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Sunday, June 7, 2009

A Week On the Wild Side (Latvian Edition)

By Claus Vistesen,

Peering out of the window on a rainy and cold Sunday (election) afternoon in Copenhagen it is difficult not to paraphrase, yet again, one the Economist's many classic cover stories but really; it sure has been one hell of ride this week in Latvia. One wonders whether politicians and economists in the central bank really want to see what happens come tomorrow as markets and the flow of news re-commence. The truth however is that they really do not have a choice. Consequently and what actually started a little more than a week ago has now steadily turned into the well known story of politicians and official authorities doing their best to maintain a crumbling edifice. Markets, analysts, and commentators, on the other hand, are beginning to smell a rat and this particular rat looks set to gnaw its way right to the core of the Latvian economic edifice in the form of the Latvian peg.

Surely, the pressure has only piled on since I last wrote about this only a few days ago. The Financial Times' blog Alphaville in this case personified by Izabella Kaminska has steadily been supplying us with the latest on the unravelling in Latvia. A particularly good piece hammers down the point that it is not only freelance bloggers such as yours truly who are questioning the Baltic (Latvian) currency peg but also, now, most professional analysts close to the situation. This is a called a market discourse and although the commitment to maintain status quo may be there one cannot make the waters go back.

However and to be fair to all parties it does seem as if the Latvian authorities got the best of the discourse this week if, that is, being the last one to shout constitutes an upper hand in this case. Consequently, both the central bank and the premier minister Valdis Dombrovkis issued strong statements to suggest that the peg will hold simply because Latvia is committed to seeing this correction through.

Latvian Prime Minister Valdis Dombrovkis pledged to push through budget cuts and ensure the inflow of international loan payments as speculation grows the Baltic state may devalue, threatening the economy of Sweden. “These rumors and speculations should finally be stopped” about the devaluation of the lats, Dombrovskis, 37, said in an interview with Latvian Independent Television today. The currency will not be devalued, he said, and the country will pass budget cuts needed to get the next tranche of money.

This is of course all well and good, but one has the distinct feeling that all this merely constitutes the inevitable last launches before the opponent finally lands the kidney blow to send you crushing into the canvas.

In terms of a more thorough look at the Latvian situation which goes beyond the immediate plethora of market jitter you could do a lot worse than visit Edward's latest post on this issue. As he sets out pointing towards, overnight interbank rates rose to a record of 20% this week and it suggest more than anything the stress being levied on the system.

Another particular issue Edward deals with is the risk of contagion and essentially fallout from a devaluation in Latvia. Certainly, this is an important question in itself but I also agree with Edward in the sense that the immediate plunge in other CEE currencies not to mention the Swedish Krona following a Latvian devaluation is not really the main issue here.

For the record, I see no decoupling and a Latvian devaluation would clearly force others to do the same, most notably I would think Lithuania and Estonia. As for the ripple effects towards the entire CEE edifice, they are likely to be substantial although not necessarily catastrophic. The real issue we need to understand I think is that that IMF program has problems and that this will become clearer and clearer as we move forward. Edward points to one very important data point in the form of a real effective exchange rate where numbers have just been published in 2008 format. This gives a very clear image of the amount of down scaling the Baltics, and indeed many of the Eastern European Economies, need. It is important to understand that there is a level effect and relative effect here in the sense that one thing is to correct relative to one's own past level, and quite another to correct relative to others.

Consequently, this is a chronic problem all across Eastern Europe and thus everybody has to correct. In this sense, the IMF are submitting those with pegged exchange rates to a dose of "medicine" which is simply too strong and which the domestic "system" cannot muster. So, my feeling is that all this goes beyond whatever effect currency speculation would have in the wake of a Latvian devaluation/default. There are clear signs that the "exit strategy" from this crisis is not working and it is next to scandalous that the IMF/EU do not realize that while these countries certainly need a strong dose of "stick" to get themselves on the right track we need to ensure that they are not obliterated over the course of the next year. I mean, this talk about Euro adoption in 2012 is just so silly and counterproductive since who the heck knows where we are in 2012. Who knows, for example, where the Eurozone itself is in 2012. Really, I cannot stress enough how these road maps of convergence need to be rethought since there has been a structural break. We need a new plan and one which factors in the change in environment.

