Cablegate: Latvia Set to Pass Budget, Considering Parex Split and Sale

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1. (SBU) Summary: The cabinet of ministers has approved a budget
for 2010 that includes 500 million Lats (USD 1 billion) in fiscal
consolidation demanded by international lenders. The second and
final reading of the budget in the Saeima (Parliament) will take
place on December 1, and the budget is expected to pass. The
disposition of Parex Bank now stands as the primary economic hurdle
facing the GOL, which was forced to take a majority interest in the
bank in 2008 to prevent a major financial catastrophe. A break-up
of the bank between performing and non-performing elements (a "good
bank/bad bank" split) has been approved in principle by the cabinet,
but questions remain on the best ownership structure to get Parex
off the GOL books while limiting political damage to those involved
in the initial takeover. It is now broadly agreed that a
devaluation of the lat is highly unlikely. (Note: Finance Minister
Repse will lead a team to New York on December 2 for meetings with
bankers on the possible sale of Latvian Government bonds. He is not
seeking meetings with USG or IMF officials, according to Ministry
officials.) End Summary.

2. (SBU) On November 23, Deputy Assistant Secretary of Treasury for
Europe and Eurasia Christopher Smart visited a number of leading
figures shaping the GOL budget and banking system, including
Minister of Finance Einars Repse, IMF Chief of Mission Mark
Griffiths, Bank of Latvia Governor Ilmars Rimsevics, Parex Bank CEO
Nils Melngailis, Latvian Mortgage and Land Bank CEO Normans Panko,
and bank regulator Irena Krumane. Interlocutors were guardedly
optimistic as a government that had only months ago seemed shaky
seems poised to deliver a budget that will meet international
obligations. Meetings regarding the future of state-owned banks
were more downbeat - although there has been progress, there are
still serious disagreements on how to deal with both Parex and the
Latvian Mortgage and Land Bank (LHZB).

The 2010 Budget

3. (SBU) The Minister of Finance and IMF representatives detailed
elements of the budget agreement that is expected to be approved by
Parliament on December 1. The final budget includes a rate hike
from 23 to 26 percent in the personal income tax, a small, but
progressive real estate tax, and increased taxes on capital gains,
cars and natural gas. The budget is based on the IMF's projection
of a 4 percent decline in GDP in 2010. IMF Chief of Mission
Griffiths expressed reservations about the temporary nature of
spending cuts, noting the GOL set many provisions to sunset in 2012,
sidestepping the need for coherent structural reform.

4. (SBU) Minister of Finance Repse appeared confident that the
budget would be approved by parliament. While he acknowledged
concerns about the temporary spending cuts, he asserted that the
cuts could easily be extended. Recognizing the challenge of making
further adjustments in the 2011 budget given Parliamentary elections
in October, Repse said taxes were high enough already, and hoped for
gradual expenditure reductions including structural reform in areas
like health care. Bank of Latvia Governor Ilmars Rimsevics was
vocal in expressing disappointment about the lack of structural
reforms in education, health care, and public administration. He
predicted a more modest decline of 1.5-2.0% of GDP in 2010.

Parex to Center Stage

5. (U) With completion of the 2010 budget, focus now turns to Parex
Bank. Although some observers (including Rimsevics) think the
entirety of Parex could hold positive value, the consensus is that
to get it off the books, the GOL will have to recognize a loss. The
Parex takeover remains poorly understood by the public and a source
of a lot of public anger, with a two billion-dollar exposure to the
Latvian taxpayer. As a result, some politicians are adamant that
the GOL not recognize a loss at all. Furthermore, due to ongoing
criminal investigations into the Parex takeover, some officials may
be concerned that a significant loss could increase the risks of
personal prosecution.

6. (SBU) Rather than leave the bad assets on the government books,
the GOL has chosen to establish a complex structure to try to sell
the assets without taking an immediate loss. The GOL has approved in
principle a plan to split Parex into a good bank (or perhaps two
good banks) and a bad bank, or Asset Management Company (AMC). The
GOL is currently insisting that Parex find simultaneous buyers for
both parts to avoid getting stuck with only the bad assets.
Rimsevics is an advocate of this approach, and Repse recommended a
task force on Parex disposition with Rimsevics as the chair.

7. (SBU) Parex CEO Melngailis said that some non-conventional
structures were being considered in order to create a good bank and
bad bank without recognizing a loss. Foremost among them would be a
structure with the good bank as a subsidiary of the AMC. Melngailis
recognized that this would be an unorthodox move, but said they had

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no choice but to "hide the hole" for political reasons. He sought
USG assistance in convincing the GOL to recognize their losses now.

8. (SBU) Melngailis suggested a subordinated ownership structure
for the AMC with private investors getting first cut at the profits,
IFC and EBRD second cut, and the GOL last, essentially underwriting
any losses. Krumane claimed that there are several EU buyers
interested in the "good bank." She said that the IFC is doing due
diligence on the AMC, but the EBRD has still not confirmed any

9. (SBU) Hanging over all of this is a 300 million euro ($447 m)
syndicated loan payment due in February that Melngailis reports
Parex will not be able to cover. He suggests they may need GOL
assistance to provide half the payment. Krumane indicated that a
portion of the IMF payments that has been earmarked for assistance
to state-owned banks could be used for this purpose if necessary.

LHZB - less of an issue?

10. (SBU) The Latvian Mortgage and Land Bank (LHZB) is fully
state-owned, and has a syndicated loan payment due in December.
Both LHZB Chairman Panko and Krumane report that LHZB has sufficient
cash to cover the loan. Enthusiasm for mixing the bad assets of
LHZB and Parex in a single bad bank or AMC is waning. However, LHZB
is still in a fairly tenuous situation, surviving on bilateral loans
from the Nordic Investment Bank and European Investment Bank. A
negative turn, such as a decline in Latvia's credit rating, could
spell significant problems for LHZB -- and the GOL. Krumane claimed
there is a buyer who has expressed interest in buying LHZB as is.

Devaluation Off the Table

11. (SBU) Rimsevics, who has steadfastly opposed devaluation, was
happy to report that it was no longer an issue. He noted with
pleasure that even Andris Skele, the head of the largest party in
the governing coalition and a vocal proponent of devaluation, had
declared it too late to devalue at the People's Party congress two
days earlier. Griffiths was less certain - although he seemed to be
approaching it more as an intellectual exercise than a policy
proposal. He noted that despite the current account surplus, many
forms of analysis still showed the Lat as overvalued, which would
continue act as a drag on any incipient recovery.

12. Comment: Completion of the 2010 budget is a positive step, but
focus should remain on carrying through with serious structural
reforms to prime Latvia for a steady recovery. The 2011 budget will
require another 500 million lat consolidation, and will be
complicated by next October's election. Before the election,
nobody will want to make politically painful decisions, and after
elections, the new government will be forced to work quickly to
complete the budget before the end of the fiscal year. On Parex,
our financially savvy interlocutors seem to recognize that losses
are unavoidable, but the governing and political class has yet to
come to terms with that reality. The sooner they do, the better.


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