Case Study 5

Economic Turmoil in Latvia

September 11, 2014

General Description and Central Issue of the Case
The Republic Latvia is a country of 24,938 square miles on the Baltic Sea, with 310 miles of shoreline. The country shares borders with Lithuania, Belarus, Estonia, and Russia. Latvia, Lithuania, and Belarus are three Baltic States that gained independence after the fall of the Soviet Union (Hill, 2013). Latvia declared independence on May 4, 1990. The population of Latvia is 2,165,165 with an ethnic makeup of Latvian 61.1%, Russian 26.2%, Belarusian 3.5%, Ukrainian 2.3%, Polish 2.2%, Lithuanian 1.3%, other 3.4% (CIA, 2014). Natural resources include peat, limestone, dolomite, amber, hydropower, timber, and arable land. Latvia is often too wet and in need of constant drainage. Approximately 3,953,686 acres of farmland or 85% of Latvia has been improved by drainage for agriculture. Latvia’s primary agricultural products are grain, rapeseed, potatoes, vegetable, pork, poultry, milk, eggs, and fish. Industry includes processed foods, processed wood products, textiles, processed metals, pharmaceuticals, railroad cars, synthetic fibers, and electronics (CIA, 2014).
The labor force sector that makes up Latvia’s GDP composition is 4.9% agriculture, 25.7% industry, and 69.4% services. Taxes make up 35.9% of Latvia’s GDP, with a public debt of 39.2%. The unemployment rate is 9.8%, and the industrial growth rate is 4.2%. Latvia has 10.9 billion in revenue and 10.95 billion in expenditures.
Last year Latvia exports were $12.67 billion, slightly up over 2012 $12.23 billion. Latvia exports food products, wood and wood products, metals, machinery and equipment, and textiles, with export partners Russia 18.2%, Lithuania 14.9%, Estonia 12.1%, Germany 7.5%, Poland 5.6% and Sweden 4.8%. Imports for last year were $15.56 billion, up over 2012 total of $15.15 billion. Latvia imports machinery and equipment, consumer goods, chemicals, fuels, and vehicles with import partners Lithuania 19.1%, Germany 11.6%, Russia 9.2%, Poland 8.2%, Estonia 7.6%, Italy 4.6% and Finland 4.4% (CIA, 2014).
The central issue of the case involves Latvia’s currency. Latvia joined the European Union in 2004 and tied it’s currency, the Lat, to the Euro. Eventually, Latvia’s goal was to adopt the Euro as the currency of Latvian. A currency board is a monetary authority that makes decisions on the valuation of a nation's currency, specifically whether to peg the exchange rate of the local currency to a foreign currency, an equal amount of foreign currency is held in reserves. The currency board then allows for the unlimited exchange of the local, pegged currency for the foreign currency (Investopedia, 2014). The Latvian government matched the Euro unit for unit with the Lat.
Around 2006, Latvia saw a large influx of foreign currency into Latvian banks. This in turn kept the interest rates artificially low, and credit was easy to obtain. Latvian banks were using this money to finance aggressive lending, including an unstable property market. Real estate investors, who could get low-interest loans, were driving real estate prices artificially high. The model was unstainable, and by 2008, the over-inflated US housing market started to collapse. Even though Latvia’s GDP grew by more than 10% in 2006, and 2007, in 2008 Latvia experienced a severe recession. The recession was a result of an unsustainable current account deficit and large debt exposure in the world economic recession. Risky loans caused the collapse of the nation’s largest bank, Parex, triggered Latvia’s recession. The country’s GDP plunged 18% in 2009, and the economy has not yet returned to pre-2008 levels, despite strong growth (Hill, 2013).
The Latvian government of Prime Minister Valdis Dombrovskis tried to slow the bank’s collapse by injecting 200 million Lats into the bank. This did nothing as people frantically withdrew their money from the banks. The government nationalized Parex bank to try to slow the bank’s collapse. This did not affect the downward spiral as institutions withdrew their currency and started exchanging Lats for Euros and U.S. dollars. Currency speculators were adding pressure to the situation by gambling that Latvia would devalue the currency and have to sell the Lats short. The Latvian central banks were forced to enter the foreign currency exchange market and buy Lats to bolster the currency peg against the Euro. In two months’ time the country had gone through 20% of their total foreign exchange reserves (Hill, 2013).
Latvia’s Goals, Constraints, and Relevant Alternatives The countries’ goals would be the same for any country experiencing economic distress. Latvia would like to capitalize on the strong economic growth they are experiencing post-2008. With substantial financial assistance from the IMF, the EU, and other international donors to defend the Latvian currency’s peg to the Euro, the Latvian economy is remaining stable, not showing signs of improvement, but not getting worse. Collectively, the assistance amounted to 9.3 billion Euros. Latvia would like to make a full economic recovery, and the government does not want the Lat devalued against the Euro. This scenario would have created more economic hardship for Latvians.
There were constraints placed on Latvia by the IMF, the EU, Sweden, and Finland, the conditions imposed on the emergency funding required significant changes in the Latvia economic policy. Those conditions included interest rate increases, wage cuts, cutbacks in government spending and tax increases (Hill, 2013). The Latvian government had to commit to stringent austerity measures as part of the agreement. These agreements pushed Latvia into a deeper recession. The lending parties felt that this action was necessary to restore confidence in the nation’s banking system (Hill, 2013). This in turn would be the catalyst for economic growth. The actions taken by the government caused rioting in the capital city of Riga with many injuries and arrests. The IMF/EU funding program concluded in December 2011 and the government remains committed to fiscal prudence and reduction of the fiscal deficit. Most companies, banks, and real estate have been privatized with the exception of a few large enterprises and Latvian national airline, which the government retains 99.8% ownership. Latvia joined the WTO in February in 1999 and intends to join the Euro zone in 2014 (CIA, 2014).
Corruption continues to be an impediment to attracting foreign direct investment and Latvia's low birth rate and decreasing population are major challenges to its long-term economic vitality (CIA, 2014).
One alternative the Latvian government did not want to pursue was the devaluation of the Lat against the Euro. This would have been devastating to the Latvian people and would have prolonged the economic recovery. Most loans were in Euros, and the devaluation would have caused immediate economic hardships, as borrowers would have been forced to repay the loans in devalued Lats. The Latvian government chose to accept financial help from outside sources; this was another alternative. A third alternative would have been to accept the international help and to impose new banking laws that would prevent this from happening again. The U.S. economic crisis caused by an over inflated housing market took down many other countries’ economies around the world. Latvia could have insulated themselves from the worst of this by implementing banking laws with more stringent restrictions on loans for residential real estate. The Latvian government needs to control spending. Taking in 10.9 billion in revenue, and having 10.95 billion in expenditures is not a sustainable model.

