Commission Report (2002): Latvia

The capacity to cope with competitive pressure and market forces within the Union

The ability to fulfil this criterion depends on the existence of a market economy and a stable macroeconomic framework, allowing economic agents to make decisions in a climate of predictability. It also requires a sufficient amount of human and physical capital, including infrastructure. State enterprises need to be restructured and all enterprises need to invest to improve their efficiency. Furthermore, the more access enterprises have to outside finance and the more successful they are at restructuring and innovating, the greater will be their capacity to adapt. Overall, an economy will be better able to take on the obligations of membership the higher the degree of economic integration it achieves with the Union before accession. Both the volume and the range of products traded with EU Member States provide evidence of such integration.

The existence of a market economy, with sufficient macroeconomic stability and progress on structural reforms, has established a favourable environment for economic growth and competitiveness. On the whole, economic policy has been conducted with a sufficient degree of predictability to allow proper decision-making by economic agents. The Latvian economy has shown resistance against external shocks, as proved by its reorientation of exports after the Russian crisis and its steady increase in exports to the EU, despite the appreciating exchange rate of the lat and the economic slowdown in Western Europe.

Average educational attainment is relatively high, although the situation is somewhat nuanced. Enrolment in higher education has increased constantly since 1997, and the number of students at higher educational establishments in 2001/02 was almost twice as high as in 1996/97. At the end of 2001, 14.4% of the population had higher education (12.7% at the end of 1996), 52.5% second-level education (52.8%), and 7.9% only basic education (10.6%). However, the majority of second-level qualifications is vocational; in many cases gained in the past, over-specialised and not adapted to current needs. In addition, the number of students in some technical courses is very small. This has created a shortage of certain skilled workers for industry. Furthermore, low remuneration has made it difficult to attract qualified teachers, particularly in rural areas. This fact is conflicting with the need of further restructuring in the agricultural sector, which implies additional efforts on education. These problems have been recognised by the government, and education has been given priority in the budget. The reform of teachers` remuneration is ongoing and is expected to be finalised in 2003. Spending on research and development is relatively low and amounted to 0.4% of GDP in 1999, out of which some 17% was spent in the business sector.

To address the high and typically structural unemployment, employment policies should focus on active labour market measures. Vocational training and retraining of all unemployed is becoming increasingly important among these labour market measures. Since 1997, the number of unemployed involved in active labour market measures has more than doubled, although the increase mainly concerns job clubs and not the more expensive but also more necessary training initiatives. The effectiveness of training is evidenced by the fact that more than two thirds of those who received special training have found employment afterwards. To provide young, unemployed people with skills demanded by employers, the legislative base for apprenticeship has recently been worked out.

Latvia has been successful in attracting foreign direct investment even in times when the privatisation process has halted. Net inflow of foreign direct investment (FDI) has equalled 5.4% of GDP on average since 1997. In 2001, FDI was significantly lower at 2.7% of GDP. However, this was due to a local investor`s take over of a foreign-owned enterprise, which is the same as negative FDI inflow. In the first quarter 2002, FDI was back at the previous higher level. By the end of 2001, 22.2% of the stock of FDI had gone into wholesales and retail trade, 17.4% had gone into financial intermediation, and 17.0% into manufacturing. The most important foreign investors were from Sweden (11.6% of total accumulated investment), Germany and the United States (each 11.5%). From 1997 to 1998, the share of total gross fixed capital formation in GDP increased from 18.7%, to 27.3%, induced by both private and public investment. The share of fixed capital formation in GDP, which was affected by the general economic slowdown in 1999 and tight fiscal policy, has since then been relatively stable at about 26%. Still, increased public expenditure on infrastructure is needed, particularly in roads and in the energy sector in rural areas.

Enterprise restructuring has proceeded well, although the agricultural sector lags behind. Promoted by the privatisation process, which is more or less complete, and a steady inflow of foreign direct investment, restructuring of enterprises has been far-reaching. The agricultural sector, however, is still characterised by many small farms with low productivity, even subsistence farming. This is reflected in the fact that the agricultural sector`s share in total employment is about three times as large as the share in total GDP. However, a process of restructuring is also taking place in the agricultural sector, as shown by the decrease of total employment, at the same time as the share of employees increases.

The structural change of the economy has been significant but recently slowing down. The structural change of the economy has continued along its previous lines; i.e. the share of industry in total value added has declined, and the share of services has grown. The share of industry has decreased from 27.4% to 18.8%, which is exclusively due to a significant fall in manufacturing. The share of services has increased from 62.1% to 70.6%, driven particularly by a strong rise in wholesale and retail trade as well as in business services. However, the changes during 2001 were almost insignificant, which might indicate that the economy has reached a more sustainable structure. In terms of employment, the development is similar.

The situation of small and medium-sized enterprises (SMEs) has improved, but entrepreneurial activity is still low. The above-mentioned co-operation with the Foreign Investors` Council in Latvia has resulted in general improvements in the fields of taxes, custom procedures, education, corruption etc. Besides these improvements of the business environment in general, some measures aimed directly at SMEs have been undertaken, such as tax exemptions, a simplified reporting system for small business, and business incubators. Access to funds for setting up business, and for SME development has been a problem. To facilitate access to funds, a program on SME crediting was approved in 1999. Together with a general decline in interest rates, the situation has improved significantly, and access to funds is now a smaller obstacle. Still, entrepreneurial activity is low with 17 active SMEs per 1000 inhabitants. SMEs employ more than 70% of total employment and create about 65% of total GDP.

State involvement in the private sector is moderate. During the period, tariff barriers have declined substantially. State aid has also declined and amounted to 1.2% of GDP in 2000, only half as much as in 1997. This development was mostly due to the decrease in support to the financial sector. A bank support programme was launched in 1994, which continued for several years. Then in 1999, the Central Bank and the government rescued the Riga Commercial Bank, which had become insolvent as a result of the Russian crisis. When these actions were completed, state aid to the financial sector decreased by 84.3% in 2000. State support to the industrial sector is mainly given in terms of capitalisation of tax debts. SMEs benefit from favourable credit lines, and small companies with less than 25 employees are entitled to tax exemptions. Subsidies are also given to the agricultural sector and represented 0.67% of GDP in 2000.

The Latvian economy is highly open with increasing trade links with the EU. Latvia is conducting a liberal foreign trade policy, aimed at finding new markets and enlarging the market share of existing markets. In February 1999, Latvia became a member of the WTO. The value of exports and imports to GDP has varied above 100%. In 2001, the sum of exports and imports represented 102.9% of GDP. Merchandise exports to the EU as a share of total merchandise exports have increased nearly every year. In 1997 they constituted 48.9%, and in 2000 64.6%. However, in 2001 the weakness of EU imports caused the share of Latvian exports to the EU in total Latvian exports to drop to 61.2%. The share of merchandise imports from the EU has been stable during the period at around 53.6%. However, exports are very much concentrated around a few branches and Latvia has made little progress in diversifying its export portfolio. In particular, the share of wood and articles of wood accounted for about 30% of total exports in 1997, and for some 34% in 2001; textiles and textile articles accounted for some 14% in 2001, one percentage point up from 1997. Still, within the branch of wood and articles of wood, there has been an orientation towards higher-value-added products.

Strong productivity growth has secured external competitiveness. Strong growth in fixed investment has made it possible for productivity to grow rapidly without extensive lay-offs. On average, productivity has grown by 5.2%, and in 2001 it grew by 7.7%. This strong rise in productivity has offset the rise in real wages in recent years, and unit labour costs have therefore been relatively stable in recent years and have secured the price competitiveness of Latvian exporters, as witnessed by the strong export performance.

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