Latvia

SEB MERCHANT BANKI NG – COUNTRY RI SK ANALYSI S Dec 16, 2008

important your attention is drawn to the statement on the back cover of this report which affects your rights.
Analyst: Rolf Danielsen. Tel : +46 8 763 83 92. E-mail : rolf.danielsen@seb.se

The collapse of Parex Banka, Latvia’s second largest commercial bank, has aggravated the
country’s already serious economic and financial situation. The government has called on the
EU, IMF and governments of other countries to provide financing. IMF has reportedly accepted
Latvia’s request not to touch the exchange rate of the Lat.

Country Risk Analysis
^Åíáîáíó=áë=ÅççäáåÖ=Ñ~ëíK==Having managed lo suslain posilive, aIbeil lraiIing grovll
llrougl lle firsl laIf of 2008, lle 3
rd
quarler drop of GDI by 4,6° comes as a slarI
reminder of lle counlry's probIems. Grovll is pIunging due lo sIoving domeslic
privale demand as seen in relaiI saIes faIIing aImosl 7° in lle firsl nine monlls of
lle year probabIy indicaling a reaI drop of some 20-25° laIing inlo accounl llal
infIalion in lle same period acceIeraled lo 16°. AIllougl price pressure is nov
cooIing fasl, lle counlry is al lle momenl facing a severe case of combined infIalion
and depression. Among domeslic demand faclors, onIy governmenl expendilures
are sliII Ieeping up, driving lle fiscaI baIance inlo a deficil llis year of around 2° of
GDI as recenl monlls' lax laIe las lurned slarpIy soull. Lxporls of goods,
lovever, are sliII Ieeping up surprisingIy veII vill a grovll rale al aImosl 14° in
lle firsl nine monlls of lle year. Hovever, a groving parl of lle exporls aclivily ÷
aIready represenling aboul laIf of lle lolaI exporl vaIue, is reIaled lo various forms
of lrading, incIuding saIes of second land cars from Weslern Lurope lo lle CIS
counlries. We fear lley couId prove eplemeraI aclivilies llal may muslroom and
vanisl overnigll. NeverlleIess, groving exporls and sIigllIy faIIing imporls lave
nov arresled lle
delerioralion of
lle exlernaI
baIances. Tle
currenl accounl
deficil slouId
reduce lo 15° of
GDI in 2008, a
veIcome
improvemenl lo
lle 23°/GDI
deficil of 2007, bul
sliII an
unsuslainabIy
ligl IeveI.
GDP
-10%
-5%
0%
5%
10%
15%
2003 2005 2007 2009

m~êÉñ=_~åâ~=Åçää~éëÉë: In mid November Iarex BanIa, Ialvia's second Iargesl
commerciaI banI vill aboul 17° of lolaI banI assels, coIIapsed afler laving suffered
SEB Merchant Banking Country Risk Analysis Dec. 18, 2008
unusuaI Iarge deposil villdravaIs. Tlere lad aIready been rumours of lle banI
laving lroubIe in refinancing foreign marIel Ioans raised in veslern counlries.
InlerbanI rales lad risen lo ligl IeveIs vill reporls of some domeslic banIs viIIing
lo pay up lo 50° for slorl lerm Iiquidily from oller banIs. In parlicuIar non-
residenl deposilors vlicl represenled Iarex BanIa's main funding source, proved
lle mosl aclive in villdraving money from lle banI.

