LATVIA CONCLUDES IMF DEAL: DIFFICULTIES REMAIN

C O N F I D E N T I A L SECTION 01 OF 02 RIGA 000401 SIPDIS DEPT FOR U.S. DEPT OF TREASURY D. WRIGHT E.O. 12958: DECL: 07/31/2019 TAGS: ECON EFIN PGOV LG SUBJECT: LATVIA CONCLUDES IMF DEAL: DIFFICULTIES REMAIN Classified By: Charge d'Affaires, Bruce R. Rogers, for reasons 1.4 b an d d. ¶1. (U) Summary. Latvia concluded an agreement and signed a new Latter of Intent (LOI) with the International Monetary Fund (IMF) on July 27 following weeks of tense and politically sensitive negotiations. The deal will allow Latvia to access the second tranche of its aid package (USD 285 million). The deal calls for small adjustments to Latvia's 2009 budget as well as targets and strategies for deficit reduction in 2010 and 2011. The IMF predicts a continuing deterioration of Latvia's economic climate over the next 18 months. While the five coalition political parties all signed the LOI, there is no guarantee they will be able to agree on specific spending cuts in the 2010 budget with parliamentary elections upcoming in 2010 and a divisive public debate amongst ministers of the coalition already in full swing. End summary. Brief Background -------------- ¶2. (U) Latvia, faced with the largest economic contraction in the European Union, signed a stand-by agreement with the IMF in December 2008. This agreement required Latvia to maintain a budget deficit in 2009 of not more than 5 percent of gross domestic product (GDP). However, a dramatic worsening of the economic situation required significant additional budget austerity measures and forced Latvia to renegotiate its agreements with the European Commission (EC) and the IMF. Budget Deficit Deterioration and IMF-EC Divergence -------------- -------------- ¶3. (C) According to the IMF's lead negotiator, Mark Griffiths, the IMF and EC are both extremely skeptical that Latvia will be able to reduce its budget deficit to the Maastricht Treaty required level of 3 percent of GDP by 2012 or even 2014. This means Latvia's adoption of the Euro may be indefinitely delayed and pressure on the Lat is likely to surge occasionally as economic conditions fluctuate. Unfortunately, Griffiths noted this was one of the few points of agreement between the EC and the IMF during their negotiations with the Latvian government. ¶4. (U) The IMF is calling for a budget deficit of no more than 13 percent of GDP in 2009 and 12 percent of GDP in 2010. This is in sharp contrast to the MOU signed between the EC and the Latvian government, as amended on July 13, which calls for a budget deficit of no more than 10 percent of GDP in 2009 and 8.5 percent of GDP in 2010. The reason for this difference is twofold. First, the IMF and EC are using different methodologies for calculating the budget deficit. And, second, they have different economic forecasts for how the Latvian economy will perform. The IMF is predicting a larger deterioration in the economy, particularly in 2010, and is calling for a larger reduction in spending. The EC, on the other hand, is calling for a smaller reduction in spending in 2010 based on a more optimistic budget and economic outlook for 2010. ¶5. (C) Griffiths acknowledged that the EC had delayed disbursement of its large tranche of money (EURO 1.2 billion, disbursed on July 27) pending progress in the IMF's negotiations. And both the IMF and the EC emphasized the importance of their coordination in their respective press releases. However, Griffiths complained that the EC had signed off on Latvia's budget deficit reduction plan prematurely and without actually looking at the numbers or structure of the cuts in the amended 2009 budget. Griffiths lamented the rushed process for the initial cuts and the failure of the EC to review the numbers prior to publicly supporting them. ¶6. (C) The amended budget cuts adopted at the behest of the IMF and EC were undertaken in a very short timeframe immediately following Latvia's municipal and European Parliamentary elections in June. Latvian politicians admit that the rushed process produced a poor result with across the board reductions rather than sustainable structural reforms. For example, Griffiths emphasized the failure of the government to adequately account for some degree of social spending required in a crisis. Unfortunately, the public and political backlash of the rushed budget process means it will be more difficult politically for the governing coalition to push through the necessary cuts to the 2010 budget this fall. ¶7. (U) It is important to note that Griffiths stressed that the IMF and EC teams had built trust during the negotiations. RIGA 00000401 002 OF 002 Griffiths expressed optimism that the IMF and EC would be more in-sync moving forward, which will be essential since any signal of divergence could unsettle the markets. Hard Work Still to Come -------------- ¶8. (U) Despite the positive outcome of the negotiations, Latvia's economic problems remain severe. The IMF is projecting an 18 percent decline in GDP for 2009 and another four percent decline in 2010. Given the contractionary nature of the fiscal cuts, the budget outlook for 2010 is expected to be even worse, requiring an additional USD 1 billion cut in 2010. Second quarter growth will show a steep decline in economic activity, as exhibited by just published figures showing a 29 percent year-on-year and 5 percent month-on-month slide in retail sales in June. ¶8. (C) This difficult economic situation and the dramatic fiscal cuts necessitated by Latvia's currency peg to the Euro have created a tense political environment. The chairwoman of the ruling New Era party, Solvita Aboltina, told PolEcon Chief that she was concerned about the 2010 budget process. Aboltina said that the largest coalition party, the People's Party, might try to bring down the current coalition by balking at concluding a budget agreement in the first or second reading of the budget bill as early as this October. (Note: The People's Party spooked the markets on July 27 when it briefly delayed its signing of the LOI after word had already leaked that a deal was done.) The current government has only been in power since March of this year, following the collapse of the previous government after street demonstrations and its failure to pass its own budget amendment. However, Aboltina said she thought it was more likely that the People's Party will talk tough but refrain from such a divisive move until closer to the parliamentary elections next fall in an attempt to avoid blame for the tough economic consequences of the budget reductions. ¶9. (C) While the IMF deal provides reason to hope that the governing coalition will cooperate on making the necessary budget cuts to stave off economic collapse. Based on the already acrimonious and very public political debate between members and even ministers of the governing coalition, the IMF deal is no guarantee that Latvia is out of the woods. ¶10. (U) Please direct any specific questions regarding this issue to Pol/Econ Chief, Hagen Maroney, at maroneyhd@state.gov. ROGERS