Public Finance Perspective - Latvia

Public Finance Perspective - Latvia

Dmitri Maslitchenko dmitri@mailroom.com

      The Latvian people have lived in the Baltic-shore territory for more than 4, years, with the Latvian language being one of the oldest living languages of Europe.  "Latvia's location at an East-West crossroads, and her ice-free ports on the Baltic Sea, have made her an inviting target for expansional powers.".(EIU, 1995).  Over the centuries, Latvia has been occupied by the Teotonic knights of Germany, the knights of Sweden and Poland, and the tsars of Russia.  World War I and the fall of the Russian tsars provided an opportunity for numerous Russian colonies to break away.  Only Latvia, Lithuania, and Estonia gained and maintained independence on November 18, 1918, by signing a treaty with the new Soviet Russian government.  Latvia quickly began to develop a successful economy and joined the League of Nations in 1922. 

      In 1940, Stalin presented Latvia with an ultimatum, admit Soviet troops or face annihilation.  During the next fifty years, the Soviet Union ruled over Latvia.  Freedom of speech and press were abolished.  Access to western printed materials, radio broadcasts, and other communications were strictly forbidden, and religious activities were destroyed.  In 1987 large human rights demonstrations began to take place, with the most notable being the 1989 joining of hands in the unforgettable Baltic Way from Tallinn through Riga to Vilnius.  

        On May 4, 1990, the Supreme Council of the Republic adopted the Declaration on the Renewal of the Independence of the Republic of Latvia.  In a referendum held in March of 1991, the people of Latvia voted overwhelmingly in favor of democratic and independent statehood for the Republic of Latvia.  "Latvia's declaration of the restoration of independence in August of 1991 resolved many of the issues prominent during the transitionary period between occupation by Russian troops and Latvian independence." (World Bank, 1995).  The declaration lays down that Latvia is "an independent democratic republic, the sovereign power of which belongs to the people of Latvia, and its statehood is determined by the 1922 Constitution"(EIU, 1995).  On September 17, 1991, the Republic of Latvia was granted full membership in the UN.  On June 5, 1993, the 5th legislature (Saeima) was elected in general and democratic elections.

An overview of the Latvian Economy

      Latvia is rapidly becoming a dynamic market economy, with Estonia being the only other former Soviet state close to Latvia in the transformation.  However, the transformation has not been without effort, the IMF reported only a 2% growth in GDP in 1994, following declines in GDP in 1992 and 1993.  The government's monetary policies and reform programs have kept inflation under 2% a month, encourtaged growth in the private sector estimated to account for over half the GDP, and encouraged growth in trade with the West. 

      "Price reform in Latvia came in several stages, bringing relative prices more in line with world prices and reducing the excess demand for goods in Latvia.".(EIU, 1995).  By 1992 less than 8% of goods and services in the consumer price index remained under price controls.  The price reform "increased GDP, contributed to an improvement in the financial position of Latvian enterprises, and assisted in the improvement of the government budget"(EIU, 1995).  However, the effects on the economy were only temporary. 

      But even the price reforms could not pull Latvia out of a economic situation that was becoming worse in 1992.  "Depleting stocks of raw materials and energy resources and the continued lack of foreign financial resources coupled with a reduction in agriculture due to a severe drought assisted in the reduction of GDP by 30%.".(EIU, 1995).  Unemployment increased to 2%, profit and income tax revenues declined, and enterprise tax arrears continued to rise.  The negative impact of these events resulted in an increasing fiscal deficit.     

Recent reform efforts...

        Since Latvia regained independence in 1991, the government of Latvia has made substantial progress in stabilizing the economy and structural reforms.  "The government has been involved in a large effort to transform the economy from a centrally planned system to a market based system.".(EIU, 1995).  A comprehensive economic program was initiated late in 1992 which focused on stabilization.  Tight monetary and fiscal policies maintained an almost balanced budget through 1993 and reduced the rate of inflation, which declined steadily from over 900% in 1992 to less than 2% in 1995 (World Bank, 1995).   Prices and trading were liberalized.  "Efforts to restructure the banking system, to privatize the economy, and to demonopolize large state owned enterprises, encouraged the development of the private sector and allowed restructuring of domestic production, removed from highly subsidized and protected markets." (World Bank, 1995). 