qÜÉ=ÖçîÉêåãÉåí=ÅçãÉë=íç=íÜÉ=êÉëÅìÉ: To save a syslemicaIIy imporlanl banI lle
governmenl came lo lle rescue in mid-November. Il bougll oul lle banI's foreign
ovners for a loIen sum and llen exlended Iiquidily lo lle banI for more llan
IVI0,4 biII., for aboul 10° of cenlraI banI reserves. Al lle same lime il aIso
Iovered banIs' reserve requiremenls lo leIp reslore Iiquidily in lle banIing syslem
al Iarge. UnforlunaleIy, llal proved lo IillIe avaiI as lle depIelion of lle cenlraI
banI's foreign exclange reserves nol onIy conlinued unabaled, bul even acceIeraled
llereby draining lle money marIel even fasler. Il las so far Iosl more llan IVI1
biII., aboul a quarler of lle lolaI. Wlal il las nol done, lovever, is lo raise poIicy
rales across lle board. Lffeclive of December 9, lle cenlraI banI raised lle inleresl on
ils marginaI funding faciIily for banIs on overdrafls beyond 5 banI days in any
caIendar monll lo lle 7-15° pa. IeveI (depending of lle exlenl of excessive
borroving). Il Iepl , lovever, oller poIicy rales, incIuding lle refinancing rale al
6° pa. some 10 percenlage
poinls beIov lle rale of
consumer price infIalion.
Negalive inleresl rale gaps
of llis order of magnilude
risI raising inveslor
molivalion lo clanneI
savings from banI accounls
inlo oller pIacemenls
incIuding in banIs abroad,
vlicl creales capilaI fIigll.

fjc=àçáåë=áå: In order lo
boIsler reserves and lo caIm
marIels, lle governmenl
finaIIy yieIded lo caIIs llal lle governmenl asI for assislance from lle LU, vlicl
subsequenlIy forvarded lle requesl lo lle IMI (InlernalionaI Monelary Iund). Tle
Ialler proved quicI in opening negolialions despile lle IacI of an updaled
consuIlalion reporl under lle ArlicIe IV of lle IMI clarler, vlicl nearIy aII
counlries are obIiged lo underlaIe every year, and vlicl are sIipped onIy vlen lle
aullorilies cannol agree vill lle IMI slaff over a reasonabIe descriplion of lle slale
of affairs and poIicy recommendalions.
1
Negolialions vill lle IMI are sliII ongoing.
Wlal las lranspired so far is llal lle IMI may be viIIing lo exlend a slandby faciIily
vorll more llan $2 biII. or aboul 10 limes Ialvia's IMI quola, in Iine vill lle recenl
IMI supporl lo IceIand. IMI las aIso announced llal il is vorIing on a program
llal mainlains lle Ialvian currenl exclange rale parily and band llereby meeling
lle aullorilies' slrong requesl nol lo loucl lle exclange rale of lle Ial.. Tlal las
surprised some observers, as devaIualion or a nev exclange rale poIicy lad been
expecled lo become a Iey condilion of lle IMI pacIage, nol onIy because of IMI's
Exchange rate and interbank mar
Latvia, Policy Rates, Refinancing Rate, LVL
Source: Reuters EcoWin
05 06 07 08
0,69
0,69
0,69
0,69
0,70
0,70
0,70
0,70
0,71
0,71
0,71
0,71
0,72
0,72
2
4
6
8
10
12
14
Exchange rate
ECB Bid rate
Policy rate
Interbank rate

1
Latvia is on a normal 12 month consultation cycle, but the IMF issued its latest regular
consultation report on Latvia in October 2006. That report has been considered by a number
of analysts as unusually critical.
2

SEB Merchant Banking Country Risk Analysis Dec. 18, 2008
previous poor experience in leIping counlries defend currency pegs, i.e. lle case of
Argenlina in 2001, bul aIso because of lle many indicalions of rapidIy eroding
Ialvian compeliliveness. (Conf. box beIov).

cáëÅ~ä=ÅçêêÉÅíáçåW=In relurn lle IMI is expecled lo demand a slrong fiscaI correclion.
In response lle governmenl recenlIy prepared a revised 2009 budgel, vlicl incIudes
severaI lax measures and a reduclion of lle saIary IeveI of governmenl empIoyees,
announced al a 15° cul. Tle Ialler mosl IiIeIy refers lo lle originaI 2009 budgel,
prepared before lle crisis lad yel deveIoped lo ils presenl slage, and il is sliII nol
cIear lov Iarge lle cul viII be compared lo lle presenl IeveI. Tle Ialesl revisions
reporledIy passed IarIiamenl Iasl veeI. Before llal lle governmenl deficil lad been
eslimaled al 2° of GDI in 2008 and up lo 6° of GDI in 2009.

