Monetary Developments in Latvia during Transition Period
by Irina Jakovleva
Since 1991, the Baltic States made the greatest progress among former Soviet republics in the transition to the market economy. Latvia as one of them retained a strong sense of identity from its interwar independence and shared a common goal – to forget the Soviet past as quickly as possible and join Europe. To pursue the goals Latvia initiated market-oriented reforms. The stabilization and structural programs were aimed at price liberalization, elimination of subsidies, tightening of finances, and establishing a liberal trade and payments system. However, one of the most significant development was newly proposed country’s monetary policy.
The main monetary goals were following:
Keep domestic inflation as low as possible
External stability of national currency.
Interest rate policy
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. First of all, temporary currency “Latvian Ruble” was issued. This currency followed the hyperinflation of the Soviet ruble, however, it allowed the Latvian government to get rid of the Soviet currency smoothly step-by-step. Later the Bank of Latvia introduced the permanent currency – Lats, which functions up to present moment. In 1993 the currency was made convertible allowing its exchange rate fluctuate. Successful financial policies have been reflected in the continuous fall of inflation from 958.7% in 1992 to 23.1% in 1995, 13.1% in 1996 and 7.0% in 1997 (www.bank.lv). Also the inflation rate was the lowest among the Baltic countries.
Since February 1994 focus of the monetary policy shifted to the exchange rate stability. The behavior of monetary aggregates was determined by developments in the foreign exchange market, velocity continued the downward trend, reflecting increased confidence in lats. Therefore the fluctuations against any particular currency in the basket depended only on fluctuations in the world money market.
In year 1995 on the monetary side, the country faced the Banking crisis. Three of the country’s most influential banks failed, including the biggest one - Bank Baltija. The failure of this bank was mainly a combination of bad banking, weak prudential regulations and “reported malfeasance”. Deposit withdrawals occurred in other banks as customers’ confidence in the banking system was shaken. This failure resulted in losses of around 8% of GDP. Later however there were no major signs of bank runs and the confidence was restored. Foreign exchange outflows also took place because foreign investors and residents lost confidence. The good news was that the exchange rate manage to stay firm and stability was returned to the foreign exchange market.
As a consequence of the Bank crisis, improvements in the supervision system were made. Later these resulted in the development and strengthening of the banking sector. In the autumn of 1998, several banks experienced problems because they had underestimated the country and credit risks involved when they invested in the Russian securities market. However, by this time, Latvia's banking sector as a whole was characterized by stability and growth. According to the estimates of the IMF the financial turmoil in Russia in August-September 1998 did not generate any major effect on the Latvian banking sector as a whole. This proves that Latvia has an effective banking supervision mechanism. Also the year 1998 was the third consecutive year marked by a stable and controlled growth in Latvia’s banking sector.
During the transition period the government and the Central Bank successfully implemented strict monetary and banking supervision policies. In 1998 full compliance with European Union requirements was achieved. To regulate the amount of money in circulation, the Bank of Latvia has introduced various monetary policy instruments, the most recent being auctions of long-term currency-swap agreements, which tend to reduce long-term interest rates on loans made.
In the recent developments, The Bank of Latvia has been successful in maintaining the lats as a strong and stable currency and managed to cope with pressures on the exchange rate. At present time Latvia again experiences inflows of capital, business risk decreased and competition among banks increased. Interest rates paid on deposits of domestic enterprises remained stable. Also in 1998 the annual inflation rate fell to 2.8%, in 1999 the annual inflation rate was at 3.2%, and in 2000 - at 2.6% (www.bank.lv).
During the transition period, every country of the former USSR has implemented economic reforms aimed at the creation of a functioning market economy. Latvia’s impressive progress and monetary development prove the success and effectiveness of long-term oriented economic reforms and shows Latvia’s ability to cope with competitive pressure.
2. IMF overview of the country's developmnet:Latvia. 1998
3. Dreifelds, Juris. "Latvia in Transition" Camridge University Press, 1996