The Baltic states are once again in the eye of the storm after leaked reports that Sweden is bracing for a full-blown economic and political "breakdown" in Latvia.
By Ambrose Evans-Pritchard, International Business Editor
Published: 7:25PM BST 05 Oct 2009
Latvia's currency peg is back on the agenda The Svenska Dagbladet newspaper said Sweden's finance minister Anders Borg had told banks secretly that Latvia's political order was unravelling, advising them to prepare for the collapse of Latvia's rescue talks.
Latvia has failed to deliver draconian spending cuts agreed to secure the next tranche of its €7.5bn (£6.85bn) bail-out from the EU, the International Monetary Fund, and Sweden, balking at 20pc cuts in pensions and a further 15pc cut in public wages.
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Mr Borg said the world's patience is running out. "It will be very hard to continue with these international programmes if they don't fulfill the spirit and the content in the agreements they have signed."
Latvia's economy contracted by 18.2pc in the twelve months to June, trumped only by Lithuania at 20.4pc. "Latvia's currency peg is back on the agenda, " said Hans Redeker from BNP Paribas. "The government has to relax policy for social reasons. The hardship this winter is going to be unbelievable."
Youth unemployment in Latvia is already 31pc, and concentrated among ethnic Russians. Premier Valdis Dombrovskis said his chief task is to "preserve social peace".
Neil Shearing from Capital Economics said the appetite for austerity has been exhausted. Latvia is "more likely than not" to devalue, toppling pegs in Estonia and Lithuania. "Financial markets elsewhere in the region are likely to be hit by contagion, with Hungary, Romania, and Ukraine most vulnerable."
The area is better able to cope with shocks than during the panic this Spring. The G20 tripled the IMF's fire-fighting fund to $750bn in April, chiefly as an insurance for Eastern Europe. This has greatly reduced risk of a liquidity crisis. It does not alter the slow-burn damage of rising defaults.
The Baltic trio financed property booms in euros (and swiss francs) because rates were lower. It was taken for granted that eventual euro entry had eliminated the exchange risk. This has become a trap. They need to devalue to break the cycle of depression, but cannot do so because of euro mortgages. Instead they hope to claw back lost competitiveness through wage deflation. This takes years, and discipline.
Mr Shearing said Latvia's economy would shink by 30pc whether it devalues or not. The peg merely draws out the agony, and slows the pace of inevitable defaults.
Washington's Center for Economic and Policy Research said the IMF is enforcing a"pro-cyclical contractionary policy" in Latvia. Foreign banks (mostly Swedish) are being rescued at the cost of local taxpayers. The IMF deal equals 34pc of GDP. Latvia is piling up debt to defend its peg. The policy may backfire in any case. Fiscal contraction is causing tax revenues to implode, feeding a vicious circle.
Lars Christensen from Danske Bank said Latvia's political class is chiefly responsible for clinging to the peg. "It's their choice, but if they want the bail-out money, they must do what they promised. They don't seem to understand that the IMF and EU are willing to walk away now that the global economy has improved and spill-over risks have been reduced," he said.
Prospects are grim whatever happens "There is absolutely no sign of stabilisation. The economy is still contracting. It's paralysis," he said.
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Oct. 12 (Bloomberg) -- Latvia will seek to strike a last- minute agreement on budget cuts today to satisfy bailout terms in the latest round of brinkmanship that has tested the patience of the country’s international loan donors.
Prime Minister Valdis Dombrovskis has signaled his Cabinet will agree on an additional 175 million lati ($362 million) in cuts at a meeting today to satisfy the International Monetary Fund, the European Union and Sweden. Coalition members are due to meet at 12 noon in Riga. European Union Monetary Affairs Commissioner Joaquin Almunia will visit Riga tomorrow.
