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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.


Latvian abroad said...

Situation is getting even worse. An article in Latvian:
Title: Security police calling bank employees to "educational" discussions

Eventually, this nonsense will end, through European Human Rights Court in the worst case, but that might take quite a long time.

Anonymous said...

I am still not sure that Latvia would actually benefit from a devaluation, as it exports almost nothing (!) and devaluation would kill people who take external products or rely on external services or investment. This is actually most people.

I agree that the current position seems unstable, but the solar system is unstable too, although I guess that the time scales differ! If Latvia could go straight into the Eurozone at the current rate, the recession would continue, but would it seriously be deeper or worse than currently foreseen?


Jekabs said...

Here is an article from LETA news agency from Dec 4. http://www.financenet.lv/zinas/latvija/article.php?id=196998

Link is to an article in Latvian, but I include a translation (you get full service!)

In negotiations with the International Monetary Fund (IMF), the government categorically will not give in to the potential calls for changes in the lat fixed exchange rate against the euro, although in informal negotiations with the IMF that possibility has been discussed, representatives of the government acknowledged to journalists today.

Prime Minister Ivars Godmanis (LPP / LC) after the extraordinary parliamentary sessions for journalists stressed that no changes in the lat fixed exchange rates will be made, it is a fundamental requirement in negotiating with the IMF. Deviations from this are not planned.

Although it will require additional spending, the government will ensure currency stability by a review of existing resources and appropriate spending cuts.

In turn, Finance Minister Atis Slakteris has recognized that in informal talks with IMF representatives they discussed possible changes to the fixed band exchange rate, which would mean a reduction in currency value.

However, today's agenda had only one option - to maintain the lat fixed band exchange rate.

Slakteris indicated that informal talks showed that some people in IMF believed that Latvia, like Argentina, should think about currency devaluation. However, that was expressed in the informal conversations, and in the official IMF delegation has not discussed such a possibility.

In negotiations with the IMF, key will be the economic stabilization plan which is to be adopted in Parliament.

Prime Minister informed the journalists that the plan could be submitted to the Parliament on 12 December or 19 December.

If members reject the plan, the government will resign, stressed Godmanis.

Slakteris stressed in a parliamentary meeting, that the government expects the gross domestic product (GDP) next year will decrease by 5%. Compared with the budget that was approved in Parliament some time ago, budget deficits, if no changes are made, may amount to one and a half billion lats, or about 10% of GDP.

"Of course, the government intends to do everything to prevent this, but it is understood that the kind of economic slowdown and a fall in revenues as Latvia is seeing now, our country has never experienced," said Slakteris.

The Minister emphasized that difficult decisions will have to be made, decisions not faced in the recent years. In fact, the world does not have many good solutions for situations of this type. "I had a conversation with IMF Executive Director, responsible for Scandinavia and the Baltic countries, and he said the IMF is now having much informal debate about what would be the best assistance to Latvia," Slakteris said.

"Many experts feel that one of the scenarios could be one that existed in Argentina, which went a currency devaluation path. This instrument, of course, is discussed behind the curtains, but the Latvian government disagrees with it, as does the Bank of Latvia. But if this path is not followed, then the real route must be taken, real spending reductions - the wage reduction route, government spending reductions and oversight spending reduction route, "said the minister.

"With such a size and scale” government will offer to the Saeima "the total reduction frame"(((that’s what it says literally, I have no idea what that means))), perhaps even before the 19 December. The government's vision for how to emerge from this critical situation, will be the basis of whether the international community, the European Commission and the IMF would be willing to give credit to Latvia, Slakteris said.

Such credit is needed for reviving the economy and for avoiding these types of drastic spending cuts that would bring the country to a halt.

"Even if we have this borrowing, spending will have to be reduced dramatically in a very harsh way, and in some areas revenue will need to be increased," warned Slakteris. "They will not be popular decisions. If we will not do this in a situation where the whole world has stopped in financial markets, one day Latvian state would not be able to finance what is called for in the budget. And then a country can experience the same thing experienced by the countries that are forced not to pay salaries or pensions. I hope and am confident that the government, the majority, and the opposition, in this moment will be able to take decisions that are not easy, but are critically needed in our country. "

As reported, the Bank of Latvia (LB) president Ilmars Rimšēvičs is convinced that the central bank will have sufficient means to keep the lat’s course stable, even though LB has already spent 20% of its reserves in intervention.

Rimšēvičs expressed this view in the "Business & Baltic States".

He categorically states that he is not considering the option of LB having insufficient means for ensuring lat’s stability. "Yes, some people get too nervous (..), and they begin to consider the most unpleasant scenarios," stresses Rimšēvičs, stating: to comfort the people, action must be very quick and decisions have to be made about the economic stabilization plan.

Commenting on the changes necessary in next year's budget, Rimšēvičs stresses that it will have to be cut by a billion lats. A budget deficit of 9% -10% of GDP implies 1.5 billion lats, but the deficit should be reduced by seven percentage points, meaning roughly a billion lats.

This amount will be borne by cutting costs and possibly increase revenue, such as raising the excise tax.

"After this painful surgery, Latvia will gain access to the IMF and / or the European Commission's funds, which could help the economy," explains the LB president.

Anonymous said...

Actually, it looks like the biggest fear of the Latvian government concerning the devaluation (oops ! There we go Droshibas Policija...) is the fact that THE national sport until the credit crunch came was to take loans in euro - while having an income in lats, supposed to be ever growing. Rates were so much better this way.
Now if you devaluate, everybody - from Janis Berzins (the Latvian Joe the plumber), to the biggest local companies, including most of the highly indebted saeima members (they all answered official questionnaires of the anti corruption board by saying that their wealth was based on bank loans) - really everybody will have a tough life paying much higher monthly installments. And this time, there won't be a possibility to refinance with another loan.

So the secret weapon - that got voted during a highly intoxicating night session December 12 th - is to raise the VAT (18 to 21% and 5 to 10% for the reduced rate). This measure comes into force on the 1st of January and all IT specialist will have a few field days to reprogram all the systems until then.

I'm just a foreign entrepreneur in Latvia, but for the last 4 years, I've seen it sliding on the slippery path of bad governance with the Latvian people either called "ignorants" - by the prime because they criticized the Govt action -, or harassed by the State Security Police - that's the full name - , or just passively accepting when they see that no court and no justice defends them whatsoever.
Maybe I don't understand the drive and nuts of economics, but please tell me how raising the VAT will help the overburdened and silenced people of Latvia.
Of course, it'll give some financial relief to a state that is not so keen on cutting on spending - when presented with the 2nd anti inflation plan, our elected officials refused the downsizing of their official cars -, it shall have a limited impact on exports - though it will severely hamper the tourism market as the hotel rates will mechanically grow by 5% for all European tourists -, but it will contract even more the internal market.
Maybe you'll find interesting the government answer to voiced critics : "we survived with a 16% inflation. Now it is down to 11%. Thus we can afford raising VAT rates by a mere 3%."
And would you wonder why I keep on working and staying here, it is out of love for this country...

Anonymous said...

ittle update on my last comment :
Not only were the VAT rates increased by a flat 5%, but quite a few products and services that were previously with a reduced rate now jumped onto the 21% bandwagon I.e. a 16% increase. Books and tourism accomodation fall into this category. With a 2009 tourism season already sold for most hotels -lots of them having huge credits- quite a few already think about closing their doors.