Page  1
100
105
110
115
120
125
130
135
9
8
m
7
9
9
m
1
9
9
m
7
0
0
m
1
0
0
m
7
0
1
m
1
0
1
m
7
0
2
m
1
0
2
m
7
0
3
m
1
0
3
m
7
0
4
m
1
0
4
m
7
source: NB P, CSO
40
45
50
55
60
65
70
75
80
corporate deposits (bn real 2004 PLN)
corporate credit (bn real 2004 PLN)
 
World Bank EU-8 
Quarterly Economic Report 
January 2005
1
Part II
 
EU-8
POLAND 
 
Political update 
PM Belka obtained a confidence vote from parliament in October bringing needed stability onto 
Poland’s political scene. The government has been able, although with difficulties, to secure 
parliamentary majority for important issues, including the 2005 budget. The government should 
work relatively undisturbed until the next elections, expected in mid-2005, while political 
parties will be preparing their campaigns. 
On the left side of the political scene reshuffles are likely, reflecting an effort to form a 
unified election block, while center and right wing parties will try to defend their current 
holdings of popular political support. Political preferences will likely be shaped by two major 
factors: the improving economic conditions and the unfolding case before the parliamentary 
investigative commission on the privatization of the Polish oil sector. 
The government in January submitted its draft National Development Plan for consultations. 
The plan will be finalized by the new government after elections and eventually form the basis 
for use of EU structural funds during 2007-13. 
Macroeconomic developments 
Output growth decelerated in the second half of 2004 as domestic demand growth slowed
.
Private consumption and fixed investment growth slowed to 3% and 4.7% yoy, respectively, in 
the third quarter. A more sustained recovery in investment is still pending despite capacity 
utilization at the highest level ever (most recent estimates put it at 80.7% against a low of 73.3 
in the first quarter of 2002) and high corporate profits and liquidity. Corporations should have 
enough resources and credit potential to sustain at least 10-15% fixed investment growth for 
the next couple of years. However, investors appear to be awaiting further stabilization of the 
business and political environment. 
 
1
This report is based on information available through end-December, 2004. 
GDP and its components
growth, %y/y
-15
-10
-5
0
5
10
0
1
q
1
0
1
q
2
0
1
q
3
0
1
q
4
0
2
q
1
0
2
q
2
0
2
q
3
0
2
q
4
0
3
q
1
0
3
q
2
0
3
q
3
0
3
q
4
0
4
q
1
0
4
q
2
0
4
q
3
source: CSO
GDP
Fixed investment
Industry
 
32591 
v3
Page  2
PLN/EUR
3.0
3.2
3.4
3.6
3.8
4.0
4.2
4.4
4.6
4.8
9
9
m
1
9
9
m
5
9
9
m
9
0
0
m
1
0
0
m
5
0
0
m
9
0
1
m
1
0
1
m
5
0
1
m
9
0
2
m
1
0
2
m
5
0
2
m
9
0
3
m
1
0
3
m
5
0
3
m
9
0
4
m
1
0
4
m
5
0
4
m
9
source: NB P, CSO
nominal
inflation differential adjusted (NEER)
Poland, tax revenue performance,
%
of GDP
0%
2%
4%
6%
8%
10%
12%
14%
16%
I
II
III
IV
V
VI
VII
VIII
IX
X
XI
XII
source: CSO, MoF
2002
2003
2004
Unemployment is slowly coming down
,
visibly diverging from the pattern of the past two 
years. With the unemployment rate at 18-19%, estimates of structural unemployment of at 
least 10% and a natural rate possibly between 4-5%, the reservoir of a available labor could 
possibly have shrunk to as low as 3-4% of the labor force. 
Poland, registered unemployment
18.0
18.5
19.0
19.5
20.0
20.5
I
II
III
IV
V
VI
VII VIII
IX
X
XI
XII
source: CSO
2002
2003
2004
 
The recent sharp appreciation of the zloty helped stabilize inflation
 with no need for further 
interest rate hikes in the last quarter of the year. CPI inflation stabilized at 4.5% yoy toward 
the end of 2004, and should decline to below 3% in the second half of 2005. The appreciation of 
the zloty reflects stronger fundamentals and represents a change from very favorable to 
neutral conditions as the rate is now around the average of previous years. Wage growth 
remains slow at around 3% yoy, and export growth and the current account balance remain 
strong. 
 
Fiscal performance in 2004 was better than budgeted on the back of strong revenues
.
The 
deficit is estimated to have undershot by 4 bn PLN. Revenues evolved more or less in line with 
stronger than expected output growth, while expenditures were held at budgeted levels. 
Nevertheless, the expansionary 2004 budget raised the deficit by 1.5% of GDP compared to the 
year before. The budget for 2005 initiates a much needed fiscal consolidation process, with the 
fiscal deficit targeted to decline by nearly 2% of GDP. 
The good macroeconomic performance allowed Poland to place 3bn in Euro-denominated bonds 
in January 2005 with a maturity of 15 years and a spread of 27 bps. Poland plans to use the 
proceeds for early repayment of more expensive Paris-Club debt. 
Reform efforts 
Page  3
Approval of further elements of the Hausner plan stalled in the last quarter of 2004. Most 
importantly, the reform of the farmers’ pension system (KRUS) remains on the agenda. Also, 
plans to unify the VAT have apparently been put on hold. KRUS reform means higher social 
security contribution for farmers, and VAT rate unification means higher food prices, both 
highly sensitive political issues.  
Table II. 1. Performance of Hauser program (general government expenditures and 
revenues, % of GDP) 
Source: Convergence program, November 2004 
At the same time, privatization efforts received a boost with the sale of a minority share in the 
largest state-owned bank (PKO) in November 2004 and the planned sale of the state insurance 
company PZU in 2005. 
World Bank activities  
The World Bank has been discussing a Country Partnership Strategy for Poland for the period 
2005-2007, both with the government and other interested parties. It is also conducting an 
update of Accounting and Auditing as well as Corporate Governance Reports on Observance of 
Standards and Codes (ROSC). In its support for judicial reform in Poland, it has further initiated 
the analysis of contract and property rights enforcement. 
Support of the coal mining sector reform continues with progress at a slower pace than 
anticipated, in particular in terms of labor retrenchment and privatization, largely due to a 
buyout market and prices. Following a successful implementation of its support for GDDKiA’s 
road maintenance program in 2004, which saw an improvement of road in good condition from 
40% to 46%, a follow-up EUR100M operation to support the 2005 maintenance program is in 
final stages of preparation with final approval expected at the end of March. An USD11m GEF 
grant was also signed in November to stimulate market-based investment in energy efficiency 
improvements. 
2004
2005
2006
2007
S
avings in total expenditure
0.06
0.79
0.62
0.93
1. not requiring legisslative changes (reduction in 
a
dministrative costs)
0.01
0.05
0.07
0.07
2. requiring legislative changes
0.05
0.74
0.55
0.87
a) approved by the Parliament
0.00
0.60
0.39
0.67
changes in defining the level and in indexation 
of retirement and disability pensions
0.00
0.42
0.12
0.33
changes in the rules of financing national 
defence requirements
0.00
0.14
0.15
0.16
changes in the rules of granting pre-retirement 
benefits
0.00
0.05
0.12
0.18
b) in the legislative process
0.04
0.14
0.16
0.20
changes in the system supporting employment 
of the disabled
0.04
0.05
0.03
0.02
other
0.00
0.08
0.14
0.17
Total additional revenues
0.07
0.71
0.76
0.75
1. not requiring legisslative changes:
0.00
0.40
0.39
0.38
a) restructuring of Polish State Railways
0.00
0.04
0.04
0.04
b) broadenning of the tax base
0.00
0.35
0.35
0.34
2. requiring legislative changes:
0.07
0.31
0.37
0.36
a) approved by the Parliament
0.07
0.04
0.04
0.04
restructuring of the hard coal mining
0.07
0.04
0.04
0.04
b) in the legislative process
0.00
0.27
0.33
0.33
additional actions
0.00
0.17
0.17
0.17
changes in the pension system for farmers 
including, inter alia, modified rules of social 
contribution payments by farmers
0.00
0.10
0.10
0.10
other
0.00
0.00
0.06
0.05
Page  4
HUNGARY  
 
