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11.02.2009

February 02, 2009 (the date of publication in Russian)

Alexander Gaponenko

LATVIA ON THE EDGE OF BANKRUPTCY. Part 1

The crash of a postindustrial economy: a case study

A WINNER THAT TURNED A LOSER

During recent years, the highest rate of economic growth in terms of GDP in the European Community was achieved by Latvia. Despite reduction of incomes from Russian oil transit, the Baltic republic managed to accumulate impressive gold currency reserves, and to reduce the foreign debt. Pareks Banka, based in Latvia's capital Riga, was the only national banking institution of the Baltic States to develop into a powerful transnational investment bank, extending its influence both to the West and the East.

However, the global economic crisis affected this country most painfully, resulting in massive social unrest and political paralysis. In his public address to his own population, Valdis Adamkus, president of the neighboring Lithuania, tried to explain the social turbulence in both states with deliberate efforts of destabilization, inspired from Russia. However, the Russian political influence in Latvia is less significant than in other Baltic states. In December 2007, local Russian communities complained that they had not received a ruble of support from Russia. It is also noteworthy that Moscow has not used the Latvian crisis for its benefit. Besides, Russia is today concentrated on its own financial problems, emerging from a tremendous decline of oil export revenues.

What has happened to Latvia? Why has this country become the prime loser of the crisis? Was that a result of unfavorable outside factors, of particular mistakes of the incumbent powers, or of certain flaws in the institutional system shaped in the earlier period? How and why is the crisis going to influence the country's financial system? Analysis of the current situation in Latvia may be useful for other new EU member states, searching for escape from the unexpected troubles.

In fact, the first symptoms of economic troubles were visible in Latvia already in early 2007. They were expressed in a shift in the economic balance that expressed itself in a few branches of economy: real estates, construction, and retail trade. Some of these negative symptoms were in fact presented as success: in particular, the increase of salaries and gross surplus of individual consumption. However, these ostensibly encouraging trends were alloyed with unbridled inflation that questioned the expected entry of the country into the Eurozone.

The anti-inflation program, initiated by the government of Aigars Kalvitis, was ambiguous and inconsistent. Trying to reduce the monetary mass, the government created obstacles for investments in real economy, while financial speculation was still booming. By the end of 2007, inflation was still on the level of 10.1%. In the first quarter of 2008, it rose to 16.4%, and in the second – to 17.7%.

Restrictions for issuing credits, imposed by the government on the banks, resulted in a rapid contraction of the output of real economy. In the third quarter of 2008, the GDP reduced by 4.5% against the corresponding period of the previous year. The monthly industrial output shrank by 8% between January and August 2008. Meanwhile, unemployment increased by one quarter.

Facing an especially significant decline in metallurgy, resulting in a tangible shortage of revenues, the Government increased domestic borrowing. Thus, social instability had been predetermined yet before the international crisis broke out.

Since August 2008, Latvia, as well as other European states, encountered direct influence of the downfall of international stock markets. This influence was indirect, as the national stock market was underdeveloped and the state investments in foreign stocks were not significant. Commercial banks, due to strict regulations, also had not significantly invested in foreign stocks.

The downfall of the national budget system was triggered by the bankruptcy of Pareks Banka that had been massively involved in international speculative operations. For some reason, the new government of Ivars Godmanis decided to accept 100% of the bank's liabilities that amounted to 1.5 billion. lats, i.e. one fourth of the national budget. In order to compensate the budget deficit, the government committed itself for large-scale foreign borrowing. Simultaneously introduced austerity measures included also elevation of the value-added tax from 18% to 21%, increase of excise taxes, suspension of tax relief for basic consumer goods, along with slashing of budget subsidies for redundancy payments, state expenses for medical treatment, and salaries in spheres of science, education, and law enforcement. At the same time, the state budget continued to invest in ambitious projects like the State Concert Hall in Riga.

It is noteworthy that throughout year 2008, foreign investments in Latvian economy did not significantly reduce: their amount was 11% larger than in 2006. Foreign investments partially compensated the negative export surplus. Lending rates did not outrange the rate of inflation. Thus, the banking system did not yet experience a serious shortage of monetary resources.

However the government, being focused on the objective of integration into the Eurozone, strictly pegged the national currency to the euro. This commitment deprived the government of crucial levers of economic regulation. At the first signs of international financial crisis, the population hurried to exchange the greatly overvalued lat for foreign currencies, particularly due out flow of qualified labor to more prosperous European states. Only for two months, between September and November, the amount of foreign currency reserves of the Bank of Latvia contracted by 21%. By spring, all the gold currency reserves would have evaporated. The panic was calmed down only in the end of December, when the government managed to reach an agreement with international financial institutions on new loans amounting to 7.5 billion euros.

The problems, related to devaluation of national currency, were thus solved. However, foreign liabilities of Latvia increased from a relatively moderate 57.6% to the critically dangerous 100% of the estimated national GDP of 2009.

 

ERRORS: ROUTINE OR SYSTEMIC?

The errors in managing the economy in crisis, undertaken by the government of Ivars Godmanis, may be explained by lack of professional qualification and its reluctance to listen to financial experts. The Prime Minister introduced ridiculous initiative, destined for prevention of financial panic and related flight of capital. Insisting that the crisis in fact exists "only in the imagination of people", Mr. Godmanis officially introduced criminal prosecution of any arguments in favor of devaluation. Criminal charges were thus imposed on a university professor who just reproduced a piece for a textbook of economics on the subject of devaluation in a 500-copy local newspaper, and on two musicians who ventured to ridicule the Bank of Latvia in a village club.

In fact, the set of measures, introduced by the incumbent government of Latvia, does not significantly differ from the financial policy of earlier governments. The powers of Latvia have been following the same model that exposed its faultiness under unfavorable international conditions.

This model, used since early 1990s, is focused on primary (non-equivalent) accumulation of capitals. It was first used for privatization of post-Soviet public property. However, this source of producing capital could not serve as a guarantee of balanced and durable economic development. As soon as the previously (mainly in the Soviet time) created resources were exhausted, this model started to generate systemic errors.

About the author:

Alexander Gaponenko, Dr. Sc. (Econ.), is the Director of the Institute for European Research, Riga, Latvia

(To be continued)


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