Commission Report (2002): Latvia

The existence of a functioning market economy

The existence of a functioning market economy requires that prices, as well as trade, are liberalised and that an enforceable legal system, including property rights, is in place. Macroeconomic stability and consensus about economic policy enhance the performance of a market economy. A well-developed financial sector and the absence of any significant barriers to market entry and exit improve the efficiency of the economy.

Overall, there has been a broad consensus about the essentials of economic policy. Governments have changed frequently in the past, but economic policy has remained stable. Some disagreements about economic policy have, nevertheless, been evident as in the case of the privatisation process. Latvia has participated in the Pre-Accession Fiscal Surveillance Procedure. In particular, the most recent Pre-Accession Economic Programme of August 2002 indicated the commitment of the Latvian government towards further macroeconomic stabilisation and market-based structural reforms. Over the past years Latvia requested a series of stand-by arrangements from the International Monetary Fund as a precautionary measure. The present one was approved in April 2001, for a period of 20 months.

Growth has been strong and broad-based, and the economy has shown a remarkable capacity to adapt to changes in the external economic environment. Real GDP has grown by about 6.1% annually, and despite the worldwide slow down in economic activity, it expanded by even 7.7% in 2001. Only in 1999 was growth significantly lower, because of the crisis in Russia. Both domestic and external demand have contributed considerably to growth. Domestic demand has mainly been driven by gross fixed capital formation and private consumption, while the contribution from public consumption has been close to nil. Most important in domestic demand has been gross fixed capital formation, increasing by 19.5% annually, and 17.0% in 2001. However, investment growth has been very volatile, with annual growth rates ranging between -4.0% and 44.0%. Private consumption, growing by 4.8% on average, has contributed nearly as much as capital formation to growth, Growing by 6.1% annually, exports have also been important for growth. They have been affected by changes in the world economy, but have managed to adapt rapidly.

Reflecting strong domestic demand, and in particular a need for investment goods, the current account deficit remains large, with no trend of decline. The trade balance recorded a large deficit, 16.3% of GDP on average. After two years of decrease, the trade deficit increased sharply in 2001 to 17.9%. This was, however, mostly explained by a large one-off investment by the Latvian Shipping Company. Latvia`s geographical position has made transit trade an important business, resulting in a surplus in the balance of services, which partly offsets the trade deficit. The deficit in the current account amounted to 8.6% of GDP on average. In 2001, the current account deficit amounted to 9.7%, of which approximately 2 percentage points was explained by the above-mentioned one-off investment. Over the years, a major part of the deficit has been covered by foreign direct investment (FDI), except for 2001, when FDI decreased at the same time as the current account deficit increased.

The unemployment rate has remained high and stable, despite rapid growth in the economy. In contrast to rapid GDP growth, employment has barely changed. After a small rise in 1998, employment has since been falling back to levels prevailing in 1997. This slow contraction in employment continued in the first quarter of 2002. The unemployment rate has been more or less unchanged, except for a minor peak in 1999. The average unemployment rate since 1997 has been 14.0%, and the 2001 unemployment rate was 13.1%. Long-term unemployment forms a large and increasing proportion of unemployment: 55.8% in 1997, and 59.1% in 2001. Considerable regional discrepancies are also a distinctive feature, pointing to low mobility of the labour force. This is attributable to several causes, for instance poor commuting facilities and a mismatch between supply and demand for skills.

Inflation has been falling to moderate levels. Average annual inflation was 3.9%, but the trend has been downward, from 8.1% in 1997 to 2.5% in 2001. Core inflation stood at 4% on average, thus very close to the overall rate of inflation. Yet the downward trend in core inflation was smoother and more sustained than for the overall inflation rate. Prices for services have increased more than twice as much as prices for goods. Part of the increase for services originates from rising fees for public services. Prices for railway transports, postal services, and telephone services for instance, have increased much more than prices on average. However, the picture during 2001 was different. Prices for services increased less than prices for goods, and prices for the above-mentioned services decreased. Annual inflation increased somewhat in the second half of 2001, mainly as a result of faster rising food prises, but started to decline again in the second quarter of 2002.

