large enterprise privatization increased its pace in
accomplishing the goal of 75% privatization by 1996. (World Bank, 1995).
Latvia is thus in the midst of recovery, assisted by the
country's strategic location on the Baltic and its well-educated
population.
The Budget System
Under former Soviet rule, public administration and management were
highly centralized. Since Latvia's independence in 1991, there has been
substantial progress in decentralization of the local governments. Until
recently, there were three levels of local government: rural districts
and small towns known as pagasts, regions which included rural districts
and small towns on their borders known as rayons, and seven major cities,
including Riga, which administered both the pagasts and the rayons.
Legislation within the past year has simplified the administrative system
to two levels ( 26 regions and 600 municipalities) and has clarified and
separated responsibilities for expenditure. "New laws provide for a
stable and transparent system of revenue assignment, formalizing
intergovernmental fiscal relations through allocations of tax revenues
between the state and the local governments, and revenue equalization
among the municipalities.". (World Bank, 1995).
Extrabudgetary Funds...
Extrabudgetary funds' budgets and operations must be approved by
Parliament. The Social Security Fund is the largest of the
extrabudgetary funds, accounting for over 28% of general government
revenue.(World Bank, 1995). This fund is administered by the Ministry of
Finance and financed through the social security tax. Expenditures of
the fund include pension payments, sick pay, maternity pay, and family
allowance. The unemployment benefits are financed through 1.5% of the
social security rate (World Bank, 1995).
Two other significant funds are the State Privatization Fund and
the Environmental Protection Fund, which are financed through sales of
government property and a natural resource tax respectively. "The State
Privatization Fund was established to manage revenues gained from the
privatization of state-owned enterprises and the sale of other
assets.".(EIU, 1995). Municipalities located within the jurisdiction of
the privatization of state-owned property also receive 5% of the
revenues. Riga is the only exception to this rule, and receives 10% of
the revenue. The Environmental Protection Fund gains revenue through the
collection of fines on polluting enterprises and also through a
percentage of the natural resource tax. The fund then utilizes the
revenue to finance projects which are expected to reduce pollution and
protect the environment.
Background of Budgetary Revenues...
During the Soviet era, Latvia was a mainecontributor to the USSR
budget, making financial transfers equivalent 20.2% of GDP.(World Bank,
1995). In 1991 those transfers stopped and resulted in a Latvian surplus
of 6.4% in GDP for the year(EIU, 1995). However, social outlays
continued to increase deficit in 1992 and 1993. The 1993 budget ended
the year with a deficit of approximately 2.9% of GDP (EIU, 1995). A new
system of taxation was introduced in January 1991, which included a
separate profit tax for companies and enterprises. In 1993, the profit
tax was levied at a rate of 45% for banking insurance and trade, 35% for
state enterprises and state companies, and 25% for all other private
companies. Personal income tax came into effect on January 1, 1994,
levied at a rate of 25% on the first Lats4.800 and 35% on the remainder
of the profit(EIU, 1995). The value-added tax (VAT) was first introduced
at a standard rate of 10% in 1992, and was raised from 12% to 18% in
November of 1993 on most products excluding food (however the VAT was
raised to 18% on food products in March of 1994). The government has
also begun to finance the deficit through the issuance of Treasury bills.
Composition of Budgetary Revenues...
Fiscal reform measures which have been implemented since 1990 have
changed the structure of budget revenues, becoming similar to the
structrue of revenues in Western Europe. Income tax revenues have
continued to increase while taxes on enterprises and domestic goods and
services have decreased. Social security contributions to total revenue
have risen to levels similar to those in Western Europe. New taxes which
have been implemented are described below according to World Bank
information as of the end of 1995.
Profit tax. This tax is levied on the net earnings of enterprises,
cooperatives, and private entities. Self-employed persons may pay either
the profit tax of the individual income tax. The tax rate of the profit
tax fluctuates between 25% and 45% depending on the institution.
Lottery, casino, and gambling profits pay a profit tax of 65%. There are
exemptions for associations which are run for charities, health, and the
handicapped. Legal deductions include expenditures by enterprises for
social purposes. "Adjustments in the value of fixed assets to an
inflation index are currently infrequent and do not follow clear
rules.".(EIU, 1995).
