Latvian patient balks at IMF medicine

October 7, 2009

Latvia has relapsed again, just months after the latest piece of sticking plaster was slapped over the Baltic country’s gaping economic wounds.

The government has failed to agree on cuts worth 500 million lats ($1 billion) next year that it promised to international creditors, led by the International Monetary Fund and the European Commission. It could only find savings of less than half that amount. Its failure to deliver has raised doubts about whether Latvia has the political will to see through the economic recovery plan it has concocted. If it does not, the result could be chaos.

Latvia has been on a 7.5 billion euro drip-feed from the IMF and Brussels since last year as part of a controversial strategy to stabilise the economy. The former Soviet republic has been on life support since a property-led boom, funded largely by euro-denominated borrowings, burst in the credit crunch. The remedy requires Latvia to cut wages and pensions in order to “grow” back into its overvalued exchange rate.

It’s called “internal devaluation”, and it’s a sort of cold turkey, tough love regime. Most countries, confronted by Latvia’s malaise, would simply devalue their currency. But the EU newcomer’s aspirations to join the euro rule that out.

The rescue deal was reconfirmed just months ago, when the IMF released the latest tranche of cash. So signs that Latvia is unwilling to deliver on its promises have been understandably met with irritation.

Latvia already has form in the non-delivery department. Riga has only to date implemented about a third of the spending cuts it promised according to a recently published IMF review of the 7.5 billion euro rescue package agreed with Riga last year.

That said, the Latvian economy has also shrunk much more than Riga or its creditors expected. So it’s not surprising that the Latvians have been wary of taking the medicine. Not only does it taste nasty but its side-effects seem to make the patient feel even worse.

The issue now is whether Riga really has the appetite to carry on taking its dose in the run-up to next year’s elections. Public opinion on the austerity measures is not coherent. Voters oppose both devaluation and the austerity measures needed to stave it off. The People’s Party, which is the largest member of the governing coalition, seems to have opted to mirror this. Thus it recently voted against a real-estate tax put forward by a government of which it remains a part.

Riga claims that it has not repudiated the deal. It remains committed to reduce the government deficit to agreed levels next year. It just doesn’t think it needs to make these cuts to achieve it. This looks like a bid for additional wiggle room. The snag for its creditors is that the conditions they set for assistance lose force once Riga has banked the cash.

All this leaves the IMF and Brussels in an uncomfortable position. Do they push Riga into compliance and risk a collapse of the coalition? Do they loosen the conditions? Or do they push the Latvians to move towards a devaluation? And what credible sanctions do they have? Pulling the package would be an act of economic euthanasia.

Moreover, the devaluation option might split the main creditors. The IMF is thought to be more sympathetic, while the EU and the Swedes are not — for strategic and financial reasons respectively. The Latvian prime minister’s contradictory statements, coalition wrangling and loud warnings from Brussels and Stockholm may all be just political theatre to ensure Riga takes the next dose of medicine. But a chaotic outcome has become more of a possibility.

Sweden’s finance minister was reported by Svenska Dagbladet to have held secret meetings with the country’s top bankers, warning them to prepare for meltdown. This could prove to be prescient advice.

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