Report No. PID8581 Project Name Latvia-Programmatic Structural Adjustment... Loan (PSAL) Region Europe and Central Asia Sector Public Sector Management/Privatization Project ID LVPE66153 Borrower(s) Republic of Latvia Implementing Agency Ministry of Finance 1 Smislu, LV 1919 Riga Tel: 371-7095680 Fax: 371-7095693 Environment Category C Date This PID Prepared November 11, 1999 Date Initial PID Prepared November 11, 1999 Projected Appraisal Date November 29, 1999 Projected Board Date March 7, 2000 1. Country and Sector Background. Latvia's transition to a market economy is almost complete. Price liberalization took place at the outset of transition in 1992 and privatization of small and medium term enterprises, although started only in 1994, was basically completed by mid 1998. Latvia now faces the difficult last stages of transition where the Government's own efficiency and effectiveness have become the main impediment to completing the path to a market economy and sustained economic growth. The former is best evidenced by the difficulties of privatizing the remaining (three) large enterprises and the latter by the system of public administration that exists in Latvia, which created conditions for corruption to flourish and by a government that allowed the creation en mass of quasi-autonomous agencies with inadequate provisions for assuring accountability and transparency with respect to resources used and services provided 2. The government has requested a Programmatic Structural Adjustment Loan (PSAL) program for improving the credibility, efficiency and effectiveness of the public sector to improve service delivery, support the return to robust private sector led growth, make the economy less vulnerable to external shocks and prepare for EU accession. Improving public sector management and reducing corruption are critical requirements for EU accession. 3. The Country's Adjustment Program builds on the macroeconomic and structural reforms made till this date. The ultimate objective of Latvia's reform program (and of the proposed PSAL that will support it) is to put the economy back on a path of rapid and sustainable growth while maintaining a sustainable external position, as to improve the well being of all its citizens. Reaching that path requires (i) returning to the conservative fiscal stance of before the Russian crisis and (ii) improving the functioning of the public sector through a comprehensive reform package that enhances its efficiency and effectiveness. This reform package focuses on (i) strengthening the credibility of public sector institutions, (ii) increasing the capacity of the state to efficiently manage its human and financial resources, and (iii) rationalizing the boundary and interrelationships between the public and private sector. 4. The challenge facing the Government for the immediate future is to reform the state institutions such as to come to an accountable and transparent state that has the capacity to govern efficiently and effectively and therefore will facilitate EU accession. The Russian crisis brought back more forcefully into focus the inherent problems in Latvia's public expenditure management system as well as the need to finalize the privatization process and in parallel to define the role of the state as a regulator of productive assets instead of as an owner. 5. The proposed Programmatic Structural Adjustment Loan (PSAL) operation would support the government in four overlapping areas: 6. Strengthening the Credibility of the Public Sector. The PSAL will support the Government's efforts to further reduce the risks and opportunities for corruption in Government and the Judiciary by supporting the challenging and politically difficult task of implementing the country's corruption prevention program. This requires building an understanding and acceptance of the proposed reforms at all levels of the bureaucracy. The program among others would support a strong role by the Corruption Prevention Council in this process. It would help the Government with the implementation of the Law on Prevention of Corruption and to develop instruments to measure vulnerability of its institutions to corruption. 7. The program will also support the strengthening of transparency and accountability of ministries and subordinated and supervised bodies through advice with respect to rationalizing the functions of government ministries. This process is currently being under taken by the bureau of administrative reform in Latvia with support of the World Bank and is an important first step toward streamlining the Government. The PSAL program will work with the government to implement the outcomes of the functional reviews of the ministries and will help with the identification of organizational structures that provide the proper incentives for the execution of ministerial functions. In addition, the program will help develop further the legal capacity for resolution of administrative disputes and help improve the oversight of public sector performance by civil society. 