Latvia is back in the headlines as talks between the government and the IMF over its second loan instalment continue to flounder over differing budgetary views.
The analyst community is now interpreting the deadlock as yet another possible chink in the armour of Latvia’s euro-peg defence. Here, for example, is the latest from RBC Capital Markets’ emerging markets team:
Latvia was back in the spotlight on Wednesday amid heightening concern/uncertainty that the IMF might freeze its loan agreement. To re-cap, in Dec-08 Latvia secured a EUR7.5bn joint EU and IMF loan package (41% coming from EU). EUR600mn was paid out from the IMF late last year and EUR1bn from the EU in early-2009, followed by an EUR1.2bn EU payout earlier this month.
However, it has not been able to secure a second EUR200mn IMF payout, as the Fund is now pushing for an even bigger fiscal adjustment as this year’s fiscal deficit is spiralling outs of control (10%/GDP+) while the gov’t is resisting, hoping to prevent an even deeper growth collapse (GDP already F at -20% this year). The IMF apparently wants to see further tax hikes (VAT, capital gains, real estate) and deeper spending cuts (notably to pensions). A bigger fiscal adjustment is now even more important as half of the latest EU EUR1.2bn funding is earmarked for banking sector support measures (not 100% for budget support as had been expected).
Moreover, any further EU funding support is conditioned on meeting IMF funding approval. Latvia’s PM signalled Wednesday he is cautiously optimistic agreement with the IMF will be reached (talks are expected to continue into next week) if the IMF is willing to show some flexibility on the pension issue.
Latvia’s five-year CDS spreads have, however, not reacted to the chaos just yet. Spreads on Wednesday were still fairly stable. The overnight rigibor rate, meanwhile, was also muted compared to the spikes experienced earlier in the year on initial lat devaluation concerns.
One reason for that may be, as RBC point out, that Latvia is not facing an imminent financing crunch just yet. Accordingly, they still have time to negotiate. But the analysts still warn none of this bodes well for the country’s currency peg in the end. In their view the government will most likely be forced to unpeg before the end of the year:
Ultimately, we don’t believe the IMF/EU will bail on Latvia given CEE FX-regime/financial asset/economic contagion risks as well as the negative impact it would have on West-European banks. However, the longer it takes Latvia to get its fiscal/funding issues in order, it will only increase risks of a disorderly economic adjustment and collapse of the fixed FX regime (we believe a de-pegging of the LVL is inevitable by year’s end), likely disturbing recent regional stability. Developments bear very close watching, and the situation could mark a signal the IMF is starting to get tougher with its clients.