Friday, October 8, 2010

Latvian Voters Endorse Austerity, Balk At Russian Option

On New Year's Day 2011, the troubled eurozone will add its 17th member, the EU's fourth smallest country, Estonia. Like the other Baltic States, Estonia saw the rapid growth experienced since EU accession in 2004 turn to a painful rapid contraction by late 2008. But the country's macroeconomic fundamentals were pretty good, better than those of most countries in "old Europe," and despite the dampened enthusiasm for expansion of the eurozone caused by the Greek and Irish and Spanish and Portuguese problems, the EU several months ago certified that Estonia will drop the kroon and join the euro.

The Estonians' neighbors in Latvia must be jealous. Home to the Baltics' largest city, Riga, which saw a big real estate bubble pop, Latvia is one of the countries hit hardest worldwide by the crisis - perhaps second to Iceland - with an 4.2% contraction in 2008 and 18% contraction in 2009. Riots in January 2009 dubbed the "Penguin Revolution" (yes, the namesake of my blog), led to the collapse of the government that ushered in the economic crisis - the second government to fall in the crisis, after Iceland's. Since then, the country, blessed by the EU and IMF, has engaged in very tough spending cuts to maintain its peg to the euro, with the aim of joining the common currency as soon as possible, hopefully in 2014 or 2015. It was somewhat of a surprise to international observers that despite the pain in Latvia, Prime Minister Valdis Dombrovskis's center-right austerity government was reelected on October 2.

At this point it looks like the Bank of Latvia will be able to maintain the tight peg, having successfully fought off speculators last year. Though the economy has continued to contract a little more (2.3%) this year, it is expected to return to growth (of 3%) next year (Economist Intelligence Unit estimates). But Latvia's austerity measures were extraordinary. The country underwent an internal devaluation of spending cuts and tax increases. Because of the EU context and the threat of contagion in Eastern Europe and of non-performing loans in neighbors like Sweden if the exchange rate peg was dropped, the IMF gave a highly unusual approval to these measures. Government workers who were not laid off had to work longer hours for lower wages. The painful measures have a political cost - the largest member of the governing coalition (but not the prime minister's party), the People's Party, exited the coalition in March for this reason. But Latvia's voters have now endorsed the measures by reelecting Dombrovskis's government. Why? It's likely a combination of pragmatic acceptance of the government's six-year-plan to reach the safety of the euro, and of Russophobia.

Latvia's population is approximately 35% ethnic Russian, the legacy of centuries of rule from Tsarist St. Petersburg or Soviet Moscow, with but two decades of independence between World Wars I and II. Latvia may have a less anti-Russian reputation than Estonia or Lithuania, but its post-Soviet governments have still been dominated by center-right nationalist parties who guided the country into the EU and NATO and established strong language laws to ensure a Latvian character to the newly independent state. The strongest opposition party for the past several years, Harmony Centre, is a center-left party led and backed by the country's ethnic Russian citizens. Though it is not a single-issue party and is backed by many ethnic Latvians, it does aim to increase the use of Russian in education and administration and improve civil rights for Russian speakers. Harmony Centre won the Riga mayoral election in July 2009. The party won 29 seats of the 100 seats in the parliament last week, coming in second to the 33 of Mr. Dombrovskis's Unity coalition, which is unlikely to seek to bring Harmony Centre into government.

Latvia has a potential to profit from being one of Moscow's closer partners within the EU, given the large presence of Russian speakers there, infrastructure links and ice-free Baltic ports not far from the Russian border. The October elections seem to show that even in tough economic times, this is not the route Latvians want to take. That or they are seeing the light at the end of the tunnel and do not want to risk losing progress made towards the euro by an economic U-turn.