Economy and Trade
After gaining its independence from the Soviet Union in 1991, Latvia reoriented its economy towards the West, which involved the wholesale privatization of state-owned enterprises. After EU accession in 2004, consumers embarked on a debt-fuelled spending spree, with Scandinavian and local banks vying to offer bigger and cheaper loans. Successive coalition governments pursued loose fiscal policies. Consequently, a major house-price bubble was inflated. Economic growth peaked at 12.2% in 2006, briefly making Latvia the EU’s fastest-growing economy. However, this economic success proved short-lived and, by December 2008, the government was forced to accept a €7.5 billion rescue package from the IMF, European Union, and Nordic governments. Conditions included the need for significant cuts in government expenditure and tax increases. Agriculture accounts for 3.3% of Latvia’s GDP, industry 22.3% and services 74.4%. Forestry and wood products account for nearly one-third of exports.
Economic Policy over 12 Months
In December 2008, Latvia accepted a €7.5bn rescue package from the IMF, European Union, and Nordic countries. The European Union is providing a €3.1 billion loan, the Nordic countries €1.8 billion, the World Bank €400 million, the Czech Republic €200 million, and the European Bank for Reconstruction & Development, Estonia, and Poland €100 million each.
Latvia required the loans because commercial borrowing had become prohibitively expensive, even for the government, whose credit ratings were downgraded to junk status by Standard & Poor’s in February 2009. The IMF-led program is focused on maintaining the currency peg at the current exchange rate, containing the fiscal deficit, and supporting the banking system. Another goal is to enable Latvia to meet the Maastricht deficit criteria for euro adoption, a move the IMF describes as “an exit route” from severe economic crisis.
The rescue package was conditional on austerity measures, including savage cuts in expenditure and tax rises, aimed at reining in the country’s current-account deficit. The package was also based on the assumption that Latvia’s economy will shrink by 5% in 2009—an optimistic view given that by February 2009, the economy was expected to subside by 12% during the course of the year. The central bank governor said, in February 2009, that the Latvian economy was “clinically dead” after it shrank 10.5% in the fourth quarter of 2008.
In December 2008, parliament approved a LVL700 million (€999 million) budget cut, and raised taxes by LVL300 million, including a rise in value added tax from 18% to 21%. However, the austerity measures have proved deeply unpopular. In January 2009, scores of protesters clashed with police as they tried to storm parliament, and, on February 20, the coalition government of Ivars Godmanis was forced out of office.
There is a growing acceptance that the successor government will find it impossible to adhere to the harsh medicine prescribed by the IMF—which also includes structural policies designed to boost productivity, and help generate a shift from the production of non-tradables to tradable goods.
Days after the government’s collapse, Fitch Ratings warned that any failure to maintain budgetary controls would delay the disbursement of international funds to Latvia, and bring the lats under renewed pressure.
After cutting the country’s credit rating to junk status in February, Standard & Poor’s said: “We believe the political commitment and public support for the current policy stance depends to a considerable degree on prospects for economic recovery in 2010, and an early Eurozone entry. . . A prolonged economic contraction would likely lead to declining public support for the current policy stance.”
Some commentators, including the IMF, believe that a better solution to Latvia’s economic woes would have been a devaluation of the lats, accompanied by its replacement by the euro.
Economic Performance over 12 Months
The global financial crisis of 2008 brought Latvia’s vulnerabilities into sharp relief. Years of unsustainable growth, and large current account deficits precipitated a full-scale balance of payments crisis in 2008. Output shrank by 10.5% in the fourth quarter, compared with the same period in 2007. Unemployment climbed to 7% in December, up from 6.1% in November. Popular dissatisfaction with the government’s handling of the economy prompted further crises, following the resignation of the centre-right coalition government of Prime Minister Ivars Godmanis, on February 20, 2009.
One reason for the economic crash was that locally owned banks, which make up 40% of the Latvian banking system, accepted deposits from abroad, and invested these funds in the country’s booming property market. This market came under pressure in 2008 after foreign credit evaporated, and confidence in Latvian banks collapsed. In the second half of 2008, Parex Banka (the country’s second largest bank, and its largest domestically owned bank) was at risk of collapse—it was nationalized in November 2008.
From August to November 2008, Latvia’s reserves fell by 20% to €3.4 billion as the central bank sought to shore up the currency peg by selling foreign reserves. However, fears about a possible systemic crisis, and the sustainability of the country’s external debt mounted. Despite the December 2008 €7.5bn IMF-led rescue package, the exchange-rate peg remained under pressure.
The currency peg is totemic for many Latvians, partly because of the country’s desire to join the euro, and because a devaluation of the lats would worsen private-sector debt problems. Some 85% of loans to consumers and businesses in Latvia are denominated in euros, and other currencies including the Swiss franc. If the exchange-rate regime were to collapse, servicing these loans would become more expensive.
Latvia’s gross domestic product contracted by 4.8% in 2008, and is expected to shrink a further 12% in 2009, and by 1–2% in 2010. Having peaked at 17.7% in May 2008, inflation had fallen to 7.7% by January 2009 on the back of lower oil prices, and the global downturn. Unveiling the IMF-led rescue package in December 2008, IMF managing director, Dominique Strauss-Kahn said: “A deep recession and a drawn-out recovery appear inevitable.”
In February 2009, Latvia suffered the ignominy of having its sovereign debt reduced to junk status by ratings agency, Standard & Poor’s. S&P reduced its rating on Latvia to BB+/B, one notch below investment grade, meaning that Latvia will have to pay more to borrow from bond markets.
Support for Inward Investment and Imports
The government of Latvia regards the attraction of foreign direct investment as critical for a successful economic recovery. A range of government agencies, including the Latvian Investment & Development Agency, are on hand to provide advice and support to importers, and inward investors. Please see its website for further details: www.liaa.gov.lv.
Corporation tax is 15%, well below the EU average of 26.3%. Pursuant to the law, “On the Liepaja Special Economic Zone,” a special tax regime applies to companies operating in the Liepaja Special Economic Zone, Rezekne Special Economic Zone, Ventspils Free Port, and Riga Free Port. Companies investing in Latvia also have a high possibility of qualifying for the EU Structural Funds scheme, which runs from 2007 to 2013.
GDP growth: −0.4% (2008, est.)
GDP per capita: US$18,500 (2008, est.)
CPI: 15.8% (2008, est.)
Key interest rate: N/A
Exchange rate: lats versus US dollar—0.4701 (2008)
Unemployment: 5.5% (2008, est.)
Current account deficit: −US$5.126 (2008, est.)
Population: 2.245 million (July 2008, est.)
Source: CIA World Factbook except where stated