Tough decisions finally showing positive results

RIGA - Rating agency Standard & Poor says that due to the substantial and sustained government wage cuts Latvia has undergone as part of austerity measures to reduce its budget deficit, the country is on the road to improved competitiveness, reports news agency Bloomberg. “Wages are adjusting sharply lower, both in the public and private sectors,” says S&P analyst Frank Gill.

“There are some indications of the beginning of a recovery of exports, and the early days of a reorientation of the trade sector towards external demand.” After a 19 percent economic collapse during last year’s third quarter, the European Union’s biggest decline, the government of Prime Minister Valdis Dombrovskis (New Era) satisfied international lenders by implementing an austerity budget and shrinking the spending deficit. Latvia’s interbank lending rates have dropped and credit-default swaps are down.

Latvia was forced to turn to a group of international lenders, led by the European Commission and the IMF, for a 7.5 billion euro loan package in late 2008 after its second-biggest bank, Parex, failed due to a run on deposits amid the turmoil in the global financial markets. The country, which runs a fixed-exchange rate to the euro, is using the so-called ‘internal devaluation’ of deflation and public and private sector wage cuts to restore competitiveness after the real-estate fueled boom of the go-go years pushed annual wage increases of about 30 percent a year. Public sector pay packages are now down about 45 percent from their 2007 peak, and private sector salaries have fallen between 5 percent and 30 percent over the last 18 months, depending on the sector.

Gill says that “Wage levels are once again very competitive versus Poland, for example. The current policy stance, while indisputably pro-cyclical, is laying the foundations to stabilize public finances. Stimulus to the economy will have to come from outside. This continues to mean that Latvia remains more vulnerable than your average economy to the external environment.” While the economy may grow in real terms in 2010, the recovery will be “largely statistical,” driven by inventory re-stocking, according to Gill. Nominal GDP will probably still decline this year, he said. The decline in output has boosted the unemployment rate to 22.8 percent in December, the EU’s highest, according to Eurostat.

“What is missing is job creation,” Gill said. “Only job creation will put a floor under the economy. Until then, without question, wage deflation and rising unemployment will weigh heavily on public finances.” S&P rates Latvia BB, two levels below investment grade, with a negative outlook, meaning that the next rating adjustment is more likely to be down than up, or unchanged. The grade may worsen if the government’s resolve to continue to shrink the deficit weakens before elections this October, Gill warns. Further evidence of a “long-term commitment” to reaching euro-adoption goals would “help anchor the rating,” he said. “There are grounds for optimism here, given the scale of adjustment that has already occurred, and the successful passage of an ambitious 2010 budget,” Gill said. “Latvia has taken measures that would be very difficult to implement in many Western European countries.”

Fitch Ratings rates the country BB+, its highest junk rating, with a negative outlook. Moody’s Investors Service, rates Latvian debt Baa3, its lowest investment grade, also with a negative outlook.