Seb Country Analysis Jan 2009 Latvia

Latvia update on the IMF-deal SEB MERCHANT BANKING – COUNTRY RISK ANALYSIS

Analyst: Rolf Danielsen. Tel : +46 8 763 83 92. E-mail : [email protected]

Latvia has signed a deal with the IMF to help it shore up investor confidence and begin an economic adjustment program centered on fiscal prudence and wage restraint in lieu of devaluation to restore competitiveness. We welcome this result as a first best solution, but also warn of an arduous implementation process in coming years and the high stakes should it not succeed. We note what seems to us as an ambiguity in the program on a crucial point and call on the authorities and the IMF to clarify this issue as soon as possible to avoid causing unwarranted investor concern.

Analysis Late December 2008, Latvia signed a 27 month Stand-by agreement with the IMF for a total of SDR 1.5 bill. (about €1.7 bill). 1 At the same time the government secured commitments for additional financing in the approximate same period worth about €5.5 bill. mainly from the European Union and two Nordic central banks. The deal also included commitments from the Nordic banks with major holdings in Latvia to roll over most inter-company loans to their local subsidiaries or branches. Such a deal does not come unexpected. In late November the Latvian government had approached the EU and the IMF for financial assistance. The country needed to restore calm in local financial markets as it was heading for a deep recession and the second largest bank in the country, Parex Banka, had experienced an abrupt run on its deposits, mainly from foreign depositors forcing the central bank to spend 20% of reserves to defend the currency peg. However, what surprised some observers was the fact that a deal had been clinched without the central bank giving up its self-imposed currency peg. Latvia’s latest consultation report with the IMF was interpreted by many as an implicit criticism of the government’s exchange rate policy against a background of rapid wage increases. They had begun to outpace productivity growth by a wide margin and were sucking investments into non-tradable activities, starving the tradable sectors, which are the export and import competing activities, of funds and sending the trade balance into a huge deficit. In similar situations in other places IMF has often been seen as adamant in its demand that countries devalue or let pegs and other fixed exchange rate policies go before any financial assistance. However, the IMF is not a bank with a right to set its terms but a member organization; As such it cannot impose solutions members will not accept. At an early stage during the negotiations, the central bank, Latvijas Banka, made it very clear that it would accept no changes to the peg. As that was under the central bank’s jurisdiction, this closed the avenue of devaluation whether others liked it or not. What the IMF could do, and what it did, was to demand other measures and policy changes to the same ends -- macro economic stabilization and restoration of competitiveness. These are to the country’s own good and will enhance its repayment capacity at the end of the program. These measures aim at consolidating the fiscal balance over a period of some years. They also set limits to changes of the central bank’s balance sheet to restore overall financial 1

IMF Country Report No. 09/3 with attachments.

important your attention is drawn to the statement on the back cover of this report which affects your rights.

