June 15, 2000

Dear Mr. Köhler:

The attached Supplementary Memorandum of Economic Policies describes the policies the Government and the Bank of Latvia intend to follow for the remainder of the program period. This economic program is based on our Memorandum of Economic Policies, dated November 10, 1999, and has been discussed and updated with the staff of the IMF, during the first review of economic developments and policies under the stand-by arrangement.

Our economic policies are focused on ensuring that the recent renewal of economic growth is durable, and that our external position remains sustainable. As such, our program is built on a reduction in the fiscal deficit this year, and a return to fiscal balance over the next several years, combined with measures to enhance the efficiency, effectiveness and transparency of the public sector. At the same time, we are continuing to put in place those structural reforms needed to ensure that Latvia reaches its full economic potential. We continue with our intention to not make any purchases under the stand-by arrangement, but would do so should circumstances warrant.

We believe that the policies described in the attached memorandum are adequate to meet the objectives of our economic program, but will take additional measures to meet these goals should the need arise. Further, we are committed to taking several actions, discussed in the memorandum and noted in the attached Table 1, prior to IMF Executive Board consideration of the first review. The second review of the program would be completed by end-December 2000. In addition to a comprehensive evaluation of economic performance under the program, this review would focus on public sector reform efforts and financial sector developments and oversight. The program will also be evaluated on the basis of a number of quarterly performance criteria for end-September and end-December and structural benchmarks, which are proposed in the attached Table 2.

Attachments

Horst Köhler
Managing Director
International Monetary Fund
Washington, D.C. 20431

Supplementary Memorandum of Economic Policies

A. Introduction

1. With the resumption of growth in the second half of 1999, Latvia has emerged from the economic recession triggered by the Russian financial crisis of August 1998. During the course of 1999, appropriate financial and structural policies helped lay the foundation for a return to robust and durable economic growth driven by the private sector. Despite the important gains achieved last year, however, significant risks remain to our continued economic recovery, most notably the persistently large external current account deficit. In this context, we intend to aim our economic program for the remainder of 2000 and over the medium term at a return to a broadly balanced budget and the completion of our structural reform agenda.

2. Following three successive quarters of negative growth, real GDP growth turned slightly positive in the third quarter of 1999, followed by growth of about 3 percent during the last quarter of that year and 4 percent during the first quarter of 2000. At the same time, inflation has remained subdued, with the twelve-month inflation rate at about 3 percent in April 2000. The current account deficit in 1999 remained broadly unchanged from the previous year, at just under 10 percent of GDP. The recent pick-up of exports to the EU and CIS markets, as well as the planned prudent financial policies, point to a moderate narrowing of the current account deficit during 2000, notwithstanding the expected rise in imports resulting from the economic recovery. The promising external outlook is reflected in the decline in the secondary market spread on Latvian Eurobonds to below 130 points, among the lowest for emerging markets.

3. A tightening of fiscal policy in the second half of 1999 contained the general government deficit to about 4 percent of GDP for the year, and the end-December performance criterion under the program was observed. Our fiscal program for 2000 aims, at a minimum, for a halving of this deficit, to below 2 percent of GDP. During the first quarter of this year, a recovery in revenues and continued expenditure restraint allowed the end-March performance criterion on the fiscal deficit to be met with a comfortable margin. With a view to developing the government debt market and providing a benchmark for the emergence of long-term private lending in lats--and taking advantage of historically low interest rates and favorable market sentiments-- the Treasury issued, for the first time, three-year bonds at end-January and five-year bonds at end-March.

4. In line with the restoration of growth and the recovery of the banking system after the financial losses related to the Russian crisis, monetary conditions have returned to normality. Since the beginning of this year, the Bank of Latvia (BoL) has reduced its lending to commercial banks. As a result, net domestic assets of the BoL and reserve money growth have been kept within the respective program ceilings for end-March 2000; both ceilings had been exceeded at end-December 1999 to accommodate banks' demands for lats to guard against potential Y2K-related problems. The BoL also met the performance criterion on net international reserves (NIR) for end-December 1999 and end-March 2000. Commercial bank credit to the non-government sector has been rising at a healthy pace—14 percent in the six months beginning October 1999—aided by a declining interest rate trend. The banking system has returned to profitability, and several banks have succeeded in strengthening their capital, in some cases with foreign participation. In the meantime, the BoL has implemented new prudential regulations on loan classification and loan-loss provisioning and adopted the capital adequacy directive, in line with commitments under the program.

