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

The IMF finally announced it’s Latvia “bailout” plan on Friday. The plan involves lending about €1.7 billion ($2.4 billion) to Latvia to stabilise the currency and financial support while the government implements its economic adjustment plan. The loan, which will be in the form of a 27-month stand-by arrangement, is still subject to final approval by the IMF’s Executive Board but is likely to be discussed before the end of this year under the Fund’s fast-track emergency financing procedures, and it is not anticipated that there will be any last minute hitches (although I do imagine some eyebrow raising over the decision to support the continuation of the Lat peg). The Latvian government admits that some of the IMF economists involved in the negotiations advocated a devaluation of the lat as a way of ammeliorating the intense economic pain involved in the now inevitable economic adjustment. But the government in Riga stuck to its guns (supported by the Nordic banks who evidently had a lot to lose in the event of devaluation), arguing that the peg was a major credibility issue, and the cornerstone of their plan to adopt the euro in 2012.

“It (the programme) is centered on the authorities’ objective of maintaining the current exchange rate peg, recognizing that this calls for extraordinarily strong domestic policies, with the support of a broad political and social consensus,” said IMF Managing Director Dominique Strauss-Kahn.

In return for the loan the IMF have agreed a “strong package of policy measures” with the Latvian government and these will involve sharp cuts in public sector salaries, and a tight control on Latvian fiscal policy. The IMF have insisted on a substantial tightening of fiscal policy: the government is aiming for a headline fiscal deficit of less that 5 percent of GDP in 2009 (compared with a anticipated deficit of 12 percent of GDP in the absence of new measures) – to be reduced to 3% in 2010 (thus the Latvian economy will face not only tight effective monetary policy in 2010 – via the peg – but also a less accommodating fiscal environment, frankly it is hard to see where the stimulus to economic activity is going to come from here) . Structural reforms and wage reductions will also be implemented, led by the public sector, and VAT will be increased, all with the longer term objective of further strengthening Latvian competitiveness and facilitating the external adjustment. The problem is really how the Latvian population are going to eke it out in the shorter term.

“These strong policies justify the exceptional level of access to Fund resources—equivalent to around 1,200 percent of Latvia’s quota in the IMF—and deserve the support of the international community,” Strauss-Kahn said.

The loan from the IMF will be supplemented by financing from the European Union, the World Bank and several Nordic countries. The EU will provide a loan of €3.1 billion ($4.3 billion), the World Bank €400 million ($557.6 million), and several bilateral creditors [including Denmark, Estonia, Norway, and Sweden] will contribute as well, for a total package of €7.5 billion ($10.5 billion).

The stabilization program forecasts that the economy will contract 5 percent next year, the Finance Ministry said in a statement yesterday. Revenue is expected to fall by 912 million lati ($1.7 billion) next year and spending will be reduced by 420 million lati.

Strangely the IMF statement was not very explicit the key topic – the currency peg – in the sense that it was a little short on argumentation as to why it considered – despite its well known waryness about such approaches, and having got its fingers very badly burnt in Argentian in 2000 – that it would be best to continue this arrangement in the Latvian case, despite the Fund’s strong emphasis on the need to current the large external balances which exist (see Current Account deficit in the chart below).

All we really know about the background to this decision is contained in the statement the IMF posted on its website on December 7:

Mr. Christoph Rosenberg, International Monetary Fund (IMF) Mission Chief, issued the following statement today in Riga :

“Following the IMF’s statement on Latvia on November 21, 2008, good progress has been made towards a possible Fund-supported program for the country.In cooperation with the European Commission, some individual European governments, and regional and other multilateral institutions, we are working with the authorities on the design of a program that maintains Latvia’s current exchange rate parity and band. This will require agreement on exceptionally strong domestic adjustment policies and sizeable external financing, as well as broad political consensus in Latvia In this context we welcome the commitment made today by the Latvian authorities. All participants are working to bring these program discussions to a rapid conclusion.”

So there seems to have been a trade-off here, between the IMF agreeing (reluctantly I think, but this is pure conjecture since there is little real evidence either way) to accept the peg, and the Latvian government agreeing to exceptionally strong adjustment policies. But the question is: was this agreement a good one, and will the bailout work as planned? I think not, and below I will present my argumentation. But before I do, I think it important to point out that the kind of internal deflation process the Latvian government has just accepted is normally very difficult to implement, which is why economists tend to favour the devaluation approach.

Just how large the competitiveness issue is in Latvia’s case can be guaged by looking at one common measure of competitiveness, what is known as the country’s real effective exchange rate. The REER (or Relative price and cost indicators) aim to assess a country’s price or cost competitiveness relative to its principal competitors in international markets. Changes in cost and price competitiveness depend not only on exchange rate movements but also on cost and price trends. The specific REER prepared by Eurostat for its Sustainable Development Indicators is deflated by nominal unit labour costs (total economy) against a panel of 36 countries (= EU27 + 9 other industrial countries: Australia, Canada, United States, Japan, Norway, New Zealand, Mexico, Switzerland, and Turkey). Double export weights are used to calculate the REERs, reflecting not only competition in the home markets of the various competitors, but also competition in export markets elsewhere. A rise in the index means a loss of competitiveness, and as we can see, Latvia has suffered a huge loss of competitiveness since 2005. There is a lot of “correcting” to do here.

