Proposal for a Council decision providing EU medium-term financial assistance for Latvia
Date: 2009-01-08
Institutions: European Commission
Subjects: EU aid, Lithuania, economic aid, economic stabilisation

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COMMISSION OF THE EUROPEAN COMMUNITIES 

Brussels, 8.1.2009 
COM(2009) 4 final 

Recommendation for a 

COUNCIL DECISION 

Granting mutual assistance for Latvia 

and 

Proposal for a 

COUNCIL DECISION 

Providing EU medium-term financial assistance for Latvia 

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Recommendation for a 

COUNCIL DECISION 

Granting mutual assistance for Latvia 

and 

Proposal for a 

COUNCIL DECISION 

Providing EU medium-term financial assistance for Latvia 

EXPLANATORY MEMORANDUM 

1. 

INTRODUCTION 

The Latvian economy has accumulated major imbalances in recent years as rapid expansion 
has  been  fuelled  by  easy  credit  conditions  and an  overly-expansionary  fiscal  stance,  against 
advice  given  by  the  Commission  and  Council,  notably  in  Opinions  on  successive  Latvian 
convergence programmes. The situation has been greatly accentuated by the global financial 
market  crisis  and  the  general  hardening  in  sentiment  towards  emerging  market  economies, 
making  access  to  credit  increasingly  difficult  and  expensive.  Latvian  capital  and  financial 
markets came under significant pressure from October onwards, reflecting increased concerns 
about  the  sustainability  of  the  country's  economic  and  financial  situation.  Particular  worries 
related to the health of the banking sector, and especially the viability of the country's largest 
domestically-owned  bank  (Parex),  heavily  reliant  on  external  funding,  which  was 
consequently taken into state ownership and control. In sum, Latvia has been confronted by 
an abrupt and severe banking sector and external financing crisis.  

Against this background, the Latvian authorities approached the EU and the IMF for financial 
support. The Commission together with the Council Presidency announced on 22 November 
that  the  EU  was  ready  to  participate  with  the  IMF  in  a  coordinated  financing  package  to 
underpin Latvia's balance of payments sustainability. However, it was stressed that a financial 
assistance  package  would  only  be  provided  subject  to  a  strong  commitment  by  the  Latvian 
authorities to implement a rigorous and credible economic adjustment programme. Based on 
discussions with the Commission and IMF, on 12 December the Latvian Parliament adopted 
the  authorities'  proposal  for  an  "Economic  Stabilisation  and  Growth  Revival  Programme" 
(hereafter  the  programme).  The  key  objectives  of  the  programme  are  to  maintain  domestic 
and  international  confidence  in  the  financial  system,  to  contribute  directly  and  indirectly  to 
arresting  and  reversing  the  deteriorating  trend  in  cost  competitiveness  and  inflation  by 
reductions in public sector wage costs as a centrepiece of a much tighter fiscal stance, and to 
strengthen the economy’s growth potential by a range of structural reforms. 

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2. 

RECENT MACROECONOMIC DEVELOPMENTS 

Following a sustained period of high growth since the end-1990s, largely based on domestic 
demand,  Latvia's  real  GDP  increased  at  double-digit  rates  in  2005-2007.  Growth  was 
primarily driven by a powerful credit expansion boosting private consumption and real estate 
investment, but this ended by mid-2007, as overvalued real estate prices could no longer be 
sustained. During these years, the structure of the economy shifted from the tradeable sector 
to the non-tradeables, undermining the external sustainability of the economy and resulting in 
serious overheating pressures. 

GDP growth fell sharply during the first three quarters of 2008, a trend expected to continue, 
driven  mainly  by  a  contraction  in  private  consumption  and  private  investment.  Private 
consumption  has  been  hit  by  high inflation,  falling  real  estate  prices,  increased  debt  service 
payment, reduced loan availability and worsened employment and income expectations. Fixed 
investment  in  construction  is  falling  in  line  with  the  ending  of  the  boom  in  the  real  estate 
market  and  investment  in  equipment  given  the  poor  demand  outlook  both  domestically  and 
abroad. The corporate sector is under heavy cost pressure, due to labour cost increases, and 
financing  is  increasingly  constrained.  EU-funded  projects  and  generally  public  projects  will 
provide some cushion against a sharp drop in other investment. However, GDP is expected to 
contract  for  a  considerable  period  with  very  weak  domestic  demand  insufficiently 
counterbalanced by an expansion of net exports.  

Labour  market  conditions  have  only  recently  started  to  ease,  but  the  reaction  on  the  labour 
market  to  the  drop  in  domestic  demand  will  be  significant.  Unemployment  has  already 
increased from 6.3% in Q2 to 7.2% in Q3 2008 and nominal wage growth is moderating, but 
from  very  high  rates.  The  Latvian  labour  market  is  presumed  to  be  fairly  flexible,  which 
should  limit  the  output  and  employment  costs  associated  with  a  realigning  of  wages  with 
productivity.  

After  peaking  in  May  2008  at  17.7%,  HICP  inflation  fell  to  11.8%  in  November.  Core 
inflation1  (11.0%  in  November)  and  services  price  inflation  are  falling  steadily,  as  demand 
pressure  wanes.  Prospects  for  a  further  strong  decrease  in  inflation  are  good,  given  the 
outlook  for  sharply  weaker  domestic  demand,  lower  public  sector  wages  (see  Section  6) 
leading to private sector wage restraint, and decreases in global commodity prices.  

