Riga, Latvia
September 29, 1998

Mr. Michel Camdessus
Managing Director
International Monetary Fund
Washington, D.C. 20431

Dear Mr. Camdessus:

1.  We have completed discussions for the second review under the stand-by arrangement (SBA) in support of the government's economic program described in our letter and accompanying Memorandum of Economic Policies dated September 8, 1997 and updated in our letter for the first review dated March 9, 1998. Since the first review, growth has been stronger than projected, and continued fiscal and monetary restraint have helped lower the rate of inflation more rapidly than anticipated. In the first half of 1998, the current account deficit has also improved in line with expectations. Economic policies have been generally as envisaged, and all performance criteria for end-June were observed, although two structural benchmarks relating to privatization of large enterprises were not met and a third on apartment privatization was met with a slight delay. Latvia is preparing to hold its third general election since regaining independence on October 3 in an environment of macroeconomic stability.

2.  The present letter describes our plans for the remainder of the program. We have formulated macroeconomic policies consistent with the existing program and our medium-term objectives. On the basis of our performance since the last review as well as our envisaged policy stance, we request that the second review be completed. In light of our comfortable international reserves position, we maintain our intention to not make any purchases unless unexpected circumstances warrant it.

Recent Economic Developments

3.  Economic developments in 1998 have been favorable. Real GDP increased by 7.6 percent in the first quarter of 1998 relative to the same period of 1997, somewhat higher than projected under the program, and preliminary data suggest that strong growth continued in the second quarter. Importantly, the industrial sector has joined services as a major source of growth. Inflation has declined much more rapidly than anticipated, aided by tight financial policies, with consumer prices rising by just 3.7 percent in the 12 months ending August, while underlying inflation, as measured by producer prices, rose by just 2.6 percent in the year ending July. The external current account deficit for the first quarter of 1998 was US$75 million (5.2 percent of GDP), significantly better than expected, as exports continued their robust growth for a wide range of products. These trends have continued through July with the trade deficit widening in line with the seasonal pattern. Capital flows, including net foreign investment, were in line with expectations. At end-August, gross official reserves had increased to US$975 million (equivalent to over three months of imports of goods and nonfactor services).

4.  Fiscal results have been considerably better than programmed, primarily reflecting the rapid growth of tax revenues. The general government accumulated a fiscal surplus of LVL 62 million (1.6 percent of estimated 1998 GDP) through June, compared with a program target deficit of LVL 15 million (0.5 percent of GDP). General government revenues exceeded expected levels by LVL 55 million, with broad gains in the personal and corporate income tax, VAT and excise taxes, due to robust economic activity and continuing improvements in tax administration. Expenditures were approximately as programmed, despite a larger-than-anticipated pension increase granted in May and pre-election pressure for other spending, as interest payments and net lending were well below expectations. Preliminary data through August suggest a continued tight fiscal stance, with an increasing financial surplus (excluding net lending).

5.  Monetary developments through July suggest a continued increase in confidence in economic policies and in the banking system, and further development of the financial sector. Lat-denominated deposits increased by 22 percent during the first half of the year, reflecting this increased confidence. Reserve money and broad money grew broadly in line with program projections, by 7 percent and 12 percent, respectively, in the first six months of the year, while NIR of the BoL increased more rapidly than projected, by 22 percent during the same period. In the first half of 1998, the pace of credit to the nongovernment sector was faster than expected, rising by 35 percent, partly as a result of the much tighter than expected fiscal policy, compared to a projection under the program of 23 percent. Recently, the rate of nongovernment credit growth has shown some signs of a slowdown, with quarterly growth declining from 21 percent in April to 16 percent in July, and the monthly increase, after peaking at LVL 35 million in March, leveling off at around LVL 25 million in the last several months. Despite this strong credit growth, the ratio of nongovernment credit to GDP is still only about 14 percent, quite low by international standards. Notably, almost 90 percent of the new credit in 1998 has been directed to enterprises, while household credit remains at only about 1 percent of GDP.

