2013 International Monetary Fund January 2013

IMF Country Report No. 13/29

July 29, 2012 January 29, 2001 January 29, 2001
January 29, 2001 January 29, 2001
Republic of Latvia: Selected Issues

This paper on the Republic of Latvia was prepared by a staff team of the International Monetary Fund
as background documentation for the periodic consultation with the member country. It is based on
the information available at the time it was completed on December 19, 2012. The views expressed in
this document are those of the staff team and do not necessarily reflect the views of the government
of the Republic of Latvia or the Executive Board of the IMF.

The policy of publication of staff reports and other documents by the IMF allows for the deletion of
market-sensitive information.


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International Monetary Fund
Washington, D.C.



INTERNATIONAL MONETARY FUND

REPUBLIC OF LATVIA

Selected Issues

Prepared by Agnese Bukovska, Bertrand Gruss, and David Moore (all EUR)

Approved by European Department

December 19, 2012

Contents Page

I. Potential Growth and the Output Gap in Latvia .....................................................................3
A. Introduction ....................................................................................................................3
B. Results ............................................................................................................................6
C. Policies to Increase Potential Growth ..........................................................................10

Figures
1.1. Actual and Natural Unemployment Rate ......................................................................5
1.2. Potential Output, Univariate Statistical Methods ..........................................................6
1.3. Potential Output, Production Function Model ..............................................................7
1.4. Output Gap and Unemployment Gap ...........................................................................8
1.5. Output GapPF and BQ Methods .................................................................................8
1.6. Contribution to Growth of Potential Output .................................................................8
1.7. Tax System Does not Encourage Employment ..........................................................10

Technical Appendix................................................................................................................ .11

References............................................................................................................... .................14
II. Microeconomic Reform Challenges ....................................................................................15
A. Introduction ..................................................................................................................15
B. Overview of Latvias Competitive Strengths and Weaknesses ...................................16
C. Judicial Efficiency and the Insolvency Framework .....................................................23
D. State-Owned Enterprises ..............................................................................................28
E. Higher Education ..........................................................................................................32
F. Vocational Education ....................................................................................................40
G. Other Structural Issues .................................................................................................47
H. Conclusions ..................................................................................................................48

2
Box
1. Europe 2020: Country-Specific Recommendations for Latvia ....................................22
Figures
2.1. Doing Business, EU Countries ..................................................................................17
2.2. Global Competitiveness Index, EU Countries ...........................................................17
2.3. Gini Coefficient, EU Countries ..................................................................................19
2.4. Innovation Index, EU Countries ................................................................................19
2.5. Europe: Clearance Rates of Litigious Civil and Commercial Cases in First.
Instance Courts, 2010........................................................................................24
2.6. EU Countries: Total Public Expenditure on Tertiary Education, 2009 .....................33
2.7. Europe: Trends in Tertiary Enrolments, 200110 .....................................................34
2.8. Latvia: Birth Rates, 19862011 .................................................................................34
2.9. Selected Countries: Quality of the Educational System, 17 (best) 200607 to
201213....................................................................................................35
2.10. Selected Countries: Number of Publications in Science Citation Index Articles
in English per Million Population, 19902010 .................................................36
2.11. Number of PhD Graduates per 1000 Population, 2010 ............................................36
2.12. Vocational Education: Numbers of Students and Institutions, 200511 ..................41
2.13. Selected EU Countries: Total Public Expenditure on Secondary Education,
2008...................................................................................................................42
2.14. EU Countries: Participation in Lifelong Learning, 2011 ..........................................44
2.15. EU Countries: Participation in Continuing Vocational Education, 2005 .................44

References............................................................................................................... .................50
3
I. POTENTIAL GROWTH AND THE OUTPUT GAP IN LATVIA
1


This note presents estimates of potential growth and the output gap in Latvia from different
methods. The estimates suggest that output was below potential in the early 2000s but the output
gap became positive and large after EU accession. The extent of overheating in the pre-crisis
boom is particularly uncertain but staff believes output was about 510 percent above potential
before the crisis. The output gap became negative and large during the crisis, reaching about -
13 percent of potential output in 2009. With unemployment still well above its natural level, the
output gap is estimated to be negative at slightly below 2 percent of potential output in 2012,
but is expected to narrow gradually and be closed in the next 34 years. Potential growth is
nevertheless expected to be substantially lower than in 200207 unless structural reforms enable
to reduce faster and further the structural level of unemployment and remove bottlenecks that
would allow attracting more investment in the coming years.

A. Introduction
1. The concepts of potential output and its associated output gap are central to many
macroeconomic policy discussions. In the near term, the level of potential output indicates the
capacity of the economy to expand without leading to inflationary pressures. Over the medium
term, it determines the sustainable pace of noninflationary output growth. Moreover, potential
output is a crucial input to assess a variety of macroeconomic outcomes, such as the stance of
fiscal policy or the sustainability of the external balance. For example, assessing whether Latvia
fulfills the commitments under the Fiscal Compact will depend on an estimate of the fiscal
position net of cyclical effects and hence on the output gap estimate.
2. However, potential output is an unobservable latent variable and its empirical
counterpart needs to be estimated. Many different methodologies have been used to estimate
potential output, each of them encompassing a different precise definition of potential output and
entailing advantages and disadvantages. No specific approach can be taken to be the correct
one and potential output estimates are subject to substantial uncertainty. This uncertainty is
probably even larger for countries like Latvia, a transition economy still going through
substantial structural changes and coming out of a severe crisis that has likely rendered obsolete
a significant part of the economys productive capacity. This note presents estimates from
various methods, argues in favor of estimates from a variant of the production function approach
and uses these estimates to discuss briefly the room for policies to enhance potential growth
going forward.

1
Prepared by Bertrand Gruss.
4
3. Analysts have relied on different methods to estimate potential output. Most methods
can be broadly classified in two groups: univariate statistical procedures and methods based on
economic multivariate models.
Univariate statistical methods - The most popular methods within univariate procedures
are filters that isolate high from low-frequency components, such as the Hodrick-Prescott
filter (HP), the Baxter and King filter (BK) and the Christiano and Fitzgerald filter (CF).
The main advantage of filters is their simplicity as they are theory-free methods that only
use statistical information from the series itself. The simplicity comes at the cost of some
drawbacks though. Filtered trend estimates suffer from significant end-sample bias, that
is, they are subject to significant revisions as data for later dates becomes available (even
if historical data are not revised). Moreover, these techniques are based only on a
statistical decomposition and ignore relevant economic information, which can
significantly bias estimates. For example, using an HP filter on a sample characterized by
a prolonged period of decreasing inflationand negative output gapas a result of tight
monetary policy would result in an underestimation of potential output. Also, in the
presence of structural changes that render obsolete part of the economys production
structure, as it is probably the case in the wake of the recent crisis, relying on filtered
potential output would most likely overestimate the positive output gap before the
structural break.

Economic models - The methods based on economic models entail a multivariate
approach based on economic theory, typically exploiting key relationships describing
goods and labor markets, the degree of capacity utilization of factors and structural
aspects of the economy. Some widely used examples include the aggregate production
function approach (PF), several variants of models using the Kalman filter and additional
information from the Phillips curve or Okuns law, structural vector autorregression
models and multivariate filter models (e.g. Benes et al., 2010). This note focuses on a
version of the aggregate PF approach and also reports results from a structural vector
autoregression model (as in Blanchard and Quah, 1989; hereafter BQ).
2

4. The benchmark model used in this note is a variant of the production function
approach. It implies assuming an aggregate production for the economy and comparing the
actual level of input factors with their potential or cyclically-adjusted level. The building block
is a Solow growth model that relies on two factors that drive growth in the supply side of the

2
We estimate a joint model of quarterly real GDP and unemployment and use a Blanchard and Quah
(1989)-type decomposition, relying on long-run economic restrictions, to identify supply and demand shocks. The
output gap is computed as the accumulation of demand shocks (to anchor the level of the output gap we assume the
2004 gap is equal to the PF methods gap estimate). We use quarterly data since 1996 and four lags as suggested by
lag length selection criteria.
5
economy: labor and physical capital. The emphasis on a production function approach reflects
both staff view that it represents an adequate framework for Latvia (where, for instance,
population dynamics and structural unemployment play an important role in potential labor and
potential output estimates) and convenience in terms of comparability, since it is the method also
used by the Latvian authorities and the European Commission.
To compute historical values of potential output, estimates of potential factor inputs are
needed. A simple and widely used approach is to estimate potential factors (labor and total
factor productivity) by HP filtering the actual factor series. The problem with this approach
is that it shifts the problems of filters highlighted for trend GDP to the trend estimates of
the inputs. The benchmark model adopted here relies on estimates of the natural rate of
unemploymentand the unemployment gapand, to the extent possible, on a variant of
the Okuns law relationship to
decompose trend from cycle in
other factor components.
3
The
natural unemployment rate used
here is a time-varying
nonaccelerating inflation rate of
unemployment (NAIRU)
estimated using a Kalman filter
and a Phillips curve relationship
between prices and
unemployment (see Technical
Appendix). The degree of
capacity utilization is used to
infer the potential level of total
factor productivity.
To compute potential output in future years, projections for the cyclically adjusted factor
inputs are needed.
The PF method can provide useful information on the determinants of potential growth.
The method relies, however, on an overly simplistic representation of the production
technology and on the approach taken to infer the potential level of factor inputs
(i.e. the NAIRU estimate and the approach adopted to infer potential productivity).



3
The PF variant used here bears similarities with the one used by the U.S. Congress and Budget Office as described
in CBO (2001)
-8
-6
-4
-2
0
2
4
6
8
10
12
14
0
5
10
15
20
25
2
0
0
0
Q
1
2
0
0
1
Q
1
2
0
0
2
Q
1
2
0
0
3
Q
1
2
0
0
4
Q
1
2
0
0
5
Q
1
2
0
0
6
Q
1
2
0
0
7
Q
1
2
0
0
8
Q
1
2
0
0
9
Q
1
2
0
1
0
Q
1
2
0
1
1
Q
1
2
0
1
2
Q
1
Unemployment gap (RHS) Unemployment rate NAIRU
Figure 1.1. Actual and Natural Unemployment Rate
(in percent)
Sources: WEO; and IMF staff estimates.
6
B. Results
Pre-crisis period
5. Estimates suggest that output was below potential in the early 2000s. Estimates from
the PF approach suggest that output was 2 percent below potential in 200203, consistent with
high unemployment and a NAIRU estimate implying an unemployment gap of around
13 percentage points (Figures 1 and 3). The estimate from the HP filter is about the same, while
output gap estimates from the BK and CF filters are negative but much smaller (Figure 2, left
chart).
6. The output gap became positive and large after EU accession in 2004. Both filters
and the PF methods suggest that output increased well above potential from about the time of EU
accession (Figures 2 and 3). The estimate from the benchmark PF approach, that incorporates
information from the goods and labor markets through the NAIRU estimate, indicate that the
widening of the output gap accelerated in 2006, consistent with price and wage inflation
developments (Figure 3).