fåíÉêå~ä=çê=ÉñíÉêå~ä=ÇÉî~äì~íáçå\=
Irovided one accepls lle argumenl
llal lle Ial las become overvaIued,
lle queslion arises lov lo reslore
compeliliveness. Tlal is normaIIy
accompIisled by some form of
devaIualion, vlicl may be an open,
nominaI, devaIualion or an inlernaI
devaIualion, meaning a simiIar
reduclion of produclion cosls as a
nominaI devaIualion vouId lave
yieIded.
2
TleorelicaIIy lle second is
lle preferred cloice as il avoids lle
probIem of bringing firevood lo an
ongoing infIalion process, bul in
praclicaI lerms lle firsl is normaIIy
regarded as lle onIy oplion reaIIy
execulabIe. Tle probIem vill lle
inlernaI devaIualion is lo ensure ils
fuII impIemenlalion in a counlry
vill an open democralic poIilicaI
process. Will lle IarIiamenl
passing lle governmenl's revised
budgel, il may lave made a good
slarl lo a successfuI inlernaI
devaIualion in parlicuIar if lle 15°
vage culs acluaIIy impIy a cul from
exisling IeveIs of lle same order of
magnilude. Anylling mucl slorl of
llal, lovever, migll nol be accepled
by marIels going forvard as il
vouId IiIeIy faiI lo give a proper
signaI lo lle resl of lle economy of
lle need for slrong vage moderalion in coming years. As a resuIl, capilaI fIigll may
once again picI up increasing lle risI of a nominaI devaIualion being forced upon
lle aullorilies, and llen probabIy in an unconlroIIed manner. -- We lave consuIled
IocaI experls vlo confirm llal lle IeveI of specificalion in lle governmenl budgel
Measures of competitivenes
100
120
140
160
1996 2000 2004 2008
REER_PP REER_CP
NEER
Two statistical time series are frequently used to
analyze competitiveness of a country, the
nominal and the real effective exchange rate
(NEER and REER). The first calculates the
exchange rate against a basket of currencies
weighed together with trade weights. The REER,
in contrast, also weighs in the inflation rates of
all countries in the basket. Therefore, if any
country has a higher inflation rate than other
countries that is not compensated by a weakening
of its exchange rate, the REER will show the
country appreciating its currency in “real terms”
and therefore likely loosing competitiveness.
The question is then which measure of inflation
to choose, the consumer price index (REER_CP)
or the producer price index (REER_PP). In the
case of Latvia the graph shows that the choice
does not make a big difference: In recent years,
they have both moved in parallel sharply up
indicating a possible big loss of competitiveness
since 2005. That has been offset only partly by
higher productivity. The NEER, by contrast, has
remained fairly stable reflecting the peg to the
Euro, the currency of Latvia’s main trading
partner.

2
Pls. Confer ”three points about the Baltics” at www.seb.se/MB under “Country analysis” for
a more comprehensive discussion of the issue.
3

SEB Merchant Banking Country Risk Analysis Dec. 18, 2008
presenlalion maIes il lard lo maIe a fuII assessmenl of lle reaI size of lle vage cul
compared lo lle presenl IeveI and ve lave lo resl our judgemenl liII smoIe cIears.

lìíäççâ: Tle furller deveIopmenl resls mucl on lle oulcome of lle finaI IMI
pacIage and lov llal viII be impIemenled. Our besl guess is llal lle counlry las
aclieved a respile for nov, vlicl slouId leIp reslore some slabiIily in lle financiaI
marIels. More peopIe viII nov IiIeIy Ieep money in Ial accounls nov llal lle risI
of an immediale nominaI devaIualion las somevlal faded, even llougl al lle
presenl inleresl rales lley Ioose money by lle day in reaI lerms. More uncerlain,
lovever, is lle slabiIily of peopIe's morlgages and oller banI Ioans. Over lle recenl
lvo years Ial Ioans lave gone compIeleIy oul of faslion, and even exisling Ial Ioans
lave been converled lo foreign currency denominalions, allracled by somevlal
Iover inleresl rales. Al lle presenl, onIy 20° of lolaI banI Ioans remain in Ial. Given
some Iingering uncerlainly over lle exclange rale ve regard llal as an anomaIy,
and vouId nol be surprised if some deblors began lo converl lleir Ioans bacI lo IocaI
currencies, even llougl lle inleresl rale differenliaI al lle presenl may appear
unallraclive. Tlal vouId Ieave banIs vill lle cloice lo eiller carry lle currency
exposure llemseIves, or ledge il. In llal case lle IiIeIy resuIl viII be capilaI
oulfIovs of lle same size, vlicl viII force lle cenlraI banI lo seII foreign currencies
from ils reserves lo avoid pressure on lle Ial.

