• All five coalition parties in the Latvian government have now signed a deal to agree with the IMF on the conditions for the payout of the next instalment on Latvia’s IMF deal.
  • This secures some calm for now, but we are worried about possible fiscal concerns later this year.
  • There are clear indications that the support for the IMF deal from the coalition government is fragile so we advise investors to keep a close eye on political developments in Latvia as the sustainability of any deal with the IMF seems questionable.

After initially saying it would not sign, last night Latvian’s People’s Party finally agreed with the other coalition parties to sign a deal with the IMF, which led to the recommendation from the IMF staff in Riga to pay out the next instalment on Latvia’s IMF loan (see the IMF staff statement here). This is likely to be received positively by the markets, but given how this deal was reached one cannot help being somewhat sceptical about what the coming months will bring.

What does the deal mean?

First of all, with the payout of the next instalment of Latvia’s loans with both the IMF and the EU it now seems likely that enough funding will be in place to keep the Latvian government afloat in fiscal terms for the rest of the year – but if the economic crisis becomes deeper than forecasted by the IMF (a drop in GDP of 18% this year) or more money for the banking sector is needed, the Latvian government might have to go back to international lenders already later this year for additional funds. Hence, the budget should be safe for this year, but there is not much room for negative “surprises”. In that respect it should be noted that Lithuanian GDP in Q2 dropped 22.4% y/y – significantly more than our expectation of 17.4% y/y and the consensus expectation of 16.7% y/y. This is in our view an indication that the drop in Latvian GDP in Q2 will also be worse than expected and that the IMF’s forecast of a drop in GDP of 18% y/y is too optimistic, which implies that the budget situation will be worse than the IMF assumes both this and next year. Therefore the budget deficit is likely to exceed 10% of GDP in both 2009 and 2010 in our view– even taking into account the planned budget cuts.

Second, effectively the EU and the IMF are now in charge of Latvia’s fiscal policy - or at least seem to have the power to veto nearly all fiscal decisions - as the supplementary Memorandum of Understanding between Latvia and the European Commission (and also likely the IMF/Latvian Letter of Intent) will seriously restrict the Latvian government in making fiscal decisions without the explicit acceptance from both the IMF and the EU.

Third, a number of fiscal measures will have to be implemented in the 2010 budget. That budget is far from having been passed. One of the measures mentioned is the possible introduction of a progressive income tax in Latvia – instead of the present flat tax. This apparently has been a demand from the IMF – or at least the IMF is suggesting this as a way to improve the budget situation. Given the state of public finances in Latvia it is obvious that a tightening of fiscal policy is warranted, however, we have a hard time seeing how the introduction of progressive taxation could bring much revenue in a country already plagued by tax avoidance (see more on the progressive income tax and the internal opposition in the Latvian government below).

Fourth, the fact that the IMF is willing to pay the next instalment to Latvia will have ramifications for other countries as the IMF has now clearly demonstrated that it is willing to accept significant fiscal slippage without it having a real impact on the likelihood of receiving funds from the IMF. Hence, the IMF now expects the budget deficit to reach 10% of GDP in 2009 – double of what originally was agreed between the Latvian government and the IMF. It is hard to imagine that other countries would not read this as an implicit acceptance from the IMF to accept fiscal slippage. In that regard it should be noted that the Romanian government, which also has IMF loans, yesterday announced that the budget deficit in 2009 will be higher than originally expected (this as the IMF starts its mission to Romania this week). IMF’s leniency on Latvia should rightly lead the Romanian government to expect that the IMF will be lenient with Romania as well.

Finally, some words of caution. With the (likely) payout of the next instalment on Latvia’s IMF loan some calm has undoubtedly been secured for now, but we stress that the political situation in Latvia is still risky, especially concerning the adoption of the promised budget cut in the 2010 budget.

While the international news agencies overnight reported that the payout of the IMF money is now more or less “a done deal” the Latvian media stressed the political divisions within the coalition government and within the coalition parties.

It has been suggested that the People’s Party is seriously divided internally about the proposed budget cuts and about whether to support the IMF deal and this morning on the Latvian TV programme Labrīt, Latvija! (“Good morning Latvia!”) the leader of the People’s Party, Mareks Seglins said that the introduction of a progressive tax is “a absurd ideology and the People's Party never will support it”. Even though one could agree with Seglins’ reservations about the introduction of a progressive tax it seems somewhat odd that he would say so after signing a deal that is likely (at least partly) conditioned on exactly the introduction of a progressive income tax in the 2010 budget. Hence, indirectly Seglins is already questioning whether the People’s Party is in fact backing the deal with the IMF or not. We think that Seglins’ comments are meant for the “local audience”, but it could unnerve the IMF, the EU and the markets if the People’s Party continues to distance itself from the IMF deal. Hence, even though the IMF wisely has chosen to stay out of the local political bickering in Latvia it cannot ignore the local political developments if they threaten the passing of the planned and agreed budget cuts.