7. Output was probably about 510 percent above potential before the crisis, although
the extent of overheating at the pre-crisis boom is particularly uncertain:
On the one hand, filter estimates suggest output might have been as much as 20 percent
above potential before the crisis. The HP filter suggests that the output gap surged to about
20 percent in 2007. Also, when the PF model is fed with HP filtered input series, the
pre-crisis output gap estimate exceeds 15 percent (using the usual value for annual data of
100 for the smoothing parameter; Figure 3, bottom right chart). But using the HP filter to
remove cyclical fluctuations is subject to significant end-sample bias: the 2007 output gap
would have been less than 5 percent if estimated with real time information (i.e. with data
up to 2007), while extending the sample up to 2009 would lead to a gap estimate for 2007
almost 3 times bigger (Figure 2, right chart).
Figure 1.2. Potential Output, Univariate Statistical Methods
Sources: WEO; Haver; and IMF staff calculations
-15
-10
-5
0
5
10
15
20
25
2002 04 06 08 10 12 14 16
HP (lambda=100)
HP (lambda=6.26)
BK
CF
Output Gap - Univariate Filters
(in percent of potential output)
-20
-15
-10
-5
0
5
10
15
20
25
2002 03 04 05 06 07 08 09 10 11 12
2007
2008
2009
2012
Output Gap - HP Filter
(in percent of potential output; different end of sample)
7

Figure 1.3. Potential Output, Production Function Model
Sources: WEO; Haver; and IMF staff calculations
-15
-10
-5
0
5
10
15
0
1000
2000
3000
4000
5000
6000
7000
8000
9000
10000
2002 03 04 05 06 07 08 09 10 11 12 13 14 15 16 17
Output Gap (RHS) Output Potential Output
Output and Potential Output
(in million chained 2000 lats and percent of potential output)
-10
-5
0
5
10
15
20
25
30
35
-10
-5
0
5
10
15
20
2002 04 06 08 10 12 14 16
Unemployment Gap
Inflation
Wage Inflation (RHS)
Unemployment Gap and Inflation
(in percent)
1.4
1.5
1.6
1.7
1.8
1.9
2.0
2.1
0.8
0.9
1.0
1.1
1.2
2002 04 06 08 10 12 14 16
Employment
Potential Employment
Working Age Population (RHS)
Labor Factor
(in million of people)
80
90
100
110
120
130
140
2002 04 06 08 10 12 14 16
TFP
Trend TFP
Alternative trend TFP
Total Factor Productivity
(Alternative trend estimates; actual TFP in 2002=100)
-20
-15
-10
-5
0
5
10
15
20
200203 04 05 06 07 08 09 10 11 12 13 14 15 16 17
Baseline
Alternative trend TFP
Filtered Factors
Output Gap
(in percent of potential output, alternative PF specifications)
8
Also, results from the HP filter are very sensitive to the choice of smoothing parameter:
when the parameter is set to 6.25, as suggested by Ravn and Uhlig (2002), the pre-crisis
estimated output gap is half the size than when the parameter is set at 100. The BK and CF
filters also indicate a very steep widening of the output gap before the crisis, though less
pronounced. All filter estimates suggest that the absolute size of the pre-crisis (positive)
gap was almost twice the size of the (negative) gap during the crisis.
On the other hand, the benchmark PF model
suggests the output gap peaked at around
5 percent of potential output before the crisis,
implying that the absolute magnitude of the
pre-crisis output gap was less than the
crisis gap. This is consistent with
developments in the labor market: while
unemployment went below the NAIRU
during the boom, the absolute magnitude of
the pre-crisis unemployment gap was less
than the size of the crisis gap. The
participation rate was also high during the
boom, but not extreme. One caveat to this
estimate is that the potential TFP series used in
the benchmark model might not be completely
clean from cyclical factors. Using an
alternative potential TFP series (subsequently
smoothed with an HP filter; see Technical
Appendix) leads to a gap estimate of about 9
percent. Estimates from the BQ model also
point to a positive output gap between 5 and 10 percent just before the crisis.
While acknowledging the uncertainty of estimates, staff believes output was significantly
above potential before the crisis, but probably in the 510 percent range rather than in the
1520 percent range.
8. The investment boom financed by capital
inflows was the main driver of potential growth
before the crisis. Growth decomposition from the
benchmark PF approach shows that in the early 2000s
and especially after EU accession, potential output
growth was driven mainly by a foreign financed
investment boom. Productivity growth also played an
important role, although this might partially reflect
underestimated rise in factors utilization.
-15
-10
-5
0
5
10
15
2002 03 04 05 06 07 08 09 10 11 12 13 14 15 16 17
Ouput gap (PF model, in percent of potential output)
Unemployment gap (unemployment rate minus NAIRU)
Figure 1.4. Output Gap and Unemployment Gap
Sources: WEO; Haver; and IMF staff calculations.
-15
-10
-5
0
5
10
2002 03 04 05 06 07 08 09 10 11 12
Benchmark PF
BQ
Figure 1.5. Output Gap - PF and BQ Methods
(in percent of potential output)
Sources: WEO; Haver; and IMF staff estimates.
-6
-4
-2
0
2
4
6
8
10
12
2002 04 06 08 10 12 14 16
TFP Labor Capital Stock Potential Output
Figure 1.6. Contribution to Growth of Potential Output
(in percent)
Sources: WEO; and IMF staff calculations
9
Crisis and recovery
9. All methods suggest that output fell well below potential in 200910. The benchmark
PF model suggests the output gap reached -13 percent in 2009. Estimates from filters range from
-8 to -10 percent. All methods have the output gap narrowing from 2010 or 2011, except for
the BQ model that shows a larger output gap in 2012 than in 2011 (although quarterly gap
estimates from the BQ model are decreasing towards end-2012).
10. The labor force and productivity were the main factors dragging potential growth
during the crisis. The sharp contraction in potential TFP in 200810 contributed significantly to
the contraction in potential growth during the crisis. This is consistent with efficiency losses in
reallocating factors across sectorsalthough the drop in TFP might be capturing
underestimation of changes in capacity utilization. Emigration flows that intensified at the onset
of the crisis affected potential employment and growth in 200708. The negative impact of labor
to potential growth in 201112 responds to an increase in structural unemployment most likely
due to hysteresisa transformation of cyclical into structural unemployment as skills of the
long-term unemployed depreciate.
11. The estimates suggest that the effect of the crisis on potential output was large.
While potential output was growing at about 6 percent per year during 200207, estimates
suggest it contracted by 7 percent between 2007 and 2011. Potential growth resumed in 2012
but, under current estimates, its 2007 level would not be attained until 201314.
Medium-term projections
12. The estimated unemployment and output gap is still significantly negative but is
projected to close in the next 3 to 4 years.
The benchmark PF model indicates that output in 2012 is still about 2.3 percent below
potential (above 3 percent using the alternative potential TFP series) but would diminish
gradually and be closed by 201516. The reason for the still negative output gap in 2012
is the estimated slack in the labor market: the unemployment rate is still about
2 percentage points above the 12.3 percent NAIRU estimate. While the NAIRU
estimate for 2012 is large, it is consistent with the unemployment rate having been
historically high in Latvia: the average unemployment rate between 1996 and 2011 was
above
13 percent.
4

According to the HP filter the output gap in 2012 is almost 5 percent and would be closed
by 2015. The HP filter output gap estimate for 2017 is positive at about 3 percent

4
Also, the estimate from using a constant-NAIRU model is almost 12 percent.
10
(although it is only 0.5 percent if the sample is extended from 2017 to 2020, highlighting
the end-of-sample bias of this method).
On the other hand, the BK and CF filters suggest that the output gap is already closed or
slightly positive already in 2012which is at odds with an unemployment rate above
15 percent and a sizeable unemployment gap.
13. Going forward, staff expects potential growth to be substantially lower than before
the crisis. Staff expects a gradual recovery of investment as FDI inflows pick up, but at a much
slower pace than in the pre-crisis years when capital flows to the region were extraordinary. A
slower pace of capital accumulation would also be associated with a more modest growth in
productivity. Labor is not expected to contribute to potential growth in the coming years. The
natural unemployment rate is expected to decrease gradually from its current estimate at
12.3 percent to 10 percent by 2015 and to slightly below 10 percent by 2017. But the gradual
reduction in the natural unemployment rate barely offsets the expected negative trend in working
age population. Altogether, staff projects potential growth to increase to about 3 percent in
201417.
C. Policies to Increase Potential Growth
14. Staff projections suggest that policies increasing potential employment could help
attaining higher potential growth in the coming years. Given current projections for
population and structural unemployment, the contribution of the labor factor to potential growth
would be almost nil in 201417. Two sets of policies could increase the contribution from labor
to growth. First, policies aimed at reducing the natural unemployment rate by addressing
structural bottlenecks that are keeping long-term unemployment at high levels could provide a
boost to potential output. In this sense, findings from the forthcoming World Bank study could
be used to: i) design ALMPs that aimed at alleviating
skill mismatches in the labor market; and ii) address
current disincentives from tax and benefit systems
that act as an unemployment trap, reducing the
attractiveness of moving from unemployment to
employment. In addition, in an effort to reduce net
emigration, the authorities are developing plans
aimed at assisting emigrants who wish to return.
Other demographic policy efforts could help in the
longer term (Staff Report, Appendix II).
15. Attaining higher potential growth will depend on fostering productivity and
attracting more foreign investment over the medium term. The growth rate of investment
observed during the boom years is not likely to return. Still, stronger investment than currently
projected and faster productivity gains could be achieved if structural reforms to address
bottlenecks were adopted (see next chapter).
30
40
50
60
70
80
90
100
S
K
M
T
R
O
E
E
U
K
A
T
G
R
L
T
F
I
I
E
D
E
S
E
E
U
F
R
E
u
r
o
I
T
P
T
C
Z
B
G
P
L
H
U
E
S
S
I
N
L
L
U
D
K
L
a
t
v
i
a
B
E
Figure 1.7. Tax System Does not Encourage Employment
(Unemployment trap, single person without children)
Sources: Eurostat
11
TECHNICAL APPENDIX

Assumptions underlying the Production Function Model:

Output- A Cobb-Douglas specification is assumed for output:
0P
t
= IFP
t
K
t
(1-u)
I
t
(u)
, where K is the capital factor, computed as explained below;
L is the labor factor and TFP is total factor productivity computed as the Solow residual;
the labor share in production (o) is assumed to be 2/3.
Labor factor The actual level of the labor factor is total employment in the economy.
1

To estimate potential employment, total employment is decomposed in two components:
the labor force and un/employment.
The potential level of un/employment is proxied by a time-varying estimate of the natural
rate of unemployment called the nonacceleraing inflation rate of unemployment
(NAIRU). The NAIRU is inferred from a Phillips curve-type regression similar to
Gordon (1997) and Boone et al. (2001) using quarterly data from 1996Q1 to 2012Q3:
n
t
= n
t
c
+B(I)(u
t
- NAIR0
t
)+J(u
t
) + C(I)z
t
+c
t

where n
t
and n
t
c
denote realized and expected core inflation
2
; u
t
denotes the
unemployment rate; z
t
is a set of variables capturing supply side shocks and normalized
to zero (in this paper, changes in consumer taxes and variations in import prices); B(L)
and C(L) are polynomials in the lag operator; the disturbance c
t
is assumed to be i.i.d.
normal with zero mean and variance o
c
2
. Expected inflation is proxied by past inflation
(n
t
c
= o

n
t-
1
=1
). We impose the sum of the weights on lagged inflation terms to be
equal to one to ensure dynamic homogeneityi.e. no relationship between inflation and
real variables in the long-runwhich is necessary for the NAIRU to be an economically
meaningful concept. The preferred specification uses one lag for inflation. NAIR0
t
is the
natural unemployment rate at period t and is modeled as an unobserved stochastic process
assumed to follow a random walk and estimated using the Kalman filter:
NAIR0
t
= NAIR0
t-1
+e
t

The disturbance term e

t
is assumed to be i.i.d. normal with zero mean and variance o
c
2
.
As it is common in the literature, o
c
2
is constrained to be a fraction of o
c
2
(see Gordon
1997). After comparing the model likelihood from using alternative values, this ratio is
set at 0.2.


