The Latvian Cat Is Out Of The Bag

Reuters this morning:

The International Monetary Fund (IMF) would back a devaluation in Latvia, but the government, central bank and European Commission are against, the prime minister was quoted on Thursday as saying. It was the first clear statement by a policy maker about a differing stance between the IMF and Latvia and its other lenders over the currency, though the Fund has warned that keeping the currency peg during a sharp downturn would be tough. “The International Monetary Fund has no objection to a devaluation of the lat, but the European Commission, Bank of Latvia (central bank) and the government do not support this solution,” Baltic news agency BNS quoted Prime Minister Valdis Dombrovskis as telling a meeting of regional journalists.

and Nordea flash comment:

According to Latvian Prime Minister Valdis Dombrovskis the IMF has no objection to a devaluation of LVL. However, he continues that the European commission, Bank of Latvia and the government are against devaluation. IMF’s opinion counts as Latvia is asking the fund for a permission to increase the budget deficit to 7% of the GDP from the agreed 5%. Latvian economic contraction has been worse than expected. Getting out of the woods requires that competitiveness must be improved. This can be done by external or internal devaluation. IMF’s stance highlights the risk of external devaluation. However, it is not a done deal since the political opposition is very hard. Some 90% of the Latvian loans are in foreign currency and hence external devaluation would affect most Latvian households and companies. Ongoing discussion emphasizes the importance of hedging the Baltic FX risk. If Latvia gives up, speculation that the other Baltic countries follow, increases.

This was always like this, and even though Ambrose Evans Pritchard glossed it all up a bit by talking about secret IMF documents that had been leaked, the information was always freely available in this report of the IMF website:

A change in the peg is strongly opposed by the Latvian authorities and by the EU institutions, and thus would undermine program ownership. The quasicurrency board has been an anchor of macroeconomic stability for more than 15 years, was able to withstand the 1998 Russian crisis, and commands popular and political support. Any change in regime would cause significant economic, social and political disruption.

The authorities and staff examined the merits of alternative exchange rate regimes. A widening of the exchange rate band to ±15 percent (as permitted under ERM2; currently Latvia has unilaterally adopted a ±1 percent band) would result in a larger initial output decline, since adverse balance sheet effects would reduce domestic demand. However, competitiveness would improve more quickly, reducing the current account deficit and fostering a more rapid economic recovery. The case for changing the parity would be stronger if it could be accompanied by immediate euro adoption. Technically, this would address many of the risks described above, and give Latvia deeper access to capital markets. With its negligible public sector debt, the government would also find it easier to borrow in euros on international capital markets. However, the EU authorities have firmly ruled out this option, given its inconsistency with the Maastricht Treaty and the precedents it would set for other potential euro area entrants.

So the only real news that Valdis Dombrovskis seems to be announcing today is that the central bank the Latvian government, the EU Commission, the ECB (and possibly) the Nordic Banks are the explicit villains of the piece.

Personally I am very sorry that we are now coming to what may turn out to be a “disordely” resolution of the four East European pegs, since I think it didn’t have to be like this, as I have argued in:

Why The IMF’s Decision To Agree A Lavian Bailout Programme Without Devaluation Is A Mistake

Why Latvia Needs To Devalue Soon – A Reply To Christoph Rosenberg

Why You Need Devaluation – An Open Letter To The People Of Estonia

Devaluation, Euro Membership And Loan Defaults – Some Thoughts For My Critics

Basically, if we go back to my last post on toxicity, and look at the causal chain:

Financial Crisis -> Real Economy Crisis -> Political Crisis

we can see that it is the political crisis which ultimately breaks the loop. Without the devaluation Latvia is stuck in a self reinforcing contraction where budget cuts slow the economy further and make necessary further cuts, while all the time more and more toxic assets are created, faster than you can borrow the money to clean them up (you know, the ball of negative energy that feeds on itself).

Update Dombrovskis “Corrects” Himself

According to the latest out of Reuters Riga, Latvian Prime Minister Valdis Dombrovskis clarified later this morning (Thursday) that the International Monetary Fund was not currently seeking a devaluation of the lat currency. Speaking to reporters at the talks he is holding with IMF representatives, Dombrovskis said his earlier words were a “historical review” of negotiations last year with the IMF. “The current agreement of an unchanged exchange rate remains in force,” he told reporters. Of course, no one doubted it. But still……..

Interestingly, the Reuters reports on the story are both written by the same journalist, yet while the first comes direct from the Riga office, the second is routed via the Stockholm one. There wouldn’t be a slight difference in perspective here depending on your vantage point, would there?

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About Edward Hugh

Edward 'the bonobo is a Catalan economist of British extraction. After being born, brought-up and educated in the United Kingdom, Edward subsequently settled in Barcelona where he has now lived for over 15 years. As a consequence Edward considers himself to be "Catalan by adoption". He has also to some extent been "adopted by Catalonia", since throughout the current economic crisis he has been a constant voice on TV, radio and in the press arguing in favor of the need for some kind of internal devaluation if Spain wants to stay inside the Euro. By inclination he is a macro economist, but his obsession with trying to understand the economic impact of demographic changes has often taken him far from home, off and away from the more tranquil and placid pastures of the dismal science, into the bracken and thicket of demography, anthropology, biology, sociology and systems theory. All of which has lead him to ask himself whether Thomas Wolfe was not in fact right when he asserted that the fact of the matter is "you can never go home again".

2 thoughts on “The Latvian Cat Is Out Of The Bag

  1. I wonder why you , and many other eurosceptic commentators are so adamant about the need for devaluation, when the Latvians themselves do not seem to want to do that.

    Whats the point of going bankrupt immediately ( because of the loans) rather than at least trying to get out of the hole slowly.

    Of course living standards will have to fall dramatically and competitiveness will have to rise , but why go through the default of foreign debts ( that will be absolutely unserviceable after a deval).

    The greater point is that Latvians themselves do not want to leave Europe or the prospect of the Euro.
    They are fed up with the local elites and this the reason for the riots.

    Same thing in Greece , my home country.
    Nobody , absolutely nobody , not even the Stalinist Greek Communist Party ,wants to leave the Euro, but everybody , even the “conservative silent majority” is fed up with the local elites.

  2. Hello currency wars,

    “I wonder why you , and many other eurosceptic commentators”.

    Just for the “avoidance of doubt” as they say. I AM NOT EUROSCEPTIC, if you look at my posts you will see I am advancing a whole series of arguments about how best to SAVE THE EUROZONE.

    As for the rest, you’ll have to read the posts I have linked to to see the arguments I present, since the whole thing is much to complicated to explain in a few lines.

    “The greater point is that Latvians themselves do not want to leave Europe or the prospect of the Euro.”

    But who is suggesting this. I am arguing (along with the IMF) that they should be admitted urgently (along with Bulgaria and the rest of the Baltics) into the eurozone, but AFTER devaulation, so they don’t immediately have to face the sort of painful deflationary process Greece and Spain now face.

    The burden of the “debt restructuring” issues which arise from the devaluation should be shared between the people who took out the loans, the banks, and the Euro System (via EU Bonds) in portions which will now need to be negotiated between the parties, that is what “restructuring” is all about.

    “Same thing in Greece , my home country.
    Nobody , absolutely nobody , not even the Stalinist Greek Communist Party ,wants to leave the Euro, but everybody , even the “conservative silent majority” is fed up with the local elites.”

    Of course, we all agree. I am in favour of “everyone in” – see my Almunia Syllogism post. Really I have no idea what you are getting at here, unless this is a comment that has been accidentally posted in the wrong post on the wrong blog.

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