Page 1 PROGRAM INFORMATION DOCUMENT (PID) APPRAISAL STAGE April 28, 2011 Report No.: AB6510 (The report # is automatically generated by IDU and should not be changed) Operation Name Second Safety Net and Social Sector Reform Program Region EUROPE AND CENTRAL ASIA Country Republic of Latvia Sector General education sector (30%); Health (30%);Other social services (30%);General public administration sector (10%) Operation ID P121796 Lending Instrument Development Policy Lending Borrower(s) REPUBLIC OF LATVIA Implementing Agency MINISTRY OF FINANCE Ministry of Finance 1 Smilsu Street Riga Latvia LV-1919 Tel: (371-6) 708-3886 Fax: (371-6) 708-3898 Agnese.Timofejeva@fm.gov.lv Date PID Prepared April 28, 2011 Estimated Date of Appraisal April 18, 2011 Estimated Date of Board Approval May 26, 2011 Corporate Review Decision Following the corporate review, the decision was taken to proceed with the preparation of the operation. I. Key development issues and rationale for Bank involvement 1. The combination of credit and housing bubbles, the global financial crisis, and acute banking pressures in Latvia contributed to a severe crisis in late 2008 . The Latvian government responded to the crisis with a reform program supported by the EC, the IMF, and bilateral donors. The program goals were to arrest the immediate liquidity crisis and to ensure long-term external stability, while maintaining the exchange rate peg through strong domestic policies. Its key elements included: (i) immediate measures to stem the loss of bank deposits and international reserves; (ii) steps to restore confidence in the banking system in the medium-term; (iii) fiscal measures to limit the substantial widening of the budget deficit, and to prepare for early fulfillment of the Maastricht criteria; and (iv) incomes policies, including the adjustment of nominal wages both in the public and private sector as well as structural reforms to rebuild competitiveness under the fixed exchange rate regime. 2. The country’s stabilization program is based on a sizeable fiscal adjustment . Expenditure cuts dominated the adjustment initially, contributing more than three-quarters of the consolidation. Spending was cut by 14 percent of GDP during 2009-2010 as compared to Page 2 projected fiscal outcomes prior to the program. As a result, the fiscal deficit declined to 6.5 percent of GDP in 2010, from 7.1 percent in 2009 (or in ESA95 terms to an estimated 7.7 percent of GDP from 9.7 percent). The size of the fiscal adjustment required, together with the economic contraction and rise in unemployment, greatly increased the risk of adverse impact on households. In addition, the government embarked on an ambitious structural reform program in the education and health sectors involving fiscal cuts. Recent economic performance has been better than expected, and Latvia has returned to positive growth in the third quarter of 2010 for the first time since the onset of the economic downturn. Yet, the unemployment rate is falling very slowly and remains high at 17.2 percent. Moreover, there appears to be a large disparity in employment opportunities depending on education levels, pointing to a possible problem of structural unemployment for the poorer socioeconomic groups coming out of the crisis. II. Proposed Objective(s) 3. This is the second operation in a program of two loans focused on Safety Net Support and Social Sector Reform; the first Special Development Policy Loan (SDPL 1) was fully disbursed on September 27, 2010. The objectives of the program are: (i) to protect vulnerable groups with emergency safety net support during the economic contraction; (ii) to mitigate the social costs of fiscal consolidation; and (iii) to ensure that structural reforms lay a foundation for medium-term improvements in the social sectors. The first loan focused on the first and second objectives given the need for an emergency response. While concentrated on continuing support for the emergency social safety net measures through to end-2011, the proposed operation expands the focus to the third objective. III. Operation Description 4. The Second Special Development Policy Loan (SDPL 2) supports the implementation of the government’s Emergency Social Sector Net Strategy (ESSNS), which is designed to mitigate the social impact of fiscal consolidation . The strategy came into legal effect on October 1, 2009 and is due to remain in place until end-2011. The strategy finances and coordinates the efforts of national and local government agencies to: (i) maintain pre-primary education and child development programs for 5 and 6 year old children; (ii) cover the costs of transporting students from communities where schools have closed to their new places of instruction; (iii) exempt needy households from health service co-payments; and (iv) subsidize their pharmaceutical costs; (v) sustain and improve general practitioner (GP) and primary health care (PHC) services and access; (vi) increase the coverage and pay-out period of unemployment insurance; and (vii) increase the coverage and amount of targeted social assistance benefits administered by local governments. For the unemployed who are not covered by unemployment insurance or other social support, the government has (viii) fortified the safety net by rapidly deploying a labor-intensive emergency public works program. 