Document ofThe World Bank

FOR OFFICIAL USE ONLY

Report No. P-7556

REPORT AND RECOMMENDATION

OF THE

PRESIDENT OF THE

INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT

TO THE

EXECUTIVE DIRECTORS

ON A PROPOSED

SECOND PROGRAMMATIC STRUCTURAL ADJUSTMENT LOAN

IN THE AMOUNT OF US$20.21 MILLION

TO

THE REPUBLIC OF LATVIA

August 15, 2002

[his document has a restricted distribution and may be used by recipients only in the performance of theirofficial duties. Its contents may not otherwise be disclosed without World Bank authorization.

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CURRENCY EOUIVALENTS(Exchange Rate Effective as of July 31, 2002)

Currency Unit= LatsUSS1.00= LVL 0.60

GOVERNMENT FISCAL YEAR

January 1- December 31

WEIGHTS AND MEASURESMetric System

ABBREVIATIONS AND ACRONYMS

AU Anticorruption Unit MoAg Ministry of AgricultureBFI Budget Financed Institutions MoF Ministry of FinanceBPAR Bureau of Public Administration Reform MoJ Ministry of JusticeCAS Country Assistance Strategy MoPSR Ministry of Public Sector & Regional ReformCEM Country Economic Memorandum M-O-M Month on MonthCIS Commonwealth of Independent States NATO North Atlantic Treaty OrganizationCOM Cabinet of Ministers NDP National Development PlanCPS Corruption Prevention Council NTR National Telecommunications RegulatorCPAR Country Procurement Assessment Review OECD Organization for Economic Cooperation & Development

CPB Corruption Prevention Bureau OED Operations Evaluation DepartmentCPI Consumer Price Index PAC Public Accounts CommitteeCSA Civil Service Administration PAR Public Administration ReformDDO Deferred Drawdown Option PAYGO Pay As You GoDEM German Mark PEM Public Expenditure ManagementEBRD European Bank for Reconstruction & Development PER Public Expenditure ReviewESW Economic & Sector Work PLP Programmatic Lending ProgramEU European Union PSAL Programmatic Structural Adjustment LoanFCMC Financial & Capital Market Commission PUC Public Utilities ComrnmissionFIAS Foreign Investment Advisory Service RHS Right Hand ScaleFDI Foreign Direct Investment SAL Structural Adjustment LoanFSAP Financial Sector Assessment Program SAO State Audit OfficeFSL Fixed Spread Loan SAPARD Special Assistance Program for Agricultural & Rural Dev

FSU Former Soviet Union SBA Stand-By ArrangementGDP Gross Domestic Product SDR Special Drawing RightGKO Gosudarspvennyi Kazanacheiskiye Obligatsii SIGMA Support for Improvement in Govemance & ManagementGMI Guaranteed Minimum Income SRS State Revenue ServiceG-24 Group 24 TA Technical AssistanceIBRD Intemational Bank for Reconstruction & Development TSO Transmission System OperatorIDF Institutional Development Fund UNDP United Nations Development ProgramIFC Intemational Finance Corporation US United StatesIFI Intemational Finance Institution VN Ventspils NaftaIMF Intemational Monetary Fund WTO World Trade OrganizationKE Knowledge Economy Y-O-Y Year on YearLASCO Latvian Shipping CompanyLBFM Law on Budget & Financial ManagementLDA Latvian Development AgencyLHS Left Hand ScaleLPA Latvian Privatization Agency

Vice President: Johannes F. LinnCountry Director Roger W. Grawe

Sector Director Cheryl W. GraySector Manager: Kyle Peters, Bemard Funck (Acting)

Team Leader: C6lestin Monga

FOR OFFICIAL USE ONLY

REPORT AND RECOMMENDATION OF THE PRESIDENT OF THEINTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT

TO THE EXECUTIVE DIRECTORSON A PROPOSED SECOND PROGRAMMATIC STRUCTURAL ADJUSTMENT LOAN

TO THE REPUBLIC OF LATVIA

Table of Contents

LOAN AND PROGRAM SUMMARY .......................... ...................................i

I. INTRODUCTION ..................................... 1.........................

II. Recent Economic Developments And Prospects .......................................................... 2

Macroeconomic Performance and Poverty ............................................................. 2Structural reforms ............................................................. 5Medium-Term Prospects and Creditworthiness ............................................................ 6

III. LATVIA'S DEVELOPMENT OBJECTIVES AND THE PSAL PROGRAM ............. 9

Objectives and Components of the PSAL Program ...................................................... 9Overall Assessment of the Program Since PSAL I ..................................................... 10Evaluation of Each Component of the Reform Program ............................................. 12

IV. THE WORLD BANK STRATEGY ............................................................ 31

Country Assistance Strategy ............................................................ 3 1Coordination with the IMF and other Donors ............................................................ 32

V. THE PROPOSED LOAN (PSAL I) ............................................................ 35

Objectives and Design ............................................................ 35Poverty and Social Impact Analysis ............................................................ 36Specific Actions Taken Prior to Board Presentation ................................................... 36Strengthening the public sector's institutional capacity .............................................. 37Rationalizing the interactions between the public and private sector .......................... 38Progress Benchmarks and Triggers for Considering PSAL III .................................... 39Monitoring and Evaluation ............................................................. 41Loan Administration ............................................................. 41Benefits and Risks ............................................................ 42

VI. RECOMMENDATION ............................................................ 43

The World Bank team for this operation was led by Celestin Monga. The operation was initiated with los Verbeek astask manager (until October 2001). The team included: Alexander E. Fleming, Lars A. Jeurling, Dick Welch (ECSPF);M Louise Fox (HDN VP); loannis N. 'Kessides (DECRG), Kathy Lalazarian, Pascale N. Kervyn De Lettenhove, RandiSusan Ryterman (ECSPE); M. Helen Sutch (PRMPS); Gary Stuggins (ECSEG); Nightingale-Rukuba-Ngaiza (LEGEC),David Satola (LEGPS); David Freese, (LOAGI); Dorris Herrera-Pol, Jose F. Molina, Hala D. Khattar (BCFPS);Inguna Dobraja, Dina Grube. Hilmar Thor Hilmarsson,.Andrejs Jakobsons, Normunds Malnacs (ECCLV); AlisonPanton, Rosario C Hablero. and 'Erlindd B. Inglis (ECSPE). Peer Reviewers included Barbara Lee (PSIVP); NickManning (PRMPS), and Joel Hellinman (ECSPE). Pradeep Mitra, Kyle Peters, Bernard Funck (ECSPE), Christopher L.Hall, Michael F. Carter (ECCU7), and Stefan Koeberle (OPCPG) provided advice and guidance.'

This document has a restricted distribution and may be used by recipients only inthe performance of their official duties. Its contents may not be otherwise disclosedwithout World Bank authorization.

List of Tables/Figure:

1. Latvia's Program Supported by PSAL ........................................... 102. Achievements on Key Benchmarks for Moving to PSAL II ......................................... 233. Latvia's PSAL Program and Its Analytical Underpinnings .......................................... 33

Annexes

1. Latvia at a Glance ........................................... 442. Key Economic Indicators ........................................... 463. Balance of Payments ........................................... 474. Letter of Development Policy ........................................... 485. Policy Matrix ........................................... 686. Key Exposure Indicators ........................................... 927. Operations Portfolio-EBRD ........................................... 938. Statement of IFC's Held and Disbursed Portfolio ........................................... 94

REPUBLIC OF LATVIASECOND PROGRAMMATIC STRUCTURAL ADJUSTMENT LOAN

LOAN AND PROGRAM SUMMARY

Borrower: Republic of Latvia

Amount: US$20.21 million

Terms: Customized terms (6 years grace with 13 years to fullrepayment for a fixed-spread loan). Although Latviamoved to Country Category IV as of July 1, 2002,because the negotiations commenced prior to July 1,2002, Latvia is still eligible for amortization terms for aCategory III Borrower.

Commitment Fee: The government has elected the Deferred DrawdownOption (DDO): I percent on undisbursed amounts,beginning 60 days after the loan agreement is signed,payable during the drawdown period while DDO is notexercised.

Front end fee: A front end fee of 1 percent of each withdrawn amountwill be paid to the Bank from the loan proceeds onlyfollowing any drawdowns.

Objectives and Description: The proposed loan of US$20.21 million is the secondProgrammatic Structural Adjustment Loan (PSAL) tosupport Latvia's reform program as outlined in ReportNo. P 7352 LV. At the outset of the program, it wasenvisaged that over a 3-year period there could be up tothree single or two tranche PSALs to support theimplementation of Latvia's reform program amountingto an overall resource envelope of approximatelyUS$100 million. Reform objectives and Latvia'sprogram have remained the same since the Boarddiscussed PSAL I namely to:

* Sustain a growth-oriented macroeconomicframework;

* Strengthen credibility of the public sector;* Jmprove institutional capacity to deliver public

services; and* Build a transparent relationship with the private

sector.

The Latvian authorities expect to achieve theseobjectives by implementing specific reforms in the areasof (i) fiscal policy; (ii) public sector management; (iii)

human resources management; and (iv) privatization andregulation (of public utilities and private business).PSAL I supported the initiation of these reforms. PSAL[I will support measures already taken to implementthose reforms and assist newly created public sectorinstitutions in their initial period of operation. PSAL IIwill also provide external resources to the governmentshould there be a financing need prior to the closing dateat end-2003. The government has elected the DeferredDrawdown Option (DDO) for this purpose.

Benefits: The actions under PSAL II will promote fiscaladjustment and improve the public sector's capacity tocarry out its role effectively and efficiently. At the sametime the actions supported by the loan will encourageprivate sector development by continuing theprivatization process and defining a transparent andeffective regulatory framework. The operation will alsoassist in the government's anticorruption effort andstreamline business regulation, leading both to a moreefficient government and a better functioning marketeconomy. Together, these measures will be a positivesignal to domestic and foreign investors about Latvia'sbusiness environment, and enhance the benefits thatLatvia will garner from timely EU accession. Finally,enhanced public sector service delivery capacity willhelp ensure that these benefits are broadly shared withinLatvia.

Risks: The deterioration of the current account deficit remainsthe main macroeconomic risk to sustaining a highgrowth regime in Latvia. Given the currency peg, ashortfall in political commitment to fiscal balance couldundermine overall sustainability. The highly politicizedenvironment in Latvia also affects political comrnitmentto public sector reform generally, especially in aprogram with such a significant emphasis on improvedgovernance. Such risks are heightened by the frequentchanges of government that have characterized Latviasince independence. In addition, continuing dependenceon multiparty coalition governments with varyingministerial portfolios increases the risk of poorinterministerial coordination and policy interventions byspecial interest groups.

These risks are mitigated to a substantial extent by thedesign and content of the PSAL loan as a single trancheoperation linked to prior actions. The LatvianGovernment has a strong track record of reformimplementation and commitment to macroeconomicbalance even in difficult political circumstances, as

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evidenced by their agreement with the IMF on ambitiousmacroeconomic targets for the SBA and ability tosupport the currency peg over an 8-year period ofconsiderable economic turmoil. The World Bank willcontinue to assist the government to mobilize thetechnical assistance required to adopt and implement itsprogram. Latvia's strong determination to join theEuropean Union also facilitates the continuity of theprogrammatic approach supported by the PSALprogram. An interministerial work group under thecoordination of the Ministry of Finance, which helped inthe preparation of PSAL U, and I, will continue its workduring the implementation phase of the reform programand improve coordination among the implementingagencies.

Schedule of Disbursements: Deferred Drawdown Option. US$20.21 millionavailable immediately after loan effectiveness (expectedin October 2002).

Poverty Category: Not applicableRate of Return: Not applicableProject ID Number: LV-PE-69890Map IBRD No. 30692

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REPORT AND RECOMMENDATION OF THE PRESIDENT OFTHE INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT

TO THE EXECUTIVE DIRECTORS ON A PROPOSEDSECOND PROGRAMMATIC STRUCTURAL ADJUSTMENT LOAN TO

THE REPUBLIC OF LATVIA

I. INTRODUCTION

1. I submit for your approval the following Report and Recommendation on a proposedSecond Programmatic Structural Adjustment Loan (PSAL II) to the Republic of Latvia for anamount equivalent to US$20.21 million to support the Government's structural reformprogram. The loan will be on customized terms (6 years grace with 13 years to fullrepayment for a fixed-spread loan). The government has selected the Deferred DrawdownOption (DDO) for this operation. The proposed loan is an integral part of the Bank's CountryAssistance Strategy (CAS)' to support the implementation of the government's NationalDevelopment Program (NDP). The PSAL II would be the second in a series of three loansplanned for FYOO-04. The Bank's Board approved the first single-tranche PSAL for Latvia inMarch 20002. The loan established a rolling medium-term policy framework setting out a 3-year reform program aimed at implementing the country's medium-term reform program,with specific progress benchmarks and outcome indicators defined and agreed with thegovernment and other donors (IMF, EU).

2. The implementation of the program supported by PSAL I has been satisfactory.Nearly all core progress benchmarks'specified in PSAL I have been satisfied. In instances forwhich the initial objectives proved too ambitious, especially given the limited capacity in thepublic sector, authorities have adjusted the medium-term program, in full agreement with theBank and other partners. While PSAL I initiated many of the reforms in the program, PSALII supports their implementation and assists some newly created public sector institutions intheir early years of operation. Overall, satisfactory progress since the approval of PSAL Ifully warrants a move to PSAL II. Subject to satisfactory progress on the program outlinedin the proposed credit, it is envisaged that in FY04 there will be a final single-tranche loan,PSAL III.

3. It was clear at the outset of PSAL I that institutional reforms of this type take timeand that their exact scope, sequencing, and pace cannot be determined with full certainty atthe outset. Therefore, the Bank decided to use the PSAL instrument as it provides a medium-term strategic framework to channel Bank support (financial as well as knowledge) to theGovernment of Latvia. In addition, the programmatic adjustment lending instrument hasproven well-suited to support gradual institutional changes that are inherently unpredictableand require flexibility. The proposed PSAL II would support reforms aimed at strengtheningthe credibility of the public sector, the efficiency and effectiveness of the public sector'scapacity to deliver services, especially to the poor, and the rationalization of the interactionbetween the public and private sector.

'See Latvia: Country Assistance Strategy - Report No. 23610-LV (April 2002).

2 See Latvia: Prograrnmatic Structural Adjustment Loan - Report No. P7352-LV (February 2000).

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4. Thanks to Latvia's track record as a strong reformer, the country's financial situationhas improved greatly over recent years. The 2001 joint World Bank/IMF Financial SectorAssessment Program (FSAP) carried out in 2001 pointed out several significantimprovements in consolidation of the banking sector as well as the entry of foreign investors.It concluded that the financial sector has recovered from the Russia crisis and has created asolid basis for further development. The government has decided to select the DeferredDrawdown Option (DDO) for PSAL II, which offers the possibility of not tapping into theresources until there is a need, as well as the absence of a penalty for non-use. Should theneed arise, the proposed PSAL II would thus provide fast-disbursing support to help addressLatvia's external financial needs and keep its medium-term reform program on'track.

5. The board documentation of PSAL I contained not only actions agreed to be takenprior to Board consideration and release of the first loan, but also measurable progressbenchmarks for subsequent PSALs. Therefore, the remainder of this document gives anassessment of progress towards meeting the objectives of the reform program as outlined inthe first PSAL operation. It also discusses modifications to the program. The reformssupported by the PSAL II program are laid out in the govermnent's Letter of DevelopmentPolicy [Annex 4] and reflected in the updated multiyear policy reforms program matrix. Thematrix shows measures completed with support of the first PSAL operation, as well asmeasures, monitorable indicators, progress benchmarks, and expected outcomes for theproposed PSAL II operation and a possible third PSAL loan [Annex 5].

II. RECENT ECONOMIC DEVELOPMENTS AND PROSPECTS

Macroeconomic Performance and Poverty

6. Economic Growth. Latvia has restored its previous track record on macroeconomicperformance. After dropping in 1994 and 1995, real GDP has grown on average by 5.1percent annually. Growing demand for Latvia's exports in both the traditionalCommonwealth of Independent States (CIS) and new EU markets and sound trade policycontributed to growth momentum in Latvia over the past 3 years. Led by investment andprivate consumption, real GDP grew by 7.6 percent in 2001 (6.8 percent in 2000) and isprojected at 5 percent in 2002. Growth has been broad-based, with especially strong gains inforestry, business services, financial intermediation, and manufacturing. The key factors inbuilding the growth momentum were the acceleration of domestic private and public demand.Domestic consumer and investment demand were supported by growing real incomes and taxrevenues, and reinforced by improving consumer and investor confidence and projections ofrising real income in the medium term. Low capital intensive and fast-maturing foreigndirect investment (FDI) contributed to an increase in the productive capacity andcompetitiveness of Latvia's manufacturing base. The economic expansion was easilyfinanced with relatively inexpensive domestic credit provided by a competitive financialsystem.

7. Monetary Policy. At an early stage of the adjustment process, Latvia introduced itsown 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. Its main goal is tomaintain price stability, thus contributing to the process of restructuring the nationaleconomy and controlling the amount of banks' reserves to limit excessive lending. The

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exchange rate policy of the Bank of Latvia is similar to that of a currency board, and themonetary base is backed by gold and foreign currency reserves. Latvia has been using theexchange-rate-based stabilization program since 1993. In mid-February 1994, the Bank ofLatvia pegged the Lats to the SDR basket of currencies and this served the country well.After reaching 109 percent in 1993, CPI inflation has been at single digit levels since 1997.In 2001 the CPI grew by 2.5 percent. Interest rates have come down significantly since the1998 Russian crisis that affected the banking system. The annualized yield on a 12-monthTreasury bill, which was 10.4 percent at the beginning of January 1999, was 4.4 percent inJuly 2002.

8. Fiscal Policy. From the outset of the transition process, fiscal policy has beenconservative with a few notable exceptions caused by internal or external shocks. Due togenerally good fiscal discipline, Latvia has low levels of public debt, and its credit ratingshave improved, giving Latvia easier and less expensive access to international capitalmarkets. However, the fiscal situation in 1999 and even in 2000 showed the consequences ofthe Russia crisis. From a surplus of 0.3 percent of GDP in 1997, the fiscal deficit rose to 3.9percent of GDP in 1999 and remained relatively high in 2000 at 3.3 percent, above the targetagreed with the IMF. While strong progress was made in 2001 by reducing the fiscal deficitto 1.9 percent of GDP, the budget for 2002 initially showed an increase of the fiscal deficit to2.4 percent. Recent discussions between the IMF and the government in the framework ofthe SBA have led the authorities to adopt a new fiscal deficit target of 1.8 percent of GDP in2002.

9. External Accounts. Following several years of small external current accountdeficits that were entirely financed by foreign direct investment (FDI), Latvia's currentaccount deficit (including official transfers) rose from 6.1 percent of GDP in 1997 to 9.8percent in 1999, with only half financed by FDI-a deterioration largely initiated by theRussian crisis. There was some improvement in 2000 when the current account deficit wasbrought to just under 7 percent of GDP in 2000 despite appreciation of the Lat against theEuro and the rise in oil prices, but it widened again in 2001, reaching 10 percent of GDP.Besides one-time ship purchases by the state-owned Latvian Shipping Company (LASCO)that accounted for 1.5 percentage points of the deficit, the deterioration reflected weakerexternal demand and strong domestic demand, especially for investment goods, whichcontinued in the first quarter of 2002.

10. Like many transition economies, Latvia has recorded relatively modest saving rates(17 percent of GDP on average over the past 5 years) while, simultaneously, investmentneeds during transition have been high (gross domestic investment averaged 25 percent ofGDP in 1996-2001). Such conditions suggest that running a sustainable current accountdeficit, both to smooth consumption over time and finance much-needed capital projects tocatch up with EU countries, may be necessary from a welfare viewpoint. This is confirmedby the evolution of the commodity structure of foreign trade: while imports of food, drinks,and tobacco decreased slightly from 6.2 percent of the total in 1996 to 6 percent in 2000,imports of base metals products, machinery, electrical equipment, transport vehicles, andparts increased from 29 to 37 percent of the total during the same period.

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11. The current account deficit is projected to 8.5 percent of GDP in 2002. The largeinvestments needed in the medium term to sustain economic growth, coupled with a catch-upin private sector consumption, will, however, necessitate a leveling off in improving theextemal current account deficit, as imports will continue to grow strongly and FDI-relatedprofit remittances are expected to rise. On the other hand, a continued strengthening ofLatvian exports to the EU, together with diversification in the export base resulting frombroad-based FDI, is projected to materialize during the period 2003-2005. As FDI isprojected to remain buoyant-because of the forthcoming privatization of the remaininglarge public enterprises like Ventspils Nafta and Lattelekom and the sale of newtelecommunications licenses-the external account is expected to be almost fully covered bynon-debt-creating flows, thereby containing Latvia's already favorable debt indicators.

12. External Debt. In spite of the wider current account deficit and the lower FDIcoverage in 2001 than in previous years, Latvia's debt indicators-including those for short-term debt-remain moderate. Public sector external debt represented 11.4 percent of GDP in2001 and total extemal debt (excluding currency and deposits) represented 49.5 percent ofGDP. While the most comprehensive measures of short-term debt, including foreignliabilities of the banking system, suggest that Latvia's short-term debt is high (43.6 percent ofGDP), these liabilities are largely matched by high-quality, liquid foreign assets.3 In addition,the Latvian banking sector is sound and well supervised. The Financial and Capital MarketCommission (FCMC) has made substantial progress in implementing the recommendationsset forth in the 2001 Financial Sector Assessment Program (FSAP). Following the re-approval of existing financial sector regulations, the FCMC will harmonize all sector-specificlegislation, regulations, and supervisory methods across sectors by end-December 2002 toreap the full benefits of unified supervision. Risk profiles for financial institutions have beenprepared, and the FCMC will consider introducing a rating system for financial institutions toenhance the effectiveness of its oversight function at a later date. In addition, the FCMC willupdate its examination manual to effectively cover all branches of the financial sector.Finally, the FCMC will continue to enhance risk-based supervision in all sectors and promotethe introduction of key consumer protection measures for the financial sector.

13. Market sentiment towards Latvia has been very favorable over recent years. InAugust 2001, rating agencies upgraded their outlook on Latvia sovereign foreign currencydebt and issued a positive report on the banking system. Developments in emerging marketsin late 2001 caused a temporary rise in Latvia's Eurobond spread, but it quickly came backbelow 100 points. And despite the delay in completing the first review under the SBA, Latviasuccessfully placed a second Eurobond in November 2001.

14. Poverty and Unemployment. Growth has been strong across all sectors of theeconomy, causing the unemployment rate to decrease from over 10 percent in the summer of1999, at the height of the impact of the Russian crisis, to 8.1 percent at the end of April 2002.While Latvia's ranking on the Human Development Index climbed from 72nd in 1997 to 63rdin 2000, and negative trends in life expectancy and mortality have stopped, Latvia still has

3 According to a recent IMF study, over two-thirds of Latvian short-term debt consists of non-residentdeposits in commercial banks. These deposits are largely redeposited in foreign banks or placed in othersecure liquid foreign assets in OECD countries chosen to match the currencies and maturities of thedeposits. When assessing vulnerability, it is reasonable therefore to exclude non-resident deposits fromshort-term debt or to net the liabilities with their corresponding assets.

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significant challenges in reducing poverty. First, it appears that the benefits of the rapideconomic recovery since the Russian crisis have not been shared equally among thepopulation of Latvia: the Gini coefficient increased from 0.30 in 1996 to 0.34 in 2000. The2000 Poverty Assessment found that 19.4 percent of the population was in poverty in thatyear.4 As in other countries in the region, such as Lithuania and Poland, and as was the casein Latvia in the mid-1990s, poverty is higher in rural as compared to urban areas. In Rigacity, where most new investment has focused and where economic growth has created mostnew opportunities, 10.8 percent of the population lives in poverty while rural poverty standsat 28.5 percent. This also reflects marked regional differences in poverty; while Riga region(encompassing Riga city and rural areas near the city) has a poverty rate of 12.6 percent, theLatgale region of eastern Latvia, along the border with Russia, is the poorest region, with apoverty headcount of 30 percent. The Poverty Assessment found that one important cause ofpoverty is the weak public service delivery mechanisms and stressed the need for moreeffective public institutions, hence the focus of this operation.

Structural Reforms

15. Latvia has made great strides in building the institutions needed for developing amarket economy. For example, prices, trade, and other markets have been liberalized, andneeded legal reform, institutional development, and social safety net improvements are beingimplemented. The remaining structural reform program is directed at attracting foreigninvestment and sustaining growth. The focus of the agenda is to implement measuresidentified as catalysts to improve the business climate, foster competition in the energy andtelecommunications sectors, complete the privatization of large-scale public enterprises, andcombat corruption.

16. The restructuring and privatization process for state enterprises has been completedwith the notable exceptions of several large companies-Latvenergo (power), Lattelekom(communications), and Ventspils Nafta (oil pipeline company). Recent privatization actionsincluded the sale of all remaining shares in Latvijas Gaze in February 2002 and the sale ofLASCO through an offering of 32 percent of its shares for vouchers and 51 percent of itsshares for cash on the Riga Stock Exchange at a price approved by the Board of the LatvianPrivatization Agency (the remainingl7 percent will go to employees, the State Pension Fund,and the privatization reserve).5

17. Parliament voted last year to put Latvenergo on the list of strategic companies not tobe privatized. The authorities went along with the decision in order to prevent a publicreferendum that might have stopped privatization for many years to come and possiblystopped efforts to restructure the company. Taking into account lessons learned in similarsituations in transition countries, the authorities and the Bank agreed that the appropriatesequencing was for Latvenergo to be broken up first so that the government was notprivatizing a monopoly, real competition over the grid could be organized, and a regulatory

4As there is no official poverty line in Latvia, the report used a poverty line estimate of 28 Lats per month,which is equal to Y/2 of the official Minimum Crisis Basket - a social minimum line defined by theGovermment.

5 The company has come under the control of the Ventspils Nafta group. The World Bank would havepreferred that a larger share be sold to a strategic investor.

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framework consistent with EU requirements could be put in place. Thanks to reformssupported by PSAL II, these steps have been taken. The government has adopted EUDirective 96/92/EC concerning common rules for the internal market in electricity indesigning its electricity market and is adopting measures to further liberalize the market. Therestructuring program for Latvenergo prepared by the government is consistent with the EUDirective. The government has increased the scope for bilateral trade for large customers bydecreasing the criteria for qualified customers from 100 GWh to 40 GWh. They plan todeepen market opening next year by further decreasing the criteria to 20 GWh, significantlyincreasing the number of consumers that can directly contract for electricity with independentgeneration companies.

18. With respect to Lattelekom, Sonera, its strategic investor, has taken the governmentto arbitration court to resolve the issue of compensation for shortening the company'sexclusivity period from 2013 to 2003. The authorities have committed themselves to theWTO and the EU to shorten this period. As indicated in the Letter of Development Policy,they are also taking steps to implement the Telecommunication Law, which was adopted bySaeima in 2001. The authorities recognize that the foundation of an efficient energy andtelecommunications sector is competition and sound regulation. To this end, and in line withthe strategy paper and work program of the Public Utilities Commission (PUC), thegovernment envisages a transition from regulated monopolies to regulatory frameworks forcompetitive markets. Key steps in this direction include completing the restructuring programof Latvenergo by end-2002 and implementing the recently adopted principles for tariffsetting, which will be applied across sectors.

19. On Ventspils Nafta, the government has received the privatization plan andcompany's financial valuation from the international investment bank hired to prepareVentspils Nafta's privatization. They have reaffirmed their commitment to privatizing theirshares in the company in 2003 in an open, competitive manner and at a fair price.