The problems of loss of external competitiveness Latvia faces are not new, nor are they unique. Russia may be a lot larger than Latvia, and Russia may also have oil, but Russia’s internal industrial core has become uncompetitive, and there is really only one sensible way of attacking this problem, and that is through devaluation, as Standard & Poor’s Director of European Sovereign Ratings argues in the extract I cite below. One of the unfortunate side effects of the fact that currency policy has become almost a matter of national strategic importance in Latvia has been that the necessary open-minded discussion of the pros and cons of the situation has not been possible.

Accompanied by generous government spending, the credit boom also fueled inflation, which weighed on the competitiveness of Russia’s noncommodity sector. As wage growth averaged nearly 30 percent over the last two years and the ruble-denominated cost of production rose, domestic manufacturers found it very difficult to compete with cheap high-quality imports. As a consequence, entrepreneurs logically avoided manufacturing and, instead, invested in much more profitable and more import-intensive sectors, such as banking, retail and construction.

The resulting structural imbalances were well camouflaged by the extraordinary growth in energy and other commodity prices. For six straight years, the earnings from Russian oil and commodity exports on world markets have increased much faster than the cost of imports, offsetting the less flattering volume effects. From 2003 through this year, the cumulative difference between export and import price inflation in Russia was a fairly remarkable 74 percent. This put upward pressure on the ruble, encouraging borrowers to take loans in dollars or euros at negative real interest rates, under the assumption that the ruble would appreciate indefinitely. But it also provided an important source of financing.
Frank Gill, director of European sovereign ratings at Standard & Poor’s in London, writing in the Moscow Times

So the Latvian competitiveness problem has become evident to everyone, and perhaps the best indication of the severity of the problem is the way that people almost laugh at the suggestion that Latvia must now live from exports (exports, what exports?, they say). However it is clear, and especially given the force of the agreed internal adjustment, that domestic demand is now dead as far forward as the eye can see as an effective driver of GDP growth, and, as can be seen in the chart below, exports are going to have a hard time of it, even after growth in other European countries picks up in 2010 (or whenever).

The competitiveness problem can be seen quite clearly in the above chart, as Latvian wage rises became detached from productivity improvements in the second half of 2005 and the rate of increase in exports shrank rapidly, while imports began to enter at a much faster rate. This process eventually itself in the first half of 2007, with import growth at first increasing rapidly, only to subsequently decline, giving in the process some positive increment to GDP from the net trade effect – as exports once more began to accelerate (creative destruction impact) even while imports fell through the floor. However as the external trade environment has darkened, even this expansion in exports has petered out, and inflation adjusted exports are currently hardly growing, and may even turn negative in the coming quarters. 2009 promises in any event to be a very hard year, but without a truly massive correction in relative prices there will be no recovery in 2010 either, and probably not in 2011. Remember, wages are now about to start falling, unemployment is about to start rising, and government expenditure is about to get pruned, so the only possible area for growth is external trade, and any inbound FDI that can be attracted to build productive capacity for exports. On top of which the correction in the current account deficit means that Latvians collectively – government, companies and households – are going to have to start saving, and a rise in net aggregate savings is basically tantamount to a brake on internal demand. So whichever way you look at it, exports are now the name of the game.

Why Keep The Peg?

Given all the problems that having the peg are likely to create, what then are the arguments for maintaining it? Well frankly, such arguments are hard to find at this point, in the sense that there are relatively few people, at least in the English language, who are willing to stick their neck out and try to justify what, in my humble opinion, is virtually the unjustifiable, and the implicit consensus among thinking economists would seem to be that this is a bad idea. The decision does, however, have its advocates, and Anders Aslund of the Peterson Institute has been bold enough to have a try, so, in the interests of balance and try and get some purchase on what the arguments might be, I am reproducing his argument in its entirety.

Why Latvia Should Not Devalue
by Anders Aslund December 9th, 2008

Latvia has a severe financial crisis, the preconditions for which have long been evident. A fixed exchange rate to the euro led to an excessive speculative influx of capital, boosting Latvia’s private foreign debt to 100 percent of GDP. Inflation soared to 16 percent, and the current account this year to 15 percent of GDP. Latvia’s budget has traditionally been almost in balance.

For most countries, devaluation would appear inevitable, and some argue that Latvia has to devalue its currency, the lat. But Latvia’s circumstances are peculiar, making the standard cure not only inappropriate but harmful. A severe wage and social expenditure freeze would be a better prescription, along the lines of a preliminary agreement on macroeconomic stabilization reached on December 8 among the Latvian government, the European Commission, the International Monetary Fund (IMF), and the Swedish government.

Now the questions are how much financing Latvia needs, who will give it, and on what conditions? The key outstanding issue has been whether Latvia should devalue or not. But given that Latvia—and Estonia—are experiencing high inflation with close to balanced budgets, devaluation is neither necessary nor desirable. A freeze of wages and social transfers would be preferable for both economic and political reasons.

First of all, thanks to Latvia’s limited GDP, $27 billion in 2007, sufficient international financing can be mobilized. The combination of IMF, EU, and Nordic funding should be sufficient.