Political update 
Opinion polls showed an increase in the support level of the ruling Socialist Party after the new 
PM Gyurcsany took office. The polls indicate that the government coalition has roughly the same 
support as the main opposition party Fidesz. 
 
The Hungarian Parliament approved amendments to the Central Bank Law, which were prepared 
by the ruling coalition. According to the new law, the central bank's Monetary Council will be 
expanded to 13 by 2007, and the Prime Minister will have the right to nominate four persons to 
the rate-setting body. Based on an early version of the proposal, the European Central Bank had 
voiced concerns about what appeared to be an attack on the independence of the central bank 
and breach of the Acquis Communautaire, but the ECB seemed to accept the final somewhat 
modified version of the law. 
 
Macroeconomic developments 
Output growth slowed in the second half of 2004 mainly due to slower consumption and 
export growth
.
Output expanded by 3.7% in Q3-2004, down from 4.0% in Q2 2004 and with 
decelerating dynamics quarter by quarter during the year. Investment remains the key growth 
driver, up nearly 13% and contributing 3.25 pp to growth in Q3 (of which 3 pp gross fixed capital 
formation alone). A rebound of investments in machines and equipment supports future export 
growth. The sector breakdown of investment reveals strong expansion in transport, storage and 
communications as well as manufacturing investment (mainly electrical and optical equipment). 
Also, investments in construction retained its strong growth fuelled by the extensive motorway 
building program of the government. At the same time consumption growth slowed to less than 
3% yoy due to slowing real wage growth, reductions of government preference schemes on home 
loans and a drop in government expenditure. Net export performance 
disappointed again, with 
export growth decelerating significantly to 10% yoy in Q3 from 18-19% in H1.
 
Investment breakdown (%, y/y)
-40
-20
0
20
40
60
80
I
0
2
I
I
0
2
I
I
I
0
2
I
V
0
2
I
0
3
I
I
0
3
I
I
I
0
3
I
V
0
3
I
0
4
I
I
0
4
I
I
I
0
4
Manufacturing
Transport, storage and communications
Construction
Real estate, renting and business activities
Total Investment
 
The current account continues to be the weakest part of the economy
.
The CA deficit for the 
first nine-months of 2004 amounted to over 9% of GDP. While the trade gap shrank in Q3, the 
income and tourism balance deteriorated. At the same time, however, non-debt generating 
financing increased to 80% of the current account gap in the third quarter triggered by higher FDI 
inflows which reached 3.4% GDP in the first nine months of the year. External debt is on the rise, 
but the state’s share in it is increasing more slowly. A rough estimate of the debt stabilizing 
current account deficit is around 6% of GDP.  
 
Page  5
Inflation is slowing
.
After fluctuating just above 7% in the second quarter, CPI inflation fell to 
5.5% in December
.
Meanwhile, the “constant tax inflation rate” dropped to 3.5% and core inflation 
to 5.0%. Monetary easing continued. with further cuts in interest rates of 150bps in the last 
quarter (for a total of 300 bps in 2004).The decline in inflation reflects currency appreciation, 
slowing household consumption and wage growth, and tighter government spending.
 
Fiscal policy remains a key credibility issue
.
During 2004 the government revised upwards the 
fiscal target twice to 5.3% of GDP from an initial level of 3.8% of GDP (or 3.1% of GDP adjusting 
for the effect of pension reform). Even this higher fiscal target is estimated to have been met only 
through additional measures of around 1.8% of GDP in 2004 and arbitrary postponement of 
expenditures into 2005. This notwithstanding, expenditures (as a share of GDP) are estimated to 
overrun the budgeted level by nearly 2% of GDP, while revenues—despite greater than expected 
VAT losses after accession and greater uses of tax credits in PIT—will be higher than projected in 
the budget by 0.4% of GDP. On the positive side,  the fiscal position improved by roughly 1.2% of 
GDP in comparison to 2003, reflecting equally stronger revenues and lower expenditures (each 
by 0.5% of GDP). The budget for 2005 targets a further reduction in the deficit to 4.7% of GDP 
(3.8% of GDP adjusting for pension reform). Expenditure would be curtailed by 1.9% of GDP 
through more effective staff management within the public sector, a 5.5% nominal reduction in 
expenditure appropriations of central budgetary institutions, introduction of zero-base budgeting 
for chapter managed appropriations (0% growth in nominal terms), and implementation of 
infrastructure projects  under PPP schemes (both capital and current spending will decline by 1% 
of GDP). 
General goverment expenditure % GDP
0
2
4
6
8
10
12
14
16
2003
2004E
2005F
2006F
45
46
46
47
47
48
48
49
49
50
50
51
Public consumption
Social transfers other than in kind
Interest payments
Subsidies
Gross fixed capital formation
T otal expenditure (LHS)
source: CP , December 2004
 