Personal income tax. This tax is levied on individual's wage
income, including bonuses, and the income of legal entities formed by
individuals. The basic rate is 25% with a marginal tax rate of 35%
applying to income which exceeds 20 times the nontaxable minimum.
Social security tax.
This tax is levied on
royalties, and other rewords for work. The tax is
following proportions by employees and employers.
37% and employees 1%. For handicapped employees,
salaries, wages, fees,
payable in the
Employers contribute
the employer pays 8%.
Value-added tax. This tax is levied on goods and services at the
manufacturing/import, wholesale, and retail stages. The standard rate is
18%, with a reduced rate of 10% being applied to meat, fish, milk, and
feed products. This reduced VAT rate was switched over to the standard
rate in 1994. There are still exemptions, including medical supplies,
concerts and theaters, and transit services.
Excise taxes and customs duties. Excise taxes are levied on the
imports of products by individuals or enterprises. Customs duties are
levied on imports and exports, with export duties ranging from 5% to 100%
and import duties ranging from 2% to 20%.
Other taxes. These taxes include a property tax, land tax, and a
natural resource tax. The property tax is placed on fixed assets of
state enterprises and unfinished buildings. A tax of 0.5% is place on
property with a value of Lats1,500 or more. A maximum rate of 4% is
applied to property exceeding a value of lats2.5million. The tax is paid
entirely to the local government. The land tax is placed on the use of
land by individuals and enterprises. The tax is paid directly to the
respective district, village, city, or municipal district budget.
Exemptions include transportation routes and individual farms up to the
first five years whose conditions are unsatisfactory. The natural
resources tax was introduced to discourage excessive use of natural
resources and accrues in the Environment Protection Fund. The tax
consists of three parts: a tax on the use of natural resources, a tax on
pollution, and punitive fines for excessive use of natural resources and
pollution. Tax rates are determined by the Environmental Protection
Committee.
Non-tax revenues. These revenues include fees which are collected
on documents and official services performed by the state, and user
charges for various public services including water and sewage.
Composition of Budgetary Expenditures...
Subsidies and transfers which once accounted for 60% of the
government expenditures have decreased significantly with reform efforts.
Subsidies on food (with meat and dairy products receiving the largest
share) which once accounted for 90% of the total subsidies, have been
dramatically reduced since 1991(World Bank, 1995). Other subsidy
expenditures which have been reduced include price support for:
agricultural producers, agro-industry subsidies, direct transfer to lowprofit farms, housing maintenance, and heating.
Social security expenditures have increased dramatically to almost
one-third of total expenditures by 1991, with over two-thirds of the fund
expenditures being pension benefits. Expenditures related to defense and
administration have been transferred to the general budget.
Debt...
Like other Baltic states, Latvia is currently liable for a portion
of the debt inherited from the former Soviet Union. However, Latvia
"disclaims responsibility for the Soviet debt based on the grounds that
its annexation to the Soviet Union was illegal under international law"
(EIU, 1995). The total external debt has been estimated at $60.6
million. Of this debt, $26 million was long-term publicly guaranteed
debt and $34.6 was an IMF credit (EIU, 1995).
Latvia has also recently tapped into the international bond
markets. The government borrowed $40 million through a two-year bond
issue, organized by Nomura Securities, on the Japanese and international
markets. The international bond market was an alternative to the Latvian
treasury bill market where demand has declined as a result of the bank
failure. The bonds are rumored to pay a low coupon rate of 5.4%, due to
low yen interest rates. Demand for domestic Treasury bills has recently
begun to increase, although most interest is centered on the short-term
bills. Interest is beginning to increase slightly in longer-term bills.
EIU forecasts that Latvian foreign debt will rise to $500 million
by the end of 1996 and $690 million by the end of 1997. Debt-service
costs will most likely continue to remain low as much of the credit is
available on concessionary terms. Recent loan agreements include a 17year $14 million credit from the World Bank for rehabilitating the
heating system, credits to assist in privatization, and transport
infrastructure (EIU, 1995).
Recent budgetary conditions...