1
Hours worked was not used in this specifications due to data concerns.
2
An alternative specification using headline inflation and other supply shock control variables (e.g. changes in
energy and food prices) was also used and the results were not significantly different.
12
The potential labor force is given by the working age population and the potential
participation rate.
3
To estimate the potential participation rate, we use a cyclical-
adjustment equation that relies on the gap between the unemployment rate and the
NAIRU as an indicator of when actual participation equals potential and that allows for
potential participation to grow at a constant rate over one or more historical periods.
4
The
cyclical-adjustment equation results from combining the following equations:
p
t
= p
t
-
+0(u
t
-NAIR0
t
) + e
t

p
t
-
= y'(I
1
, I
2
, , I
N
)
where p
t
and p
t
-
are actual and potential participation levels; 0 is an estimated coefficient
on the sensitivity of participation to the unemployment gap; y is a vector of N coefficients
and I

is a trend variable that takes zero values up to the break point in period i.
Historical values for the potential participation rate are calculated as the fitted values
from the regression with the unemployment rate constrained to equal the NAIRU at each
period. Only one trend break, in 2000, is assumed for the final model specification.

Capital factor and TFP While in principle
the capital input does not need to be cyclically
adjustedas the unadjusted level already
represents its potential contribution to growth
cyclical variations in the rate at which it is used
get reflected in the TFP series if capital is not
adjusted. Variations in utilization rates were
particularly large in Latvia around the recent
crisis. Some studies use data on capacity
utilization to infer the potential level of TFP.
5
In this study, a simpler approach is taken.
The capital factor is assumed equal to the capital stock in the economy, computed
according to the perpetual inventory approach (with depreciation assumed to be 8 percent
per year), multiplied by the ratio of capacity utilization.
6
Potential capital is obtained by

3
For the purpose of this analysis, labor statistics up to 2011 have been estimated by staff by extrapolating the
correction introduced in 2011 due to Census data for the period in between census years (200011).
4
This approach is similar to the one used by the Congress and Budget Office to estimate potential output in the
U.S.; see CBO (2001).
5
For example, a new method being used by the European Commission to estimate trend TFP relies on the
Kalman filter and data on capacity utilization to disentangle cyclical and structural variations in TFP; see
DAuria et al. (2010).
6
The level of capacity utilization is proxied by the capacity utilization in manufacturing from managers
answers to business and consumer surveys published by the National Statistical Office.
50
55
60
65
70
75
80
2002 04 06 08 10 12 14 16
Capacity Utilization Long-run mean
Capacity Utilization
(Capacity utilization, industry, in percent)
Sources: Haver; and IMF staff calculations.
13
imposing capacity utilization at its long-run average. The Solow residual after correcting
the capital stock by the degree of capacity utilization is assumed to represent the
structural level of efficiency in the economy and is taken as the benchmarkpotential TFP.
Arguably, the resulting TPF series might still include cyclical elements such as variable
utilization not captured by the capacity utilization rate used (e.g. as we are not correcting
the labor factor by variations in the intensive margin). As a robustness exercise we
construct an alternative potential TFP series by HP filtering the benchmark series (with a
low smoothing parameter of 6.25). Estimates from both approaches differ mainly in
magnitude of the pre-crisis output gap estimate (Figure 3). As the process to obtain the
alternative potential TFP series embeds no economic information and might be
smoothing out non-cyclical variations, the unfiltered series is used for the benchmark
model specification.
14
REFERENCES
Benes, J., K. Clinton, R. Garcia-Saltos, M. Johnson, D. Laxton, P. Manchev and
T. Matheson, 2010, Estimating Potential Output with a Multivariate Filter,
IMF Working Paper 10/285 (Washington: International Monetary Fund)..

Blanchard, Olivier J. and Danny Quah, 1989, The Dynamic Effects of Aggregate Demand
and Supply Disturbances, American Economic Review, Vol. 79, No. 4, pp. 65573.

Boone, Laurence, Claude Giorno, Mara Meacci, Dave Rae, Pete Richardson and Dave
Turner, 2001, Estimating the structural rate of unemployment for the OECD
countries, OECD Economic Studies, vol. 2001(2), pages 171216.

Congressional Budget Office (CBO), 2001, CBO's Method for Estimating Potential Output:
An Update.

DAuria, Francesca, Ccile Denis, Karel Havik, Kieran McMorrow, Christophe Planas, Rafal
Raciborski, Werner Rger, and Alessandro Rossi, 2010, The production function
methodology for calculating potential growth rates and output gaps, European
Economy, Economic Paper No. 420, European Commission.

Gordon, Robert J., 1997, The Time-Varying NAIRU and Its Implications for Economic
Policy, Journal of Economic Perspectives, American Economic Association,
vol. 11(1), pp. 11-32.

Ravn, Morten O. and Harald Uhlig, 2002, On Adjusting the HP-Filter for the Frequency of
Observations, The Review of Economics and Statistics, 84(2): pp. 37138.

15
II. MICROECONOMIC REFORM CHALLENGES
1

A. Introduction
1. Latvias reform challenge is ongoing. Latvia has seen two decades of sweeping
political, economic, and social changes since regaining its independence in 1991, beginning with
the reintroduction of a market economy, and with additional impetus from preparations for EU
and NATO accession in 2004. More recently, Latvia needed further reforms to restore
competitiveness and the public finances as boom turned to bust in 200809. Much has been
done. Even so, a significant reform agenda remains ahead.
2. Latvia is recovering well from its 200809 crisis. Latvia implemented a very strong
macroeconomic adjustment programwith international financial supportin response to the
2008 financial and balance-of-payments crisis. Central to the adjustment was a massive fiscal
consolidation, and unwinding of previously rapid price and wage increases, to close the gap
between incomes and productivity. A firm recovery has taken hold, with real GDP expanding
rapidly in 2011 and 2012and, in contrast to the 200407 boom, the external imbalances are
under control. Yet Latvia continues to face major long-term challenges: unemployment and
poverty rates are still high, the working-age population is falling, and income levels are still low
by EU standards. Thus, an overarching challenge for policymakers is to promote economic
growth that can raise living standards sustainably, while avoiding a repeat of past imbalances.
3. Future growth will come in a context of constraints on macroeconomicfiscal and
monetarypolicies. While the most difficult fiscal measures are now in place, and the general
government deficit has been sufficiently reduced for Latvia to meet the Maastricht deficit
criterion, fiscal space is still limited. And monetary policy is centered on the peg to the euro,
with a view to euro adoption in 2014. To be sure, the stability associated with disciplined
macroeconomic policies is a necessary condition for sustained economic growthand Latvia is
by no means alone in facing policy constraints. But to promote growth more actively, Latvian
policymakers need to look beyond fiscal and monetary policies.
4. This paper discusses the microeconomic reforms that are most needed to support
growth. The next section provides an overview of recent evidence on strengths and weaknesses
in Latvias business environment. The following sections focus in more detail on three areas in
which reform efforts in progress could bear most fruit: the efficiency of the legal framework,
including the insolvency framework; governance of state-owned enterprises (SOEs); and higher
and vocational education. Though some of these areas, including SOEs and education, clearly
have fiscal implications, the paper emphasizes non-fiscal aspects, i.e. supply-oriented reforms
aiming primarily at removing impediments to growth.

1
Prepared by Agnese Bukovska and David Moore.
16
B. Overview of Latvias Competitive Strengths and Weaknesses
5. Fostering growth is an EU-wide challenge, but the challenges differ from country to
country.
Barkbu et al. (2012) discuss policies to promote growth in Europe as a whole, with an
emphasis on labor and product market reforms, but recognizing regional differences.
They recommend granular reforms: in southern Europe, these reforms should address
insider-outsider gaps in the labor market and relative price misalignments that hold back
the competitiveness of the tradable sector. In northern Europe, reforms should target
higher labor participation and a more vibrant services sector.
Turning to the case of Latvia, three different sources of information help identify the
country-specific challenges: international survey evidence, progress on the structural
reform agenda during the 200811 program, and more recent Latvia-specific analysis of
strengths and weaknesses.
International survey evidence
6. Survey evidence is mixed on the competitiveness of Latvias business environment,
but on balance suggests it lags the other Baltic and EU-27 countries.
Latvia does relatively well in the World Banks Doing Business ratings, in 2013 ranked
overall at 25 out of 185 economies (Figure 1). Even so, despite its rise in the rankings
through the past few years, Latvia fell back four places in the most recent survey as other
countries made improvements of their own. Latvias ranking is in line with those of
Estonia and Lithuania (21
st
and 27
th
respectively).
In the subindicators,
2
Latvia ranks well in starting a business, reflecting changes in
2011 to simplify procedures. Latvia ranks less favorably on protecting investors
(70
th
out of 185).
The 201213 Global Competitiveness Report of the World Economic Forum (WEF)
ranks Latvia 55 out of 144 countries (Figure 2). This is well behind Estonia (34
th
) and
Lithuania (45
th
), but represents a notable improvement from two years ago, when Latvia
ranked 70
th
out of 139. Latvias WEF subindicators are most favorable for labor market
efficiency, and least favorable on business sophistication, innovation, and market size.
In addition, Latvia ranks 106
th
in efficiency of legal framework in settling disputes,
corroborating a Doing Business finding.

