The Latvian people have lived in the
Baltic-shore territory for more than 4,000 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
"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.".
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
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' 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
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
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
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
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
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,
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
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
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
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
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).
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
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 200,000 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,
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
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
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 $50,000. 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
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 4,000
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 300,000 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
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
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
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).
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.
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 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).
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.
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.
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
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 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.