Реферат: Public Finance Perspective - Latvia

<span Courier New"">Public FinancePerspective — Latvia

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<span Courier New"">DmitriMaslitchenko dmitri@mailroom.com

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<span Courier New"">      The Latvian people have lived in theBaltic-shore territory for more than 4,000 years, with the Latvian languagebeing one of the oldest living languages of Europe.  «Latvia's location at an East-Westcrossroads, and her ice-free ports on the Baltic Sea, have made her an invitingtarget for expansional powers.».(EIU, 1995).  Over the centuries, Latvia has been occupiedby the Teotonic knights of Germany, the knights of Sweden and Poland, and thetsars of Russia.  World War I and thefall of the Russian tsars provided an opportunity for numerous Russian coloniesto break away.  Only Latvia, Lithuania,and Estonia gained and maintained independence on November 18, 1918, by signinga treaty with the new Soviet Russian government.  Latvia quickly began to develop a successfuleconomy and joined the League of Nations in 1922. 

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<span Courier New"">      In 1940, Stalin presented Latvia with anultimatum, admit Soviet troops or face annihilation.  During the next fifty years, the Soviet Unionruled over Latvia.  Freedom of speech andpress were abolished.  Access to westernprinted materials, radio broadcasts, and other communications were strictlyforbidden, and religious activities were destroyed.  In 1987 large human rights demonstrationsbegan to take place, with the most notable being the 1989 joining of hands inthe unforgettable Baltic Way from Tallinn through Riga to Vilnius.  

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<span Courier New"">        OnMay 4, 1990, the Supreme Council of the Republic adopted the Declaration on theRenewal of the Independence of the Republic of Latvia.  In a referendum held in March of 1991, thepeople of Latvia voted overwhelmingly in favor of democratic and independentstatehood for the Republic of Latvia. «Latvia's declaration of the restoration of independence in Augustof 1991 resolved many of the issues prominent during the transitionary periodbetween occupation by Russian troops and Latvian independence.» (WorldBank, 1995).  The declaration lays downthat Latvia is «an independent democratic republic, the sovereign power ofwhich belongs to the people of Latvia, and its statehood is determined by the1922 Constitution»(EIU, 1995).  OnSeptember 17, 1991, the Republic of Latvia was granted full membership in theUN.  On June 5, 1993, the 5th legislature(Saeima) was elected in general and democratic elections.

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<span Courier New"">An overview ofthe Latvian Economy

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<span Courier New"">      Latvia is rapidly becoming a dynamicmarket economy, with Estonia being the only other former Soviet state close toLatvia in the transformation.  However,the transformation has not been without effort, the IMF reported only a 2%growth in GDP in 1994, following declines in GDP in 1992 and 1993.  The government's monetary policies and reformprograms have kept inflation under 2% a month, encourtaged growth in theprivate sector estimated to account for over half the GDP, and encouragedgrowth in trade with the West. 

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<span Courier New"">      «Price reform in Latvia came inseveral stages, bringing relative prices more in line with world prices andreducing the excess demand for goods in Latvia.».(EIU, 1995).  By 1992 less than 8% of goods and services inthe consumer price index remained under price controls.  The price reform «increased GDP,contributed to an improvement in the financial position of Latvian enterprises,and assisted in the improvement of the government budget»(EIU, 1995).  However, the effects on the economy were onlytemporary. 

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<span Courier New"">      But even the price reforms could not pullLatvia out of a economic situation that was becoming worse in 1992.  «Depleting stocks of raw materials andenergy resources and the continued lack of foreign financial resources coupledwith a reduction in agriculture due to a severe drought assisted in the reductionof GDP by 30%.».(EIU, 1995). Unemployment increased to 2%, profit and income tax revenues declined,and enterprise tax arrears continued to rise. The negative impact of these events resulted in an increasing fiscaldeficit.     

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<span Courier New"">Recent reformefforts...

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<span Courier New"">       Since Latvia regained independence in 1991, the government of Latvia hasmade substantial progress in stabilizing the economy and structuralreforms.  «The government has beeninvolved in a large effort to transform the economy from a centrally plannedsystem to a market based system.».(EIU, 1995).  A comprehensive economic program wasinitiated late in 1992 which focused on stabilization.  Tight monetary and fiscal policies maintainedan almost balanced budget through 1993 and reduced the rate of inflation, whichdeclined steadily from over 900% in 1992 to less than 2% in 1995 (World Bank,1995).   Prices and trading wereliberalized.  «Efforts torestructure the banking system, to privatize the economy, and to demonopolizelarge state owned enterprises, encouraged the development of the private sectorand allowed restructuring of domestic production, removed from highlysubsidized and protected markets.» (World Bank, 1995). 

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<span Courier New"">      An important element of the reform effortswas the introduction of a national currency in 1992 which allowed the Bank ofLatvia to pursue an independent monetary policy.  «Tight monetary policy was supported bya broadly balanced government budget in conjunction with tax-based incomepolicy.» (World Bank, 1995).  Since1993 the country has had a stable currency, the LAT.  «The nominal exchange rate, sinceintroduction, has continued to remain fairly stable against the dollar.».(EIU, 1995).   

