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IMFSurvey Magazine: Countries & Regions

global financial crisis

Latvia Caught in Vicious Economic Downturn

By Camilla Andersen
IMF Survey online

May 28, 2009

  • Latvia hit particularly hard by global economic crisis
  • Difficult policy choices driven by widening budget deficit and euro adoption goal
  • Further budget cuts needed but essential social spending should be protected

Latvia is in a deep recession, with the economy projected to contract this year by more than 15 percent. Plunging revenues are opening up a wide fiscal gap, which the new government is trying to plug.

Back in December last year, the European Union (EU), the IMF, the World Bank, and the Nordic countries backed Latvia’s adjustment policies with financing worth €7.5 billion ($10.5 billion). The IMF’s share of this aid package is €1.7 billion ($2.4 billion), while the EU has offered €3.1 billion ($4.3 billion) in support.

But some of that financing, including from the IMF, has been delayed because of the fall of the previous government, and the formation in March 2009 of a new five-party coalition government led by Valdis Dombrovskis. The EU’s Economic and Monetary Affairs Commissioner Joaquin Almunia said May 6 that the EU would like to see more progress on budget and structural reforms before it releases the second tranche of its aid program, worth about €1 billion. The IMF, for its part, is working to complete the first review of its program. A mission is currently in Riga, working closely with the European Commission and other international partners. Completion of this review will release another tranche of financing from the IMF worth €200 million.

In this interview, the IMF’s new mission chief for Latvia, Mark Griffiths, and Christoph Rosenberg, an advisor in the IMF’s European Department who coordinates the IMF’s work on the three Baltic Republics, talk about the huge challenges that face Latvia today. The government, which is firmly committed to adopting the euro by 2012, is contemplating deep spending cuts to address its ballooning budget deficit and ensure that it can meet the Maastricht criteria for joining the EU’s monetary union.

IMF Survey online: Latvia has been hit particularly hard by the global economic crisis. Why did its economy prove to be so vulnerable?

Rosenberg: In the years that followed Latvia’s acceptance into the EU, the economy experienced a huge boom, with growth rates above 10 percent of GDP. But during this time, large imbalances were building. In fact, the country had been on the IMF’s radar screen for a long time. As far back as 2005, we warned publicly that the economy was in danger of overheating.

Continued strong credit growth, with bank credit to the private sector reaching 95 percent of GDP last year, double-digit current account deficits, peaking at 25 percent of GDP in 2007, and a large buildup of private external debt amounting to about 130 percent of GDP, made Latvia extremely vulnerable to the credit crunch. When the global crisis erupted last year, resulting in a sudden stop of the capital inflows that had financed the boom, these vulnerabilities created a perfect storm.

Griffiths: Another factor that increased Latvia’s vulnerability were imbalances in its large domestic banking system, with one bank in particular—Parex Bank—very exposed to a sudden outflow of nonresident deposits.

Rosenberg: Behind all these vulnerabilities also lay a loss of competitiveness. A lot of the capital inflows that drove economic growth went into nontradable sectors, such as real estate, retail, and financial services. Overall wage levels went up both in these sectors and in the rest of the economy.

While the housing market and financial sector generated growth in the short term, in the long term these two sectors will not be able to generate the income necessary to service the large debt Latvia built up during the boom years—especially today, with the global environment being what it is. So a fundamental reorientation of the economy and a more competitive wage level will be necessary.

Griffiths: The high inflation rate during the boom years also made Latvia less competitive. With the economy growing rapidly, inflation remained much above European levels and the exchange rate was fixed. This drove up overall costs.

"When the global crisis hit last year, resulting in a sudden stop of the capital inflows that had financed the boom, these vulnerabilities created a perfect storm."

IMF Survey online: What are the most immediate challenges facing the government?

Rosenberg: The government is dealing with a dramatic downturn of the economy. Output fell by an estimated 18 percent year on year in the first quarter of 2009, and could fall by a similar amount for the year as a whole. Such numbers of course have huge implications for the economy as a whole, for unemployment, and for the budget. That’s the government’s most immediate challenge. In particular, it is dealing with a dramatic loss of revenues and has had to make large adjustments in the budget to remain at a level that’s consistent with the country’s strategy of maintaining the peg to the euro.

