Facebook Blogging

Edward Hugh has a lively and enjoyable Facebook community where he publishes frequent breaking news economics links and short updates. If you would like to receive these updates on a regular basis and join the debate please invite Edward as a friend by clicking the Facebook link at the top of the right sidebar.

Monday, June 29, 2009

Are The IMF and The ECB Lining Up Against The EU Commission Over Latvia?

There was a very interesting and revealing press conference given by IMF First Deputy Managing Director John Lipsky and European Central Bank governing council member Christian Noyer in Paris on Thursday. Christian Noyer said that, in his opinion, Baltic countries like Latvia would not be helped by joining the single currency (the euro) prematurely.

"It's in the interest of candidate countries not to enter too early because it risks making the economic situation unbearable," Noyer said.
Lipsky, for his part stressed the region could not depend on any particular foreign exchange regime to shield it from the effects of the financial market crisis:

"If there is a solution it begins with macro policies," Lipsky said. "No single exchange rates solution, or exchange regime represents a solution to these kinds of problems. What is important is that the currency regime is credible and coherent".

Do I detect a shift in emphasis here? Certainly Latvia's currency regime is not credible (most external observers now consider devaluation inevitable), nor is it - in my opinion - coherent. And there has only been a deafening silence coming out from the IMF in recent days on the topic.

The EU finance ministers have decided to support maintenance of the peg, but that is hardly surprising, however, Swedish Prime Minister Fredrik Reinfeldt told Reuters, again rather revealingly, that "We think that a clear signal of support from the EU would help them to achieve support from the IMF." That is, the IMF is wavering, and the EU is putting pressure. This, approach, however, suffers from the flaw that it is hardly either coherent or convincing.

Now the Latvian parliament approved budget cuts of 500 mn Lati for the 2009 budget on June 16, a vote which lead the EU to decide to release the next 1.2 billion euro tranche of the emergency loan to Latvia. So why is the IMF still assessing the situation? Some draw consolance in the idea that the IMF’s share of the program is smaller - only 1.7 billion euro in comparison to the 3.1 billion which is coming from the European Commission. But this is to neglect the strategic role the IMF is playing in the whole process. If the IMF isn't leading, then what is it doing. Evidently, the fissures which may be developing between the Commission on the IMF approaches only serve to draw more attention to the complexity of the whole current EU economic and political architecture.

Latvia is a sovereign country, also member of the European Union. Looked at from one point of view, what was the IMF doing there in the first place. But once they have taken leading responsibility, it is not wise for the Commission to try to claw this back from them. After all, the whole process is supposedly intended to raise investor confidence, something which is hard to do if there is not unity of purpose.

Meanwhile liquidity conditions continue to remain tight, and Rigibor interest rates shot up again at the end of last week, following the termination of the summer solstice holiday.

The last official news we have said simply that the IMF would decide on the Latvian loan after June 26. Well we are now after June 26, and we are still none the wiser.

Meanwhile Latvian's continue to save, and outstanding private debt fell in May to 14,140.2 million Lats from 14,252,4 million Lats in April. They year on year change is now down to only 1.6%, and will more than likely turn negative in June, which means that, with the government also trying to save hard, continuing contraction is completely guaranteed without exports.

And today we have two additional pieces of relevant news. Firstly, and most interestingly, former IMF chief economist Kenneth Rogoff - now a Harvard University professor - has said the IMF made a mistake, and should never have allowed Latvia to keep the peg. (That is, he agrees with what Krugman and I have been arguing all along). The IMF, however, is still maintaining an apparent vow of silence on the whole situation, or so it seems, and have yet to pronounce. Hello, EU Commission, how can you lose your heads, when all around you are keeping theirs?

