Latvia on the brink

Latvia's troubled economy

Baltic brink

Dec 18th 2008
From The Economist print edition

Latvia has chosen economic torture over complete collapse

ONE of the more dramatic and controversial financial rescues in modern European history has been taking shape in Latvia over the past three weeks, led by officials from the International Monetary Fund and backed by neighbouring countries, the European Union and other institutions. Latvia’s central bank has burned through €1 billion ($1.4 billion), around a fifth of its reserves, since mid-October to defend the national currency, the lat. This is pegged to the euro in an arrangement similar to a currency board, but with an even bigger lump of foreign currency to back local money in circulation. As a stopgap measure, the Swedish and Danish central banks this week offered a combined €500m in short-term swap facilities, allowing the central bank to keep exchanging lats for euros. The IMF-led bail-out—so far agreed only in outline—is likely to amount to over €7 billion, with contributions from the Fund, Nordic countries and Latvia’s Baltic neighbour, Estonia.

The deal does not require Latvia to devalue its currency. This is highly controversial inside the IMF, where memories of the debacle over Argentina’s abandonment of its currency board in 2002 are still painful. But ending the currency peg would be tricky, not least because the central bank’s independence is constitutionally entrenched. It would bring little lasting benefit. And it would be deeply unpopular. Some 85% of loans to Latvian households and firms are denominated in euros and other foreign currencies.

The clinching argument was the damage that a devaluation could wreak elsewhere. Swedish and Finnish banks, which own the bulk of Latvia’s banking system, could find their own creditworthiness suffering. Although total exposure to Latvia is still small, the perception of risk is damaging. In late October, the Swedish government launched a loan guarantee plan of SKr1.5 trillion ($190 billion) to allay fears about its banks’ future.

A Latvian devaluation would also be likely to topple the currency boards of Estonia and Lithuania, and to endanger the precarious stability secured in recent weeks in other wobbly east European countries such as Hungary. The IMF said this week that it did not believe that either Estonia or Lithuania needed to abandon their currency boards. However, big current-account deficits there and in other east European countries remain a worry.

The bail-out plan makes unprecedented demands for fiscal adjustment to trim both the current-account deficit and inflation. After some years of double-digit growth (during which a complacent government signally failed to cool the economy), Latvia faces a 5% or greater contraction in GDP next year. The tax rises and spending cuts that have been agreed upon are worth a full 7% of GDP. Public-sector salaries will fall by 15%. Private employers are making deep wage cuts too.

Latvia’s flexible economy may fare better than the political system, which is notable for fragmented parties, squabbling mediocrities, dodgy business lobbies and abuse of power (the security police briefly arrested an economics lecturer who urged people to keep their savings in foreign currency in cash). The prime minister, Ivars Godmanis, is a heavyweight, but lacks a competent team. This matters as the plan calls for big structural changes, including thorough reform of the financial system. The crisis was precipitated by the near-failure of a locally owned bank, Parex, which enjoyed a lively offshore business taking deposits from Russians, some of which appear to have been lent, unwisely, to locals. Having pushed the central bank into printing 200m lats ($390m) to support Parex, the government is now nationalising it.

Assuming that the bilateral elements in the plan are finalised, it may yet be agreed upon at an IMF board meeting shortly before Christmas. Any delay risks creating new room for speculators to try to attack the currency, and for locals to panic and turn more lats into euros (after some unwise remarks by the finance minister about a possible devaluation, the central bank lost more than €100m in reserves in a single day). Negotiating the plan has involved hectic late-night sessions in which outside officials have given locals copious instructions on the details of reform measures and the lobbying needed to gain support for them. It seems to have worked. But only for now.