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<span Courier New"">      The government has also made reformprogress in several other areas which include fiscal policy and the social safetynet.  «Fiscal reform measuresreplaced the Soviet tax system with a modern tax system and shiftedexpenditures significantly from subsidies and transfers to enterprises, toother areas.».(EIU, 1995).  Thegovernment is still working in other areas including extrabudgetary funds andtax collection capacity.  A number ofreform measures have also been taken to improve the social safety net,including the introduction of unemployment benefits and allowances to poor families.  However financial resources for social safetynet reform measures continue to decrease as unemployment and pensions costscontinue to increase.  «Financing ofthe social safety net has been re-examined to address its dependence on thewage base which has inflated the cost of labor and discouragedemployment.».(EIU, 1995).

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<span Courier New"">      Progress has also been made in structuralreforms.  Prices have been liberalized,the trading has opened, banking institutions have been privatized, as have beena number of small businesses and agricultural land.  Latvia also seems to have weathered thebanking crisis and the economy has begun to recover late in 1995 and has sinceexperienced some growth in 1996.  Thebanking system has moved towards fairly stable and functioning privatebanks.  Progress has also been made inland restitution and agricultural privatization.  Much of the agriculture has already beenprivatized and the government plans to increase the pace of privatization ofstate enterprises.  Approximatelytwo-thirds of the enterprises owned by government have been privatized.  Privatization of large enterprises has beenat a slower rate, with only 85 of the 200 proposed projects completed by late1994.(World Bank).  With the approval oflaws establishing the Privatization Agency and the State Property Fund, thelarge enterprise privatization  increasedits pace in accomplishing the goal of 75% privatization by 1996. (World Bank,1995). 

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<span Courier New"">        Latvia is thus in the midst of recovery,assisted by the country's strategic location on the Baltic and itswell-educated population.

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<span Courier New"">The Budget System

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<span Courier New"">      Under former Soviet rule, publicadministration and management were highly centralized.  Since Latvia's independence in 1991, therehas been substantial progress in decentralization of the local governments.  Until recently, there were three levels oflocal government:  rural districts andsmall towns known as pagasts, regions which included rural districts and smalltowns on their borders known as rayons, and seven major cities, including Riga,which administered both the pagasts and the rayons.  Legislation within the past year hassimplified the administrative system to two levels ( 26 regions and 600municipalities) and has clarified and separated responsibilities forexpenditure.  «New laws provide fora stable and transparent system of revenue assignment, formalizingintergovernmental fiscal relations through allocations of tax revenues betweenthe state and the local governments, and revenue equalization among themunicipalities.». (World Bank, 1995).

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<span Courier New"">ExtrabudgetaryFunds...

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<span Courier New"">      Extrabudgetary funds' budgets andoperations must be approved by Parliament. The Social Security Fund is the largest of the extrabudgetary funds,accounting for over 28% of general government revenue.(World Bank, 1995).  This fund is administered by the Ministry ofFinance and financed through the social security tax.  Expenditures of the fund include pensionpayments, sick pay, maternity pay, and family allowance.  The unemployment benefits are financed through1.5% of the social security rate (World Bank, 1995).   

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<span Courier New"">      Twoother significant funds are the State Privatization Fund and the EnvironmentalProtection Fund, which are financed through sales of government property and anatural resource tax respectively. «The State Privatization Fund was established to manage revenuesgained from the privatization of state-owned enterprises and the sale of otherassets.».(EIU, 1995). Municipalities located within the jurisdiction of the privatization ofstate-owned property also receive 5% of the revenues.  Riga is the only exception to this rule, andreceives 10% of the revenue.  TheEnvironmental Protection Fund gains revenue through the collection of fines onpolluting enterprises and also through a percentage of the natural resourcetax.  The fund then utilizes the revenueto finance projects which are expected to reduce pollution and protect theenvironment. 

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<span Courier New"">Background ofBudgetary Revenues...

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<span Courier New"">      During the Soviet era, Latvia was amainecontributor to the USSR budget, making financial transfers equivalent20.2% of GDP.(World Bank, 1995).  In 1991those transfers stopped and resulted in a Latvian surplus of 6.4% in GDP forthe year(EIU, 1995).  However, socialoutlays continued to increase deficit in 1992 and 1993.  The 1993 budget ended the year with a deficitof approximately 2.9% of GDP (EIU, 1995). A new system of taxation was introduced in January 1991, which includeda separate profit tax for companies and enterprises.  In 1993, the profit tax was levied at a rateof 45% for banking insurance and trade, 35% for state enterprises and statecompanies, and 25% for all other private companies.  Personal income tax came into effect onJanuary 1, 1994, levied at a rate of 25% on the first Lats4.800 and 35% on theremainder of the profit(EIU, 1995).  Thevalue-added tax (VAT) was first introduced at a standard rate of 10% in 1992,and was raised from 12% to 18% in November of 1993 on most products excludingfood (however the VAT was raised to 18% on food products in March of1994).  The government has also begun tofinance the deficit through the issuance of Treasury bills. 

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<span Courier New"">Composition ofBudgetary Revenues...

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<span Courier New"">      Fiscal reform measures which have beenimplemented since 1990 have changed the structure of budget revenues, becomingsimilar to the structrue of revenues in Western Europe.  Income tax revenues have continued toincrease while taxes on enterprises and domestic goods and services havedecreased.  Social security contributionsto total revenue have risen to levels similar to those in Western Europe.  New taxes which have been implemented aredescribed below according to World Bank information as of the end of 1995. 

