Public Information Notice No. 98/30

Press Information Notice: IMF Concludes Article IV Consultation with Latvia

April 14, 1998

The IMF Executive Board on March 23, 1998 concluded the Article IV consultation¹ with Latvia.

Background

Latvia has reached an advanced stage of transition and macroeconomic stabilization, and is now in the process of putting in place the comprehensive structural changes required to establish the institutional basis of a market economy. The authorities have established a record of prudent financial policies, enhanced the soundness of the banking system, and moved forward on a broad front of structural reforms.

These policies were reflected in very good economic performance during 1997. Real GDP growth accelerated in the second half of 1997, and is estimated at 6 percent for the year. Reflecting this strong economic growth, official unemployment has begun to decline, falling from 7½ percent in mid-year to 7 percent at end-January 1998. Inflation has declined steadily, reaching 7 percent at end-year, and falling further to just over 6 percent by end-February 1998. Excluding increases in remaining administered prices, such as for utilities and housing, consumer prices rose by just 4.5 percent during 1997. The external current account deficit for 1997 is estimated at just under 7 percent of GDP, while continued strong inflows of foreign direct investment contributed to a balance of payments surplus, and the external public debt-to-GDP ratio declined to about 7 percent of GDP.

A prudent fiscal policy stance has been a major contributor to lower inflation and interest rates and higher private sector investment. The general government accumulated a fiscal surplus of 1.3 percent of GDP in 1997. Revenue increased as a percent of GDP, owing to improvements in tax administration and the impact of increased profits on the corporate income tax. On the expenditure side, smaller-than-expected increases in indexed transfers resulting from the better inflation performance, lower interest payments, and shortfalls in public investment all contributed to the sizable surplus. This trend has continued through the first two months of 1998, with a significant general government surplus accumulated through February; for 1998 as a whole, the general government is expected to show a small fiscal deficit.

Monetary developments during 1997 reflected a continued increase in confidence in economic policies and the banking system, and an acceleration in the development of the financial sector. Broad money grew by nearly 32 percent during the year, in real terms, while velocity declined substantially. Despite rapid growth in domestic credit to the nongovernment sector, equal to 69 percent in real terms for the year, Latvia’s domestic credit-to-GDP ratio, at about 10 percent, remains quite low by international standards. Although interest rates on bank deposits are slightly below current inflation, the level of deposits grew by 57 percent last year, reflecting increased confidence in the banking system and strong expectations of further inflation decline. Real interest rates increased during 1997, and have continued this trend thus far in 1998, and virtually all real interest rates are now positive on a forward-looking basis. Banking supervision continued its improvement since the banking crisis of 1995, and the banking system has strengthened considerably. Financial sector regulation is being further enhanced in 1998, including by expanding the focus of financial oversight to the growing number of nonbank financial institutions.

Latvia made significant progress in liberalizing trade in 1997, and the regime is characterized by generally low tariffs (with the exception of some agricultural goods), no quantitative restrictions and virtually automatic import licensing, and only a few specific import tariffs and export duties. Free trade agreements now exist with 25 countries while Most Favored Nation agreements exist with 22 countries. Substantial progress has been made toward accession to the WTO, with agreements on bilateral negotiations effectively reached with all but one country.

Good overall progress has been made on implementing structural reforms. With respect to enterprise privatization, over 300 purchase agreements were concluded in 1997 (about 200 remain) and the private sector now accounts for about 65 percent of GDP. However, the process of privatizing the largest infrastructure enterprises has slowed somewhat, and may not be completed during 1998. Apartment privatization has moved ahead as scheduled, with over 20 percent of all previously government-owned apartments now in private hands, and measures have been taken to speed progress over the medium term. In the area of enhancing property rights, land registration is advancing, and draft legislation before parliament would establish registers for movable property, further supporting credit market development. With regard to the public sector, the process of improving tax administration is continuing, a civil service census was completed and recommendations for public sector reform drafted, and legislation for the second stage of pension reform is being prepared.

Executive Board Assessment

Executive Directors commended the authorities for their prudent financial policies, which had cemented macroeconomic stability, and for making substantial headway toward putting in place the comprehensive structural changes required to establish a market economy.

Directors reviewed progress under the Stand-By Arrangement and noted that continued prudent fiscal and monetary policies, combined with progress on a broad range of structural reforms, had contributed to better than expected results for economic growth and inflation. All performance criteria at end-December 1997 had been met, except for a structural performance criterion. However, Directors noted that Latvia’s economy still faces important challenges and risks in both the short term and medium term, stemming from rising pressures for higher spending and a slowdown in the privatization of large enterprises. Therefore, they stressed the importance for the authorities to maintain prudent macroeconomic policies and to accelerate the pace of structural reforms, with a view to creating the conditions for sustained economic growth and full integration into the European economy.

Directors noted that a tight fiscal policy had been a major contributor to Latvia’s positive economic performance, but expressed concern that the approved budget for 1998 shows a significantly larger deficit than in the program. They urged the authorities to maintain a tight fiscal stance and to resist the growing election-year pressures for increasing spending. Directors noted the gains made in tax administration, in particular for customs and social taxes, and encouraged the authorities to continue improving tax collection. In this context, Directors expressed a strong concern about expanded use of tax-free economic zones, which tend to complicate tax administration, reduce transparency, and distort economic decision making. They urged the authorities to develop more appropriate policies for regional development. Directors also encouraged the authorities to continue the ongoing pension reform, accelerate the process of public administration reform, and increase the transparency of the budget process.

Directors considered that the exchange rate peg had served Latvia well and remained appropriate. They generally agreed that Latvia’s external position was broadly satisfactory, given the low level of external debt, the long-term nature of most of the capital inflows, and the large share in imports of capital and intermediate goods. Directors cautioned, however, that pressures on the current account deficit required close monitoring, and they welcomed the authorities’ readiness to tighten fiscal and monetary policy in the event of adverse balance of payments developments.

Directors were encouraged by the increased confidence in the financial system and the steps taken by the authorities to achieve strong supervision of banks and an appropriate regulatory framework for the financial sector. They welcomed the authorities’ intention to closely monitor the development of credit, and take action, if necessary, to curb credit growth and ensure the continued health of the banking system.

Directors urged the authorities to accelerate their program of structural reform in order to foster sustained economic growth and to move toward their goal of EU accession. While recognizingthat structural reforms had reached an advanced stage, Directors expressed concern about the recent slowing of some of these, and especially the recent delays in the privatization of large enterprises. They urged the authorities to give renewed emphasis to completing the privatization process. Directors also attached importance to the strengthening of property rights, and the introduction of a land registration system.

Directors encouraged the authorities to continue to strengthen their legal system and enhance transparency. In this context, they welcomed the decision by the government to publish the letter of intent.