8. Another issue addressed under this umbrella is the proliferation of public sector agencies. Recent years have seen a rapid growth of agencies (there are at least 150) as an organizational form, whereby selected governmental functions entrusted to a Ministry are delegated to agencies under its jurisdiction. In Latvia, there are three kinds of governmental agencies: (i) subordinate, (ii) supervised and (iii) under ministerial management. They carry out a range of tasks including service delivery, regulatory monitoring, and asset management. Agency formation does not appear to be related to an objective assessment of the suitability of different types of activity for management or delivery of services. Rather it appears to be motivated by incentives to escape centralized standards and controls. The only legal framework for agencies is the private sector joint stock company legislation, together with the addition of supplementary regulations and the creation of a management layer, sometimes including -2 - Government proxies, between the Ministry and the agency. The current legislative framework is weak in specifying procedures for creating agencies, their financial and managerial accountability, standards for recruitment, promotion and pay; procurement practice; measures of performance and performance evaluation, and their treatment of fees and other revenues. The result has been ad hoc creation of governmental agencies with inadequate regulation and insufficient budgetary control, as they do not have to keep their accounts at the Treasury, resulting in both policy and fiscal risks. The current legal structure under, which the agencies operate, is not appropriate for a public sector institutions responsible for implementing public policy and able to raise their own revenues. It presents clear opportunities for corruption because of the opportunity for rent seeking, for interpreting with discretion its own charter and for loose accountability procedures. It also creates great problems for budget and expenditure management. 9. Strengthening the Public Sector Institutional Capacity. Under this component the World Bank will work with the Government of Latvia on improving the incentives for recruitment and retention of high quality staff and with the rationalization of its public expenditure management system. As integral part of the Government's reform strategy the PSAL program will support the introduction of a unified and transparent structure of pay and incentives that will reward skills appropriately and enable people to be recruited and retained in public service as well as supports the need to strengthen public expenditure management to eliminate the budget deficit, reduce the size of the public sector and increase public investment 10. Continuing Pension Reform while ensuring financial sustainability of the pension system. This part of the program aims at supporting the Government in its efforts to finalize its pension reform agenda and assisting with its efforts to (re-)ensure the financial sustainability of the pension system. As such this component will support the need to take two key actions. First, the program will support the Government in its efforts to pass an acceptable second tier law. Second, there is a need to come to an agreement on how and when to amend some of the recent measures that have been taken in the second half of 1999, which impacted the financial sustainability of the pension system. 11. Rationalizing the interactions between the public and private sector. Latvia's privatization program has been stalled for some time, mostly because of unclear sector policies, sector legislation, lack of a consistent and stable regulatory framework and last but not least political commitment to move forward with divesting state interests in the remaining large enterprises. It is important to resume this process and the PSAL program will support the privatization process and the formulation of the regulatory framework in such a way as to (i) promote open competitive markets, industrial restructuring and growth; (ii) bring in new management competence, technical and marketing skills and access to international capital markets; (iii) reassure the international financial community that Latvia is committed to privatization and open markets; and (iv) realize substantial cash revenues for the state budget at a time of increasing budget deficits. 12. Latvia has decided to establish a consolidated supervisory agency for all financial supervision by merging the existing supervisory entities. The - 3 - law establishing this new agency is in an advanced stage of preparation. The PSAL will support Latvia with establishing this agency while at the same time strengthening the capacity for supervision, particularly of non-bank financial institutions, which represent the weak link in the current set-up for financial regulation, and supervision. 13. Latvia's business regulatory system contains many of the formal mechanisms that are essential for building an effective and transparent regulatory environment. The PSAL program will support the strengthening of the regulatory system in four ways. First, it will commit the Government to providing regulatory drafters with training and information on how to predict the budgetary, economic, and social impact of proposed regulations. Second, it will commit the Government to developing inspection standards, which then will be piloted in two inspectorates. This work will build on a review of inspectorates conducted by BPAR in 1998. Third, it will require the Government to establish clear and simple annual reporting requirements for all regulatory bodies, to pilot these requirements in ten regulatory bodies, and to plan to bring all regulatory bodies into conformity with these requirements. Finally, it will commit the Government to resolving problems of regulatory coordination in one especially difficult, but important area, construction permits. 