6.  Banking regulation and supervision have continued to improve and the banking system has strengthened considerably, with the number of core banks increasing to 23 by August from 13 at the beginning of 1997, and the share of nonperforming loans showing a sharp decline in the last 12 months. In addition, the risk-weighted capital adequacy ratio for the banking system stood at 21 percent at end-June compared with the required minimum of 10 percent. A deposit insurance law was passed in May and is to come into effect on October 1. Nonbank financial institutions have increased in importance, and will likely continue to do so, aided by the strengthening of the legal framework; laws on private pension funds and investment companies came into effect on July 1, while a new law regulating insurance companies came into effect on September 1.

7.  Recent developments in Russia have had, and will continue to have a material impact on the Latvian economy, but we expect this to be manageable. The depreciation of the rouble and the conversion of Russian treasury bill debt to long-term debt have had an impact on the Latvian banking sector, although this impact has been moderated by the fact that many banks had anticipated these developments and had liquidated some of their holdings of rouble-denominated assets. Nevertheless, Russian assets still account for about 10 percent of total commercial bank assets, and a small number of banks will experience substantial losses. The operations of Kapitâlbanka (the ninth largest bank in Latvia), with a relatively large exposure to Russian treasury bills, have been suspended, and its household deposits transferred to the Savings Bank. Riga Commercial Bank (the fourth largest) experienced large withdrawals by depositors in the days following the outbreak of the Russian crisis, but the situation stabilized in less than a week, aided by BoL actions. In particular, the BoL enhanced the bank's liquidity by purchasing its portfolio of Latvian treasury bills, prohibited the withdrawal of term deposits ahead of maturity from the commercial bank in question, and installed administrators in the bank. Those two banks had the largest exposure to Russia. The impact on other banks, although important in a few cases, will be manageable and will not create any systemic risk for our financial sector. We believe that this highlights the underlying resilience of the Latvian banking system and the high standards of supervision applied by the BoL.

8.  In addition to the impact on the banking sector, the Russian crisis may dampen foreign direct investment in Latvia, should investors begin to view the entire region more skeptically, although we believe that our strong record in macroeconomic policy will protect us to a great extent. Goods exports to Russia will certainly decline and some exporters are already facing payments problems. However, the share of exports to Russia has been falling recently, to about 16 percent of total exports, and Latvia's transit trade could increase to the extent that Russia is able to increase its exports worldwide. Finally, some firms have felt a significant impact from a number of restrictions (both formal and informal) imposed by Russia on economic relations with Latvia, beginning in April. However, the overall impact of these restrictions on the Latvian economy has been relatively small, in part because the extent of their implementation has been somewhat unclear.

9.  Good progress continues to be made in implementing structural reforms. The goal of completing privatization of almost all state enterprises by mid-1998 has largely been achieved, but the privatization of two of the four largest enterprises has stalled, and end-June structural benchmarks for Latvenergo and the Latvian Shipping Company were not met. Apartment privatization is moving ahead as scheduled as are measures to strengthen property rights, including enhancing the use of land as collateral. We retain as a primary objective accession to the EU, and remain committed to policies consistent with this goal.

Macroeconomic setting

10.  Our basic economic strategy remains unchanged. Latvia has established a solid record of macroeconomic stability and has gone a substantial way toward implementing the structural reforms needed to provide the foundation for sustained economic growth. The main challenge now facing the economy is to complete our program of structural reforms, including enterprise, apartment, and land privatization, the extension and refinement of financial sector regulation, the strengthening of property rights, and civil service reform, all of which will help further develop an efficient market-based economy supported by an effective public sector and retain the confidence of the international community to continue to attract needed foreign direct investment. At the same time, we will need to ensure that financial policies remain cautious and consistent with a sustainable external current account position, in particular given the increasingly uncertain external environment.

11.  While growth in 1998 showed a trend toward substantially exceeding the program target of 6 percent, the impact of the ongoing Russia crisis may already be felt in the last quarter of the year, leading to an outturn of about 6 percent. We anticipate that continued increased national savings and investment, including public investment in core infrastructure, and enhanced efficiency arising from structural reforms and foreign direct investment, will generate similar real GDP growth over the long term, allowing an increase in real per capita consumption and, at the same time, a gradual reduction in the external current account deficit. However, the volatile economic environment is expected to dampen growth in 1999 and 2000 to perhaps 4-5 percent. Average inflation is likely to be lower than the originally targeted 5 percent in 1998, and is expected to decline further over the medium term, as fiscal and monetary restraint is maintained, and despite remaining administrative price increases.