-5
0
5
10
15
2
0
9
9
:
Q
1
9
9
:
Q
3
0
0
:
Q
1
0
0
:
Q
3
0
1
:
Q
1
0
1
:
Q
3
0
2
:
Q
1
0
2
:
Q
3
0
3
:
Q
1
0
3
:
Q
3
0
4
:
Q
1
0
4
:
Q
3
Household net savings (%GDP)
Household final consumption expenditure (y/y, %)
Net real wages (y/y, %)
0
20
4
0
6
0
80
100
120
140
1
60
M
a
r
-
9
6
M
a
r
-
9
7
M
a
r
-
9
8
M
a
r
-
9
9
M
a
r
-
0
0
M
a
r
-
0
1
M
a
r
-
0
2
M
a
r
-
0
3
M
a
r
-
0
4
Gross external debt (% GDP)
Government gross external debt (% GDP)
Gross external debt (% Eksport)
.
Page  6
Additional safeguards have been built into the 2005 budget, but risks remain
.
A
special 
reserve amounting to 0.5% of GDP has been created and new procedural safeguards will be 
introduced (e.g. imposing a ceiling on appropriation of normative subsidies for social and public 
education purposes, introduction of possibilities for blocking, reducing or canceling appropriations 
by government, introduction of obligation for maintaining balance for extra-budgetary funds, and 
stricter control on appropriations for pharmaceutical subsidies). By modifying the regulatory 
s
ystem the government intends to limit the risk of reallocation of appropriations to operational 
costs within the public administration. Despite these safeguards, there are risks that the deficit 
target will again be exceeded, on the basis of optimistic assumptions on GDP, consumption 
growth, the effect of tax changes, PPP schemes and the effectiveness of tightening measures 
that were introduced. Further planned tax cuts may also weaken revenues. 
 
Reform efforts 
Changes on the political scene and approaching elections have continued to hamper a 
greater push on the reform side
.
Nevertheless, some progress was made on privatization and 
fiscal management. On the other hand, there was little progress on other essential structural 
reforms, especially in health care and public administration. 
 
Some progress was made in advancing the remaining privatization agenda
.
Privatization 
revenues in 2004 amounted to 1.8% of GDP, the third highest annual revenue ever. The State 
Privatization and Holding Company placed bonds convertible into Richter shares for the 25% 
state owned stake in the pharmaceutical company and sold part of its stake in leading oil and gas 
company MOL.  
 
Some elements of fiscal reform were introduced
 and are planed for 2005. In 2004, the 
government adopted specific measures to enhance effective financial management of central 
budgetary institutions’ expenditures and introduced a zero-base planning system for chapter-
managed appropriations. For 2005, the government plans to implement new measures in order to 
strengthen fiscal discipline (e.g. tighter control on unused appropriations, financial processing 
during the year, and reduction in the number of automatically fulfilled expenditure appropriations).  
 
The government also plans a new labor program
.
Parliament started debating the latest 
proposal to help invigorate Hungary’s labor market, offering subsidies to employers that hire fresh 
graduates, mothers returning from maternity leave or unemployed over 50. The program offers 
special tax relief for employers who choose their staff from the specified groups. The government 
reimburses half of the employers’ social security payments on gross wages up to HUF 90,000 a 
month, which translates into a maximum of HUF 13,050 monthly savings per employee.  
 
In healthcare
,
limits were introduced for pharmaceutical subsidies, and system of risk allocation 
between producers and the government will be initiated. Further, performance volume limits were 
introduced to control expenditure on patient care. The government may submit its plans 
concerning the future of state-owned healthcare facilities to Parliament in the near future (a 
referendum to halt hospital privatization failed in December). 
 
Page  7
CZECH REPUBLIC
 
Political update 
T
he government seems to have shifted its emphasis to structural reforms due 
inter alia 
t
o
the perceived unpopularity of fiscal reforms proposed by the preceding government. 
Thus, recent efforts have concentrated on improving the business environment to attract 
FDI and active employment policy. Nevertheless, the ruling coalition fared poorly in 
regional and Senate elections in November, with the latter being won by the main 
opposition party Civic Democrats (ODS). 
 
Macroeconomic developments 
Output growth slowed in the third quarter of the year, and for 2004 is likely to be similar to 
2003
.
For the first nine months of the year, output growth amounted to 3.7% yoy, the 
same pace as in 2003. In Q3-2004, real GDP growth slowed to 3.6% yoy (from 4.0% in the 
previous quarter) as a result of weaker consumption (mainly government). Meanwhile, 
fixed-asset investment and exports remained strong (up by 10% yoy and 23% yoy, 
respectively, in Q3), and net exports for the first time since 2001 contributed positively to 
GDP growth. On the supply side, industry made the largest contribution to growth, but 
agriculture also grew rapidly. The robust growth of new export orders and vigorous 
growth of capital investment in manufacturing bode well for continued export-oriented 
growth.  
Contributions to GDP growth (%) 
-4.0
-3.0
-2.0
-1.0
0.0
1.0
2.0
3.0
4.0
5.0
6.0
Q1 03
Q2
Q3
Q4
Q1 04
Q2
Q3
Final Consumption Expenditure
Fixed
Change in Inventories
Net export
GDP
7
Inflation remained muted. 
CPI inflation slipped below 3% yoy in November, with underling 
inflation hovering around 2%. The strengthening crown and falling inflation have served 
to tighten monetary conditions thus postponing potential further interest rate hikes. Wage 
growth remains moderate under pressure from rising unemployment. Real wage growth 
in Q3 was running at around 4% yoy, with civil servant salaries the most buoyant.  Modest 
real wage growth should continue in 2005 year as the planned large increase in wages 
for the security forces was delayed and the government plans to freeze politicians’ pay. 
Further, minimum wage growth will slow in 2005. 
Page  8
Average real wage growth per actual person (y/y)
-4
-2
0
2
4
6
8
10
12
14
16
9
9
Q
1
Q
3
0
0
Q
1
Q
3
0
1
Q
1
Q
3
0
2
Q
1
Q
3
0
3
Q
1
Q
3
0
4
Q
1
Q
3
Total
Business sphere
Non-business
sphere
 
The current account deficit is stuck at a relatively high level. 
The current account deficit 
is running at just over 6% of GDP, with an improving trade balance offset by deterioration 
of the income balance reflecting higher transfers of dividends on direct and portfolio 
investment and rise in the volume of reinvested earnings. FDI inflows recovered to 4.5% of 
GDP in Q1-Q3 from less than 3% of GDP in 2003 manifesting both active government 
investment promotion and renewed privatization efforts. 
 