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<span Courier New"">      Profit tax.  This tax is levied on the net earnings ofenterprises, cooperatives, and private entities.  Self-employed persons may pay either theprofit tax of the individual income tax. The tax rate of the profit tax fluctuates between 25% and 45% dependingon the institution.  Lottery, casino, andgambling profits pay a profit tax of 65%. There are exemptions for associations which are run for charities,health, and the handicapped.  Legaldeductions include expenditures by enterprises for social purposes.  «Adjustments in the value of fixedassets to an inflation index are currently infrequent and do not follow clearrules.».(EIU, 1995). 

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<span Courier New"">      Personal income tax.  This tax is levied on individual's wageincome, including bonuses, and the income of legal entities formed byindividuals.  The basic rate is 25% witha marginal tax rate of 35% applying to income which exceeds 20 times thenontaxable minimum. 

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<span Courier New"">      Social security tax.   This tax is levied on salaries, wages, fees,royalties, and other rewords for work. The tax is payable in the following proportions by employees andemployers.  Employers contribute 37%  and employees 1%.  For handicapped employees, the employer pays8%.

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<span Courier New"">      Value-added tax.  This tax is levied on goods and services atthe manufacturing/import, wholesale, and retail stages.  The standard rate is 18%, with a reduced rateof 10% being applied to meat, fish, milk, and feed products.  This reduced VAT rate was switched over tothe standard rate in 1994.  There arestill exemptions, including medical supplies, concerts and theaters, andtransit services. 

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<span Courier New"">      Excise taxes and customs duties.  Excise taxes are levied on the imports ofproducts by individuals or enterprises. Customs duties are levied on imports and exports, with export dutiesranging from 5% to 100% and import duties ranging from 2% to 20%. 

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<span Courier New"">      Other taxes.  These taxes include a property tax, land tax,and a natural resource tax.  The propertytax is placed on fixed assets of state enterprises and unfinished buildings.  A tax of 0.5% is place on property with avalue of Lats1,500 or more.  A maximumrate of 4% is applied to property exceeding a value of lats2.5million.  The tax is paid entirely to the localgovernment.  The land tax is placed onthe use of land by individuals and enterprises. The tax is paid directly to the respective district, village, city, ormunicipal district budget.  Exemptionsinclude transportation routes and individual farms up to the first five yearswhose conditions are unsatisfactory.  Thenatural resources tax was introduced to discourage excessive use of naturalresources and accrues in the Environment Protection Fund.  The tax consists of three parts:  a tax on the use of natural resources, a taxon pollution, and punitive fines for excessive use of natural resources andpollution.  Tax rates are determined bythe Environmental Protection Committee. 

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<span Courier New"">      Non-tax revenues.  These revenues include fees which arecollected on documents and official services performed by the state, and usercharges for various public services including water and sewage. 

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<span Courier New"">Composition ofBudgetary Expenditures...

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<span Courier New"">      Subsidies and transfers which onceaccounted for 60% of the government expenditures have decreased significantlywith reform efforts.  Subsidies on food(with meat and dairy products receiving the largest share) which once accountedfor 90% of the total subsidies, have been dramatically reduced since 1991(WorldBank, 1995).  Other subsidy expenditureswhich have been reduced include price support for:  agricultural producers, agro-industrysubsidies, direct transfer to low-profit farms, housing maintenance, andheating. 

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<span Courier New"">      Social security expenditures haveincreased dramatically to almost one-third of total expenditures by 1991, withover two-thirds of the fund expenditures being pension benefits.  Expenditures related to defense andadministration have been transferred to the general budget. 

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<span Courier New"">Debt... 

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<span Courier New"">      Like other Baltic states, Latvia iscurrently liable for a portion of the debt inherited from the former SovietUnion.  However, Latvia «disclaimsresponsibility for the Soviet debt based on the grounds that its annexation tothe Soviet Union was illegal under international law» (EIU, 1995).  The total external debt has been estimated at$60.6 million.  Of this debt, $26 millionwas long-term publicly guaranteed debt and $34.6 was an IMF credit (EIU,1995). 

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<span Courier New"">      Latvia has also recently tapped into theinternational bond markets.  Thegovernment borrowed $40 million through a two-year bond issue, organized byNomura Securities, on the Japanese and international markets.  The international bond market was analternative to the Latvian treasury bill market where demand has declined as aresult of the bank failure.  The bondsare rumored to pay a low coupon rate of 5.4%, due to low yen interest rates.  Demand for domestic Treasury bills hasrecently begun to increase, although most interest is centered on theshort-term bills.  Interest is beginningto increase slightly in longer-term bills. 

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<span Courier New"">      EIU forecasts that Latvian foreign debtwill rise to $500 million by the end of 1996 and $690 million by the end of1997.  Debt-service costs will mostlikely continue to remain low as much of the credit is available onconcessionary terms.  Recent loanagreements include a 17-year $14 million credit from the World Bank forrehabilitating the heating system, credits to assist in privatization, andtransport infrastructure (EIU, 1995).

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<span Courier New"">Recent budgetaryconditions...    

