Document of The World Bank For official use only Report No. 49937 - LV I TER ATIO AL BA K FOR RECO STRUCTIO A D DEVELOPME T PROGRAM DOCUME T FOR A PROPOSED LOA I THE AMOU T OF EURO 200 MILLIO (US$282.65 MILLIO EQUIVALE T) TO THE REPUBLIC OF LATVIA FOR A FI A CIAL SECTOR DEVELOPME T POLICY LOA August 25, 2009 Finance and Private Sector Development Department Central Europe and the Baltic Countries Department Europe and Central Asia Region This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization. ii LATVIA - GOVER ME T FISCAL YEAR January 1 ­ December 31 CURRE CY EQUIVALE TS (Exchange Rate Effective as of August 25, 2009 Currency Unit LVL US$1.00 0.49 Weights and Measures Metric System ABBREVIATIO A D ACRO YMS AMC Asset Management Company IDA International Development Agency BoL Bank of Latvia IEG Independent Evaluation Group C/A Current Account Deficit IFI International Financial Institution CAR Capital Adequacy Ratio IFC International Financial Corporation CAS Country Assistance Strategy IMF International Monetary Fund CDS Credit Default Swap LDP Letter of Development Policy CEBS Committee of European Banking Supervisors LGD Loss Given Default CEE Central and Eastern Europe LPP Legal Protection Proceedings CPS Country Partnership Strategy LTV Loan to Value DPL Development Policy Loan LVL Latvian Lati DRWG Debt Restructuring Working Group MIGA Multilateral Investment Guarantee Agency European Bank for Reconstruction and EBRD Development MoE Ministry of Economy EC European Commission MoF Ministry of Finance ECB European Central Bank MoJ Ministry of Justice EIB European Investment Bank MOU Memorandum of Understanding ELA Emergency Liquidity Assistance NPL Nonperforming Loan EMBI Emerging Market Bond Index PDL Past Due Loan ESA European System of Accounts PER Public Expenditure Review EU European Union PFM Public Financial Management FCMC Financial and Capital Market Commission PRAF Prompt Remedial Action Framework FDI Foreign Direct Investment ROA Return on Assets FIAS Foreign Investment Advisory Service ROE Return on Equity FSAP Financial Sector Assessment Program SPV Special Purpose Vehicle FSI Financial Stability Indicator US$ US Dollar FX Foreign Exchange TA Technical Assistance GDP Gross Domestic Product VAT Value Added Tax International Bank for Reconstruction and IBRD Development WB World Bank Vice President: Philippe Le Houerou Country Director: Theodore Ahlers Sector Director: Fernando Montes-Negret Sector Manager: Sophie Sirtaine Task Team Leader: Sophie Sirtaine FOR OFFICIAL USE ONLY LATVIA FI A CIAL SECTOR DEVELOPME T POLICY LOA TABLE OF CO TE TS LOA A D PROGRAM SUMMARY ................................................................................ 1 I. I TRODUCTIO .......................................................................................... 5 II. COU TRY CO TEXT ................................................................................. 5 A. RECE T DEVELOPME TS ............................................................................................... 5 B. MACROECO OMIC OUTLOOK A D DEBT SUSTAI ABILITY ........................................ 10 III. THE GOVER ME T'S REFORM PROGRAM ..................................... 19 A. THE OVERALL REFORM PROGRAM ............................................................................. 19 B. FI A CIAL SECTOR REFORM ...................................................................................... 20 C. CO SULTATIO S .......................................................................................................... 23 IV. BA K SUPPORT TO THE GOVER ME T'S PROGRAM ................. 24 A. LI K TO THE COU TRY PART ERSHIP STRATEGY .................................................... 24 B. COLLABORATIO WITH THE IMF A D OTHER DO ORS ............................................ 26 C. RELATIO SHIP TO OTHER BA K OPERATIO S .......................................................... 29 D. A ALYTICAL U DERPI I GS .................................................................................... 29 E. LESSO S LEAR ED ....................................................................................................... 29 V. THE PROPOSED OPERATIO ............................................................... 31 A. OBJECTIVE A D RATIO ALE ....................................................................................... 31 B. OPERATIO DESCRIPTIO A D POLICY AREAS.......................................................... 32 C. EXPECTED OUTCOMES OF THE OPERATIO ............................................................... 35 D. CO SULTATIO S O THE OPERATIO ........................................................................ 37 VI. OPERATIO IMPLEME TATIO ........................................................ 37 A. POVERTY A D SOCIAL IMPACTS ................................................................................. 37 B. E VIRO ME TAL ASPECTS ......................................................................................... 39 C. IMPLEME TATIO , MO ITORI G, A D EVALUATIO ................................................ 39 D. FIDUCIARY ASPECTS .................................................................................................... 40 E. DISBURSEME T ARRA GEME TS ................................................................................ 41 F. RISKS A D RISK MITIGATIO ...................................................................................... 42 A EX 1. LETTER OF DEVELOPME T POLICY ..................................................................... 45 A EX 2. POLICY ACTIO S MATRIX .................................................................................... 49 A EX 3: OVERVIEW OF THE LATVIA BA KI G SECTOR ................................................. 50 A EX 4. FU D RELATIO S OTE ....................................................................................... 59 A EX 5. GOOD PRACTICE PRI CIPLES FOR CO DITIO ALITIES....................................... 63 A EX 6. COU TRY AT A GLA CE ........................................................................................ 64 The Financial Sector Development Policy Loan was prepared by a Bank team consisting of Sophie Sirtaine (Task Team Leader), Krishnamurti Damodaran (FPDFS), Simon Christopher Walley (GCMNB), Adolfo Rouillon (LEGPS), Bujana Perolli (ECSPF), Paulina Holda, Emilia Skrok (ECSPE), Iwona Warzecha (ECSPS), Ruth Neyens and Erik Huitfeldt (expert consultants). Marialisa Motta (CICRA), Neil Cooper, Fernand Naert, Andrew Lovegrove, and Richard Lysakowski (expert consultants) provided related technical assistance to the authorities. Useful comments and inputs were received from Juan Zalduendo (ECACE), Bernard Funck, Swati Ghosh (ECSPE), Truman Packard, Mohamed Ihsan Ajwad (ECSHD), and Penelope Williams (ECCU5). This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not be otherwise disclosed without World Bank authorization. LOA A D PROGRAM SUMMARY LATVIA FI A CIAL SECTOR DEVELOPME T POLICY LOA Borrower Republic of Latvia Implementing Agency Ministry of Finance, Financial and Capital Market Commission, Bank of Latvia, Ministry of Justice, Ministry of Economy Financing Data IBRD Loan Front end fee: 100 bp Terms: IBRD Loan at 6 month LIBOR for Euro plus a fixed spread, with 10 year maturity, including 5 year grace period, commitment linked and with level repayment pattern. Interest rate: Libor + 200 bp Amount: 200 million (US$282.65 million equivalent) Operation Type Financial Sector Development Policy Loan (DPL) prepared as part of an international financial support package; financing is also being provided by the International Monetary Fund, the European Commission, and some European countries and other multilateral institutions. The Bank's assistance is part of a joint IFI initiative, where the EBRD, the EIB, and the World Bank Group have pledged to support banking sectors in Central and Eastern Europe with up to 24.5 billion over a two year period. Main Policy Areas The loan supports a comprehensive financial sector reform program, including: (i) short term measures aimed at containing the financial sector crisis, and (ii) long term structural reforms aimed at enhancing the resilience of the system to future potential shocks. The short term crisis management measures include measures to strengthen the banking sector's solvency and liquidity, as well as measures to facilitate the renegotiations of corporate and mortgage debts with the objective to avoid the closure of viable firms and the foreclosure of residential properties wherever possible. · The banking sector strengthening measures include: (i) conducting stress tests of the banking sector under severe macro-economic conditions and requiring banks showing signs of solvency or liquidity problems under the stress tests to prepare capital increase and liquidity contingency plans; (ii) preparing a detailed Contingency Plan for the banking sector, ensuring prompt government intervention as and where needed; and (iii) improving the bank resolution framework to enable swift bank interventions. · The debt renegotiation facilitation measures include: (i) amending the insolvency framework to enable out-of-court corporate restructuring negotiations, (ii) publishing guidelines to facilitate renegotiations of corporate and mortgage debts, and (iii) organizing seminars on this subject to increase awareness of options among borrowers. 2 The long term structural reforms include (i) strengthening critical banking sector regulations, including asset quality and capital adequacy regulation, (ii) strengthening prudential supervision, especially through the adoption of a Prompt Remedial Action Plan by the supervisory authority, and (iii) conducting a consumer protection review. Key Outcome Indicators · Adequate provisioning of NPLs (target: provisions to fully meet regulatory requirements) · Well-capitalized banks (target: average CAR of banking system to remain above 10%) · Stabilization of resident and nonresident deposits (baseline: -4% deposit growth from Dec. 08 to May 09; target: 0% monthly growth achieved by end 09)1 · Adequate handling of potential bank distress · Increased number of corporate rehabilitations initiated (base line: 22 cases between January 2008 and June 2009; target 30 cases by end 2009) · Increased number of mortgage debt restructuring (base line: 14% of mortgages restructured by June 2009; target: 20% by end 2009) · Early identification of bank-level and system-level vulnerabilities · Early remedial actions taken to address vulnerabilities · 10% decrease in spread on credit default swaps and of the emerging market bond index (EMBI) reported spread for Latvia compared to Dec. 2008 levels 1/ · Action plan established by CRPC to implement recommendations of consumer protection review Program Development The Development Objective of the operation is to ensure long term Objective(s) and financial stability in Latvia. Contribution to CAS Risks and Risk 1. Financial instability - With a contraction of real GDP for 2009 of Mitigation 18 percent, and another year of negative growth expected in 2010, banks in Latvia are expected to suffer from very high levels of NPLs over the medium term. In addition, with highly volatile deposits, and no access to market funding, liquidity problems cannot be excluded. 2. The risk is mitigated by the policy actions supported by the proposed operation, including reforms in crisis management, bank resolution, debt restructuring, and supervision and regulation. In addition, the authorities have completed stress tests, which have increased their awareness of where problems in the banking sector might arise. This in turn enables them to intensify their supervision of specific institutions as needed. A Strategic Contingency Plan is also in preparation including a detailed strategy for banks that may pose a threat to financial stability. 3. Macroeconomic risk - The Government is undertaking a very ambitious economic adjustment program based on a macroeconomic strategy that includes severe fiscal consolidation measures and wage cuts under the fixed exchange rate regime. The severity of the measures may make them difficult to implement. Also, the much higher government deficits will make it harder to meet the Maastricht criteria and may delay 1 These indicators are influenced by other factors, such as the general economic conditions in the region. 3 the program's exit strategy of Euro adoption. Deflation may be even deeper than currently projected, which could also jeopardize Euro adoption. However, the economy may also recover faster than expected if global growth resumes faster. 4. The IMF program framework, reinforced by continued international support, particularly from the EU, seeks to mitigate these risks. The risk is also mitigated by the size of the multilateral financial package, equivalent to 35 percent of GDP, in support of the Government's program. In addition, the support of Latvia's international partners, particularly the EU, represents a key safeguard to the IMF program. The EU's commitment of 3.1 billion under the international support package has provided important space for implementation of the programmed reforms. In a July 27 press statement announcing their disbursement of 1.2 billion, the EU affirmed that it will continue to work closely with the Latvian authorities and the IMF to ensure Latvia implements successfully its economic reform program and its timely repayment of, all loans associated with the international program to support Latvia. Thus, while the risks are significant, continued current account surpluses, Latvia's strong commitment to the program, expected improvements in global financing conditions, and EU support provide key safeguards. 5. Political risk - The severe adjustment measures may alienate the electorate, weaken political consensus on the structural reforms required for an income-based real depreciation of the Lat, and ultimately lead to early elections. This could exacerbate an already complex environment for economic management and sustained and in-depth structural reforms. 6. This risk is partially mitigated by the adhesion of all coalition parties to the revised IMF Letter of Intent, wide consultations on the program, and the implementation of laws and regulations to support the reforms. The Letter of Intent with the IMF of August 2009 was signed by all parties of the coalition government, notwithstanding earlier questions by some of them on the need for a Fund arrangement. In addition, the 2010 budget reforms have been the subject of wide consultations, including with line ministries, municipal governments, and social partners. Finally, many reforms supported by this operation are being implemented by amendments to laws and regulations that ensure a solid framework for crisis resolution and structural reforms. 7. Social Risk - The cuts in fiscal spending create a risk that some important social services are cut and that the gains Latvia made since accession in converging with EU welfare standards will be lost. 8. The risk is mitigated by the provision of funding to social safety nets and a restructuring of public expenditures partly informed by analytical work prepared prior to the crisis with support from the World Bank. In addition, a Social Sector, Public Administration, and Safety Nets DPL is under preparation, aimed at mitigating the social and poverty impacts of the crisis and of the Government's fiscal consolidation, through measures in public sector reform, social protection, education, and 4 health. Other mitigating factors include the measures supported by this proposed DPL to ensure financial stability, therefore avoiding potential losses to depositors, and to facilitate debt restructuring and avoid foreclosures of residential properties wherever possible. 9. Insufficient institutional capacity - The reforms in the banking system require an increased capacity of the supervisor to anticipate deteriorating trends and undertake the necessary corrective actions. 10. The risk is mitigated by the proposed policy reforms to strengthen the regulatory and supervisory framework, specifically in areas of higher risks (such as asset quality and provisioning). The operation supports measures designed to enhance the capacity of the supervisor to monitor the banking system and react in a timely and effective manner, the conduct of stress tests, the preparation of a Strategic Contingency Plan, an improved stress testing framework, the establishment of a Prompt Remedial Action Plan, as well as strengthened prudential regulations. The Bank has provided and will continue to provide technical assistance in these areas relying on Trust Funds. Operation ID P115709 I TER ATIO AL BA K FOR RECO STRUCTIO A D DEVELOPME T PROGRAM DOCUME T FOR A PROPOSED FI A CIAL SECTOR DEVELOPME T POLICY LOA TO THE REPUBLIC OF LATVIA I. I TRODUCTIO 1. This document describes a program supported by a Development Policy Loan (DPL) for financial sector reforms to the Republic of Latvia for an amount of 200 million. The loan is part of an international financial support package of 7.5 billion, to which the International Monetary Fund (IMF) committed 1.7 billion, the European Commission (EC) 3.1 billion, Nordic countries (Sweden, Denmark, Finland, and Norway) 1.8 billion, European Bank for Reconstruction and Development (EBRD) 0.1 billion, and the Czech Republic, Poland, and Estonia 0.4 billion. The Bank's proposed share in the package is 400 million, to be provided through two DPL operations of 200 million each. To date, Latvia has received about 3.0 billion from the rescue package from the IMF and the EC.2 2. This loan will support crisis management measures and structural reforms to stabilize the financial sector and increase its resilience to future shocks. The reforms are to be implemented by the Financial and Capital Market Commission (FCMC), the Bank of Latvia (BoL), the Ministry of Finance (MoF), the Ministry of Justice (MoJ), and the Ministry of Economy (MoE). The Bank is also preparing a social sector DPL that will aim to minimize the social impact of the crisis by ensuring that safeguards are in place to maintain critical social services (including in health and education) in the midst of the economic contraction and fiscal adjustment. The loan will be a Euro-denominated fixed spread loan of LIBOR plus 200 basis points, a front-end fee of 100 basis points, with a maturity of 10 years. II. COU TRY CO TEXT A. RECE T DEVELOPME TS Growing macro imbalances and buildup of vulnerability, 2004-2007 3. Following its accession into the EU in 2004, the Latvian economy experienced rapid economic growth averaging over 10 percent per year. This high growth was driven almost entirely by domestic demand, encouraged by rapid credit growth, large real wage increases, and expectations of a progressive catching-up with European Union (EU) living standards. New investment was concentrated in the non- 2 This amount includes the second tranche of the IMF expected to be disbursed soon after their board meeting of August 27, 2009. 6 tradable sectors, creating a real estate boom, which culminated in an over 60 percent growth in housing prices in both 2005 and 2006. 4. Pro-cyclical fiscal policy contributed to the domestic boom. Real public expenditures grew by 80 percent between 2003 and 2007 as the authorities spent cyclically strong tax revenues and began receiving substantial inflows of net EU grants. However, despite strong revenue growth, the fiscal balance remained in deficit in most years (except in 2007 when the budget saw a small surplus of 0.7 percent of GDP). High levels of spending, for example in health and education, did not lead to strong outcomes, indicating the presence of important spending inefficiencies. Large wage increases in the public sector contributed both to maintaining a sizeable premium over average wages in the private sector and to crowding out fiscal space for additional productive spending on human and physical capital. Pension benefits linked to wage growth rose in parallel, representing an important source of fiscal risk. Some large-scale, non-EU funded, off- budget investments, especially at the municipal level, generated contingent liabilities, while the pace of absorption of EU funds was over-estimated and the recurrent cost implications of such investment projects were inadequately budgeted in medium-term fiscal plans. 