(objectives and implementation)
The Bank of Latvia began its work when the Republic of Latvia declared its independence in 1991. It has now become a fully operational central bank. The Bank of Latvia is independent of the Government and operates in accordance with a special law that regulates its activities. The main goal of the monetary policy after the introduction of the national currency was to achieve the stabilization of currency, preventing the growth in inflation and maintaining price stability, thus creating a stable financial environment.
Neither the Parliament, nor the Government, including the Ministry of Finance, are in position to influence or overrule the decisions made by the Bank of Latvia, especially those concerning the monetary policy. The members of the governing body of the Bank, including the President, are appointed by the Parliament for six years, and normally cannot be dismissed ahead of that term.
The Bank of Latvia licenses and supervises commercial banks and other credit institutions. At end-May 1995, there were 53 licensed commercial banks in Latvia. The relatively large number of banks is a result of liberal licensing requirements in the recent past. It is inevitable that we can expect consolidation of the banking industry in the near future. Three of the banks are owned by the State: the Universal Bank of Latvia, the Latvian Savings Bank, and the Mortgage and Land Bank. Only one foreign bank (Société Générale, France) has so far been licensed. The remaining banks are either privately owned, or they are joint-stock companies with private and State capital. Several banks have foreign participation, with predominance of Russian capital.
Banks form the most essential part among financial institutions. Other financial intermediaries like pension and investment funds are at the very beginning of development.
Financial intermediation in Latvia is at its early stage of development. Stock Exchange has not started its activity up to now, but it can be assumed that it will enter the market in July 1995. In economies in transition, where financial markets are undeveloped, it is a common objective of monetary and fiscal authorities to encourage their development. The buying and selling of bonds and formal equities (stocks) is a relatively new field in Latvia. The Ministry of Finance (Treasury) has started issuing the Government T-bills at end-1993. The Bank of Latvia acts as an agent of the Government in primary market auctions of government securities. T-bills are issued with a maturity 1, 3 and 6 months and a nominal value of 100 thousand lats (about 50 - 55 thousand US dollars). The average weighted discount rate decreased from about 24% in first auctions (end-1993) to about 18% in the first quarter of 1995, increasing again to about 23% in April - May of this year. The Ministry of Finance sets the volume of the bills offered and the maximum discount rate. Bills are sold to the bidders with the lowest discount rates. Every commercial bank licensed in Latvia can participate in these auctions. Direct participation of foreign banks in securities auctions is under discussion.
From April 1994, the Bank of Latvia participates in the secondary market with restricted amounts of T-bills in order to ensure market activities of commercial banks. However, secondary market for securities is rather small. There are no repos, securities lending and derivatives market up to now.
Other component of financial market is the interbank money market. Approximately ten banks participate in this market on a regular basis. Monthly amount traded in domestic interbank market is not high, fluctuating among 20 - 25 million lats, representing about 1% of GDP.
Activity in the market is constrained because of the perceived risks involved in lending to some banks. At the same time, monthly amount of credits to foreign banks is almost ten times higher. Interbank credits with maturity up to one month are predominant in the domestic market (average interest rate 21% - 22%), but overnight credits (with interest rate close to 6%) dominate dealings with foreign banks.
Latvia has one of the most liberal foreign exchange regimes in the world. Transactions in both lats and foreign currencies are allowed, and the Bank of Latvia ensures a free flow of capital. Foreign enterprises can repatriate their profits in any currency.
Both Latvian residents and foreigners can open accounts in domestic and foreign banks in national and foreign currencies. Although all prices in Latvia have to be denominated only in our national currency, lats, foreign currencies are not prohibited and they can be used even for domestic payments, as long as parties involved agree.
To ensure free convertibility of lats, the Bank of Latvia has officially promised to buy and to sell any amount of SDR basket currencies to commercial banks at their request and without any restrictions. With the final introduction of the national currency in mid-1993, the lats has been declared fully convertible. Lats in circulation are backed by the Bank of Latvia foreign currency and gold reserves, which have grown from 61 million lats at the end of 1992 to 253 million lats (close to 500 million US dollars or 4 months of imports) two years later.
