Brief Latvia EU Loan Update

Well, there is still effectively no word from the IMF. But The EC did today release an addendum to its memorandum of understanding with Latvia identifying a number of economic and fiscal policy measures it wants the country to enact before it receives next chunk of funding. The document, which is a pretty rough-and-ready PDF photocopy, can be found here. Reading the document, one thing seems certain: the upcoming tranche of 1.2 billion euros will not now be sufficient to cover the budget deficit for 2009, since the EC requires half of the money to be set aside for the financial sector - which prompts the question, is the nationalized Parex bank really as healthy as the government and the bank's leadership have previously said it was?

Other items of interest in the document are the proposal to raise VAT in 2010 from 21% to 23% if other forms of revenue raising cannot be identified. The impact on already very hard pressed retail sales is not too hard to imagine. The introduction of a residential real estate tax is also proposed with local authorities being empowered to increase the real estate tax to 3% of cadastral values. If implemented, this will do only one thing: further reduce Latvian real estate values which are already down 50% from their peak, and on whose bottoming-out any hope of ultimate recovery depends.

Which is another way of saying that in macro economic terms the document leaves rather a lot to be desired, and essentially it is hard to find any item which is actually going to stimulate rather than flatten a recovery.

Also worthy of note is the requirement that Latvia now has to closely coordinate policy with the EU and the IMF.

"All significant Cabinet decisions or other decisions with a fiscal impact, including on social security or any guarantee scheme, shall be announced and undertaken only after discussions with the EC and the IMF,"

The document also stipulates that the government will have to report every month on all key aspects of spending and revenue, including providing a breakdown for each ministry as well as for local governments. These performance criteria, given the now near total dependence of the country on external support - de facto, as a sovereign state Latvia has effectively ceased (at least temporarily) to exist, some 19 years or so after its foundation - are not surprising in and of themselves, but it could have been hope that the country would have been better served in terms of the kind of advice which is being offered. The document repeated that Latvia should aim to reach a budget deficit of 10 percent of gross domestic product (GDP) this year, 8.5 percent in 2010, 6 percent in 2011 and 3 percent in 2012, numbers which, if my back of the envelope calculations are not totally awry mean that Latvia's debt to GDP will be outside the EU 60% limit by the time the deficit comes down under 3%, depending on GDP performance in 2010 and 2011. In any event it will be touch and go. So you enter by one door, only to leave by the other.

IMF Imposes New Conditions On Latvia

Izabella Kaminska at FT Alphaville has the story (via Reuters):

The International Monetary Fund has put forward new, difficult conditions for Latvia to receive further loans, the prime minister said on Wednesday in a further sign the Fund is being tougher than the European Commission.

It isn't clear at this point what these conditions are. Rumour has it they may be an end to the flat income tax, or a hike in VAT. A hike in VAT would be more hari-kiri, since this would again hit consumption AND would boost inflation at a time when they are trying to deflate to carry through an internal currency correction. It also isn't clear whether this is a serious attempt to add new conditions (which I find unlikely, given how advanced the distemper is) or whether this is a way for the IMF to get themselves off the hook (ie leave the EU Commission to stew in its own juice) without having a public and potentially damaging break with the EU. The IMF need to find some sort of exit strategy I think (since Latvia evidently at this point doesn't have one), or it risks losing its own credibility if it puts a seal of approval (by granting the next tranche) on something which most external specialists now think could end up in a very messy grande finale. Argentina ghosts are stalking the corridors in Washington, not because of the similarities between the two countries (they are, at the end of the day pretty different), but because of the way giving a final "kiss of death" loan to a country can ultimately come back and haunt you.

Update One

The local Latvian news agency is saying that if Latvia and the IMF do not sign the new agreement by Friday, Latvia may not see the next chunk of the IMF loan and it could jeopardize the further funding from the EC. This could be brinksmanship, but even brinkmanship can go badly wrong if the other party can't concede. And who is the other party here? Latvia or the EU Commission, since they already said they are happy with progress. What a muddle!

Update Two - Thursday Afternoon

Bloomberg's Aaron Eglitis reports this afternoon that Friday may in fact not be any kind of deadline. He quotes Caroline Atkinson, head of external relations at the IMF, in Washington, to the effect that the head of the IMF mission in Riga is returning to Washington this weekend as scheduled, while the mission itself would “continue its work.” This suggests there will be no final decision this week. She also said there was “broad consensus among all the parties involved” about the goals for Latvia, declining to go into specifics.

Rumourology has it that the IMF wants the government to become more effective in revenue collection, with the fear that the current contraction may be so strong due to the fact that part of the economy is disappearing back into a "grey area" as a backdrop. Various proposals are being floated around, but perhaps it would be better to wait for some concrete information before speculating about this.

