Global Insight Perspective | |
Significance | Latvia's government is seeking financial support from the IMF and the European Commission to overcome the recession in the country, rescue banks, and maintain the euro-based exchange rate peg. |
Implications | The government's decision could be regarded as a beneficial move for the country's outlook because it potentially raises the scope of funds available to the government to fight the recession. |
Outlook | Although IHS Global Insight still assumes that the euro peg will be maintained, the economy will fall steeply in 2009. However, the government's decision will make it easier to push through necessary reform. |
Latvia’s government has applied for financial support from the IMF, being the next country from Europe to join the queue in Washington, following Iceland, Ukraine, Hungary, and Serbia. Prime Minister Ivars Godmanis told reporters yesterday about the government’s decision, which had been subject to speculation for a couple of weeks. Moreover, in addition to the IMF application, the government has also started talks with the European Commission over potential sources for financial support. Preliminary conclusions might be reached already next week, the prime minister said. In the meantime, Estonia’s and Lithuania’s governments said that they do not plan to follow Latvia’s example and seek help from either the IMF or the European Union (EU) at this stage.
Latvia’s economy was already slowing sharply before the global financial crisis fully broke out in the third quarter, having been hit by home-grown woes from a bursting housing price bubble and surging private debt. Meanwhile, with a downturn looming in any case, the global financial meltdown has made things even worse, making refinancing the country’s large external debt stock and service obligations virtually impossible for those banks that cannot rely on foreign parents.
The government therefore had to take over and bail out the country’s third-largest bank, Parex bank, less than two weeks ago (see Latvia: 10 November: Latvian Government Takes Over Second-Largest Bank), injecting 200 million lats (US$352 million) immediately and guaranteeing a further 700 million euro (503 million lats) of a syndicated loan that is due in 2009. Given the current state of global capital markets, the state will most likely have to pay for the loan itself, or let the bank go bankrupt. However, the majority of the banking sector is dominated by Scandinavian banks, including Swedbank, SEB, and Nordea, which have not indicated a withdrawal from the Latvian market so far.
Latvian authorities have currently to fight on three major fronts: the first is the banking sector and the support for Parex bank in particular; the second is the economic recession, which has severely hit fiscal revenues and will inflate the state’s budget deficit well beyond the Maastricht threshold of 3% of GDP in 2009; and the third, and perhaps the most important one, is the euro-based exchange rate parity of the lats, which the government and the central bank have maintained so far at all cost. The latter is of utmost importance because a devaluation of the lats against the euro would trigger mass default among the private sector, since more than 90% of private-sector credit is denominated in foreign currency, mainly in euro.
The lats has remained firmly within its corridor of +/-1% around the central parity of 0.702804 lats per euro, yet the central bank has spent around 600 million euro during the last seven weeks to defend the peg, Reuters reported. Foreign-exchange reserves shrank to some US$5.5 billion at the end of October, down from a peak of US$6.5 billion at the end of May 2008. The majority of reserves are apparently in U.S. dollars, since reserves decreased in dollar terms but actually rose slightly in euro terms, reflecting the euro’s depreciation against the U.S. dollar during recent months.
Outlook and Implications
The government’s decision to seek support from the IMF and the European Commission officially is not quite as concerning as it might seem at first sight. Latvia, although being haunted by a huge current-account deficit of its own, is not Iceland, and it will be able to defend the currency peg even in the longer term. The question is, however, at what cost. Defending the peg means that less funds are available for banking sector rescue operations, or to cushion the impact of the recession. If the IMF grants support, Latvia will be able to shield the economy against a worst-case scenario and avoid the country plunging into a deep black hole in 2009. Fighting on all three fronts successfully at the same time is simply not possible given the scope of financial funds available to the government and the central bank. The fact that the government has finally decided to turn to the Fund and the Commission for financial support could even be regarded as a beneficial move for the country’s outlook from this points of view. Moreover, since the IMF will virtually sit at the cabinet table from now on, pushing through necessary reforms and spending cuts might become easier, although the people on the street may be less than impressed.