Economic Turmoil in Latvia
What kind of crisis was Latvia experiencing in 2008, a currency crisis, banking crisis, or debt crisis? What started Latvia’s turmoil was a banking crisis. In 2008, Parex, Latvia’s largest private bank, revealed that it was in financial distress and requested government assistance. The bank that had made some risky and extended loans during the country’s more prosperous years, found itself on the verge of collapse. While government tried to save the bank by injecting 200 million lats (about $390 million) into the bank, the institution did not recover and was shortly nationalized.
However, this only increased fear that the Latvian currency would have to be devalued and investors began to pull their currency out changing it into euros and dollars. Currency speculators also joined the chaos, betting that the government would have to devalue the lat and selling it short. Eventually, the IMF, the European Union, neighboring Sweden and Finland, and the World Bank provided assistant to the country to help it pull out of what had turned into a currency crisis. 2. If the IMF had not stepped in with support, what do you think might have occurred?
It is difficult to predict what would have been of Latvia with so many uncertain variables. However, I think that if the IMF had not stepped in to aid Latvia, the economy would have collapsed completely. One possible outcome would have been the devaluation of the lat against the euro. This would only have been a short-term solution, as it would have created many additional problems. One of the biggest issues being the fact that many Latvians had borrowed in euros. The depreciation of the lat would cause a dramatic increase the cost of servicing these loans in local currency.
Which in turn, would cause immediate hardship for local borrowers. 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 political consequences of those actions be? It is uncertain whether the Latvian government would have been able to avoid the 2008 crisis. The government could have established more strict regulations to prevent risky types of loans early on. Another preventative step would have been to raise interest rates when the economy started overheating, as critics had suggested.
This would have allowed the government to more easily control the circulation of money and the value of the lat. However, it is impossible to determine whether these policies would have, in fact, prevented the turmoil in Latvia. 4. What do you think the short-run consequences of the IMF policies will be for Latvia? What might the long-term consequences be? The IMF’s recovery plan was very demanding and extreme. Almost immediately, Latvia would endure a radical change in its economic policy. As part of the agreement with IMF, Latvia would face increases in interest rates, wage cuts, sharp cutbacks in government spending, and tax increases.
This would cause a recession in the short-term, but it would instill a sense of confidence in the country’s banking system and in the ability of the government to maintain the peg of the lat to the euro. Ideally, these modifications in the long run would cause conditions in the Latvian economy to improve and the country to start to grow again. Also, I believe that the government will be monitoring and regulating the economy more attentively in order to continue growing and avoid future fiscal crisis. Hopefully in 2014, Latvia will be stable and qualify to adopt to euro.