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Friday, July 24, 2009

It Isn't Only Canicular Heat They Are Suffering From In Latvia

Maintaining the peg also requires substantial political commitment. If this commitment were to falter, there is a risk that the execution of the difficult but necessary policies required under the authorities’ program could also weaken. However, all political parties are strongly committed to the exchange rate peg.
How the world changes in six months. The above lines come from the IMF "Republic of Latvia: Request for Stand-By Arrangement - Staff Report" of January 9 2009. But just today we can read in a Baltic newspaper:

"Reliable sources tell LETA that the International Monetary Fund (IMF) has stipulated that the loan agreement document must be signed by all ruling coalition parties in Latvia, thereby showing their resolve to implement it."
The reason the IMF are now so edgy is spelled out by Reuters Political Risk Correspondent Peter Apps:

A string of other countries are also facing stark cuts, and analysts say in many - like Latvia - domestic politics could well intervene as elected politicians are unwilling to face the political consequences of cuts demanded by the IMF and wider financial markets.
So what the IMF are evidently worried about is the possibility that some coalition members may support the agreed measures just long enough to get the payout, and then effectively disown them. This seems to be a far cry from the substantial political commitment that was earlier considered to be so essential to maintaining the peg.

And the issue goes well beyond Latvia, since as Apps points out, a string of other countries are in a similar if currently marginally better condition, including Bulgaria, Romania, Lithuanis and Hungary, all busily making cuts while coming to rely more and more on multilateral lenders.

So if there is no clear resolution to Latvia's growing dispute with the IMF, the European Union could end up facing a dilemma - whether to bail out troubled emerging European countries who won't make cuts or face the consequences of not doing so. As Lars Christensen, head of emerging markets research at Danske Bank in Copenhagen says:

"This could be a test case for Europe....In Latvia, it's domestic politics that really become the driver. The question is what the EU would do if the IMF walks away."
A good question.

In the above quoted IMF document, they also make the following point:
Correcting currency misalignment without nominal depreciation is extremely difficult, as experience from other currency board and fixed exchange rate countries continues to show. Large external financial support and sustained wage and fiscal discipline by both the private and public sectors are required. Failure could entail substantial reputational risks for both the authorities and international institutions.

The last sentance is important, failure could entail substantial reputational risks for the international institutions involved, in particular in this case for the IMF and the EU Commission. This loss of credibility should the peg eventually collapse in chaos is one of the considerations that lead some of us to argue strongly from the start against going down this road. But few would listen.

Beyond the immediate issues of the peg, there are also serious structural considerations which make this kind of "body-with-two-heads" approach less than desireable in delicate situations such as this. Even if all we have here is - as some would suggest - a soft-cop hard-cop duet, the policy of letting the EU Commission permanently play the role of soft cop is hardly desireable, especially for the message it will be sending to Southern Europe, where our improvised duo may soon find themselves once more forced into action. And especially also for financial markets where nervousness about the ability of Europe's complex institutional structure to handle the evident continuing weaknesses in the banking system is still highly evident. Leaving the impression that the EU itself is not able single handedly to deal with its own recalcitrant offspring is not exactly the best way to convince the sceptics.

Today's Latvia Roundup

The exact state of play in the negotiations with the IMF is still far from clear. Latvia's Prime Minister Valdis Dombrovskis said on Thursday that talks with the IMF were making progress on issues of pensions and taxes and results of the talks are expected early next week, but since we have been getting news like this for some days now it is hard to draw conclusions.

Izabella Kaminska at FT Alphaville thinks the analyst community is increasingly interpreting the deadlock as yet another (and possibly decisive) chink in the armour of Latvia’s euro-peg defence, citing in particular the latest research note from the RBC Capital Markets’ emerging markets team. While Capital Economics' Neil Shearing is even more explicit:

Relations between the IMF and Latvia are deteriorating quickly, raising the prospect that the loan programme that is vital to maintaining the country’s currency peg could collapse altogether..... with relations between both sides souring, and the pain in the real economy intensifying, it remains to be seen how long a new agreement will hold. Indeed, there is a growing risk that the programme could collapse altogether, which would spell the end of the currency peg and trigger a round of debt restructuring.
As for me, I agree with Neil, this situation has now become so unstable, while the internal devaluation is working so slowly, that the Fund really need to think about how to handle the damage containment issue. The crisis is far from over in the East and South of Europe, and the risk of a spark from this whole fiasco setting either Athens or Madrid alight is most certainly non-negligable. I advise all concerned to think very carefully at this point about the implications of what they are doing, for the sake of all our well-being. The Maginot line may still be far from broken, but a distant fortress on our outer defence ring may well be about to fall. Let's just learn the lessons shall we?


Observer said...

You conclude, "So what the IMF are evidently worried about is the possibility that some coalition members may support the agreed measures just long enough to get the payout, and then effectively disown them."

This is evident from some of the measures taken. E.g. the working week for many state institutions has been reduced to 4-days on reduced pay. Obviously at some stage they will have to work again 5 days and costs will be back where they were.

The EU and IMF have slowly come to realise the realities of Latvian politics.

As no party alone or even a two-party coalition can wield any power the entire state has been partitioned into fiefdoms for political parties. Each party gets a bunch of ministries/institutions/state companies where they can rule as they please.

In order to avoid to step on each others turf the budget cuts have been brainlessly uniform across all ministries.

Even the tax office is now on 4-days working-week - how stupid can you be in a country where tax evasion is endemic ?

