Latvia's Crisis Mirrors Eastern Europe's Woes

Linards Naglis says he can't sleep at night. For the past 15 years, the enterprising Latvian has made a good living as a project manager for a consortium of Western investors in his Baltic homeland, buying up land to be used for real estate development. But recently, Naglis—and nearly all of his company's staff—was handed his notice as business evaporated. Now, instead of planning family holidays to Florida, he worries about how he will pay household bills. His life savings, invested in property in Bulgaria, have vanished, too. "I never thought I'd be in this situation, to be honest," he says. "I wasn't expecting to be a millionaire, but I expected a comfortable, decent life. Now I really don't know what will happen."

Naglis' story is in many ways a metaphor for his entire country. Of all the nations hit by the global financial crisis, none has suffered such a devastating reversal of fortune as Latvia. The tiny Baltic Republic saw its economy shrink by a heart-stopping 10.5% year-over-year in the last quarter of 2008. A further gross domestic product slump of 12% is forecast for 2009. Despite a $7.5 billion bailout from the International Monetary Fund in December, the government is being forced into severe economic measures, including public-sector wage cuts of 15%.

It's a remarkable turn of events for a country that until recently was regarded as an economic success story. In the capital Riga, what immediately catches the eye is the striking evidence of recent economic development. The city has become a magnet for Western tourists, turning the city center into a colorful maze of fancy boutiques, cafs, and restaurants. Modern bank branches, mostly Scandinavian banks such as Sweden's Swedbank (SWEDA.ST) and SEB (SEBA.ST), are visible on every street corner.

Yet these conspicuous signs of wealth are deceptive. In January the picturesque streets of Riga's medieval old town became the unlikely setting for violent clashes between stone-throwing youths and police, after a peaceful demonstration by 10,000 anti-government demonstrators turned sour. Political turmoil culminated with the resignation of the center-right coalition government on Feb. 20. Latvia's newly appointed Prime Minister, Valdis Dombrovskis, has admitted the country is "on the brink of bankruptcy," urging the nation to accept the IMF-backed austerity package or face financial ruin.

Real Estate Repercussions

What went wrong? As the global recession bites, Latvia, a small and open economy, is being hit especially hard by declining exports. Its problems are exacerbated by having a currency pegged to the euro—a linchpin of the country's economic policy that now looks increasingly problematic. But the foundations of the crisis were in fact laid years earlier.

It's a familiar tale of an overheated property market, fed by lax credit, excessive borrowing, and complacent regulators. "This real estate market was insane," says Aleksis Karlsons, a hotel owner and property developer in Riga. "The mentality set in: I own an apartment or two—that means I'm rich. People thought they were wealthy without doing anything." At their peak two years ago, apartment prices in Riga reached €2,000 per square meter ($234 per square foot). They have since plunged by more than 50%.

While ordinary Latvians can be partly blamed for their naivete, the government bears an even heavier responsibility for failing to prick the bubble when it had the opportunity. "The government did nothing to stop the party. Instead it joined in," says Peteris Strautins, chief economist of Swedbank in Riga.

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