Are Baltic Devaluations Now In The Works?

Now this is a very interesting question, isn't it? The only honest answer I can give is that I don't know, and indeed I haven't the faintest idea. The government of Latvia (the Baltic state which is currently most rife with "rumours" about imminent devaluations) works in its own wondrous ways, and neither we (nor Latvia's citizens) have any idea at all how they plan to lift their country out of the deepest depression they have experienced in many a long year.



What I do know is that, economically speaking,the present situation is simply unsustainable, and something is going to have to be done. Indeed the country's government is in talks with both the IMF and the EU Commission about this very topic as I write. My own opinion is that domestic consumption is now dead (as a growth driver) for as far ahead as the eye can see (and maybe even further), that the country's citizens now need to start to save rather than borrow more, and that the only way Latvia can turn itself around is by exporting more than it imports. But for a country which ran a 23% current account deficit in 2007 this is going to be very difficult objective to achieve, since after two years of very strong inflation Latvia's relative prices with the rest of the world are completely uncompetitive.

Historical experience has taught us that it is not an easy thing to tell people "we are going to cut your wages by between 5 and 10% this year, next year, and then possibly the year after". Apart from the fact that voters don't like to hear this kind of talk, you can also enter into a deflation dynamic which then comes to be very hard to break out of. Hence, according to conventional economic wisdom, devaluation tends to be the preferred option. And it is my opinion that, despite all the attendant difficulties, devaluation is the best option among the unappetising list of unpleasant options presently available to Latvia (and the other Baltic states, and Bulgaria). Unfortunately, having reached this point there are simply no "pleasant" options available.

The curious thing is that for voicing this opinion I could go to prison in Latvia.

According to the Baltic Course online newspaper Ventspils University College lecturer Dmitrijs Smirnovs was detained for two days recently on suspicion of spreading rumors about the devaluation of the Latvian currency. He was detained in connection with an opinion that he had expressed during a debate about the development of the Latvian economy and the future of the Latvian banking and credit system. His arrest followed the publication of his opinion in Ventspils' local newspaper Ventas Balss. According to the newspaper report he said the following:

"The U.S. problems are trifling, compared to what awaits us. They have now reached the bottom and will start to recover. Problems in the European Union have only just begun and we may be hit by a crisis that is ten or maybe twenty times worse than that in the United States. The Swedish banks will no longer be able to offer inexpensive loans through their subsidiary banks in Latvia. They will tell us to pay back the debts! How will we pay them – with the real estate? We have no assets to pay back the debts! [..] The pyramid has been built and now we have to wait until it collapses. [..] The only thing I can suggest now: first of all, do not keep your money in banks, second: do not save money in lats, as it is very dangerous at the moment."

Dmitrijs Smirnovs appears to have been detained by members of the Latvian Security Police, who seem to have been charged with the special mission of protecting the integrity of the Lat at this very delicate point in Latvian history. And while some of the advice Smirnovs offered to his audience may have been ill-advised (given the delicate nature of the problems involved), they are opinions, and in a free and democratic society he should be at complete liberty to express them.

In fact Smirnovs is not the only such case to have arisen in recent days, and Baltic Course report that two more people are "under investigation" by the State Security Police. According to Latvian newspaper the Telegraf Latvian police previously detained a journalist under suspicion of spreading rumors about the Baltic nation's financial system during the global market crisis (also see this report and debate in comments about the same issue in Baltic Business News, while the same source reports that in the Finish newspaper Kauppalehti - which is evidently not controlled by the Latvian Security Police - they are simply discussing whether the Lat will be devalued before Xmas or in two to three months time).

The police held a journalist working for a Latvian newspaper yesterday evening in an investigation that started on Oct. 6 due to ``rumors about the Baltic country's financial system,'' police spokeswoman Kristine Apse-Krumina said, according to the Russian- language newspaper. She gave no details on what rumors the journalist is accused of spreading. Another investigation has been started following a run on currency exchange booths in the capital Riga last weekend that was caused by rumors about a devaluation of the lats, she added.

