Mr Repse describes general economic developments
and banking in Latvia
Notes delivered by Mr Einars Repse, Governor Bank of Latvia, at the 5th Annual International
Conference and Exhibition "Banking and Finance in the Baltics 99", held in Riga on 13-15 October
1999.
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General economic developments
Since 1996 and until the third quarter of 1998 Latvia experienced a period of accelerated economic
development.
It was characterised by:
• High GDP growth - 8.6% in 1997 and the same level of growth in the first half of 1998.
• Continuously declining inflation - 2.8% at year end 1998.
• Growth in exports and orientation of trade increasingly towards the European Union (EU).
• This has been a continuous and sustainable trend backed by sound and responsible economic
policies of the government. No budget deficit - even a surplus was recorded in 1997 and
1998. Public borrowing in mid-1998 was just around 10% of GDP.
• These policies were and continue to be strongly supported by the tight monetary policy
pursued by the Bank of Latvia. For more than 5 years, the cornerstone of this policy has been
and continues to be exchange rate stability. The national currency has been pegged to the
SDR (the IMF basket of currencies) since February 1994, and its value against the SDR has
remained unchanged.
• Macroeconomic stability, improving investment climate and continuing structural reforms
have all contributed to increasing investor confidence. Foreign direct investment (FDI)
attracted in 1996-1997 more than doubled and in 1997 constituted 9.3 % of GDP, covering
the current account deficit.
However, unfavourable external developments, first and foremost the Russian crisis, caused
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a considerable slow-down in Latvia's economic growth in the second half of 1998 and at the
beginning of this year.
• The budget for 1999 originally adopted by the central government was balanced. Under
current circumstances, however, a fiscal deficit of 3-3.5% of GDP is planned for this year. It
is important to stress that this was an extraordinary measure. The government has every
intention to reduce the deficit to a minimum next year, and a balanced budget remains its
objective for the near future.
• Despite the unfavourable external conditions, the Latvian economy already shows signs of
recovery. After the first six months of 1999, there has been a visible upward trend of
economic activity, particularly due to a much stronger performance in the service sector.
Substantial number of Latvia's export-oriented businesses have made concerted efforts to
find new markets, and the geography of Latvian foreign trade has expanded as a result.
Currently, more than 60% of Latvian foreign trade is with the EU countries, and new export
partners have been found in Latin America, Middle East and other regions.
• FDI still remains the main source of financing for the current account deficit. Denmark,
USA, Sweden, Germany, Russia and the United Kingdom are at the top of the investor's list.
• These positive developments allow us to forecast a moderate GDP growth of roughly 1% in
1999, with annual inflation remaining low at approximately 2.5%.
The Central Bank
The main objective of the monetary policy of the Bank of Latvia, as defined by law, is price stability.
Independence of the Bank of Latvia is guaranteed by law and ensured in practice. No institution or
person can influence the Bank of Latvia's decisions. The Governor and members of the Board of
Governors are appointed by the parliament for a six-year term and cannot be dismissed, thus their
personal independence is ensured. The central bank's budgetary independence is also secured.
The Bank of Latvia has adopted the full set of indirect, market-based monetary policy instruments in
use at the European Central Bank. Currently we are in the process of fine-tuning these instruments and
increasing their efficiency.
Capital movements
Both current and capital account transactions have been fully liberalised from the first days of Latvian
independence. There are virtually no restrictions on cash and capital flows to and from Latvia.
Banking sector development
At present there are 25 commercial banks in Latvia, including a branch of the French Société Generale
and subsidiaries of the German Vereinsbank, Finnish Merita Nordbanken and Estonian Hansabank.
Important foreign banking institutions are major shareholders in several Latvian banks.
The restructuring of the banking sector is practically complete: the industry is almost entirely in
private hands. Only one medium-sized bank (Mortgage and Land Bank) remains state-owned, and
another one (Latvian Savings Bank) has the state as an important shareholder (41%).
At end-September 1999, total assets of the banking sector reached Lats 1.73 billion (around
USD 3 billion), and total equity - Lats 169 million (around USD 290 million).
Stable growth from 1996 to the first half of 1998; impact of the Russian crisis after August 1998
The banking sector reported particularly rapid growth starting with the second half of 1996. It was
stable, orderly and controlled growth that went hand in hand with positive developments in the real
economy and occurred within the tight framework of banking regulations and strengthened
supervision.
In 1996-1997, the annual increase in the banking sector's main indicators (assets, equity and deposits)
was in the range of 50-60%. This growth, which continued during the first half of 1998, was very
much fostered by considerable improvement in the economic and legal environment in Latvia.
The Russian crisis of 1998 held the development back somewhat: some contraction of the banking
sector took place in the last quarter of 1998.
Most banks proved able to withstand the external shock and re-orient their investment and lending
policies rapidly. The first 9 months of 1999 witnessed stable growth of 10% to 15% in all major
banking indicators (assets, equity, deposits and credits). The total profit of the Latvian banking
industry reached Lats 17 million in the first three quarters of 1999.
Bank lending
Development has been most pronounced in the area of bank lending, and it has continued despite the
Russian crisis. The remarkable increase in bank lending was not accompanied by deterioration of
credit portfolios - on the contrary, the quality of bank assets has improved considerably since 1996.