-´-
=
qÜÉ=Åçää~éëÉ=çÑ=i~íîá~Ûë=ëÉÅçåÇ=ä~êÖÉëí=Ä~åâ=áå=ãáÇ=kçîÉãÄÉê=Ü~ë=ìëÜÉêÉÇ=áå=åÉï=
êÉ~äáëã=íç=íÜÉ=éçäáíáÅ~ä=ÇÉÄ~íÉ=~åÇ=éêçãéíÉÇ=íÜÉ=ÖçîÉêåãÉåí=íç=ëÉÉâ=áåíÉêå~íáçå~ä=
~ëëáëí~åÅÉ=áåÅäìÇáåÖ=Ñêçã=íÜÉ=fjc=íç=ÅçîÉê=íÜÉ=ÅçåÅçãáí~åí=äçëë=çÑ=êÉëÉêîÉë=~åÇ=
Å~äã=Ñáå~åÅá~ä=ã~êâÉíëK==qÜ~í=ã~ó=åçï=~ééÉ~ê=~ë=íÜÉ=ä~ëí=ÜçéÉ=Ñçê=~å=ÉÅçåçãó=íÜ~í=
áë=~äêÉ~Çó=Ä~ííÉêÉÇ=Äó=~=ëÉîÉêÉ=ÇÉÅÉäÉê~íáçå=ÑçääçïáåÖ=óÉ~êë=çÑ=ìåëìëí~áå~ÄäÉ=çîÉêJ
éÉêÑçêã~åÅÉK==tÜáäÉ=áí=áë=ëíáää=íçç=É~êäó=íç=àìÇÖÉ=íÜÉ=áåáíá~íáîÉ=åçí=âåçïáåÖ=íÜÉ=Ñáå~ä=
êÉëìäíI=ëçãÉ=ã~ó=ÑáåÇ=áí=ëìêéêáëáåÖ=íÜ~í=íÜÉ=fjc=êÉéçêíÉÇäó=Ü~ë=~äêÉ~Çó=~ÅÅÉéíÉÇ=íÜÉ=
ÖçîÉêåãÉåíÛë=êÉèìÉëí=Ñçê=~å=áåíÉêå~ä=ê~íÜÉê=íÜ~å=~å=ÉñíÉêå~ä=ÇÉî~äì~íáçåK=qÜ~í=áë=
ÉîÉå=ãçêÉ=ëç=áÑ=áí=ëÜçìäÇ=~ééÉ~ê=íÜÉ=ÄìÇÖÉí=íáÖÜíÉåáåÖ=ïáää=åçí=Öç=~=îÉêó=Ñ~ê=ï~ó=áå=
ãÉÉíáåÖ=íÜÉ=åÉÉÇ=Ñçê=Åçëí=êÉÇìÅíáçåë=áå=íÜÉ=ÉÅçåçãó=íç=êÉÖ~áå=ÅçãéÉíáíáîÉåÉëëK=
eçïÉîÉêI=Ü~îáåÖ=ÅçåÑáÇÉåÅÉ=áå=íÜÉ=åÉÖçíá~íçêëI=ïÉ=ÖáîÉ=íÜÉ=Ñáå~ä=çìíÅçãÉ=çìê=ÄÉåÉÑáí=
çÑ=íÜÉ=ÇçìÄíK==^Ö~áåëí=íÜ~í=ã~ó=ÄÉ=åçíÉÇ=ÅçåíáåìÉÇ=ÜáÖÜ=ÉîÉåí=êáëâ=~ë=êÉÑäÉÅíÉÇ=áå=
çåÖçáåÖ=íìêÄìäÉåÅÉ=áå=íÜÉ=ÇçãÉëíáÅ=ã~êâÉíë=
K===
hÉó=ÑáÖìêÉë OMMU
IopuIalion (miIIions) 2,3
GDI/capila ($) 14774
GDI (clange) -2°
InfIalion 16°
Curr.Acc. baIance/GDI -15°
Reserves/imporls (monlls) 4
Budgel baIance/GDI -2°
Governmenl debl/GDI 10°
Graph: The risk profile of Latvia is narrow on the top,
reflecting the country's strength on resilience which is
important for an investment grade country. However, that
is now being over-powered by a dangerous mix of
weakening liquidity combined with event and info risk.
bñíÉêå~ä=ê~íáåÖëW=
Iilcl: BBB-/neg
S&I: BBB-/neg
mÉÉêëW
Hungary
Lslonia
Iilluania
0
2
4
6
8
10
12
14
Resilience
Liquidity
Information
Absence of event
risk
Macro balance
Latvia Average EM
Hungary
How to read the chart?
Moving out from the center
reduces risk.