Second, devaluation is likely to aggravate inflation and it could start a snowball effect of higher inflation and repeated devaluations. A devaluation would not be less than 20 percent and it would cause greater social and economic disruption.

Third, the great number of mortgages held in euros would force a massive blow-up of bad debt and mortgage defaults, which in turn would seriously harm the population, the housing sector, and the banking sector and thus the economy as a whole. Such a banking crisis is not necessary. One of the three big banks, Parex Bank, has already gone under, but the other two, the Swedish banks Swedbank and SEB, are strong enough to hold, if no devaluation occurs.

Fourth, Latvia’s main macroeconomic problem is inflation. Devaluation would initially aggravate inflation, while a wage and social expenditure freeze would sharply reduce inflation. High inflation has led to the excessive current account deficit. Latvia does not suffer from any structural terms of trade shock

Fifth, a freeze on wages and public expenditures would strengthen the budget, while devaluation is likely to lead to severe budget strains.

Sixth, the Latvian population seems politically committed to the fixed exchange rate, and it seems prepared to take a freeze of incomes and public expenditures, and if necessary even cuts. Therefore, devaluation could lead to undesirable and unwarranted political convulsions.

Finally, devaluation in Latvia would inevitably drag down Estonia as well, and all the effects would be doubled, while Estonia might hold its own without Latvian devaluation. Lithuania, which does not really have any serious financial problems, could also be harmed. I would have recommended that the Baltics abandon their fixed exchange rates a few years ago, but this is the wrong time to do so.

The argument I am making applies only to very small economies with basically sound economic policies. Russia and Ukraine are in a very different situation. Both suffer from major structural changes in terms of trade because of slumping commodity prices, and they should let their exchange rates float downward with their terms of trade.

The main arguments in favour of the peg would thus seem to be as follows:

1/ Latvia’s situation is exceptional (is that also true of Bulgaria, Estonia and Lithuania?). It is hard to know what to make of this. Certainly the comparison with Ukraine and Russia does not seem appropriate, since these are ultimately competitor countries as far as manufacturing industry goes, and they are devaluing not because of their raw material exports (agriculture and energy) are too high, but because the price of the products from their manufacturing industries are too high due to all the earlier internal inflation, and the attempts to maintain the currency value via the controlled “corridor”.

2/ A severe wage and social expenditure freeze would be a better prescription than devaluation. Well they would be a good prescription, but they simply are not possible, since simply freezing things where we are won’t work, the imbalances are too large, so we are talking about sharp reductions in wages and public spending (as nominal GDP goes sharply down, then even a 5% fiscal deficit will mean spending has to contract – by 420 million lati according to the budget forecast – although the IMF has agreed to a policy of protecting social expenditure as much as possible).

3/ Then there is the forex mortgage situation. This I agree is a major problem, as devaluation implies default, and an oncost for Sacndinavian banks. But if we are sending the entire Latvian population through all this simply to attempt to avoid defaults on mortgages we are making a mistake, since obviously the sharp rise in unemployment we can expect and the sharp fall in wages can have a similar impact. I mean, one way or another the REER (see above) is going back to the 2005 level, so the mortgages will be just as unaffordable, and in my view the best solution to this would be for the Scandinavian (and Italian – Unicredit) banks to take a haircut, and receive compensation via their domestic bank bailout programmes. This would be a much more equitable sharing of the costs of the forex lending programme having gone wrong. To take another example, Spain is not devaluing from the euro, yet a hefty round of mortgage defaults (and builder bankruptcies) is now expected. So it is really a case of default through one door, or default through the other one. Which way would you like to go, sir?

4/. That devaluation would provoke inflation. Well this is just the point, devaluation would only provoke significant inflation IF Latvia still didn’t have an independent monetary policy (to restrain domestic demand), but since part of the reason for devaluation is precisely to recover control over monetary policy again, this argument seems to me not to be completely valid, and it seems to be forgetting the other problem, deflation, which is much more likely to become Latvia’s real problem over the next two or three years. Trying to run some form of Quantitative Easing (which is the new “in” term for how best to handle monetary policy in the midst of a liquidity trap, which may well be where Latvia and several other CEE economies are now headed) without independent monetary policy is quite frankly, completely impossible. If we look at the chart for the producer price index I reproduce below, we will see that the PPI (which is normally regarded as an indicator of coming inflation) is no longer climbing, and seems set to start to come down., and this could easily be an early warning signal for forthcoming deflation.

5/. The Latvian population seems politically committed to the fixed exchange rate, and appears prepared to take a freeze of incomes and public expenditures. This may well be true, and is an impression I get when I look at some of the comments on my blog. Many Latvians (and citizens of other Baltic states) have accepted the peg as some indication of “post-independence” indication of national “seriousness”, and that any stepping-back from it would be seen as some kind of defeat. I understand this view, but I think it is a mistake, since sometimes it is better to accept defeat in order to live to fight again another day. I think Latvian politicians are to some extent reacting to this kind of pressure, to some extent thinking about their own invested social capital, and to some extent under pressure from Nordic banks. In any event all three of these seem to have more influence than the rational arguments about the advisability of the peg. There is no doubt in my mind that the coming recession will be longer and deeper if the peg is maintained. Indeed I am almost certain that the attempt to sustain it will fail (and that we will see some kind of rerun of Argentina 2000 – in all three Baltic countries and Bulgaria) and really the sooner the population become aware of this the better. Basically what we witnessed in Argentia in 2000 was basically a process of growing battle fatigue and war weariness, as the population were asked to make one sacrifice after another in support of a policy which couldn’t work, and only lasted as long as it could. The end product is that when the peg finally breaks the local population will be severely disillusioned, and the politicians will totally lack credibility, which is a sure recipe for chaos, as we saw in Argentina in 2001.