Latvian central bank Governor Ilmars Rimsevics has also been holding a press conference in Riga today, and he took the opportunity to suggest that the country’s budget deficit was likely to grow to between 9.5 percent and 10 percent this year. If this is the case, then this would obviously put Latvia outside the 60% gross debt to GDP criteria by 2010, which would make euro membership as an exit strategy non viable over the relevant horizon in my view. Just a long shot, but maybe that is what they are all arguing about. The EU clearly has to offer the four peggars more in the way of a carrot, although they themselves need to remember - looking over at Slovakia and Slovenia - that mere euro membership is no panacea to cure all ills.

The IMF/EU Commission Rift On Latvia Seems To Be Deepening

Two weeks ago I drew attention to a revealing press conference given by IMF First Deputy Managing Director John Lipsky and European Central Bank governing council member Christian Noyer where it seemed a rather different posture was being taken on the Latvian question than that which is being transmitted from Brussels. Then P O'Neill found a message on Twitter which suggested the topic of the Latvian budget had been unexpectedly added to the EcoFin agenda.

Today Bloomberg report that Barclays Capital’s chief economist for emerging Europe Christian Keller thinks that the IMF's posture of continuing to withhold funds even after the approval of the spending cuts “signaled that the rift between the IMF and EU has widened” .

Now I don't want to see connections were there are none, but it is a coincidence that Christian Keller works for the same Barclays capital whose Head of Emerging Markets Strategy Eduardo Levy-Yeyati recently published a lengthy analysis on the influential Is Latvia the new Argentina? - where he argued that: "The strategy of engineering an “internal” depreciation under a peg in Latvia (via contractionary fiscal policy, wage cuts and price deflation) implicit in the IMF program is proving too painful, if not self-defeating as in the 2001 collapse of Argentina’s currency board"

Now the publication of this article was interesting since Eduardo Levy-Yayati is not just any old economist. Previous to joining Barclays Capital, as his Voxeu biography informs us, he was

"a Senior Financial Sector Advisor for Latin America & the Caribbean at The World Bank. Previously, a Senior Research Associate at the Inter-American Development Bank, the Director of Monetary and Financial Policies and Chief Economist for the Central Bank of Argentina, and the Director of the Center for Financial Research and Professor of Economics and Finance at Universidad Torcuato Di Tella. He has also worked as consultant for the IMF, the World Bank, the Inter-American Development Bank, the Japan Bank for International Cooperation, among many public and private institutions. His research on emerging markets banking and finance has been published extensively in top international economic journals. "

That is, Señor Levy-Yayati is an extremely experienced economist, an old Argentina hand, and enjoys some considerable influence over emerging markets issues in Washington. So was the appearance of the article in Voxeu at the end of June totally coincidental? He certainly is experienced enough to know what he is doing in these matters. And was it also a coincidence that only a week later former chief economist at the International Monetary Fund Ken Rogoff - surely another person who knows perfectly well what he is doing - gave an interview where he said that "Latvia should devalue the lats to avoid a worsening of its economic crisis" and that "the IMF made the wrong decision when it allowed Latvia to keep its currency peg"?

The IMF cannot say what it really thinks for obvious reasons, but could we construe Levy-Yayati and Rogoff as thinking out loud on the funds behalf?

The clash between the two institutions (should such a clash exist) derives from “ideological differences” according to Keller. "The IMF is focused on economic questions such as the sustainability of the currency peg, the use of economic stimulus or the idea of fast-track euro adoption......The EU’s main concern is political, such as euro-adoption rules and the implementation of convergence programs".

This all rings pretty true, and it rings even truer when you note that the Latvian Prime Minister Valdis Dombrovskis said only last week that the country "may not need the IMF share of the financing". As Keller says, “The Latvia program has become a headache for the IMF.”

Postscript

Latvian foreign trade was down again in May, at 618.3 mln lats it was 4.2% (or 27.1 mln lats) lower than it was in April (no green shoot here) and 38.5% (or 387.6 mln lats) down on May last year, according to provisional data of Latvian Statistics Office. May exports were down 30.1% over May 2008, while imports were down an incredible 43.7%. Over the January – May period foreign trade was down by 35.4% on the same period in 2008. Exports were down by 27.7% and imports by 39.9%.






Industrial output fell back again in May over April, by 0.4% on a seasonally adjusted basis according to the statistics office. Year on year it was down 19.3%.





And domestic demand continues to weaken. Retail sales were down 0.48% in May over April, and 24.14% year on year, according to Eurostat data.





Latvia’s inflation rate fell to 3.4 percent in June, the lowest annual rate since October 2003, from 4.7 percent in May. Prices were down 0.5% on the month, but this is way too slow for the kind of internal devaluation process which is underway. At this rate the loss of GDP will be truly massive before the internal currency correction has taken place.