      An important element of the reform efforts was the introduction of a national currency in 1992 which allowed the Bank of Latvia to pursue an independent monetary policy.  "Tight monetary policy was supported by a broadly balanced government budget in conjunction with tax-based income policy." (World Bank, 1995).  Since 1993 the country has had a stable currency, the LAT.  "The nominal exchange rate, since introduction, has continued to remain fairly stable against the dollar.". (EIU, 1995).   

      The government has also made reform progress in several other areas which include fiscal policy and the social safety net.  "Fiscal reform measures replaced the Soviet tax system with a modern tax system and shifted expenditures significantly from subsidies and transfers to enterprises, to other areas.".(EIU, 1995).  The government is still working in other areas including extrabudgetary funds and tax collection capacity.  A number of reform measures have also been taken to improve the social safety net, including the introduction of unemployment benefits and allowances to poor families.  However financial resources for social safety net reform measures continue to decrease as unemployment and pensions costs continue to increase.  "Financing of the social safety net has been re-examined to address its dependence on the wage base which has inflated the cost of labor and discouraged employment.".(EIU, 1995).

      Progress has also been made in structural reforms.  Prices have been liberalized, the trading has opened, banking institutions have been privatized, as have been a number of small businesses and agricultural land.  Latvia also seems to have weathered the banking crisis and the economy has begun to recover late in 1995 and has since experienced some growth in 1996.  The banking system has moved towards fairly stable and functioning private banks.  Progress has also been made in land restitution and agricultural privatization.  Much of the agriculture has already been privatized and the government plans to increase the pace of privatization of state enterprises.  Approximately two-thirds of the enterprises owned by government have been privatized.  Privatization of large enterprises has been at a slower rate, with only 85 of the 200 proposed projects completed by late 1994.(World Bank).  With the approval of laws establishing the Privatization Agency and the State Property Fund, the large enterprise privatization  increased its pace in accomplishing the goal of 75% privatization by 1996. (World Bank, 1995). 

        Latvia is thus in the midst of recovery, assisted by the country's strategic location on the Baltic and its well-educated population.

The Budget System

      Under former Soviet rule, public administration and management were highly centralized.  Since Latvia's independence in 1991, there has been substantial progress in decentralization of the local governments.  Until recently, there were three levels of local government:  rural districts and small towns known as pagasts, regions which included rural districts and small towns on their borders known as rayons, and seven major cities, including Riga, which administered both the pagasts and the rayons.  Legislation within the past year has simplified the administrative system to two levels ( 26 regions and 600 municipalities) and has clarified and separated responsibilities for expenditure.  "New laws provide for a stable and transparent system of revenue assignment, formalizing intergovernmental fiscal relations through allocations of tax revenues between the state and the local governments, and revenue equalization among the municipalities.". (World Bank, 1995).

Extrabudgetary Funds...

      Extrabudgetary funds' budgets and operations must be approved by Parliament.  The Social Security Fund is the largest of the extrabudgetary funds, accounting for over 28% of general government revenue.(World Bank, 1995).  This fund is administered by the Ministry of Finance and financed through the social security tax.  Expenditures of the fund include pension payments, sick pay, maternity pay, and family allowance.  The unemployment benefits are financed through 1.5% of the social security rate (World Bank, 1995).   

      Two other significant funds are the State Privatization Fund and the Environmental Protection Fund, which are financed through sales of government property and a natural resource tax respectively.  "The State Privatization Fund was established to manage revenues gained from the privatization of state-owned enterprises and the sale of other assets.".(EIU, 1995).  Municipalities located within the jurisdiction of the privatization of state-owned property also receive 5% of the revenues.  Riga is the only exception to this rule, and receives 10% of the revenue.  The Environmental Protection Fund gains revenue through the collection of fines on polluting enterprises and also through a percentage of the natural resource tax.  The fund then utilizes the revenue to finance projects which are expected to reduce pollution and protect the environment. 

Background of Budgetary Revenues...

      During the Soviet era, Latvia was a mainecontributor to the USSR budget, making financial transfers equivalent 20.2% of GDP.(World Bank, 1995).  In 1991 those transfers stopped and resulted in a Latvian surplus of 6.4% in GDP for the year(EIU, 1995).  However, social outlays continued to increase deficit in 1992 and 1993.  The 1993 budget ended the year with a deficit of approximately 2.9% of GDP (EIU, 1995).  A new system of taxation was introduced in January 1991, which included a separate profit tax for companies and enterprises.  In 1993, the profit tax was levied at a rate of 45% for banking insurance and trade, 35% for state enterprises and state companies, and 25% for all other private companies.  Personal income tax came into effect on January 1, 1994, levied at a rate of 25% on the first Lats4.800 and 35% on the remainder of the profit(EIU, 1995).  The value-added tax (VAT) was first introduced at a standard rate of 10% in 1992, and was raised from 12% to 18% in November of 1993 on most products excluding food (however the VAT was raised to 18% on food products in March of 1994).  The government has also begun to finance the deficit through the issuance of Treasury bills. 