14. Objective. The main objective of the Loan would be to help the economy to return to sustained and rapid growth and improved welfare of its citizens through reforms that enhance government efficiency and effectiveness. Governance and institutional reform is the backbone of the reform program supported by the Programmatic Structural Adjustment Loan. The reforms build for a large part on work started under the first SAL and which after completion of the first SAL continued to be supported through the Bank's work such as IDFs on Public Sector Reform and infra-structural regulation and its comprehensive anti-corruption agenda. The loan would assist the Government in establishing more efficient institutional arrangements for making strategic policy decision and in establishing accountability for their implementation. 15. Financing and Implementation. The PSAL is in the process of design and discussions with the Government. At present a loan of about $40 million is envisaged. The loan would be made at the standard World Bank rate over a period of 13 years, including four or five years grace. The loan would be made to the Republic of Latvia, represented by the Ministry of Finance, as the Borrower. The loan would be released in two equal tranches following board approval and on fulfillment of the specific second tranche release conditions. 16. Following the identification mission of the PSAL, a counterpart team had been formed, which is chaired/coordinated by the Ministry for Special Assignments for co-operation with international agencies, and includes representatives from various Ministries. This team has been active in the dialogue with the Bank and is expected to continue to help in the implementation of agreed policy measures to be supported by the PSAL. 17. Poverty Category. The proposed PSAL will have an important effect on poverty, since it will support growth objectives in a stable environment as well as measures to improve service delivery of government and to reform the pension system. By contributing to low levels of inflation the PSAL program - 4 - will prevent further erosion in the real living standards of the poor. The objectives of improving public administration and management of resources will make possible improvements in the cost effectiveness of those Government social programs that are especially important for the poor. 18. Environmental Aspects. The loan would have no direct impact on the environment (in line with the World Bank operational directive 4.01) and has been placed in category C that does not require an environmental assessment. 19. Benefits and Risks. Benefits. The actions under the PSAL will aid fiscal adjustment and will ensure the sustainability of the reform process by strengthening the institutional infrastructure needed to improve the public sector's capacity to carry out its role effectively and efficiently. At the same time the SAL's actions will also encourage private sector development by finalizing the privatization process and defining a clear and transparent regulatory framework. By reducing the public sector corruption and streamlining business regulation which are essential not only for an efficient and effective government but also for an efficient working market economy and will significantly facilitate the prospects to enter the EU within a reasonable time period. An efficient working market economy can allocate investments to those sectors that will bring the largest return to the country in the form of sustained and high growth. The PSAL measures would also provide a positive signal to international institutions and investors regarding the Government's commitment to reform and the transition towards a full fledge market economy. 20. Risks. Institutional and governance reform is inherently risky. Any number of contingencies could divert attention from, and could thereby sidetrack or even derail, the process of building the institutional infrastructure necessary for improved public sector performance. Such risks are heightened by the limited time that on average a Government is able to stay in office. The other important risk would be failure to maintain macroeconomic stability, which would decrease the confidence in the current exchange rate arrangements and would result in capital flight and a possible return of high inflation and interest rates. Lack of political commitment could delay fiscal adjustment and the implementation of structural reforms and could also impede the reform process of the pension system, which in turn would severely undermine fiscal sustainability. Poor coordination among the ministries involved is a further risk that could adversely affect the program's implementation. 21. To reduce these risks, the IBRD will continue to assist the Government in mobilizing the technical assistance necessary to adopt and implement the reforms and would also deepen the ongoing dialogue with the Government on structural reform and would work closely with the other donors (and the NGOs) to provide this technical assistance. Moreover, the SAL disbursements are strictly tied to the adoption of policy conditions. The inter-ministerial work group under the coordination of the Ministry of Finance, which helped in the preparation of the PSAL, is expected to continue its work during the implementation phase of the Loan and to improve coordination among the implementing agencies. Subsequent Bank group operations would seek to sustain and deepen the reforms initiated under this operation. Contact Points: The InfoShop - 5 - The World Bank 1818 H Street, N.W. Washington, D.C. 20433 Telephone: (202) 458-5454 Fax: (202) 522-1500 Task Manager Jos Verbeek, ECSPE The World Bank 1818 H Street N.W. Washington, DC 20433 Telephone: (202) 473-3935 Fax: (202) 522-2753 Note: This is information on an envolving project. Certain components may not be necessarily included in the final project. Processed by the InfoShop week ending January 7, 2000. - 6 -