There were 206,000 people unemployed in Latvia in May, or 16.3 percent of the labour force, according to the latest Eurostat data. This is slightly down on earlier data, but since these results are survey based, and such rapid changes make it difficult to apply such methodologies, I don't think we need suspect any kind of "foul play". The rise is dramatic enough as it is, as can be seen in the chart below. This makes me wonder were we will be by mid 2010.




One area where the central bank has had some success has been in getting overnight interbank lending rates down again, and the overnight Rigibor is now back around 3% (13 July), but the 12 month rates are still very high (20.2% 13 July) which does suggest that while market participants are fairly sure the peg is safe in the short term, they are not at all convinced about what is going to happen in the longer term. And in this they seem to be making a valid judgement, since this is the situation at the time of writing.






Meatime Latvia's natality continues to suffer under the weight of the crisis, there were 1750 live births in May, down 15.3% on May 2008. Thus, not only are we playing with the countries short term future here, we are also putting the possibility of having a long term one at risk.




Where Is The Endgame?

When it comes to the short term dynamics of the looming currency crisis in Emerging Europe, one of the Baltic Three, probably Latvia, will most likely be the first to concede its peg, as Eduardo Levy-Yeyati says this is just too painful, and the loss of GDP which is taking place while the politicians are dithering is fearful.

But when Latvia does leave its peg, then others are almost bound to follow. Everything depends on whether the EU Commission and the IMF are proactive or limit themselves to a mere reactive, problem-containment role. If the Latvian currency realignment is done in an organised and systematic fashion, then it may, even at this late date, be a containable process. For this to happen the EU Commission have to stop playing with the politics of the situation, realise that the Maastricht criteria were not written in tablets of stone, and start to formulate a reasonable exit stratgey for all the Eastern members of the EU. They need, that is, to start thinking practical economics, the way the IMF now seem to be doing. The macro economics of this was always clear and straightforward.

But if the Latvian situation is simply left to fester, and the country falls into the grip of a growing political anarchy, then containment will be much more difficult, since panic will more than likely set in.

A similar situation pertains in Bulgaria (see my latest post on Bulgaria, since the similatities are evident). Absent a Latvian devaluation, it is not unthinkable that the Lev peg may be maintained in Bulgaria for another year or so. But if the Bulgarian authorities do go down this road, then we face the severe risk of a a further raggedy ending, since the problem is not one of sustaining the peg, but of restoring competitiveness and economic growth, and this is much more difficult without a formal devaluation. And if Bulgaria does go hurtling off that cliff on which it is currently perched, then just be damn careful it doesn't drag half of South Eastern Europe careering after it. The EU Commission need to begin to resolve this mess, and the need to begin now!

Estonia's Neck Goes Into A Latvian-style Noose

Well, today is the 30 of June, and still no news from the IMF on releasing the next tranche of the Latvian loan. Perhaps this is one of the reasons why (via Ott Umelas at Bloomberg).

Estonia’s fiscal deficit under European Union terms more than doubled in the first quarter from a year earlier, indicating the Baltic country may not be able to adopt the euro in January 2011. The deficit, including social security and state and municipal spending, rose to 5.57 billion krooni ($502 million) from 2.06 billion krooni a year earlier, according to data published on the statistics office’s Web site today. The gap corresponds to 2.5 percent of gross domestic product, according to Bloomberg calculations based on the Finance Ministry’s forecast for Estonian GDP for 2009.

The first-quarter figure means the government will have to keep the deficit at 0.5 percent of GDP for the rest of the year to meet euro-entry criteria. Finance Minister Jurgen Ligi has said he sees no improvement in the economy before the third quarter. The minority Cabinet of Prime Minister Andrus Ansip has cut the 2009 budget deficit by 16 billion krooni, or 7.3 percent of GDP, in recent months to avoid depleting state reserves and keep the fiscal deficit at last year’s level of 3 percent of GDP, the same as the EU’s budget-deficit threshold. This would allow Estonia to adopt the euro in January 2011, the government’s main economic goal.

So why a "Latvian-style" noose? Because these countries have built for themselves a sort of "paradox of fiscal thrift" connundrum, whereby the more you cut, the more GDP falls, the more revenue rises, the more spending grows, the more the fiscal deficit goes up, the more you have to cut, and so on. In the end, as Kenneth Rogoff said yesterday, it simply becomes too painful. There seems no way Estonia can achieve a 3 percent deficit this year at this point. And remember what IMF First Deputy Managing Director John Lipsky said last week.

“If there is a solution it begins with macro policies,” Lipsky said. “No single exchange rates solution, or exchange regime represents a solution to these kinds of problems. What is important is that the currency regime is credible and coherent”.

Estonia now has no exit strategy, at least not to join the euro in 2011 it doesn't And then we have Lithuania and Bulgaria to think about. Basically, the ECB and the European Commission should never have drawn a line in the sand across the original Maastricht criteria. But it's too late for that now.