Public Information Notice No. 99/71

Public Information Notice: IMF Concludes Article IV Consultation with Latvia

August 10, 1999

On July 28, 1999, the Executive Board concluded the Article IV consultation with Latvia.¹

Background

Latvia has a solid record of macroeconomic stability and substantial progress on structural reforms. At present, the authorities are facing the challenge of maintaining a balance of economic policies aimed at limiting the impact of the Russian crisis while ensuring a sustainable external position. Significant steps forward have also been made toward concluding the agenda of structural reforms, which will ensure future sustainable growth.

Macroeconomic developments were severely affected by the Russian economic crisis. Real GDP declined by 1.9 percent in the fourth quarter of 1998 and further contraction is estimated for the first quarter of 1999. As a consequence, the rate of unemployment rose to 10.1 percent in May, up from 7 percent a year earlier. Meanwhile, inflation has continued to fall amid continued tight monetary policy and weak domestic demand, reaching 1.9 percent in May. The current account deficit surged to 9.5 percent of GDP in 1998 but has since narrowed substantially reflecting the slowdown in economic activity and continued robust export growth to non-CIS countries. Capital inflows remained strong in 1998 as increased medium and long-term borrowing by banks and enterprises offset a decline in foreign direct investment; external public debt remained at 7.4 percent of GDP.

The consolidated general government ended 1998 with a slight surplus, contributing to lower inflation and interest rates and providing room for a marked expansion of private sector credit. The 1999 fiscal budget aims for a consolidated fiscal deficit of 2.8 percent of GDP, based on an 8 percent growth in revenues and a 13 percent growth in expenditures. As a result of the economic slowdown, overall tax revenues only increased by 1.5 percent on an annual basis during the first four months of 1999. With several expenditure items restrained at their 1998 levels ahead of the February budget approval, the fiscal deficit was contained at 0.9 percent of GDP in the first quarter. However, with the Budget Law coming into effect, expenditures have started to increase sharply.

Monetary developments in the second half of 1998 were to a large extent dominated by the August events in Russia. Reserve money, broad money and net foreign assets of the BoL and commercial banks declined in the months immediately following the outbreak of the crisis. The situation has since stabilized and over the year, reserve and broad monies grew by 7 percent and 6 percent, respectively. However, most monetary aggregates still remain below their pre-crisis levels and in March there was a temporary bout of uncertainty as the largest commercial banks experienced significant withdrawals of deposits amid reactions to the suspension of operations of Rigas KomercBanka and in anticipation of the publication of banks' audited 1998 financial statements. Longer-term lending rates and interbank rates rose substantially following the outbreak of the crisis but have since stabilized and even started to decline. Nongovernment credit growth has slowed substantially since August, rising by 51 percent in 1998 and by 3.3 percent in the first quarter of 1999. There are currently no signs of a deterioration in bank loan portfolios as a result of the very high credit growth in the first half of 1998 and non-performing loans have declined since 1997.

As a result of the Russian crisis and the ensuing deterioration in banks' domestic operating environment, most prudential indicators, including earnings and liquidity, worsened in 1998. The average risk-weighted capital adequacy ratio declined from 21 percent at end-1997 to about 17 percent at end-1998. The process of banking sector consolidation has continued: as a result of bank closures, suspension of operations, and mergers, the number of operating banks recently declined to 24 compared with 30 at end-August 1998. Still, despite its current difficulties, the banking sector has been successful in attracting significant FDI flows, particularly from Scandinavia. In response to the financial spillover from Russia, prudential regulations were further tightened through increased risk weight for non-OECD sovereign debt instruments and the introduction of limits on country exposure. The authorities have also continued to strengthen general banking supervision, moving Latvia close to full compliance with the Basel Core Principles and relevant EU directives. Development of non-bank financial intermediaries has been supported by improvements in the legal framework, and a law on the creation of a unified financial sector supervisory agency is currently being drafted.

