Latvian prime minister Valdis Dombrovskis might be forgiven for expecting a pat on the back from his coalition partners. Since coming to power this April, Dombrovskis has managed to secure more than E1.4 billion of a total E7.5 billion international loan package. He has also won a concession from the IMF that Latvia’s budget deficit can increase to 13% of GDP instead of the previously agreed 5%.
“By the beginning of October we are to receive E200 million from the World Bank, which makes us well set for this year and the beginning of next year,” Dombrovskis tells Emerging Markets in an interview in Riga.
But Dombrovskis seems more likely to receive a dagger between the shoulder blades than a pat on the back, with his coalition partners the People’s Party working to undermine him even as Latvia’s coffers fill up again.
“What do they want to achieve? That’s not very clear, but certainly they are changing their positions on several issues where they formerly had a clear position,” says Dombrovskis.
What he calls the People’s Party’s “games” stem from the unusual position it finds itself in. It is the largest party in parliament and government but retains hardly any support among the electorate, who hold it responsible for leading the country into crisis during the “fat years” – to use former prime minister Aigars Kalvitis’ phrase – of economic excess.
The People’s Party was virtually wiped out in June’s European elections but until the next general election in October 2010 retains its parliamentary muscle. It seems to be hell-bent on making life for Dombrovskis, from the rival New Era party, as difficult as possible.
The hope must be that he will be saddled with the blame for the recession as well as the austerity measures that were a way of combatting it.
Prominent People’s Party ministers have refused to implement further spending cuts. Indeed the party indulged in brinkmanship over whether it would sign a second letter of intent with the IMF, and one of its MPs apparently accidentally leaked market-sensitive information during a parliamentary debate called, at the People’s Party’s request, on September 9.
Dombrovskis does a good job of hiding any exasperation, preferring to point out the inconsistency of his bothersome colleagues, for instance over the introduction of a new property tax, which the People’s Party says it opposes.
“The decision to broaden the base of real estate tax was already taken by the previous government when we had Atis Slakteris as finance minister from the People’s Party. It was also agreed in the letter of intent to the IMF signed by the People’s Party, so really it’s a bit unclear why they are changing their mind,” says Dombrovskis.
SENSITIVE INFORMATION
He rejects the People’s Party’s claims that the agreements signed with the IMF contain any sinister secrets. “The [second] letter of intent has a few technical provisions which are not made public. They are not politically sensitive by any means, but at the request of the Bank of Latvia and the Treasury they were not made public because they include market sensitive information,” he says. They include plans for future placements on the world’s financial markets.
“We would give an unfair advantage to the market by disclosing exactly what the plans are. That’s normal procedure, and exactly the same procedure was used in the first letter of intent. At that time the People’s Party did not seem to object.”
Despite the evidence to the contrary, Dombrovskis insists the People’s Party aren’t planning to destroy his administration from within. “Political stability is needed to negotiate with international lenders – that’s understood even by the People’s Party,” he says.
It may be that the return of political chicanery is a sign that Latvia’s vertiginous recession is bottoming out (if a second quarter figure of minus 18.7% year-on-year can be described in such terms). But more likely it increases the danger were the country to be thrown into fresh turmoil – particularly given the effect political instability could have on the country’s already weak ratings. Standard and Poor’s rates Latvia ‘BB’, two notches below investment grade.
“The three main priorities we see to overcome the crisis are: first, fiscal consolidation; second, stimulating the economy, and third, establishing a minimum social security network,” says Dombrovskis.
“Fiscal consolidation is most immediately linked to the international loan package. We passed budget amendments in June which included fiscal consolidation of 500 million lats, and we are to decide on a further fiscal consolidation of 500 million lats in the 2010 budget.”
He says: “Cuts will not be as dramatic as this year because this year it was 500 million in half a year whereas next year it’s 500 million for the whole year. However, there are fewer places to cut.”
With anger at the closure of hospitals and schools as well as unemployment running at around 17%, the question of Latvia’s euro adoption date has slipped down the agenda – even if nominally it remains a priority.
But with Latvia unlikely to meet the Maastricht 3% of GDP budget deficit criteria any time soon, Einars Repse, the finance minister, has adopted a strategy of saying a firm date will be announced two years before it happens – with 2014 being suggested, if vaguely, as a possibility.
ESTONIAN LINE
Neighbouring Estonia has taken a different line. It was the second EU member state to enter a technical recession, but throughout the downturn has promoted the idea that replacing the kroon with the euro is its number one priority. Barely a press conference passes in Tallinn without a repetition of the mantra “euro adoption at the earliest opportunity”.