One of the other cases under investigation by the State Security police appears to be a member of the Latvian pop group "Putnu balle" based on statements made during a pop concert in Jelgava on November 9. Kristine Apse-Krumina, aide to the Security Police chief, stated that the cases was opened following a complaint from a bank, which alleged that lead singer Valters Fridenbergs had urged the people to withdraw their money from Parex banka and Latvijas Krajbanka during the warm up to the concert. According to band manager Anete Kalnina what actually happened was:

"As it often happens at concerts, the band members communicated with the public, telling jokes about themselves as well as many other things. The band had performed two songs when the guitarist Karlis Bumeistars had to tune his guitar, which is when Valters Fridenbergs started talking to the public," Kalnina said. Commenting the current situation in Latvia, Fridenbergs said that the audience had better hear the concert to the end, and only then rush to ATMs. "The people at the culture center got the joke, and laughed. It was not an encouragement" to withdraw money from banks, said Kalnina.

Evidently State Security Police charged with the investigation of seditious devaluation rumours have no such sense of humour, although maybe having to attend a few more pop concerts wouldn't be a bad therapy for them.

I myself received what could be termed a "mild threat" on my Latvian blog, following my publication of an opinion by Bank of America analyst, David Hauner, about the need to devalue:

``They will keep the pegs at the current exchange rates well into 2009, but reset the rates to devalue against the euro later, when markets have calmed,'' Hauner said.

This attracted the following warning from unidentified commenter LV, who would seem to me to quite possibly be a member of the above mentioned "Keystone Cops" group.

Apparently you are disseminating false information about the Latvian financial system. Please note that this may constitute a crime under Latvian law. In order to prevent the spreading of false rumours regarding the Latvian financial system the Latvian Security Police has also opened a telephone hot line so that false rumour spreaders can be reported and tracked down.

He then cited some rigmarole in Latvian which he invited me to use a Google translator to understand. I replied as follows:

Well I don't know what the Latvian law says, and quite frankly I don't especially care. You stopped having a dictatorial system when the old Soviet Union broke up, and there is a UNIVERSAL right to express an OPINION under any concept of democracy I know.

Actually the extract you cite comes from an analyst from Bank of America, and it is an opinion and not a fact. As far as I know he has no priviledged information, but if you have any doubts better you contact him direct.

My OPINION is also that the peg is impossible to hold in the longer term (ie it needs to be corrected before euro entry, for the reasons I explain), and logically since there is then a further delay in entering the euro after the devaluation it is better to do it sooner rather than later.

This is my opinion as a mecro economist and specialist in the Latvian economy, if expressing this opinion is illegal in Latvia, then really I don't know what Latvia is doing in the EU, let alone thinking about euro membership. For tyhis kind of thing you'd be better off with Putin and Medvedev. Open economies don't work that way, or didn't you notice, 22 world leaders just met to affirm that the best way out of the present financial crisis is to have the maximum TRANSPARENCY possible.

As I say above, this is all a very delicate issue, and university lecturer Dmitrijs Smirnovs was undoubtedly ill-advised to use the specific wording he did, not because he committed any known offence, but simply becuase he could have provoked a run on the banks, and this would only make the matter worse. On the other hand - and assuming they do have to devalue - it is a very unfortunate state of affairs that all those who actually know and understand what is happening have already changed their money over, while "ordinary Latvians" (like those in Smirnovs' audience) who have no idea what is happening, but (ill-advisedly perhaps) like to trust their leaders will simply lose a significant part of their savings.

Better never to have come to this point, but then, saying that doesn't help very much, does it?

Back in August 2007 I was asked the following question by a reader of my Latvian blog:

I want to thank you for your continuing efforts to explain what is happening in the Baltics in general and Latvia in particular. I live in Latvia and will be heading to the bank tomorrow to move our family's savings out of Lats and into Euros while the peg is still intact. (Or is there a better idea?).

