€5bn question is whether IMF will force Latvia to give up currency peg

By bne IntelliNews December 1, 2008

Nicholas Watson in Prague -

With the announcement from the Latvian finance minister on Monday, December 1 that the government is seeking €5bn from the International Monetary Fund and EU to bolster the ailing economy, that answers the question about how much. The other, now €5bn question is whether the IMF will demand in return that Latvia gives up the foreign currency peg that fixes the rate of the lat against the euro. No one is quite sure, though the hunch is that the two sides will do everything to help Latvia keep it.

Latvian Finance Minister Atis Slakteris told Reuters in an interview that his experts reckon €5bn would be enough to help solve the economic crisis, and he plans to take this to the government and then to the IMF and EU. "It seems to me this is a realistic estimate: about €3bn for supporting the economy and about €2bn could be linked directly to the budget deficit and more direct government expenses," he was quoted as saying.

The Latvian economy was already feeling the pressure from years of double-digit growth and rampant lending when the financial crisis began sweeping through the world's emerging markets. The result has been a sharp curtailment of growth that plunged the country into recession. Latvia estimates its GDP will contract 5% next year. Likewise, the other two Baltic states - Estonia, which is also in recession, and Lithuania, which is flirting with it - expect to suffer a contraction in GDP next year, with Estonia's falling 3.5% and Lithuania's falling 1.5%.

Slakteris said he hoped to conclude talks with the international lenders as soon as possible, but it was premature to say when the negotiations would end. But even after the talks have been concluded, analysts say it will probably take more time for the details of the plan to emerge, principally what will happen to the currency peg that ties Latvia's currency, the lat, to the euro within a 15%-plus/minus band.

As part of their aspirations to adopt the euro, all three Baltic states pegged their currencies to the euro, allowing them to fluctuate within a band of plus/minus 15%. This is a de facto currency board, which works by a central bank ensuring there are enough currency reserves to guarantee that all holders of its notes and coins can convert them into euros.

The precedent for the IMF demanding that Latvia give up the peg is Argentina, which in 2001 got the IMF to finance its currency board for several months before promptly devaluing the currency in December - something that severely damaged the institution's credibility. "It's unlikely the IMF will want to repeat that mistake," says one analyst.

Given that domestic consumption as a growth driver for Latvia is now effectively dead, the only way that Latvia can turn itself around is by exporting more than it imports. But for a country that ran a 23% current account deficit in 2007, this is going to be very difficult objective to achieve, since after two years of very strong inflation Latvia's relative prices with the rest of the world are completely uncompetitive. It's no secret, therefore, that the IMF and European institutions favour a floating currency as a way forward out of the present crisis and help the country regain its competitiveness.

However, Neil Shearing, an economist with Capital Economics, counters that the difference with Argentina is the sheer scale of Latvia's borrowing in foreign currencies. A devaluation would force scores of businesses and households who had borrowed in euros to the wall. Indeed, the Bank of Latvia warned in a statement on November 25 that devaluation of the lat would significantly increase the burden of liabilities on the borrowers, as about 80% of the loans to Latvian households have been issued in euros. A devaluation would also cause a wave of price rises of imported goods, raw materials and energy resources, meaning that the expected relief to exporting businesses would be either short lived or non-existent, argued the central bank.

"So it's a difficult question. Our hunch is that the IMF and Latvia will do everything to keep the peg, but that of course will involve a fall in the real exchange rate and much lower or even negative wage growth over the next few years," says Shearing.

Edward Hugh, a widely read independent economist, also admits he hasn't "the faintest idea" what the IMF will decide, but points out that experience has taught us that it's not an easy thing to tell people that "their wages will fall by between 10% this year, next year, and then possibly the year after." As such, according to conventional economic wisdom, devaluation would be the preferred option. "And it is my opinion that, despite all the attendant difficulties, devaluation is the best option among the unappetising list of unpleasant options presently available to Latvia (and the other Baltic states, and Bulgaria). Unfortunately, having reached this point, there are simply no 'pleasant' options available."

Dominoes falling

If the IMF decides not to risk a repeat of its Argentina embarrassment, the next question is whether this move would lead to the demise of the region's other currency pegs.

An Organisation for Economic Co-operation and Development (OECD) economist, who asked not to be named, told bne that he isn't convinced the currency boards in the Baltics will hold, and "if the first goes, they would probably all go - including Bulgaria's currency board."

What might help maintain the pegs of the other two Baltic states is that their banking sectors are totally dominated by big foreign banks, much more so than in Latvia, whose second largest bank, Parex, has had to be rescued by the state. However, Bulgaria's currency board is looking the next most vulnerable as the country's economy starts to display alarming imbalances.

In early December, Finance Minister Plamen Oresharski will present the Bulgarian government's convergence programme to the European Commission that outlines the country's macroeconomic policy and reforms for the period to 2011. This will, says the government, include a commitment to keep the current currency board arrangement under which the Bulgarian Lev is pegged to the euro with a fixed exchange rate of 1.955 leva per euro until it joins the Eurozone.

However, economists note that Bulgaria's current account deficit has widened to around 23% of GDP in Bulgaria, while at the same time its ability to finance this deficit has deteriorated, with foreign direct investment only plugging about a half. This means its economy is highly susceptible to capital outflows. "However, Bulgarians have their hands tied by a currency board that pegs the lev rigidly to the euro. That rules out devaluation to restore competitiveness, which is a concern as exports sag. It also removes a potential buffer, because the central bank cannot adjust interest rates," say economists at RGE.

While Bulgaria does possess considerable fiscal reserves that can be used to prop up its currency, the true extent of damage done to the country's economy from the global financial crisis is set to emerge over the next few months and that fixed exchange rate is looking increasingly fragile.

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