Indeed, if anything the position is arguably worse in Latvia at the present time, since the optimum conditions for a free and open debate about the alternatives aren’t exactly in place at the moment it seems very hard to know what the population at large would decide if they had complete access to all the arguments.

6/. Finally, devaluation in Latvia would inevitably drag down Estonia as well. This is undoubtedly a consideration in the mind of the IMF (and Lithuania, and Bulgaria) but really all of this will have to be faced by all four countries sooner or later, especially since the only way out of their recession will be, as I am saying, through exports, and most of the other competitor countries (look even what is happening to the Polish zloty and the Czech Koruna as I write) will see the partities of their respective currencies well down on the euro as we enter the recovery.

Where Is Growth Now Going To Come From?

Basically the key argument for devaluation is that it is easier to manage an economy with a low level of inflation (please note I am saying low, very low, certainly below 2%, ask Ben Bernanke or the Japanese is you don’t believe me) than it is to manage an economy which is in deflation freefall. The big danger in Latvia is not only that there can be a real (ie price adjusted) contraction in the economy of 5% in 2009 (or more, the economy is down 4.9% year on year in Q3 2008, and things are certainly going to get worse), but that this contraction may be accompanied by price deflation (ie actually falling wages and prices) which means nominal (current price) GDP would decrease by the size of the real contraction plus the fall in prices. Thus we could see a very large drop in nominal GDP in 2009 and 2010. If realised this would be a very difficult situation to handle, and I doubt the people currently taking policy decisions in Latvia are fully aware of the implications (although the IMF economists should know better). In particular the deflationary debt dynamics would be very hard to control, and again, especially without independent monetary policy.

It is important to remember that these loans which have been agreed to are simply that, loans, to guaranteee the external financial stability of the country during the forthcoming correction, but they do not, in and of themselves solve any of the real economy problems. And they will need to be repaid if they are used, and will nominal Latvian GDP heading down, the cost of repaying them effectively goes up in terms of real Lat earnings. This is what debt deflation means.

The International Monetary Fund on Friday said it now expects a net income of
about $11 million in fiscal year 2009, and not a shortfall of $294 million as
previously forecast, as more countries turn to it for rescue loans in a
deepening financial crisis. “The improved income outlook reflects new lending
activity that is estimated to generate additional fund income of about $247
million, assuming all disbursements under the recently approved arrangements are
made as scheduled,” the IMF said. Since early November, the IMF has approved
rescue packages for Hungary, Iceland, Ukraine and Latvia as the global crisis
spreads to more emerging economies.

I am citing the above Reuters report, not as a criticism of the IMF – they are simply doing their job as best they can, and under very difficult circumstances – but to remind people that the IMF is effectively a bank, and these are loans, and interest is paid, and there are no “freebees” here, and definitely no “free lunches” – not even in the newly established Latvian soup kitchens.

So we should ask ourselves where growth is going to come from – the growth that will now be needed to repay the capital and interest on these loans. Certainly not from household consumption if we look at the chart below, or from government consumption given the restraint on public spending. The private consumption position can only deteriorate as wages fall and unemployment rises.

Not from manufacturing industry in the short term (until prices correct, and the external recovery starts), and again look at the chart.

And finally don’t expect an investment driven recovery (again see chart) until the demand for Latvian exports picks up, and it becomes attractive to start expansing capacity.

Basically I feel the biggest condemnation which can be made of the package which has been announced is that it doesn’t seem to contain one single policy for stimulating the economy, and stimulation and a return to growth is what Latvia badly needs by now.

And the worst case scenario outcome of the way all this is being handled (and the issue that actually concerns me the most) is the possibility that young people decide to start migrating out of the country again, in order seek a new future and to start sending money home to help their families confront the difficult circumstances. Since Latvia’s population is already declining this would be the cruelest cut of all, and one would have to then ask just what kind of future really awaits this unfortunate country?

This entry was posted in A Fistful Of Euros, Economics and demography by Edward Hugh. Bookmark the permalink.

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".

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

  1. this blog always has interesting analysis and i understand why devaluation is necessary to make your exports competitive but since macroeconomics is not my thing i have a question: why does the trade deficit need to be balanced? why can’t imports be higher than exports? or why can’t imports fall to the level of the low, uncompetitive exports? i think imports are pretty much discretionary stuff, like audis, fancy foods and all that.

  2. Hi,

    “why does the trade deficit need to be balanced?”

