Latvia Economy Watch

BELLS In Hell That Don't Go Ting a Ling a Ling

2011-05-23T16:22:00.038+02:00

After the BRICS, came the PIGS. Now a new acronym is being born, that of the BELLS. These particular "ding-dongs", however, are not a set of hollow cast-metal instruments suspended from the vertex and rung by the strokes of a clapper, they are countries, countries which may, like those unfortunate WWI British soldiers whose love of their country and sense of duty lured them into one of the most senseless conflicts of modern European history, be headed towards their own pretty unique form of modern purgatory.

The BELLS are a group of four countries (Bulgaria, Estonia, Latvia and Lithuania) who in their wisdom decided to adopt and then stick "come hell or high water" to a currency peg with to Euro. Thus was opened one of the more interesting and lively chapters in modern macroeconomic debate.

Now talk of some sort of ultimate inferno here may strike a pretty discordant note with many readers, since most of the economic chatter of recent days has centred on how the BELLS constitute a positive example, not to mention a most attractive alternative to all those dreadful sounding PIGS. According to GaveKal's François-Xavier Chauchat, for example, the BELLS should be seen as a ray of "Hope For EMU Peripherals", since just like the PIGS the BELLS have also had their own debt crisis, one which was so severe at the time that it put into question the very sustainability of their fixed exchange rate regimes. However, in these most fortunate of cases, the bad times are now well and truly behind us since a happy combination of IMF programmes and fiscal consolidation (coupled in Estonia's case with subsequent admission into the Euro group) eventually led them out of crisis, and without the need for any sort of sordid devaluation to boot. And then, as they say in Spanish "fueron felices y comieron perdices" (or to put it the English way, "they all lived happily ever after"). Or did they?

Well, on Chauchat's view, the BELL crisis was always more of a liquidity than a solvency one (see chart below) – and this despite the fact, which he notes, that Latvia was very often argued to be a modern equivalent of the Argentina of the late 1990s (an assertion which, he says, has ultimately proved to be wrong, although in fact on this particular solvency vs liquidity argument, the true test will be the ability of Latvia to pay back the 7.5 billion euro EU/IMF bailout loan, in full and on time, and especially the very onerous 2014/15 installments). From a macroeconomic perspective, however, the big issue was always one of just how the hell these countries were going to dig themselves out of the hole they had dug themselves into, and do so at the same time as staying on the peg.

A Profession That Is Losing Its Grip On Reality?

The view that the BELLS have somehow proved the monstrous regiment of professional macroeconomists totally wrong is now quite widespread (for a balanced and more nuanced version of the argument see this post by my fellow RGE Economonitor blogger Ed Dolan) , and indeed such sentiment may well form part of a much more general dispute between micro- and macroeconomists about how to find solutions to the present crisis. Only last week the Latvian Prime Minister Valdis Dombrovskis presented a book in Riga which he has co-authored with Anders Åslund of the Peterson Institute which has the rather assertive title: How Latvia Came through the Financial Crisis. The associated press release proudly states that a key lesson to be learnt from the resolution of Latvia’s financial crisis is that "devaluation is neither the panacea nor the necessity that many economists make it out to be".

Not content with this statement our authors go even further, striking what some might consider to be a rather too "close up and personal" tone:

"Finally, the international macroeconomic discussion was not useful but even harmful. Whenever a crisis erupts anywhere in the world, a choir of famous international economists proclaim that it is “exactly” like some other recent crisis—the worse the crisis, the more popular the parallel. Soon, prominent economists led by New York Times columnist Paul Krugman claimed that “Latvia is the new Argentina.” A fundamental problem is their reliance on a brief list of “stylized facts,” never bothering to find out the facts".

As a macroeconomist who has been deeply involved in the Latvian debate I have to say that if such statements weren't so foolish (and ill-befitting of the Prime Minister of any country) I would want to protest that they were extraordinarily condescending and even verging on being insulting. As someone who has spent hours and hours during this crisis perusing excel sheets and making charts trying to fathom what is going on in the BELLS (and in particular in Latvia) I have to say I certainly don't recognise myself in this paragraph, and if anyone could be bothered to take a look at that infamous Krugman piece they would find he was basing his argument not on some obscure set of stylised facts, but on my detailed analysis of the problem (right or wrong, but here it is - why the imf's decision to agree a Latvian bailout programme without devaluation is a mistake).

The funny thing is that, far from having learnt from the error of my ways, I still consider the original IMF decision to have been a mistake, although I would point out that I personally never suggested Latvia was like Argentina (another thing is to say that much of what is going on along Europe's periphery of late carries with it a distinct sense of Argentina deja vu), since I actually think that Argentina is an example of what not to do and that if you are looking for historical precedent for what should be going on in Latvia (read the BELLS) Turkey would be a much better role model. I also think that one of the conclusions we will eventually be able to draw from this whole sorry affair is that those who specialism is not macroeconomics would do better dedicating more of their precious time to trying to understand what we are saying rather than engaging in ill-informed ideological polemic. And I say this since I believe that the Latvians themselves deserve better. They may well not be able to avoid serving as guinea pigs, enabling macro- and microeconomists to see just who is right, but they surely don't merit being converted into yet another ideological football. Didn't we have enough of that during the Soviet years!

On the other hand, and before getting into the actual analysis, I want to stress that I personally am not advocating devaluation of the Lat at this point in time. Even though I still consider it a mistake not to have devalued, and an even bigger mistake on the part of the EU leadership not to have accepted the IMF proposal for immediate devaluation and Euro entry, I accept that the decision not to devalue represented the democratic will of the Latvian people (following the advice of the IMF given the EU response), and it was for precisely this reason that I declined to go to Latvian in August 2009 and speak at a meeting organised by the then governing People's Party, since I think I was only being asked to go there to cause trouble.

The difficult thing here is not to cause trouble (which is easy) but to find realistic solutions, which is why we need free and open debate.

Did Latvia's Internal Devaluation Cut Hard Enough And Deep Enough?

The point, I think, is this: if Latvia is not going to recover the competitiveness all agree it lost through a normal devaluation process (for whatever reason) then it needs to do so via the procedure which has become known as "internal devaluation" (a procedure which in an earlier era was known by the name of "wage and price deflation"), and indeed this is what the Latvians have attempted to do.

So the question now is has this worked? Or put another way, has the internal devaluation gone far enough and deep enough? The conventional wisdom has it that it has, but I, for one, am not convinced, and looking at the latest round of Latvian data serious questions arise as to whether the recovery is strong enough or sustainable in the longer term.

Growth started to return to these economies in the second half of 2010, but with capital inflows now well below pre-crisis levels they have now entered a lengthy and difficult adjustment process. With domestic demand well below earlier highs and still struggling, exports have now become the prime mover of economic growth. Since the recovery in external demand has produced a rapid return to earlier export peaks the impression of a return to earlier economic dynamism has been created. I think this interpretation of the recent strong export growth is misleading, since it is one thing to recover lost ground, and quite another to attract the FDI needed to seriously expand capacity and keep increasing exports beyond their pre crisis peak. Strong year-on-year increases in exports have moved headline GDP numbers forward, but as 2011 continues annual export growth rates will drop substantially, and may even get stuck at a snail’s pace, meaning that the respective economies will be struggling to find growth, create jobs, and maintain the servicing of their external debt.

The most worrying piece of evidence I have found is the failure of capital investment to rebound alongside exports. In part this is understandable, since a lot of the earlier capital investment was in property, but this offers only part of the explanation, since for these economies to really take off as export driven strong new investment growth in plant and equipment will be needed. In order for these economies to attract investment in sufficient volume they will need to recover a large part of the competitiveness lost between 2005 and 2008, when wage growth far outpaced productivity gains. However, given the difficulties faced in lowering the exchange rate, they can only realistically try to recover lost ground through sustained productivity improvements, a lengthy and slow process, and in the meantime the debt and population ageing problems keep ticking away

In my opinion, and despite some early encouraging signs, it is far from self-evident that the so called “BELLS” (Bulgaria, Estonia, Latvia and Lithuania) are going to be able to export their way out of trouble in the way they need to (given the collapse of internal demand) with the current relative price structure. It is my considered opinion that the “internal devaluation” process may have been underambitious and allowed to come to a halt far too soon. And indeed, if we get to the point, this is why so much of the conventional macroeconomic wisdom and advice leans towards open devaluation, simply because it is hard to maintain the political consensus for long enough to carry out a deep and painful deflation adjustment, and indeed this is the lesson drawn from the 1930s that I was brought up on.

Export Dependency and An Ageing Workforce

In addition two major unresolved issues may leave a legacy, one which could weigh down any recovery and lead to more serious problems when the next recession eventually arrives. Many observers seem to forget that it is one thing navigating a leaky ship when you have the wind behind you, and quite another one going face-forward into a tempest.

In particular there are two things which preoccupy me about the present situation:

a) The existence of a substantial debt overhang the credit crunch which exists as a result
b) The demographic challenges the country faces, and in particular the impact of a rapidly ageing and declining population.

But before getting into this, let's take a serious look at the current state of play in the Latvian game.

Worrying Signs In Latvia

The first thing I notice when I start to go through the Latvian data is that despite a substantial improvement in exports:

GDP growth is currently slowing.

Latvian GDP expanded by a quarterly 1.5% in Q3 2010, by 0.9% in Q4 and by 0.2% in Q1 2011. Thus Latvian GDP has been steadily slowing, and this despite the fact that the export environment in the first three months of this year was exceptionally positive, and Latvian exports were booming. Latvian GDP fell by around 25% during the crisis, and has subsequently rebounded by 5% (over 5 quarters). We are far from a "V" shaped recovery, and pardon me if I mention it, but it is precisely the sort of thing most macroeconomists were imagining would happen.

Essentially the problem is that consumer demand has failed to recover, and if my analysis (about ageing and the debt overhang) is right then it will continue to fail to recover (all of this, incidentally, is what I argued would happen after the crisis broke out).

Industrial output languishes (partly because the non-tradeable sector is contracting as fast as the tradeable one is expanding).

While capital investment fails to recover:

Obviously a large part of the investment slump is due to the decline in consumption activity, but there is little sign of a serious pick-up in ex-construction investment, and anyway, outside of construction there was comparatively little investment going on in the period before the bust, and very little FDI.

So Where Is The Problem?

Basically the Latvian economy faces three main problems

i) a debt overhang
ii) a declining and ageing population
iii) a high level of unemployment, low rate of job creation, and a substantial wage differential with Western Europe which encourages young people to emigrate and drift west.

The first two problems put a serious brake on economic growth, and it is this that exacerbates the third problem, which then in its turn feeds back and aggravates the first two.

Cheap interest rates, supported by the peg and the prospect of Euro membership meant that Latvian households and corporates were able to get themselves heavily into debt. And debt in Euros (which is why the devaluation difficulty exists) - over 85% of Latvian mortgages are Euro denominated.

Now the Latvian economy is experiencing a sharp credit crunch, private sector credit which was increasing in 2007 at a rate of around 65% is now falling at a rate of 9% per annum.

Has The "Internal Devaluation" Been Called To A Halt Too Soon?

Claims that Latvia's internal devaluation has been deep and effective are widespread.The following claim from Commerzbank's Barbara Nestor is typical:

"The competitiveness adjustment has been substantial; labour costs fell 25% from the peak. The gap that opened up between productivity growth and labour costs in the boom years has already been closed. Exports responded sharply. Resources have not been switched among sectors, but production has been redirected from domestic use to exports".

The IMF itself is also pretty congratulatory. In this months press release announcing completition of the fourth review of the standby arrangement they state:

"Strong policy actions under the SBA have helped restore confidence, contributed to economic recovery, and enabled significant progress toward Latvia’s goal of euro adoption. The government has continued to achieve substantial fiscal savings while also protecting the poorest through social safety net spending and a temporary public works jobs program, and is strengthening its active labor market policy efforts. Looking ahead, the government has committed to meet the Maastricht criteria for euro adoption and strengthen the financial sector, which should further enhance confidence and support a rebound in growth".

Or again in the joint IMF/EC Statement on Latvia on the Review Mission:

The Latvian economy is now showing clear signs of recovery, with economic growth of 3.3 percent expected this year, reflecting the Latvian authorities’ continued implementation of their economic program. Their policy agenda for 2011 sets the stage for meeting the conditions for euro adoption in January 2014, and for sustaining the economic recovery

But is the Latvian economy showing clear and unequivocal signs of recovery? This is exactly the question I am asking here. Part of the issue is whether the competitiveness correction has so far been deep enough to ensure a higher level of competitiveness in the non-tradeable sectorer and a shift of resources from non-tradeable to tradeable. Certainly when the IMF programme was being contemplated, the extent of the correction needed and the difficult challenge which implementing it would involve was not doubted by anyone. Here's what the IMF had to say at the time of the staff report on the standby facility request (IMF emphasis):

In addition to maintaining the existing fixed (narrow-band) exchange rate, staff considered a number of alternative exchange rate options. These included, inter alia: (i) widening the current exchange rate bands to the full 15 percent range permitted under ERM2; and (ii) accelerated euro adoption at a depreciated exchange rate.

The main advantage of widening the bands is that it should eventually deliver a faster economic recovery. Although growth would be depressed in the short run by balance sheet effects, the economy might then bounce back more sharply, and a Vshaped recovery would likely start in 2010. This reflects a faster improvement in competitiveness since high pass-through (reflecting Latvia’s openness to trade and liberalized movement of labor within the European Union) would be dampened by the negative output gap. Enhanced competitiveness would also reduce the current account deficit more quickly. This would come mainly from import compression, with a relatively slow response of Latvia’s underdeveloped export sector, especially as the external environment is not as supportive as in previous devaluation-induced recoveries as Argentina, Russia or East Asia.

So at the time a 15% exchange rate adjustment was being contemplated. Did we get that? Well I personally don't think so. If we look at the CPI, the drop (from peak to trough) is only something like 3%.

In fact the producer price index fell a little further, maybe by about 12%.

But as can be seen, in both the CPI and the PPI case, since these indexes bottomed prices are now rising again. And indeed they are rising faster than is the case in those countries with which the Latvian currency is pegged (the Eurozone 17).

So in fact, and especially if we take as a point of reference the start of 2007, we can see that the actual price correction has been comparatively small, and indeed the position is once more deteriorating, even though output in the Latvian economy is over 20% below its pre-crisis peak. Is that really such a flexible situation?

A similar pattern emerges if we look at wage costs and productivity.

As we can see, despite having a relatively high standard of living Germany has managed to maintain unit labour costs relatively stationary over the last decade, due to rising productivity. Latvia evidently has not. This has nothing to do with being rich or poor, as can be seen from the years 2000 to 2004 Latvian living standards were rising, but they were rising in line with productivity, which is of course perfectly sustainable, and basically the pattern you want to see. Then from 2005 onwards the link was broken, and Latvian wages exploded in a way which was totally unsustainable. During 2008 and 2009 unit labour costs started to improve (in part because a lot of very unproductive workers in construction lost their jobs, the pattern in Spain is similar) but from the start of 2010 onwards the process has been in reverse gear again, and once more it is interesting to note that German labour costs (even though the economy is booming) are not following suit.

A lot of ink has been spilt writing about the large drop in wages in the public sector (possibly over 20%) but unfortunately public sector workers normally don't export, and if we come to look at private sector wages, and especially hourly wage rates, then we again find that the correction has not exactly been massive, and of course, inter-annual wage rates are once more starting to rise.

The rough and ready measure most macroeconomists like to use when it comes to competitiveness changes if the Real Effective Exchange Rate, and as we can see from the chart below, the loss of competitiveness (when compared in this case with Finland) since 2005 has been substantial. But then when we use REERs most people who really aren't that convinced that exchange rates matter tend to be not very impressed.

So let's try and put the argument another way. The real proof of the pudding is in the eating, and the real test of Latvian competitiveness is whether, now that it is totally export dependent, the Latvian economy will be able to produce sufficient economic growth and employment such that the weight of the debt can be steadily burnt down. And let us remember here the currency pegger's (or euro member's) catch 22: growth in nominal GDP is what matters when it comes to reducing debt, and nominal GDP is composed of real growth and inflation, so in a way inflation could be beneficial, but any inflation you have which is over the level of your countries of reference (the Euro Area 17) will lose you competitiveness in a way which reduces real growth, so you are up against a limit on both sides (deflation, which makes you more competitive, only compounds the debt problem) and possible the most appropriate characterisation of the situation would be "trapped".

The real problem now is that the credit-bust economies are totally export dependent for growth. What does this mean. Well let's take this simple and rough-and-ready expression:

GDP = Domestic Consumption + Investment + Government Spending + Net Trade

(Growth in Net Trade = Growth In Exports – Growth in Imports)

Which means growth in GDP = Growth in the sum of the above factors. Now we know that domestic consumption is in decline, and that investment in plant and equipment will only return in statistically interesting volumes to meet the needs of export growth. We also know that government spending is being reduced (that is what the IMF programme is centered on), so all we are left with for a real growth driver is exports.

But when we come to look at the SIZE of the Latvian export sector, we will see it is way to small for the job. The chart below comes from national accounts published by the Latvian statistics office, it shows GDP and value added in manufacturing industry. I think it is obvious that the proportion here is horribly small (only slightly over 10%), since even though Baltic economies generally are fairly open, many of the exports are in fact imports that have been reprocessed so actual proportion of their value produced in the country is not large. Germany by comparison (which is a modern economy, with reasonable living standards) has over 40% of GDP originating in value added in manufacturing. Yet this tiny part of the Latvian economy is now about to do the heavy lifting? It just doesn't make sense. Nor does it make sense that the IMF focus so much attention on reducing the fiscal deficit and virtually none on this issue, yet it is on resolving this issue that Latvia's economic future belongs.

There is another piece of evidence that Latvia's internal devaluation has eased up far to soon, and this comes from the current account. A great deal of praise was lauded on Latvia for the rapidity with which the current account went into surplus. In part this was the "ouch" effect, as financing dried up, people lost their jobs, and imports fell sharply. Exports, as we have seen, also improved, and this certainly helped. But there was another factor which we should also take into account, and that was what happened to the income account. This is composed of interest payments and returned profits and dividends. Now Latvia has a net external debt of not far short of 100% of GDP, and this involves a lot of interest payment. As is well known, most of this debt is denominated in Euros, and attached to Euribor interest rates, so of course, as the ECB brought rates down, interest payments came down in like fashion. At the same time, as the economy was contracting by 25% firms were producing a lot less in the way of profits, and there were far fewer dividends.

Now things are improving again, and as we can see in the chart below, the current account is once more moving back towards deficit. This is not a good sign.

So there we are, these are my causes of concern, and I think it is now over to those who already feel that the devaluation debate has been shown to be irrelevant to suggest what they think should be done next to put Latvia back on the "internal devaluation" track again. When I suggested at the start of this post that Latvia might be stuck in a peculiar kind of hell, possibly limbo would be a better term. Latvia's current situation is hardly comfortable. Unemployment is still very high, and new employment is only arriving in a trickle. Meantime the debts are still there, and the problems people are having paying them haven't gone away. In this sense a "restructuring bomb" is still ticking away under Latvia, and rather than continually crying victory maybe it would be better if more people (Prime Ministers included) dedicated a little more of their energy to trying to defuse it.

This post first appeared on my Roubini Global Econmonitor Blog "Don't Shoot The Messenger".

The Social Impacts of the Economic Slowdown: The Latvian experience

2010-07-20T22:10:00.002+02:00

Guest Post by Eliana Marino

The economic and financial crisis that started in 2008 seems to be on its way to being overcome by many EU member states, but the population in some of the most touched countries is still labouring under the ongoing effects of the slowdown. Latvia, which underwent an annualised decline of 18% of GDP in the first quarter of 2009 and still has the highest unemployment rate in the EU, is experiencing a veritable revolution in its population structure and is preparing to face serious demographic challenges.

The strong recession experienced in the last few years has sadly confirmed the high propensity of Latvian people to migrate for economic reasons and generated a real “exodus” of working age population.

Before 1999, a peak of emigration was registered due to the endogenous migration potential of the collapsed Soviet Union, but, from 1999 to 2002 the outflows seemed to stabilize and to show a slowing trend. This trend changed with the accession to the European Union and the immediate application of the free movement of labour by UK, Ireland and Sweden, which decided to open their borders to New Member States immigrants without any transitional restrictions. These conditions created an increase in the number of emigrants in 2006 and the “old” member states definitely replaced the Russian Federation and the ex Soviet Republics as main countries of destination.

The decline of the outflow in 2007 is linked to Latvian extraordinary economic growth which appeared to guarantee an increase in the wellbeing of the population. This situation started to deteriorate in the second half of 2008, generating a new rise in emigration decisions and increasing more and more in the following year.