4

SEB Merchant Banking Country Risk Analysis Dec. 18, 2008

Key data: 2003 2004 2005 2006 2007 2008 2009 2010
GDP (mill. US$) 11,2 13,8 16,0 19,9 27,2 33,5 30,1 31,5
GDP/capita (US$) 4801 5945 6969 8709 11930 14774 13354 14036
GDP (change) 7,2% 8,7% 10,6% 12,2% 10,3% -1,8% -6,0% -4,7%
Investments/GDP 28% 32% 35% 37% 36% 34% 33% 31%
Budget balance/GDP -1,4% -1,1% -1,1% -0,9% 0,7% -2,1% -6,0% -6,0%
Govt debt/GDP 14% 14% 15% 12% 11% 10% 16% 21%
CPI inflation (%) 2,9% 6,2% 6,7% 6,6% 10,1% 15,5% 7,8% 4,4%
Money demand (%) 19,3% 20,4% 31,6% 32,2% 3,5% 19,6% 6,7% 7,3%
Stock prices 288 414 676 656 595
Interest rates 2,9% 3,3% 2,5% 3,3% 5,2% 3,7% 2,4% 2,2%
Exch. Rate ($) 0,57 0,54 0,56 0,56 0,51 0,48 0,56 0,56
Trade/GDP (%) 97% 104% 110% 111% 109% 100% 112% 110%
Oil price (Brent) $29 $38 $54 $65 $73 $96 $50 $53
Billions US $
Export of goods 4,7 6,0 7,7 8,9 12,1 14,7 15,4 16,3
Imports of goods 6,1 8,2 10,0 13,2 17,6 18,8 18,2 18,2
Other: 0,5 0,4 0,3 -0,2 -1,0 -1,0 1,2 1,0
Current account -0,9 -1,8 -2,0 -4,5 -6,5 -5,2 -1,5 -0,9
(% of GDP) -8% -13% -12% -23% -24% -15% -5% -3%
FDI 0,3 0,6 0,7 1,7 2,2 2,7 2,4 2
Loan repayments -0,8 -1,1 -2,7 -2,5 -5,7 -6,5 -7,0 -7,4
Net other capital flows 1,6 2,7 4,3 7,5 11,2 10,1 6,7 6,2
Balance of payments 0,2 0,5 0,3 2,1 1,2 1,1 0,5 0
Reserves 1,4 1,9 2,2 4,4 5,6 6,6 7,2 7
Total debt 8,8 12,7 14,5 22,8 38,0 43,6 46,6 49,0
o/w short term debt 5,6 7,7 7,5 10,5 16,5 17,9 18,6 19,6
Sources: Oxford Economics and SEB estimates
Rating histor
,5
,5
,6
y
Fitch (eoy) BBB+ A- A- A- BBB+ BBB-
S&P (eoy) A- A- A- A- BBB+ BBB-
Type of government: Parliamentary Democracy
Next elections 2010 - Parliamentary, 2011 - Presidential
Other:
Latest PC deal None
Latest IMF arrangements 1992 SBA
Bank Credits
private enterprises [ar 12 months]
persons [ar 12 months]
Source: Reuters EcoWin
00 01 02 03 04 05
P
e
r
c
e
n
t
10
20
30
40
50
60
70
80
90
OMX Riga Index, Total return
Source: Reuters EcoWin
99 00 01 02 03 04 05 06
I
n
d
e
x
100
200
300
400
500
600
700
800
O M X R i g a In d e x
S o u rc e : R e u t e rs E c o W i n
0 3 0 4 0 5 0 6 0 7 0 8
I
n
d
e
x
1 0 0
2 0 0
3 0 0
4 0 0
5 0 0
6 0 0
7 0 0
8 0 0
A n n u a l g r o w t h r a t e s
B a n k C r e d i t s
p ri va te e nt e r p r i s e s [a r 1 2 m o nt hs ] p e r s o ns [ a r 1 2 m o nths ]
S o u rc e : R e u te rs E c o W i n
0 0 0 1 0 2 0 3 0 4 0 5 0 6 0 7 0 8
P
e
r
c
e
n
t
1 0
2 0
3 0
4 0
5 0
6 0
7 0
8 0
9 0
H o u s e h o l d s
C o m p a n i e s
FDI 2002-06
Other
Health,
education
Transport
Utilities,
hotels,
constr
Agricult.,
mining
Wholesale
& retail
Manufactur
ing
Finance,
real estate
E x c ha n ge r a t e a n d in t e r ba n k m a r
L a tvi a , P o li c y Ra te s, Re fi na nc i ng Ra te , L V L
S o u rc e : R e u t e r s E co W i n
0 5 0 6 0 7 0 8
E
U
R
/
L
V
L
0 ,6 9
0 ,6 9
0 ,6 9
0 ,6 9
0 ,7 0
0 ,7 0
0 ,7 0
0 ,7 0
0 ,7 1
0 ,7 1
0 ,7 1
0 ,7 1
0 ,7 2
0 ,7 2
%