5. We have continued to make progress on structural reforms. While privatization of the three remaining large public enterprises has continued to face obstacles, important steps have been taken. In March 2000, the cabinet of ministers approved a plan for restructuring and privatizing parts of Latvenergo, and the Law on Concerns—needed for effective restructuring—has recently been passed by parliament. Progress has also been made in reinforcing the regulatory structure for utilities, improving the business climate, enhancing the legal and judicial system, and strengthening the efficiency and transparency of the public sector. Parliament has also adopted legislation to implement the second, fully-funded, tier of the pension system beginning July 1, 2001. Finally, we have abolished the temporary import tariff on pork products, effective June 1, 2000, and otherwise maintained our very liberal trade regime.

B. The Government's Program for 2000-01

Macroeconomic Framework

6. While Latvia's economic prospects have improved with the resumption of growth in late 1999, the persistently large current account deficit, coupled with a lower level of FDI than that prior to the Russia crisis, could pose a risk to a sustainable external position. We are, therefore, committed to strengthening our financial and structural policies with a view to lowering the external current account deficit, reinforcing FDI inflows, and—more generally—creating an environment conducive to private sector activity. Such a policy mix, underpinned by the maintenance of the successful exchange rate peg to the SDR, will also help maintain confidence of the international community in Latvia. We recognize the need to closely monitor external developments, and stand ready to further tighten financial policies as needed to maintain the sustainability of our external position and avoid undue pressure on the exchange rate peg.

7. Against this background, our main macroeconomic objectives for 2000 and 2001 are as follows: (i) real GDP growth at 4 percent and 6 percent, respectively; (ii) inflation at about 3 percent, slightly above the level of EU countries; and (iii) a decline in the external current account deficit to under 9 percent of GDP and under 8 percent of GDP respectively. We also expect that by 2001, more than two-thirds of the external current account deficit will be financed by FDI.

Fiscal Policies

8. Latvia's fiscal policy aims to achieve approximate fiscal balance over the medium-term, on a cyclically-adjusted basis. To this end, we aim to contain the general government fiscal deficit to at most 2 percent of GDP this year. We are committed to retain all revenues above the levels projected under the Fund-supported program for further deficit reduction. Moreover, should data for the first quarter of 2000 provide clear indication that the current account deficit is not on a declining trend, we would seek to quickly implement additional spending cuts. In this context, a joint IMF-World Bank technical assistance mission will visit Latvia in late May to suggest areas in which expenditure savings could be attained, in both the short- and medium-term, without sacrificing key public service delivery. Prior to the Fund Executive Board's consideration of the first review, we will agree with Fund staff on a series of contingency measures which could be implemented to generate savings of up to 0.5 percent of GDP this year.

9. The government remains fully committed to continuing to enhance the transparency and efficiency of public sector operations. Toward this end, parliament passed, in November 1999, amendments to the Law on Budget and Financial Management which, inter alia, will bring all accounts of budget-financed institutions into the Treasury, and introduce a requirement for state institutions to submit annual audited reports to the Treasury as of 2001. Further, the Law on the Institutional Framework for Public Administration and the Law on Public Sector Agencies--aimed at containing the recent proliferation of public agencies, and ensuring the agencies' openness, accountability and transparency--have been presented to parliament, with passage expected this year. We will strictly adhere to the moratorium on the creation of new agencies while awaiting the passage of this legislation. We will also seek to reduce further the use of earmarked taxes in the context of the 2001 budget and, in any case, will neither introduce new earmarked taxes nor expand existing ones. Recent government decisions to effect public spending by cabinet decision directly from the Latvian Privatization Agency (LPA), bypassing the Treasury, have complicated expenditure management and the implementation of macroeconomic policy, and reduced the transparency of fiscal operations. Therefore, we will, prior to consideration by the Fund's Executive Board of the first review, pass a cabinet resolution that all privatization receipts, beyond those covering the administrative costs and reserve fund of the LPA, be transferred to the Treasury.