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<span Courier New"">      Efforts to improve budgeting, budget execution, and accountability in governmentfinances continue in Latvia.  Budgetarylaw entitled «Law on Budget and Financial Management» was passed byParliament in April of 1994.  This lawsets rules regarding formulating, approving, financing, implementing, andauditing the annual budgets of central and local governments.  According to this law, the Cabinet ofMinisters must submit annual central government budget proposals to Parliamentby October 1 for approval of the year preceding the new budget.  If the annual budget has not been approvedprior to the implementation date, the government must operate with thepreceding year's budget allocations until the new budget is approved.  «The law also regulates governmentborrowing and lending, the granting of guarantees, and the budgetary powers andprocedures for local governments.» (IMF, 1995).

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<span Courier New"">      The budget law also creates a TreasuryDepartment within the Ministry of Finance which is responsible for theexecution, reporting, and accounting of the state budget.  (A Treasury area was created by the Ministryof Finance in 1993 which was mainly responsible for the auction of short-term(28 day) treasury bills.)  The TreasuryDepartment, since creation, has eventually expanded to include other functionssuch as the responsibility of assets and liabilities and the social securitysystem.

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<span Courier New"">      Efforts were also made to increaseefficiency in the collection of taxes. The State Finance Inspection Board, responsible for the collection ofdomestic taxes, and the Customs Department, responsible for foreign trade taxes,were combined in accordance with law passed by Parliament in 1993.  The new department, the State RevenueService, began work in mid-1994.

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<span Courier New"">Budget and fiscaldevelopments... 

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<span Courier New"">      Latvia has had a pattern of tight fiscalmanagement, and despite the pressures on revenue and expenditure arising fromthe transitional economy, government finances (as a percent of GDP) haveremained relatively stable. «Government has taken steps to improve the administration of taxeson goods and services in an effort to allow for additional expenditure on bothinvestment and wages and pensions within budget organizations.».(EIU,1995).  Tax measures include an increasein VAT rates and the introduction of excise taxes on gasoline and cars.  Improvements have been made in the collectionof taxes at the border and enforcement of tax evasion penal codes.  Efforts are also being made to computerizethe collection of the VAT and excise tax. 

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<span Courier New"">      Government surpluses have fluctuatedaround approximately 1% of GDP.  Local andcentral governments have remained generally balanced or have shown a slightsurplus.  The Ministry of Finance repaidit's debt to the Bank of Latvia in early 1993 through foreign financing.  «Due to budget proposals, governmentbond issuance, and tax measures, the general government financial deficit hascontinually been reduced to within approximately 1.5% of GDP.».(WorldBank, 1995).  Revenues from taxcollection have in general continued to increase while expenditures, despiteincreases, have been kept below budget levels. 

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<span Courier New"">      «Within the past several years,attempts have been made to adjust specific tax structures to offset theincreasing expenditures by unifying the profit tax to within a range of 25-35%and switching the graduated income tax schedule over to a flat income tax rateof 25%.».(World Bank, 1995). Minimum wages have also increased 100% since 1994.   

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<span Courier New"">IntergovernmentalRelations

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<span Courier New"">      The general government is composed of acentral government, local government, and extrabudgetary funds including theSocial Security Fund, the Environment Protection Fund, the State PrivatizationFund, and the Foreign Exchange Budget. Local government revenue is obtained through large transfers of fundingfrom central governments and personal income tax collection within theirjurisdiction.  VAT and profit taxes godirectly to the central government, while approximately 50% of personal incometax goes directly to local government. The remaining 50% is held and administeredthrough the Local Budget Equalization Fund (LBEF), «developed to adjustfor disparities between different regions and cities by making availableadditional resources»(EIU, 1995). Funding transfers from LBEF to local government for services aredetermined by formula.  LBEF funding forlocal government services includes: investment, education, health care, socialbenefits, and grants. Local governments are responsible for maintaining theseservices.  Local government expendituresfor social benefits constitutes over half of total government spending in thisarea.  LBEF infrastructure allocationsare determined separately, cities and rural areas receive funding based onpopulation. (IMF, 1995). 

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<span Courier New"">      Currently, local governments are largelyresponsible for municipal services such as water, sewage, and solid wastecollection and disposal.  Localgovernments currently do not have the resources necessary to make investmentssuch as the rehabilitation of existing sewage facilities.  «The need for external financing tosupport public infrastructure services and municipalities has become a prioritywith both the Government's Public Investment Program and the Bank's CountryAssistance Strategy.».(EIU, 1995). 

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<span Courier New"">MonetaryDevelopments   

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<span Courier New"">      Monetary policy has centered around theobjectives of maintaining price stability and stabilizing the exchangerate.  «The Bank of Latvia hascontinued to use the purchase and sale of foreign exchange to maintain a stableexchange rate.».(EIU, 1995).  In theabsence of developed financial markets (specifically interbank money markets),the Bank of Latvia has had little effect on refinancing policies.  In an effort to improve  management of band funds, the Bank of Latviaintroduced minimum reserve requirement for all banks.  Treasury bill auctions were also introducedto finance the budget.  However,participants of the auction are still limited to only a few large banks andinterest focuses on purchases of short-term bill. 

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<span Courier New"">      In 1993, the lats were introduced toreplace the interim currency, the ruble (which was valued at par with theRussian ruble).  The conversion ofLatvian rubles to lats proceeded very smoothly, and was completed in 1994.  Rubles currently account for a very smallportion of total currency issued. Posting of prices in foreign currencies was made illegal in Latvia,although the use of foreign currency is still allowed. 