20. The government has implemented 68 of the 77 suggested measures in its Action Planto Improve the Business Environment. The anticorruption fight was aided by the adoption ofkey legislation and the creation of the Corruption Prevention Bureau (CPB), which endedprevious agency fragmentation in this area. These measures are considered adequate byWorld Bank staff.

Medium-Term Prospects and Creditworthiness

21. Latvia's prospects depend on its ability to reduce the current account deficit tosustainable levels and implement structural reforms to improve the management,accountability, and performance of the public sector, as supported by the PSAL program.Given the role of fiscal policy as the main instrument to contain current account pressures inview of Latvia's fixed exchange rate regime, the authorities recognize the need for fiscaldiscipline. Reduction in the fiscal deficit will mainly come from limited expenditureincreases. Expenditure is expected to increase slightly to 39 percent of GDP in 2004 withadequate resources directed towards such strategic priorities as EU and NATO accession.Government revenue is projected to increase to about 38 percent of GDP. As a result,Latvia's fiscal deficit is projected to fall below 1 percent of GDP in 2004. But the authorities'intention to move toward a balanced fiscal position over the medium term will require majorefforts, especially in the implementation of policy measures to enhance control over local

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government-finances. The authorities have already adopted several key measures to enhancelocal government fiscal control, including amendments to the Law on Local GovernmentBudgets clarifying that borrowing requires approval by the Ministry of Finance and is subjectto limits under the budget law.

22. The current account deficit is expected to improve over the medium term. Sustainedimplementation of structural reforms would foster private sector activity, enhance efficiency,promote job creation, and spur growth. Large public and private investment needs suggest,however, that improvements in the current account may come only slowly, and would mainlyresult from further fiscal consolidation. Nevertheless, FDI inflows would keep external debtat moderate levels.

23. Sources of Growth. Growth will depend in the medium term on how the governmentinteracts with the private sector. Hence, a continuation of the initiated structural reforms,particularly privatization, liberalization, and development of institutions that enhance themarket environment, will be important to maintain the economy's current momentum.Therefore, the government's program aims to implement reforms that improve its credibility,strengthening the way the government handles its financial as well as human resources andimproving its ability to credibly commit to a regulatory environment that supports a dynamicmarket economy.

24. Initially GDP growth is to be driven by further export gains in the EU and aconsolidation of the recovery of exports to the CIS. GDP is expected to grow at around 5percent in 2002, and GDP growth is expected to stabilize around that percentage in themedium term. Furthermore, GDP growth will depend significantly on the implementation ofthe PSAL-supported reform program. Further improvements in the functioning of theGovernment of Latvia, in particular, its interaction with the private sector and lowering thecosts and barriers to investment will increase the private sector's willingness and ability toinvest. Private investments (excluding changes in stocks) recovered strongly during 2001.They increased from 22.6 percent of GDP in 2000 to 23.7 percent in 2001 and are expectedto stabilize around 23 percent in 2005. As public investment is expected to increase as wellfrom around 3.7 percent of GDP for 2001 to around 5 percent by 2004, mostly driven by EUaccession investment requirements, overall investments are expected to rise to close to 30percent of GDP in 2004.

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25. Financing Requirements. Under the above-outlined scenario, Latvia will needsubstantial capital inflows to finance its current account balance. The current accountdeficit is expected to improve from an estimated 10 percent for 2001 to 7.3 percent ofGDP in 2004.

26. Between 2002 and 2004, the gross external financing needs are estimated at aboutUS$2.84 billion. These resources are necessary to finance US$2.04 billion in current accountdeficits, US$269 million in increases in international reserves, and the remainder-US$528million-to fulfill debt repayment obligations. Direct foreign investment is expected tofinance about 50 percent of these needs, driven by privatizing the remaining large enterprisesto strategic foreign investors, improving the investment climate through businessderegulation, and establishing a stable regulatory framework. Public resources will finance11 percent of these financial requirements, of which 80 percent will be through loans. Theremainder of the public sector foreign financing will come from grants, mostly from the EU.The final 37 percent of the financing needs for the period 2002-04 will have to come fromloans directed towards the private sector in Latvia.

27. The fiscal consolidation to occur with the assistance of the PSAL and the secondSBA with the vIMF should further reduce the government's needs to borrow abroadcommercially. Reducing the fiscal deficit will also lead to a sigrificant reduction in theneed for domestic deficit financing. Latvia's public and publicly guaranteed medium-termh and long-termn debts are expected to slowly decrease in the coming years with theexpected imnprovement of the current account balance. However, total external debt mayincrease to around 55 percent of GDP in 2004, up from 49.5 percent at the end of 2001.The ratio of total debt service to exports will decrease to around 4.7 percent of exports by2003, again as a result of decreased borrowing needs relative to GDP and exports.6

6 Source: Calculations based on the International Investmnent Position of Latvia, published by the Bank ofLatvia. These numbers exclude Currency and Deposits.

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IE. LATVIA'S DEVELOPMENT OBJECTIVES AND THE PSAL PROGRAM

Objectives and Components of the PSAL Program

28. The main thrust of the PSAL-supported program is improving governance, forexample, directly through business regulation or indirectly through transparency andaccountability of government. Such improvements will further enhance the institutionalcapacity to support a market economy. The 2000 Poverty Assessment identified ineffectivepublic sector institutions and weak governance as important constraints to growth andequitable development in Latvia. Various studies carried out by the government and donorshave also concluded that ineffective public sector institutions, insufficient human capacity,misguided resource allocation, public intervention in some sectors where market failures arenot observed, lack of transparency in the use of public funds, and corruption have deterredprivate investment, which is an essential ingredient to higher growth, better employmentopportunities, and poverty reduction. An ineffective public sector has also led to inadequateservice delivery outside Riga, the capital city.

29. Refocusing the role of the state and promoting good governance are two of the mainguiding principles of Latvia's National Development Plan. The government's strategyassumes that the state will only intervene in the context of a clear definition of its powers androle as compared with those of civil society and the private sector. Public intervention will beguided by two major motivations: compensating for market failures in the allocation ofresources and promoting social equity. Against that background, public sector reform isconsidered a prerequisite to the successful implementation of Latvia's EU accession strategy.The PSAL program assists the government in introducing a better-targeted social assistancesystem for the poor. It supports these objectives by facilitating a return to a moreconservative fiscal position and by helping create transparent and accountable institutionalcapacity to appropriately interact with the private sector and Latvian citizens in a market-driven economy. The public sector reform program, therefore, consists of a multiyearmodernization of Latvia's public sector, particularly in the following policy areas: (i)maintaining macro-stability, especially through a lower fiscal deficit; (ii) improving publicgovernance; (iii) improving effectiveness and efficiency of service delivery, especially to thepoor; and (iv) finalizing the privatization process and implementing an effective regulatoryframework. The objectives, reform areas, and priorities of those components of Latvia'sreform program that the PSAL program supports are shown in Table 1.

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TABLE 1. LATVIA's REFORM PROGRAM SUPPORTED BY PSAL

Objectives Reform Areas PrioritiesA. Retuming to a Macro * Fiscal and Monetary * Correcting the macro-imbalances that re-emergedEconomic Framework Policy after the Russian crisisConducive to robustgrowth * Pension Reform * Ensuring financial viability of the pension system

B. Strengthening the * Anticorruption * Reducing risks and opportunities for corruption inCredibility of the Public Govemment and the JudiciarySector

* Govemment * Strengthening transparency and reporting of theAccountability and ministries and bodies subordinated, supervised andTransparency managed by them

C. Strengthening the * Administrative * Streamlining the structure of the public sectorPublic Sector Institutional Efficiency * Increasing the efficiency and transparency of theCapacity public sector

* Human Resource * Improving incentives for recruitment and retention ofManagement staff

* Public Expenditure * Developing transparent and unified public accountsManagement * Strengthening accountability for the use of resources

. Developing performance oriented-budgets in lineministries

* Developing a medium-term budget* Enhancing local accountability

* Social Assistance * Preventing negative consequences to households ofpoverty

D. Rationalizing the * Privatization and * Moving most of the significant remaininginteraction between the Regulation commercial state firms to the private sector.public and private sector * Fostering the development of stable governance

structures

* Financial Supervision * Achieving a uniform approach to supervision offinance and capital markets

* Strengthening of financial supervision system withparticular emphasis on non-bank financial institutions

* Business Regulation * Strengthening of the legal and regulatory process

Overall Assessment of the Program Since PSAL I

30. Main Outcomes. Overall, the program under PSAL I, as measured against theoriginal policy triggers, has been successfully implemented and progress fully justifiesmoving to PSAL II.

31. The first PSAL focused in large part on initiating reforms in the areas of fiscaltransparency, regulation, and government structure. It, therefore, supported a significantamount of drafting of new legislation and amendments to existing legislation, which wassubmitted to and/or adopted by the Saeima. In addition, the Cabinet adopted severalregulations to start implementation of the reform program. The preparation of the Public

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Sector Agency Law and the Law on Public Service Regulators are two examples of how thePSAL program slowly but surely is moving from an agenda with a strong focus on drafting oflegislation and regulation to an agenda that focuses on implementation of the adoptedlegislation and regulations.

32. The adoption by the Saeima of the Public Sector Agency Law is a major step towardsimproved accountability for and transparency of budget resources. It also makes thegovernment's budget more comprehensive by requiring all funds to be recorded with theTreasury. Until the adoption, public sector agencies were allowed to operate under privatesector based legislation such as the Joint Stock Company Law. The new legislation makesthem operate under an appropriate legal framework accompanied with adequate provisionsfor ensuring accountability, but also with enough managerial flexibility to improve servicedelivery. PSAL II and III will focus on assisting the government with implementing thisimportant piece of legislation.

33. Another example of progress along these lines is the adoption of the Law on PublicService Regulators, which establishes a single Public Utilities Regulatory Board. PSAL Isupported drafting and submitting the law to the Saeima as well as developing animplementation plan. PSAL II and III would focus on implementing the law, which wasadopted by the Saeima in October 2000. The reform program supported by the two loans willassist with drafting the subsidiary legislation and creating the Board as well as building upthe capacity needed to make it operational.

34. Adjustments to the PSAL Program. There are a few notable exceptions to thisoverall satisfactory record. As explained in Table 2, these concern the following policyareas: (i) adoption by the Saeima of a new criminal procedures code and (ii) privatization ofLattelekom, Latvenergo, and Ventspils Nafta (see paras. 14-16). In response, the Bank (i)delayed Board discussion of PSAL II, (ii) agreed with the authorities on a US$20 millionloan instead of the original amount of US$40 million, and (iii) reviewed the medium-termprogram with the authorities and other major donors to take better account of capacityconstraints and evolving knowledge of existing conditions. In instances where the initialobjectives were too ambitious, especially given the public sector's limited capacity, themedium-term program has been adjusted, in full agreement with the Bank and other donors.For instance, in the case of the Latvenergo privatization, the Bank took another look at theLatvenergo privatization and agreed with the sequencing proposed by the authorities (gettingthe regulatory framework right and dividing up the company to bring more competition to thesector).

35. On the other hand, the Latvian Government has also undertaken new initiativessurpassing the initial understanding under the PSAL that aire partly based upon new analyticalwork done by the Bank and overlap with the PSAL program in the areas of anticorruptionand policy coordination and strategic planning. In light of these developments, thegovernment and the Bank agreed to adapt the program to reflect new initiatives and re-prioritize the program as necessary.

Evaluation of Each Component of the Reform Program(See Table 2 below)

Component A: Returning to a Macroeconomic Framework Conducive to Robust Growth

Correcting the macro-imbalances that reemerged after the Russian crisis

36. Issues Prior to PSAL I. In late 1998 and early 1999, economic developments inLatvia were dominated by the negative spillover of the Russian crisis on the financial andtrade sectors. Real GDP declined by about 0.5 percent on an annual basis in the first half of1999 after having contracted by 1.7 percent in the fourth quarter of 1998. The collapse in theCIS export market led to a sharp rise in the extemal current account deficit in the latter partof 1998, contributing to a deficit of almost 10 percent of GDP in 1998 and 1999. The fiscaloutcome for 1999 was affected adversely by the impact on revenue of slower economicgrowth, as well as the higher pension and unemployment benefits and wage increases grantedin late 1998. As a result, the consolidated general govemment deficit reached 3.9 percent ofGDP in 1999.

37. Performance under PSAL I and Remaining Agenda. The government reduced itsfiscal deficit in 2000 but by less than that agreed with the IMF, i.e., from 3.9 percent for 1999to 3.3 percent of GDP for 2000. The outcome for 2000 was an improvement relative to 1999,but disappointing in the light of the economy's strong recovery during 2000. This lower-than-expected deficit reduction reflected a shortfall in tax revenues caused by difficultiescollecting excise taxes and unexpected corporate income tax repayments that stemmed fromthe 1999 economic downtum, as well as increased spending. As a result the govemmentmissed the performance criteria for the general govemment deficit under the first SBAprogram for end-September and end-December 2000. The authorities were able to reduce thefiscal deficit to 1.9 percent of GDP in 2001.

38. As noted in paras. 5-10, recent macroeconomic developments in Latvia have beenvery positive. The only discouraging development was that the extemal current accountdeficit was 8.5 percent of GDP in 2001 (excluding the one-time effect of the purchase ofthree tankers by the Latvian Shipping Company) and is projected to remain at the same levelin 2002.

39. Reforns Supported by PSAL II. The govenmment recognizes that establishingmacroeconomic stability will provide a firm basis for the economic restructuring necessary tomove the economy onto a sustained growth path and maintaining it requires swiftimplementation of the structural and public sector reform agenda supported by the PSAL. Inthe framework of the dialogue on PSAL II, the Latvian authorities have agreed to a furtherreduction of the fiscal deficit that would ensure a viable current account balance and reduceLatvia's vulnerability to extemal shocks in the future. This is consistent with the IMFprogram: The SBA targets a fiscal deficit of 1.8 percent of GDP in 2002 and 1.5 percent in2003.

Ensuring financial sustainabilitv of the pension system

40. Issues Prior to PSAL I. In 1998, the Latvian authorities adopted two measures thatseverely affected the financial sustainability of the pension system: (i) the govemment

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provided a one-off pension increase that permanently raised all pensions by approximately 10percent, and (ii) the government allowed a recalculation of pensions for pensioners whocontinued to work that was regressive and unfair as it more than doubled pensions for a selectgroup of pensioners. In the fall of 1999, a new government took office and proposed a set ofemergency measures to restore financial viability to the pension system. Unfortunately, theamendments did not get the full support of the Saeima, and a weaker set of measures wasapproved. As a consequence, the pension system was able to return to a much-neededsurplus and still has incentive mechanisms in place that are unfair and economicallyinefficient.

41. Performance under PSAL I and Remaining Agenda. With support from PSAL I, theSaeima adopted legislation to establish a second tier of the pension system, for which theMinistry of Finance has developed implementation arrangements. The government hasbegun a campaign to communicate the how and why of pension reform to the population. The

.government's reform program is geared towards completing the pension reform agenda by2005 and achieving an equitable and financially sound system that is less likely to contributeto macro-imbalances when the economy is affected by an adverse shock. In 2001, furtherpension reform resulted in the creation of a three-tier pension system that is one of the mostadvanced among the transition countries. It includes a privately funded and managed pillar.Mechanisms for better targeting of social assistance are being implemented.

42. Reforms Supported by PSAL II. The PSAL is assisting the government in its efforts toensure that the pension system deficit is eliminated, savings are increased, and equality oftreatment within age cohorts is improved. The government has taken steps to ensure that thefiscal impact of the pension system is clear and it is financially viable in the future. After areview was conducted of the November 1999 amendments' impacts, new amendments to thePension Law were submitted to and subsequently adopted by the Saeima. They remove allprohibitions to working and taking a pension, curb early retirement, and regulate futureindexation. The authorities are reviewing progress with the implementation of the second tierand will adopt changes if necessary. They have also developed regulations to permit privatesector asset management.

Component B: Strengthening the Credibility of the Public Sector

Reducing risks and opportunities for corruption in government and the judiciary

43. Issues Prior to PSAL I. The 2000 World Bank report on corruption7 characterizedLatvia as a country with medium levels of administrative corruption and high levels of statecapture. The government recognized this result and revised its anticorruption strategy to putappropriate emphasis on curbing state capture while ensuring appropriate emphasis oncombating administrative forms of corruption. The Corruption Prevention Council (CPC)formed in 1997 was responsible for developing and implementing an anticorruption strategy,but was considered largely ineffective. Within the State Revenue Service (SRS), anAnticorruption Unit (AU) had been operating and was responsible for evaluating declarationsof income and assets of public officials to identify cases of conflict of interest as well asillicit enrichment. The government agreed that the procedures used by the AU were not

7 See the World Bank report Anticorruption in Transition: a Contribution to the Policy Debate prepared forthe World Bank-IMF 2000 Annual Meetings in Prague.

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sufficiently developed to fulfill this important task. Judicial reform was high on thegovemment's agenda and the Cabinet of Ministers had mandated the Ministry of Justice todevelop an action plan to consolidate the judiciary system. Yet, despite the govemment'sefforts, public opinion polls repeatedly ranked judicial institutions among the most corruptand inefficient public institutions in the country.

44. Performance under PSAL I and Remaining Agenda. As it was clear that the CPCrequired additional staff and resources to function properly, the govemment appointed anExecutive Head of the Secretariat to the CPC and endowed the secretariat with adequate staffpositions and resources. To improve the CPC's transparency and accountability to thepublic, a regulation was put in place allowing the CPC to publish the status ofimplementation of all measures identified in the anticorruption program. In addition, the CPCwas asked to establish a mechanism to effectively monitor and report on changes ofcorruption in the public sector. For the latter, preparatory work was initiated by the CPC, butit has not been able to establish effectively its monitoring capacity.

45. In the framework of the PSAL program, the govenmment requested that the AU andrelevant agencies develop a set of guidelines to effectively identify conflict of interest andcases of illicit enrichment. These guidelines consist of: (i) forms for declarations of incomeand assets, and a training manual on how to process and assess the declarations, (ii) a manualand training curriculum for public sector employees that will guide them in situations ofconflict of interest, and (iii) a draft manual and curriculum for training public sectoremployees in situations of conflict of interest. In addition, these declarations have beensubmitted by key government officials, such as the President of the State, (Deputy) PrimeMinister(s), Ministers, and parliamentary secretaries, and published. Although thegovernment published the above-mentioned declarations, it was not able to develop fullypoints (i), (ii), and (iii) as the AU functioned without a manager for 6 months. A newmanager was appointed in November 2000, and the government decided to draft a new lawregulating prevention of conflict of interest and illicit enrichment.

46. With regard. to judicial reforms, the Minister of Justice has adopted severalinstructions to: (i) provide greater transparency in communications between judges andlitigants in criminal and civil cases, (ii) mandate an element of randomization in assigningjudges to handle court cases where appropriate, (iii) require all court decisions and rulings tobe made public, and (iv) provide training to judges and prosecutors in new laws prior to theirenactment.

47. Reforms Supported by PSAL II. Public accountability and transparency are keyelements of the PSAL program. The authorities reevaluated their anticorruption strategy andset up three different working groups: (i) one that is redrafting the anticorruption law; (ii) onethat is designing a new anticorruption unit, the Corruption Prevention Bureau, which wouldcombine the responsibilities of the anticorruption unit of the State Revenue Service and theCorruption Prevention Council and also have limited investigative powers; and (iii) a thirdgroup that worked on a new set of laws regulating the financing of political parties andelection campaigns. These laws have appropriate safeguards and mechanisms fortransparency, accountability, and audit. They have all been adopted by Parliament.

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Strengthening the transparency and accountability of public sector institutions

48. Issues Prior to PSAL I. In the first years of independence, Latvia followed theexample of many other countries and delegated the execution of policies to semi-autonomouspublic sector agencies. This was done in an ad hoc manner and without having a clearlydefined institutional framework of public administration or legislative framework foroperation of the agencies, especially financial management, in place. In 1998, thegovernment passed the law on openness of information and implementation regulation.However, many government officials were not aware of the implications of this regulationnor had the ministries set up capacity to respond to requests for information by the public. In1999, the Cabinet of Ministers adopted an instruction on Annual Public Reports, and allministries were requested to prepare and circulate the first drafts of these annual reports.However, the format of these reports needed to be revised to focus more on actualperformance. Also, regulatory bodies and inspectorates had to be added to the list of publicinstitutions that are required to submit these reports.

49. Performance under PSAL I and Remaining Agenda. To improve the legislation, thelaws on institutional framework of public administration and public sector agencies weredrafted and submitted to the Saeima for their enactment. In the meantime, -the Cabinet ofMinisters adopted a moratorium on the creation of public sector agencies until the Saeimahad adopted the law on Public Sector Agencies. The Law on Public Sector Agencies wasenacted in March 2001. For the law on the institutional framework for public administration,the Saeima decided to expand its scope to include all public sector structures as well ascombine it with the existing law, which guides the responsibilities and operations of theCabinet of Ministers. To further enhance access to public information, the Cabinet ofMinisters adopted regulations for implementing the law on openness of information, whichstipulates more clearly the classification of information and the institutional arrangements forensuring access to information. For 2000, all public institutions, including regulatory bodiesand inspectorates, had to prepare an annual report. To follow up on the initiated reforms withrespect to reporting requirements for public bodies, the government and the Bank havedecided to review the current procedures. As a consequence, the government adoptedamendments to its instruction on Public Annual Reports. These amendments, which requirethe preparation of more performance-focused reports, have been adopted by the Cabinet ofMinisters and are to be used in all public institutions, including regulators.

50. Reforms Supported by PSAL II. In the framework of PSAL II, in March 2001, thegovernment prepared and submitted to Saeima the Law on Public Sector Agencies, whichdefines a transparent, accountable, and financial management regime for public sectoragencies. A second law, on the framework of public administration, was also adopted in June2002, which regulates the establishment, subordination, control, accountability, and fundingarrangements for public administration bodies.

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Component C: Strengthening the Public Sector's Institutional Capacity

Streamlining the structure of the public sector and increasing administrative efficiency andtransparency

51. Issues Prior to PSAL I. Latvia's public administrative structures, its pay structure,and its ability to deliver services effectively had not kept up with demands for govemmentservices and interventions by the. dynamic market-driven economy in which it operates.Also, several studies highlighted the need for better coordination and strategic planning at thecenter of government. For example, there were a number of ministries and entities at thecenter of government responsible for public sector reform initiatives: the Ministry of Financeled public expenditure management reforms and the Ministry of Economy prepared Latvia'sstrategic vision for economic development and public investment program. A department inthe Ministry of Finance coordinated the national development plan and handled technicalassistance as well as grants and loans from EU, EBRD, and the World Bank; the Ministry forPublic Sector Reform and Local Government Reforms (MoPSR) was responsible for publicadministration and civil service issues.

52. Performance under PSAL I and Remaining Agenda. As a result of the reformssupported by PSAL I, the govermnent decided to reorganize the Chancellery and give itpolicy coordination and strategic planning responsibilities. The PSAL program alsosupported actions to facilitate building up capacity within government, particularly in theChancellery, to better coordinate policy and facilitate strategic planning. The govemmentworked with the World Bank and the European Delegation to streamline the structure of thepublic sector as a means to increase its effectiveness and efficiency. To support this workand address the reforms of the public administration more adequately, the govemmentmerged the Bureau of Public Administration Reform (BPAR) with the Secretariat of theMinister of Special Assignments for Public Sector and Regional Reforms (MoPSR). Toensure that the secretariat could successfully fulfill its mission, it prepared a blueprint ofpublic administrative reforms. The blueprint clearly assigned responsibilities for the designand coordination of specific elements of the reform program and allocated staff andbudgetary resources commensurate with this assignment, but omitted a clear action plan. TheSecretariat also designed a mechanism to monitor and report to the Cabinet and the public atlarge on changes in public sector management and performance.

53. At the government's request, an instrument for strategic planning was developed withassistance from the Bank through an IDF grant. The so-called functional review includedredefining the objectives of line ministries, taking into account EU accession objectives andexisting functions and staff employed so that organization and functions could be reviewedand reoriented in relation to objectives. The review assumed no change in the overall budgetenvelope for the ministry and its subordinated and supervised bodies and was followed bycreation of an action plan, agreed with the ministry, to be executed within its budgetenvelope. Some positive results have been achieved, but implementation was uneven,hampered by the inadequate support given to the Bureau of Public Administration Reform,which has been responsible for coordinating the process both within and among ministries.As a consequence, the review lacked an upfront memorandum of understanding of whatwould be done with the outcome. Another weakness of the functional review was that itsresults were not explicitly linked to a public expenditure review of the ministries' programsor a review of the appropriateness of its policies.

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54. Reforms Supported by PSAL I. Reforms under the PSAL II program helped addressthe insufficient capacity in the Chancellery and the reorganization of the MoF. TheChancellery now includes a policy coordination unit, and the MoF has better control over itsinstruments for overall fiscal discipline. Coordination of government policy is now clearly aresponsibility of the Chancellery. Consequently, the Secretariat of MoPSR was asked by theCabinet to redraft the blueprint for public sector reform. The revised blueprint includes aclear action plan with deadlines for implementing specific public sector reforms. In addition,the Secretariat of MoPSR has established a mechanism to monitor and report on the changesin public sector management and performance. It publishes an annual report partly based onthe Public Annual Reports by Latvia's public entities. On a semi-annual basis, it reports inthe official Gazette progress in the implementation of its reform program.

55. The functional review instrument has been redesigned. It now includes themethodology used for sector-oriented public expenditure reviews and a policy evaluationcomponent. This will improve the process of identifying functions and tasks that contributeeffectively to the priorities of the government. The new functional review methodology wassuccessfully used to review the organizational structure of the Ministry of Agriculture. AnAction Plan for restructuring the ministry was agreed upon, and adequate resources wereassigned for its implementation. The Secretariat has been given the task of monitoringimplementation. In addition, functional reviews were started at the Ministries of Economyand the Ministry of Justice during the first PSAL period. An important improvement will bethe completion of the restructuring of the Ministry of Agriculture, according to the 2001 ActionPlan. The methodology developed for conducting fundamental reviews will be used for thepreparation of the 2003 budget in selected ministries. To ensure that this instrument will beeffectively used, the government has allocated budgetary resources (equivalent to five staff at thelevel of deputy head of a department), instructed the Public Sector Reform Coordination Councilto monitor the implementation of the recommendations of the review, and made the lineministries undergoing that review incorporate its recommendations in their strategic plans.

Incentives for recruitment and retention of staff

56. Issues Prior to PSAL I. Several recent studies concluded that Latvia's pay systemdepends heavily on bonuses and management contracts. The govemment acknowledged thatthis system did not ensure transparency and equitable rewards for equal work. In addition tothe need to improve the public sector pay system as a means to motivate the public sectorworkforce, a new civil service law was needed to promote the development of a professionaland loyal civil service cadre. To support these improvements, the Cabinet of Ministers hadalready agreed in 1998 on a concept for civil service developments, which has beentransformed with the help of SIMGA/OECD and the World Bank into a new Law on CivilService, but it has not been fully implemented.

57. Performance under PSAL I and Remaining Agenda. The government established aninterministerial working group to design a competitive pay system for the Latvian publicsector. A draft program was prepared and included a unified and broad-banded pay systemthat is comprehensive, uniform, and transparent. But the financial implications of theproposed system and the various options for its implementation remained to be finalized.