Fiscal policy and public sector reform

12.  The conservative fiscal policy of 1997–98 has played a crucial role in helping to bring inflation and interest rates down and allowing increased bank credit to the private sector. We intend to continue this cautious policy during the remainder of the year and over the medium term, while addressing needs in a number of priority areas, including health care and economic infrastructure. We recognize that given the rapid private sector credit growth, the still-sizable current account deficit, and the volatile external environment, maintaining a cautious fiscal policy remains extremely important. A supplementary budget passed in May allows for an increase of about LVL 25 million (0.7 percent of GDP) in pension spending and about LVL 40 million (1.0 percent of GDP) in other authorized spending, about half of which is for education and health care. Despite this higher spending, we anticipate that, if present trends continue, we would end the year with approximately a zero fiscal deficit for the general government, substantially better than the deficit of LVL 16 million (0.4 percent of GDP) targeted under our economic program, as a result of our much better-than-expected revenue performance. However, recent changes in the global economic environment add considerable uncertainty to this projection; in particular it is possible that tax collection may slow significantly in the fourth quarter if economic activity declines more than anticipated, making it difficult to overperform on the program target. Given this considerable risk, we intend to maintain the annual fiscal target of the program, but at the same time refrain from any additional spending beyond that already included in the supplementary budget, and dedicate any additional revenue resulting from continued overperformance to deficit reduction. We will continue to monitor closely private sector credit growth, as well as external developments and their impact on revenues, and we stand ready to undertake additional fiscal tightening should the achievement of the fiscal targets be threatened, by limiting expenditures to levels below those envisaged in the budget. The 1999 budget, currently under discussion, will be consistent with our macroeconomic objectives. We aim, under conservative revenue projections, for a zero financial deficit (i.e. excluding net lending) for the basic budget and for no change in the underlying fiscal stance relative to the outcome for 1998. Recent external developments, however, may require a reassessment of 1999 budgetary policies.

13.  We recognize the importance over the medium term of rationalizing public expenditure, in order to reduce the tax burden and improve the effectiveness of the public sector. In July, cabinet approved a concept paper on civil service reform, which will serve as the basis for a new civil service law. This law, a draft of which is expected in early 1999, would help to improve the quality and accountability of civil servants, and provide a framework for implementing a more competitive and transparent wage structure. Based on this concept paper, ministries and agencies are taking a variety of steps to eliminate the duplication of activities, devolve certain activities to the private sector, and enhance the efficiency of service provision. Aiding in this process, training (by PHARE) is underway which will allow ministries to expand their internal audits to include managerial, rather than simply financial, aspects of their operations; pilot audits will begin in late 1998. In addition, beginning next year, external audits of each ministry will be undertaken as a means of generating specific recommendations for improving efficiency.

14.  We view the completion of pension reform as an important step in increasing retirement income, raising private savings, and developing capital markets. A law regulating the third tier of the pension system—voluntary private pensions—is in place as of July 1, 1998. Draft legislation for the fully-funded pension scheme (second tier) has been presented to cabinet, and will be sent to parliament during 1998. It is anticipated that this second tier, to be implemented beginning 2000, will be mandatory for those under 30 years of age and, for the first two years, publicly managed. We recognize the importance of limiting pension increases in order to ensure the financial sustainability of the pension system, and to finance the implementation of the second tier as a fully-funded scheme.

15.  We have continued to improve our tax administration, as reflected in the revenue performance to date. A pilot project in three local offices, utilizing new debt collection procedures, proved successful last year, and was expanded to all offices in 1998. The use of business plans and revenue targets for regional offices has also had a significant impact on tax collections. We plan to build on these gains over the medium term, including through a five-year modernization project (with World Bank support) which will, inter alia, enhance audit capabilities and allow development of a system for tracking VAT payments and credits. We are also taking steps beginning in 1998 to improve the judiciary in the tax area, including a two-year program for the training of judges.