Since 1994, the lat has been pegged against the SDR, which has served as a nominal anchor in monetary policy, and helped to secure price stability. Within the limits set by the goals of exchange rate stability and low inflation, monetary policy also aims at avoiding excessive volatility in interest rates. Partly reflecting the decline in inflation, and the growing credibility of the fixed exchange rate, interest rates have slowly declined. The average lending rate stood at 14.8% in 1997 and 10.2% in 2001. To move closer to the standards prevailing in the EMU area, reserve requirements have been lowered continuously, from 8% in 1997 to 5% as from January 2002. This monetary policy framework has led to stable and relatively low money market rates over the whole period. Real interest rates have also shown relatively low and stable levels over the period.

Since the peak in the budget deficit in 1999, fiscal policy has been directed towards budget balance in the medium term. At the beginning of the period, Latvia had a budget surplus, 1.8% of GDP according to national figures. However, the economic slowdown in 1999, and the subsequent increase in unemployment, together with tax reductions, changed the situation. In 1999, revenues increased slowly, and social expenditure increased rapidly, which resulted in a budget deficit of 5.3% of GDP in harmonised EU standards, ESA95. Benefiting from strong growth, and only modest increases in expenditure, the budget deficit decreased in the subsequent years. In 2001, it stood at 1.6% of GDP. In 2001, a compulsory funded pension scheme (``second pillar'') was introduced. Although this step will make public finance more sustainable over the medium term, in the short term it causes additional government expenditure. Furthermore, tax reductions were proposed, which will put additional stress on the budget. A second main task of fiscal policy, apart from budget balance in the medium term, is the reform of the tax system, aiming at a lower overall tax burden and a shift of taxation from production to consumption. In line with that, the corporate tax will be cut in stages down to 15% in 2004. Social security contributions and the real estate tax have also been discussed to be reduced. However, the reduction of the real estate tax will be compensated by a broadening of the tax base, expected to more than compensate for the reduction of the tax rate. Average general government gross debt for the period amounts to a comparatively low 13.6% of GDP. It has been increasing every year, in 2001 by 2.1 percentage points to 16.0% of GDP.

The macroeconomic policy mix has been adequate and managed to cope with external shocks. The monetary framework, defined by the peg of the lat, has been stable and predictable. Fiscal policy has been responsive to this framework, by adopting a prudent stance overall, translating into relatively low deficits on average, and flexibility in times of adverse economic shocks. This was in particular the case in 1999 in the aftermath of the Russian crisis, when automatic stabilisers were allowed to play freely and some tax arrears were extended, leading to a temporary sharp increase in the government deficit in 1999.

Price liberalisation was completed prior to 1997, and market forces determine the majority of prices of goods and services. The proportion of items whose prices are regulated has been the same for several years, at about 20% of consumer price index, CPI. It is mainly prices for the services of public utilities that are still regulated; e.g. electricity, gas, water and telephone services. A cost-recovery mechanism is in place.

The share of the private sector increased rapidly up to 1998 and has continued to increase since, but at a slower pace. Some 62% of GDP were produced in the private sector in 1997, which had increased to 69% by 2001. In terms of employment, the percentage is slightly higher. The land reform is close to being completed, and about 90% of agricultural land are in private hands. A real-estate market exists and a system of mortgage lending is fully operational. The privatisation of apartments is ongoing. Of all apartments, some 95% are assigned for privatisation, and of these about 77% had been privatised by 31 October 2001.

