LATVIA: HARD SELL FOR GOVERNMENT ANTI-INFLATION

C O N F I D E N T I A L SECTION 01 OF 03 RIGA 000497

SIPDIS

SIPDIS

E.O. 12958: DECL: 07/05/2017
TAGS: ECON EFIN EINV PGOV LG
SUBJECT: LATVIA: HARD SELL FOR GOVERNMENT ANTI-INFLATION
PLAN, BUT DEVALUATION STILL UNLIKELY

REF: RIGA 166

Classified By: Ambassador Catherine Todd Bailey, for Reasons 1.4 (b) an
d (d)


1. (C) Summary. The government's anti-inflation plan has
been received skeptically, as evidenced by the downgrading of
Latvia's credit rating by Standard and Poor's in May. A
research group's June recommendation that Latvia devalue its
currency to help fight inflation and restore export
competitiveness gained press attention, but banking industry
experts and the government continue to discount the
possibility of a change in the lat-euro peg. Banking and
government sources cite the Bank of Latvia's coverage of the
lat with foreign reserves and the government's low debt to
GDP level as sources of stability. Political calculations
also do not make a devaluation as desirable as some academics
depict. Though large inflationary forces are still working
through the economy, an apparent slowdown in consumer lending
and real estate prices may reduce some of that pressure, if
government ministries can resist spending on favorite
projects. End Summary.

Government Takes Action
--------------


2. (C) The GOL's official response to recent inflation
concerns began on March 6, when the Latvian Cabinet of
Ministers endorsed an anti-inflation plan developed by a
Finance Ministry-led task force. The plan included 34
measures, with the most notable items aimed at decreasing
internal demand by moving the government's budget from
deficit to surplus by 2009 and limiting big-ticket government
construction projects, altering tax policy to curb real
estate speculation and purchases of luxury cars, and the
imposition of new regulations to control the growth of
consumer lending. The Bank of Latvia endorsed the plan, but
in meetings with the embassy, the Governor of the Bank
admitted that the plan was the bare minimum the government
could credibly propose. The plan was received skeptically by
banks and credit rating agencies, but the Bank of Latvia and
the ministries of Economics and Finance have been
consistently upbeat with predictions that the plan's positive
effects would be seen by this summer.

Skeptical Reaction
--------------


3. (U) The rating agencies Standard and Poor's and Fitch both
noted their concerns with the pace of the government's
response to inflation over the last year and several press
articles questioned the government's commitment to reigning
in spending. The current budget valid through the end of the
year envisions extra spending for such items as NATO program
implementation and increasing wages for medical workers,
pensioners, judges and other officials. Doubts about the
government's ability to control spending were put in the
spotlight in early May when the Finance Minister floated a
proposal to increase the Value-Added Tax (VAT) from 18% to
20%, explaining that the "national budget cannot meet the
ministries' increasing demands anymore". This proposal was
quickly scuttled, aided by the Bank of Latvia's public
assessment that the VAT increase would raise average annual
inflation by 1 to 1.7 percentage points.


4. (U) The Saeima (Parliament) passed a package of
legislation to implement the anti-inflation plan on May 17,
however that was overshadowed the same day by an announcement
by Standard & Poor's (S&P) that they were lowering Latvia's
credit rating from A- to BBB . S&P attributed the
downgrading to an increased risk of a hard landing for the
Latvian economy and persistent external imbalances (Latvia's
current account deficit reached 25.7% of GDP in the first
quarter of 2007).

Optimism Pounded by BICEPS
--------------


5. (U) The government decried S&P's move as too hasty, and in
early June was able to point to a marginal drop in annualized
monthly inflation when the economic data for May was released
(8.2%, down from 8.9% in April),the first decrease in
inflation growth in six months. Once again, though, the
government's optimism was overshadowed by a gloomy forecast.
The Baltic International Center for Economic Policy Studies
(BICEPS) issued a study on June 7 which stated that recent
surges in producer prices and wages (with wage increases as
high as 23% over last year in some sectors, and a roughly 30%
hike in natural gas prices taking effect on May 1) had
already put more inflation into the pipeline, and that it is

RIGA 00000497 002 OF 003


possible that the Latvian economy has "shifted from a
position of simple overheating to something more serious in
structural terms". The economic press quickly picked up on
the study's conclusion that the lat (Latvia's currency) is
pegged to the euro at an unfavorable rate which is harming
Latvian exports and undermining the effectiveness of the
anti-inflation plan's fiscal measures. The report concluded
by mentioning the dreaded subject of currency devaluation
(see reftel),stating that "Latvia may eventually find itself
in a situation where the pain of a long and costly period of
deflation may be weighed against the cost of altering the peg
to strengthen competitiveness - and where the latter may be
the rational and less painful choice".

