THE ROOTS OF THE LATVIAN BANK FAILURES

The Roots of the Latvian Bank Failures

by Paul A. Goble

On September 27, Bank of Latvia director Einars Repse told journalistsin Riga that Latvia had survived the worst period of the financialcrisis sparked by the failure of the Baltija Bank last spring.He further insisted that the Latvian banking system was now showingsigns of recovery. Such a conclusion is almost certainly prematuregiven the enormous direct and indirect costs of the failure ofthat bank, the difficulties that Latvia and her neighbors arelikely to continue to face because of the inherent weaknessesof their financial systems, and the role that Russian banks andquite possibly the Russian government has played in using thiscrisis to expand its economic and political influence in Latvia.And because the West has failed to note, let alone react to, whathas happened in Riga, there is every likelihood that the Moscow-inducedcrisis there will be repeated in other former Soviet republics.

Costs Direct and Indirect

The direct costs of the failure of the the Baltija Bank last springhave been enormous: One Latvian resident in five had his savingsin that bank, and most of these holdings are still beyond thereach of the depositors. According to the Bank of Latvia, 53%of all deposits in all banks were frozen as a result of the crisis.As a result, Latvians have pulled their deposits from the bankswhen they could, thus reducing the amount of money available forloans and increasing interest rates. Ten other banks have failed,and the number of active banks in Riga declined from 55 at thestart of the year to 39 in September. Many of those are in troubleand unless they find new international partners may fail soon.And the Bank of Latvia was forced to use 18.5% of its hard currencyreserves to defend the national currency.

The banking crisis quickly spilled over into a more general politicalone. First, the Latvian government was forced to spend more moneyto bail out some banks lest the crisis cripple the country. Asa result, the budget deficit increased dramatically angering theIMF and World Bank and forcing the Latvian government to pay everhigh rates for the money it did raise through borrowing and toeffectively default on some of its commitments: at the end ofSeptember, the Latvian government had to confront the indignityof one of Latvia’s airplanes being "arrested" at Moscow’sSheremet’evo airport for non-payment of landing fees.

Second, the government was forced to proceed with ever more rapidprivatization, creating a "fire sale" situation whereforeigners–including Russians–could purchase large chunks ofthe Latvian economy at incredibly low prices. In August, the RussianGAZ company purchased one-third of the Riga Automobile Factory;and at present, the Russian LUKOIL concern is pressing hard topurchase a controlling interest in Latvia’s oil and gas pipelinesand port facilities.

Third, the failure of the banks and the government’s uncertainresponse created a crisis in confidence among the population aboutthe government itself. Opinions have polarized in the currentelection campaign with some seeing a way out in an anti-Russiannationalism, and others deciding that the collapse of the bankingsystem was just one more indication that Latvia has no choicebut to cooperate more closely with Moscow.

What Triggered the Crisis?

The Bank of Latvia argues that the collapse of the Baltija Bankwas the result of the inherent weaknesses of the Latvian economyand banking system. Latvia lacks a real estate market, a functioningstock exchange, and experience in operating banks. But Latviaby virtue of its geographic position earlier had assumed thatit could easily play the role of intermediary between Russia andEurope. As a result, the banking system was overbuilt, underregulated,and often corrupt. The sources of capital were often obscure–manyLatvians believe that some of the banks were created with KGBfunds from Russia–or even nonexistent–according to a story makingthe rounds in Riga today, more than one bank has hyphenated itsname with a foreign country to suggest that it has ties that itin fact does not. Consequently, Latvians quickly learned thata bank is not a bank is not a bank.

But all of these problems do not explain either the timing orthe precise reasons for the collapse of the Baltija Bank. Variousnewspaper accounts from the Baltic states and Moscow, however,allow us to piece together at least an outline of what happened.The directors of the Baltija Bank made a large number of bad loans,they then attempted to cover themselves by a variety of financialarrangements with the Intertek Bank in Moscow; and then when theloans began to go bad, they found themselves at the mercy of theRussian bank. For both political and economic reasons, the Russianbank refused to hold some of the paper it had held and pulledsome of its own deposits out of the Baltija Bank.