External  imbalances  have  been  very  large  with  an  unsustainable  build-up  of  external 
liabilities,  but  in  2008,  with  falling  domestic  absorption,  external  borrowing  declined 
substantially.  The  balance  of  payments  and  external  investment  position  is  discussed  in 
Section 5 below. 

3. 

PUBLIC FINANCES 

Public finance has a heightened responsibility in Latvia due to the limited scope of monetary 
policy under a quasi-fixed exchange rate regime2. Nevertheless, Latvia pursued a pro-cyclical 
fiscal  policy  during  the  domestic  demand  boom  years  of  2005-2007,  in  spite  of  improving 

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Defined as the overall index excluding energy and unprocessed food. 
Latvia has a long tradition of pegging the exchange rate of its currency, the lats, from 1994 to the SDR 
and  from  2005  to  the  euro.  In  May  2005,  Latvia  entered  ERM  II,  unilaterally  adopting  a  +/-  1% 
fluctuation corridor around the central parity. 

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headline  budgetary  outturns  and  against  repeated  advice  given  in  Council  Opinions  on 
successive  updates  of  Latvia's  convergence  programme.  Windfall  revenues  were  typically 
spent through the process of intra-year supplementary budgets and no reserves were created 
for worse times. Public sector wage growth became a driver of private sector wage increases, 
with comparable wage levels higher in the public sector. In Latvia over 30% of the employed 
work in the public sector and, given that the service sector is proportionally large, around 75% 
of GVA, public sector wage-setting plays a large role in influencing private sector wages.  

During the first ten months of 2008, VAT revenues slowed dramatically (down by 3% y-o-y), 
driven  by  a  steep  fall  in  private  consumption.  Revenues  from  other  major  tax  categories 
initially  held  out  relatively  well  on  the  back  of  high  inflation,  but  these  favourable  effects 
have  also  started  to  fade.  The  Latvian  Treasury  estimates  that  the  2008  consolidated  state 
budget  deficit,  which  includes  the  central  government  and  the  social  security  fund  budget, 
may  be  around  2½  to  2¾%  of  GDP3.  Taking  into  account  the  possibility  that  in  current 
circumstances the local government sector might show a small deficit (despite limits intended 
to  result  in  the  sub-sector  maintaining  balance  or  surplus),  the  2008  deficit  of  the  general 
government sector appears to be close to 3% of GDP. 

The budget for 2009 as passed by Parliament on 14 November targeted a consolidated central 
government  deficit  of  1½%  of  GDP,  but  based  on  an  unrealistic  output  contraction  of  only 
1%. It included substantial direct tax reductions and expenditure increases. It was then already 
clear  that  output  would  decline  by  a  significantly  larger  amount  and  that  in  the  absence  of 
countervailing  measures  the  deficit  risked  widening  to  very  large  figures.  Including  a  very 
small  deficit  of  local  governments,  the  general  government  deficit  was  projected  by  the 
authorities  to  be  1.8%  of  GDP  with  a  primary  deficit  of  1.1%  of  GDP.  In  view  of  tax 
collection data in the last months of 2008 and deteriorating economic prospects for 2009, the 
outlook for the general government balance became significantly worse than the Commission 
services'  autumn  forecast  projection  of  a  5.6%  of  GDP  deficit.  By  contrast,  the  end-2007 
general government debt ratio, 9.5%, was one of the lowest in the EU.  

4. 

FINANCIAL MARKETS  

Latvia's  financial  system  is  almost  exclusively  dominated  by  the  banking  sector,  which  has 
developed very quickly over the last ten years. Two segments can clearly be identified. On the 
one  hand,  foreign-owned  banks,  principally  funded  directly  through  loans  from  parent 
companies,  share  about  70%  of  the  market.  On  the  other  hand,  domestic  banks  are  funded 
principally  through  foreign  syndicated  loans  and  non-resident  deposits.  The  importance  of 
non-resident  deposits,  which  stood  at  43.5%  of  all  deposits  other  than  from  monetary  and 
financial  institutions  (MFIs)  at  the  beginning  of  November  2008,  is  a  particularly  salient 
feature. Latvia's financial system relies therefore primarily on external financing, whether it 
comes  from  parent  companies,  non-resident  deposits,  or  foreign  syndicated  loans.  The 
resulting  very  high  and  increasing  level  of  foreign  liabilities  has  its  counterpart  in  loans  to 
residents, predominantly in foreign currency (close to 90% of all loans). Domestic credit has 
risen from 10% of GDP in 1997 to 90% in 2007. It appears, therefore, that the two main risks 
that affect Latvia's banking system are liquidity and credit risks. 

