Nicholas Watson in Prague -
There's been a lot of speculation recently that Latvian politicians want to allow the lat to fluctuate more widely against the euro (read: fall against the euro) and so are looking to replace the leading cheerleader for the local currency, Latvian central bank chief Ilmars Rimsevics, when his first term expires in December. That's very unlikely, say analysts.
The speculation about the fate of Rimsevics began in earnest when the local Russian-language newspaper Bizness i Baltiya reported in early August an unnamed source as saying that the ruling coalition is considering replacing Rimsevics with another candidate who could be relied on to widen the lat's fluctuation band against the euro to 15%.
Rimsevics is the architect of the policy from 2005 to keep the lat in a very tight band against the euro of just plus/minus 1% from its midpoint of 0.702804 per 1. This is a much more constrictive policy than the plus/minus 15% fluctuation that is actually allowed under the Exchange Rate Mechanism, or ERM II, of which Latvia is a member. The ERM is the precursor to joining the euro, which Latvia had hoped to accomplish by 2008. However, with inflation soaring to 9.5% in July, the highest in Europe and above even that of Russia, both the Latvian Prime Minister Aigars Kalvitis and Rimsevics were forced to admit this summer the country will need at least five years or more to get inflation down to levels that would allow it to join the Eurozone, meaning 2012 at the earliest.
With hopes for joining the euro anytime soon receding, some politicians within the largest party of the ruling coalition, the PM's People's Party, or Tautas Partija, are reportedly looking for the Bank of Latvia (BoL) to widen that band to the plus/minus 15%, which no one is in any doubt would result in an immediate fall of the lat an effective devaluation. These people argue that allowing the lat to fall would make the country's exports more competitive and enable its local producers, such as those producing food and dairy products, to compete on better terms against importers. This would help Latvia start to make a dent in the ballooning current account deficit, which stood at 21% of GDP in 2006 and reached around 26% in the first quarter of this year.
High current account deficits are nothing new for Latvia; during the 1990s, the country ran pretty high current account deficits. The problem now as oppose to then is that the deficits of the 1990s were financed by foreign direct investment (FDI) from a swathe of privatizations; some 84% of the deficit was covered by FDI in 1996-2000. However, after most of these state-owned assets were sold off, FDI covered just 30% of the current account deficit in 2001-05, putting the emphasis on borrowing. Foreign debt has increased sharply, from just 22% of GDP in 1996 to around 112% of GDP in 2006.
Latvia's widening current account deficit, rapid private sector credit growth (60% in both 2006 and 2005) and high inflation rate show that the economy, which grew at 11.3% in the second quarter, is overheating. This prompted first Standard & Poor's and then Fitch Ratings on August 17 to downgrade Latvia to reflect the likelihood of the economy suffering a very hard landing.
PM Kalvitis inevitably refused to comment directly on the report in Bizness i Baltiya, though there was no ringing endorsement for the BoL president and the work he is doing at the bank. Kalvitis said on August 9 that coalition parties hadn't decided yet about who they would support for the presidency of the central bank, the issue is not on the coalition's agenda and wouldn't be on the agenda any sooner than October. The PM refused to even comment on Rimsevics' work at the central bank until he receives independent evaluations from his aides. The two men have often disagreed about policy in public, though analysts say that recently, with Latvia's economy coming under increasing pressure, they have presented a more united face, in public at least.
Regardless, there are several reasons why the coalition will refrain from replacing Rimsevics and allow him to serve another term, as he stated he wanted to do in an interview on local television on August 9.
The first is practical. "There was talk that the main party of the ruling coalition wants to replace the governor but again its just rumours. I have spoken with some people who are close to politicians and they say that they wouldn't get approval from the other parties in the coalition to do that," says Zigurds Vaikulis, head of markets analysis at Parex Asset Management in Riga.