Most of the loans - more than 90% - are issued to the private sector.
A gradual shift towards medium- and long-term lending normally associated with lending to the
productive sector of the economy has been ongoing and currently accounts for 63% of total loans.
Loan loss provisions
At the end of September 1999, the share of non-performing loans in total loans for the whole banking
sector was 6% (bad or "lost" loans 1%). This indicator has considerably improved since the end of
1996.
In our opinion, these figures indicate realistic credit risk assessment and, in a transition economy, can
scarcely be provided any lower that proper evaluation methods are used. Our loan-loss provisioning
scheme is very tight (tighter than in western economies) and strictly enforced, so that non-performing
loans do not pose any threat to the stability of the banking system.
Banking sector: legislation and supervision
General
The legislative framework for banking meets EU requirements and in some respects exceeds them.
International Accounting Standards (IAS) have been fully introduced; annual reports are prepared in
accordance with IAS and audited by internationally recognised auditing firms. Practical supervision is
very tight and bank inspections are more frequent than in EU countries.
Licensing
Required minimum initial capital to establish a bank is 5 million euro. There are no restrictions for
foreign banks to establish subsidiaries or branches in Latvia except for prudential requirements, which
are the same for domestic and foreign banks.
Legislation
The principal basis - the Law "On Credit Institutions" - was adopted in 1995 and incorporates
subsequent amendments. The Bank of Latvia regulations make the requirements set by the law more
specific. The whole set of regulations normally used by a supervisory authority is in place and
corresponds to EU standards. The regulations apply to minimum initial capital, own funds, capital
adequacy ratio, liquidity requirements, large exposures, open foreign exchange positions, loan
classification and provisioning.
The law against money laundering came into effect on 1 June 1998. The law fully conforms to the
respective EU directive: it requires customer identification, keeping records on all transactions, defines
suspicious transactions and obliges banks to report them to a special control institution (Disclosures
Office).
Law on deposit guaranties came into effect on 1 October 1998. Presently deposits are guaranteed up to
the rather moderate level of Lats500, however, the law sets a timetable for increasing this amount to
the level required by the EU directive. Initially the law will cover only natural person deposits, and
later on we will apply to legal persons as well.
Remaining tasks
We are currently working on the implementation of two more advanced EU directives, relating to
consolidated supervision and capital adequacy. This means that by the end of 1999 the regulatory
framework for banking activities in Latvia will be completely harmonised with EU requirements.
Practical supervision
Banking supervision in Latvia is well advanced and among the strictest in Central and Eastern Europe.
The Bank of Latvia has been invited by the EU Tacis (Technical Assistance to CIS) programme to
participate in a major project aimed at bank restructuring in Ukraine.
Currently there are 55 staff members in our Credit Institutions Supervision Department. A number of
them deal with on-site banking inspections, others with off-site analysis. Our inspection teams visit
each commercial bank 2 to 3 times per year, in addition to regular audits by external auditors. In 1998,
95 on-site inspections by the Bank of Latvia took place in Latvian commercial banks. Compared to
western practices, these figures are very high. Due to the improvement of analytical skills of our staff,
in the future more emphasis, as elsewhere, will be put on off-site analysis, and the frequency of on-site
inspections will obviously decrease.
As a result of all this work, we have been able not only to set regulations for banks, but also to fully
enforce their compliance.
Bank of Latvia's policies and the introduction of the euro
Our policy responses to the euro are based on the general objectives set by our country. Accession to
the EU is a strategic aim for Latvia, and we see entry in the European Monetary Union as a part of this
task.
We have adopted the fulfilment of Maastricht convergence criteria as a medium-term target, and will
be able to meet all of them in 4 to 5 years. Latvia already complies or is close to complying with most
of them:
• the public debt is much lower than Maastricht requirements, i.e. 13% of GDP;
• there has been no budget deficit in 1997 and 1998; the fiscal situation in 1999 was strongly
influenced by external factors, and the government intends to reduce the deficit in 2000
below Maastricht requirements;
• the Lats has been pegged to the SDR at a constant exchange rate since 1994, and, in
principle, we are meeting the currency stability criteria;
• inflation has declined to a stable level below 3%, close to the Maastricht targets;
government bond yield rates, while still high, are on the downward trend, and we expect to
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be able to meet the requirements in the medium-term.
The Bank of Latvia will be prepared to join the European System of Central Banks at the time of
Latvia's accession to the EU. The structure and objectives of the Bank of Latvia, the degree of its
independence and the set of monetary policy instruments are fully in line with those defined for the
European System of Central Banks.
During the pre-accession period, the exchange rate peg of the Lats to the SDR will be maintained. This
peg has served us well and has ensured less exchange rate fluctuation than a peg to any single
currency. In addition, the composition of Latvia's foreign trade by settlement currencies closely
resembles the composition of the SDR basket, with USD being the major component in both.
However, we are closely monitoring the new European currency. We hope that the euro will become a
stable currency and anticipate its wider use in world trade. If this happens, we will have all the
necessary economic grounds for joining the European Monetary Union after Latvia's accession to the
EU.