The privatisation process is nearly completed, but some large companies are still state-owned. Privatisation of small and medium-sized enterprises was by and large completed in mid-1998. However, the process has been slower since then. Nevertheless, some progress has been achieved, and only a few large enterprises remain to be privatised. The privatisation of Latvian Gas was carried out in several stages and successfully completed in February 2002, with two German and one Russian investors emerging as the major shareholders. The conditions for the sale of the remaining state-owned shares in Ventspils Nafta and the Latvian Savings Bank are being worked out. The sale of Lattelekom is expected to resume as soon as the ongoing arbitration case, concerning the curtailing of Lattelekom`s monopoly, is settled. An important step forward was the sale of 83% of the shares in the Latvian Shipping Company (LASCO) in 2002. The privatisation of LASCO started more than five years ago, but was interrupted several times. A large stake, close to 50%, has now been bought by Ventspils Nafta, which is itself partly (32%) owned by the state. This transaction might have an impact on the scope for selling the remaining state share in Ventspils Nafta. In mid-2000, it was decided that the Latvian electricity utility, Latvenergo, should be temporarily removed from the list of enterprises to be privatised. Latvenergo, as well as the Latvian railway company, Latvijas Dzelzcels, is currently under restructuring.

No significant barriers to market entry or exit are present. In 1999, a long-term co-operation between the authorities and the business community, represented by the FICIL, began. The aim was to identify and remove obstacles and administrative barriers in the business environment. 77 measures to improve the business environment have been suggested, and up to mid-2002 68 had been undertaken. Following the success of this work the co-operation has recently been broadened to incorporate a wider range of the business community. New firms have been created every year at the average rate of about 7% of total firms. The rate is slowly declining, naturally as the total number of firms is steadily increasing, and in 2001 the rate was about 6%. A new bankruptcy law became effective in late 1996, and was followed by a peak in liquidations during 1997 and 1998. Almost 10% of the existing companies were liquidated both years. Since then, about 2% of companies have been liquidated annually on average. However, the lack of administrative and judicial capacity is still a problem, and results in lengthy court proceedings and poor supervision of enterprises, which in turn makes life easy for tax evaders and those who do not obey laws and regulations.

The legal framework for enterprises is in place, although enforcement of relevant legislation still poses problems. Several important steps have recently been taken to create a comprehensive legal system. In July 2001, the computerised national Land Book was introduced, strengthening the legal certainty in the real estate market. In October 2001, a new unified utilities regulator, the Public Utilities Commission, started its activities. Finally, an important and long awaited change in company law was the new Commercial Code that came into force in January 2002. The law simplifies legislation, makes it more transparent, and brings it into line with EU requirements. However, the business community still points at the lack of administrative capacity, which undermines the enforcement of the legislation.

The financial sector is functioning well, although intermediation is still low. On average, domestic credit to the private sector has increased by some 46% annually since 1997. However, the increase has taken place from low levels. Thus it only amounted to 28.6% of GDP at the end of 2001, roughly double the ratio compared to that in 1997. 22 banks are currently operating in Latvia. Although some of them are very small and operating in market niches, this relatively high number of market operators guarantees a sufficient degree of competition, as witnessed by the downward trend in spreads between interest rates on loans and deposits. The spread for short-term loans and deposits has significantly declined from 9.4 percentage points to 5.9 in 2001, and for long-term loans and deposits from 7.2 to 3.6. Foreign involvement in the banking sector has been large and stable during the last years. The privatisation of the banking sector is almost complete and state ownership amounted at the end of 2001 to just 3.7% of total bank capital, whereas foreigners held 67.8%.

The financial sector has reached an adequate degree of stability. As a share of total loans, non-performing loans have decreased from 10.0% to 2.8%. All banks fully comply with the capital adequacy requirements. The capital adequacy ratio was 16.2% on average between 1997 and 2001, but has been declining and was 14.2% at the end of 2001. The sector as a whole reports stable profits. Supervision of the capital markets has improved significantly. In July 2001, the new Financial and Capital Market Commission started to operate. The commission unifies the supervision of the financial and capital markets into one body, and has been given far-reaching independence, similar to that of the central bank. Latvia is close to full compliance with the Basle Core Principles.

The non-bank financial sector is small, but slowly expanding. Stock market capitalisation has risen from 8.4% of GDP to 9.3%. A bond market did not exist in 1997, and its capitalisation only amounted to 5.7% of GDP in 2001. Part of that rise is due to the issue of government securities aimed at developing domestic financial markets, exceeding the budget financing needs. However, the introduction of the second pillar in the pension system in July 2001 is expected to promote the expansion of the capital market in the coming years.

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