Net migration has always been negative and, combined with a Total Fertility Rate among the lowest in EU, it strongly contributed to a progressive and continuous decline of the total population.

Official data, as analyzed above, cannot provide a real portrait of migration dynamics in Latvia. While the registration of immigrants is enough reliable due to the strict controls at the external borders of the EU, emigration statistics are completely unreliable because the large majority of emigrants did not declare its departure and no alternative method is adopted to catch up their real number. The gap between registered and factual data is showed by the comparison with statistics provided by the destination countries, as showed in the graph below:

More recent data were collected through the EU funded project The Geographic Mobility of the Labour Force , consisting of a survey conducted in 2007. The study arrived at the conclusion that a bit more than 40˙000 people emigrated between 2004 and 2005 (87% more than registered data). The authors forecasted that intensive emigration was expected to continue and that, looking at the number of respondents who said that they wonted to leave and at those who already did something in pursuit of this dream, by 2010 between 10˙000 and 16˙000 people were supposed to leave Latvia, thus totaling 50˙000 to 80˙000 emigrants from 2004 to 2010.

These estimates were presented in 2007 when Latvia was going through a period of sustained economic growth and no one could even imagine the economic collapse which the country is undergoing in this moment.

The survey, which I personally conducted in Riga from September to December 2009 and which involved some of the major Latvian experts on migration issues, showed that around 30,000 people are supposed to have left Latvia in 2009 and the same number is forecasted also for 2010.

These massive emigration flows from Latvia can strongly affect the future demographic and economic structure of the country, creating serious problems of labour shortage, unsustanability of the pension system and huge population decline.

Since the years of great economic growth, Latvia experienced a huge problem of labour shortage due not only to the lack of high skilled professionals but also to the general discrepancy between demand and offer of labour. In 2006-2007 this situation was one of the main topics of political and public debate and, under the pressures of the enterprises, the government approved a more liberal immigration policy in order to select labour force from abroad.

The downturn of 2008 caused an inversion of the trend: enterprises were obliged to reduce the labour force and the employment rate decreased together with the level of wages. These elements represented the main push factors for emigration and they are currently generating a real “exodus” of the labour force, creating dangerous structural problem in Latvian economy. Actually, lack of labour and especially of high skilled professionals will be a veritable challenge for the economic recovery of the country and nowadays it is one of the main reasons of concern for Latvian politicians and intellectuals.

From the demographic point of view, the impact of emigration can be considered under two different aspects:

- emigration of working age population makes the demographic burden increase: the number of inactive people (children and retired people) exceeds the number of active people, creating serious challenges for the sustainability of the welfare system;

- the most part of the outflows consists of working age population (from 15 to 65 years old) that includes people in reproductive age (from 15 to 49 years old). A huge number of emigrants in this particular age group means a further reduction of the natural increase of the population. In fact, they will probably have their children abroad or the migration decision itself will discourage the creation of numerous families.

This situation has to be combined with the low levels of Total Fertility Rate which characterize the country since more than 20 years ago. In Latvia, the first demographic transition to a rational regime of reproduction began at the end of XIX Century and the total fertility rate was lower than the replacement level already in the second half of the Century, due to repressions and harsh living conditions during the wars and the Soviet occupation. The replacement level was met only in the 80s after the introduction of partially paid child birth leave. Since then, the birth rate has decreased to unprecedented level and has represented an issue of serious concern for Latvian government. In particular, the decline of total fertility rate accelerated during the economic and political transition, since the Soviet centralized welfare collapsed and the national government opted for a shock therapy instead of a gradual and progressive transition to the market economy.

However, Latvian government recognised the need to ensure reproduction of the population as a prerequisite for the nation’s existence and started to evaluate adequate tools for family support. The adoption of successful family policies made the birth rate level stabilize since 1999 and start to increase at the beginning of the XXI Century. Anyway, the total fertility rate never reached the replacement level and it is still among the lowest in the EU (average 1.4 children per woman in the period 2005-2010 ).

As a consequence of these indicators, Latvian population dropped from 2.5 to 2.2 million people in 15 years and the negative growth rate is expected to accelerate in the next years.

The experts interviewed in the last months of 2009 proposed different solutions to both economic and demographic challenges but they agreed on the fact that a more liberal immigration policy might be really helpful to solve problems of labour shortage and pension sustainability as well as to contribute to the inversion of the negative demographic trends. However, this proposal, which is one of the main topic of public debate since the economic boom, is in direct conflict with the hostility of national population toward immigrants. Latvian critical historical experience with integration of different ethnicities is the clearest explanation of this hostility and probably some years are still needed to overcome these cultural barriers.

In definitive, the results of the survey allow to conclude that Latvia needs some important structural reforms (concerning an efficient social policy, a comprehensive population policy, a strong action against corruption and a reduction of the bureaucratic burden) to be implemented by the national government in order to prepare the country to play its role at the European and international level and to take the best advantages from the opportunities provided by the integration and globalization process. The first step to achieve this objective is the promotion of a cultural change whose main goal is to dump the “dependency from the past” and to open mental and factual borders to modernity.

Footnotes

1/ Latvija Statistika (Central Statistical Bureau of Latvia), www.csb.gov.lv, accessed on April 17th 2010

2/ Herm A. et Al, THESIM-Toward Harmonised European Statistics on International Migration, Country Report Latvia, Sixth Framework Programme, priority 8.1: Policy Oriented Research, Integrating and Strengthening the European Research Area, December 2004

3/ Krišjāne Z. et Al., The Geographic Mobility of the Labour Force, National Programme of European Structural Funds “Labour Market Research”, project “Welfare Ministry Research”, University of Latvia, co-financed by the European Union, 2007

4/ Eglīte P., National Policy for Increasing the Birth Rate in Latvia, in Humanities and Social Sciences Latvia, University of Latvia, Institute of Economics-Latvian Academy of Sciences, 2008

5/ UNdata, www.data.un.org accessed on January 30th 2010

Latvia: Living in the Land of Extremes

2010-07-20T22:05:00.001+02:00

Guest Post by Morten Hansen, Stockholm School of Economics in Riga

Here in Latvia the internal devaluation continues and the debate is whether the economy is flexible enough for this experiment. I say perhaps it is, Edward says perhaps it isn’t but one thing is for sure: the Latvian economy is (possibly perversely) indeed flexible.
I would like to illustrate this point with a series of numbers for the extremes that we have witnessed in Latvia so in the following I list a series of macroeconomic variables and the times at which they were at their extremes during the boom and during the current bust. After that I try a little discussion of why the development was so extreme here.

Numbers are from the Central Statistical Bureau of Latvia and from the Bank of Latvia, I use monthly data when I can, otherwise quarterly. All growth rates are y-o-y.

GDP growth – from the biggest increase in the EU to the biggest decline
2006 Q3: +12.7%
2009 Q3: –19.1%

Inflation – the highest inflation rate in the EU becomes the biggest rate of deflation in less than two years
2008 V: +17.9%
2010 II: –4.2%

Wage growth – again both are extremes also in an EU context
2007 Q3: +32.9%
2009 Q4: –12.1%

Unemployment rate (among 15-64 years)
2007 Q4: 5.4%
2010 Q1: 20.7%

Current account (% of GDP) – has anyone ever seen a +40 percentage point turnaround in the current account balance in less than three years?
2006 Q4: –27.2%
2009 Q2: +14.2%

Credit growth, households
2003 VIII: +85.8% (an early spike but growth rates in excess of 60% continued for several years)
2010 IV: –5.1%

Credit growth, firms
2006 II: +54.7%
2010 III: –7.9%

Money supply growth (M2)
2006 X: +43.9%
2009 VIII: –12.5%

Closely linked to the three latter sets of statistics one can note that house prices dropped some 53% in 2009, see here p. 6, again the largest decline in the EU, while several years during the boom had recorded increases around 60% y-o-y.

But one variable hasn’t changed and here I am of course thinking of the exchange rate which remains at a parity of 0.702804 LVL/EUR and is managed in a narrow +/–1% band. Those who follow Latvia will know, however, that there were great market uncertainties surrounding the peg first in March 2007 then in November 2008 (at the time of the nationalization of Parex Bank) where 10-14 November was the week with the biggest ever intervention by Bank of Latvia, which sold 267.65 mill. EUR. Altogether mid-November – mid-December saw a loss of some 18% of foreign reserves – more details on interventions here. In terms of interest rates the June 2009 scare saw the overnight interbank rate (RIGIBOR) peak at 33% on 26 June.

Latvia is not the only country with a credit boom, with a housing boom or with problems of overheating but one may ask why it was so violent here, why almost all numbers were and are more extreme. I shall try to provide some explanations below.

1. The Latvian credit boom was not just a boom, it was more of an avalanche as it represented the emergence of the financial sector. Whereas loans to individuals and enterprises constituted some 16% of GDP in 2000 this reached 91% of GDP in 2008 X, when loans saw their peak.

2. There was a naïve belief in rapid income convergence both among politicians (see this story from the Baltic Times in 2006 where a goal was formulated by Latvia’s First Party to raise Latvia’s standards of living to those of Ireland in ten (!!!!!) years….). This belief must at least to some extent have been shared by the banks since it can explain why they provided large loans compared to actual income.

3. The belief – or certainly the hope thereof – was strong among ordinary people, too. For decades during Soviet rule most had been denied the possibility of one’s own flat or car. Thus it is not surprising that when something called a loan appears as a possibility, many took it. One may also call it the result of a financially uneducated people which is not to say that such do not exist elsewhere, just look at the subprime market in the US or Brits (and others) buying summer houses in Bulgaria or Turkey.

4. Latvia’s fiscal policy was highly procyclical during the boom thus exacerbating this boom; major consolidation efforts now act as similar procyclical fiscal policy, this time exacerbating the bust.

5. Too late (2007) Latvia introduced a credit register – there is a story about one person who managed to borrow from no fewer than 25 different banks….

6. Latvia has many more banks than Estonia or Lithuania and this perhaps led to more aggressive and less prudent lending to keep up market shares.

7. Some also suggest that due to the attractiveness of Riga and its seaside resort/city Jurmala to people from Russia even more froth was created in the Latvian real estate market.

8. The public economic-political debate was poor in the ‘fat years’ and it was somehow ‘unpatriotic’ to argue that problems were building up.

9. And, lastly and more speculative, but I could imagine that some of the Swedish and other foreign banks that entered brought with them a perception at the subconscious level of the Latvian market being similar to their home markets in terms of customers’ realism and honesty, features that were not always met. Some customers had unrealistic expectations of their future pay (but can you really blame them when wages were growing in excess of 30% a year?), some were most likely dodgy customers from the outset and the banks were a tad naïve. I am speculating but from conversations with bankers I am also sure I am right….

And in the end one may just wonder what the total cost of miscalculations due to an environment of extreme macroeconomic uncertainty has been for individuals, enterprises, banks and the public sector.

To end on a lighter note: At the time of writing the outdoor temperature is +32° (90F), which is hot here. Less than half a year ago we had temperatures down to –30° (–22F) so Latvia is not just extreme with respect to economic indicators.

Too Soon To Cry "Victory" On Latvia?

2010-02-26T13:55:00.010+01:00

"Doom-mongers" - the Economist tells us - "are licking their wounds". And why exactly are they licking their wounds? Well for two years now (apparently) they have been telling us that "the struggle to save the lat’s peg to the euro was bound to end in tears". As you could imagine right in the very forefront of these so called doom-mongers is to be found yours very truly (and here), and of course Nobel Economist Paul Krugman (and here).

But while I have never thought of myself as especially adverse to admitting defeat when faced with compelling reasons to do so, just why, we might ask ouselves, should we start to think about licking our wounds right now (and why our wounds, since it is poor old Latvia which has been subjected to all the blood-letting implied by this none-too-convincing "thought experiment" turned reality)?

Well, in the first place, given the dramatic current account correction, Latvia's outlook has been revised from negative to stable by Standard and Poor's rating agency, which means - when you get down to the nitty gritty - that they don't expect any further downward revisions in Latvia's sovereign credit rating in the next six months.

Standard & Poor’s, a rating agency, has raised its outlook on Latvia’s debt from negative to stable (ie, it no longer expects further downgrades). The current account, in deficit to the tune of 27% of GDP in late 2006, is in surplus. Exports are recovering. Interest rates have plunged and debt spreads over German bonds have narrowed (see chart). Fraught negotiations with the IMF and the European Union have kept a €7.5 billion ($10 billion) bail-out on track, in return for spending cuts and tax rises worth a tenth of GDP.

And anyway, Latvia is not as bad as Greece.

Even so, Latvia looks good when compared with Greece. It did not lie about its public finances or use accounting tricks. Strikes have been scanty. Protests are fought in the courts, not the streets. Both Greece and Latvia have had hard knocks, but Greeks became used to a good life that they are loth to give up. Latvians remain glad just to be on the map.

As evidence for just how much better Latvia is doing than Greece the Economist cite the movements in the respective bond spreads, and of course, the extra interest the Greek government has to pay to raise money (with respect to equivalent German bonds) is now marginally more than the extra interest Latvia has to pay, but then Greece has yet to go to the IMF.

But just in case both these arguments seem rather like clutching at straws when compared to the "gravitas" of the situation, there is a "clincher".

"despite a fall in GDP last year of 17.5%, Latvia seems to have achieved
something many thought impossible: an internal devaluation. This meant regaining competitiveness not by currency depreciation but by deep cuts in wages and public spending. In a recent discussion of Greece, Jörg Asmussen, a German minister, praised Latvia for its self-discipline".

Well, I'm sure that having a positive reference from a German minister in a discussion on Greece is a positive sign, but hang on a minute: just what internal devaluation is our author talking about here, and what deep cuts in wages and salaries? According to the latest available data from the Latvian Statistics Office, average wages in Latvia were down 10% in September 2009 over 2008, but since wages in September 2008 were up 6.5% over wages in September 2007, when the Latvian economy was already in deep trouble and wages and prices were already seriously out of line, then they have only actually fallen back some 4.15% over the two year period. I am sure these cuts are painful (a 20% unemployment rate, and young people emigrating is even more painful), but I would hardly call this a "deep cut" yet awhile.

The thing to remember here is the difficult characterists imposed by the presence of a peg. Latvian real wages (when adjusted for inflation) may well have fallen more, but this is to no avail (and simply makes the internal consumption problem worse), since what matters are the Euro equivalent prices of Latvian wages and exports. This is one of the reasons why in these circumstances a peg is such a horrible thing.

And if you're still not very convinced, let's try the Eurostat equivalent data for average hourly wage costs, which had in fact only fallen by 3.5% year on year in the third quarter of 2009.

Why the difference between average wages and average hourly labour costs? Well, given the depth of the recession people are obviously earning less, since they are working less, but this doesn't help overall competitiveness, since what matters here is the hourly cost of each unit of labour. I'm sorry if this is all fairly turgid economic data stuff (yawn, yawn, yawn) but if you want to cry victory, you really do need to check your facts a bit first.

In fact, as I said in my last post, additional evidence from the consumer price index suggests the "internal devaluation" is only working at a hellishly slow pace. Prices were only down by 3.3% in January 2010 over January 2009 according to the latest HICP data from Eurostat.

And while producer prices have fallen a little further - by 6.6% in January over January 2009 - there is still a long long way to go.

Basically there is no doubt that Latvia's great economic fall may be coming to an end, but as I explained in this post here, that is not the same thing at all as resuming growth. To get back to growth Latvia's internal devaluation needs to be driven hard enough and deep enough to generate a sufficient export surplus to drive headline economic growth at a sufficient speed to start creating jobs again. This is not about a fiscal adjustment, it never was, and it is little consolation for Latvia to be compared with Greece and told that they are doing just that little bit better. Cry Victory we are told, and unlease the jobs of war. Would that things were as easy done as said!

Latvia's Economy Contracts Almost 18 Percent in Q4 2009

2010-02-10T09:38:00.011+01:00

Well, as we say in English, it never rains but it pours. Latvia, which has had the deepest recession of all 27 European Union member states, contracted by nearly 18 per cent in the fourth quarter of 2009. 'Compared to the same period of 2008, gross domestic product (GDP) value has decreased by 17.7 per cent,' according to the national statistics office statement.

The fall was led by a 30-per-cent annual drop in the retail sector. Retail sales are now down by 36% from their April 2008 peak and there is little sign of any turnaround at this point.

Industrial output, which rose slightly over the quarter, fell back again in Deecember (by a seasonally adjusted 4.2%) following a sharp rise in November. Output is still down more than 17% from the February 2008 peak.

Latvian exports were down again in December, making for the second consecutive monthly fall. Despite all the fuss about internal devaluation the CPI was only down by 3.1% in January over January 2009. Prices are still far from being competitive, and no early rebound in export growth is to be expected. Over 2009 as a whole exports - at 3,571.6 mln lats – were down over 2008 by 19.4%, but imports - at 4,633.7 mln lats – fell even further, by 38.4% which is why the trade deficit reduced substantially, but note there was still adeficit. The deficit fell from 225.3 mln Lats in January to 69.7 mln Lats in December. Over 2009 as a whole foreign trade turnover totalled ay 8.2 billion lats, a drop of 31 per cent when compared to 2008.

Unemployment hit 22.8% in December according to Eurostat data, the highest in the European Union.

And even that famed "internal devaluation" seems to be working hellishly slowly. As I say, prices were only down by 3.1% in January 2010 over January 2009 (and probably even less on the EU HICP measure) according to the latest data from the Latvian statistics office.

Even the statistics office statement that GDP actually grew by 2.4 per cent compared to the third-quarter offers cold comfort, since this data is not seasonally adjusted, and the economy will almost certainly be back down again in the first quarter of 2010.

Meanwhile the consequences of this strong recession in Latvia - more and more Latvians are leaving in search of work elsewhere, while fewer and fewer young people feel confident enough to have children (see chart below) - will leave a long scar, which will be hard to heal, and which make the long term future and sustainability of the country even more uncertain.

As the Washington based CEPR argue "the depth of the recession and the difficulty of recovery are attributable in large part to the decision to maintain the country’s overvalued fixed exchange rate, because it prevents the government from pursuing the policies necessary to restore economic growth". Maybe next time someone will learn the lesson before tragedy strikes, and not afterwards.

Latvia Is Back In The News, And Expect More To Come

2009-12-24T07:52:00.000+01:00

The Latvian government is getting nervous about the level of lending coming from Swedish banks. According to the Financial Times, "Latvia’s prime minister has warned Swedish banks they risk choking off recovery in the Baltic state’s crisis-hit economy unless they resume lending". The Latvian authorities are complaining, it seems, that banks such as Swedbank and SEB, which dominate the Latvian market, have reined in credit as they struggle to contain rising bad loans amid the deepest recession in the European Union.

“The . . . abrupt stopping of credit is a very problematic issue,” said Valdis Dombrovskis, the prime minister. “We expect Swedish banks to start [lending] again. “Of course you can say that Latvians were borrowing irresponsibly but to borrow irresponsibly you need someone to lend irresponsibly,” he said. “We had very easy credit in a very overheated economy. Now we have almost no credit in a very deep recession.”

Well, here is some of the background. After an extended period when private credit was rising at nearly 60% a year, the Latvian credit bubble suddenly burst, with very unpleasant consequences for everyone. Since mid 2007 the annual rate of new credit has been falling rapidly, and turned negative in June this year. In fact total credit has been falling since October 2008.

Lending to households alone has also fallen back, after shooting up dramatically over several years.

And Latvian base money (M1) has also been falling.

In fact, and unsurprisingly (given that it is what we are seeing everywhere in the exploded bubble economies) the only sector which isn't deleveraging at this point is the government one.

So it seems hard to me to simply blame mean banks for not doing enough about a situation which many saw coming, but few were willing to do anything to avoid. Sure, the banks made a lot of bad decisions, but so did many other people, and each and every party is trying to extricate themselves from the mess as best they cab. In fact total Latvia debt is not in fact falling at this point in time, since while many individual Latvians have been frantically deleveraging, the government has been borrowing at a faster rate than ever, in part to bail out Parex bank, and in part to fund the ongoing fiscal deficit. In the meantime Latvian GDP has dropped sharply, falling back again in the third quarter at an even faster rate than in the second one. Which means that despite the fact that private indebtedness is falling, the level of private debt to GDP is still probably rising.

This unfortunate situation is only further reinforced by the fact that prices are falling - not too fast as yet, only an annual 1.4% in November, but they are falling, and they will fall further, and this means that the percentage of debt to GDP will again rise, and this is especially bad news for the Latvian government (even though the drop in prices is a desired objective, no win-win strategy left to use now) since any fall beyond that anticipated is likely to push up the total debt level of 60.4% of GDP currently being forecast by the EU Commission for 2011.