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<span Courier New"">      Latvia's move toward a convertiblecurrency came in two stages.  In May1992, in response to a shortage of Russian ruble banknotes, the Latvian rublewas introduced as a parallel currency to the Soviet one in circulation.  The two traded equally until Latvia becameflooded with Soviet rubles.  Latviareplaced the ruble with the rublis as the legal tender.  In 1993, the rublis was strong enough to moveon to the second stage, the introduction of the national currency, thelats.  The rublis was gradually phasedout and ceased to be legal tender on October 18, 1993.  In June of 1994 the exchange rate wasLats0.57:$1. 

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<span Courier New"">      Latvia did not use a 'currency boardsystem', and lats have been allowed to float freely.  As a result, the independent central bank hashad a very important role.  Itstrengthened the rublis prior to the introduction of the lats through marketintervention, the placement of Russian rubles in a stabilization fund, and highinterest rates. 

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<span Courier New"">Social Safety Net

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<span Courier New"">      «Latvia currently operates apay-as-you-go system of public pensions and unemployment benefits, along withother allowances for general social assistance including allowances for familieswith children.».(World Bank, 1995). All social safety net benefits included in the central government budgetare financed through the payroll tax. Employers pay a general rate of 37% and employees pay 1%.  The social tax for agriculture is divided betweenenterprises and the worker at 18.5% and .5% respectively. (IMF, 1995). 

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<span Courier New"">      Due to the aging population of Latvia andthe expansive coverage of the system, pensions are the largest component of thesocial security expenditures.  Afterconsultation with a collection of advisers from the World Bank and the Swedishgovernment, Latvia passed legislation reforming its existing pension system andcreated a new, funded mandatory savings program.  In 1993, the pension system was switched overfrom a flat-rate average for nonworking pensioners ($25 per month regardless ofwork history or disability status) to a system of tiered benefits based on workhistory.  A permanent pension law iscurrently under implementation.  This lawwill separate social funds from the central government budget, and willintroduce a multitier pension system which will separate publicly fundedpensions from privately funded pensions based on need.  The law will also increase the retirement age(IMF, 1995).

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<span Courier New"">      In addition to pensions, the socialsecurity system pays family allowances and unemployment benefits.  Allowances are granted to families based onthe number of children and the age of the parents.  Unemployment benefit expenditures haveremained at low levels.  Enterprisescontinue to pay two-thirds of unemployment benefits directly.  Total payments for allowances and benefitsamount to approximately 2.5% of GDP. Efforts have been made to increase public works programs which relocateand train workers.  Efforts have alsobeen made to set the social benefits to a more realistic minimum subsistencelevel.  «Local municipalities havealso been given clearer guidance in prioritizing social assistanceprograms.».(EIU, 1995).

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<span Courier New"">      The main developmental issue facing Latviais the acceleration of the pace of structural reform while maintaining a stableeconomy.  «One of the key elementsof the government's policy agendas is to support the develop the country'shuman resources to meet the needs of a market economy, and at the same time protectthe most vulnerable residents during the transition.».(World Bank,1995).   

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<span Courier New"">Structural Reform

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<span Courier New"">      By1994, Latvia had made substantial progress toward stabilization and a marketeconomy.  Economic recovery was inprogress, real wages had started to increase, and gross international reserveswere at an all-time high. (EIU, 1995). The deterioration in the fiscal deficit at the end of 1994 and thebanking crisis in 1995 halted the trend of economic recovery.  The reserves went to a deficit and the bankcrisis destroyed the confidence in the banking system.  «The central bank maintained thestability of lats throughout the crisis by selling 18.5% of its foreigncurrency reserves.».(EIU, 1995). The Bank of Latvia eventually succeed in restoring stability.   

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<span Courier New"">      The new government elected in December of1995 was committed to reducing public sector borrowing requirements and tolimiting the fiscal deficit.  Thisincluded improvements in tax administration to reduce tax arrears and increasecollection.  «Implementation oflegislation requiring stronger regulatory and supervisory measures led to amajor reduction in the number of banks licensed for operation and helped tostabilize the banking system.» (IMF, 1995).  New banking legislation included theestablishment of a deposit insurance fund and an agency to deal with failingbanks.  Treasury bill demand hasincreased since the banking crisis, there has been a recovery of reservesthrough fiscal policy, and improved confidence in economic policies.  Closely supervised banking and strictenforcements have also assisted in the return to a relatively stable bankingsector.  The government has alsorestricted the number of banks which can accept deposits to 16. 

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<span Courier New"">The bankingcrisis...  

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<span Courier New"">      Banka Baltija, Latvia's biggest bank, withover 200,000 private depositors, was declared insolvent and put under Bank ofLatvia administration on May 23, 1995. The bank was declared bankrupt on December 12, 1995 after the initialproblem was uncovered by Cooper's and Lybrant during audits earlier in theyear.  Ernst & Young later discovered200 million lati ($365 million) in losses to be unrecoverable and the bank wassoon after declared bankrupt.  AlthoughLatvia limited compensation to 500 lati per personal saver, the increasedexpenditure by the state budget raised the budget deficit from approximately 2%to 4% of GDP. (World Bank, 1995).  Thebank failure contributed to a weak economy, decreased GDP, decreased industrialproduction.  Latvia responded to the crisisby «withdrawing the right to take deposits from a number of banks, hiringinternational auditors to conduct regular inspections, requiring that banks'quarterly balance sheets be published in the government newspaper no later thana month after the quarter's close, improving cooperation between the police andthe bank, and passing new banking legislation which makes it more difficult foroffshore banks to be bank shareholders and sets requirements for minimum equitycapital, liquidity, and other banking indicators» (World Bank, 1995).   