    Well it doesn’t. You can run surpluses, or deficits. But you can only run deficits for as long as people are willing to lend you the money. People are no longer willing to lend countries like Latvia the money to square their deficits, which is why the IMF et al have had to be called in – otherwise you get melt-down. But this aid is only temporary, while you straighten things out, hence you need to balance the books, and indeed, as I am saying you need to get an export surplus, since you still have to pay back all the debts you ran up over the years when you had the deficit, and you need to get some economic growth (to be able to pay for pensions and health systems and things like that as your population ages, and the base of the pyramid shrinks.

    “or why can’t imports fall to the level of the low, uncompetitive exports?”

    Again, they can and they will if all other things remain equal. The point is then your economy simply starts to shrink and shrink, and even more so as the young people leave as things get worse and worse.

    Apparently in Iceland they had a survey which found roughly one third of the young people wanted to leave, rather than spend their life paying off all the debt. It would be interesting to see this type of poll in Latvia one year from now.

  3. well, people in iceland (or should it be waterworld, now after the meltdown?) prove to be what economists call ‘rational agents’, don’t they?

    when you say ‘People are no longer willing to lend countries like Latvia’ who is they? the foreign banks of exporters to latvia? i’ve seen this written elsewhere but don’t quite understand the main mechanism by which these international flows work.

  4. What a terrible mistake.

    Except for freedom and the right of self-determination themselves, there is nothing more important to Latvians than the Lat. It has a symbolic value that’s akin to how Britons feel about Sterling and Americans the Dollar. I am Latvian, I know.

    That said, I cannot believe that Latvian politicians would EVER make the cutbacks demanded in public sector employment, as mandate by the IMF in this deal.

    It’s not going to happen, folks. Does anyone realize that the public sector employs a HUGE amount of people? I don’t know if there are any reliable Latvian statistics available (as it’s a source of national shame to Latvians that there are so many people “working” for the state, hence no reliable statistics can be obtained) but there can be no doubt that the state easily employs around 45 to 50% of all working people. In Latvia, working for the state is a job of last resort. Look at it as welfare – writ large.

    If the Latvian state lets a huge amount of these people go, there will be A LOT of civil unrest. That and emigration to euroland.

    What’s more, Brussels will be seen as the villain in all this, if it comes to pass, and the ECB can forever more forget about Latvia ever joining the eurozone.

    Come to think, then the IMF SHOULD push their demands as anything that damages the Brussels Politburo and the rest of the hacks in Brussels on the gravy train is a damn fine thing. Plus, the Latvians will get $10bn in free handouts in the process! 🙂

  5. The program was approved today. The short statement makes clear that a primary objective of the government is the quickest possible entry to the eurozone. It’s a little strange to have an exchange rate regime objective dominate all other objectives but as you say, between the lines it seems not to be what the Fund would have pursued had the staff economists had their way.

  6. Pingback: Latvia is the new Argentina (slightly wonkish) - Paul Krugman Blog - NYTimes.com

  7. Pingback: Latvia is the new Argentina (slightly wonkish) - Paul Krugman Blog - NYTimes.com

  8. Thank you for the very interesting analysis and especially for short quick look to Russian state of affairs. Now we see in Russia so-called step-by-step devaluation of the national currency.
    However in some discussion in Russian blogs “shock” or “high speed” devaluation is considered as more preferable.
    Could you explain for non macro-economist – is it important the “speed of devaluation”?

  9. Pingback: Travelling Through Latvia In Good Company (Ultra-Wonkish) | afoe | A Fistful of Euros | European Opinion

  10. You said it right: “…this unfortunate country…” I returned to Latvia after 46 years in the U.S., and have been here for the last 14 years. I have been watching with amazement a government with little sense of responsibility ride a wooden horse as if that thing were a god, and whipping that horse and yelling “Progress, Progress, giddy up, Progress”. At this moment “progress” in this part of Latvia (near the Estonian border), my neighbors tell me there are 7 crews cutting what forest is left. During the 17 years of renewed independence, the Latvian government has done little but demoralize the nation further (after the Soviets) by setting an example in corruption and how to make “progress” without anyone at the top taking on the sacrifice of responsibility.

  11. I advise everyone reading this post to immediately read the Shock Doctrine by Naomi Klein.

    It’s happened in Chile, Argentina, China, Russia, Iraq, and Poland.

    Once Friedman-ite Free Market ideology is imposed by the IMF, then they have you on the hook for servicing the loans as the currency devalues when hit by currency traders. Your public assets and corporations will be raided by government elites from within and American multi-nationals. A few people, many of them US execs and shareholders, will become wealthy by way of their plunder. Your workers standards of livings will fall.

    The last few times this has been tried in Asia and recently Cananda, workers (who also are voters or at least citizens who can protest) are starting to figure it out. Using periods of economic or natural disaster to push through “free market” policies that make a few disgustingly wealthy at the expense of the ruined lives of millions of innocents is beyond immoral, it’s evil.

  12. Pingback: The Irish Economy » Blog Archive » Adjustment Packages: Learning from Latvia

  13. Hi again Andy,

    “when you say ‘People are no longer willing to lend countries like Latvia’ who is they? the foreign banks of exporters to latvia? i’ve seen this written elsewhere but don’t quite understand the main mechanism by which these international flows work.”

    Well, there are two mechanisms, one via government bonds, and the other via bank lending.