Composition of Budgetary Revenues...

      Fiscal reform measures which have been implemented since 1990 have changed the structure of budget revenues, becoming similar to the structrue of revenues in Western Europe.  Income tax revenues have continued to increase while taxes on enterprises and domestic goods and services have decreased.  Social security contributions to total revenue have risen to levels similar to those in Western Europe.  New taxes which have been implemented are described below according to World Bank information as of the end of 1995. 

      Profit tax.  This tax is levied on the net earnings of enterprises, cooperatives, and private entities.  Self-employed persons may pay either the profit tax of the individual income tax.  The tax rate of the profit tax fluctuates between 25% and 45% depending on the institution.  Lottery, casino, and gambling profits pay a profit tax of 65%.  There are exemptions for associations which are run for charities, health, and the handicapped.  Legal deductions include expenditures by enterprises for social purposes.  "Adjustments in the value of fixed assets to an inflation index are currently infrequent and do not follow clear rules.".(EIU, 1995). 

      Personal income tax.  This tax is levied on individual's wage income, including bonuses, and the income of legal entities formed by individuals.  The basic rate is 25% with a marginal tax rate of 35% applying to income which exceeds 20 times the nontaxable minimum. 

      Social security tax.   This tax is levied on salaries, wages, fees, royalties, and other rewords for work.  The tax is payable in the following proportions by employees and employers.  Employers contribute 37%  and employees 1%.  For handicapped employees, the employer pays 8%.

      Value-added tax.  This tax is levied on goods and services at the manufacturing/import, wholesale, and retail stages.  The standard rate is 18%, with a reduced rate of 10% being applied to meat, fish, milk, and feed products.  This reduced VAT rate was switched over to the standard rate in 1994.  There are still exemptions, including medical supplies, concerts and theaters, and transit services. 

      Excise taxes and customs duties.  Excise taxes are levied on the imports of products by individuals or enterprises.  Customs duties are levied on imports and exports, with export duties ranging from 5% to 100% and import duties ranging from 2% to 20%. 

      Other taxes.  These taxes include a property tax, land tax, and a natural resource tax.  The property tax is placed on fixed assets of state enterprises and unfinished buildings.  A tax of 0.5% is place on property with a value of Lats1,500 or more.  A maximum rate of 4% is applied to property exceeding a value of lats2.5million.  The tax is paid entirely to the local government.  The land tax is placed on the use of land by individuals and enterprises.  The tax is paid directly to the respective district, village, city, or municipal district budget.  Exemptions include transportation routes and individual farms up to the first five years whose conditions are unsatisfactory.  The natural resources tax was introduced to discourage excessive use of natural resources and accrues in the Environment Protection Fund.  The tax consists of three parts:  a tax on the use of natural resources, a tax on pollution, and punitive fines for excessive use of natural resources and pollution.  Tax rates are determined by the Environmental Protection Committee. 

      Non-tax revenues.  These revenues include fees which are collected on documents and official services performed by the state, and user charges for various public services including water and sewage. 

Composition of Budgetary Expenditures...

      Subsidies and transfers which once accounted for 60% of the government expenditures have decreased significantly with reform efforts.  Subsidies on food (with meat and dairy products receiving the largest share) which once accounted for 90% of the total subsidies, have been dramatically reduced since 1991(World Bank, 1995).  Other subsidy expenditures which have been reduced include price support for:  agricultural producers, agro-industry subsidies, direct transfer to low-profit farms, housing maintenance, and heating. 

      Social security expenditures have increased dramatically to almost one-third of total expenditures by 1991, with over two-thirds of the fund expenditures being pension benefits.  Expenditures related to defense and administration have been transferred to the general budget. 

Debt... 

      Like other Baltic states, Latvia is currently liable for a portion of the debt inherited from the former Soviet Union.  However, Latvia "disclaims responsibility for the Soviet debt based on the grounds that its annexation to the Soviet Union was illegal under international law" (EIU, 1995).  The total external debt has been estimated at $60.6 million.  Of this debt, $26 million was long-term publicly guaranteed debt and $34.6 was an IMF credit (EIU, 1995). 

