Viewing cable 07RIGA166
Title: LATVIA: DEVALUATION UNLIKELY BUT INVESTORS NERVOUS

IdentifierCreatedReleasedClassificationOrigin
07RIGA1662007-03-06 12:09:00 2011-08-30 01:44:00 CONFIDENTIAL Embassy Riga
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C O N F I D E N T I A L SECTION 01 OF 02 RIGA 000166 
 
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E.O. 12958: DECL: 03/05/2017 
TAGS: ECON EINV EFIN PGOV LG
SUBJECT: LATVIA: DEVALUATION UNLIKELY BUT INVESTORS NERVOUS 
 
 
Classified By: Ambassador Catherine Todd Bailey, for Reasons 1.4 (b) an 
d (d) 
 
¶1. (U) Summary.  Three weeks of debate on whether Latvia will 
need to devalue its currency has left investors nervous. 
While key players agree that the risk of devaluation remains 
remote, they also agree that serious concerns exist regarding 
Latvia's macroeconomic situation.  Talk of devaluation and 
the downgrading of Latvia's outlook by Standard & Poor's may 
give the government political cover to make tough decisions, 
but it remains to be seen if the political will exists for 
the government to take on vested interests and implement 
unpopular measures to combat inflation and cool the 
overheated economy. End of Summary. 
 
Finally noticing the Check Engine light 
--------------------------------------------- ------ 
 
¶2. (U) A three-week public discussion on the state of the 
Latvian economy has left markets and investors nervous.  The 
spark of the debate was a February 10 article in the leading 
newspaper Diena by Morten Hansen, Head of the Economics 
Department at the Stockholm School of Economics in Riga. 
Latvian media previously expressed concern about Latvia's 
inflation rate, which at close to 7% last year was the EU's 
highest, but this was generally outweighed by reports of 
Latvia's EU-best GDP growth, higher wages and low 
unemployment.  The Hansen article changed the focus of the 
debate by characterizing devaluation of the Lat, the national 
currency, as a credible possibility. 
 
So how bad does it look? 
-------------------------------- 
 
¶3. (U) General warnings about Latvia's overheating economy 
are nothing new.  Local press has for some time debated 
anti-inflation measures and the advisability of moving 
forward with large public building projects.  A January 12 
Economist article laid out all the worrisome statistics: GDP 
growth up to 12% annually, home prices rising by 2% per 
month, a current account deficit at a whopping 24% of GDP, 
and real wage growth vastly outstripping productivity gains. 
The article made a dire forecast- that the inflationary 
pressures likely if GDP growth continued growing in excess of 
10% could lead to a hard landing and economic stagnation in 
Latvia. The forecast of problems to come was muted by a 
prediction that Latvia's growth was likely to slow to 7% 
annually in 2007-11.  The article downplayed the possibility 
of a devaluation, and made it clear that the Bank of Latvia's 
strong credibility made such a move unlikely. (Hansen himself 
told PolEcon Off separately that he shared the Economist's 
views). 
 
So if we all agree, why are we still talking? 
--------------------------------------------- -------- 
 
¶4. (C) Devaluation concern touches Latvian society to a 
greater degree than talk of inflation and overheating because 
of one simple factor - almost all lending in Latvia is done 
in Euros.  Everyone, from the biggest oligarch to young 
Latvians trying to pay their huge mortgage and consumer loan 
bills, knows that if they end up needing more lats to pay the 
same euro-denominated loans, they are in deep trouble. 
 
¶5. (U) If the Hansen article weren't enough to rattle 
investors, Latvians were treated to a series of related 
events.  At first the news was calming, with Diena newspaper 
running a follow-on article on February 13 on how most 
experts agree that the risk of lat devaluation remained 
trivial, and printing on February 16 a column from the 
Governor of the Bank of Latvia, Ilmars Rimsevics, in which he 
promised that the Bank will not devalue while he's in charge. 
 
 
¶6. (C) The calm was short lived.  The weekend of February 
17-18 saw a run of people trying to sell lats for euros.  The 
run, which according to Rimsevics was an orchestrated scare 
using cell phone text messages to spread rumors of imminent 
devaluation, led some small currency-exchange businesses to 
run out of euros.  The Interior Ministry promptly opened an 
investigation (stating that they would pursue the rumor 
instigators with possible economic sabotage charges that 
carry 5 to 12-year jail sentences). 
 
