Page last updated at 08:21 GMT, Monday, 8 June 2009 09:21 UK

Latvia's dramatic fall from grace

By Orla Ryan
Business reporter, BBC News

Vansu bridge, Riga
Latvia is in recession after several years of boom

For Latvia, it has been a pretty dramatic fall from grace.

Until recently, the tiny Baltic state was a star performer in Eastern Europe.

Its picturesque capital was a destination for tourists, it attracted floods of capital from Swedish banks and its growth rate was high.

Fast forward a few years and it is a very different picture. The economy is forecast to shrink 18% this year, unemployment is rising and the lat, its currency, is in danger of devaluation.

The government has denied it will devalue the lat, but if it does, fears exist that it will have an impact far beyond the borders of this tiny state, home to just over two million people.

Seeds of destruction

Latvia is, to a large degree, a victim of the global financial crisis, but the seeds of its downfall were planted well before the current slowdown.

Not that long ago, "the Baltics were star performers in Eastern Europe," said Ed Parker at Fitch Ratings.

When Latvia joined the EU, expectations were high that the country could soon join the euro and living conditions would improve. It fixed the lat to the euro, allowing it to move within a small band.

A small and open country, Latvia quickly attracted investment. The big Swedish banks established subsidiaries and an influx of foreign capital helped sustain a real estate boom.

Rising domestic consumption, a thriving property market and capital inflows all helped spur growth.

German Chancellor Angela Merkel (R) greets Latvian Prime Minister Valdis Dombrovskis during an official welcoming ceremony at the chancellery in Berlin April 29, 2009
Latvian Prime Minister Valdis Dombrovskis(l), has tried to reassure investors

But says Fitch's Parker, "one of the problems was that a lot of this foreign capital was directed to real estate development and mortgages rather than building an export oriented manufacturing base".

"[This was] in contrast to countries like Poland, where a lot of [foreign direct investment] FDI was used to set up manufacturing plants. A lot of the development [in Latvia] went into the real estate sector."

At the same time, its fast growth and a fixed exchange rate pushed prices higher. Latvia became an expensive place to do business.

"This excessive optimism plus the entry and aggressive lending policies of foreign banks, led to a huge credit boom and huge current account deficit," said Fitch's Parker.

When the capital stopped flooding in, as the credit crunch forced banks to tighten lending, the economy froze.

These figures make grim reading . The economy is forecast to shrink by up to 18% this year, the latest budget proposes a 40% cut in spending and pay cuts of 20% for state workers.

Last December, Latvia sealed a 7.5bn euro bailout from the IMF and the EU. If it is to continue to draw down on this money, it needs to make further cuts, likely to be painful for Latvians, already adjusting to a new economic reality.

When a government bond auction failed, fears rose that the government may have to devalue its currency, possibly abandoning its peg with the euro.

Could it spread

A devaluation would have serious consequences for Estonia and Lithuania, its two biggest trading partners.

"The moment you devalue Latvia, their products become more competitive at the expense of Lithuania and Estonia. These two countries are Latvia's two biggest trading partners," said Barclay Capital's Christian Keller.

For banks which have invested in Latvia, a devaluation also has serious consequences.

"If we look at the Swedish bank exposure, it is relatively large," said Mr Keller.

"Swedish banks have six per cent of their assets in the Baltics. If you take the stress-test of Riksbank, forty per cent of the losses they estimate are coming from the Baltics.

"There is a disproportionate impact from the Baltics on Swedish banks' financial performance."

More worryingly for some analysts is psychological contagion - where investors look at countries which have common characteristics and wonder if they have similar problems.

This means that if other countries with currency pegs - countries such as Lithuania, Estonia and Bulgaria - may come under pressure to abandon them.

If Latvia doesn't devalue, its alternative is to struggle to maintain the current peg and impose large wage cuts to try to restore competitiveness.

Whichever option it chooses, it is likely to be "pretty painful," said Parker.

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