Liquidity  risk  has  already  materialised  through  sustained  liquidity  pressures  since  October 
2008. Expecting repayment difficulties, two foreign syndicates clearly implied that they might 

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Figure in national methodology, excluding local governments 

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request early payment of loans to Parex Bank totalling 0.8bn EUR due in February and June 
2009. This prompted the partial nationalisation of the bank on 10 November 2008. However, 
the  public  loan  guarantees  thereby  granted  were  deemed  insufficient,  leading  to  the  full 
nationalisation of Parex at the beginning of December and the imposition of limits on deposit 
withdrawals  (50,000  EUR/month  for  individuals).  Despite  these  measures,  Parex  and 
domestic  banks  with  similar  business  models  have  since  experienced  very  substantial  non-
resident  deposit  withdrawals,  of  which  only  a  small  part  has  been  redeposited  with  other 
banks  in  Latvia.  The  systemic  liquidity  pressure  prompted  the  Bank  of  Latvia  on  13 
November  to  announce  further  reductions  of  its  required  reserve  ratio  from  7%  to  5%  for 
short-term liabilities and from 5% to 3% for liabilities with a maturity of over 2 years, thereby 
freeing  liquidity  (these  decisions  took  effect  in  two  1pp  steps  on  24  November  and  24 
December).  However,  the  drain  on  reserves  has  continued,  and  the  net  international 
investment position of the Bank of Latvia deteriorated by 0.9bn EUR in the period from the 
beginning  of  October  2008  to  the  end-year.  Resident  and  non-resident  deposits  in  foreign-
owned  banks  increased  over  the  same  period,  and,  crucially,  liquidity  support  from  parent 
companies seems secured.  

Credit  risk  has  not  yet  materialised  substantially,  but  is  expected  to  increase  in  the  coming 
months.  While  overdue  loans  have  already  increased,  non-performing  loans  so  far  remain 
below 1% of total loans, also due to the ongoing restructuring of problem loans. However, the 
negative  impact  of  the  expected  prolonged  recession  on  residents'  income  and  therefore  on 
their  ability  to  repay  debts  will  clearly  mount.  Solvency  ratios  will  decrease,  and  may 
approach the regulatory minimum, in which case capital injections may be needed. 

The  current  and  future  position  of  the  banking  sector  is  dependent  on  objective  factors  but 
also  on  credibility  and  confidence-related  expectations.  It  is  key  at  the  current  juncture  to 
ensure confidence so as to stabilise the deposit base and ease liquidity pressures going ahead. 
Given  constrained  public  finances,  restoring  confidence  in  the  financial  sector  through 
government  intervention  would  only  be  credible  if  accompanied  by  strong  international 
financial support. 

5. 

BALANCE OF PAYMENT AND EXTERNAL FINANCING REQUIREMENTS 

Latvia's  economic  boom  until  2007  was  characterized  by  the  emergence  of  large  external 
imbalances and an unsustainable build-up of external liabilities. Gross external debt exceeded 
135% of GDP at the end of 2007 (with net external debt at 52% of GDP). The international 
investment position at end-2007 widened to net liabilities of 79% of GDP, with net liabilities 
at the end of the second quarter of 2008 estimated to have widened to 82% of GDP.  

In  2008,  with  falling  domestic  absorption,  external  borrowing  has  declined  substantially. 
According to the preliminary estimates of the Bank of Latvia, the current account deficit fell 
to about 12½% of GDP in the third quarter of 2008 (from a peak of over 27% of GDP in the 
fourth quarter of 2006). In 2009 the goods trade deficit is expected to remain around 10% of 
GDP (as in last months of 2008), but, given a positive services balance and improving income 
account,  the  current  account  deficit  would  be  narrower.  In  order  to  ensure  that  the  basis  of 
GDP growth switches from shrinking domestic demand to increasing exports, there is a need 
to realign wages more closely with productivity and to progress with structural reforms that 
strengthen the economy's supply side. 

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While a correction of the current account deficit from its unsustainable levels of recent years 
is a critical element in re-establishing a sound balance-of-payments situation, in itself it will 
not be enough to achieve external sustainability, taking into account the country's large stock 
of  debt,  most  of  it  short-term.  External  financing  is  expected  to  remain  under  significant 
pressure for some time, with the availability of foreign credit being reduced, potential drains 
on non-resident as well as resident deposits, and a worsened outlook for inward investment. A 
further  drain  on  foreign  currency  reserves  (which  decreased  by  around  25%  between  the 
beginning  of  October  and  early  December  2008)  would  jeopardise  the  viability  of  Latvia's 
exchange  rate  peg.  Against  this  background,  external  financial  assistance,  backed  up  by  a 
strong policy programme, will be required to ease liquidity constraints in the short term while 
supporting an orderly external adjustment in the medium term.  

In  light  of  the  above,  the  Commission  is  of  the  opinion  that  there  is  a  serious  threat  to  the 
Latvian  balance  of  payments.  The  Commission  thus  recommends  to  the  Council  a  decision 
granting mutual assistance.  

6. 

LATVIA'S  "ECONOMIC  STABILISATION  AND  GROWTH  REVIVAL  PROGRAMME": 
MACROECONOMIC AND FINANCIAL SYSTEM MEASURES 

Ongoing  discussions  between  the  Latvian  authorities  and  potential  contributors  to  a 
coordinated package of international financial assistance led to the adoption by the authorities 
of an ambitious policy programme (as noted above, submitted to Parliament and approved by 
it  on  12  December).  The  programme  is  based  on  maintaining  the  existing  peg  of  the  lats, 
which  will  remain  a  key  policy  anchor  going  forward.  The  programme  aims  to  address 
financial sector vulnerabilities, correct fiscal imbalances and improve competitiveness while 
maintaining  the  narrow-band  exchange  rate.  It  includes  an  immediate  and  sustained  fiscal 
consolidation,  a  comprehensive  bank  resolution  strategy,  a  strengthened  crisis  management 
capacity  of  regulatory  authorities,  comprehensive  structural  reforms,  as  well  as  other 
important  measures.  It  assumes  a  macroeconomic  scenario  of  GDP  contractions  of  5%  in 
2009  and  a  further  3%  in  2010,  giving  way  to  weak  recovery  of  2%  in  2011.  The  fiscal 
strategy targets a general government deficit of not more than 3% of GDP by 2011, aiming to 
meet the Maastricht deficit criterion in that year. 

