OREANDA-NEWS. February 04, 2007.General Economic Developments. Of late, the statistical data more clearly signal stabilization of the so far overly buoyant and in some aspects even imbalanced economic development, reported the press-centre of Bank of Latvia.

Growth in manufacturing slowed down in October and November. The seasonally adjusted volume index of industrial output recorded a year-on-year decline by 6,7% in October and by 4,8% in November. This pronounced drop in both months was mostly driven by shrinking output in the major manufacturing sector of food products and beverages (by 18,3% and 15,9% respectively) primarily as a result of the demise of Latvia's sugar industry.

The performance of the state JSC Latvijas dzelzcels was particularly successful in October and November, with freight turnover increasing by 27,3% year-on-year. The overall freight turnover at Latvian ports, however, strengthened only by 1,8%.

Retail trade turnover (including motor vehicle sales and automotive fuel retailing) expanded by 10,7% in October and 10,4% in November (an increase of 29,2%, 24,0% and 16,8% against the first, second and third quarters respectively). At the same time, the number of newly registered passenger cars dropped 20,6% in the fourth quarter (36,1% in December).

In December 2007, inflation surged to 14,1%. The rising costs of previous periods, to a great extent driven by higher expenditure on energy and labour, made some administered prices soar (those of house maintenance and transport services in particular), and a stable domestic demand brought about a particularly steep rise in non-administered service prices (13,5% per annum on average). Moreover, in the second half of 2007, the pressure of the global food market trends on grain and dairy product prices in Latvia intensified. Fluctuations of oil prices were in part offset by depreciation of the US dollar, hence fuel price rises were less pronounced and contributed a mere 0,2 percentage point to inflation.

With costs on an upward trend (driven also by projected escalation of energy costs) and due consideration of lagged effects, inflation rate is likely to be the very last indicator to respond to the national action plan for stabilisation of macroeconomic situation and moderation in the economic growth. The current upward inflation trend is likely to continue at the beginning of 2008, with easing anticipated only in spring or even mid-year. This assumption builds on administratively regulated price rises, both already in effect and to be approved by the Public Utilities Commission in the near future, on excise tax increases (substantial for tobacco products, moderate for fuel) and on the impact of energy prices on the components of core inflation.

With the high inflation rate of the first half of the year heading for a gradual slowdown, inflation may be down to around 9% by December 2008, according to the Bank of Latvia forecasts. Turbulence in the oil market and global food market fluctuations do not suggest a more dynamic price stabilisation scenario, with the average annual inflation rate at around 13%.

In December 2007, the general government consolidated budget incurred a financial deficit of 168,4 million lats (almost twice below the indicator year-on-year). Hence the financial surplus since the beginning of the year rose to 94,0 million lats or 0,7% of the projected GDP, which is above the GDP level forecast in the amended budget for 2007 (54,5 million lats or 0,4% of GDP).

Banking Sector and its Development
Banking services in the Republic of Latvia are offered by twenty-one banks and three branches of foreign banks as well as by credit institutions or their subsidiaries registered in the countries of the European Economic Area that have submitted their applications to the Financial and Capital Market Commission. Three electronic money institution and three money market funds have also been registered with the Bank of Latvia.

According to the Financial and Capital Market Commission data, foreign shareholders owned 68.8% of the total paid-up share capital in Latvian banks at the end of 2006. They held over 50% of paid-up share capital in eleven banks.

Restructuring of the banking sector has been accomplished, and the industry is almost entirely in private hands. The State of Latvia is the owner of the SJSC Latvijas Hipoteku un zemes banka, which also functions as a development bank (at the end of 2006, its share capital accounted for 8.2% of the total paid-up bank capital).

According to preliminary data, banks' profit reached 375,0 million lats in 2007 (an increase of 108,0 million lats or 40,4% year-on-year).

Bank of Latvia
The main objective of the Bank of Latvia, as stipulated by the Law "On the Bank of Latvia", is to regulate the amount of money in circulation with the aim of maintaining price stability through the implementation of monetary policy.

Independence of the Bank of Latvia is guaranteed by the Law "On the Bank of Latvia". The Bank also meets all prerequisites, as established by the European Central Bank, for independence of a central bank. No institution or person can influence the Bank's decisions. The Governor of the Bank is appointed by the Saeima of the Republic of Latvia. Likewise, upon the Governor's recommendation, it appoints members of the Board of Governors for a six-year term. The Governor, the Deputy Governor and members of the Board of Governors may be discharged before their term of office only if they have tendered their resignation, if a court decision on sentencing any of them for a deliberate crime has taken legal effect, or if the Governor, the Deputy Governor or a member of the Board of Governors is not able to officiate for a period exceeding six successive months because of illness or another reason.

The Law prohibits the Bank of Latvia from granting direct credit to the Government to cover budget deficit. Likewise, the Bank of Latvia does not have the right to buy government securities on the primary market.

The Bank of Latvia has developed and is using the same full set of indirect market based monetary policy instruments that are used by the European Central Bank.