To which I diplomatically replied as follows:

I wish I could be the bearer of better tidings. I think history has been so unkind to all the peoples of Eastern Europe, they really do seem to be entitled to be dealt a kinder set of cards than the ones they actually have. Really, I think you will appreciate that, even if I could hardly claim to be widely read on this blog, I do want to be responsible, and thus am unlikely to say anything which I feel could be in any way damaging to the Latvian outlook.

However, if you ask me this question:

"Or is there a better idea?"

Then I have to say that I personally can't think of one. For the rest, at this point, you will have to read between the lines I'm afraid.

I will try, when I find the time, to treat the currency peg issue in a somewhat theoretical fashion, but I fear it is reality itself which will put it back on our collective agendas in a much more practical one. I simply don't see how you can have the level of cost inflation (and the wage increases have still to feed through to producer prices and the end customers over many months) and still hope to sell exports. And if you are going to cut domestic demand, which is what they are doing, then selling exports is the only effective way to live.

Basically, as the observant reader will note, my core discourse has not changed very much over the last 18 months or so, nor will it - Latvian State Police or no Latvian State Police.

Will They Be Investigating The EU Commission?

One of the very sad and ironic aspects of the present case is that the Latvian government is currently, as I indicate at the start of this post, in discussions with both the EU Commission and the IMF about the future of the Latvian economy, and I think it is hardly a closely kept secret that both these institutions favour a floating currency, and thus logically a "flexibilising" of the Lat peg as a way forward out of the present crisis,

The European Union was really as explicit as it could be at the end of last week when it make clear that it is more than ready to provide financial assistance to Latvia, but that any aid will be conditioned on a programme to underpin balance-of-payments stability. And what could bring more stability to the Latvian balance of payments (ie induce more exports and suck in less imports), well evidently a change in the relative values of the Lat and the Euro - really at this point there are no other alternatives.

The EU, in their statement said they were "in close consultations" with Latvian authorities, and with the International Monetary Fund in order to develop a joint response to what were described as the "growing tensions'' in Latvia's financial markets.

``The EU stands ready to participate in a coordinated financing package with the IMF conditional upon a strong commitment by the Latvian authorities to implement a rigorous and credible adjustment program in order to underpin balance-of- payments sustainability in Latvia".

The statement did not specify when the aid would be granted or the amount involved. As regards the Latvian extenal position, the chart below of the current account deficit says it all. There is a whopping imbalance, and even though the deficit will be less this year, this is largely due to a collapse in imports as domestic demand has collapsed, and the need to export competitively issue still remains to get to grips with.




And Maybe They Should Check Out The IMF While They Are At It

Also it looks more and more likely that the International Monetary Fund is insisting Latvia abandon its currency peg in return for a bailout.

“Eventual Fund help might…be conditional on giving up the currency board regime and allowing faster real exchange rate depreciation to rebuild competitiveness,” according to economists at BNP Paribas SA in a research note.

And as Citigroup economist David Lubin notes: "The IMF’s own credibility was severely damaged as a result of its decision to continue financing Argentina’s currency board in the run-up to that country’s December 2001 devaluation, and we think it is unlikely that the IMF will want to repeat that mistake".

So maybe the lads and lasses of the State Security Police better hop on an airplane over to Washington, with a notepad and well sharpened pencil handy perhaps, just to see if they can gather any signs or sedition, or even, who knows, even "conspiracy" over at that end.


Dwindling Reserves

Meanwhile Latvia's foreign exchange reserves continue to dwindle, since the Latvian central bank announced today that they bought 130.3 million lati ($232.7 million) in the domestic foreign exchange market last week to support the currency after it weakened to the limit of its trading band. The lats fell to 0.7098 against the euro for the eighth consecutive week, prompting the bank to step in and buy it. Under the Lavian currency board system the currency is allowed to rise or fall 1 percent from a midpoint with the euro. The previous week the central bank acted to support the currency when it bought 189.8 million lati, which was the biggest weekly purchase it has made in at least two years.


