Baltic thaw, Aegean freeze

Latvia’s economic free fall has halted, and it may now do better than Greece

Feb 25th 2010 | RIGA | From The Economist print edition

DOOM-MONGERS are licking their wounds. For two years bankers have said that a Latvian devaluation was inevitable. The struggle to save the lat’s peg to the euro was bound to end in tears. And a panic in Latvia could topple the wobbly economies of Estonia and Lithuania, which have similar exchange-rate regimes, with repercussions extending across eastern Europe and to Scandinavian banks that lent recklessly in the Baltics.

Yet despite a fall in GDP last year of 17.5%, Latvia seems to have achieved something many thought impossible: an internal devaluation. This meant regaining competitiveness not by currency depreciation but by deep cuts in wages and public spending. In a recent discussion of Greece, Jörg Asmussen, a German minister, praised Latvia for its self-discipline.

Standard & Poor’s, a rating agency, has raised its outlook on Latvia’s debt from negative to stable (ie, it no longer expects further downgrades). The current account, in deficit to the tune of 27% of GDP in late 2006, is in surplus. Exports are recovering. Interest rates have plunged and debt spreads over German bonds have narrowed (see chart). Fraught negotiations with the IMF and the European Union have kept a €7.5 billion ($10 billion) bail-out on track, in return for spending cuts and tax rises worth a tenth of GDP.

At the centre of Latvia’s crisis was its biggest locally owned bank, Parex. Until it went bust, Parex was a byword for high living and murky dealings. Its new American-born boss, Nils Melngailis, has refinanced its debts, divided its assets into good and bad, and aims soon to unfreeze depositors’ cash. He found plenty of savings. Selling a fleet of sports cars and ending the use of private jets cut travel costs by 90%. Overall, he cut the bank’s costs by 40% in 2009, with 30% more to come.

Even if a catastrophe has been averted for the moment, Latvia’s economy remains troubled. Unemployment, at 22.8%, is the highest in the EU. Growth is unlikely to resume until late 2011. After a decade of prosperity based on a construction boom, cheap manufacturing and transit from Russia, Latvia needs new sources of income. The biggest task is to harness local brainpower. Emigration has been a safety valve for jobless Latvians, but the country loses if fraying public services, high taxes and low pay drive its more productive workers abroad. And nobody seems to be trying to stop them. Even his fans would hesitate to call the prime minister, Valdis Dombrovskis, charismatic or visionary.

Confidence in institutions is feeble—support for the EU is lower than in any other member state. Politicians are uninspiring, with most parties run by tycoons who escaped blame for economic mismanagement. A sense that the rich and powerful evade justice is pervasive. At Vincents, a Riga restaurant where dinner for two can cost $400, the owner, Martins Ritins, says business is booming. On Valentine’s Day he opened on a Sunday for the first time in years and almost every table was taken.

As politicians’ credibility dwindles, Russian influence grows. A pro-Russian party won control of Riga last year. Latvia’s president, Valdis Zatlers, will go to the Soviet-tinged celebrations in Moscow on May 9th to mark the 65th anniversary of Victory Day. Hawks see this as a sell-out. A visit to Riga by Russia’s foreign minister, Sergei Lavrov, in April may be a step towards normal relations—or a sign that Russia sees Latvia as a swing state in the Baltic.

Even so, Latvia looks good when compared with Greece. It did not lie about its public finances or use accounting tricks. Strikes have been scanty. Protests are fought in the courts, not the streets. Both Greece and Latvia have had hard knocks, but Greeks became used to a good life that they are loth to give up. Latvians remain glad just to be on the map.