PROGRAM INFORMATION DOCUMENT (PID) Appraisal stage Report No Operation Name Financial Sector Development Policy Loan Region

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1 Public Disclosure Authorized Public Disclosure Authorized Public Disclosure Authorized Public Disclosure Authorized PROGRAM INFORMATION DOCUMENT (PID) Appraisal stage Report No Operation Name Financial Sector Development Policy Loan Region EUROPE AND CENTRAL ASIA Sector Financial Sector Project ID P Borrower(s) LATVIA Implementing Agency Ministry of Finance, Financial and Capital Market Commission, Bank of Latvia, Ministry of Justice, Ministry of Economy Date PID Prepared August 24, 2009 Date of Appraisal August 20, 2009 Authorization Date of Board Approval September 24, Country and Sector Background Following its accession into the EU in 2004, the Latvian economy experienced rapid economic growth averaging over 10 percent per year. This high growth was driven almost entirely by domestic demand, encouraged by rapid credit growth, large real wage increases, and expectations of a progressive catching-up with EU living standards. New investment was concentrated in the non-tradable sectors, creating a real estate boom, which culminated in an over 60 percent growth in housing prices in both 2005 and Pro-cyclical fiscal policy contributed to the boom in domestic demand, which fuelled large macroeconomic imbalances. Consumer inflation had been rising since accession. The labor market showed signs of overheating as migration of Latvians to the EU15 countries added to labor shortages and wage pressures. As a result, rapid wage growth outstripped productivity growth undermining Latvia s international competitiveness. Driven by high domestic demand, the current account deficit widened from 12.8 percent of GDP in 2004 to almost 23 percent in The growth in domestic credit, which fuelled the domestic demand, resulted in rising household and corporate indebtness. The expansion of credit was largely financed by external borrowing from private banks resulting in high loan-to-deposit ratios. As a result, Latvia s external indebtedness increased significantly. Latvia entered the financial crisis with significant vulnerabilities, in particular a large current account deficit, high external debt, and a very high loan to deposit ratio in the financial sector. In the context of the global financial crisis in the second half of 2008, these vulnerabilities coalesced into a financial and balance of payments crisis. Concerns among foreign banks about their overexposure to the Baltic countries resulted in a sharp slowdown in credit. The slowdown in credit, in conjunction with a weakening external demand in the context of depreciation against the euro of the currencies of some of Latvia s external partners, and deterioration in economic sentiment, led to a significant downturn in domestic economic activity. While the current account narrowed by 10 percentage points during the course of 2008, vulnerabilities to external

2 shocks remained high. Moreover, tax revenues fell in the wake of the economic downturn, resulting in increasing fiscal pressures and a widening budget deficit. These macroeconomic imbalances led financial markets to become increasingly concerned about the sustainability of the peg arrangement leading to a sharp decrease in foreign exchange reserves to defend the peg, a downgrade by rating agencies, and a sharp increase in Latvia s Eurobond spread and 5-year CDS spread. Liquidity runs from nonresident and resident depositors aggravated these outcomes and led to a deposit run on the largest domestic bank, which the government decided to intervene in December These developments led the Government to seek external financial support and to agree to an IMF-led stabilization program 2. Operation Objectives The operation is being prepared as part of an international financial support package; financing is also being provided by the International Monetary Fund, the European Commission, and some European countries and other multilateral institutions. The Bank s assistance is part of a joint IFI initiative, where the EBRD, the EIB, and the World Bank Group have pledged to support banking sectors in Central and Eastern Europe (CEE) with up to 24.5 billion over a two year period. The objective of the operation is to support the Government s reforms in containing the financial sector crisis and enhancing the resilience of the banking system to future potential shocks. Specifically, these reforms include measures to: (i) strengthen the banking sector s solvency and liquidity; (ii) facilitate the renegotiations of corporate and mortgage debts with the objective to avoid the closure of viable firms and the foreclosure of residential properties; (iii) strengthen critical banking sector regulations; (iv) strengthen prudential supervision; and (v) improve consumer protection. 3. Rationale for Bank Involvement The severe negative impact of the crisis on Latvia s banking sector and real economy provides a strong rationale for the operation. Latvia is one of the countries most affected by the financial crisis in CEE. While Latvia graduated from IBRD in April 2007, the Government continued an ongoing program of analytical and technical assistance work with the Bank, and requested Bank support when the crisis curtailed the country s access to external finance. The operation is consistent with the Bank s mandate in its Articles of Agreement to provide funding to members when they are not able to access funding in the market under reasonable terms. By supporting the restoration of financial stability in Latvia, the operation contributes to reducing the risk of contagion effects to other CEE countries, the risk of further severe economic and social costs in Latvia, and in reducing the poverty impact of the crisis. In addition, the experience gained by Bank staff in dealing with the crisis in Latvia can be usefully applied to other countries in the region.