Latvia continued to make progress in trade liberalization in 1998 and 1999, and in February this year, Latvia formally joined the WTO. Most specific import tariffs have been converted to ad valorem tariffs and basically all export duties have been removed. In 1998, a new system of customs valuation was implemented. There have been several tariff reductions thus far in 1999 and only a few increases, including a recent temporary increase in the import tariff on pork meat to 70 percent in response to dumping allegations. The average production-weighted MFN tariff for agricultural products has been reduced to 34 percent but a proposal under the previous SBA to further reduce agricultural tariffs has not yet been passed.

Executive Board Assessment

Executive Directors commended the authorities for the continuation of prudent financial policies in 1998 and for the progress with the comprehensive structural changes required to establish a market economy. They noted that overall growth performance had been satisfactory in 1998, despite the adverse impact of the Russian crisis, and inflation had declined more quickly than expected. Looking forward, Directors stressed the need to pursue sound fiscal and monetary policies to support the exchange rate peg, to rapidly conclude the agenda for structural reform, and to further strengthen the financial system.

Noting Latvia's record of prudent fiscal policy in underpinning its positive economic performance, Directors were concerned by the significant expansion of the fiscal deficit foreseen under the 1999 Budget Law, and emphasized the need to ensure underlying fiscal stability. They welcomed the new government's reassessment of the economic situation and its plans for immediate steps to achieve fiscal consolidation in 1999, and for further measures in 2000. Directors also welcomed the new authorities' intention to formulate an economic program that could be supported by the Fund. Building on their efforts so far, the authorities were encouraged to continue to broaden the tax base and improve tax collection. Overall, however, Directors considered that the primary emphasis in fiscal consolidation should be on containing expenditure pressures. In this regard, they referred in particular to the need to reform the pension system and also the civil service while ensuring appropriate restraint in public sector wages.

Directors considered that the exchange rate peg to the SDR had served Latvia well and remained appropriate, even though a switch to a euro peg in the medium term appeared to be desirable. Directors agreed that Latvia's external position was broadly sustainable, given the strong productivity growth in the past several years, which had contributed to a sharp increase in the share of exports to the EU, as well as the substantial inflow of foreign direct investment. However, in light of the doubling of the current account deficit in 1998, Directors emphasized the essential need to continue to monitor the external position carefully, particularly in view of the still volatile international situation. They welcomed the authorities' readiness to further tighten fiscal policies in the event of adverse balance of payments developments and also noted the critical role of credit policy in sustaining the pegged exchange rate.

Directors were encouraged by the increased confidence in the financial system and the steps taken by the authorities to strengthen the supervisory framework of banks and nonbank financial institutions over the past several years. They noted that the Russian financial crisis had revealed important weaknesses in the Latvian banking system, but commended the authorities for their quick reaction to the situation by further tightening prudential regulations and immediately extending liquidity support to the banking system. They considered that the share that the Bank of Latvia would assume in the Riga Komercbank (RKB) should be divested as soon as market conditions allowed. Directors urged the authorities to be vigilant for any signs of deterioration in the quality of loan portfolios, to continue raising prudential standards, and to facilitate wherever possible further orderly consolidation of the banking sector.

Directors recognized that structural reforms had reached an advanced stage. However, they stressed that a determined effort was needed to reinvigorate the process in certain areas. They expressed concern regarding the slowdown in large-scale enterprise privatization, while also noting the need for privatization to be carried out in a manner that would contribute to the ultimate goal of promoting efficiency. Directors also expressed some concern about the incomplete program of reduction in agricultural tariffs and occasional initiatives to reverse trade liberalization.

Directors welcomed progress made in apartment privatization, land registration, the strengthening of property rights, and continued improvements in the business climate and in governance, even though they considered that further efforts were still needed in all these areas. They encouraged the authorities to continue to strengthen their legal system, in particular through greater consistency in the implementation of laws and regulations. They also encouraged efforts to further reduce barriers to foreign investment and to address the need for modernization in agriculture.

Directors welcomed Latvia's participation in the pilot project for the publication of Article IV staff reports.