    Since the levels of accumulated government debt (with the notable exception of Hungary) are normally quite small in Eastern Europe, bond sales are not as important a potential problem as they are in, for example, Southern Europe.

    Private – household and company – debt is the big problem in the CEE region, and this is very big difference from Argentina, where the main problem was sovereign debt, and after that corporate debt, but households were not very exposed.

    Essentially, this private lending is funded through what are called “wholesale money markets”, as has been the case in Spain.

    Basically countries who have an external funding deficit (or current account deficit) have this because they do not do enough saving (same case US) and thus need to borrow from others to do the spending. In the wholesale money market banks who do not have a sufficient deposit base can sell what are called covered bonds (a form of residential mortgage backed security) to raise money to lend. It is these covered bond markets who have had the most problems in recent times, and since it is very hard for banks now to sell these bonds this would be one very direct way in which ‘People are no longer willing to lend countries like Latvia’ .

    The they here may well be people like you, if you have a pension fund, since some of the main purchasers of these bonds in the past have been pension funds, and similar. So they they is effectively “us”. This is why Germany, Austria and Sweden – to name but three – are having to bail out their banking system, since it was savers in these countries who did the lending.

    One other flow of funds would come direct from a bank (mother bank) in, say, Austria to a subsidiary in Latvia. These funds do not come so much now, as the risk is evident. Also, no one wants to do forex lending any more in the East, since regardless of Latvia’s short term decision not to devalue, no one is sure what happens in the longer run.

  14. hello Eriks,

    “That said, I cannot believe that Latvian politicians would EVER make the cutbacks demanded in public sector employment, as mandate by the IMF in this deal.”

    I’m afraid they will Erik. And there will be more, since as I am suggesting, I don’t think this will work, but they won’t give up at the first attempt.

    Basically if the Latvian politicians don’t comply with their pledge then the IMF will threaten to withhold thesecond tranche of the loan, with the sort of consequences we are now seeing in Ukraine. The problem with having a structural CA deficit is that you are effectively unable to pay your bills (as Spain is finding out to its cost right now), and if the bank (in this case the IMF) cuts the credit, you just have to fold, There is no other way, although I doubt Latvia’s politicians are being very effective in communicating this to the population at the moment.

  15. Hi Mike,

    “However in some discussion in Russian blogs “shock” or “high speed” devaluation is considered as more preferable. Could you explain for non macro-economist – is it important the “speed of devaluation”?”

    Well, this is tricky. Basically one short sharp devaluation is the best move. But then you need sufficient reserves to protect your target level during the expectations transition period.

    So you need to devalue and float, but you need to get the devaluation more or less right, or you have a mess. Markets tend to overshoot, and then come back up, so it is legitimate to try and avoid this extreme volatility.

    Ukraine is a huge mess at present (new post coming soon), since the political factions cannot agree, and while one group want an excahnge rate near to 8 to the USD (which looks reasonable, and must have been agreed with the IMF, its a devaluation of about 60% over the year) the other group is trying to protect a rate of nearer 7, and are threatening to put the cb governor in prison (from the parliament) if he doesn’t start intervening.

    The main argument about the “slow lane” devaluation is that it creates uncertainty about the future, and burns up reserves as you go, instead of saving them to defend the new level a bit while the market settles. This is the problem Russia is having now. Better to do it, get it over with, and move on. Too much “foreplay” is never a good thing.

    Basically I am arguing that one of the big underlying issues in the East is the demography, but it is far from being the only issue, and all this “inteventionism” and temptations to try to control (which presumeably reflects decades of authoritarianism), or “currency corridor” nonsense (like the old NKVD corridors I suppose, dark and with a lot of screaming) really forms part of a mindset which is a huge obstacle to progress and economic well-being in the countries concerned.

  16. Hi Edward,
    Thanx for your comments!
    Guess “narrow currency corridor” is a symbol of “stability” for Russian goverment, something like Holy Graal. It seems to them that the narrow corridor (USD/RUR) is a sign of “government skills”.

  17. Hi again Mike,

    “Guess “narrow currency corridor” is a symbol of “stability” for Russian goverment, something like Holy Graal. It seems to them that the narrow corridor (USD/RUR) is a sign of “government skills”.”

    Yes, I think you have a point here. Also, it underlines their “exceptionalism”, which I think is important to them, since no one to their West practices this. Fear of uncertainty might also be a factor. Basically there is also a tragi comic fatalism dynamic going on here since they always try to maintain a “tight corridor” (I guess there is a Freudian view available here) but in the end it widens and widens till they have no alternative to devaluation.

    Printing money on this view would be the lubricant no one can resist. Actually I have a Russia blog – Russia Economy Watch – and you might be interested in one of the comments someone just put up. The part in italics at the start is me.


    So all they had to do was manage the domestic economy, and balance out the cash flow from the oil. But this they spectacularly failed to do, accepting pay increases all round as if there was no tomorrow, and allowing companies (and to some extent individuals) to get round local monetary policy and borrow forex at cheaper rates, so the whole thing became very highly levereged. Basically what is scewing everything now is the need to devalue. I can’t believe they have been so stupid, since they had so many things in their favour. Why was it they couldn’t see things which were absolutely obvious to me (see the key posts list at the top of the right sidebar)

    This I don’t know but I think they were always like this as far as I can remember and I was following them from the days of Perestroyka. I was actually still there in the beginning. Anyway, they were always somehow doing this combination of failing to tackle inflation properly and not letting rouble to devalue.

    In fact, it took them so long to get the connection between inflation and money printing that I am not even sure that they comprehend it properly now. I don’t mean Kudrin, but people around him. So this was the situation from the beginning, even though it might be less obvious during the first years when the economy was a wreck and nothing held for long including the rouble.

    I think their way of mismanaging the economy locks them in a very predictable cycle. Lets say in 1998 they defaulted, rouble collapsed and almost immediately the industry started grow. Then the oil and commodities booms have arrived. Then they locked rouble in this corridor, failed to tackle inflation, inflated their bubble with imports driven consumption getting out of hand.

    This time it will be pretty much a replay of the same story. At some point rouble will collapse, this will give their manufacturers and others the competitiveness they were missing, imports will slump, a lot of internal demand will be destroyed by devaluation. Then the oil market recovers and so it all starts again with the government steadily inflating the next bubble, until something happens and this one will explode too.

  18. Hi again Edward,

    Thank you for the interesting idea about the predictable cycle. This idea can be useful to estimate prospects of Russian manufacturers at a current stage of the cycle.

    I can ask one more question on correctness practical conclusions from your macroeconomic concept?
    For example, software vendor (say, ERP system) needs to estimate what manufacture has the greatest prospects of development in the near future at the current stage of the cycle. So the vendor should pay attention to manufacturers of such production which now has the big share of import.
    It is a right approach from your point of view?

  19. Unless you’re advocating ‘printing money’, I fail to see how the Latvia government can fund any kind of stimulus program.

    A fixed currency works when there is a substantial reserve to back it up. China and HK are the best example. The alternative is capital control (e.g. Malaysia), but that brings with it all kinds of inefficiency and corruption. A small country with a free floating currency can be decimated by Hedgefunds. If they can make billions from shorting the Lat, they will make billions from shorting the Lat.

    The actual solution to Latvia’s problem is simple : convert all the debt from Euro to Lats by government decree, impose capital control for a few years, and then float the currency. In this case, they don’t even need the IMF. Of course, the foreign banks would be screwed, but they deserve to be screwed.

  20. When we talk about Latvia being the next Argentina, let’s not forget the Argentinian default in 2001. After a few years of pain where politicians can paint the IMF, the EU and Swedish banks as the villains, it seems to me very likely that Latvian political opinion will be moving in this direction.

    Another interesting scenario, assuming that Russian gas and oil revenues recover faster than the Latvian economy (which seems a good bet), would be for Latvia to look East for salvation. While the right-wing Nationalist bent of the current political establishment might make this seem unlikely, a few years of economic failure from the current crop of pols might make nostalgia for the stable days of the USSR a more viable political position (particularly bearing in mind that ~50% of the population is of Russian origin). The “failure” represented by a devaluation of the Lat after several years of pain might be the catalyst for such a political realignment.

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  23. Hello again Mike,

    Sorry for the delay in getting back.

    “So the vendor should pay attention to manufacturers of such production which now has the big share of import. It is a right approach from your point of view?”

    Well this would seem to be a reasonable conclusion. Domestic output is likely to substitute for imports given the new relative currency values.

  24. I think i have an idea why they decided to keep the peg for the time being.

    Devaluation would mean that most of the people would not be able to pay back their loans. The amount of loans given to the private sector in the last 5 years is staggering. This means that a large number of companies and private persons will go bankrupt in a very short amount of time. I don’t have the numbers (i hope IMF did), but i assume that 10-15% of all private loans would default. This would wipe out the Nordic banks (Swedbank and SEB especially) and the banking sector as we know it would cease to exist. This also means that practically no new loans would be given out in the near future. Any attempt to recover from the recession implies that the country has a somewhat functional banking sector and at least some exporters would get loans to make things better in the long run. If you devalue, the banking sector will be gone. So as I understand the current situation is a compromise to keep the banks somewhat alive. Devaluing would bring on the doom & gloom scenario immediately and also would leave Latvia without any banks and no real vision or hope to come out of the recession. This of course doesn’t mean that IMF and Latvia could not make a new deal next year which included devaluation.

  25. Fellas,

    Most of you are barking up the wrong tree here. It’s all well and good to talk about macro economics, but remember WHO the IMF is lending these billions to, and critically: what are the strings attached.

    I stick with my original contention that proposing the devaluation of the LAT is political suicide for ANY Latvian politician or political party.

    You guys don’t get it. If Riga actually follows through fully with this IMF agreement, their will be tens-and highly likely hundreds- of thousands of new unemployed with a snowball’s chance in hell of getting a new job. In a country with only about +/- One million folks of working age, that’s a HUGE number.

    As very few of you read Latvian newspapers, you won’t see how this proposal will be treated in Latvia; so I’ll do it for you right now and it goes something like this: “we need the $ for reforms and investment”. Very, very little will be mentioned, locally, about the attached strings and the bit about when and how the money must be repaid will be skimmed over in the press. That’s it. Everyone in Latvia will want to forget the reform and repayment obligations, press included, and they will. You see, everybody is in on the conspiracy of silence be it consciously or subconsciously.

    Cutting to the chase, bottom line is that Riga will fudge the numbers w/respect to reforms. If anyone here thinks that the IMF will be able to validate the numbers to OK the next set of the payments, dream on. Cooking the books in heavily Soviet influenced countries is a specialty. As Benjamin kungs confirms, corruption is rampant in Latvian political circles.

    Short story (and the names have been omitted).
    I was friends with the brother or sister of Latvia’s Minister of Economics. Not the current one, and I’ll leave it at that. Anyway, we were chatting about Latvian politics and the conversation inevitably turned to corruption. I said that it was an obligation of those in power to look out for the interests of those who were not. He/She retorted: “why? Why shouldn’t the politicians in power steal if they can?” He/She was being 100% serious. Now, is that clear enough for everybody? (P.S. His/Her brother the Minister is/was considered by all as one if the “not so greedy as the rest of the politician” crooks. No joke, guys. Verbatim truth.

    Go right ahead and believe the IMF will give the Latvians the money if you want. As I’ve said already, I hope the Latvians get the free money. Some is bound to make it past the sticky fingers of Riga’s “Elite” – and I use that term very loosely indeed.

    The IMF will pay out every penny, and the Latvians will make nothing more than token reforms. You can count on it. Then in a few short years we will read in the Wall Street Journal a short story indicating the IMF billions to Latvia are all gone (I’d bet at least 40 to 50 percent will have “magically” disappeared to vaults in Zurich or the Caymans).

    And that will be that.

    Uz redzesanos

  26. The question is not: Devaluation or not devaluation.

    The question is: Eurorize fully or not.

    You are overlooking two points:

    1. Latvia is already almost completely eurorized in all but name. Every major internal transaction and almost all external transactions are priced in Euros (disregarding USD based commodity transit). The main components still priced in Lats are salaries and the few locally produced products and services.

    The currency board regime in combination with the fear of a devaluation has further eurorized the economy as the central bank buys Lats against Euros. Therefore the Lat monetary base has shrunk further.

    Due to the aggressive lending in Euros by the Swedish banks the role of the central bank has been completely undermined. The central bank cannot influence interest rates anymore, it cannot influence the monetary base.

    As Latvia is already largely eurorized the effect of a devaluation would be simply a wholesale salary reduction across all employees.

    2. Wage deflation is already happening in a major way. Almost all Latvian companies and also the government are reducing salaries – apart from sacking employees.

    Devaluation is therefore superfluous.

    In any case devaluation is no solution

    Latvia is not Argentina which exports commodities in a major way. It cannot trade itself out of the situation by devaluing.

    To simplifiy: Latvia is a service country which serves as a transit point and laundering heaven for CIS commodity countries. Apart from that you have some tourism and some wood exports.

    Devaluation might bring in a few more sex tourists and also drive more workers outside the country who then remit funds back home to support the family. Thats it.

    Eurorize now:

    The fear of a devaluation deters investments and lending, even if the loans and investments are priced in Euros. Lenders and investors rightly fear that a devaluation shock would further derail the economy.

    The Swedish banks have stopped almost all lending, also due to the devaluation fear.

    As outlined above Latvia is simply a service extension of other countries, a safe heaven, transit point (and entertainment spot). To undermine that is simply foolish.

    Latvia must seek to strengthen its role and not create uncertainty.

    It is about time for the EU and Latvia to realise that keeping the Lat, a currency which is hardly used, is serving no one. It simply creates uncertainty.

    Latvia can easily eurorize unilaterally as the currency board fully covers all issued Lats.

    If Kosovo and Macedonia can eurorize without even being EU members then surely Latvia can any day.

  27. What loan defaults? The banks in Latvia do not believe there will be many defaults. They charge 3 x higher interest on Lat loans versus Euro loans so they are encouraging a move to euros. The banks are charging at least 3 x times higher euro rates for loan restructuring for longer terms in euros. So if families are supposedly hurting, then banks don’t agree.

    The IMF is culpable as many Latvians expected the Lat to depreciate and salted away funds to get through the adjustment. Now with a high lat making Latvia uncompetitive these saved funds will be drawn on until depleted.

    I have 750,000 in euro loans and want the Lat to depreciate. A depreciation in line with the UK and Poland etc would keep Latvia competitive and me in business. But now the IMF idea will strangle me and a lot of others.

    Having loans in euros and not lats means more than the theory of having favourable exchange rates. Being subjected to eurowide professional policy is the advantage and not the exchange rate.

    The IMF debt has to be denominated in Lats so that repayment is in lats. I for one will protest an IMF expecting a euro repaymant when the lat finally crashes.

    How could there be inflation in Latvia when PVN is going up 16% for my businesses?

    The problem has always been that the Latvian government has done next to nothing to improve exports. The Foreign Investors Council in Latvia has a Board that has openly stated that they do not want to go to the effort to attract any members that export as their objective is to feather their own nests.

    So why is the IMF trying to strangle Latvia? I can give them the benefit of the doubt and assume that they know that the only way to break the corruption in Latvia is to break Latvian economically and then take control.

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