Efforts to improve budgeting, budget execution, and accountability
in government finances continue in Latvia. Budgetary law entitled "Law
on Budget and Financial Management" was passed by Parliament in April of
1994. This law sets rules regarding formulating, approving, financing,
implementing, and auditing the annual budgets of central and local
governments. According to this law, the Cabinet of Ministers must submit
annual central government budget proposals to Parliament by October 1 for
approval of the year preceding the new budget. If the annual budget has
not been approved prior to the implementation date, the government must
operate with the preceding year's budget allocations until the new budget
is approved. "The law also regulates government borrowing and lending,
the granting of guarantees, and the budgetary powers and procedures for
local governments." (IMF, 1995).
The budget law also creates a Treasury Department within the
Ministry of Finance which is responsible for the execution, reporting,
and accounting of the state budget. (A Treasury area was created by the
Ministry of Finance in 1993 which was mainly responsible for the auction
of short-term (28 day) treasury bills.) The Treasury Department, since
creation, has eventually expanded to include other functions such as the
responsibility of assets and liabilities and the social security system.
Efforts were also made to increase efficiency in the collection of
taxes. The State Finance Inspection Board, responsible for the
collection of domestic taxes, and the Customs Department, responsible for
foreign trade taxes, were combined in accordance with law passed by
Parliament in 1993. The new department, the State Revenue Service, began
work in mid-1994.
Budget and fiscal developments...
Latvia has had a pattern of tight fiscal management, and despite
the pressures on revenue and expenditure arising from the transitional
economy, government finances (as a percent of GDP) have remained
relatively stable. "Government has taken steps to improve the
administration of taxes on goods and services in an effort to allow for
additional expenditure on both investment and wages and pensions within
budget organizations.".(EIU, 1995). Tax measures include an increase in
VAT rates and the introduction of excise taxes on gasoline and cars.
Improvements have been made in the collection of taxes at the border and
enforcement of tax evasion penal codes. Efforts are also being made to
computerize the collection of the VAT and excise tax.
Government surpluses have fluctuated around approximately 1% of
GDP. Local and central governments have remained generally balanced or
have shown a slight surplus. The Ministry of Finance repaid it's debt to
the Bank of Latvia in early 1993 through foreign financing. "Due to
budget proposals, government bond issuance, and tax measures, the general
government financial deficit has continually been reduced to within
approximately 1.5% of GDP.".(World Bank, 1995). Revenues from tax
collection have in general continued to increase while expenditures,
despite increases, have been kept below budget levels.
"Within the past several years, attempts have been made to adjust
specific tax structures to offset the increasing expenditures by unifying
the profit tax to within a range of 25-35% and switching the graduated
income tax schedule over to a flat income tax rate of 25%.".(World Bank,
1995). Minimum wages have also increased 100% since 1994.
Intergovernmental Relations
The general government is composed of a central government, local
government, and extrabudgetary funds including the Social Security Fund,
the Environment Protection Fund, the State Privatization Fund, and the
Foreign Exchange Budget. Local government revenue is obtained through
large transfers of funding from central governments and personal income
tax collection within their jurisdiction. VAT and profit taxes go
directly to the central government, while approximately 50% of personal
income tax goes directly to local government. The remaining 50% is held
and administered through the Local Budget Equalization Fund (LBEF),
"developed to adjust for disparities between different regions and cities
by making available additional resources"(EIU, 1995). Funding transfers
from LBEF to local government for services are determined by formula.
LBEF funding for local government services includes: investment,
education, health care, social benefits, and grants. Local governments
are responsible for maintaining these services. Local government
expenditures for social benefits constitutes over half of total
government spending in this area. LBEF infrastructure allocations are
determined separately, cities and rural areas receive funding based on
population. (IMF, 1995).
Currently, local governments are largely responsible for municipal
services such as water, sewage, and solid waste collection and disposal.
Local governments currently do not have the resources necessary to make
investments such as the rehabilitation of existing sewage facilities.
"The need for external financing to support public infrastructure
services and municipalities has become a priority with both the
Government's Public Investment Program and the Bank's Country Assistance
Strategy.".(EIU, 1995).