The financial assistance negotiations with the EU, IMF and other parties, which highlighted 
serious  future  budget  deficits,  led  the  government  to  adopt  an  amended  outline  budget  for 
2009;  this  was  passed  by  Parliament  on  12  December  consistently  with  the  emergency 
economic stabilisation programme. The amended budget, based on the revised GDP forecast 
of  a  5%  contraction  in  2009,  takes  into  account  the  recent  deterioration  in  the  economic 
outlook and targets a general government fiscal deficit of below 5% of GDP4, implying only 
slight  structural  adjustment  compared  with  the  estimated  2008  outturn  (but  much  higher 
compared  with  the  budget  passed  in  November).  In  addition,  a  fully-fledged  supplementary 
budget law for 2009 consistent with the December budget outline should be adopted by end-
March 2009.  

On the expenditure side, consolidation is centred on a large reduction of public sector wages 
(by  15%  in  average  compensation  relative  to  the  original  14  November  2008  budget  -  but 
which  only  partially  reverses  the  large  real  increases  registered  in  recent  years)  and  further 

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This assistance programme acknowledges that Latvia will be in EDP in 2009. 

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staff reductions; in addition there is a large planned reduction in non-personnel current costs. 
A reduction of subsidies (excluding social support) and in expenditure on goods and services 
and  tightening  of  local  governments'  spending,  are  among  the  other  significant  measures 
planned. In this regard, national co-financing for EU-funded projects will be maintained at the 
planned level and help move the economy towards the tradable sector. On the revenue side, it 
comprises a 3pp increase in the standard VAT rate to 21%, an increase from 5% to 10% in the 
reduced VAT rate applicable to a much narrower tax base (principally medicines), increased 
excise  tax  on  fuel  (achieving  EU  acquis),  and  some  partial  offset  by  a  2pp  reduction  in  the 
personal income tax rate.  

Further  fiscal  consolidation  is  planned  for  2010,  and  the  medium-term  fiscal  framework  is 
anchored on the ambition of achieving in 2011 a general government deficit of no more than 
3% of GDP, consistent with the Maastricht fiscal convergence criterion. Imposition of further 
expenditure  restraint  in  2010,  introduction  of  a  capital  income  tax  (10%);  increase  in  real 
estate and property tax by removing exemptions in order to broaden the tax base will produce 
further  consolidation  in  that  year.  Furthermore,  measures  will  be  taken  to  strengthen  the 
design  and  implementation  of  budgetary  procedures  by  the  adoption  of  a  new  fiscal 
framework and budgetary reform law. 

In addition to the fiscal package described above, as a pre-condition for any external financial 
support, a resolution is being sought for Parex Bank under which the existing shareholders no 
longer hold any ownership interest. Following a first audit, the government has already taken 
control  of  over  85%  of  the  equity  of  the  bank.  Management  has  been  replaced.  The  new 
management is developing a resolution plan, consistent with minimising losses to the state. It 
will  seek  a  firm  commitment  in  the  near  future  from  external  parties  to  renew  Parex's 
syndicated funding.  

Other measures aim to guarantee wider banking sector stability in the medium to longer term. 
As a first step, the authorities will aim to restore confidence in the banking system. Targeted 
examinations will be conducted in the banking system to ensure that all banks are solvent and 
sufficiently  capitalized.  Viable  banks  in  need  of  capital  increases  will  be  required  to  seek 
private restructuring via outside investors or mergers, or capital support from parent banks.  

Almost all current external debt is owed by the private sector. In order to bring debt levels in 
line  with  sustainable  growth  in  the  future,  and  in  addition  to  prudential,  supervisory  and 
monetary policy  measures, debt  restructuring is an  important component  of the programme. 
The  appropriate  legal  basis  for  maturity  and  currency  restructuring  of  existing  debt  will  be 
strengthened.  Facilitating  insolvency  procedures  and  quick  implementation  of  rehabilitation 
plans will also be made a priority.  

The  economic  policy  programme  also  includes  structural  reform  measures  supported  in  the 
context of the Lisbon strategy, such as the active labour market and life long learning policies, 
greater  involvement  of  private  sector  actors  in  R&D  and  innovation  activities,  export 
promotion measures and removal of administrative burdens for businesses. 

7. 

EU  SUPPORT  UNDER  THE  BALANCE  OF  PAYMENTS  FACILITY  PART  OF 
INTERNATIONAL EFFORT 

In the light of the serious balance of payments difficulties being experienced by Latvia, and 
conditional on the Latvian authorities' firm commitment to implement a major programme of 

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economic  adjustment,  the  Commission,  following  consultation  with  the  Economic  and 
Financial  Committee  on  12  January  2009,  recommends  to  the  Council  the  granting  of  the 
mutual assistance foreseen by Article 119 of the Treaty.  