58. Reforms Supported by PSAL II. The Cabinet of Ministers adopted in 2002 a publicsector pay concept that supports the introduction of a broad-banded, transparent, and uniform

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pay scale, with performance evaluation mechanisms. Within the framework of preparationand supervision of PSAL II, the government requested technical assistance from the Bank toensure that the proposed new regulations correspond with the concept adopted and willindeed improve the public sector's ability to retain high-quality staff and motivation theircommitment to a civil service career. To enable analyzing the budgetary consequences ofthe proposed new pay system, the Ministry of Finance has developed the methodology for asurvey of the existing pay structure. The new Law on Civil Service was adopted by theSaeima in 2002. It required the Cabinet of Ministers to issue instructions on how to undertakeperformance evaluation of the civil service. The instruction was issued and the first round ofperformance evaluations performed in 2002.

Public expenditure management

59. Issues Prior to PSAL I. Compared to other transition countries, Latvia's publicexpenditure management system was considered reasonably well-performing in the area offiscal discipline and had significantly improved financial accountability. However, thegovernment recognized that Latvia lacked a comprehensive strategic planning frameworkthat would allow the government's overall policy commitments, policy priorities ofindividual line ministries, and targets with budget allocations to be linked.

60. Performance under PSAL I and Remaining Agenda. The government passed PolicyPlanning Framework guidelines and amendments to the Law on Budget and FinancialManagement (LBFM) to bring all accounts of budget-financed institutions (BFIs) into thebudget and initiated a process in which all BFIs will have their accounts solely with theTreasury. In addition, the government recognized that there was room for improving itsprocurement methods. The Bank carried out a Country Procurement Assessment Review(CPAR) and discussed its findings with the government in late 2000. The government alsoadopted an action plan to tackle the main recommendations from the CPAR, which were alsoincorporated into the new law on procurement.

61. Reforms Supported by PSAL II. Although the first year of the PEM program focusedmostly on comprehensiveness, transparency, and accountability issues, groundwork wasunderway to set the stage to improve performance orientation in line ministries, promote.strategic planning, and foster a medium-term perspective to budget management. As a firststep, and parallel to the functional reviews discussed above, the government undertook publicexpenditure reviews (PERs) in the ministries of Agriculture and Justice. These PERs focusedon assessing whether allocations were made according to priorities and expenditure programswere efficient and effective. It became clear that there was a need to link the PERs directlywith the functional reviews and expand them with a policy review component. Thegovernment also decided to present the budget to the Saeima with a medium-term macro-fiscal framework and require that those new policies would be "costed-out" for a 3-yearperiod, accompanied by offsetting measures, to limit the open-endedness of the budgetprocess.

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Component D: Rationalizing the Interactions between the Public and Private Sector

Privatization

62. Issues Prior to PSAL I. In early 1999, Latvia's remaining privatization programs(in particular, enterprises in the energy sector and the Latvian Shipping Company) had beenstalled for some time. In addition to railways and post, companies still under publicownership were larger SOEs, including those for shipping, power, telecommunications, andthe oil pipeline, where the privatization progress had been slower than planned. The delayswere caused by unclear sector policies and sector legislation, lack of a consistent and stableregulatory framework, and lack of political commitrnent.

63. Performance under PSAL I and Remaining Agenda. Latvia successfully privatizedmost large state owned enterprises. The methods used to hire reputed intemationalinvestment banks/advisors and their application in the privatization process were significantlyimproved and brought in line with best practice. Privatization of state owned enterprisesattracted significant foreign direct investment. The government was unable to proceed withthe privatization of the national electricity utility, Latvenergo, as envisaged under PSAL I.The case of Latvenergo indeed showed the fragility of support for market-oriented reforms insome segments of the population. When privatization of Latvenergo was prepared and aboutto be launched in mid-2000, non-govemmental organizations with the support of the politicalopposition mobilized society for a nationwide public vote that effectively stopped the itsprivatization for the time being. Notwithstanding this result, the govemment has taken stepsto restructure Latvenergo following European directives and open up the energy market tocompetition. With respect to Lattelekom, Sonera, the strategic investor, took the Ggvernmentof Latvia to arbitration court to resolve the ongoing dispute about compensation for theshortening of the exclusivity period from 2013 to 2003. This put the privatization on holdand postponed deliberation in the Saeima of the new telecommunications law that wassubmitted as part of the program to be supported by PSAL I.

64. Reforms Supported by PSAL IL LASCO was privatized in early 2002 by a sale of 32percent of the company's shares for vouchers and 51 percent of its shares for cash on thelocal stock exchange. Of the remaining govermment shares, 6 percent will be sold toemployees and pensioners of the company for privatization vouchers by the end of the year,10 percent will be transferred without compensation to the State Special Pension Budget, and1 percent will constitute the privatization reserve. The privatization process of VentspilsNafta was slower than anticipated. However, an international investment bank hired by thegovernment has produced the privatization plan and financial valuation for the company. Itis expected that the company will be brought to the point of sale in 2003. The prospects forthe privatization of Lattelekom are favorable. The authorities have acquired reputedinternational advisors to assist them during the arbitration and are committed to proceedingswiftly with privatizing government shares once the case has been decided upon. With respect toLatvenergo, the ongoing restructuring will enable efficiency gains from improved competitivepressures and facilitate the effective privatization later on.

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Regulatory framework

65. Issues Prior to PSAL I. Because public utilities figure prominently among theenterprises remaining to be privatized, regulatory and privatization reforms were closelyinterlinked. In the energy sector (electricity, gas), the existing regulation needed to beenhanced to ensure that rate-setting is based on economic criteria and that increasedcompetition contributes to lower input costs. In the telecommunications sector, a regulatorymechanism designed to facilitate the transition to a fully liberalized market was needed. Themain objective of the PSAL program in this area was to ensure that a regulatory frameworkwas put in place which: (i) mimicked the market as much as possible and allowedcompetition to function where it could without distortion (ii) assured competitive service,quality, and price levels; (iii) desisted from unilaterally imposing changes in policy thatwould diminish promised investor value; (iv) weighed the costs of rules against the expectedbenefits; and (v) paid efficient and competitively neutral attention to social goals such asuniversal service. Moreover, to enhance public accountability and ensure strict adherence todue process, the prograrm sought to establish fundamental principles that would serve as atransparent basis for all future regulatory and other policy determinations in the infrastructuresectors.

66. Performance under PSAL I and Remaining Agenda. Under the reform programsupported by PSAL I, the government submitted the Law on Public Service Regulators andthe Law on Telecommunications to the Saeima, adopted the concepts for market structures inelectricity and telecommunications sectors, and established an interministerial workinggroup. The working group developed an action plan to strengthen the regulatory frameworkand capacity in each sub-sector sector (energy, telecommunications, and post and railwayservices) and to prepare for the anticipated changes when the Saeima adopted the Law onPublic Service Regulators. The Law on Public Service Regulators was adopted in October2000, and the interministerial working group is indeed preparing the secondary legislationnecessary to make the new regulatory body operational in 2001. The main organizationaloutcome of this legislation was that all infrastructural public services were brought under theauspices of a single regulatory authority, the Public Utilities Commission. Discussion of thetelecommunications law in the Saeima has been postponed due to the ongoing litigation withLattelekom's strategic investor.

67. Reforms Supported by PSAL II. The Public Utilities Commission (PUC), the newregulatory agency for infrastructure, became operational on October 1, 2001. The agency hasbeen given an appropriate start-up budget and has made significant progress in establishingits organizational structure. Professional staffs with the needed expertise in relevanleconomic and legal principles have been recruited. The PUC has also published "Strategyand Basic Principles for Operation of PUC," adopted a price cap principle for tariff setting,and been working to establish its "charter" in order to specify and publicly articulate theprinciples that will serve as a transparent basis for its future regulatory and other policydeterminations. The PUC has been working to establish rules that ensure fair treatment foiconsumers who lack competitive alternatives as well as nondiscriminatory access olcompetitors to bottleneck infrastructure facilities. In collaboration with the World Bank, theagency organized a training workshop for its staff in June 2002, where experts from federalregulatory agencies of the United States made presentations on important issues of regulator)due process, ethics, and the economics of regulation.

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Financial sector regulation

68. Issues Prior to PSAL I. The Latvian financial system suffered from the 1995 bankingcrisis and the 1998 Russian crisis. A number of banks were substantially weakened, and twohad their licenses suspended. Rigas Komersbanka, one of Latvia's largest banks, wasrendered insolvent by substantial losses in Russian GKOs (the Bank was subsequentlyrehabilitated by its shareholders, by conversion of deposits into equity, and by an injection ofcash from the Bank of Latvia). The objective of the reform program in this area was toachieve a uniform and integrated approach to supervision of financial and capital markets.

69. Performance under PSAL I and Remaining Agenda. The government made goodprogress in strengthening its banking supervision and agreed that the previous regulatorystructure might not fully accommodate the growth of non-bank financial institutions in thecountry. At the same time, the authorities took steps to introduce a new law establishing anintegrated financial regulatory body, which was drafted and adopted with support from PSALI. For the agency to be successful, it needed to strengthen its capacity to supervise non-bankfinancial institutions and ensure that that the new agency is independent and that itsformation does not undermine the credibility of its current banking supervision.

70. Reforms Supported by PSAL II. An action plan for strengthening supervision of non-bank financial institutions like pension funds, investment companies, leasing companies, andthe securities market was prepared, leading to the creation of a unified agency, the Financialand Capital Market Commission (FCMC). A chairman and co-chairman have been appointedand confirmed by Parliament. The new body was assigned adequate resources and becameoperational in July 2001. The FCMC has made substantial progress in implementing therecommendations set forth in the 2001 joint World Bank/IMF Financial Sector AssessmentProgram (FSAP) and is already scrutinizing banks' credit policies and risk strategies.

Business regulation

71. Issues Prior to PSAL I. Latvia's regulatory system had many of the formalmechanisms necessary for building an effective and transparent regulatory framework thatcan interact efficiently with Latvia's business community. However, evaluating regulatoryproposals remained difficult, especially in terms of consistency with existing laws andregulations as well as their budgetary impacts.

72. Performance under PSAL I and Remaining Agenda. To streamline the regulatoryprocess, the Ministry of Justice completed a manual for drafting laws and regulations basedon good legislative techniques. The Ministry of Finance also prepared a draft manual forassessing the budgetary consequences of the proposed draft laws and regulations, and createda uniform definition and procedure of "normative acts" ensuring that all these acts areadequately reviewed by the Ministry of Justice prior to adoption by the Cabinet of Ministers.To make this an effective mechanism, the School of Public Administration developed atraining program for staff on how to undertake impact analysis. To improve the functioningof state bodies that enforce regulations, such as inspectorates, the government took action tostrengthen their capabilities to monitor their actions and improve the accountability of thestate bodies that enforce regulation. The Cabinet also adopted new rules and procedures forinspections. In addition, a workshop on inspection reform was conducted to gather feedback

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on the proposed reforms. Selected inspectorates agreed to pilot the new rules and procedures,and a training module for inspectorates on these issues was prepared.

73. Reforms Supported by PSAL II. PSAL II measures have assisted the government withdrafting new procedures for collecting fines, with initiating implementation of the newinspection guidelines in the remaining inspectorates, and with designing the annual reportingrequirements of inspectorates. Furthermore, the inspectorates have discussed these newreporting requirements and have implemented them in at least 50 percent of the inspectorates.The government has also completed-an Action Plan to Improve the Business Environmentand implemented 68 of its 77 suggested measures.

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Table 2: Achievements on Triggers for Moving to PSAL II

j'5sit rUd dioo faisiR101infiRS 9 0IBiSWd`,2-1«eN -N l-~%14laren etStatuiss gE's;: i->4'af'e s-|tXSJbtIFeiic 1. TiA d4.T~1. 4'p,j C*-~.~Ft.

Maintain an appropriate macroeconomic The Borrower has maintained an appropriate Tri2aer fulfilled. The IMF has recently reachedframework. macroeconomic policy framework, consistent with agreement with the Latvian authorities on the

the objective of the Program, as determined on the macroeconomic framework. Its Executive Boardbasis of indicators agreed to by the Borrower and has completed the first and second reviews ofthe Bank. Latvia's economic performance under the stand-by

arrangement.Implement pension system reforms, including: (a) The Saeima has adopted amendments to the Law Trieeer nartiallv fulfilled. The main issue forremoving all prohibitions to working and taking a on State Pensions, removing prohibitions to financial sustainability is that indexation getspension; (b) improving the equity of system, (c) working and taking a pension, improving the regulated by law and that early retirement getscurbing early retirement, (d) regulating future equity of the system, curbing early retirement, and curbed within the PSAL time frame. Theindexation, and (e) reducing regressive social tax regulating future indexation. amendments to the Law on Pensions submitted toexernptions. Parliament included the immediate curbing of

early retirement. However, the decision of theSAEIMA was to set the date for the removal ofearly retirement on July 1, 2005. Given thecomplexity of the policy measures implied by thereform, the start date of 2005 for curbing earlyretirement appears reasonable. The other measuresare more focused on fairness and improving thefunctioning of the labor market. Comnponent (e) ofthe original benchmnark was focused on trying totackle the insurance lobby that had been able to getexemption from payroll taxes. However, duringPSAL II preparation, it was agreed that this wasnot core to the proper functioning of the pensionsystem and as such was dropped.

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UBbard' .2~.4 ~"- '~'Currenit Status V.~~i~j C. ommef "4 ji F..'.jA ',jj'cti ns ie ,tlB ' :'; 2';t C r e; ;;' ' , ; ' |

An additional action identified by Government The Saeima has adopted the "Law on the This action was added during appraisal to supportCorruption Prevention Bureau," establishing a the creation of a bureau that would merge thecorruption prevention bureau (CPB) with the different prevention activities, conflict of interestauthority to: (a) detect and resolve ex ante cases of activities, and detection and evaluation of cases ofconflict of interest; (b) detect and evaluate possible possible illicit enrichment into one agency.cases of conflict of illicit enrichment; (c) monitorcorruption and corruption prevention in publicsector bodies; (d) advise the Cabinet of Ministers,individual ministers, and other heads of publicsector bodies, on methods to strengthen corruptionprevention; (e) prepare and evaluate legislationrelated to corruption prevention; and (f) educateofficials and the public about corruptionprevention.

CPC to publish, on an annual basis, changes in The CPC Secretariat has published changes to and Trienier fulfilled. The CPC publishes Corruptioncorruption in the public sector; such publication is progress in the impleimentation of the Corruption Prevention Plan implementation results on annualinstitutionalized. Prevention Plan basis.

The Cabinet of Ministers has submitted to the Law on "Political Party Financing" has beenSaeima the Law on Political Parties, with adequate adopted, which stipulates: (i) more preciseprovisions for transparency, oversight, and audit. disclosure procedures to report on election

campaign expenditures and (ii) assignment ofmonitoring political party finances to independentbody.

The Saeirna adopts a new Criminal Procedures CoM has adopted concept of a new criminal Tri2eer not fulfilled. The govermment hasCode procedure code, which provides for streamlined incorporated this action in its Letter of

procedures that promote efficiency and reduce the Development Policy..__________________________.____________ opportunities for corruption.

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K -_:M -WI s as Ff.iP3L iBG rfeiithk, ,ifi,i%AfflrNeWe __C 1:J IEiimW firti- D~~~oru m e n 0tion' 11"M Fi O

Cabinet of Ministers agrees on an action plan to The Cabinet of Ministers has adopted a regulation Trieeer fulfilled. The government has exceededbring all public sector organizations into identifying: (a) criteria for the role and the initial expectations regarding this and hasconforrnity with the laws on the Institutional responsibilities of each public agency, (b) the identified additional actions to be undertaken.Framework for Public Administration and on mechanism through which a public agency can bePublic Sector Agencies. created, and (c) criteria on which to decide which

agencies to divest.

The Law "On the Framework of PublicAdministration" has been adopted by theParliament.

The "Law on Public Sector Agencies" has beenadopted by the Saiema.

Action plan is adopted which: (i) establishes The Ministry of Justice of the Government of the Tri2eer fulfilled. Points (i-iii) have been assignedcapacity in public-sector bodies to respond to Borrower has assigned the task to provide to the data inspection unit. During preparation ofpublic requests for information, (ii) reports on guidance and coordinate the implementation of the PSAL nI consultancy report on this issuecompliance with the law, and (iii) educates public Petitions Act and the Law on Openness of concluded that it was more important to build upon procedures for obtaining government Information to the data inspection unit. capacity at the center first before building up thedocuments. capacity at the line ministries and other public

bodies. The expected action was appropriatelyrefocused to deal with this advice.

The Borrower has adopted Administrative The Borrower has adopted a time-bound plan for Trinuer fulfilled. The government has obtained anProcedure Law and CoM has prepared action plan the implementation of the Administrative IDF grant to help with the implementation of thisfor the implementation of APL based on survey of Procedure Law and identified one staff member in law.needs of the ministries and other administrative each ministry who has been assigned thebodies. responsibility for implementing this law is that

ministry.An additional action was identified by The CoM has adopted an updated and revised PSAL I (see C. 1. Page 7) supported the blueprintgovernment. To be seen as a continuation of the Medium-Term Public Sector Reform Prograrn, of this Public Sector Reform Strategy. In Julybenchmark supported under PSAL I on the which includes clear assignment of responsibilities 2000, the new PM strengthened his Chancelleryblueprint of the Public Sector Reform Strategy and deadlines for the implementation of specific office such that it would be better positioned to

public sector reforms. coordinate policy initiatives, to give guidance withregard to strategic planning, and to take a moreactive role in public sector reforms.

-25 -

,Ad'sr &dt6ii - 1 Board "n' -urre66'96 dt ' :X *; 4 i!~ ~Docwnentaion 14~~ .- ~~~~;:~*Jl;~ L~

As the reform strategy had been clearly enrichedand contains a well specified time-bound actionplan, government and the Bank agreed on actionswhich would allow continuation of our dialogueon the instruments for public sector reform (i.e.,fundamental reviews and sector oriented PERs)and integration in the PSR implementation plan.

An additional action was identified by The Borrower has designed and piloted a This is a strengthening of the so-called "functionalgovernment. This is an expansion of the methodology for conducting fundamental reviews review" instrument that government began tobenchmark supported under PSAL I on functional which are to be used to support the 2003 budget institute already prior to PSAL I. As supporters ofreviews preparation in selected ministries and shall, among the reviews could point to tangible results from the

other things, include: (a) a methodology to review reviews, GoL has decided to expand the scope ofand identify priority policies and programs and (b) the review instrument as well as to add an explicita memorandum of understanding between the memorandum of understanding to the instrumentcentral agencies and the line ministries to be which was absent from the functional reviewreviewed regarding what will be done with the instrument; previously there had only been anresults of the review implicit enforcement mechanism of what to do

with the outcome of the functional reviews.

Therefore, the government's expansion of theinstrument, piloting of it, and inclusion of anexplicit upfront agreement of what to with theresults of the review has strengthened the reformprogram supported by PSAL II.

Same as above The Borrower has allocated resources to support This is also a strengthening of the so-calledthe fundamental reviews and to train at least three "functional review" instrument.government staff in the fundamental reviewmethodology.

Cabinet of Ministers adopts regulations on the pay The Borrower through its Ministry of Finance has Trigger partially fulfilled. The government hassystem in entire public sector, with a schedule for prepared a draft regulation on pay reform and not fully taken the initially agreed action. Whilethe gradual introduction of the new pay scale estimates of its cost of implementation; and the the Cabinet of Ministers (CoM) adopted atimetable. Cabinet of Ministers has: (a) reviewed the draft regulation (May 14, 2002) on the new pay system

and cost estimates, (b) accepted the draft in in principle, it does not yet include a schedule forprinciple, and (c) adopted a schedule requiring the the gradual implementation of the new pay scale.Ministry of Finance to provide the Cabinet of Further, certain technical problems remain in the

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Ministers detailed options for the gradual phasing draft design of the new system, including: (i) thein of the pay reform. use of too rnany grades, resulting in the wide

dispersion of grades across positions; (ii) gradeinflation in some ministries, caused by the absenceof any mechanism to ensure that job evaluationswere comparable across ministries; and (iii) theunder valuation of some occupations, caused bythe use of identical criteria and weights across alloccupations. The Bank shared these views with thegovernment which will examnine this design from apractical perspective and identify a tireline forresolving these problems and which will enablethe Ministry of Finance to propose options for adetailed plan for the gradual phasing in of the newpay system by the date indicated in the Cabinetunder_varegulation, which is October 8, 2002.

An additional action was identified by The Cabinet of Ministers has issued its first annual This additional action by government clearly linksgovernment, budget priority statement, including: (a) an overall up with the efforts at the center of Government to

fiscal strategy; (b) budget priorities, and (c) criteria link policies and resources and to ensure thatfor annual budget priority setting to be used resource allocations across line ministries reflectstarting with the budget for 2003. Government priorities. It sets the framework for

priority settin inacluding guidelines and forbuilding up institutional capacity within the lineministries to undertake a more comprehensiveapproach to strategic planning. This is astrengthening of the reform program supported bythe PSAL operation.

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L Wi ogrn dA'A'&i6ii I-p6!fi " National means-tested social assistance benefit is The Saeima has completed its first reading of the Trigger partiallv fulfilled. In the Fall of 2001, theimplemented and monitoring system is in place. new Law On Social services and Social Ministry of Welfare submitted to the Saeima for

Assistance, which provides for the nationwide the 3r4 reading amendments to the Socialimplementation of national means-tested social Assistance Law for nationwide implementation ofassistance benefit and improves the organization national means-tested social assistance benefitand administration of the social assistance system. foreseeing that the guaranteed minimum income

benefit will be paid only in cash. This change wasnot accepted by the parliamentary commission andthe amendments were returned to the Cabinet ofMinisters. Since then, the government decided tochange the strategy in preparing a legislative basisfor improved social assistance system in Latvia.With the help of foreign technical assistance, theMinistry of Welfare has developed a new Law onSocial Services and Social Benefits, whichforesees the nationwide implementation ofnational means-tested social assistance benefit(GMI) and imnproves the organization andadministration of social assistance services andbenefits. The draft law provides for both cash andin-kind payment of the national means-testedsocial assistance benefit, and the government hasinformed the Bank that the Cabinet of Ministers'regulation will determine the exact method of GMIpayment.

Implementation of the action plan for Subsidiary legislation needed for the Public Trieeer fulfilled. The subsidiary legislation is instrengthening of regulatory capacity and transfer in Utilities Commission to operate has been approved place, and transfer of the regulatory responsibility2001 of all sectoral regulatory responsibilities to by the Cabinet of Ministers. to the PUC took place as scheduled on October Is",the Public Services Regulatory Council (Public 2001.Utilities Commission)Issuance by the Public Services Regulatory The Borrower through the Public Utilities Triaaer fulfilled. The PUC adopted andCouncil of a set of principles to serve as a Commission Board has adopted the Strategy of the published the strategy paper in January 2002.transparent basis for its policy analysis and Public Utilities Commission ("Strategy and Basicdeterminations. Principles," and published it in the officialDevelop and announce the Council's medium-term newspaper Latvyas Vestnesis and the website

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AgreedeActioA -- 1ditdi:: g& C t CommeSts

regulatory agenda. www.sMrk.gov.1vInternational investment banks/advisors (and other The Borrower has hired experts to prepare and Trieeer fulfilled. LPA has hired appropriateappropriate specialists, e.g., lawyers) hired, if carry out the privatization of Ventspils Nafta (VN) advisors/investment banks to help with thenecessary, to sell all, or most, of the state's and Latvia Shipping (LS). privatization efforts with VN and LS. Note thatshareholding in Lattelekorn, Latvenergo, Latvijas Latvenergo was put on the list of companies not toGaze, Latvian Shipping, and Ventspils Nafta. be privatized; for Lattelekom the government hired

a legal firm to advise and assist the Governnentwith the arbitration case. With respect to LatvijasGaze, its sale through the local stock market tookplace without the need to bring additional experts.

Sales to be cornpleted before March 2001. The Borrower has: (i) adopted a time-bound action Trigger Dartially fulfilled. Partial fulfillment ofplan on how to proceed with the sale of its this has been reflected in the reduction of the loanremaining shareholdings, except for two, in amount of the PSAL II from US$40 mnillion toLatvijas Gaze; (ii) adopted a new time-bound US$20 million. The divestiture of governmentaction plan for the sale of Latvia Shipping; and remaining interest in Latvija Gaze has been(iii) submitted the first regular report and completed. Latvian Shipping has been soldevaluation by the international investment bank for through an offering of 32 percent of its shares forVentspils Nafta to the Bank for review. vouchers and 51 percent of its shares for cash on

the Riga Stock Exchange at a price approved bythe Board of the Latvian Privatization Agency.The balance of the shares (17 percent) will go toemployees, the State Pension Fund and theprivatization reserve. In the case of VentspilsNafta, a privatization plan has not been preparedand the requirement of preparing for privatizationand offering the government's shares in thecompany for sale has been moved to PSAL IIIbenchmarks.

Harmonize the energy law consistent with the The Cabinet of Ministers has approved a detailed Trizzer fulfilled. The government has adoptedchosen market model, the regulatory framework, restructuring program for Latvenergo which meets EU Directive 96/92/EC concerning common rulesand EU and Baltic integration. the EU Directive 96/92/EC concerning common for the internal market in electricity in designing

rules for the internal market in electricity. its electricity market and is taking steps to furtherliberalize the market.

The Borrower has established the Transrnission Triager partially fulfilled. Latvenergo hasSystem Operator as a separate legal entity with its separated the Transmission System Operator

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F.ALgid Acion s as seclfi in PSgALIBard 4, Ii 'C ;

own management, staff, and separate accounts. (TSO) as a separate joint stock company under theLatvenergo holding company. The TSO hasseparate Board, management, staff, and accounts.Under the current Energy Law, the govermnentproposes that the assets be leased fromLatvenergo. However, the proposed market modeland changes in energy legislation would providefor transmission, as well as generation anddistribution, to be established as separate legalentities with their own assets. The governmentagreed to share the draft leasing agreementbetween the TSO and Latvenergo with the Bankfor its review and comments. The govermnent hasagreed to publish system prices as per Chapter 3 ofthe Grid Code as evidence of independence of theTSO.

MoJ evaluates draft laws and regulations based on The Cabinet of Ministers has approved the Trigger fulfilled. The revised policy actionits standards described in its drafting mnanual. methodology for legal and regulatory impact reflects a key additional step, towards meeting the

analysis PSAL Ill core indicator, namely that all lineministries implement adequate regulatory impactassessment procedures.

The Cabinet of Ministers has approved a concept This policy measure was added to reflect ourwith a time-bound action plan of gas market concern with gas pricing mechanism used inliberalization in line with EU Gas Directive 98/30, Latvia, an issue that became apparent after PSAL Idealing, in particular, with third party access and was approved by the Board. Therefore, thiselaborating on gas pricing methodologies that deal measure is a first step in the process of coming to awith separation of storage, transmission, change in the methodology of pricing as well asdistribution, and sales costs and tariffs. well as allowing for more competition.

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IV. THE WORLD BANK STRATEGY

Country Assistance Strategy

74. In April 2002, the Board discussed the new Country Assistance Strategy (CAS) forLatvia (23610-LV). The Latvian authorities have requested the World Bank Group to take alead role in key areas not explicitly covered by the EU acquis communautaire. Accordingly,the CAS, for the next 3 years focuses on assisting all segments of the population to benefitfrom Latvia's admirable economic growth performance by helping to:

(a) Create a policy environment that encourages new enterprise entry and job creation;(b) Support crucial public sector reforms to make government more efficient;(c) Achieve more balanced and sustainable development outside Riga, thus promoting

poverty reduction in those areas; and(d) Make available more effective and better quality social sector programs and services

throughout the country.

75. Focus in these areas accords with the selective approach set out in the FrameworkforWorld Bank Group Support to EU Accession Countries of Central and Eastern Europe8, andthe comparative advantage of other external agencies and of the World Bank in Latvia. TheCAS is predicated on the assumption that Latvia in the not-too-distant future will become amember of the EU. While an operational relationship with the World Bank Group need notcome to an end upon accession, it is possible that, as Latvia moves closer to its goal of entryinto the EU and as financing from the EU and other institutions becomes more available, thecountry may voluntarily limit its future borrowing and technical assistance requests.