Monetary Developments
Monetary policy has centered around the objectives of maintaining
price stability and stabilizing the exchange rate. "The Bank of Latvia
has continued to use the purchase and sale of foreign exchange to
maintain a stable exchange rate.".(EIU, 1995). In the absence of
developed financial markets (specifically interbank money markets), the
Bank of Latvia has had little effect on refinancing policies. In an
effort to improve management of band funds, the Bank of Latvia
introduced minimum reserve requirement for all banks. Treasury bill
auctions were also introduced to finance the budget. However,
participants of the auction are still limited to only a few large banks
and interest focuses on purchases of short-term bill.
In 1993, the lats were introduced to replace the interim currency,
the ruble (which was valued at par with the Russian ruble). The
conversion of Latvian rubles to lats proceeded very smoothly, and was
completed in 1994. Rubles currently account for a very small portion of
total currency issued. Posting of prices in foreign currencies was made
illegal in Latvia, although the use of foreign currency is still allowed.
Latvia's move toward a convertible currency came in two stages. In
May 1992, in response to a shortage of Russian ruble banknotes, the
Latvian ruble was introduced as a parallel currency to the Soviet one in
circulation. The two traded equally until Latvia became flooded with
Soviet rubles. Latvia replaced the ruble with the rublis as the legal
tender. In 1993, the rublis was strong enough to move on to the second
stage, the introduction of the national currency , the lats. The rublis
was gradually phased out and ceased to be legal tender on October 18,
1993. In June of 1994 the exchange rate was Lats0.57:$1.
Latvia did not use a 'currency board system', and lats have been
allowed to float freely. As a result, the independent central bank has
had a very important role. It strengthened the rublis prior to the
introduction of the lats through market intervention, the placement of
Russian rubles in a stabilization fund, and high interest rates.
Social Safety Net
"Latvia currently operates a pay-as-you-go system of public
pensions and unemployment benefits, along with other allowances for
general social assistance including allowances for families with
children.".(World Bank, 1995). All social safety net benefits included
in the central government budget are financed through the payroll tax.
Employers pay a general rate of 37% and employees pay 1%. The social tax
for agriculture is divided between enterprises and the worker at 18.5%
and .5% respectively. (IMF, 1995).
Due to the aging population of Latvia and the expansive coverage of
the system, pensions are the largest component of the social security
expenditures. After consultation with a collection of advisers from the
World Bank and the Swedish government, Latvia passed legislation
reforming its existing pension system and created a new, funded mandatory
savings program. In 1993, the pension system was switched over from a
flat-rate average for nonworking pensioners ($25 per month regardless of
work history or disability status) to a system of tiered benefits based
on work history. A permanent pension law is currently under
implementation. This law will separate social funds from the central
government budget, and will introduce a multitier pension system which
will separate publicly funded pensions from privately funded pensions
based on need. The law will also increase the retirement age (IMF,
1995).
In addition to pensions, the social security system pays family
allowances and unemployment benefits. Allowances are granted to families
based on the number of children and the age of the parents. Unemployment
benefit expenditures have remained at low levels. Enterprises continue
to pay two-thirds of unemployment benefits directly. Total payments for
allowances and benefits amount to approximately 2.5% of GDP. Efforts
have been made to increase public works programs which relocate and train
workers. Efforts have also been made to set the social benefits to a
more realistic minimum subsistence level. "Local municipalities have
also been given clearer guidance in prioritizing social assistance
programs.".(EIU, 1995).
The main developmental issue facing Latvia is the acceleration of
the pace of structural reform while maintaining a stable economy. "One
of the key elements of the government's policy agendas is to support the
develop the country's human resources to meet the needs of a market
economy, and at the same time protect the most vulnerable residents
during the transition.".(World Bank, 1995).
Structural Reform
By 1994, Latvia had made substantial progress toward stabilization
and a market economy. Economic recovery was in progress, real wages had
started to increase, and gross international reserves were at an all-time
high. (EIU, 1995). The deterioration in the fiscal deficit at the end of
1994 and the banking crisis in 1995 halted the trend of economic
recovery. The reserves went to a deficit and the bank crisis destroyed
the confidence in the banking system. "The central bank maintained the
stability of lats throughout the crisis by selling 18.5% of its foreign
currency reserves.".(EIU, 1995). The Bank of Latvia eventually succeed
in restoring stability.