5. The ESSNS is aimed at protecting the vulnerable from the adverse impacts of the crisis, and also at supporting the reform program that underpins fiscal adjustment in the education and health sector . The government has embarked on a “funds follow the student” financing reform in the education sector to increase efficiency and education quality in light of the shrinking school-age population. The switch to this form of financing creates incentives to increase the low teacher-pupil ratio in Latvia and decrease school infrastructure. In the health Page 3 sector, structural reforms delivering fiscal adjustment aim to improve administrate capacity and transparency, and to rationalize the provision of care. Primary health care services are being protected and reforms are aimed at substituting expensive inpatient services to the extent possible through increased use of outpatient surgery and alternatives to overnight hospital stays. The high inpatient costs are being tackled by reducing the number of hospital beds and making more effective use of co-payments to manage demand for services. The aim is not solely to increase efficiency, but to improve health outcomes through better primary care. The operation would also support the government goal to restore the contribution rate for second pillar pensions to 6 percent by January 1, 2013. With the 2010 Public Expenditure Review, the World Bank has also engaged with government on other important structural reforms, including increasing the retirement age for pensions, the development of training-based labor market programs and a move to a voucher scheme for training, and the formulation of a health sector strategy. IV. Rationale for Bank Involvement 6. Latvia graduated from Bank financing in 2007 . The global financial crisis led to an exceptional request by the government of Latvia for renewed access to World Bank lending resources. The proposed operation is consistent w ith the Bank’s Articles of Agreement. Pursuant to Article III, Section 4 (ii), the Bank may make loans to any member country, subject to Board approval, if “[it] is satisfied that in the prevailing market conditions the borrower would be unable otherwise to obtain the loan under conditions which in the opinion of the Bank are reasonable for the borrower .” The crisis has exposed underlying macro-vulnerabilities, and the deep economic contraction that followed left Latvia with significant borrowing needs and constrained access to external financing on reasonable terms. The World Bank delivered exceptional support to Latvia through special development policy lending support. To accompany this, a Public Expenditure Review was conducted jointly with the IMF in 2007, and a follow-up Public Expenditure Review was conducted as part of a World Bank program of technical assistance in 2010. There are two related World Bank operations: the Financial Sector Development Policy Loan approved on September 22, 2009 and First Safety Net and Social Sector Reform Development Policy Loan (SDPL 1) approved on March 4, 2010. The proposed operation is the final operation under the SDPL support program and would complete World Bank crisis lending activities in Latvia. V. Tentative financing Source: ($m.) Borrower 0 International Bank for Reconstruction and Development 142.08 Borrower/Recipient IBRD Others (specifiy) Total 142.08 Page 4 VI. Tranches (if applicable) ($m.) First Tranche 142.08 Total 142.08 VII. Institutional and Implementation Arrangements 7. In putting in place the ESSNS, procedures and adequate financing were incorporated to allow close monitoring of its implementation and evaluation of its impact. On monitoring, the government regularly monitors around 35 indicators pertaining to the ESSNS and publishes the information on the internet. 1 Baseline and updated data are provided by the respective specialized agencies for the pertinent functions and tracked according to the indicators and outcome measures as shown in the Monitoring and Results Framework (see Annex 8). 8. The State Audit Office of the Republic of Latvia (SAO) has evaluated the government’s performance in implementing the ESSNS supported by the proposed loan. The State Audit Office reports independently to Parliament and is a key institution for public sector accountability. The audit of the ESSNS has been has been disseminated by the State Audit Office, including being made publicly-available on the internet. The audit made extensive use of country databases and information to cross-check the implementation of the ESSNS at the national and municipal level against the stated policies and aims of the program. The audit came up with a number of recommendations for improving control and compliance for the implementation of the ESSNS strategy, and the relevant government agencies have agreed to an Action Plan to put in place these recommendations by October 2011 (see Annex 5 for the action plan). The audit and its use by the government represent an innovative use of country systems by the government of Latvia to monitor and evaluate a Bank-supported program, and to use