The central bank has now bought 613.4 million lati over the last eight weeks. Foreign currency reserves have fallen about 18 percent since the end of September to around $5.4 billion at the end of October, it said. This month's moves have decreased the reserves to about $4.9 billion.

And Latvia's three-month interbank lending rates surged to their highest in a decade today as banks effectively stopped trading with each other, according to Kaspars Jansons, head of money markets at Parex Banka. The three-month RIGIBOR, Latvia's interbank lending market, rose to 13.5 percent, the highest since November 1998 when Russia defaulted on its debt, and up nearly 20 percent from 11.18 percent on Nov. 14. Janson is quoted by Bloomberg as saying "There is a lack of credit lines in between banks......Banks are not really trading with each other." He also said that a need for lati has driven some banks to raise deposit rates to as high as 10 percent for lati-denominated accounts.

Estonia's Recession Deepens As Latvian Finances Struggle To Find Air

Estonia's economy shrank again in the third quarter - by an annual 3.3 percent, thus clocking up the second-worst performance (after Latvia) in the 27 nation European Union, and offering us plenty of signs that the country's worst economic recession since 1994 is set to deepen. The contraction fulfils the basic technical criterion of recession since it follows a 1.1 percent fall in the second quarter according to data released by the statistics office yesterday (Thursday).




With the global market crisis and credit crunch weighing on the world's leading economies, and especially with Germany - the eurozone's largest economy and principal economic powerhouse itself entering recession, the prospects for any export driven recovery have definitely now faded off into the distance. Estonia and Latvia now lead the Eastern European slowdown, following repeated warnings over the past year of about the risks of an economic "hard landing'', warnings which were not unfortunately headed due to hopes that the eurozone itself would hold out against the US downturn (the United States is still not technically in recession) and that Scandinavian Banks would have little trouble funding growing forex debts (these banks are themselves now seeking support from the Swedish government). As I said, Estonia's economy is contracting the second fastest, since Latvia's economy shrank 4.2 percent in the third quarter, and currently has the worst growth rate in the EU.

``The effect of the financial crisis on the real economies of our main trading partners remained modest in the third quarter but will definitely increase,'' according to Martin Lindpere, an economist at the Estonian central bank. ``External demand is therefore expected to weaken in the coming quarters, and unfortunately, the contraction of the Estonian economy will accelerate.''

The central bank forecast suggests the Estonian economy may shrink between 1.8 percent and 2.7 percent this year, and between 2.1 percent and 4.5 percent next year. Really there is a high degree of uncertainty attached to next years forecast, since nobody is really sure at this point how bad things can get, either inside or outside the Baltics (Russia's economy is unwinding fast even as I write), or when exactly recovery will commence.

Quarter on quarter the economy contracted by 1%, following a revised 1.1% contraction in the second quarter.

All the signs are that the contraction may even accelerate in the fourth quarter. Estonian industrial output, which dropped 3.8 percent in September, has fallen in six of the seven months up to September, and looks almost certain to contract further in October-December . Likewise retail sales which have also been down for six of the past seven reported months.

More Trouble On The Way As The Currency Pegs Come Under Pressure


Lithuania, Latvia and Estonia mayall need to devalue their currencies over the next year as they seek to stave off a recession, according to a recent report from Bank of America Corp. With inflation still running at around three times the average rate across the 15-nation euro region and a slump in domestic demand that looks like it will be very hard to turn around amid the need to export may leave the Baltic states with little alternative but to abandon their currency pegs in the second half, on the view of David Hauner, a Bank of America strategist based in London.

``They will keep the pegs at the current exchange rates well into 2009, but reset the rates to devalue against the euro later, when markets have calmed,'' b Hauner said.