p
.
a
.
2
4
6
8
10
12
14
E xcha nge r a te
EC B Bid ra t e
Po l i cy r ate
In t e rb a n k ra t e



5

SEB Merchant Banking Country Risk Analysis Dec. 18, 2008

aáëÅä~áãÉê=

`çåÑáÇÉåíá~äáíó=kçíáÅÉ=

Tle informalion in llis documenl las been compiIed by SLB Merclanl BanIing, a
division villin SIandinavisIa LnsIiIda BanIen AB (pubI) (“SLB¨).

Opinions conlained in llis reporl represenl lle banI's presenl opinion onIy and are
subjecl lo clange villoul nolice. AII informalion conlained in llis reporl las been
compiIed in good faill from sources beIieved lo be reIiabIe. Hovever, no
represenlalion or varranly, expressed or impIied, is made vill respecl lo lle
compIeleness or accuracy of ils conlenls and lle informalion is nol lo be reIied upon
as aullorilalive. Anyone considering laIing aclions based upon lle conlenl of llis
documenl is urged lo base lis or ler inveslmenl decisions upon sucl invesligalions
as le or sle deems necessary. Tlis documenl is being provided as informalion onIy,
and no specific aclions are being soIiciled as a resuIl of il: lo lle exlenl permilled by
Iav, no IiabiIily vlalsoever is accepled for any direcl or consequenliaI Ioss arising
from use of llis documenl or ils conlenls.

SLB is a pubIic company incorporaled in SlocIloIm, Sveden, vill Iimiled IiabiIily. Il
is a parlicipanl al major Nordic and oller Luropean ReguIaled MarIels and
MuIliIaleraI Trading IaciIilies (as veII as some non-Luropean equivaIenl marIels)
for lrading in financiaI inslrumenls, sucl as marIels operaled by NASDAO OMX,
NYSL Luronexl, Iondon SlocI Lxclange, Deulscle B∏rse, Sviss Lxclanges,
Turquoise and Cli-X. SLB is aullorized and reguIaled by IinansinspeIlionen in
Sveden: il is aullorized and subjecl lo Iimiled reguIalion by lle IinanciaI Services
Aullorily for lle conducl of designaled inveslmenl business in lle UK, and is
subjecl lo lle provisions of reIevanl reguIalors in aII oller jurisdiclions vlere SLB
conducls operalions.

SLB Merclanl BanIing. AII riglls reserved.


6