CA balance (% GDP)
-7
-6
-5
-4
-3
-2
-1
0
0
0
I
.
Q
I
I
.
Q
I
I
I
.
Q
I
V
.
Q
0
1
I
.
Q
I
I
.
Q
I
I
I
.
Q
I
V
.
Q
0
2
I
.
Q
I
I
.
Q
I
I
I
.
Q
I
V
.
Q
0
3
I
.
Q
I
I
.
Q
I
I
I
.
Q
I
V
.
Q
0
4
I
.
Q
I
I
.
Q
I
I
I
.
Q
Current Account
Trade balance
Income balance
 
Fiscal policy remains on track for slow, but gradual consolidation. 
The general 
government deficit in 2004 is estimated at 5.2% of GDP, similar to the outcome for the 
year before when adjusting for special factors that year. Tax reforms raised revenues by 
about 
0.5% GDP in 2004.
The budget for 2005 targets a further reduction in the deficit in 
2005 4.7% of GDP, with expenditures set to decline by 1.8% of GDP and revenues 
projected to decline by 1.3% of GDP reflecting mainly tax changes (reduction in 
effective taxation of corporate profits, and tax relief for families with children). On the 
expenditure side, a number of discretionary measures were introduced to curb 
expenditure growth (limited wage growth, global reduction in all expenditure 
categories). As a result almost all expenditure items were impacted, with social subsidies, 
transfers, and government consumption declining the most. The main risks relate to 
potential costs of contingent liabilities (e.g. lease of 14 Gripen fighters). 
 
The updated convergence program confirms the deficit reduction strategy from May 
2004
.
According to this, the general government deficit would be contained to 3.8% of 
GDP in 2006 and decline to below the reference value in 2008.  
Page  9
Table II. 2 Additional Savings Measures Suggested by the Ministry of Finance 
2005
2006
2007
Reduction of social benefits expenditures
0.03
0.06
0.06
Reduction of state social support benefits
0.02
0.03
0.03
Reduction of expenditures on passive employment policy
0.03
0.06
0.06
Reduction of sickness benefits expenditures
0.07
0.06
0.06
Deferral of State Employees' Service Act
0.00
0.00
0.25
Elimination of the valorization mechanism and reduction of severance pay 
and retirement pay for members of army and police forces
0.00
0.13
0.17
Prolongation of freezing the salaries of constitutional officials, MP's, judges 
and state attorneys beyond the year 2006
0.00
0.00
0.04
Reduction of expenditure categories implemented in the state budget for 
2005
0.09
0.08
0.07
Reduction of selected expenditure categories and global cut of 4 % in the 
state budget for 2006
0.00
0.49
0.43
Total
0.24
0.92
1.19
Source: 
staff calculations based on updated CP, November 2004.
 
Reform efforts 
Fiscal reforms approved in late 2003 were implemented in 2004
.
The main changes were 
on the tax side, but there were also adjustments on the expenditure side (increasing 
efficiency of pension and health insurance systems, controlling wage growth, improving 
management of other expenditure categories). The medium-term expenditure 
framework for 2005 - 2007 includes additional policy plans for meeting medium-term 
fiscal targets. However, these remain largely of an administrative nature. 
 
A
new Act on Employment came into effect from October 1, 2004
.
This allows for the 
creation of private profit-oriented employment agencies, which may contract-out and 
enhance flexibility in the labor market. Also, the new Act focuses on extension of active 
employment policies (including a new possibility for employees to join the re-qualification 
process when they are assumed to lose their jobs soon). Amendments to the acts on 
material poverty and subsistence minimum are under preparation and their planned 
adoption with effect from 1 January 2006 should align the structure and construction of 
social benefits better with job-seeking incentives. 
 
Further efforts to improve business conditions
 consisted of revamping cumbersome 
business registration procedures, reform of the judiciary system (the goal of which is to 
improve the functioning of courts, ensure faster and smoother court proceedings and 
the punish judges who neglect their duties), and tax changes (accelerated depreciation 
and increased R&D allowances). 
 
The bulk of 
privatization
 proceeds in 2004 came from sale of a 63% stake in the oil 
company Unipetrol. Also, the government is going ahead with the long-planned 
privatization of the last national telecommunications operator in Central Europe (Cesky 
Telecom) and metallurgical firm Vitkovice Steel in 2005. At the same, however, the 
privatization plans for electricity conglomerate CEZ, Czech Airlines and the Czech Airport 
Authority appear to have been pushed back to beyond 2006. 
 
Page  10
An 
amendment to the Act on Energy
 in line with EU regulations became effective from 
January 1, 2005. This will further open up the electricity market and free up electricity 
prices. The Act introduces greater competition in the selection of the universal service 
provider and stipulate legal separation of distribution activities from production and/or 
trade by the end of 2006. In the gas sector, implementation of the amended Energy Act 
looks set to bring welcome increase in market access.  
 
Page  11
Panel. Contribution to GDP, December 2004 revision 
 After-revision 
Before 
revision 
-6
-3
0
3
6
9
1Q03
2Q03
3Q03
4Q03
1Q04
2Q04
3Q04
Consumption
Fixed investment
Stock
Net export
GDP growth
-6
-3
0
3
6
9
1Q03
2Q03
3Q03
4Q03
1Q04
2Q04
Consumption
Fixed investment
Stock
Net export
GDP growth
 
Source: Statistical Office of Slovak Republic and staff calculation. 
SLOVAK REPUBLIC
 
Political update 
General support for the ruling coalition strengthened. In December, the ruling coalition 
r
eceived 38.8% in a poll organized by the Statistical Office, which is close to the maximum of 
40.6% when it took over. The minority government (with 69 out of 150 MPs) has been able to 
secure approval in Parliament for major reforms and foreign policy issues, including EU 
negotiations with Turkey and the presence of Slovak soldiers abroad.  
The budget for 2005 was also approved in December by 82 out of 150 MPs, even though only 69 
MPs formally belong to the ruling coalition. 
Ivan Šramko took over as Governor of the NBS in January. The decision-making Board of the 
Central Bank became more stable as it now consist of seven people of whom five will remain in 
their position until 2010 (one position remains vacant).  
Macroeconomic developments 
Macroeconomic developments remain favorable
.
In November 2004, the OECD published a 
positive Economic Outlook on Slovakia. In December, S&P upgraded Slovakia’s rating from BBB+ 
to A-, the same level as Hungary and the Czech Republic. 
Growth eased to a still robust 5.3% in the third quarter of 2004
.
While net exports 
contributed negatively by 3.7%, stocks and consumption continued to rise. Export growth at 
15.3% was the weakest of the last four quarters. Real GDP revisions for the period since 2002 in 
December 2004 revealed higher output growth in 2003 and stronger contribution from 
consumption. 
 
Unemployment declined further
.
While the registered rate seemed to stabilize just below 13% 
in November, the LFS shows a reduction from 19.3% in Q1-2004 to 17.5% in Q3. However, 
unemployment is still slightly above its level one year ago. Meanwhile, the duration of 
unemployment continues to rise. 
The current account deficit remains within comfortable margins
,
despite an increase in the 
third quarter to 2.4% of GDP. Estimates for 2004 deficit are in the 2.2-3.5% of GDP range. FDI 
picked up in 2004 to an estimated Euro 1.8 billion, although it was still lower than in 2002. 
Several new projects were contracted in the automotive sector, electronics and engineering. 
 
