Consolidation for dummies

Latvia is well underway to stabilizing its public finances, but …

It really shouldn't be necessary to address, once again, the necessity for and strategy behind the consolidation efforts of the government but, given a continuing torrent of weird comment, it appears to be so. So here we go again….

1) It was upon Latvia's request that a loan package of 7.5 bill. EUR was put together at the end of 2008. It was not imposed on Latvia.

2) The main lender is the EU, followed by the IMF. Involved as lenders are also Sweden, Denmark, Poland, Estonia and the Czech Republic plus the World Bank and the European Bank for Reconstruction and Development.

3) The main points of the package were to recapitalize Parex, support the banking system in general and allow the government to run a budget deficit. Without the package Latvia would have had to balance its government budget i.e. it would have had to impose even more draconian austerity as was done.

4) The main exercise during 2009 – 2011 has been to create sustainable government budgets i.e. a level of expenditure more or less matched by the level of taxation and not the expenditure-revenue-out-of-sync fiscal policy of 2004 – 2007.

5) And the consolidation efforts have been successful: a) RIGIBOR, the interbank interest rate is now roughly at par with EURIBOR, indicating that financial markets no longer believe in devaluation of LVL, b) Latvia has been able to sell 10-year lats government debt for less than 7% interest rate, twice as high as for Germany, yes, but way lower than e.g. for Greece and, c) Latvian CDS spreads (the price of insuring against default) are currently a bit below Lithuanian ones, having come down no less than 1,000 basis points. In short, financial markets have reasonable confidence in the Latvian consolidation efforts.

6) And this credibility is of course exactly what is needed when, later this year, Latvia plans to sell much more debt by refinancing some of the international loans: As long as financial markets believe in the Latvian programme and as long as the same financial markets believe in Latvia's willingness to and ability to repay they will refinance at low interest rates, which is EXACTLY what the country wants.

7) Enter people like Armands Strazds, one of the "people whose ideas are ahead of our time", who in Neatkariga 14 February 2011, seemingly thinks that it would be ‘normal' if Latvia defaults on the international loans since the lenders have not earned this money but taken it out of thin air (check comments and analysis in English by my colleague, Young Dombrovskis, here). The latter statement is just preposterous – the EU countries for instance cannot print money – they have sold bonds to make the loan available to Latvia. The former is, well, also preposterous and expresses cynicism and arrogance vis-à-vis the lenders: a) the money borrowed has allowed budget deficits in Latvia i.e. not as much austerity as would otherwise have been needed, it has kept Parex afloat and helped save the banking system (we may dislike banks but try to do without them….) and b) Latvia's accumulated debt from this exercise is not even very high as can be seen from the graph below (Note: the debt ratio will have risen in 2010 due to the big budget deficit but it is still much lower than in most other EU countries and actually quite easily manageable, see example below).

The latest estimates say that Latvian debt-to-GDP will reach their maximum at 51%, way below e.g. Germany which certainly hasn't even remotely contemplated not to pay. Why not? Partly because Germans understand debt dynamics better than most Latvians, it seems.

Use a debt ratio of 51%, assume an interest rate of eventually 4% (Belgium currently pays a bit over 4% but also has a mountain of debt compared to Latvia), assume an inflation rate of 3% and a GDP growth rate of 4% (not that ambitious). This would still allow Latvia a budget deficit on the part of the budget not related to interest payments of more than 1% of GDP and still see the debt ratio shrink. Manageable? Piece of cake! The simple math here is to ensure that debt grows slower than nominal GDP, which actually doesn't take that much to achieve.

So Latvia is well underway to stabilizing its public finances after the spending frenzy of 2004-2007. But derailing this consolidation effort is certainly possible – it just requires political clout behind the dumb and preposterous statements my Mr. Strazds (and others) and before you can say ‘devaluation', financial markets will have reassessed Latvia's determination, interest rates will spike and the currency will come under renewed trouble.

So could we please ensure, for the good of Latvia (pun indeed intended!), that such voices remain marginalized?