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Fitch Ratings said in a report published December 2 that Latvia, which is currently negotiating a financial support package from the International Monetary Fund, the EU and other international lenders, would need €5bn to stabilise its economy and forestall growing risks of a severe economic and financial crisis.

"Latvia needs a substantial international support package to stabilise its economy. If Fitch judges that the support package is not of sufficient size, design and credibility to forestall a severe economic and financial crisis, then it would further downgrade Latvia's ratings," says Eral Yilmaz, associate director in Fitch's Sovereign Group. On November 11, Fitch downgraded Latvia's foreign currency rating to 'BBB-' from 'BBB', and placed it on 'Rating Watch Negative'.

Latvia has been hit by a severe slowdown that's pushed its once high-flying economy into recession. The Latvian government was then forced last month to take over the country's second largest bank Parex, which has assets equivalent to more than 20% of GDP and non-resident deposits of about €1.5bn. This still didn't stem the outflow of deposits, which is putting pressure on the local currency, the lat. The central bank has spent approximately €0.9bn of its reserves since the end of September trying to prop up the local currency at the weak end of the 1% fluctuation band around its peg to the euro.

A question of size

Fitch forecasts Latvia's external financing needs in 2009 under three different scenarios, which will influence how large the financial package should be.

The external financing need projected in Fitch's base-case scenario is €6.0bn, compared with an external financing need of €3.4bn under the optimistic scenario and a much larger €13.5bn 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 €5bn, assuming a €1bn 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 €5bn which Fitch believes Latvia needs," it says. "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," it says.

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