The Lithuanian litas and Estonian kroon have been little changed over the past three months based on their currency board systems that peg them to the euro at fixed rates. The Latvian lat is allowed to rise or fall 1 percent from a midpoint to the euro. The countries also participate in the European Union's exchange-rate mechanism, under which central banks must keep currencies within a 15 percent trading band against the euro.

Andres Sutt, deputy governor of the Estonian central bank, said the kroon's peg
to the euro will remain unchanged and that a devaluation would ``lack any
economic rationale.''

"The competitiveness of Estonian exporters has remained good; wage growth, inflation and loan growth have declined very rapidly, as has the current account deficit, lowering Estonia's dependence on external financing,'' Sutt said "The finances of banks operating here are also strong. All this characterizes the flexibility of the Estonian economy and its ability to adjust.''

In fact Estonia and Latvia continue to run a goods trade deficit, making it impossible to drive headline GDP growth from exports. Latvia's central bank Governor Ilmars Rimsevics also said ecently that "devaluation is an absolutely unrealistic scenario,'' while the Lithuanian central bank Governor Reinoldijus Sarkinas was cited by the Baltic News Service on August 19 as saying that the exchange-rate system "shouldn't change at all.''

Nonetheless the economic rationale for devaluation becomes more compelling by the day, as the Baltic countries if they are one day to enter the euro will need to do so at a much lower partity than the current one to be able to get growth in the longer term.

There are obviously two principal drawbacks to devaluation against the euro, the first of these is that foreign exchange debts will suddenly rise, and this is why the Baltic countries will undoubtedly need EU aid in sorting out the mess. Secondly there will be a delay in euro membership. Countries aiming to adopt the euro must spend at least two years in the Exchange Rate Mechanism, or ERM-2, to demonstrate the stability of their currency. Lithuania and Estonia began participating in the system in 2004, the same year they entered the European Union. Latvia joined a year later. If the Baltic countries devalue then the clock will need to be reset, but then again, eurozone entry with the economies in an economic slump (rather than a mere recession) does not seem to be an attractive proposition either. These economies will need time to get things straight again, so the delay in euro entry does not seem to be an inordinately large obstacle, in and of itself.

Lithuania's ambition to be among the first countries in eastern Europe to adopt the common currency was thwarted in May 2006 as inflation accelerated. Estonia and Latvia were also forced to delay the changeover, and of course it has been this whole process of delay that put the spanner in the works and has lead to the whole boom bust cycle taking the form it has, as euro membership ebbed off into the distance.

``If your real exchange rate is overvalued, there are two options: either devalue, or accept a recession to make inflation fall relative to the trading partners,'' Hauner said. ``So the Baltics have the choice between a deep
recession or postponing euro-zone accession. I think they will choose the latter.''

EU Readying-Up Aid


The Baltic States now have some hard decisions to take, but the EU and the IMF are there ready to support. The European Commission hopes to come to a decision on providing financial support for Latvia "fairly soon", according to European Commission spokesman Jonathan Todd.

``We've been in close touch with the Latvian authorities for the past week and those contacts are continuing. We hope to be able to adopt a decision fairly soon,'' Todd told journalists at a Brussels press conference today.

Latvian authorities also themselves reported on Wednesday that they were in talks with the European Commission about possible financial assistance following the decision to take over Parex Banka AS, Latvia's second-biggest bank, as liquidity tightened and depositors withdrew funds. Following the nationalisation Latvia added about 200 million lati ($357.8 million) in liquidity to Parex to shore up its finances.

``We don't need the money now,'' said Edgars Vaikulis, a spokesman for Prime Minister Ivars Godmanis, yesterday. ``We are just in consultations,'' he said. Turning to the International Monetary Fund for support in the future was also a possibility, he said.

Latvia's 26 banks lost about 461 million lati, or about 4.6 percent of their total deposits, during October, according to a statement from Latvia's Financial and Capital Markets Commission. Latvia would prefer to turn to the commission and not the IMF, according to Karlis Leiskalns, head of the Latvian Parliament's budget and financial committee, speaking on Latvijas Radio this week.