3 4. Financing ( m.) Source: Borrower 0 International Bank for Reconstruction and Development 200 Total Institutional and Implementation Arrangements The implementation of this operation will require close coordination with the institutions responsible for implementation, including the Ministry of Finance, the Bank of Latvia, the Financial and Capital Market Commission, the Ministry of Justice, and the Ministry of Economy. Specific indicators are being used to monitor the implementation of the operation including: the evolution of resident and nonresident deposits and of non-deposit funding sources, evolution of NPLs and provisioning levels, capital adequacy levels, percentages of nonperforming loans that are restructured, number of effective corporate restructuring, and number of foreclosure processes. 6. Benefits and Risks The benefits of the proposed DPL include: (i) increasing the capacity of the financial authorities to anticipate risks in the banking sector and avoid a systemic crisis that could be very costly to depositors; (ii) enhancing the capacity of the financial authorities to deal with distressed banks and thus help preserve taxpayers money; (iii) encouraging viable corporate rehabilitations that would otherwise be pushed to bankruptcy, thereby contributing to preserving employment and the economic fabric; (iv) helping household debtors renegotiate their debts with the banks, avoiding foreclosures wherever possible, and (v) facilitating a resumption in lending. In addition, the implementation of the recommendations of the consumer protection review, supported by the operation, will improve the laws and regulations to protect consumers of financial services as well as their means of complaints. The operation involves high risks but supports already implemented reforms that are crucial to the success of the Government s program. The main risks include: (i) risks to financial instability; (ii) macroeconomic risk; (iii) political risk; (iv) social risk; and (v) risk of insufficient institutional capacity. A risk to the proposed operation is that of further banking sector problems. With a large contraction of GDP for 2009 and expected negative growth for 2010, banks in Latvia are expected to suffer from very high levels of non-performing loans over the medium term. Higher unemployment and falling real wages create pressure on households and the corporate sector, creating repayment problems on mortgages and corporate loans. Therefore, banks may see their solvency and liquidity constrained. This risk is mitigated by the operation s proposed policy reforms. The program includes reforms in crisis management, bank resolution, debt restructuring, and supervision and regulation strengthening. This should enable banks and the corporate sector to handle better future potential problems should the economic situation deteriorate.

4 Another risk is that the Government s macroeconomic strategy may not be sustainable. The Government is undertaking a very ambitious economic adjustment program based on a macroeconomic strategy that includes severe fiscal consolidation measures and wage cuts, in spite of which a substantial rise in the public debt-to-gdp ratio is expected. The IMF program framework, reinforced by continued international support, particularly from the EU, seeks to mitigate these risks. The risk is also mitigated by the size of the multilateral financial package, equivalent to 35 percent of GDP, in support of the Government's program. In addition, the support of Latvia s international partners, particularly the EU, represents a key safeguard to the IMF program. The EU s commitment of 3.1 billion under the international support package has provided important space for implementation of the programmed reforms. The viability of the program may be also be undermined if the political consensus on the structural reforms weakens. A centre-right coalition government led by Prime Minister Valdis Dombrovskis was formed in March Parliamentary elections are due in October However, the severe and politically risky adjustment measures may alienate the electorate and lead to early elections. This could exacerbate an already complex environment for sustained and in-depth reforms. All five governing coalition parties supported the passage of the revised 2009 budget. However, tensions over spending cuts are rising among the political parties, which affect the previously broad political consensus supporting the program. This risk is partially mitigated by the adhesion of all coalition parties to the revised IMF Letter of Intent, wide consultations on the program, and the implementation of laws and regulations to support the reforms. There is also a risk that the deep austerity measures create a disruption in social services and social unrest. The cuts in fiscal spending create a risk that some important social services are cut and that the gains Latvia made since accession in converging with EU welfare standards will be lost. The risk is mitigated by the preparation of a social safety net DPL, aimed at mitigating the social and poverty impacts of the crisis and of the Government s program. The DPL proposes measures in public sector reform, social protection, education, and health aimed at mitigating the poverty and social impacts of the crisis and of the spending cuts. Other mitigating factors include the measures supported by this proposed DPL to ensure financial stability, therefore avoiding potential losses to depositors, and measures to facilitate debt restructuring and avoid foreclosures of residential properties wherever possible. Finally, the operation also faces the risk that the supervisor is not able to anticipate deteriorating trends and undertake the necessary corrective actions. The risk is mitigated by the fact that the proposed policy reforms aim to strengthen the regulatory and supervisory framework. The operation includes measures designed to enhance the capacity of the supervisor to monitor the banking system and react in a timely and effective manner. It also includes the conducting of stress tests, the preparation of a Strategic Contingency Plan for the banking sector, an improved stress testing framework, the establishment of a Prompt Remedial Action Plan, as well as strengthened prudential regulations. In addition, the Bank has provided and will continue to provide technical assistance in these areas.