10. Given the already high tax rates in Latvia, we will refrain from increasing such rates any further in 2000, but will continue our efforts to strengthen tax administration. We are improving our taxpayer audits by basing audits on specific risk factors, centralizing audit decisions, and improving coordination between the State Revenue Service and other national data bases. We are also implementing measures to address difficulties in collecting excises on petroleum products, including by extending fuel taxes to any petroleum product that can be potentially used as fuel, thereby limiting the ability of importers to escape taxes by mixing petroleum products after importation. We will also simplify tax administration with respect to our free ports and tax-free zones by clarifying the tax benefits offered, and eliminating those benefits not consistent with EU regulations. We will, prior to Fund Executive Board consideration of the first review, submit amendments to this effect to Parliament, which we expect to be enacted by end-December 2000.

11. The 2001 budget will seek to achieve a deficit of less than 1 percent of GDP, which would be achieved primarily by further reductions in the expenditure-to-GDP ratio. We recognize the importance of improving our prioritization of public spending, in particular given the pressures for higher spending resulting from the EU accession process. The budget will reflect the impact of the new public sector wage bill and the Civil Service Law, as well as the continued efforts to identify cost-savings, including through functional reviews of ministries.

12. Progress toward eliminating the structural component of the fiscal deficit will require further efforts to improve the sustainability of the Pension Fund. Pension amendments passed in November 1999 appear to have reversed a substantial portion of the worsening in Pension Fund finances, with the deficit of the fund expected to decline by 0.8 percentage points of GDP over 1999-2000. To further strengthen Pension Fund finances we will, by end-December 2000, submit to parliament amendments to the pension law which will, inter alia, gradually reduce the scope for early retirement; and allow individuals to work and receive their full pension. It is expected that the latter will have a significant impact on labor market participation and social tax collections.

Monetary and Exchange Rate Policies and Financial Sector Supervision

13. The exchange rate peg to the SDR has served Latvia well, and we intend to maintain this peg until EU accession. While the recent appreciation of the lats vis-à-vis the euro has affected Latvia's external competitiveness somewhat, other indicators, such as dollar wages and the return of robust export growth during the most recent two quarters, suggest that Latvia remains competitive. We will continue to pursue an appropriately tight monetary policy to support the exchange rate peg and meet our inflation objective.

14. In line with the economic recovery, and supported by the renewed soundness of the banking system, our revised monetary program for the remainder of 2000 is based on the assumption of a continued gradual increase in money demand and in the money multiplier. We will contain the growth of reserve money to 10 percent, relying principally on our open market instruments. In addition, to support this policy stance, the government will keep all proceeds in excess of its financing needs on accounts with the central bank. As, based on current indications, credit to the non-governmental sector could grow by more than 25 percent in 2000, broad money is programmed to expand by 21 percent during the period. To ensure that such credit growth remains sustainable, we will carefully monitor the quality of bank portfolios, the adequate use of collateral, and the appropriateness of loan loss provisioning.

15. In order to foster longer-term lending in lats, and help deepen financial markets, the BoL intends to offer monthly long-term foreign exchange swaps to commercial banks; the first such offer was held in early May. The BoL remains fully committed to ensuring that such swap operations do not adversely effect our ability to meet our inflation and exchange rate objectives. Therefore, we will limit the swap amounts auctioned to a maximum of LVL 10 million per month until October, and will ensure that any excess liquidity in lats is appropriately reduced through open market operations. We will review our experience and seek to agree upon future policies regarding these swaps with Fund staff, in the context of the second review of the program.

