MSNBC/Financial Times
Robert Anderson

Latvia, Europe’s most overheated economy, has plunged into political crisis, making it even more vulnerable to fragile global financial sentiment.

Aigars Kalvitis, the prime minister, on Tuesday survived a vote of no-confidence but his unpopular government is expected only to stagger on until parliament approves a belt tightening budget that it will begin debating on Wednesday.

Mr Kalvitis – a former dairy manager who after just three years in office has become the country’s longest-serving premier – has lost the confidence of party bosses after bungling the dismissal of Aleksejs Loskutovs, the country’s top anti-corruption investigator.

He last week had to fly back early from the European Union summit in Lisbon after the largest demonstration since the country’s independence in 1991 forced two rebel ministers from his People’s party to leave the cabinet.

Mr Kalvitis rejected calls for his own resignation on Friday, saying: “We have to take responsibility … the coalition has decided to move ahead.”

Ironically, the political turbulence has struck just as leading economic indicators have begun to improve and the government appears to be finally getting serious about tackling macro-economic imbalances.

Latvia, which suffered a domestic run on the currency, the lat, in February, is considered one of the economies in Europe most vulnerable to worsening ¬global credit conditions.

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Few lat-denominated assets are held by foreigners, making a speculative attack difficult but the size of the economic imbalances has forced the authorities to deny rumours that an adjustment of the exchange rate peg is imminent.

A consumer boom financed by foreign banks has built up a gross external debt that reached 117 per cent of gross domestic product at the end of last year and a current account deficit that hit 11 per cent of GDP in the second quarter.

Following an anti-inflation package in March and slower bank lending growth, the economy appears to be cooling rapidly. Property prices have been falling for half a year, while retail sales, new car registrations and monthly current account deficit figures have recently begun declining.

“The adjustment started to happen later than it should have, therefore it will probably be more compressed and harsh than we would like to see,” says Erkki Raasuke, chief executive of Hansabank, the Swedbank subsidiary that is Latvia’s largest bank. “Nevertheless, we are still seeing a good orderly adjustment going on.

“We expect a fairly quick recovery and then fairly sound growth over the coming years, though not at the rates of previous years.”

Mr Kalvitis has belatedly thrown his weight behind the anti-inflation drive by speaking out against excessive private consumption and wage demands, and moving to tighten fiscal policy. The government now expects to run a budget surplus of 0.4 per cent of GDP this year, rather than the forecast deficit of 1.4 per cent. Next year it plans a surplus of 1 per cent, followed by 1.2 per cent in 2009 and 1.5 per cent in 2010.

Government working groups also aim to produce a battery of supply-side proposals at the end of the year, focused on improving export competitiveness, productivity and labour supply. “They have done enough,” says Kenneth Orchard of Moody’s rating agency, which changed its outlook to stable from positive in September but retains an A2 rating two notches above its peers. “For many years it was all talk and no action. Finally they are doing something.”

However, further reform is now in doubt because of the political turbulence, which will damage domestic and foreign confidence.

Mr Kalvitis demanded the dismissal of Mr Loskutovs because of minor financial irregularities at the anti-¬corruption office. However, most observers believe the real reason was due to the office’s threat to impose a large fine on the People’s party for rampant over-spending in last year’s general election campaign.

The anti-corruption office has also worried politicians by pursuing investigations into Aivars Lembergs, the powerful mayor of Ventspils, as well as a digital television scandal, in which Andris D??le, a former People’s party premier, is a witness. The fall-out from these two affairs could have wide repercussions.

After last week’s rally parliament looks unlikely to approve Mr Loskutovs’ dismissal, sealing Mr Kalvitis’s fate. The coalition will probably try to nominate a new premier once the budget is passed next month, though there is no obvious candidate.

Given that trade unions are demanding higher public sector wage rises and are collecting signatures for a referendum on early elections, any successor may find staying in power as daunting a challenge as Latvia’s economic woes.