This crisis developed immediately after the Latvians blew up thehated Russian Skrunda radar site–something the Latvians wereentitled to do under their agreement with Mosocw–because in thewords of one Russian journalist, "What did the Latvians expectafter they blew up our radar site?" Now a Russian court hasdismissed a Latvian suit against the Intertek Bank, finding thatIntertek had behaved responsibly and had returned the portfolioagreements to the Baltija Bank. But the director of the BaltijaBank Valentina Golushko to which the paper was reportedly returnedhas disappeared. The Latvian banking authorities plan to appealthe Russian court’s decision but have little hope of winning.

Obviously, Moscow did not bring down a healthy Latvian bank. Butit seems very likely that Russian bankers–many of whom are involvedwith the Russian mafia and the Russian government–exploited theweakness of the Baltija Bank for both economic and political gain.That conclusion reflects not only the events of the past six monthsbut even more the statements of Russian officials over the pastfour years.

A Russian Strategy for Dealing with the Baltic States

Because of Western interest in the Baltic states, Russian officialshave grudgingly acknowledged a kind of Baltic exceptionalism concerningtheir policy toward former Soviet republics. To promote its influenceand control in what Russian officials call the "near abroad,"Moscow can and has used military force in the Caucasus and CentralAsia with impunity. It can and has used direct economic blackmailin the case of Belarus, Ukraine, and Moldova. But with regardto the Baltic states, Moscow has recognized that the use of forceor even direct economic steps such as blockades are counterproductiveand instead has used a variety of other measures–charges of humanrights violations, for example–to press its case.

Moscow’s strategy in this regard was developed almost immediatelyafter the Baltic states reclaimed their independence. In 1992,the Russian foreign ministry leaked to Baltic diplomats in Moscowa copy of a Russian position paper outlining how Moscow woulduse normal economic intercourse to dominate the Baltic statesafter Russia had withdrawn her troops. (At the time, many in theBaltic states took this statement to be extremely positive: itindicated that Moscow was planning to pull its troops out at longlast.)

In 1993, a group of advisors to the Russian foreign ministry publisheda small pamphlet in which they urged Moscow to use economic means–manipulationof trade, involvement in banking and business, and so on–to putpressure on the Baltic countries because such means were far lesslikely to cause what the writers called an "allergic"reaction on the part of the West. More recently, Russian bankshave sought to increase their leverage in the Baltic capitals,and Russian companies have sought to purchase major parts of theBaltic economies.

Most of this activity has gone unreported in the West becauseon the surface at least it seems entirely natural and reasonable:a large country with enormous economic assets is actively involvedwith the economies of the countries around its periphery. Andat one level, it is entirely possible that some Russian activityin this regard is innocent. But it seems clear from the statementsof Russian officials–most recently Defense Minister Pavel Grachevon September 25–that Moscow intends to use such Russian involvementin the Baltic economies to try to prevent the Baltic states fromslipping out of the Russian orbit and moving into NATO’s. Giventhe inherent weaknesses of the banking system particularly inLatvia, it is no surprise that such a strategy is attractive tothe Russians.

To date, Moscow has had much less success in penetrating the Estonianbanking system–which is far more diversified and has grown lesscrazily than its counterpart in Latvia–or in Lithuania–whereRussian influence seems guaranteed by geography. (As long as Kaliningradremains an important Russian possession, Lithuania’s freedom ofaction is much constrained.) As a result, in those two countries,Moscow has used a different economic strategy, one based on shiftinggoods and services from one port to another, apparently at randombut certainly in a destabilizing way. Thus, the shipping revenuesof one port have varied widely from year to year, a pattern thatundermines the economic activity and tax receipts of the countriesinvolved. Given its success in using the banking weapon in Riga,however, Moscow is almost certain to try to use it elsewhere bothin what it calls "the near abroad" and even in EasternEurope.

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Is there a Baltic defense? Estonia seems to have found one: thedevelopment of close ties with large banks in Scandinavia, Germany,and Western Europe. But ultimately, these small countries on therim of Russia can only be secure if they are embraced by the Westeconomically and militarily. To date, the West has failed to payattention to the role that Moscow played in the collapse of theBaltija Bank. As a result, the Baltic countries feel that muchmore insecure and have stepped up their demands to join NATO.Should they succeed, Moscow will once again have overplayed itshand; should they fail, the Baltic countries seem certain to facea Hobson’s choice of greater nationalism which will only isolatethem from the West or greater cooperation with a Russia that hasnever looked upon them with favor.