What’s Happening in Latvia?

The Latvian economy appears to be dying. At the end of last year, the EU and IMF cobbled together a $10.4 billion support fund that’s doing no good. The small nation says its economy will shrivel by some 18% this year, which means it probably won’t be able to meet the 5% of GDP budget deficit limit specified in the EU/IMF package, which means it may not qualify to receive the $2.4 billion due to be lent at the end of this month.

The country is doing so poorly that it may no longer qualify to receive the funds it needs to improve its situation, so it will do worse, so it will not qualify for another package, so the vicious spiral will persist. As with the Federal Reserve’s stress tests for U.S. banks, the assumptions used by the IMF proved far too optimistic. Their worst-case scenario called for a Latvian GDP drop of 5%, not 18%.

As you read this, Latvia is going nuts slashing public programs in a frantic effort to qualify for its EU/IMF package. These spending slashes will exacerbate the recession there, and the country may still not qualify for the package. If, after the cuts, the recession deepens and the package fails to arrive, Latvia may default on its obligations and see its currency devalued. Indeed, a slew of beetle-browed onlookers says devaluation is all but guaranteed.

Why should anybody care about that? After all, Latvia is home to just 2.2 million people and is only a $35 billion economy. From the BBC, here’s why:

If Latvia is forced to abandon its currency peg to the euro, other countries in the region, such as Estonia and Lithuania, may be forced to abandon theirs as well. The Latvian crisis could also hit European banks invested in Latvia. Swedbank, the biggest lender in the Baltic region, is seen as particularly vulnerable and Sweden’s krona has been hit hard in recent days.

To which, RGE Monitor adds:

If a balance-of-payments crisis occurs in the Baltics and it spills over into other Eastern European economies (please note that this is a big ‘if’), then the Eurozone could be affected. The Eurozone’s exposure results from Western European banks’ heavy exposure to Eastern Europe, via subsidiaries, where they hold 60-90% market share (as a % of assets), depending on the country. Given the [Central and Eastern European Countries’] strong financial linkages with Western Europe, the health of Eastern Europe’s economies and its banks could potentially afflict Western European banks.

And here we thought we were out of the economic woods.

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