76. Since FY91, the Bank has financed 17 operations, committing US$393 million, ofwhich US$28.6 million are undisbursed. These included projects in education, health,municipal infrastructure and services, agriculture finance and rural development, districtheating, solid waste management, tax systems strengthening, and structural adjustment. Overthe past 5 years, the Operations Evaluation Department (OED) has completed six evaluationsof projects in Latvia, all of which received satisfactory ratings. These reviews notedsubstantial institutional development and capacity building impacts of Bank-financedprograms. Lessons learned include: (i) government commitment was essential; (ii)government strategy and intersectoral expenditure allocations needed greater consistency;(iii) forecasts for demand for municipal infrastructure projects have been too optimistic;(iv) it is necessary to raise institutional and regulatory capacity at the municipal level, inparticular, the ability to handle corporatization and privatization; (v) the Bank should becareful to focus on areas not financed from other sources; and (vi) project-related legal,regulatory, and institutional issues should be better resolved before approval stages. Whilecrediting the first Programmatic Structural Adjustment Loan (PSAL) with strengtheningpublic sector capabilities and credibility and rationalizing the public/private relationship-hence rating it satisfactory-OED suggested that it was ambitious; that actions were toofront-loaded; and that these lessons should be incorporated into the later tranches of thePSAL program.

8 SecM2001-0564, October 10, 2001.

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77. The assistance strategy described in the 2002 CAS reflects a declining demand byLatvia for Bank lending and an increased demand for the Bank's analytic and advisoryassistance. Specifically, over FY02-FY05, lending of US$110-120 million would be forpublic sector management and govemance strengthening, health, education, and housing (seeFigure 1). Economic and sector work (ESW) is planned, among other things, in the areas oflabor market reforms and a Country Economic Memorandum (CEM) on prospects for growthand evaluating public sector reforms implemented to date and on the Knowledge Economy(KE). International Finance Corporation (IFC) activities are expected to continue the focuson accelerating growth and job creation.

Coordination with the IMF and Other Donors

78. The achievement of the reform objectives supported by the PSAL program will bestrengthened by the Bank's close collaborations with the IMF and EU in particular. Thegovernment's overall reform program has been designed to take place within a framework formacroeconomic stability consistent with the government's Stand-By Arrangement (SBA)with the IMF. On April 20, 2001, the IMF Board approved a 20-month SBA in the amount ofSDR 33 million. Because of disagreements between the Fund and the government about thesize of the projected 2002 fiscal deficit, a mission during October-November 2001 did notcomplete discussions for the first review. However, in concluding the stand-alone 2001Article IV Consultation on January 18, 2002, the IMF Board noted that the Latvianauthorities had successfully implemented their 2001 economic program and that economicperformance had been among the best of the EU accession countries. Strong budgetimplementation during the first half of 2002, including with respect to the indicative targetsfor the first two quarters, has put Latvia in a position to hold the 2002 fiscal deficit to 1.8percent of GDP. The measures supported by the PSAL and SBA are mutually reinforcing,with the IMF program focusing primarily on fiscal outcomes and the Bank's programsupporting improvements to public sector management structures and processes.

79. EU institutions are increasing their support to Latvia. During the period 1992-1999,the EU allocated about £248 million through the EU PHARE program to address issuesincluding anticorruption, judiciary reform, public administration reform, and publicexpenditure management. The Bank closely coordinates with the EU on the ongoing PSALprogram to ensure that the reforms supported by the PSAL are consistent with andcomplement the necessary reforms to implement the acquis communautaire.

80. EU pre-accession aid for 2000-2006 will consist of aid from EU PHARE and willalso include investment support and technical assistance for agricultural and ruraldevelopment through the Special Assistance Program for Agricultural and RuralDevelopment (SAPARD) and for the environment and transport sectors through the pre-structural instrument ISPA. During 2000-2002, total EU financial assistance will amount to£90 million for EU PHARE, £66.6 million for SAPARD, and between £109.2 and £171.6 forISPA. Multilateral banks including EIB, the European Bank for Reconstruction andDevelopment, the NIB, and the Nordic Environment Finance Corporation providecofinancing for the EU pre-structural instruments. Several bilateral donors are also veryactive in Latvia. The Bank team is in regular contact with those donors that, in a number ofcases, have provided cofinancing and other support for Bank-financed projects. The Bank

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has also organized donor coordination meetings, for example, in the context of PSALpreparation.

- 33 -

Fiure 1: LATVIA'S PSAL PROGRAM AND ITS ANALYTICAL UNDERPINNINGS

Main Anah Povesty Asssment Studies on PublicSto eom PbiEsndtrReewc Mad s

MaloAsoLwknl Report ma Fiscal Clcantamlio and Csyacity Buildia Repas ott KnomledeRssm Conr Pcoolic.ins AM a

g.7tU nSivtudy on Reguu tory Dcl en ttc Seto" Aesnt La(* abr Martkt Stu Regi*nac toltty,tst And Cap

000 2tOBaidge: 20ItlOI Badge: 2002 lf2B2dgt /2003 Budge:

fBdket CYk I

Mrch 2000 Dec. 2001 Apr. 2002 Aug. 2002 Aug. 2003

CAS and Governnwent 1 1 lDcelopmeni A iendalment

Prooosed IBRD

| Macweoconoti Macrocc c Macroecnomic

Key Porkc an Stability Stbtility Stability

Blwnhtidosial Rftt * Public Sector Rcform Public Sector Reform Public Sector Reform* Instituional Capacity *Intitutional Capaity * tInstitutinal Capacity

* Interactirn between * Intclmctiu bctwecn * Intcrtactin betwcre

the public and priatac thc public and printe the public and private

secton secto sectors

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V. THE PROPOSED LOAN (PSAL II)

Objectives and Design

81. Rationale and Objecffves. The PSAL series was designed to help the Latvianeconomy return to sustained and rapid growth and achieve poverty reduction through reformsthat enhance government efficiency and effectiveness. It supports the implementation ofLatvia's NDP in the following areas: (i) macroeconomic stability, (ii) public sectormanagement, (iii) human resources management, and (iv) privatization and regulation ofpublic utilities and private business.

82. Sequencing. The first single-tranche PSAL for Latvia (PSAL I) established a rollingmedium-term policy framework setting out a 3-year reform program aimed at implementingthe medium-term development agenda, with specific progress benchmarks and outcomeindicators defined and agreed with the authorities. The rolling nature of the policy frameworkallows for flexibility in the design of an adequate policy mix, depending on countrycircumstances. The PSAL II program builds on the outcomes of PSAL I, as shown in thepolicy matrix discussed with the authorities [Annex 5]. It updates the program's details basedon experience and developments over the past 2 years. To ensure consistency in the medium-term reform program, indicative prior actions for PSAL III have been formulated and agreedto with the government, drawing on the progress benchmarks and specific triggers laid outduring negotiation of PSAL I and II. PSAL III will also depend on satisfactory overallprogress against the agreed social and structural benchmarks and CAS triggers and acontinuing satisfactory macroeconomic framework.

83. Links with the CAS. The overall PSAL program has been designed to help thegovernment address its policy objectives as stated in the CAS. Like each of the three loansenvisaged under the PSAL program, the proposed PSAL II would provide financial resourcesand knowledge transfers to support Latvia's reform agenda as described in the CAS. TheBank has a large investment portfolio in the areas of subnational government operations andsocial service delivery. The PSAL II operation therefore focuses more on fiscalsustainability, accountability, and transparency; efficiency and effectiveness of servicedelivery by the public sector; and an appropriate framework for interaction between theprivate and public sector. The PSAL approach is particularly helpful in regard to theinstitutional changes needed in these areas.

84. Analytical Underpinnings. In preparing PSALs, the Bank tearn has been able todraw upon an increasing body of analytical work prepared over the past 3 years, of whichthe great bulk has been prepared collaboratively between IBRD and the government. InFYOO-02, the non-lending activities included, among other things, a poverty assessment,a report on fiscal decentralization, a public expenditure review, a country procurementassessment review, and a financial sector assessment. In FY03-04, analytical worksupported by the Bank will include a Labor Market Study and assistance to agovernment-led effort on the knowledge economy. These advisory activities provide agood understanding of Latvia's development problems, the analytical framework fordesigning and evaluating macroeconomic and sectoral strategies, the need for andavailability of external financing, and the strengths and weaknesses of its fiduciarysystems. They help harmonize IBRD, IMF, EU, government, and other donors'

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perspectives, and generate public discussion of the country's development options withthe aim of creating public support for the ambitious reform agenda ahead.

85. Poverty and Social Impact Analysis. If implemented in full, the policies envisagedunder the current PSAL series are unambiguously pro-poor. The proposed PSAL will have animportant effect on poverty, because it will support overall growth objectives as well asmeasures to improve service delivery by the government, e.g., social assistance payments,and reform of the social insurance framework. By contributing to fiscal sustainability andlow inflation, the PSAL program will prevent further erosion in the real living standards ofthe poor. The objectives of improving public administration and management of resourceswill enable improvements in the cost-effectiveness of government social programs that areespecially important for the poor. It will also support implementation of a national means-tested social assistance program.

Specific Actions Taken Prior to Board Presentation

86. The detailed medium-term reform program associated with this loan is outlinedbelow and set out in the Letter of Development Policy and the multiyear matrix of policy andinstitutional reforms. Specific actions of the PSAL program, the triggers, and theperformance benchmarks draw from and elaborate on the NDP. The stage for this operationhas been set by a number of important decisions already taken and fully implemented prior toBoard presentation to demonstrate the government's commitment to moving forward with itsmedium-term development agenda. These decisions affect actions in the four components ofthe reform program supported by the PSAL:

Returning to a macroeconomicframework conducive to robust growth

* The Borrower has maintained an appropriate macroeconomic policy framework,consistent with the objective of the Program, as determined on the basis of indicatorsagreed to by the Borrower and the Bank;

* The Saeima has adopted amendments to the Law on State Pensions, removing allprohibitions to working and taking a pension, improving the equity of the pensionsystem, curbing early retirement, and regulating future indexation.

Strengthening the credibility of the public sector

* The Saeima has adopted the Law on the Corruption Prevention Bureau, with the authorityto: (a) detect and resolve ex ante cases of conflict of interest, (b) detect and evaluatepossible cases of illicit enrichment, (c) monitor corruption and corruption prevention inpublic sector bodies, (d) advise the Cabinet of Ministers, individual ministers, and otherheads of public sector bodies on methods to strengthen corruption prevention, (e) prepareand evaluate legislation related to corruption prevention, and (f) educate officials and thepublic about corruption prevention.

9 See The Republic of Latvia: Poverty Assessment, 2 volumes, Report no. 20707-LV, World Bank, 2000.

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* The CPC Secretariat has published changes to and progress in the implementation of theCorruption Prevention Plan.

* The Saeima has adopted the Law on the Framework of Public Administration.

* The Saeima has adopted the Law on Public Sector Agencies.

* The Borrower, through its Cabinet of Ministers, has adopted a regulation identifying: (a)criteria for the role and responsibilities of each public agency, (b) the mechanism throughwhich a public agency can be created, and (c) criteria with which to decide what agenciesto divest.

* The Borrower, through its Ministry of Justice, has assigned the task to provide guidanceand coordinate the implementation of the Petitions Act and the Law on Openness ofInfornation to the data inspection unit of the Ministry of Justice.

* The Borrower, through its Ministry of Justice, has adopted a time-bound action plan forimplementing the Administrative Procedure Law and identified one staff member withineach ministry who has been assigned the responsibility to secure implementation of thislaw in his or her ministry.

Strengthening the public sector's institutional capacity

* The Borrower, through its Cabinet of Ministers, has adopted a time-bound action plan forthe implementation of the Medium-Term Public Sector Reform Program in all lineministries.

* The Borrower, through its MoPSR, has designed and piloted a methodology forconducting fundamental reviews that are to be used to support the 2003 budgetpreparation in selected ministries and shall, among other things, include: (i) amethodology to review and identify priority policies and programs and (ii) amemorandum of understanding between the central agencies and line ministries regardingwhat will be done with the results of the review.

* The Borrower, through its Ministry of Public Sector and Regional Reform, has allocatedresources to support the fundamental reviews and train at least three government staff inthe fundamental review methodology.

* The Borrower, through its Ministry of Finance (MoF), has prepared a draft regulation onpay reform and estimates of the cost of its implementation, and the Cabinet of Ministers(CoM) has (a) reviewed the draft and cost estimates, (b) accepted the draft in principle,and (c) adopted a schedule requiring the MoF to provide the CoM by October 8, 2002,detailed options for phasing in the pay reform.

* The Borrower, through its Cabinet of Ministers, has issued its first annual budget prioritystatement, including: (a) an overall fiscal strategy, (b) budget priorities, and (c) criteriafor annual budget priority-setting to be used starting with the budget for 2003.

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* The Saeima has completed its first reading of the new law on social services and socialassistance, which provides for the nationwide implementation of national means-testedsocial assistance benefits and improves the organization and administration of the socialassistance system.

Rationalizing the interactions between the public andprivate sector

* Subsidiary legislation, needed for the Public Utilities Commission to operate, has beenapproved by the Cabinet of Ministers.

* The Borrower, through the Public Utilities Commission Board, has adopted the strategyfor the Public Utilities Commission ("Strategy and Basic Principles") and published it inthe official newspaper Latvijas Vestnesis and the website, http://www.sprk.gov.lv/.

* The Borrower has, in the case of the privatization of LASCO, (i) made a public offeringof 32 percent of the shares for privatization vouchers, (ii) sold 51 percent of the shares tostrategic and financial investors for cash through the Riga Stock Exchange at a priceapproved by the Board of the Latvian Privatization Agency, and (iii) agreed that thebalance of the shares will go to employees and the State Pension Fund by December 31,2002.

* The Borrower has submitted the first regular report and evaluation by the internationalinvestment bank for Ventspils Nafta to the Bank for review.

* The Borrower, through its Cabinet of Ministers, has approved a detailed restructuringprogram for Latvenergo that meets the unbundling and market-opening requirements ofthe European Union Directive No. 96/92/EC concerning common rules for the internalmarket in electricity.

* The Borrower, through its Ministry of Economy, has prepared an electricity marketmodel that meets EU directives on market liberalization for its consideration.

* The Borrower has established the transmission system operator as a separate legal entitywith its own management, staff, and separate accounts.

* The Borrower, through its Cabinet of Ministers, has approved a concept with a time-bound action plan of gas market liberalization in line with European Union Gas DirectiveNo. 98/30, dealing, in particular, with third party access, and elaborating on gas pricingmethodologies that deal with separation of storage, transmission, distribution, and salescosts and tariffs.

* The Borrower, through its Cabinet of Ministers, has approved a methodology for legaland regulatory impact analysis.

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Progress Benchmarks and Triggers for Considering PSAL III

87. PSAL III will be predicated on satisfactory performance under PSAL II andfulfillment of a predominant part of the triggers agreed for a next operation. If progress isfound to lag behind expectations, a judgment will be made on whether to adapt the medium-term program, to reduce the amount of the next loan, or to delay it until further progress hasbeen made. The reform program to support Latvia's continued implementation of its NDPunder PSAL III will draw from the findings of analytical work on growth, competitiveness,and labor market issues (Country Economic Memorandum), as well as continuing work onpublic sector reform and other key sectoral issues. In addition to satisfactory macroeconomicpolicies and overall program implementation, PSAL III will depend on substantial progressin strengthening public sector governance and the assumption that sector policies andinstitutions will focus increasingly on poverty reduction. The precise actions for PSAL IIIwill be formulated and agreed at the time of negotiations, drawing on the medium-termprogram set out in the Letter of Development Policy. At this time, it is envisaged that criticalpolicy and institutional reform measures as a basis for PSAL III will depend on satisfactoryprogress in meeting the following triggers:

Macroeconomic framework

Maintenance of an appropriate macroeconomic framework.

Transparency and accountability in public sector management

Anticorruption. Satisfactory progress on the implementation of the anticorruption program, asmeasured, for example, by:

(i) Appointment of the head of the Corruption Prevention Bureau (CPB); adoption of astructure that serves functions; allocation of sufficient human, physical, and financialresources to the CPB; adoption of performance indicators; implementation of the mechanismto monitor and report on changes in corruption; the start-up of operations; and

(ii) Transfer of responsibility to the CPB for investigating possible cases of conflict ofinterest and illicit enrichment and supervision of the finances of political parties.

Judicial reform. Satisfactory progress in the implementation of the medium-term action planfor judicial reform, as measured, for example, by:

(i) Publication on a semiannual basis of agreed performance indicators by the Ministry ofJustice, for example, on public confidence in the judiciary; and

(ii) Implementation of a time-bound action plan by the Ministry of Justice for strengtheningits monitoring of commercial cases, administrative cases, and public confidence in thejudiciary.

Transparency and accountability ofpublic sector institutions. Satisfactory implementation ofthe Administrative Procedure Law, as measured, for example, by:

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(i) Annual publication of a statistical report on appeals and users' satisfaction with the,procedures; and

(ii) The conversion of at least 25 existing non-profit state enterprises into agencies to makethem consistent with the Law on Public Sector Agencies, which defines a transparent,accountable, and financial management regime for all public sector agencies.

Institutional capacity

Pay reform. The Cabinet of Ministers has adopted regulation on pay reform, including adetailed schedule for its implementation; actual implementation has started.

Social assistance. Satisfactory implementation of the new social assistance system, asmeasured, for example, by the Saeima adopting the Law on Social Services and by theimplementation of policy measures to:

(i) Improve the targeting of the neediest; and

(ii) Strengthen the incentive and monitoring systems in place.

Rationalizing the interactions between the public and private sector

Privatization. Satisfactory implementation and completion of the remaining privatizationagenda, as measured by preparing and offering for sale Ventspils Nafta (VN) and, as soon aslitigation is over, the govemment's shares in Lattelekom.

For both VN and Lattelekom, the govemment will use an international investment bank,hired though international competitive tender, and will offer its shares for sale in an open,competitive manner and at a fair price to the govemment, with the process to be attested to asfair, open, and competitive by the investment bank

Regulatoryframework.

(i) Timely adoption by the Public Utilities Commission of gas, electricity, andtelecommunications tariffs according to transparent, published methodologies.

(ii) Adoption by the Public Utilities Commission of rules governing access to thetransmission grid in electricity and bottleneck network facilities in telecommunications.

Energy sector. In the electricity sector:

(i) The annual electricity consumption threshold for Qualified Customers to 20 GWh will bereduced.

(ii) The Transmission System Operator is licensed and operates as a fully independent entitywith an independent Board of Directors.

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(iii) The government has adopted an electricity market model and has revised energylegislation that will meet EU directives for electricity market liberalization.

Monitoring and Evaluation

88. Monitoring Arrangements. Latvia's PSAL program has set clear benchmarks in allareas, together with expected outcomes to be achieved after completion of reforms. Thesebenchmarks are not conditions of future lending, but guideposts to signal when progress hasadvanced or is falling behind in any given area. If progress is adequate, Latvia's reformprogram could be supported through subsequent annual PSALs under the programmaticlending framework, subject to the approval of the Board of Executive Directors. Latvia andthe Bank will agree on the appropriate size and timing of future PSALs over the next 3 yearsas program implementation progresses.

89. Through regular reviews and in the context of the preparation and supervision of thenext PSAL, the Bank will monitor the implementation of the agreed benchmarks. Workingclosely with the government and other donors, the Bank's support will focus on directlymonitorable results. Policy reforms, which are critical for the PSAL program to achieve itsmacroeconomic and poverty reduction objectives, have been discussed with the authoritiesand are included in the Letter of Development Policy [Annex 5]. Progress under the proposedmnd future PSALs will be reviewed on the basis of implementation of triggers andbenchmarks, as presented in paragraph 87 and the matrix of policy measures in Annex 4. Themain monitoring instruments for PSALs would be: (i) the reviews of the structural reformprogram, carried out on an ongoing basis by staff of the Riga Office and, more formally, atleast every 6 months by the Bank team in coordination with the IMF and the EU; updates ofthe NDP through its progress reports; public expenditure reviews; policy workshops; and3elected economic and sector work.

Loan Administration

90. Borrower and Loan Amount. The proposed PSAL will be made to the Republic ofLatvia, represented by the Ministry of Finance. The loan, which would be released in asingle tranche of US$20.21 million, will be on customized terms (6 years grace with 13 yearsto full repayment for a fixed-spread loan.).

91. Disbursement. The government has decided to select the Deferred DrawdownOption (DDO) for this operation, which offers the possibility of not tapping into theresources until there is a need, as well as the absence of a penalty for non-use. This implies acommitment fee of I percent on undisbursed amounts, beginning 60 days after the loanagreement is signed, payable during the drawdown period while DDO is not exercised. Afront-end fee of 1 percent of each withdrawn amount will be paid to the Bank from the loanproceeds only following any drawdowns. Upon approval of the loan and notification by theBank of loan effectiveness, the government may submit a withdrawal application. TheMinistry of Finance will open and maintain a deposit account in the Bank of Latvia. TheCBRD will deposit the proceeds of the loan in this account at the request of the Ministry ofFinance. If, after deposit in this account, the proceeds of the loan are used for ineligiblepurposes (for example, to finance items imported from non-member countries, or goods orservices on the IBRD's standard negative list), the IBRD will require the borrower to either:(i) return that amount to the account for use for eligible purposes or (ii) refund the amount

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directly to the IBRD, in which case, the IBRD will cancel an equivalent undisbursed amountof the loan.

92. Accounts, Auditing, and Closing Date. The IBRD reserves the right to require anaudit of the deposit account. The closing date of the loan will be December 31, 2003.

93. Environmental Impact. The proposed operation is an adjustment loan. Therefore,the requirements of Operational Directive (OD) 8.60 apply. The program supported under thisloan strengthens Latvia's capacity to implement its existing environmental laws. Latvia hasmade good progress over recent years in improving its environmental performance. TheGovernment has finalized the Environmental Chapter of EU accession negotiations and isimplementing acquis communautaire. Major environmental laws are in place, including theGeneral Environmental Protection Law and the Law on Protected Areas. Environmentalcompliance and enforcement systems are functional. Latvia is a party to major globalenvironmental conventions. The country is also implementing the Helsinki Convention onProtection of the Baltic Marine Environment.

Benefits and Risks

94. Benefits. The actions under PSAL II will promote fiscal adjustment and improve thepublic sector's capacity to carry out its role effectively and efficiently. At the same time, theactions supported by the loan will encourage private sector development by continuing theprivatization process and defining a transparent and effective regulatory framework. Theoperation will also assist in the government's anticorruption effort and streamline businessregulation, leading both to a more efficient govermnent and a better functioning marketeconomy. Together, these measures will be a positive signal to domestic and foreigninvestors about Latvia's business environment, and enhance the benefits that Latvia willgarner from timely EU accession. Finally, enhanced public sector service delivery capacitywill help ensure that these benefits are broadly shared within Latvia.

95. Risks. The deterioration of the current account deficit remains the mainmacroeconomic risk to sustaining a high growth regime in Latvia. Given the currency peg, ashortfall in political commitment to fiscal balance could undermine overall sustainability.The highly politicized environment in Latvia also affects political commitment to publicsector reform generally, especially in a program with such a significant emphasis onimproved governance. Such risks are heightened by the frequent changes of government thathave characterized Latvia since independence. Furthermore, continuing dependence onmultiparty coalition governments with varying ministerial portfolios increases the risk ofpoor interministerial coordination and policy interventions by special interest groups.

96. These risks are mitigated to a substantial extent by the design and content of thePSAL loan as a single tranche operation linked to prior actions. The Government ofLatvia has a strong track record of reform implementation and commitment tomacroeconomic balance even in difficult political circumstances, as evidenced by theiragreement with the IMF on ambitious macroeconomic targets for the SBA and ability tosupport the currency peg over an 8-year period of considerable economic turmoil. TheWorld Bank will continue to assist the government to mobilize the technical assistancerequired to adopt and implement its program. Latvia's strong determination to join the

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European Union also facilitates the continuity of the programmatic approach supportedby the PSAL program. An interministerial work group under the coordination of theMinistry of Finance, which helped in the preparation of PSAL II and I, will continue itswork during the implementation phase of the reform program and improve coordinationamong the implementing agencies.

VI. RECOMMENDATION

97. I am satisfied that the proposed loan complies with the Articles of Agreement of theBank and I recommend that the Executive Directors approve the loan.

James D. WolfensohnPresident

by Shengman Zhang

Washington, D.C.August 15, 2002

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Latvia at a glance 8/16/02

Europe & Lower-POVERTY and SOCIAL Central middle-

Latvia Asia Income Development diamond*

2001Population, mid-year (millions) 2.4 475 2,046 Life expectancy

GNI per capita (AUas method, US$) 3,300 2,010 1,140GNI (Atas method, US$ billions) 7.8 956 2,327

Average annual growth, 199541

Population (%) -1.1 0.1 1.0 GN

Labor force (%) -0.6 0.6 1.3 GNI I Groper pnmary

Most recent estimate (latest year available, 1995-01) capita enrollment

Poverty (% of population below national poverty line)Urban population (% of total population) 69 67 42Life expectancy at birth (years) 70. 69 69Infant mortality (per 1,000 live births) 14 21 32

Child malnutrition (% of children under 5) .. .. I1 Access to improved water source

Access to an improved water source (% of population) .. 90 80Illiteracy (% of population age 15+) 0 3 15Gross primary enrollment (% of school-age population) 96 100 114 Latvra

Male 98 101 116 Lower-middle-income groupFemale 93 99 114

KEY ECONOMIC RATIOS and LONG-TERM TRENDS

1981 1991 2000 2001Economic ratios'

GDP (US$ billions) .. 11.0 7.2 7.5Gross domestic investmenVGDP 30.0 33.7 26.7 29.0 TExports of goods and services/GDP .. 35.2 45.8 45.7 rade

Gross domestic savings/GDP 34.8 43.5 18.1 17.4Gross national savings/GDP .. .. 19.8 18.9

Current account balance/GDP .. .. -6.9 -10.0 DomesticInterest payments/GDP .. 0.0 1.1 1.1 . Investment

Total debttGDP .. 0.0 40.2 49.5 savingsTotal debt service/exports .. .. 7.1 4.7Present value of debtVGDP .. .. 13.2 15.0Present value of debtlexports ..

Indebtedness1981-91 199141 2000 2001 200145

(average annual growth)GDP 6.7 -0.2 6.8 7.6 5.8GDP per capita 6.2 1.0 7.4 8.5 6.6 Lower-rniddle-income groupExports of goods and services .. 4.0 16.1 9.3 6.1

STRUCTURE of the ECONOMY1981 1991 2000 2001 Growth of investment and GDP(%)

(% of GOP)Agrculture 13.8 23.1 4.5 4.5 eIndustry 50.0 43.9 25.4 24.9 4 t.

Manufacturing 45.1 35.7 14.7 14.9 20+-

Services 36.2 32.9 70.1 70.6 o4

Private consumption 57.5 46.2 62.1 62.5 *201 96 97 956 O 0

General govemment consumption 7.8 10.3 19.8 20.0 GDI -- *-GDP

Imports of goods and services .. 25.5 54.3 57.2

1981-91 199141 2000 2001 Growth of exports and Imports (%)

(average annual growth)Agnculture 4.8 -4.8 9.2 5.9 oIndustry 7.6 -3.7 5.8 8.5 30

Manufacturing 8.7 -3.7 7.0 9.5 20

Services 5.7 4.2 7.1 8.1 10

Private consumpton 6.8 -1.0 5.6 7.0 0 l l O o

General govemment consumption 4.5 7.3 -1.9 1.8 -10

Gross domestic investment 0.3 4.6 0.6 27.2 Eports lmports

Imports of goods and services .. 6.6 11.9 15.0

Note: 2001 data are preliminary estimates.