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<span Courier New"">      These developments are a result of anumber of deficiencies common to the banking system of transitionaleconomies.  «Banks tend to lendextensively to their own shareholders who have no intention of paying them back,lending is extremely concentrated in a specific type of activity ( thefinancing of import-export transactions and transit transactions), and banksborrow money on exchange rate risk.». (EIU, 1995).  Problems also arise due to the deficientlegal base and the absence of specific key institutions in the economy.  «Absence of a recourse for banks indealing with enterprises who are not current on their loans forces banks toroll over credits rather than foreclose on the enterprise.».(EIU,1995).                                                                                                                                                                           Significant progress has been made in therestructuring and privatizing of former commercial branches of the Bank ofLatvia, including the establishment of the Universal Bank of Latvia from amerger of 21 former Bank of Latvia branches. With the assistance of the World Bank, a rehabilitation andprivatization program was initiated two years ago for the Universal Bank ofLatvia.  The government has alsorehabilitated the State Savings Bank for privatization.  A number of banks are connected to theSociety of Worldwide Interbank Telecommunications (SWIFT), an internationalfunds transfer system, and banks are beginning to introduce credit and debitcards and cash-advance services to clients.   

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<span Courier New"">Statisticsrelated to structural reform (see tables at end of paper)...    

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<span Courier New"">      In the 1980's, Latvia's economy grew at afairly high rate, with the GDP averaging 3.9% a year in 1989.  The GDP decline started in 1990 and reached apeak in 1992 of 33.8%, mainly due to Russian energy supply shortages (EIU,1995).  The biggest GDP decline in 1993was in the construction sector, with output falling 65%, mining followed with a60% decline, and manufacturing 40%. Services recorded a 7.6% fall. Agriculture and forestry remained fairly stable, fluctuating slightlyaround 23% in 1992 and 1993.  The energysector shrunk from 6.3% to 2.2% in 1993. The largest sector of the economy is currently the service sector whichaccounts for 48.6% of the GDP in 1993 (EIU, 1995). 

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<span Courier New"">      TheIMF currently estimates that approximately three-fourths of the populationworks in the material sector due to the shift from away from industries andinto services.  Unemployment has risensteadily with the biggest job losses being in the state sector.  In April 1994, 6.6% of the workforce wasofficially registered as jobless, the highest rate in the Baltic region.  The employment figure understates the truelevel of joblessness, as many workers are on unpaid leave, or on short-timework, or are underemployed (EIU, 995). 

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<span Courier New"">      The government has ended the policy ofwage indexation which was in place until the middle of 1992.  The government has also introduced a wage taxto penalize enterprises which raised salaries in excess of governmentguidelines.  In 1993 real wages rose by6.8%, followed by a 32% drop in 1992, with wages in industry up by 8.2% (EIU,1995). 

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<span Courier New"">      Inflation accelerated sharply as Latviagradually liberalized prices and removed subsidies.  Annual average inflation went from 124.5% in1991 to 951.2% in 1992 (EIU, 1995).  Therate peaked in November 1992 with an inflation rate of 1,445% (EIU, 1995).  One of the countries greatest successes hasbeen bringing inflation under control through tight monetary policy whichincluded high interest rates.  By the endof 1993, inflation remained close to 35%. Rising food costs are attributed as the main factor in continued highinflation (EIU, 1995). 

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<span Courier New"">Trade andInvestment Regulations...

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<span Courier New"">      Latvia overhauled the tariff regime in1992, and created a Tariff Council to monitor processes and establishdirectives.  Import tariffs were appliedin 1992, with the overall system favoring domestic industry andagriculture.  The rates change regularlydepending on policy, however the tariff for imports fluctuates between 15% and20% depending on country status.  Tariffscan be up to 45% on goods that can be produced locally (EIU, 1995).  With the Baltic Free Trade Agreement, whichcame into effect in April 1994, Latvia retained export tariffs on limestone,raw hide, scrap metals, and timber, in a continued effort to stand behinddomestic industry. 

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<span Courier New"">      Foreign investment is regulated by theForeign investments in Latvia law which came into effect in November 1991.  Latvia has focused on a number of areas whichneed foreign investment.  These includewood and timber processing industries, the energy sector, agro-industrialmachinery, textile production, and modernization of transport systems.  Incentives in the law include a two yearholiday from the profit tax for foreign investors with a stake of more than30%, followed by a 50% reduction in following years (EIU, 1995).  In January of 1993 the minimum investmentlevel was set at $50,000.  Growth inforeign investment has been dramatic, with over 3, 800 companies from over 80countries coming to Latvia.  In 1993,Latvia attracted approximately 7% of its GDP from direct foreign investment(EIU, 1995). 

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<span Courier New"">Privatization ofland, housing, and enterprises...