5. The boom in domestic demand fuelled large macroeconomic imbalances. Consumer inflation had been rising since accession, from 6.2 percent in 2004 to over 10 percent in 2007. The labor market showed signs of overheating as migration of Latvians to the EU15 countries added to labor shortages and wage pressures. As a result, rapid wage growth outstripped productivity growth undermining Latvia's international competitiveness. Driven by high domestic demand, the current account deficit widened from 12.8 percent of GDP in 2004 to almost 23 percent in 2007. 6. The growth in domestic credit, which fuelled the domestic demand, resulted in rising household and corporate indebtedness, often in Euros. Much of the banks' lending was directed towards households in the form of mortgage loans; the share of households in total bank assets rose to 28 percent by end 2007 (equivalent to 40 percent of GDP, up from 18 percent of GDP in 2004) with mortgage loans almost doubling each year until mid-2007. As a result, the indebtedness of corporate entities and households more than tripled between 2004 and 2007, exceeding 80 percent of GDP. 7. The expansion of credit was largely financed by external borrowing from private banks resulting in high loan-to-deposit ratios. For foreign banks (which account for almost 60 percent of the banking system), their parent institutions were the main source of financing. Domestic banks relied substantially on short term syndicated loans (as well as non-resident deposits). Overall the loan to deposit ratio at 248 percent in 2007 was the highest in the region. With the bulk of the loans denominated in foreign currency (around 86.3 percent of total loans in 2007 were FX denominated, out of which 96 percent in Euros), and much of it unhedged, the banking sector also became indirectly vulnerable to foreign exchange risk (that is, through the risk of an increase in credit losses). 7 8. As a result, Latvia's external indebtedness increased significantly. Latvia's external debt to GDP rose from 90 percent of GDP in 2004 to 127 percent by 2007, with short term debt to GDP rising to over 55 percent of GDP in 2007. 9. Overall, Latvia entered the financial crisis with significant vulnerability, in particular a large current account deficit, high external debt, and a very high loan to deposit ratio in the financial sector (see Table 1). Table 1. Latvia: Vulnerability Indicators 2002-2004 2005 2006 2007 2008 Fiscal indicators Balance of general government /GDP, ESA 95 -1.6 -0.4 -0.5 -0.4 -4.0 Balance of general government /GDP, GFS (IMF) -1.6 -1.1 -0.9 0.7 -3.3 Primary Balance of the Public Sector /GDP, ESA95 -0.9 0.2 0.0 0.1 -3.1 Primary Balance of the Public Sector /GDP, GFS (IMF) -0.8 -0.5 -0.4 1.1 -2.9 Gross debt of general government /GDP, ESA95 14.3 12.4 10.7 9.0 19.5 Gross debt of general government /GDP, GFS (IMF) 13.6 11.6 9.9 7.8 17.0 Foreign Currency to Central Government Debt in (in %) 55.9 56.0 58.1 61.5 47.7 External indicators Current Account Balance /GDP -9.2 -12.5 -22.5 -22.5 -12.6 Net Direct Investment /GDP 2.9 3.6 7.5 6.7 3.3 Gross external debt/GDP* 81.8 99.4 114.0 127.6 128.2 Net external debt /GDP* 24.9 35.6 44.0 49.3 56.5 Gross external debt (% of exports)* 284.1 296.9 371.2 447.4 457.5 Net external debt (% of exports)* 86.1 106.3 143.2 173.0 201.8 Short-term External Debt/Total External Debt 59.0 49.3 44.1 43.2 33.5 Gross Reserves/Short-Term External Debt (in %) 29.8 41.6 33.0 35.7 Financial indicators Foreign currency deposits/Total deposits (%) 38.3 40.6 41.2 48.2 48.6 Foreign currency loans/Total loans (%) 60.6 69.8 76.8 86.3 88.3 Domestic credit to private sector (yoy change %) 47.0 64.3 58.4 34.2 11.7 Loan to deposit ratio (%) 168.1 192.0 215.6 247.6 287.8 Sovereign Credit Default Swap (ave) -- -- 8.1 12.3 133.8 Sovereign Credit Default Swap (eop) -- -- 12.3 133.8 819.0 Sovereign Debt Ratings: Standard and Poor's (eop) A- A- A- BBB+ BBB- Eurobond Secondary Market Spread (in basis points) 16 19 58 446 Sources: Latvian statistical office, Central Bank, Ministry of Finance, Eurostat, WB staff The impact of the international financial crisis 10. In the second half of 2008, in the context of the global financial crisis, these vulnerabilities coalesced into a financial and balance of payments crisis. The large macroeconomic imbalances made Latvia one of the most vulnerable countries by the time the global financial crisis started to unfold. 11. Concerns among foreign banks about their overexposure to the Baltic countries resulted in a sharp slowdown in credit. The slowdown in credit, in conjunction with a weakening in external demand in the context of depreciations against 8 the Euro of the currencies of some of Latvia's external partners, and deterioration in economic sentiment, led to a significant downturn in domestic economic activity. 12. While the current account narrowed by 10 percentage points during the course of 2008, vulnerabilities to external shocks remained high. The current account deficit narrowed to 12.6 percent of GDP, following a significant drop in imports on the back of stagnating domestic demand. Nevertheless, external debt remained high at 128 percent of GDP at end 2008, with debt maturing within one year (including non-resident deposits at call) exceeding 50 percent of GDP. This exposed Latvia to the risk of a sudden capital stop. 13. Moreover, tax revenues fell in the wake of the economic downturn, resulting in increasing fiscal pressures and a widening budget deficit. For 2008, the Government targeted a surplus of 1 percent of GDP but with rapidly weakening domestic demand and related tax revenues, the deficit exceeded 3 percent of GDP, despite attempts to cut appropriations at the end of the year. 14. These macroeconomic imbalances led financial markets to become increasingly concerned about the sustainability of the peg arrangement as well as the potential fiscal implications of the contingent private sector liabilities. The currency peg came under substantial pressure in September 2008 and, by November 2008, the BoL's foreign exchange reserves had fallen by 20 percent to Euro 3.4 billion. Latvia was downgraded by rating agencies and its Eurobond spread increased to around 600 basis points, while the 5-year Credit Default Swap (CDS) spread jumped to around 1000 basis points in November 2008. Liquidity demands from non-resident depositors aggravated these outcomes. 15. The banking sector had entered the crisis with good financial stability indicators (FSIs). At the end of 2007, the capital adequacy ratio stood at 11.1 percent, the liquidity ratio (liquid assets as a proportion of liabilities maturing in 30 days) at more than 55 percent (above the regulatory minimum of 30 percent), the Return on Assets (ROA) at 2 percent, and the Return on Equity (ROE) at 24 percent (Annex 3). 16. However, the reliance of the financial sector on external financing made it highly vulnerable to liquidity shocks. As noted, a large proportion of the banking system in Latvia is foreign owned, involving primarily subsidiaries of Swedish banks (see Annex 3). The introduction of financial support schemes by home authorities of these banks boosted confidence and helped stabilize their deposits in Latvia. By contrast, locally owned banks, which, as noted, relied on more fragile forms of finance -- syndicated loans and non-resident deposits -- faced considerable redemption pressures given the worsened global liquidity conditions in late 2008. While deposits fell significantly in the whole banking system, non-resident deposits were particularly affected, with Parex Bank -- the largest domestic bank and the second largest bank in Latvia -- losing one quarter of its deposits between end August and November 2008. 17. The deposit run on Parex Bank led to the state taking a majority stake in the bank's capital and to a restriction on deposit withdrawals. Parex Bank is 9 considered systemically important (and therefore too big to fail) given its role in the domestic payment system and in municipal financing, its large branch network and large market share. In mid-November 2008 therefore, in the face of growing illiquidity, the Government took a 51 percent stake in the bank. This, however, failed to stem the outflow of deposits and the authorities had to increase its liquidity support. In early December 2008, the Latvian Financial and Capital Market Supervisory Authority (FCMC) restricted withdrawals by corporates and individuals from the bank and the State further increased its shareholding to 85 percent. New management was put in place to work out a resolution that would minimize losses for the state and allow for a return of the bank to the private sector. Further risks to the bank's stability came from the need to roll-over Euro 775 million of syndicated loans falling due in February and June 2009. Negotiations with syndicated lenders led to the rescheduling of payments in March 2009. A due diligence analysis, focused on the bank's asset quality, liquidity and solvency, was conducted by PricewaterhouseCoopers in early 2009, on the basis of which additional provisions were booked in the 2008 financial statements. In April, EBRD approved the acquisition of 25 percent plus 1 of the ordinary shares of Parex Bank for LVL 59.5 million (84.2 million) and a subordinated loan of 22 million qualifying as Tier 2 capital. 18. These developments led the Government to seek external financial support and to agree to an international stabilization program, supported by the EC, the IMF, EBRD, Nordic and Central European countries and the World Bank. The requested rescue package amounted to 7.5 billion; equivalent to 35 percent of GDP. 19. The international stabilization package is anchored on maintaining Latvia's exchange rate peg through strong domestic adjustment policies and substantial external financing. The 27 month program is based on preserving the Lat exchange rate peg to the Euro within a narrow band. The authorities have chosen to maintain the quasi currency board that served them well in the past. Among other factors, they have taken into consideration the balance sheet effect of a potential devaluation and the risks that this would result in severe corporate, banking sector and social distress, which could further contribute to output contraction and sever Latvia's links to capital markets for a protracted period of time. While maintaining the peg, exceptionally strong domestic adjustment policies, including very substantial fiscal consolidation and sizable external financing, would be needed. 20. The key elements of the program focus on measures to stabilize the financial system, measures to achieve a large fiscal consolidation, and income policies based on nominal wage reductions, while maintaining unchanged the exchange rate peg. Financial sector measures aimed at stemming the loss of bank deposits and international reserves and reforms to restore confidence in the banking system in the medium-term. Fiscal measures concentrated primarily on spending and incomes policies aimed at achieving a large fiscal consolidation. Fiscal consolidation was to be backed by structural reforms, strengthening public financial management as well as comprehensive reforms of the education system and of the civil service and state administration. 10 21. However, the economic downturn proved much more severe than expected, creating challenges for the implementation of the agreed program and delaying the disbursement of funds. As discussed below, economic activity data in early 2009 suggest a sharp deterioration in the economy. During a mission in February 2009, the IMF also identified delays in achieving the originally envisaged fiscal savings. After the Government failed to pass a supplementary budget in March as had been agreed in the stabilization program (partly due to political changes), the IMF delayed the release of its second tranche (200 million), with the expectation that the Parliament would adopt budget amendments in June 2009. 22. On June 16, the Parliament passed a supplementary budget with additional spending cuts of LVL 500 million (US$991 million). The measures include revenue increases (amounting to 0.61 percent of GDP) through higher excise tax rates, lowering the threshold of tax-exempt income, and increases in state revenue from dividends. On the expenditure side, the reductions (amounting to 5.48 percent of GDP) come from a lower wage bill (reflecting a 20 percent nominal wage reduction and a fall in public sector employment) and lower social transfers (including a 10 percent nominal pension cut and a 70 percent reduction of pensions for working pensioners, which are both challenged in the constitutional court). Mitigating measures to the potential poverty impact of these cuts are being defined by the Government in coordination with the World Bank and IMF teams. Based on this supplementary budget, the EC approved on June 26 the disbursement of its second tranche of 1.2 billion (US$1.6 billion). The EC further agreed on a budget deficit of 8.5 percent in 2010, 6.5 percent in 2011, and 3 percent by 2012; this is the fiscal path that is contained in Latvia's revised Economic Stabilization and Growth Revival Programme (ESA basis). The IMF has recently concluded negotiations and the disbursement of the second tranche of about 200 million is expected to take place soon. The IMF Board meeting is scheduled to take place in late August 2009. The Czech Republic is also expected to disburse 200 million shortly. B. MACROECO OMIC OUTLOOK A D DEBT SUSTAI ABILITY 23. The economy is now expected to decline by 18 percent in 2009 and by 4 percent in 2010. Data from early 2009 suggest a sharp deterioration in the economy, with output falling 18 percent year on year in the first quarter and retail sales and industrial production experiencing a larger contraction than originally anticipated. Construction and consumer durables spending have fallen sharply (car sales were down by 80 percent in the first quarter), in part reflecting the unavailability of credit. Labor force surveys indicate a 14 percent unemployment rate in the first quarter, up 4 percentage points in three months. The labor market deterioration is expected to continue with unemployment rising to about 17.5 percent in 2010. Over the medium term a very gradual economic recovery is projected. Output growth is expected to return to positive territory in 2011 when the economy is expected to grow by around 1.5 percent (Table 2). 11 Table 2. Latvia: Selected Economic Indicators Actual Projected 2004 2005 2006 2007 2008 2009 2010 2011 Output (Annual growth rate, in percent, unless otherwise stated) Real GDP (annual growth rate, in percent) 8.7 10.6 12.2 10.0 -4.6 -18.0 -4.0 1.5 Private consumption 9.8 11.2 21.2 14.8 -11.0 -25.3 -8.0 0.3 Government consumption 2.1 2.7 4.9 3.7 1.5 -12.0 -10.0 -2.0 Gross fixed investment 23.8 23.6 16.4 7.5 -13.2 -29.0 -11.5 1.0 Exports of goods and services 9.4 20.2 6.5 10.0 -1.3 -15.5 1.3 4.4 Imports of good and services 16.6 14.8 19.4 14.7 -13.6 -28.5 -10.0 1.5 Nominal GDP (in billions of euros) 11.1 12.9 15.9 21.0 23.1 18.5 17.0 16.9 Prices and employment HICP (average, in percent) 6.2 6.9 6.6 10.1 15.3 3.1 -3.5 -2.5 Unemployment rate (LFS, average, in %)) 10.4 8.7 6.8 6.1 7.5 15.8 17.4 16.9 Avg. monthly wage (lats) 210.9 245.8 302.4 397.6 479.3 421.5 387.8 387.0 Percent change 9.6 16.5 23.0 31.5 20.5 -12.0 -8.0 -0.2 Consolidated general government 1/ (In percent of GDP) Revenue 33.9 35.3 36.1 36.2 35.2 35.3 35.6 35.6 Expenditure and net lending 35 36.4 36.9 35.6 38.5 48.4 47.6 45.1 Fiscal balance 2/ -1 -1.1 -0.9 0.7 -3.3 -13.0 -12.0 -9.5 Balance of Payments Gross official reserves (in billions of euros) 1.6 2 3.4 4 3.7 3.4 4.4 5.7 (In percent of GDP , unless otherwise stated) Current account balance -12.8 -12.5 -22.5 -22.5 -12.6 4.5 6.4 5.1 Trade balance -20.2 -19 -25.6 -23.9 -17.0 -8.3 -5.6 -6.0 Capital and financial account 26.7 8.5 -24.8 -18.0 0.0 Gross External Debt 93.3 99.4 114.0 127.6 128.2 160.8 171.3 174.9 Terms of trade (annual growth rate, in %) 5.0 -2.1 0.3 5.1 -0.1 0.4 0.0 0.5 1/ National definition - includes economy-wide EU grants in revenue and expenditure. 2/ Fiscal balance excluding bank restructuring costs. Source: IMF, and staff calculations. 24. The measures included in the supplementary budget should contain the 2009 fiscal deficit to around 13 percent of GDP. However, the supplementary budget relies heavily on one-off measures. The measures also rely on across the board budget cuts, thus being regressive in nature. In the baseline, the fiscal deficit is expected to improve marginally in 2010 relative to 2009 to around 12 percent of GDP. In view of the projected continued decline in economic activity in 2010, achieving a 12 percent of GDP deficit next year will require further significant fiscal adjustment. The Government has 12 already committed to introducing targeted expenditure cuts and tax measures amounting to 4 percent of GDP and has broadly identified further measures estimated to yield 2½ percent of GDP should this prove necessary. 25. Fiscal consolidation has been accompanied by a major redeployment of public spending. The initial emphasis of the program was to rein in the public expenditure relative to GDP in the face of the incipient recession. The spending-to-GDP ratio had increased from 35.6 percent in 2007 to 38.5 percent in 2008 (see Table 3), mainly as a result of an increase in social transfers and government consumption, and would have bulged further if the initial, highly expansionary budget had been adopted for 2009. In the event, a new budget law was adopted on December 12, 2008 as an integral part of the Government's economic stabilization program, with expenditure reductions of about 5 percentage points of GDP (compared to the baseline) in a bid to keep the spending-to-GDP ratio in 2009 close to the 2008 level. Major consolidation measures targeted broad economic categories particularly through cuts in nominal public sector wage, rationalizing subsidies and outlays on goods and services, while core social protection and EU-supported project spending were maintained. 26. This first round of fiscal measures proved insufficient to stabilize the spending to GDP ratio in the face of the economic contraction and inertial effect of the generous pension increases granted in 2008. In response to these trends, the Government adopted additional fiscal consolidation measures that combine further broad- stroke measures with more surgical interventions to tease out efficiency gains through structural reform of key government programs (drawing in part on earlier World Bank PER recommendations) including to increase the efficiency and quality of education, strengthen efficiency and targeting of healthcare services, make limited and targeted pension reductions, and reduce less targeted social spending. At the same time, the amended 2009 program provides funding of some 1½ percent of GDP in 2009 to expand social safety nets and accelerate the absorption of EU funds and other foreign financial assistance. 27. Although the spending to GDP ratio is now set to expand markedly in 2009, the net result of these two waves of fiscal measures has been to change substantially the composition of spending, with the share of social protection measures rising from 22 to 30 percent of the budget (8 to 14 percent of GDP), and that of the wage bill dropping from 20 to 16 percent of the budget (stable in percentage of GDP as a result of the latter's contraction). 