2
Some of the Doing Business subindicators seem more reliable than others. Latvias ranking for getting credit
(4
th
out of 185) seems too favorable given the extent of deleveraging. And a caveat to Latvias unfavorable ranking
on protecting investors is that Finland has the same ranking (70
th
out of 185) on this subindicatorwhich is hard
to square with other indicators for Finland showing a particularly strong business environment.
17



0
10
20
30
40
50
60
70
80
90
0
10
20
30
40
50
60
70
80
90
Source: World Bank.
(2013 rankings, of 186 countries)
Figure 2.1. Doing Business, EU Countries
0
10
20
30
40
50
60
70
80
90
100
0
10
20
30
40
50
60
70
80
90
100
Source: World Economic Forum.
(2012-2013 rankings, of 144 countries)
Figure 2.2. Global Competitiveness Index, EU Countries
18
Latvia-specific analysis
7. The Latvian Competitiveness Report 2011 (LCR) provides a careful diagnostic of
Latvias competitiveness. The report, commissioned by the authorities and prepared by
independent academics, assesses Latvias relative strengths and weaknesses. It finds Latvias
strengths include:
its strong growth and diversification in exports coming out of the crisis; and
its physical infrastructure for transport and logistics.
But weaknesses include:
high inequality (Figure 3);
limited innovation (Figure 4);
low manufacturing productivity;
the quality of education, especially in the higher and vocational sectors;
underdeveloped financial markets;
and a large informal economy, estimated at some 40 percent of GDP.
For the most part, the LCR limits itself to a diagnostic approach. While it tries to avoid
prescribing detailed policy responses, putting the onus on policymakers to draw their own
conclusions, it does recommend actions prioritizing actions to curb the informal economy
(including an overhaul of tax administration), to improve the quality of education, and to build
on Latvias strengths in transport and logistical infrastructure.
8. The LCR notes the costs to competitiveness where flouting of the rules is
widespread. Most obviously, the informal economy distorts competition, biasing activity
towards short-term gains and against longer-term productive investments. The LCR also finds
that, while the Latvian labor market has been flexible in practice, much of this flexibility reflects
circumvention of formal employment rules: this is costly in terms of resources diverted to
circumvention and to the credibility of labor market institutions. And, while not attempting a
detailed analysis of Latvias legal efficiency, the LCR does find that perceived inefficiencies in
both legislation and implementation are discouraging investment, and that a high number of
business disputes is contributing to resource misallocation and lower competitiveness.
9. The LCR distinguishes between the relatively good quality of primary and
secondary education, and deeper problems in higher and vocational education. In terms of
enrolments of preschool children in education, a low share of 15-year-olds with insufficient
knowledge of reading, mathematics and science, and the share of early school leavers, Latvia
performs better than the EU average, even if short of the Europe 2020 targets. But only a low
share of adults take part in lifelong learning. In the secondary education sector, the introduction
of the money follows the student principle in 2009 represented a major reform. Latvias scores
in the Program for International Student Assessment (PISA) are below the OECD average,
indicating room to improve quality, but are not an obvious outlier. Problems are deeper in higher
and vocational education (sections E and F).
19




10
15
20
25
30
35
40
10
15
20
25
30
35
40
Source: Eurostat.
(Data for 2011, except * 2010)
Figure 2.3. Gini Coefficient, EU Countries
0.0
0.1
0.2
0.3
0.4
0.5
0.6
0.7
0.8
0.0
0.1
0.2
0.3
0.4
0.5
0.6
0.7
0.8
Source: Innovation Union Scoreboard 2011, Maastricht Economic and Social Research
Institute on Innovation and Technology.
(Data for 2011)
Figure 2.4. Innovation Index, EU Countries
20
10. The authorities are incorporating the LCR findings into their own policy planning
document, the draft National Development Plan 201420 (NAP).
The NAP is intended to ensure the consistency of sectoral policies through the next EU
budget period, and to promote reforms while fostering recognition of sectoral budget
constraints. It is premised on the main findings on the LCR, in particular acknowledging
high inequality, the large grey economy, and weak innovation.
In response, the NAP sets three priorities: economic growth; securitability, i.e. to
empower individuals, with a view to mitigating inequality and mitigating Latvias
demographic decline; and development of Latvias regions. The NAP largely defers to
line ministries to elaborate the details of intended sectoral measures to meet these goals.
3

The authorities envisage parliamentary approval of the NAP in December 2012.
11. The regular half-yearly report of the Ministry of Economics (MoE) sets out the
ongoing policy agenda for the business environment and other structural areas of economic
policy. The most recent report (MoE, 2012) reviews Latvias progress in implementing its
National Reform Programme for 201114, introduces the governments ideas for a new
industrial policy, and discusses developments in energy, construction, tourism, competition, and
other structural policies.
12. Other stakeholders regularly contribute to the structural policy debate. One forum is
the National Economy Council (NEC), an advisory institution of stakeholders including the
MoE, business groups, trade unions, local governments, and academics (MoE, 2012). In
addition, the government holds an annual consultation with the Foreign Investors Council in
Latvia (FICIL); the June 2012 Government of Latvia-FICIL communiqu
4
discussed structural
challenges including the need to address weaknesses in the Latvian court system, the gap
between insolvency law and procedures, and the need for good corporate governance for
state-owned enterprises.

3
However, the NAP proposals on regional developmentwhile consistent with earlier long-range planning
documentsare now proving controversial. The NAP envisages focusing resources on 9 larger cities and
21 development centers: the trade-off is that smaller municipalities would miss out, but resources would no longer
be spread too thinly to be effective.
4
See http://www.ficil.lv/index.php/documents/communique/
21
Structural issues and the EU-IMF program
5

13. Latvias balance-of-payments assistance from the European Union included
significant conditionality on non-fiscal structural areas. While the IMF part of the program
focused on restoring macroeconomic and financial stability, the EU institutions followed a
somewhat broader mandate. As well as supporting policies to promote competitiveness under a
fixed exchange rate, the EUs part of the program explicitly took into account the goals of the
Europe 2020 growth strategy. In its first post-program surveillance (PPS) report on Latvia, the
European Commission (2012) summarized the remaining structural agenda as follows:
The main challenges for the government, as presented in the latest National Reform Plan
(NRP) and Convergence Programme (CP), are to continue reducing budget deficit and debt
levels, refocus and adequately finance active labour market policies, reform and better target
the social safety net, improve the judiciary system and the economys energy efficiency,
strengthen the capacity to monitor and enforce competition, and continue reforms in higher
and vocational education.
While progress is remarkable in many areas, the PPS mission revealed less progress than
expected as regards several conditions included in the latest Memorandum of Understanding,
notably on management of state owned enterprises (SOEs), public administration and the
unified public sector wage grid reforms, strengthening of the competition framework, and
setting up of the Development Bank.
Drawing on PPS findings, and as part of the Europe 2020 process, the European Council made
country-specific recommendations in these areas in July 2012 (Box 1).
14. IMF structural conditionality during the 200811 program focused relatively
narrowly on fiscal and financial sector reforms. The Stand-By Arrangement (SBA) included a
fairly high number of benchmarks on areas that could deliver permanent deficit reduction, or
were aimed at resolving financial sector weaknesses. Benchmarks on SOEs had a fiscal as well
as a structural rationale. Even so, given the need for Latvia to restore competitiveness under its
fixed exchange rate, discussions
6
through the program period pointed to the need for structural
reforms outside these core macroeconomic and financial areas. In addition, following up on its
technical assistance in 200910 on debt restructuring issues, the IMFs Legal Department
provided technical advice to the justice ministry during the development of a new insolvency law
that was introduced in 2010.

5
For a more complete overview of program issues from the IMF perspective, please see the upcoming Ex-Post
Evaluation of Exceptional Access Under the 2008 Stand-By Arrangement. For the European Commissions
perspective, see Giudice et al (2012).
6
See for example, IMF Country Report No. 12/171, the staff report for the 2010 Article IV Consultation.
22

Box 1. Europe 2020: Country-Specific Recommendations for Latvia

The European Council made the following recommendations to Latvia in July 2012:

1. Ensure planned progress towards the timely correction of the excessive deficit. To this end,
implement the budget for the year 2012 as envisaged and achieve the fiscal effort specified in the
Council recommendation under the Excessive Deficit Procedure. Thereafter, implement a budgetary
strategy, supported by sufficiently specified structural measures, for the year 2013 and beyond, to
make sufficient progress towards the medium-term budgetary objective (MTO), and to respect the
expenditure benchmark. Use better than expected cyclical revenue to reduce government debt.

2. Implement measures to shift taxation away from labour to consumption, property, and use of
natural and other resources while improving the structural balance; ensure adoption of the Fiscal
Discipline Law and develop a medium term budgetary framework law to support the
long-term sustainability of public finances; restore contributions to the mandatory funded private
pension scheme at 6 percent of gross wages from 2013.

3. Take measures to reduce long-term and youth unemployment by fighting early school leaving,
promoting more efficient apprenticeships and VET [vocational education and training], enhancing the
quality, coverage and effectiveness of active labour market policy and its training component and
through an effective wage subsidy scheme.

4. Tackle high rates of poverty and social exclusion by reforming the social assistance system to
make it more efficient, while better protecting the poor. Ensure better targeting and increase
incentives to work.

5. Further encourage energy efficiency by providing incentives for reducing energy costs and
shifting consumption towards energy-efficient products, including vehicles, buildings and heating
systems. Promote competition in major energy networks (electricity, natural gas, heating) and
improve connectivity with EU energy networks.

6. Take measures to improve management and efficiency of the judiciary, in particular to reduce
the backlog and length of procedures. Take steps to improve the insolvency regime and the mediation
laws.

7. Continue reforms in higher education, inter alia, by implementing a new financing model that
rewards quality, strengthens links with market needs and research institutions, and avoids
fragmentation of budget resources. Design and implement an effective research and innovation policy
encouraging companies to innovate, including via tax incentives, upgrading infrastructure and
rationalising research institutions.

____________
Source: Council of the European Union (2012)
http://ec.europa.eu/europe2020/europe-2020-in-your-country/latvija/index_en.htm

23
Reform priorities
15. While the different information sources point to several areas for reform, they
consistently identify the need to upgrade judicial efficiency and the insolvency framework,
SOE governance, and higher and vocational education. Encouragingly, the authorities have
reform plans for each of these areas; but implementation is largely still to come. The following
sections consider in turn the challenges in these sectors, the authorities proposed responses; and
the prospects for their proposals to deliver lasting improvements.
16. Reforms in these and other areas would help address high structural
unemployment. The previous chapter on potential output finds that the natural unemployment
rate (NAIRU) remains high, at around 1213 percent. Further reform efforts could contribute to a
lower NAIRU in several ways. First, a more efficient legal system and better business
environment would be conducive to higher rates of investment and economic growth, increasing
overall employment. Second, an education sector better aligned with the needs of employers
would contribute to higher productivity and to reducing skills mismatches. Third, as discussed in
the accompanying Staff Report, tax-benefit reforms could promote incentives to work; a
forthcoming World Bank study due in spring 2013 is expected to include important
recommendations on this issue.
C. Judicial Efficiency and the Insolvency Framework
Background
17. Multiple sources point to costly inefficiencies in the judicial system.
In the WEF Global Competitiveness Index 201213, Latvia ranks 106
th
out of
144 countries for the subindicator efficiency of legal framework in settling disputes.
Latvias weakest Doing Business rating is in the area of investor protection.
Discussions with stakeholders corroborate the survey evidence, with representatives of
foreign investors describing the legal system as a bottleneck.
The Council of the European Union (2012) notes a large backlog of proceedings in the
first and second instance courts in civil and commercial cases, especially as regards
contractual obligations and insolvencies.
18. While efficiency indicators are favorable for administrative and criminal courts,
indicators for civil courts are low by EU standards. CEPEJ (2012) reports core efficiency
indicators for European courts using 2010 data. On the positive side, Latvias clearance ratethe
ratio of resolved to incoming caseswas 99.6 percent for criminal cases and 95.8 percent for
administrative law cases in first-instance courts. This is in line with EU peer countries. However,
for litigious civil and commercial cases in first-instance courtsmost relevant for contract
enforcementthe clearance rate was only 85.8 percent (Figure 5), compared with between
24
90 and 110 percent in most EU peer countries. According to Ministry of Justice (MoJ) officials,
the backlog peaked in 2011 and remains significant, but they expect the number of resolutions in
2012 to exceed the number of new incoming cases.
19. Multiple sources indicate that low access fees, and excessive discretion for judges to
adjourn cases, have contributed to delays. In principle, low fees have been intended as
promoting universal access to justice. In practice, according to discussions with stakeholders,
they have provided incentives for routine appeals against unfavorable first-instance rulings
adding considerably to the burden on Latvias three-instance legal system. FICIL (2012a)
recommends higher fees for larger claims, noting that the state fee for claims of LVL 1,000,000
is almost ten times higher in Estonia and about three times higher in Lithuania. In addition,
according to the LCR and FICIL (2012a), parties to legal proceedings have considerable scope
for delaying tactics, for example by simply not turning up in court. FICIL (2012a) recommends
modifying the Law on Civil Procedures to reduce judges room for discretion and instead
provide for automatic sanctions against such tactics.
Figure 2.5. Europe: Clearance Rates of Litigious Civil and Commercial Cases
in First Instance Courts, 2010

