Latvia’s central bank chief has dismissed suggestions the Baltic nation is lurching towards default, as experts sound the alarm over its solvency.
The prospect of a sovereign default has increased dramatically as prospects recede of a successful outcome to talks between Latvia and the IMF on a bailout loan, Lars Christensen, senior analyst at Danske Bank, said.
“The Latvian government would have to cut public spending very dramatically in order to avoid a default,” he said, adding that this is “mission impossible” for authorities.
Without the IMF loan, the country will face greater capital outflows and eventual currency devaluation as reserves dwindle, Christensen added.
The IMF extended the recession-ravaged country a $10.2 billion loan last December, but authorities missed the 5% deficit target for a second tranche in March.
But Latvia would need to cut spending by 40% to fulfil the IMF target, the government has said. Officials are now pushing to renegotiate the target 7% in order to receive the tranche in June.
Central bank governor Ilmars Rimsevics told Emerging Markets that the “government’s commitment to reduce expenditures” will stabilize an economy that is “slowing and gradually being rebalanced to improve the competitiveness in the future”. He added that the IMF programme is “good” and “simply has to be carried forward.”
But Rimsevics sharply dismissed suggestions that chances of a currency devaluation have increased as the economy plummets. “This has never been and never will be an option,” he said.
Latvian authorities maintain a fixed exchange rate to help borrowers pay off the large stock of euro-denominated debt and to support a 2012 eurozone entry bid – but at the expense of sharply decreasing nominal wages and prices.
The central bank has spent around 500 million euros buying lats to support the currency regime so far this year. Last week, the Swedish central bank increased the upper limit of euros available in its currency swap agreement with the Latvian central bank.
Rimsevics said the country’s bid to adopt the euro in 2012 – which calls for a maximum 3% deficit – is realistic if the government slashes spending and wages fall massively. The European Commission forecasts Latvia’s deficit could reach 13% in 2010.
The governor argued that “deflation is not the problem for Latvia” although he acknowledged inflation could fall to around 1% to 2% by the end of the year.
Nevertheless the country’s plunging growth has raised concerns about possible deflation that could trigger a sharp depreciation of the real exchange and hike the cost of paying off foreign-currency debt.
Danske bank predicts a deflation rate of 0.2% in 2010. It says that capital inflows will return in 2011. On Monday, the country’s statistics office announced the economy shrank by 18% year-on-year in the first quarter of the year – more than expected by analysts.