Latvia is the only remaining country of the three Baltic states that has not adopted a currency board arrangement and has a flexible exchange rate regime. The exchange rate against foreign currencies was managed floating and appreciated from winter 1992/1993 till February 1994; afterwards it has been pegged to the SDR (at rate 1SDR=0.7997LVL).
Since the rate is not permanently fixed, some room for monetary and exchange rate policy actions remains in case foreign exchange flows become significant. The foreign exchange rate policy of the Bank of Latvia is similar to that of currency board, but as a fully fledged central bank, the Bank of Latvia grants credits to banks and the Government (in restricted amounts), and it may drain liquidity from and add it to the banking system. The present exchange rate objective is to maintain a stable relationship to the SDR basket currencies. Revaluation of the national currency has been done away with, and further fluctuations of the exchange rates will depend solely on changes in the world currency market.
The main objectives are to formulate and implement monetary policy in order to maintain price stability. As a result of the tight monetary policy, inflation rate has decreased from almost thousand per cent in 1992 to 35% in 1993, and 26% in 1994. Therefore, at the moment the ultimate goal of the monetary policy in Latvia is to ensure stability of the exchange rate, with lats effectively pegged to the SDR.
Monetary policy instruments
The monetary policy instruments used more or less actively by the Bank of Latvia to meet monetary goals are:
At present, the liquidity of the banking system is mainly influenced by the Bank of Latvia's purchases and sales of foreign exchange. The participation in the foreign exchange market is aimed at stabilizing the exchange rate against the SDR, and not controlling reserve money. The Bank of Latvia freely buys and sells convertible foreign currencies in non-cash transactions; these are mostly US dollars and German marks. A rapid inflow of convertible currencies in our country took place in 1993. The Bank of Latvia purchased over 270 million US dollars more than it sold. During 1994, the situation was similar, but net purchases of currency were lower, about 80 million US dollars. In 1995, a slight predominance of net selling took place.
The Bank of Latvia can inject liquidity into system through its refinancing facilities - credit auctions, as well as lombard credits or, in cases of severe financial difficulties, extraordinary credit facilities. During the last two years, the Bank of Latvia adopted a tight credit policy in order to limit the monetary impact of net purchases of foreign exchange. Maturity of auction credits is up to 30 days, auctions are carried out weekly. The Bank of Latvia establishes the minimum acceptable interest rate, which is not published prior to the auction. This rate cannot be lower than the refinancing rate. The annual interest rate of refinancing, which is arranged by the Board (actually 25%) only serves as a signal rate from the central bank to the participants in the money market. Participants in the auctions can be banks registered in Latvia with stable financial parameters. In order to maintain liquidity of commercial banks, lombard credits with maturity up to two weeks are offered. Lombard credit is granted for the collateral and priced at five percentage points above the refinancing rate. At the moment, the Bank of Latvia works for setting up automatic end-of-day short-term (overnight) drawing facilities for banks at its disposal.
According to the Law, the central bank has the right to grant short-term credits to the Government, but these credits may not exceed 1/12 of the budget revenue for the current year. The Ministry of Finance makes use of these rights and utilizes the Bank of Latvia credit line systematically. Nevertheless, it is important to stress that these credits are not granted to cover the fiscal deficit, but to help solve the cash flow problems in the state budget.
Since August 1993, all non-bank deposits in domestic and foreign currencies independent of maturity are subject to 8% reserve requirements, which must be met in lats. In case of failure to meet the reserve requirements, the Bank of Latvia will charge a fine of 2.5 times the refinancing rate of the shortage.
To withdraw excess liquidity from the banking system, the Bank of Latvia approved accepting of time deposits for deposit auctions in March 1995. Rate of interest and the term (31 days, fixed) of the deposits were announced a week prior to the auction. However, in situation of overall shortage of liquidity in the system, time deposits is an additional instrument with a small impact. Further on the Bank of Latvia plans to expand the arrangement for issuing negotiable Certificates of Deposits.