Furthermore,  the  Commission,  following  consultation  with  the  Economic  and  Financial 
Committee,  proposes  that,  after  adopting  the  above-mentioned  decision  of  the  Council  to 
provide mutual assistance to Latvia on a recommendation from the Commission, the Council 
adopts a decision providing under the EU facility for Member States (as governed by Council 
Regulation  (EC)  No  332/2002  of  18  February  2002)  a  medium-term  financial  assistance  to 
Latvia of up to EUR 3.1 billion to underpin its balance of payments sustainability.  

Medium-term  financial  assistance  would  intervene  at  a  moment  when  Latvia  is  seriously 
threatened  with  loss  of  domestic  and  international  confidence  in  its  financial  system,  has  a 
worsening fiscal situation, and faces substantial financing pressures in the near term. Overall, 
the  assistance  is  to  facilitate  necessary  external  and  internal  adjustments.  Total  estimated 
financing needs in the period up to first quarter of 2011 are 7.5bn EUR. This sum comprises 
allowance for the expected external (current and capital) account deficit, deposit withdrawals, 
incomplete rollover of maturing loans, errors and omissions in the balance of payments and 
international reserve accumulation to a prudential level. 

The  support  would  be  provided  in  conjunction  with  the  IMF  and  other  multilateral  and 
bilateral  support.  It  would  be  disbursed  in  six  instalments  and  linked  to  economic  policy 
conditions.  The  proposed  decision  would  expire  three  years  after  its  entry  into  force.  The 
economic  policy  conditionality  attached  to  EU  loan  disbursements  will  be  set  out  in  a 
Memorandum  of  Understanding  to  be  concluded  with  the  Latvian  authorities;  principal 
elements of this conditionality are the following: 

to 

to  2011.  Relative 

fiscal  consolidation  over 

the  original 
the  period 
A  major 
14 November 2008 budget, a very large fiscal consolidation is planned for 2009, targeting a 
budget deficit of no higher than 5% of GDP, with further consolidation in 2010. Underpinning 
budgetary  measures  include:  notably,  (i)  adoption  of  a  clearly-set  medium-term  fiscal 
programme  designed  to  reduce  the  general  government  budget  deficit  to  lower  than  Treaty 
reference  level  of  3%  of  GDP  by  2011;  (ii)  within  medium-term  budgetary  ceilings,  the 
reduction  of  average  public  sector remuneration in  nominal  terms by  approximately 15% in 
2009;  this  should  also  apply  to  local  governments,  government  agencies  and  state-owned 
companies; (iii) the elimination of bonuses and similar payments; (iv) a reduction of at least 
5% in public sector and local government employment; (v) substantial reductions in subsidies 
(excluding social support) and expenditure on goods and services; (vi) implementation of EU-
funded projects at previously planned levels. 

Financial conditionality measures aiming to guarantee wider banking sector stability in the 
medium  to  longer  term.  As  a  first  step,  the  authorities  will  aim  to  restore  confidence  in  the 
banking  system.  Targeted  examinations  will  be  conducted  in  the  banking  system  to  ensure 
that  all  banks  are  solvent  and  sufficiently  capitalized.  Viable  banks  in  need  of  capital 
increases  will  be  required  to  seek  private  restructuring  via  outside  investors  or  mergers,  or 
capital  support  from  parent  banks.  An  important  stage  in  this  process  was  the  separate 
announcements  on  18  December  2008  by  three  major  foreign  parent  bank  groups  of  their 
commitment to remain in Latvia and support their operations there. 

Debt  restructuring  in  the  private  sector  in  order  to  reducing  vulnerabilities  from  high  debt 
levels  (almost  all  the  external  debt  is  owed  by  the  private  sector),  and  in  addition  to 

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prudential,  supervisory  and  monetary  policy  measures.  The  appropriate  legal  basis  for 
maturity  and  currency  restructuring  of  existing  debt  should  be  strengthened.  Facilitating 
insolvency procedures and quick implementation of rehabilitation plans must also be made a 
priority.  This  includes  amending  the  insolvency  law  to  facilitate  workouts  between  viable 
enterprises and their creditors and improving the personal bankruptcy framework. 

Structural measures in the area of incomes policies, fiscal discipline and budget process and 
management.  The  Budget  and  Financial  Management  law  will  be  amended  to  strengthen 
provisions on financial responsibility, transparency and accountability and the medium term 
budgetary  framework  will  be  made  operational.  A  special  committee  will  be  established  to 
monitor wage restraint and to issue recommendations to ensure that wages evolve in a way to 
restore competitiveness. 

Structural reform measures supported inter alia in the context of the Lisbon strategy, such as 
the  active  labour  market  and  lifelong  learning  policies,  greater  involvement  of  the  private 
sector  in  R&D  and  innovation  activities,  export  promotion  measures  and  the  reduction  of 
administrative burdens for businesses. 

To ensure the necessary flexibility in the current market context, it is proposed to allow the 
option  of  using  interest  rate  swaps  for  the  borrowing  operation  which  finances  the  loan.  In 
order to safeguard the EU budget, the counterparties of a potential swap would have to be of 
the highest credit quality. 

