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Latvia is a small country nestles in Eastern Europe. Nothing from this country seemed remarkable to the global financial world before November 2008. After 2008, Latvia became a different story altogether.
This small nation was also suffering from the crisis that rocked the world in 2008. The people lost billions of dollars, and some of the biggest banks failed. However, while the rest of the world resorted to bailouts, the Latvian government took a different path.
The economies that used bailouts are on the brink of yet another collapse whereas the Latvian economy has withered the storm and is now growing by leaps and bounds. This is what makes the Latvian case study interesting.
Many economists are suggesting that the Eurozone should adopt the Latvian method, take some tough decisions, feel the pain for a while and then come out stronger.
In this article, we will have a closer look at the crisis and the resultant decisions that made Latvian economy a role model for much larger economies.
The Latvian crisis started dramatically with the fallout of the Parex bank. The Parex bank was by far the largest bank in Latvia at that time. However, it did not hold a lot of Latvian funds.
Most of the money held in the banks belonged to foreigners. The Parex bank was believed to be an ethical bank with a clean balance sheet. All major auditors had good reviews of the Parex bank.
However, during the 2008 crisis, it was found out that the bank held over 50% of its assets in toxic loans! The bank went bust almost overnight. This also exposed a lot of shady back room deals that Parex bank was a party too.
At the height of the crisis, the Latvian economy was going into a tailspin. The government decided to use the taxpayer’s money to bail out the Parex bank. This did not go well with the population. This is because there had been several instances wherein retail banks had failed, and Latvian government did not bailout the savings of ordinary citizens.
Parex bank used to hold the money of the oligarchs and high net worth Latvian individuals. A lot of the money invested in the bank belonged to the foreigners. It is for this reason that the Latvian people started protesting the transfer of their wealth to cover the losses made by high net worth individuals.
The Latvian crisis was also tainted by the existence of the EBRD fraud. The EBRD was a body formed by wealthy western nations to rescue the failing economy of Latvia.
The EBRD apparently purchased the Latvia shares, which were worthless at the time! However, it later came to light that the EBRD had a put option on the shares. This means that they had the right to sell the shares back to the Latvian government in 4 years for 20% more than the price that they bought it for. This was obviously not a sale. It was an eyewash that the Latvian government had orchestrated to get itself off the hook while it figured out how to manage the crisis.
The Latvian government decided to follow the policy of internal devaluation. Unlike external devaluation, the central bank is instructed to maintain a fixed rate in relation to other currencies. The devaluation happens in terms of bringing the resource costs down.
One of the main targets of internal devaluation is wages. The Latvian government cut down the wage costs by as much as 30% for its own employees. This led to a cycle of wage cuts across public and the private sector.
In the short run, this policy ended up shrinking the economy even further. Since people were afraid of losing their jobs, they would not spend any money. This caused a further dip in sales and job losses. The GDP of the country shrank by 25%, and Latvia underwent a recession in the short term.
However, over the longer term, the Latvian economy became more productive. The threat of job loss got the best out of the workers. Also, lower wages made the country have a lower cost of production as compared to its neighbors.
Latvia, therefore, became a major exporter in the Eastern European region. For the past 4 years, the Latvian economy is growing at 5% rate. This rate is pretty high given the low standards in the Eurozone.
Also, the unemployment rate has now fallen back into the 10% category. The Latvian economy is showing many signs of an early recovery. If managed properly, Latvia could be on the path to rapid development very soon.
To sum it up, Latvia withered the financial crisis storm with the help of a different policy called internal devaluation. There is still a lot of debate regarding the success or failure of this policy.
However, the fact that Latvia survived the crisis and is growing today seems proof that internal devaluation indeed works. The IMF, World Bank, and other lenders are suggesting similar measures for other European nations who are defaulting on their debt and are likely to face a crisis.
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