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Monetary Policy of the Bank of Latvia

After regaining independence in 1991, Latvia initiated market-oriented reforms. The stabilization and structural reform programs were aimed at rapid price liberalization, elimination of subsidies, tightening of finances, and establishing a liberal trade and payments system. At an early stage of the adjustment process Latvia introduced its own currency, thus enabling the Bank of Latvia to pursue an independent monetary policy. The right to issue the national currency is vested with the Bank of Latvia. The Bank of Latvia has legal and practical independence in designing and implementing monetary policy.

The most important task of the Bank of Latvia is to maintain price stability, thus contributing to the process of restructuring the national economy. This task is a difficult one, especially for the central bank of a small country with an open economy that is undergoing extensive institutional and structural changes. As the liberalization of prices and convergence to the world price level form a part of the transition process, the central bank has to fight inflation, which is only partly caused by monetary factors.

The Bank of Latvia’s monetary policy aims at maintaining exchange rate stability and controlling the amount of banks’ reserves so as to limit excessive lending. The exchange rate policy of the Bank of Latvia is similar to that of a currency board, and the monetary base is backed by gold and foreign currency reserves.

Main principles of the Bank’s Monetary Policy

Convertibility of the National Currency

Latvia has established one of the most liberal foreign exchange regimes in the world. Latvian residents and foreigners alike are allowed to open accounts in lats and foreign currencies without any restrictions. They can buy and sell lats freely or exchange them for other currencies. To ensure free convertibility of the lats, the Bank of Latvia buys and sells unlimited amounts of the SDR (Special Drawing Rights) basket currencies to banks at their request. There are no restrictions even on capital account transactions.

No Restrictions on Capital Movements

Latvian legislation and the policy of the Bank of Latvia ensure free movement of capital to and from Latvia. Both foreign currency and the lats can freely enter and leave the country. Foreign investors can repatriate their profits in any currency without restriction.

External Stability of the National Currency

Latvia has been using the exchange-rate-based stabilization program since 1993. In mid-February 1994, the Bank of Latvia pegged the lats to the SDR basket of currencies (at the rate 1 SDR = 0.7997 LVL). Experience shows that fixing the exchange rate to a basket of currencies instead of a single currency serves to promote long-term stability to which the Bank remains strongly committed. The fixing of the exchange rate, if it is durable and credible, reduces uncertainty, eliminates exchange risk and provides businesses with a sound basis for planning and pricing, thereby fostering investment and international trade relations. A stable exchange rate imposes a constraint on domestic monetary policy (a so-called nominal anchor), which could be regarded as a useful safeguard against unsound policies.

Internal Stability

Successful financial policies have been reflected in the continuos fall of inflation from 958.7% in 1992 to 23.1% in 1995, 13.1% in 1996 and 7.0% in 1997. In 1998 the annual inflation rate fell to 2.8%, in 1999 the annual inflation rate was at 3.2%, and in 2000 — at 1.8%.

Interest Rate Policy for Additional Liquidity Management

The liquidity of the banking system is mostly influenced by foreign exchange operations. The Bank of Latvia intervenes in the foreign exchange market by setting the exchange rates, and thus has a strong stabilizing impact on the markets.

Financial flows and the interplay of demand and supply in financial markets are the real determinants of interest rates. The Bank of Latvia, however, has an important role in managing bank liquidity so as to avoid excessive volatility in interest rates. The Bank of Latvia sets the refinancing rate as a reference rate for the banking system. The Bank of Latvia intervenes in the interbank money market by setting discount rates for selling and buying of Treasury bills and by entering into repurchase and reverse repurchase, and currency swap agreements. Bank time deposits with the Bank of Latvia are used to neutralise excessive liquidity.

The other important interest rate is the collateralized credit (Lombard) rate, which currently is 2-4 percentage points higher than the refinancing rate depending on the term of credit usage. This rate sets upper limit to the money market interest rates on respective time deposits.

Future Outlook

The Bank of Latvia has been successful in maintaining the lats as a strong and stable currency that proved capable of withstanding destabilizing pressures on the exchange rate caused by the banking crisis of 1995. At present Latvia again experiences inflows of capital.

To be more efficient in fulfilling its main task, maintaining of price stability, the Bank of Latvia continually evaluates and improves existing monetary policy instruments and operations, aiming at more active day-to-day bank liquidity management.

In order for the transition from a centrally planned economy to a market one to be successful, several crucial factors must be in place. These include a sound monetary policy, a reliable and efficient legal and tax system, and structural reforms leading to more efficient and competitive ways of organizing production. The Bank of Latvia ensures the stability of the national currency as a necessary precondition, yet it cannot ensure economic recovery single-handedly. Only joint efforts by the Bank, the Government and the Saeima (the Parliament) will create a stable economic and political environment.

Source: Bank of Latvia

The central bank has conducted a successful monetary policy. The anchor of monetary policy continues to be the pegging of the Lat to the SDR. The peg has fulfilled its main goal, to ensure price stability. Low and stable inflation, and a financial account surplus allowed the central bank to relax monetary policy somewhat, leading to a fall in short-term interest rates of approximately 2 percentage points, between 1999 and 2000. The relaxation of monetary policy was supported by tight fiscal policy aimed at reducing both the current account deficit and the budget deficit.

The restructuring of the Latvian banking sector is well advanced. The sector consists of 22 commercial banks. The government holds shares in only 2 banks (100 % of the Mortgage & Land Bank, and 32.1 % of the Savings bank), accounting for 3.7 % of total capital. Nonresidents hold 66.5 % of total share capital in the banking sector. The concentration remains largely the same as last year, with 5 banks having 64 % of total assets, and the two largest having 37 %. The large amount of banks seems to indicate that some further consolidation could be expected.

The financial sector has reached an adequate degree of stability. In 2000 nearly all banks showed profits. Total net profits in 2000 were approximately 38 million lats, 20 million more than in 1999. The capital adequacy ratio was 14 % at the end of 2000 and 15 % at the end of March 2001, well above the 10 % required by domestic regulation. The amount of bad loans declined, despite the rapid increase in lending last year. At the end of 1999, the share of bad loans amounted to 6.2 %, at the end of 2000 to 4.6 %, and at the end of the first quarter of 2001 to 4.4 %. A unified supervisory institution for the whole financial sector became operational from July 2001. Previously, the central bank was responsible for the supervision of banks. However, since the new body is only starting its operations, due attention should be paid to a smooth transfer of responsibilities, to securing its independence and to ensuring the quality of its supervision activities.