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Recommendation for a 

COUNCIL DECISION 

Granting mutual assistance for Latvia 

THE COUNCIL OF THE EUROPEAN UNION, 

Having regard to the Treaty establishing the European Community, and in particular Article 
119, 

Having  regard  to  the  recommendation  from  the  Commission  made  after  consulting  the 
Economic and Financial Committee, 

Whereas: 

(1) 

(2) 

(3) 

(4) 

(5) 

(6) 

Against  a  background  of  very  high  external  financing  needs,  Latvian  capital  and 
financial markets have recently come under pressure, reflecting a general deterioration 
in market sentiment, and increasing concerns about the health of the Latvian economy 
given  its  large  imbalances  in  terms  of  wide  external  deficit  and  very  large  external 
debt, weakening public finances and high rates of cost and price inflation. The Latvian 
banking  sector  has  experienced  serious  liquidity  and  confidence  problems.  The  level 
of foreign currency reserves has decreased as the central bank intervened to preserve 
the currency peg.  

The  Council  regularly  reviews  the  economic  policies  implemented  by  Latvia,  in 
particular  in  the  contexts  of  Latvia's  convergence  programme  and  National  Reform 
Programme, as well as in the context of Convergence Reports.  

Latvia's total external financing needs up to the first quarter of 2011 are estimated at 
EUR 7.5 billion. 

The  Latvian  authorities  have  requested  substantial  financial  assistance  from  the  EU 
and  other  international  financial  institutions  and  countries  to  support  balance  of 
payments sustainability. 

There is a serious threat to the Latvian balance of payments which justifies the urgent 
granting  of  mutual  assistance  by  the  Community  in  conjunction  with  the  IMF  and 
other contributors. 

The  financial  assistance  package  would  be  provided  subject  to  a  strong  commitment 
from  the  Latvian  authorities  to  implement  an  ambitious  fiscal,  financial  system  and 
structural  reform  programme  to  facilitate  the  necessary  external  and  internal 
adjustments, to stabilize the economy and to restore economic policy credibility. The 
Commission will review regularly and closely, in collaboration with the EFC, that the 
economic policy conditions attached to the assistance are fully implemented. 

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HAS ADOPTED THIS DECISION:  

The Community shall grant mutual assistance to Latvia. 

This Decision is addressed to the Member States. 

Sole article 

Done at Brussels,  

For the Council 
The President  

EN 

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Proposal for a 

COUNCIL DECISION 

Providing Community medium-term financial assistance for Latvia 

THE COUNCIL OF THE EUROPEAN UNION, 

Having regard to the Treaty establishing the European Community,  

Having regard to Council Regulation (EC) No 332/20025 of 18 February 2002 establishing a 
facility providing medium-term financial assistance for Member States' balance of payments 
and in particular Article 3(2), 

Having regard to the proposal from the Commission made after consulting the Economic and 
Financial Committee (EFC), 

Whereas: 

(1) 

On [….] the Council decided to grant mutual assistance for Latvia. 

(2) 

(3) 

(4) 

Against  a  background  of  very  high  external  financing  needs,  Latvian  capital  and 
financial markets have recently come under pressure, reflecting a general deterioration 
in market sentiment, and increasing concerns about the health of the Latvian economy 
given its large imbalances in terms of wide external deficit, weakening public finances 
and high rates of cost and price inflation. The Latvian banking sector has experienced 
serious liquidity and confidence problems. The level of foreign currency reserves has 
decreased as the central bank intervened to preserve the currency peg. 

Latvia's total external financing needs up to the first quarter of 2011 are estimated at 
EUR 7.5 billions. 

It  is  appropriate  to  provide  Community  support  to  Latvia  of  up  to  EUR  3.1  billion 
under  the  Facility  providing  medium-term  financial  assistance  for  Member  States' 
balance  of  payments  established  by  Regulation  (EC)  No  332/2002.  Community 
assistance  should  be  provided  in  conjunction  with  a  loan  from  the  International 
Monetary  Fund  of  SDR  1.5  billion  (1200%  of  Latvia's  IMF  quota,  around  EUR  1.7 
billion)  under  an  IMF  Stand-by  arrangement  approved  on  23  December  2008.  The 
Nordic countries (Sweden, Denmark, Finland and Norway) are to contribute EUR 1.8 
billion  together,  the  World  Bank  -  EUR  0.4  billion,  the  European  Bank  of 
Reconstruction and Development, the Czech Republic, Poland and Estonia - a total of 
EUR  0.5  billion,  bringing  the  total  to  EUR  7.5  billion  over  the  period  to  the  first 
quarter of 2011. 

(5) 

The  Community  assistance  should  be  managed  by  the  Commission.  The  specific 
economic policy conditions agreed with the authorities of Latvia after consultation of 
the  EFC  should  be  laid  down  in  a  Memorandum  of  Understanding.  They  should 
include inter-alia measures intended to stem immediate liquidity pressures, to restore 

5 

OJ L 53 23.2.2002, p.1. 

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12 

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long-term  stability  by  strengthening  the  banking  sector,  to  correct  fiscal  imbalances 
and  to  adopt  domestic  policies  that  will  improve  competitiveness.  The  measures 
should include an immediate and sustained fiscal consolidation, a comprehensive bank 
resolution  strategy,  a  strengthened  crisis  management  capacity  of  regulatory 
authorities,  comprehensive  structural  reforms,  as  well  as  other  important  measures. 
The  detailed  financial  terms  should  be  laid  down  by  the  Commission  in  the  Loan 
Agreement. 