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<span Courier New"">      Privatization vouchers are being used inthe privatization of land, housing, and medium and large scaleenterprises.  The distribution ofvouchers began in 1993, and is based on the recipients number of years inLatvia and their citizenship status. Restitution of land to its former owners is open to both residents andforeigners.  This first phase of voucherdistribution has proceeded quickly, with numbers jumping from 4,000 at the endof 1989, to 57,500 at the end of 1993. The second phase, restitution of ownership rights, has proceeded at amuch slower pace.  The Land Registrybecame fully operational in 1994, and has spent the past several years dealingwith over 300,000 claims (EIU, 1995).       The process of land restitution andprivatization has proceeded most rapidly in rural areas, which is covered bydifferent laws.  The law on urban landreform restored ownership rights to former owners regardless of citizenship.  Claims for restoration of land ownershiprights were submitted to local governments. Privatization of apartments was accomplished by giving priority toexisting tenants and then opening the rest to a public sale.  Foreign investors were not allowed topurchase housing. 

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<span Courier New"">       In1994 the Parliament created, through the adoption of laws, the LatvianPrivatization Agency and the State Property Fund.  Both agencies are independent, although theyare supervised by the Ministers of Economy and Finance, respectively.  The State Property Fund is responsible forall state-owned enterprises.  The agencyis responsible for the monitoring of enterprise operations using standardcommercial criteria.  «The StateProperty Fund oversees the corporatization and restructuring of the enterprises,along with the appointment of their boards.».(IMF, 1995).  The agency also is responsible for overseeingthe privatization of the Latvian Universal Bank and the State Savings Bank.  The agency receives income from enterprises,and uses some of theses funds to reinvest in the structuring of otherenterprises.  Public utilities haveremained state owned, and it is unlikely that they will be privatized. (IMF,1995). 

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<span Courier New"">      The Latvian Privatization Agency is anonprofit state-owned company. «Under privatization laws, the privatization of state enterprisescan be initiated by anyone who submits a proposal to this agency.».(IMF,1995).  The Latvian Privatization Agencysubmits proposals to the Cabinet.  AfterCabinet approval of the proposal, the State Property Fund transfers theenterprise to the Privatization Agency, who announces the initiative to seekprivatization of the enterprise and proposals. The Latvian Privatization Agency uses auctions, corporatization, and liquidationmethods for privatization.  Revenues fromthe privatization go to the agency to cover expenditures.  The remainder goes to funds within local andstate government.

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<span Courier New"">      The Latvian Privatization Agency has beencriticized by some consultants as being slow-paced and selling companies offtoo cheaply.  Privatization was sped upin 1994 due to goals of the Latvian Privatization Agency, in hopes ofprivatizing 200 companies a year and 75% of all state enterprises by the end of1996.  In addition to the privatizationof land, enterprises, and banks, the government set up a number of institutionsto provide support to small businesses. The centers are nonprofit organizations which provide information,counseling, and training for small to medium sized firms. 

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<span Courier New"">The reopening ofthe stock exchange...

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<span Courier New"">      A stock exchange has also been set up inRiga to trade shares in privatized companies. Latvia's stock exchange reopened on July 25, 1995, after being closedfor 55 years following the country's annexation by the Soviet Union.  The exchange originally listed five companyshares.  Trading takes place once a weekon Tuesdays.

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<span Courier New"">Recommendationsfor further structural reforms...

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<span Courier New"">      The World Bank has encouraged furtherstructural reforms by encouraging growth in the private sector which reduceslarge budgetary deficits, the high ratio of expenditure to GDP (39%), and thelarge tax burden on businesses. «Further privatization of enterprises and property, the enforcementof financial discipline on banks and enterprises, and the improvement of theefficiency of the market through the adoption of cost recovery plans will playimportant roles in private sector development.». (World Bank, 1995).  Structural reform in the public sector shouldfocus on providing sufficient funding for maintenance and public investments,the reform of local finances to improve cost effectiveness of social services,the reform of intergovernmental fiscal transfers, the consolidation of smalllocal government units, the reform of social insurance to lower costs andimproved services, adoption of a regulatory framework for a privately managedpension system, improved tax administration through improved effectiveness intax collection, and the strengthening of the institutional capacity formanagement of public finances through «improved management of publicborrowing and monitoring of public expenditures»(World Bank, 1995).     

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<span Courier New"">LatvianOutlook...

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<span Courier New"">      Latvia's economic policy was restrained bythe fiscal deficit inherited from the outgoing government, which amounted to$177 million by the end of the year.(IMF, 1995).  IMF suggests that the government mustcontinue with a program of large cuts, creating job loss and reducinginfrastructure spending.  Economicrecovery will most likely continue at a slow pace due to reduced governmentspending, the banking crisis, and the fiscal deficit.  Since 1994, the number of banks has shrunkfrom 64 to 39.  In 1995 alone, anotherten banks were shut down and a number are under criminal investigation.  According to the 1995 audit, only 16 banksmade a profit and among these, around six are believed to be viable andproperly managed.  «More banks willcontinue to disappear as more than half of the banks have been barred fromtaking deposits.». (IMF, 1995). Confidence will return slowly to the banking sector.       

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<span Courier New"">Sectoral reform

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<span Courier New"">      Efforts in the social sector include the«establishment of an affordable and equitable social security system thatpreserves work incentives, improvement in the delivery of health care servicesthrough more efficient and effective use of resources, and the adaptation ofthe education system, particularly to vocational education and adultretraining, to the needs of the market economy»(IMF, 1995).

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<span Courier New"">Agriculture...