Latvia should devalue the lats to avoid a worsening of its economic crisis, said Kenneth Rogoff, a Harvard University professor and former chief economist at the International Monetary Fund, in an interview with Direkt. The IMF made the wrong decision when it allowed Latvia to keep its currency peg, Rogoff said in Visby, Sweden today, according to the Swedish news agency. While a quick devaluation would be best for Latvia, Rogoff doesn’t believe it will happen for a long time because the IMF and Europe will provide the Baltic nation with loans, Direkt reported. In a normal situation, Latvia would already have devalued the lats and defaulted on its debt, Rogoff said, according to the news agency. World leaders have decided no countries should be allowed to fail and Latvia is benefiting from that, he said.
Secondly Central bank governor Ilmars Rimsevics has given an interview to Reuters TV. He will go down with his ship, like every good Captain should, but there will be no lifeboats for the rest of you.

Latvia will stick to its currency peg and not devalue, even if the country fails to win further loans from the European Union and International Monetary Fund, its central bank governor said on Monday. "People who are expressing that (a devaluation is possible) lack some education and knowledge and I am sorry. There is absolutely nothing to do with devaluation in Latvia," he told Reuters at the Bank for International Settlements (BIS) meeting. "If the cuts (in the budget) won't be made, there would not be financing available, but that in no way would influence or affect the currency peg," Rimsevics added.
The European Central Bank also today urged urged Latvia to rethink plans to siphon off half of its central bank's profits to help rebuild the country's battered finances. Latvia's government plans to up the amount of central bank profits it takes, to 50 percent from the current 15 percent.

In a legal opinion published on its Web site on Monday, the ECB warned the move risked hurting Latvian central bank independence and wiping out funds designed to be a financial safety net for country's troubled banks. "The use of central bank financial resources may be counterproductive from the credibility point of view if confidence in the financial stability and independence of the National Central Bank is undermined," the ECB said.

"It is important to shield the rules related to the distribution of profits from third-party interests and to ensure a legal framework that provides a stable and long-term basis for the central bank's functioning."

One of the most crucial questions going forward is will the process of relative price adjustment, while still keeping the peg, be able to balance the economy, or will it turn out to be intolerable, thus leading nevertheless to devaluation in the end. Although wage growth and inflation are slowing, one could ask whether the adjustment is fast enough to enable Latvia to keep the currency pegged. Uncertainty about the answer is likely to keep the devaluation fears as well as the uncertainty in the FX and money markets alive in the future.
Annika Lindblad: Nordea

Well quite, this is one of the things I have been arguing all along, and now those who in theory support the maintenance of the peg begin to "worry" that the rate of price and wage decline may not be fast enough to maintain the peg. Wouldn't it have been better to have thought a little more about this, before embarking on what is evidently such a risky endeavour.

At the end of the day what we could really say here is, that in a bid to defend credibility, all credibility has now been lost, and things will only get worse from here on in. Tragedy has already repeated its self as tragedy, and now its about to become one of the sickest of all sick comedies. I think it's time to put a stop to the agony.


Latvia's Central Statistical Bureau announced yesterday that retail sales rose slightly in May (as compared to April), by a seasonally adjusted 0.9%. Year-on-year, though retail sales were still well down, by a working day adjusted 26.4% over May 2008. So it is hard to talk about any kind of "green shoot" here.


Anonymous said...

gotta love watching the agony of textbook "experts" and other forex market monkeys who believe Latvia equals Argentina because they know a few macro numbers...

Edward Hugh said...

Enjoy, enjoy! Of course, the textbook doesn't say Latvia is Argentina. What it does say is that the kind of "internal devaluation" Latvia is trying to implement is too painful to work, and this is now obvious to everyone, I think. Now watch what happens next in Spain. What a mess!

Funs said...

Thanks for the update Edward!

This is disturbing that we don't see any fact based analysis like this going on at government level.

I think we will not see a devaluation in Latvia any time soon. Suffering? A lot of.

Our leaders will keep the peg until the last breath because of their business ties and business is massively credited in EURO.

The EU and EC do no want to see us devaluate, so we can count on large amounts of help before they realize the that this plan is not sustainable.


Funs (LV)

Edward Hugh said...

Hi Funs,

"The EU and EC do no want to see us devaluate"

Yep, but the EC need to carry the IMF with them, and at this point the IMF have gone awol. We need to watch and wait.


j said...