Page  12
Inflation eased
.
CPI inflation in December declined to 5.9% yoy from a peak of 8.5 % in July. 
Core inflation remained at around 2. In December, the NBS announced its new monetary 
program for 2005-08 focused on “inflation targeting under ERM conditions”. While inflation 
targets for 2006-08 did not change (below 2.5% in 2006 and then below 2%), the target for 2005 
increased from 2.4-3.3% to 3-4%. Despite further cuts in interest rates, several rounds of 
market intervention and relatively high inflation, the koruna continues to appreciate (5.5% yoy 
at end-December 2004). 
The fiscal outcome for 2004 was better than expected on the back of strong revenue 
performance
.
State budget revenues exceed plans by 4.5% (while expenditures were raised 
only by 0.7%), reflecting better than expected personal income tax collections (36%), corporate 
income tax collections (35%) and value added tax (2%). The fiscal deficit in 2004 is estimated at 
3.9% of GDP compared to 3.6% of GDP in 2003. The budget for 2005 targets a broadly 
unchanged fiscal balance with a fiscal deficit of 3.8% of GDP, but adjusted for pension reform 
the deficit would decline to 3.4% of GDP (the pay-as-you-go pillar revenue shortfall is projected 
at 0.4% of GDP in 2005, 1.0% of GDP in 2006 and 1.1% of GDP in 2007). 
 
In December the International Center for the Settlement of Investment Disputes ruled against 
the government in a long pending case with the Czech Bank, CSOB. The ruling obliges Slovakia 
to compensate CSOB with Sk25 billion by end-January 2005, which is about 1.9% of the Slovak 
GDP. The debt stems from a guarantee issued by the Slovak government in the early 1990s for 
bad assets taken over from CSOB by the Slovak consolidation agency. In 1996, the then 
government refused in Slovakia to pay this debt. The plan is to use a combination of state 
financial assets, privatization revenues and 2005 state budget resources. 
Reform efforts 
Major changes in the operation of pension and health care systems started in January 
2005
.
While the impact of the introduction of the 2
nd
 pillar of the pension system will be a long 
run affair,  implementation of the health care legislation is expected to bring improvements 
quickly. 
Panel. Budget revenues of selected taxes 2003 and 2004 
 
Personal Income Tax 
Corporate Income Tax 
Value Added Tax 
0
25
50
75
100
125
150
01
02
03
04
05
06
07
08
09
10
11
12
PIT 2003
PIT 2004
0
25
50
75
100
125
150
01
02
03
04
05
06
07
08
09
10
11
12
CIT 2003
CIT 2004
0
25
50
75
100
01
02
03
04
05
06
07
08
09
10
11
12
VAT 2003
VAT 2004
Source: Ministry of Finance and staff calculation.
Foreign Direct Investment, SKbn
 
0
50
100
150
200
250
300
1
Q
0
2
2
Q
0
2
3
Q
0
2
4
Q
0
2
1
Q
0
3
2
Q
0
3
3
Q
0
3
4
Q
0
3
1
Q
0
4
2
Q
0
4
3
Q
0
4
0
20
40
60
80
100
1
20
140
160
FDI gross
FDI net (RH-y)
 
Quarterly. Source: NBS and staff calculation. 
Page  13
The pension reform goes a long way toward improving the sustainability, adequacy, 
affordability, and robustness of the pension system
.
The long run deficit of the pension 
system is estimated to be reduced by more than 80 percent, although some further reform 
measures are needed in the future to ensure long-term viability. Pensions in the new system 
seem reasonably adequate with individuals who contribute receiving reasonable pensions. 
However, many people with incomplete work histories and widows who previously had access 
to the pension system will get small or no pensions from the new system. Adequate resources 
for a well designed social assistance system are critical to ensure that significant portions of 
the elderly population do not fall into poverty. The new funded pillar will receive 9% of the 
total 14% employer contributions, while employee contributions of 4% will continue to be 
directed to the PAYG system. Any current worker may choose to join the mixed system, but 
participation will be mandatory for all new entrants to the labor market. 
 
Box II 1. 
Characteristics of Pension Reforms in the EU8
 
Nine other Eastern European countries have undertaken multi-pillar reforms to their pension 
systems, Bulgaria, Croatia, Estonia, Hungary, Kazakhstan, Kosovo, Latvia, Poland, and Russia. 
The design of each of the systems is different. Slovakia has one of the largest second pillars 
among the Central European countries. Like many of the other countries, Slovakia has chosen 
to retain a first pillar which closely links contributions and benefits through the point system. 
In the case of Latvia, Poland, and Russia link between contributions and benefits is provided 
through a system of notional accounts. In the remaining countries (Bulgaria, Croatia, Estonia, 
Hungary), with the exception of Kazakhstan and Kosovo, who eliminated their first pillars, this 
link occurs within a traditional defined benefit PAYG system. Slovakia is almost unique in 
having eliminated a minimum pension. Kazakhstan also does not provide a minimum pension to 
new entrants. The Slovak approach has been to use social assistance to cover all re-
distributional requirements while the pension becomes a contribution based instrument only. 
Slovakia has one of the largest second pillars among the Central European countries. In every 
case, but Hungary, the contribution collections are centralized as opposed to decentralized 
(central collections and transfer of contributions to the private funds, as opposed to the 
decentralized, i.e. direct collections of contributions by private funds) 
However, the centralized collection has not been sufficient to lower costs in countries like 
Croatia. 
Characteristic of Pension Reforms in EU8 [include Slovakia]
 