And the pain doesn't stop, since having cut 500 million lati ($1 billion) in spending in its 2009 supplementary budget, the government initially resisted the idea of finding an additional 500 million lati of savings in the 2010 budget arguing that with no policy change the deficit was expected to be lower than the 8.5 percent target. Valdis Dombrovskis said in October his government could cut only 325 million lati in the 2010 budget and still meet the 8.5 percent target agreed with international lenders. The lenders did not agree, and Swedish Premier Fredrik Reinfeldt even intervened to tell Latvia it “must correct” its deficit. Following the rebuke further measures were passed equal to 500 million lati for 2010, and the country now targets a deficit of 7.6 percent of GDP. This is to be followed by a budget deficit target of 6 percent of gross domestic product in 2011, in order to finally arrive at the magic number of 3 percent deficit in 2012.

But considerable doubt exists over the ability of the Latvian authorities to fulfil these objectives. Which is why Mark Griffiths, IMF mission head in Latvia, describes the situation facing the government as challenging, and why the EU Commission base their Autumn forecasts on much higher deficit levels. The problem is that with domestic prive deflation (which is, remember, what Latvia is aiming for, the so called "internal devaluation" what is called nominal GDP (that is current price, unadjusted GDP) is likely to fall faster that the so called "real" GDP (adjusted for inflation) and this has two very undersireable consequences. In the first place debt to GDP goes up even faster, and the revenue which government receives (which is based on actual prices) drops faster than GDP, causing more instability in public finances. The deflator has shown falling prices since early this year and the EU commission is forecasting a drop of 5% for 2010.

So basically, in this climate, with unemployment rising, and wages falling, and an economy contracting at nearly 20% a year, it isn't hard to understand why not that much new bank lending is going on. Those who are creditworthy are trying hard to save, while those who need to borrow normally aren't that creditworthy, so Dombrovskis' plea is rather like asking the bank to subsidise new bad debts, and that is really not something you can do, and especially not when you are going along the course you are following because you wanted to, and against one hell of a lot of external advice. What kicked the whole process off was a short sharp credit crunch, but now it is the contraction in the real economy which is following its own dynamic, till someone finds a way to put a stop to it. It is the drop in output that is preventing banks from lending, and not banks being unwilling to lend that is causing the contraction to continue.

But there is another point in the FT article which should give food for thought.

Mr Dombrovskis...ruled out devaluation of the lat. While breaking the currency’s fixed exchange rate with the euro would help Latvia’s exporters, it would increase the burden of euro-denominated loans, which account for 85 per cent of lending, he said.

“We would not see much benefit from devaluation because we are a very small and open economy which means that any competitiveness gains we may get would be very short-lived,” he said. “We would redistribute wealth from pretty much all the population to a few exporters.”

Well, we haven't advanced too far in all these months, now have we, if we are still wheeling out the argument that "external" devaluation will hit holders of euro denominated loans, since it should be generally recognised that the (very painful) internal devaluation which is now taking place is hitting Euro loan and Lati loan holders alike. And the argument is a strange one to use just shortly after the statistics office announced that due to the rapid reduction in the number of those employed and to the fact that many of them changed their working conditions from full-time to part-time, the number of hours worked in the 3rd quarter of 2009 fell by an annual 27.3%, while labour costs fell during the same time period by 30.1%. This fall in disposable income, and the continuing prolongation thereof, poses a far greater threat to the continuity of Latvian loan payments than the 15% reduction in the value of the Lat as compared to the Euro which the IMF proposed in the autum of last year would have done. Indeed, it is, in and of itself, one of the pernicious consequences of having resigned yourself to an "L" shape non-recovery. Stress on the banking system only goes up and up, as incomes and employment fall, and the government has less and less ammunition left to counteract the contractionary pressure.

It is like sitting it out in freezing weather at the North Pole, in the vain hope that help will arrive. But help will not arrive, and the cruel truth about the post-crisis shock world we live in, is that nobody is coming to help you if you will not help yourself. In this sense, what Latvia doesn't need is more international borrowing (hasn't there been enough of that already) but some kind of meaningful strategy to start paying back the debt. But this means putting people back to work, and selling abroad, and financing Latvian lending from Latvian savings, and not pleading for yet more capital inflows to finance non-productive activities (attracting investment would be another matter, but as things stand right now the environment is far from "appetising", and according to the latest data from the Statistics Office, non-financial investment in Latvia was only 402.8 mln lats in the third quarter, a fall of 39% on the 3rd quarter of 2008).

And just to be clear, what we have seen to date is not a 30% drop in unit labour costs (which would, of course, mean a great boost to competitiveness), rather it is a drop in earnings due to the fact that the output people could have produced just isn't needed, since no one is willing and able to buy it. In fact according to the data of the Statistics Office to hourly labour costs fell by only 3.9% in the 3rd quarter when compared with the same period a year earlier. Hardly a massive drop, and especially not when the large annual increases of ealier quarters are taken into account (see chart below). The internal devaluation has a long course still to run!

Pensions Dilemma

But Latvia is back in the news today for more reasons, since the constitutional court has just ruled against the government pension cuts, drawing a question mark over Latvia's ability to meet the terms of its international lending commitments.

"The decision to cut pensions violated the individual's right to social security and the principle of the rule of law," the court said in its judgement, which cannot be appealed. The pension cuts - in place since July - formed a vital part of the Latvian government's list of austerity measures, as it struggles comply with terms of the IMF-lead bailout, and the constitutional inability to implement them is another hammer blow against the credibility of the current Latvian administration.

According to the Baltic Course, Valdis Dombrovskis told Latvian State Radio that the Constitutional Court's ruling on pensions must be carried out, and not debated. I am sure this will really come as music to the ears of people in Brussels and Washington. Basically pension reform forms a key part of the mid term strategy for sustainability of Latvian finances, and without the ability of the Latvian government to carry these out, then frankly the coherence of the whole strategy falls apart. If the Latvian constitution does not permit pension changes, then the Latvian constitution has to be changed, and the only surprising thing is that all this wasn't forseen when the initial loan negotiations took place in late 2008. Basically, it is impossible for the EU Commission and the IMF to accept any other view, since if any state could ring fence a whole part of social provision before entering debt negotiations, then non of the structural reform programmes could possibly work. This may seem harsh, but it is the price you have to pay for becoming insolvent as a society. Latvia's problems are NOT short term liquidity ones, but problems of the sustainability of an entire economic and demographic model, and, as in the case of Greece, these problems will not be solved by two or three years of (rather painful) fiscal deficit cosmetics. Real changes need to be made, and especially in raising the long term growth potential of the country, and frankly it is these changes which we have yet to see evidence for.

The issue is not simply one of limping into the Euro in 2012, even if as Mark Griffiths, the IMF’s mission head in Latvia, said in Riga last week the Latvian government does face a lot of “hard work” in trimming the budget deficit enough to qualify for euro adoption, and how much more so if they cannot constitutionally implement the cuts they agree to.

“The key is meeting the deficit targets, and meeting the Maastricht criteria and euro adoption, that’s the path,” Griffiths said. “The government needs to work hard over the next year to find the measures which will deliver that adjustment to meet those targets. It’s going to be a challenging task.”

Oh yes, and Latvia was also in the news yesterday for another reason, since Latvian stocks dropped the most among equity markets worldwide as small investors sold stocks before the government starts to tax investment gains. The OMX Riga Index fell as much as 4.3 percent to 271.55, its lowest intraday level since August 21. In dollar terms, the drop was the biggest among 90 benchmark indexes tracked by Bloomberg. The reason for the sell off was that Latvia’s 2010 budget includes measures which will impose taxes on dividends, gains from trading stocks and bonds and interest income. These measures were agreed to in order to ensure the continued transfer of the 7.5 billion-euro bailout from the European Commission and the International Monetary Fund.

Latvian investors have increasingly sold their holdings ahead of the Dec. 31 deadline. Dividends and interest income will be taxed at 10 percent, while tax on gains from trading stocks and bonds will be 15 percent.

As Unemployment Climbs, Latvians Start To Pack Their Bags

Finally one that wasn't in the news, but should have been, since while everyone knows that at 20.3% Latvia's unemployment is the highest in the European Union (see chart below), what they don't know is that more Latvian's than even are now being forced to leave their country in search of work.

According to a report by Oļegs Krasnopjorovs, economist with the Bank of Latvia, during the first half of 2009 8,300 Latvian residents left for Great Britain, a twofold increase over the year earlier period. 3,600 people emigrated to crisis-ridden Ireland in the first 11 months of 2009 - 3% more year-on-year. Among the new EU member states, Latvia has seen the sharpest increase in emigration to these two countries.

According to Krasnopjorovs, the data (which comes from the UK and Irish social security systems) confirm the trend identified by the Latvian Statistics Office, who examined data on long-term migration. In the first ten months of 2009, the number of long-term emigrants was 6,300, up 18% more year-on-year; moreover the steepest rise took place in the last few months, reaching a ten-year peak. For several years now the number of emigrants has exceeded that of immigrants in Latvia, with the exception of the second half of 2007 when a sharp rise in salaries and a steep drop in unemployment were fuelled by the credit and construction boom, leading to labour force shortages and the expectation that incomes would rise even further.

Exports Still The Key

The real problem here, of course, is that the Latvian economy remains mired in deep recession, and shows few signs of real recovery, something which is not surprising given that domestic consumption is in limbo land (where it is likely to stay), while the Prime Minister seems to attach little priority to boosting exports, and regaining competitiveness. Indeed, the contraction has rather gathered than lost momentum in recent months, and on a seasonally adjusted basis Latvian GDP fell another 4% between the second and third quarters of 2009. This was much faster than the 0.2% contraction between Q1 and Q2.

Year on year Latvian GDP fell by 19.0% in the third quarter.The decrease was largely due to a 28.7% drop in external trade (share in GDP 15.6%), a 18.2% one in transport and communications (12.5% GDP share), an 17.4% fall in manufacturing (10.2% GDP share, incredible) and by a 36% drop in construction (7.5% GDP share, not far below manufacturing).

Private final consumption fell by 28.1%. Government final consumption decreased by 12.4%, while expenditure on gross capital formation fell 39.4%. Goods exports (68.2% of total exports) fell by 11.7% and services exports by 20.5%. Goods imports (82.1 % of total imports) were down much more sharply - by 36.6% -and services imports by 29.1%. Which meant net trade was positive, otherwise the fall in GDP would have been greater, and nearer to the levels seen in domestic demand.

And entering the fourth quarter there were few signs of any real improvement. Retail sales fell in October by 1.3% from September (on a seasonally adjusted, constant price basis).

As compared to October 2008 sales were down by 29.1%. The drop was even larger in the non-food product group – 32.3%. According to Eurostat data, sales are now down nearly 35% from their April 2008 peak.

Industrial output, however, seems to be holding up a little better, and output has stabilised since the spring. The problem is that manufacturing industry is now such a small share in GDP that it will be hard to pull the entire economy on the basis of anything other than very strong rates of increase. Industrial production was up in October by 0.1% over September, marginal, but at least it wasn't a fall. Unfortunately most of the increase was in the energy sector, with electricity and gas up by 10.3%, mining and quarrying contracted, by 2.1% as did manufacturing, by 1.9%.

Compared to October 2008 industrial output was down by 13.5%, Output in manufacturing fell by 15.8%, in mining and quarrying by 11%, while in electricity and gas output was only down by 2%. Output is now down around 21% since the February 2008 peak.

There is one positive glimmer on the Latvian horizon at the present time, and that is, of course, exports which were up by more than 4.4% (or 31.7 mln lats) when compared with September.

As a result, the surplus in the current account of Latvia's balance of payments reached 10.1% of gross domestic product (or LVL 327.9 million) in the third quarter. The surplus is however rather smaller than in the second quarter, which was 14.2% of GDP.

With export growth exceeding that of imports, the combined goods and services balance was positive for the second consecutive quarter, standing at 0.3% of GDP (or LVL 11.2 million). This effect is more due to services than to goods exports, since the goods trade balance is still in deficit (see chart), so there is still a long road to travel.

The largest third quarter capital inflows registered under the capital and financial account were the result of government borrowing from the IMF-lead support programme. There was some new foreign direct investment in Latvian companies to the amount of LVL 370.2 million, which to some extent offset direct investment outflows. Net external debt shrank by LVL 0.5 billion in nominal terms, but due to the fall in GDP (as I explained earlier) the ratio of net external debt to GDP posted only a tiny drop, reaching 56.4%, and gross external debt to GDP (excluding foreign assets) was up, reaching 145.8%.

So, as I say, a start has been made, even if there is still a long, long road to travel. Internal devaluation is the chosen path of the Latvian people, the best thing I can suggest at this point is to get it moving in earnest (in fact there is some evidence from November producer prices that the rate of price fall is now accelerating), and that Latvia's leaders start to value what they have (that is, export potential) instead of dreaming of what they can no longer have (dynamic domestic consumption driving growth). Living in the past is never a good idea, not even in the sentimental moments of Yuletide. A Merry Xmas to you all!

Latvia's Agony Continues In The Second Quarter - With Little Relief In Sight

2009-09-08T21:44:00.000+02:00

Latvia’s economy shrank a revised 18.7 percent in the second quarter of 2009 over a year earlier in what was the second-steepest drop in the entire European Union (worsted only by Lithuania) according to detailed data released by the statistics office yesterday. The contraction, which is now the largest since quarterly records began in 1995, was revised down from a preliminary estimate of a 19.6 percent annual drop. And Latvia's problem can easily be seen in the above charts which show the most recent movement in exports, and quarterly data for constant price imports and exports. The Latvian economy grew driven by domestic consumption and increased borrowing during 2006 and most of 2007, but then the country ran out of extra sources of cash, and so imports slumped, followed by exports as the global economy entered crisis. Now its time to pay back, which means the lines we see in 2006 and 2007 will now need to be repeated, only this time with exports on the top and imports below. Of course, really doing this will only be possible once the global economy recovers. But the key question is, will Latvian export capacity be ready when that critical moment comes, or will Latvia's agony continue, stuck in a horrid "L" shaped "non-recovery"? The most recent data on foreign trade, which saw exports fall and the trade deficit once more widen suggest that the latter danger is far from being a mere theoretical one.

And I am not the only one to be raising it, since according to the latest report out from Nordea Bank, Estonia, Latvia and Lithuania, may well suffer deeper economic contractions than previously estimated as government austerity measures simply serves to sap domestic demand while export growth remains muted.

So well done Nordea! But please permit me to say that this discovery does come as a bit rich from analysts who have persistently remained in denial that the key to Latvia's recovery was a substantial reduction in the price level in order to facilitate exports (on my view better achieved by formal devaluation, but by the express desire of the elected political leaders of the Latvian people now being carried out via a convoluted and painful process known as "internal devlauation").

Still, it is interesting to see mainstream analysts starting to question the current orthodoxy that fiscal prudency will (due to the impact on investor confidence) lead to recovery in Eastern Europe, while here in the West our leaders have just re-affirmed the need to maintain fiscal stimulus, given the fragility of even those earliest signs of recovery.

Indeed the analyst consensus is becoming more and more pessimistic. Danske Bank say the following in their latest Emerging Markets report:

"Worries over Latvia’s public finances continue. Despite aggressive cuts in public spending so far this year, total central government spending in August 2009 was, extraordinarily, exactly the same as in August 2008. This is partly due to spending cuts being offset by increased social spending, and partly to some ministries and agencies awarding their employees big pay increases in June this year before imposing cuts in July as part of the IMF/EU programme. It is still too early to say that everything is fine in the state of Latvia."

In the following monthly report I will examine just what evidence there is for the idea that Latvia's economy has actually bottomed out.

The Fall In GDP Continues

Latvia’s economy shrank an annual 18.7 percent last quarter, following a drop in gross domestic product of 18 percent in the first quarter. The charge downwards was lead by a decrease in private final consumption which fell an annual 23.21% (year on year - see chart). Government final consumption dropped bya mere 6.9%, but expenditure on gross capital formation (which includes the critical investment item) crashed by 38.1% - with construction (which forms part) down 29.5% (see chart below). Goods exports (63.6% of total exports) was down by 19.1% and the export of services by 15.7%. The slump in imports was, of course) even worse with the volume of goods imports (78.8% of total imports) down 39.4%, and the volume of services imports by 38.2%.

But Slows On A Quarterly Basis

Quarter on quarter, however, the rate of contraction did slow slowed substantially, from an 11% rate in the first quarter to a 1.6% rate in the second quarter. But even though the rate of contraction is now much, much slower, the economy is still contracting, so I think it is not quite accurate to say we have hit bottom yet. And hitting bottom is not the same as recovering, since there is unlikely to be any rapid bounce back, and any "recovery" is likely to have an "L" shape with a slight upward slope.

Meanwhile, and hardly surprisingly, during the month Latvia’s credit rating was lowered by Standard & Poor’s, with the long-term foreign currency rating being lowered to BB, two notches below investment grade, from BB+, with a negative outlook. According to S&P's:

“The rating action reflects our view of the political and economic challenges as a result of rapidly contracting nominal and real incomes and the associated pressures on public finances, as the country struggles to improve its growth prospects while maintaining a fixed exchange rate regime.....The outlook for growth beyond that remains highly uncertain, not least due to highly leveraged household balance sheets.”

S&P's estimate that Latvia’s general government debt, which stood at 19 percent of GDP last year, will grow to over 80 percent in 2011, an estime which is broadly in line with current EU Comission forecasts.

The International Monetary Fund also agreed on August 27 to disburse the second installment (of around 200 million euros) of the 1.7 billion-euro credit line approved last December. The decision followed a long period of uncretainty. Latvia’s government is trying to cut spending/or raise revenue by 500 million lati ($1 billion) a year between now and 2012, in a bid to get the budget deficit below 3 percent of GDP as part of an attempt to meet euro adoption criteria.

The IMF said in their statement that the program had been adjusted to reflect:

- a significant increase in the program’s fiscal deficit ceiling in 2009 (up to
13 percent of GDP, compared with 5 percent in the original program) to avoid
measures that would harm the most vulnerable, and

- an allowance of 1
percent of GDP in additional resources for social safety nets.

The statement which Moody's following the IMF decision asserting that Latvia’s Baa3 government bond rating - the lowest investment grade, - was being kept at stable was hardly surprising, although the justification they gave - that the bond issuance was supported by “significant, extraordinary fiscal assistance” from international lenders - surely was significant, and very much to the point. The EU Commission and the IMF are now guaranteeing and in order to do this have effectively assumed sovereign responsibility fo the country (see Appendix below).

Moody's were also a little more optimistic than S&Ps on government debt, since they estimated it would only rise to about 60 percent of gross domestic product in 2010 and fluctuate from about 60 percent to 65 percent over the medium term. I think this is too optimistic, basically for the sort of reasons S&Ps are giving. On the other hand they did also state that a currency devaluation, while not being their central scenario, "was a clear risk, along with additional problems in the banking sector".

Little Sign Of Any Recovery In Main Indicators

If we now come to the future, we have to note there is little hard evidence at this point for any real recovery - nor should we expect to see any. Industrial output is still falling, and was down 1.4 percent in July over June, and 17.7% year-on-year (over July 2008). This compared with a 18.5% annual fall in the previous month.

Latvia's industrial output started falling in February 2008, and has now fallen 22.4% from it peak.

Retail sales were down 1% in July over June, and 29.5% over July 2008.

Retail sales have now been falling since April 2008, and are now 31.18% below their peak.

The Trade Defict Widens in July As Exports Drop Back

Latvia's July trade deficit was 95.2 million Lati up from 67 million Lati in June. This was the first increase since December 2008. Latvian foreign trade turnover came in at 613.3 mln lats in July, down by 3.8% or 24.5 mln lats in current price terms than a month earlier and and down by 41.1% over July last year.

In the January – July 2009 period foreign trade turnover was 4517.6 mln lats – down by 36.1% or 2547.5 mln lats over the same period in 2008.

In July exports were down by 32.6% over July 2008 and imports down 46%. Over January to July exports were down by 27.2% or 705.4 mln lats, while imports were down by 41.2% or 1842.1 mln lats over the same period a year ago.

Unemployment Continues To Rise, And As It Does Bad Loans Pile Up In the Banking Sector

Latvia's unemployment rate hit 17.4% in July according to Eurostat data, and again this was the second highest level in the European Union (after Spain). Naturally with unemployment rising to such levels the number of distressed loans continues to rise and bad debt provisions in the banking sector wnet up again - to 6.6 percent of the total credit portfolio in July from 6.1 percent the month before, according to credit supervisor FKTK.

The FKTK also said in a statement that bank losses by the end of the first seven months had hit 400 million lats ($817.6 million), up from 346.8 million lats at the end of the first half.

