Trouble in the Baltics Latvia's Crisis Mirrors Eastern Europe's Woes

Until recently, it was regarded as an economic success story. Now, Latvia could be on the "brink of bankruptcy."
Von Jason Bush

Linards Naglis says he can't sleep at night. For the past 15 years, the enterprising Latvian has made a good living as a project manager for a consortium of Western investors in his Baltic homeland, buying up land to be used for real estate development. But recently, Naglis -- and nearly all of his company's staff -- was handed his notice as business evaporated. Now, instead of planning family holidays to Florida, he worries about how he will pay household bills. His life savings, invested in property in Bulgaria, have vanished, too. "I never thought I'd be in this situation, to be honest," he says. "I wasn't expecting to be a millionaire, but I expected a comfortable, decent life. Now I really don't know what will happen."

Recent rapid growth of the Latvian economy has now turned into rapid shrinkage.

Recent rapid growth of the Latvian economy has now turned into rapid shrinkage.


Naglis' story is in many ways a metaphor for his entire country. Of all the nations hit by the global financial crisis, none has suffered such a devastating reversal of fortune as Latvia. The tiny Baltic Republic saw its economy shrink by a heart-stopping 10.5 percent year-over-year in the last quarter of 2008. A further gross domestic product slump of 12 percent is forecast for 2009. Despite a $7.5 billion bailout from the International Monetary Fund in December, the government is being forced into severe economic measures, including public-sector wage cuts of 15 percent.

It's a remarkable turn of events for a country that until recently was regarded as an economic success story. In the capital Riga, what immediately catches the eye is the striking evidence of recent economic development. The city has become a magnet for Western tourists, turning the city center into a colorful maze of fancy boutiques, cafés, and restaurants. Modern bank branches, mostly Scandinavian banks such as Sweden's Swedbank and SEB, are visible on every street corner.

Yet these conspicuous signs of wealth are deceptive. In January the picturesque streets of Riga's medieval old town became the unlikely setting for violent clashes between stone-throwing youths and police, after a peaceful demonstration by 10,000 anti-government demonstrators turned sour. Political turmoil culminated with the resignation of the center-right coalition government on Feb. 20. Latvia's newly appointed Prime Minister, Valdis Dombrovskis, has admitted the country is "on the brink of bankruptcy," urging the nation to accept the IMF-backed austerity package or face financial ruin.

Real Estate Repercussions

What went wrong? As the global recession bites, Latvia, a small and open economy, is being hit especially hard by declining exports. Its problems are exacerbated by having a currency pegged to the euro -- a linchpin of the country's economic policy that now looks increasingly problematic. But the foundations of the crisis were in fact laid years earlier.

It's a familiar tale of an overheated property market, fed by lax credit, excessive borrowing, and complacent regulators. "This real estate market was insane," says Aleksis Karlsons, a hotel owner and property developer in Riga. "The mentality set in: I own an apartment or two-that means I'm rich. People thought they were wealthy without doing anything." At their peak two years ago, apartment prices in Riga reached €2,000 per square meter ($234 per square foot). They have since plunged by more than 50 percent.

While ordinary Latvians can be partly blamed for their naivete, the government bears an even heavier responsibility for failing to prick the bubble when it had the opportunity. "The government did nothing to stop the party. Instead it joined in," says Peteris Strautins, chief economist of Swedbank in Riga. Even at the height of the boom, when the economy was growing by an unsustainable 11 percent a year, Latvia ran a budget deficit. Latvia's current account deficit, the excess of imports over exports and capital inflows, reached a colossal 25 percent of GDP in 2007.

These clear failures of macroeconomic management go a long way toward explaining why Latvia's situation is now so dire. But in some respects, like its Baltic neighbors Lithuania and Estonia, whose economies also are in trouble, Latvia is suffering because it followed orthodox economic advice, liberalizing its financial sector and opening the economy to outside capital and investment. "Accession to the European Union and the promise of accession to the euro gave investors a great feeling of security," says Jerry Wirth, president of RBM Property Group in Riga. He notes that many investors from Western Europe, including both individuals and banks, rushed to participate in the great property bubble.

A Painful Hangover

The implications go well beyond Latvia. To a greater or lesser extent, all the countries in Central and Eastern Europe are now waking up to a painful hangover after years of credit-fueled growth financed largely by Western banks. "They adopted a growth model that we used to think was the right one, based on capital flows, convergence, and European values," admits Erik Berglof, chief economist for the European Bank for Reconstruction & Development in London. "The model wasn't the mistake. The mistake was the lack of architecture to support the model," he adds, referring to the failure to monitor credit flows and the resulting bubble in asset prices. Now, he says, concerted international action is vital to manage the crisis facing the entire region, backed up by "significant financial resources."

That idea has become a topical theme of late, amid growing recognition that Eastern Europe's mounting economic woes could become contagious and start to affect Western European economies as well. But recognizing the danger of international contagion is so far proving easier than figuring out an appropriate response. Some Eastern European leaders were dismayed when, on March 1, German Chancellor Angela Merkel flatly rejected a Hungarian proposal for a €180 billion ($226 billion) aid package for the region. Other lifelines may be available, however. In February, G-7 finance ministers agreed in principle to double the IMF's funding this year to $500 billion, with details still to be hammered out at the IMF's annual meeting in April.

Even if such support measures are eventually put in place, they will do little to ease the immediate pain in badly affected countries such as Latvia. Long-term relief depends on global economic recovery, which still seems depressingly distant. In the meantime, most Latvians are putting a brave face on their difficulties, and praying for better times.

Bush is BusinessWeek's Moscow bureau chief
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