The new government elected in December of 1995 was committed to
reducing public sector borrowing requirements and to limiting the fiscal
deficit. This included improvements in tax administration to reduce tax
arrears and increase collection. "Implementation of legislation
requiring stronger regulatory and supervisory measures led to a major
reduction in the number of banks licensed for operation and helped to
stabilize the banking system." (IMF, 1995). New banking legislation
included the establishment of a deposit insurance fund and an agency to
deal with failing banks. Treasury bill demand has increased since the
banking crisis, there has been a recovery of reserves through fiscal
policy, and improved confidence in economic policies. Closely supervised
banking and strict enforcements have also assisted in the return to a
relatively stable banking sector. The government has also restricted the
number of banks which can accept deposits to 16.
The banking crisis...
Banka Baltija, Latvia's biggest bank, with over 200,000 private
depositors, was declared insolvent and put under Bank of Latvia
administration on May 23, 1995. The bank was declared bankrupt on
December 12, 1995 after the initial problem was uncovered by Cooper's and
Lybrant during audits earlier in the year. Ernst & Young later
discovered 200 million lati ($365 million) in losses to be unrecoverable
and the bank was soon after declared bankrupt. Although Latvia limited
compensation to 500 lati per personal saver, the increased expenditure by
the state budget raised the budget deficit from approximately 2% to 4% of
GDP. (World Bank, 1995). The bank failure contributed to a weak economy,
decreased GDP, decreased industrial production. Latvia responded to the
crisis by "withdrawing the right to take deposits from a number of banks,
hiring international auditors to conduct regular inspections, requiring
that banks' quarterly balance sheets be published in the government
newspaper no later than a month after the quarter's close, improving
cooperation between the police and the bank, and passing new banking
legislation which makes it more difficult for offshore banks to be bank
shareholders and sets requirements for minimum equity capital, liquidity,
and other banking indicators" (World Bank, 1995).
These developments are a result of a number of deficiencies common
to the banking system of transitional economies. "Banks tend to lend
extensively to their own shareholders who have no intention of paying
them back, lending is extremely concentrated in a specific type of
activity ( the financing of import-export transactions and transit
transactions), and banks borrow money on exchange rate risk.". (EIU,
1995). Problems also arise due to the deficient legal base and the
absence of specific key institutions in the economy. "Absence of a
recourse for banks in dealing with enterprises who are not current on
their loans forces banks to roll over credits rather than foreclose on
the enterprise.".(EIU, 1995).
Significant progress has been made in the restructuring and
privatizing of former commercial branches of the Bank of Latvia,
including the establishment of the Universal Bank of Latvia from a merger
of 21 former Bank of Latvia branches. With the assistance of the World
Bank, a rehabilitation and privatization program was initiated two years
ago for the Universal Bank of Latvia. The government has also
rehabilitated the State Savings Bank for privatization. A number of
banks are connected to the Society of Worldwide Interbank
Telecommunications (SWIFT), an international funds transfer system, and
banks are beginning to introduce credit and debit cards and cash-advance
services to clients.
Statistics related to structural reform (see tables at end of paper)...
In the 1980's, Latvia's economy grew at a fairly high rate, with
the GDP averaging 3.9% a year in 1989. The GDP decline started in 1990
and reached a peak in 1992 of 33.8%, mainly due to Russian energy supply
shortages (EIU, 1995). The biggest GDP decline in 1993 was in the
construction sector, with output falling 65%, mining followed with a 60%
decline, and manufacturing 40%. Services recorded a 7.6% fall.
Agriculture and forestry remained fairly stable, fluctuating slightly
around 23% in 1992 and 1993. The energy sector shrunk from 6.3% to 2.2%
in 1993. The largest sector of the economy is currently the service
sector which accounts for 48.6% of the GDP in 1993 (EIU, 1995).
The IMF currently estimates that approximately three-fourths of the
population works in the material sector due to the shift from away from
industries and into services. Unemployment has risen steadily with the
biggest job losses being in the state sector. In April 1994, 6.6% of the
workforce was officially registered as jobless, the highest rate in the
Baltic region. The employment figure understates the true level of
joblessness, as many workers are on unpaid leave, or on short-time work,
or are underemployed (EIU, 995).
The government has ended the policy of wage indexation which was in
place until the middle of 1992. The government has also introduced a
wage tax to penalize enterprises which raised salaries in excess of
government guidelines. In 1993 real wages rose by 6.8%, followed by a
32% drop in 1992, with wages in industry up by 8.2% (EIU, 1995).