Lending was again down, and the total credit portfolio fell by 0.7 percent in July. The level of debts with delayed payments of more than 90 days rose to 13 percent of the credit portfolio from 12 percent at the end of June.

What About The Internal Devaluation, Is It Working?

Well, prices have started falling, and the consumer price level was down in August by 1.0% compared to July. The average prices of goods fell by 1.3%, and of services by 0.4%. But if we compared to August 2008 we find that consumer prices (as measured on the Latvian national index) have incredibly still increased by 1.8% (down admitdely from the 2.5% rate of increase in July), which leads me to ask, given the pain that all of this is evidently causing, are prices still falling too little and too late to do any real good.

The central bank seems to think the process is working, since they point out on their website that the real effective exchange rate of the lat, which is one measure of the price competitiveness of Latvian goods versus those of the country's major trading partners, improved between April and July, marking the first four-month gain since the beginning of 2005. We need to remember howvere that the REER index showed prices developing far faster than trading partners all the way from 2006 through to April 2009 (see comparative chart with Finland below) so there really is a long long way back down to go. And if we look at the chart immmediately below, we will see that while the gap is closing Latvian prices are still in a worse position in August 2009 (as compared to other Eurozone countries) than they were in August 2008 - that is over the last year as a whole the position has even deteriorated.

A similar picture can be found in producer (factory gate) prices, which have only recently moved into negative territory on an annual basis. To get a comparison, German producer prices were down 7.8% year on year in July, while

In fact, while export prices are dropping substantially, import prices are also falling (see chart), and thus the real rate of price correction is still quite small.

I therefore contend that this weeks statement from Unicredit Group Chief Economist Marco Annunziata to the effect that, “For the region as a whole and for Latvia, we have gone through the worst,” is way too premature. Conditions are not improving, and as Moody's suggested pressures in the banking system are still building up. It is an open empirical question at this point whether we have the worst behind us. Even over a longer term horizon it is hard to see the grounds for optimism, since there are certainly no "green sprouts" to be seen on the new babies front, with year on year three month moving average being stuck around the 8% drop level. This depression is going to cast a long shadow over the future of the Latvian people, let's hope for everyone's sake that all those responsible (the government, the IMF, and the EU Commission) are fully aware of their hsitoric responsibilities here.

Appendix: IMF and EU Conditions from the respective Letters of Intent.

According to the letter of intent signed by the Latvian Government, The Central Bank and the IMF, a number of new reporting obligations were agreed to. These include:

* Consolidated central (basic and special budgets), local and general government operations based on the IMF fiscal template
* Detailed information on revenues from EU funds at the general government level, and EU-related spending by the central government, including transfers to local governments for EU-related spending
* Consolidated central and general government bank restructuring operations
* Privatization receipts received by the general government budget (in lats and foreign exchange, and payments in governments bonds)
* Information on debt stocks and flows, domestic and external (concessional and non concessional), by currency, and guarantees issued by the (i) consolidated central, local and general governments and (ii) public enterprises (including the Latvian guarantee agency and
the Rural guarantee fund), including amounts and beneficiaries
* Information on new contingent liabilities, domestic and external, of the consolidated central, local and general governments
* Data on general government arrears, including to suppliers
* Data on operations of extrabudgetary funds
* Data on the stock of the general government system external arrears
* Balance sheet of the BoL, including (at actual exchange rate) (i) data on components of program NIR; (ii) government balances at the BoL, broken into foreign exchange balances—distinguishing various program partner sub-accounts for program financing—and balances in lats.
* Balance sheet of the BoL (in program and actual exchange rates) (i) data on components of program NIR; (ii) government balances at the BoL, broken into foreign exchange balances—distinguishing various program partner sub-accounts for program financing—and balances in lats.
* Consolidated accounts of the commercial banks
* Monetary survey
* Currency operations, including government foreign receipts and payments and breakdown of interbank market operations by currencies (interventions)
* Aggregated data on free collateral—available, unpledged collateral held at the Bank of Latvia
* Daily data with banks’ current accounts, minimum reserve requirements, stock of repos and fx swaps
* Foreign exchange rate data
* Volume of foreign exchange lats trades
* Projections for external payments of the banking sector falling due in the next four quarters, interest and amortization (for medium and long-term loans)
* Projections for external payments of the corporate sector falling due in the next four quarters interest and amortization (for medium and long-term loans)
* The stock of external debt for both public and private sector

The Letter of Intent follows the earlier signing of a Supplementary Memorandum of Understanding between the Latvian government and the European Union. The terms of this understanding contained the following Monitoring and Reporting protocols.

Monitoring fiscal developments

• Monthly revenue and expenditure break-down of social budget, including data on social
benefits' hand-outs (unemployment, family, etc).
• Monthly state basic budget expenditure breakdown per type of expenditure for each
ministry or other relevant budget entity.
• Monthly revenue and expenditure break-down of local governments, including data on
GMI hand-outs and other benefits included in category "other social support".
• Monthly information on debt stocks and flows and guarantees given on new debt,
contracted by the (i) consolidated central, local and general governments and (ii) public
enterprises.
• Monthly data on new contingent liabilities of the consolidated central, local and general
governments.
• Monthly data on state budget loans and PPP projects.
• Monthly information on central government (i.e., ministries and agencies) and state
owned companies' staff and remuneration levels, institution-by-institution, showing last
months'/years' trends.
• Monthly data on general government arrears, including to suppliers.
• Bi-weekly Treasury cash-flow assessment of central government financing needs.

Monitoring financial developments

• Monthly statements of the operations on the special account.
• Monthly report on the amount of mortgage loans converted from EUR to LVL.
• Monthly report on outstanding loans split by currency and detailed to households
(housing, consumer, other) and non-financial corporations (by sector).
• Notify DG ECFIN whenever there is a consultation process with DG COMP related to
financial sector stabilization (i.e., Parex).
• Monthly report on banking sector stabilization measures.

Monitoring structural reforms

• Monthly data on budget allocations to and appropriations of line ministries for financing
of EU Structural funds and Cohesion fund projects (including which programming
period they are related to).
• Monthly data on the amounts disbursed to final beneficiaries for project
implementation, by ministry and by EU Structural funds and Cohesion fund projects
(including which programming period they are related to).
• Monthly data on the amounts spent by state budget financed entities as final
beneficiaries on EU Structural funds and Cohesion fund project implementation, by
ministry and by EU fund (including which programming period they are related to).
• Monthly financial reports on reaching the Structural Funds and Cohesion Fund
expenditure targets by the Managing Authority.
• Quarterly qualitative assessment reports on reaching the Structural Funds and Cohesion
Fund expenditure targets by the Managing Authority.
• Quarterly assessment of policy options taken by the government regarding poverty,
health and pensions.

Is It Hot In Latvia In August?

2009-07-29T11:37:00.001+02:00

Well the big news this morning is that the IMF mission to Latvia has finally reached agreement with the Latvian government on a new policy package that will give the country access to about $278 million in new financing. Details of the deal are scant at the moment, since the Letter of Intent will not be published until the IMF board approves the agreement, but it seems the terms of the IMF deal are (on the face of it) tough: additional budget cuts worth a reported 500 million lats ($1.02 billion) for 2010, a progressive income tax with the possibility of an increase in VAT if the cuts do not reduce the budget deficit to the stipulated level.

Really, this agreement changes very little in my opinion. As Capital Economics' Neil Shearing points out, many people are assuming that with the rapid Current Account adjustment in many CEE countries, the threat to external financial stability has largely gone away. But as Neil argues, while theoretically, it should be enough for the countries just to move back to balance, practical experience from Argentina etc suggests that as recovery arrives the CA tends to move from large deficit to large surplus. And this of course means exports growing at a much faster rate than imports. This is the only practical way to pay down the debt.

And as Afoe's own Claus Vistesen puts it:

This is all about the composition of the external balance and what kind of extensions foreign creditors give. Now, the benefit of the peg is of course that you can begin to accumulate foreign assets at reasonable valuation to your liabilities. HOWEVER, the only way to reasonably begin this process is of course to actually begin accumulating those assets and in order to so so, you need productive investment targeted at foreign operations and this is very difficult unless the "internal devaluation" has run its course. Essentially, domestic investment to serve foreign markets are not productive until deflation has taken its toll.

So basically the message is, whatever the final details of the new agreement, stay tuned and keep watching, since all of this is far from over.

Edward Will Not Be Going To Latvia In August

The little news of the day is that I will not be attending the conference on Latvia's economic future which members of the Peoples Party are trying to organise for August, even though I was invited. As the Latvia Daily Diena (Latvian only I'm afraid) which reports on the preparations for the conference puts it "E. Hugh, who declared himself a defender of the lat devaluation, however, declined to participate, adding he'd like to maintain political neutrality." Well, this is fair enough as a presentation of my opinion, but, just for the record, here's what I actually did say.

First of all I would like to say thank you very much for thinking of me and inviting me to your conference....

....while I think a decision to accept the original IMF proposal of a 15% devaluation of the Lat, and pressure the EU Commission into euro entry was the best option last autumn, this is now no longer the situation. So while I was advocating devaluation back then, what I am saying now is that in my opinion devaluation is inevitable at some point, but that it will now be an unholy mess. Serious contagion problems will most likely ensue, and so in this sense I am no longer "advocating" Latvian devaluation. Ideally it needs to take place as part of a much more general solution to problems in the economies of the Eastern European countries who are members of the EU.

If Latvia is simply forced off the peg, then we should all watch out. I am in Spain, and I am expecting consequences here.

Thirdly, I am not in basic disagreement with the IMF, and would not wish to do anything which may make their work more difficult. Basically, from where I am sitting the issue is to put pressure on the EU institutional structure in an attempt to get them to recognise some of the basic ABCs of economics.

Lastly, I would emphasise that I am an economist, a mere technician of economic systems, and not a politician. I am explicitly non politicial, and am maintaining this stance both vigourously and adamantly.

Basically, as I said, I consider devaluation inevitable..... tomorrow, in August, after Christmas, in 2011, I don't know when. I also know that the longer it is in coming, the more serious the consequences will be, due to the continuous degradation in the credibility of the associated institutions (IMF, ECB, EU Commission, EBRD etc). This is all now quite likely to eventually become (via the other Baltic states, Bulgaria, Hungary, Romania and even Ukraine and Serbia) a very serious problem, with potentially major global implications.

So there will be a before and after. After devaluation there will need to be a major rethink about where Latvia is going. Devaluation is not an end in itself, it is simply a means to an end, a begininning. We also need to think about how Latvia will earn its living, pay off its debts, and find its way in the world.

Long term structural, and strategic economic thinking are needed.

Here I think I do have a part to play. As you may well have noticed, my view is that the ongoing demographic deterioration of your country lies at the heart of your macro economic problems.

I think this deterioration needs to be addressed as soon as possible, and I see three large issue.

i) Productive capacity needs to be increased substantially. This means increasing the labour force, and this means (as outlined in the World Bank Report, From Red To Grey) facilitating large scale inward migration. Given the serious political implications of encouraging ethnic Russian migration into your country, I see only two viable source regions, the Central Asian Republics in the CIS, and Sub. Saharan Africa. Possibly this solution will not be widely popular with Latvian voters. Well, they do have the right to choose. Your country can take the measures needed to become sustainable, or you can watch it die, as the economy shrinks, and the young people leave. That, I think, is your choice.

The other two measures you need to take are contingent on the first being implemented, since without the first measure you will simply not dispose of the economic resources for the other two.

ii) A serious policy to support those Latvian women who do wish to have children. But with major financial advantages, not half measures, and propaganda stunts. You need policies that can work, and I know plenty of demographers with ideas.But this needs money. Important quantities of money. And gender empowerment, right across the economy, at every level. We have formal legal equality in the labour market, but evident biological and reproductive inequality, in that only one of the parties gets to bear the children. The institutional resources of the state need to redress this imbalance.

iii) Major reforms in the health system to address the underlying male life expectancy problem. You can only seriously hope to raise the labour force participation rates at 65 and over if people arrive at these ages in a fundamentally healthy condition. In economic terms, simple investment theory shows why this is the case. A given society spends a given quantity of resources on producing a given number of children, those who have citizens who live and work longer evidently get a better return on their investment. If you want to raise Latvian living standards, you have to raise the life expectancy. And this apart from the evident human issues.

OK, I am saying no for the moment, but I would like to stress that when conditions change, I would be more than willing to come to your country to try to help. But not for a day, for a month, and not to give a talk, but to work with some serious people who are willing to roll their sleeves up and do the serious spadework that will be needed to find those solutions you so badly need.

Basically, my feeling is that the issues you face are so complex that public debate is unlikely to produce a very fruitful outcome at this point. You need a long term education process, and for the time being more or less technocratic solutions, but not the technocratic solutions you are being offered by the EU now (which basically won't work), technocratic solutions which get to the heart of the problem and set your country on a sustainable path.

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

2009-07-24T00:22:00.000+02:00

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?

Why Latvia Is In Such A Mess

2009-07-22T14:22:00.000+02:00

Hat Tip to Aleks Tapinsh - "No wonder this country is in such a mess. Someone posted this video of a payday at the Elkor electronics chain in Latvia. The paycheck as you can see comes in an envelope, in cash. No one pays any taxes. And everyone happy. Or not".

Second example: Prime Minister Valdis Dombrovskis cited in a press conference in Riga yesterday the fact that some companies, including state-owned companies like Latvian Railways, had tried to cheat the social security system by significantly raising the wages of some of its employees (in his example from 1,000 lats a month to 12,000 lats a month), thus apparently raising their pay into the social security system. That way, if a person gets laid off, they'd get 70 percent of the new and improved wage.

Now two recent quotes from my blog interpreting yesterday's comment from the Economy Minister - (Viz: "Representatives sitting in Washington and educated at Yale do not fully understand what is going on in Latvia”)

"To provide with logic behind quote of the economics minister, I believe he thought that the EC and IMF does not realize the scope and importance of grey economy in the country. With that figure hard to estimate (ranging from 15%-40%). Any increase of Tax base will only push the economy on the gray side both for individuals (tax exemption on income earned) and for companies (unaccounted cash revenue, forgone taxes,etc). Thus resulting in even less tax revenue that initially had and larger budget deficit to balance. As for VAT tax, as a sign of protest, some of the local companies have publically annouced the full closure of their business if the VAT is raised to 23%."

"Yep, stupid comment when at the same time you are reaching out your hands to receive their money... That said, the IMF does not really fully understand if they think they can introduce e.g. a progressive income tax and raise more revenue. Very hard to do in a country that does not believe that higher taxes will benefit the population and where tax avoidance is an art mastered by most."

Danskebank's EMEA Daily Latvian Quote Of The Day

2009-07-21T15:18:00.000+02:00

Quote of the day: "Representatives sitting in Washington and educated at Yale do not fully understand what is going on in Latvia", Latvian Economics Minister Kampars yesterday on the Latvian TV programme 900 sekundes.

As they point out, when the borrowers publicly criticise the lenders in this way, something must be going on.

While Mr. Kampars might be right on his assessment of the IMF staff, it is certainly unhelpful for further negotiations (if there are to be any) to bad mouth the institution that is supposed to give Latvia a loan. In our view it increasingly looks like the IMF will not pay out the next instalment on Latvia’s loan. This not only has ramifications for Latvia, but should also be a reminder to investors that the IMF is not just a “money machine” that automatically bails out all countries with funding needs.

Also Danskebank provide some simple calculations to illustrate the extent to which Latvia does still need the IMF funds:

A back of the envelope calculation illustrates this. In June, central government spent about EUR 125m more than came in revenues and funding. Assuming that this “burn rate” continues for the rest of the year (August-December) then that adds up to EUR 625m for the rest of the year. Furthermore, during the rest of the year EUR 715m worth of t-bills are maturing which need to be rolled over. Hence, the refinancing of maturing debt and the monthly cash burn adds up to EUR 1,340m. In our assessment the Latvian state treasury probably has EUR 540m in liquidity at the moment. That leaves the Latvian central government with a funding need of EUR 799m. This is why it is important that the EC in the Supplemental MoU ties up half of the EUR 1.2bn instalment for the financial sector, as the amount that will be “free” to cover the budget deficit will be less than the funding need (EUR 600m vs EUR 799m).

Thus, according to Danske the Latvian government will be around 200 million euros short by the end of the year – unless it is able to roll over more than half of the maturing debt, something which would require sustained perfect conditions for issuance in the local money markets for the rest of the year, unlikely given that the international markets are more or less closed to Latvian debt, and that non receipt of the IMF share would hardly increase the risk appetite.

Parex Update

The situation at Parex bank seems to be giving rise to all sorts of speculation at the moment. It has been suggested that the Banks owners have been systematically taking advantage of the bailout to line their own pockets. Some support for this view can be found in the statement of the Latvian Finance Ministry last Friday that it had asked the state prosecutor's office to probe Parex takeover last year.

RIGA, July 17 (Reuters) - Latvia's Finance Ministry said on Friday it had asked the state prosecutor's office to probe the state takeover last year of a major bank that helped trigger the need for the country's IMF-led bailout.

The IMF has delayed its latest share of lending in the bailout, though the EU has decided to give a further 1.2 billion euros. The prime minister said he would hold more talks next week with the International Monetary Fund (IMF). Some local media reports and politicians have criticised the wisdom of taking over the country's second largest bank, Parex, and the way it was done. Most recently the media has reported that some former employees left with big handouts. Finance Minister Einars Repse said he had asked the prosecutor's office to investigate the takeover to clear up such controversies

What the connection is (if any) between the "Parex affair" and all the other unknowns we have in our equation set at the moment still remains to be seen.

And finally, to close, here's yet another Latvia quote, this time from former IMF chief economist Ken Rogoff:

“It is so clear that Latvia’s peg is ultimately unsustainable, all protestations by Latvian government officials notwithstanding,” said Kenneth Rogoff, a former chief economist at the I.M.F.. “But ultimately unsustainable pegs can go on for years before crashing and burning, and Brussels seems to be willing to pay a lot to get past the financial crisis before cutting the cord on Latvia.”

Brief Latvia EU Loan Update

2009-07-20T20:34:00.000+02:00

Well, there is still effectively no word from the IMF. But The EC did today release an addendum to its memorandum of understanding with Latvia identifying a number of economic and fiscal policy measures it wants the country to enact before it receives next chunk of funding. The document, which is a pretty rough-and-ready PDF photocopy, can be found here. Reading the document, one thing seems certain: the upcoming tranche of 1.2 billion euros will not now be sufficient to cover the budget deficit for 2009, since the EC requires half of the money to be set aside for the financial sector - which prompts the question, is the nationalized Parex bank really as healthy as the government and the bank's leadership have previously said it was?

Other items of interest in the document are the proposal to raise VAT in 2010 from 21% to 23% if other forms of revenue raising cannot be identified. The impact on already very hard pressed retail sales is not too hard to imagine. The introduction of a residential real estate tax is also proposed with local authorities being empowered to increase the real estate tax to 3% of cadastral values. If implemented, this will do only one thing: further reduce Latvian real estate values which are already down 50% from their peak, and on whose bottoming-out any hope of ultimate recovery depends.

Which is another way of saying that in macro economic terms the document leaves rather a lot to be desired, and essentially it is hard to find any item which is actually going to stimulate rather than flatten a recovery.

Also worthy of note is the requirement that Latvia now has to closely coordinate policy with the EU and the IMF.

"All significant Cabinet decisions or other decisions with a fiscal impact, including on social security or any guarantee scheme, shall be announced and undertaken only after discussions with the EC and the IMF,"

The document also stipulates that the government will have to report every month on all key aspects of spending and revenue, including providing a breakdown for each ministry as well as for local governments. These performance criteria, given the now near total dependence of the country on external support - de facto, as a sovereign state Latvia has effectively ceased (at least temporarily) to exist, some 19 years or so after its foundation - are not surprising in and of themselves, but it could have been hope that the country would have been better served in terms of the kind of advice which is being offered. The document repeated that Latvia should aim to reach a budget deficit of 10 percent of gross domestic product (GDP) this year, 8.5 percent in 2010, 6 percent in 2011 and 3 percent in 2012, numbers which, if my back of the envelope calculations are not totally awry mean that Latvia's debt to GDP will be outside the EU 60% limit by the time the deficit comes down under 3%, depending on GDP performance in 2010 and 2011. In any event it will be touch and go. So you enter by one door, only to leave by the other.

IMF Imposes New Conditions On Latvia

2009-07-15T11:36:00.000+02:00

Izabella Kaminska at FT Alphaville has the story (via Reuters):

The International Monetary Fund has put forward new, difficult conditions for Latvia to receive further loans, the prime minister said on Wednesday in a further sign the Fund is being tougher than the European Commission.

