Fitch downgraded Latvia's foreign currency Issuer Default Rating (IDR) to 'BBB-' (BBB minus) from 'BBB' and placed Latvia's IDRs on Rating Watch Negative (RWN) on 11 November 2008 following the failure of the country's second-largest bank, Parex banka, last month. The Latvian government's takeover of Parex banka, which has assets equivalent to more than 20% of GDP and non-resident deposits of about EUR1.5bn, has failed to stem deposit outflow. The Bank of Latvia (central bank) has spent approximately EUR0.9bn of its reserves since the end of September to maintain the lats at the weak end of the 1% fluctuation band around its peg to the euro. The Latvian government is currently negotiating with the EU and the IMF on the size and conditions of a financial support package.
Fitch's report provides forecasts for Latvia's external financing needs in 2009 according to three different scenarios, which offer guidance on how large an appropriate external support package might need to be. The external financing need projected in Fitch's base-case scenario is EUR6.0bn, compared with an external financing need of EUR3.4bn under the optimistic scenario and a much larger EUR13.5bn under the worst case, pessimistic scenario. According to Fitch's base-case scenario, the agency estimates that Latvia could need a total financing package from the IMF, EU and other lenders of the order of EUR5bn, assuming a EUR1bn reduction in the Bank of Latvia's official reserves.
Fitch calculates that an IMF financing package equivalent to the same percentage of Latvia's IMF quota as it provided to Hungary, coupled with EU and World Bank contributions that correspond to the same percentage of GDP as was given to Hungary, would only cover two-thirds of the EUR5bn which Fitch believes Latvia needs. However, as Latvia's external imbalances are greater (relative to GDP) than Hungary's, Fitch would expect the international financing package to represent a larger multiple of Latvia's IMF quota and a greater share of its GDP than was offered to Hungary.
Fitch has previously flagged the vulnerability of Latvia's exchange rate peg to a loss of confidence among deposit holders and has highlighted the large volume of non-resident deposits in the banking system. The agency believes the Bank of Latvia would take strong steps to defend the exchange rate, allowing a reduction in the domestic money supply to match the rundown in central bank official reserve assets to maintain reserve coverage of the monetary base. However, if there is a continuing withdrawal of non-resident deposits or other calls on foreign currency, then it will become increasingly difficult for the authorities to both provide support to the banking system and maintain the currency peg, while a sharp contraction in the monetary base could cause a deep recession that would adversely affect public finances and bank asset quality.