      Latvia has also recently tapped into the international bond markets.  The government borrowed $40 million through a two-year bond issue, organized by Nomura Securities, on the Japanese and international markets.  The international bond market was an alternative to the Latvian treasury bill market where demand has declined as a result of the bank failure.  The bonds are rumored to pay a low coupon rate of 5.4%, due to low yen interest rates.  Demand for domestic Treasury bills has recently begun to increase, although most interest is centered on the short-term bills.  Interest is beginning to increase slightly in longer-term bills. 

      EIU forecasts that Latvian foreign debt will rise to $500 million by the end of 1996 and $690 million by the end of 1997.  Debt-service costs will most likely continue to remain low as much of the credit is available on concessionary terms.  Recent loan agreements include a 17-year $14 million credit from the World Bank for rehabilitating the heating system, credits to assist in privatization, and transport infrastructure (EIU, 1995).

Recent budgetary conditions...    

      Efforts  to improve budgeting, budget execution, and accountability in government finances continue in Latvia.  Budgetary law entitled "Law on Budget and Financial Management" was passed by Parliament in April of 1994.  This law sets rules regarding formulating, approving, financing, implementing, and auditing the annual budgets of central and local governments.  According to this law, the Cabinet of Ministers must submit annual central government budget proposals to Parliament by October 1 for approval of the year preceding the new budget.  If the annual budget has not been approved prior to the implementation date, the government must operate with the preceding year's budget allocations until the new budget is approved.  "The law also regulates government borrowing and lending, the granting of guarantees, and the budgetary powers and procedures for local governments." (IMF, 1995).

      The budget law also creates a Treasury Department within the Ministry of Finance which is responsible for the execution, reporting, and accounting of the state budget.  (A Treasury area was created by the Ministry of Finance in 1993 which was mainly responsible for the auction of short-term (28 day) treasury bills.)  The Treasury Department, since creation, has eventually expanded to include other functions such as the responsibility of assets and liabilities and the social security system.

      Efforts were also made to increase efficiency in the collection of taxes.  The State Finance Inspection Board, responsible for the collection of domestic taxes, and the Customs Department, responsible for foreign trade taxes, were combined in accordance with law passed by Parliament in 1993.  The new department, the State Revenue Service, began work in mid-1994.

Budget and fiscal developments... 

      Latvia has had a pattern of tight fiscal management, and despite the pressures on revenue and expenditure arising from the transitional economy, government finances (as a percent of GDP) have remained relatively stable.  "Government has taken steps to improve the administration of taxes on goods and services in an effort to allow for additional expenditure on both investment and wages and pensions within budget organizations.".(EIU, 1995).  Tax measures include an increase in VAT rates and the introduction of excise taxes on gasoline and cars.  Improvements have been made in the collection of taxes at the border and enforcement of tax evasion penal codes.  Efforts are also being made to computerize the collection of the VAT and excise tax. 

      Government surpluses have fluctuated around approximately 1% of GDP.  Local and central governments have remained generally balanced or have shown a slight surplus.  The Ministry of Finance repaid it's debt to the Bank of Latvia in early 1993 through foreign financing.  "Due to budget proposals, government bond issuance, and tax measures, the general government financial deficit has continually been reduced to within approximately 1.5% of GDP.".(World Bank, 1995).  Revenues from tax collection have in general continued to increase while expenditures, despite increases, have been kept below budget levels. 

      "Within the past several years, attempts have been made to adjust specific tax structures to offset the increasing expenditures by unifying the profit tax to within a range of 25-35% and switching the graduated income tax schedule over to a flat income tax rate of 25%.".(World Bank, 1995).  Minimum wages have also increased 100% since 1994.   

Intergovernmental Relations

      The general government is composed of a central government, local government, and extrabudgetary funds including the Social Security Fund, the Environment Protection Fund, the State Privatization Fund, and the Foreign Exchange Budget.  Local government revenue is obtained through large transfers of funding from central governments and personal income tax collection within their jurisdiction.  VAT and profit taxes go directly to the central government, while approximately 50% of personal income tax goes directly to local government. The remaining 50% is held and administered through the Local Budget Equalization Fund (LBEF), "developed to adjust for disparities between different regions and cities by making available additional resources"(EIU, 1995).  Funding transfers from LBEF to local government for services are determined by formula.  LBEF funding for local government services includes: investment, education, health care, social benefits, and grants. Local governments are responsible for maintaining these services.  Local government expenditures for social benefits constitutes over half of total government spending in this area.  LBEF infrastructure allocations are determined separately, cities and rural areas receive funding based on population. (IMF, 1995). 