It isn't clear at this point what these conditions are. Rumour has it they may be an end to the flat income tax, or a hike in VAT. A hike in VAT would be more hari-kiri, since this would again hit consumption AND would boost inflation at a time when they are trying to deflate to carry through an internal currency correction. It also isn't clear whether this is a serious attempt to add new conditions (which I find unlikely, given how advanced the distemper is) or whether this is a way for the IMF to get themselves off the hook (ie leave the EU Commission to stew in its own juice) without having a public and potentially damaging break with the EU. The IMF need to find some sort of exit strategy I think (since Latvia evidently at this point doesn't have one), or it risks losing its own credibility if it puts a seal of approval (by granting the next tranche) on something which most external specialists now think could end up in a very messy grande finale. Argentina ghosts are stalking the corridors in Washington, not because of the similarities between the two countries (they are, at the end of the day pretty different), but because of the way giving a final "kiss of death" loan to a country can ultimately come back and haunt you.

Update One

The local Latvian news agency is saying that if Latvia and the IMF do not sign the new agreement by Friday, Latvia may not see the next chunk of the IMF loan and it could jeopardize the further funding from the EC. This could be brinksmanship, but even brinkmanship can go badly wrong if the other party can't concede. And who is the other party here? Latvia or the EU Commission, since they already said they are happy with progress. What a muddle!

Update Two - Thursday Afternoon

Bloomberg's Aaron Eglitis reports this afternoon that Friday may in fact not be any kind of deadline. He quotes Caroline Atkinson, head of external relations at the IMF, in Washington, to the effect that the head of the IMF mission in Riga is returning to Washington this weekend as scheduled, while the mission itself would “continue its work.” This suggests there will be no final decision this week. She also said there was “broad consensus among all the parties involved” about the goals for Latvia, declining to go into specifics.

Rumourology has it that the IMF wants the government to become more effective in revenue collection, with the fear that the current contraction may be so strong due to the fact that part of the economy is disappearing back into a "grey area" as a backdrop. Various proposals are being floated around, but perhaps it would be better to wait for some concrete information before speculating about this.

Latvian central bank Governor Ilmars Rimsevics has also been holding a press conference in Riga today, and he took the opportunity to suggest that the country’s budget deficit was likely to grow to between 9.5 percent and 10 percent this year. If this is the case, then this would obviously put Latvia outside the 60% gross debt to GDP criteria by 2010, which would make euro membership as an exit strategy non viable over the relevant horizon in my view. Just a long shot, but maybe that is what they are all arguing about. The EU clearly has to offer the four peggars more in the way of a carrot, although they themselves need to remember - looking over at Slovakia and Slovenia - that mere euro membership is no panacea to cure all ills.

The IMF/EU Commission Rift On Latvia Seems To Be Deepening

2009-07-13T16:16:00.001+02:00

Two weeks ago I drew attention to a revealing press conference given by IMF First Deputy Managing Director John Lipsky and European Central Bank governing council member Christian Noyer where it seemed a rather different posture was being taken on the Latvian question than that which is being transmitted from Brussels. Then P O'Neill found a message on Twitter which suggested the topic of the Latvian budget had been unexpectedly added to the EcoFin agenda.

Today Bloomberg report that Barclays Capital’s chief economist for emerging Europe Christian Keller thinks that the IMF's posture of continuing to withhold funds even after the approval of the spending cuts “signaled that the rift between the IMF and EU has widened” .

Now I don't want to see connections were there are none, but it is a coincidence that Christian Keller works for the same Barclays capital whose Head of Emerging Markets Strategy Eduardo Levy-Yeyati recently published a lengthy analysis on the influential Is Latvia the new Argentina? - where he argued that: "The strategy of engineering an “internal” depreciation under a peg in Latvia (via contractionary fiscal policy, wage cuts and price deflation) implicit in the IMF program is proving too painful, if not self-defeating as in the 2001 collapse of Argentina’s currency board"

Now the publication of this article was interesting since Eduardo Levy-Yayati is not just any old economist. Previous to joining Barclays Capital, as his Voxeu biography informs us, he was

"a Senior Financial Sector Advisor for Latin America & the Caribbean at The World Bank. Previously, a Senior Research Associate at the Inter-American Development Bank, the Director of Monetary and Financial Policies and Chief Economist for the Central Bank of Argentina, and the Director of the Center for Financial Research and Professor of Economics and Finance at Universidad Torcuato Di Tella. He has also worked as consultant for the IMF, the World Bank, the Inter-American Development Bank, the Japan Bank for International Cooperation, among many public and private institutions. His research on emerging markets banking and finance has been published extensively in top international economic journals. "

That is, Señor Levy-Yayati is an extremely experienced economist, an old Argentina hand, and enjoys some considerable influence over emerging markets issues in Washington. So was the appearance of the article in Voxeu at the end of June totally coincidental? He certainly is experienced enough to know what he is doing in these matters. And was it also a coincidence that only a week later former chief economist at the International Monetary Fund Ken Rogoff - surely another person who knows perfectly well what he is doing - gave an interview where he said that "Latvia should devalue the lats to avoid a worsening of its economic crisis" and that "the IMF made the wrong decision when it allowed Latvia to keep its currency peg"?

The IMF cannot say what it really thinks for obvious reasons, but could we construe Levy-Yayati and Rogoff as thinking out loud on the funds behalf?

The clash between the two institutions (should such a clash exist) derives from “ideological differences” according to Keller. "The IMF is focused on economic questions such as the sustainability of the currency peg, the use of economic stimulus or the idea of fast-track euro adoption......The EU’s main concern is political, such as euro-adoption rules and the implementation of convergence programs".

This all rings pretty true, and it rings even truer when you note that the Latvian Prime Minister Valdis Dombrovskis said only last week that the country "may not need the IMF share of the financing". As Keller says, “The Latvia program has become a headache for the IMF.”

Postscript

Latvian foreign trade was down again in May, at 618.3 mln lats it was 4.2% (or 27.1 mln lats) lower than it was in April (no green shoot here) and 38.5% (or 387.6 mln lats) down on May last year, according to provisional data of Latvian Statistics Office. May exports were down 30.1% over May 2008, while imports were down an incredible 43.7%. Over the January – May period foreign trade was down by 35.4% on the same period in 2008. Exports were down by 27.7% and imports by 39.9%.

Industrial output fell back again in May over April, by 0.4% on a seasonally adjusted basis according to the statistics office. Year on year it was down 19.3%.

And domestic demand continues to weaken. Retail sales were down 0.48% in May over April, and 24.14% year on year, according to Eurostat data.

Latvia’s inflation rate fell to 3.4 percent in June, the lowest annual rate since October 2003, from 4.7 percent in May. Prices were down 0.5% on the month, but this is way too slow for the kind of internal devaluation process which is underway. At this rate the loss of GDP will be truly massive before the internal currency correction has taken place.

There were 206,000 people unemployed in Latvia in May, or 16.3 percent of the labour force, according to the latest Eurostat data. This is slightly down on earlier data, but since these results are survey based, and such rapid changes make it difficult to apply such methodologies, I don't think we need suspect any kind of "foul play". The rise is dramatic enough as it is, as can be seen in the chart below. This makes me wonder were we will be by mid 2010.

One area where the central bank has had some success has been in getting overnight interbank lending rates down again, and the overnight Rigibor is now back around 3% (13 July), but the 12 month rates are still very high (20.2% 13 July) which does suggest that while market participants are fairly sure the peg is safe in the short term, they are not at all convinced about what is going to happen in the longer term. And in this they seem to be making a valid judgement, since this is the situation at the time of writing.

Meatime Latvia's natality continues to suffer under the weight of the crisis, there were 1750 live births in May, down 15.3% on May 2008. Thus, not only are we playing with the countries short term future here, we are also putting the possibility of having a long term one at risk.

Where Is The Endgame?

When it comes to the short term dynamics of the looming currency crisis in Emerging Europe, one of the Baltic Three, probably Latvia, will most likely be the first to concede its peg, as Eduardo Levy-Yeyati says this is just too painful, and the loss of GDP which is taking place while the politicians are dithering is fearful.

But when Latvia does leave its peg, then others are almost bound to follow. Everything depends on whether the EU Commission and the IMF are proactive or limit themselves to a mere reactive, problem-containment role. If the Latvian currency realignment is done in an organised and systematic fashion, then it may, even at this late date, be a containable process. For this to happen the EU Commission have to stop playing with the politics of the situation, realise that the Maastricht criteria were not written in tablets of stone, and start to formulate a reasonable exit stratgey for all the Eastern members of the EU. They need, that is, to start thinking practical economics, the way the IMF now seem to be doing. The macro economics of this was always clear and straightforward.

But if the Latvian situation is simply left to fester, and the country falls into the grip of a growing political anarchy, then containment will be much more difficult, since panic will more than likely set in.

A similar situation pertains in Bulgaria (see my latest post on Bulgaria, since the similatities are evident). Absent a Latvian devaluation, it is not unthinkable that the Lev peg may be maintained in Bulgaria for another year or so. But if the Bulgarian authorities do go down this road, then we face the severe risk of a a further raggedy ending, since the problem is not one of sustaining the peg, but of restoring competitiveness and economic growth, and this is much more difficult without a formal devaluation. And if Bulgaria does go hurtling off that cliff on which it is currently perched, then just be damn careful it doesn't drag half of South Eastern Europe careering after it. The EU Commission need to begin to resolve this mess, and the need to begin now!

Estonia's Neck Goes Into A Latvian-style Noose

2009-06-30T13:10:00.001+02:00

Well, today is the 30 of June, and still no news from the IMF on releasing the next tranche of the Latvian loan. Perhaps this is one of the reasons why (via Ott Umelas at Bloomberg).

Estonia’s fiscal deficit under European Union terms more than doubled in the first quarter from a year earlier, indicating the Baltic country may not be able to adopt the euro in January 2011. The deficit, including social security and state and municipal spending, rose to 5.57 billion krooni ($502 million) from 2.06 billion krooni a year earlier, according to data published on the statistics office’s Web site today. The gap corresponds to 2.5 percent of gross domestic product, according to Bloomberg calculations based on the Finance Ministry’s forecast for Estonian GDP for 2009.

The first-quarter figure means the government will have to keep the deficit at 0.5 percent of GDP for the rest of the year to meet euro-entry criteria. Finance Minister Jurgen Ligi has said he sees no improvement in the economy before the third quarter. The minority Cabinet of Prime Minister Andrus Ansip has cut the 2009 budget deficit by 16 billion krooni, or 7.3 percent of GDP, in recent months to avoid depleting state reserves and keep the fiscal deficit at last year’s level of 3 percent of GDP, the same as the EU’s budget-deficit threshold. This would allow Estonia to adopt the euro in January 2011, the government’s main economic goal.

So why a "Latvian-style" noose? Because these countries have built for themselves a sort of "paradox of fiscal thrift" connundrum, whereby the more you cut, the more GDP falls, the more revenue rises, the more spending grows, the more the fiscal deficit goes up, the more you have to cut, and so on. In the end, as Kenneth Rogoff said yesterday, it simply becomes too painful. There seems no way Estonia can achieve a 3 percent deficit this year at this point. And remember what IMF First Deputy Managing Director John Lipsky said last week.

“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”.

Estonia now has no exit strategy, at least not to join the euro in 2011 it doesn't And then we have Lithuania and Bulgaria to think about. Basically, the ECB and the European Commission should never have drawn a line in the sand across the original Maastricht criteria. But it's too late for that now.

For Background Reading and Arguments on All This, See:

Why The IMF's Decision To Agree A Lavian Bailout Programme Without Devaluation Is A Mistake
Why Latvia Needs To Devalue Soon - A Reply To Christoph Rosenberg
Latvia - Devalue Now or Devalue Later
The Long And Difficult Road To Wage Cuts As An Alternative To Devaluation
Why You Need Devaluation - An Open Letter To The People Of Estonia<
Devaluation, Euro Membership And Loan Defaults - Some Thoughts For My Critics

And For Why It Is The Baltics Have The Problem In The First Place, See

Is The Latvian Economy Running Out Of People?

The Clock Is Ticking Away Under Latvia
Taking Solow Seriously - Does Neoclassical Steady State Growth Really Exist?
Latvian Population Dynamics
Hard or Soft Landing in Latvia?
Latvian Fertility

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

2009-06-29T17:56:00.000+02:00

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.

Update

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.

Facebook Links

2009-06-20T07:57:00.000+02:00

Quietly clicking my way through Bloomberg last Sunday afternoon, I came across this:

Facebook Members Register Names at 550 a Second

Facebook Inc., the world’s largest social-networking site, said members registered new user names at a rate of more than 550 a second after the company offered people the chance to claim a personalized Web address.

Facebook started accepted registrations at midnight New York time on a first-come, first-served basis. Within the first seven minutes, 345,000 people had claimed user names, said Larry Yu, a spokesman for Palo Alto, California-based Facebook. Within 15 minutes, 500,000 users had grabbed a name.

Mein Gott, I thought to myself, if 550 people a second are doing something, they can't all be wrong. So I immediately signed up. Actually, this isn't my first experience with social networking since I did try Orkut out some years back, but somehow I didn't quite get the point. Either I was missing something, or Orkut was. Now I think I've finally got it. Perhaps the technology has improved, or perhaps I have. As I said in one of my first postings:

Ok. This is just what I've always wanted really. A quick'n dirty personal blog. Here we go. Boy am I going to enjoy this.

Daniel Dresner once broke bloggers down into two groups, the "thinkers" and the "linkers". I probably would be immodest enough to suggest that most of my material falls into the first category (my postings are lo-o-o-ng, horribly long), but since I don't fit any mould, and Iam hard to typecast, I also have that hidden "linker" part, struggling within and desperate to come out. Which is why Facebook is just great.

In addition, on blogs like this I can probably only manage to post something worthwhile perhaps once or twice a month, and there is news everyday.

So, if you want some of that up to the minute "breaking" stuff, and are willing to submit yourself to a good dose of link spam, why not come on in and subscribe to my new state-of-the-art blog? You can either send me a friend request via FB, or mail me direct (you can find the mail on my Roubini Global page). Let's all go and take a long hard look at the future, you never know, it might just work.

Another Round in Latvia?

2009-06-17T13:09:00.001+02:00

By Claus Vistesen: Copenhagen

I will forgive my readers if they think that my coverage of the recent debacle surrounding the potential for an imminent devaluation in Latvia has been a bit asymmetric. I mean, here I was; throwing fuel on the bonfire when it looked as if the cracks would make the edifice tumble and now as it seems that those cracks have been temporarily mended, I have gone silent. Well, not entirely then, and this post is thus to show that I actually do attempt to provide a balanced coverage.

Consequently, it seems as if the defences will hold in Latvia, but the apparent vote of confidence from the IMF and the EU commission and thus promises that the external loan financing will continue will not come for free. In order to make due on the loans the Latvian government is planning an unprecented range of spending cuts amounting to an astonishing 10% of the entire fiscal budget according to Bloomberg reporter Aaron Eglitis. These massive cuts include, among other things, a 10% pension reductions and a full fat 20% wage reductions for state employees. As prime minister Dombrovskis is quoted; these cuts should be more than enough to please the debtors in the form of the EU and, most notably, the IMF to whose mercy Latvia finds itself. One would surely hope for Dombrovskis that he is right.

And by all means, it does seem as if markets have been calmed so far [click on picture for better viewing].

As we can see overnight rates have fallen to much more comfortable levels the past few days and we have even had the news that the central bank were actually selling Lats in the open market in stead of its hitherto valiant efforts to maintain the peg, by sucking up domestic Lat liquidity pushing overnight rates up to a massive 100-200% according to a number of, I should say, unofficial reports. Medium term financing in the form of the 3 month and 6 month RIGIBOR remain elevated compared to last month, but so far the massive squeeze in short term financing seems to have abated. Overnight rates consequently fell from an officially reported high of 24.60% to 8% on the 15th of June and further down to a soothing 5% here on Tuesday.

Does it end here then? This seems to be the inevitable question we must ask ourselves.

I have my doubts. First of all, it is difficult to see the big difference here. The fundamentals still look anything but solid and the underlying weaknesses remain. As Edward noted recently in a thorough analysis of Latvia's long term economic potential, the crisis has long and deep roots which go beyond the question of default now or default later. More importantly however, Latvia has now effectively begun a great experiment to see whether it pays off to literally dismantle one's society with the aim to fulfill a distinctly narrow economic objective in the form of a fixed exchange rate. To add insult to injury, the peg itself is not the main goal. Eurozone membership is, and apart from the obvious question of whether such a membership would be a desirable outcome for Latvia at all, I have my serious doubt that we will ever get there.

But that is somwhat for the long term. In the short term, the horizon is still littered with uncertainty and I tend to agree with Danske Bank's Lars Christenses as he dryly notes:

“There really hasn’t been any fundamental change,” said Lars Christensen, head of emerging markets at Danske Bank A/S in Copenhagen. “The only thing that has changed is how long they can postpone a devaluation. The issues are still there, and what will happen when they need the next loan installment?”

This sounds about right to me and although it distinctly seems as if Latvian policy makers are determined to do whatever it takes, the costs will be immense and one has to wonder whether the fort will hold forever? I don't think it will.

The Clock Is Ticking Away Under Latvia

2009-06-13T22:54:00.000+02:00

As the European Commision and the IMF conduct their latest post-Keynesian "social and economic experiment" in Latvia to see whether it is possible to revive an economy which is contracting at an annual rate of 18% under the weight of debt deflation relying almost exclusively on a process of drastic fiscal cuts - a process which today is glorified with the name of "internal devaluation" but which in the 1930s was simply called what it is: wage and price deflation - a new problem looms its head. What, we might like to ask ourselves will be the long run consequence for Latvia's already fragile demographic dynamic if we don't get a most-optimistic-scenario-best-case outcome here? That is, if instead of a devaluation-driven "V" shaped recovery, we get not a "U" shaped one (the optimistic scenario), but rather "L" shaped stagnation (a distinct possibility on my view, if wages and prices simply take too long correcting to competitive rates) what will be the implications for the longer term future of the country?

The question I want ask here is simply whether or not short term decision taking on the part of the Latvian government (the crisis "exit strategy") may not produce knock-on effects on the short term decision process of potential Latvian parents leading them to postpone decisions on parenthood, such that the impact of the crisis is a further deterioration in long run population dynamics, and hence, ironically, in potential economic performance? What I am asking is whether or not there may be a kind of "vicious circularity", whereby one negative feedback process influences another in a way which produces a very unfortunate outcome. Not for nothing do we say that social systems are complex ones!

But before we go into the nitty gritty of all this, I would like to just take a quick look at two charts.

Structurally, they look quite similar don't they? They are both output charts, showing year-on-year changes in production. The second is a chart for industrial products, and the first is a chart for children. Strange they should look so similar, isn't it? Or is it? Below I will go into some recent work by economists and demographers which providing a theoretical background within which we may be better able to understand the sort of complex processes we can see operating in Latvia. At the end of the post we will then breifly take a brief look at some of the conclusions it might be possible to draw from what is happening.

Theoretical Background

Basically there are two key line of approach which may help get to grips with the present situation, one of these is the Low Fertility Trap hypothesis advanced by the Austrian demographer Wolfgang Lutz. The other is the cohort-size-driven relative-income-hypothesis advanced by US economist Richard Easterlin. You can find a nice summary of Wolfgang Lutz's low fertility trap hypothesis in this earlier post by Claus Vistesen. Essentially Lutz argues that the negative dynamic associated with long term below replacement fertility may produce self reinforcing processes such that the anticipated "rebound" in fertility levels simply does not take place. Needless to say there is considerable (negative) evidence in support of the idea that societies where fertility falls to "lowest-low" levels (defined as below 1.3) have considerable difficulty in reovering sustainable longer term fertility levels (circa 2.1) even if the reasons for such difficulty are still a matter for debate. Essentially there are three components to the Lutz hypothesis, and these can be seen in the diagram below:

As Lutz says the key idea is that once fertility falls below a certain level (and even in the event that the hypothesis proved to be well founded this level could only be determined empirically, on the basis of actual experience) a self-reinforcing demographic regime may be established from which it is hard to escape, in the sense of raising fertility back up towards replacement levels. The cut-off point which Lutz et al start from is 1.5 (and in this they take their lead from a proposal by Peter Macdonald in this paper ). This figure does seem to have some coherence in terms of actual experience to date, since with the exception of Denmark - which did briefly fall under 1.5 tfr in the 1990s - no country seems to have gone below this and come, and stayed, back up again.