¶7. (U) This was followed by Standard and Poor's February 19 
announcement that they were lowering Latvia's outlook from 
stable to negative, based on the increased likelihood of a 
hard landing.  More bad news hit on February 21 with reports 
that the interest rates on the RIGIBOR inter-bank money 
market index had risen from around 5% to almost 9%, 
reportedly caused by devaluation rumors and Scandinavian 
 
RIGA 00000166  002 OF 002 
 
 
investors trying to decrease their risks from lat devaluation 
by increasing loans in lats. 
 
¶8. (U) The latest jolt came from the Financial Times, whose 
March 1 article reported that the Danish bank Danske Bank had 
issued an analysis which compared Latvia's economic situation 
to that of Asian countries before the 1997 crisis.  Danske 
Bank's chief economist, Carsten Valgreen, was quoted 
predicting that a crisis in Latvia could "trigger contagion 
across the fast-growing Baltic states of Estonia and 
Lithuania and into eastern Europe". 
 
Government Response 
------------------------------ 
 
¶9. (C) Aside from Rimsevics' February 16 article, the main 
government response has been to speed up the release of 
recommendations from a task force that the Finance Ministry 
organized last year to develop anti-inflation proposals. 
Rimsevics indicated in a January meeting with the Ambassador 
that the task force recommendations would be ready in April, 
but the Finance Ministry subsequently announced the findings 
will be presented to the Cabinet of Ministers on March 6. 
 
¶10. (C) Given that the lat is pegged to the euro, thus 
eliminating monetary policy options to fight inflation, media 
speculation about the task force's recommendations focus on 
fiscal policy measures - new taxes on real estate 
transactions and reassessing the cadastral value of 
properties, delaying large public building projects, and 
running a government budget surplus.  The key interest among 
analysts and investors, though, is not so much what measures 
are suggested, but whether there is the political will to 
implement the recommendations. 
 
Will the government act? 
------------------------------- 
 
¶11. (C) In the course of the last three weeks, PolEcon Off 
has heard similar worries from Hansen and Rimsevics that the 
government has not recognized the necessity of curbing 
Latvia's excessive GDP growth and accompanying inflation. 
PolEcon Off met with the Standard and Poor's analysts who 
authored the recent outlook change when they visited Riga on 
February 8, and they said that during their 2006 meetings in 
Riga they noted that the GOL had no interest in tackling its 
macroeconomic problems, but understood the attitude given 
that parliamentary elections were looming.  The analysts 
expressed dismay, however, that their 2007 meetings with 
government officials post-election had displayed a continued 
lack of interest in the subject. 
 
¶12. (C) Both Hansen and Rimsevics said they did not know if 
the government would accept taxes on real estate 
transactions, given that so many key figures in Latvian 
political life have significant financial interests in real 
estate and continuation of the status quo would be beneficial 
to those holdings.  Hansen also remarked that increasing 
taxes across the board would be unpalatable to the government 
as there is a degree of tax competition among the Baltic 
states. 
 
Implications for the US and the road forward 
--------------------------------------------- ----------- 
 
¶13. (C) Comment: Having the Latvian economy hit with a hard 
landing or a devaluation of the lat would have only marginal 
economic impact on American interests.  Only one bank in 
Latvia is American-owned and any decrease in bilateral trade 
and investments between Latvia and the US would not be 
significant from the perspective of the huge US economy.  The 
main negative impact to the US would be the possible 
tightening in Latvian government resources to expend on such 
items as foreign assistance, a diminution of Latvia's 
pro-free market voice in the EU and, if Danske Bank's 
analysis is correct, the combined spillover effect into the 
economies of other allies in the Baltics and Eastern Europe. 
To avoid this economic crisis, most agree that the GOL must 
act soon to curb growth and inflation.  The recent statements 
by Standard & Poor's and Danske Bank give the government 
political cover to enact measures that would have been 
difficult to support three weeks ago.  If the government can 
tighten spending and begin to curb real estate speculation, 
it could influence the economy towards a more sustainable 
trend long-term.  End Comment. 
BAILEY