Wednesday, June 10, 2009


I bet you haven't thought much about Latvia for most of your life. That's about to change. Nouriel explains:

Once an investor darling, Latvia’s booming, double-digit growth earlier this decade was accompanied by massive imbalances - a current-account deficit approaching 25% of GDP (among the world’s widest) and an external debt load that peaked at over 140% of GDP. The correction in these imbalances would have been challenging under any circumstances, but the global financial crisis and consequent drying up of capital inflows have raised the likelihood of a full-blown balance of payments crisis. Latvia’s currency, the Lat (LVL), is pegged to the euro within a ±1% fluctuation band, and such pegs do not tend to survive harsh economic adjustments like that now underway. In countries with flexible exchange rates, domestic demand does not have to bear the full brunt of correction in external imbalances as currency depreciation can shoulder some of the burden.

Latvia’s economy is currently on life support. Although agreement was reached in December on a € 7.5 billion (US$ 10.4 billion) IMF and EU-led rescue package, the government is now forecasting an 18% contraction in growth in 2009, making it one of the world’s fastest shrinking economies. The immediate focus is on whether Latvia will receive the € 1.7 billion (US$ 2.4 billion) installment of its loan package due in late June. The key stumbling block is Latvia’s ability to meet the 5% of GDP budget deficit limit laid out in the loan terms. The problem is not that Latvia’s government has been spending recklessly. Rather, the issue is that the drop-off in Latvian growth has been so precipitous, far beyond that envisioned when the loan agreement was signed just six months ago, that extreme fiscal belt-tightening is now required to meet the loan terms. A 5% GDP contraction was assumed in the original agreement, as compared to the 18% now forecast.

Latvia has been going to agonizing extremes to make the June payout happen, dramatically slashing public sector salaries. More spending cuts are in the works. As Prime Minister Dombrovskis has pointed out, these belt-tightening measures will likely trigger an even deeper recession. Even with the cuts, Latvia’s budget deficit is still expected to come in above the limit, and it remains unclear whether the IMF and European Commission are willing to relax the loan conditions. As RGE Monitor
warned in early May: if Latvia does not receive the latest tranche of its IMF-led loan, the country will likely be facing a double whammy of default and devaluation.