Less than 90 percent
From 90 percent to
less than 100 percent
From 100 percent to
less than 110 percent
110 percent and over
Data not supplied
Not a CoE member state
Source: CEPEJ (2012).
25
20. Stakeholder perceptions of the arbitration system limit its effectiveness as an
alternative to civil courts. Latvia has around 120 arbitration institutions, compared with 2 in
Estonia and 3 in Lithuania.
7
To the extent that private parties lack confidence in the neutrality of
arbitration institutions, their incentives are stronger for dispute resolution instead through the
civil court systemadding to the backlog. The LCR interprets the high number of arbitration
institutions in Latvia as a sign of a potential quality problem, since Latvia is too small to have
sufficient qualified experts to staff them. FICIL (2012a) recommends stricter qualifications for
establishing arbitration institutions and for individuals to serve on them.
21. The legal framework for insolvency has been significantly upgraded since the crisis.
8

The corporate insolvency law was amended in two steps. In July 2009, amendments strengthened
incentives to restructure corporate debt, including through procedures for expedited court
approval of restructuring plans under Legal Protection Proceedings (LPPs). In 2010, parliament
approved a new insolvency law that streamlined liquidation procedures to speed up the exit of
nonviable firms and further refine LPP procedures. In line with international best practice, the
new law replaced two tests for insolvency, the balance-sheet test and the cash-flow test, with
a single cash-flow test. In addition, a new personal insolvency law also became effective in 2010.
Under this framework, an individual debtor will be fully discharged from his/her remaining debt
liabilities after successfully implementing a repayment plan closely monitored by the court.
22. Nevertheless, the insolvency framework remains prone to abuse. In 2011, a number
of reports emerged of apparently financially sound companies nevertheless being subjected to
insolvency proceedings.
9
In a high-profile case in early 2012, a large retail foreign investor was
put into insolvency on the basis of a claim it disputed,
10
prompting the acting prosecutor general
to file a protest with the Supreme Court Senate; only several months later were the insolvency
proceedings dismissed. FICIL (2012b) argues that insolvency administrators are not accountable

7
See the LCR, and Lawin (2009).
8
For further information see Erbenova et al. (2011). The IMFs Legal Department provided technical assistance to
the MoJ in the design of amendments to the insolvency framework.
9
See, for example, Ir magazine, May 19, 2011.
10
Under section 57(2) of the Law on Insolvency, a legal person is liable to insolvency proceedings if its unpaid debt
exceeds LVL 3,000, and if three weeks after a warning from its creditor, has not paid its debt or raised justified
objections to the claim.
Under section 67 of the Law, an administrator has rights including to sell the property of the debtor (671), and to
liquidate branches or representation offices of the debtor (672).
The Law does not provide for an appeal against a court decision to launch insolvency proceedings and appoint an
administrator. UNCITRAL (2005) recommends allowing the debtor a right to appeal, though without an appeal
granting suspensive effect (so as to deter frivolous appeals).
26
for their actions under current law; it proposes specifying them in the law as part of the judicial
system, effectively increasing disclosure requirements and other controls.
Authorities response
23. Evaluation of judges performance begins in 2013. Amendments to the Law on
Judicial Power were approved in June 2011, providing for every judge to be evaluated during the
three years from January 2013. Although the Ministry of Justice may express opinions, the
evaluations will be carried out by other judgescrucial for maintaining judicial independence.
Judges will also be provided training in newer areas of the law, such as insolvency, anti-money
laundering, and cybercrime.
24. Logistical improvements are under way. With assistance from a Swiss-supported
judicial modernization project, sound recording and videoconferencing equipment is being
installed in all courtrooms. This enables witnesses to appear in court remotely, reducing costs of
travel and delays. In addition, all records of court decisions will be anonymized and made
available electronically; under amendments to the Law on Judicial Power, only decisions entered
into the new electronic system would be considered authentic.
25. The MoJ envisages further changes to the legal framework intended to promote
judicial efficiency:
The introduction of a pure instance system, requiring that all cases be submitted in the
first instance in district courts, to reduce fragmentation of court competencies. The
necessary legislation is in effect for criminal cases (with a transitional period to 2015)
but remains pending for civil cases (transitional period envisaged to 2019).
Parliament is in the final stage (third reading) of reviewing amendments to the civil
procedure law that would restrict presentation of new evidence in appeal courts, with a
view to ensuring full introduction of evidence at the first instance.
Amendments to the law on the commercial register, to prevent illegal takeovers of
enterprises, are in parliament at the second reading stage. The amendments would create
a special court outside Riga (in Jurmala or Jelgava) to rule on disputes between
shareholders.
The government approved a draft law on mediation in November 2012, which would
transpose the EC directive 2008/52/EC to facilitate mediation as an alternative dispute
resolution mechanism in civil and commercial cases. Parliamentary approval is pending.
The MoJ is working on a proposal, for presentation in January 2013, to significantly
tighten the requirements for accrediting arbitration institutions.
27
26. Next steps on the insolvency framework are still under discussion.
The MoJ is working on amendments to the insolvency and civil procedure laws, to make
clearer that disputed claims cannot be used to trigger insolvency. Possible amendments to
the civil procedure law could give the courts clearer jurisdiction to turn away cases
brought under the insolvency law, but in which the alleged debtor objects to ostensible
creditor claims (see footnote 12).
On a separate track, parliamentarians have reopened the law on insolvency for discussion.
Proposals include the reintroduction of the balance-sheet test and easing conditions for
personal insolvency. Banking groups object to these proposals.
Assessment
27. The judicial system is inherently difficult to reform quickly. Judicial independence
constrains the degree to which executive government or parliament can force reform. Yet,
judicial independence correspondingly requires judicial accountability. The introduction of an
evaluation system for judges, by judges, appears to be a major step in this direction, though the
results are yet to be seen.
28. Pending legislative and procedural changes augur well for accelerating judicial
processes. Measures to introduce the pure instance system and require full presentation of
evidence in first-instance courts appear promising, as do the logistical improvements to court
infrastructure, though there may be room to accelerate the transition to the pure instance
system in civil cases somewhat earlier than end-2019. Measures to streamline the system of
arbitration institutions could be politically contentious, but are warranted both to restore
confidence in arbitration options and to reduce the load on civil courts. Further consideration
could be given to the system of court fees, to strike the right balance between access to justice
and reducing incentives for delaying tactics.
29. On the insolvency framework, the focus should be on better implementation. Some
minor legal changes could be helpful, for example by introducing a right of appeal (but without
suspensive effect) in cases of involuntary insolvency. But it should be clear that current law
already excludes disputed claims as grounds for insolvency; a judicial decision to the contrary
does not reflect a failing of the insolvency law itself. To reduce risks of such cases, a rigorous
judicial evaluation process may be a better medium-term corrective. Best international practices
that were introduced with the new insolvency law in 2010, including the single cash-flow test
for insolvency, should remain in place.
28
D. State-Owned Enterprises
Background
30. Oversight of state-owned enterprises remains a challenge, from both fiscal and
governance perspectives. Latvia has a large number of SOEsmore than 140 as at
end-2009whose ownership and control is dispersed among many agencies. Some SOEs are
predominantly commercial; others perform governmental functions. While there are exceptions,
relatively little information has been publicly available about SOE performance and operations
an environment conducive to risks that loss-making SOEs require state support. Similar issues
arise for at the local level for municipally owned companies. In addition, and somewhat
unusually, most Latvian SOEs lack supervisory boards, which were abolished in 2009 to curb
political influence; but this leaves the burden on capacity-constrained ministries to supervise the
management.
31. Some Latvian SOEs perform well. The Baltic Institute of Corporate Governance finds
that Latvia has both the best and the worst SOEs in the Baltic region (BICG, 2012). On the
positive side, it finds SOEs with the strongest corporate governance include Citadele Bank,
which had been carved out of the failed Parex Bank in 2010; and 51 percent state-owned
Lattelecom, which imported strong governance practices from its foreign parent company.
32. But fiscal and governance risks have materialized in some other SOEs:
Energy: Latvenergo senior officials, including the CEO, were arrested and replaced in
2010 following a bribery investigation by the anti-corruption bureau.
11
BICG (2012)
finds that the new management board was very cautious in the aftermath of the scandal,
referring decision-making responsibility to the statewhich may conflict with the states
role of monitoring the enterprise.
Air transport: airBaltic incurred heavy losses in 2010 and 2011, requiring a state
bailout to keep the airline from collapse. In contrast to Lattelecom, the partly private
ownership of airBaltic had not translated into stronger governance: despite owning
53 percent prior to the bailout, the state was unable to access airBaltics accounts even as
losses increased. The government incurred bailout costs of 0.4 percent of GDP in 2011.
The European Commission is currently assessing the consistency of this support with
state aid rules: the former private partner had agreed to participate in the bailout, but
could not provide the financing, leading the state to take full control of the airline. A new

11
See KNAB (2012).
29
management team is now pursuing airBaltics restructuring, and the government is
seeking a new private investor.
12

Rail transport: Pasazieru vilciens (PV) signed a large tender in early 2012 to purchase
railway passenger cars, whose provisions were contrary to EU procurement rules, and
despite guidance from the government not to go ahead. The government subsequently
replaced PV management and cancelled the contract; at time of writing it is unclear
whether the Latvian state is still liable to the supplier under the cancelled contract.
33. Both the IMF and EU programs had included structural benchmarks on SOEs;
progress was uneven. The two-part approach was straightforward: first, take stock of the states
shareholdings (end-September 2010); second, assess the best way to manage them (end-2010).
The first benchmark was met. The second benchmark was eventually met in late 2011, though
with implementation issues left for later.
34. The first consolidated annual review of SOEs was completed in 2010. The Annual
Review of Latvian State-Owned Assets 2009 (ARLSOA) was the first exhaustive list of Latvias
state-owned enterprises, including basic information on their finances and employment, prepared
by a combination of local financial experts, the BICG, and the prime ministers office. The report
included 142 SOEs with total assets of EUR 10.2 billion, combined turnover of EUR 3.2 billion,
and over 52,000 employees. The ARLSOA estimated the potential for SOEs to pay additional
dividends of over LVL 70 million annually if their corporate governance could be raised to the
level of EU peers.
35. Nongovernmental organizations have recommended a number of reforms:
BICG (2010) has called for clearer ownership policies and information on the
governments portfolio of enterprises; stronger oversight and control; effective regulatory
regimes in regulated industries; and a public and enforceable dividend policy.
13

BICG (2012) also recommends the reintroduction of supervisory boards for SOEs, on the
grounds that Latvian SOE boardswith exceptions such as Citadele and Lattelecom
are management boards staffed fully by insiders, and do not hold the enterprise and its
managers to account. BICG argues that the capacity of line ministries to exercise the
necessary professional oversight is generally severely constrained.

