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Thursday, May 28, 2009

Devaluation Imminent in the Baltics?

By Claus Vistesen: Copenhagen

Even when liars tell the truth, they are never believed. The liar will lie once, twice, and then perish when he tells the truth.

One thing which is certain at the moment is that the rumour mill is grinding hard and that it is very difficult to get a clear picture of what is going on. It is too cumbersome for me to go into the entire background here (I assume most of you are familiar with the Baltic and CEE situation), but if you want some background try this or this which will give you the opportunity to browse a myriad of articles. The situation is however pretty simple. Ever since it became clear that the Baltics was going to suffer not only a hard landing, but a veritable collapse on the back of the financial crisis one obvious question always was whether these economies could maintain the Euro peg throughout the correction process. So far the peg have held and the countries, as well as the IMF who have been called for aid, have been committed to the peg and thus the future entry in the Eurozone.

But this has come at a price and as international economics 101 tells us, the only way you can correct with a fixed exchange rate and an open external account is through deflation and a very sharp drainage of domestic capacity. And so it has come to pass that particularly in Latvia who has come under the receivership of the IMF the scew has been turned, (and turned and turned) and now the question is how much more can the public and the goverment take. In a recent article in the NYT the situation is well described as the Latvian government scrambles to meet ends on the IMF's pre-condition to continue funding the bailout programme.

One very significant indication that things are near its breaking point came when Central Bank Governor Ilmars Rimsevics launched the idea that, since the liquidity in Lati is being drained in order to keep the peg and because the cuts needed to abide by the IMF rules are immense, public employees might be submitted to receive their pay in "vouchers" in stead of actual Lati. As Edward points out, this is straight out of the vaults of the Argentian crisis' annals. This is one of the things you get with a peg maintained too tightly during a deflationary crisis. It deprives you from liquidity. Now, in some sense this all about the next installment of IMF funds of course and whether Latvia will (can) make the needed budget cuts to please the fund to such an extent that they will continue to slip the bailout checks in the mail.

Essentially, under the peg, the central bank has to buy Lati in the open market to maintain the peg since there is, naturally, a pressure on the peg as everybody want's euros. So, the central bank is forced to drain the economy from liquidity to maintain the peg in an environment where the economy is contracting at about 20% over the year. This is not fun and, as it were, not sustainable given the trajectory of these economies. In this sense devaluation is no cure but a simple prerequisite (and necessity) for the healing process to begin.

Even more significant it appears that the the foreign banks, so important in the Baltic story since they basically provided the liquidity inflows to fund the boom, are beginning to accept the basic point I, and others, have made so often before. This is the point that although a devaluation would entail default on a large batch of Euro denominated loans, this default would come in either case as a result of the utterly horrid contraction. In this sense it was very significant that the SEB Chief Executive Annika Falkengren pointed out;

"In total we would have the same size of credit losses, but (if there is no devaluation) they would be a little more regular and over a longer time frame," SEB Chief Executive Annika Falkengren told Swedish radio. "In the case of a devaluation they would be pretty much instantaneous."

This is important because one prerequisite for the peg to hold was always that the foreign banks explicity backed it since they pretty much finance the majority of the credit needed to hold these economies afloat and particularly so Latvia. Essentially, on the Swedish side of things it appears that they are pretty much treating this as over and done.

According to Dagens Industri' Torbjörn Becker, leader of the Eastern European Institute of the School, a devaluation is likely. "The alternative to a devaluation in Latvia is to wait until the reserve is drained and the economy will disappear into a black hole, " he told the DI. Torbjörn Becker believe that neighbors Estonia and Lithuania follow.

Moreover, the Riksbank just recently bolstered its foreign currency reserve with an amount equal to 100 mill SEK which can be interpreted as a precautionary measure to deal with a potential fallout in the Baltics.

