Latvia says monetary fund is adding terms on rescue money

Latvia said Wednesday that the International Monetary Fund had imposed fresh conditions for it to qualify for rescue money, intensifying an emerging split with the European Union over a 7.5 bn Euro bailout last year.

Latvia’s rescue program has run into trouble repeatedly since it was agreed upon last autumn. There have been riots in Riga, the capital, and a change of government. Assistance money has been disbursed late or not at all.

Analysts said other countries that have received help from the IMF, like Hungary and Ukraine, could also be affected by uncertainty over Latvia, raising the prospect of renewed financial turbulence in emerging markets.

The stakes are particularly high because Latvia has pegged its currency to the euro and is reluctant to give that up.

Teams from both the IMF and the European Union are in Riga again this week. The prime minister, Valdis Dombrovskis, said the negotiations had turned contentious, largely over how quickly to cut the country’s budget deficit.

"The talks are fairly difficult," he told Latvian radio. "The conditions the IMF is proposing are also fairly difficult."

A devaluation would hit banks from other European countries that are heavily invested in Latvia especially hard, particularly Sweden. It also could highlight the dwindling credibility of plans across the region for countries in Eastern Europe to eventually adopt the euro.

An outright Latvian default, however, seems unlikely, analysts said.

"A default of a sovereign government in the European Union is simply not going to be contemplated, politically speaking," said Daniel Gros, director of the Center for European Policy Studies in Brussels. "No one considers that acceptable."

Christian Keller, chief economist for emerging Europe at Barclays Capital in London, said a more orderly devaluation might be possible.

Both the IMF and the European Union declined to comment on the continuing talks.

The IMF has long been skeptical that Latvia could restructure its economy at a time of crisis without devaluing its currency, but swallowed its reservations for the sake of a quick solution last year, said two former IMF officials, who spoke on condition of anonymity because they were no longer with the fund.

Now that the crisis has eased, the IMF seems to be more willing to make tougher demands that could lead to a devaluation. But to publicly call for such a move might upset markets.

The European Union, by contrast, has focused on supporting one of its members.

A currency devaluation would be a standard prescription to ease Latvia’s pain because it would promote exports and ease pressure to cut wages when domestic demand is collapsing at a harrowing pace.

Latvian officials have countered that heavy euro-denominated debts among households and companies would make a devaluation suicide. It also would put off the day when Latvia could adopt the euro.

But critics point out that the current policy of budget and wage cuts is no cakewalk, either.

Latvia is trying to rebalance an economy that shrank 18 percent in the first quarter by cutting government spending and wages, a process known as an "internal devaluation."

It wants to reduce a budget deficit, which could hit 10 percent of gross domestic product this year, to 3 percent by 2012, a vital threshold for euro membership. But that has proved political dynamite in Latvia.

The European Union delayed disbursement of a 1.2 billion euro, or $1.7 billion, portion of the rescue fund until the Latvian Parliament passed a package of budget cuts in June. The IMF has not yet provided a $200 million loan that was due in March.

The differences between the IMF and the European Union appear to boil down to an assessment of the political will in Latvia to reduce government spending, with the Europeans more sanguine than the fund.

The IMF is also haunted by memories of Argentina, which pegged its currency to the dollar with IMF support before defaulting in 2001, while the European Union is standing behind one of its smallest members.

"It is so clear that Latvia’s peg is ultimately unsustainable, all protestations by Latvian government officials notwithstanding," said Kenneth Rogoff, a former chief economist at the IMF. "But ultimately unsustainable pegs can go on for years before crashing and burning, and Brussels seems to be willing to pay a lot to get past the financial crisis before cutting the cord on Latvia."

© 2009 New York Times News Service