Mike Collier in Riga -
Is the European Central Bank preparing to abandon the currencies of the Baltic states amid fears that the region's overheating economies are becoming unsupportable? That's the interpretation of a leading economist who believes the bank won't intervene to protect the kroon, lat and lita if they come under pressure, even though they are "hard pegged" to the euro.
Lars Christensen, economist with Danske Bank, wondered on October 4 whether comments from ECB board members Lorenzo Bini Smaghi and Jurgen Stark earlier that week were a way of telling the Baltic countries and Bulgaria to give up their exchange rate pegs.
Bini Smaghi told a closed-door conference of central bankers in Frankfurt on October 1 that the requirements for budgetary and structural policies for countries with an exchange rate linked to the euro might just be too demanding to counteract the cyclical effects of very low real interest rates; Stark warned that the current situation might not be sustainable for some of the hard-pegged countries.
"On the back of Bini Smaghi's comments one could raise the question whether the ECB would help the national central banks to defend the present pegs if they were to come under pressure," Christensen said.
He pointed out that when the Baltic States joined ERM-II, the precursor to adopting the euro, the countries committed themselves to reducing imbalances in their economies. However, "the developments in inflation and the current account in the Baltic countries show that they have failed to do this," he said. "The ECB might use that as an excuse not to even defend the 15% fluctuation band."
Certainly, the economies of the Baltic states are in a bit of a mess. As part of their aspirations to adopt the euro, all three adopted the 15%-plus/minus band in which their currencies are allowed to fluctuate against the euro. Though they passed initial convergence criteria, they were then presented with one final hurdle - average inflation that must not exceed the average of the three lowest rates in the EU, plus 1.5%.
However, inflation is so rampant in all three Baltic states - currently 7.2% in Estonia, 11.4% in Latvia and 7.1% in Lithuania - that there seems little hope of reigning it in, particularly because the pegging of their currencies has robbed the region's central bankers of the most potent counter-inflationary tool at their disposal. Without the ability to intervene on the money markets, the only other method likely to have an inflation-countering effect would be stockpiling budget surpluses. Yet only now are Latvia and Lithuania adopting 1% GDP surplus targets for 2007 and even Estonia's 1.3% surplus plan for 2008 was described by Hansabank analyst Maris Lauri as "overly optimistic."
Put simply, all three Baltic economies are teetering on the brink of a damaging crash that would likely force currency devaluation and ejection from the ERM-II. That in turn could have knock-on effects throughout Central and Eastern Europe, and even into the Scandinavian countries which have ploughed billions into in the region's banking sectors.
"We believe this issue is of extreme importance for the Central and Eastern European markets," said Danske Bank's Christensen. "To us, it is quite clear that urgent policy action is needed to bring down the imbalances. These countries will not get any help from the ECB in defending their currency pegs unless action is taken very soon."
Christensen reckons the European Commission's thinking on the subject is probably in line with the ECB's. "The Commission is unsatisfied with the speed of reforms and is likely to play hardball if some of [the 2004 accession states] get into economic problems due to the New Europe boom turning into a bust," he said.
Reaction to the speeches has been divided into two camps. The first is that the ECB doesn't know what to do when presented with the Baltic economies, which seem to defy traditional economic theory. However, a second interpretation is both more persuasive and more worrying.
Throughout both speeches, the central bankers posed questions including, "How large should the budget surplus be to counteract the inflationary effects?"; "How far-reaching should structural reform be?"; and, "How is it possible to keep inflation under control by pegging the exchange rate [when] the euro-area economy is growing at less than a third of what a catching-up economy should aim to achieve?"
It could just be that the ECB was taking the chance to publicly air questions it has itself been asking the Baltic states for months. So far, the ECB has received scant response from the governments and no real acknowledgement that their economies are in a parlous state, according to sources.
Certainly, judging from the comments of Bank of Latvia spokesman Martins Gravitis, there appears to be no sense of urgency. "We are fully aware of the problems that accompany the fixed peg, but neither are the fluctuating regimes problem-free safe havens," he told bne. "Both the central bank and the government are in agreement about the action that needs to be taken to end this year with a budget surplus and at least double it next year. The central bank has been calling for at least a 1% surplus for 2007 and 2% for 2008."
"This should translate into slower inflation during next year and a gradual slowdown of the economy to what is a more sustainable level," he said confidently.
Provided the current "unsustainable" imbalances can be sustained for the year or so before today's measures have a tangible effect, Gravitis could be right. However, if everything goes pear-shaped before that - as seems increasingly likely - then such plans will end up looking like Elastoplasts on a severed limb.
Bank of Estonia spokesman Tanel Ross also insists that there is no need to change the economic policies that have, "served Estonia so well for almost a generation."
"The fixed rate of exchange remains a successful anchor for macroeconomic stability and economic reform," he told bne.
Ross went even further than his Latvian counterpart, saying that what the central bank did not fully anticipate was a series of mostly positive shocks to the economy in connection with EU accession.
"First, EU accession provided a further credibility boost and readjustment of risks by investors that, in turn, resulted in a one-off increase of Estonia's asset prices, both in real estate and credit markets," he said. "Second, Scandinavian banking groups implemented their strategies in the region. Consequently, credit became much more readily available on more favorable terms. Third, regional labour market integration provided for increased opportunities to work temporarily abroad, mostly in Finland. The combination of these factors provided an extra boost to domestic demand that pushed the growth rate higher than we expected."
"This additional impulse is now subsiding and we expect growth rates to move gradually closer to sustained medium-term levels in next years, as these shocks have run their course," he said.
The Lithuanian central bank would appear to be more realistic. Spokesman Kestutis Vanagas admitted that, "You need good policies and some luck in order to become a member of the euro club."
Despite towing the party line with regard to how well the currency board has served the country so far, Vanagas makes no attempt to hide the huge imbalances in the Lithuanian economy. "Lithuania would need some 5% budget tightening in order to shave off 1 percentage point of inflation," he said. "Ten to 15 years ago, current account deficits of 5% were regarded as a deadly limit. The transition economies seem to have defied gravity with their [deficits]. We do not think that is sustainable."
In other words, as anyone who's attempted to defy gravity knows: what goes up, must come down.
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