      Currently, local governments are largely responsible for municipal services such as water, sewage, and solid waste collection and disposal.  Local governments currently do not have the resources necessary to make investments such as the rehabilitation of existing sewage facilities.  "The need for external financing to support public infrastructure services and municipalities has become a priority with both the Government's Public Investment Program and the Bank's Country Assistance Strategy.".(EIU, 1995). 

Monetary Developments   

      Monetary policy has centered around the objectives of maintaining price stability and stabilizing the exchange rate.  "The Bank of Latvia has continued to use the purchase and sale of foreign exchange to maintain a stable exchange rate.".(EIU, 1995).  In the absence of developed financial markets (specifically interbank money markets), the Bank of Latvia has had little effect on refinancing policies.  In an effort to improve  management of band funds, the Bank of Latvia introduced minimum reserve requirement for all banks.  Treasury bill auctions were also introduced to finance the budget.  However, participants of the auction are still limited to only a few large banks and interest focuses on purchases of short-term bill. 

      In 1993, the lats were introduced to replace the interim currency, the ruble (which was valued at par with the Russian ruble).  The conversion of Latvian rubles to lats proceeded very smoothly, and was completed in 1994.  Rubles currently account for a very small portion of total currency issued.  Posting of prices in foreign currencies was made illegal in Latvia, although the use of foreign currency is still allowed. 

      Latvia's move toward a convertible currency came in two stages.  In May 1992, in response to a shortage of Russian ruble banknotes, the Latvian ruble was introduced as a parallel currency to the Soviet one in circulation.  The two traded equally until Latvia became flooded with Soviet rubles.  Latvia replaced the ruble with the rublis as the legal tender.  In 1993, the rublis was strong enough to move on to the second stage, the introduction of the national currency, the lats.  The rublis was gradually phased out and ceased to be legal tender on October 18, 1993.  In June of 1994 the exchange rate was Lats0.57:$1. 

      Latvia did not use a 'currency board system', and lats have been allowed to float freely.  As a result, the independent central bank has had a very important role.  It strengthened the rublis prior to the introduction of the lats through market intervention, the placement of Russian rubles in a stabilization fund, and high interest rates. 

Social Safety Net

      "Latvia currently operates a pay-as-you-go system of public pensions and unemployment benefits, along with other allowances for general social assistance including allowances for families with children.".(World Bank, 1995).  All social safety net benefits included in the central government budget are financed through the payroll tax.  Employers pay a general rate of 37% and employees pay 1%.  The social tax for agriculture is divided between enterprises and the worker at 18.5% and.5% respectively. (IMF, 1995). 

      Due to the aging population of Latvia and the expansive coverage of the system, pensions are the largest component of the social security expenditures.  After consultation with a collection of advisers from the World Bank and the Swedish government, Latvia passed legislation reforming its existing pension system and created a new, funded mandatory savings program.  In 1993, the pension system was switched over from a flat-rate average for nonworking pensioners ($25 per month regardless of work history or disability status) to a system of tiered benefits based on work history.  A permanent pension law is currently under implementation.  This law will separate social funds from the central government budget, and will introduce a multitier pension system which will separate publicly funded pensions from privately funded pensions based on need.  The law will also increase the retirement age (IMF, 1995).

      In addition to pensions, the social security system pays family allowances and unemployment benefits.  Allowances are granted to families based on the number of children and the age of the parents.  Unemployment benefit expenditures have remained at low levels.  Enterprises continue to pay two-thirds of unemployment benefits directly.  Total payments for allowances and benefits amount to approximately 2.5% of GDP.  Efforts have been made to increase public works programs which relocate and train workers.  Efforts have also been made to set the social benefits to a more realistic minimum subsistence level.  "Local municipalities have also been given clearer guidance in prioritizing social assistance programs.".(EIU, 1995).

      The main developmental issue facing Latvia is the acceleration of the pace of structural reform while maintaining a stable economy.  "One of the key elements of the government's policy agendas is to support the develop the country's human resources to meet the needs of a market economy, and at the same time protect the most vulnerable residents during the transition.".(World Bank, 1995).   

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, 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,.  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, 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, 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.