The IMF has now asked for the suspension of private-public partnerships. Quite obviously such projects are a possible conduit where state funds can be misappropriated.

Den Danske Bank summarizes it nicely:
"In the local Latvian media it is reported that the People’s Party’s reluctance to support the IMF deal is a result of IMF’s apparent demands to stop all public-private partnerships (PPP) in Latvia. We believe it is very likely that this has indeed been a demand from the IMF, as observers have seen this as a key source of extracting “rent” from EU-sponsored infrastructure projects. To put it in another way — PPP has been perceived as a source of corruption in Latvia for years.

One would have thought that the crisis encourages Latvian politicians to rethink their ways and perhaps try some honest approaches.

Not so. As one hears, since the crisis hit state officials and politicians have become even more daring and aggressive to syphon off the few remaining state funds.

With tax office and police on reduced pay and on a motivational low things are easier than ever...

The mentality is difficult to understand for most Western minds. Fact of the matter is that neither prison nor loss of job deters corruption in Latvia. Having been in prison is no career-stopper in the former Soviet Union.

Honest and sane Latvians were hoping that the crisis would bankrupt those corrupt elites and that a new wave of people would sweep in.

That is why Latvians are happily taking the worst in stride - as long as the corrupt elites are also bankrupt and gone.

The problems outlined above apply equally to the private sector.

You mentioned: "which means that all these people at SEB and Swedebank who lost all that money for the Swedish taxpayers knew the reality behind the loans"

The top Swedish banker have been amazingly naive and put Latvians into key positions.

Therefore the Swedes did not realise that many loans were given because loan officers etc. received kick-backs from their clients.

Swedbank*s recent announcement that 53% of their mortgage loans exceeded the value of the property, says it all.

Looking through the property foreclosures these days one sees eye-popping mortgages on properties, in some cases exceeding the market value at the top of the market by tripple digit percentages.

The Swedes have now learnt their lesson and have put Swedes, Brits and Germans on the task of sorting out their Baltic loan mess.

It appears that the IMF has learnt the lessons a lot faster than the Swedish banks. Good luck to them.

Robert said...

I can agree with aboslutely everything what Observer says. However I still think that IMF is not fully aware that political situation in Latvia is extremelly dire.
Just today in the morning interview the boss of People's Party said that hiss party would never support neither progressive income tax neither increased VAT. It is a speculation, but at least one of those things are to be believed mentioned in the letter of intent to IMF as a contingency action.
In this case it looks like the paper is worth nothing and political parties are really not commiting themselves.

Hans said...

Both comments touch the part that no foreign analysts/observers, IMF specialists/ EU people are fully taking into account. It seams that IMF starts to see this as a problem but their rather positive statement today indicates that they will get burned here.

I believe that Latvia has low chances to avoid de facto default. It might be able to sustain service of the government loans but it would come at enermous cost to society.

There should be some rather radical and well thought out solutions to get us out of the mess. But there is little hope to get them from our government. We have to take into account that elections are due in October 2010. It means that there is short period of time to recover from unpopular reforms. This comes on top of the social discontent which is rising in the society. It creates adverse motivation for governing parties - right decisions will hurt their re election chances.

Anonymous said...

A perfect comment by Observer, which clearly and precisely shows what's going on in Latvia.

Actually, this is just a small part of the mess we can see here, and it seems that it might take decades to make a tunaround, as the root of problems lies deeply into fundamental values and perception of people living here. Precisely, the private sector is a mirror image of public sector. Both are ignorant, ready to steal everything from the State. I would attribute this phenomenon largely to the disastrous education quality, which concentrates on teaching how to fill in blanks, rather than creating understanding of different principles and values.

In regard to the IMF mission, one of the most painful problems here is the catastrophic lack of competence (we get back to education) within institutions responsible for all the reforms and proposals for austerity measures. Informally, employees at the Ministry of Finance admit that there have never been any guidelines or medium-term planning for fiscal policy, which is why it was pro-cyclical. I have been [un]lucky to see what those institutions prepare for meetings with the IMF, and almost all those materials/proposals are superficial and of unbelievably low quality. Sometimes one gets a feeling that no individual at those institutions can make an adequate, comprehensive quantitative analysis of what one or another proposal implies to the real economy. Latvia has a number of graduates from Oxford, Harvard, Wharton etc, but the State has never bothered trying to attract this brainpower. Getting high in the bureaucratic hierarchy has always been a matter of politics, instead of one's capability or intellectual capacity. As a bright illustration serves the State Secretary at the Ministry of Finance - a graduate from Latvian University with a degree in law. Does he know what fiscal policy is? I wouldn't be so sure.

In the end, here is an article with a bit different opinion. Would be nice if Edward could comment on this: http://www.piie.com/realtime/?p=836

Hynek Filip said...

What never ceases to fascinate me is the speed at which Latvia and other Baltic nations have gone out of favor, and out of fashion.

Two, three years ago, the Baltics were darlings of the West, the reforms (whatever they were) were applauded and Western banks were granting loans to anybody who asked.

Our own (Czech) government was repeatedly advised by Western analysts and advisors that we should follow the fantastic example of the Baltic nations.

Well, we did not do anything like that, and it seems that we have been right.

So I would be extremely cautious to follow those who now say "everything is wrong with Latvia, and Estonia and Lithuania are even worse".

It is fashionable to say that these days, but a wise man does not follow the latest trends in fashion.

True, the Baltic economies have fallen rather deep, and may fall even deeper, but that surely does not mean that everything is wrong with them.