Friday, October 19, 2007

Latvia & devaluation

Eastern Europe

Baltic blues

Oct 18th 2007 | TALLINN
From The Economist print edition

Europe's fastest-growing economies hit choppy waters

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DEVALUATION would be horribly painful and solve nothing. That is Latvia's defence, as its inflation rate and current-account deficit soar, and speculators hover over its pegged exchange rate. On paper, the small Baltic economy looks nastily exposed, as, to a lesser extent, do its neighbours Lithuania and Estonia (see chart). All three have overheating economies and fixed exchange rates: a risky mix. Some fear the region could be eastern Europe's Achilles heel.

Latvia is in the worst situation. Year-on-year inflation in September was a whopping 11.4%; the current-account deficit over a fifth of GDP. Bank lending, much of it in foreign currencies, has soared, creating a property bubble in the capital, Riga. Overheating has hurt competitiveness. To some the national currency, the lat, looks like the likeliest casualty.

Latvia's position was not helped when Jürgen Stark, a board member of the European Central Bank, said earlier this month that ex-communist countries wanting to join the euro zone faced “substantial challenges”, banker-speak for “forget it”; Lorenzo Bini Smaghi, another ECB board member, publicly questioned the ability of these countries to keep inflation under control while maintaining fixed exchange rates, a stance that means adopting what is de facto the euro zone's monetary policy.

Yet a devaluation is far from inevitable. The Latvian banking system is largely foreign-owned. If overstretched borrowers start to default, that will hurt shareholders abroad, mainly in Sweden, not the stability of the whole financial system. If scared banks rein in lending and construction companies go bust, that would help produce a much-needed soft(ish) landing. Indeed, that may already be under way. Furthermore, speculating against thinly traded currencies is tricky. It may also be pointless: the Latvian central bank has enough reserves to redeem every lat in circulation, and more besides. And as Jon Harrison of Dresdner Kleinwort, a bank, points out, Latvia has little foreign debt and a strong credit rating. It could borrow in euros to ease a local credit squeeze.

The problem for Latvia is the lack of monetary-policy levers. The currency peg means it cannot raise interest rates. Even when banks cut back on their lending, other financial entities, such as leasing companies, can fill the gap. That leaves only fiscal policy; yet the government, an uninspired coalition stronger on business practice than economic theory, has shied away from the big surplus that might slow the economy and reassure outsiders. The 2008 budget foresees a surplus of only 1%, rising to 1.5% in 2010. Outsiders think 3% would be a good start.

A forced devaluation in Latvia would be ruinous for the middle class—at least for those who stayed to experience it. Tens of thousands of Latvians have gone to work abroad already. Any gain in nominal competitiveness might well be counterbalanced by an even tighter labour market.

Estonia and Lithuania would be at risk if Latvia did devalue. But elsewhere, a crunch in the Baltics would be more spectacular than significant. The combined GDP of the three Baltic economies is barely 1% of the euro zone's. Their plight might worsen wobbles in Kazakhstan, say, but most other ex-communist countries would weather the storm. The main change would be in the mood music. When liquidity was plentiful, lending in eastern Europe looked like a source of easy profit. Now the region's bottlenecked economies and lacklustre governments stand more harshly exposed.


Aleksejs Nipers said...

Some comments:

"The currency peg means it cannot raise interest rates"
It does not - you can rise, but there are other problems with that when the currency is pegged.

"Outsiders think 3% would be a good start"
3% of GDP.

Colleen said...


Reuters: The U.S. ambassador to Latvia has expressed worries about the future of democracy in the Baltic state after a series of recent scandals and warned of the danger of a slide into corruption if nothing was done.

Using unusually strong terms for a NATO ally, U.S. Ambassador Catherine Todd Bailey said it was up to Latvians themselves to stand up for their own freedoms. "We have seen a pattern of events that appear to be inconsistent with our shared values," Bailey, head of the U.S. mission in Riga since February 2005, said in a speech Tuesday at the University of Latvia.

Colleen said...

Oh, btw, is the falling hyperpower advocating "regime change" in Latvia?

Is it because Latvia hasn't joined Estonia, Georgia, and Poland in hastily confronting Moscow in every opportunity?

Fact is, Latvia has recently improved its relations with Russia. The two sides are ratifying a mutually-beneficial border agreement. Russia's Alpha Bank is buying Parex. The Baltic Times wrote on 7/26/07: "In stark contrast to the icy chill between Tallinn and Moscow, Latvian-Russian relations are on the up, with a succession of cross-border meetings taking place and more planned for the future."

Meanwhile, on 8/7/07, Latvia's President Valdis Zatlers said on the Ekho Moskvy radio that Latvia will develop and strengthen relations with Russia. "We want to develop relations with Russia. Both nations should take steps in the economic, cultural and social spheres to meet each other halfway," he said.

And now the U.S. cannot stand Latvia.

Veiko Spolitis said...

To Colleen:

Unfortunately you have not followed the news that owners of Parex declined the offer of the Alfa Bank.
Latvian relations with Russia have improved, but what was the price paid for that? It is very probable that after the fall of Aigars Kalvitis government we would learn that Kalvitis would step into shoes of Gerhard Schroeder and Goran Persson.

The Latvian A-Team or popularly dubbed wannabe oligarchs are mostly to be blamed for the US ambassador delivering this academic speech. If you want to learn more about the background of the spech, then go to the US state department webpage and learn more about the Condi Rice "Transformational Diplomacy" speech at Goergestown University on January 2006.

Jim Hass said...

the economics of the Latvian situation is totally independent of Riga's kissing up to Moscow. Boom bust cycles are painfully to live through, and difficult to prevent without broad political consensus. A currency board presupposes real budgetary discipline. With a substantial debt, and mostly denominated in a foriegn currency, Argentina endured years of deflation, huge unemployment and eventually default. Friends wouldn't wish that on a friend.

Edward Lucas said...

Thanks to Aleksejs for his comment. Budget surpluses and deficits are normally measured as a percentage of GDP. Sorry if that wasn't clear. I theory you can raise interest rates in a fixed currency regime, but the result will be a wall of hot money coming in which will be destabilising and force you off the peg, so the case is effectively trivial, I think (anyone else have a better explanation?) The bank of latvia does have small flexibility in the money market exchange rate though, but not enough to have a real tightening effect.

Colleen: I wonder if you are seeing Russia in too rosy a light...

Giustino said...
This comment has been removed by the author.
Giustino said...

Just because Latvia and Estonia are next to each other doesn't means their geopolitical situation is identical.

Latvia's warmer posturing towards Russia is probably because it has closer economic ties to Russia. They see it in their economic interest to pursue those ties.

On the other hand, 75 percent of direct foreign investment in Estonia comes from two countries -- Sweden (55 percent) and Finland (20 percent).

The state itself sees competition in the transit market as futile and would rather concentrate on other sectors of the economy.

So, it's not exactly in the foreign or domestic investor classes' interest that Estonia have chummy ties with Russia. Estonia is one of the few foreign countries where the Swedes absolutely dominate. Why would they want Russian illiberalism creeping into their market?