III. ECONOMIC TRENDS AND OUTLOOK Since independence was restored in August 1991, Latvia has made steady progress toward replacing the centrally-planned, socialist system imposed during the Soviet period with a structure based on free-market principles. Latvia's growing private sector is estimated to account for as much as 50 percent of the country's GDP. The country is on the verge of becoming the first post- Soviet economy to achieve macroeconomic stability, having lowered inflation to an annual rate of 34.8 percent in 1993. Latvia essentially balanced its state budget in 1993 and is projecting a deficit of just under two percent of GDP in 1994. Led by recovery in light industry and a boom in commerce and finance, the economy is expected to expand by 4 percent in 1994 and 5-6 percent annually for the remainder of the decade. Economic separation from the Soviet Union, collapse of central planning and privatization of agriculture contributed to the shrinkage of Latvia's economic output by 34 percent in 1992 and 20 percent in 1993. In viewing the development of the economy since 1991, it should be noted that official statistics tend to underreport the booming private sector, suggesting that the Latvian economy and the Latvian people are doing much better than is reflected in the official output statistics. In the first half of 1993, service industries are estimated to have made up 54 percent of Latvia's GDP. Other leading sectors were manufacturing (22 percent of GDP), agriculture and forestry (15 percent of GDP), energy (5 percent of GDP) and construction (4 percent of GDP). Latvia is the only post-Soviet economy to have introduced a freely-convertible national currency, the lat, while relying on market forces to determine the exchange rate. Its laissez faire policies with respect to foreign exchange have contributed to Riga's becoming a financial center for the former USSR. Latvian authorities reported a trade surplus of 36.4 million lats in 1993, based on exports of 675.6 million lats and imports of 639.2 million lats. The data are based on customs declarations and are not a reliable reflection of Latvia's total trade; Western observers believe, and Latvian officials concede, that Latvia probably experienced a trade deficit in 1993. Recorded trade data suggest that Russia is Latvia's largest trade partner, accounting for 28.5 percent of the country's recorded exports and 28.1 percent of its recorded imports. Invisibles flow and net officials transfers were positive in 1993; estimates are that Latvia experienced a balance of payments surplus in 1993. Assuming the lat remains relatively strong, Latvia is expected to record stronger balance of trade deficits in 1994-95, as imports outpace exports. Structural reform has proceeded most rapidly in agriculture and in the privatization of small enterprises. Over 58,000 private farms have been established and most remaining collective farms transformed into private joint-stock companies. However, many of Latvia's new farmers are operating at subsistence levels due to lack of financial resources and credit. Control over urban and rural property is being returned to former owners; legal mechanisms for title registration, sale and mortgaging of real property are not yet fully developed. The food- processing industry is undergoing privatization, which has already been completed for the dairy industry. Overall, however, the pace of privatization of large industrial enterprises has been slow, as only about a dozen of Latvia's largest industrial enterprises have been privatized. Industrial privatization has lagged, in part because large enterprises are perceived by potential investors as outdated, inefficient dinosaurs with doubtful or limited futures. Recovery in light industry and Riga's emergence as a regional financial and commercial center are offsetting shrinkage of the state-owned industrial sector and agriculture. Foreign investment in Latvia is still modest compared with levels in Poland, Hungary and the Czech Republic, but is expected to expand as stabilization takes firmer hold. In January 1994, the Latvian Government calculated that direct foreign investment amounted to $140 million; this statistic is based on registered statutory capital of foreign joint ventures and is unreliable. Information available to the U.S. Embassy suggests that American companies are planning to invest in projects with a total value of $75-100 million. While distress slaughtering and sell-off of livestock herds will make Latvia a net importer of meat and dairy products in 1994, it has historically been a net exporter of agricultural products, led by dairy products, processed meat and fish. In 1993, Latvia exported $173.5 million and imported $70.6 million in agricultural products. Prior to independence, the Soviet Union was Latvia's largest market for food products, accounting for 66 percent of the country's total agricultural market. Forestry products accounted for about 9 percent of Latvian total exports in 1993. Transportation facilities are adequate to sustain expanded trade. Riga boasts the largest airport in the Baltic region plus the only container terminal between St. Petersburg and Poland. The Riga airport is being modernized and expanded in 1994 with EBRD funding. The largest export terminals in the Baltic Sea for Russian oil and chemicals are located at the Latvian port of Ventspils. Major infrastructure projects under consideration include construction of a thermo-electric power plant at the port city of Liepaja and construction of the "Via Baltica," a modern highway running through the Baltic countries on a north-south route.