It Isn't Only Canicular Heat They Are Suffering From In Latvia

Maintaining the peg also requires substantial political commitment. If this commitment were to falter, there is a risk that the execution of the difficult but necessary policies required under the authorities’ program could also weaken. However, all political parties are strongly committed to the exchange rate peg.

How the world changes in six months. The above lines come from the IMF "Republic of Latvia: Request for Stand-By Arrangement - Staff Report" of January 9 2009. But just today we can read in a Baltic newspaper:

"Reliable sources tell LETA that the International Monetary Fund (IMF) has stipulated that the loan agreement document must be signed by all ruling coalition parties in Latvia, thereby showing their resolve to implement it."

The reason the IMF are now so edgy is spelled out by Reuters Political Risk Correspondent Peter Apps:

A string of other countries are also facing stark cuts, and analysts say in many - like Latvia - domestic politics could well intervene as elected politicians are unwilling to face the political consequences of cuts demanded by the IMF and wider financial markets.

So what the IMF are evidently worried about is the possibility that some coalition members may support the agreed measures just long enough to get the payout, and then effectively disown them. This seems to be a far cry from the substantial political commitment that was earlier considered to be so essential to maintaining the peg.

And the issue goes well beyond Latvia, since as Apps points out, a string of other countries are in a similar if currently marginally better condition, including Bulgaria, Romania, Lithuanis and Hungary, all busily making cuts while coming to rely more and more on multilateral lenders.

So if there is no clear resolution to Latvia's growing dispute with the IMF, the European Union could end up facing a dilemma - whether to bail out troubled emerging European countries who won't make cuts or face the consequences of not doing so. As Lars Christensen, head of emerging markets research at Danske Bank in Copenhagen says:

"This could be a test case for Europe....In Latvia, it's domestic politics that really become the driver. The question is what the EU would do if the IMF walks away."

A good question.

In the above quoted IMF document, they also make the following point:

Correcting currency misalignment without nominal depreciation is extremely difficult, as experience from other currency board and fixed exchange rate countries continues to show. Large external financial support and sustained wage and fiscal discipline by both the private and public sectors are required. Failure could entail substantial reputational risks for both the authorities and international institutions.

The last sentance is important, failure could entail substantial reputational risks for the international institutions involved, in particular in this case for the IMF and the EU Commission. This loss of credibility should the peg eventually collapse in chaos is one of the considerations that lead some of us to argue strongly from the start against going down this road. But few would listen.

Beyond the immediate issues of the peg, there are also serious structural considerations which make this kind of "body-with-two-heads" approach less than desireable in delicate situations such as this. Even if all we have here is - as some would suggest - a soft-cop hard-cop duet, the policy of letting the EU Commission permanently play the role of soft cop is hardly desireable, especially for the message it will be sending to Southern Europe, where our improvised duo may soon find themselves once more forced into action. And especially also for financial markets where nervousness about the ability of Europe's complex institutional structure to handle the evident continuing weaknesses in the banking system is still highly evident. Leaving the impression that the EU itself is not able single handedly to deal with its own recalcitrant offspring is not exactly the best way to convince the sceptics.

Today's Latvia Roundup

The exact state of play in the negotiations with the IMF is still far from clear. Latvia's Prime Minister Valdis Dombrovskis said on Thursday that talks with the IMF were making progress on issues of pensions and taxes and results of the talks are expected early next week, but since we have been getting news like this for some days now it is hard to draw conclusions.

Izabella Kaminska at FT Alphaville thinks the analyst community is increasingly interpreting the deadlock as yet another (and possibly decisive) chink in the armour of Latvia’s euro-peg defence, citing in particular the latest research note from the RBC Capital Markets’ emerging markets team. While Capital Economics' Neil Shearing is even more explicit:

Relations between the IMF and Latvia are deteriorating quickly, raising the prospect that the loan programme that is vital to maintaining the country’s currency peg could collapse altogether..... with relations between both sides souring, and the pain in the real economy intensifying, it remains to be seen how long a new agreement will hold. Indeed, there is a growing risk that the programme could collapse altogether, which would spell the end of the currency peg and trigger a round of debt restructuring.

As for me, I agree with Neil, this situation has now become so unstable, while the internal devaluation is working so slowly, that the Fund really need to think about how to handle the damage containment issue. The crisis is far from over in the East and South of Europe, and the risk of a spark from this whole fiasco setting either Athens or Madrid alight is most certainly non-negligable. I advise all concerned to think very carefully at this point about the implications of what they are doing, for the sake of all our well-being. The Maginot line may still be far from broken, but a distant fortress on our outer defence ring may well be about to fall. Let's just learn the lessons shall we?