16.  One tax-free economic zone and two free-trade zones are functioning, and a second tax-free economic zone, in Rezekne, has recently begun operation; in all, some 30 enterprises are operating in these zones. A recently completed government review of these zones indicates that we have incurred a sizable revenue loss, while much State Revenue Service manpower has been diverted to administering taxes in these areas. We are considering amendments to harmonize legislation in this area with EU and WTO norms. In the future, we intend to pursue the objectives of regional development primarily through other, more efficient, means.

Monetary and exchange rate policies

17.  We continue to believe that our pegged exchange rate to the SDR has served Latvia well, and remains consistent with near-term targets and policies. Should capital flow instability threaten macroeconomic equilibrium, recourse would first be made to open market operations and fiscal adjustment. Latvia has maintained its external competitiveness despite a real exchange rate appreciation relative to major western trading partners over the past several years, reflecting, in large part, a catch-up of the initial undervaluation and recent productivity gains resulting from economic reform and foreign direct investment. The overall trade-weighted real effective exchange rate has, moreover, remained virtually unchanged over the past two years. In addition, exports and foreign direct investment remain buoyant, and the overall balance of payments position remains fairly strong. In this regard, we believe that recent developments in Russia will have a real, but manageable, impact on Latvia.

18.  We anticipate that the recent trend toward a gradual slowing in private sector credit growth will continue over the remainder of the year, reinforced by the impact of recent developments in Russia on our banking system; for the year as a whole we anticipate growth of about 80 percent in nominal terms, down from 92 percent at end-June. We continue to view the stronger-than-expected credit growth over the past year as a largely positive development, increasing the low level of monetization of the economy. There are, as yet, no signs of a slowdown in the process of disinflation, a rise in the current account deficit, or a deterioration in bank loan portfolios. We are of the view that the new credit is of generally high quality, in particular given improved loan evaluations and business accounting and auditing standards, and as loans are collateralized to an increasing extent. The total stock of non-performing loans has fallen from LVL 49 million or 10 percent of total loans at end-1997 to LVL 40 million or 6 percent of total loans at end-June 1998. Nevertheless, in particular in light of the new risks created by the Russian financial crisis, we will continue to monitor closely developments in these areas, and stand ready to take rapid action should problems begin to be perceived. Further, given that some warning signs, such as the quality of loan portfolios, may appear only with a substantial lag, we are also prepared to take measures should the growth of credit reverse its recent slowing trend. These measures would potentially include increases in repo rates, sales of treasury bills held by the BoL and increases in reserve requirements.

Financial sector developments

19.  We are taking a number of steps to refine further and extend financial sector oversight, and to address several issues brought to the fore by the recent developments in international financial markets. As a major step toward our goal of extending coverage of prudential regulations and monitoring to the entire financial sector, we are moving ahead with plans to implement consolidated banking supervision as of January 1, 1999. Draft regulations for such supervision are being prepared, in particular for preparation of consolidated balance sheets and annual accounts. In addition, draft regulations for trust operations of banks have been approved by the BoL and a proposal for new reporting requirement for banks' investments into financial institutions has been prepared. A concept paper for an independent regulatory agency covering oversight of all bank and nonbank financial institutions has now been approved by Cabinet. The BoL has decided to increase the risk-weighting of banks' holdings of "Zone B" (non-OECD) government securities from zero to 50 percent, and to introduce country-risk limitations. Early this year, the risk-weighting on correspondent accounts with Zone B credit institutions was increased from 80 percent to 100 percent. The BoL has also increased its supervision of banks with heavy exposure toward Russia.

External Sector Policies and Prospects

20.  We remain confident that the external current account deficit remains sustainable. First, the deficit continues to be financed primarily by foreign direct investment, and the debt-to-GDP ratio is expected to remain low and approximately constant, at about 8 percent of GDP, over the medium term. Second, nontrade-related short-term capital appears to be limited, and steps to enhance financial sector oversight will help to ensure that capital inflows are used productively. Third, the central bank's gross official reserves continue to rise and remain equivalent to more than three months of imports of goods and nonfactor services. Finally, the growth of imports is strongest for capital goods, suggesting that significant new investments are taking place.