Inflation accelerated sharply as Latvia gradually liberalized
prices and removed subsidies. Annual average inflation went from 124.5%
in 1991 to 951.2% in 1992 (EIU, 1995). The rate peaked in November 1992
with an inflation rate of 1,445% (EIU, 1995). One of the countries
greatest successes has been bringing inflation under control through
tight monetary policy which included high interest rates. By the end of
1993, inflation remained close to 35%. Rising food costs are attributed
as the main factor in continued high inflation (EIU, 1995).
Trade and Investment Regulations...
Latvia overhauled the tariff regime in 1992, and created a Tariff
Council to monitor processes and establish directives. Import tariffs
were applied in 1992, with the overall system favoring domestic industry
and agriculture. The rates change regularly depending on policy, however
the tariff for imports fluctuates between 15% and 20% depending on
country status. Tariffs can be up to 45% on goods that can be produced
locally (EIU, 1995). With the Baltic Free Trade Agreement, which came
into effect in April 1994, Latvia retained export tariffs on limestone,
raw hide, scrap metals, and timber, in a continued effort to stand behind
domestic industry.
Foreign investment is regulated by the Foreign investments in
Latvia law which came into effect in November 1991. Latvia has focused
on a number of areas which need foreign investment. These include wood
and timber processing industries, the energy sector, agro-industrial
machinery, textile production, and modernization of transport systems.
Incentives in the law include a two year holiday from the profit tax for
foreign investors with a stake of more than 30%, followed by a 50%
reduction in following years (EIU, 1995). In January of 1993 the minimum
investment level was set at $50,000. Growth in foreign investment has
been dramatic, with over 3, 800 companies from over 80 countries coming
to Latvia. In 1993, Latvia attracted approximately 7% of its GDP from
direct foreign investment (EIU, 1995).
Privatization of land, housing, and enterprises...
Privatization vouchers are being used in the privatization of land,
housing, and medium and large scale enterprises. The distribution of
vouchers began in 1993, and is based on the recipients number of years in
Latvia and their citizenship status. Restitution of land to its former
owners is open to both residents and foreigners. This first phase of
voucher distribution has proceeded quickly, with numbers jumping from
4,000 at the end of 1989, to 57,500 at the end of 1993. The second
phase, restitution of ownership rights, has proceeded at a much slower
pace. The Land Registry became fully operational in 1994, and has spent
the past several years dealing with over 300,000 claims (EIU, 1995).
The process of land restitution and privatization has proceeded
most rapidly in rural areas, which is covered by different laws. The law
on urban land reform restored ownership rights to former owners
regardless of citizenship. Claims for restoration of land ownership
rights were submitted to local governments. Privatization of apartments
was accomplished by giving priority to existing tenants and then opening
the rest to a public sale. Foreign investors were not allowed to
purchase housing.
In 1994 the Parliament created, through the adoption of laws, the
Latvian Privatization Agency and the State Property Fund. Both agencies
are independent, although they are supervised by the Ministers of Economy
and Finance, respectively. The State Property Fund is responsible for
all state-owned enterprises. The agency is responsible for the
monitoring of enterprise operations using standard commercial criteria.
"The State Property Fund oversees the corporatization and restructuring
of the enterprises, along with the appointment of their boards.".(IMF,
1995). The agency also is responsible for overseeing the privatization
of the Latvian Universal Bank and the State Savings Bank. The agency
receives income from enterprises, and uses some of theses funds to
reinvest in the structuring of other enterprises. Public utilities have
remained state owned, and it is unlikely that they will be privatized.
(IMF, 1995).
The Latvian Privatization Agency is a nonprofit state-owned
company. "Under privatization laws, the privatization of state
enterprises can be initiated by anyone who submits a proposal to this
agency.".(IMF, 1995). The Latvian Privatization Agency submits proposals
to the Cabinet. After Cabinet approval of the proposal, the State
Property Fund transfers the enterprise to the Privatization Agency, who
announces the initiative to seek privatization of the enterprise and
proposals. The Latvian Privatization Agency uses auctions,
corporatization, and liquidation methods for privatization. Revenues
from the privatization go to the agency to cover expenditures. The
remainder goes to funds within local and state government.