28. The Government intends to further reduce the deficit in 2010 and beyond, mostly through further expenditure restructuring. It has established a consultative Reform Management Group to advise on the drafting of the 2010 budget. The Government will carry out a broad public service reform to keep the public sector wages and salaries close 7 percent of GDP through further targeted wage cuts. Moreover, in order to preserve the sustainability of the pension system, it will also prepare a pension reform that will include reviewing all special pension regimes. As a result, the structure of spending is likely to further change in coming years, towards a lower share of public consumption and limited increase in spending on pension (Table 3). 13 Table 3. General Government Operations, 2005-14 (in percent of GDP, unless otherwise indicated) 2009 2009 initial rev. 2005 2006 2007 2008 prog.*) progr. 2010 2011 2012 2013 2014 Total Revenue and Grants 35.3 36.1 36.2 35.2 34.8 35.3 35.6 35.6 35.7 36.8 36.8 Total Expenditure 36.4 36.9 35.6 38.5 39.8 48.4 47.6 45.1 43.2 41.8 39.8 of which: Wages and Salaries 7 7.1 7.2 7.8 5.9 8 7.6 7.6 7.3 7 7 Goods and Services ... .... 5.1 5.7 4.1 5.4 5.6 5.5 5.3 5.1 4.9 Interest 0.6 0.6 0.3 0.4 1.2 1.7 3.4 4.9 6 6.9 7.5 Subsidies and Grants 17 16.6 14.2 16.6 20.1 23.9 25.9 24.7 23.6 22.7 21.8 Social Support 8.3 8 7.4 8.5 10.1 14.4 15.7 14.7 14 13.5 12.9 Subsidies to companies and institutions 8.6 8.5 6.9 7.3 10 9.3 10.1 9.9 9.5 9.1 8.7 Capital expenditures 4.3 4.8 5.1 4.5 4.7 4.2 4.6 4.6 4.4 4.8 4.7 Measures to be identified ... ... ... ... ... 0 -3.7 -6.4 -7.3 -8.6 -10 General Government Balance -1.1 -0.8 0.6 -3.3 -5 -13.1 -12 -9.5 -7.5 -5 -3 Memo item: Social Support share (% of total) 22.8 21.7 20.8 22.1 25.4 29.8 33.0 32.6 32.4 32.3 32.4 Pensions share (% total) 16.8 16 14.3 15.3 17.9 16.7 18.9 20.0 19.9 20.1 20.6 Wages and Salaries share (% of total) 19.2 19.2 20.2 20.3 14.8 16.5 16.0 16.9 16.9 16.7 17.6 Source: IMF *IMF Program from 2008 29. From double digits in 2008, inflation is falling rapidly to around 3 percent and the current account is expected to show a surplus of 4.5 percent in 2009. The faster than anticipated improvement in the current account balance has been driven primarily by the collapse of imports rather than improved competitiveness, reflecting the continued contraction of domestic demand. The decline in wages in Q1 2009 has resulted in a slight depreciation of the unit labor cost-based real effective exchange rate. The current account is expected to continue to run a surplus over the next few years. 30. The capital and financial account is expected to weaken considerably to reach a deficit of 25 percent of GDP in 2009. Outflows result from the repayment of Parex Bank's syndicated loans, difficulties in rolling-over syndicated loans faced by local banks, a small decrease in the exposure of foreign banks to Latvia, and a continued outflow of non-resident deposits. Improvement is expected in the capital and financial accounts from 2010 onwards when the capital account deficit is expected to narrow to 18 percent of GDP. It should be balanced in 2011. 14 31. Latvia's balance of payments needs would be financeable under the baseline assumptions (Table 4). The projected financing requirements of a total of Euro 15.2 billion over 2009-QI 2011 would be covered by the projected current account surpluses, a partial rollover of amortizing debt, some inflows of FDI and official financing. The rollover rates assumed under the baseline scenario are relatively conservative at 0 percent for Government and state banks throughout 2009 and 2010, 90 percent in 2010 for foreign affiliated banks, 30 percent in 2009 and 50 percent in 2010 for other domestic banks. The baseline also allows a cushion for possible repatriation of 35 percent of deposits through end-2010. 32. Public and external debts are projected to increase sharply. Public debt is projected to rise to 44 percent of GDP in 2009 and peak at just below 90 percent of GDP in 2013 before declining slightly (Table 5). External debt is projected to peak at 175 percent of GDP in 2011, entering only then a gradual decline and reaching 164 percent of GDP by 2013. Even with sharper fiscal consolidation assumptions, public debt would only enter a gradual decline at the beginning of the next decade.3 The EU has affirmed that it will continue to work closely with the Latvian authorities and the Fund to ensure Latvia implements successfully its economic reform program and its timely repayment of all loans associated with the international program to support Latvia. 3 Table 5 and Figure 1 are based on what Fund staff consider the more likely scenario--one that involves a more gradual fiscal consolidation. However, the authorities have announced they intend to pursue a sharper fiscal consolidation. Specifically, their path towards the Maastricht criterion involves sharp fiscal consolidation in 2010 and 2011 with the intent of meeting the 3 percent target (ESA terms) by 2012--as opposed to the 7.5 percent fiscal deficit envisioned in a more gradual fiscal consolidation as the one in this report. The authorities' proposed fiscal consolidation path could put additional pressure on output but, if a faster-than-expected recovery were to materialize and the fiscal adjusts more rapidly, then lower level of debt--close to the debt Maastricht criterion--could be achievable by 2012. 15 Table 4. Program financing (in billions of Euros) 2009 2010 2011 Total financing requirements -6.42 -7.17 -1.66 Medium and long term debt amortization 1/ -2.24 -3.70 -1.34 ST liabilities (incl. nonresident deposits) -3.88 -2.71 -0.16 Other financing needs net (incl. trade credit) -0.29 -0.77 -0.15 Total financing sources 6.42 7.17 1.66 Current account deficit 0.83 1.08 0.26 Medium and long term debt 1.17 2.55 1.07 Direct investment, net 0.21 0.42 0.09 Other financing resources 0.59 1.13 0.28 Change in gross reserves (increase -) 0.16 -1.01 -0.44 Prospective official financing (exc. IMF) 3.10 2.40 0.30 Prospective Fund credit 0.39 0.59 0.10 Note: Rollover assumptions: 0 percent throughout for government and state banks in 2009 and 2010; 70 percent in 2009 and 90 percent in 2010 for foreign affiliated banks; 30 percent in 2009 and 50 percent in 2010 for other domestic banks and 80 percent throughout for corporate; nonresident deposits repatriation of 35 percent through end-2010. 33. Stress tests highlight the high degree of sensitivity of the debt sustainability. More rapid and sustained deflation than envisaged under the program would lead to substantially higher government debt ratios. Likewise, slower deficit reduction (for example, due to reform fatigue) would also result in government debt ratios approaching 100 percent of GDP. Overall, the sustainability of the public debt is most dependent on the size of the primary deficit, and the sustainability of the external debt would be most affected by a devaluation (see Figure 1). Public debt scenarios are relatively less sensitive to a devaluation shock, as well as to shocks originating in lower growth, higher interest rates, or a contingent liability shock. The external debt is less sensitive to shocks originating in lower growth, higher interest rates, or a non interest rate current account shock. 16 Table 5. Public and External Debt Sustainability (percent of GDP) 2007 2008 2009p 2010p 2011p 2012p 2013p Public sector debt Baseline public sector debt 7.8 17.0 43.5 74.2 87.2 89.2 90.0 o/w foreign currency denominated 4.4 10.4 32.3 54.6 58.7 54.4 49.2 Change in public sector debt (A) -2.1 9.3 26.5 30.7 13.1 2.0 0.8 Identified debt creating flows (B) -3.5 6.4 25.1 23.7 16.8 3.6 0.7 Primary deficit -1.1 2.9 11.3 8.7 4.6 1.5 -1.8 Revenue and grants 36.2 35.2 35.3 35.6 35.6 35.7 36.8 Primary (non interest) expenditure 35.2 38.1 46.7 44.3 40.2 37.2 35.0 Automatic debt dynamics -2.4 -0.6 6.0 7.2 5.0 2.1 2.6 Other identified debt creating flows 0.0 4.1 7.8 7.8 7.2 0.0 0.0 Residual including asset changes (A-B) 1.4 2.8 1.4 7.0 -3.7 -1.6 0.1 Public sector debt to revenue ratio (in percent) 21.4 48.3 123.0 208.4 245.1 250.0 244.3 External debt Baseline external debt 126.8 126.9 160.8 171.3 174.9 169.9 164 Change in external debt (C) 12.0 0.1 34.0 10.5 3.6 -5 -5.9 Identified debt creating flows (d) -11.5 -1.8 20.9 -3.1 -11.0 -16.1 -15.9 Current account deficit excl. interest 18.5 7.8 -12.3 -14.1 -8.4 -8.6 -8.3 payments Net non debt creating capital inflows -6.0 -3.0 -3.2 -3.6 -3.4 -4.7 -5.0 (negative) Automatic debt dynamics -23.9 -6.6 36.4 14.6 0.8 -2.8 -2.5 of which from nom. interest rate 4.1 4.9 7.8 7.7 3.4 3.7 3.7 of which from real GDP growth -8.7 5.3 28.6 7.0 -2.5 -6.4 -6.3 Residual, including changes in gross 23.5 1.9 13.1 13.5 14.6 11.1 10.1 foreign assets (C-D) External debt to exports ratio (in percent) 307.2 305.9 439.8 417.6 393.5 370.6 351.0 Source: IMF. Note: The IMF lending to the central bank is not included in the public debt sustainability analysis (it is only included in the external debt sustainability analysis). The authorities have a more ambitious scenario aimed at meeting Maastricht criteria by 2012, in which case the public and external debt paths would adjust more rapidly. = 17 Figure 1. Public and External Debt Sustainability--Bound Tests 1/ External Debt Sustainability External Debt Sustainability (in percent of GDP) (in percent of GDP) Public Debt Sustainability Public Debt Sustainability (in percent of GDP) 3/ (in percent of GDP) Primary balance (PB) shock and no policy change scenario (constant primary balance at 2009 level) 140 No policy change 120 PB shock 139 100 92 80 89 60 40 Baseline 20 0 2004 2006 2008 2010 2012 2014 Sources: International Monetary Fund, Country desk data, and staff estimates. All shocks are defined in terms of historical standard deviations (10-year averages). 1/ Shaded areas represent actual data. Individual shocks are permanent one-half standard deviation shocks. Figures in the boxes represent average projections for the respective variables in the baseline and scenario being presented. T en-year historical average for the variable is also shown. 2/ One-time real depreciation of 30 percent occurs in 2009. 3/ The chart also includes a scenario in which the primary balance is kept at the projected 2009 level. 4/ One-time real depreciation of 30 percent and 10 percent of GDP shock to contingent liabilities occur in 2009, with real depreciation defined as nominal depreciation (measured by percentage fall in dollar value of local currency) minus domestic inflation (based on GDP deflator). 18 34. In the financial sector, after funding a credit boom from 2004-2007, foreign-owned banks are now retrenching and deposit outflows continue. In the first quarter of 2009, foreign banks repaid 0.8 billion, equivalent to just below 10 percent of their liabilities to the parent institutions, reversing a trend of increased exposure until 2008. Nonresident deposit outflows have continued, albeit at a slower pace than at the end of 2008. Residents have also begun to accumulate assets abroad. 35. In addition to tight liquidity, banks are facing a sharp increase in non- performing loans ( PLs) as a result of the economic recession. NPLs overdue by more than 30 days have increased from 2 percent of total loans at end-2007 to 15.5 percent at end-May 2009. Loans overdue by more than 90 days increased from 3.6 percent at end-2008, to 10.7 percent at end-May 2009.4 The increase in NPLs is seen across the board, reaching 15 percent for mortgages, 29 percent for real estate developers, and 12 percent for corporate loans. A large proportion of household mortgages have negative equity.5 So far, the need to provision for bad loans has caused system-wide losses at an annualized rate exceeding 2 percent of GDP. Further deterioration can be expected. 36. As a result, lending standards and margins have tightened, so that overall, credit has fallen by 3 percent since December 2008. 37. The stress tests conducted by the BoL and the FCMC indicate that increased capital buffers and robust liquidity contingency plans are needed. As of January 2009, the total buffer for credit losses stood at 4 percent of the loan portfolio. However, due to the rapid increase in provisioning, increased capital buffers are needed for foreign and domestic banks alike. Under the proposed program, the FCMC has required all banks to prepare solid capital increase plans to address potential shortcomings as identified by the stress tests. The need for additional capital may lead to some consolidation in the banking sector. 38. While the immediate deteriorating conditions in Parex Bank have been controlled, uncertainties remain regarding its future. Deposit outflows have slowed, albeit under continuing deposit withdrawal restrictions, improving the bank's liquidity position. In May 2009, the Privatization Agency made an investment of about LVL 141 million, on behalf of the state, into Parex Bank's capital, and issued a subordinated loan in the amount of LVL 50 million, bringing Parex Bank CAR to about 11 percent. In addition, the Cabinet of Ministers approved the bank's restructuring plan. However, uncertainties remain regarding the banks' future, including: (a) the continuation of limits on deposit withdrawals -- the authorities have committed to remove the partial freeze as conditions stabilize; (b) EBRD's involvement as a shareholder -- the EBRD and the Government have signed an agreement on the purchase of Parex Bank's shares; the transaction is expected to be concluded in August 2009; (c) the need to develop a plan that would ultimately allow the re-privatization of the bank; and (d) the European 4 PDLs at 1 day overdue increased from 15 percent at end-2008 to 22.9 percent at end-May 2009. 5 Note that banks in Latvia retain full recourse on their claims, which provides a strong incentive for mortgage holders to continue serving their loans. 19 Commission has begun a standard procedure of investigation into the state aid provided to Parex Bank, in line with EU competition rules. 39. The overall outlook is subject to exceptional risks and uncertainties. Achieving a real exchange rate depreciation without a nominal exchange rate depreciation will depend critically on undertaking strong domestic adjustment involving sustained wage and fiscal discipline. The success of the program also hinges on the stabilization of the financial sector, which the Government is addressing through a strong contingency plan to deal with potential liquidity or solvency problems. A new Government was formed in March, after budget discussions led to the resignation of the Prime Minister in February. The announcement of unpopular measures such as a 20 percent salary cut for teachers brought thousands of protestors in the streets of Riga in early April. And in June, following the newly approved budget amendments that entailed further spending cuts, the Health Minister resigned on the basis that the new cuts would undermine the effectiveness of the health care system. The depth of social and other spending cuts may lead to further social instability, although the Government is putting in place a number of mitigating measures in coordination with the IMF and World Bank teams. III. THE GOVER ME T'S REFORM PROGRAM A. THE OVERALL REFORM PROGRAM 40. The main objectives of the authorities' recovery program of end 2008 and of 2009 are to: (i) stem immediate liquidity pressures; (ii) restore long-term stability by strengthening the financial sector, correcting fiscal imbalances and adopting domestic policies aimed at improving competitiveness while maintaining the fixed exchange rate; and (iii) strengthen the long-term structural performance of the economy. In the financial sector, the immediate objective of the program is to stabilize the sector and restore depositor confidence. 41. With the severe economic contraction, the Government had to propose stronger fiscal adjustment measures in June 2009 than originally planned. Under the updated program, the budget deficit is to be reduced to 3 percent of GDP in 2012 and the Government is to take all necessary measures to meet the Maastricht criteria to join the Euro zone in 2014. 42. As mentioned above, the authorities' recovery program is centered on maintaining Latvia's quasi-currency board at the current exchange rate parity. The exchange rate peg has been considered an anchor of macroeconomic stability for more than 15 years. It withstood the 1998 Russian crisis. When the recovery program was established, the merits of an alternative exchange rate regime were reviewed. The Government decided that, while an exchange rate adjustment might lead to a quicker correction of the real exchange rate, the associated risks and costs would outweigh any potential benefits: (i) undermining program ownership, (ii) balance sheet effects since a very high percentage of deposits and loans are denominated in foreign currency, (iii) an 20 insignificant reduction in external financing needs as external debt to GDP would increase sharply, and (iv) likely adverse repercussions on financial stability and spill over risks in the Baltic countries and South-Eastern Europe. 43. The GDP contraction is turning out to be much sharper than anticipated. The authorities expect output to drop by 18 percent in 2009 and a further 4 percent in 2010. Inflation is expected to fall sharply, to about 3 percent in 2009 with deflation in the following two years. The current account is projected to show a surplus of 4.5 percent of GDP in 2009. By contrast, the capital and financial account is expected to deteriorate to a deficit of 24.8 percent of GDP. B. FI A CIAL SECTOR REFORM 44. Following the takeover of Parex Bank, the Government has taken significant measures to ensure stability in the financial sector, including: (i) restoring immediate stability by resolving the troubled Parex Bank and recapitalizing the state- owned Mortgage and Land Bank, (ii) conducting a due diligence of the banking system, enhancing the monitoring of banks' liquidity and capital, and improving the framework for bank resolution, (iii) establishing a debt restructuring framework, and (iv) stepping up financial sector supervision and regulation. Restoring Stability at Parex Bank 45. Given its systemic nature, the authorities have addressed the immediate deteriorating conditions in Parex Bank through public intervention and the planned entry of EBRD as a minority shareholder: · When a run on Parex Bank started in November 2008, the BoL and the MoF provided lender of last resort liquidity to the bank and the FCMC imposed deposit withdrawal limits on Parex Bank depositors in Latvia and at its branches abroad. Individuals and enterprises with up to 10 employees have been prohibited from withdrawing more than LVL 35,000 (US$65,000) a month, enterprises with 250 employees have a higher limit of LVL 350,000 a month, and no limits exist on larger enterprises. Withdrawals are also prohibited for corporate clients if they are not for immediate operational activities. The authorities have committed to remove the partial freeze as conditions stabilize. · As these measures were insufficient to stop the run, emergency legislation was submitted to the Parliament permitting government intervention and full bank takeover. The Law on Bank Takeovers was adopted in December 2008. · On December 5th, the Government took over 85 percent of the shares from Parex Bank strategic investors at a nominal price, diluting the minority to about 15 percent. It appointed new professional management to run the bank. The new management has made progress in stabilizing the bank and preparing for its eventual resolution. Deposit outflows have slowed, albeit helped by continuing restrictions. 