Control of the money supply
To prevent the price raise, the Bank of Latvia continued to control the real money supply. In 1993, it increased by over 3% average per month, by 1.7% in 1994, and has shrinked a little in the first quarter of 1995. Broad money for these two years has grown mainly due to the growth in household and enterprise deposits, and credits granted by credit institutions. Commercial bank credits to enterprises and individuals have risen by over 80% in 1993, 36% in 1994, and 5% in the first quarter of 1995.
Deposits, in their turn, have increased by 58%, 51% and decreased by 0.3%, respectively. Major part of credits was granted to private enterprises in trade, but deposits were mainly attracted from households.
The growth rate of reserve money in 1993 exceeded increase in broad money, standing above 100%. The growth rate diminished to 20% in 1994 as the result of changes in foreign exchange transactions of commercial banks with the Bank of Latvia. In the first half of 1994, foreign currency was mainly sold, thus withdrawing part of issued lats. Similar case was observed in the first quarter 1995.
For more than two years, interest rates charged by commercial banks on credits experienced a slow though definite reduction. Commercial banks followed reduction of the Bank of Latvia refinancing rate, which was 120% at the beginning of 1993, declining to 27% at the end of 1993, and to 25% currently. Annual interest rates on credits to non-banks, that were above 100% two years ago, now are on the level of 30% - 40%.
After a sharp increase of deposit rates in 1993 (up to 70% - 90%), rates decreased further on, tending to stabilize little below the average annual inflation limits 17% - 20% from the end of 1994.
The high interest rates on deposits, especially long-term, led to a rapid increase in both deposits of residents and non-residents with domestic commercial banks. For a long time banks held huge excess reserves in the central bank, and most of them did not experience any liquidity problems. Banks' excess reserves were gradually eliminated during 1994, as they became more active in the Treasury bill market.
From the central bank's viewpoint, the state budget is one of the macroeconomic fundamentals whose status is essential for the credibility and feasibility of Latvia's monetary policy. On the one side, tightening of monetary policy affects the level of economic activity in general, and this means lower tax revenues and higher expenditures. On the other side, fiscal policy should address structural issues, and care should be taken that cumulative budget deficits do not grow too much, placing the Government in an unstable debt situation. The results of fiscal policy in 1993 appeared more successful than the forecast. Budget deficit had been projected about 1.5% of GDP, but in fact there was a small surplus at the end of the year. Opposite 1994, the actual execution of the state budget revenue was lower than the estimates at the beginning of the year, and deficit amounted to 2.4% of GDP. Ninety per cent of deficit was financed with Treasury bills, thus reducing the state loans from the Bank of Latvia. The fiscal deficit for 1995 is arranged with the deficit of about 1.7% of GDP.
While the Bank of Latvia is pressured at times by political groups to grant more credits or to devaluate lats, the relationship between the central bank and the Government is collaboration and mutual interest to attain a common goal: a strong economy. By main-taining a stable currency and keeping a possibly low rate of inflation, the Bank of Latvia has got one foot of Latvia's economy on a solid ground. Through privatization and wise investment, the Government can work to get the other foot - production - on a solid ground as well.
Balance of payments figures show that the real foreign balance had a positive impact on growth in 1991, 1992 and 1993. However, the foreign trade balance turns into negative (about 8% of GDP) in 1994. Current Latvia's foreign debt is 200 million lats (10 per cent of GDP), but the amount of credit contracts is notably higher (about 17 per cent of GDP). This creates increasing troubles in economic circles.
A considerable reduction in inflation should be noted as a positive development alongside the successful completion of currency reform. This may reasonably be considered the main achievement of the monetary policy implemented by the Bank of Latvia during the few years. The Bank has been very successful so far and now the main tasks are to look for new monetary instruments and improve the existing ones.
Stabilization policy is balancing on the edge. On the one side, too weak policy might continue inflation, while, on the other side, too tough stabilization can result in persistent unemployment.
Higher unemploy-ment and problems with tax collection might mean strengthening of pressure on the state budget, resulting in cuts in public employment in health, education, etc. Nevertheless, there are good indications of inflation falling further, a stable economic environment for investors, and a faster development of economy.