Best Alternative Plan and Implementation The best alternative plan would be to change the banking laws, increase exports and agricultural, end government corruption at all levels, and control spending. Getting the unemployment rate down from 9.8% would also help with the economic recovery. Developing industry and increasing the industrial growth rate beyond 4.2% would also be a positive step. According to former U.S. Federal Reserve chairman Ben Bernanke, runs on the banking system during the U.S. Great Depression caused much of the economic damage (Bank run, 2014).
Latvia should have suspended withdraws of cash from Latvian banks as a stopgap measure to halt the currency speculation and to help the Lat maintain its strength against the Euro. The government would need to explain why this measure would have to be undertaken. If the people did not understand why they could not get their deposits out of the bank, there could be political unrest that may destabilize the government further complicating the situation.

Reference
Hill, C. (2013). International business: Competing in the global marketplace. United States of America: McGraw-Hill Education
Central Intelligence Agency (CIA). (2014, June). The world factbook. Retrieved September 11, 2014 from the CIA Web site: https://www.cia.gov/library/publications/the-world-factbook/geos/lg.html
Investopedia (2014, June). Definition of Currency Board. Retrieved September 11, 2014 from Investopedia Web site: http://www.investopedia.com/terms/c/currency_board.asp
Bank run. (2014, August 28). In Wikipedia, The Free Encyclopedia. Retrieved September 11, 2014, from Wikipedia Web site: http://en.wikipedia.org/wiki/Bank_run