On 18 May 2000, the Bank of Latvia was assigned quality management ISO 9002 certification. The Bank of Latvia has adjusted its quality management system to the new version of the standard and on 7 May 2003 received certification confirming compliance with ISO 9001:2000. The certification was reissued on 3 May 2006.

Movement of Capital and the Payment System
Both current and capital account transactions have been fully liberalised in Latvia. There are virtually no restrictions on cash and capital flows to and from Latvia. The Bank of Latvia ensures full convertibility of the lats by buying from and selling to banks unlimited amounts of euro at their request.

In 2000, the Bank of Latvia introduced the real-time gross settlement system SAMS (the inter-bank automated payment system), which enables safe and efficient settlement on the Latvian interbank market and in the Bank of Latvia's monetary policy operations. The Bank of Latvia joined TARGET2, the single European payment system enabling real-time euro payments of the participants of the Latvian financial market, in November 2007.

Banking Legislation
General. The legislative framework for banking in Latvia meets the EU requirements in full, and in some areas the requirements are even more rigorous. The International Accounting Standards (IAS) have been fully introduced; banks' annual reports are prepared in accordance with IAS and audited by internationally recognised auditing firms. Practical supervision of the banking sector in Latvia is very tight and bank inspections are conducted more frequently than in the EU Member States.

Legislation. The Law "On Credit Institutions" (in effect as of 24 October 1995) has been amended on several occasions. The instructions and regulations of the Financial and Capital Market Commission and the Bank of Latvia complement the provisions of this Law and are binding on all credit institutions. The whole set of regulations for measuring the performance of credit institutions and the report submission procedure are in place and fully conform to the EU standards.

The Law "On Prevention of Laundering of Proceeds Derived from Criminal Activity" (in effect as of 1 June 1998) fully conforms to the relevant EU directives: it requires customer identification and record keeping on all transactions, identification of suspicious and unusual transactions, and their reporting to the Board of Prevention of Legalization of Proceeds from Criminal Activity.

The Law "On Deposit Guarantees" (in effect as of 1 October 1998 with amendments on 15 March 2007) stipulates that as of 1 January 2008 the deposit guarantee shall be increased consistently with the EU requirements (not in excess of 20 000 euro translated into lats at the exchange rate quoted by the Bank of Latvia for the day when the withdrawal of a deposit becomes impossible irrespective of the depositing date). A deposit guaranty is also applicable to the deposits of legal persons as of 2003.

As of 1 July 2001, a single supervisory authority, the Financial and Capital Market Commission, successor in this area to the Bank of Latvia, supervises the financial sector. Hence, the banking sector is subject to even more rigorous and effective consolidated supervision that currently ranks among the strictest in Central and Eastern Europe.

Latvia's Integration in the European Union and Introduction of the Euro
Following Latvia's accession to the EU, the Bank of Latvia's policy is based on the strategic goal to prepare the country for a full-fledged participation in the Economic and Monetary Union. In the light of its commitment, Latvia is aiming towards both nominal and real convergence with the EU member states. Though real convergence is a long-term objective, Latvia is well on its way of achieving it.

Since 1996, real GDP growth in Latvia has exceeded the average GDP growth rate in the EU countries (except in 1999), thus gradually narrowing per capita income differences.

The structure of Latvia's GDP is in line with that of industrially developed countries: the share of agriculture, hunting and forestry in total value added declined from 8,6% in 1995 to 3,6% in 2006, that of manufacturing from 20,1% to 11,8%, respectively, whereas the share of services increased from 61,2% to 74,8%.

The role of the EU in Latvia's foreign trade is strengthening: 74,9% of total exports from Latvia went to the EU countries in 2006.

Although Latvia complies with the majority of the Maastricht convergence criteria necessary for joining the Economic and Monetary Union already now, the initial plan for the adoption of the euro in 2008 has been revised due to the high rate of inflation.

Sources: data of the Treasury, the Central Statistical Bureau and Eurostat.

The peg of the lats to the euro - the first most significant monetary adjustment following Latvia's accession to the EU - was effected on 1 January 2005, followed by joining the Exchange Rate Mechanism II (ERM II) on 2 May. The latter is an arrangement for exchange rate pegging and simultaneously a procedure for testing maturity of the euro-adopting accession countries. Latvia's participation in the ERM II is important for compliance with the Maastricht convergence criteria and becoming a full-fledged member of the Economic and Monetary Union. Since joining the ERM II, Latvia's monetary system has to operate within it for at least two years.

In September 2007, the Latvian Government revised the initial plan for the adoption of the euro and decided to specify the target date at the latest 24 months prior to the actual changeover to the euro when the three-year forecasts of Latvia's Convergence Programme come close to the compliance with the Maastricht criteria. According to the Ministry of Finance, Latvia's changeover to the euro might tentatively take place in 2011-2013. The introduction of the euro in Latvia will be an issue of the EU multilateral relations affecting common interests of all EU countries. Therefore, the projected timeframe for the introduction of the euro is merely tentative and will gain an official status only after the completion of all negotiations and other formal procedures.