“They’re in the clear for the time being, but similar temporary disagreements will likely recur,” said Richard Segal, a fixed-income desk strategist at Knight Libertas U.K. “There is a history of Latvian politicians becoming complacent and trying to sneak in lower budget cuts, which the EU and IMF notice at the last minute. I wouldn’t rule this out in future.”
The IMF, the EU and Sweden agreed to give Latvia a 7.5 billion-euro ($11 billion) loan in December and urged the government to adopt tougher austerity measures. Swedish Prime Minister Fredrik Reinfeldt, who holds the EU presidency, on Oct. 5 said Latvia “must correct” its deficit while Riksbank Governor Stefan Ingves has said the country risks being “left in the cold.”
‘Fruitful’
International admonitions grew more strident in tone after Latvia said it could achieve a targeted 8.5 percent deficit of gross domestic product in 2010 by cutting 325 million lati off the budget, 175 million lati less than the IMF, the EU and Sweden had demanded.
The IMF on Oct. 9 said it concluded a visit to Latvia that included “fruitful” discussions about the loan program. An IMF staff team visited Latvia as part of a technical mission in consultation with the European Commission and plans to return in November, together with the EU, for a review of the program, it said in a statement.
Finance Minister Einars Repse said if the bailout program is suspended, Latvia will be forced to balance its budget next year and “live hand to mouth.”
In the event of a suspension, Moody’s Investor’s Service will cut the Baltic country’s credit rating, and the country may have to repay part of its loan early, depleting its reserves, Repse said on national television last night.
‘Wrong Kind’
Billionaire George Soros called on the EU to ease its budget-cut demands to slash budget spending in an interview with Swedish public radio on Oct. 10.
“The pressure for them to reduce government spending when the problem is in the private sector is a wrong kind of policy that ought to be avoided,” said Soros. “I think the European Union countries are in a position and out to help Latvia more than they are currently doing,” he said. Soros said he had no currency positions in the Baltics.
Less severe loan terms might have saved both sides some pain, Knight’s Segal said, adding that Latvia, which pegs the lats to the euro, and its creditors would benefit from making agreements more flexible, with policy requirements contingent on economic developments.
Dombrovskis is trying to limit the pain the budget cuts are inflicting on the economy through legislative changes. The premier on Oct. 6 asked his civil servants to investigate the option of capping mortgage holders’ liability, a move perceived by some investors as a first step toward shielding the internal economy from a devaluation.
Little Impact
According to Segal, the proposal “would not have as much of an impact as a lot of people seem to think.”
Swedish lenders would suffer the deepest blow from the plan, which would swell loan losses. The krona dropped as much as 1.5 percent against the euro on Oct. 7, after investors learned the news. Stockholm-based Swedbank AB, the region’s biggest bank, lost 2.4 percent the same day.
Investors need to take loan losses at Swedbank and SEB AB, the second-biggest Baltic lender, into account when assessing the potential harm the mortgage proposal may inflict, Segal said.
“The impact of any plan on the future value of the Swedish banks in Latvia has to be compared with what they have already written down and I think a lot of commentators have overlooked that,” he said.
Swedbank’s gross provisions for Latvian loans were 4.5 billion kronor in the first half, or 12.77 percent of total lending, the bank said on July 17. SEB, which doesn’t provide country-specific figures for the region, said net credit losses in the Baltics for the same period were 4.93 percent. That compares with Swedbank’s 7.36 percent loss ratio for the region.
‘Bottom Occurred’
“Clearly the bottom of the economic cycle has occurred, we couldn’t have said this three or four months ago and therefore I’m pretty sure that a compromise will happen sooner or later,” Segal said.
The $34 billion Latvian economy “probably bottomed out during the second and third quarter,” Dombrovskis said on Oct. 2, citing Economy Ministry forecasts. Fitch Ratings on Oct. 6 forecast a 4 percent output contraction next year after an 18 percent slump in 2009. Swedbank expects Latvia’s GDP to shrink 2 percent next year, it said on Sept. 29.
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