Andrus Ansip, the prime minister, heads a minority two-party coalition after a third party walked out in a disagreement over changes to labour law designed to increase the flexibility of the labour market.
Officially the euro target date remains 2011, which central bank governor Andres Lipstok says is “clearly achievable”.
But with the economy expected to contract by 14.5% in 2009, Jurgen Ligi, the finance minister, says spending cuts in addition to those already made will be necessary in the 2010 budget. Sensitive areas such as healthcare will be affected. “Next year the need still exists to also cut real, basic wages,” Ligi told the Estonian parliament on September 16.
Violeta Klyviene, a senior Baltic analyst at Danske Bank, believes Estonia is in a better financial position than the other Baltic states, but the chance for early euro adoption is on a knife edge.
“Despite recently implemented fiscal tightening, the risk of breaching the 3% of GDP budget deficit in 2009–10 is significant,” she says. “The Estonian government hopes to be in line with the GDP target mostly due to additional dividend income. However, Eurostat might classify this as extraordinary income and exclude it from the deficit calculation.”
LITHUANIA: stabilizing influence
Lithuania’s Andrius Kubilius seems the most steady of the three leaders one year on from his election. But with Lithuania’s GDP dropping by even more than Latvia’s in the second quarter of 2009 – 20% year-on-year – it’s a relative notion.
“The economic situation is stabilizing, though we cannot talk about it coming back to the level of recent years,” Kubilius tells Emerging Markets in Vilnius.
“Despite the fact that the recession in the Baltic states has been deeper than elsewhere, all of us are stabilizing at around the level we were at in 2006. But we are confident we can keep our public finances stable.” He is reluctant to name a target date for euro adoption.
Kubilius’ appointment of Ingrida Simonyte as finance minister has acted as a stabilizing influence: she has been sure-footed so far in balancing the need for budget cuts against a desire for economic stimulus.
“The biggest mistakes in the past were related to the perception that the convergence process can be very speedy and at no cost,” says Simonyte. “For management of public finances, an important lesson is that financial commitments for the future must be sustainable not only in the medium term, but even in the long term to prevent public debt from sudden increases.”
Eurozone membership remains “a top priority” she says. “The current crisis shows clear benefits of being within the eurozone. Much will have to be done in the area of public finances as the fiscal deficit, being above the Maastricht limit, will be a challenge for the next two years. Due to the uncertainties over the economic outlook, it is not easy to name any concrete date for euro entry.”
Simonyte says: “A need for possible financial assistance cannot be ruled out, and Lithuania as a member of the EU and IMF would use this opportunity if needed.”
Nordea bank economist Annika Lindblad says the focus this autumn will turn towards Lithuania’s next Eurobond placement. “The confidence of private-sector lenders would support the notion that no rescue package from the IMF is necessary,” she says.
DEVALUATION TENSIONS
But no matter what paths Estonia and Lithuania plot individually, they run the risk of having their euro aspirations dashed by Latvia if it is forced to devalue its currency – a strategy favoured by the People’s Party, says Neil Shearing, an emerging Europe analyst at London-based Capital Economics.
“I suspect that what happens in Latvia will govern what happens in the rest of the region,” he says.
If Latvia should receive a competitive boost via a devaluation, then it will deepen the competitiveness problems in Estonia and Lithuania, with a good chance that if Latvia goes the other two currencies will also go.”
The contagion could spread throughout central and eastern Europe, Shearing believes. Latvia’s attempt at an ‘internal devaluation’ via falls in wages and prices in the real economy may be brave, but it is a painful process.
“Such is the scale of the falls in wages and prices needed to restore some semblance of competitiveness that I find it difficult to believe we are going to see this process through. There is no historical precedent for it – no one has ever managed to boost their real exchange rate while keeping the nominal rate constant,” he says.
Provided Latvia manages to weather the storm, Estonia and Lithuania could join the eurozone in 2013, Lindblad predicts, with Latvia crossing the line later.
“Although the risk of devaluation in Latvia has subsided, the neighbouring countries will continue to monitor the situation, as devaluation could prove disastrous to the currencies of the other Baltic countries as well.”
But this hardly addresses the logic of euro adoption. Small, open, export-oriented countries desperately need to be able to run their own monetary policies, argues Maya Bhandari at Lombard Street. “It is a mystery that countries in the region are still looking to the euro for support,” she says.