``I can't say that Latvia won't go to the IMF for help,'' he said. ``The IMF will come with conditions, and one of the basic conditions will be to cut the social budget. I'm completely against taking from the IMF, unless the state becomes bankrupt.''

More Credit Agency Downgrades In The Works

Moody's Investors Service have announced that they may cut their ratings on Latvijas Krajbanka AS and Norvik Banka, citing concerns about the Latvian lenders' asset quality due to the worsening recession in the Baltic country. Moody's have assigned a negative outlook to both banks' D- bank financial strength ratings and Krajbanka's Ba2 long-term deposit rating and Norvik Banka's Ba3 long-term deposit ratings.

``The economic downturn, which is already under way, is now likely to be more acute than previously anticipated and thus have a negative impact'' on both banks' asset quality ``in the near future,'' Moody's said.

Earlier in the week Fitch cut Latvian debt to the lowest investment- grade rating of BBB- and signaled it may reduce again to the category of high-risk, high-yield or junk.

``In the absence of substantial and timely international financial support, Latvia faces the likelihood of a severe financial and economic crisis and a further downgrade of its ratings,'' Eral Yilmaz, associate director for Fitch's sovereigns group in London, said in a statement.

Update Wednesday 19th November

The Latvian central bank bought 189.8 million lati ($338 million) in the domestic foreign exchange market last week to support the national currency after it weakened to the limit of its trading band, according to the latest statement from the central bank. The lats fell to 0.7098 against the euro for the seventh consecutive week, prompting the bank to buy it. The currency is allowed to rise or fall 1 percent from a midpoint to the euro. The central bank has now bought 483.1 million lati over the last seven weeks. It had foreign currency reserves of about $5.4 billion at the end of October, which means that at the present rate of attrition there are enough foreign exchange reserves to hold out for about eight months, though obviously an EU/IMF bailout will cover this end of the problem, the question is why, given Latvia's need to export, you would want to defend the present exchange rate if you are having to enter an IMF programme in any event.

Latvian Inflation Falls Back Again In October

Latvia's October inflation rate decreased to an annual rate of 13.8 percent, the fifth straight month the indicator has fallen as the economic contraction which has followed the boom bust cycle starts to get a grip. Month on month prices were still up by 1.2% over September. That is they were still growing at a 7.2% annual rate. Thus, despite the drop, Latvia continues to have far too much inflation, and still has the highest inflation in the 27-member European Union. In 2006 the economy expanded 12.2 percent, in Q3 2008 it contracted by 4.2% over Q3 2007.



While the slowing pace of consumer-price growth will be welcome news to Latvians, we need now to look out carefully for a new menace: deflation. From now on we will be looking at the evolution in the index itself as well as the year on year changes, to see if we can spot just exactly when the economy falls over into deflation mode, and see if we can judge just how fast prices will fall - and the economy contract as a consequence. At the present time however there seems to be little danger of deflation, as the consumer price index goes hurtling onwards and upwards.




The Central Bank Buys More Lati


The Latvian central bank bought LVL 16.3 million in the domestic foreign exchange market last week to support the Lat after it weakened to the limit of its trading band, according to data from the central bank. The lats fell to 0.7098 against the euro for the fifth consecutive week, prompting the bank to buy in defence of the band. In principle the currency is allowed to rise or fall 1 percent from a midpoint to the euro. The central bank has now bought LVL 293.3 million over the last six weeks. At this point the peg is not under any great threat, since Latvia had foreign currency reserves of about USD 5.4 billion at the end of October, or a little over four months of imports. Four months imports is normally considered the minimum however to protect a currency from attack, so they do need to watch out. The most likely situation is that the bank and the government are already, as I reported on this blog some weeks ago, in day to day contact with the IMF.

Latvian Government Nationalises Parex Bank

Latvia's government announced today that it has decided to take over the nation's second most important financial institution after the bank ran into liquidity difficulties. The Latvian government apparently decided late yesterday (Saturday) to take a 51 percent stake in Parex Bank, Latvia's second largest bank by total assets, following the preparation of data that indicated the bank was headed toward insolvency.

