Analytics, Economics, EU – Baltic States, Financial Services, Latvia, Loan

Latvian government announced on Wednesday that the entire € 7.5bn economic rescue package for the country would be thrown into doubt unless the country reached agreement with the International Monetary Fund over the latest aid installment. However, the country received already about € 1,5 bn in order to avoid the catastrophe.  

Discussions could drag into a third week

Valdis Dombrovskis, country’s prime minister, acknowledged that further support from European countries, which are providing the bulk of aid, could be at risk if negotiations with the IMF failed. He acknowledged that delay “will make talks with the European Commission regarding the next payment more difficult”, wrote Andrew Ward in Financial Times, 22.07.09.

Latvian officials on Wednesday said the negotiations, which were supposed to conclude on Friday, could drag into a third week but voiced confidence a deal was within reach.

“Both sides are co-operating and working hard to reach agreement,” said Diane Krampe, spokesperson for the finance ministry, adding that Latvia accepted the need to modify the original deal to reflect the worsening economy.

However, some say that that it looked increasingly likely the IMF would not pay out, as the bank does not automatically bail out all countries with funding needs.

On the dark side of the street

Latvia needs international help to stabilise its banking system, cover its ballooning budget deficit and refinance government debt as the country struggles to contain its economic malaise.

The IMF’s hard-line stance has provoked anger in Latvia (including Artis Kampars, Latvia’s economics minister), with complaints that many of the fund’s prescriptions will worsen the country’s economic plight.

The IMF has taken a tougher approach than the European Commission, which gave the go ahead to its latest €1.2bn installment earlier this month.

The IMF has made no public comment on negotiations since the IMF spokesperson said last week that the fund was working to ensure austerity measures did not hurt the poor.

”We have been particularly concerned to... help the authorities to protect the most vulnerable,” said Caroline Atkinson, IMF’s representative on external relations.

Latvia received €600m from the IMF at the end of last year and €1bn from the European Commission early this year.

Main problem is lat

Already in June Robert Anderson and Stefan Wagstyl revealed some of the most acute Latvian problems [Latvia: A lat to worry about. – Financial Times, June 16 2009].

With the backing of Latvian reforms from IMF and the European Union, the country intends to “redress” the domestic economy and thus maintain its exchange rate peg to the euro. That would allow it entry into the single currency zone within the next four years, argued FT’s writers.

After months of deliberations, Latvian government in the beginning of June put together a package of measures that will reduce, for example public sector workers’ wage by 20% and pensioners by 10%.

Latvia ran into trouble managing the unprecedented surge in credit-fuelled economic growth that rushed through central and Eastern Europe, driven by EU enlargement and globalisation. As a small economy, Latvia and other Baltic States were swamped with foreign loans, chiefly from Swedish and other Scandinavian banks, particularly into their already overheated property markets. While Estonia and Lithuania worked to slow the pace, Latvia’s leaders ignored calls for restraint until it was too late. The European Central Bank has lent Sweden € 3bn to guard against its banks’ Baltic exposure.

The end came last autumn with a currency and banking crisis, which forced the government to go to an IMF/EU consortium’s emergency aid plan worth € 7.5bn.

Financial market’s problems in Latvia have eased  – as well as a threat of lat’s devaluation since the 500m lat national austerity package helped to acquire the first € 1.4bn credit line.  

Latvia has faced persistent speculation that it could be forced to devalue its currency, the lat – breaking its currency peg to the euro; but the finance ministry has repeatedly ruled out such a move.

Latvia sees the currency peg as the linchpin of its economic policies. It helped drive down inflation and is the route to euro entry. Latvia’s governments have often been weak but have always defended the peg and supported the powerful central bank, where both the prime minister and finance minister used to serve.

Morgan Stanley analysts argue that devaluation is inevitable and obviously getting closer; even the IMF is warning that “correcting currency misalignment without nominal depreciation is extremely difficult”.  

Small and vulnerable country like Latvia is responding to the crisis with budget cuts, mainly containing deficits by reducing public spending in the way described above. Here Latvia has gone far than any other EU country in cutting public servants’ wages. Under the IMF/EU rescue terms, Latvia has pledged to keep its budget deficit to 5% of GDP.

But with the economy contracting much faster than then forecast, the deficit could reach 12% without remedial action. Even with the latest cuts, it will be 7%, argued FT writers, a figure that breaks the IMF’s normal boundaries.

After years of the fastest growth in the EU, Latvia can expect the GDP’s reduction by about 18-20% in 2009, which is the worst in the EU’s recession outlook. The perspectives for 2010 and beyond depend on the economies of western Europe and Russia, Latvia’s main trading partners. “Without dramatic improvements in the pan-European economy, Riga seems set for further rounds of tax increases and spending cuts to keep the deficit down and convince the IMF to continue its support and qualify for eurozone membership by the government’s 2013 target date”, predicted FT writers in June.

The economic and financial situation is deeming in all eastern European countries (see tables below).

Troubled economy

Some emerging markets experts (e.g. from Goldman Sachs) acknowledged that if Latvia succeeds in getting out of the crisis safely, it would send a powerful signal that the ex-Communist countries, having endured the turmoil of socialism-to-capitalism transformation since 1991, have had the potentials and resilience to cope with the current economic and financial problems.

If Latvia fails, as the reforms are being politically extremely painful, it could have a damaging effect on other transitional eastern economies in the region, e.g. Estonia, Lithuania, Hungary and Bulgaria.

Some western governments suggested to devalue lat (and in this way spreading some of the costs to foreign creditors) and to trying to boost the economy by making Latvian exports more competitive. However, the IMF’s officials were divided over the intention to defend the lat’s peg and devaluation; but were finally persuaded by pressure from EU and Latvian government to sustain the status quo.

Latvian officials argue that in a small economy, where 60% of export value is in imported content, devaluation will not do much except encourage inflation. With some 90% of all loans in euros, they add, it could bankrupt tens of thousands of companies and individuals. But the price of avoiding devaluation will be huge economic, social and political strains.

Some opposition politicians predict a rough autumn as unemployment rises from the present 16% today to a further 20% at the end of the year. Jobless for more than a few months find their benefits reduced to just 30 lats a month.

The economic crisis could also exacerbate tensions between the Latvian majority and ethnic Russians, who comprise about 30% of the population. “Harmony Centre”, a coalition often seen as pro-ethnic Russian, made strong gains in June EP. One of the Center’s leaders, Alfreds Rubiks, a former Riga mayor, said: “Our government backs this budget but people do not.”