Latvia’s Dilemma: Financing Accession Costs While Maintaining Fiscal Constraint
by Inna Steinbuka

By carrying out successive economic programs endorsed by the Fund and supported by its stand-by arrangements, Latvia was able to accelerate the accession process and the convergence with EU member states. (Stand-by arrangements are IMF credits that finance temporary balance of payments deficits of member countries and must be repaid within 3¼–5 years.) The new program, under a "precautionary" stand-by arrangement for 2000–01, seemed to be consistent with the accession strategy. (The arrangement is considered "precautionary" because the money is available, but the Latvian authorities are not supposed to use it, only in case of a crisis.) However, Latvian policymakers realize that they face a rather difficult tradeoff between the extra budgetary spending implicitly required by the EC for EU membership and the tight fiscal policies required by the Fund.

Fear that high current account deficits leave the Baltic countries vulnerable to external shocks is the key reason why the Fund requires tight fiscal policies in all of these countries. Although the outlook for Latvia’s external sector has improved since 1998 (table 1), the current account deficit remains relatively large. Current improvement probably cannot be sustained in light of the expected acceleration in domestic demand. Latvia exports low value-added items, such as food products, textiles, and wood, while importing high value-added products, such as transport equipment and electronics. The need for imported capital equipment to modernize industrial production is likely to grow rather than diminish, as will demand for oil and gas. As a result, the current account deficit is likely to increase.

In the past decade, the current account deficit was comfortably covered by foreign direct investment. This trend continued in the first three quarters of 2000, despite delays in large-scale privatization. Ensuring external sustainability remains one of the key challenges over the medium term.

Fiscal tightening is crucial in Latvia, largely because the country has adopted a fixed exchange rate regime that leaves limited scope for the active use of monetary instruments. In the past decade, the fiscal deficit was relatively low, exceeding the 3 percent target only in 1994 (because of increases in net lending), in 1995 (because of the banking crisis), and in 1999 and 2000 (because of the Russian crisis) (table 2). The Fund—which monitored the 16-month economic program that started in late 1999—was not happy with the results, criticizing the government for failing to reduce the deficit. As a result, the program was suspended before its completion.

Lithuania also failed to meet its fiscal targets in 2000, but its economic program was nevertheless endorsed by the IMF. There, however, modest overshooting of the target reflected the ongoing recession and the impressive reduction of the current account deficit. In contrast, in Latvia the economy is expanding rapidly, thus fuelling imports, and the difference between the actual and the target fiscal deficit was larger than in Lithuania. In Estonia, where economic prospects look good, the government did not request a new arrangement with the IMF after the successful completion of its last program, in 2000. By early 2001 Lithuania was the only Baltic country that had an economic program supported by an IMF precautionary stand-by arrangement.

The Latvian government is now ready for a new 20-month program, which it expects the IMF to support. The new program includes the typical medicines used to combat an increase in external imbalance and potential pressure on local currencies: tightening of fiscal policies and accelerating structural reforms.

The European Commission (EC) requirements and guidelines for macroeconomic and structural reforms are addressed in the "Joint Assessment of Economic Policy Priorities," prepared jointly by the EC and the Latvian government. This document is generally consistent with the Fund-supported programs. Three differences are noteworthy, however. First, the joint assessment is aimed at medium-term priorities, while the Fund programs focus on near-term objectives. Second, the Fund-supported program clearly lays out the government’s responsibilities and provides a timetable for full and timely implementation. It is more specific than the EC-Latvia Assessment , which allows the authorities flexibility in selecting and adjusting their policy mix in order to achieve the medium-term priorities. This document thus provides a framework for dialogue between the Latvian authorities and the EC rather than specifying a set of policies. Third, implementation of Fund-supported programs is well monitored through a set of quantitative performance criteria, indicative targets, and structural benchmarks. In contrast, compliance with the accession strategy is monitored by the government and EC staff.

The EC’s "Progress Report on Latvia," which evaluates Latvia’s ability to assume the obligations of EU membership, presents an overall assessment of the chapters on the acquis communautaire. That implicitly imposes some potential pressure on Latvia’s fiscal position, because it requires that Latvia adopt EU environmental and other standards. Some experts estimate that the extra spending requirements for EU accession may be as high as 5 percent of GDP for several years in all candidate countries. The EC Office estimates that the costs of meeting environmental requirements alone could amount to 2–5 percent of GDP a year. EU transfers to Latvia to finance at least part of such spending could be somewhat above 1 percent of GDP in 2001, at best these transfers would rise only modestly over the medium term.

Financing these costs under the tight fiscal framework will be difficult for Latvia. The only sensible way to do so is to improve prioritization and management of public spending.

The preparation of a Pre-Accession Economic Program has already helped policymakers focus on medium-term budgetary targets. In the years to come, however, the Latvian government will have to handle the difficult tradeoff between fiscal discipline and extra spending.