Now Lutz identifies three potential self reinforcing processes - population momentum, ideational processes, and economic factors - but in this post I want to focus on one of these, the economic one. The explanatory mechanisms we are offered are full of self-reinforcing feedback processes, as can be seen from the diagram below (incidentally please click over the image for better viewing):

Based on work which Claus Vistesen and I have been doing applying Modgigliani's Life Cycle Model of consumption and savings in the context of rising population median ages I think it is now possible to flesh out just how some of these processes work (see, for example, this post, or my Taking Solow Seriously - Does Neoclassical Steady State Growth Really Exist? post, or Claus here on Japan's engine failure).

Essentially, the argument we are developing is that as median ages rise beyond a certain point - 42/43 let's say - the structural characteristics of an economy change. While younger economies - let's say with median ages in the 35 - 39 range - are driven by large scale borrowing (on aggregate), domestic consumption surges, and, of course imports and current account deficits to match the domestic savings weaknesses. More elderly societies exhibit higher relative savings levels (Japan, Germany and Sweden would be the classic cases), can no longer rely on domestic consumption to anything like the same extent, and increasingly come to depend on export growth and lending abroad to achieve economic growth. This situation is highly unstable, as we are witnessing now in the Swedish case, since as the consumer booms in the younger societies fail, exports slump and many of the loans go bad. This is not a very satisfactory state of affairs, but it is in fact what is happening. This is the demographic transition we are all part of.

Basically, I would argue it is possible to think about four economic mechanisms which "feed" the low fertilility "loop" in the longer run.

1) In order to compete for exports the elderly export-dependent economies have a permanent pressure on their tradeable sectors, whereby outsourcing is continuous and ongoing, wages are continuously compressed, and structural reform is permanent. Since the very export dependence is only further reinforced by the continuing process of change in the population pyramid (ie domestic demand never "recovers" as such) this is all self-reinforcing. That is to say, the more time passes the more there is downward pressure on the wages of young people, and this pressure evidently influences decision taking about parenthood among young people.

Indeed the negative re-inforcing mechanism on domestic consumption can be even stronger, as can be seen from this chart for German retail sales. These, it will be noted, have been falling since the start of 2007, despite the fact that 2007 was a "bumper" year for the German economy. This has nothing to do, please note, with any supposed impact of the global economic crisis, since it evidently pre-dates this. And what happened in January 2007 which set this decline in motion? Guess what, a three percent hike in VAT consumption tax. The hike was, ironically, introduced in order to help pay ageing society health costs. So just like the theory predicts, the consumption of young people is squeezed to help pay the cost of high elderly dependency ratios, and it is squeezed with important structural consequences for the economy. There has been a great deal of noise and hot air spoken of late about who did, and who did not, see this crisis coming, but I would direct your attention to this post by Claus Vistesen on A Fistful of Euros in February 2007 - a (then) 22 year old business school student in economics at the Copenhagen Business School giving Master Classes in economics.

So watch out Latvia, since you just hiked your VAT consumption tax!

2) Due to the comparatively lacklustre economic growth performance there is a constant shortfall in the tax income necessary to guarantee existing welfare and pension commitments. This shortfall is produced by the low levels of trend growth (think Italy, Germany and Japan) which you can generate exclusively on the basis of export growth. Since the changing pyramid structure (here is another part of the feedback loop) means that an increasing part of the voting population comes to be over 50, the tendency, as we are in fact seeing, is to attempt to maintain welfare commitments by increasing the tax burden, which affects the consumption and earning possibilities of the young directly.

3) Migration factors. As societies age, the general lack of economy growth, and the tendency towards increased retirement ages and higher participation rates at the older ages, all mean that there is a relative lack of well paying jobs at the entry level, a phenomenon which makes outward migration an increasingly attractive proposition for educated young people (again, as we are seeing in Germany and in Italy). This out-migration once more feeds back into the structural evolution of the population pyramid. If the out migration is in part compensated for by in-migration of lower skilled workers, then this tends to retard the process of moving towards higher value work, a feedback which one more time would seem to find reflection in lower wage levels on average in the younger age groups.

4) Impediments on pro-natal policies. The pressure on fiscal resources which result from the previous three factors mean that effectively it becomes increasingly difficult to generate the resources to finance really meaningful pro-natal policies which might attempt to "tease" fertility back up towards a higher level. As time goes by this problem only gets worse.

Easterlin and Macunovich

Lutz, for his part, bases his economic feedback mechanism on the cohort impact theory of Richard Easterlin and on the relative income hypothesis he uses as the transmission mechanism for this. According to Easterlin changing cohort size produces either a crowding-out (the baby boom) or a crowding-in (declining fertility) phenomenon. The hypothesis posits that, other things being constant, the economic and social fortunes of a cohort (those born in a given year) tend to vary inversely with the relative size of that cohort, which is itself approximated by the crude birth rate in the period surrounding the cohort's birth. The cohort mechanisms operate mainly through three large social institutions – the family, the school and the labour market. Diane Macunovich has a good summary of Easterlin's ideas and their application to fertility changes in Relative Cohort Size, Source of A Unifying Theory of the Global Fertility Transition (Macunovich, 2000, online here).

The operation of this general 'crowding mechanism' means that large birth cohorts face adverse economic and social conditions, higher unemployment, and lower than expected wages, outcomes which are significantly at odds with their material aspirations. As a result, they postpone family formation and have fewer children. This line of research now represents a long-standing tradition in the United States, where an ongoing body of work (Easterlin 1975, 1978, 1980, 1987, Macunovich 1998a, 1998b, 2000, 2002, Bloom, Freeman, and Korenman, 1987, Korenman and Neumark, 2000) has posited the idea that the relative size of young cohorts entering the labour market has far-reaching implications for wages, inflation, unemployment rates, etc, as well as for a variety of cohort impacting factors like living standards and family behaviour. The core idea behind the crowding thesis is also now being applied in studies of the 'greying' phenomenon in the United States as the large 'boom generation' steadily approaches retirement age. .

On the other hand, the crowding-in syndrome should mean that the reduced cohorts which follow the fertility decline should find employment opportunities easier to obtain, and salaries relatively higher. The result of this is rising income expectations and aspirations for a better life all round. Insofar as these are realised there is an associated "birth spurt" as young people's confidence in starting families (or adding to them) grows and grows. This is the phenomenon we saw at work in Latvia - complete with the very high rates of wage inflation - in the years of boom - even if the heightened aspirations was more the product of a "pinching" of young labour supply through out migration than it was of lower fertility at that point, that impact is still to come basically. Now, however, we see the other side of the coin, as the sharp contraction produced by the rapid deflating of the earlier boom throws everything into reverse gear.

The argument here is not that demographic movements produce the boom bust, but that such processes serve to amplify the distortions, and this is what we can quite clearly see happening in Latvia I feel.

So far Maconovich and Easterlin, but Lutz and his colleagues offer a further, and most suggestive) direction for analysis: low fertiliy (via the population momentum impact) accelerates the process of societal ageing, and boosts the importance of the elderly dependency ratio. This in turn cuts growing pressure on health, welfare and pension benefits, generates a general pessimism about the future and lowers expectations about future income growth. Thus the earlier rising income expectations which were previously associated with those "narrow" cohorts, now become more difficult to sustain as the fiscal burden weighs down on younger generations, and this has the consequence that they continually postpone starting families.

The general pessimism that ensues, coupled with ongoing pension reforms which effectively reduce guaranteed benefits at a time when life expectancy is increasing, only serves to produce an increase in saving for the future, which, of course immediately represents a drag on current consumption. The drag on consumption leads to a far more lethargic level of economic growth, and this only adds to the negative cycle since it effectively induces young people to delay further having children in order to attempt to maintain current income. This type of economic chain reaction, especially plausible in the light of what we have actually seen happening in Germany and Japan (the two countries who have advanced furthest in this particular demographic transition), does seem to be one of the possible mechanisms through which Lutz's trap - should it in fact exist - might operate.

In fact Macunovich takes the Easterlin theory even further, and tries to use it to develop a general theory of the whole demographic transition as a process operating almost in its entirety via cohort effects. At this level I find her argument not entirely convincing. The cohort dimension is however very evident in the US baby-boom phenomenon, and the subsequent fertility reaction, and indeed this has had the consequence that population ageing is being seen very much as a cohort phenomenon in the United States, but this US experience is perhaps hard to generalise. What is evident though, is that the cohort phenomenon, and the changes in economic dynamic that it produces, does generate very real and important short run effects, and this is just where Lutz's idea becomes important, since if the population process is not a homeostatic (self regulating) one (which it isn't at this point) but rather a path-dependent one, where long run outcomes are highly sensitive to short run changes, then the short run impacts we are seeing operating now in a country like Latvia (and Hungary, and Ukraine) become potentially very important indeed, since - via another of Lutz's pathways (the population momentum one) they can in fact make the difference between long run sustainablility and unsustainability for a country, and I do wish that the EU Commission and the IMF would open up their ears, and listen to this argument, at least just a little bit. The evidence is mounting, the only thing which is not clear is for how long people are effectively able to ignore it. Not until it is too late to react, I hope.

The Relative Income Low Fertility Trap Mechanism At Work In Latvia?

Well, as I said ealier both the argument and the evidence on how a restricted cohort might lead to strong rising income expectations are clear enough, and now there is little doubt that Latvia is facing a very sharp economic contraction. This is leading to falling living standards, deteriorating employment stability expectations, growing pessimism, and of course (as we will see below) falling births.

Indeed only this weekend the Latvian Cabinet met in emergency session, in order to reach to agreement a the package of measures to be put before parliament. These measures - I think it is hard this part really is the unkindest "cut" of all - are actually being demanded by the leaders of the European Union (via their representatives on the European Commission) in order to agree the release of the next tranche of the Latvian "bail out" loan, and among measures being discussed are a reduction of 10% in both state pensions and maternity and child care benefit. The former may be hard, but unavoidable the latter, as we will see, more or less amounts to voluntarily agreeing to slit your own thoat.

Monthly Births The New "Lagged" Indicator For Latvia?

Let's take a look at the problem. Births have long been falling in Latvia. In the mid 1980s they hit a peak, at a little over 40,000 annually. Then, in harmony with what most economists and demographers would expect, fertility dropped sharply, and hit a historic low in the mid 1990s (under the impact of the transition shock) - with a peak to trough fall of something over 50%. As we can then see in the chart below, fertility rebounded in the late 1990s under the impact of rising living standards, and due to the fact that more or less record numbers of people entered the childbearing age group.

Unsurprisingly then, the Latvian period fertility measure (the total fertility rate) started to tick upwards again from the record low of 1.12 hit in 1998.

But what has been happening to births since the crisis broke out? Well, fortunately the Latvian statistics office do publish monthly live birth stats, so this is one indicator we can track fairly easily. Here's the chart from the start of 2007, but there is so much volatility (seasonal variation?) that it is hard to see exactly what is going on.

However, if we apply an old economist's trick, and look at the year on year variation, the pattern gets a bit easier to see.

And then if we apply another seasoned economist's "quick and dirty" procedure to iron out a bit of the seasonal variation by smoothing with a three month moving average chart, the picture seems very clear indeed. As output drops, and living standards fall, so to does Latvian society's "production of children".

And of course, the negative population dynamic goes even further than this, since we have out-migration to think about. We have official monthly figures from the stats office, and even if these undoubtedly underestimate the size of the movement, the data quite possibly does give reasonable evidence of the trend, and what we can see in the chart below is not good news, since the rate of emigration is obviously rising.

Now these two factors, migration and births have a direct impact on a third indicator - population median age, and as we can see this is rising in Latvia, and very rapidly, with pronounced and important implications for both elderly dependence and economic performance. And of course, the median age assumptions for future fertility between now and 2020 where made on the more postivive outlook of improving fertility which prevailed before the crisis.

Now, from our more general studies of the economic impacts of ageing population, it is apparent to Claus Vistesen and I that the medain age of forty is something of a watershed for any population. The entire structural characteristics of an economy begin to change from this point in the ageing process, and the economy becomes increasingly export dependent as we can see in the case of high median age societies like Japan, Germany and Sweden.

But something is different in the Baltics, since male life expectancy is much lower than in the above mentioned countries, on average nearly 10 years lower, as can be seen from the comparison between Germany and Latvia to be seen in the chart below.

Now, from a strictly pragmatic point of view someone might be tempted to say, well "where's the problem there, less pensions to pay" (leaving aside the obvious humane issues), but this isn't the point, since the dependency ratios are set to rise sharply even assuming this mortality rate. The problem is that most of the remedies for offsetting the ageing population dependency issues assume the viability of raising labour force participation levels in the 55 to 65 age groups, and in the Latvian case many of the men involved - the ones whose infusion into the labour force is set to "dynamise" the economy - either simply aren't there, or are in very poor health.

So no, this is not simply one more plea for leaders of Latvia to get to work and devalue the currency. It is a plea to those leaders to stop and think a little about the implications of what they are doing. Surely no one can be happy to see their country flushed down the tubes in quite this way?

And for purposes of comparison, here is the chart for Hungary. Actually this one really is fascinating for those of you who know anything about what has been happening in Hungary. In June 2006 there was a major financial crisis in Hungary. And guess what? You can see this in the births nine months later. Then births recover again, and then, of course, they start to deteriorate. Now the crisis hit Hungary sharply in October 2008, so if this theory is at all right, we should see another sharp deterioration in Hungarian births around August/September 2009.

References

Bloom, D., R. Freeman and S. Korenman. 1987. “The Labor Market Consequences of Generational Crowding”, European Journal of Population, 1987, 131–176.

Easterlin RA (1975). “An Economic Framework for Fertility Analysis” Studies in Family Planning, 6(3):54-63.

Easterlin RA (1978). "What Will 1984 be Like? Socioeconomic Implications of Recent Twists in Age Structure," Demography, 15(4):397-432 (November).

Easterlin RA (1980). Birth and Fortune: The Impact of Numbers on Personal Welfare, Basic Books: New York.

Easterlin RA (1987). “Easterlin Hypothesis”, pp.1-4 in J Eatwell, M Milgate, P Newman (eds) The New Palgrave: A Dictionary of Economics 2, Stockton Press: New York.

Korenman S and Neumark D (1997). Cohort Crowding and Youth Labor Markets: a cross-national analysis”, NBER #6031,
Cambridge, MA.

Lutz, Wolfgang, Maria Rita Testa, Vegard Skirbekk, 2006. The "Low Fertility Trap" Hypothesis, Paper presented at the Population Association of America (PAA) 2006 Annual Meeting, March 30 - April 1, Los Angeles, California

Lutz, Wolfgang, Maria Rita Testa, Vegard Skirbekk, 2005. The "Low Fertility Trap" Hypothesis power point presentation at the Postponement of Childbearing in Europe conference held at the Vienna Institute of Demography, 1-3 December 2005, Vienna, Austria

Macunovich, D.J. 2002, Birth Quake: The Baby Boom and Its Aftershocks. Chicago: University of Chicago Press

Macunovich, D.J. 2000, Relative Cohort Size: Source of a Unifying Theory of Global Fertility Transition? Population and Development Review, Volume 26 Issue 2, June 2000

Macunovich, D.J. 1998a, Relative Cohort Size and Inequality in the U.S. American Economic Review (Papers and Proceedings) May 1998 88(2):259-264

Macunovich, D. J. (1998) “Fertility and the Easterlin hypothesis: An assessment of the literature.” Journal of Population Economics 11:53-111.

A Good/Bad Time To Stop Having Babies

2009-06-13T21:48:00.000+02:00

Guest post by Doug Muir

This post originally appeared on A Fistful Of Euros In March.

Here follows a bit of demographic speculation. It’s guesswork right now, but we’ll know in a year or two if I’m right.

Interesting Fact #1: birthrates tend to drop during recessions, and the drop tends to correlate with both the severity of the recession and the speed of its onset. The current recession is looking to be a bad one, and it happened pretty quickly, so we can reasonably expect a sharp drop in birth rates. I say “expect” because it hasn’t happened yet — human biology being what it is, we won’t see the first effects until nine months after most people became aware of the recession. This summer, more or less.

– Makes sense, right? Babies are expensive; more to the point, babies limit your options. They make it harder to move to a different city, change careers, stop working for a while. When times are hard and uncertain, babies become a luxury. For individuals and families, a recession is a good time to put childbearing on hold.

However…

Interesting Fact #2: all across Communist Eastern Europe, birth rates declined slowly through the 1970s and ’80s… and then crashed after 1990, dropping to very low levels and staying there through most of the decade. In some countries they bounced back a bit, in others not, but in almost all cases there’s a big “birth gap” from about 1991 until at least 1997, and often later. This is in contrast to, say, Germany or Italy or Greece, where birthrates declined more smoothly.

Put these two facts together, and there’s a problem.
See, a country’s total birthrate depends on two things. One is the fertility of its women — especially its women in peak childbearing years, 18-35. The other is the total number of women in those childbearing years. If your country has very few young women, then the country as a whole can’t have a high birth rate, even if every young woman is having lots of kids.

Still with me? Well, consider: Eastern Europe saw birthrates crash after 1990. That means that, all across the region, the number of fertile women is starting to decline sharply. In Russia and Ukraine, Bulgaria and Serbia and Hungary, there just aren’t many 18 year olds relative to the total population. And year by year, as the “empty” birth cohorts of the 1990s move into their peak child-bearing years, the number of fertile women will continue to decline.

Okay, this isn’t news. Demographic projections have taken it into account for years. But now there’s a new factor: the recession.

What’s likely to happen is that the countries of Eastern Europe will be hit with a double punch: few childbearing women, and those women having few children. Demographically, the recession is coming at the very worst possible time: roughly one generation after birthrates crashed across the region. This suggests that over the next couple of years, countries like Russia and Ukraine are going to see record low birthrates in both absolute and relative terms. This, in turn, suggests that starting next year, long-term demographic projections for those countries are going to start nosing downwards.

Now, there is one glimmer of hope here. Across most of Eastern Europe, women still tend to start having children sooner than their Western sisters. The average age of birthing mothers in Germany is 29.5; in Sweden, it’s over 30; in Bulgaria, it’s about 25. So there is some slack, demographically speaking. If the recession is short, young women can simply pick up where they would have, only a year or two later. The babies not born in 2010 might just be born in 2012 instead. In this respect, the East is better off than the West; countries where the average birthing mother is already over 30 don’t have this margin.

But if the hard times drag on… well, some of the demographic projections for Eastern Europe were pretty drastic already. By the 2030s, Romania’s population is supposed to shrink by about 10%, Bulgaria’s by over 15%, Ukraine’s by roughly 20%. The recession is likely to make those numbers even more alarming.

So: a good time for individual women and families to stop having babies. But for their countries, maybe not so much.

Lost In The Latvian Translation?

2009-06-13T20:16:00.000+02:00

According to reports in the Baltic Course newspaper, Latvian Finance Minister Einars Repse (of the New Era party) is not against the strikes and rallies that are being organised in response to the proposed state budget cuts, he is, however, opposed to any violent protests and subsequent civil unrest.

Rallies and strikes are a good thing, but disturbances will not solve anything," Repse pointed out after a meeting with Latvian Free Trade Unions Association representatives today. As the finance minister explains, he realizes that "people are really concerned and desperate", however, damaging government buildings will not contribute to improving the situation in any way as repairing the buildings would have to be paid for with state budget money anyway.

I'm sure he can't have quite put it like this - if he did then a Finance Minister actually supporting strikes against his own measures would be a first, I think (what is happening in Latvia is surreal, but not this surreal, surely) - and that the question is a translation one, but still. It does illustrate the difficult position local politicians are being put in when it comes to defending the EU Commission and IMF inspired measures in the face of their own voters - as I already forecast it would be in my post The Long And Difficult Road To Wage Cuts As An Alternative To Devaluation back in January. More to the point is this, which is real enough:

Working pensioners' pensions will be slashed 70%, all other pensioners will see their pensions shrink by 10%. Also maternity and child care benefits will be cut by 10%.

Now, I know the aim is to bring prices down, but how can a country which is effectively dying for lack of children (post coming on this later) be actually cutting child allowances. Frankly I find this even harder to believe than the idea of a Finance Minister supporting strikes against his own policies. It is nevertheless true. Everything, I see, is possibile in Latvia, except, of course, devaluation.

More "Green Shoots" - Latvian Exports, German and Japanese Capital Goods Output

2009-06-10T09:42:00.000+02:00

Well yesterday there was plenty of fresh news for collectors of "green shoot" negatives. Starting in Latvia, where the Statistics Office announced that exports were down by 30.9% year on year in April (the fastest rate of decline to date), while imports dropped a massive 45.6%. It looks like the Latvian Parliament is set to pass another round of budget cuts today, in the hope that these will bring back growth (how is not clear). All I can say is "these poor people", I do wish those who were advising them had a better idea what they were doing.