Moreover, I think we have established by now that the Eurozone is no magic potion and in fact faces a series of very severe tests on Spain, Italy not to mention the mental crush it will be when Germany does not recover because I can tell you; in terms of domestic demand she won't. Basically as I see it, the option has always been to "let the CEE in", but that would also take a much stronger coordination on the fiscal side and essentially joint European financing through Euro bonds. At the moment, this is far to big a step for the gents in Frankfurt and Brussels to consider. So, no decoupling in an immediate devaluation context, but more importantly, I tend to look at this more structurally than a simple question of how much the e.g. Forint and Leu will fall in the context of a Latvian devaluation.

At the end of day, this is a question of swallowing those camels and accepting the idea that the current solution being applied is out of touch with reality. Essentially, I don't think the parties involved quite understand the structural damage many of the CEE, and Latvia in particular, have suffered. As per usual I am implicitly referring to the importance of factoring in demographics but then again; it is absolutely amazing that none of the presumed experts here has added this variable to the equation yet. As Edward says towards the end in his entry ...

That is, the simple fact of the matter is that there is no exit strategy. The programme simply doesn't work. It is "over determined", since whichever way you look at it, there is always one more problem than there is solution. Gentlemen. I think its time to give up. Honourably, but to give up. Come on out of the bunker, white flags and hands in the air will not be called for. There's a world out here waiting for you, it's on your side, and there will be a tomorrow.
I couldn't have put it much better myself, I really couldn't.


Anonymous said...

You've made quite an effort to put together a comprehensive analysis. You point out that the current strategy of internal devalutation etc. does not show any convincing results and therefore conclude that it is failing, and another approach (devaluation) is tried, tested and more likely to produce a recovery (or along those lines). There is however one thing that practically all foreign commentators fail to account for. The "medicine" (any sort of budget amendments, reforms) has not been applied internally. Well, practically not at all. What has been done in the first months of the year is some cosmetic reshuffling in government institutions, without any real effect on the ground. Mainly because the leading parties have been wating for the municipal (and EP) elections on the June 6 to pass, so that the new balance of power in municipal elections would become known, and all "bad" decisions have been postponed to the June 12 when then budget amendments are going to be passed.
This is one thing that might be hard for outsiders to grasp - the government here has done exactly nothing (except some nice talking) for about 6 months for purely political reasons. So it's not a surprise that data does not show any signs of the experimental "measures" working - there have been no (real) measures:)
And since the Bank of Latvia seems to have enough reserves to technically maintain the peg even if practiaclly all the lats were converted into euros draining it's reserves, the peg will stand for a while I beleive. The fact that the amount of lats in circulaton decreased reapidly in the wake of the global crisis certainly helps. The shortage of lats also mean that it's impossible to launch a speculative attack on the currency. If you had some, you'd get some really nice rates from the local banks here:) So even if the central bank sounds arrogant about it's position on the peg - it does have upper ground, at least for now.
You are right that this is a new economic experiment, that the government is attmpting here. You also might turn out to be right about the experiment failing, eventually. If that's going to be the case it will take some time to become obvious. And since the experiment has not really started, the jury will be out only after June 12.

Edward Hugh said...


Thank you for your thoughtful comment.

"This is one thing that might be hard for outsiders to grasp - the government here has done exactly nothing (except some nice talking) for about 6 months for purely political reasons."

Actually, no. I live in Spain, and next August will be the second anniversary of the onset of the crisis here. Yet the government is still in total denial, although unlike Latvia they still have the financial freedom to spend money at will (this will come to an end next year, I think).

And each time we hear, after the next elections. But there are always more elections after the next ones, which is why I am sceptical that this road can work at all, since the political actors can never carry the voters with them on things like this, and especially the longer the crisis runs without things improving.

Rather than the local politicians, I tend to hold the IMF and the EU Commission responsible for the situation you describe, since they aren't novices, and should have been ready for all this, we have seen it so many times before in one country after another. When you are paying the bills, you should always get the results upfront, before you pay.

Now over six months have been wasted, and while I was sceptical from the outset I now think that what they want to do has become impossible.