By Gideon Rachman
Published: August 3 2009 20:22
A writer who projects emotions on to the weather is guilty of the “pathetic fallacy”. But, at the risk of sounding both pathetic and fallacious, it was entirely appropriate that the sky darkened and the thunder cracked as I approached the office of the Latvian prime minister in Riga last week. The gloomy atmosphere reflected the dark mood in a small, embattled country of 2.2m people. While business headlines in the rest of the world speak of clearing skies and rays of sunshine, the Baltic states are still in the midst of a howling economic gale.
Despite the region’s small size, the intensifying crisis in the Baltics cannot be treated as a freakish local squall of little concern to outsiders. Bank failures or plunging currencies in the three Baltic nations – Latvia, Lithuania and Estonia – could threaten the fragile prospect of recovery in the rest of Europe. These countries also sit on one of the world’s most sensitive political fault-lines. They are the European Union’s frontier states, bordering Russia.
The economic downturns in the region are shocking. Last week, Lithuania announced that its economy had shrunk by 22.4 per cent, at an annual rate, during the second quarter of 2009. Latvia and Estonia are likely to record similar falls when they announce their figures. Dalia Grybauskaite, the Lithuanian president, told me last week that her country might have to apply to the International Monetary Fund for a loan. Latvia has already trodden that path. Last week it agreed its second loan in eight months from the IMF and the EU.
The injection of cash is the good news. The bad news is that, in return for shoring up state finances, the new IMF deal will require the Latvian government to impose yet more pain on its suffering population. Public-sector wages have already been cut by about a third this year. Pensions have been sliced. Now the IMF requires Latvia to cut another 10 per cent from the state budget this autumn.
So far, the population has treated the downturn with remarkable equanimity. There is little sign of extremist political parties making headway. But the government has good reason to fear a winter of discontent. Unemployment benefits last just nine months in Latvia. Many Latvians lost their jobs at the beginning of this year – and will lose their income from the state this autumn. Officially, unemployment is 11 per cent, unofficially it is 16 per cent and rising fast. Heating bills also shoot up in the cold Latvian winter. Cutting police pay by 30 per cent in such circumstances seems slightly foolhardy.
It would be easier if the Latvian government could point to some prospect that things will eventually improve. But the country seems to be locked into a downward spiral. Property prices – which a few years ago made flats in Riga pricier than apartments in much richer western European cities – have collapsed. The banks will not lend. Jobs are going, wages are falling, the government is cutting.
With no hint of a domestic revival, the Balts have to pray for a revival in the world economy. But the Russians and the Germans are not buying. “Our export markets on both sides are closed,” says Ms Grybauskaite.
One way to ease the pressure might be to devalue local currencies and so boost exports. But the Baltic states are all grimly hanging on to their “pegs” – fixed exchange rates with the euro. In Latvia about two-thirds of private loans have been taken out in euros. The government fears that devaluation would bankrupt many citizens. But wage cuts could simply provide an alternative route to bankruptcy.
Latvia’s paymasters – the EU and the IMF – seem divided. The IMF has been open to the idea of scrapping the peg. Brussels is firmly against, fearing that it would trigger currency instability, bank failures and competitive devaluations across the EU.
The Latvian and Lithuanian governments are adamant that they will not devalue. That is what all governments in their position always say – right up until the moment when the dreaded decision is made. Their reluctance is not simply to do with economic risk. The Balts also worry that if they devalue, they might come to look like second-class members of the European club – a dangerous position for countries that were part of the Soviet Union less than a generation ago.
The rest of the EU is already beginning to feel a little further away. The collapse of the main Lithuanian airline earlier this year means that the number of European cities you can fly to from the capital, Vilnius, has halved this year.
I last visited Vilnius in the early 1990s, when the place still felt very Soviet. It is moving and impressive to see how prosperous and cared-for the city now looks – and how many visitors from western Europe are visiting the sights and drinking in the cafés. Riga, too, now looks more like western Europe than Russia.
But, for the first time for a long time, there is a sense that these gains are under threat. The EU authorities in Brussels are well aware of what is at stake and are overseeing Latvia’s recovery efforts with an almost imperial authority. Europe’s fear of the destabilising effects of devaluation is completely understandable. But, in an effort to preserve the impression of stability in the Baltics, the defenders of the peg risk creating the conditions for another almighty economic thunderclap later this year.
Copyright The Financial Times Limited 2009
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