The International Monetary Fund may insist Latvia abandon its currency peg in return for much-needed aid, economists say, a move that would derail the country’s euro adoption aspirations and intensify pressure on other fixed-currency regimes in emerging Europe.
Latvia said last week it is seeking aid from the IMF and the European Union for its struggling economy, and initial indications on securing funding look positive. IMF head Dominique Strauss-Kahn said Friday the Fund “stands ready to rapidly assist,” while the E.U. pledged over the weekend it would take part in a coordinated rescue package. But economists say that the IMF may demand, in exchange for aid, that Latvia devalue its currency to boost export competitiveness.
That would put strong pressure on Lithuania, Estonia and Bulgaria – East European members of the E.U. that also have currencies fixed to the euro, economists say. “Eventual Fund help might…be conditional on giving up the currency board regime and allowing faster real exchange rate depreciation to rebuild competitiveness,” said economists at BNP Paribas SA in a research note. Citigroup Inc. economist David Lubin said: “The IMF’s own credibility was severely damaged as a result of its decision to continue financing Argentina’s currency board in the run-up to that country’s December 2001 devaluation, and we think it is unlikely that the IMF will want to repeat that mistake.”

“I am an economy n00b, so let me ask.Doesn’t this condemn the ideo of monetary integration?”

Well, it isn’t as simple as all that, but yes, it does make it more complicated than many seem to imagine.

“What would they do if Latvia was in the eurozone?”

It is, and it’s called Spain, and it has all the Latvian problems in slightly milder, but still pretty severe, form. So we are just about to find out, aren’t we. Impose substantial deflation is my guess, but it won’t be exactly funny to watch.