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<span Courier New"">      Agriculture is the second largest sectorin the Latvian economy and has been one of the country's main sources ofincome, employment, and foreign exchange earnings.  By the end of 1995, agriculture andagro-processing accounted for nearly 19% of the GDP, employed about 17% of thelabor force, and produced 10% of all exports (IMF, 1995).  After going through a major downsizing, theproduction in agriculture stabilized in 1995. «Agriculture has substantial potential to again become a reliablesource of income and employment for most of the rural population.». (IMF,1995).  However, adjustments will need tocontinue through policy reforms, investment strategies, and marketconditions.  Latvia has already begun toredirect agricultural exports to markets outside the former Soviet Union.  The Agricultural Development Project, thefirst investment project supported by the bank in the Baltic countries, wasimplemented to encourage agricultural development through the goals of landreform, extension services, and rural business development and marketing.«The primary challenge facing the sector, which currently accounts for 20%of GDP and 16% of employment in Latvia, is to increase its efficiency andexport potential and ensure that output markets are competitive and prices arenot artificially suppressed.» (IMF, 1995). 

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<span Courier New"">Industry...

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<span Courier New"">      Under Soviet rule, the Latvian economybecame deeply integrated with the rest of the USSR.  Large industrial enterprises were created,many of them in heavy industry and defense, with production being almostcompletely dependent on imports of raw materials from Russia.  Latvia, as a result, developed a nearmonopoly in a number of finished goods exports, supplying 93% of Soviet railwaypassenger carriages, 89% of radio sets, 79% of freezing equipment, 78% ofbuses, 72% of solid organic fertilizer spreaders, 70% of diesel engines andgenerators, 69% of tape and cassette recorders, and 66% of rubber footwear(EIU, 1995).  Latvian's industry sufferedheavily after independence as Russia started charging world prices for energy,resulting in an industrial production fall of 32% by 1992, with the maincasualties being machine-building, steel works, food and light industry.  Although the decline has slowed, figuresshowed a decline of another 38% in 1993 and another 20% in January of 1994(EIU, 1995).

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<span Courier New"">      Industry currently accounts for nearlyhalf of the GDP and less than one-third of employment in the economy.  The privatization of municipally owned smallenterprises has progressed significantly, with around two-thirds of allenterprises being sold.  Privatizationhas been slowed in some cases due to requirements that new owners retain theentire work force and/or the same line of activities for a specific time periodor the duration of the lease. Privatization of medium and large scale enterprises has proceeded at aslower pace due to delays in legislation enactment and the process of ministryreviews.  It is interesting to note thatthere has been a 44% fall in state sector employment between 1990 and1993.  However, over half of allindustrial production was still accounted for by state enterprises in 1993.

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<span Courier New"">      «Restrictionson foreign investment are being eased with preferential treatment being givenunder the latest tax system structure.».(EIU, 1995).  An Anti-Monopoly Committee was alsoestablished to supervise monopoly tariffs and possibly recommend break-ups oflarge enterprises who have large market power. A regulatory body was put together to oversee the activities of theenergy sector and to provide for disussion of tariff policies.   

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<span Courier New"">Energy...

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<span Courier New"">      Latvia currently must import all itsnatural gas and oil products and about half of its electricity needs.  Despite substantial adjustments in energyprices, underpricing still persists, creating a substantial burden on thebudget.  «Industrial energy pricesneed to be adjusted to reach economic costs, and a program to eliminatehousehold energy subsidies systematically should be introduced.» (IMF,1995).  Latvia has very little domesticresources of energy, and is thus almost entirely dependent on imports from theUSSR.  This total dependence on Russianenergy is a serious constraint on the Latvian economy.  Almost 93% of all primary energy was importedin 1990, with 58.5% of imported energy consisting of oil and 33% consisting ofnatural gas (EIU, 1995).  In 1992,Russian exporters demanded hard currency at market prices, as opposed to thebefore heavily subsidized prices. Imports of gas supplies continue to be disrupted due to Latvian unpaidbills to Russia.

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<span Courier New"">Health Care...

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<span Courier New"">      The number of physicians in relation tothe population is high in Latvia by international standards, however, thenumber of physicians to nurses and other paramedics is low.  The IMF recommends that «the health caresystem needs to be restructured to achieve greater internal efficiency.».(IMF, 1995).  The health status ofLatvia's 2.6 million people (of which one million live in Riga) has continuedto deteriorate since the beginning of the decade.  At the end of 1993, life expectancy for menwas 63 and for women 75.  «Immediateconcerns include the shortage of medical equipment, the poor condition of thefacilities at the state and district institutions, the inadequate focus onredirecting limited resources from expensive curative impatient care tocost-effective public health programs, and inexperience in developing andimplementing preventative programs to provide broad ranging primary health careservices.». (IMF, 1995).  The mainchallenge facing the current health sector reform is the coordination of acombination of measures to improve the effectiveness of health services andcontain costs.  Appropriate policies,strategies, and programs will have to be implemented to achieve theseobjectives.  Short-term objectives arerecommended to include «supporting the government in the reform of thehealth sector through technical assistance in policy and strategy formulationand the development of cost-effective programs»(IMF, 1995). 

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<span Courier New"">Education,Training, and Research...

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<span Courier New"">      Latvia has a rich history of educationaldevelopments, and in 1990 extensive reforms were introduced to bring the

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