The second concerns the terrible signal that replacing the central bank president would send to the markets, which are already extremely jittery over Latvia's teetering economy. The central bank is supposed to be independent, so replacing Rimsevics with someone who would almost certainly widen the currency band and thus effectively devalue the currency would be a direct breach of this independence. The European Commission would be furious.
The third has to do with other consequences of allowing the currency to fall. Latvians, in anticipation of the country joining the Eurozone in 2008, have, almost to a man and woman, taken out their mortgages in euros rather than lats - around 70% of borrowing is now in euros. And these mortgages are relatively large, given that the cost of a flat in Riga will set you back 3,020 per square metre, which is around the same level as Copenhagen, Helsinki and Stockholm, according to research by the Global Property Guide. This property bubble, which has been fuelled by the rapid economic growth and easy lending policies of the international banks who dominate the banking system in Latvia, is close to bursting point. Therefore, allowing the lat to fall would push up the level of people's already high repayments at the same time the value of those properties are falling would be a sure-fire recipe for disaster. Ordinary people hurt by the crash would punish those responsible at the next elections.
Rimsevics also has his loyal band of supporters, many of them powerful, none more so than the new president. On August 9, President Valdis Zatlers was quoted by the Latvian News Agency as saying that Rimsevics is the best candidate for the post of central bank president. "BoL is in safe hands," Zatlers said a notably stronger endorsement than any offered by the PM.
Assuming Rimsevics does serve another term, might he be tempted to compromise and widen the band himself? Not likely.
Rimsevics has already proved his mettle in defending the lat. In February, rumours swept through the markets that the central bank was ready to devalue the lat in an attempt to let the air out the ballooning current account deficit. Traders reported that one day the lat was firmly ensconced at the tight end of the plus/minus 1% range; by the time they returned to their desks the next day the lat had moved to other side of the band. The BoL began to intervene in the market and spent some 330m over next two months keeping the lat within the band. The central bank has recently started selling lats again and buying euros after the lat firmed back to the top end of its band.
Another speculative currency attack is no more likely to succeed. The economy, with its large external liabilities, makes it dangerously exposed to external shocks and so is a prime candidate for such a currency attack. However, Fitch Ratings says the local money market is too small for this to happen. "The risk of a currency crisis is currently remote, as shallow markets imply that there are few local-currency assets to sell or liquid investments to short-sell, making the likelihood of a speculative attack on the lat a weak prospect," Fitch said in its report in August.
Rimsevics' adherence to the strong-lat policy is intimately tied up in with his repeated insistence that he fully intends to take Latvia into the euro. Allowing the lat to fluctuate more widely against the euro, and thus no doubt to devalue, would fuel inflation as the cost of the food and fuel that Latvia imports in large quantities would rise. Such a move would make a mockery of the country's anti-inflation plan, which was launched in March and appears, albeit slowly, to be showing signs of having the desired effect.
Even though inflation came in at 9.5% in July, the central bank said it expects to see disinflation kicking in this year as the inflation-busting plan, which involves stamping down consumption through measures including restricting the issuance of personal loans and mortgages, takes effect. Indeed, as evidence of the plan working housing prices in Latvia fell by an average 8% in July.
Even so, the ratings agencies' criticism of the inflation-curbing plan remains that by itself this policy will be insufficient to restore the economy to a sustainable growth path. "Even under the framework of the plan, the Bank of Latvia expects the current account deficit to fall below 20% only in 2009 while the Ministry of Finance expects that the plan will only lower inflation marginally during the next two years, by 0.5% in 2008 and 2009," reckons David Heslam of Fitch. "Latvia's gross external debt burden will therefore continue to rise in the medium-term, worsening comparisons with rating peers."
What the government also needs to do, argue some economists, is draw up a tighter state budget rather than continue splurging tax revenues from the booming economy that it traditionally indulges in. This would arguably give the markets and business a clear signal that the economy is being stabilised. If the government does this, and also keeps Rimsevics on board at the central bank, the lat could hold its value and the economy achieve the soft-landing everybody so dearly desires.
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