21 · A due diligence analysis, focused on the bank's asset quality, liquidity and solvency, was conducted by PricewaterhouseCoopers in early 2009, on the basis of which additional provisions were booked in the bank's 2008 financial statements. · The new management of Parex Bank, assisted by independent advisors, developed a resolution plan, consistent with minimizing losses to the state and depositors, considering various options. The plan was submitted to the FCMC in early 2009. · Dealing with Parex Bank's outstanding syndicated loans presented a key challenge, but negotiations with syndicated lenders were finalized in March 2009. Both loans (775 million) had been in technical default since November 2008. The agreement with the syndicated lenders sets out a repayment schedule of 30% in March 2009, 40% in February 2010, and 30% in May 2011. · On March 24, 2009, the Government decided to increase Parex Bank's capital by LVL 227 million. Following the EC's approval, in May, the Privatization Agency made an investment in Parex Bank's capital of about LVL 140.7 million and issued a subordinated loan in the amount of LVL 50 million, ensuring a CAR of about 11 percent. · The Government and EBRD signed an agreement on April 16, 2009 on EBRD's purchase of 25 percent plus 1 ordinary shares of Parex Bank for LVL 59.5 million (84.2 million) and a subordinated loan of 22 million. The subordinated loan has been extended in July 2009 and the equity transaction is expected to be completed in August 2009. · In the short term, the main remaining challenge is to progressively lift the deposit withdrawal limits in order to enable the bank to start operating normally again. In the longer term, the challenge will be to re-privatize the bank. Crisis resolution 46. The authorities have made substantial progress in managing the effects of the crisis on the banking system by taking the following measures: · Adopting operational guidelines for the provision of emergency liquidity assistance (ELA) by clarifying procedures for inter-agency coordination, cross- border arrangements, and the treatment of collateral. · Reviewing regulations on emergency liquidity support so that they are consistent with international practice and provide for adequate safeguards. · Recapitalizing the state-owned Mortgage and Land Bank in January. The Government has further agreed to refocus the bank on core activities crucial for 22 the economy (i.e. financing SMEs, business start-ups, infrastructure, and other national development projects) and to minimize commercial banking operations. · Requesting an independent auditor to carry out a focused examination of the banking system and assess whether all banks are solvent and have sufficient liquidity. The audits were conducted by independent auditor companies in March 2009 and found that the banks were well-capitalized under the current level of NPLs. · Enhancing monitoring of individual banks and improving supervisory coordination with the BoL and home supervisors of foreign banks. The FCMC introduced quarterly information on "problem" loans from Q3 2008, and daily liquidity reports. It has also increased the frequency of prudential reporting, and has had regular meetings with bank top management. FCMC has discussed, with external auditors, special audit and annual audit results for all banks and has requested external audits of interim financial statements for the first half of 2009. From March 2009, FCMC has required banks to submit internal audit results regularly and key domestic banks to submit weekly cash flow projections. 47. The authorities have also amended the legal framework for bank resolution to allow effective intervention in potentially troubled banks and restore confidence in the system. The Law on Bank Takeovers was adopted in December 2008. It sets the legal framework for bank takeovers by the state. The Amendments to the Deposit Guarantee Law of October 2008, February 2009 and June 2009 increase the amount of guaranteed compensation to one depositor up to EUR 50,000 and provide a clearer and faster compensation procedure. Amendments to the Credit Institutions Law and the Financial and Capital Market Commission Law were adopted in February 2009, which provided the FCMC with extensive and flexible powers to deal with troubled banks. The amendments provided the FCMC with the right to appoint an official administrator to take over the management of a credit institution and to undertake Purchase and Assumptions transactions on failed banks. A few weaknesses remain in the law that are being addressed through further amendments. 48. The authorities have made substantial progress in establishing a debt restructuring framework: · Amendments to the Insolvency Law to encourage out-of-court restructurings and improve the insolvency framework were approved by Parliament in June 2009 and became effective on July 1, 2009. These amendments allow for out-of- court debt renegotiations through a new out-of-court Legal Protection Proceedings (LPP) option. The amendments also streamlined the insolvency regime. Further amendments to the Insolvency Law are under preparation to further improve these processes. Several workshops were organized to raise awareness on these new frameworks amongst practitioners. 23 · Amendments to the Civil Procedure Code to improve the mortgage foreclosure process and help the rehabilitation of household debtors have been prepared by the MoJ. The process for foreclosing on a mortgaged property in Latvia is expensive and time-consuming. The auctions process is very lengthy, including 3 separate auctions that are 3 months apart. Foreclosure procedures were streamlined in March 2009. Additional amendments have been prepared shortening the auction notice period and reducing the number of auctions. 49. The Government has prepared, but put on hold, a state guarantee program for restructured loans. As small borrowers are afraid to engage in loan renegotiations with their banks, the Government has designed a guarantee program to relieve borrowers' debt service to a level commensurate with their payment capacity. However, taking into account the limited fiscal resources of the Government as well as other high social priorities in the country the program will be launched only if it is possible to allocate financial resources for its implementation. 50. The authorities have also taken measures to improve the supervision and regulation of the financial system. The FCMC has revised regulations on assets valuation and provisioning (effective as of April 2009), has stepped up supervisory guidance on banks internal capital adequacy assessment process and calculation of additional capital buffers above the minimum regulatory requirements (also effective from April 2009), is updating regulations on liquidity risk management to incorporate Basel guidelines and the recommendations of the Committee of European Banking Supervisors (CEBS), and is in the process of revising regulations on credit risk management. C. CO SULTATIO S 51. An extensive consensus building process has taken place on the program, culminating with the formal signing of the revised Letter of Intent to the IMF by all coalition parties. The underlying consultations have focused heavily on the fiscal, social and wage aspects of the Government's program. Following a social summit with the Prime Minister on June 8, 2009, the "social partners" (namely, the Latvian Employers Confederation, the Latvian Association of Free Trade Unions, the Latvian Association of Local and Regional Governments, and the Latvian Chamber of Commerce and Industry) endorsed the revised fiscal strategy for 2009. The same social partners were subsequently invited to join the Reform Management Group established to advise the Government on drafting the 2010 national budget and the budget perspectives for 2010- 12. In a separate development, the National Tripartite Co-operation Council (between Government, employers, and trade unions) has established a Committee to Promote Wage Restraint with a mandate to (i) monitor the implementation of measures to reduce and streamline nominal wages (and bonuses) in the public and private sectors, and (ii) issue recommendations to ensure that the deterioration in competitiveness is corrected and that compensation evolves in the future in line with the constraints imposed by the fixed exchange rate. Following a discussion with the full National Tripartite Co- 24 operation Council, the committee's initial recommendations have been recently presented to the Prime Minister and Parliament. IV. BA K SUPPORT TO THE GOVER ME T'S PROGRAM A. LI K TO THE COU TRY PART ERSHIP STRATEGY 52. Latvia joined the Bank in 1992. As a member, it received analytical and advisory support and loans totaling US$416 million for 19 operations that have supported Government's actions to implement structural reforms, improve public finance management, modernize the welfare system and the health, education, and infrastructure sectors, and reduce pollution in the Baltic Sea. 53. Latvia graduated from World Bank financing in 2007 and became a donor to the International Development Agency (IDA) of the World Bank Group during the 15th replenishment of IDA. The last Country Assistance Strategy (CAS) for 2002-2005 was launched during the period when Latvia's overriding objective was to prepare for accession to the European Union -- a goal which was achieved in 2004. The Government of Latvia requested the Bank to support priorities, which were not covered by the EU's acquis communautaire. As a result, the CAS focused on assisting Latvia's efforts to improve productivity growth, public sector reform, development outside the capital, and social sector reform. The six lending projects under this CAS closed with satisfactory outcomes. 54. Following graduation from the World Bank, Latvia made full use of the limited free technical assistance available to graduates, which expired at the end of fiscal year 2009. The Bank provided technical assistance to the Government of Latvia to help promote development in lagging rural regions, manage public finances strategically through medium-term budgeting, and develop a public-private partnership framework. At the request of the Ministry of Finance, a Public Expenditure Review was conducted jointly with the IMF in 2007. The recommendations from this review are informing the social sector reforms being undertaken by the Government today. 55. Latvia also entered into a technical cooperation agreement with the Bank, on a fee-for-service basis, in the area of climate change. Under this agreement, the Bank supported the Ministry of Environment's efforts to implement a pilot greening program financed by revenues from international emissions trading. 56. The global financial crisis led to an exceptional request by the Government of Latvia for renewed access to World Bank resources. The proposed operation is consistent with the Bank's Articles of Agreement. Pursuant to Article III, Section 4 (ii), the Bank may make loans if "[it] is satisfied that in the prevailing market conditions the borrower would be unable otherwise to obtain the loan under conditions which in the opinion of the Bank are reasonable for the borrower." In this case, the Bank is satisfied that, in the prevailing market conditions, Latvia would have been unable to 25 otherwise borrow under reasonable terms, as confirmed by the very high CDS rates for Latvia since the beginning of the crisis (although Latvia's CDS went down in recent months, it remains well above those in neighboring countries and well above its level before the crisis ­ Figure 2). The crisis has exposed underlying macro-vulnerabilities, and the deep economic contraction that followed left Latvia with significant borrowing needs and constrained access to external financing on reasonable terms. In response to international efforts to stabilize Latvia's economy, the Bank is proposing two development policy loans totaling 400 million in close coordination with the IMF and the EU. The DPLs are a part of the 7.5 billion package, which also includes contributions from the IMF, EU the Nordic countries, the Czech Republic, Poland and Estonia. Figure 2. Evolution of CDS rate, Dec. 2008 to Aug. 2009 Source: Bloomberg 57. The proposed two DPL operations underpin reform programs in the financial and social sectors. Building on the Bank's comparative advantage in financial crisis resolution and in financial and social sector structural reforms, the proposed financial sector DPL aims to build Latvia's capacity to (i) address financial sector challenges that arise in the context of the global crisis; (ii) accelerate mortgage- and corporate debt-restructuring; and (iii) strengthen the regulation and supervision of the financial sector. The social safety net DPL, which would be presented to the Board at the end of 2009, will support measures to (i) mitigate short social costs of fiscal consolidation; (ii) ensure fiscal consolidation creates an opportunity for reform that will improve long-term performance and outcomes in the social sectors and public administration; and (iii) protect vulnerable groups during the deep economic recession with emergency safety net support. The financial sector operation was prepared first in order to respond to the need for crisis containment in the financial sector. The social safety net operation and related technical assistance are timed to influence the provisions 26 for social safety net measures in the 2010 budget, due to be presented to the Latvian Parliament in late 2009. 58. During the 27-month stabilization program, continued policy dialogue is envisaged between the Bank and the Latvian authorities combined with technical assistance to support the implementation of ongoing structural reforms, particularly in the social sectors and public administration where there is continued interest in capacity- building. B. COLLABORATIO WITH THE IMF A D OTHER DO ORS 59. The Bank program supports and complements the international rescue package of the IMF, EC, EBRD, ordic countries, and other lenders. The rescue package amounts to 7.5 billion, of which the Bank would provide 400 million. The proposed operation would provide 200 million of this amount.6 The proposed Loan is a development policy loan with customized terms offered by the Bank in response to the exceptional tightening of financial market conditions resulting from the global financial crisis and economic recession. The IMF operation was approved on December 23, 2008 and the EC operation on January 20, 2009. The Bank team has collaborated very closely with the Fund team and discussed complementarities and mutually supportive measures. Table 6 lays out the measures supported by the WB and the IMF, and shows their complementarities. The EC has also coordinated its program in the financial sector with those of the Bank and the Fund. 60. The Bank's assistance is part of a joint International Financial Institutions (IFI) initiative, where the EBRD, the European Investment Bank (EIB), and the World Bank Group have pledged to support banking sectors in Central and Eastern Europe with up to 24.5 billion over a two year period. The World Bank Group committed to investing 7.5 billion (2 billion by the IFC in the banking and infrastructure sector and advisory services; 3.5 billion by IBRD to address banking sector issues, and 2 billion by MIGA). Thus far, the World Bank Group has approved 688 million, of which 500 million by MIGA for political risk insurance, and 188 million by IBRD for financial sector support. The IFC is focusing on equity and trade finance, for which demand is expected to pick up later in the year. 61. The operation includes crisis resolution measures and structural reforms aimed at strengthening the Government's ability to mitigate ongoing and future risks in the banking sector. The operation goes beyond immediate support for stabilizing the banking system and includes structural forward-looking supervisory and regulatory measures aimed at ensuring long term financial stability (see Annex 3). 6 The Social Safety Net and Public Administration Reform Development Policy Loan will contribute 200 million. 27 Table 6. Key aspects of World Bank and IMF support to the Government's program FI A CIAL SECTOR STABILITY A D CRISIS MA AGEME T Area World Bank IMF (initial LoI) Joint WB/IMF Crisis Resolution 1. Strengthen banking sector solvency and 2. Enhance LOLR facilities by: liquidity by: 1. Adopting operational guidelines 1. Completing stress tests of the banking clarifying procedures for provision of sector to assess its resilience to a emergency liquidity assistance (ELA) to potential worst case scenario. clarify procedures for inter-agency 2. Based on the results of the stress tests, coordination, cross-border arrangements, preparing a Strategic Contingency and the treatment of collateral Plan for the financial sector, requiring 2. Reviewing and, if necessary, revising banks to increase capital buffers and regulations on emergency liquidity prepare robust liquidity contingency support with the aim of ensuring they plans. are: (i) consistent with international practice, and (ii) provide for adequate safeguards · Complete a focused examination of the banking system by international audit firms, to ensure that banks are solvent and have sufficient liquidity. Bank Resolution · Amend the Credit Institution Law to align · Amend to banking laws to give FCMC, BoL · Amend the Credit Institutions Law to enable Framework the legal framework for bank resolution, inter and the Government powers to restore financial swift bank resolutions if necessary. alia as per The IMF-World Bank Global stability in case of systemic crises and enhance Bank Insolvency Initiative principles the special bank insolvency regime Distressed Asset · Amend Civil Procedure Law to simplify the · Develop a comprehensive private debt · Amend the Insolvency Law to (i) remove Management mortgage foreclosure process. restructuring strategy potential obstacles to out-of-court proceedings for corporate restructuring; (ii) · Promote proper debt restructuring through: allowi pre-packaged restructuring (i) Preparing guidelines for both mortgage agreements; and (iii) introduce further 28 and corporate debt restructuring, addressing, flexibility and easier access to insolvency inter alia, rules of engagement for all parties, proceedings changes in legal framework, and elements of proper restructuring. Supervisory and 3. Take measures to strengthen financial sector Regulatory Framework supervision and regulation by: 1. Establishing an improved stress testing framework based on multiple scenarios and a revised credit risks module, to be operated on a regular basis 2. Introducing a Prompt Remedial Action Framework (PRAF) at FCMC that establishes a matrix of triggers and a range of discretionary and non- discretionary supervisory actions. 3. Strengthening the prudential regulations for banks, for asset quality, capital adequacy, liquidity risk management, and credit risk management 4. Undertake a comprehensive review of consumer protection laws, regulations, and institutional set-up for the financial sector, in line with international good principles, and prepare an action plan for improvements. 29 C. RELATIO SHIP TO OTHER BA K OPERATIO S 62. This loan is not directly related to any recent Bank operation, but earlier operations supported development of Latvia's financial sector. The Enterprise and Financial Sector Restructuring Investment Project (approved in 1994) aimed at supporting the Government's reforms in the enterprise and financial sector, focusing on enterprise privatization & bank restructuring; the Financial Sector Technical Assistance Project (approved in 2001) provided technical assistance for the development of the financial sector; and the Financial Sector Assessment Program (FSAP) Follow-up TA (approved in 2003) aimed at developing the capital market. 