LATVIAN PRIME minister Valdis Dombrovskis emerged from a marathon emergency budget meeting yesterday to say the severe spending cuts decided on have saved his country from bankruptcy. That was certainly their main objective, but saving Latvia from devaluation comes a close second. Either outcome would have a major ripple effect on neighbouring states, which is why this crisis is suddenly attracting much closer international attention.
After joining the European Union in 2004 Latvians embarked on a spree of cheap loans, property speculation and consumer spending, financed by foreign banks and enthusiastically endorsed by its political leaders. Some 200,000 households in its population of 2.3 million people took out mortgages, most of them denominated in euro and mainly borrowed from Swedish banks. Last year’s crash has hit Latvia exceptionally hard. The European Union and the International Monetary Fund came to the rescue in January with a €7.5 billion credit facility predicated on deep cuts in state spending and tax increases to rebalance its state finances.
These budget cuts have been made ahead of a forthcoming €1.2 billion drawdown on that loan. State salaries are cut by 20 per cent, parental allowances by 10 per cent, pensions by 10 per cent and by a savage 70 per cent for those who are also working after retiring. This will save some €700 million a year – and there is more to come in the next budget, including probably property and capital gains taxes and a possible shift from the existing flat rate 24 per cent income tax to a more progressive system.
Unemployment is nearly 12 per cent and climbing. There is as yet no sign of the violent protests which broke out in January, but Latvians are shell-shocked. Should pressure mount for a devaluation against the euro they would be exposed to much higher mortgage payments, which would cause many to default. That is why there has been a co-ordinated effort by the European Central Bank to help. This week it agreed to provide a €3 billion loan to Sweden in support of its banking system which faces soaring losses in Baltic states.
A Latvian devaluation could be contagious elsewhere in central and eastern Europe, similarly exposed to euro-denominated lending. But it may be the only way to head off an economic collapse. It would then be necessary to bring Latvia into the euro zone despite its weakness in order to protect the whole system.