The diamonds show four key indicators in the country (in bold) compared with its income-group average. If data are missing, the diamond will

be incomplete.

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Latvia

PRICES and GOVERNMENT FINANCE1981 1991 2000 2001 Inflation I%)

Domestic prkces(% change) 25Consumer prices .. .. 2.6 2.5 20Implicit GDP deflator 2.7 158.2 4.1 1.6 ito

Government finance s(% of GDP, includes current grants) oCurrent revenue .. .. 37.4 35.9 99 97 98 99 00 01

Current budget balance .. .. 1.3 -1.2 - GOP deflator - O CPIOverall surplus/deficit .. .. -3.3 -1.9

TRADE

(Us$ millions) 1981 1991 2000 2001 Export and Import levels (USS mill.)

Total exports (fob) . .. 2.058 2.216 4.000Commodity 1 .. .. . 3,500Commodity 2 .. .. 3,000Manufactures .. .. 1,711 1 ,810 2,5000

Total imports (cdf) .. .. 3.117 3,587 12,500Food .. .. 285 314 . __Fuel and energy .. .. 135 143 s.0Capital goods .. .. 521 593 0

95 98 97 go 99 00 01Export price index (1995=100) . .. 102 105 9 8 9 8 9 0 0

Import price index (1995=100) .. .. 107 109 *Exports ImnortsTerms of trade (1995=100) .. .. 96 97

BALANCE of PAYMENTS

(US$ millions) 1981 1991 2000 2001 Current account balance to GDP (#)Exports of goods and services .. .. 3,271 3,451 0 _Imports of goods and services .. .. 3,886 4,318 -2Resourre balance .. .. -15 -867

Net income .. .. 24 30Net currenttransfers .. .. 98 80 4 i ICurrent account balance .. . -493 -758 -8 *

Financing items (net) .. 521 1,072 a10Changes in net reserves .. .. -28 -314 -12

Memno:

Reserves including gold (US$ millions) .. .. 919 1,218Conversion rate (DEC, local/lUS$) .. .. 0.6 0.6

EXTERNAL DEBT and RESOURCE FLOWS

1981 1991 2000 2001(US$ millions) Compostlion of 2001 debt (US$ mill.)Total debt outstanding and disbursed 0 0 3.186 4.070

IBRD 0 0 242 286 A 266IDA 0 0 0 0 C: 25

Total debt service 0 0 265 181 0* : 320IBRD 0 0 21 32IDA 0 0 0 0

Composition of net resource flows G: 2,127Official grants .. .. 32 46Official creditors 0 0 -7 39 F: 1,286Private creditors 0 0 -233 -33Foreign direct investment .. .. 398 194Portfolio eqluity .. .. -319 132

Worid Bank programCommitments 0 0 72 0 A - IBRD E -BilateralDisbursements 0 0 63 40 B -IDA D -Other multilateral F -PrivatePrincipal repayments 0 0 9 16 C -IMF G -Short-termNetflows . 0 0 54 24

interest payments 0 0 12 16Net transfers 0 0 42 8

Development Economics 8/16/02

- 45 -

-Key Economic IndiC4tors -19,95-2005 _______

- ACual £snae - ~ prqeced

A""'m"ve scenario .- - 99 ZQQ Q1 2093': 204 2005

-7 -36% 7.4% 8.5% 5.0% 6.0% o 6.00% 6.0%/

Population -. 4% 06 -. % 0.% 00 0.0%11 0.0%*GDP (consmt npries) 10%/6 6.8% 7.6%05/o 6.-00% 6.0% 6.00%-Exports of goods and services . 71 1.% 93 6.2% 6.0%/ 5-.9%, 6.0%/Import of goods and serices .- 93% . I1.9% 15.0%' 7.0%- 5.2% -5160% 5.3%TrmsofTrade- - 1.8% -- -3.4%0 .% . 07% 07. O. 05 0GrossDomestic lnvestmnent - 7 /9 '06' 72 .8 .% 96/

Money Supply (M2X).-. 80 > 2.%- 20.8% 9.% 9.0% - 9.0% 9. O9.0

CPI (averge) '~ '2.4%A -2.6% 2.5% - .% 3.0% 3.0% 3.00%

Naftional Account (% of MP).-Gosdomestic investmnot (nel- cbarkges int stocks) . 26.7% 26.76% 29. . A -28.0% 29.0%e 29.60W

Public invesimnot 01Y47% 4.06% 3.7%. 3.7% 4.2% 5,0% - 5.1%

.Piivael nvestmet . 22.00%a 22.7%. 25.3%, 24.2%.o 23.80% 24.00% 24.6%/Gross national savings-- 17.1% ~~~~19.8 18.9% 19.3% -2G.6%1 .24.8% 22.5%

Ptivate savlno--63 19.2% :17.1% 7.% 17 M9% 17.7%/ '17.8%

Balnc Of Paments~ (% oGDP) - .

Expout of goods and services . - 43.7%/ 45.8%1/ 45.7%/ 45.6% '45.8% . 45.8o 45.7h -

bnp6rts of goods and savices 54.1% 54.3% 57.2% 58.0% 57A4% .57.1% 56.7%Npticoine,receipts. . '0.5%l 0.0% . 01% 1.2% '.0.9% . .7% 04/%.unrent accoutbalance- . 98 m..6.9% -40.00/o -4.3%l -7.5% -73 /

Currnmt account balance (mill. UJSS) -654- -493 -7S8 -6k' '658 .7G3 -745

qGross Reserves (mill. US$)- 944l.4 '919.3, _ .1218.3 1358.7 1410.2 - 486.8 1589.3Cross Rsseveaas nonthsoQfimrport 2.9 26 , 3.2- 3.3 3.1. 3.0. 2.9RER (1995,= 100; period average,) -149.5 1.53.4 151.3 151.3 113 113 151.3EXChaftgezrate (LVIUUS 0-59 0.61 0.63 0.63 . :0.63 0.63 .0.63

Govrnmat lnace % f (31)?-Government deficit/surplus- - -3.9%/ -3.3%,- -1.9%/ -1.8Vw -1.5%16 -0.9%- -0.3%

Total revenue and Grants 40.0% 37.4%/ 35.9% 36.3% 36.9% o 38.3% - 38.4%Total Ex#ienditure. anid net lendig, 43.96% 40.7% .. 37.8% . 38.1% 38.4%/ 39.1% 3.8

GovernmenitDebt to GDP - 31: 13.2% 15.0%1 13.90/. 14,2% . 13.9%.o 13.2%.Govemrnent Savigs to GDP o-- - 0.8 o .7%/-.- -4.8% I.8% -2.7%. 4.1%., 4. %.

M2Xtuv niatr % fG, "2-606 - 29.4% .32.50%- 32.86% 32.7% 32.7%/ 32.6%/

Dometstic Credit -. -18.9%., -. 24.4% 32.2% 31.0%1/ ,,30.1% 29.2% - 28.5%/- ofwhic4 to C-vermmet (net 2.1% .5. : .7 22 2.4%. 2.4%I 2.3%

Egposuire Indic.trExtermal Debt (mill. US$) . , 25-. - 2877.5 -3738.1 .4111.9 -4451.3 *.5341.6 . 5705.0External Debt/GD? - - 38.7%1 ~40.20/ 49.% - 54% - 49.9*1 4.6-.537

Debtservice'toexpot ' .%- 7.1%-- 4.7% 4.4%- 4.70a -8.7% - 6.7%Netlnternafionallnve~strnent,P_ositionQn(MD. US$) -1827.1: -2145.6 -2937.3 -326014 -3586.4 -4031.1 -3921.6Met Interntional-Inves~MtmePosition/rDP -. -. 727.4% --30.0% - -3,8.9%O -39.9%/ -40.2% -41.4%/ -44.90%

-46

-Lagvli¢: . -- -' -- s ; s ; ,. -

Balance of Payments 1999-2005 . .Actual Esimated Projected

Indicative scenario 'i.299 . 201)1 2002 2003 2004 2005

CUnRRuENTr ACCOUbrr | i- + -653'6 -4935 -757.8 -681.7 -657.8 -70281 ; -7444 .5

, Goods; exprt . o. b. . 1889. 2,58,3' '22158 23705 ,6014 28898: 32011Goods:ikumportsf.o.bl . 1 - , 29161 : 3116.5! 3566;5 '3735.8 '4066.9 4447.2 - 4866.8 i

,Balnce on Goads 4 - -10271 51 13507 13653 14655 15664 16657 /

.Ser :inet, . ' 33.0 2 4427 834 5455 6293 6779 741.1Baknce on Gnoods *ud Se kes . :.; 11 -615.4 -867.3 -- 819.8 -836 2 8885 -96

Inomwenet : 554 244 298. 82 07 --17.9 " ,53.5Blance on Go ,SvkesandIncome 7465 -5910 8375 ' 806 8355 906. I 9781

Current trapsfers: net . ' 93.0 97.5 79.7 .'199 1777 203.6 233'6

CAPrTALACCOUNTBALANCE , i,26 29.4 -37.1 - 401 44.0 480 524 '

'.iNANCIALACCOUNTBAL CE 7681 . ' 514.0 9971 96 678 735 79

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LATVIJAS REPUBLIKAS MINISTRU PREZIDENTSPrime Minister of the Republic of Latvia

36 Brilvibas Blvd., Riga LV-1520, Latvia, tel. +371 7082800; fax +371 7286598

August 6, 2002

Mr. James D. WolfensohnPresidentInternational Bank for Reconstruction and Development1818 H St. NWWashington, D.C.

Dear Mr. Wolfensohn:

Subject: Proposed Second Programmatic Structural Adjustment LoanLetter of Development Policy

1. Since our country regained its independence, we have consistentlypursued reforms and modernization of our society and public sector, with theultimate objective of moving from a centrally-planed economic and socialsystem to one in which the market is allowed to be the main mechanism forallocation of our scarce resources. We expect that the reforms supported bythe Programmatic Structural Adjustment Loan (PSAL) program and outlinedin this letter to you will accommodate Latvia's goal of joining the EU andhelp to bring about a sustained reduction in poverty.

2. I will not repeat many of the issues discussed in the letter ofdevelopment policy, dated February 16, 2000, which accompanied the first

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Programmatic Structural Adjustment Loan PSAL documents that wereapproved by your Executive Board on March 16, 2000. This letter was sentto you by my predecessor, Mr. Skele. My Government still subscribes to thecontent of that letter. I propose, therefore, that I inform you about theprogress that has been made since the first PSAL was approved, that Ioutline to you the measures that have been taken to keep the program ontrack as well as the measures that are intended to be taken during theremaining phase of our reform program supported by the PSAL.

3. In certain areas, we have made less progress, in particularprivatization and initially in fiscal consolidation; in other areas we haveadjusted the program to incorporate new analytical information that hasbecome available about the outstanding issues and their possible solutions,e.g. anticorruption. We have also worked with your team to incorporateissues that clearly overlap with the reform program supported by the PSAL,but were not apparent during the preparation of PSAL I, i.e. issues related togas sector liberalization. I will bring your attention to these issues as Idiscuss the progress with the overall reform program and the next steps thatwe intend to take.

General progress under the PSAL program and PSAL II measures

Returning to a Macroeconomic Framework conducive to robust growthi

4. The macro economic framework of our reform program focuses onmeasures to further reduce the macro imbalances that re-emerged after theRussian crisis. It is clear that Latvia was affected more severely thaninitially expected. This has shown its impact especially on our fiscaloutcomes. In support of the short-term stabilization objectives of our reformprogram, we have reached a new agreement with the International MonetaryFund (IMF) on an 18 month precautionary Stand-By Arrangement (SBA),which was approved by the IMF board on April 20, 2001 for SDR 33million. This program will be in place until the end of 2002.

5. A detailed account of this program is provided in a Letter of Intentand the Memorandum of Economic Policies that we submitted to the IMF inour request for the precautionary SBA in June 2002. We recently reachedagreement with the IMF on a fiscal deficit target of 1.8 percent in 2002 andon a plan to achieve this target through increased fiscal revenues anddelayed non-essential expenditures. So far, fiscal performance for the firsttwo quarters of 2002 has been consistent with our objectives. We are

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committed to stay within the targets agreed under the second SBA and tomaintain an appropriate medium-term macroeconomic framework not onlyfor the duration of the program but also thereafter as it will greatly facilitategrowth and our integration with the European Union. Our economyexperienced a strong recovery during 2000, which has even become strongerduring 2001. This cumulated in a growth rate of 7 percent for 2001, one ofthe highest since we regained our independence. To ensure that our macroframework supports such a rapid growth path, we will closely monitor andupdate our macro economic framework in close collaboration with your staffand, especially, with the IMF.

6. Besides the issues discussed above with respect to the macroeconomic framework and the need to have control over our overall fiscalposition, we need to address remaining pension issues this time such that ourpension system is fair, its fiscal impact is clear and is financially viable inthe future. All of us are aware that the system needs to be put on a securefinancial footing such that it does not contribute to our fiscal deficit today orin the future. For this reason we have reviewed the impact of the November1999 amendments and have submitted new amendments to the Saeima,which have subsequently been adopted, to the Pension Law that remove allprohibitions to working and taking a pension, curb early retirement andregulate future indexation. Now these amendments have been passed, weintend to focus our attention to ensure that the second tier will operateproperly. Therefore, we are reviewing progress with the implementation ofthe second tier and will adopt changes if necessary. We have also developedregulations to permit private sector asset management. During theremainder of the pension reform program supported by the PSAL, we willcontinue to take actions that will ensure that all three tiers of the pensionsystem are in place and operating appropriately. Of course, we will continueto closely monitor the financial viability of the pension system andundertake further adjustments if it turns out that our earlier amendments arenot having the expected result.

STRENGTHENING THE CREDIBILITY OF THE PUBLIC SECTOR

Anti corruption and conflict of interest management

7. I would like to congratulate you on the anticorruption report,"Anticorruption in Transition: a Contribution to the Policy Debate" that yourstaff prepared for the World Bank-IMF 2000 annual meetings in Prague. I

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would also like to thank your staff, who worked on this report, and visitedLatvia to discuss with the Cabinet the findings and the implications of thisreport as it helped us understand the issues of how to deal with corruptionmuch better. In the light of the conclusions of the report, we havereevaluated our anticorruption strategy. We have set up three differentworking groups: (i) one to redraft the anticorruption law; (ii) one to design anew anticorruption unit, Corruption Prevention Bureau, which wouldcombine the responsibilities of the anticorruption unit of our state revenueservice and the Corruption Prevention Council and which will in additionhave limited investigative powers; and (iii) a third one that worked on a newset of laws regulating the financing of political parties and electioncampaigns. These laws have appropriate safeguards and mechanisms fortransparency, accountability, and audit. They have all been adopted byParliament. All these measures confirm our commitment to fight corruptionin our country and will help reducing 'state capture,' which was found to bethe main corruption impediment in Latvia in your Prague report.

8. As a consequence, we have established in law the CorruptionPrevention Bureau (CPB). The new bureau will begin its operations towardsthe end of 2002. It will absorb the corruption prevention activities ofdifferent public sector bodies, including responsibilities for investigatingpossible cases of conflict of interest and illicit enrichment and supervision ofpolitical parties finances. We are committed to ensuring that the new bureauhas the human, physical, and financial resources it will need to execute itsfunctions effectively. We are now engaged in the process of recruiting thehead of the new bureau. Upon assumption of office, he or she will lead thedesign of the organizational structure of the CPB, recruit qualified staffusing transparent procedures, prepare appropriate operational proceduresand manuals, and train staff in those procedures. To ensure CPB'saccountability, performance indicators will be designed which includecollecting public feedback on attitudes toward and experiences withcorruption. We have already designed a survey instrument for this purposeand had hoped to implement it on a regular basis even before theestablishment of the CPB, but this proved to be impractical. We do publishinformation on progress in the implementation of our overall anticorruptionstrategy on a regular basis.

9. Education is a key pillar of our anticorruption strategy. The School ofPublic Administration (SOPA) is playing an important role in training ourpublic officials in understanding conflict of interest. For that purpose, SoPAhas prepared a draft manual and curriculum for training public sector

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employees in conflict of interest and trained its own instructors as well as allnewly hired public officials. The CPC Secretariat has also conductedspecialized workshops on conflict of interest and provided civic educationon corruption prevention. We expect that these actions will contribute to anincreased understanding by public officials of conflict of interestprohibitions and other ethics standards. We will continue to implementthese training activities over time.10. An important step that we have taken to improve the transparency andcredibility of the privatization process is to invite a Non GovernmentalOrganization (NGO) to monitor key privatizations. One NGO, Delna,monitored the privatization process of Latvia Shipping and we expect thatthe Latvia Privatization Agency (LPA) will continue to invite a qualifiedNGO to monitor key privatizations. In the coming year, as a way of furtherenhancing the Government's credibility with the public, we will also ask theLatvian Procurement office to invite a qualified NGO to monitor their largeprocurements.

Judicial Reform

11. We undertook many actions last year to strengthen the credibility ofour Judiciary. With support of the PSAL program we have further deepenedour reform efforts in this area. The Ministry of Justice, with help fromUNDP, has developed and adopted a medium term strategic action plan forreform of Latvia's Judiciary. This ambitious action plan is designed to (i)increase efficiency, (ii) strengthen incentives, (iii) guarantee independence,(iv) enhance transparency and openness, and (v) collect feedback from thepublic.To monitor the performance of the judiciary and the effectiveness ofthis reform program in particular, the Ministry of Justice is publishing, on anannual basis, statistics on changes in its own performance. It is nowengaged in a process of reforming this system of performance monitoring tobetter monitor the effectiveness of its reform program. It has conducted areview of this system, with an aim to strengthen its monitoring of (i)commercial cases; (ii) administrative cases; and (iii) public confidence in thejudiciary. As part of this effort, it has prepared an action plan that willintegrate information systems of the lower courts and the Supreme Court.Next year, we will begin implementing this action plan, as well as prepare anaction plan to include information on prosecution and court execution intothis monitoring system.

12. We have taken a number of additional measures that also aim atincreasing the transparency of the judiciary. Users of courts have

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complained that judicial corruption often takes place in the private chambersof judges, when parties to civil or criminal proceedings or their legal counselmeet privately with the judge. These 'ex parte' communications are nolonger permitted. To enforce this procedure, all renovated or new courtbuildings now provide judges with secured chambers that restrict access, sothat ex parte communications cannot easily take place. To increase publicaccess to judicial decisions and provide greater judicial accountability, manyof the district court, appeal court and Supreme court decisions are nowpublished. Review of decisions for criminal cases is now facilitated by theintroduction of cumulative indexing of decisions. Cumulative indexing forcivil cases will be introduced shortly.

13. Initially we had expected to submit to Saeima a new criminalprocedure code, which had been in preparation for the last six years.However, the proposed concepts prepared by the Ministry of Justice werenot fully in line with standards advocated by the Council of Europe nor dothey allow for cost saving streamlined procedures. In addition, the Ministerof Justice was concerned that as many European countries themselves areredrafting their criminal procedures code, passing of the current versionwould have made the law outdated within a few years. Therefore, we havedecided to redraft the Law so that it will be in conformity with Council ofEurope standards for among others streamlined procedures and whicheliminates all ex parte contact between judges and litigants, unless properlyrecorded. The new concept has been approved by the Cabinet and work onthe new draft law had begun. To be able to state that the judicial systemoperates more efficiently and effectively with less corruption and withincreased public confidence, we intend to continue to implement this judicialreform program, and monitor its implementation and effectiveness overtime.

Law on Public Sector Azencies

14. During the preparation of PSAL I, our staff worked closely with theBank's team to draft two important laws. The first is the law on theFramework of Public Administration, which regulates the establishment,subordination, control, accountability and funding arrangements for publicadministration bodies. This law was adopted in June 2002. The second isthe law on Public Sector Agencies, which defines a transparent, accountable,and financial management regime for our public sector agencies. TheSaeima adopted this law in March 2001. To support implementation of these

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laws, we adopted extensive implementation regulations, which define (i) thetasks and functions that an agency can perform; (ii) the mechanism throughwhich an agency under the new law can be created; and (iii) the criteria todecide which of the current set of agencies to bring under the articles of thenew Law, to divest, or to bring back into the normal structure of the lineministry. On the basis of these regulations, our Cabinet of Ministers hasestablished the procedure for review of non-profit state-owned companies,and reorganization of some of them into public agencies. These initial stepsneed to be followed up in the years to come with steps to implement thisimportant piece of legislation. According to a timetable approved by theCabinet of Ministers in April 2002, next year at least 25 non-profit state-owned enterprises will be converted into public sector agencies under thislaw; other bodies will be divested, liquidated, or converted into other legalforms.

Openness of information.

15. Access to information is an important part of participatory andcredible Government. We want to facilitate this process and we have,therefore, decided to further streamline the process by which the public canget access to information. The Ministry of Justice has established a centralunit with the capacity to coordinate government implementation of, andprovide guidance and expertise on, the Petitions Act and the Law onInformation Access. The unit will be developing a system for monitoringthe implementation of the law, which includes (i) a mechanism formeasuring fulfillment of public requests for information; and (ii) publicationof these measures in the annual reports of public sector bodies. Our publicsector bodies already publish annual reports. Soon, we will adopt aregulation that these annual reports must provide information on (i) therights of the public to information; (ii) the procedures for public to accessinformation; and (iii) the extent of fulfillment of public requests forinformation. Next year, we expect that all action plans will be fullyimplemented such that the public has easy and simple access to ourdocuments

Annual reports of public institutions

16. To follow up on the initiated reforms with respect to reportingrequirements for public bodies, we decided to review the current procedures.As a consequence, we have prepared amendments to the instruction onPublic Annual Reports. These amendments, which require the preparation

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of more performance-focused reports, have been adopted by our Cabinet ofMinisters, and are to be used in all public institutions including regulators.We have even started to publish them on the Internet to facilitate access byour constituents. Our Development Agency (LDA) has also conductedsurveys and it reports on the opinion of the private business sector and thepublic at large with respect to the performance of various institutions. It isclear that we will need to follow up on the surveys and to ensure that thiswork continues. I have asked the Chancellery office to monitor thesedevelopments.

Administrative procedures.

17. Proper Administrative procedures are extremely important to give thepublic at large recourse against undue Government decisions or interferencein their lives. With your team, we have been working on revising ouradministrative procedures and this has cumulated in a new law that has nowbeen adopted by the Saeima. It is clear that this puts in place an importantlink with the other components of the reform program that aim to improveour credibility. We have also developed and adopted an implementationplan.

18. The next steps that we need to take will focus on implementation ofthis important law. To monitor progress closely with the Law'simplementation, we will design a system that measures compliance with thenew Law. This will include publication, on an annual basis, of a statisticalreport on appeals and users' satisfaction with the procedures.

STRENGTHENING INSTITUTIONAL CAPACITY IN THE PUBLIC SECTOR

Streamlining the structure of the public sector and increase administrativeefficienca and transparency

19. Work undertaken for our Government by Sir Robin Mountfieldinitially commissioned by the European Delegation in Latvia made it clearthat we had to strengthen our efforts with respect to public sector reform.One of his main conclusions was that the Government of Latvia had a 'holeat the heart of Government'. As a result, we decided to strengthen the officeof the Chancellor by revamping its management and by adding a unit to itsstructure with clear responsibilities in the areas of policy coordination. Inaddition, the Bank's recently completed Public Expenditure Review shows

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that indeed one of the main culprits in our public management system is alack of policy coordination and strategic planning at the center and at thelevel of line ministries.

Blue print for Public Sector Reform

20. The Ministry of Public Sector Reform (MoPSR) was asked by theCabinet to redraft the blueprint for public sector reform. The blueprint,which is now revised, includes a clear action plan with deadlines for theimplementation of specific public sector reforms to ensure that we stay ontrack with this important reform program and that we can keep the staffresponsible for its implementation accountable. Work is progressing welland the Cabinet has received and adopted the proposals for reform by theline ministries as a follow up of the adoption of the original blue print. Inaddition, the Secretariat of MoPSR has established a mechanism to monitorand report on the changes in public sector management and publishes, on anannual basis, changes in public sector management and performance, partlybased on Public Annual Reports by our public entities. From now on theSecretariat will, on a semiannual basis, report in our official Gazette onprogress in the implementation of this reform program. The Cabinet ofMinisters has established a Public Sector Reform Coordinating Councilwhich coordinates the implementation of the time-bound action plan for themedium-term public sector reform program.

Functional and Fundamental reviews

21. To facilitate the work on policy and strategic planning (see for moredetail below), the Secretariat of MoPSR, with help from the new policycoordination unit in the Chancellery office and the Ministry of Finance, hasexpanded the scope of the functional review instrument. This instrument hasbeen expanded and includes a policy review as well as a review of theefficiency of the expenditures undertaken by our line ministries, andinstitutional structure review. Notwithstanding these enhancements, we areproceeding with the implementation of the outcomes of the functionalreviews undertaken so far. A main accomplishment will be the completionof the restructuring of the Ministry of Agriculture, according to the actionplan that we agreed upon last year. We expect that the methodologydeveloped for conducting fundamental reviews will be used for thepreparation of the 2003 budget in selected ministries. To ensure that this

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instrument will be effectively used, we have allocated budgetary resources(equivalent to five staff at the level of deputy head of a department),instructed the Public Sector Reform Coordination Council to monitor theimplementation of the recommendations of the review, and made the lineministries undergoing that review to incorporate its recommendations intheir strategic plans.

Incentives for recruitment and retention of staff

22. Our government has collected detailed information on the existing paystructure such that different implementation options could be calculated. Wehad decided to overhaul our current pay structure as it is not transparent, nordoes it provide equitable pay for equal work. Last year we decided on asystem that would be broad banded, transparent, and would have a uniformpay scale for the public sector. The Ministry of Finance has drafted aregulation for the new pay system that was approved in principle by theCabinet. The Ministry of Finance is now working on implementationregulations, which include a schedule for its gradual introduction. Inaddition, the Government as part of its preparation strategy has conducted aworkshop for state secretaries and deputy state secretaries to discuss the payconcept. Parallel to the implementation efforts we have begun developingthe functional requirements for a permanent database on public sectoremployment, pay and functions to improve our capacity to monitor thesedevelopments and their budgetary consequences. The database is expected tobe functional as the pay reform is implemented. The updated regulations arescheduled to be submitted to the Cabinet of Ministers on October 8, 2002.

23. Obviously, the above actions will need to be followed up by the actualimplementation of the new pay system for the public sector. We will alsotake steps to ensure that the gathering of statistics on public sector as well asprivate sector pay will be continued such that we can conduct research ondevelopments of private sector pay and among others its financialimplications for the public sector.

Civil Service.

24. An integral part of the pay reform is the introduction of performancereviews of our staff. In 2000, we passed a new civil service law, whichrequires that we evaluate our staff's performance. This year we haveestablished a procedure for performance reviews, trained our managers in

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conducting performance reviews of our civil service, and conducted our firstround of performance evaluations. We will soon publish an annual report onthe development of the civil service.

Improving public expenditure management

25. One of our main objectives of our reform program is to improve themanagement of our financial resources. Better management will not onlyimprove the functioning of the Ministry of Finance and its capabilities tomonitor our financial situation but it will also improve policy coordinationand strategic planning among the agencies at the center and between theagencies at the center and the line ministries.