16. We currently are in close to full compliance with the Basle Core Principles of Effective Banking Supervision (BCP) and the relevant EU directives, and will continue to modernize our prudential regulations in line with any updates of internationally agreed regulations. We will, by end-June 2000, implement the prudential regulations to cover the market risk. In addition, we will ensure that our high standards of banking supervision will be maintained during and after the transfer of the BoL's Supervision Department to the newly created Unified Financial Sector Supervision Agency, which is expected to become operational by July 1, 2001. In this regard, we will strive to enhance regulation and supervision of non-bank financial institutions, including insurance companies, pension funds, and securities markets, so that we comply with relevant EU regulation in these areas by the time unified supervision takes effect. In particular, the Securities Market Commission will, by end-September 2000, adopt the directives on capital adequacy and investor protection, for implementation by January 1, 2001. Finally, the BoL will, by end-September 2000, divest its investment in Pirma Latvijas Banka (formerly Rigas KomercBanka).

Structural and Trade Policies

17. We recognize that completion of our program of enterprise privatization will play an important role in continuing to attract foreign direct investment and restructure the economy. Therefore, we will seek to largely complete privatization of the remaining public enterprises by end-March 2001. As a means to address technical difficulties experienced during this last stage of the privatization process, and to ensure best commercial practices and maximum benefits for Latvia, we will appoint international advisors for the divestiture of the Latvian Shipping Company (LASCO) and Latvenergo by end-Setember 2000. In the case of Latvenergo, the government intends to complete restructuring of the enterprise into separate generation, transmission and distribution subsidiaries by end-December 2000, and aim to complete the sale of 49 percent of the government's share in the two Riga Combined Heat and Power Plants early in 2001. We are also studying the possibility of closer cooperation between Latvenergo and the Estonian energy company. As regards Lattelekom, completion of privatization awaits the conclusion of negotiations with the private owner on compensation for relinquishing its monopoly rights earlier than initially agreed. While negotiations have been more protracted than hoped, we anticipate the sale of the remaining government-owned shares in early 2001.

18. The establishment of a strong regulatory framework for public utilities remains a key objective for securing a competitive post-privatization environment. To this end, Parliament will pass by end-September 2000 the Law on Public Service Regulators, which will create a "superregulatory agency" for all public utilities effective January 1, 2001. In addition, we will complete by end-December 2000 the work of the interministerial working group to implement the law and organize the transition and absorption of the currently separate regulatory bodies. The new telecommunications law, to be adopted by end-June 2000, will create an independent telecom regulator by end-December 2000, which would later become part of the new superregulatory agency.

19. Our commitment to maintain a liberal trade regime is unchanged. We have adopted legislation reducing agricultural tariffs in line with our WTO agreements, and lowering all tariff rates above EU levels to EU levels, effective April 1, 2000. Further, we shall not introduce any new specific tariffs or export subsidies.

20. We believe that the policies described above will help ensure that Latvia enjoys durable and sustainable economic growth in 2000 and beyond, and that its external position remains sustainable. We stand ready to adopt any additional measures deemed necessary to meet these objectives.

ANNEX I

Performance Criteria on General Government Fiscal Deficit and Indicative Targets on Central Government Revenue Limits on the General Government Fiscal Deficit Target   Outcome   (In millions of lats)   January 1, 1999-September 30, 1999 (indicative) 114     88 January 1, 1999-December 31, 1999 154   153 January 1, 2000-March 31, 2000 26     11 January 1, 2000-June 30, 2000 54   January 1, 2000-September 30, 2000 63   January 1, 2000-December 31, 2000 81   Indicative Targets on Central Government Revenue Target   Outcome   (In millions of lats)   January 1, 1999-September 30, 1999 894   887 January 1, 1999-December 31, 1999 1235   1209 January 1, 2000-March 31, 2000 290   291 January 1, 2000-June 30, 2000 605   January 1, 2000-September 30, 2000 943   January 1, 2000-December 31, 2000 1290

The general government is defined to include the central government basic and special budgets and the local governments basic and special budgets. The general government fiscal deficit is defined as the increase in net claims on the general government of domestic and foreign banks, plus the net increase in all other claims on the general government of domestic and foreign financial and nonfinancial institutions or households, plus the privatization receipts net of the legally stipulated administrative expenditures of the Latvian Privatization Agency.

The net claims of domestic and foreign banks, including the Bank of Latvia, on the general government are defined as all claims of these institutions on the general government, less all deposits of the general government with these institutions. The claims of the banking system on the general government include, but are not limited to: bank loans (including overdrafts) to the general government and securities issued by the general government held by banks. Deposits of the general government with banks include domestic or foreign currency deposits with banks.