Griffiths: The government also has to find a way to make the economy recover, something that’s exceedingly difficult, given the world-wide economic recession. And while doing all this, the authorities need to keep an eye on their ultimate goal: to adopt the euro and extricate Latvia from currency risk.

IMF Survey online: The EU, the IMF, the World Bank and others have backed Latvia’s policies for stabilizing the economy. What is the status of the IMF-supported program?

Griffiths: We have worked closely with the European Commission, the World Bank, and the Nordic countries to make this program work. The EU in particular has played a central role and has put up most of the financing to support Latvia’s stabilization efforts. As for the IMF-supported program, we are working to complete the first review, which will release another tranche of financing for Latvia of €200 million.

IMF Survey online: Latvia’s government is strongly committed to maintaining the peg to the euro, even though this will require a large fiscal adjustment. Why such determination?

Rosenberg: The alternative strategy—abandoning the peg—would also be associated with large economic short-term costs. That is clearly one reason why there is such a strong preference in Latvia for maintaining the peg. Latvia also has a clear exit strategy in place: meeting the Maastricht criteria and adopting the euro by 2012.

It goes beyond that, though. The peg has been a symbol of Latvia’s stability and independence, and has been in place since the country won independence from the Soviet Union in 1991. For the government, keeping the peg will lead to euro adoption within the foreseeable future. This exit strategy—euro adoption—justifies, in their eyes, the current sacrifices. The EU and the Nordic countries support this strategy, too, provided the government fulfills the conditions for joining monetary union.

IMF Survey online: The conditions for the IMF loan have been criticized as overly harsh. Is the IMF disregarding the social costs of economic adjustment?

Rosenberg: Let me first stress that this is the authorities’ program—they have very strong ownership of the policies that underpin it. As we agreed with the government back in December 2008, the original program made a very deliberate effort to protect social spending. In fact, we agreed that it should increase under the program from 21 to 25 percent of the budget, or by 1 percent of GDP between 2008 and 2009, bringing it closer to EU and OECD averages.

Needless to say, these goals will be very difficult to achieve given the rapidly deteriorating economy. Given the constraints on financing, more adjustment may be necessary—even though we are aware that an excessively tight fiscal policy could create a downward spiral in the economy. The government is currently revisiting the budget and will discuss it and other related issues with the IMF’s review mission. But within an even smaller level of overall spending we are still advising to protect critical social spending.

IMF Survey online: The new government has called for even larger cuts to government spending to make sure it will be able to meet the criteria for adopting the euro in 2012. Is such a large fiscal adjustment desirable, or even feasible?

Griffiths: We are aware that any program at this stage is risky. But as already mentioned, adopting the euro would provide a credible exit strategy from the current peg and allow the country to benefit from the stability of the common currency. The government prefers a very ambitious timeframe for joining the EU’s monetary union, which in turn requires substantial short-term fiscal adjustment. The IMF and the European Commission are working closely with the government on a fiscal strategy that achieves substantial adjustment but also protects essential social spending.

The budget choices facing Latvia today are extremely difficult. But it’s also important to remember that without assistance from the EU, the IMF, and other partners, Latvia wouldn’t have been able to run a budget deficit at all. It might even have had to run a surplus, in which case the adjustment would have been much, much harsher than it already is.

"But within an even smaller level of overall spending we are still advising to protect critical social spending."

IMF Survey online: When do you think Latvia’s economy will start to turn around?

Griffiths: Well, the good news is that inflation is falling rapidly, and the current account is moving into a small surplus. This is well ahead of the schedule that was set out in the IMF-supported program, so the economy is adjusting quite rapidly—faster, in fact, than we had anticipated. But 2009 will be an incredibly tough year.

Latvia will need substantial assistance from the international community to ease the social costs of the crisis. However, the new government is committed to a strong economic reform program, with support from the EU, the Nordic countries, and the IMF. As long as this program is implemented, Latvia should start to recover in 2010.

Comments on this article should be sent to imfsurvey@imf.org


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