The Latvian Privatization Agency has been criticized by some
consultants as being slow-paced and selling companies off too cheaply.
Privatization was sped up in 1994 due to goals of the Latvian
Privatization Agency, in hopes of privatizing 200 companies a year and
75% of all state enterprises by the end of 1996. In addition to the
privatization of land, enterprises, and banks, the government set up a
number of institutions to provide support to small businesses. The
centers are nonprofit organizations which provide information,
counseling, and training for small to medium sized firms.
The reopening of the stock exchange...
A stock exchange has also been set up in Riga to trade shares in
privatized companies. Latvia's stock exchange reopened on July 25, 1995,
after being closed for 55 years following the country's annexation by the
Soviet Union. The exchange originally listed five company shares.
Trading takes place once a week on Tuesdays.
Recommendations for further structural reforms...
The World Bank has encouraged further structural reforms by
encouraging growth in the private sector which reduces large budgetary
deficits, the high ratio of expenditure to GDP (39%), and the large tax
burden on businesses. "Further privatization of enterprises and
property, the enforcement of financial discipline on banks and
enterprises, and the improvement of the efficiency of the market through
the adoption of cost recovery plans will play important roles in private
sector development.". (World Bank, 1995). Structural reform in the
public sector should focus on providing sufficient funding for
maintenance and public investments, the reform of local finances to
improve cost effectiveness of social services, the reform of
intergovernmental fiscal transfers, the consolidation of small local
government units, the reform of social insurance to lower costs and
improved services, adoption of a regulatory framework for a privately
managed pension system, improved tax administration through improved
effectiveness in tax collection, and the strengthening of the
institutional capacity for management of public finances through
"improved management of public borrowing and monitoring of public
expenditures"(World Bank, 1995).
Latvian Outlook...
Latvia's economic policy was restrained by the fiscal deficit
inherited from the outgoing government, which amounted to $177 million by
the end of the year.(IMF, 1995). IMF suggests that the government must
continue with a program of large cuts, creating job loss and reducing
infrastructure spending. Economic recovery will most likely continue at
a slow pace due to reduced government spending, the banking crisis, and
the fiscal deficit. Since 1994, the number of banks has shrunk from 64
to 39. In 1995 alone, another ten banks were shut down and a number are
under criminal investigation. According to the 1995 audit, only 16 banks
made a profit and among these, around six are believed to be viable and
properly managed. "More banks will continue to disappear as more than
half of the banks have been barred from taking deposits.". (IMF, 1995).
Confidence will return slowly to the banking sector.
Sectoral reform
Efforts in the social sector include the "establishment of an
affordable and equitable social security system that preserves work
incentives, improvement in the delivery of health care services through
more efficient and effective use of resources, and the adaptation of the
education system, particularly to vocational education and adult
retraining, to the needs of the market economy"(IMF, 1995).
Agriculture...
Agriculture is the second largest sector in the Latvian economy and
has been one of the country's main sources of income, employment, and
foreign exchange earnings. By the end of 1995, agriculture and agroprocessing accounted for nearly 19% of the GDP, employed about 17% of the
labor force, and produced 10% of all exports (IMF, 1995). After going
through a major downsizing, the production in agriculture stabilized in
1995. "Agriculture has substantial potential to again become a reliable
source of income and employment for most of the rural population.". (IMF,
1995). However, adjustments will need to continue through policy
reforms, investment strategies, and market conditions. Latvia has
already begun to redirect agricultural exports to markets outside the
former Soviet Union. The Agricultural Development Project, the first
investment project supported by the bank in the Baltic countries, was
implemented to encourage agricultural development through the goals of
land reform, extension services, and rural business development and
marketing. "The primary challenge facing the sector, which currently
accounts for 20% of GDP and 16% of employment in Latvia, is to increase
its efficiency and export potential and ensure that output markets are
competitive and prices are not artificially suppressed." (IMF, 1995).
Industry...