12
See the Staff Report for the Fifth Review Under the Stand-By Arrangement (IMF Country Report No. 12/31),
Box 1.
13
Baltic Institute of Corporate Governance, Baltic Guidance on the Governance of Government-owned Enterprises,
June 2010. Available at: http://www.corporategovernance.lt/en/news/17
30
FICIL, while generally supportive of the above (FICIL, 2012c), has also suggested
privatizations of SOEs by initial public offering to support capital market development
(FICIL, 2011).
Authorities response
36. Development of a strategy for SOEs has moved ahead, albeit more slowly than the
EU-IMF program envisaged. An end-2010 benchmark envisaging a reform strategy for the
sector proved ambitious. But in May 2012, the government approved two concept papers,
Concept for Commercial Activities of Public Persons and Concept for Management of State
Capital Shares. Although the concept papers envisaged the necessary legislation to be in place
by January 2013, political agreement on the draft legislation is still pending at time of writing.
37. The government-approved proposal envisages a new institution to oversee SOEs,
and enhanced reporting of financial information:
The new institution, a partially centralized ownership agency or centralized
governance institution (CGI) reporting to the prime minister, would begin operations in
2013 and take shareholdings in selected SOEs as of January 2014. The CGI would
establish corporate governance guidelines, supervise their implementation, monitor the
SOEs financial objectives, and introduce a new system for SOE financial reporting.
Decisions would be taken later on which SOEs would remain under line ministries and
which would be transferred to the new CGI.
All SOEswhether under the CGI or under a line ministrywould be required to
provide financial information to the CGI. Initial proposals envisaged quarterly reporting
from the first quarter of 2013; current proposals envisage semi-annual reporting.
Reporting to the CGI would be mandatory for SOEs in which the state shareholding
exceeds 50 percent, and recommended for other companies with state participation.
38. The economics minister has been candid about the need for reform. From
MoE (2012):
Management of state companies is one of the fields reasonably criticised by the
international organizations and local business organizations. Management of state
companies should serve as a good practice. Unfortunately, we are currently lagging
behind our closest neighbours who already make the best out of the better management of
state capital shares. Therefore, the decision of the Cabinet of Ministers is somewhat
historical, because we have made a step closer to good, efficient and professional
management of state capital shares.
39. A working group is currently reviewing each SOE to consider its future status.
A working group including staff of the MoE and the cross-sectoral coordination unit (under the
31
prime minister) is assessing each enterprise under two criteria: whether the enterprise responds to
a particular market failure; and/or whether the enterprise serves a clear strategic interest of
Latvia. SOEs that do not meet these criteria will be considered for privatization.
Assessment
40. The introduction of an effective CGI would be a welcome measure. Neighboring
countries, including successful examples in Sweden and Finland, offer good role models of how
the CGI model can work in practice. For example, the introduction of centralized ownership
steering in Finland in 2007 separated the states ownership and regulatory functions, improving
governance and transparency.
14
In Latvia, it remains to be seen what share of enterprises will be
transferred to the new CGI, and which will remain directly under line ministries. Political
agreement and parliamentary approval of the legislation necessary to establish a strong CGI, with
clear and transparent operational objectives, should be a priority.
41. Enhanced SOE financial reporting is critical for curbing fiscal and governance
risks. The introduction of semi-annual or (better) quarterly financial reporting would represent a
major improvement in transparency. It would reduce risks of a repeat of the case of airBaltic in
2011 when neither the public nor the authorities had access to the accounts. It would allow less
threatening losses and inefficiencies to be detected and addressed at an earlier stage and enhance
incentives for efficiency gains.
42. Any privatizations of SOEs should be orderly and transparent. While a number of
privatization methods work well in principle, it will be important that future privatizations avoid
the intransparent approaches of the early 1990s. Sales should be timed to avoid fire sales and
defend taxpayer interests. Appropriate regulatory frameworks should be in place prior to
privatizations. The use of public offeringsin increasing use in other countries as a privatization
method
15
has pros and cons. On the positive side, it could contribute to capital market
development, and listing disclosure requirements could contribute to transparency. But enhanced
disclosure should be part of SOE reporting anyway; and diffuse private shareholders may find it
difficult to exert influence if the state maintains concentrated ownership stakes.
43. Supervisory boards are good in principle, but require a critical mass of expertise to
be a workable improvement. Concerns about the burden on ministries alone to supervise SOEs
are valid. But, to avoid any return to past politicized boards, Latvia needs a sufficiently large
pool of qualified professionals who are ready to act as board members. BICG provides executive
education training in an effort to develop such a pool, but this is a work in progress. To the

14
See OECD (2011).
15
See OECD (2009).
32
extent that capacity constraints in practice weaken the case in principle for reintroducing
supervisory boards, they also reinforce the case for establishing a strong, well-resourced CGI.
E. Higher Education
Background
44. Latvia has a very high number of higher education institutions (HEIs). For a
population of 2 million, Latvia has 58 accredited HEIs that provide either academic or
professional
16
higher education (AIKNC, 2012), of which 36 are public, 20 are private, and 2 are
branches of foreign universities. The public HEIs are a mix of universities and public colleges
for professional education. According to the Ministry of Education and Science (MoES), about
50 percent of students enrolled in public academic education study in the two largest state
universities (MoES, 2011a). Other Baltic countries have far fewer HEIs: Lithuania (population
3.4 million) has 27 HEIs (14 universities, 13 colleges), while Estonia (population 1.4 million)
has 16 HEIs (6 universities, 10 colleges) in Estonia.
17

45. Public expenditure on tertiary education is very low by EU standardsand thinly
spread over many institutions. Eurostat data for 2009 on public expenditure on tertiary
education show Latvia as spending the least in the EU (0.79 percent of GDP), compared with an
EU average of 1.22 percent of GDP (Figure 6). A caveat is that 2009 was the worst crisis year
for Latvia. However, MoES (2010a, 2011a) reports state budget financing for the HEIs (private
and public) of 0.64 percent of GDP in 2009 and falling to just 0.54 percent in 2010. A
government-approved action plan of the MoES (2010b) envisages a gradual increase in state
budget financing for higher education to 1.2 percent of GDP in 2013. This still implies very
limited resources for a high number of institutions. In addition to providing resources directly to
HEIs for research, the state covers tuition fees for some study places (budget places). The
HEIs themselves determine tuition fees for the remaining study places. Students are entitled to
state-guaranteed student loans.

16
HEIs that provide higher professional education are colleges. These institutions also provide vocational secondary
education.
17
Sources: AIKOS (2012), and Estonian Ministry of Education and Research (2009).
33
Figure 2.6. EU Countries: Total Public Expenditure on Tertiary Education, 2009
(in percent of GDP)


46. Enrolments in HEIs are falling. In contrast to rising enrolments in the EU as a whole,
and a milder upward trend in countries that joined the EU in 2004, enrolments in Latvian HEIs
have been falling steadily since the mid-2000s (Figure 7). This reflects the decline in Latvias
birth rate over the past two decades (Figure 8) and the emigration wave since 2004. MoES data
show the number of new students admitted to HEIs falling from 44,000 in 2005 to around 32,000
in 2011, a decrease of 27 percent.
47. The combination of a disproportionately high number of institutions, limited
financing, and falling student numbers generates seriouspotentially even unsustainable
strains on the higher education system.
0.0
0.5
1.0
1.5
2.0
2.5
3.0
Source: Eurostat.
34
Figure 2.7. Europe: Trends in Tertiary Enrolments, 200110
(Index 2001 = 100)


Figure 2.8. Latvia: Birth Rates, 19862011


48. Survey evidence suggests Latvia lags behind with respect to the quality of education.
According to the WEF Global Competitiveness Index 201213, Latvias educational system
considerably lags its neighboring countries (Figure 9). Although the WEF does not deeply
analyze these results, they are corroborated by the LCR findings, which emphasize the quality
problem in higher education.
90
100
110
120
130
140
2001 2002 2003 2004 2005 2006 2007 2008 2009 2010
Source: Eurostat.
EU-27
NMS-8
Latvia
0
10,000
20,000
30,000
40,000
50,000
1986 1989 1992 1995 1998 2001 2004 2007 2010
Source: Statistics Latvia.
35
Figure 2.9. Selected Countries: Quality of the Educational System, 1-7(best),
2006-07 to 201213

49. Latvias HEIs have low rates of international publication and doctoral graduations.
Based on the number of international publications, the LCR finds that Latvian researchers are
falling behind their colleagues in Estonia and Lithuania (Figure 10). Dombrovsky (2010) notes
that the number of PhD graduates per 1000 people is one of the lowest in the EU (Figure 11).
The LCR emphasizes that the small number of people pursuing studies at the highest level
threatens the future development of the higher education system, since the academic workforce
in Latvia is ageing and there is no source of replacement. It also finds that the higher education
has lost effectiveness in promoting innovation.
3.4
3.6
3.8
4.0
4.2
4.4
4.6
2006-2007 2007-2008 2008-2009 2009-2010 2010-2011 2011-2012 2012-2013
V
a
l
u
e
Edition
OECD EU27 CEE EE LT LV
Source: World Economic Forum (2012).
Latvia
36


Figure 2.11. Number of PhD Graduates per 1000 Population, 2010


50. Latvian HEIs are subject to Latvian language requirements. The Law on Higher
Education Institutions stipulates Latvian as the language of instruction in the public HEIs, with
the possibility to implement at most 20 percent of the study program in an official EU language.
This does not apply to the final exams and thesis. International students can pursue their studies
0
200
400
600
800
1,000
1,200
1,400
1,600
1,800
2,000
1990 1995 2000 2005 2010
Articles in English per Million Population, 19902010
Latvia
Estonia
Lithuania
Sweden
EU12
EU15
Source: Latvian Competitiveness Report 2011.
Figure 2.10. Selected Countries: Number of Publications in Science Citation Index
0.00
0.10
0.20
0.30
0.40
0.50
0.60
Source: Eurostat.
37
in an official EU language, but their study programs are separate from the programs for local
students. The language requirements also make it difficult for HEIs to hire foreign academics
who lack fluency in Latvian.
51. Multiple sources point to skill mismatches between HEI graduates and employer
needs. According to the State Employment Agency (2008), about 52 percent of employees in
2008 were working in fields other than those for which they had qualified. This suggests that the
HEIs and other educational institutions are not providing adequate skills and knowledge to future
employees, and/or that the study programs and student enrollment in those programs are not
linked to labor market needs. According to MoES (2011a), in 2011 around 40 percent of all
students were enrolled in social sciences, business and law fields, while only 24 percent pursued
their studies in engineering, manufacturing, construction, natural sciences, mathematics and IT.
This does not correspond to labor market demands: the WEF 201213 Global Competitiveness
Report ranks Latvia 110
th
out of 144 countries for availability of scientists and engineers. Given
the large number of HEIs, and falling student numbers, the resulting large supply and duplication
of study programs generates perverse incentives for HEIs to relax enrollment conditions and
course requirements. This is convenient for students, at least in the short run: it is common for
students to combine studies with work at the expense of class attendance and time for
independent studies (see LCR, and Auers et. al, 2007). FICIL (2010) argues for reducing the
number of HEIs to address fragmentation and quality issues.
52. HEIs have a tradition of autonomy. According to the Law on Higher Education, HEIs
independently determine the content of the study programs, their organizational and governance
structure, and the remuneration their staff. Each HEI elects its own constitutional assembly and
senate, each comprising faculty and student representatives; the assembly elects the rector. The
government regulates procedures for the accreditation of HEIs and their study programs with the
MoES. An HEI may be reorganized or closed by its founder; in the case of state HEIs, this
requires a government decision on the basis of the recommendation of the minister of education
and an advisory opinion from the Council of Higher Education.
18

