Case study 4 – Economic Turmoil in Latvia

1.) In 2008 Latvia experienced a banking crisis that stemmed from a poorly regulated banking sector. The banking sector was using aggressive lending to grow the increased inflow of foreign capital, most of which came from Russia. This lead to a property bubble, similar to what was happening in the United States of America (US), prices were being bid up by borrowers who had access to cheap loans.
Before the government could step in to control the bubble that was created the property bubble in the US burst sending a rippling affect through the world. This was hardest felt by the banking sector, which now had to reclaim their loans while investors were withdrawing their money as quickly as they …show more content…

Many individuals or private entities would have generated an income in return for the Lat however their debt was foreign and serviced in the Euro. These individuals and entities would have defaulted on their repayments and the foreign debt predominately from Russia, Sweden and Finland. If this was the case the foreign banks that had loaned money to Latvian banks and Latvian citizens stood to lose their investments or had the investments restructured. It is possible that the foreign banks imposed political and economic pressure on the IMF and the Latvian government to avoid devaluating the Lat versus the Euro in fear of the economic effect in the foreign market.
4.) The short term consequences directly stem from the conditions of the IMF loan. The internal devaluation strategy included increases in interest rates and tax as well as severe wage reductions in the public sector and similar deductions in government spending. These austere conditions imposed by the IMF and the Latvian government were focused on rectifying the economic downturn in the shortest space of time without jeopardising the adoption of the Euro. In the short term the austerity sent the Latvian economy into recession; national output fell by 25%l, unemployment increased from 5.3% to 20% and is sitting currently around 15% (Weisbrot, 2012), inflation slowed, foreign direct investment left Latvia and the governments’ trade deficit climbed. The unemployment situation was worsened by the