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 agro-processing 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 cost-effective 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.  

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