What kind of crisis was latvia experiencing in 2008

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Reference no: EM13229425

Latvia, a country of 2.5 million people, is one of the three Baltic states that gained independence after the collapse of the Soviet Union. For most of the 2000s, the economic story in Latvia has been one of rapid eco- nomic growth powered by a vibrant private sector. The country joined the European Union in 2004 and pegged its currency, the lat, to the value of the euro. The eventual goal for Latvia was to adopt the euro. To maintain parity against the euro, Latvia used a varia- tion of a system known as a currency board, where local currency in circulation is backed, unit for unit, by re- serves of foreign currency, which in Latvia's case was primarily the euro.

From 2006 onward repeated warnings indicated the Latvian economy might be overheating. Increasingly, an economic boom was being sustained by inflows of foreign money into Latvian banks, particularly from Russia. For their part, the banks were using these funds to finance aggressive lending, including leading to an increasingly frothy property market, with prices being bid up by borrowers who could get access to cheap credit. Critics urged the government to rein in the lend- ing by raising interest rates, but to no avail. What the government failed to do, the market ultimately did anyway.

The boom started to unravel in 2008 as a global eco- nomic crisis that began with overvaluation in the U.S. property market rolled around the world. For Latvia, the trouble began when the nation's largest private bank, Parex, revealed it was in financial distress. Hurt by rising defaults on the risky loans it had made, Parex sought government help. The government stepped in, initially injecting 200 million lats (about $390 million) into the bank. This did not solve Parex's problems. With deposi- tors rapidly withdrawing money, the government was forced to nationalize the institution. Far from halting the crisis, this seemed to deepen it as individuals and institutions started to pull their money out of the lat, changing it into euros and U.S. dollars. Currency specu- lators also joined the fray, betting that the government would have to devalue the lat and selling lats short. This put enormous pressure on the Latvian currency, forcing the country's central banks to enter the foreign ex- change markets, buying lats in an attempt to maintain the currency peg against the euro. In less than two months, the bank went through more than a fifth of its total foreign exchange reserves, but the money contin- ued to flow out of the country.

One solution to the crisis would have been to devalue the lat against the euro. However, this would have created additional problems. Many Latvians had borrowed in euros. If the lat was depreciated against the euro, the cost of servicing their loans in local currency would have jumped by an amount equal to the depreciation, causing immediate economic hardship for local borrowers.

In December 2008, the Latvian government ap- proached both the European Union and the International Monetary Fund, asking for help. The IMF took the lead in putting together an international rescue package, which totaled some 7.5 billion euros in loans from the IMF, the European Union, neighboring Sweden and Finland, and the World Bank. These funds were to be used to protect the value of the lat against the euro. Sweden and Finland contributed 1.8 billion euros to the fund, largely because Swedish and Finnish banks had large stakes in Latvian banks, and the concern was that problems in Latvia could damage the banking systems of these two countries.

As part of the conditions for the loan, the IMF re- quired significant change in economic policy from the Latvian government, including interest rate increases, wage cuts, sharp cutbacks in government spending, and tax increases. There was no question that these policies would push Latvia into a deep recession. The belief of the IMF, however, was that they were necessary to re- store confidence in both the country's banking system and in the ability of the government to maintain the peg of the lat to the euro. Once that has been achieved, so the argument goes, conditions will improve and the country will start to grow again. Be that as it may, some Latvians reacted to the deal by rioting in the streets of Riga, the capital. Forty people were hurt, including 14 police officers, and 106 arrests were made, suggesting that the road ahead would be bumpy.

Case Discussion Questions

1. What kind of crisis was Latvia experiencing in 2008, a currency crisis, banking crisis, or debt crisis?

2. If the IMF had not stepped in with support, what do you think might have occurred?

3. Could the Latvian government have headed off the 2008 crisis? What policy actions could it have to do this? What might the economic and politi- cal consequences of those actions have been?

4. What do you think the short-term consequences of the IMF policies will be for Latvia? What might the long-term consequences be?

Reference no: EM13229425

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