Latvia budget could be Europe's devaluation nightmare (News Feature)

Oct 7, 2009, 11:32 GMT

By Mike Collier, dpa

Riga (dpa)- The national budget of the Baltic state of Latvia is not something that generally makes international headlines. But the 2010 budget is managing to do just that - before it has even been agreed.

The reason is simple. Latvia's 2010 budget could affect the economic future of large parts of Europe.

Since it agreed a 7.5-billion-euro economic aid package a year ago with lenders including the International Monetary Fund (IMF), European Union, World Bank and regional governments including Sweden, Latvia has found itself in the international spotlight as it wrestles with painful reforms and cuts, while simultaneously trying to maintain its currency peg to the euro.

'The eyes of the financial world are on us,' said central bank governor Ilmars Rimsevics on October 1.

Public sector workers including teachers and nurses have been laid off and those that retain their jobs have seen their wages cut by a third. Pensions have been reduced and unemployment has climbed to more than 18 per cent.

The government of Prime Minister Valdis Dombrovskis managed to find 500 million lats' (1 billion dollars) of savings in a supplementary 2009 budget in June but is resisting calls from lenders to do the same with the 2010 budget, arguing that cuts of 225 million lats will be sufficient to keep the budget deficit within agreed limits.

With EU Finance Commissioner Joaquin Almunia demanding on Tuesday that the original target be stuck to, Dombrovskis finds himself on a collision course with Latvia's creditors.

'We have to defend our interests and work to ensure that this program helps the economy recover as soon as possible ... social tension should not be increased needlessly,' he said on Latvian radio on Wednesday.

At the same time, opposition parties and even the largest two parties within Dombrovskis' ruling coalition are advocating devaluation of the national currency, the lat, as a way of kick-starting an economy that is expected to contract by 18 per cent this year.

If devaluation occurs it could trigger devaluations in neighbouring Lithuania and Estonia and onwards across a large swathe of central and Eastern Europe among countries yet to adopt the euro.

The 2010 budget was originally scheduled to be presented to parliament on October 23, but the government now says October 28 is the likely date and is reserving the right to change the date again, adding to market jitters.

The immediate cause of last year's crisis was the emergency nationalisation of the country's second-largest bank, Parex, at a cost of more than a billion dollars.

However, the root cause was even more serious: an economy that had spent the best part of a decade propped up on cheap credit and a real estate bubble. The global credit crunch put paid to both, leaving Latvia close to 'bankruptcy' according to Dombrovskis.

Lenders are making it clear that unless Latvia sticks to the terms of the agreements it has signed, no more money will be forthcoming.

'We are not the police of the EU member states, but ... we expect to see the conditions of the agreement fulfilled. If the answer is 'no', the rest of the loan that is available will not be able to come,' the European Commission's Elena Flores told a banking conference in Riga this month.

Sweden is particularly anxious. Swedish and other Scandinavian banks dominate the Latvian banking market. The two largest, SEB and Swedbank, have lent around 14 billion dollars in Latvia, with mortgages accounting for around 6 billion dollars. Devaluation would cause the incidence of bad loans to soar as Latvians paid in lats would struggle to service loans taken out in euros.

Swedish Prime Minister Frederik Reinfeldt and his Finance Minister Anders Borg have both told Latvia to stick to its word in recent days.

'The international community's patience with the Latvians is limited. They must deliver a responsible fiscal policy,' Borg said on October 2.

He will not be reassured by a surprise announcement from Dombrovskis on October 6 that the law governing house repossessions will be changed so that banks will be obliged to find alternative accommodation for foreclosed families. Borrowers' liabilities will also be limited to the value of their collateral rather than the full loan amount.

Danske Bank economist Par Magnusson warned that the new law could be a precursor to devaluation and would certainly increase banks' losses.

'With property prices down some 70 per cent from the peak, it must be tempting to stop paying mortgage loans for borrowers with negative equity, which applies to the majority of mortgage borrowers in Latvia today,' he said. 'The major advantage from the Latvian government's point of view is that devaluation will no longer pose a big problem.'