Prime Minister Ivars Godmanis stated that Parex was functional but in need of liquidity. He also said the government had faced a choice of either taking control of the bank or allowing it to enter bankruptcy. The government also suggested that there were no plans to rescue any of Latvia's other 25 banks at the moment, but that the possibility could not be excluded in the future.

The government bought the majority stake in Parex for 2 lats ($3.70). Another 34 percent stake in the bank will be held as collateral by the state-owned Hipoteku Bank. Obviously the fact that they have had to nationalize Parex bank was yet was another blow to Latvia's deteriorating economy, and to the governments present strategy for addressing the crisis. On Friday we learnt that gross domestic had fallen by an annual 4.2 percent in the third quarter.

Parex Bank was almost unique in both the Latvia and Baltic context in that it was homegrown. Founders Valery Kargin and Viktor Krasovitsky established the bank in 1992, one year after Latvia split from the Soviet Union and achieved independence.

A majority of the banking industry in the Baltic states of Estonia, Latvia and Lithuania are owned by Scandinavian financial institutions, and hence, up to now, have been somewhat shielded from the downturn.

This is obviously the first, and not the last, piece of news of this kind we are going to get during the present economic slump, and the nationalisation decision is sure to heat up the debate about whether or not to seek IMF protection, and indeed whether (or when) to break the Lat-Euro peg.

Latvia's Economy Contracts By 4.2% in Q3 As Moody's Downgrades The Credit Rating

Latvia's economy shrank an annual 4.2 percent in the third quarter, the fastest drop since at least 1994, according to today's flash estimate from the Riga-based statistics office (Friday). This follows a 0.1% year on year expansion in the second quarter.


We do not have quarter on quarter statistics at this point, but if we apply the minus 4.2% calculation over last years Q3 2007 constant price number, then what we get is 2.147 billion Lati, and a GDP graph which looks like this:



Which may have little analytic value (since the data is not seasonally corrected), but does enable us to form a pretty rough and ready visual impression of what is going on, where the annual contraction data remains rather abstract. The economy definitely peaked and started to enter contraction mode after the summer of 2007, and now we need to keep watching and waiting to see just how far it is we go.

The statistics office will release constant price and seasonally adjusted data for the third quarter on Dec. 9. The last time Latvia's economy contracted on a year on year basis (by 2.2 percent) was in 1994, according to data from the Latvian central bank.


Coincidentally Moody's Investors Service today downgraded Latvia's credit rating to A3 from A2, the third-lowest investment grade level, citing a worsening global liquidity crunch and economic slowdown.Moody's warned today that tighter global liquidity could affect some of Latvia's 26 banks, many of whom rely on syndicated loans to finance operations.

``The global liquidity crisis will probably cause a shock to the Latvian banking system, which will reverberate throughout the rest of the economy,'' Kenneth Orchard, a senior analyst at Moody's, said before the report. ``Unless there are major improvements in the European syndicated loan market by early 2009, the government and central bank will be forced to take remedial action.''

Latvian Retail Sales Plummet As Inflation Remains Stubbornly High

Latvian retail sales fell by a whopping 13.4 percent year on year in September (on a working day adjusted basis), thus clocking up the biggest decline registered in the country in over nine years



Seasonally adjusted sales were down 4.1 percent in September from August, according to data from the national statistics office last week. The yearly decrease was the biggest since July 1999, when they fell 14 percent.

Increases in retail sales have steadily ground to a halt over the last year as banks have tightened credit producing a rapid slowdown in domestic demand for consumer goods. As far as we can see the retail sales index peaked in April, and now we are steadily heading on down. It is a good moment to ask ourselves, will we ever get back to the April level again? (This is not as silly a point as it might seem, since evidence is mounting that the ageing and shrinking population phenomenon is leading retail sales to peak in one economy after another - see Germany here, Italy here, and Hungary here).



