IMF Survey: Latvia Caught in Vicious Economic Downturn

IMF News, May 28, 2009

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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.
The government is firmly committed to adopting the euro by 2012 and is contemplating deep spending cuts to address its ballooning budget deficit and ensure it can meet the Maastricht criteria for joining the EU’s monetary union.
A mission is currently in Riga working to complete the first review of the IMF-supported program, which will release another tranche of financing from the IMF worth €200 million.

Large imbalances built up during the post-EU-accession boom:
- Growth rates above 10 percent of GDP during the boom years.
- Bank credit to the private sector reached 95 percent of GDP last year.
- Double-digit current account deficits, peaking at 25 percent of GDP in 2007.
- Large buildup of private external debt amounting to about 130 percent of GDP.
Concentration of capital inflows into nontradable sectors (real estate, retail, financial services) and rising overall wage levels undermined competitiveness.
High inflation during the boom years remained much above European levels while the exchange rate was fixed, driving up overall costs.
Imbalances in the domestic banking system, with Parex Bank particularly exposed to sudden outflow of nonresident deposits.
The sudden stop of capital inflows when the global crisis erupted created a "perfect storm."

Managing a dramatic economic downturn:
- 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.
Addressing a dramatic loss of revenues and a ballooning budget deficit while maintaining the peg to the euro.
Finding ways to make the economy recover amid a worldwide recession.
Reconciling short-term fiscal consolidation with the goal of euro adoption by 2012.

In December, the EU, the IMF, the World Bank, and the Nordic countries backed Latvia’s adjustment policies with financing worth €7.5 billion ($10.5 billion).
- IMF’s share: €1.7 billion ($2.4 billion).
- EU support: €3.1 billion ($4.3 billion).
Some financing has been delayed due to 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 has indicated it would like to see more progress on budget and structural reforms before releasing the second tranche of its aid program, worth about €1 billion.
The IMF is working to complete the first review to release €200 million.

The original program agreed in December 2008 deliberately aimed to protect social spending:
- Social spending was to increase from 21 to 25 percent of the budget, or by 1½ percent of GDP between 2008 and 2009.
Given the deteriorating economy and financing constraints, more adjustment may be necessary, but the IMF and authorities advise protecting critical social spending within an even smaller level of overall spending.
The government prefers a very ambitious timeframe for euro adoption, which requires substantial short-term fiscal adjustment; IMF and European Commission are working with the government to achieve substantial adjustment while protecting essential social spending.
Without assistance from international partners, Latvia might have had to run a surplus, implying an even harsher adjustment.

Positive adjustment indicators:
- Inflation is falling rapidly.
- The current account is moving into a small surplus, ahead of the schedule set out in the IMF-supported program.
Despite faster-than-anticipated adjustment, 2009 is expected to be an "incredibly tough year."
Latvia will need substantial assistance from the international community to ease social costs.
If the reform program is implemented with support from the EU, the Nordic countries, and the IMF, Latvia should start to recover in 2010.

Projected contraction this year: more than 15 percent
IMF/EU/World Bank/Nordic financing package: €7.5 billion ($10.5 billion)
IMF share of aid package: €1.7 billion ($2.4 billion)
EU support: €3.1 billion ($4.3 billion)
Second EU aid tranche under conditionality: about €1 billion
IMF tranche pending on completion of first review: €200 million
Bank credit to private sector: 95 percent of GDP (last year)
Current account deficit peak: 25 percent of GDP in 2007
Private external debt: about 130 percent of GDP
Output fall: estimated 18 percent year on year in Q1 2009
Social spending target: increase from 21 to 25 percent of the budget, or by 1½ percent of GDP between 2008 and 2009
Euro adoption target year: 2012
Expected start of recovery: 2010

Source: IMF Survey online, May 28, 2009.