The saddest part is that overwhelming majority of Latvian people believe that devaluation is bad or even evil thing - recent survey showed that 78% (of 4000 respondents) are against devaluation. This also somehow explains why politicians and CB are so strongly against the process - such decision would be last in their political career.
Interesting that another survey in early 2007 showed that 74% of respondents believed that real estate prices in Latvia will continue to climb and 81% (!) that salaries will also continue to rise.

Latvian abroad said...


It's not surprising. The Latvians get bombarded with "devaluation will be horrible" opinions from the media on a regular basis.

The financial and the media elites are both firmly anti-devaluation and have enough power to shape the public opinion

Reinis said...

Edward, you make really good and well argued point that devaluation in Latvia would make sense and would benefit country in long run (compared to alternative - desperately maintaining peg). Likewise you show that from macro economical point of view it could be actually imminent. And logically thinking I can only agree with you on this. Still for it to actually happen some policy making would be required (unless Latvia goes into situation where it does not have resources to maintain the peg). But taking on decision to devaluate brings up one painful question - how to handle massive business and household debt that is mostly in euros. And not being able to answer this question is most likely reason why Latvian government likewise Bank of Latvia not only rules this option out, but actually has somewhat hostile attitude regarding this topic. So I'd argue, that until this could be answered in reasonable manner no-one of Latvian policy makers dears to consider it realistic alternative - everyone is afraid of massive inevitable defaults that would follow.
Therefore I would actually like to challenge you to state some *realistic* scenarios how Latvian government would be able to handle this massive business and household euro debt in case of devaluation?

Edward Hugh said...

Hi Reinis,

Well, without wanting to be a bore, the initial outset of all of this from me and Krugman was that the euro denominated loans issue is irrelevant, in the very technical and significant sense that if you practice and internal devaluation of say 20% on wages and prices, the effect on loan defaults is at least the same, with the nuance, made by Krugman, that on the internal devaluation path, even those with loans in Lati get to default.

This is a technical finding, and based on a wide range of experience in this topic, especially over at the IMF, which is why the IMF has always been a reluctant passenger in this whole process, but they seem to have gone along out of respect for the undoubted will of the Latvian people. But I am not clear that they will continue much longer, since they will increasingly put their own credibility at risk, and if global confidenmce in the IMF was badly damaged by a fiasco in a small country like Latvia, then that would be a ridiculous outcome, wouldn't it?

"Still for it to actually happen some policy making would be required"

The way I see it is this. The IMF have won the ECB over. Now the ECB and the IMF are pressuring the EU Commission. If they are successful in this, and this is to do with diplomacy, it isn't anything you see in public, but the EU can't be seen publicly to be "fissured" in this way, or at loggerheads with the IMF. So it is a very powerful leaver. Then if the EU Commission cross the Rubicon, the Latvian government will have no alternative but to do as it is told. This is already happening with all these cuts.


Solutions? None are easy. The most similar experience in this sense is not Argentina, but the Tequilla crisis in Mexico in 1992. Argentina's problem was state debt, in Mexico firms and individuals had done a lot of borrowing in dollars.

As it happens I have a friend here in Barcelona who worked with the Mexican banks on the solution to the crisis. The solution is straightforward, even if implementing it isn't. The debt is divided in 3 - part is assumed by the banks (the loses I mean), part by the government, and part by the private individual. If the economy is returned to growth, then these latter can start paying again, although the capital value will have been written down.

The banks just have to take it on the chin, or get help from the Swedish government, and the government, well this will involve "restructuring" (a fancy word for default I suppose) in consultation with the EU and the ECB. We also need to change the Maastricht criteria and put a timetable for euro entry, a credible one.

Edward Hugh said...

Basically, if nothing is done you are headed for default, as sure as night follows day. Now here is some similar explanation from a mail from a friend who has worked in debt restructuring.


I really wonder what would happen with the Latvian legal/financial/social system, if every fourth or every fifth citizen were technically bankrupt.

How would the banks enforce the loans? Would the debtors declare themselves bankrupt? How would the banks sell the houses and other real estate? Who would manage such a massive number of insolvencies? Would there be recourse after repossession? Plus myriads of other problems.