63. There has also been considerable analytic work on the financial system, including an FSAP in 2001 that assessed the financial sector's strengths, weaknesses, and vulnerabilities to macroeconomic shocks, the observance of international standards and codes on the regulation and supervision of banking, payment systems, insurance, and securities. The FSAP was updated in 2007, assessing financial sector developments and progress since the 2001 FSAP, regulatory and supervisory responses to rapid credit growth, arrangements for home-host supervisory coordination and crisis management, contingency planning, as well as insolvency and creditor rights. D. A ALYTICAL U DERPI I GS 64. The FSAP update of 2007 provided a strong analytical underpinning for this operation and the authorities' crisis response preparedness. The FSAP Update of 2007 assessed the overall financial system stability and vulnerabilities, worked with the authorities to improve stress-testing, reviewed contingency planning, assessed home-host supervisory coordination, the insolvency system, and evaluated the supervisory procedures for validation of banks' internal rating-based models. The report also focused on emerging issues including those related to the fast pace of credit growth. The main issues in the financial sector identified in the FSAP update remain relevant for this operation: improving the contingency framework, strengthening the legal framework for insolvency proceedings, creating a favorable environment for out-of-court restructurings, enhancing the stress-testing framework, improving bank supervision to mitigate systemic risks, and increasing home-host coordination. E. LESSO S LEAR ED Lessons from previous Bank involvement in Latvia 65. The Bank has played an important role in supporting Latvia's transition through lending, policy dialogue, and analytical and advisory assistance since 1992. The Bank's partnership with Latvia has advanced structural reforms in a number of areas, including in public administration, the social and health sectors, privatization, and the regulatory systems for the banking sector and utilities. Many of these reforms were carried out under the Programmatic Structural Adjustment Loan and helped the country deal with the aftermath of the Russian financial crisis of 1998. 30 66. The capacity to design and implement coherent policies, programs and projects has been a central factor in the success or failure of previous operations. The Bank and the EU, during the pre-accession program, have contributed to substantially enhancing administrative capacity in various areas targeted by the reforms. However, in general, the capacity of the public sector to prioritize, plan and implement policies in an effective and efficient manner remains limited. Therefore, technical assistance may be needed for both design and implementation of complex structural reforms. 67. Government ownership of the reforms has also been crucial for the successful implementation of reforms. The proposed reforms need to support the Government's agenda and priorities and an extensive dialogue with the Government is necessary to ensure acceptance and ownership of the reforms. In addition, strong leadership from the center of the Government, i.e. the Cabinet of the Prime Minister, has been important, especially for politically sensitive reforms. In addition, the operation should support the understanding of, and the appropriate popular support for the reforms through a carefully planned and implemented communication strategy by the Government. 68. Flexibility has been also an important factor in the success of the previous operations. The policy reform agenda needs to be realistic in terms of content and timing, avoiding overambitious goals to be accomplished in a short time. Risks, including political risks, need to be carefully weighed in the preparation of the operation. Lessons from previous macro-financial crises 69. Lessons from previous macro-financial crises have been incorporated in the loan design. IEG recently conducted a comprehensive review into its responses to earlier financial crises.7 Notably, the largest Bank crisis-response programs for South Korea, Argentina, Turkey, Thailand, Indonesia and Russia have been reviewed and critically assessed. Based on the report and other IEG assessments and discussions in a rapidly changing global context, IEG suggests considering the following points in helping countries to deal with the crisis: · The main generic lesson from the Bank's responses to previous crises relates to the importance of an early response. The fiscal cost of interventions can be quite large, but the cost of inaction can be even larger. The proposed Bank operation comes at a time when the Latvian banking system is undercapitalized but still has enough capital and potential for new capital increases as to sustain operations in the short-term. The value of preparedness is also taken into account in the design, including through the preparation of an ex ante contingency plan for the banking sector. · The speed and focus of the Bank's response are both crucial for good outcomes during and after crises. Past crisis support was much more successful when it was nested in a results framework (explicit or implicit) that incorporated selective coverage, and focused on the Bank's comparative strengths. The proposed operation incorporates 7 "Lessons from Past Financial Crisis", Independent Evaluation Group, The World Bank, 2009. 31 this lesson by focusing on policy actions that address directly the immediate needs of stabilizing the financial sector. · The quality of the intervention is crucial. The content of the reform program is essential. By supporting a comprehensive reform of the financial sector, including short term crisis management and long term structural reforms, the proposed operation addresses all key vulnerabilities. · Coordination among key partners, particularly with the IMF, is critical, as differences of views surface quickly during crises and are potentially damaging to achieve better results. Collaboration across the World Bank also strengthens program effectiveness. The proposed DPL incorporates fully this lesson; the Bank operation has been designed with the IMF and other key donors active in the sector, and the team includes experts from various departments across the Bank. · The adequacy of resources is essential, including through efforts to leverage with partners. This loan is part of a large coordinated international rescue package representing about 35 percent of GDP and leveraging resources from various IFIs and bilateral donors. · During past financial crises, poverty issues did not get sufficient attention. It is crucial to factor in the implications for social safety nets from the beginning of the crisis, rather than later. In addition, previous crises have shown the importance of focusing on public expenditure issues or integrating social safety net programs from the early stages of any effort. This is being done through the complementary IMF program and the Social Safety Net and Public Administration Reform Development Policy Loan. V. THE PROPOSED OPERATIO A. OBJECTIVE A D RATIO ALE 70. The objective of the proposed operation is to support the Government's reforms in the financial sector to build a sound financial system able to absorb the effects of the crisis and the contraction of economic activity and to resist potential future shocks. The operation will restore and contribute to maintaining financial stability. This will help minimize the impact of the financial crisis and contribute to economic recovery and growth. It falls within the objectives of the Joint IFI Initiative to support banking sectors in Central and Eastern Europe affected by the crisis. 71. The proposed operation will contribute to the international financial support package, led by the IMF and the EC. The direct financial contribution of the operation is modest: 200 million in an overall package of 7.5 billion. However, the overall contribution of the operation is significant as it strongly complements and reinforces the IMF measures (see Table 6). The operation supports measures designed to assist the authorities in managing the 32 current crisis and stabilizing the banking system, and in putting in place adequate frameworks to ensure a sound financial system in the future. 72. The severe negative impact of the crisis on Latvia's banking sector and real economy provides a strong rationale for the operation. Latvia is one of the countries most affected by the financial crisis in Central and Eastern Europe (CEE). While Latvia graduated from IBRD in April 2007, the Government continued an ongoing program of analytical and technical assistance work with the Bank, and requested Bank support when the crisis curtailed the country's access to external finance. The operation is consistent with the Bank's mandate in its Articles of Agreement to provide funding to members when they are not able to access funding in the market under reasonable terms. By supporting the restoration of financial stability in Latvia, the operation contributes to reducing the risk of contagion effects to other CEE countries and the risk of further severe economic and social costs in Latvia. In addition, the experience gained by Bank staff in dealing with the crisis in Latvia can be usefully applied to other countries in the region. B. OPERATIO DESCRIPTIO A D POLICY AREAS 73. The proposed operation supports the Government's reforms in the financial sector designed to address immediate problems in the banking sector and ensure longer term financial stability. Building upon and complementing the measures agreed with the IMF and the EC, the operation proposes crisis resolution and structural reforms in the financial sector aimed at: (i) identifying vulnerabilities in the banking sector and request additional capital and liquidity contingency plans as and where appropriate, (ii) strengthening the capacity of the authorities to address potential problems that may arise in the financial sector in the context of the current financial crisis, (iii) accelerating mortgage and corporate debt restructuring in light of rapidly increasing defaults, (iv) strengthening the regulation and supervision of the financial system, and (v) strengthening consumer protection in the financial sector. The prior actions supported by this operation are described in detail below and are summarized in the Policy Actions matrix in Annex 2. Crisis Resolution Capital Adequacy Strengthening 74. To strengthen the health of the banking sector, the authorities have taken the following measures: · The BoL completed stress tests of the banking sector to assess its resilience to a potential worst case scenario (Prior Action 1). The BoL, with inputs from the FCMC on provision rates for Past Due Loans (PDLs), conducts stress tests of the banking sector on a quarterly basis. In view of the current deteriorating conditions in the economy and the banking sector, the BoL and the FCMC agreed with the Bank to conduct joint stress tests with March 2009 banking sector data using a baseline scenario and two severe macro and financial sector scenarios, acceptable to the Bank and the IMF. The results of the stress tests have highlighted the impact of such potential severe stress events on the banks' capital adequacy and liquidity ratios and have provided the 33 authorities with a better understanding of where potential problems could arise in the banking sector. · The FCMC required, on the basis of the stress tests, banks in need of enhanced capital buffers to prepare a capital strengthening plan by end July. As a result, four banks have completed capital increases, and another four are in the process of increasing capital. In addition, banks that could face liquidity problems have to present the FCMC with robust liquidity contingency plans. · The Borrower prepared, on the basis of the stress tests, a Strategic Contingency Plan for the banking sector (Prior Action 2). If the situation in the Latvian banking sector continues to deteriorate, it is critical that the authorities are prepared to intervene in a timely manner to maintain stability. The Strategic Contingency Plan includes a typology of potential actions and interventions by the FCMC in response to potential liquidity or solvency problems in the banking sector, a strategy for the resolution of potentially illiquid or insolvent banks according to their systemic importance and other relevant parameters; and clear responsibilities for the implementation of, and the communication about such strategy. The plan also addresses the case of a systemic crisis. Bank Resolution Framework 75. The Borrower's Parliament has approved amendments to the Credit Institution Law with a view to strengthen the legal framework for bank resolution to enable swift bank resolution if necessary (Prior Action 3). On the basis of an assessment of the alignment of the Credit Institution Law with international best practices for bank resolution, inter alia as per the IMF-World Bank Global Insolvency Initiative principles, the legal framework for bank resolution has been significantly strengthened. This was done in February 2009 when the Borrower's Parliament approved amendments to the Credit Institution Law, which enables the authorities to implement a wide variety of strategies to solve potential problems in the banking sector. A few weaknesses, which remain in the Law, are being addressed through further amendments. Distressed Asset Management 76. In view of the deteriorating credit quality, the authorities have strengthened the debt restructuring framework. It is critical that proper mortgage and corporate debt restructurings begin as quickly as possible, inter alia, to strengthen the banks' balance sheets, reduce uncertainty for debtors, allow economic and financial activity to resume, and avoid residential foreclosure wherever possible. The authorities have undertaken measures to: (i) enhance the corporate rehabilitation and insolvency legal framework, (ii) improve the mortgage foreclosure process, and (iii) prepare guidelines for corporate and mortgage debt restructurings as well as hold debt restructuring seminars to raise awareness amongst all parties of proper elements of debt restructurings. 34 · The Borrower has enhanced the corporate rehabilitation and insolvency legal framework (Prior Action 4). The insolvency framework was amended in July 2009 when the Borrower's Parliament approved amendments to introduce an expedited corporate restructuring proceeding (the LPP). The Borrower's parliament has approved amendments to the Insolvency Law with a view to: (i) removing potential obstacles to out-of-court proceedings for corporate restructuring; (ii) allowing pre- packaged restructuring agreements; and (iii) introducing further flexibility and easier access to insolvency proceedings. A series of subsequent amendments are under preparation to: (i) introducing further flexibility to the LPP plan and eliminating the settlement and recovery procedures; (ii) make access to insolvency proceedings easier; (iii) achieve efficiency in the liquidation of assets in bankruptcy cases; (iv) increase the insolvency administrators' efficiency; (v) streamline the liquidation procedure; and (vi) solve other issues such as the taxation treatment of debt forgiveness, voting rights of secured creditors, and the liability of directors and officers where insolvency proceedings are not timely petitioned. · The Borrower's Parliament has approved amendments to the Civil Procedures Law to simplify the mortgage foreclosure process (Prior Action 5). The foreclosure process ­ to be used as last resort solution only ­ has been simplified. Further measures will include: (i) a reduction in the number of auctions from 3 to 2, (ii) a shortening of the auctions notice period, and (iii) the ability to use a bank guarantee when bidding for a property rather than have necessary cash. · The Borrower has implemented a debt restructuring program (Prior Action 6) entailing the publication of guidelines for corporate and mortgage debt restructuring, addressing, inter alia, rules of engagement for all parties, elements of proper restructuring, and debt restructuring options. The authorities have committed to organize a debt restructuring seminar in early November 2009 to raise awareness of proper restructurings and of the new legal framework amongst all parties. Structural Reforms The Supervisory and Regulatory Framework 77. In addition to crisis resolution measures, the Borrower has implemented structural reforms to strengthen the supervision and regulation of the financial system: · The BoL has adopted an improved stress testing framework based on multiple scenarios and a revised credit risks module, to be operated on a regular basis (Prior Action 7). The authorities have enhanced the stress testing framework to identify bank- level and system-level vulnerabilities under various macro-economic scenarios. In addition, the credit risk module has been revised to be aligned with the revised asset quality regulation of the FCMC. 35 · The FCMC has adopted a prompt remedial action framework (PRAF) that sets a matrix of triggers and a range of discretionary and non-discretionary supervisory actions (Prior Action 8). The FCMC has prepared a PRAF that establishes an appropriate range of supervisory actions for use when a bank has not complied with laws, regulations, or supervisory decisions. The PRAF provides clear prudential objectives and actions to be taken when a bank breaches prudential requirements reflecting an adverse change in the financial position of the bank. · The FCMC has issued strengthened prudential regulations on asset quality and capital adequacy, and committed to issue strengthened regulations on liquidity risk and credit risk management (Prior Action 9). The FCMC has revised its guidelines on asset quality and capital adequacy. In addition, FCMC has prepared a draft liquidity risk management regulation, which is to be revised on the basis of CEBS recommendations and EC directives, and the FCMC has included the issuance of regulations on credit risk management in its action plan for 2009. · The Borrower has completed a comprehensive review of consumer protection laws, regulations, and institutional set-up for the financial sector, in line with international good practices (Prior Action 10). Rapidly expanding credit in recent years, combined with a lack of financial literacy, has resulted in significant consumer protection issues. A thorough review of these issues has been completed by the Borrower, through the Consumer Rights Protection Center, in collaboration with the Bank. A workshop was held with key stakeholders to discuss the main recommendations of the review relating to: (1) consumer disclosure, (2) business practices of financial institutions, (3) dispute resolution mechanisms, and (4) financial education. 78. The proposed operation has applied good practice principles for conditionalities, as described in Annex 5. C. EXPECTED OUTCOMES OF THE OPERATIO 79. The main outcome of the operation will be to help restore financial stability and improve the resilience and functioning of the financial sector. The measures proposed by this operation will contribute to: (i) enhancing the banks' capacity to absorb the impact of the ongoing economic recession by strengthening their capital buffers (this should enable banks to adequately provision NPLs while maintaining an adequate CAR); (ii) increasing the capacity of the authorities to monitor the banking sector and efficiently handle potentially troubled banks; (iii) increasing confidence in the banking sector (this should help stabilize deposits and non deposit external funding sources, and contribute to decreasing the credit default swap rate for Latvia); (iv) improving the frameworks for corporate rehabilitations, insolvencies, and mortgage foreclosures (this should lead to a higher number of successful corporate rehabilitations and increased mortgage debt renegotiations); and (v) improving consumer protection in the financial sector. Table 7 outlines the main objectives, outcomes, and outcome indicators of the proposed operation. 