In Luxembourg today, Latvian Finance Minister Einars Repse told reports: "We will be cutting no less than 10 percent of our GDP over three years but this will bring our imbalances down and pave a very solid basis for recovery,". He means, of course, expenditure equivalent to 10% of GDP - which means 3.3 percent a year. The mystery is, how such cuts will help restore growth. All West European economies are increasing spending, following the normal intuition of supporting an economy in time of weakness. And remember, Latvia has not gotten into this mess by excessive government spending. Back in 2007, before all this started, debt to GDP was around 10%. It's the money lost by the banking sector (with Parex in the forefront) which is causing all this. Oh, I know, I know, they are following the new orthodoxy:

In emerging market countries with debt overhangs, the “Keynesian” effect of fiscal adjustment is likely to be outweighed by “non-Keynesian” effects related to expectations and credibility. Non- Keynesian effects have to do with the offsetting response of private saving to policy-related changes in public saving. In particular, if fiscal adjustment credibly signals improved public sector solvency, a fiscal contraction could turn out to be expansionary, as private consumption rises based on the view that future tax hikes will be smaller than previously envisaged.
IMF - Hungary, Request for Stand-By Arrangement, November 4, 2008

But I still have no idea of the exact mechanics of quite how people imagine all this can work in the current environment, when the private sector is also totally loaded up with debt. Meanwhile exports go down and down, falling from 288 million Lats in March, to 274.2 million in April.

The only saving grace here was that the goods trade deficit was also down, and fell from 124.6 million Lat in March to 96.9 million Lat in April.

Basically I agree with the following from Morgan Stanley's Oliver Weeks:

We continue to think that devaluation in Latvia is eventually almost inevitable. The timing seems largely to depend now on the EU, but may not be quite as imminent as the market seems now to expect. We believe the IMF is likely to be reluctant to keep funding the peg, but the EU is paying for most of the support programme, and may choose to accelerate disbursement to delay this another few months while Estonia shores itself up, and perhaps agrees on a loan as protection.....
The government and central bank do not appear quite ready to capitulate yet, and technically fx policy is a decision for the central bank alone. We agree with the views of the advisor that helped to trigger the latest panic but would not make too much of his interview since such views are not uncommon and the government has many advisors.....
We think the government will eventually accept the EU s position has not been to Latvia s benefit, encouraging maintaining the peg but also not allowing EUR entry, hence effectively prolonging the pain. There are also signs that politicians are positioning themselves not to be too damaged by devaluation. Note Scandinavian banks are already positioned short local currencies they will be affected by the wave of defaults to follow but these were eventually likely anyway. We think devaluation is inevitable and obviously getting closer, but this is still not an open market where foreign consensus on devaluation is immediately irresistible.

Which is effectively to say that a move which now has many advantages for Latvia, and few evident disadvantages, is being postponed due to fear of the impact on other countries (and not just Estonia and Lithuania). Latvia is being sacrificed at this point to the "greater good", but the support she is receiving is in the form of loans (to be repaid), not gifts.

First Mover Advantage?

One additional and highly relevant argument to consider is raised by Variant Perception's Jonathan Tepper:

One final point worth making is that defaulting - for a country on the verge of it - is often, paradoxically, not always a bad idea. If you have two countries, both of whose finances are in a fractious state, and one decides to renege on its debt while the other struggles on and tries to meet its commitments, then the former country is generally able to return to financial health more quickly. They can start again and are able to get their economy back to a situation that nurtures growth, while the non-defaulting country struggles on with the damaging spending cuts and tax rises necessary to pay back their creditors. Markets have short memories, and often misprice the risk of the defaulting country once it starts to borrow again. Argentina, for one example, after its default in 2001/02, had to wait only 3 years for its cost of borrowing to return to a level commensurate with a typical emerging market economy (see chart below - click on image for better viewing).

German Capital Goods Output Falls

Let's start with the story so far. According to GDP data for the first three months of this year, German companies invested 16.2% less in machinery, equipment and vehicles in Q1 than they did in the last quarter of 2008.

But perhaps this fall in investment bottomed out after the first quarter? Well, apparently not, since according to the Economy Ministry in Berlin today, German industrial output declined again in April (over March) with the lead role being taken in the fall by investment goods. Manufacturing output was down 2.9 percent from March (when it rose 0.6 percent), and from a year earlier by 24.2 percent (when adjusted for working day changes).

Output of investment goods such as machines slumped 6.4 percent in April from the previous month, and by 29.6 percent year on year (following a 23.9 percent drop in March). Production of intermediate goods fell 1 percent and manufacturing output slipped 2.9 percent from March. Output of consumer goods rose 0.5 percent in April from the previous month. Energy production was up 5.8 percent and construction output rose 0.5 percent.

And despite the fact that many were putting a brave face on yesterday's April industrial orders data, orders for investment good were down month on month by 4.4 percent in April (following a 5.6 percent rise in March over February.

German industrial orders, a key indicator in Europe's biggest economy, were stable in April compared with the previous month, the economy ministry said on Monday. Orders had risen strongly in March, their first rise in six months, and the ministry said the latest reading, a change of exactly zero percent, showed a "noticeable improvement in the medium-term perspective" for German industries. The March figure was revised slightly higher moreover to a gain of 3.7 percent from a previous estimate of 3.3 percent. Analysts were divided on what the steady result meant, but most saw the glass as half-full as Germany struggles to pull out of its worst post-war slump.

Export orders for investment goods were down 5.1 percent following a 9.1 percent increase in March. Year on year, export orders for investment goods were down no less than 46 percent (down from only a 34.9 percent annual drop in March). Anyone who can see signs of a developing recovery here - the German Technology Ministry said they saw signs of a "noticeable improvement in the medium-term perspective" (see citation above) - might like to explain to me how, since I certainly can't see it.

Similar results were found in a survey by Frankfurt-based trade association VDMA. German plant and machinery orders dropped an annual 58 percent, the most since data collection started in 1950, after falling an annual 35 percent in March, according to the association. Export orders were down 60 percent while domestic demand dropped 52 percent. The VDMA is forecasting a decline in orders of between 10 percent and 20 percent for the year as a whole.

“Signs of a trough aren’t recognizable yet,” according to VDMA Chief Economist Ralph Wiechers.

Japan A Similar Picture

Japan’s economy - just to remind ourselves - shrank at a record rate in the first quarter as exports collapsed and businesses drastically cut back on investment spending (an almost identical picture to the German one). Gross domestic product fell by an annualized 15.2 percent in the three months ended March 31, following a revised fourth- quarter drop of 14.4 percent. The economy contracted 3.5 percent in the year ended March 31, the most since records began in 1955.

As in Germany, employment and consumer spending held up reasonably well - only dropped by 1.1 percent year on year. But business investment was down a record annual 10.4 percent, and a massive 35.5% over the last quarter. And companies are likely to keep cutting spending because the decline in external demand has left factories operating well below capacity level, and semi idle workforces can only be retained for so long.

While industrial output bounced back a bit in April, general machinery products continued to fall, and were down 14.5 percent month on month, a sign that managers remain wary of upgrading factories and equipment before they are convinced an economic recovery has taken hold. If you look at the chart below (click on image for better viewing) you will see that the year on year drops (indicated by black triangle) in machine output continued to be massive in April, with production of general machinery down almost 50 percent on the year.

And the future continues to look very bleak. Japanese companies plan to slash capital-investment spending by 16% in 2009 according to the business daily Nikkei, the steepest drop in the history of their survey. Companies suggested they expect to spend 22.7 trillion yen ($230 billion) on capital investments in fiscal year 2009, a 4.28 trillion yen decrease from a year ago, according to the survey which covered 1,475 firms.

Previously the steepest cut in spending was a 12% decline in 1993. This year's decline marks the second year in a row that capital-investment spending dropped.The Nikkei reported that with 15 of 17 manufacturing sectors planning capital-investment cuts, spending by manufacturers overall is expected to drop a record 24% to a total of 11.7 trillion yen.

According to the survey, electronics firms will spend 3 trillion yen, a 29% drop from a year ago, and automakers said they'd spend 2.3 trillion yen, a 33% decrease. Among manufacturers, only the food and pharmaceutical industries intend to increase spending.

And the conclusion of all this? Well it is clear that there will be no recovery lead by export dependent economies like Japan and Germany. But this is not the big problem. The big problem is who is actually going to lead the world forward with a new round of import growth? At the present time this is a question without an answer.

And talking of which, I can only agree with this sentiment from Brad Setser:

"Like everyone else, I am curious to see what China’s May trade data tells us. If China truly is going to lead the global recovery, China needs to import more – and not just import more commodities for its (growing) strategic stockpiles."

Brad, you will find if you follow the link over, has been busy digging for green shoots over in the Korean trade data, but he had a hard time finding them.

A Week On the Wild Side (Latvian Edition)

2009-06-07T19:04:00.000+02:00

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.

Latvia - Devalue Now or Devalue Later?

2009-06-03T17:42:00.000+02:00

The Latvian economy is certaily stuck in a hard and not especially pleasent place at the moment, and really one chart tells it all, since as we see above the local interbank overnight interest rates have been storming upwards and through the roof over the last two weeks. As a result of this unfortunate state of affairs the country has attained a higher profile in the international news media than most Latvians would ever have dreamt possible, or even, probably, considered desirable. Ever since Claus Vistesen's last post, my inbox hasn't stopped filling up with reports, analyses, forecasts etc. (apart from Claus, FT Alphaville's Izabella Kaminska has had a steady stream of posts - here, here, here and here - while RGE analyst Mary Stokes is a regular follower of the issues - and see again here for some thoughts on the contagion question).

The first issue that hits you is, can such a small country really be that important? The answer is, yes it can, and for a variety of reasons, although among these one is paramount, the so called "contagion" risk. As Danske Bank put it in their latest Emerging Markets Europe analysis:

Increasing concerns regarding a possible devaluation in Latvia yesterday spilled over into other countries in CEE. Although the direct link between the Baltic markets and others such as Poland, Hungary and Romania is very limited it is only natural that concerns over the situation in Baltic States triggers renewed concerns regarding the position in Central and Eastern Europe where many countries to a greater or lesser extent face problems similar to those in the Baltics. Those most at risk from negative spill-over effects are Latvia’s neighbours Estonia and Lithuania although we would expect contagion to affect countries in the region most like Latvia in terms of macroeconomic imbalancessuch as Romania and Bulgaria.

Personally, I think it possible that the immediate contagion risk may be being a little overdone at the present time. Certainly there will be immediate implications from any eventual Latvian devaluation for Baltic neighbours (and co-peggers) Estonia and Lithuania, and well as for more distant Bulgaria. A Latvian decion to break loose will, effectively, be the end of the road for the pegs, even if the unwinding may not necessarily be immediate. And beyond the Baltics and Bulgaria pressure will inevitably mount on other countries facing longer term economic and financial difficulties like Hungary and Romania (which may leave you asking just who exactly there is left inside the EU but outside the Euro - Poland and the Czech Republic to be precise), but my personal feeling is that while we may see everyone placed under stress we are unlikely to see dramatic short term "negative events". If I were looking for these it would rather be towards Russia I would be looking, and to the future path of oil prices, since if things were to go the wrong way on that front then the shock waves from Russia could easily destabilise all the rest of Central and Eastern Europe at one foul swoop.

But then, my relative lack of alarm on the contagion front stems from my perception of the present crisis in the East as less one of short term liquidity and balance of payments pressures, and more one of a longer term sustainability issues, given the relative poverty of the region when compared with West European neighbours, and the rapid population ageing and decline issues it is facing.

Ideological Lock-in?

Latvia is certainly hemmed in on all fronts at the moment, what with the 18% year on year GDP contraction registered in the first quarter, the projected 9.2% of GDP fiscal deficit for 2009 (if more cuts are not made), the rise of overnight interbank interest rates into the high teens, soaring credit default swap rates - Latvia's five-year credit default swap rose to a high of 721.1 basis points on Thursday - and almost vanishing Lati liquidity inside the country.

But over and beyond the immediate concerns, and contagion risk Latvia is currently a test-bed for a number of issues with implications which extend well beyond the borders of this small Baltic country. In particular three questions stand out.

a) The rather counter intuitive idea - which I call the new orthodoxy in this post - that even during strong recessions a fiscal contraction could turn out to be expansionary, if it signals a long term determination towards fiscal rectitude. The IMF put the idea thus:

In emerging market countries with debt overhangs, the “Keynesian” effect of fiscal adjustment is likely to be outweighed by “non-Keynesian” effects related to expectations and credibility. Non- Keynesian effects have to do with the offsetting response of private saving to policy-related changes in public saving. In particular, if fiscal adjustment credibly signals improved public sector solvency, a fiscal contraction could turn out to be expansionary, as private consumption rises based on the view that future tax hikes will be smaller than previously envisaged.
IMF - Hungary, Request for Stand-By Arrangement, November 4, 2008

b) The idea of "internal devaluation" as a viable strategy for carrying out a substantial correction in relative wages and prices for a country with a currency peg and large balance sheet exposure to foreign exchange loans. Now it may well be that currency peggars are likely soon to become an extinct species, given the difficulties they tend to produce when such pegs unwind, but the Baltic countries may still be considered as test cases for others who don't (for whatever reason) have an independent currency and thus a serviceable monetary policy. Countries like Ireland and Spain, for example, who are facing a sharp correction, but being inside the eurozone currency area have no local currency of their own to devalue and are hence now destined to follow a similar path to the one being pioneered in the Baltics.

c) The idea that structural reforms can - in the context of a country with long term low fertility, declining working age populations and rising elderly dependency ratios - free up sufficient growth potential to offset the underlying population dynamic and, as the IMF put it in the above citation, credibly signal the possibility of future public sector solvency.

So Latvia is at the heart of a massive experiment, of the kind which lead me to lament on my about page that "Economists hitherto have tried hard enough and often enough to change the world, the real difficulty however is to understand it." Since the question I cannot help asking myself in the Latvian context is: to what extent do we really understand what we are doing here?

The thing is, all of the above mentioned theories - "internal devaluation", "stimulatory fiscal tightening" and structural reforms to offset declining working age population - sound splendid enough, but are the the theories themselves actually valid? How do we test them? And do the measures adopted on the basis of "believing" in them actually work? And are there sufficient grounds for accepting both the validity of the thoeries and the efficacy of measures based on them to ask for sacrifice on the scale that is currently being demanded from the Latvian people? And do we have any consensually agreed benchmarks which would enable us to decide whether the measures are working? Do we indeed - and by "we" here I mean the EU Commission and the IMF - have any inspectable performance indicators against which to measure progress?

Certainly, for every inch of success that is painfully clawed forward (the positive CA balance, for example), we seem to be constantly thrown back a yard by a host of additional problems (the growing fiscal deficit issue, etc), and not for the first time, we - the economists - find ourselves playing with fire, when we, of course, aren't the ones who risk getting burnt in the process!

Plethora Of Statements.

Both the European Commission and InternationalMonetary Fund (IMF) have been busying themselves over the last week making extensive statements on Latvia's 2009 budget amendment process - which is, after all - what lies at the heart of the issue. What has been notably absent however in all these public declarations, is any indication about when exactly the much needed money will arrive. And this is not a request for information simply at the convenience of Latvian lawmakers, it is the sort of information market participants badly need to receive in order to take the kind of decisions which would bring the situation more back under control for the Latvian authorities, and meantime the ambiguity continues.

European Economic andMonetary Affairs Commissioner Joaquín Almunia said in his prepared statement he believes the new budgetary proposals to be a step in the right direction. But how much of a step are they, since he also stressed that more was still needed to contain the rapid increase in the budget deficit. So again, just how much more is needed, and are Latvia's politicians capable of delivering? Or is the pain simply too much to stand?

"Sadly, the economic recession is proving more severe than expected inLatvia
bringing hardship for many and increasing the deficit to higherlevels than
expected. Latvia needs to reduce the deficit in asustainable way with
significant budgetary and structural measures,although I acknowledge that the
original fiscal targets in thegovernment's economic program are no longer within
reach. I alsounderstand there are limits on how much the deficit can be reduced
toallow some breathing space for the economy and for the people ofLatvia,
especially the sections of population most in need. I takenote that the
authorities want to control government debt and maintaintheir exchange rate peg.
The supplementary budget presented this weekis a first step. The Commission
wants to support government's efforts.I am looking forward to seeing additional
steps adopted during the second reading of the budget, as announced by the
government,"

On the other hand, Caroline Atkinson, the IMF's director of external relations, restricted herself to saying the fund agrees with the comments made by Joaquin Almunia to the effect that the supplementary budget presented by the government this week represents an initial move in the right direction. "The government's budget is a first step, and there is more work to be done," she said. Again, how much more work?

When directly asked the key question as to whether the IMF would support a depegging of the lat from the euro, she simply stated that the fund hasn't changed its stance. "We have commented before that the situation is challenging and that there is a need for action, and I think the authorities have stressed the importance of controlling the government debt and deficits and maintaining the peg," she said. That is to say, the Fund's position is that on this topic the government decides. On the other hand, with Latvia's financial and currency markets coming under increasingly evident stress, and Prime Minister Valdis Dombrovskis saying the country needs the second portion of the loan by early next week, the Fund remains meticulously silent on when exactly the next tranche will be paid, and on what it would take for them to release the money. Of course, negotiating in public is not the most desireable of things, but then having hoardes of market participants speculating on what you might be saying isn't exactly a comfortable situation either.

Marek Belka, head of the European Department at the International Monetary Fund, also limited himself on Friday to saying Latvia may need to make further spending cuts as well as increase taxes if it is to stabilize the economy.

The Latvian central bank, for its part, noting all the emphasis on "the government decides" side, and obviously not wanting to be forgotten, issued, for its part, a statement openly defending the currency peg, and warning of "dire losses" for Latvian citizens should the currency be devalued. The bank effectively ticked off public officials and advised them to be more careful what they say when speaking and the national currency and its stability in future. It also took the unusual step of underlining that the central bank was an independent institution, and is the only body empowered to take decisions about changing the currency rate. This was notable, as it could be seen as suggesting that someone else thought they had the ability to take such decisions, and it could also be read as a warning to anyone tempted to think they had such powers.

Meantime the recession goes on, and on.........

Industrial Output Stabilises

Latvian industrial output was in fact up in April over March - by 4.8% on a seasonally adjusted basis. Mining and quarrying were up by 1.8%, manufacturing by 5%, and electricity and gas by 4.6%. Some sectors were up sharply, clothing output, for example, rose 14.6%, pharmaceuticals by 11.6%, and chemicals by 9.7%. On the other hand electrical equipment was down on March by 19.5%, while other transport equipment (defined as ships and boats, railway locomotives and rolling stock) was down 13.2%. Such stabilisation was consistent with what we have been seeing in other countries, and at this point does not enable us to draw and longer term conclusions.

As a result of the improvement in April the year on year output drop fell to 16.9% (after adjustment for calendar effects). The fall was thus weaker than the 23.4% year on year drop in March and a 24.2% one in February.

The core of the problem is exports, since with domestic demand now sunk into a deep hole, and fiscal austerity the "ordre du jour", exports are the only hope for growth. I mean, this is evident from a simple formula:

Changes in GDP = Changes in private domestic demand + changes in government spending + changes in the net trade impact (exports minus imports)

Clearly Latvia's economy is not condemned simply to shrink forever, but it can come to rest at quite a low level, and for it to rebound something needs to drive growth. What I am arguing is, other things being equal, and relative prices being right, that a combination of new investment for greenfield sites directed to axports (which is a plus for private domestic demand) plus the exports themselves could provide the stimulus which starst to turn the motor over. Devaluation is half of the answer here, with the other half coming from having a responsible government, a serious reform programme which encourages confidence in the country and economic and political stability. End all the speculation which surrounds the continuation of the currency peg would be one way to move forward on the second half of the agenda.

The Latvia statistics office have yet to give us detailed data for Q1 GDP, but they initially reported that the 18% annual decline was broad-based, with manufacturing down 22%, retail trade down 25% and hotel and restaurant services output 34% lower (all from a year earlier). "The economic situation is of course very serious," Latvian Prime Minister Valdis Dombrovskis reportedly told a press conference in Stockholm recently, and who could disagree.

Latvian exports are also well down, falling 23% year on year in March, an improvement on the 29% drop in February, but still substantial. Going by the April industrial output numbers we could expect a further improvement in April too, nonetheless far, far more will be needed to start to turn this situation around.

In fact, Latvia still ran a goods trade deficit of just under 400 million Lati in the first three months of the year, down significantly from the 650 million Lati in the last three months of 2008, but still large, especially since GDP is shrinking fast.

Lavia's current account has however improved spectacularly, and was back in surplus (although only marginally) as of January this year according to central bank data. This transformation is entirely logical and anticipated (even if the speed of the correction was not), since Latvia is now about to become a net saver, with a current account surplus, and with an economy which is driven by exports, which at the end of the day is what the whole devaluation debate is all about.