Under Soviet rule, the Latvian economy became deeply integrated
with the rest of the USSR. Large industrial enterprises were created,
many of them in heavy industry and defense, with production being almost
completely dependent on imports of raw materials from Russia. Latvia, as
a result, developed a near monopoly in a number of finished goods
exports, supplying 93% of Soviet railway passenger carriages, 89% of
radio sets, 79% of freezing equipment, 78% of buses, 72% of solid organic
fertilizer spreaders, 70% of diesel engines and generators, 69% of tape
and cassette recorders, and 66% of rubber footwear (EIU, 1995).
Latvian's industry suffered heavily after independence as Russia started
charging world prices for energy, resulting in an industrial production
fall of 32% by 1992, with the main casualties being machine-building,
steel works, food and light industry. Although the decline has slowed,
figures showed a decline of another 38% in 1993 and another 20% in
January of 1994 (EIU, 1995).
Industry currently accounts for nearly half of the GDP and less
than one-third of employment in the economy. The privatization of
municipally owned small enterprises has progressed significantly, with
around two-thirds of all enterprises being sold. Privatization has been
slowed in some cases due to requirements that new owners retain the
entire work force and/or the same line of activities for a specific time
period or the duration of the lease. Privatization of medium and large
scale enterprises has proceeded at a slower pace due to delays in
legislation enactment and the process of ministry reviews. It is
interesting to note that there has been a 44% fall in state sector
employment between 1990 and 1993. However, over half of all industrial
production was still accounted for by state enterprises in 1993.
"Restrictions on foreign investment are being eased with
preferential treatment being given under the latest tax system
structure.".(EIU, 1995). An Anti-Monopoly Committee was also established
to supervise monopoly tariffs and possibly recommend break-ups of large
enterprises who have large market power. A regulatory body was put
together to oversee the activities of the energy sector and to provide
for disussion of tariff policies.
Energy...
Latvia currently must import all its natural gas and oil products
and about half of its electricity needs. Despite substantial adjustments
in energy prices, underpricing still persists, creating a substantial
burden on the budget. "Industrial energy prices need to be adjusted to
reach economic costs, and a program to eliminate household energy
subsidies systematically should be introduced." (IMF, 1995). Latvia has
very little domestic resources of energy, and is thus almost entirely
dependent on imports from the USSR. This total dependence on Russian
energy is a serious constraint on the Latvian economy. Almost 93% of all
primary energy was imported in 1990, with 58.5% of imported energy
consisting of oil and 33% consisting of natural gas (EIU, 1995). In
1992, Russian exporters demanded hard currency at market prices, as
opposed to the before heavily subsidized prices. Imports of gas supplies
continue to be disrupted due to Latvian unpaid bills to Russia.
Health Care...
The number of physicians in relation to the population is high in
Latvia by international standards, however, the number of physicians to
nurses and other paramedics is low. The IMF recommends that "the health
care system needs to be restructured to achieve greater internal
efficiency.". (IMF, 1995). The health status of Latvia's 2.6 million
people (of which one million live in Riga) has continued to deteriorate
since the beginning of the decade. At the end of 1993, life expectancy
for men was 63 and for women 75. "Immediate concerns include the
shortage of medical equipment, the poor condition of the facilities at
the state and district institutions, the inadequate focus on redirecting
limited resources from expensive curative impatient care to costeffective public health programs, and inexperience in developing and
implementing preventative programs to provide broad ranging primary
health care services.". (IMF, 1995). The main challenge facing the
current health sector reform is the coordination of a combination of
measures to improve the effectiveness of health services and contain
costs. Appropriate policies, strategies, and programs will have to be
implemented to achieve these objectives. Short-term objectives are
recommended to include "supporting the government in the reform of the
health sector through technical assistance in policy and strategy
formulation and the development of cost-effective programs"(IMF, 1995).
Education, Training, and Research...
Latvia has a rich history of educational developments, and in 1990
extensive reforms were introduced to bring the system more in line with
the educational system in Western Europe. The education system should
continue to be adapted, particularly in the areas of vocational education
and adult retraining, to the needs of the market economy.
Environment...
Latvia's level of air pollution is considerably lower than most
other countries in Central Europe. Many problems center around the
inadequate attention given to environmental issues when developing urban
areas. Problems with solid waste management are currently found
throughout the country.
Transportation...
Transportation in Latvia consists of 2, 397 km of railway, of which
a very small portion are electrically run. There are 20,500km of roads.
The country has a national airline, Air Latvia, which is in the process
of being privatized.