The Executive Board of the Riksbank has decided to restore the level of the foreign currency reserve by borrowing the equivalent of SEK 100 billion. This needs to be done because the Riksbank has lent part of the foreign currency reserve to Swedish banks. We have also increased our commitments to other central banks and international organisations. The Riksbank needs to maintain its readiness to supply the Swedish banks with the liquidity required in foreign currency.

Finally, there is Danske Bank, aka Lars Christensen in the context of the CEE, who warns of a serious event risk in the Baltics in today's daily installment on emerging markets.

The event risk has risen sharply in the Baltic markets and we advise outmost caution. Yesterday, the Swedish central bank Riksbanken said it will increase its currency reserve by SEK 100 bn through a loan from the Swedish debt agency. Investors seem to believe that this is a buffer to deal with potential problems arising from the Baltic crisis.

(...)

With worries over the Baltic situation on the rise there is a significant risk of negative spill-over to other markets in CEE. Therefore we see clear downside risk on the CEE currencies and a risk of a sharp sell-off in the CEE fixed income markets in the coming days. We especially see value in buying USD/HUF, but potentially also USD/PLN on an escalation of the Baltic crisis.

Basically, the way I see it is that there is only so much the currency boards can do and in Latvia's case, after having already spent over 500 million euros buying lats, I think we are moving steadily towards the end game. Of course, there is an obvious risk that I will perish further down the road with this one, but then again, so be it. It is imperative that investors and stakeholders entertain the possibility of a multiscale Baltic devaluation and, obviously, a sharp CEE sell off in the wake.

18 comments:

Juris said...

Just another rumour article. It sure may be that end game is close. It remains to be seen if it is for Latvian currency peg or overconfident speculators.

Robert said...

More about Latvian devaluations in swedish news today.

http://di.se/ and look for article "Analytiker: Baltikum måste devalvera".

Rumours or not, it has already effected the sweds quite a lot as the Krona is falling rapidly after the news this week.

j said...

Latvian Finance Minister however this morning said that there will be no devaluation.

Anonymous said...

Polish economy seems to be in GREAT condition during CRISIS - GDP 0,8 in PLUS !!! so danish banks are saying shxxx about baltics - there is big difference between Poland and Latvia - look only into GDP and population ;)

Robert said...

To j:

It is only the small problem that it is not the Latvian Finance Minister nor Latvian Central Bank that decides about the devaluation but the IMF, EU, ECB and Sweden.
Even though I am often critical to the Swedish government I think they have the knowledge about what is happening in Latvia and the IMF:s considerations that they make the necessary steps to at least minimize the damage to the Swedish economy.

Robert said...

Here is another article in the swedish newspaper DN
http://www.dn.se/ekonomi/dags-lata-lettland-devalvera-1.879613
Where one of swedens more prominent economists lays out his thoughts.

j said...

Today in news - last week Central Bank has spent 134.5 mln eur to support LVL. It is the biggest weekly amount this year, first week of April (with 105 mln eur) comes next.

Dmitri said...

This is certainly a speculative article, however, the conclusion tells the story: investors need to be aware of the unfolding events. Personally, at this point in the game, I don't think the EU or the IMF would like to see a devaluation (would be too painful). Devaluations are built on the credibility of the central banks to hold prices in check, but with the dodgy government that will surely be a difficult task.

Robert said...

You can now, 1 of june, read that the interior minister Marek Seglins will "evaluate" a devaluation of the LAT.

Robert said...

How long can it take to remove a bandaid? (However it is not just Latvia that do not make good decisions, just look at Chryster and GM in the US. They also should have filed Chapter 11 in december 2008)
I just hope that this long road to the unevitable devaluation will have the good with it that the Latvian people now will make the necessary changes in thier contry to be competitative in the longer run.

Edward Hugh said...

Bloomberg this morning: Bengt Dennis, the former Swedish central bank governor and an adviser to the Latvian government on how to cope with the economic crisis, said the Baltic country will need to devalue its currency. “No one knows if there will be a devaluation tomorrow or in a few months -- the timeframe is always uncertain -- but we have moved beyond the question of whether there will be a devaluation and should instead focus on how it will be carried out,” Dennis told Swedish state television SVT last night.

