While Latvia has a history of short-lived coalition governments, the collapse of Prime Minister Ivars Godmanis's four-party coalition government comes during a period of severe economic stress. The economy shrunk by 10.5% year-on-year in Q408 and Fitch estimates the economy contracted by over 4% during 2008 as both domestic and external demand have fallen sharply. The agency is forecasting a contraction of around 10% in 2009 which implies that the government will have to take supplementary measures to meet its target budget deficit of 5% of GDP. The budget is based on the assumptions of a 5% contraction of the economy in 2009 and an inflation rate of under 6%. It already includes significant expenditure-cutting measures such as a 15% reduction in state administration wages and an increase in both VAT and excise tax rates. Failure to agree to Prime Minister Godmanis's proposal to cut expenditure by reducing the number of ministries was a contributing factor to the government's collapse. Fitch believes Latvia's new government will include parties from the present coalition and that there is little appetite to shift policy away from the requirements of the IMF programme. Nevertheless, the extent of the recession and economic pain from the austerity measures being felt by the country increases the risk of a popular backlash and could thwart the sustained implementation of the IMF programme.
Fitch notes that deposit withdrawals from the Latvian banking system are continuing: 16% of total non-resident deposits have been taken out of the system since the beginning of December. Around a quarter of the withdrawals were from Parex banka (RD), where a deposit freeze on large private depositors is still in place. The government has recently agreed to act as guarantor for the repayment of Parex banka's EUR775m syndicated loan which the bank is trying to restructure.
Fitch warned in December 2008 that the severity of the austerity measures implies some execution risk to fiscal and other economic adjustment programmes, and hence IMF-led funding. A protracted delay in forming a new government or new elections could, however, delay the implementation of the austerity measures and make it harder to keep the budget in line with objectives. This, in turn, could affect the disbursement of the loans from the IMF and others. Fitch believes a failure of the IMF programme would increase pressure on the domestic banking system and the currency peg, putting negative pressure on the country's ratings.