53. An assessment of HEI study programs, commissioned last year by the Council of
Higher Education (CHE), has become highly contentious. The assessment reviewed around
850 accredited HEI study programs, finding that 55 were of poor quality and should be closed,
and 210 require serious improvements (AIP, 2012). The education minister argues that these
findings understate the quality problemsthe MoES identified 182 poor-quality programsand

18
According to the Law on Higher Education, the 12-member Council of Higher Education (CHE) includes
representatives from 9 educational organizations: the Latvian Academy of Science, the Association of Art Higher
Education Institutions, the Latvian Association of Education Managers, the Colleges Association of Latvia, the
Council of Rectors, the Latvian Association of University and College Professors, the Education and Science
Workers Trade Union, the Latvian Students Association, and a representative of non-state HEIs. The CHE also
includes 2 business group representatives and the education minister ex officio.
38
has accused the CHE of tampering with the results. The MoES will commission an independent
audit of the project.
Authorities response
54. The education minister proposes deep reforms to higher education:
Concentrating funding for HEIs according to course quality;
Creating incentives for discontinuing poor-quality courses and reducing the number of
HEIs;
Reforming student financing to better link tuition costs to future income;
Easing language restrictions to promote openness of HEIs; and
Reforming governance structures for HEIs.
Although detailed policy proposals are not yet available in written form, the minister has
released a video to explain his intentions.
19

55. As an initial measure, the government has approved new accreditation regulations
that exclude poor-quality study programs from state budget financing. On the basis of the
September 2012 regulations, the MoES will commission an independent international institution
(included in the European Quality Assurance Register) to assess the HEIs. Accreditation of
insitutions will be decided by the CHE, which will accredit an institution if half or more of its
study programs are accredited. The accreditation committee will involve representatives of both
public and private stakeholders accepted by the education minister, in an effort to avoid previous
practice whereby accreditation decisions were by insiders (Ir, 2012a). The education minister
also proposes to make it mandatory for lecturers to conduct research (Ir, 2012b).
56. MoES is developing a proposal to reform the financing model of the higher
education system. Currently, the tuition fees of around 35 percent of students are covered by
state fundingthe so-called budget placeswhile the remaining 65 percent have to ensure
their own financing. Though full details of the reform are not yet available, the intention is to
introduce a universal student deferred-fee system, repaid contingent on income after graduation
(Dombrovsky, 2011). According to MoES, this would be similar in nature to a progressive
income tax, on the grounds that people with higher education earn by about 40 percent more than
others (MoES, 2011b). At this stage this is not the governments position; opposition to the

19
See http://www.youtube.com/watch?v=Lh6ySXwiaS0 (in Latvian).
39
reform is significant within the coalition, with some arguing that the proposal would aggravate
emigration (Diena, 2012a).
20

57. The MoES has prepared legislative amendments that would enable greater usage of
foreign languages in HEIs. The education minister proposes that Latvia follow the practice of
Estonia and Lithuania where the lecturers are appointed based on the results of international
competition. Under the envisaged amendments, Latvian HEIs would have more flexibility to
teach purely in English, raising their attractiveness to foreign students and making HEIs more
competitive. The amendments would enter into force starting from the next study year. Coalition
agreement is pending; the amendments would then need parliamentary approval.
58. The education minister has also suggested reforming HEIs governance structures.
The intention is to address the self-isolation of HEIsthe flip side of their independence. The
minister points to a closed academic club in Latvia, especially in the social sciences. He cites
Denmark as a good example of how to address the problem: more than half the members of a
Danish academic senate come from outside the university, for example from the business sector.
This fosters cooperation between HEIs and wider society, and in particular narrows the distance
between the education system and the labor market, all without government interference in the
design of academic studies. The ministry is developing a proposal for new governance structures
for HEIsentailing new councils for HEIs with two thirds of their members representing non-
HEI stakeholderswith a view to their introduction by the beginning of the next study year
(September 2013). The new council would decide on strategy and budget issues, as well as elect
the rector. The HEI would retain its autonomy with respect to decisions on academic issues.
Assessment

59. The authorities proposals to reform higher education would seek to address the
sectors pressing sustainability and quality challenges. The very high number of HEIs relative
to population, falling student numbers, and the case for concentrating the limited available
financing, taken together would make selective HEI closures seem inevitable. The MoES, in
allocating funding (including EU funds), can create powerful incentives for the retention or
closure of individual institutions; targeting funding to course quality is a logical approach.
Greater openness of HEIs to international students and foreign academics would foster quality;
more flexible language rules would break down an important barrier to openness. Since fiscal
space will remain constrained and HEIs continue to face limited financial means, efforts to
restructure the financing model of the higher education, with a view to improving both quality
and accessibility, are timely.

20
Chapman and Tulip (2008) provide a concise overview of international experience with income-contingent
student loans (ICL) and other forms of financing tuition. They caution that the effectiveness of ICL depends on the
effectiveness of a countrys income tax system to track graduate incomes and collect debts.
40
60. Details remain to be elaborated in a number of key areas. The authorities have
explained the intended direction of reforms; the ideas appear to correspond to the underlying
problem. But a policy paper with details is not yet available. And seemingly small technical
issues have the potential to cause bigger problems. For example, the international experience
with income-contingent loans to finance student tuition is generally favorable, but is based on
efficient collection of repayments by tax authorities. For Latvia, the proposal now being
developed by the authorities would need to take into account capacity constraints in tax
administration evident from the shadow economy.
21
More generally, the eventual outcomes will
hinge on implementation.
61. Political economy obstacles are formidable. The independence of HEIs limits the
extent to which even a determined minister with a coherent plan can impose reform unilaterally.
Under current law, closures of individual state HEIs need to be ratified by the Cabinet, based on
guidance from the Council for Higher Educationa majority of whose members are drawn from
HEIs. And the assessment of course quality is proving contentious in practice. This points to the
desirability of cooperation, where it can be found, from stakeholderssome of whom will lose
out from reforms from which the wider public will benefitand to the need to build wider
political support to implement necessary changes to the system. The political sensitivity of
language issues in Latvia is an additional complication for a sector in need of greater access to
expertise from outside.
F. Vocational Education
Background

62. Under the Law on Vocational Education, the Ministry of Education and Science
finances vocational education institutions (VEIs) and in co-operation with employers
designs the study programs. The VEIs under the MoES are financed from the state budget,
with money per student for teachers wages and school maintenance. The MoES also approves
the by-laws of the schools, which among other things determine the number of students to be
admitted and the content of the study programs. The MoES develops standards for vocational
education in cooperation with professional associations.
63. Student numbers are falling (Figure 12). In 2011 around 12,000 students started
vocational education programs compared to 14,000 in 2008 and 15,000 in 2005. As with falling
tertiary enrolments, this reflects the sharp fall in birth rates in the 1990s (see above). In 2010 the
Ministry of Education and Science initiated a reform of the network of vocational education
institutions (VEIs) aiming to reduce the number of state schools, to promote efficient use of

21
This is a main finding of the Latvian Competitiveness Report 2011.
41
resources, and to modernize the remaining schools. The number of state vocational schools
22
fell
from 59 in 2009 to 38 in 2012, and could further fall to 30 in 2015. The intention is that 14 of
these schools would have the status of a competence center (criteria: sufficiently large number of
students, students on average have good results in the qualification exams, the institution actively
cooperates with employers, etc.). Currently there are 6 competence centers. Financing of
vocational education is low compared with financing of general secondary education (Figure 13).
Figure 2.12. Latvia: Vocational Education: Numbers of Students and Institutions, 200511
(At beginning of each study year)




22
Apart from state vocational schools, VEIs are local government-owned or private. Including non-state VEIs, the
total number of VEIs was down from 85 in 2009 to 65 in 2011. In 2011, around 88 percent of vocational education
students were enrolled in state vocational schools.
Collegeseducational institutions which provide 1st level higher vocational education programs, as well as
vocational education and secondary vocational education programsare considered as HEIs rather than VEIs in the
national statistics.
30
40
50
60
70
80
90
100
20
25
30
35
40
45
2005 2006 2007 2008 2009 2010 2011
Number of students, thousands (left scale)
Number of vocational education institutions (right scale)
Source: Statistics Latvia.
42
Figure 2.13. Selected EU Countries: Total Public Expenditure on Secondary Education, 2008
(Secondary vocational and secondary general education, in percent of GDP)


64. A widespread view in Latvian society has been that the vocational education is
inferior to general education. The study Prestige of the Vocational Education in Latvia
(Analtisko ptjumu un stratiju laboratorija, 2007) found that, in students view, vocational
education was less valuable than general education, with vocational education chosen by
students who misbehaved and did not want to study. The education minister has acknowledged
that the vocational education has been disadvantaged for many years and has lacked investments.
In addition, limited options for teachers to raise their qualification and professional skills, and
low teachers salaries that deter industry specialists from teaching, negatively affect the quality
of vocational education and training (VET) and consequently the prestige of VEIs.
65. Different financing models of general and vocational education are resulting in an
unhealthy competition for basic education graduates. In both cases the money is distributed
based on the money-follows-student principle. But general education is financed by the local
governments (receiving transfers from the state budget), while vocational education is financed
directly by the central government. The authorities confirm reports that competition for students
is a problem: some local governments try to discourage basic education graduates from entering
vocational education by impugning the reputation of vocational schools and by offering different
benefits including financial support if students continue their studies in general education (Diena,
2012b).
66. The Latvian Competitiveness Report 2011 indicates that the vocational education
system does not meet labor market needs. The LCR cites survey evidence that employers see
VEIs failing to supply students with sufficient practical skills in their chosen profession. Latvia
0.0
0.2
0.4
0.6
0.8
1.0
1.2
1.4
1.6
1.8
CY SE FI EE LV FR AT HU CZ BG NL PL DE SK LU LT MT
ISCED 3-4 General ISCED 3-4 Vocational
Source: CEDEFOP (2012a).
43
does not have a meaningful apprenticeship system. Employers are involved in vocational training
mainly through their role in defining the curriculum of vocational schools.
67. Employers may lack motivation to participate in vocational training. According to
the MoES (2009), all VEI graduates have undergone vocational training and received a positive
evaluation by their supervisors. In addition, all graduates have to pass a qualification exam and
the exam committees comprise employees of commercial companies. Theoretically, employers
are involved not only in defining the curriculum, but they can also take part in running and
assessing the practical training. However, they are not obliged to offer apprenticeships. The VEIs
cannot always ensure that their students undergo an apprenticeship in a real company and
sometimes end up providing the training at the school premises, which hardly resemble the field
experience. According to the Employers Confederation, employers would like to see more
incentives for providing apprenticeships, such as compensation or tax incentives, ensuring work
clothing, better cooperation with the VEIs, and greater involvement in the long-term planning of
the vocational education content.
68. The labor market has changed more quickly than the supply of VET programs
(CEDEFOP, 2012b). The real work environment, technologies, working methods are in a
constant transformation, while it takes time and requires substantial financial investment to
adjust the study programs and the equipment to the actual situation in the labor market. The
MoES (2009) found that, given changing labor market needs, demand increased for VET
programs with a relatively short duration. This also shows the importance of close cooperation
between the VEIs and the business sector in ensuring practical training for the students in a
company.
69. The LCR points to insufficient adult involvement in lifelong learning. According to
the Europe 2020 targets, Latvia is falling behind with respect to adult participation in education
and training, which was only 5 percent compared with the EU27 average of 8.9 percent in 2011,
and the EU-wide target of 15 percent in 2020 (see Figure 14). The MoES (2009) acknowledges
that the supply of VET programs does not correspond to adult education needs, for two reasons.
First, the time-consuming design of the study and training programs makes them outdated by the
time they are actually implemented. Moreover, given the changing skills required in the labor
market, the demand for shorter VET programs is on the rise. Second, limited flexibility in these
programs precludes the employees from combining work with education and training.