Inflation Falling, But There's Still A Long Way To Go

Latvia's inflation fell for the fourth month straight in September, and was down to 14.9 percent. Monthly inflation over August was at 1.1 percent, due largely to a jump in textile and education prices.



Latvia has had the European Union's highest annual inflation rate for more than a year now, a strange trophy to obtain, this one. Inflation peaked at 17.7 percent in May, and has since been slowing steadily. Indeed if we look at the actual movement of the index, rather than the year on year changes, we can begin to ask another, and even stranger question: at what point will Latvia's inflation move registering positive increases to registering negative ones? That is, when will we move from inflation to deflation?



Possibly for many people this question (like the peak retail sales one) will appear to be almost ridiculous. But it isn't. If you look at the CPI index itself (this now becomes much more important than the year on year inflation rates, since what we need to watch for are the price movements from month to month. In general the rate of increase from one month to another has been slowing, and the September uptick of 1.1 % in the index over August was a bit of an anomaly, since in July the CPI was only up 0.3% over June, while in August it was down by 0.4%. So we should not be surprised to see the index hit a ceiling at some point, and and after that it start to come down, at least temporarily, the extent of the decline will depend on how sharply the Latvian economy contracts in 2009, and just how drastically domestic demand drops back.. Basic economic theory in fact leads us to expect this (on the back of falling commodity and food prices and in a situation where internal capacity is way above the sum of internal and external demand available to the Latvian economy at current prices). Thus there is only one way for prices and wages to go (at least in the short term): down. Although people may struggle with all this yet awhile before they accept the inevitable.


Latvian unemployment is now slowly creeping up. In September there were 57544 Latvians registered as unemployed. In comparison with August the number of unemployed increased by 1311, and the Latvian State Employment Bureau are now forecasting that the unemployment rate - which now stands at 5.3% using the persons registered methodology - will reach 8 percent next year.





Bleak Outlook


Latvia's economy clocked up a 10.5 percent growth in gross domestic product in 2007, following 11.9 percent growth in 2006. Since that time Lativia's economy has turned sharply downward, with GDP expanding only 0.2 percent during the first six months of 2008 - down from 10.2 percent over the same period in 2007.

And the future seems to be even more bleak with the IMF forecasting that Latvia's gross domestic product will decrease 0.9% in 2008. Only Ireland and Estonia are forecast to see their GDP contract by more than Latvia – by 1.8% and 1.5%, respectively. The IMF also expects that Latvia's GDP will shrink another 2.2% next year.

The IMF also expect inflation to remain high in Latvia. According to IMF estimates, annual inflation in Latvia could reach 15.3% this year, 10.6% in 2009 and 6.7% in 2007. On the other hand, they expect the current account deficit to decrease to 15.1% of GDP this year and 8.3% in 2009.

Latvia needs to cut spending in next year's budget to avoid rising loan costs as turmoil in financial markets drives up borrowing rates, central bank Governor Ilmars Rimsevics said in Dienas Bizness.

``The global financial crisis has strongly dried up the flow of money: borrowing abroad for a reasonable price has become practically impossible,'' Rimsevics wrote in an Ed-op piece for the Riga-based newspaper.

The central bank forecasts growth between zero and 0.5 percent next year, which would widen the budget gap to as much as 4 percent. Rimsevics also said that Latvia may end next year with a fiscal deficit of 5.5 percent of GDP, in an interview with Leta newswire today. A shortfall that size would be ``unacceptable" he said accusing the Latvian government of having given up trying'' to cut spending. As can be easily imagined, Rimsevics song, when coupled with an IMF forecast of an 8.3% CA deficit for 2009, will be like sweet music to the ears of the global investment community at this point.

It is thus hardly surprising that Fitch Ratings recently cut Latvia's credit rating to BBB from BBB+, the second lowest investment grade, citing a deterioration of the European economy.