the results to improve implementation and results. Given the complex nature of structural reforms and emergency assistance supported by the program of development policy lending, it would have been difficult for the Bank team to conduct such a comprehensive and thorough evaluation, and hence, the SDPL series has benefitted much from the institutional set-up for conducting audits of government programs in Latvia. VIII. Risks and Risk Mitigation 9. Risks . Risks to the proposed operation are moderate to high. The risks are related to the economy, political and social support for the ongoing fiscal adjustment program, and possible reversal of the social sector structural reform program supported by the World Bank’s SDPL loan series. Economic risks are moderate. Overall, the macroeconomic outlook has notably improved since the previous World Bank loan (SDPL 1) was approved and risks have diminished. Growth performed better than expected in 2010, as did the fiscal outturn. Political 1 The Ministry of Regional Development and Local Government had the initial responsibility for monitoring implementation of the ESSNS, and for submitting regular reports to the Cabinet of Ministers on progress. This responsibility shifted to the Ministry of Welfare following a restructuring of government ministries on January 1, 2011. Page 5 risks remain moderate to high, and relate to the challenge of maintaining the support of the governing coalition and society at large for the ongoing fiscal stabilization program. Despite the difficult economic conditions that the population has faced, social stability has endured. 10. The government has reiterated its commitment to the structural reform program and implementation risks are moderate in 2011. With regard to the structural reform agenda, there has been much progress in the implementation of reforms by the Ministry of Health and Ministry of Education and Science. There is a risk that there may be a reversal of the structural reform program if fiscal pressures ease and political pressures for increasing schools/hospital infrastructure and staffing mount. On education, a court case has been initiated to challenge the constitutionality of the addition of social considerations to the criteria for awarding state support to students in higher education. This has the potential to reverse the reform supported by SDPL 1. Regarding pensions, the government has reiterated its commitment to preserving the sustainability of the three pillars of the pension system and to restoring contributions to the second pillar to 6 percent of gross salaries by 2013, provided that the budgetary situation improves in line with forecasts. There is, however, a risk that a more gradual restoration in the second pillar pension contributions may occur and that the 6 percent rate may not be put in place by 2013. 11. Mitigation of Risks . The SDPL program will help to mitigate the economic and social risks of the stabilization program. The proposed SDPL 2 facilitates the fiscal reforms in the social sectors. The technical assistance program that has accompanied the SDPL program has supported the fiscal stabilization program. In supporting the implementation of the ESSNS, the SDPL program lowers the social costs inflicted by the rapid fiscal adjustment and sector structural reforms. In supporting the monitoring and making public the results of the ESSNS — including the use of country systems to audit, evaluate and feed into program re-design—the SDPL supports greater governance and accountability. IX. Poverty and Social Impacts and Environment Aspects 12. The policies supported by the SDPL program are expected to have a significant positive social impact, particularly by mitigating the adverse effects of the economic crisis for the poorer groups in society . The measures in the program have been designed to protect the funding of basic needs and services for low income households and to boost expenditure on programs targeted to people affected by the crisis. 13. The specific policies supported by the proposed development policy loan are not likely to have significant effects on Latvia’s environment, forests, and other natural resources . Unanticipated and unintended risks of adverse effects to the environment and natural resources are likely to be minor. Latvia has adequate environmental controls in place. Latvia’s environmental legislation and regulation is reinforced by EU environmental directives, including the EU’s guidelines on adoption of environmental assessments at the planning and programming level (June 2001) and the EU’s Environmental Liabilities Directive setting out liability for damage to properties and natural resources (April 2007). Page 6 X. Contact point World Bank Contact: Emily Sinnott Title: Senior Economist Tel: (202) 458-4960 Email: esinnott@worldbank.org Borrower Contact: Agnese Timefejeva Title: Deputy Director, International Financial Policy Department, Ministry of Finance, Latvia Tel: (371-6) 708-3886 Fax: (371-6) 708-3898 Email: Agnese.Timefejeva@fm.gov.lv XI. For more information contact: The InfoShop The World Bank 1818 H Street, NW Washington, D.C. 20433 Telephone: (202) 458-4500 Fax: (202) 522-1500 Web: http://www.worldbank.org/infoshop