(6) 

The  assistance  should  be  provided  with  a  view  to  stemming  immediate  liquidity 
pressures  and  conditional  on  policies  to  restore  long-term  stability  by  strengthening 
the  banking  sector,  correcting  fiscal  imbalances  and  adopting  domestic  policies  that 
will improve competitiveness, while maintaining the narrow-band exchange rate at its 
existing central rate. 

HAS ADOPTED THIS DECISION:  

Article 1 

1. 

2. 

1. 

2. 

3. 

1. 

2. 

3. 

The Community shall make available to Latvia a medium-term loan amounting to a 
maximum of EUR 3.1 billion, with a maximum average maturity of five years. 

The  Community  financial  assistance  shall  be  made  available  during  three  years 
starting from the first day after the entry into force of this Decision. 

Article 2 

The  assistance  shall  be  managed  by  the  Commission  in  a  manner  consistent  with 
Latvia's  undertakings  and  recommendations  by  the  Council.  Those  conditions  shall 
be laid down in a Memorandum of Understanding. The detailed financial terms shall 
be laid down by the Commission in the Loan Agreement. 

The Commission shall, in collaboration with the EFC, verify at regular intervals that 
the  economic  policy  conditions  attached  to  the  assistance  are  fulfilled.  The 
Commission shall keep the EFC informed of possible refinancing of the borrowings 
or restructuring of the financial conditions. 

Latvia  shall  be  ready  to  adopt  and  implement  additional  consolidation  measures  to 
stabilize the economy, in case such measures will be necessary during the assistance 
programme. The Latvian authorities shall consult the Commission in advance of the 
adoption of any such additional measures. 

Article 3 

The Community financial assistance shall be made available by the Commission to 
Latvia in a maximum of six instalments, the size of which will be laid down in the 
Memorandum of Understanding. 

The  first  instalment  shall  be  released  subject  to  the  entry  into  force  of  the  Loan 
Agreement and Memorandum of Understanding. 

If  required  in  order  to  finance  the  loan,  the  prudent  use  of  interest  rate  swaps  with 
counterparties of highest credit quality shall be permitted. 

EN 

13 

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4. 

5. 

The  Commission  shall  decide  on  the  release  of  further  instalments  after  having 
obtained the opinion of the EFC. 

implementation  of 

The  disbursement  of  each  further  instalment  shall  be  made  on  the  basis  of  a 
(Economic 
satisfactory 
Stabilisation and Growth Revival Programme) of the Latvian Government, included 
in  the  convergence  programme,  and,  more  particularly,  of  the  specific  economic 
policy  conditions  laid  down  in  the  Memorandum  of  Understanding.  These  shall 
include, inter alia: 

the  new  economic  programme 

(a) 

(b) 

(c) 

(d) 

(e) 

(f) 

Adoption of a clearly-set medium-term fiscal programme designed to lower by 
2011 the general government deficit to not more than the Treaty reference level 
of 3% of GDP.  

Execution  of  the  budget  for  2009  as  amended  by  the  supplementary  budget 
adopted  12  December  2008  (and  to  be  amended  in  detail  during  the  first 
quarter of 2009), targeting a general government deficit of no higher than 5% 
of GDP.  

Reduction of average public sector remuneration in nominal terms in 2009 by 
at least 15% relative to the original 14 November 2008 budget and a further 2% 
in 2010-2011.  

Reduction  during  2009  of  at  least  5%  in  public  sector  and  local  government 
employment. 

Strengthening  the  design  and  implementation  of  budgetary  procedures  by  the 
adoption of a fiscal framework and budgetary reform law. 

Introduction of a clear and transparent wage payment system for direct public 
administration  employees  and  establishment  of  a  single  human  resource 
planning and management system for public administration institutions. 

(g)  Mechanisms to ensure wider banking sector stability in the medium to longer 
term,  including  a  wide  range  of  supervisory,  prudential  and  monetary  policy 
measures.  These  should  limit  credit  growth  to  sustainable  levels  and  avoid 
heavy  reliance  on  unsecured  foreign  funding.  Targeted  examinations  shall  be 
conducted  in  the  banking  system  to  ensure  that  all  banks  are  solvent  and 
sufficiently capitalized.  

(h) 

(i) 

(j) 

Appropriate  measures  regarding  private  sector  debt  restructuring.  The 
appropriate legal basis for maturity and currency restructuring of existing debt 
insolvency  procedures  and  quick 
shall  be  strengthened.  Facilitating 
implementation of rehabilitation plans shall also be made a priority.  

Ensuring  that  the  remaining  minority  shareholders  of  Parex  Bank  do  not 
benefit  from  the  resolution  of  the  bank  and  measures  to  enhance  financial 
stability, by means of fully nationalising Parex Bank. 

Structural reform measures supported in the context of the Lisbon strategy and 
implemented in Latvia's National Reform Programme, including active labour 
market  and  lifelong  learning  policies,  greater  involvement  of  private  sector 

EN 

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actors  in  R&D  and  innovation  activities,  export  promotion  measures  and 
removal of administrative burdens for businesses.  

(k) 

Implementation of EU-funded projects at the planned level to help improve the 
contribution of the tradeable sector to economic growth.  

(l)  Measures  to  improve  access  to  financing  for  companies  and  entrepreneurs, 
whose  applications  for  Structural  Funds  have  been  approved,  or  who  may  be 
planning to apply for Structural Funds.  

