Latvia

Latvia's economic woes

Lat in the lurch

Jun 11th 2009 | RIGA
From The Economist print edition

Vultures are circling over Latvia

LIKE many small countries, Latvia has struggled to attract outsiders’ attention. Now it is famous, and hating it. The economic contraction—GDP down nearly a fifth, imports and exports down by more than 40%—is on a scale rarely seen in peacetime. Life support for the economy is being given by outsiders. Foreign banks are nervous (see article). Much depends on parliament accepting more big budget cuts: nearly $1 billion this year and the same next year. The package includes ditching the flat tax on incomes. The government agreed to this new budget, belatedly, on June 8th.

That should unlock the next $1.67 billion tranche of aid from the European Union and the IMF, part of a $10.6 billion deal from late last year. But is it throwing good money after bad? Some bits of good news suggest that the economic collapse may have halted. Latvia’s flexible economy means it may manage painful reforms that amount to an “internal devaluation”. That could regain lost competitiveness and restore growth.

Others think that Latvia must sacrifice the peg to the euro that has been the centrepiece of economic policy. The Bank of Latvia has spent over a tenth of its reserves in the past fortnight propping up the lat. Interest rates have spiked, and a government debt auction failed last week. Sweden’s central bank is borrowing €3 billion ($4.2 billion) from the European Central Bank, in case it needs to shore up Swedish banks that lent in Latvia. Past crises in Latin America and East Asia echo ominously. Bengt Dennis, a Swedish adviser to Latvia’s government, says devaluation is inevitable.

But the lat’s guardian, the Bank of Latvia’s governor, Ilmars Rimsevics, is unshaken, pointing to the “beauty” of the currency-peg system. All lats in circulation are backed by euros. If people want to switch, they can, but as interest rates rise, holding lats becomes more attractive, he argues. The central bank’s independence from government is legally impregnable.

Joaquín Almunia, the EU’s monetary affairs commissioner, backed the peg this week. But political weakness still overshadows Latvia’s chances. The steely (critics say arrogant) Mr Rimsevics is barely on speaking terms with the prime minister. Latvia’s real deficit is not in the public finances but in the state’s credibility, squandered in the past by spendthrift and sleazy politicians.