36 Table 7. Objectives, Expected Outcomes, and Outcome Indicators Objectives Key Expected Outcomes Outcome Indicators Conduct stress tests and · Enhanced understanding of · Adequate provisioning of NPLs strengthen capital potential liquidity and solvency (target: provisions to fully meet adequacy gaps in the banking sector regulatory requirements) · Building of strengthened capital · Well-capitalized banks (target: buffers and contingency average CAR of banking system liquidity plans in all banks to remain above 10%) · Increased confidence in · Stabilization of resident and banking sector leading to nonresident deposits (baseline: - stabilization in deposits and in 4% deposit growth from Dec. 08 lending volumes. to May 09; target: 0% monthly growth achieved by end 09)8 Strengthen the bank · Increased capacity of the · Adequate handling of potential resolution framework supervisor/regulator to handle bank distress by the authorities distressed banks Establish an efficient · Facilitated corporate · Increased number of corporate debt restructuring rehabilitation and debt rehabilitations initiated -base line: framework restructuring 22 cases between January 2008 · Faster insolvency framework and June 2009; target 30 cases by · Faster mortgage foreclosure end 2009 process · Increased number of mortgage debt restructuring-base line: 14% of mortgages restructured by June 2009; target: 20% by end 2009 Strengthen financial · Enhanced stress testing · Early identification of bank-level supervision and framework and system-level vulnerabilities regulation · Establishment of an early · Early remedial actions taken to remedial action framework address vulnerabilities · Strengthened prudential regulations Strengthen consumer · Improved consumer protection · Action plan established by CPCR protection framework in the financial to implement recommendations of sector consumer protection review Overall program · Increased confidence by · 10% decrease in spread on credit investors in Latvian financial default swaps and of the emerging sector market bond index (EMBI) reported spread for Latvia / compared to Dec. 2008 levels 8 8 These indicators are influenced by other factors, such as the general economic conditions in the region. 37 D. CO SULTATIO S O THE OPERATIO 80. The design of the program has benefited from consultations with relevant stakeholders (as required by OP 8.60). As mentioned above, the Government's overall program has benefited from wide consultations culminating in the formal signing of the revised Letter of Intent to the IMF by all coalition parties. The Government's financial sector reforms, including those supported by this operation have also benefited from wide consultations. In particular, the Latvian and foreign bankers associations, financial sector regulators and donors engaged in the sector have been consulted at key junctures on the design of the program. In addition, intensive discussions took place with the Latvian banking association on all key aspects of the program, leading to their wide acceptance of the financial sector reform program and their specific endorsement of the guidelines for corporate and debt restructuring. Consultations were also held with the newly created Latvian Borrowers' Association. The authorities have also met with banking sector representatives to discuss reform options and priorities for the banks. Bank staff has also consulted with stakeholders, including banking sector representatives, borrower's representatives, and representatives of the key foreign investors in Latvia's financial sector. Open and consistent communication of the program's objectives and structure remain important going forward. VI. OPERATIO IMPLEME TATIO A. POVERTY A D SOCIAL IMPACTS Poverty and social impact of the proposed operation 81. The measures supported by this operation are expected to have positive social and poverty impacts. The deteriorating conditions in the economy and the banking sector are likely to further strain businesses, increase unemployment, and increase poverty in the country. However, this operation mitigates some of the negative effects of the crisis on poverty as it aims to: (i) increase the capacity of the financial authorities to anticipate risks in the banking sector and avoid a systemic crisis that could be very costly to depositors; (ii) enhance the capacity of the financial authorities to deal with distressed banks and thus help preserve taxpayers' money; (iii) encourage viable corporate rehabilitations that would otherwise be pushed to bankruptcy, thereby contributing to preserving employment and the economic fabric; (iv) help household debtors renegotiate their debts with the banks, avoiding foreclosures wherever possible, and (v) facilitate a resumption in lending. In addition, the implementation of the recommendations of the consumer protection review will improve the laws and regulations to protect consumers of financial services as well as their means of complaints. Poverty and social impact of the government program 82. Simulations show that Latvia will experience a sharp rise in poverty, widening of the poverty gap, and a rise in income inequality. Analysis of the distributional impact of the economic crisis on households in Latvia was based on household survey data (Latvian EU- SILC 2006 database) and focused on the impact of the growth slowdown through labor 38 markets.9 Assuming 18 percent contraction in GDP (affecting mainly trade, hotels and restaurants, construction and manufacturing) and 11.2 percent contraction of employment (concentrated in the same sectors) the percentage of people in poverty will increase from 14.4 to 20.2.10 The poverty gap, which measures the poverty deficit of the entire population, will increase from 5.9 to 8.3 percent.11 Finally, income inequality will increase, with the Gini coefficient increasing from 39.3 to 41.3 percent. It should be noted that these simulations do not include the countervailing measures implemented by the Government to specifically address the impact on poverty. 83. There are substantial differences in how the impact of the crisis is felt across regions and specific population groups. The largest increase in poverty is observed in the poor region of Latgale where the majority of employed people are likely to have been working in precarious, low wage jobs. The impact of the crisis is also felt more sharply in households where a man is the primary income earner, which to a large extent is explained by the contraction in the male-dominated construction sector. Households in which economically active members have few skills (education levels of high school or less) suffer relatively more. Finally, households with children also suffer a greater impact. 84. The IMF and the Bank have worked with the Government to mitigate these impacts. With regards to the likely impact of the fiscal consolidation measures included in the Government's program, the IMF and the Bank teams have assisted the Government to focus the cuts on reducing excesses and inefficiencies and to improve the quality of spending. In addition, the increased emphasis and resources devoted to safety nets will mitigate some of these impacts. 85. The Bank's package of lending will include implementation of the Government's cross sector Emergency Safety et Strategy, supported through a parallel social safety net DPL (expected in December). As structural reforms are implemented, the Government is also committed to alleviating the social costs of fiscal adjustment, and to ensuring an adequate level of social service provision is maintained across the country. Moreover, in the context of the current economic contraction and high levels of unemployment, this commitment extends to strengthening the safety net to respond to the immediate needs of vulnerable households. With technical input from the World Bank, the Government has developed and will implement an Emergency Safety Net Strategy to finance essential services and benefits delivered by national agencies, and locally by municipal governments. The strategy aims to ensure that the Government is responding across the social sectors in a coordinated way, and providing additional resources to municipal governments who are at the "front line" of responding to increased household vulnerability in the wake of 9 The impacts quantified are direct short-run impacts, and hence they do not take into account the general equilibrium effects. 10 A household is in poverty if its total household income is below LVL 90 per capita, or approximately US$ 6 per person per day. In Latvia, this line is known as the "needy" line. 11 The poverty gap ratio is the sum of the income gap ratios for the population below the poverty line (z), divided by the total population (n). It can be expressed as follows: 39 the economic contraction. An Emergency Social Safety Net strategy is almost complete and ready to be presented to the Cabinet as part of the 2010 budget process. The Government's response to the social cost of the contraction is already well underway. With the World Bank's technical input, the Government has already taken measures to ensure a timely response, including extension of unemployment insurance (passed in March 2009), allocation of support from the European Social Fund to an expansion of public employment programs, and improving the targeting of social assistance. 86. The Emergency Safety et Strategy underpins fiscal consolidation and structural reforms by deploying supplementary support to ensure basic social services are maintained. The strategy will coordinate the efforts of national and local government agencies to maintain: support for schooling for 5 and 6 year olds; the costs of transporting students from communities where schools have closed to their new places of instruction; the costs of maintaining financial support to subsidize the health service co-payments of needy households; adequate financing from the Health Insurance Fund to sustain and improve general practitioner and primary health care services and access; and increased financing for the targeted social assistance benefits and services that municipalities are mandated to provide to eligible groups, while increasing the income level qualifying for assistance so that it reaches a higher percentage of poor households. Furthermore, given the extent and likely duration of economic contraction and resulting levels of unemployment, the Government will extend the coverage of unemployment insurance. For the growing number of unemployed who are not covered by unemployment insurance or other social support, the Government will fortify the Emergency Safety Net by re-allocating financing from the European Social Fund to expand and rapidly deploy labor-intensive public works/emergency employment programs, to implement pre-existing local development projects. B. E VIRO ME TAL ASPECTS 87. The policies supported by the operation are not likely to cause significant effects on the country's environment and natural resources. Latvia has adequate environmental controls in place. Its environmental legislation is reinforced by EU environmental directives. Prior to EU accession, Latvia made significant progress in transposing EU legislation with regards to the adoption of environmental impact assessments, water quality, waste management, industrial pollution control and risk management, air quality, nature protection, etc. None of the policy areas described in the operation is expected to have any significant link to the environment.12 C. IMPLEME TATIO , MO ITORI G, A D EVALUATIO 88. The implementation of this operation will require close coordination with the institutions responsible for implementation, including the Ministry of Finance, the Bank of Latvia, the Financial and Capital Market Commission, the Ministry of Justice, and the Ministry of Economy. 12 EU website: http://europa.eu/scadplus/leg/en/lvb/e15104.htm. 40 89. The implementation of the policy actions set forth in the policy matrix (Annex 2) has required technical discussions amongst the Bank and the implementing institutions. Throughout the operation, the Bank has provided technical assistance to the authorities, including to: (i) review the credit institution law and assess the adequacy of the bank resolution framework, (ii) prepare a Strategic Contingency Plan for the banking sector, (iii) prepare corporate and mortgage restructuring guidelines, (iv) prepare a seminar to raise awareness about proper elements of loan restructuring, (v) review the Insolvency Law, and (vi) design a Prompt Remedial Action Framework. Latvia has decided to take advantage of the Bank-FIAS insolvency TA program to assist it with the corporate debt restructuring framework. The Bank is likely to also provide TA in public administration reforms. 90. Specific indicators are being used to monitor the implementation of the operation. At the banking sector level, the agreed policy reforms are expected to lead to an overall healthier banking sector. Thus, several indicators are being used to monitor progress in achieving the desired program outcomes. The Bank, in collaboration with the Latvian financial authorities, is monitoring, among other, the following: · evolution of resident and nonresident deposits and of non-deposit funding sources · evolution of NPLs and provisioning levels · capital adequacy levels · percentages of loans that are restructured · number of effective corporate restructuring · number of foreclosure processes. These indicators will serve to evaluate the impact of the policy changes supported by the proposed operation. Other overall indicators will be monitored as well, such as the spreads on credit default swaps, as well as the EMBI spreads. These monitoring indicators will serve as useful market benchmarks to determine if the market is confident that the program is generating the desired outcomes. D. FIDUCIARY ASPECTS Public Financial Management System and Budgetary Resources 91. The Latvian Public Financial Management (PFM) system is supported by an established legal and institutional framework. In recent years, Latvia has introduced a series of PFM reforms and enhancements.13 The most significant reforms were the phased introduction of a performance based budgeting, the introduction of a medium term framework, the capacity building of the State Audit Office, and the implementation of the web-based IT system supporting budget planning and execution. These reforms have resulted in a stronger PFM system characterized by a centralized cash management within a single treasury account structure, a web-based on line reporting system updated twice per month, timely preparation and audit of government financial statements and a strong audit capacity of the State Audit 13 The most recent World Bank diagnostic work that focused on selected sectors within the Public Expenditure Review was conducted in 2007. 41 Office supported by private sector sworn auditors involved in auditing of the BoL and local governments. 92. As a result, the fiduciary risk associated with this operation is low, although further PFM improvements are needed, including to address the following issues: exposure of the budgetary framework to the economic downturn due to lack of clear procedures on budget cuts, insufficient implementation of medium-term planning and performance budgeting (in practice performance indicators focus on outputs rather than outcomes, budget execution is still monitored on the basis of budget appropriations, there is tendency to use incremental budgeting), inadequate budgetary expenditures monitoring and enforcement especially at the local government level, deficiencies in accounting at the ministerial and local government level resulting in negative audit opinions, fragmentation of the budget into base and special (earmarked for special purposes), insufficient accountability framework of the sector ministries related to the overall performance of the sector (including quality of the delivery of services by local governments). Foreign Exchange Environment 93. The BoL is a member of the European System of Central Banks, and its legal independence is granted by the Law on the Bank of Latvia. The main objective of the Bank of Latvia is to maintain price stability and the primary tasks include management of foreign currency and gold reserves. The BoL acts also as advisor to the Parliament and the Government with regard to the monetary policy, which follows the ECB practice. The BoL does not engage in any commercial activity, and its operation related to the execution of its tasks is mainly financed from income on foreign currency and gold reserves management. The Parliament has supervisory role over the BoL. 94. A recent Safeguards Assessment of the BoL concluded that the BoL has a relatively strong safeguards framework in place. A Safeguards Assessment of the BoL was conducted in October 2001 and an update assessment was concluded on July 8, 2009. The update assessment confirmed that the BoL has a relatively strong safeguards framework in place. The BoL financial management and operations are transparently disclosed and presented on its website. The BoL annual financial statements are regularly audited jointly by the State Audit Office and reputable independent auditors and the most recent audit reports, for 2006-2008 have unqualified audit opinions. E. DISBURSEME T ARRA GEME TS 95. The proposed loan will follow the World Bank's disbursement procedures for development policy lending. Loan proceeds will be disbursed in one tranche to the foreign currency account at the BoL. Disbursement will be made upon meeting tranche conditionalities, declaration of loan effectiveness and submission of a withdrawal application to the IBRD. At the request of the MoF, the IBRD will deposit the proceeds of the loan into the designated account at the BoL, which forms part of the country's official foreign exchange reserves. The Borrower shall ensure that upon the deposit of the Loan into said account, an 42 equivalent amount is credited in local currency14 to the Single Treasury Account also kept in the BoL and that is available to finance budgeted expenditures. Disbursements will not be linked to specific purchases, thus no procurement requirements will be necessary. The Government shall maintain accounts and records with respect to the deposit of loan proceeds at the BoL. If the loan proceeds are used for ineligible purposes as defined in the loan agreement, IBRD will require the borrower to refund the amount directly to IBRD. Amounts refunded to the Bank upon such request shall be cancelled. 96. o additional fiduciary arrangements will be required. The Bank will not require an audit of the designated account, but will require the Government to provide a confirmation to the Bank in the form of an official letter from the Ministry of Finance on the amounts deposited in the foreign currency account and credited to the budget management system (Single Treasury Account) within 30 days of receiving the funds. F. RISKS A D RISK MITIGATIO 97. This operation involves high risks but supports already implemented reforms that are crucial to the success of the Government's program. Risk of financial instability 98. A key risk to the proposed operation is that of further banking sector problems. With a contraction of real GDP for 2009 of 18 percent, and another year of negative growth forecasted for 2010, banks in Latvia are expected to suffer from very high levels of NPLS over the medium term. Higher unemployment and falling real wages create pressure on households and the corporate sector, especially small firms. This in turn creates repayment problems on mortgages and corporate loans. While banks are in the process of bringing in new capital, it cannot be excluded that some may face solvency problems. In addition, with highly volatile deposits, and no access to market funding, liquidity problems cannot be excluded. 