This  Decision  is  addressed  to  the  Republic  of  Latvia.  It  shall  be  published  in  the  Official 
Journal of the European Union. 

Done at Brussels,  

For the Council 
The President 

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BUDGETARY IMPACT STATEMENT 

(cf. Article 16 of the Internal Rules) 

POLICY AREA: TITLE 01 – ECONOMIC AND FINANCIAL AFFAIRS 

ACTIVITY: FINANCIAL OPERATIONS AND INSTRUMENTS 

TITLE  OF  ACTION:  EU  MEDIUM-TERM  FINANCIAL  ASSISTANCE  FOR 
LATVIA 

1. 

2. 

3. 

NAME  OF  THE  PROPOSAL:  BUDGET  HEADING  CONCERNED  AND 
TITLE 
01  04  01  01  EC  guarantee  for  Community  loans  raised  for  balance-of-payments 
support 
LEGAL BASIS: 
Art. 119; Council Regulation N° 332/2002 of 18 February 2002.  
OVERALL FIGURES FOR THE FINANCIAL YEAR (IN EUROS) 
This item constitutes the structure for the guarantee provided by the European Union. 
It will enable the Commission to service the debt (principal, interest and other costs) 
should the debtor (Latvia) default.  
The  budget  entry  ("p.m.")  reflecting  the  budget  guarantee  will  be  activated  only  in 
the case of an effective call on the guarantee. It is expected that normally the budget 
guarantee will not be called. 

CA 

3a – Current year 
Not applicable 

Initial appropriation for the 
financial year (budget) 

Transfers 

Additional appropriation  

Total appropriation 

Appropriations  already  set 
aside  by  another  work 
programme 

Balance available 

Amount  for  the  action 
proposed 

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3b – Carry overs 
Not applicable 

Carry-overs 

Appropriations  already  set 
aside 
another  work 
by 
programme  

Balance available 

Amount 
proposed 

for 

the  action 

3c – Next financial year 
Not applicable 

Initial appropriation for the 
financial year (budget) 

Transfers 

Additional appropriation 

Total appropriation 

Appropriations  already  set 
aside  by  another  work 
programme 

Balance available 

Amount 
proposed 

for 

the  action 

CA 

CA 

p.m. 

p.m. 

4. 

DESCRIPTION OF THE ACTION 
The  proposed  medium-term  financial  assistance  to  Latvia  consists  of  a  Community 
loan (to be financed by Community borrowings in the international capital markets) 
in  the  amount  of  EUR  3.1  billion.  It  will  be  provided  in  the  context  of  an 
international financing package, and in particular by an IMF loan of SDR 1.5 billion 
(around  EUR  1.7  billion)  supported  by  the  stand-by  facility.  The  Nordic  countries 
contribute  with  EUR  1.8b.  and  Estonia,  Czech  Republic,  Poland  and  EBRD  have 
also committed a total of EUR 0.5 billion.  
The assistance reflects the willingness to support Latvia, whose capital and financial 
markets have come under pressure due to general deterioration in market sentiment 
towards emerging markets. The Community medium-term financial support to Latvia 
is  intended  to  stem  immediate  liquidity  pressures,  to  restore  long-term  stability  by 
strengthening the banking sector, to correct fiscal imbalances and to adopt domestic 
policies  that  will  improve  competitiveness,  while  maintaining  the  narrow-band 

EN 

17 

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exchange  rate.  The  economic  policy  package  hereby  supported  includes  an 
immediate  and  sustained  fiscal  consolidation,  a  comprehensive  bank  resolution 
strategy,  a  strengthened  crisis  management  capacity  of  regulatory  authorities, 
comprehensive structural reforms, as well as other important measures.  
The assistance managed by the Commission in consultation with the Economic and 
Financial Committee is a way to ensure that the EU remains closely involved in the 
shaping  of  economic  policies  in  Latvia  and  that  those  policies  are  consistent  with 
Latvia's undertakings in the EU and recommendations by the Council, in particular as 
concerns  the  implementation  of  the  National  Reform  Programme,  as  well  as  of  the 
convergence programme.  
The  Community  borrowings  raised  on  the  capital  markets  or  from  financial 
institutions  for  the  purpose  of  extending  the  loan  to  Latvia  are  covered  by  the 
Community  guarantee.  The  loan  is  raised  on  the  capital  markets  or  from  financial 
institutions.  The  amount  in  principal  of  loans  which  will  be  granted  to  Latvia 
amounts to EUR 3.1 billion. 
The  structure  for  the  guarantee  provided  by  the  European  Union  will  enable  the 
Commission to service the debt should Latvia default. 
In order to honour its obligations, the Commission may draw on its cash resources to 
service  the  debt  provisionally.  In  this  case,  Article  12  of  Council  Regulation  (EC, 
Euratom)  No  1150/2000  of  22  May  2000  implementing  Decision  2000/597/EC, 
Euratom  on  the  system  of  the  Communities’  own  resources  (OJ  L  130,  31.5.2000, 
p. 1) will apply. 
METHOD OF CALCULATION ADOPTED 
Not applicable. 
PAYMENT SCHEDULE (IN EURO) 
Not applicable. 

5. 

6. 

Heading  Appropriations 

Payments 

Year n 

Year n+1  Year n+2  Year n+3 

Subsequent 
financial 
years 

Year n 

Year n+1 

Year n 

Year n+1   

Total 

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