To the extent that foreign project financing, including for net lending, exceeds (falls short) of programmed amounts, the limit on the fiscal deficit shall be adjusted upward (downward) by these excess amounts. The programmed amounts are as follows: January 1-September 30, 1999, lats 12 million; January 1-December 31, 1999, lats 18 million; January 1-March 31, 2000, lats 2 million; January 1-June 30, 2000, lats 7 million; January 1-September 30, 2000, lats 16 million, and January 1- December 31, 2000, lats 21 million..

For the calculation of the indicative target on central government revenue, the central government shall be defined as the basic budget plus the special budgets. Revenue as defined for these purposes excludes the nonbudgeted (self-earned) revenues of individual ministries. For the formulation of revenue targets through end-June, it was assumed that the railway fund was included in the central government special budgets. The revenue floor is calculated as:

Total general government tax revenue
- (minus) local government tax revenue (comprising personal income tax revenues allocated to local governments and real estate and property taxes collected by local government)
+ (plus) other non-tax revenue of the central government basic and special budgets (excluding nonbudgeted revenue)
- (minus) EU grants to central government basic and special budgets.

The limits on the general government fiscal deficit will be adjusted downward by the extent to which the central government revenue exceeds the respective indicative targets.

Monthly data on net claims of the domestic banking system on the general government are taken from the balance sheets of the Bank of Latvia and the consolidated accounts of all commercial banks operating in Latvia. The Ministry of Finance shall provide information on, and confirm the amounts of general government deposits held abroad, disbursements of foreign loans to the general government, net sales of all Latvian State Treasury securities and any other Government debt instruments, borrowing from the nonbank sector, gross privatization receipts and the uses of such receipts, net lending operations of the general government, expenditures under the PIP and any other data regarding the fiscal balance.

ANNEX II

Net Domestic Assets of the Bank of Latvia
and the Banking System

Net domestic assets of the Bank of Latvia are defined as the difference between: (i) reserve money (issuance of lats plus deposits of commercial banks with the Bank of Latvia (including obligatory reserves)); and (ii) the Bank of Latvia's net international reserves (as defined in Annex III to this memorandum). Both (i) and (ii) will be expressed in lats. Net domestic assets of the Bank of Latvia would thus include: net credit to the general government; credit to commercial banks; and other net assets.

The foreign currency-denominated components of the balance sheet of the Bank of Latvia will be converted into lats at the official exchange rate of the lats to the U.S. dollar prevailing at the end of the respective quarter. The prevailing cross exchange rates will be used to convert items denominated in currencies other than the U.S. dollar. Balance of payments assistance accruing to the government will be converted into lats at the prevailing official exchange rate at the time the loan is disbursed and recorded as a government deposit in the balance sheet of the Bank of Latvia.

The ceilings on net domestic assets are established on the basis of an assumption of disbursements in balance of payments assistance of US$ 75 million in the fourth quarter of 1999, US$ 40 million in the first quarter of 2000, US$ 45 million in the second quarter of 2000, US$ 0 million in the third quarter of 2000, and US$ 0 million in the fourth quarter of 2000. The outcome for the fourth quarter of 1999 was US$ 75 million and for the first quarter of 2000 US$ 40 million. For the derivation of the targets for the third and fourth quarter of 2000, it is assumed that disbursements in balance of payments assistance in the second quarter of 2000 will be US$ 0 million. The net domestic assets ceilings (both at the Bank of Latvia and banking system levels) will be adjusted upward (downward) for any shortfall (excess) in disbursements from foreign creditors of balance of payments assistance relative to the programmed levels. The limits indicated in the table below are stock numbers for the respective date and will be monitored monthly from the balance sheet of the Bank of Latvia.