99. This risk is mitigated by the operation's proposed policy reforms. The program includes reforms in crisis management, bank resolution, debt restructuring, and supervision and regulation strengthening. This should enable banks and the corporate sector to handle better future potential problems should the economic situation deteriorate. In addition, the authorities have completed stress tests, which have increased their awareness of where problems in the banking sector might arise. This in turn enables them to intensify their supervision of specific institutions as needed. In addition, banks have been required to bring in additional capital and prepare liquidity contingency plans. Finally, a Strategic Contingency Plan is in preparation including a detailed strategy for banks that may pose a threat to financial stability. Macroeconomic risk 100. There is a risk that the Government's macroeconomic strategy is not sustainable. The Government is undertaking a very ambitious economic adjustment program based on a macroeconomic strategy that includes severe fiscal consolidation measures and 14 The Bank can also agree that the proceeds of the loan will remain in loan currency (EUR). 43 wage cuts under the fixed exchange rate regime, in spite of which a substantial rise in the public debt-to-GDP ratio is expected. The severity of these measures increases the difficulty of implementing the Government's program. In addition, there is a risk of more prolonged need for extraordinary official financing support resulting from potential fiscal financing constraints, and the need for further measures to limit the deficit so as not to exceed Latvia's financing sources and setting debt on an unsustainable path. In the worst case, if the contraction proves deeper or the authorities prove unable to deliver on the fiscal adjustment, the resulting high deficits would raise risks to debt sustainability and capacity to repay donors. Also, the much higher government deficits will make it harder to meet the Maastricht criteria and may delay the program's exit strategy of euro adoption. Deflation may be even deeper than currently projected, which could also jeopardize Euro adoption. Other things equal, more rapid deflation will result in a greater competitiveness improvement, and better prospects for sustainable growth. However, in the absence of precedents it is unclear how the European institutions will judge continued deflation in the context of requirements for price stability, creating further uncertainty for euro adoption. 101. The IMF program framework, reinforced by continued international support, particularly from the EU, seeks to mitigate these risks. The risk is also mitigated by the size of the multilateral financial package, equivalent to 35 percent of GDP, in support of the Government's program - although this will add substantially to Latvia's indebtedness. In addition, the support of Latvia's international partners, particularly the EU, represents a key safeguard to the IMF program. The EU's commitment of 3.1 billion under the international support package has provided important space for implementation of the programmed reforms. In a July 27 press statement announcing their disbursement of 1.2 billion, the EU affirmed that it will continue to work closely with the Latvian authorities and the IMF to ensure Latvia implements successfully its economic reform program and its timely repayment of, all loans associated with the international program to support Latvia. Thus, while the risks are significant, continued current account surpluses, Latvia's strong commitment to the program, expected improvements in global financing conditions, and EU support provide key safeguards. Political risk 102. The viability of the program may be undermined if the political consensus on the structural reforms weakens. A centre-right coalition government led by Prime Minister Valdis Dombrovskis was formed in March 2009. Parliamentary elections are due in October 2010. However, the severe and politically risky adjustment measures may alienate the electorate and lead to early elections. This could exacerbate an already complex environment for sustained and in-depth reforms. All five governing coalition parties supported the passage of the revised 2009 budget. However, tensions over spending cuts are rising among the political parties, which affect the previously broad political consensus supporting the program. The resignation of the health minister over the cuts in the health sector indicates that support for the drastic measures may be starting to erode. 103. This risk is partially mitigated by the adhesion of all coalition parties to the revised IMF Letter of Intent, wide consultations on the program, and the implementation of laws and regulations to support the reforms. The Letter of Intent with the IMF of August 44 2009 was signed by all parties of the coalition government, notwithstanding earlier questions by some of them on the need for a Fund arrangement. In addition, the 2010 budget reforms have been the subject of wide consultations, including with line ministries, municipal governments, and social partners. Finally, many reforms supported by this operation are being implemented by amendments to laws and regulations that ensure a solid framework for crisis resolution and structural reforms is in place. Social Risk 104. The deep austerity measures create a risk of disruption in social services and of social unrest. The cuts in fiscal spending create a risk that some important social services are cut and that the gains Latvia made since accession in converging with EU welfare standards will be lost. 105. The risk is mitigated by the preparation of a social safety net DPL, aimed at mitigating the social and poverty impacts of the crisis and of the Government's program. The DPL proposes measures in public sector reform, social protection, education, and health aimed at mitigating the poverty and social impacts of the crisis and of the spending cuts. Other mitigating factors include the measures supported by this proposed DPL to ensure financial stability, therefore avoiding potential losses to depositors, and include measures to facilitate debt restructuring and avoid foreclosures of residential properties wherever possible. Insufficient institutional capacity 106. The reforms in the banking system require an increased capacity of the supervisor to anticipate deteriorating trends and undertake the necessary corrective actions. 107. The risk is mitigated by the fact that the proposed policy reforms aim to strengthen the regulatory and supervisory framework, specifically in areas of higher risks (such as asset quality and provisioning). The operation includes measures designed to enhance the capacity of the supervisor to monitor the banking system and react in a timely and effective manner. It also includes the conducting of stress tests, the preparation of a Strategic Contingency Plan for the banking sector, an improved stress testing framework, the establishment of a Prompt Remedial Action Plan, as well as strengthened prudential regulations. In addition, the Bank has provided and will continue to provide technical assistance in these areas. 45 A EXES A EX 1. LETTER OF DEVELOPME T POLICY 46 47 48 49 A EX 2. POLICY ACTIO S MATRIX Objectives Prior Actions Outcomes Crisis resolution 1. The BoL, with inputs from the FCMC, has completed stress tests of the banking sector in order to Well-capitalized banks assess its resilience to potential worst case scenarios. Capital adequacy strengthening 2. The Borrower has prepared a Strategic Contingency Plan for the financial sector on the basis of the Preparedness to handle specific bank problems or a systemic results of the stress tests referred to in paragraph 1 above. crisis 3. The Borrower's Parliament has approved amendments to the Credit Institution Law with a view to Bank resolution framework Adequate legal framework for the resolution of banks in distress strengthen the Borrower's legal framework for bank resolution. 4. The Borrower's Parliament has approved amendments to the Insolvency Law with a view to: (i) removing potential obstacles to out-of-court proceedings for corporate restructuring; (ii) allowing pre- Enhanced capacity of viable companies to reorganize and packaged restructuring agreements; and (iii) introducing further flexibility and easier access to restructure their debts through efficient out-of-court proceedings insolvency proceedings. Distressed asset management 5. The Borrower's Parliament has approved amendments to the Borrower's Civil Procedure Law in order to simplify the existing mortgage foreclosure process. Timely and effective mortgage foreclosures 6. The Borrower has implemented a debt restructuring program entailing: (i) the approval by the Increased awareness of elements of proper out-of-court Consultative Council of guidelines for corporate debt restructuring and their publication by the Ministry restructurings leading creditors and debtors to engage in an of Justice; and (ii) the approval and publication by the FCMC of guidelines on mortgage debt increasing number of out-of-court restructurings restructuring. Structural reforms 7. The BOL has adopted an improved stress testing framework based on multiple scenarios and a revised credit risks module to be operated on a regular basis. Early identification of bank-level and system-level vulnerabilities Supervisory framework strengthening 8. The FCMC has adopted a remedial action framework that establishes a matrix of triggers and a range of discretionary and non-discretionary supervisory actions for use when a bank has not Early remedial actions taken to address vulnerabilities complied with the laws, regulations and supervisory decisions. 9. The FCMC has: (i) issued revised and strengthened prudential regulations for asset quality and capital adequacy; (ii) prepared a draft liquidity risk management regulation to be revised on the basis Enhanced capital adequacy, asset quality, liquidity risk, and credit Regulatory framework stregthening of the recommendations of the Committee of European Banking Supervisors and the directives of the risk management by banks European Union; and (iii) included the issuance of regulations on credit risk management in its action plan for 2009. 10. The Borrower has completed of a comprehensive review of consumer protection laws, regulations Improved consumer protection framework and effective handling of Consumer protection and institutional set-up for the financial sector in line with international good practices. consumer complaints 50 A EX 3. OVERVIEW OF THE LATVIA BA KI G SECTOR 1. Latvia's financial sector is dominated by the banking sector, which is largely foreign-owned. Banks account for about 90 percent of total financial sector assets. The banking sector comprises 21 commercial banks (of which 19 private and 2 state-owned) and six foreign bank branches. Over 60 percent of the banking system is owned by banks from Sweden and other Nordic countries. In total, 77 percent is foreign owned. 2. Between 2004 and 2008, bank credit in Latvia expanded at one of the highest rates in the region. Annual growth in bank loans to the private sector increased by an average of 50 percent from 2004 to 2007. As a share of GDP, lending to the private sector increased from about 40 percent in 2003 to 89 percent in 2007 (the highest ratio among the new EU member states), and to about 90 percent in 2008. During that period, loans have grown faster than deposits: deposits increased by an average of 34 percent from 2004 to 2007. Deposits increased from about 26 percent of GDP in 2003, to 36 percent in 2007, and to 31 percent at end-2008. Figure 3. Credit to the Private Sector and Deposits to GDP, 2000-2008 140 45 120 40 35 100 30 80 25 60 20 15 40 10 20 5 0 0 2000 2001 2002 2003 2004 2005 2006 2007 2008 2000 2001 2002 2003 2004 2005 2006 2007 2008 Source: IFS 3. Credit growth has been funded primarily by external borrowing from private banks, exposing the banking sector to substantial liquidity risks. The rapid credit expansion has been largely financed by external borrowings from private banks, resulting in a high loan to deposit ratios. The loan to deposit ratio in Latvia was the highest in ECA at about 287.8 percent at end-2008, up from 168 percent in 2004. Foreign parents of Latvian banks have provided an increasing share of the external funding, from 67 percent of total non-deposit borrowings in 2005 to 78 percent at end- May 2009. From 2005 to end-2008, borrowings from parent banks increased by about 260 percent to more than LVL 7.2 billion ­ but decreased to about LVL 6.5 billion at end-May 2009. While foreign banks relied on their parent banks for funding, the domestically owned banks relied mainly on short-term syndicated loans and non-resident deposits for financing (from Russia, Ukraine, and other CIS countries). 51 Figure 4. Loan to Deposit Ratios in selected ECA countries in 2008 300.0% 250.0% 200.0% 150.0% 100.0% 50.0% 0.0% ia e ia ia s ia n ia ry j an si a n ia nd ria tia va b lic YR bli c tv ain on an aru rg sta en ga i s a la a a o u F u La Ukr Est i thu Bel eo akh rm un rba Ru om Po ul g Cro ol d Rep ni a, ep L G z A H ze R B M k R a A do ch K va e l o ac Cze S M Source: IFS Figure 5. Foreign Banks' Borrowings from Parent Banks (LVL mln) 8,000 7,000 6,000 5,000 4,000 3,000 2,000 1,000 0 2005 2006 2007 2008 - May 09 Source: FCMC 4. Much of banks' lending was directed to households. Household loans increased by 85 percent in 2004-2005, 76 percent in 2005-2006, 39 percent in 2006-2007, and 7 percent in 2007-2008. Its share in total banking sector assets reached 28 percent at the end of 2007 and over 28 percent at end-2008 (equivalent to over 40 percent of GDP, from 18 percent of GDP in 2004). Mortgage loans grew particularly fast, almost doubling each year until mid-2007, which fuelled a construction boom and real estate asset bubble. Mortgage loans increased from about 12 percent of GDP in 2004 to 32 percent of GDP in 2007, and about 31 percent at end-2008. Corporate loans increased from 32 percent of GDP in 2004 to about 50 percent of GDP at end-2008. As a result, indebtedness of corporate and households almost doubled between 2004 and 2007, exceeding 80 percent of GDP. 52 Figure 6. Corporate and household loans as a percentage of GDP, 2004-2008 60 50 40 30 20 10 0 2004 2005 2006 2007 2008 Household loans in % of GDP Housing Loans in % of GDP Consumer Credit in % of GDP Corporate loans in % of GDP Source: FCMC 5. Much of the lending has been in foreign currency, primarily to unhedged borrowers, exposing the banking sector to foreign exchange risk. The share of FX loans as a proportion of total loans has increased from 70 percent in 2005 to 87 percent at end-May 2009, one of the highest in ECA countries.15 From 2005 to end-May 2009, the share of FX household loans (mortgage, consumer credit, and other loans to households) increased from 70 percent to 88 percent, the share of FX mortgage loans increased from 73 percent to 96 percent, and the share of FX corporate loans increased from 69 percent to 91 percent in the same time period. The high volume of foreign currency denominated loans exposed the banking sector to a foreign exchange risk as most borrowers do not generate income in foreign currency. Figure 7. Share of FX loans, 2005-2009 100 90 80 70 60 50 40 30 20 10 0 2005 2006 2007 2008 May-09 Corporate loans Mortgage loans Consumer credit Household loans Source: FCMC 15 91 percent of loans in foreign currency are in Euros. 53 6. Since the financial crisis, growth of the banking sector has slowed down starting in mid-2007. From 2006 to 2007, total financial sector assets grew by 38 percent, loans by 36 percent, and deposits by 31 percent. From 2007 to end-2008, total assets grew by 6 percent, loans by 12 percent, and deposits decreased by 6 percent. 7. The banking system entered the crisis with adequate prudential ratios, but much vulnerability has emerged. The capital adequacy ratio stands at 12.75 percent as of end-May 2009. While the banks remain well-capitalized, rising non-performing loans are straining capital buffers. Non-performing loans (overdue by more than 90 days) rose from 0.4 percent of the loan portfolio at end-2007 to 3.6 percent at end-2008, and to 10.7 percent as of May 2009. In response to increasing NPLs, banks' provisioning has also increased from 0.5 percent in 2007, to 2.2 percent at end-2008, and to 4.4 percent as of May 2009. Banks report a strong liquidity ratio of about 50 percent in May 2009 (above the regulatory minimum of 30 percent). However, funding liquidity risks are high, especially for local banks that have been facing increasing difficulties in rolling over syndicated loans and other short term financing. 54 Table 8. Structure of the Latvian Financial System, 2002-2009 Dec-02 Dec-03 Dec-04 Dec-05 Dec-06 Dec-07 Dec-08 Mar-09 Number % of Number % of Number % of Number % of Number % of Number % of Number % of Number % of total total total total total total total total assets assets assets assets assets assets assets assets Commercial banks 22 86.7 22 86.6 22 86.5 22 86.0 21 85.2 21 88.6 21 84.5 21 77.4 Private 21 83.1 21 82.9 21 82.9 21 82.1 20 81.3 20 84.6 19 65.9 19 61.5 Domestic 12 44.5 12 42.0 13 43.2 13 36.3 11 29.7 10 30.8 9 17.6 9 13.6 Foreign 9 38.6 9 40.9 8 39.6 8 45.8 9 51.5 10 53.8 10 48.3 10 47.9 State-owned 1 3.6 1 3.8 1 3.7 1 3.9 1 3.9 1 4.1 2 18.6 2 15.9 Branches of foreign banks 1 3.6 1 4.1 1 4.6 1 4.8 3 5.6 4 7.6 6 11.0 6 10.3 Nonbank financial institutions 98 9.8 122 9.3 132 8.8 131 9.2 145 9.2 147 3.8 156 4.5 151 12.3 Credit unions 26 0.1 28 0.1 32 0.1 34 0.1 34 0.0 35 0.0 35 0.0 35 0.0 Leasing companies 24 6.2 23 5.6 28 5.6 18 5.9 20 6.0 22 0.0 23 0.0 23 7.5 Electronic Money institutions 0 0.0 0 0.0 0 0.0 2 0.0 3 0.0 6 0.0 7 0.0 6 0.0 Securities companies Securities brokerage companies 8 0.1 6 0.1 6 0.1 5 0.0 6 0.0 6 0.0 7 0.0 6 0.0 Investment management companie 6 0.0 8 0.1 10 0.0 10 0.1 13 0.1 14 0.1 15 0.1 15 0.1 Investment funds 9 0.3 16 0.4 15 0.4 17 0.6 21 0.6 34 0.9 38 0.6 35 0.6 Life insurance companies 6 0.7 6 0.5 5 0.4 5 0.3 5 0.3 4 0.3 4 0.3 4 0.3 General insurance companies 14 1.9 13 1.7 12 1.5 12 1.2 11 1.1 11 1.2 11 1.3 11 1.3 Pension funds (Tier III) 4 0.3 5 0.3 5 0.3 6 0.3 6 0.3 6 0.3 6 0.3 6 0.3 State funded pension scheme (Tier II) 1 0.3 17 0.4 19 0.6 22 0.7 26 0.7 9 1.1 10 1.9 10 2.2 Total financial system 121 100.0 145 100.0 155 100.0 154 100.0 169 100.0 172 100.0 183 100.0 178 100.0 Source: FCMC, BoL 55 Condition of the banking sector since 2007 Balance Sheet Characteristics 8. Reported liquidity is strong, with a liquidity ratio (liquid assets to short term liabilities) of about 50 percent at end-May 2009. Since 2007, the liquidity ratio has been at over 50 percent, above the regulatory minimum of 30 percent. However, funding liquidity risks are high given the high reliance of banks on non deposit, mostly external, sources of funding. 9. Capital adequacy is adequate, albeit with rapidly increasing non-performing loans. The capital adequacy ratio increased from 11.1 percent in 2007, to 11.8 percent at end-2008, and to 12.75 percent at end-May 2009. The Tier 1 capital ratio has also increased from 9.8 percent in 2007, to 10.5 percent in 2008, and 11.1 percent at end-May 2009. The banks are thus well-capitalized, although rising non-performing loans are straining their capital buffers. Loans more than 90 days overdue have increased from 0.4 percent in 2007, to 3.6 percent in 2008, and to 10.7 percent at end-May 2009. Loans overdue by more than 30 days have increased from 2 percent in 2007, to 7.8 percent in 2008, and to 15.5 percent at end-May 2009. The increase in NPLs is seen across the board, with loans overdue by more than 30 days reaching 15 percent for mortgages, 29 percent for real estate developers, and 12 percent for corporate loans.16 Banks' provisioning has also increased, from 0.5 percent of total loans in 2007, to 2.2 percent at end-2008, and to 4.4 percent as of May 2009. 