Experts Still Say Devaluation is Remote Possibility
-------------- --------------


6. (C) Despite the renewed public discussion of devaluation
that the BICEPS report generated, government and banking
sector economists still view devaluation as a very remote
possibility. Pol-Econ Chief spoke with economic specialists
from both GE Money Latvia and HansaBanka, and both said that
they did not see devaluation as a likely option for the
government. They cited, as often do the Ministry of Finance,
Prime Minister's Office and the Bank of Latvia, that the
central bank has enough foreign reserves to fully cover the
Latvian currency. The minor run on the lat that occurred
earlier this year, it is also pointed out, was not from banks
or institutional speculators, but was initiated by a
text-messaging campaign that the government believes was
linked to smaller currency exchange businesses trying to
capitalize on devaluation rumors. HansaBanka's economist,
Peteris Strautins, also pointed to the political cost of
devaluing the currency. While average consumer debt is at a
level comparable with other EU countries, he noted that
consumer debt levels have grown rapidly (60% over last year)
from a low base, and there are many Latvian households
dangerously overextended on credit. Given that 70% of
lending in Latvia is done in euros, a devaluation of the lat
would have disastrous consequences for those consumers, and
they could vent their economic frustrations on the ruling
coalition.


7. (C) Strautins added that a key stabilizing factor for the
government is the very low level of state debt (10% of GDP),
giving the government broad leeway to take on more debt to
address any politically-sensitive issues or needs during a
prolonged deflationary period. He said that he thought many
inflationary factors had in fact already turned the corner,
citing that consumer lending has started to drop
substantially, construction is slowing because of labor
shortages, and the real estate market is seeing falling
prices in some areas. (The Bank of Latvia's governor
confirmed these trends in a June 7 interview.) Strautins
said that this would help the government's anti-inflation
plan with reduced GDP growth. His main concern, Strautins
noted, is that the plan had come in too late and the effect
could be too much of a brake on the economy if it is indeed
slowing. He stated that he could envision GDP growth
dropping all the way to 4% next year (from 12% in 2006) in a
worst case scenario.


8. (C) Comment. At this time, it is impossible to say if the
government's anti-inflation plan can make a substantial dent
in inflation over the upcoming year, though there are
encouraging signs that lending and real estate pressures have
peaked. The BICEPS report cited a 15-month lag between
producer price increases and the resultant consumer price
inflation, so we will not immediately know if reductions from
any current cooling of the economy can offset the inflation
already in the pipeline. Energy prices will take another hit
in 2008, with a projected 15-18% hike in electricity rates,
and inflation expectations will be hard to overcome as
workers ask for further wage increases to make up lost buying
power. The government and Bank of Latvia continue to do
their jobs in maintaining optimism, and the government
projects 2007 inflation to end up in the 7-8% range. The
Bank of Latvia does appear committed to maintaining the
current lat-euro peg, and has the foreign reserves to do it.
From the political side, it is virtually impossible to see
the government opting for the BICPEPS report's recommendation
of a quick fix through devaluation of the lat under current
conditions. The thousands of consumers suddenly having to
earn more lats to pay off their euro-denominated debts would
likely blame the government directly for mismanagement of the
economy, while any blame for hardships caused by the current
anti-inflation measures could potentially be deflected
towards outside entities such as the credit rating agencies,
Nordic banks, or even the EU. While the government's efforts
address the current inflation dynamics, they do not address

RIGA 00000497 003 OF 003


the coming the tidal wave of $4.5 billion USD spread over
seven years of EU Structural Funds which will soon be hitting
the Latvian economy. End comment.
BAILEY