26. To complete the reforms that aim to develop transparent and unifiedaccounts, one of the measures we took is to ensure that all Budget FinancedInstitutions (BFIs) will have their accounts with the Treasury for the nextbudget year (2003). Another measure in this area is that the Ministry ofFinance (MoF) ensures that new agencies operating under the new Law onPublic Sector Agencies open accounts only with the Treasury. Last year theCabinet adopted a regulation for the financial reporting of agencies. Thisyear the MoF has monitored compliance with .the financial reporting ofagencies and has submitted a report on last year's financial indicators to theCabinet of Ministers for their review. To improve fungibility of our scarceresources the Cabinet has agreed to abstain from new earmarking of taxesand to abstain from allowing the creation of own revenue for specialbudgets. We expect to have a discussion on earmarking and own revenuewithin the Cabinet next year, and to clarify the proper balance betweenrevenue autonomy and fungibility of budget resources.

27. The State Audit Office (SAO) has also undertaken several measuresto strengthen its role in this process. It has developed a methodology toestimate the budget coverage of its audit plan and has indicated that its auditplan for 2001 included an estimated minimum of 20 percent of theGovernment's basic and special budgets. It has also undertaken a audit ofaccounting and reporting standards that the Central Government uses andwhich are under the SAO's purview. In addition, the financial resources ofthe SAO have been reevaluated and now meet the requirements of theincrease in number of audits that it is to be delivered to Saeima. During thecoming year, it is expected that the SAO will be able to audit all CentralGovernment's accounts on an annual basis and that they are to be published.

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28. Given the success we are seeing with the modernization effort of theinternal audit, we have be able to move forward with this component muchfaster than initially expected. The MoF has started to focus already oncreating processes and mechanisms that will ensure follow up on internalaudits by responsible parties given that the capacity improvements havetaken place at a faster speed. The reform efforts in this area have resulted inthe submission by the MoF of an annual compiled audit report to Cabinet,which has taken a decision on the proposed recommendations and the followup mechanisms, so as to ensure implementation of the adoptedrecommendations. We have also set up an Audit Council with well-definedresponsibilities, which will further assist the MoF with building up internalaudit capacity in all of our line ministries. Until now the MoF had pilotedthe internal audit procedures with a few line ministries. The coming year weexpect to expand this to all line ministries.

29. I would like to take the opportunity to thank you for the excellentreport, Country Procurement Assessment Review (CPAR) that yourprocurement staff has done for us. We obviously want to improve ourprocurement procedures and safeguards. Therefore, we have adopted anaction plan that tackles the main recommendations from the CPAR. A firststep was the adoption of a new Law on Public Procurement by Saeima. TheGovernment has also brought secondary legislation more in line withinternational best practice. We have also established an autonomousProcurement Provision Bureau.

30. Next year we expect to strengthen our bid procedures, includingadministrative review of bidders' protest, and introduce standard pre-qualification documents for goods, civil works and consultant services. Newadministrative procedures are also developed which will help theGovernment with debarring of firms and individuals who engage infraudulent and corrupt activities related to public procurement.

Development of performance-oriented budgets in line ministries.

31. To be able to improve performance orientation of line ministries, weneed to have a strong center that can guide the line ministries during thisprocess. As mentioned above, the Government decided to strengthen theChancellery's office with a policy coordination unit. This unit has preparedin close coordination with other central agencies the Government's firstannual budget priority statement which included our overall fiscal strategy,our budget priorities, and criteria for annual budget priority setting

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mechanisms to be used starting with the budget for 2003. The Cabinet has

approved this first annual budget priority statement. The unit has alsoprepared guidelines in policy making and strategic planning for our lineministries. It will also prepare Guidelines for strategic planning for our lineministries. The Ministry of Agriculture has successfully piloted the strategicplanning exercise and will use its new strategic plan in the preparation of the2003 budget. We expect that these measures will facilitate greatly our abilityto redirect our resources to those objectives, and in particular EU accessionrelated expenditures which are our highest priority. In addition, the MoF hasprepared a draft methodology of Public Expenditure reviews and the Cabinet'has adopted an expenditure review program that covers all the lineministries. We plan to start these expenditure reviews as soon as possible.

32. The initial stage of the reforms in this area clearly aims to strengthenthe central institutions of our Government. Next steps in the coming yearwill focus on (i) issuing regulations and guidelines for all line ministries forstrategic planning; (ii) helping pilot line ministries to develop their strategicplans and annual performance programs and to use these as the basis of theirbudget request, (ii) developing an action plan that strengthens the MoF's andthe (pilot) line ministries evaluation capabilities.

Development of a medium-term budget.

33. This year the Cabinet has discussed and issued a medium-term fiscalpolicy statement and a medium-term macro and fiscal framework submittedby the MoF. The cabinet has also issued methodology guidelines formedium term budget planning in line ministries. This year the 2002 Budgetactually includes not only these statements but also an explanation offorecasting assumptions and fiscal risks. The budget also provides financinginformation together with an analysis of the sources of the financing of thebudget. We plan to follow up these developments by establishing a FiscalPolicy Consultative Board to consider the medium tenn fiscal plan (MTFP)of the MoF.

Local Government Finances

34. Given that we have around 570 municipalities, improvingtransparency and accountability for our Local government finances is not aneasy exercise. Nevertheless, we have prepared and published localgovernment accounts in line with the new accounting and debt managementprocedures, carried out pilot programs for improved accounting andfinancial reporting systems at selected municipalities and carried out an

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analysis of performance achievements. We have also reviewed theequalization mechanism and decided to reform the system of expenditureneed calculation, because it is currently subject to political manipulation.

35. During the coming year, we will need to prepare an evaluation of thefinancial management system, report on the scope of the training system forlocal Government staff (number of staff trained per municipality), andpublish reports on the financial situation of local governments. This willthen have significantly contributed to improve the accountability andinformation about budget execution by local governnents.

Social Assistance.

36. We enjoy our ongoing dialogue with your staff in the social sectors, inparticular in the light of the social welfare project. All of this work pointedto the fact that our social assistance programs are poorly targeted and as suchdo not reach the vulnerable and poor of our society in a manner that theycould and should. During the first year of the PSAL, we piloted a meanstested social assistance benefit system and developed a new monitoringsystem to support this means tested benefit system. The program has beenquite successful and we have decided to embed the new system in our SocialAssistance Law. Therefore, we have submitted amendments for nationalimplementation to Saeima, which were adopted. The Ministry of Welfarehas also developed and submitted to the Cabinet for its considerationimplementation regulations such that the amendments can be swiftly madeoperational. In addition, an action plan for placing gatekeeping, referraldecisions and financing responsibilities for social care, and social assistancewith one level of government was prepared for discussion but we have notbeen able to reach a decision on this yet.

37. During next year, we will focus on further evaluation of the newsocial assistance system in particular through analyzing the householdbudget survey to see if indeed the services are better targeted. In addition,we will define measures that will improve on the incentive and monitoringsystems that facilitate the allocation of social assistance expenditures.

Rationalizing the Interactions between the Public and Private Sector

Privatization and Re-aulatorv framework.

38. As you know, Latvia has completed all but a few large privatizations.Privatization of the remaining large enterprises has been a much more

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difficult process than we had envisaged at the outset. of the PSAL program.Although, it is clear that we have made significant improvements in theprocess, besides the divestiture of our remaining interest in Latvija Gaze andthe privatization of Latvian Shipping through the sale of 83 percent of thegovernment's shares, the other privatizations have not been done.

39. With respect to Lattelekom, Sonera, its strategic investor, has taken usto arbitration court to resolve the issue of compensation for the shortening ofthe company's exclusivity period from the year 2013 to 2003. You areaware that we have committed ourselves to the WTO and the EU to shortenthis period. However, the undesirable result of this arbitration court case isthat we have had to stop the process for divesting our remaining interest inLattelekom. Also the intended merger of Sonera with Telia has createdadditional delays in the arbitration process. I want to assure you that wehave acquired reputed international advisors to assist us during thearbitration and that we will proceed swiftly with the privatization of ourshares once the case has been decided upon. We are committed to privatizeour shares in the company, when they become available, in an open,competitive manner and at a fair price for the government, with the processto be attested to as being fair, open and competitive by the investment bankwe will use for this transaction.

40. We have continued work on the implementation of theTelecommunication Law, which was adopted by Saeima in 2001. In themeantime, the newly established multisectoral regulatory body is proceedingwith the building up of the regulatory capacity needed to oversee the rapidlychanging telecommunications sector based upon best practices used inOECD countries. The primary goal of the adopted regulatory framework isto facilitate, during the coming years, the transition to a fully liberalizedtelecommunications sector.

41. The new regulatory body is expected to define and announce itsmedium-term regulatory agenda for the telecommunications sector and startwork in the following areas: (a) generating a reasonable, practical approachto price regulation, including the identification of cost, technical and otherdata, which the regulated entities will be compelled to furnish, determinationof the cost of capital, depreciation, and other needed elements of regulatoryaccounts; (b) establishing an interconnection framework defining the termsand conditions of access to bottleneck telecommunications facilities; and (c)establishing rules for spectrum allocation. We have already classified theservices to be regulated and have developed a numbering plan. A definition

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of universal service and the establishment of a competitive neutralmechanism to support universal goals is also to be defined shortly.

42. In addition to the unfortunate delay in the divestiture of our interest inLattelekom, we were forced by Parliament to put Latvenereo on the list ofstrategic companies not to be considered for privatization. I would,however, like to reiterate- that our. overall objective in the energy sector isindeed to establish governance, policy, and regulatory framework, andmarket structure that is consistent with EU directives, Baltic integration andabove all promotes competition. We had expected that the privatization ofLatvenergo would have been part of the reforms to accomplish thisobjective. We expect that the ongoing restructuring will enable efficiencygains from improved competitive pressures and facilitate the effectiveprivatization later on. To facilitate these changes, the Government hasprepared revisions to the market model which would deepen the reforms andincrease competition. To bring market pressure to Latvenergo to improve itsefficiency, we have decreased the criteria for qualified customers from 100GWh to 40 GWh and plan to decrease this further to 20 GWh in 2003. Inaddition, we have asked the Public Utilities Commission to review thetransmission and distribution tariffs as they were found prohibitively highand were seen as a barrier to competition. We plan to review the pricingcriteria and methodology to see if further price reductions are warranted.The Public Utilities Commission is also working closely with itscounterparts in Estonia and Lithuania to facilitate improved conditions forelectricity trade.

43. To be consistent with the EU directives for energy, we have approveda detailed restructuring program, to take steps toward meeting EU criteria(EU Directive 92/96). Of particular importance we have- established:generation and distribution as separate cost centers under a holding companywith separate management, staff and accounts. The Transmission SystemOperator has been established as a separate legal entity with it's ownSupervisory and Management Boards. The Government will continue toimplement these reforms by establishing generation, transmission anddistribution as separate, independent legal entities each with their ownBoards. The Ministry of Economy has replaced the double tariff schemefor hydro, wind and CHP generation plants with incentives for renewableenergy and environmentally friendly technologies in a manner that isconsistent with those of the EU.

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44. We had to postpone the privatization process of Latvia Shippingshortly before the auction was to take place, because of non-compliance bythe two strategic investors with respect to the privatization regulations.Subsequently, we privatized the company by a sale of 32. percent of thecompany's shares for vouchers and 51 percent. for cash on the local stockexchange. Of the remaining government shares, 6 percent will be sold toemployees and pensioners of the Company for privatization vouchers, 10percent will be transferred without compensation to the State SpecialPension Budget and 1 percent will constitute the privatization reserve.

45. Progress with the privatization process of Ventspils Nafta, our oilpipeline company, has also been less satisfactory than we had anticipated.We have received from the international investment bank, hired to preparethe privatization for Ventspils Nafta, the privatization plan and the financialvaluation for the company. We fully expect to sell our interest in thiscompany next year. We will continue to use the same process that we haveagreed under the PSAL I operation and will use international investmentbanks to prepare and privatize our very few remaining large enterprises. Weare committed to privatizing our shares in the company in an open,competitive manner and at a fair price to the government with the processand price to be attested to as fair, open and competitive by the investmentbank.

46. The organization and architecture of post-privatization market andgovernance structures are critical to the success of the privatization processand the overall reform program in Latvia. To define our post-privatizationgovernance structures, Saeima has adopted two important laws in this area:the Law on Public Services Regulators and the Law on Unified FinancialSupervision Agency. In both areas, the appointed council members have agood understanding of what work needs to be done to be able to implementthe new laws. Nevertheless, the time needed to draft all subsidiarylegislation, in particular to make the Law on Public Services Regulatorsoperational was significant. The inter-ministerial working group has beenable to submit to the Cabinet all the draft secondary legislation, which hasalready been approved by the Cabinet. The Public Utilities Commission(PUC), the new regulatory agency for infrastructure, became operational onOctober 1, 2001. The agency has been given an appropriate starting upbudget and made significant progress in setting up its organizationalstructure. Professional staffs with the needed expertise in the relevanteconomic and legal principles have been hired. Moreover, the PUC has

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published "Strategy and Basic Principles for Operation of PUC" and adoptedprice cap principle for tariff setting, and been working to establish its"charter" in order to specify and publicly articulate the principles that willserve as a transparent basis for its future regulatory and other policydeterminations. The PUC has been working to establish rules that ensurefair treatment for consumers who lack competitive alternatives, andnondiscriminatory access of competitors to bottleneck infrastructurefacilities. In collaboration with the World Bank, the agency organized atraining workshop for its staff in June 2002, where experts from federalregulatory agencies of the United States, made presentations on importantissues of regulatory due process, ethics, and the economics of regulation.

47. During the next year we will need to monitor closely the developmentof the PUC's medium term regulatory agenda, work to establish the basicelements of accounting regulation, and finalize the methodologies forregulating end-user tariffs and access to bottleneck infrastructure facilities.In 2003, we expect that we will have offered our shares in Ventspils Naftafor sale in an open, competitive manner.

Financial Sector Regulation.

48. We have introduced and Saeima has adopted new legislation thatallows us to establish an integrated financial regulatory body (FCMC). Weare very much aware that formation of this new agency should notundermine the credibility of the current supervision structures. We haveappointed a chairman and a co-chairman who have designed and decided onthe establishment of the organizational form for the FCMC along functionalresponsibilities and have prepared a (draft) budget for the new body. Inaddition, the supervisory council of this new body has been appointed, abudget has been allocated, and an agreement on a training program has beenreached.

49. Our next reforms in this area will be structured such that they willhelp Latvia to reach its goal of a robust and efficient financial regulatoryregime that has adopted a seamless approach to financial supervision.

Business regulation

50. It.is in our best interest to ensure that our regulatory system has themechanisms that are essential for building an effective and transparentregulatory framework that can interact efficiently with our business

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community. To streamline this process the Ministry of Justice hascompleted a draft manual for drafting laws and regulations based on goodlegislative techniques. Our Ministry of Finance has prepared a draft manualfor assessing the budgetary consequences of the proposed draft laws andregulations. Further to this, the Ministry of Justice has created a uniformdefinition and procedure of 'normative acts' that will ensure that all theseacts are being reviewed by the Ministry of Justice prior to adoption by theCabinet of Ministers. Relevant government staff has been trained in costand benefit analysis and regulatory impact assessment. The preparedmanuals are indeed used to evaluate draft laws and regulations, and toundertake the impact assessments. We plan to make sure that all lineministries implement adequate regulatory impact assessment procedures.

51. To improve the functioning of state bodies that enforce regulationssuch as our inspectorates, we have taken action to strengthen theircapabilities in assessment of the impact of their regulatory enforcementactions, their capabilities to monitor their actions and to improve theaccountability of the state bodies that enforce regulation. To be morespecific, the Secretariat of the MoPSR has prepared and the Cabinet hasadopted new rules and procedures for inspections in the above-mentionedareas. To create ownership under its constituency, a coordination council forinspectorates with rotating presidency has been set up to help steer theimplementation of this particular reform program. An important outstandingissue was the collection of fines, which was not as transparent as we wouldhave liked it to be. Therefore, we have drafted new procedures forcollection of fines. We have started the implementation of the newinspection guidelines in the inspectorates, which had not done so anddesigned annual reporting requirements of our inspectorates. In addition,our inspectorates have discussed these new reporting requirements and havebegun implementing them. By next year, we anticipate that at least 50percent of the inspectorates will have successfully implemented them.

52. The goal of our reform program in this area is to come to aninspection process that will be clear and accountable and where theinspected bodies will have a larger voice regarding the mechanisms of theinspection process. To accomplish this, we will need to focus on ensuringthat the relevant parties will review the reporting guidelines; that theperformance measures and reporting requirements in all inspectorates areimplemented; that feedback from inspected bodies is used in theperformance evaluations of inspectors and inspectorates; and that

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satisfactory action on reported cases of corruption in inspections is takenduring the remainder of the program.

53. Another business regulation area which we are trying to improve, isregulatory coordination, especially in construction. Improvements can bemade to minimize delay and costs to the private sector. We have recognizedthis and we have set up a working group to advise us on this issue. TheLatvia Development Agency has played a pivotal role in this and hasdeveloped recommendations to improve upon the current regulatoryframework. We have acted on the initiatives and adopted two regulations:one that streamlines the procedures for receiving construction permits, and asecond one that puts in place a more transparent method to determine fees.The responsibility to ensure that the municipalities issue permits incompliance with the new regulations has been given to the Municipal Board.The Municipal Board has also disseminated information on the newregulations and procedural practices coming from it.

54. In addition we have published reports that among others summarizesfeedback from real estate developers, architects and building constructorswith our goal being to improve efficiency of the permit process, limit theprevalence of. corruption and to make sure that all parties involvedunderstand their rights but also their responsibilities.

55. To end up with a smooth and efficient process of granting constructionpermits and to have reached this goal through a participatory process, weneed to make sure that all the FIAS recommendations in this area are beingimplemented and that we continue to request feedback from regulated bodiesto evaluate performance of regulators; and that we take satisfactory action inreported cases of corruption.

Prime Minister A.B&rziq§

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LATVIA PSALII: POLICY REFORMS PROGRAM MATRIX:GOVERNMENT'S POLICY OBJECTIVES AND IMPLEMENTATION BENCHMARKS

A:l. OBJECTIVE:! CORRECTING THE MACRO-IMBALANCES -- I

Issue: Latvia experienced a Government has reached The Borrower has maintained Maintenance of an appropriate An appropriate macroeconomicrecession and the re-emergence agreement with the IMF on a an appropriate macro-economic macroeconomicframework framework that allows for robust

of macro-imbalances during new Stand-By agreement in policyframework, consistent and sustainable growth and

most of 1999. December 1999. with the objective of the which reduces the volatility toProgram, as determined on the external shocks.basis of indicators agreed to bythe Borrower and the Bank.

A.2. OBJECTIVE: ENSURING FINANCIAL VIABILITY OF THE PENSION SYSTEM

Issue: Lack of funded pension Saeima has adopted legislation The Saeima has adopted All three tiers of the pension An equitable and financially

system, 1998 changes to the to create the second tier of the amendments to the Law on State system are in place. sustainable pension system.

ay pension law and policy measures pension system. Pensions, removing aft Pension system deficit isoo compromised system financial prohibitions to working and eliminated, savings have

sustainability. Ministry of Finance has prepared taking a pension, improving the increased, and equality ofacceptable implementation plan equity ef the pension system, treatment within age cohorts has

for second tier. curbing early retirement, and improved.regulating future indexation.

Ministry of Welfare has preparedplan for refotr ring PAYGO The Ministry of Welfare haspension system, including reviewed the progress of thecommunication plan, technical implementation ofithe secondanalysis of refoem options. tier pension system and has

developed regulations to permitprivate asset management.

B.1: OBLJECTIVE: REDUCING RISKS AND OPPORTUNITIES FOR CORRUPTION IN GOVERNMENT AND THE JUDICIARY

Issue: The Govemment of The Saeima has adopted the Anticorruption. Satisfactory 'Me institutional structure for

Latvia is committed to "Law an condtion cuddin progress on the inplementa inon corruption prevention is

undertaking policy and Prevention Bureau" with the of the an a-corruption program, strengthened.institutional reforms to reduce authority to: (a) defect and as measuredfor example by. coffuption. This process was resolve exv ante cases of conflict The Anticoffuption Program is started under the leadership of of interest; (b) detect and (i) Appointment of the head of effectively implementedrthe Corruption Prevention evaluate possible cases of the Corruption Prevention r

Council (CPC). In the initial co nflict of illicit en rich men t; (c) Bureau (CPB); adoption of a4phase the CPC required monitor corruption and structure that serves-functions;

lBenchmarks in bold and italic in column PSAL 1, March 2000, were loan conditions included irn the loan a'greemcnt of PSAL I. Benchmarks in bold and italic in column PSAL

11, August 2002, are loan conditions that are included in the loan agreement of PSAL It. Benchmarks for PSAL 111, Fall 2003, are indicative; those in bold and italic are triggers.

additional staff and resources to corruption prevention in public allocation of sufficient human,be able to execute its program. sector bodies; (d) advise the physical, and financial

During the first year of the PSAL Cabinet of Ministers, individual resources to the CPB; adoptionprogram it became clear that ministers, and other heads of of performance indicators;their was a need to combine the public sector bodies, on methods implementation of thedifferent prevention activities to strengthen corruption mechanism to monitor andinto one body e.g. the prevention prevention; (e) prepare and report on changes inactivities of the CPC and the evaluate legislation related to corruption; the start up ofconflict of interest activities of corruption prevention; and ( operations; andthe ACU (see below) as well as educate officials and the publicto investigative corruption cases. about corruption prevention. (ii) Transfer of responsibUity to

the CPB' for investigatingpossible cases of conflict ofinterest and ilicit enrichmentand supervision of thefinancesof political parties.

Issue: Prevention program An Executive Head of the The CPC Secretariat has The CPB publishes (i) changes to Process for monitoring andSecretariat to the CPC has been published changes to and and progress in the reporting on progress inappointed, with adequate staff progress in the implementation implementation of the anticorruption to the public ispositions andfunds, including of the Corruption Prevention Corruption Prevention Plan and created.alsofor public education. Plan (ii) measures of changes in

corruption in the public sector. Public awareness of how toCPC has published, and will report cases of corruption iscontinue on a quarterly basis, the The CPB ensures that the criteria increased.status of implementation of its used to establish public sectorAnticorruption Program. agencies and annually review

their performance include criteriaCPC has established a related to the prevention ofmechanism to monitor and report corruption. These may include:on changes in corruption in the (i) ex ante clearance of thepublic sector, based at least agency head for conflict ofpartly on feedback from the interest; (ii) implementation ofpublic; baseline statistics are arrangements to ensure publiccollected. dissemination of agency

information, in compliance withthe Petitions Act and the Law onInformation Access; (iii)implementation of appropriatecomplaint and appealsmechanisms, in compliance withthe Law on AdministrativeAppeals; (iv) implementation ofappropriate procedures andsafeguards in the agency'sprocurement system.

Issue: impact assessment to _ The new independent financial The CPB monitors that the risks Draft Legal acts are reviewed

Benchmarks in bold and italic in column PSAL 1, March 2000, were loan conditions included in the loan agreement of PSAL I. Benchmarks in bold and italic in column PSAL11, August 2002, are loan conditions that are included in the loan agreement of PSAL 11. Benchmarks for PSAL 111, Fall 2003, are indicative; those in bold and italic are triggers.

corrution Itshead has adopted assessed.an ctin lantoimplement the

reconmmendations. 'Me CPB implements proceduresfor officials and the public to

The CPC Secretariat has report on cases of corruption.reviewed seven key draft laws or These procedures include aregulations with regard to their system for monitoring thevulnerability to corruption. disposition of these complaints.

Issue: involvement of Civil The Latvian Privatization The LPA continues to invite a Civil Society is actively involvedSociety in monitoring Agency has invited a qualified qualified NGO to monitor key in monitoring the privatizationprivatization and large NGO to monitor key privatizations. process and large procurements.procurements. privatizations.

The Latvian Procurement Officeinvites a qualified NGO to

_____________________________ monitor large procurements.Issue: The Anticorruption Unit AU has developed the set of A system has been designed that The CPB (or the SRS ACU) The understanding of public(AU) in the State Revenue documents and procedures to requires politicians, ministers, establishes procedures for officials of conflict of interestService (SRS) is responsible for effectively identify conflict of state secretaries, procurement clearing ex ante politicians, prohibitions and other ethicsevaluating declarations of interest and cases of illicit officials, and other officials in ministers, and other senior standards is increased.

0 incomes and assets of public enrichment, including: (i) positions especially at risk of officials for possible conflicts of

I officials to identify cases of (i) adequate forms for declaration of conflict of interest to declare and interest. These include The Corruption Prevention Lawconflict of interest and (ii) illicit income and assets; (ii) a draft resolve their conflicts upon procedures for: (i) recusing an is effectively implemented.enrichment. At present, the manual and curriculum for assumption of their office and official from deciding on issuesprocedures used by the training SRS staff in processing prior to realization of any for which s/he has a conflict,Anticorruption Unit are not and assessment of declarations; conflict of interest. All other especially when assetssufficiently developed to fulfill (iii) a draft manual and officials would be required to potentially creating conflictsthis task. A complementary curriculum for training of the declare and resolve their cannot be sold or divested uponsystem that requires public public sector employees in conflicts prior to any realization the official's assumption ofofficials to report potential situations of conflict of interest. of a conflict of interest. office and (ii) sale or divestitureconflicts as they arise to their Appropriate sanctions for failure upon the official's assumption ofsuperiors or to a coordinating Annual declarations submitted to do so would be imposed. office of assets potentiallybody such as the AU is presently by the President of the State, creating conflicts.not in place. Prime Minister, Deputy Prime

Ministers, ministers and The CPB (or the SRS ACU)parliamentary secretaries are clears all state secretaries forpublished on an annual basis. possible conflicts of interest.

The CPB (or the SRS ACU)prepares to clear all politicians, e

ministers, and other senior UQofficials that are elected or wappointed as a consequence of O.,the October 2002 elections.

Benchmarks in bold and italic in column PSAL 1, March 2000, were loan conditions included in the loan agreement of PSAL I. Benchmarks in bold and italic in column PSAL11, August 2002, are loan conditions that are included in the loan agreement of PSAL 11. Benchmarks for PSAL 111, Fall 2003, are indicative; those in bold and italic are triggers.

developed and inmplemented.Issue: Education on Corruption Th colof Public CPB (oT CPC Secretariat inprevention. Adminishtraion (SoPA) has collaboration with the SRS

prepared a draft manual and ACU) conducts specializedcurriculum for training public workshops on conflict of interestsector employees in conflict of for (i) Parliamentarians; (ii)interest. Ministers; (iii) State Secretaries

and Deputy State Secretaries;The SoPA has trained its (iv) SRS staff; (v) judges, andinstructors to teach conflict of (vi) other important groups.interest. The SoPA will train allnew public officials in conflict of The School of Publicinterest. Administration trains all new

public and existing publicThe CPC Secretariat has officials in conflict of interest;conducted a workshop with: (i) conflict of interest trainingjudges; (ii) prosecutors; and (iii) continues to be mandatory for allpolice on enforcement of the new public officials.Law on Corruption Prevention.

The CPB (or SPC Secretariat)The CPC Secretariat has continues to provide civicprovided civic education on education on corruption

.___________________________ corruption prevention. prevention.Issue: Within the current system Law on "Political Party New disclosure forms are used Disclosure and accountability ofof political party finance, no Financing" has been adopted, which require more detailed political party finances have beenclear authority or responsibility which stipulates: (i) more information on the revenues and improved and made available tofor checking the submissions of precise disclosure procedures to expenditures of political parties. the public.political parties is established. report on election campaignNor do the submissions contain expenditures; (ii) assignment of The unit responsible forall needed information or does monitoring political party reviewing the accuracy andthe Government have the finances to independent body completeness of financialinstitutional capability to disclosures adopts and publishesevaluate and analyze the procedures for auditing thesubmissions. disclosures.