Country 
Starting 
Date 
First 
Pillar 
Target 
Retirement 
Age 
Benefit 
Indexation 
Size of 
second pillar 
as percent of 
payroll 
Providers 
of Funded 
Pillar 
Switching 
strategy to new 
system 
Hungary 
Operating 
January 
1998 
PAYG 
DB 
62/62 
50% 
prices-50% 
wages 
6
percent 
Private 
Mandatory new 
entrants 
Voluntary 
others 
Poland 
Operating 
January 
1999 
NDC1/ 
60/65 
80% 
prices-20% 
wages 
7.2 percent 
Private 
Mandatory <30, 
Voluntary 30
–
50 
Latvia 
Operating 
July 2001 
(NDC 
January 
1996) 
NDC 
62/62 
Mixed 
price/wage 
indexation 
2
percent 
growing to 9 
percent 
Private 
and Public 
Mandatory <30, 
Voluntary 30–
50 
Estonia 
Operating 
July 2002 
PAYG 
DB 
63/63 
50% 
prices-50% 
wages 
6
percent 
Private 
Voluntary 
(opt-out +2 
percent) 
Source: The World Bank, Slovak Republic: Pension Policy Reform Note. September 13, 2004 
1/  NDC is notional defined contribution, a system that has the same features as DC but is not funded. 
Page  14
The success of health care reform depends crucially on how effectively the new legislation 
will be implemented.
 The Slovak Parliament passed the six pieces of legislation that form the 
basis for Slovakia’s far-reaching health system reform, which should result in better care, more 
satisfied patients and lower arrears. Secondary legislation is now needed to manage a smooth 
transition to the new system of care. Promoting competition wherever it is possible will be a 
major challenge. 
In December 2004, the government announced its plan for the development of a 
competitive national economy in line with the EU’s “Lisbon Strategy”
.
The government 
strategy explicitly recognizes that structural reforms to promote a knowledge-based economy 
can only succeed if there is a strong macroeconomic foundation and structural reforms which 
focus on: (i) shared responsibility of an individual for his/her social situation, social policy that 
does not distort incentives of individuals to be active and creative, reduces absolute poverty, 
and maintains an effective social security network; (iii) maintenance of  minimal health care 
and pension security for all while ensuring sustainable health care and pension systems. 
Specific development priorities consist of: (i) modern education policy, high employment rate 
and coping with demographic trends; (ii) IT literacy, e-government, and wide access to 
internet; (iii) improvement in the quality of research and development and public support of 
private innovation; (iv) enforcement of law, infrastructure and services in network industries, 
quality of public service, and effective access to capital market for all enterprises. 
A
new framework for bankruptcies was approved in December
.
Creditors’ rights were 
enhanced and trustees became licensed. The goal is to shorten the duration of cases (currently 
3-7 years), and increase the volume of revenues recovered (currently only 5-10%). The law 
should secure active behavior of related parties and make proceedings faster, increase 
responsibility and accountability, allow better restructuring of assets, make creditors’ right 
coherent with other legislation, maximize the recovery rate and reduce corruption. The law on 
trustees deals with the large number of trustees in Slovakia (above 1,000 compared to 2,500 in 
Great Britain) and their professional skills. Trustees will be licensed by the Ministry of Justice, 
educated by licensed private companies, and monitored by the ministry and bankruptcy courts. 
The new framework will be financed both by the state budget and fees. 
World Bank activities  
A
human capital technical assistance loan for Euro 5 million was negotiated in November
.
The Government intends to consolidate reforms undertaken to date and to couple them with 
forward-looking and mutually consistent employment and social cohesion policies in order to 
achieve a lasting decline in poverty and social exclusion. The loan will contribute to these 
objectives by developing the human resources involved in policy-making, strengthening the 
management systems and processes governing policy preparation and ensuring the capacity for 
evidence-based policy monitoring.
 
The World Bank, in cooperation with the Liberal Institute Foundation, organized on November 9 
an international conference on Enterprise and Financial Sector Restructuring in Slovakia. The 
conference was organized under the auspices of the Slovak Ministry of Finance. Finance 
Minister Ivan Miklos and Roger Grawe, Country Director for Slovakia, were among the speakers 
at the conference. The conference was attended by around hundred people, representing the 
Slovak Government, financial market institutions, commercial banks, academics, international 
organizations, think tanks, and media.  
Other 
The IMF concluded its 2004 Article IV mission to Slovakia on November 10
.
The main 
recommendations were for the central bank to focus more on reducing inflation and to target a 
somewhat tighter fiscal stance in 2005 (adjusting for net transfers from the EU and pension 
reform costs, it is estimated that the budget implies a fiscal expansion of about ¼ percent of 
GDP in 2005). 
 
Page  15
SLOVENIA
 
Political update 
Following parliamentary elections in October, which brought a victory to the centre-right 
S
lovenian Democratic Party (SDS), a new coalition government (formed with New Slovenia - 
NSi) headed by Prime Minister Janez Jansa took office in December. The new government 
controls 49 seats in the 90-seat parliament. The main policy plans for 2005 include prudent 
conduct of macro policies in the ERM2, tax reform, and easier business conditions for SMEs.  
Macroeconomic developments 
Output growth slowed in the third quarter of 2004, but was high for the year as a whole
.
Real GDP growth decelerated to 3.9% yoy in Q3-2004 (from 4.6% yoy in the previous quarter) as 
investment growth weakened. The first nine months of the year resulted in output growth of 
5.8% yoy. Employment is rising and the unemployment rate stabilized at 6.0% in the third 
quarter. Inflation, after falling for several months, rose to 3.6% yoy in November reflecting 
seasonal price increase of food, clothes, and shoes as well as the higher prices of oil, refined 
petroleum products and gas. There were downward pressures on the exchange rate through 
October, but this has since been reversed. Real wage growth is running at around 2% yoy, well 
behind productivity growth at around twice this rate. The current account deficit remained low 
at 0.3% of GDP in the first nine months of 2004. Meanwhile, the net financial outflow amounted 
to 2.5% of GDP. The fiscal deficit in 2004 is estimated at around 2.1% of GDP, slightly higher 
than envisaged in the May 2004 Convergence Program, due to the inclusion of the activities of 
two extra-budgetary funds within the general government and the change in the composition of 
expenditures and revenues in 2004. For the years 2005 and 2006, the general government’s 
deficit figures will be 2.1% of GDP and 1.8% of GDP, respectively. The gradual decrease in the 
general government deficit will come from both cyclical factors and continuing expenditure 
restructuring. (Revenues are expected to decline by 0.5% of GDP by 2006, as a result of tax 
reform and impact of EU accession). 
 
Reform efforts 
Tax reform has become a hot political issue
.
The tax reform proposals submitted by the 
previous government—aimed at reducing taxes on labor and increasing taxes on capital—were 
criticized for risking to reduce fiscal revenues and endanger meeting the nominal convergence 
criteria, as well as providing an unclear and inconsistent legislative framework. While the tax 
reform has not yet been approved, it will reportedly be difficult to pull back. The government 
will monitor revenue developments closely. 
A
December 2004 
amendment to the Company Act
 introduced international accounting 
standards for companies from January 2005 and for banks and insurance companies from 2007. 
 
