Domino devaluations

By bne IntelliNews February 6, 2009

Robert Anderson in Stockholm -

Riots in Riga and mounting pressure on the government to resign have raised fears that Latvia won't be able to keep to the strictures of its €7.5bn International Monetary Fund-led rescue programme agreed at the end of last year. But many economists - particularly outside the country - question whether the IMF plan will work even if the politicians implement it. They predict that Latvia will be forced to devalue the lat anyway before it hopes to join the Eurozone in 2012-13, that its neighbours will probably have to follow suit and that the repercussions will be felt far beyond the Baltic states.

"They will devalue at some stage," predicts Torbjorn Becker, director of the Stockholm Institute of Transition Economics. "They can't enter the euro with this exchange rate with their economy going down the drain."

Economists usually recommend devaluation rather than deflation as the preferred solution to balance of payments crises, precisely because the latter is too painful for most countries to implement.

What makes Latvia's position especially worrying is that at a time when other EU member states are launching fiscal boosts to reflate their economies, Latvia and the other Baltic states are imposing austerity packages that threaten to worsen their current recessions. Worse, Latvia's austerity plan is one of the most ambitious in the current round of IMF rescue packages. According to Capital Economics, the package of cuts and tax hikes represents 7% of GDP compared, for example, with the 2.5% of GDP in the IMF's earlier rescue of Hungary.

The Latvian government predicts that the Latvian economy will contract by 5% this year, but several new forecasts estimate that the decline could be far worse. Capital Economics predicts 10% and even the European Commission forecasts a 6.9% contraction. "There is a concern that ever tighter economic policies send the economy into an extended downward spiral, which results in missed budget targets, repeated rounds of fiscal tightening, further growth downgrades etc. and ever growing speculation that the currency peg will eventually be scrapped," RBC Royal bank warned recently.

If Latvia's attempt to maintain its fixed exchange rate collapsed - in the same way as Argentina in 2000 - it would be the worst of all possible worlds. After experiencing the agony of deflation, it would then suffer a devaluation that would damage asset prices and raise the burden of foreign borrowing. The country's eventual foreign debt/GDP ratio would be enormous, because foreign debts would have risen in value while GDP plummeted. Foreign banks, particularly the region's largest investors Swedbank and SEB of Sweden, would also suffer a huge hit on the value of their assets. Both banks would need recapitalisation by their shareholders or the Swedish state.

If Latvia abandoned its currency peg, Estonia and Lithuania would come under pressure to also abandon their currency boards. Both are already rushing to slash public spending as tax revenues fall, because seeking foreign loans to plug their budget gaps would be extremely difficult in the current global financial environment.

A Latvian devaluation would also affect risk perceptions throughout Central and Eastern Europe and could destabilise several other countries, notably Bulgaria and Romania. Bulgaria, which also runs a currency board, is expected to have a current account deficit of almost a quarter of GDP this year, while Romania, with a floating exchange rate, has large current account and budget deficits.

Reputations at risk

Failure to defend the currency peg would also damage the credibility of the IMF and the European Central Bank, which has established a precedent by extending aid to support Latvia's narrow band within the 15% ERM2 currency band. "Correcting currency misalignment without nominal depreciation is extremely difficult," the IMF pointed out in its own report on the Latvian stabilisation plan. "Failure could entail substantial reputational risk for both the authorities and international institutions."

Many economists have criticised the IMF plan because it doesn't include a devaluation of the lat. "Currency misalignment created a lot of the problem that you see today, so they haven't dealt with the underlying problems," says Becker. He points out that Latvian competitiveness has also worsened in recent months as the currencies of some their main export markets such as Sweden depreciate against the euro, to which the lat is pegged.

Even the IMF predicts that a devaluation - through widening the currency band - would benefit the Latvian economy in the long run by improving export competitiveness, though it would cause a deeper initial contraction because of the impact on the balance sheets of companies and households. "Recession could be protracted, perhaps more so than if an alternative strategy had been adopted," the IMF says.

It estimates that with a devaluation the economy would contract by 7% this year, but would recover to the 2008 level by the end of 2012, while the stabilisation plan forecasts that GDP will still be 2% below that level in the first quarter of 2013. A lot will depend, of course, on how quickly the rest of Europe recovers from recession.

IMF officials have indicated that the organisation was divided over the wisdom of defending the lat's peg, but was finally persuaded by the refusal of the Latvian government to contemplate devaluation and by pressure from the country's European partners.