16 Loans overdue by more than 90 days averaged 10.5 percent for mortgages, 21 percent for real estate developers, and about 9 percent for corporate loans. Loans at 1 day overdue (an indication of future NPLs) averaged 23 percent for mortgages, 38 percent for real estate developers, and about 16 percent for corporate loans. 56 Table 9. Balance Sheet of the Latvian Banking System, 2007-2009 (million of Lats) Dec-07 Dec-08 May-09 Assets Cash and Deposits at MFIs and credit institutions 5146.2 3,822 3,611 Loans 14916.1 16,589 16,090 Government 78.0 171 161 Financial institutions 992.0 1,054 845 Non-financial companies 7673.0 8,774 8,629 Households 6135.6 6,566 6,432 Others 37.5 24 23 Central government securities 334.1 1,192 709 Other securities 986.9 965.8 903.2 Other assets 532.7 674.2 789.6 Total Assets 21916.0 23,243 22,102 Liabilities & Capital Liabilities to the Central Bank 6.9 639 362 Liabilities to MFIs 8780.4 9,743 8,851 Deposits 10179.1 9,760 9,321 Debt securities and derivatives 351.2 254.4 239.1 Provisions 118.0 398 747 Other liabilities 539.3 435.6 398.8 Total liabilities 19974.9 21,230 19,919 Subordinated liabilities 204.7 310 462 Equity 1736.5 1,703 1,721 Total liabilities and capital 21916.0 23,243 22,102 Source: FCMC Income Statement Characteristics 10. Profitability of the banking sector has declined drastically since 2008. The Return on Equity decreased from 24 percent in 2007, to 3.6 percent in 2008, and to a dramatic -19.7 percent as of May 2009. The Return on Assets has also declined from 2 percent in 2007, to 0.27 percent in 2008, to -1.54 as of May 2009. As of May 2009, the Latvian banking sector incurred losses of about LVL 146 million, mainly due to the need to provision for non-performing loans. 57 Figure 8. Return on Assets and Return on Equity, 2004-2009 2.5 30 2 20 1.5 1 10 0.5 0 0 -0.5 -10 -1 -20 -1.5 -2 -30 2004 2005 2006 2007 2008 May-09 ROA ROE Source: FCMC Table 10. Income Statement of the Latvian Banking System, 2007/2009 (thousands of Lats) December-07 December-08 May-09 et interest income 506,282 551,838 179,881 Interest Income 1,128,131 1,400,367 482,855 Interest Expenses 621,849 848,529 302,974 et non-interest income 340,344 291,916 135,701 Fees and commissions 159,410 165,407 53,811 Trading 114,240 102,925 54,096 Other non-interest Income 66,694 23,583 27,794 Other Expenses 385,275 438,629 164,476 Bad and doubtful debts expenses (net) 29,174 290,565 310,814 Net income (loss) before tax 432,176 114,561 -159,708 Income tax 60,880 37,035 -13,840 Total income (loss) after tax 371,297 77,525 -145,868 Source: FCMC Likely evolution of the banking sector 11. Latvia's banking sector structure is likely to be affected by the crisis. Firstly, the Government has committed to refocus the activities of the public Mortgage and Landes Bank on its core developmental mandate. The new public bank Parex should be re-privatized in the medium term. Secondly, some consolidation could take place among smaller banks. Finally, foreign banks active in Latvia could review their strategy in Latvia and beyond. 58 Table 11. Key Indicators of the Latvian Banking System, 2002-2009 (in percent) 2002 2003 2004 2005 2006 2007 2008 May-09 Capital Adequacy Regulatory capital to risk-weighted assets 13.1 11.7 11.7 10.1 10.2 11.1 11.8 12.8 Regulatory Tier 1 capital to risk-weighted assets 12.1 10.8 10.4 8.8 8.8 9.8 10.5 11.2 Capital to Assets 8.7 8.4 8 7.6 7.6 7.9 7.7 8.7 Asset Quality Annual growth of bank loans/ 30.8 41.6 46.1 59 56.2 37.2 11 -3 Sectoral distribution of loans (in % of total loans) Agriculture, hunting, and related service activities n.a. n.a. 2.6 2.2 1.8 1.6 2.2 2.2 Construction and real estate activities n.a. n.a. 12.2 16.1 18.9 18.8 19.6 20.4 Industry and trade n.a. n.a. 33 26.1 22 21.6 22.5 22.4 Financial intermediation n.a. n.a. 9 10.2 8 6 6.1 5.0 Households n.a. n.a. 29.9 34.9 39.4 40 38.4 38.9 Non-residents n.a. n.a. 13.2 10.6 9.9 12.1 11.2 11.2 NPLs to total loans 2 1.4 1.1 0.7 0.5 0.4 3.6 10.7 Provisions to NPLs 78.3 89.4 99.1 98.8 116.6 129.8 58.0 40.7 Provisions to total loans 1.5 1.2 1.1 0.7 0.5 0.5 2.2 4.4 Earnings and Profitability ROA (after tax) 1.5 1.4 1.7 2.1 2.1 2 0.27 -1.6 ROE (after tax) 16.4 16.7 21.4 27.1 25.6 24.3 3.63 -19.7 Net interest income to total income 32.9 33.2 36.6 36 34.5 32.5 30.1 25.8 Liquidity Liquid assets to total assets 38 33.5 33.7 26.7 23.9 25 21.6 19.5 Liquid assets to short term liabilities 62.1 57.9 58.1 52.3 51.1 55.7 52.8 50.2 Loans to total assets 48.1 52.5 55.8 63.6 68.4 68.1 71.4 72.8 Long-term loans to total loans 36.9 41.6 47.4 48.3 52.1 56.5 59.1 59.3 Demand deposits to total deposits 71.9 73.2 72.2 70.6 68.3 60.9 49.7 47.3 FX loans to total loans 66.5 67.9 71.7 73.4 74.1 81.8 85 87 Households Household debt to GDP 7.5 12.6 18.6 28.6 40.9 42.4 41.3 n.a. /In May 2009, growth calculated from end-2008 Source: IMF, BoL, FCMC 59 A EX 4. FU D RELATIO S OTE I TER ATIO AL MO ETARY FU D Republic of Latvia--Staff Assessment Letter for the World Bank August 24, 2009 This note provides the IMF staff's assessment of recent macroeconomic developments and prospects in Latvia. The assessment is based on findings of the May and July 2009 Review missions under the Stand-By Arrangement (SBA) as well as recent data releases. Recent Developments and Outlook 1. The downturn is much deeper than anticipated at the launch of the program. Real GDP fell by just under 20 percent year-on-year in the first half of 2009, compared with the program projection of a 5 percent decline for the year as a whole. The main causes have been the bursting of the credit and real estate bubble, a collapse in domestic demand, and the much worse than expected international environment. Registered unemployment reached 11½ percent by end-June, up from 7 percent at the end of last year, but labor force surveys show an unemployment rate of 14 percent in the first quarter. As a negative output gap has emerged, inflation has declined sharply to around 2½ percent in July (from a peak of 18 percent year on year in mid-2008). 2. Falling domestic demand has led to a rapid correction in the current account while the capital account has weakened considerably. The decline in exports induced by weak global demand has been more than offset by a collapse in imports, which fell nearly 40 percent year-on- year in the first quarter of 2009. Together with the emergence of an income account surplus due to losses on FDI investment in Latvia, the import collapse has resulted in a current account surplus of 740 million (4 percent of annual GDP) through June. However, the capital account has weakened as domestically owned banks have made larger than expected loan repayments, foreign banks have reduced exposure to their Latvian subsidiaries and residents have accumulated assets abroad. 3. The banking sector is suffering strains caused by the downturn, lower real estate prices, and global deleveraging. The stock of credit has fallen by 3 percent since end-2008. A large proportion of household mortgages have negative equity and the share of loans reported to be at least 90 days overdue has risen above 10 percent. The need to provision for bad loans has caused system-wide losses at an annualized rate exceeding 2 percent of GDP. However, the FCMC reports that the banking system is adequately capitalized. 4. Fiscal deficits rose above program targets in the first half of 2009, reflecting both the sharper-than-expected downturn and weak program implementation: 60 · Although all the tax increases (about 2½ percent of GDP) announced in December 2008 were introduced, only around one third of the 4½ percent of GDP in originally planned expenditure cuts were implemented in the first half of 2009. Significant cuts were instead made on mandated expenditure including EU-financed spending and transfers to local governments, which will later need to be reversed. · Tax revenues fell sharply in the first half of this year. VAT receipts declined by 30 percent year-on-year, despite the increase in the VAT rate from 18 to 21 percent and the removal of most exemptions. Direct taxes have been more robust, reflecting lower than projected declines in officially recorded wages and the tendency of corporate income tax payments to lag corporate profits. 5. Financial markets have been strained, although the peg has been successfully defended in the face of heavy pressure. Since end-December, there has been pressure on international reserves including net FX sales to the private sector of 1.8 billion. Numerous shocks have contributed to instability, including political uncertainty, press reports of possible devaluation, and a failed treasury bill auction in June. However, following the subsequent announcement of the 1.2 billion EC disbursement, pressures eased considerably. The lats appreciated within the band, and the central bank started to buy foreign exchange. Gross reserves stood at more than 4 billion in mid-August, above their end-December level. Nevertheless, forward foreign exchange rates remain depreciated, and CDS spreads high, implying concerns over the stability of the peg and the sustainability of government debt. 6. The recession is projected to continue into 2010. Staff and the authorities forecast a GDP decline of 18 percent for 2009 as a whole (a projection made before the Q2 GDP release) with the downturn expected to continue until the second half of next year alongside a continued increase in unemployment. Consequently, year-on-year deflation is expected by the end of this year. As domestic demand remains weak, the current account surplus is expected to widen further in 2009 and remain in surplus. Program Implementation 7. Latvia faces considerable obstacles on its way to euro adoption, the exit strategy envisaged under the program. The general government deficit is likely to exceed 12 percent of GDP in 2009, and would increase further in 2010 without significant further measures. The authorities need to balance their objective of defining a sustainable and structurally sound fiscal reform, consistent with the strategy of adopting the euro as early as possible, against the need to minimize further pressure on economic activity and to protect the most vulnerable at a time of painful dislocation: · Fiscal Policy: Implementation of fiscal policy will need to be significantly strengthened. Although the June 2009 supplementary budget included some courageous decisions, it also has serious drawbacks including substantial across-theboard and one-off expenditure cuts, and regressive tax increases. The authorities recognize that fiscal consolidation will have to contend with headwinds from the output deterioration--and deflation--that are eroding the revenue base. Against that background, it may take longer than originally envisaged to attain the Maastricht fiscal criteria, with potential confidence effects from possible delay in euro adoption. In the staff's view, measures amounting to 6½ percent of GDP in 2010 are needed to reduce the deficit, followed by approximately 4 percent of GDP in measures each subsequent year until the deficit can be brought 61 below 3 percent of GDP. · Financial Sector: Restoring confidence in the financial sector requires a strategy to ensure banks remain liquid and adequately capitalized. Preemptive capital increases by two large foreign banks are welcome and will give them scope to absorb the loan losses likely in the coming months. The authorities are seeking to minimize the contingent liabilities from domestic banks, particularly those in state ownership, and restrict issuance of new guarantees. · Monetary Policy: An agreement to exchange program money off-market will result in a welcome reduction in the Treasury's influence on the exchange rate. The BoL is committed to introducing new instruments that will absorb excess liquidity. These initiatives could prevent interest rate volatility, which is inevitable under a currency board, from being excessive or destabilizing. Relations with the Fund 8. Staff level agreement for completion of the First Review has been reached and is now pending Board approval. The Second Review of the program is expected in the fall of 2009. Discussions will focus on an update of the macroeconomic framework; the size and phasing of the required fiscal adjustment, including the 2010 budget; financial sector stability; and structural reforms. 62 63 A EX 5. GOOD PRACTICE PRI CIPLES FOR CO DITIO ALITIES Principle 1: Reinforce Ownership There is ownership and commitment at the executive and parliamentary level as evidenced by a number of policy actions taken under the multilateral package. The Bank's contribution is based on analysis conducted during preparation and accepted by the authorities as the basis for further policy actions to add to and strengthen the set of reforms underway. The Bank team includes experts with field experience in the country and knowledge of the executive, parliamentary, and other consultative and consensus building procedures. Principle 2: Agree up front with the government and other financial partners on a coordinated accountability framework The program is very closely coordinated with the other collaborating donors/partners, namely, the IMF and the EC. The accountability framework delineated in the policy matrix contains very specific actions with associated indicators for measuring results to determine success of the program. Principle 3: Customize the accountability framework and modalities of Bank support to country circumstances The policy measures are specifically geared to support the government's reform program and mitigate future risks generated by the financial crisis. The funding is earmarked for potential gaps with a view to ensuring financial stability. Principle 4: Choose only actions critical for achieving results as conditions for disbursement The policy actions focus only on those that are considered crucial toward strengthening the financial sector. The actions are those which contain key added value features as contributions from the Bank to the policy agenda. Other actions, already agreed with the other partners, are essential to the overall basis of the program and complement the policy measures developed by the Government. Principle 5: Conduct transparent progress reviews conducive to predictable and performance-based financial support As this is a single tranche DPL, all the conditions will be implemented prior to Board approval and thus monitoring will take place prior to Board approval. Monitoring will take place during loan implementation. 64 A EX 6. COU TRY AT A GLA CE Latvia at a glance 9/24/08 Euro pe & Upper Ke y D e v e lo pm e nt Indic a t o rs Central middle Latvia A sia inco me Age distribution, 2007 (2007) Male Female P o pulatio n, mid-year (millio ns) 2.3 445 823 75-79 Surface area (tho usand sq. km) 65 23,972 41,497 60-64 P o pulatio n gro wth (%) -0.5 0.0 0.6 Urban po pulatio n (% o f to tal po pulatio n) 68 64 75 45-49 GNI (A tlas metho d, US$ billio ns) 22.6 2,694 5,750 30-34 GNI per capita (A tlas metho d, US$ ) 9,930 6,051 6,987 15-19 GNI per capita (P P P , internatio nal $ ) 16,890 11 1 ,1 6 1 1 ,868 0-4 GDP gro wth (%) 10.3 6.8 5.8 10 5 0 5 10 GDP per capita gro wth (%) 10.9 6.7 5.1 percent ( m o s t re c e nt e s t im a t e , 2 0 0 0 ­ 2 0 0 7 ) .25 P o verty headco unt ratio at $ 1 a day (P P P , %) .. 5 .. Under-5 mortality rate (per 1,000) P o verty headco unt ratio at $ 2.00 a day (P P P , %) .. 11 .. Life expectancy at birth (years) 71 69 70 60 Infant mo rtality (per 1,000 live births) 8 23 22 Child malnutritio n (% o f children under 5) .. .. .. 50 40 5 A dult literacy, male (% o f ages 1 and o lder) 100 99 94 30 5 A dult literacy, female (% o f ages 1 and o lder) 100 96 92 Gro ss primary enro llment, male (% o f age gro up) 96 98 121 20 Gro ss primary enro llment, female (% o f age gro up) 93 96 109 10 0 A ccess to an impro ved water so urce (% o f po pulatio n) 99 95 95 A ccess to impro ved sanitatio n facilities (% o f po pulatio n) 78 89 83 1990 1995 2000 2006 Latvia Europe & Central Asia a N e t A id F lo ws 19 8 0 19 9 0 2000 2007 (US$ millio ns) Net ODA and o fficial aid .. 3 91 162 Growth of GDP and GDP per capita (%) To p 3 do no rs (in 2006): Euro pean Co mmissio n .. 0 52 134 30 Denmark .. 1 10 8 15 Germany .. 1 6 6 0 A id (% o f GNI) .. 0.1 1.2 1.2 -15 A id per capita (US$ ) .. 1 38 70 -30 Lo ng- T e rm E c o no m ic T re nds -45 95 05 Co nsumer prices (annual % change) .. .. 2.6 6.7 GDP implicit deflato r (annual % change) 0.5 24.1 4.2 13.3 GDP GDP per capita Exchange rate (annual average, lo cal per US$ ) .. 0.0 0.6 0.5 Terms o f trade index (2000 = 100) .. .. 100 107 19 8 0 ­ 9 0 19 9 0 ­ 2 0 0 0 2 0 0 0 ­ 0 7 (average annual gro wth %) P o pulatio n, mid-year (millio ns) 2.5 2.7 2.4 2.3 0.5 -1.2 -0.6 GDP (US$ millio ns) .. 7,447 7,833 27,154 3.2 -1.5 9.0 (% o f GDP ) A griculture 1 1 .8 21.9 4.6 3.7 2.1 -5.2 3.2 Industry 50.9 46.2 23.6 21 .5 4.6 -8.3 8.4 M anufacturing 46.0 34.5 13.7 1 .8 1 4.4 -7.3 7.1 Services 37.2 31.9 71.8 74.8 3.2 2.7 9.0 Ho useho ld final co nsumptio n expenditure 59.4 52.7 62.5 65.8 2.3 -3.9 10.0 General go v't final co nsumptio n expenditure 7.9 8.6 20.8 17.0 5.0 1.8 2.4 Gro ss capital fo rmatio n 25.6 40.1 23.7 38.4 3.4 -3.7 17.0 Expo rts o f go o ds and services .. 47.7 41.6 44.6 .. 4.3 9.0 Impo rts o f go o ds and services .. 49.0 48.7 64.9 .. 7.6 13.2 Gro ss savings .. 56.0 18.9 16.9 22°E 23°E 24°E 25°E 26°E L AT V IA SELECTED CITIES AND TOWNS ESTONIA COUNTY (RAJON) CAPITALS LATVIA NATIONAL CAPITAL RIVERS To MAIN ROADS Nomme To To Viljandi RAILROADS Haademeeste 58°N COUNTY (RAJON) BOUNDARIES Rujiena Gulf of Ainazi VALMIERAS To Tartu INTERNATIONAL BOUNDARIES Valka Kolka Riga Salacgriva Aloja Renceni Mazirbe LIMBAZU To To Pskov 28°E Dunte Valga To Pskov Dundaga Roja Limbazi VA L K A S Ape Baltic 1 Pope Rubene Valmiera Virese ALUKSNES TA L S U Smiltene Sea Ventspils Mersrags Stiene Aluksne Leci Ugali Saulkrasti Cesis Uzava VENTSPILS Talsi Vilaka R US S I AN RU S SI Ligatne Gulbene Stende Engure RIGA CESU Jaunpiebalga GULBENES Balvi F E D. 57°N Bolderaja Sigulda Alsunga Vangazi To 57°N Kuldiga 3 RIGAS BALVU Ostrov Pavilosta Tukums Jumala RIGA Ropazi KULDIGAS Suntazi Ergli MADONAS Kapini Silderi TUKUMA Salaspils Gaizinkalns Madona To Ogre OGRES (312 m) Lubanas Karsava Krasnogorodskoye Aizpute Berzaune Ezers Lutrini Olaine 4 Da D Skrunda Broceni ug Lielvarde ava Barkava Saldus Plavinas 2 Durbe Dobele Jelgava REZEKNES Liepaja SALDUS Jaunjelgava Tiltagals 6 Ludza Iecava Atasiene L I E PA J A S D O B E L E S JELGAVAS Aizkraukle Rezeknes Auce BAUSKAS A I Z K R A U - Jekabpils LUDZAS Priekule Ezere Bene Barbela Nica To Eleja Bauska KLES JEKABPILS Livani Raznas Zilupe Idritsa To Skaistkaine PRE U P R E I ILLJU Ezers Telsiai Viesite Malta Preili To Siauliai To Nereta Bukmuiza Rucava Panevezys Akniste Da ug To Dagda ava Birzai va 56°N Spogi To Subata DAUGAVPILS Viski KRASLAVAS 56°N Kretinga Ilukste Kraslava PROVINCES: To 5 Indra To Rokiskis 1. Ventspils City LITHUANIA Daugavpils Piedruja Novopolotsk 2. Liepaja To Dusetos 3. Jurmala BELARUS 4. Jelgava 0 20 40 60 Kilometers To Dukstas 5. Daugavpils JANUARY 2005 IBRD 33432 6. Rezeknes 0 20 40 Miles This map was produced by the Map Design Unit of The World Bank. The boundaries, colors, denominations and any other information shown on this map do not imply, on the part of The World Bank 21°E Group, any judgment on the legal status of any territory, or any 22°E 23°E 24°E 25°E 26°E endorsement or acceptance of such boundaries.