Page  16
LITHUANIA 
 
Political update 
Following parliamentary elections in October 2004, a new government was formed in December 
through a four party alliance of the Labor Party, Social Democrats (LSDP), New Union/Social 
Liberals (NU/SL), and New Democracy Union. Algirdas Brazauskas (LSDP) remained Prime 
Minister in the new government. The current government will naturally face more challenges 
both political and economic. Contrary to the previous cadence, which was working within the 
narrow frames of accession to the EU and NATO road, the current will need to deal with 
meeting Maastricht criteria, and maintaining sustainable growth in order to diminish income 
gap between new and senior EU members.  
Macroeconomic developments 
Output growth remains robust despite slowing in the third quarter of 2004
.
Though 
Lithuania’s economic growth slowed somewhat in 2004, it remained well above the EU-8 
average. In Q3 2004 real GDP increased by 5.8% yoy, resulting in 6.7% growth yoy over the first 
9
months. Output growth continues to be led by consumption and to a lesser extent 
investment, while net exports continue to contribute negatively. On the supply side, all sectors 
are showing good dynamics with the exception of primary producers.  
-8
-6
-4
-2
0
2
4
6
8
Q3
Ave Q1-Q3
GDP
Consumption
GFCF
Changes in inventories
Net Export
Contribution of growth factors to GDP growth (%, y-o-y)
Source: CSO, staff calculations
S
ource: CSO, staff calculations
 
Unemployment is receding rapidly and labor shortages emerging
.
The unemployment rate 
declined to 10.6% in Q3, the lowest rate since independence. Only agriculture and forestry are 
experiencing declining employment. In addition to rapid output growth, labor migration is 
playing a role. The migration boom, including of highly qualified labor, has unveiled the 
structural imbalances of the labor market, showing that there is not much room left for further 
declines in unemployment and potentially undermining medium-term growth prospects. A 
shortage of qualified labor has already imposed upward pressure on wages that over time may 
impact inflation. 
Page  17
1340
1
360
1
380
1400
1420
1
440
1
460
1
480
1500
2003 Q1 
2003 Q2
2003 Q3
2003 Q4
2004 Q1 
2004 Q2
2004 Q3
0
2
4
6
8
1
0
1
2
1
4
16
Employed, thous. persons
U
nemployment rate, %
Labor market indicators in Lithuania
Source: CSO of Lithuania
 
Inflation appears to have stabilized for the time being
.
The CPI index went up 2.9% yoy in 
December after spiking to 3.3% in October. The highest inflation was in health care and 
transportation. At the same time, record high world oil prices have put upward pressures on 
PPI (6.8% yoy in December). 
98
99
100
101
102
103
104
I
II
III
IV
V
VI
VII
VIII
IX
X
XI
2003
2004
Inflation in Lithuania, %
Source: CSO
 
The current account deficit remains large despite strong exports
.
The current account 
deficit declined to 7.7% of GDP in Q3 (compared to 11.0% of GDP in Q2). While exports are 
growing rapidly, this reflects partly higher prices for mineral products. FDI inflow rebounded 
strongly in 2004, but remained relatively low compared to other EU8 countries (in per capita 
terms). On the positive side, the share of green-field investment has shot up with privatization-
related FDI amounting to only 6.6% of total FDI  
In 2004 the fiscal deficit is balancing on the edge of 3% of GDP.
 The budget for 2005 targets 
a
deficit of 2.7% of GDP, but there are risks of slippage, bearing in mind co financial projects 
postponed for 2005 and repeal of the tax on roads in the second half of 2005.  
Page  18
0
200
400
600
800
1000
1200
1400
1600
Other income
Other tax income
Excises
VAT
Income tax
Corporate tax
EU funds
2005
2004
N
ational budget income, EUR mio
Source: MF, staff calculations
 
Reform efforts 
Reforms in recent years have focused on EU accession while less attention was given to sectors 
which were not that much covered by 
Acquis 
–
mainly education and health.  
The main reform initiative involved changes in the pension system
.
A
small second pension 
pillar with mandatory private savings was introduced in 2004, and a third pillar with voluntary 
private savings was started from January 1, 2005. People have until July 1, 2005 to decide on 
whether they want to shift to the new, first and second pillar mixed system. The share of 
contributions redirected from the social security fund to the second pillar was 2.5% in 2004, 
rising by 1 pp every year to reach 5.5% in 2007.  
Some important steps have also been taken to improve social protection
.
Unemployment 
benefits will become more generous from 2005, mainly through shortening of the necessary 
insurance periods, prolonging the duration of benefits, and linking benefits to the previous 
salary. Also, the lump sum birth allowance has been increased by 1/3, and the Government 
intends to gradually increase the maternity/paternity allowance from 70% to 100% of the salary 
received. Other plans include a gradual rise in the minimum monthly wage (from LTL 500 to 
LTL 600 in 2006), increasing the tax-exempt income minimum (in 2006 supposed to reach LTL 
390, against current LTL 290),
 
and base pension. 
World Bank activities 
Accession to the EU means a new stage in the relationship between the Bank and Lithuania, 
with a transition from a borrower-lender relationship to a partnership based more on analytic 
work and technical advice targeted at the key challenges Lithuania faces.  
The ongoing lending program includes five active projects dealing with social policy community 
services, municipal development, Klaipeda Port and health and education reforms. 
Commitments for these projects total about US$ 120, projects are performing well and are 
scheduled for completion by June 2006.  
The Bank’s non-lending work program includes a recent Education Financing Policy Note, Rural 
Finance Note, Trade and Transport Facilitation Audit as well as telecommunications/rural 
internet access, health, civil service and municipal strategic planning TA. 
Lithuania’s Investment Climate Assessment is to be launched soon, a study on Growth in the 
Baltic States is on its way, the key findings might be found in the special issue of the quarterly 
report and an international seminar on Transport Sector Restructuring in the Baltic States is 
scheduled in February in Vilnius. 
 
Page  19
LATVIA 
 
Political update 
The minority government headed by of Indulis Emsis of the Union of Greens and Farmers 
collapsed after its coalition partner People's Party rejected the draft 2005 national budget. 
After an extended period of inter-party consultations, the President appointed the twelfth 
Government since restoration of Latvia's independence in 1991. Government is headed by 
Aigars Kalvitis, who succeeded in bringing together a broad four party right-wing coalition 
(People's Party (TP), New Era (JL), Latvia's First Party, and the alliance of the Green and 
Farmers' Parties) and covers 70 seats out of 100 in the Saeima. Moreover, the grand coalition 
was supported by Fatherland and Freedom Party, and three independent MPs. While one half of 
the cabinet remained unchanged, tensions may emerge between the People's Party and New 
Era (with controversial former Prime Minister Einars Repse getting the portfolio of Defence 
Minister). 
The new government’s broad reform plans include (in order of priority): 
1. Solving the health care crisis and developing a well-functional healthcare system. 
2. Establishing a balanced medium-term state budget and curbing inflation. 
3. Enhancing competitiveness and developing a knowledge-based economy. 
4. Ratifying the Constitutional Treaty of the European Union. 
5. Finalizing the privatization process. 
Macroeconomic developments 
Strong output growth continued
.
Latvia continues to maintain leadership in the EU in terms of 
GDP growth. Real GDP growth in Q3 accelerated to 9.1% yoy, pushing the nine month rate to 
8.5%. Latvia’s spectacular growth was underpinned by booming domestic demand. On the 
supply side, the shift towards the service sector continues: with transport and communication, 
construction, real estate, renting and business activities, wholesale and retail trade, and 
financial intermediation leading the way. Despite the remarkable growth rates, unemployment 
has remained fairly stable during 2004 indicating that the benefits of growth may not be shared 
equally among all groups of the population. Higher labor market flexibility remains a key 
challenge in improving the situation.  
Real GDP growth, %, y-o-y
6.4
7.2
5.1
6.8
5.9
6.2
8
6.4
7.5
8.8
7.7
9.1
6.4
6.8
9.7
7.1
7.3
5.8
2001
2002
2003
2004 IQ
2004 IIQ
2004 IIIQ
Estonia
Latvia
Lithuania
 
