<u>private sector R&D.</u><sup>9</sup> And this in turn entailed a parallel increase in the sophistication of private sector enterprises so that they had the capacity and interest in financing and conducting R&D. All this is currently missing in Latvia. Therefore, merely increasing the volume of R&D spending will do little to remedy Latvia’s problems unless this increase is preceded by significant institutional reforms.

Fortunately, while the challenges and dilemmas facing Latvian policy makers are daunting, the situation is far from hopeless. On the contrary, with hard work, good policies, political consensus, and an intelligent use of EU structural funds, Latvia can be well on its way to a bright, successful future. EU structural funds could be especially important in this process. Latvia will soon have an **<u>opportunity</u>** to benefit from large inflows of EU grant funds. But this is only an opportunity which can be either squandered or exploited. It is generally recognized that some previous EU entrants squandered this opportunity and others used it to create the foundation for a dynamic, competitive economy. The lesson for Latvian policy makers, therefore, is rather straightforward: If utilized productively and wisely, EU structural funds can provide Latvia with an opportunity to design and finance comprehensive programs, based on international lessons of experience and best practice, to improve the competitiveness of Latvian enterprises, make Latvia a more innovative economy, create a large and growing pool of high wage employment opportunities, and ensure that Latvia’s NIS efficiently and effectively converts knowledge into wealth.

This paper is designed to help Latvian leaders (i) develop and clear diagnosis of the innovation and competitiveness challenges facing Latvia as it prepares to enter the EU and, more importantly (ii) design and implement policies and programs to ensure that Latvia reaps the maximum possible benefits from EU structural funds. Section II analyzes the current structure of Latvia’s production, imports, and exports. This analysis will show that Latvia is currently producing and exporting primarily low value added goods and services and importing high value added, knowledge-intensive goods and services. Latvia, in other words, is running both a merchandise trade deficit and a knowledge deficit. There is nothing wrong with obtaining knowledge embedded in imported goods and services. Indeed, all successful economies must import knowledge. But many Latvian enterprises have no clear policy for, or capacity to, implement a policy of industrial upgrading – i.e., a strategy for shifting from the production of low value added goods and services to the production of higher value added goods and services. Unless this problem is resolved, Latvia’s current knowledge deficit will be a recipe for declining terms of trade, declining standards of living, and long term economic stagnation.

> 9   Official statistics suggest that the share of R&D financed by the Latvian private sector is 40%.  While this is below the OECD and EU average of close to 67%, it would appear to be a rather respectable level, especially given Latvia’s relatively low per capita GDP.  However, most of the private R&D in Latvia is performed by a few foreign telecom firms.  All other Latvian firms combined finance a relatively small share of total R&D.  Thus, the task for Latvia is much greater than the official statistics would suggest.  This issue is explored in greater detail below.  For additional data on the share of R&D financed by the private sector in various OECD and non-OECD countries, see OECD, <u>Science, Technology and Industry Scoreboard, 2003, especially Section A.4.1 and A12.1.</u>

10