44
Figure 2.14. EU Countries: Participation in Lifelong Learning, 2011
(Percentage of population aged 25-64)


70. Employees themselves appear reluctant to invest in training. In 2005 the share of
employees participating in the continuing vocational training was only about 15 percent one of
the lowest in the EU (Figure 15).
Figure 2.15. EU Countries: Participation in Continuing Vocational Education, 2005
(Percentage of employees)

Source: CEDEFOP, European Centre for the Development of Vocational Training.

0
5
10
15
20
25
30
35
Source: Eurostat.
0
10
20
30
40
50
60
70
45
Authorities response

71. The governments action plan calls on the MoES to prepare for transferring the
ownership of the VEIs to local governments or sectoral associations by 2015. On the one
hand, this could stop the unhealthy fight for students between secondary general and secondary
vocational schools. Elimination of the differences in the allocation procedure of state transfers
would make the local governments neutral whether the student attended the vocational or general
school. On the other hand, the authorities are aware that the majority of local governments are
not willing to take over vocational schools until the unclear financing issues are resolved.
72. The MoES is exploring other governance models as well. It is considering a proposal
of the Latvian Chamber of Industry and Trade to establish a governing council for each VEI,
similar to the situation for higher education institutions. Another idea involves creating
integrated schools to provide both general and vocational education.
73. Work on the restructuring of the content of vocational education programs is
underway with expected completion at the end of 2013 (MoES, 2012). The project is co-
financed from the ESF with total financing amounting to LVL 2.5 million. The business sector is
involved in redesigning the vocational education programs, which should narrow the skills
mismatch gap in the labor market in coming future. This aims to solve the problem of program
consolidation and reduce the number of programs. The intention is also to structure the VET
programs in modules, to make the programs more flexible to the changing labor market needs.
The authorities also hope to increase the employers willingness to support apprenticeship
programs, which has been an issue previously, as this is the only way how students could learn to
work with the latest technologies.
74. The MoES plans to make vocational education more attractive by promoting career
guidance and counseling, increasing financial support to students and improving VEI
teacher qualifications. To satisfy the increasing labor market demand for qualified specialists
the government intends to increase the proportion between the students studying in general
secondary education institutions and in VEIs after completion of basic education from 60-40 to
50-50. An important instrument for achieving this would be to create a position of career
counselor in VEIs. However, the availability of sufficient funding is unclear. Apart from that,
there are also intentions to provide additional financial support, for example by increasing the
ESF stipend to an average of 70 lats.
23
As a part of another ESF project, the MoES will invest in
raising the qualification of the vocational education teachers (MoES, 2012).

23
Currently each vocational education student receives a state stipend of 7 lats per month and can apply for an
additional ESF stipend of 10 to 50 lats per month. This would be in force until the end of 2015.
46
75. Given limited fiscal space, EU funds remain the only source of funding
modernization of VEIs. The ERDF program has been reserved for modernizing the schools,
after their number is reduced (MoES, 2012). LVL 113 million will be available for modernizing
the schools during 201420. This will help to fully equip and modernize
11 VEIs. 15 schools will be able to implement some development projects. The funding for the
renovation of the remaining schools and for the development of new programs in
11 modernized schools would come from the EU funds available during the next financial
perspective (201420).
Assessment

76. The process of concentrating resources in fewer VET institutions is appropriate,
especially given the falling number of students. This helps to reduce the fragmentation and
facilitate specialization of VEIs, which facilitates closer cooperation with employers. Given a
smaller number of students, VEIs have spare capacity and infrastructure that can be used to
provide adult education as well.
77. However, the proposed decentralization of VETs to local governments is risky. The
authorities fairly argue that local governments have perverse incentives to try to draw students
away from VET schools towards general education schools raises concerns. But the
decentralization runs some risk of reversing the recent efforts to concentrate resources into fewer
but more viable institutions. At the same time, financing issues remain unclear and local
governments do not seem willing to take over these schools without additional financial transfers
from the central government to cover maintenance costs. A school-by-school approach could
work better: the largest VEIs could remain under the ministrys supervision, while the ownership
of smaller schools in rural areas could be transferred to local governments that agree to cover the
maintenance costs. In the small municipalities, integrated school programsthat is, combining
vocational and general educationcould make better use of the available resources.
78. The VEIs role in retraining should be strengthened. The low adult participation in the
lifelong learning and the high structural unemployment signals the need for well designed adult
training programs. The VEIs, especially those that are modernized, are the best placed
institutions to provide such training, even within the tight available resource constraints.
79. Employers should be more closely involved in VET on a permanent basis. Employers
also benefit from a functioning VET system because the supply of skilled labor increases. But
the current share of the workplace content in the VET programs is only about 20 percent, which
is insufficient to ensure rapid transition of the students to the labor market. The ESF project
offers a way forward: it has involved formation of 12 sector expert councils that will help to
redesign the VET programs. If this contributes to employers willingness to provide practical
training, the study programs could better accommodate labor market needs. However, the
changing labor market implies a need for more long-term forms of cooperation, for example by
making greater use of the sector expert councils.
47
80. The introduction of career counselors could help raise the VEIs attractiveness. It is
important to provide full information to students before they decide whether to continue their
studies in general upper secondary education or pursue VET. This and other measures could help
to raise the prestige of VEIs and foster more widespread recognition that general and vocational
education each serve different needs and career paths. Career counselors could also intermediate
between students and companies, further strengthening each VEIs cooperation with employers.
However, the introduction of counselors has yet to take place, and will to a large extent depend
on the available funding. This project should be a priority in allocating the EU funding for
education.
G. Other Structural Issues
Competition policy
81. While the crisis led to improvements in competitiveness via price and wage falls
vis--vis other countries, competitive pressures appear to have eased within Latvia. IMF
(2012) suggests that widespread bankruptcies of small firms during the crisis have dampened
product market competition. EC (2012b) shares these concerns, pointing to limited competition
in construction, healthcare and pharmacy, public services, and food supply (dominated by two
big chains).
82. Limited capacity at the Competition Council remains a challenge. The authorities
recognize the importance of increasing product market competition, but have previously noted
difficulty in attracting qualified personnel to work in the Competition Council given low public
sector pay (IMF, 2012). A new Competition Council head, appointed in June 2012, is seeking to
build the agencys capacity for econometric analysis, to supplement information from external
complaints.
24

83. More work is needed to fill information gaps on product market developments and
regulations. Numerous studies at the European level draw on the OECD index of product
market regulation. The OECD has previously extended its database to non-OECD countries,
including those on track for accession such as Estonia; see Wlfl et al. (2010). A similar exercise
for Latvia could yield useful results, if capacity constraints allow for this, and could be made a
priority in the context of Latvias current efforts to join the OECD.
Public procurement
84. Large procurements are being made subject to more stringent checks. In response to
the PV passenger car tender, new rules apply for public procurements above LVL 1,000,000 or
connected with EU funds: draft contracts now need to be cleared with the Ministry of Finance,

24
Interview with Skaidrite Abrama, The Baltic Course, July 6, 2012.
48
Ministry of Justice, and the State Chancellery, followed by review by the Cabinet of Ministers.
The new rules do not affect the role or independence of the Procurement Monitoring Bureau.
85. Parliament is considering legislation to expand the centralized public procurement
system to local governments, and to introduce administrative penalties for violations of
procurement procedures. The draft legislation is in line with EC program recommendations.
Administrative penalties would range from warnings for minor infractions; fines on members of
procurement committees (natural persons, rather than their institutions) between LVL 50 and
LVL 500; and disqualification from future contracts (combined with fines) for serious violations.
Industrial policy
86. The MoE is developing a new industrial policy, which the World Bank is peer
reviewing. The MoE and the World Bank organized a practitioners workshop and public
discussion in December 2012 to discuss work in progress, and provide advice on good
international practice for resolving coordination failures. At this event, the economics minister
outlined principles for an industrial policy that would avoid a picking winners approach and
minimize risks of rent-seeking, and instead emphasize the need to identify and address market
and government failures, and for dialogue with stakeholders.
H. Conclusions
87. The authorities have developed, in varying degrees of detail, reform plans in several
areas where these are particularly needed. In general, and with some caveats, this paper finds
that planned reforms to the judiciary, SOE governance, and higher and vocational education
would address the underlying problems in these sectors. In specific areas:
Judicial efficiency: welcome measures are in train to address court system delays, both
directly and by making alternative dispute resolution methods more reliable. Scope may
remain to accelerate the introduction of the pure instance system in civil courts.
Insolvency: the priority should be to improve implementation of the insolvency law
adopted in 2010. Best international practices that were introduced with the new law,
including the single cash-flow test for insolvency, should remain in place.
State-owned enterprises: conceptually approved reforms would do much to promote
transparency and address long-standing fiscal and governance risks, but political
agreement is still needed on the necessary legislation.
Higher education: the minister has outlined controversial proposals consistent with a
diagnostic of the sector. But details remain to be fleshed out; support from coalition
partners is uncertain; and stakeholder resistance is evident.
49
Vocational education: efforts to concentrate resources in fewer institutions, supported by
investments in modernization, are welcome, as is greater involvement of employers in
course design. But the proposed decentralization of vocational schools is questionable.
88. A common challenge across these sectors is political economy: how to build support
for moving from plan to implementation. The above areas are difficult to reform, and in some
cases the interests of established stakeholders and the broader public will differ. In addition to
the usual political economy issues, the judicial and academic sectors have important traditions of
independence. This means policymakers need to navigate between two valid and legitimate
considerations: institutional independence and institutional accountability. The current dispute
over the assessment of course quality in higher education is an example of the difficulty. But the
launch in 2013 of an evaluation process for judges, by judgesthough yet to be tested in
practicecould become a good example of independence and accountability being reconciled.
89. Progress on the microeconomic reform agenda would bolster Latvias already
strong recovery. Latvia has already implemented a very strong macroeconomic adjustment,
underpinned by numerous structural reforms, which has been critical to restore external and
fiscal sustainability. And Latvias growth performance over the past two years has been
impressive. Post-crisis, Latvias competitive strengths and weaknesses are increasingly well
understood. This means that the opportunities are therethough implementation will be key
for structural policies to contribute to sustainably higher rates of investment, employment, and
living standards.

50
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