Latvian abroad said...

The local rumors are that Seglins' party might leave the government.

Dombrovskis is still claiming that devaluation is not being considered (despite Bengt Dennis' claims above).

The political situation is a complete mess.

Edward Hugh said...

Hi LA,

Hope you are well. It looks like things really are coming to the boil now.

Dombrovskis's office just issued the following:

Prime Minister Valdis Dombrovskis in relation to an opinion expressed by Bengt Dennis, member of the High Level Advisors Group to the Government of Latvia, about devaluation of the Latvian national currency:

“I hereby announce that an opinion by Bengt Dennis, member of the High Level Advisors Working Group to the Government of Latvia, which he expressed today to the Bloomberg news agency about an inevitable devaluation of the Latvian national currency – lats – is not true, and should be evaluated as expert’s personal, individual opinion which has nothing to do with issues concerned in the first sitting of the High Level Working Group, as well as with the position of the Government of Latvia on overcoming the economic crisis.

The negotiations of the Government of Latvia and the international investors are based on a requirement of a stable national currency that all parties comply with and confirm.”

The thing is obviously falling apart at the seams. Which really always the most substantive argument for devaluation - ie that the political and other social sub-systems would never stand the strain of "internal devaluation".

Before it might have been orderly. Now it looks like we might get -as you say - a total mess, with international agencies and local politicians alike totally deiscredited to boot.

Claus is preparing a post for this afternoon.

Latvian abroad said...

Hi Edward,

I'm fine. The things are getting difficult here for many people but I'm not affected personally much yet. And I do have a substantial cushion of savings from the years abroad. (I'm only wondering if holding them in a EUR account in Swedbank is safe enough.)

What do you think of Dennis' statement? Did he indeed voice a personal opinion in a form in which it could have been mistaken for a Latvian government opinion? I find it hard to believe that someone with a substantial political experience would do that.

Edward Hugh said...

Hi LA,

It is very hard to read tealeaves :)

"I find it hard to believe that someone with a substantial political experience would do that."

Definitely. No one gives such an opinion in an interview with Bloomberg unless they wish to produce an effect. The only issue here is what effect?

Does he think that the position now is unsustainable? (See Claus's latest post - and remember this is how things ended after his last attempt at "internal devaluation" in Sweden). Or is he reflecting pressure from Sweden.

I think at this point we all need to be careful to avoid provoking currency runs (or accusations of trying to do same). All I would say is that things are moving fast, this is not the end of the world, and that there will be plenty of time later to freely debate the issues which have arisen during all of this experience.

Latvian abroad said...

Meanwhile, the Latvian political elite has gone into damage-control mode. Seglins is claiming he suggested to discuss devaluation just because "a public discussion would help to show that devaluation is not a good option". A bit ridiculous but he has to come up with some excuse.

The disagreements in the coalition have also become invisible to public, for now.

Edward Hugh said...

"Polish economy seems to be in GREAT condition "

Well, I wouldn't go that far. The economy only grew by 1.9% year on year - India (for example) grew by 5.8% year on year,I would call what happened in Poland a good performance under the circumstances.

We now have seasonally adjusted quarter on quarter data from Eurostat for Poland yet, and it would seem they continued to expand in the first quarter (0.4%according to Eurostat), and that is truly good news.

The central bank are now forecasting zero growth (ie no contraction) over the year as a whole, and while I think they may be over optimistic, Poland is certainly in better shape than the Baltics.

I don't suppose they fact they have been able to devalue the Zloty by 20% has anything to do with it? And Poland may yet enter the euro before any of the Baltic countries. I don't see the recent Zloty devaluation as any impediment in this sense. What will matter is the ability to demonstrate longer term overall stability and sustainability, which is what the Baltic countries are notably failing to serve up.

Anonymous said...

Parex bank would not change Lats to Euros for me today. Absolutely refused.