Inflation has shot up
.
CPI inflation in December hit 7.3% yoy, affected also by higher fuel and 
energy prices. The biggest rise in prices in 2004 was recorded in the healthcare sector (over 
14%). Inflation is also fueled by a credit boom that shows no signs of abating. Mortgage lending 
continues to be the key driver of credit expansion. As of November, loans to residents were up 
by 47% yoy, but the share of credits-to-GDP remains fairly low. The Bank of Latvia raised the 
refinancing rate from 3.5% to 4% in November. Also, from January 24, 2005, banks’ liabilities to 
foreign banks will be included in the compulsory reserves. On December 30, 2004, the lat was 
re-pegged from the SDR to the Euro at an exchange rate of 1 EUR = 0.702804 LVL. The Bank of 
Page  20
Latvia will unilaterally keep the bound of ±1% around the central rate. Prime Minister Kalvitis 
has stated that the Government is not planning to carry out any specific anti-inflation 
measures. 
 
The current account deficit has increased throughout 2004. 
EU accession and growing 
income have been the key contributing factors to the increasing current account deficit, which 
is expected to exceed 12% of GDP in 2004. Only about one third of the deficit was financed by 
inflows of foreign direct investment in 2004. The increase has mainly been financed by private 
borrowing abroad, while public sector debt still remains at low levels by international 
standards. The outlook for 2005 is more optimistic with the current account deficit expected to 
decrease by several percentage points.  
Fiscal policy was strong in the first nine months of the year
.
The general government 
recorded a surplus for the first eleven months of 2004, and the deficit for the year stood at 
only 1.1% of GDP (or 79 million LVL) - the result has been better than expected due to strong 
revenues throughout 2004, and represents an improvement from the 1.8% deficit in 2003. The 
budget for 2005 that brought down the Emsis government was smoothly passed several weeks 
later, with only minor changes. In line with the intention of the Latvian government to solve 
the escalating problems of the health care sector, a substantial increase in health care funding 
was included in the budget. 
Reform efforts 
The recent focus has been on addressing the crisis in the health care system
.
However, it is 
unlikely that increasing spending on health care is sufficient to overhaul the existing system, 
even taking into account continuously increasing funding in coming years (according to the 
Ministry of Health, full implementation of health care reform would require at least twice as 
much as is planned). The situation has not stabilized yet, and anesthetists and intensive-care 
staff may continue striking for higher wages and reduced working hours. According to the World 
Health Organization, Latvia spends the lowest percentage of GDP on health and also sits at the 
bottom of the EU8.  
World Bank activities  
The activities in Latvia are currently limited to non-lending services and maintaining policy 
dialogue. The World Bank initiated a discussion on Programmatic Structural Adjustment loan 
(PSAL) progress with the Government It has also finalized a report on Tertiary Education and 
Innovation Systems in Latvia. Further, the World Bank announced a Development Marketplace 
competition in October and organized a workshop on Cities’ Alliance project in November. 
Finally, a study on Growth in the Baltic countries is under way. 
 
0
200
400
600
800
1000
1200
1400
I
II
III
IV
V
VI
VII
VIII
IX
7.7
7
.8
7.9
8.0
8.1
8.2
8
.3
8.4
8.5
8.6
8.7
Mortgage loans, eop, mio LVL
Interest rate for mortgage loans, %
Development of mortgage market in Latvia, 2004
Source: CB
0
2
4
6
8
10
12
I
II
III
IV
V
VI
VII
VIII
IX
X
XI
C
PI
P
PI
I
nflationary developments in 2004, yoy, % 
Source: CSO
Page  21
ESTONIA
 
Political update 
The latest polls suggest that public sentiment may be shifting to the left, from the ruling 
center-right, pro-liberal parties towards socially orientated political parties. Municipal 
elections are scheduled for October 2005, and the political climate is already heating up.  
 
Macroeconomic developments 
GDP growth remains solid
.
In Q3-2004 real GDP expanded by 6.1% yoy, led by strong domestic 
demand. The most rapid growth was recorded in domestically oriented sectors, i.e. financial 
intermediation, hotels and restaurants, and utilities. The unemployment rate in Q3 remained 
at 10%, but emerging bottlenecks in the labor market has pushed up wage growth to over 9% 
yoy in Q3. However, strong productivity growth is still holding down unit labor costs. 
The current account deficit declined somewhat as exports swelled
.
In Q3-2004 the CAD 
declined to just over 9% of GDP. Exports accelerated substantially, reaching the same annual 
growth rate as imports of 24%.  
 
Inflation and interest rates edged up.
 Despite the increase in CPI inflation from 1.3% in 2003 
to 3.0% in 2004 (annual averages), price stability has not become a significant concern in 
Estonia. Some of the 2004 price increases are linked to EU accession and are not expected to 
be repeated in 2005. The most significant price increases were observed in transport (+5.4%, 
mainly due to significant increases in fuel prices) and health sectors (+4.7%). Despite rising 
interest rates (6.0% in December compared to 5.4% at the beginning of 2004), credit growth 
remains rapid. However, the peak of the mortgage boom appears to have been passed. 
 
0
5
10
15
20
2
5
2003 Q1 
2003 Q2
2003 Q3
2003 Q4
2004 Q1
2004 Q2
2004 Q3
Lithuania
Estonia
Latvia
CA in Baltics, % GDP
Source: CBs
Page  22
0
2
4
6
8
10
12
2003
Q1 
2003
Q2
2003
Q3
2003
Q4
2004
Q1
2004
Q2
2004
Q3
Unemployment rate
Gross wages, yoy
Unemployment and wages, %
Source: CSO
 
Reform efforts 
Estonia was upgraded to fourth place (after Hong Kong, Singapore and Luxembourg) on the 
2005 global index of freedom (Heritage Foundation). It was the only EU8 country ranked as 
“free.” 
Despite one of the lowest tax burden in Europe, the government has plans for further tax cuts 
in 2006. The intention is to reduce the flat income tax rate from 26% percent to 20% in order to 
diminish the gap between corporate and individual taxation levels. At the same time, there are 
strong pressures to improve social policies. 
 
Other 
 
The IMF concluded its 2004 Article IV consultation in November
.
The Fund points out that 
the high and continued current account deficits may not be sustainable during the medium 
term, and that adequate fiscal policy will play an important role in concerns about the current 
account deficit and inflation. The report also points out the importance of labor market 
flexibility in maintaining external competitiveness and supporting the currency board.