It is becoming more and more apparent that Latvia will not meet the demands of the agencies and organizations offering it loans of up to 7.5 billion EUR. Budget and public sector wage cuts of up to 40 % would effectively destroy education, medicine and law enforcement as they exist now. It does not matter that, theoretically, there are considerable inefficiencies and possibly great waste in the structures of governance which, after careful analysis and planning, could be reduced and eliminated. There is no time for surgical reconstruction, the government will or would have to use an axe instead of a scalpel.
Faced with the collapse of core public services and, probably, even the “untouchable” pension system, the government will most likely not be able to carry out deep enough cuts to satisfy the International Monetary Fund (IMF) and other lenders. It will not receive any external funds and, at some point during the summer, simply go bankrupt.
What will happen next under this scenario, is that the government will declare a moratorium (if not default) on its foreign debt, while the Bank of Latvia will be forced to let the lat (LVL) float freely (effectively quitting the pre-Euro accession process). This will enable the government to basically print money and undo some of the wage cuts, allowing public service employees to at least be able to pay for subsistence goods and services on the Latvian domestic market (food, rent and utilities).
The devaluation will be a disaster for all those with mortgages and loans in EUR as well as for the Swedish parent banks of Latvian banks that have lent billions over the past few years. By some calculations, the default of a substantial part of the Latvian private sector could knock several percentage points off the GDP of Sweden. For this reason, there could be radical measures taken by Swedish banks and the Swedish government. One measure could be the nationalization by the Swedish government of Latvian subsidiaries of Swedish banks. Another could be the formation of a “bad bank” style asset management company, as was done in Sweden in the early 1990s. One thing is clear -- there would be little sense in trying to foreclose on thousands, possibly tens of thousands of mortgages in default. There would simply be no market for these properties, as prices have already collapsed. The “bad bank” could take over most of these mortgages and simply wait for better times, renegotiating terms with the occupants of many houses and apartments, possibly selling off some at a later date.
A drop in the foreign exchange rate of LVL (possibly by 25 to 30 % -- a wild guess) as well as a surge in the money supply will eventually push the country back into double-digit inflation, at least on imported goods and services and domestic goods and services with substantial imported inputs (energy, raw materials). At the same time, Latvian export prices will drop by as much in the short-term, catching up with or exceeding the depreciation of “competing” currencies such as the Swedish krona and the Polish zloty. This could give a temporary boost to the export sector of the economy. Whether that will suffice to turn around the decline in Latvia’s GDP (possibly up to 20 % in 2009) is doubtful. The mass default of private, EUR denominated mortgages will freeze new lending and destroy any credit standing the economy had, so on can probably forget about a recovery in lending to spur the economy. Most likely, Latvia will stagnate with high inflation until 2015 or beyond. With a recovery of the global economy in late 2010 or 2011, we will witness a new wave of labor emigration to other EU countries. This will not be a purely economic choice, but also a choice of governance and social environment made possible by Latvia’s membership in the EU. Latvian socio-economic exile/emigrant communities in Ireland, Great Britain and possibly Sweden will grow and essentially become permanent, contributing only repatriated funds to the Latvian economy. But all of these processes will, to a large extent, be the result of short-sighted, ignorant and corrupt policies over many years, leading to irreversible economic decline and societal degeneration.
