LATVIA: DEVALUATION UNLIKELY BUT INVESTORS NERVOUS

C O N F I D E N T I A L SECTION 01 OF 02 RIGA 000166

SIPDIS

SIPDIS

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
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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?
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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?
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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

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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
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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