5 7. Poverty and Social Impacts and Environment Aspects The policies supported by the operation are not likely to cause significant effects on the country s environment and natural resources. Latvia has adequate environmental controls in place. Its environmental legislation is reinforced by EU environmental directives. Prior to EU accession, Latvia made significant progress in transposing EU legislation with regards to the adoption of environmental impact assessments, water quality, waste management, industrial pollution control and risk management, air quality, nature protection, etc. None of the policy areas described in the operation is expected to have any significant link to the environment. The measures supported by this operation are expected to have positive social and poverty impacts. The deteriorating conditions in the economy and the banking sector are likely to further strain businesses, increase unemployment, and increase poverty in the country. However, this operation mitigates some of the negative effects of the crisis on poverty as it aims to: (i) increase the capacity of the financial authorities to anticipate risks in the banking sector and avoid a systemic crisis that could be very costly to depositors; (ii) enhance the capacity of the financial authorities to deal with distressed banks and thus help preserve taxpayers money; (iii) encourage viable corporate rehabilitations that would otherwise be pushed to bankruptcy, thereby contributing to preserving employment and the economic fabric; (iv) help household debtors renegotiate their debts with the banks, avoiding foreclosures wherever possible, and (v) facilitate a resumption in lending. In addition, the implementation of the recommendations of the consumer protection review will improve the laws and regulations to protect consumers of financial services as well as their means of complaints. Simulations show that Latvia will experience a sharp rise in poverty, widening of the poverty gap, and a rise in income inequality. Analysis of the distributional impact of the economic crisis on households in Latvia was based on household survey data (Latvian EU-SILC 2006 database) and focused on the impact of the growth slowdown through labor markets. Assuming 18 percent contraction in GDP (affecting mainly trade, hotels and restaurants, construction and manufacturing) and 11.2 percent contraction of employment (concentrated in the same sectors) the percentage of people in poverty will increase from 14.4 to The poverty gap, which measures the poverty deficit of the entire population, will increase from 5.9 to 8.3 percent. Finally, income inequality will increase, with the Gini coefficient increasing from 39.3 to 41.3 percent. It should be noted that these simulations do not include the countervailing measures implemented by the Government to specifically address the impact on poverty. There are substantial differences in how the impact of the crisis is felt across regions and specific population groups. The largest increase in poverty is observed in the poor region of Latgale where the majority of employed people are likely to have been working in precarious, low wage jobs. The impact of the crisis is also felt more sharply in households where a man is the primary income earner, which to a large extent is explained by the contraction in the maledominated construction sector. Households in which economically active members have few skills (education levels of high school or less) suffer relatively more. Finally, households with children also suffer a greater impact.

6 The IMF and the Bank have worked with the government to mitigate these impacts. With regards to the likely impact of the fiscal consolidation measures included in the Government s program, the IMF and the Bank teams have assisted the Government to focus the cuts on reducing excesses and inefficiencies and to improve the quality of spending. In addition, the increased emphasis and resources devoted to safety nets will mitigate some of these impacts. The Bank s package of lending will include implementation of the Government s cross sector Emergency Safety Net Strategy, supported through a parallel social safety net DPL (expected in December). As structural reforms are implemented, the Government is also committed to alleviating the social costs of fiscal adjustment, and to ensuring an adequate level of social service provision is maintained across the country. Moreover, in the context of the current economic contraction and high levels of unemployment, this commitment extends to strengthening the safety net to respond to the immediate needs of vulnerable households. With technical input from the World Bank, the Government has developed and will implement an Emergency Safety Net Strategy to finance essential services and benefits delivered by national agencies, and locally by municipal governments. The strategy aims to ensure that the Government is responding across the social sectors in a coordinated way, and providing additional resources to municipal governments who are at the "front line" of responding to increased household vulnerability in the wake of the economic contraction. An Emergency Social Safety Net strategy is almost complete and ready to be presented to the Cabinet as part of the 2010 budget process. The Government's response to the social cost of the contraction is already well underway. With the World Bank's technical input, the Government has already taken measures to ensure a timely response, including extension of unemployment insurance (passed in March 2009), allocation of support from the European Social Fund to an expansion of public employment programs, and improving the targeting of social assistance. The Emergency Safety Net Strategy underpins fiscal consolidation and structural reforms by deploying supplementary support to ensure basic social services are maintained. The strategy will coordinate the efforts of national and local government agencies to maintain: support for schooling for 5 and 6 year olds; the costs of transporting students from communities where schools have closed to their new places of instruction; the costs of maintaining financial support to subsidize the health service co-payments of needy households; adequate financing from the Health Insurance Fund to sustain and improve general practitioner and primary health care services and access; and increased financing for the targeted social assistance benefits and services that municipalities are mandated to provide to eligible groups, while increasing the income level qualifying for assistance so that it reaches a higher percentage of poor households. Furthermore, given the extent and likely duration of economic contraction and resulting levels of unemployment, the Government will extend the coverage of unemployment insurance. For the growing number of unemployed who are not covered by unemployment insurance or other social support, the Government will fortify the Emergency Safety Net by re-allocating financing from the European Social Fund to expand and rapidly deploy labor-intensive public works/emergency employment programs, to implement pre-existing local development projects.

7 8. Contact point Contact: Sophie Sirtaine Title: Sector Manager Tel: (202) Location: Washington DC, USA (IBRD) 9. For more information contact: The InfoShop The World Bank 1818 H Street, NW Washington, D.C Telephone: (202) Fax: (202) pic@worldbank.org Web: