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Wednesday, December 24, 2008

Travelling Through Latvia In Good Company

Well, it seems I'm not the only one who thinks that the IMF have made a bad decision here, this year's economics Nobel Prize winner Paul Krugman seems to agree. From his New York Times blog:

I’ve been saying this for a couple of weeks, but Edward Hugh has the goods.

Hugh puts his finger, in particular, on one gaping hole in the logic of the opponents of devaluation. We can’t devalue, they say, because the Latvian private sector has a lot of debts in euros, and a devaluation would make it very hard for borrowers to service those debts. As Hugh points out, the proposed alternative — sharp wage cuts, and basically a major domestic deflation — will also make it hard to service those debts. In fact, I’d be a bit more specific than Hugh: other things equal, a nominal devaluation and a real depreciation achieved through deflation should have exactly the same effect on debt service (unless some of the debt is in lats rather than euros, in which case devaluation would do less damage.)

This looks like events repeating themselves, the first time as tragedy, the second time as another tragedy.

And while I am talking about travelling in good company, here's Claus Vistesen's Xmas piece on the Latvian peg issue for you all to enjoy.

IMF and the Baltics

by Claus Vistesen

The ink on the post below suggesting that I would wind down for Christmas (and exam preparation) has hardly dried before I am forced back into action (more or less that is).
And the occasion?

Well, I am not going into too much background here, but one event important to remember (out of so many this year) was the announcement of the € 1.7 billion IMF stand-by-agreement for the Baltics. The bail-out plan itself is not so interesting in the sense that it has been on the drawing board for a some months, but the juicy part was the firm IMF position that the euro pegs should remain (and presumably that this means a future for Euro membership).
This surprised me since I have been relentlessly arguing that whatever kind of route the Baltics would take out of the current mess it would be one in which the pegs would need to be tweaked (or abandoned all together).

Now, the surprise did not, obviously, spring from the fact that the IMF [1] chose to take a route other than the one I expected, but more so from the fact that I have always thought that the alternative in the form of a very painful deflationary correction wouldn't be plausible in a policy context. As such, my analysis of the Baltics have always been grounded in two related policy objectives. Given the size of the imbalances inherent in the economy as well the situation surrounding the foreign banks and their balance sheet exposure a deal would ultimately have to be struck which allowed the Baltics to regain competitiveness through the loosening of the pegs as well as measures to shore up the black hole which would be left in the balance sheets of foreign banks' subsidiaries operating in the Baltics.

By some strenuously confirming the pegs it seems to be me that the cure might just end up killing the patient which is another way to say that I wholeheartedly believe that the IMF's decision to solidify the pegs is a mistake.

My colleague Edward Hugh thinks the same and in a recent whopper of a post (follow-up here) he argues why. I recommend you to read the whole thing but pay especially attention to following which sets the stage nicely both in the context of political and economic issues.

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.

I think it is important to stress that a lot is riding on this one not least in the context of that small, but ever so important issue, of getting it right in the context of the CEE economies. Because, we really do need to get it right less we want to be confronted with half a continent worth of testaments to why the standard neo-classical assumption of convergence and catch-up growth be reconsidered (which may of course ultimately be the end case anyway).

And don't for a minute think that this is just me and Edward's attempt to personify Don Quixote in his fight against those dreaded wind mills. That is, unless you believe that Paul Krugman too is pulling a Don Quixote.

In the context of the wonkery of exchange rate economics, Krugman hits the proverbial nail on the head since as I have shown on several occasions; the crossover currency exposure in these economies is substantial. The vast majority of business and household liabilities are in Euros (driven to a large extent by lower interest rates and the simple fact that more than half of these economies' financial sector is maintained by the subsidiaries of foreign banks). This is clearly a problem in the context of a devaluation but it is a well known problem and one which quite simply needs to be managed sooner or later since continuing to maintain the imbalances won't work. This brings me to Krugman's and essentially also one of Edward's main points (taken from Krugman);

(...) other things equal, a nominal devaluation and a real depreciation achieved through deflation should have exactly the same effect on debt service (unless some of the debt is in lats rather than euros, in which case devaluation would do less damage.)

Finally, I would pay special attention to the last sentence in Krugman's small plug since this is really a question of making a right decision and not a wrong one in the context of the evidence presented before you. I still think that the Baltics need to come off the pegs (especially if the Euro is now set to take on another round of re-balancing as the USD caves in to the Fed's QE measures); the alternative in the form of wage and price deflation may be a very dangerous road to take.
[1] whose mission in the Baltics is headed by Christoph Rosenberg whose writings we get to enjoy from time to time in the context of RGE's economics blogs (the European vintage most often).
[2] For some of my latest excursions into this subject I recommend you to go here and here.

Monday, December 8, 2008

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?

Sunday, November 23, 2008

Are Baltic Devaluations Now In The Works?

Now this is a very interesting question, isn't it? The only honest answer I can give is that I don't know, and indeed I haven't the faintest idea. The government of Latvia (the Baltic state which is currently most rife with "rumours" about imminent devaluations) works in its own wondrous ways, and neither we (nor Latvia's citizens) have any idea at all how they plan to lift their country out of the deepest depression they have experienced in many a long year.

What I do know is that, economically speaking,the present situation is simply unsustainable, and something is going to have to be done. Indeed the country's government is in talks with both the IMF and the EU Commission about this very topic as I write. My own opinion is that domestic consumption is now dead (as a growth driver) for as far ahead as the eye can see (and maybe even further), that the country's citizens now need to start to save rather than borrow more, and that the only way Latvia can turn itself around is by exporting more than it imports. But for a country which ran a 23% current account deficit in 2007 this is going to be very difficult objective to achieve, since after two years of very strong inflation Latvia's relative prices with the rest of the world are completely uncompetitive.

Historical experience has taught us that it is not an easy thing to tell people "we are going to cut your wages by between 5 and 10% this year, next year, and then possibly the year after". Apart from the fact that voters don't like to hear this kind of talk, you can also enter into a deflation dynamic which then comes to be very hard to break out of. Hence, according to conventional economic wisdom, devaluation tends to be the preferred option. And it is my opinion that, despite all the attendant difficulties, devaluation is the best option among the unappetising list of unpleasant options presently available to Latvia (and the other Baltic states, and Bulgaria). Unfortunately, having reached this point there are simply no "pleasant" options available.

The curious thing is that for voicing this opinion I could go to prison in Latvia.

According to the Baltic Course online newspaper Ventspils University College lecturer Dmitrijs Smirnovs was detained for two days recently on suspicion of spreading rumors about the devaluation of the Latvian currency. He was detained in connection with an opinion that he had expressed during a debate about the development of the Latvian economy and the future of the Latvian banking and credit system. His arrest followed the publication of his opinion in Ventspils' local newspaper Ventas Balss. According to the newspaper report he said the following:

"The U.S. problems are trifling, compared to what awaits us. They have now reached the bottom and will start to recover. Problems in the European Union have only just begun and we may be hit by a crisis that is ten or maybe twenty times worse than that in the United States. The Swedish banks will no longer be able to offer inexpensive loans through their subsidiary banks in Latvia. They will tell us to pay back the debts! How will we pay them – with the real estate? We have no assets to pay back the debts! [..] The pyramid has been built and now we have to wait until it collapses. [..] The only thing I can suggest now: first of all, do not keep your money in banks, second: do not save money in lats, as it is very dangerous at the moment."

Dmitrijs Smirnovs appears to have been detained by members of the Latvian Security Police, who seem to have been charged with the special mission of protecting the integrity of the Lat at this very delicate point in Latvian history. And while some of the advice Smirnovs offered to his audience may have been ill-advised (given the delicate nature of the problems involved), they are opinions, and in a free and democratic society he should be at complete liberty to express them.

In fact Smirnovs is not the only such case to have arisen in recent days, and Baltic Course report that two more people are "under investigation" by the State Security Police. According to Latvian newspaper the Telegraf Latvian police previously detained a journalist under suspicion of spreading rumors about the Baltic nation's financial system during the global market crisis (also see this report and debate in comments about the same issue in Baltic Business News, while the same source reports that in the Finish newspaper Kauppalehti - which is evidently not controlled by the Latvian Security Police - they are simply discussing whether the Lat will be devalued before Xmas or in two to three months time).

The police held a journalist working for a Latvian newspaper yesterday evening in an investigation that started on Oct. 6 due to ``rumors about the Baltic country's financial system,'' police spokeswoman Kristine Apse-Krumina said, according to the Russian- language newspaper. She gave no details on what rumors the journalist is accused of spreading. Another investigation has been started following a run on currency exchange booths in the capital Riga last weekend that was caused by rumors about a devaluation of the lats, she added.

One of the other cases under investigation by the State Security police appears to be a member of the Latvian pop group "Putnu balle" based on statements made during a pop concert in Jelgava on November 9. Kristine Apse-Krumina, aide to the Security Police chief, stated that the cases was opened following a complaint from a bank, which alleged that lead singer Valters Fridenbergs had urged the people to withdraw their money from Parex banka and Latvijas Krajbanka during the warm up to the concert. According to band manager Anete Kalnina what actually happened was:

"As it often happens at concerts, the band members communicated with the public, telling jokes about themselves as well as many other things. The band had performed two songs when the guitarist Karlis Bumeistars had to tune his guitar, which is when Valters Fridenbergs started talking to the public," Kalnina said. Commenting the current situation in Latvia, Fridenbergs said that the audience had better hear the concert to the end, and only then rush to ATMs. "The people at the culture center got the joke, and laughed. It was not an encouragement" to withdraw money from banks, said Kalnina.

Evidently State Security Police charged with the investigation of seditious devaluation rumours have no such sense of humour, although maybe having to attend a few more pop concerts wouldn't be a bad therapy for them.

I myself received what could be termed a "mild threat" on my Latvian blog, following my publication of an opinion by Bank of America analyst, David Hauner, about the need to devalue:

``They will keep the pegs at the current exchange rates well into 2009, but reset the rates to devalue against the euro later, when markets have calmed,'' Hauner said.

This attracted the following warning from unidentified commenter LV, who would seem to me to quite possibly be a member of the above mentioned "Keystone Cops" group.

Apparently you are disseminating false information about the Latvian financial system. Please note that this may constitute a crime under Latvian law. In order to prevent the spreading of false rumours regarding the Latvian financial system the Latvian Security Police has also opened a telephone hot line so that false rumour spreaders can be reported and tracked down.

He then cited some rigmarole in Latvian which he invited me to use a Google translator to understand. I replied as follows:

Well I don't know what the Latvian law says, and quite frankly I don't especially care. You stopped having a dictatorial system when the old Soviet Union broke up, and there is a UNIVERSAL right to express an OPINION under any concept of democracy I know.

Actually the extract you cite comes from an analyst from Bank of America, and it is an opinion and not a fact. As far as I know he has no priviledged information, but if you have any doubts better you contact him direct.

My OPINION is also that the peg is impossible to hold in the longer term (ie it needs to be corrected before euro entry, for the reasons I explain), and logically since there is then a further delay in entering the euro after the devaluation it is better to do it sooner rather than later.

This is my opinion as a mecro economist and specialist in the Latvian economy, if expressing this opinion is illegal in Latvia, then really I don't know what Latvia is doing in the EU, let alone thinking about euro membership. For tyhis kind of thing you'd be better off with Putin and Medvedev. Open economies don't work that way, or didn't you notice, 22 world leaders just met to affirm that the best way out of the present financial crisis is to have the maximum TRANSPARENCY possible.

As I say above, this is all a very delicate issue, and university lecturer Dmitrijs Smirnovs was undoubtedly ill-advised to use the specific wording he did, not because he committed any known offence, but simply becuase he could have provoked a run on the banks, and this would only make the matter worse. On the other hand - and assuming they do have to devalue - it is a very unfortunate state of affairs that all those who actually know and understand what is happening have already changed their money over, while "ordinary Latvians" (like those in Smirnovs' audience) who have no idea what is happening, but (ill-advisedly perhaps) like to trust their leaders will simply lose a significant part of their savings.

Better never to have come to this point, but then, saying that doesn't help very much, does it?

Back in August 2007 I was asked the following question by a reader of my Latvian blog:

I want to thank you for your continuing efforts to explain what is happening in the Baltics in general and Latvia in particular. I live in Latvia and will be heading to the bank tomorrow to move our family's savings out of Lats and into Euros while the peg is still intact. (Or is there a better idea?).

To which I diplomatically replied as follows:

I wish I could be the bearer of better tidings. I think history has been so unkind to all the peoples of Eastern Europe, they really do seem to be entitled to be dealt a kinder set of cards than the ones they actually have. Really, I think you will appreciate that, even if I could hardly claim to be widely read on this blog, I do want to be responsible, and thus am unlikely to say anything which I feel could be in any way damaging to the Latvian outlook.

However, if you ask me this question:

"Or is there a better idea?"

Then I have to say that I personally can't think of one. For the rest, at this point, you will have to read between the lines I'm afraid.

I will try, when I find the time, to treat the currency peg issue in a somewhat theoretical fashion, but I fear it is reality itself which will put it back on our collective agendas in a much more practical one. I simply don't see how you can have the level of cost inflation (and the wage increases have still to feed through to producer prices and the end customers over many months) and still hope to sell exports. And if you are going to cut domestic demand, which is what they are doing, then selling exports is the only effective way to live.

Basically, as the observant reader will note, my core discourse has not changed very much over the last 18 months or so, nor will it - Latvian State Police or no Latvian State Police.

Will They Be Investigating The EU Commission?

One of the very sad and ironic aspects of the present case is that the Latvian government is currently, as I indicate at the start of this post, in discussions with both the EU Commission and the IMF about the future of the Latvian economy, and I think it is hardly a closely kept secret that both these institutions favour a floating currency, and thus logically a "flexibilising" of the Lat peg as a way forward out of the present crisis,

The European Union was really as explicit as it could be at the end of last week when it make clear that it is more than ready to provide financial assistance to Latvia, but that any aid will be conditioned on a programme to underpin balance-of-payments stability. And what could bring more stability to the Latvian balance of payments (ie induce more exports and suck in less imports), well evidently a change in the relative values of the Lat and the Euro - really at this point there are no other alternatives.

The EU, in their statement said they were "in close consultations" with Latvian authorities, and with the International Monetary Fund in order to develop a joint response to what were described as the "growing tensions'' in Latvia's financial markets.

``The EU stands ready to participate in a coordinated financing package with the IMF conditional upon a strong commitment by the Latvian authorities to implement a rigorous and credible adjustment program in order to underpin balance-of- payments sustainability in Latvia".

The statement did not specify when the aid would be granted or the amount involved. As regards the Latvian extenal position, the chart below of the current account deficit says it all. There is a whopping imbalance, and even though the deficit will be less this year, this is largely due to a collapse in imports as domestic demand has collapsed, and the need to export competitively issue still remains to get to grips with.

And Maybe They Should Check Out The IMF While They Are At It

Also it looks more and more likely that the International Monetary Fund is insisting Latvia abandon its currency peg in return for a bailout.

“Eventual Fund help might…be conditional on giving up the currency board regime and allowing faster real exchange rate depreciation to rebuild competitiveness,” according to economists at BNP Paribas SA in a research note.

And as Citigroup economist David Lubin notes: "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".

So maybe the lads and lasses of the State Security Police better hop on an airplane over to Washington, with a notepad and well sharpened pencil handy perhaps, just to see if they can gather any signs or sedition, or even, who knows, even "conspiracy" over at that end.

Dwindling Reserves

Meanwhile Latvia's foreign exchange reserves continue to dwindle, since the Latvian central bank announced today that they bought 130.3 million lati ($232.7 million) in the domestic foreign exchange market last week to support the currency after it weakened to the limit of its trading band. The lats fell to 0.7098 against the euro for the eighth consecutive week, prompting the bank to step in and buy it. Under the Lavian currency board system the currency is allowed to rise or fall 1 percent from a midpoint with the euro. The previous week the central bank acted to support the currency when it bought 189.8 million lati, which was the biggest weekly purchase it has made in at least two years.

The central bank has now bought 613.4 million lati over the last eight weeks. Foreign currency reserves have fallen about 18 percent since the end of September to around $5.4 billion at the end of October, it said. This month's moves have decreased the reserves to about $4.9 billion.

And Latvia's three-month interbank lending rates surged to their highest in a decade today as banks effectively stopped trading with each other, according to Kaspars Jansons, head of money markets at Parex Banka. The three-month RIGIBOR, Latvia's interbank lending market, rose to 13.5 percent, the highest since November 1998 when Russia defaulted on its debt, and up nearly 20 percent from 11.18 percent on Nov. 14. Janson is quoted by Bloomberg as saying "There is a lack of credit lines in between banks......Banks are not really trading with each other." He also said that a need for lati has driven some banks to raise deposit rates to as high as 10 percent for lati-denominated accounts.

Friday, November 14, 2008

Estonia's Recession Deepens As Latvian Finances Struggle To Find Air

Estonia's economy shrank again in the third quarter - by an annual 3.3 percent, thus clocking up the second-worst performance (after Latvia) in the 27 nation European Union, and offering us plenty of signs that the country's worst economic recession since 1994 is set to deepen. The contraction fulfils the basic technical criterion of recession since it follows a 1.1 percent fall in the second quarter according to data released by the statistics office yesterday (Thursday).

With the global market crisis and credit crunch weighing on the world's leading economies, and especially with Germany - the eurozone's largest economy and principal economic powerhouse itself entering recession, the prospects for any export driven recovery have definitely now faded off into the distance. Estonia and Latvia now lead the Eastern European slowdown, following repeated warnings over the past year of about the risks of an economic "hard landing'', warnings which were not unfortunately headed due to hopes that the eurozone itself would hold out against the US downturn (the United States is still not technically in recession) and that Scandinavian Banks would have little trouble funding growing forex debts (these banks are themselves now seeking support from the Swedish government). As I said, Estonia's economy is contracting the second fastest, since Latvia's economy shrank 4.2 percent in the third quarter, and currently has the worst growth rate in the EU.

``The effect of the financial crisis on the real economies of our main trading partners remained modest in the third quarter but will definitely increase,'' according to Martin Lindpere, an economist at the Estonian central bank. ``External demand is therefore expected to weaken in the coming quarters, and unfortunately, the contraction of the Estonian economy will accelerate.''

The central bank forecast suggests the Estonian economy may shrink between 1.8 percent and 2.7 percent this year, and between 2.1 percent and 4.5 percent next year. Really there is a high degree of uncertainty attached to next years forecast, since nobody is really sure at this point how bad things can get, either inside or outside the Baltics (Russia's economy is unwinding fast even as I write), or when exactly recovery will commence.

Quarter on quarter the economy contracted by 1%, following a revised 1.1% contraction in the second quarter.

All the signs are that the contraction may even accelerate in the fourth quarter. Estonian industrial output, which dropped 3.8 percent in September, has fallen in six of the seven months up to September, and looks almost certain to contract further in October-December . Likewise retail sales which have also been down for six of the past seven reported months.

More Trouble On The Way As The Currency Pegs Come Under Pressure

Lithuania, Latvia and Estonia mayall need to devalue their currencies over the next year as they seek to stave off a recession, according to a recent report from Bank of America Corp. With inflation still running at around three times the average rate across the 15-nation euro region and a slump in domestic demand that looks like it will be very hard to turn around amid the need to export may leave the Baltic states with little alternative but to abandon their currency pegs in the second half, on the view of David Hauner, a Bank of America strategist based in London.

``They will keep the pegs at the current exchange rates well into 2009, but reset the rates to devalue against the euro later, when markets have calmed,'' b Hauner said.

The Lithuanian litas and Estonian kroon have been little changed over the past three months based on their currency board systems that peg them to the euro at fixed rates. The Latvian lat is allowed to rise or fall 1 percent from a midpoint to the euro. The countries also participate in the European Union's exchange-rate mechanism, under which central banks must keep currencies within a 15 percent trading band against the euro.

Andres Sutt, deputy governor of the Estonian central bank, said the kroon's peg
to the euro will remain unchanged and that a devaluation would ``lack any
economic rationale.''
"The competitiveness of Estonian exporters has remained good; wage growth, inflation and loan growth have declined very rapidly, as has the current account deficit, lowering Estonia's dependence on external financing,'' Sutt said "The finances of banks operating here are also strong. All this characterizes the flexibility of the Estonian economy and its ability to adjust.''

In fact Estonia and Latvia continue to run a goods trade deficit, making it impossible to drive headline GDP growth from exports. Latvia's central bank Governor Ilmars Rimsevics also said ecently that "devaluation is an absolutely unrealistic scenario,'' while the Lithuanian central bank Governor Reinoldijus Sarkinas was cited by the Baltic News Service on August 19 as saying that the exchange-rate system "shouldn't change at all.''

Nonetheless the economic rationale for devaluation becomes more compelling by the day, as the Baltic countries if they are one day to enter the euro will need to do so at a much lower partity than the current one to be able to get growth in the longer term.

There are obviously two principal drawbacks to devaluation against the euro, the first of these is that foreign exchange debts will suddenly rise, and this is why the Baltic countries will undoubtedly need EU aid in sorting out the mess. Secondly there will be a delay in euro membership. Countries aiming to adopt the euro must spend at least two years in the Exchange Rate Mechanism, or ERM-2, to demonstrate the stability of their currency. Lithuania and Estonia began participating in the system in 2004, the same year they entered the European Union. Latvia joined a year later. If the Baltic countries devalue then the clock will need to be reset, but then again, eurozone entry with the economies in an economic slump (rather than a mere recession) does not seem to be an attractive proposition either. These economies will need time to get things straight again, so the delay in euro entry does not seem to be an inordinately large obstacle, in and of itself.

Lithuania's ambition to be among the first countries in eastern Europe to adopt the common currency was thwarted in May 2006 as inflation accelerated. Estonia and Latvia were also forced to delay the changeover, and of course it has been this whole process of delay that put the spanner in the works and has lead to the whole boom bust cycle taking the form it has, as euro membership ebbed off into the distance.

``If your real exchange rate is overvalued, there are two options: either devalue, or accept a recession to make inflation fall relative to the trading partners,'' Hauner said. ``So the Baltics have the choice between a deep
recession or postponing euro-zone accession. I think they will choose the latter.''

EU Readying-Up Aid

The Baltic States now have some hard decisions to take, but the EU and the IMF are there ready to support. The European Commission hopes to come to a decision on providing financial support for Latvia "fairly soon", according to European Commission spokesman Jonathan Todd.

``We've been in close touch with the Latvian authorities for the past week and those contacts are continuing. We hope to be able to adopt a decision fairly soon,'' Todd told journalists at a Brussels press conference today.

Latvian authorities also themselves reported on Wednesday that they were in talks with the European Commission about possible financial assistance following the decision to take over Parex Banka AS, Latvia's second-biggest bank, as liquidity tightened and depositors withdrew funds. Following the nationalisation Latvia added about 200 million lati ($357.8 million) in liquidity to Parex to shore up its finances.

``We don't need the money now,'' said Edgars Vaikulis, a spokesman for Prime Minister Ivars Godmanis, yesterday. ``We are just in consultations,'' he said. Turning to the International Monetary Fund for support in the future was also a possibility, he said.

Latvia's 26 banks lost about 461 million lati, or about 4.6 percent of their total deposits, during October, according to a statement from Latvia's Financial and Capital Markets Commission. Latvia would prefer to turn to the commission and not the IMF, according to Karlis Leiskalns, head of the Latvian Parliament's budget and financial committee, speaking on Latvijas Radio this week.

``I can't say that Latvia won't go to the IMF for help,'' he said. ``The IMF will come with conditions, and one of the basic conditions will be to cut the social budget. I'm completely against taking from the IMF, unless the state becomes bankrupt.''

More Credit Agency Downgrades In The Works

Moody's Investors Service have announced that they may cut their ratings on Latvijas Krajbanka AS and Norvik Banka, citing concerns about the Latvian lenders' asset quality due to the worsening recession in the Baltic country. Moody's have assigned a negative outlook to both banks' D- bank financial strength ratings and Krajbanka's Ba2 long-term deposit rating and Norvik Banka's Ba3 long-term deposit ratings.

``The economic downturn, which is already under way, is now likely to be more acute than previously anticipated and thus have a negative impact'' on both banks' asset quality ``in the near future,'' Moody's said.

Earlier in the week Fitch cut Latvian debt to the lowest investment- grade rating of BBB- and signaled it may reduce again to the category of high-risk, high-yield or junk.

``In the absence of substantial and timely international financial support, Latvia faces the likelihood of a severe financial and economic crisis and a further downgrade of its ratings,'' Eral Yilmaz, associate director for Fitch's sovereigns group in London, said in a statement.

Update Wednesday 19th November

The Latvian central bank bought 189.8 million lati ($338 million) in the domestic foreign exchange market last week to support the national currency after it weakened to the limit of its trading band, according to the latest statement from the central bank. The lats fell to 0.7098 against the euro for the seventh consecutive week, prompting the bank to buy it. The currency is allowed to rise or fall 1 percent from a midpoint to the euro. The central bank has now bought 483.1 million lati over the last seven weeks. It had foreign currency reserves of about $5.4 billion at the end of October, which means that at the present rate of attrition there are enough foreign exchange reserves to hold out for about eight months, though obviously an EU/IMF bailout will cover this end of the problem, the question is why, given Latvia's need to export, you would want to defend the present exchange rate if you are having to enter an IMF programme in any event.

Monday, November 10, 2008

Latvian Inflation Falls Back Again In October

Latvia's October inflation rate decreased to an annual rate of 13.8 percent, the fifth straight month the indicator has fallen as the economic contraction which has followed the boom bust cycle starts to get a grip. Month on month prices were still up by 1.2% over September. That is they were still growing at a 7.2% annual rate. Thus, despite the drop, Latvia continues to have far too much inflation, and still has the highest inflation in the 27-member European Union. In 2006 the economy expanded 12.2 percent, in Q3 2008 it contracted by 4.2% over Q3 2007.

While the slowing pace of consumer-price growth will be welcome news to Latvians, we need now to look out carefully for a new menace: deflation. From now on we will be looking at the evolution in the index itself as well as the year on year changes, to see if we can spot just exactly when the economy falls over into deflation mode, and see if we can judge just how fast prices will fall - and the economy contract as a consequence. At the present time however there seems to be little danger of deflation, as the consumer price index goes hurtling onwards and upwards.

The Central Bank Buys More Lati

The Latvian central bank bought LVL 16.3 million in the domestic foreign exchange market last week to support the Lat after it weakened to the limit of its trading band, according to data from the central bank. The lats fell to 0.7098 against the euro for the fifth consecutive week, prompting the bank to buy in defence of the band. In principle the currency is allowed to rise or fall 1 percent from a midpoint to the euro. The central bank has now bought LVL 293.3 million over the last six weeks. At this point the peg is not under any great threat, since Latvia had foreign currency reserves of about USD 5.4 billion at the end of October, or a little over four months of imports. Four months imports is normally considered the minimum however to protect a currency from attack, so they do need to watch out. The most likely situation is that the bank and the government are already, as I reported on this blog some weeks ago, in day to day contact with the IMF.

Sunday, November 9, 2008

Latvian Government Nationalises Parex Bank

Latvia's government announced today that it has decided to take over the nation's second most important financial institution after the bank ran into liquidity difficulties. The Latvian government apparently decided late yesterday (Saturday) to take a 51 percent stake in Parex Bank, Latvia's second largest bank by total assets, following the preparation of data that indicated the bank was headed toward insolvency.

Prime Minister Ivars Godmanis stated that Parex was functional but in need of liquidity. He also said the government had faced a choice of either taking control of the bank or allowing it to enter bankruptcy. The government also suggested that there were no plans to rescue any of Latvia's other 25 banks at the moment, but that the possibility could not be excluded in the future.

The government bought the majority stake in Parex for 2 lats ($3.70). Another 34 percent stake in the bank will be held as collateral by the state-owned Hipoteku Bank. Obviously the fact that they have had to nationalize Parex bank was yet was another blow to Latvia's deteriorating economy, and to the governments present strategy for addressing the crisis. On Friday we learnt that gross domestic had fallen by an annual 4.2 percent in the third quarter.

Parex Bank was almost unique in both the Latvia and Baltic context in that it was homegrown. Founders Valery Kargin and Viktor Krasovitsky established the bank in 1992, one year after Latvia split from the Soviet Union and achieved independence.

A majority of the banking industry in the Baltic states of Estonia, Latvia and Lithuania are owned by Scandinavian financial institutions, and hence, up to now, have been somewhat shielded from the downturn.

This is obviously the first, and not the last, piece of news of this kind we are going to get during the present economic slump, and the nationalisation decision is sure to heat up the debate about whether or not to seek IMF protection, and indeed whether (or when) to break the Lat-Euro peg.

Friday, November 7, 2008

Latvia's Economy Contracts By 4.2% in Q3 As Moody's Downgrades The Credit Rating

Latvia's economy shrank an annual 4.2 percent in the third quarter, the fastest drop since at least 1994, according to today's flash estimate from the Riga-based statistics office (Friday). This follows a 0.1% year on year expansion in the second quarter.

We do not have quarter on quarter statistics at this point, but if we apply the minus 4.2% calculation over last years Q3 2007 constant price number, then what we get is 2.147 billion Lati, and a GDP graph which looks like this:

Which may have little analytic value (since the data is not seasonally corrected), but does enable us to form a pretty rough and ready visual impression of what is going on, where the annual contraction data remains rather abstract. The economy definitely peaked and started to enter contraction mode after the summer of 2007, and now we need to keep watching and waiting to see just how far it is we go.

The statistics office will release constant price and seasonally adjusted data for the third quarter on Dec. 9. The last time Latvia's economy contracted on a year on year basis (by 2.2 percent) was in 1994, according to data from the Latvian central bank.

Coincidentally Moody's Investors Service today downgraded Latvia's credit rating to A3 from A2, the third-lowest investment grade level, citing a worsening global liquidity crunch and economic slowdown.Moody's warned today that tighter global liquidity could affect some of Latvia's 26 banks, many of whom rely on syndicated loans to finance operations.

``The global liquidity crisis will probably cause a shock to the Latvian banking system, which will reverberate throughout the rest of the economy,'' Kenneth Orchard, a senior analyst at Moody's, said before the report. ``Unless there are major improvements in the European syndicated loan market by early 2009, the government and central bank will be forced to take remedial action.''

Sunday, November 2, 2008

Latvian Retail Sales Plummet As Inflation Remains Stubbornly High

Latvian retail sales fell by a whopping 13.4 percent year on year in September (on a working day adjusted basis), thus clocking up the biggest decline registered in the country in over nine years

Seasonally adjusted sales were down 4.1 percent in September from August, according to data from the national statistics office last week. The yearly decrease was the biggest since July 1999, when they fell 14 percent.

Increases in retail sales have steadily ground to a halt over the last year as banks have tightened credit producing a rapid slowdown in domestic demand for consumer goods. As far as we can see the retail sales index peaked in April, and now we are steadily heading on down. It is a good moment to ask ourselves, will we ever get back to the April level again? (This is not as silly a point as it might seem, since evidence is mounting that the ageing and shrinking population phenomenon is leading retail sales to peak in one economy after another - see Germany here, Italy here, and Hungary here).

Inflation Falling, But There's Still A Long Way To Go

Latvia's inflation fell for the fourth month straight in September, and was down to 14.9 percent. Monthly inflation over August was at 1.1 percent, due largely to a jump in textile and education prices.

Latvia has had the European Union's highest annual inflation rate for more than a year now, a strange trophy to obtain, this one. Inflation peaked at 17.7 percent in May, and has since been slowing steadily. Indeed if we look at the actual movement of the index, rather than the year on year changes, we can begin to ask another, and even stranger question: at what point will Latvia's inflation move registering positive increases to registering negative ones? That is, when will we move from inflation to deflation?

Possibly for many people this question (like the peak retail sales one) will appear to be almost ridiculous. But it isn't. If you look at the CPI index itself (this now becomes much more important than the year on year inflation rates, since what we need to watch for are the price movements from month to month. In general the rate of increase from one month to another has been slowing, and the September uptick of 1.1 % in the index over August was a bit of an anomaly, since in July the CPI was only up 0.3% over June, while in August it was down by 0.4%. So we should not be surprised to see the index hit a ceiling at some point, and and after that it start to come down, at least temporarily, the extent of the decline will depend on how sharply the Latvian economy contracts in 2009, and just how drastically domestic demand drops back.. Basic economic theory in fact leads us to expect this (on the back of falling commodity and food prices and in a situation where internal capacity is way above the sum of internal and external demand available to the Latvian economy at current prices). Thus there is only one way for prices and wages to go (at least in the short term): down. Although people may struggle with all this yet awhile before they accept the inevitable.

Latvian unemployment is now slowly creeping up. In September there were 57544 Latvians registered as unemployed. In comparison with August the number of unemployed increased by 1311, and the Latvian State Employment Bureau are now forecasting that the unemployment rate - which now stands at 5.3% using the persons registered methodology - will reach 8 percent next year.

Bleak Outlook

Latvia's economy clocked up a 10.5 percent growth in gross domestic product in 2007, following 11.9 percent growth in 2006. Since that time Lativia's economy has turned sharply downward, with GDP expanding only 0.2 percent during the first six months of 2008 - down from 10.2 percent over the same period in 2007.

And the future seems to be even more bleak with the IMF forecasting that Latvia's gross domestic product will decrease 0.9% in 2008. Only Ireland and Estonia are forecast to see their GDP contract by more than Latvia – by 1.8% and 1.5%, respectively. The IMF also expects that Latvia's GDP will shrink another 2.2% next year.

The IMF also expect inflation to remain high in Latvia. According to IMF estimates, annual inflation in Latvia could reach 15.3% this year, 10.6% in 2009 and 6.7% in 2007. On the other hand, they expect the current account deficit to decrease to 15.1% of GDP this year and 8.3% in 2009.

Latvia needs to cut spending in next year's budget to avoid rising loan costs as turmoil in financial markets drives up borrowing rates, central bank Governor Ilmars Rimsevics said in Dienas Bizness.

``The global financial crisis has strongly dried up the flow of money: borrowing abroad for a reasonable price has become practically impossible,'' Rimsevics wrote in an Ed-op piece for the Riga-based newspaper.

The central bank forecasts growth between zero and 0.5 percent next year, which would widen the budget gap to as much as 4 percent. Rimsevics also said that Latvia may end next year with a fiscal deficit of 5.5 percent of GDP, in an interview with Leta newswire today. A shortfall that size would be ``unacceptable" he said accusing the Latvian government of having given up trying'' to cut spending. As can be easily imagined, Rimsevics song, when coupled with an IMF forecast of an 8.3% CA deficit for 2009, will be like sweet music to the ears of the global investment community at this point.

It is thus hardly surprising that Fitch Ratings recently cut Latvia's credit rating to BBB from BBB+, the second lowest investment grade, citing a deterioration of the European economy.

Tuesday, October 21, 2008

Sweden Bails Out It's Banking Sector

Well, don't those days when everyone was arguing that the Baltic economies were going to be just fine, since they were such small beer that foreign banks would be only too happy to keep funding them until the cows came home. Well, the cows it seems have just reurned to their sheds.

Sweden has become the latest European country to take steps to stabilise its financial system by guaranteeing up to $205bn of new bank borrowing and creating a fund to take direct stakes in banks.

Stockholm had insisted there were few problems in its banking sector, but on Monday it was forced to match the stabilisation measures of other European governments and respond to fears its lenders might not escape the global financial crisis unscathed.

In particular there were worries a sharp correction in the economies of the Baltic nations of Latvia, Estonia and Lithuania could undermine its banks, which control two-thirds of lending in the three former Soviet states. Fears about this exposure were one reason share prices of Swedbank and SEB almost halved this year.

The new package involves a pledge to guarantee up to $205bn (€150bn, £120bn) of new medium-term bank borrowing and a separate SKr15bn ($2bn, €1.5bn, £1.2bn) fund that can be used to buy preference shares in any bank that needs a capital boost. As part of the legislation, which will go before parliament next week, the government will also assume the powers to take over banks.

This shoring-up of Sweden's banks could be thought of as an initial protection against any break in the Baltic pegs since as John Hempton points out in a detailed analysis of the situation:

If the Lati doesn't devalue its only because people (i.e. Swedbank) are prepared to continue to fund it. This is not pretty at all. All in Hansa owes Swedbank over 30 billion Swedish Kroner – all denominated in Euro and which can't be paid. The equity capital of Hansa (roughly 7 billion Swedish Kroner) is also going to default.

And there is always Claus Vistesen's most recent examination of the whole position if you are in the mood for a longer read.

And, oh yes, there is also the news that the Latvian central bank bought 24.8 million lati ($47.3 million) in the market last week to support the national currency after it weakened to the limit of its trading band, according to a statement by the bank.

The lats weakened to 0.7098 against the euro for the third consecutive week, prompting the bank to buy the currency to keep it within its trading band. The lats is allowed to move 1 percent on either side of a midpoint against the euro. The central bank has now bought about 151.5 million lati over the last three weeks to support the currency

Tuesday, October 14, 2008

The Baltic States May Soon Follow Hungary Into IMF Receivership

Well, the Icelandic authorities seem to have bitten the bullet, and after some coming and going agreed to accept assistance from the IMF. An IMF mission is on the island preparing a plan which will then be put to the Icelandic government (protocols here are important). Under negotiation are the terms of any possible loan. According to Einar Karl Haraldsson (a political adviser to the Icelandic government) the plan is expected to be finalized in the next few days, after which the government will have to decide whether to accept the aid and the terms under which it is being offered.

Meantime a growing number of countries now seem to be at risk of following Iceland and Hungary into the arms of the IMF, with the Baltic republics of Estonia, Latvia and Lithuania now looking particularly vulnerable, according to a warning from the International Monetary Fund itself yesterday.

Dominique Strauss-Kahn, managing director of the IMF, which was formally approached yesterday for assistance by Hungary as well as Iceland, said: "The fallout for most banking systems in emerging and developing economies has been limited so far but signs of stress are growing, " Strauss-Kahn said some banks in eastern Europe have become increasingly exposed to struggling property markets, having raised funds on international money markets in the same way as the ill-fated Icelandic banks.

For the time being the various national governments are denying the possibility, with Edgars Vaikulis, spokesman for Prime Minister Ivars Godmanis, being quoted in Bloomberg as saying "There is no reason to speak of threats to the Latvian financial system......Latvia's situation is different from some of the eurozone members.''

I'm sure that the latter statement is true, even if not in the sense that Vaikulis meant. Nonetheless the Latvian government has taken the step of raising guarantees on all bank deposits to 50,000 euros ($68,225), in line with an earlier decision by European Union finance ministers.

In my view the threat to the Baltic financial systems is real, as is the threat to the Bulgarian and Romanian ones. Action, of some form or another needs to be taken, and soon. Latvia and Estonia are now in deep recessions, and Lithuania, while still clinging on to growth, can't be far behind. Basically it is hard to see any revival in domestic demand in the immediate future, which means these countries now need to live from exports. But with the very high inflation they have had it is hard to see how they can restore competitiveness while retaining their currency pegs to the euro. The IMF will almost certainly insist on a currency float as a condition of rescue, and if you look at the speeches of Lorenzo Bini Smaghi and Jürgen Stark over the last year, it is clear that thinking at the ECB runs along pretty much the same lines. So better get it over and done with now I would say, and take advantage of the shelter offered in the arms of the IMF. Indeed the more I look at what is happening, the more it would appear that a division of labour was agreed to in Paris last weekend, with the EU institutional structure sorting out the mess in Ireland and the South of Europe, and the IMF taking care of all that broken crockery out there in the EU10.

In what is likely to become a sign of the times Hungary's MKB Bank announced that yesterday that it is going to stop providing euro- and Swiss franc-denominated loans until further notice. In defence of its decision MKB said the huge volatility registered in the value of forint in recent weeks, and especially the strong depreciation at the end of last week, make the outlook on the currency extermely uncertain. Most other Hungarian banks are expected to follow MKB's lead. This practice of bringing an end to the extremely dangerous practice of offering foreign exchange denominated loans in countries running large external deficits is now likely to come to a screeching halt all across the CEE and CIS economies, and bit by bit the IMF will have to be brought in to offer support during the transition back to reality.

For a full and thorough analysis of the current threat to the Baltic economies, see this whopping post this morning from Claus Vistesen.

The CEE and the Baltics - Moving Towards the Center of the Storm?

by Claus Vistesen: Lausanne

As I peer out my window over towards the Alps and the northern entrance to Le Vallé du Rhône I can't help asking myself whether some of those experiments which are habitually conducted a mere 40 kilometers from my current habitat haven't gone terribly wrong? With every passing day getting I find it more and more difficult to avoid associating all those worthy attempts to uncover that illusive Hick's Particle with the all-encompassing black hole into which our financial markets seem to be getting sucked with a disturbing velocity, despite the numerous efforts by the global financial authorities to invent some sort of monetary equivalent to "anti-matter".

But while the current crisis is pretty much a generalised global one, if there is one region where the crisis is making its presence more acutely than elsewhere, that place is Eastern Europe, and among the ranks of the regional casualties high on the list come the three Baltics countries, Estonia, Latvia and Lithuania. That this is the case should not really strike us as so strange. On many occasions since the credit crisis went global back in the summer of 2007 many analysts (including yours truly) have been flagging the risk of a hard landing in Eastern Europe. This unfortunate situation has now by and large materialised and the only question which really arises is how hard is "hard" going to be? A couple of recent tentative signs suggest that the big eye of the credit crunch, not unlike Sauron with his glance toward Frodo et al., is fixing Eastern Europe fast in its gaze.

In terms of Russia, we have already witnessed the speed with which financial markets have turned the tide for the erstwhile high powered economy. Now that oil is dipping into negative on an annual basis, the screw may just get turned a little more.

In Ukraine, the market for the state's sovereign debt almost collapsed during the past week as credit default swaps (insurance against loses on debt) rose almost 40% to 1700 basis points as rumours mounted on an early election as well as the government made steps to take over one of the country's big banks. Furthermore and as could be expected the Hryvnia took another beating. A similar situation seems be unfolding in Hungary where prominent government and central officials were dipatched spent part of their Friday trying to avoid a rout on the Forint in the spot markets. Meanwhile, and as a natural bed-fellow to this the stock market, and especially financials, were pumelled. In many ways, the Hungarian predicament resembles more and more a tragedy in the making which is also why the IMF is moving in to calm things down as well as attempt to bring the boat back on course.

The situation in Ukraine and Hungary is important. It highlights the flipside of de-pegging from the Euro (and in the case of the Hryvnia, the USD) in the expectation that subsequent appreciation will help quell inflation. Such a strategy perhaps seemed clever at the time (personally, I always had my doubt), but now as the tide turns downside risk is substantial. From a macroeconomic point of view this is extremely significant. a major part of Eastern Europe's expansion has been supplied by foreign credit and more importantly with loans denominated in foreign currency (mostly Swiss and Euro loans in Hungary and Ukraine). It does not take much of an economist to see the potential abyss of downside risk in the form of translation exposure. As Edward puts it in a recent note;

Basically, the crossover we need to be thinking about in macroeconomic terms is the one between the Swiss Franc and the Hungarian Forint, given the exposure of Hungarian households to Swiss Franc denominated mortgages, and the impact on internal demand which is to be expected if the current dramatic decline continues.

To cap it all off, the significant increase in stress levels of Eastern Europe aslo appears to be sending tremors towards Austria where the banking sector is highly involved as intermediary for swiss denominated consumer and housing finance.

And in the Baltics?

While things are likely about to get very interesting in Eastern Europe the recent tumultous events in financial markets seem to have spared the Baltics from the worst repercussions. This only goes for the more theatrical "Iceland type" events however. If we look at the real economy it is evident that a sharp correction has now begun, something which was confirmed as the data from Q1 2008 rolled in. If we take a look at the most important data pieces, the Baltics have now almost entered a collective recession (even if Lihuania is performing above par).

Both in Estonia and Latvia output contracted for the second consecutive quarter in the second quarter while output in Lithuania stayed surprisingly strong. On the inflation front it finally seems that the pressure is abating somewhat even if of course this is a process that works with considerable rigidities relative to the decline in output. In this way, the Baltics still find themselves in a situation of stagflation.

One very interesting development in this regard however is the evolution of labour costs. If we look at the development up until Q1 2008 the y-o-y increase was one of 7-10% per quarter, but that changed strikingly in Q2. As such, in Estonia and Latvia quarterly labour costs fell to 2.9% and 2.4% respectively Lithuania entered wage deflation. It is still too early to gauge a trend here but it is obvious that for the Baltic economies to correct while simultaneously maintaining a fixed exchange rate regime the correction mechanism would fall entirely on the domestic sector's ability to become more competitive.

And this is now becoming more than a passing preoccupation.

In this way, and while the external deficits have been reduced (mainly due to a sharp drop in imports) the imbalances are still very much present, not least because a negative income balance remains to keep the balance in red. As I have argued before this can only go on until it can't, which is a cryptic way of saying that something at some point has got to give. Unfortunately for the Baltics, the watchdogs of global credit markets (the rating agencies) have begun to seriously turn their scent on to the contradictory fundamentals of these three economies.

Last week, the Baltics's sovereign ratings were consequently collectively downgraded by Fitch Ratings which followed an earlier decision by Moodys to lower the region to negative. The reason cited will not surprise regular observers of these economies (indeed readers of this blog's eastern europe installments). Head of sovereings in Europe Edward Parker from Fitch consequently noted that the worse than expected correction in financial markets coupled with the vulnerable macroeconomic enviroment as the main reasons for the downgrade. More specifically, the mixture of external deficits funded to a large extent by inflows of credit (e.g. some 30% for Lithuania) supplied by foreign banks lies at the root of the decision and incidentally, as it were, also at the root of the macroeconomic vulnerabilities of the Baltic economies.[1]

In this context it is interesting to initially peruse the graphs plotting cross currency exposure and overall leverage (Latvia data only for households).

The point conveyed by the graphs above is one of the main reasons for an increasing risk of a more than traditional adverse outcome from this crisis. It is thus important to understand that the Baltics are still dependent on inflows of foreign credit even as the economy slows and that this shows up, in part, through the substantially higher leverage in foreign currency relative to the total leverage ratio. Especially the extra graphs in the Lithuanian case is interesting in that it shows how the marginal increase in total leverage from 2003 and onwards almost exclusively can be attributed to an increase in leverage of foreign currency loans relative to foreign denominated demand deposits.

This is of course where things begin to get interesting because if we look at the companies supplying the credit to the Baltics, they are increasingly looking to get sucked down into the maelstroem that has fit financial markets. Most prominently is of course the Swedish bank Swedbank which perhaps has the biggest exposure to Baltic markets (through Hansabank). Analysts have persistently been voicing warnings on Swedbank's aggressive lending policy in the Baltics, but if we look at activity in Q2 Swedbank continued to expand credit to the Baltics. And this is not a mere problem of a Swedish bank potentially having to retreat from a growth market gone sour. No, this has the potential to become a full blown macro catastrophe in which the Swedish Riksbank will be faced with the rather odd dilemma of having to bail out a domestic bank, in part, in order to allow the relatively benigh unwinding of macroeconomic imbalances in the Baltics.

It is extremely important in this regard to be aware of the narrative that Swedbank and the rest of the short term credit providers effectively are the only ones keeping the boat afloat. The logic, as brilliantly detailed by John Hempton here, goes as follows. The credit needed on a flow basis to sustain the Baltics' external deficit is being supplied by foreign banks and mostly through loans denominated in Euros (this last thing being very important). Consequently, this presents Swedbank et al. with a rather delicate problem. For the Baltic currencies (or one of them) not to devalue they need funding and more importantly, they need funding on their way down into whatever abyss that may now have opened. Now, as my colleague Edward pointed out in another context it is not the most pleasant of dilemmas to be confronted with the choice of having your throat slit with the stanley knife or the chainsaw. However, this may the situation which now confronts Swedbank, the Baltics, as well as potentially the Swedish Riksbank in the current situation which increasingly resembles some of Kafka's best creations. Hempton makes it very clear when he says;

If the Lati doesn't devalue its only because people (i.e. Swedbank) are prepared to continue to fund it. This is not pretty at all. All in Hansa owes Swedbank over 30 billion Swedish Kroner – all denominated in Euro and which can't be paid. The equity capital of Hansa (roughly 7 billion Swedish Kroner) is also going to default.

The juicy point here is of course the presence of massive translation risk which would arise as the liabilities (denominated in Euros) multiplied in value relative to the asset side.[2] More importantly, this would not only potentially crash Swedbank but also potentially the Baltic economies, and this is something we should attempt to avoid.

However, it is not easy to see where to go from here. One fascinating correlation between micro and macro data is epitomized in the graphs below which shows the evolution in the total stock of loans broken up on currency denomination.

First of all, it is very interesting to peruse the graphs shown above in connection with the graphs plotting cross currency and overall leverage (Latvia data only for households). In my opinion these graphs, taken together, resemble the epitomy of the kind of risk the Baltics face. As such, it is not only a case of devleveraging which, given the multiples, would be bad enough; it is also about the crisis that would emerge if the pegs were abandoned to restore competitivness. However, whether to keep the pegs or not may not be entirely up the Baltic economies themselves. Rather we can easily imagine a situation in which the decision of whether to keep the pegs would reside within the halls of a Swedish bank and perhaps even ultimately the Swedish Riksbank.

How does this compute then?

One way to approach the answer is to look at the total evolution of loan stocks (accounted on a flow basis. One striking feature is that the growth of loans denominated in Euros continue to markedly outpace loans denominated in local currency. This is a well known story in the Baltics and one which I have discussed several times [3], but the key point here is that as the economic edifice now visibly crumbles credit flows continue to enter the Baltic economies. Given the rapid deteriration of the real economy this seems rather contradictorary. However, it is is not, and it essentially means two things.

First of all, it means that whoever is doing the credit service increasingly is throwing good (and presumably scare) money after bad money. From a standard profit maximizing point of view this would seem and odd behavior unless of course there is more to the story than meets the eye. This brings us to the second point and was detailed above in the context of Swedbank et al. and their exposure in foreign currency (with receivables in domestic currency). Ultimately, the situation in the Baltics surrounding the pegs is beginning to resemble more and more like the attempt to cling on to something which is becoming more and more unsustainable by the day. Obviously, the foreign banks could stick it out, but the question is whether they can afford it.

In fact, I believe the only scenario which we, with certainty, can say will not continue is the current one in which lending is expanded on a linerging basis. As such, we need de-leveraging and we are going to get it one way or the other. The only question is whether it will be through Swedbank et al. closing the tap or through a move by Baltic authorities to loosen the peg (in which case Swedbank would be in grave trouble). The alternative would of course be a significant bout of internal deflation which we, with the incoming wage cost data, may already be seeing. The problem with this process though is that it takes time at the same time as it is politically unacceptable. I would seriously question in this regard the usefulness of continuing to look toward the future for potential Euro membership. At some point it should dawn on market participants and politicians alike that this is very unlikely to materialize.

Finally, we may ask the question of whether it is enough? I don't think so and while it still may end up being part of the correction I think that the extent to which these economies need to shore up their competiveness will also include a tweak of the currency peg [4].

Where do We Go From Here?

At the current juncture in financial market the answer to such a question is bound to riddled with uncertainty. In Lithuania, the people just elected a new parliament and while people may be more worried about the immediate need to secure stable gas deliveries from Russia and winter approaches, it is difficult to see how the attention on the crisis can anything but increase as we move forward. In this respect, and as an aside, Lithuania does seem to somewhat different from its northern bretheren in that the leverage ratios and debt multiples are not as high as in neither Estonia nor Latvia. Obviously, this may ultimately come down to comparing one ugly duckling with a slightly less ugly duckling.

As regards Latvia, Alf Vanags and Morten Hansen recently published a detailed analysis on the future path of the Latvian economy faced with the incoming financial crisis and potential global recession. Their conclusion is rather dire with respect to the potential loss of output between and now and 2010. As the authors make painfully clear, this fact obviously brings into the question the whole idea of convergence towards the illusive EU15 living standards not to speak of the convergence towards their own steady state which we really don't anything about at this point.

I would tend to apply the same analysis to Estonia even if Estonia seems to benefit from a stronger external environment and in particular with the economy's strong affiliation with the Finnish economy.

Ultimately however the immediate challenge for the Baltics at this point in time is damage control and more specifically how to wrigle themselves out of the current vice of dependence on credit inflows at the same time as the economy needs to restore competiveness. So far, the show goes on with Swedbank in particular continuing to supply the credit. However, if the recession rolls in, in a manner predicted by most analysts the ensuing squeeze of consumers may make it difficult for Swedbank not to sustain massive losses, not to mention what would happen with the peg and households and companies' liabilities.

The end point of all this clearly appears to envision a fiscal response; at least as a part of the solution. What is critical for the Baltics at this point is consequently that the currenct economic downturn is managed in such a way to minimize the risk of a collapse of the financial system as foreign banks shut down operations. Whether this entails the maintaining of the Euro peg is a difficult question to answer. One thing is pretty certain however and this is that the kind of wage and price deflation needed to correct the imbalance would be a disaster for any political leadership.

Of the three economies Latvia clearly seems to be the most vulnerable to a rout, and given the proximity of the economies sudden unexpected events in one country could easily spread to the others. Here is to hoping that it does not come to that.


[1] - Sometimes things actually fit together.

[2] - Here the asset side would be both deposits as well as future cash flows which would be in domestic currency (for households). For Swedbank itself, main point Hempton highlights is simply the fact that Hansabank would become an immensely heavy ball and chain since the whole thing would have to be written down with the devaluation itself.

[3] - See for example Christoph Rosenberg's brilliant piece on drivers of FX loans in Eastern Europe. As per reference to my own analysis (limited to Lithuania though) Rosenberg finds that lower interest rates on Euro loans as well as the fact that these economies effectively has outsourced the developmentment of their financial system to foreign banks are strong explanatory factors.

[4] - One thing which could provide relief here would be a slump of the Euro which would allow the CEE economies to restore competitiveness at the same time as maintaining the peg to the Euro. However, I think this is rather unlikely because it would imply a level of the Euro which would be in accordance with either the US' need to correct nor the ECB's inflation focus.