The disclosures of politicalparties are published on a timelybasis.

Small grants are provided to (IQqualified NGOs to monitor 4 t

political party financing. CD

Issue: Despite the introduction The Minister of Justice has MoJ has adopted a Medium term Satisfactory progress in the The judicial system operatesof an initial set ofjudicial issued an instruction to provide strategic action plan for the implementation of the medium- more efficiently and effectively,

lBenchmarks in bold and italic in column PSAL 1, March 2000, were loan conditions included in the loan agreement of PSAL 1. Benchmarks in bold and italic in column PSAL11, August 2002, are loan conditions that are included in the loan agreement of PSAL 11. Benchmarks for PSAL 111, Fall 2003, are indicative; those in bold and italic are triggers.

institutions among the most and litigants in criminal and civil increase efficiency, (ii) to example by: Public confidence in thecorrupt and inefficient public cases, specifically requiring: (i) strengthen inc-entives, (iii) judiciary is increased.institutions in the country. all opposing parties to be guarantee indcpendence, (iv) (i0) Publication on a semiannualAdditional reformns are needed to represented in any contacts with enhance transparency and basis of agreed performancereduce both corruption and the judges (reform of ex-parte openness, and (v) collect indicators by" the Ministry ofperception of corruption in the contact) and (ii) if all parties feedback from the public Justice, for example, on publicJudiciary. cannot be represented then the confidence in the judiciary; and

communications to be recorded; The Ministry of Justice hasfurther a system for monitoring published, on an annual basis, (ii) Implementation of a time-implementation of this procedure statistics on changes in its bound action plan by theis designed. performance. Ministry of Justicefor

strengthening its monitoring ofMinister of Justice has issued an MoJ has conducted a review of commercial cases,instruction mandating an element its system for monitoring the administrative cases, andpublicof randomization in assignment performance of courts and confidence in thejudiciary.of judges to handle court cases judges, with an aim to strengthenwhere appropriate; a system for its monitoring of (i) commercial Dissemination of the medium-monitoring implementation of cases; (ii) administrative cases; term strategy for judicial reformthis procedure is designed. (iii) public confidence in the to the public

judiciary; it has discussed theThe Minister of Justice has review's recommendations in a The Ministry of Justice begins toissued an instruction, which workshop that includes the implement its action plan forrequires all court decisions and participation ofjudges; a draft integrating justice informnationrulings to be published with a instrument for monitoring public systems.system of cumulative indexing. confidence has been prepared.The publications are stored The Ministry of Justice haselectronically and are available The Ministry of Justice has prepared a time-bound plan for:to the public at low cost in those prepared a time-bound plan for (i) integrating the informationcourts that are computerized. integrating information systems systems of the procuracy and

of lower courts and Supreme courts and (ii) addingThe Minister of Justice has Court information about courtissued an instruction providing execution into this system.for (i) training ofjudges and All renovated or new courtprosecutors in new laws prior to buildings meet the demands of All renovated or new courttheir enactment; (ii) appropriate ex-parte communication reforms. buildings meet the demands ofbudget allocation to the Judicial ex-parte communication reforms.Training Center to comply with An appropriate system ofthe requirement referred to cumulative indexing has been All court decisions and rulingsabove. The Judicial Training developed for criminal cases. are available electronically atCenter prepares a three-year low cost. Qtraining plan.

An appropriate system of CD

cumulative indexing has been_____________________________ ______________________________ _________________________ developed for civil cases.developed for civil cases.

'Benchmarks in bold and italic in column PSAL 1, March 2000, were loan conditions included in the loan agreement of PSAL 1. Benchmarks in bold and italic in column PSAL11, August 2002, are loan conditions that are included in the loan agreement of PSAL 11. Bench;aarks for PSAL 111, Fall 2003, are indicative; those in boldand italic are triggers.

_i i_l_=E20

B.2* OBJECTIVE: STRENGTHEN TRANSPARENCY AND REPORTING OF THE MINISTRIES AND BODIES SUBORDINATED, SUPERVISED OR-MANAGED BY THEM -

Issue: There is no clearly The Cabinet of Ministers has The Salema has adopted the Satisfactory implementation of Institutional Framework ofdefined institutional framework adopted concept for the Law On Law "On the Framework of the Administrative Procedure public administration is wellof public administration, or the Institutional Framework for Publc Administration Law, as measuredfor example defined with clearly statedlegislative framework for Public Administration, which by publcation, on an annual accountability mechanisms andoperations of public agencies. defines the kinds of public The Saiema has adopted the basis, of a statistical report on financial and policy reportingThe latter has lead to an ad-hoc institutions within the public "Law on Public Sector appeals and users' satisfaction requirements for various types ofcreation of agencies without sector. Agencies". with the procedures; and public institutions, which leadsadequate legal basis and to improvements in theiraccountability mechanisms. The Law on the Institutional The Borrower, through its All agencies have been reviewed financial performance andwork has been commenced to Frameworkfor Public Cabinet of Ministers has and the Cabinet makes decision program performance indicators.prepare conceptual issues for the Administration has been adopted a regulation on their status.govemment on: (i) structure of submitted to Saeima. identifying: (a) criteria for thethe public administration and (ii) role and responsibilities of each At least 25 existing non-profitexecutive agencies. Concept for the Law On Public public agency; (b) the state enterprises are converted

Sector Agencies has been mechanism through which a into agencies to make themadopted by the Cabinet of public agency can be created; consistent with the Law onMinisters, which defines: (i) and (c) criteria on which to Public Sector Agencies whichtypes of agencies; (ii) regulations decide which agencies to divest, defines a transparent,for the formation of agencies of accountable, andfinancialvarious types; (iii) procedure for The Cabinet of Ministers has management regimefor allagency approval; (iv) procedure agreed on a list of public sector public sector agencies.to ensure openness; (v) organizations that will bemechanisms for accounting reviewed according to the law onmechanisms and financial Public Sector Agencies.control, including requirementsfor reports; (vi) adequateprovisions for transitions; and(vii) state liability conditions.

Law on Public Sector Agencieshas been submitted to Saeima.

Cabinet of Ministers hasadopted measure to impose aMoratorium on the creation onagencies till Saeima passes Lawon Public Sector Agencies.

Issue: Law on Openness of Cabinet of Minister has adopted The Borrower through its A time-bound action Plan is Easy and simple access toInformation and regulations has implementing regulationsfor Ministry of Justice has assigned adopted which: (i) establishes govemment documents isbeen passed. However, the Law on Openness of the task to provide guidance and capacity in public-sector bodies ensured through effective OQimplementation of the law is Information, stipulating (i) coordinate the implementation to respond to public requests for operation of the Law onweak because of lack of: institutional arrangements for of the Petitions Act and the Law information; (ii) report on Openness of Information. 0 D(i) weak capacity of ministries to ensuring easy access to public on Openness of Information to compliance with the law; andrespond to public requests infomnation, including the data inspection unit. (iii) educate public on .__ _ _

Benchmarks in bold and italic in column PSAL 1, March 2000, were loan conditions included in the loan agreement of PSAL 1. Benchmarks in bold and italic in column PSAL11, August 2002, are loan conditions that are included in the loan agreement of PSAL 11. Benchmarks for PSAL III, Fall 2003, are indicative; those in bold and italic are triggers.

theF aslllual IsFrulu:s vzannual reports ofstn poubectso.bodies; (ii) mechanisms forindividuals to appeal denials of Significant progress ininformation; and (iii) a system implementation of action plan isfor monitoring the compliance of achieved in all Ministries.state bodies with the law. Secretariat of MoPSR has

submitted to the CoMregulations on the structure ofannual reports of public sectorbodies; regulations are adoptedby the CoM.

Annual reports of public-sectorbodies include informnation on:(i) rights of public toinfortnation; (ii) procedures forpublic to access information; (iii)measures of fulfillment of publicrequests for infornation;inclusion of this information inthe annual reports isinstitutionalized.

Issue: 'Me Cabinet of Ministers Surveys are conducted by LDA The Secretariat of the MoPSR All public institutions provideadopted an instruction on Annual and reports published on private monitors the publication of reports on their performance toPublic Reports. The ministries sector and public's opinion on annual reports by public sector the public.prepared and circulated the very the performance of various bodies; MoF monitors financialfirst public annual reports in institutions. reporting requirements.1999; in year 2000 all publicinstitutions including regulators All regulatory bodies haveand inspectorates must prepare implemented reportingthe annual report. Reporting requirements which are postedrequirements must be clear and on the intemet.useful for public for all kinds ofpublic entities. .Issue: The current The Saiema has adopted the Action plan to bring all public Effective operation of the newAdministrative Procedure Law Administrative Procedure Law sector institutions into Administrative Procedure Lawdoes not meet requirements of a (APL), which protects the compliance with this law is provides a fair framework fordemocratic state. A new draft individual's right to appeal adopted. relations between a citizen andAdministrative Procedure Law is decisions of the state; this law the state.in the Saeima. The Cabinet of defines: (i) the procedure for Progress is made inMinisters has postponed the appealing administrative implementing this action plan. aw reviewing of this draft until decisions to decision making o__

Benchmarks in bold and italic in column PSAL 1, March 2000, were loan conditions included in the loan agreement of PSAL 1. Benchmarks in bold and italic in column PSAL11, August 2002, are loan conditions that are included in the loan agreement of PSAL 11. Benchmarks for PSAL 111, Fall 2003, are indicative; those in bold and italic are triggers.

adoption Law of the Institutional institutions; (ii) the procedure for A system for monitoringFramework of Public appealing administrative compliance with the APL law isAdministration. decisions to the Judiciary; and designed; this system will

(iii) adequate enforcement of include publication, on an annualdecisions taken during appeals basis, of a statistical report onprocess. appeals and users' satisfaction

with the procedures.The Borrower has adopted atime-bound planfor theimplementation of theAdministrative Procedure Lawand identified one staff in eachministry, which has beenassigned the responsibilityforimnplementing this law is that

Cl:: OBJECTIVE: STREAMLINE THE STRUCTURE OF THE PUBLIC SECTOR AND INCREASE ITS ADMINISTRATIVE EFFICIENCY AND TRANSPARENCYIssue: The Public Sector Reform The Secretariat of MoPSR has The CoM has adopted an The Secretariat of MoPSR Depth and scope of the publicprogram is substantial, prepared a program (blueprint) updated and revised Medium publishes in the official Gazette, sector reform process isdemanding, and will need to be with attached to it an action plan Term Public Sector Reform on a semiannual basis, progress increased.sustained over a period of years. to implement public Program, which includes clear in the implementation of itsGreater resources than are administration reform, which assignment of responsibilities reform program. Quality of public servicecurrently allocated will be includes: (i) clear assignment of and deadlines for the delivery is increased.required to coordinate and responsibilities for the design implementation of specificsupport implementation of the and coordination of the specific Public Sector reforms.reforms throughout the public elements of the reform program;administration structures, as well (ii) an allocation of staff and The CoM has established aas to monitor results. budgetary resources Public Sector Reform

commensurate with this Coordinating Council, to beassignment of responsibilities. supported by the Secretariat of

the MoPSR.The Secretariat of MoPSR hasdesigned a mechanism to The Borrower, through itsmonitor and report to the Cabinet Cabinet of Ministers hasof Ministers and public on adopted a time-bound actionchanges in public sector plan for the implementation ofmanagement performance. the Medium Term Public Sector

Reform Program in all lineministries.

Public Sector Reform o Coordinating Council has CDestablished a mechanism to I .

monitor and report on the

'Benchmarks in bold and italic in column PSAL 1, March 2000, were loan conditions included in the loan agreement of PSAL 1. Benchmarks in bold and italic in column PSAL11, August 2002, are loan conditions that are included in the loan agreement of PSAL 11. Benchmarks for PSAL 111, Fall 2003, are indicative; those in bold and italic are triggers.

_, -~ ';'.-*'^'t;'. ' s .BENCH tARKS 'I` M WTI _-Bt E_f rF O'E1 E f "P-S!i(Ul: 'l%fiireb'2000. ' ! 7,PSZL01I-.;AQUg -20002 PS, ifl "Fall -2603" o *

implementation of the MediumTerm Public Sector ReformProgram.

Secretariat of MoPSR monitors The Borrower through its 'Me CoM has adopted a time- The structure and functions ofIssue: The functions and the implementation of the action MoPSR has designed and bound plan by which remaining Govemment meet demands ofstructure of ministries do not plan of reorganization of the piloted a methodologyfor ministries will be subjected to a modem market economy and EUfully meet the demands of a Ministry of Agriculture to ensure conductingfundamental fundamental review and how the pre-accession.European market economy. To that the action plan meets the reviews which are to be used to review will be used thereafter.address this problem, BPAR need to: (i) integrate into the EU; support the 2003 budgetcommissioned development of a (ii) bring the Ministry into preparation in selected Implementation of the keymethodology for functional and conformity with future laws on ministries and shall inter alia, recommendations ofstructural reviews of ministries. the Institutional Framework for include: (a) a methodology to fundamental reviews hasThis methodology was used to Public Administration and on review and identify priority progressed without undue delay.conduct functional review of the Public Sector Agencies; (iii) policies and programs, and (b)Ministry of Agriculture early establish clear lines of a memorandum of1999; the recommendations of accountability and reporting; and understanding between thethe review were only partly (iv) strengthen systems for central agencies and the lineimplemented. Also, the measuring the substantive and ministries to be reviewedremaining ministries need to be financial performance of bodies regarding what will be donereviewed. managed by the ministry. with the results of the review

Secretariat of MoPSR has The Borrower has allocatedcompleted the interviews for the resources to support thein depth functional review of the fundamental reviews, and toMinistry of Economy. train at least three staff in the

fundamental reviewSecretariat of MoPSR has methodology.launched the in depth review ofthe functions of the Ministry ofJustice. . ._ . _.

C.2: OBJECTIVE: STRENGTHEN HUMAN RESOURCE MANAGEMENT BY IMPROVING INCENTIVES FOR RECRUITMENT AND RETENTION OF HIGH QUALITY STAFF

Issue: Currently the pay system Cabinet of Ministers has The Borrower, through its The Cabinet of Ministers has The comprehensive pay systemin the public sector is relies adopted the conceptfor a broad- Ministry of Finance has adopted regulation on pay for public sector begins toheavily on bonus payments and banded, transparent uniform prepared: (i) a draft regulation reform, including a detailed provide a fair, transparent andmanagement contracts. This pay scale in the public sector, on pay reform; and (ii) schedulefor its implementation equitable reward for the worksystem does not ensure a which rewards merit and estimates of the cost of its and actual implementation has ensuring retention of highlytransparent and equitable reward minimizes discretionary and ad implementation. The CoM has: started skilled personnel.for the work. A new and hoc bonuses and which includes: (a) reviewed the draft and costcomprehensive pay system for (i) job descriptions at a sufficient estimates; (b) accepted the draft The database on public sector The Government is able tothe entire public sector is needed level of dis-aggregation; (ii) in principle; and (c) adopted a employment, pay, and functions monitor and evaluate the impact goto improve motivation for highly criteria to be used in defining schedule requiring the MoF to is established, with regular of the pay system.qualified staff to work in public pay for specific public sector provide the CoM by October 8, procedures for updating the o_|

Benchmarks in bold and italic in column PSAL I, March 2000, were loan conditions included in the loan agreement of PSAL I. Benchmarks in bold and italic in column PSAL11, August 2002, are loan conditions that are included in the loan agreement of PSAL II. Benchmarks for PSAL 1II, Fall 2003, are indicative; those in bold and italic are triggers.

*., $ | J ENERMAR NC- HNN K;K,aBJE(TsiWlgtEl!! Ni311t;gZc.52000[lg -iSLliMAu2'0-02T--:4s-8 APSAeHIl-. Fal1-20031-"' ;-:.i 4FIT 1

institutions and to ensure wide jobs; (iii) levels of pay that 2002 detailed optionsfor the inforrnation.transparency and equitability. are competitive with the private phasing in of the pay reform.

sector for basic professions andcompetitive with a medium term Ministry of Finance hasbudget framework; (iv) census conducted a survey of theand methodology for a statistical existing pay structure.database on pay, employment,and functions in the public sector A workshop has been conductedto be used in planning and for state secretaries and deputycontrol of pay and staff state secretaries to discuss paydevelopment (see above); (v) concept.compatibility with Civil Servicedevelopment; and (vi) principlesfor transiting to the new system.

Ministry of Finance has designedthe methodology for a survey ofthe existing structure of pay, tobe used to design the new paysystem.

l Issue: A new Law on Civil The Cabinet of Ministers has Procedure for performance Performance reviews are A professional and loyal cadre ofService is needed to ensure submitted the Law on Civil reviews has been established. institutionalized. civil servants is developed,development of professional and Service to Saeima, which is which is able to provideloyal civil servants. The Cabinet harmonized with the reform of Training of managers in Yearly reports on the leadership in the efficientof Ministers adopted the Concept comprehensive public sector pay conducting performance reviews development of the Civil Service delivery of public services.On Civil Service Development in system and improving the system has been conducted. are institutionalized.1998. The draft law On Civil of incentives for public servantsService has been developed and through: (i) performance reviews First round of perfortnanceharmonized with administered by superiors, (ii) reviews has been completed.SIGMA/OECD, the World Bank performance of the servants in

conformity with ethic principles. The MoPSR Secretariat hasprepared and submittedsecondary legislation to theCabinet for implementation ofthe Civil Service Law by January

I _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ 2001 .C.3: IMPROVING PUBLIC EXPENDITURE MANAGEMENT

C.3.a:. Objective.: Develop'transparent and unlfled'public accounts

Issue: The budget is not 1. Comprehensiveness of the The budget is morecomprehensive. Resource budget. comprehensive by the inclusionmanagement outside of the of all budget-financed _budget promotes 1. 1. Bringing Budget Financed MoF has brought all BFIs in the institutions in the Annual Budget o mismanagement, fiscal Institutions (BFI) into the budget of 2002. Law.expansion and build-up of Budget.

Benchmarks in bold and italic in column PSAL 1, March 2000, were loan conditions included in the loan agreement of PSAL 1. Benchmarks in bold and italic in column PSAL11, August 2002, are loan conditions that are included in the loan agreement of PSAL II. Benchmarks for PSAL Ill, Fall 2003, are indicative; those in bold and italic are triggers.

contingent liabilities. Activities of public institutions

Saeima has passed amendments MoF ensures that new agencies are well defined and accountedto the Law on Budget and open accounts only with for, reducing opacity in resource

Financial Management Treasury management.(LBFM) bringing aU accountsof the BPI into the Budget,introducing a requirementforstate institutions to submitannual audited reports to theState Treasury as of 2001 andgives powers to the Ministry ofFinance to require and definereports on the operations of allsubordinate enterprises.

MoF has issued instructions toBFIs and commercial banks thatall accounts in commercial banksshould be transferred to theTreasury.

oo The Treasury has proof that BFI,corresponding to at least 30°/o ofstate budget, currently holdingaccounts in commercial banks,hold accounts exclusively withTreasury.

MoF has prepared principles forbudget 2001 preparation for allBFIs to be brought back intobudget, includingrevenue/expenditureclassification.

1.2. Establishing Central registerfor institutions under themanagement of ministries

Ministries and central publicCabinet of Ministers has adopted institutions submit financialregulation for the financial reports of business companiesreporting of agencies. managed by them to the State

Treasury in compliance with theprocedure set forth in the Cabinet o

of Ministers regulation Ill1.

Benchmarks in hold and italic in column PSAL 1, March 2000, were loan conditions included in the loan agreement of PSAL 1. Benchmarks in bold and italic in column PSAL

11, August 2002, are loan conditions that are included in the loan agreement of PSAL 11. Benchmarks for PSAL III, Fall 2003, are indicative; those in bold and italic are triggers.

QW 'uLMoF has agreed to submitmonitoring of financialindicators for the previousfinancial year to the Cabinet ofMinisters on an annual basis bySeptember 30.

2. Transparency of budget. Issues related to implementation Issues related to implementation(Issues related to moratorium on of the Public Sector Agency of the Public Sector Agencycreation of new agencies and Law: See B.2 Law: See B.2Public Sector Agency Law: SeeB.2)3. Fungibility of the budget. The Cabinet of Ministers has As part of the ministry ceiling

agreed to no new (i) earmarking setting process, the Cabinet ofof taxes and (ii) creation of own Ministers has identified therevenue for special budgets. policies and programs financed

by special budgets, which are tobe reviewed until next year'sceiling setting process.

Ministries submit their policyand programs reviews to CoM,and CoM uses the results insetting the budget priorities

._________________________ __________________________ statem ent for 2003.

C.3.b: Objective: strengthen accountability-for-the use of resources

2. Strengthening Financial The SAO has developed All Central Governments'External Audit function. methodology to estimate budget accounts are audited on a yearly

coverage of audit plan. basis.The State Audit Office (SAO)has prepared and adopted an The audit plan for 2001 Audit Reports are published.action plan to strengthen its encompasses an estimatedfunctioning as to provide full minimum 20 percent of basic andfinancial attestation audit. special budgets.

SAO has submitted a program of SAO has undertaken audit ofaudits for 2000 to the Parliament accounting/reporting standardsfor information. of the Central Budget

institutions' under SAO purview(based on FTI report). e

The action plan to strengthenState Audit functions onfinancial management has beenimplemented. n

Benchmarks in bold and italic in column PSAL 1, March 2000, were loan conditions included in the loan agreement of PSAL 1. Benchmarks in bold and italic in column PSAL11, August 2002, are loan conditions that are included in the loan agreement of PSAL 11. Benchmarks for PSAL 111, Fall 2003, are indicative; those in bold and italic are triggers.

7J~~4~~4j41 ~~~ ~~ ~. ~~ ~~ .. ~~... "-O.-CONEI'-A *'

~OBJE GTjVEJISSUgE T-, ',Y PSWAL: 1 a iRb 'O0O 0 PSALb-lOOOr; 1 ' ; , -1_; v .iBudget for extemal auditincreased to meet requirementsfor increase in number ofdeliverable outputs

Publication of the number of: (i)audit reports to Saeima; (ii)formal interpellations by Saiemato the Executive; (iii) correctivemeasures adopted; (iv) correctivemeasures taken.

3. Audit of BFIs The Government has agreed toexercise its right as owner of

Review of 1998 accounts and BFIs to require audits fromfinancial audit reports of budget- agencies. The Govemment alsofinanced institutions by extemal agrees on sanctions to be takenaccountants has started. against non-compliant BFIs.Conclusions of the report to besubmitted to Cabinet. MoF has reported to the CoM on

the compliance of all BFIs withregulations on financial

a) . statements.0 4. Strengthening the Internal MoF has presented an Annual MoF reports to Cabinet on

audit function compiled audit report to Cabinet. implementation of the annualcompiled reports'

Intemal audit strategic plan for 3 Cabinet of Ministers has recommendations.years has been adopted in MoF, discussed compiled reportsMinistries of Transport, submitted by MoF and Intemal All ministries perform intemalEnvironment and Agriculture Audit Council, and has taken a audit based on agreed plan adfocusing in particular on the decision on the report's corrective actions taken iffollowing audit functions: recommendations, has taken a necessary.systems and compliance audits. decision on follow up

mechanisms and will follow the Extension of peer review role byRealistic annual plans with implementation of decisions. the MoF to all ministries.monitorable outputs, e.g. # auditperformed, has been approved in Intemal audits as per 2000 Pilot intemal audit unitsabove line ministries. agreement in pilot ministries evaluated by Audit Council.

performed and corrective actionsProcedures have been prepared taken. Monitoring of actions byby the MoF for the follow up and the intemal audit department andmonitoring of compiled audits' regular reporting to Staterecommendations in above secretary.ministries.

Agreement on 2001 audit plan ° CDMinistry of Finance has for all ministries. )

developed methodology for peer

Benchmarks in bold and italic in column PSAL 1, March 2000, were loan conditions included in the loan agreement of PSAL 1. Benchmarks in bold and italic in column PSAL11, August 2002, are loan conditions that are included in the loan agreement of PSAL 11. Benchmarks for PSAL 111, Fall 2003, are indicative; those in bold and italic are triggers.

P. ': ~~~h. 0 i~~S MI:Au ug 02 ~ ~ ~ i i0 .review. Establishment of Audit Council

I with defined responsibilities.More heads of audit units havebeen appointed. Implementation of peer review

role by the MoF in pilotministries has continued.

5. Strengthen procurement Saeima has adopted the law on Strengthen the bid protest To provide leadership in themanagement public procurement mechanism and introduce improvement of the economy,

administrative review of bidders' efficiency and transparency ofSecondary regulations has been protest. the public procurement. System.brought more closely in line withinternationally recognized best Draft standard pre-qualificationpractice. and bidding documents for

goods, civil works and consultantAn autonomous Procurement services, including specificSupervision Bureau has been prohibitions against fraudulentestablished and corrupt activities

Introduce an administrativeprocedure for debarring firmsand individuals who engage infraudulent and corrupt activities

oo related to public procurement.C.3.c: Objective:;Development of performance-orientedibudgets In line ministries

Issue: Budgets are divorced 1. General Reforms The Borrower, through its Link between polices andfrom policies and performance. Minister of Finance has agreed to Cabinet of Ministers has issued resources established, and

organize a discussion with itsfirst annual budget priority commitment by line ministriesCabinet of Ministers on detailed statement, including: (a) an deliver on services.PEM reform measures under the overaUlfiscal strategy; (b)

budget priorities; and (c) Allocations reflect morecriteria for annual budget government's priorities.priority setting to be usedstarting with the budgetfor the Policies are increasingly binding.year 2003.

CoM has agreed to limit thesubmission of new policyinitiatives to the budget process.To support this process policyplanning guidelines have beendeveloped for policymaking,strategic planning, andsubmission of new initiatives tothe budget process.

2. Public Expenditure Reviews. I__

Benchmarks in bold and italic in column PSAL 1, March 2000, were loan conditions included in the loan agreement of PSAL 1. Benchmarks in bold and italic in column PSALIt, August 2002, are loan conditions that are included in the loan agreement of PSAL 11. Benchmarks for PSAL 111, Fall 2003, are indicative; those in bold and italic are triggers.

(PER) focusing on assessing (i) Expenditure Reviews to be responsibilities have beenallocations according to undertaken. assigned within MoF,priorities; (ii) efficiency and (iii) Chancellery and the lineeffectiveness of expenditure in ministries.Justice and Agriculture

Public Expenditure Reviewscompleted in those ministries asidentified with the expenditurereview program.

The CoM has adopted anexpenditure review program andresponsibilities have beenassigned within MoF,Chancellery and the lineministries.

3. Strategic planning A Memorandum of The Govemment issues theUnderstanding for the regulations for Strategicimplementation of the pilot with Planning.respect to strategic planning inthe Ministry of Agriculture has Pilot ministries preparedbeen developed and signed by strategic plans and annualthe Chancellery, MoF, MoAg. performance programs which are

used as the basis of their budgetDraft Guidelines have been request.developed for Strategic Planningand the Ministry of Agriculture The Govemment identifies ahas been selected to pilot these second group of ministries toguidelines. prepare strategic plans during

2002-2003.

Develop action plan forstrengthening evaluationfunction of MoF and pilot lineministries.,

C.3.d: 3Objective:. development:of almedium-term budget

Issue: The yearly focus of the The Cabinet has agreed to The 2002 Budget includes Cabinet of Ministers established Medium-term outlook forbudget does not allow focus on discuss (i) a draftfiscal strategy explanations of forecasting a Fiscal Policy Consultative Government fiscal operations C

policies and leads to instability in statement and (ii) medium-term assumptions and fiscal risks and Board to consider the medium induces more predictability.policies and unpredictability of macro/fiscalframework provides financing information term fiscal plan (MTFP) of theresources. submitted by the Ministry of together with an analysis of the MoF

Finance. sources of financing.