21.  Nevertheless, in the present international environment, the current account deficit clearly merits continued close attention. This is particularly true since, despite recent improvements in balance of payments data, weaknesses remain in the data on the nature of capital inflows and on the composition of trade between investment and consumer goods. We stand ready to tighten monetary and fiscal policy as necessary in the event of adverse balance of payments developments. We recognize the importance as well of increasing private savings over the medium term, including by enhancing the possibilities for using collateral, in order to reduce reliance on foreign inflows. The Central Statistics Bureau and the BoL are continuing efforts to further improve balance of payments statistics, including its timeliness, and we will continue to work with Fund staff to improve the data base on external and financial sector vulnerability.

22.  Latvia has made significant progress in liberalizing trade during the last several years, and this has continued in 1998. On May 1, we converted the specific import tariffs on confectionaries to ad valorem tariffs, and submitted to parliament legislation to do the same for specific tariffs on alcoholic beverages and tobacco; once this legislation is approved, the only remaining specific rate will be on sugar. In addition, we have already passed legislation that will, by end-1998, remove all remaining export duties except on books more than 50 years old and antiques. In January, tariffs on a number of products (including wine and cigarettes) were lowered and the new system of customs valuation began to be implemented. In May, tariffs on a number of capital goods were reduced to zero, bringing the simple (unweighted) average tariff for the economy to below 6 percent. With respect to agriculture, the production-weighted basic tariff for all products was reduced to 34 percent in July 1997. We recognize, however, that our commitment under the program to reduce further agricultural tariffs by June 1998 has not been met. By the time of consideration by the Fund's Executive Board of this review, the cabinet will approve for submission to parliament legislation lowering the average production-weighted tariff on a set of agricultural products as defined under the program to no more than 30 percent; these changes will take place no later than January 1, 1999. We now anticipate that WTO accession will be approved by the General Council of the WTO in October.

Privatization and Property Rights

23.  We recognize that prospects for sustained economic growth are tied to a completion of the process of structural reform. We have made good progress in enterprise privatization in 1998, and the process is more or less complete for small- and medium-sized enterprises. With respect to large enterprises, the privatization of Ventspils Nafta has remained on track, with the government ownership share declining to 45 percent following a July public offering (a reduction of government ownership to below 50 percent was an end-June structural benchmark). In addition, a public offering of 15 percent of Latvijas Gaze and an additional offering of a 10 percent block of shares to employees began in August; by the end of this process in late September, it is expected that about 58 percent of Latvijas Gaze will be in private hands. However, privatization of the Latvian Shipping Company has been delayed reflecting political roadblocks as well as a significant difference between the official valuation of the company and the valuations undertaken by the potential strategic investors and the external auditors; as a result, the structural benchmark of selling at least 20 percent of the shares by end-June 1998 was not met. The restructuring of Latvenergo was initiated as of January 1 this year and the cabinet reached agreement on the mode of privatization in April. However, a moratorium on Latvenergo's privatization process imposed by parliament made a planned official announcement regarding the mode of privatization (an end-March structural benchmark) impossible. A recently enacted Energy Law excludes for the time being hydropower stations and transmission units from the privatization of Latvenergo, permitting the initiation of privatization for thermoelectric power and distribution units.

24.  We recognize the importance of setting a timetable for concrete measures to signal to both domestic and foreign investors a continued commitment to completing privatization. In this context, the cabinet has proposed to parliament that it cancel its moratorium of Latvenergo's privatization, and following cancellation by parliament, the government would quickly take the necessary steps to privatize the thermoelectric power and distribution units. With respect to the Shipping Company, regulations for privatization of the company will be approved by the time of consideration by the Fund's Executive Board of this review, after which final negotiations can begin with potential strategic investors; we anticipate privatization of the Shipping Company will take place during 1999.

25.  In other areas of structural reform, we have made strong progress. The end-June structural benchmark of completing the registration of 160,000 properties in the Land Book was met and a register for collateral based on movable property was established in February. Energy arrears are no longer a serious problem, although we still aim to shorten the heating payment schedules to 60 days over the next two years. The program target of privatizing 32 percent of government-owned apartments was met with a slight delay. As of August 31, 1998, 34 percent of apartments were privatized. We anticipate that by end-year some 40 percent of these apartments were privatized. We have made significant progress as well in enhancing bank lending through the use of collateral and toward completing the process of land privatization and registration.