Maybe it is just because I lack a bit of imagination, but I am really unable to imagine a country where a very significant
part of population has gone bankrupt overnight. At least, I can not imagine any such country remaining stable and functional.

So this is what worries me most about this tragic story, the apparent lack of plan how to deal with the "private" euro
denominated loans after devaluation.

However, there are possibilities how to allow for devaluation and, at the same time, save one third of Riga from the trip to the bankruptcy court. In the very first place, the creditors must "admit defeat" and start providing for loan losses. Which is apparently being done on the Swedish side. Then, once the loans have been partly written off, somebody (an EU-backstopped agency?) may buy them at, say, half the face value.

It would be assumed that the loans are actually worth about that. Then, the bought-out loans could be restructured in such manner as to prevent the debtors from having to default.

If the loan portfolio turned out to be even less valuable (which they may, and may not), then the guarantor (EU?) would cover the losses.

Of course, we could discuss moral hazard etc., but it would make little sense to me. In fact, if we let one third of Latvia go bankrupt, what will be the easiest way out for those suddenly made insolvent? Emigrate.

Even nowadays, despite globalisation and all that, it is so very easy to escape ones debts. You "just" go, drive across the border and settle elsewhere.

It is most fascinating indeed that the "internal devaluation" crowd leads the general population to the same destination (named mass insolvency), yet does not really bother thinking about such little details, either.

Edward Hugh said...


"The saddest part is that overwhelming majority of Latvian people believe that devaluation is bad or even evil thing"

I agree, and see in this a mirror of the recent opinion polls which show that most US citizens put more emphasis on containing the deficit than they do on restoring growth.

Macro economnics is a very hard subject, and it gets worse when the ordinary person in the street has to decide on the most technical of questions. Particularly when another group of people are demagogically shouting "economists got it all wrong, and understand nothing.

Incidentally you guys, get into facebook, and contact me, this is where the possibility of debate is.

Anonymous said...

"I agree, and see in this a mirror of the recent opinion polls which show that most US citizens put more emphasis on containing the deficit than they do on restoring growth."

Governments need to implement policies that promote sustainable growth. The problem with many government initiatives at the present time (specifically including, but not limited to, the United States):

1. They are an attempt to reinflate the credit bubble, and postpone (or eliminate) painful adjustments.

2. The economy "adjusts" to stimulus conditions rather than to the equilibrium.

3. Rather than any permanent gain, they merely shift consumption forward.

4. Policies such as massive deficits can cause permanent harm (higher taxes and interest rates).

The main cause of this whole mess was a bias toward short term thinking (borrow a lot of money to satisfy desires now, and don't worry about how to pay it back) on every level imaginable.

I don't want to say that this is the ideal time to cut budget deficits to zero, but I definitely fall into the do less rather than more category. Economies are likely to fix themselves more quickly without government intervention.

Edward Hugh said...


Just two quick points:

"Economies are likely to fix themselves more quickly without government intervention."

Well, this would include getting rid of the peg then, since this is a very massive form of government intervention, and precisely what prevents the system adjusting.

"The economy "adjusts" to stimulus conditions rather than to the equilibrium."

Well, without getting technical, I assume that this "equilibrium" you are referring to is the neo classical assumption one. I have serious doubts whether this exists in any meaningful sense in an epoch of massively below replacement fertility. There is no homeostatic mechanism.

The village pond has been over fished, with everybody free riding their retirement on everyone else's children.So I am not in any way optimistic that all this will correct. Rather, I think some countries will simply die.

I don't have the same objections you do to shifting consumption around inter-temporally via government spending, but that is a different issue. And anyway, globally you may be right, we may be resource constrained, and there may be people in other poorer countries who need what oil we have more than Europeans and Americans do at this point.

"The main cause of this whole mess was a bias toward short term thinking"

Well, I think the main cuase of this whole mess was greed, and people thinking they could live well beyond their means. Now I think we are going to be more ecological, and less consumerist, for the simple reason that we won't have the wherewithall to do all that consuming, so we'll have to find another way to spend our time. Not all bad.