Net domestic assets of the banking system are defined as the difference between the liabilities of the banking system to the nonbank public (M2X) and net foreign assets of the banking system. Net foreign assets will be converted into lats at official prevailing exchange rate at the end of the respective quarter. Net foreign assets of the banking system are the sum of all gross claims on nonresidents, less liabilities to nonresidents. Thus, net domestic assets of the banking system include: net credit to the general government; gross credit to the nongovernment sector; and other net assets. Beginning with the target for September 30, 2000, in line with international accounting practice, the net domestic assets of the banking system include the amount of foreign equity in Latvian commercial banks, lowering the target accordingly. As of March 31, 2000, foreign equity amounted to LVL 129 million.

The indicative limits shown in the table below are stock numbers and will be monitored monthly from the consolidated balance sheets of the banking system.

Net Domestic Assets of the Banking System
		Target	Outcome
		(In millions of lats)
Ceiling for September 30, 1999 (actual preliminary)		531	531
Ceiling for December 31, 1999		564	633
Ceiling for March 31, 2000		594	653
Ceiling for June 30, 2000		612
Ceiling for September 30, 2000 1/		660
Ceiling for December 31, 2000		696
1/ As of September 30, 2000, the program definition includes foreign equity of commercial banks, which is recorded in "other net assets".

Target for the Net International reserves of the Bank of Latvia

Net international reserves of the Bank of Latvia consist of gross international reserves minus liabilities in all foreign currencies, both expressed in U.S. dollars.

For purposes of the program, gross international reserves will comprise all liquid foreign assets of the Bank of Latvia in convertible currencies which are readily available, including monetary gold, holdings of SDRs, any reserve position in the Fund, holdings of foreign exchange, and any deposits with nonresident financial institutions and excluding claims on residents. Gross international reserves generated from foreign exchange swaps of all maturities will be excluded from the program definitions for end-September 2000 and end-December 2000. For purposes of the program, foreign liabilities will be defined as use of Fund credit, and currency liabilities of the Bank of Latvia, including pledged, collateralized, or otherwise encumbered liabilities.

For the entire period of the program the exchange rates of the SDR, and currencies vis-à-vis the U.S. dollar, will be those prevailing at the end of each quarter.

The performance criteria on the floor for net international reserves of the Bank of Latvia are specified below, and will be monitored from information provided monthly by the Bank of Latvia. The floor on net international reserves is established on the basis of an assumption of disbursements in balance of payments assistance of US$ 75 million in the fourth quarter of 1999, US$ 40 million in the first quarter of 2000, US$ 45 million in the second quarter of 2000, US$ 0 million in the third quarter of 2000, and US$ 0 million in the fourth quarter of 2000. The outcome for the fourth quarter of 1999 was US$ 75 million and for the first quarter of 2000 US$ 40 million. For the derivation of the targets for the third and fourth quarter of 2000, it is assumed that disbursements in balance of payments assistance in the second quarter of 2000 will be US$ 0 million. The net international reserves floor will be adjusted downward (upward) for any shortfall (excess) in disbursements from foreign creditors of balance of payments assistance relative to the programmed levels.

ANNEX IV

External debt limits apply to external debt of original maturities of up to and including one year and to nonconcessional medium- and long-term external debt of original maturities of more than one year that are contracted or guaranteed after June 30, 1999 by the government, the Bank of Latvia or any other agencies on behalf of the government, with sub-limits for such debt of maturities of more than one year up to and including five years. The stock of medium- and long-term debt was US$ 883 million as of June 30, 1999. The definition of the government is the same as in Annex I. For the purpose of measuring the performance criteria on short-term (0-1 year maturity) external debt, the outstanding stock of this debt, which excludes normal import-related trade credits, was zero at June 30, 1999. Excluded from the limits are use of Fund resources; but other balance of payments support of maturity longer than one year would be covered by these limits, including loans from official creditors and foreign banks. Contracted loans shall be valued in the currency of transactions and converted into U.S. dollars at the exchange rate prevailing at the time the loan is contracted.

Compliance with the limits shall be verified at quarterly intervals for the dates shown above. Information on the contracting and guaranteeing of external debt, as well as the outstanding stock of government debt with maturities of up to and including one year, will be reported by the Ministry of Finance to Fund staff.

In addition to the performance criteria specified above, a continuous performance criterion respecting the nonaccumulation of external arrears by the government applies.