Latvia - which has a law penalising scaremongering about devaluation - fears that it would cause massive disruption, because 90% of loans are in foreign currency and private sector net foreign exchange debt is 70% of GDP. For its part, the EU fears the contagion effect of devaluation on other CEE countries and the repercussions this would have for Western European banks.

The IMF advances two other main arguments against devaluation. Firstly, choosing a drawn-out orderly adjustment gives Latvia time to improve its insolvency regime, strengthen the capital base of banks and allow private debt restructuring. Secondly, the Latvian economy would not benefit much from devaluation, particularly in the current global environment. The economy is dominated by non-export sectors such as real estate and finance. Until recently, it was also operating at more than full capacity. Devaluation would, therefore, stimulate inflation without significantly boosting exports.

Nevertheless, the IMF foresees that the risks to the stabilisation programme are "considerable" because of the size of the deflationary adjustment of wages and prices required.

The first risk is that Latvian wages and prices will not adjust sufficiently quickly, companies will not improve productivity and competitiveness, and the economy will remain stuck in recession. Here a lot will depend on whether Latvian companies and workforces are as flexible as they are said to be. There is already some evidence that wages are coming down, made easier by the fact that part is often paid in bonuses. "The chances are that the Baltic labour markets are sufficiently flexible to adjust without devaluations," says Gunnar Tersman, emerging markets economist for Handelsbanken in Stockholm. "In any case, we are not there yet where we can say decisively that the wage cost level is a problem [for competitiveness]."

The second risk is that popular discontent will force the government to shy away from the austerity measures that it has promised the IMF, or backtrack when the going gets tough. The economy would remain stuck in recession and the IMF would have to halt aid or lose credibility.

The Latvian government is already the most unpopular in the EU and popular discontent is growing as the recession deepens. However, January's riots in Riga don't prove that the IMF plan is in danger yet. The demonstrations were against an unpopular government rather than the IMF plan, and it was peaceful until marred by troublemakers at the end. Latvians are used to economic turbulence and support their currency peg as a source of stability. So far, they seem prepared to accept some hardship to defend it.

Political instability

A more immediate worry is whether the Latvian government has the necessary political strength and expertise to implement the IMF plan. The IMF report emphasises that the plan requires "strong political leadership and mobilisation of public support," and that "maintaining this commitment through an anticipated prolonged recession could be challenging."

Prime Minister Ivars Godmanis has committed himself to the IMF plan. He is a veteran both of the collapse of the command economy at Latvian independence in 1991 and the economic turbulence caused by the 1997 Russian financial crisis. He was nominated by President Valdis Zatlers precisely because of this experience, and this crisis will be his last chance to cement his reputation.

PM Godmanis and his team are now putting together a package of policies agreed with the IMF to improve the competitiveness of exporters and stabilise the financial sector. So far, the IMF plan is supported by the opposition, which is divided and appears reluctant to take over responsibility for handling the crisis.

The next few months will be critical, as the IMF report recognised: "If Latvia's exchange rate peg is to be maintained, domestic policies need to be radically strengthened to generate the needed real depreciation."

However, the government remains deeply unpopular and fractious. Moreover, Godmanis is not a good communicator and has failed to sell this package to voters. The IMF deal was rushed through parliament in one sitting without real debate. As the implications of the plan become clear, his government will encounter stiffer opposition.

Already, opposition parties are mobilising to bring the government down, while coalition parties are manoeuvring to avoid blame for the looming economic pain. The president has called for the ruling coalition to be broadened to give the plan greater political backing, but his appeal has so far gone unanswered. On February 4, the government survived a no-confidence vote, but few believe it can keep going in the same way as before. "Something will happen," says Paul Raudseps, editorial page editor of the daily Diena. "Everyone realises the current situation is unsustainable."

If the government cannot be broadened, there is a big risk that elections will be brought forward from October next year. President Zatlers has even threatened to call elections if parliament does not pass a package of political reforms.

Whether elections are brought forward or not, the IMF plan faces grave danger over the next 18 months. If elections were brought forward, this would divert the government from the reform package and encourage all parties to make unrealistic manifesto promises. The current coalition parties would suffer a complete rout, opinion polls show, and untested opposition parties would take over.

Nevertheless, holding elections now, before voters really feel the pain, might be the best chance for the IMF plan to work. If elections happen later, opposition to the plan might solidify and a new government could pledge to abandon it. "The later the election takes place, the larger the danger to the IMF plan," reasons Raudseps.

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Domino devaluations

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