Jan 19, 2009

SEB Merchant Banking Country Risk Analysis Jan 19, 2009

balances in the economy lest inflation gets out of control and more central bank reserves are lost through interventions. These measures are laid down in performance criteria which the government has to fulfil on a quarterly basis over the next two years for the release of additional tranches of the loan beyond the SDR 0.5 bill. (€0.6 bill) it received upon signing the agreement. In addition there are other criteria, so-called indicative targets and structural benchmarks, including a “ceiling on general government wage bill”. Many economists, including ourselves, will point to the latter as a key issue for the long term success of the adjustment program. In recent years, public sector salaries have increased much faster than average private sector wages up to the point where many government jobs now pay off better than their equivalents in the private sector. Many have seen that as an anomaly given the perceived higher job security in the public sector. Government wages are also often seen as the trend-setter for private sector wages, which also have increased sharply, if not as dramatically as in the public sector. In general, a reduction of labour costs is paramount to restoring competitiveness and hence the viability of the Latvian economy. Such would have been the immediate effect of an outright nominal devaluation. However, the authorities and the IMF are right in pointing out that a nominal devaluation could also have triggered a new bout of double-digit inflation that might have rendered the first devaluation ineffective and left the country in an inflation spiral. Against the background of the deep recession the country is now heading for, we are not entirely convinced of the relevance of that argument but acknowledge the general merits to it. What the country has opted for with this IMF package is sometimes called an internal devaluation not to be confused with a regular external (nominal) devaluation. So what’s the snag? Why do not all countries go for wage reductions or an internal devaluation rather than an external devaluation when faced with eroding competitiveness? The IMF report lists a handful of countries that over the last 20-30 years have improved its competitive position as measured by the so-called real effective exchange rate without outright external devaluations. However, we find this list somewhat surprising. It includes for instance Saudi Arabia in the period 2002-2006, which was a boom period for that country with no pronounced domestic cost reduction program to the best of our knowledge. It was the Saudi ryal’s peg to a weakening dollar that resulted in a real devaluation and improved competitiveness. To us that seems an irrelevant experience in the context of Latvia. We think similar arguments may apply to some of the other countries in the sample and remain unconvinced of the prevalence of successful internal devaluations at least in modern countries with an assertive populace as in Latvia. Two exceptions deserve to be noted however: Hong Kong in 1998 and Germany in the late 1990’s and early 2000’s. Otherwise it is our impression that successful internal devaluations have been and remain rare incidents. Principally, internal devaluation is a first best solution to weakening competitiveness. The problem lies in its implementation. On this score we are concerned that some observers will point to what may appear as an ambiguity on a crucial point. The main text of the IMF report says “To improve competitiveness, the authorities are cutting wages and bonuses in the public sector by 25% in 2009 compared to 2008.” (Page 18) However, in its “Letter of intent” the government speaks only of “…approximately 15 percent cuts in compensation of all public sector employees with effect from January 1, 2009” (Page 68) and further down it makes clear that these wage cuts refer to the original budget for 2009 (Page 70) which was adopted before the crisis had come to a head and to the best of our understanding contained rather generous wage hikes. A 25% wage reduction would indeed be impressive and set an example for the entire country. Moreover, it would likely silence any further calls for an external devaluation. However, if the latter is the correct interpretation – i.e. 15% cut on already hiked up wages, some investors could soon come to realize that the hoped for improvements to competitiveness may not come very soon. If also others find this somewhat confusing, we encourage the authorities and the IMF to clarify this issue as soon as possible as we think maximum clarity on this point would do much to help what is likely to become a difficult implementation process under any circumstances. The IMF takes comfort from the fact that the program was accepted by the majority of the Saeima (parliament) in late December without much trouble. That was indeed a great 2

SEB Merchant Banking Country Risk Analysis Jan 19, 2009

achievement, but since then cracks may have appeared in the unity. Last Friday one of the main political parties demanded snap elections to give the electorate a chance to have a say over the new economic program, a move the central bank quickly denounced as potentially undermining financial market stability. The same day the municipality of Riga announced a budget for 2009 that appeared to interpret the IMF agreement on wage reductions in the most lenient manner. Last week also saw the first larger political demonstration against economic policies for years in down-town Riga, which unfortunately ended in serious violence. The devil is therefore not only in the detail but in the actual implementation and whether other politicians than those in the Saeima will follow the spirit of the agreement rather the most lenient interpretation of its letter. On a positive note, however, we take notice of recent weeks’ improved stability in the Latvian foreign exchange market without central bank intervention.

Exchange rate (LVL/€) 0,717 0,715 0,712 0,710 0,707 0,705 0,702 0,700 0,697 0,695 0,692 0,690

jan

mar

maj

jul 08

sep

nov

jan 09

14 13 12 11 10 9 8 7 6 5 4 3

Latvia, Spot Rates, EUR/LVL, Close Interbank Rates, RIGIBOR, 1 Month, Fixing, LVL Source: Reuters EcoWin

Key numbers according to IMF:

2007 10.3 10.1 19.7 6.2 0.7 -24

GDP % growth: CPI % growth: Real gross wage % growth Unemployment % rate Government balance %/GDP Current account balance %/GDP =

3

2008 -2.0 15.5 5.2 6.7 -3.0 -15

2009 -5.0 5.9 -4.6 9.0 -4.9 -7

SEB Merchant Banking Country Risk Analysis Jan 19, 2009

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