'Benchmarks in bold and italic in column PSAL 1, March 2000, were loan conditions included in the loan agreement of PSAL L. Benchmarks in bold and italic in column PSAL11, August 2002, are loan conditions that are included in the loan agreement of PSAL 11. Benchmarks for PSAL 111, Fall 2003, are indicative; those in bold and italic are triggers.

Fiscal framework is based on CoM has issued the methodologyaggregate deficit target and guidelines for medium termconstraints on financing basic budget planning.budget lifted.

CoM has issued the Mediumterm Fiscal Policy Statement.

Issue: The budget process is The Cabinet of Ministers has Revised Cabinet Regulation No. The Budget process is gearedopen-ended and disjointed; ; the decided that the Cabinet 160 adopted by Cabinet of towards transparency and policylack of output-based control by Regulation (#160) will be Ministers. choices.the central agencies invites amended to respect theunaccountable behavior and following principles: (i) aft newinefficiencies. policy proposals by line

ministries to Cabinet must beaccompanied by offsettingmeasures; and (ii) in orderforthe proposal to be submitted toCabinet of Ministers, fiscal costsof these proposals and offsettingmeasures must be prepared byline ministriesfor 3 years; (iii)and reviewed by MoFfortechnical accuracy of coss.

C.3.e::ObJective: Enhance Local AccountabilIty

Issue: Local accountability is MoF has commenced work to To allow for more stability and Prepare evaluation of the Provide information to centralnecessary for high-quality local develop improved financial predictability in the equalization financial management system govemment and local citizens.decisions and successful accounting and reporting mechanism, the MoF has and reports on the scope of thedecentralization. procedures for local reformed the system of training system (number of staff

govemments. expenditure needs calculation. trained per municipality).

Promote client surveys and Publish reports on localopinion polls and other forms of govemment financial situation.community feedback as inputinto budget and investmentdecisions.

'C.4: OBJECTIVE: IMPROVE TARGETING OF SOCIAL-ASSISTANCE AS A MEANS'OF, PREVENTING NEGATIVE CONSEQUENCES TO HOUSEHOLDS OF POVERTY BY IMPLEMENTING ANATIONAL SOCIAL SAFETY NET PROVIDING INCOME SUPPORT TOTHE LOWEST,INCOME HOUSEHOLDSIssue: The current social Cabinet of Ministers has The Saeima has completed its Satisfactory implementation of Social assistance system cost-assistance framework does not adopted concept paper with first reading of the new Law On the new social assistance effectively prevents poverty, andeffectively reach the poor in implementatdon plan, to Social services and Social system, as measuredfor supports inclusion of vulnerableLatvia; multiple financing implement a national means- Assistance, which providesfor example by the Saeima adopting groups.sources do not encourage tested social assistance beneft the nadonwide implementadon the Law on Social Services anndefficient use of resources (money targeted at the very poorest of national means tested social policy measures to: The client receives cost effectivedoes not follow the client). households. assistance benefit and improves social care services according to " x

the organization and (i) Improve the targeting of the her or his needs v cI Agreement has been reached that administration of the social neediest; and I

Benchmarks in bold and italic in column PSAL 1, March 2000, were loan conditions included in the loan agreement of PSAL 1. Benchmarks in bold and italic in column PSAL11, August 2002, are loan conditions that are included in the loan agreement of PSAL 11. Benchmarks for PSAL 111, Fall 2003, are indicative; those in bold and italic are triggers.

t, ' . ' .' 3 s-t 1 , BENCHNtARKS' X -. --{OBIECTIVEtISSUE'- E'-.:PSAL :11 larch 2000 A PSAL II: August 2002 .1 PSALtIII:WFall 2003 ' C' !TONiE

implementation begins in some assistance system.municipalities in 2000 after (ii) Strengthening the incentiveCabinet of Ministers has adopted and monitoring systems inthe concept. place.

An action plan for placinggatekeeping and referraldecisions and financingresponsibilities for social careand social assistance with onelevel of government has beenprepared and has been adoptedby CoM. Ministry of Welfareprepares analysis (based on theresults of the fitst six months) ofthe nationwide implementationof national means tested socialassistance benefit

co___

ID.1. OBJECTiVE: EMOVE MOST OP THE SIGNIFICANT REMAININGICOMMERCIAL STATE-FIRMS TO THE PRIVATE SECTOR TO PROMOTE OPEN MARKETS, RESTRUCTURING ANDINDUSTRIAL GROWTH WHILE FOSTERING THE DEVELOPMENT OF STABLE GOVERNANCE STRUCTURES AND ADHERING TO FUNDAMENTAL PRINCIPALS FOR ITS-REGULATORYINTERVENTIONS -

Regulatory Issue: The Cabinet of Ministers has Subsidiary legislation, needed Establishment of the basic Establishment of an effective,Government needs to commit to submitted the Law On Public for the Public Utiities elements of accounting well-focused, and flexible post-regulatory stability and should Services Regulators to the Commission to operate, has regulation. privatization govemancenot intervene in those areas were Saeima. been approved by the Cabinet of structure that serves the publicmarket forces are likely to bring Ministers. (i) Timely adoption by the interest, mimics the market to thegood results and the govemment The Cabinet of Ministers has Public UtUities Commission of maximum extent possible, andshould adhere to fundamental adopted concepts for the market The Borrower, through the gas, eledricity and stipulates a preference forprinciples by which it guides its structure in electricity and Public Utilities Commission telecommunications tariffs market-like policy solutions andinterventions. telecommunications as a basis Board, has adopted the Strategy according to transparent, detenninations.

for proceeding with of the Public Utilities published methodologiesprivatization/divestiture in these Commission ("Strategy andsectors and for reaching Basic Principles"), published it (ii) Adoption by the Publicagreement with existing in the official newspaper Utilities Commission of rulesinvestors in Lattelekom. Latvijas Vestnesis and the governing access to the

website www.sPrkrzovlv transmission grid in electricityand bottleneck networkfacilities

Interministerial working group is Inter-ministerial working group in telecommunications.developing an action plan for has elaborated and implemented (IQstrengthening the regulatory a technical assistance plan to The above-mentioned tariffs andframework and capacity in each enhance regulatory capacity. rules need to strike a proper 0sub-sector (energy, telecom, post balance between promotingand railway services) and for Agreement has been reached on competition and ensuring the

XBenchmarks in bold and italic in column PSAL 1, March 2000, were loan conditions included in the loan agreement of PSAL 1. Benchmarks in bold and italic in c6lumn PSAL11, August 2002, are loan conditions that are included in the loan agreement of PSAL 11. Benchmarks for PSAL IlI, Fall 2003, are indicative; those in bold and italic are triggers.

establishing, staffing and a proposal for the structure, financial viability in theorganizing the Public Services organization, and operational operation of bottleneck facilities;Regulatory Council in arrangement for a unified and, in the case of electricity,accordance with agreed sectoral regulatory agency. facilitate trade between the threepolicies and sectoral and multi- Baltic countries."sectoral laws (e.g. on Public The full five people CommissionServices Regulators and on Board was appointed in time totelecommunication submitted to start its operations on October 1,the Saeima and existing law on 2001 and an efficientenergy as amended if necessary). management structure andThe action plan includes the incentives have been preparedtransfer of the statutory for implementation.responsibilities of the The Commission has undertakenTelecommunications Tariff The Commission has reviewed a review of the skill mix of itsCouncil, the current regulatory and revised, as needed, the - staff, identified priorities for newfunctions of the Ministry of budget for the first year of staffing and developed aTransport and the energy operation. comprehensive training program.regulation board, as well as theregulators of postal and railway The Public Utilities Commissionservices to the Public Services has published its first Annual

00 Regulatory Council in a manner ReportLJ and on a timetable which ensuresthe most effective build up ofregulatory capacity.

Ministry of Economy (co-signedby Ministry of Transport) hasissued a decree establishing aninter-ministerial working groupto prepare an action plan for theestablishment of the multi-sectoral regulatory agency andfor strengthening the regulatoryregime in each sub-sector;electricity, gas,telecommunication, post andrailway services.

Privatization Issue Latvia must Cabinet of Ministers has The Borrower has in the case of Satisfactory implementation anduse best commercial practices decided to use reputed the privatization of LASCO, completion of the remaining(use of reputed international international 'investment made a public offering of 32 privatization agenda, asinvestment banks and legal banks/advisors'for divestiture percent of the sharesfor measured by the preparing andfirms) to privatize successfully of Government ownership privatization vouchers and sold offeringfor sale of Ventspilsthese important state companies Lattelekom, Latvenergo, 51 percent of the shares to Nafta (VN) and, as soon as °csuch that market prices are Ventspils Nafta, Latvijas Gaze strategic andfinancial investors litigation is over, theobtained. Regulation must be and Latvian Shipping if for cash through the Riga Stock government's shares in rput in place, where required, to necessary and as agreed with Exchange at a price approved Lattelekom.

Benchmarks in bold and italic in column PSAL 1, March 2000, were loan conditions included in the loan agreement of PSAL 1. Benchmarks in bold and italic in column PSAL11, August 2002, are loan conditions that are included in the loan agreement of PSAL II. Benchmarks for PSAL III, Fall 2003, are indicative; those in bold and italic are triggers.

s w=ze s.^.1NM* -~IC.S.:tv MO ar NIT VW Al r -- - V. 1N

protect the public interest and the World Bank by the Board of the Latvianencourage competition. Privatization Agency. The For each of VN and Lattelekom,

Ministry of Economy has balance of the shares will go to the government will use anprovided the World Bank with a employees and the State international investment bank,planfor when and for what Pension Fund by December 31, hired though internadonalpurpose to use internadonal 2002. competitive tender, and will'investment banks/advisors' and offerfor sale its shares in anhow these wiU be procured. The Borrower has submitted the open, competitive manner and

first regular report and at a fair price to theCabinet of Ministers has evaluation by the international government, the process to bedecided to ensure that the investment bankfor Ventspils attested toas fair, open andLatvian Privatization Agency Nafta to the Bank for review. competitive by the investmentwiU use best commercial bank.,practice as agreed with theWorld Bank (1) to procureinternational 'investmentbanks/advisors' if necessary andas agreed with the Bank and (2)to privatize/divest its interest inthefive enterprises.

Cabinet of Ministers hasapproved fundingforinternational 'investmentbanks/advisors' up to anamount of Lats 3millionfor LPAin the expenditure plan of thePrivadzation Fund. _

D.2: ENERGY SECTOR: REGULATION ANDPRIVATIZATION

Issue: Develop a Governance Cabinet of Ministers has CoM has decreased the criteria Energy Sector. In the electricity Establishment of a policy and

structure for the electricity approved and announced with for Qualified Customers from sector: regulatory framework and

supply industry and privatize the respect to Latvenergo to 100 GWh to 40 GWh. industry structure that isindustry. establish the Daugava Hydro (i) Reduction of the annual consistent with EU directives

Plants, Riga Combined Heat The Cabinet of Ministers has dectricity consumption and will continue to permit aand Power Plants, transmission approved a detailed threshold for Qualified smooth transition to liberalizedand (one or more) distribution restructuring program for Customers to 20 GWh; electricity supply industry and anunits as subsidiaries. In Latvenergo which meets the EU effective regulatory structure thataddition, the Government wiUl Directive 96/92/EC concerning (U)The Transmission System is consistent with the changingdivest 49% of its ownership in common rules for the internal Operator is licensed and technological characteristics ofthe Riga Combined Heat and market in electricity. operates as a fully independent the industry. oQPlants and privatize non-core entity with an independent _

business activities. Board of Directors.;The Ministry of Economy has

prepared a market model which (iii) The Government hasmeets EU Directives on market adopted electricity market model

Benchmarks in bold and italic in column PSAL 1, March 2000, were loan conditions included in the loan agreement of PSAL 1. Benchmarks in bold and italic in column PSAL

11, August 2002, are loan conditions that are included in the loan agreement of PSAL 11. Benchmarks for PSAL III, Fall 2003, are indicative; those in bold and italic are triggers.

= DMatjck l M I _ _2302nliberalization,for consideration and has revised Energyby the Government. legislation that will meet EU

Directivesfor electricity marketThe Borrower has established liberalization.the Transmission SystemOperator as a separate legal The Transmission Systementity with its own management, Operator will publish balancingstaff and separate accounts.

The Ministry of Economy hasprepared and submitted anamendment to the Energy Law toreplace the current double-tariffscheme for CHP plants, windand small hydros. Theamendmends have beenapproved by the Parliament. TheTransmission System Operatorhas published power systeminformation outlined in Chapter3 of the Grid Code.

co Issue: Develop a well The Cabinet of Ministers has Adjust the accounts of vertically Establishment of a policy and-1 functioning Governance approved a concept with a time integrated company Latvijas regulatory framework that is

structure for the Gas sector and bound action plan of gas market Gaze in order to provide for consistent with EU directivesand privatize the industry. liberalization in line with EU higher degree of transparency and will continue to permit a

Gas Directive 98/30, dealing, in through separation of accounting smooth transition to liberalizedparticular, with third party systems for storage, gas supply industry and anaccess, and elaborating on gas transmission, distribution, and effective regulatory structure thatpricing methodologies that deal sales of natural gas, as well as is consistent with the changingwith separation of storage, separate non-core activities of technological characteristics oftransmission, distribution and Latvijas Gaze company. the industry.sales costs and tariffs

Establish third party access totransmission and distributionnetworks.

D3: TELECOMMUNICATIONS SEcToR:;REGULATioN AND PRIvATzATiON

Issue: The creation of a pro- Cabinet of ministers has Liberalization of infrastructure Complete tariff re-balancing. The development of a modemcompetitive regulatory submitted Tele-communications and establishment of competition telecommunications market thatframework for the law to Saeima after rules that are transparent and Establishment of methodology is responsive to consumer andtelecommunications sector that is amendments to the current draft non-discriminatory. for estimating costs that business needs and the (Iconsistent with the sector's to require an independent approximates the best practice requirements of the global rapidly changing technological regulator to be established by Establishment and publication of methods that are used in OECD information economy and o and economic characteristics and 2001 the latest, and to allow the procedures for deciding what countries. internet-based commerce and in - xwhere the Government privatizes telecommunications regulator to services to regulate which the govemment no longerits remaining shares in the sector be part of the Public Services I_I Definition of universal service has any significant ownership

Benchmarks in bold and italic in colunm PSAL 1, March 2000, were loan conditions included in the loan agreement of PSAL 1. Benchmarks in bold and italic in column PSAL11, August 2002, are loan conditions that are included in the loan agreement of PSAL 11. Benchmarks for PSAL III, Fall 2003, are indicative; those in bold and italic are triggers.

1__ -_______ _ _ | = -- MI I , ,j I_ _OJ|_ _ _ S3

by using best commercial Regulatory Council starting Medium-term regulatory agenda and the establishment of a interest or control, exceptpractices. 2001. in the telecommunications sector competitively neutral mechanism exercised by the independent

defined and work in the to support universal service regulator.The Cabinet of Ministers has following areas will have goals.provided LPA with a mandate to commenced: (a) generating anegotiate exclusivity agreement reasonable, realistic approach to Establishment of rules forand related issues with private price regulation, including the allocating the spectrum.investors in Lattelekom based on identification of cost, technicalthe concept for a competitive and other data, which themarket structure adopted (see regulated entities will bealso D. 1.). compelled to fumish,

determination of the cost ofcapital, depreciation, and otherneeded elements of regulatoryaccounts; (b) establishment ofan interconnection frameworkdefining the terms and conditionsof access to bottlenecktelecommunications facilities; (c)classification of services; and (e)development of a numberingplan.

Legislation approved defining:(i) the list of telecomnmunicationsservices to be regulated by theRegulatory Commission; (ii) aclear demarcation ofresponsibilities between the MoTand the Regulatory Commissionon issues related totelecommunications policy; and(iii) the rules for licensing.

D.4: OBJECTIVE: ACHIEVEMENT OFA UNIFORM APPROACH TO SUPERVISION OF-FINANCE-AND CAPITAL MARKETS AND STRENGTHENING-OF FINANCIAL SUPERVISION SYSTEM WITHPARTICULAR EMPHASIS ON NON-BRANK FINANCIAL INSTITUTIONS .

The current regulatory structure Cabinet of Ministers has Formal establishment of the Program in place for A robust and efficient financialdoes not fully accommodate the submitted the Law on Unified FCMC by July 1, 2001. strengthening supervision, regulatory regime that hasgrowth of non-bank financial Financial Supervision Agency especially for the NBFI's. adopted a seamless approach toinstitutions in Latvia. The to Saeina Appointment of the Council of financial supervision.Government is introducing a new the FCMC. Corruption vulnerability reviewlaw establishing an integrated Work has been initiated that is to completed.financial regulatory body. result in an action plan (i) for Organizational form for theHowever, there is a need to: strengthening supervision of FCMC established along The establishment of astrengthen the supervision of financial institutions like the functional lines. Consultative Council. ° 0non-bank financial institutions; pension funds, investment A Xensure that the new agency is companies, leasing firms and the Draft budget in place for the Establishment of a Memorandum

Benchmarks in bold and italic in column PSAL 1, March 2000, were loan conditions included in the loan agreement of PSAL 1. Benchmarks in bold and italic in column PSAL11, August 2002, are loan conditions that are included in the loan agreement of PSAL H. Benchmarks for PSAL 111, Fall 2003, are indicative; those in bold and italic are triggers.

independent, and; that its securities market; (ii) for the FCMC. of Understanding between theformation does not undermine structure, organization, and FCMC on the one hand and thethe credibility of banking operational arrangement for a Agreement on a training program BOL and (MoF) on the other.supervision. unified regulatory agency; and with the Swedish FSA, to be

(iii) that set out the change established by June 30 by I)management program covering Letter from FCMC to Swedishthe arrangements of transition FSA and 2) joint letter fromfrom the current regulatory FCMC & Swedish FSA to SIDAstructure to the new unified for a two phase program 1)regulatory agency, including matching of people an needsdevelopment of communication identification during summerstrategy. 2001 and 2) follow-up with

specific training in areasidentified during 2001-2003

WB assisted training program forcorporate govemance forinsurance industry, insiderregister and intemet trading ofsecurities concluded by June 30,

oo 2001 .'VO *D.5: OBJECTIvE: STRENGTHEN LEGAL AND REGULATORYPROCESS, TO ENSURE MORE EFFICIENT REGULATION AND REDUCE THE COSTS TO THE PUBLIC SECTORCREATED BYABUSE OF REGULATORY POWER. -

Issue: Neither the Ministry of MoJ has completed a draft The Borrower, through its All line ministries implement Laws and regulations will goFinance nor the Ministry of manualfor drafting laws and Cabinet of Ministers, has adequate regulatory impact through a thorough assessmentJustice has been able to establish regulations based on good approved methodologyfor legal assessment procedures. before being adopted; as aa rigorous process for evaluating legislative techniques. and regulatory impact analysis. consequence they will be moreregulatory proposals; various A computerized database effectively implemented.national programs have not The Ministry of Justice has MoJ trains staff of other agencies containing all normative acts,succeeded in coordinating the created a special unit to in the application of the drafting with appropriate indexing, is Public participation in legaldevelopment of new regulations, implement a unified system for manual. produced. drafting is increased.or in ensuring consistency in the drafting laws and regulations,regulations across sectors, or with the capacity to train MoJ evaluates draft laws andeven within the same sector. officials in other ministries in regulations based on itsThis has resulted in the adoption drafting techniques. standards described in itsof regulations that are difficult or drafting manual.costly to implement. MoJ has created a

comprehensive definition of Government staff is trained in"normative acts" and ensures legal and regulatory impactthat all draft normnative acts are assessment. Isubmitted to it prior to adoption.

m

The Ministry of Finance has iprepared a draft manual for ° xassessing the budgetaryconsequences of draft laws and

Benchmarks in bold and italic in column PSAL 1, March 2000, were loan conditions included in the loan agreement of PSAL 1. Benchmarks in bold and italic in column PSAL11, August 2002, are loan conditions that are included in the loan agreement of PSAL 11. Benchmarks for PSAL 111, Fall 2003, are indicative; those in bold and italic are triggers.

Administration has developed a. ~~~~~~~~training program in impact

analysis.Issue: State inspectorates that Secretariat of MoPSR has MoF and Secretariat of MoPSR Secretariat of MoPSR designs Inspection process will be clear

enforce regulations have made drafted and Cabinet has adopted draft new procedures for the the structure and evaluation and accountable; inspected

little effort to create clarity and instructions (including internal collection of fines eliminating criteria of the annual reporting bodies will have a larger voice

consistency in their enforcement regulations and guidelinesfor payment through personal requirements for inspectorates regarding the mechanics of

procedures. Lack of transparency inspections) for inspections, contact, and requiring fine and discusses these with process.

and accountability in inspections which include: (i) rulesfor payment only through bank inspectorates.

procedures creates excessive ensuring transparency of transfer. Implementation of laws and

costs for Government and inspection procedures; (ii) rules Performance measures and regulations is monitored to

business. In addition, the for documenting violations; (iii) New rules and procedures in reporting requirements are determine whether their impact

Govemment currently does not separation of inspectionsfrom conformity with inspection implemented in all inspectorates. is as envisioned.

employ effective reporting collection of fnes; (iii) appeal guidelines are implemented in

requirements for regulatory procedures; and (iv) the all inspectorates by Experience with implementation

bodies. Annual reporting arrangementsfor ensuring September 2000. of new rules and procedures in

requirement for all state bodies feedback from inspected bodies. all inspecting agencies is

have recently been adopted but The School of Public reviewed.

instructions on requirements for A horizontal coordination Administration trains inspection

content of reports have not been council for inspectorates with personnel in (i) the application of Feedback from inspected bodies

sufficiently clear or thorough, rotating presidency has been set new rules and procedures; (ii) is used in the performance

substantially decreasing the up to steer the implementation effective treatment of clients; evaluations of inspectors and

quality and usefulness of the the reform of inspections. (iii) conflict resolution; and (iv) inspectorates.

reports. Procedures for utilizing performance management.

the reports in evaluation of Workshop on inspections reform Satisfactory action on reported

performance of regulatory bodies has been conducted. cases of corruption in inspections

are absent. is taken.

Two inspectorates have beenselected to pilot new inspections Performance measures are

guidelines. defined for 50% of theinspectorates.

A training program forinspectorates has been prepared, Adjusted reporting requirements

which focuses on: (i) application are implemented in 50% of the

of new rules and procedures; (ii) inspectorates.effective treatment of clients;(iii) conflict resolution; and (iv) Annual reports of inspectorates

performance measurement. for 2002 take into account new wrequirements for structure of

annual reports.Issue: Regulatory coordination Workshop on regulatory reform Reports are published Time for processing permits is Granting of construction permits o C

is especially problematic in the has been conducted. summarizing feedback from real reduced. operates smoothly and

area of construction, which estate developers, architects and efficiently.

1 Benchmarks in bold and italic in column PSAL 1, March 2000, were loan conditions included in the loan agreement of PSAL I. Benchmarks in bold and italic in column PSAL

11, August 2002, are loan conditions that are included in the loan agreement of PSAL 11. Benchmarks-for PSAL 111, Fall 2003, are indicative; those in bold and italic are triggers.

R-EjT;E2!.-SI lE3I _P-SRTM!Ql Wi-Irch20001M jl PSI'AL'LDllBuFustw2002Bf>'. S0LiIISFl1203tjF+P O, T C0lEinvolves several different LDA has developed building contractors on: (i) Feedback from regulated bodiesregulatory bodies. recommendations on efficiency of permit process; (ii) is used in evaluating Participatory approach is used to

management, use and design of prevalence of corruption; (iii) performance of regulators and strramline permit process.Working Group already transparent regulations, appeals, understanding of their rights and organizations.established to prepare public participation, regulatory responsibilities.recommendations by October 1, control over natural monopolies, Consultative mechanisms are1999 for reform of regulation of infrastructure finance, and policy Municipal Board disseminates used in other areas where permitsconstruction. on historic structures and information on new regulations are required.

districts. and procedural practices

'Benchmarks in bold and itulic in column PSAL I, March 2000, were loan conditions included in the loan agreement of PSAL 1. Benchmarks in bold and italic in column PSAL11, August 2002, are loan conditions that are included in the loan agreement of PSAL 11. Benchmarks for PSAL 111, Fall 2003, are indicative; those in bold and italic are triggers.

- _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ =._ ._ =_____.__:___ ______,U__

- Actual . Eslimated . - ProjecteWndicAtive scexario 1999 20m.m 20=4 200

Total debS ous an 2657 adisbursed (TDO) (ill. U$-^) 2657 3I186 4070 439, 4837 5724 6359

Net Disbursemcts' (mill. -US$) 266 -24 -.36 213 260 346 362

Total debt service ;TX)(mnilll. USs) . . . 283 265 Ra81 183 215 428 357

DeDo nlni~ debt stevle minc1it4s (%)}..r ',

. DO/XGS .86.4 $6.5 11,7.9 118.0 11,8.4 128.5 . 30 .9TDO/&DP 39.9 44.6 53.9 53.8 54.3 58.8 59.9: S/Xfl CiS . - 9.2 7.i 5.2 . 4.? ; 5.3 9.6 7.3

J1BiRD expes1i indioa ors (e/%..)JlRD DS/publicdebtsseviee 21.7 16.9 292 31.6 29.0 -1.3 '13.9

- Preenrred creditor DSfpublic-de"b service 58.6 68.8 7{X8 74,7 67.0 82.4 23.5-IBRDDS/XGS - . 0.6 0.5 0.2 0.5 0.5 0.7 . 0,8Share of IBRD portfolio 0.1 0.1 0.1 0.1 01

Operaims PWofIW1 (IRDnDA and Gmnts

AS Of 0M. 01002aosd PrqeS 11

T.W DO d (A) 2OD.1 Mh h- b- r. 0 05

TOW D0o,d (COsd) 27 46cr Wh rzn rwfP 365cs

T.W Obo..0 (Adk- * ) 30848ad ~ hO f - pW8 3807

ToW U.1SoW (AdWO) 2573TotW UnAd-d (G.W) &00T.W U.M,ud (AdS k-d) 28.73

.~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~~~~~~~~~~~~~~bc . _Ae Fc

D haec nswwm FSA, _d Tnd MCd

SVPWraWWo Rating bkdna AocurM In US$8 MM81)anumi

Prs ID p N8rilohnT P Fbd Ya IBRD IDA GRANT ancei. Uadsb. OrId Fn RaVdP049172 EDUC IMPROVMT S KS 1999 311 568219 -68P058520 HEALTH S S 1999 12 4 537948 8P074410 HOUSING UL S S 2002 2 03 2 03P06S476 UEPAJASW MGUT S S 2001 222 Z188671 0-8 0317638P040663 SOUD WASTE MGMT S S 1998 7 98 4.0356878 3.4 0 136678P045718 SJD WASTE MGMT(GES 1998 612 0987999 1 1P056858 STATE REVENUE SERVIC S S 1999 5 2.14307 2.9 0034277w P0368O7 WELFARE REFORM S S 1997 181 6.247844 7.6Osi nral Resul 784 512 2871743 152 0467492

a SUanod _ cklrigtto datonus aBWMdsbuS I tlUtodots a rpqiBdatPpz

Statement of IFC'sHeld and Disbursed Portfolio

As of 6/30/2002(In US Dollars Millions)

Held Disbursed

FY Approvw Company Loan Equity Quasi Partic Loan Equity Quasi Partic2001 LinstowVai 17 0 8 35 0 0 0 0

Total Portfolio: 17 0 8 35 0 0 0 0

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Report No.: P 7556 LVType: PR