Flawed Latvia Rescue Defers EU's Financial Disintegration

With numbers in the trillions being thrown around today, it was no surprise that the recently concluded $10.50 billion rescue package for Latvia failed to find its way into the news headlines. The emergency aid amounts to $4,000 for every man, woman and child in Latvia; and, in that respect alone, the IMF-driven bailout qualifies as the largest ever in relation to a country’s size. But, more importantly, all that the $10.50 billion will do is to postpone the need for Europe to address painful, long-outstanding issues relating to its integration.

For Europe, and for the Nordic region in particular, Latvia’s viability as a credible modern-day nation-state is crucial. “The concept of a successful communism-to-capitalism transition is being finally tested,” a parliamentarian in Riga, Latvia’s capital, declared as talks with the IMF wound down late last month. “Our success will influence not only shape of the rest of Baltics (including Estonia and Lithuania) but also the other former Soviet satellites in Eastern Europe.” Significantly, nearly 70% of the money for Latvia will originate in Europe, though the conceptual format of the package was structured by the IMF.

Not that the IMF has a record to be proud of. In the 1990s for example, the IMF signed six loan restructuring agreements with Argentina. None of those agreements addressed the most fundamental of issues: Where is the growth going to come from to service international debt obligations and to maintain currency stability? Latvia strongly resisted a devaluation of its currency (the lat) in order not to default on foreign loans; but the same reluctance to devalue is creating conditions which will make it impossible to comply with its debt obligations.

The EU, of course, is not only worried about Latvia. Hungary, which secured a $25 bailout from the IMF, the World Bank and the EU last year, continues to struggle to implement IMF-imposed austerity measures. “The last item on our agenda today is growth,” a Hungarian central banker conceded. The fact is that none of the former Soviet satellites were qualified to merge (economically and financially) with Western Europe; today, albeit with the wisdom of hindsight, the May 1, 2004, “Eastern Bloc” enlargement of the EU appears destined to drag the older EU members further into a veritable quagmire, as if their own problems were not enough.

In addition to being justified on other considerations, the case for modest short positions in Europe-based Exchange-traded funds (ADRU, FEU, FEZ, PEH) and aggressive shorts in geographically-specific ETFs is supported by a thorough examination of the terms of Latvia’s $10.50 billion package; while Sweden (EWD) has a significant exposure to the Baltics, Austria (EWO) will suffer from a rapid, and often uncontrollable, dwindling of the consumer market in South-Eastern Europe.

Going back to Latvia, the IMF and the EU have refused to acknowledge certain key historical realities. Latvia’s entry into the modern world, engineered by Czar Peter (“the Great”), who conquered Latvia in the 18^th century, was primarily due to the transformation of Riga into the third largest port in the Russian Empire, even surpassing St. Petersburg in trade volume. But since Czar Peter, no Latvian ruler (i.e. a succession of independent Latvian governments since the First World War and the Soviet Union after the Second World War) have been able to find that right balance between industrial growth, agricultural productivity and people migration. In fact, several hundred factories built in and around Riga during, and prior to, communist rule, are now desperately in need of upgrading, if they are to survive at all. And Latvia’s agricultural complex today is entirely at the mercy of “exportable produce” to its EU neighbors.

In contrast to the economic status of the former Soviet satellites, countries like the UK, Germany and France have undergone a thorough transition to capitalism over an extended period of time. But has Latvia’s IMF package addressed this systemic imbalance between Western and Eastern Europe? No. A drastic devaluation of the lat is a prerequisite for such an imbalance to be corrected. Without that, Latvia and, for that matter, other former Soviet satellites (with the possible exception of the Czech Republic, Slovakia and Poland, at this juncture) will lurch from one crisis to the next.

Disclosure: Author holds short positions in ADRU, EWD, EWO