In fact, the headline current account surplus number is a bit illusory, since it has been produced by a combination of two factors, neither of which are totally desireable in and of themselves. This is why we could say that the surplus is a forced one, and that Latvia is being forced to become a net saver. In the first place there is the improvement in the goods trade deficit, which as I say, is more produced by a the fall in imports (which follows the decline in domestic spending power and living standards) than it is by any improvement in exports (which have of course been falling):

And secondly we have movement in the income balance, from deficit to surplus, and this, ironically, is produced by the fact that the internal collapse in economic activity means that the income return on Latvian investments (equities, profitability of enterprises etc) has dropped much more than the return on investments made by Latvians outside the country (where things may also be bad, but not as bad as they are in Latvia). Thus ironically, Latvian's who have had the foresight to borrow funds from the Latvian branches of Swedish banks to invest in economic activities in Sweden may well be faring rather better than those very banks themselves who lent money to be used in Latvia.

Retail Sales

Apart from the drop in imports, perhaps the best short term indicator of the contraction which is taking place in internal demand is to be found in the retail sales numbers. These were actually up slightly in March compared to March - by 0.3%, on a constant price seasonally adjusted basis. The improvement was largely in the sale of food products, which increased by 2.7% on the month, while sales of non-food product fell by 1.1%.

Compared to April 2008 however sales were down by 29.6% (working day adjusted, constant price data), following a 27.3% fall in March. Since April last year seems to have been the peak month, we can expect the annual drops to reduce, although the actual level of sales may well keep falling (see chart below).

Apart from the credit crunch and the consequent difficulty in borrowing money, the other factor which is producing the slump in retail sales is the dramatic rise in unemployment, which according to Eurostat data has surged from a low of 6.1% in April 2008 to the present 17.4%. And it continues to rise.

The Eurostat numbers are rather different from the Latvian Labour Board ones, since the latter is based on a different methodology (and is thus not part of any "sinister conspiracy" to hide the facts - for a full discussion of the issues involved see my recent post on the same issue in Spain), but if you compare the charts, the undelying trend is evidently similar, a sharp upward climb.

Restoring Competitiveness

The principal conclusion we can draw from all this then is that it would be foolish to expect any recovery in economic activity to come from Latvian domestic demand, and this problem will only be added to by the impact of debt deflation on houseowners who, according to Global Property Guide, have just seen their properties fall at the fastest rate anywhere on the planet - it wasn't that long ago that Latvia and Estonia were leading everyone up - with prices down by 50% year on year in the first quarter, and the drop over the last quarter of 2008 being an incredible 30%.

So we need to look to exports. But this is where we hit a problem, since all the inflation which took place during the boom side of the boom-bust have made Latvian prices and industries totally uncompetitive when it comes to its main trading partners. If we look at the latest Real Effective Exchange Rate Data (curiously enough released by Eurostat last Friday), it should not surprise us to learn that the worst loss in competitiveness occured in 2008.

The above chart compares Finland and Latvia, and gives us an idea of just how much competitiveness the Latvian economy has lost since the index was set in 1999. In fact the graphs are even more interesting, since we can see that there was a period - between 2002 and 2005 - when, despite the fact that living standards were rising, productivity was rising faster, and Latvia actually improved its competitiveness vis-a-vis Finland. It is that earlier dynamic which now need to be recovered.

But as we can see from the sharp upward rise the the Latvian REER post 2006, the structural damage has been substantial, and this large scale of the correction needed makes the "internal devaluation" path - even if it were working, and even if markets were accepting it, which in neither case is true - particularly onerous. Prime Minister Dombrovskis himself estimated only last week that any devaluation would need to be of the order of 30% (and looking at the chart it is hard to disagree), and this is already much larger than the 15% "adjustment" in the trading band the IMF were considering during the original loan negotiations.

Ideally improvements in competitiveness can be achieved in two ways, through productivity enhancements which can be attained via structural reforms, and through changes in the wage and price level. Unfortunately the former needs time to work, and time is now absolutely something Latvia hasn't got, with the recession biting deeper by the day, and the markets hot on the heels of the government. So we need the wage and price correction. Well, people have supposedly been working on this for some six months or so now, so just how far have we got? Let's take a look.

Well, if we look at average gross wages and salaries, they fell 1st quarter of 2009 by 6.2% over the last quarter, but when compared with the first quarter of 2008 they are still up - by 3.5%. Of course, given the rise in unemployment the actual volume of wages and salaries paid is down even more - by 10.9% on the year, and by 17.2% over the last quarter. But this is a dop in living standards produced by the recession, and not a fall in unit labour costs.

In fact, according to data from the Latvian Statistics Office, the level of gross wages and salaries has so far only fallen back to the level of August 2008. This contrasts with a lot of anecdotal evidence I have been receiving in comments which speak of far larger reductions, but there you are, that is what the data says.

But restoring competiveness via internal devaluation is about reducing wages and prices in like measure, it is not simply about reducing wage costs, since slashing wages without reducing prices is only to cut living standards, and this in and of itself serves no evident purpose, and indeed causes untold hardship.So how are things going with prices?

Well, not much better. According to the statistics office, as compared to March, the average consumer price level in April was down by 0.4%. The average prices of goods decreased by 0.3%, but compared to April 2008, consumer prices still increased, and were up by 6.2%. In fact both the general and the core idexes (by core I mean ex energy, food, alchohol and tobacco) were still above the January level, so on the consumer prices front we have yet to take even the first step into attacking the loss of competitiveness reflected in the 2008 REER.

What about producer (or factory gate) prices then? Well, here the situation is a bit better, since as compared to March, April producer prices were down by 0.9%, while as compared to April producer prices fell by 2.6% (the first month of year on year drop). In the case of export prices, the situation was even better, since these were down by 9% year on year in April. In fact in both cases (domestic and export) prices have been falling since last July, which is hardly surprising since energy costs (which were a major component in the recent producer price spike) have fallen sharply. And remember, what interests us here is competitiveness, and energy prices have been falling everywhere. What Latvia needs is to improve its relative prices vis a vis its main reference markets.

Money Supply Problems

One indicator of the degree of stress which the Latvian economy is currently experiencing is the way in which bank lending (which fuelled the earlier boom) is now falling across the board. Year on year the numbers are still in positive territory, but the annual lending growth rate is steadily heading for zero - it decelerated to 4.3% in April (of which lending to non-financial corporations fell to a 9.2% growth rate while lending to households was down to 1.3% year on year). But month on month lending is contracting, and has been so doing since October. Loans to resident financial institutions, non-financial corporations and households contracted by 115.9 million lats or 0.8% in April alone.

Commercial credit and mortgage lending are both falling (by 3.4% and 0.8% respectively) and the negative momentum continues.

Money supply data show a similar tendency, even if in April M3 increased by 67.4 million lats and M2 by 63.6 million lats over March. Nevertheless the annual rate of decline in both measures of money supply continued to accelerate (to 8.2% and 8.1% respectively).

M1 - which consists of currency in circulation + checkable deposits (checking deposits, officially called demand deposits, and other deposits that work like checking deposits) + traveler's checks (ie assets that can be used to pay for a good or service or to repay debt) - has been falling now since December 2007.

Net foreign assets held by the Bank of Latvia fell by 218.7 million lats in April. According to the central bank the decrease in foreign reserves was a result of Bank of Latvia interventions (selling euro) and a reduction in foreign currency deposit held by the government as it drew down what remained of the last tranche of the international loan. Latvia has now spent about 503 million euros buying lats so far this year to support the currency. The bank had previously spent about 1 billion euros in 11 weeks last year defending the currency prior to the 7.5 billion-euro IMF-lead bailout.

Reserves had to some extent been boosted by currency swaps made available by the Swedish and Danish central banks. Indeed only in May Sweden’s central bank raised the amount of euros available for its Latvian counterpart to swap for lats to 500 million euros and extended the term of the agreement. The swap agreement dates back to last December, and allowed the Latvian central bank to borrow up to 500 million euros for lats. Under the original agreement the Riksbank was to provide 375 million euros and the Danish cb 125 million euros. However, according to the most recent statement from Swedish Finance Minister Anders Borg the Swedish government have now decided: so far and no further (see below).

Deteriorating Liquidity Conditions

As noted at the start of this post, Latvia is now suffering from a major Lat liquidity squeeze. And the shortage of lati on the internal market lifted has steadily been lifting interbank rates. One indication of the shortage was the inability of Latvia’s Treasury during the week to sell bills at a first auction at which 50 million lati (35 million euros) were offered. The Treasury did finally manage to sell a much smaller quantity (2.75 million lats - 4 million euros) . The problem is not one of price (yield) but of liquidity - there is simply a shortage of lati in the system overall as those who have the local currency sell and buy euros to protect against possible devaluation.

The lack of liquidity pushed Latvian interbank lending rates to their highest levels on record on Friday as the central bank removed lati from the market in an attempt to stem speculation. The six-month Rigibor rate rose to 16.00 percent. The three-month rate rose to 17.92 percent while the overnight rate rose to 19.6 percent. Obviously with levels like this devaluation becomes inevitable, but as Dombrovskis stresses: “This was a momentary situation and the moment when we have an agreement with the international lenders the market will calm down,” - for the time being at least. The critical question at this point is not whether a new agreement with the EU and the IMF is possible (it surely is), but rather whether it is worth the effort, since the government may well be in a situation were it is forced to agree to a series of extremely painful cuts only to find itself in the very same position three or six months from now.

Deficit Connundrum

As we can see, the Latvian people are being asked to make a bet in support of an economic idea, the idea (as presented above) that a fiscal contraction under present circumstances could turn out to be expansionary. Personally I am absolutely not convinced of the validity of this argument. What will convince lenders and investors to return to Latvia is:

a) a convincing commitment to structural reform and fiscal rigour in the longer term
b) a serious adjustment in relative wages and prices which converts Latvia once more into an attractive destination for export oriented investments.

At the present time we have the worst of both worlds here, since all the government's time, energy and attention is being focused on short term fiscal objectives, while the rate of price adjustment is far too slow. That is, the existing programme is NOT working, and I find myself wondering, do the IMF representatives have performance criteria, and if so what are they? And are these (assuming they exist) being in any way fulfilled, since the only visible positive outcome at this point is the recovery of a current account surplus, but if this is being achieved at the price of generating a massive fiscal deficit, then it is hard, really, to cry victory.

The general government consolidated budget showed a deficit of 190.8 million lats in April, with an accumulated deficit since the start of the year of 332.8 million lats). According to the central bank, the deterioration in the general government consolidated budget was largely the result is two processes: a) a revenue fall of 24.7%; and b) an increase in expenditure of 15.9%. Tax revenues were sharply down in all tax groups, with corporate income tax, VAT and personal income tax revenues dropping most (by 84.9%, 26.9% and 15.5% respectively).

The expenditure surge was primarily fuelled by payments of subsidies and grants which expanded by 70.3%. Rising expenditure for social benefits (by 26.2%) and the growth in interest expense (84.7%) were other significant contributors. General government gross debt increased by 143.2 million lats in April (to 3 119.0 million lats).

The consensus is that the current budget as agreed in a first reading before Latvia’s parliament last week implies a deficit of 9.2% of gross domestic product. It is anticipated that spending will be cut further via ammendments in the second reading scheduled for June 17 and that these should be sufficient to obtain additional disbursements from the European Commission and the International Monetary Fund. The question is not really (at this point) whether the Latvian parliament will pass the ammendments, but whether Latvia can hang out that long in the absence of stronger verbal and substantive support, and whether the measures if implemented will have the anticipated results.

On the latter point, as I have already indicated, I am extremely sceptical, and on the former, as we have seen statements from both the EU and the IMF have been much softer than might have been hoped for, while one leading ally (the Swedish banks and government) have now taken a much more ambiguous stance.

Swedish Finance Minister Anders Borg described the situation in Latvia as “markedly worrisome” in a statement on the Swedish government website at the end of last week. However, when it came to practical measures Borg was a lot less forthcoming, limiting himself to stating that Sweden would not offer Latvia any additional bilateral loan over and above the current contribution to the international bailout, adding the in his opinion the most important step forward was a show of determination by the government to rein in the budget gap. “They have to show that they have control over their public finances”. It is of the “utmost importance” that Latvia take “concrete and well-defined” additional measures to limit its public deficit to ensure that the IMF and the European Commission resume loan payment, he told reporters last week.

Swedbank, the largest bank in the Baltic states, has also stressed that they are fully prepared for a possible currency devaluation in Latvia. “We feel comfortable about our action preparedness regardless of which way the Latvian government chooses to go,” Chief Executive Officer Michael Wolf wrote in a statement published on the bank’s Website last week. As he also indicates, he gets the main point about the debt default problem:

“It’s not given that an external devaluation, over a longer period of time, will lead to larger credit losses for the banks,” Swedbank said. “But an external devaluation would give bigger credit losses during a shorter period of time as it directly hits the payment capacity for the many customers who have loans in euros.”

So What Happens Next?

Well , this is very hard to say, but certainly the omens - and especially Friday's Rigibor overnight reading - do not look good.

There is now evidently a growing consensus among observers that some sort of devaluation is well nigh inevitable, with the only real question being when. Certainly the trading community seem to be anticipating such a move, and forward contracts now price the lat some 53 percent below its current spot rate of 0.7073. Bloomberg quote fund manager Paul McNamara , from Augustus Asset Managers, as stating that “There seems to be a reasonable market consensus that Latvia will devalue", and I think this is a fair view.

Caroline Atkinson, director of external relations for the IMF, limited herself to describing the economic situation as “challenging", adding that there was clearly "a need for action.” She also pointed out the need for flexibility, which could refer to the IMF and the budget limit, or could refer to felixility on the part of the government, given the fact "the authorities have stressed the importance of controlling the government debt and deficits in maintaining the peg."

The problem is not that the IMF and the ECB would cease to support the Latvian government if they choose to continue down their chosen path, the question is really will they be able to continue down their chosen path, and indeed does it any longer make sense for them to do so?

No Exit Strategy

During this whole process one thing has become abundantly clear from the IMF statements, for the Latvian government's chosen path to be viable, there needs to be an exit strategy. Really it is very well worthwhile everyone reading the recent interview with IMF Survey Magazine (end of May) given by the IMF’s new mission chief for Latvia, Mark Griffiths, and Christoph Rosenberg, advisor in the IMF’s European Department and coordinator of the IMF’s work in the three Baltic Republics, since it makes a number of things very clear.

Particularly of note are Rosenberg's insistence (which has been a constant on his part throughout the process) that ownership of the adjustment program rests with the Latvian government:

"Let me first stress that this is the authorities’ program—they have very strong ownership of the policies that underpin it."

and secondly, having a viable exit strategy is central to success.

"The alternative strategy—abandoning the peg—would also be associated with large economic short-term costs. That is clearly one reason why there is such a strong preference in Latvia for maintaining the peg. Latvia also has a clear exit strategy in place: meeting the Maastricht criteria and adopting the euro by 2012."

But really, we now need to ask, is this exit strategy still viable? Certainly on the current path it may be possible (on the back of very considerable sacrifices on the part of the Latvian people) to bring the deficit down below the 3% limit in 2011 (although whether the EU Commission and the ECB would regard this as a sustainable process is another issue), but what about the 60% gross debt to GDP ratio? In their April forecast the EU commission pencilled in debt to GDP at 50.1% in 2010 (up from 9.0 in 2007 and 19.5 in 2008). That is debt to GDP is rising very fast (indeed some might say exploding). At the same time this 2010 estimate, which already makes being within the 60% limit in 2011 a reasonably close call (too close for my comfort anyway) is based on GDP contractions in 2009 and 2010 of 13.1% and 3.2% respectively, and we already know that the contraction in 2009 will be significantly greater than the EU forecast.

But it is worse than this, since not only is GDP contracting, prices are also falling (in fact, under the "internal devaluation" scenario this is what we want). But what this means is that nominal (or current price) GDP will fall faster than real GDP, with consequent negative consequences for the debt to GDP ratio (since as GDP falls, the money value of the debt remains constant). In fact the more successful the price correction the higher short term debt to GDP will rise. At the present time the EU forecast GDP deflators of only minus 2.2% in 2009 and minus 3.6% in 2010. But as we have seen above, for growth to return to the Latvian economy prices need to correct by far more than this, and hence debt to GDP will inevitably rise more than forecast - either because prices don't correct fast enough, and hence GDP contracts more (worst case) or that they correct rapidly (but with negative consequences for debt to GDP. This looks suspiciously like a Maastricht lose-lose to me.

That is, the simple fact of the matter is that there is no exit strategy. The programme simply doesn't work. It is "overdetermined", 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.

Update on the Potential for Devaluation in Latvia

2009-06-02T16:38:00.000+02:00

By Claus Vistesen: Copenhagen

As I pointed out recently in the context of Latvia and the impending potential for a devaluation there is a distinct risk of falling victim to the sin of crying wolf. Yet, as the plot inevitable thickens I am maintaining, as it were, my cry. There are two significant points to think about in the context of what we might call recent developments. First of all there is the news that the 2009 deficit envisaged in the budget before the Latvian parliament will amount to 9.2% of GDP - significantly higher than the original IMF agreed "limit" of 5%, and even well above the latest negotiating objective of the Dombrovskis government of 7%. Of course, this is just number salad but at the end of the day it is important because it determines whether and under what condition the IMF funded bailout packaged continues. The fact that Latvia reports a deficit of this magnitude almost amounts to throwing in towel in my opinion or at least it means that the playing field is now a different one when it comes to IMF funding. Finally, and in case you think that Latvia has not already cut spending just look at the following estimates for cuts in the public sector:

Taking into account that the budget amendments envisage steep spending cuts, the amendments must be passed immediately, so that the ministries and other government agencies know how much money they will be allotted from the budget this year, stressed the Finance Ministry.

It is planned that the Defense Ministry's budget will be reduced LVL 30.8 million, the budget of the Finance Ministry will be cut LVL 14 million, Interior Ministry - LVL 10.4 million, Education and Science Ministry - LVL 22.1 million, Agriculture Ministry - LVL 20.5 million, Transport Ministry - LVL 109.5 million, Welfare Ministry - LVL 7.2 million, Justice Ministry - LVL 7.4 million, Culture Ministry - LVL 15.9 million, Health Ministry - LVL 39.3 million, and Regional Development and Local Governments Ministry - LVL 10.8 million.

The initial demands would of course represent even deeper cuts and this is the main point in this case; just how much pain can you inflict under a fixed exchange rate before the dam breaks? As it appears, everyone has a breaking point and with e.g. property prices slumping 50% y-o-y in Q1 alone it is not difficult to see the boom-bust nature of Latvia's recent economic performance.

Another and very important part of the picture comes from the fact that it is not only the IMF who is footing the bill in Latvia. Consequently and this is the case for all three Baltic economies the expansion has effectively been characterised by the outsourcing of the financial sector to particularly Nordic banks' subsidiaries and most notably Swedish owned banks. This creates a large dilemma in the context of devaluation since most of the of the credit to corporates and households have been provided in Euros as result of the so-called road map towards Euro entry which was perceived as a fait accomplit. Recently, RGE analyst Mary Stokes explicitly tackles this question in the context of the entire CEE edifice. Mary frames the issue neatly when she says:

The general idea is that these parent banks (as well as the CEE economies in which they operate) are likely to be collectively better off if they all continue to support their Eastern European subsidiaries. The problem, however, is they may not be individually incentivized to do so.

Mary is initially positive in the sense that we won't see a large scale withdrawal of foreign banks from Eastern Europe citing recent evidence in the context of Romania, Hungary and Serbia where foreign banks have pledged to support their subsidiaries despite strong economic head-winds. However, she also makes a very important point when she coins the notion of the asymmetric prisoner's dilemma. What lies behind this term is the idea that because different foreign banks are exposed to a different degree in different parts of Eastern Europe with different economic fundamentals the idea of a common commitment across the board may be difficult. One key ingredient here is of course, as Mary notes via Fitch ratings, that the extent to which banks are exposed relative to their parent companies differ substantially. This is simply to say that while some banks are indeed able to shoulder the inevitable losses which will come in a CEE context, some are threatened on their life [1]. Finally, there is the risk that if one bank decide to give up its support for the subsidiary and thus the domestic economic edifice in its current form, so will other banks do the same. On a macroeconomic level this would of course be tantamount to one economy deciding to devalue which would immediately, one would assume, force others to follow suit.

As you can probably tell by now I am getting closer to the topic at hand. Consequently, I believe that what is now materialising with Latvia as the main venue is exactly this asymmetric prisoner's dilemma that Mary is talking about.

Let us begin first with the simple and ominous sign that lending conditions in the Latvian interbank market have become increasingly tight recently. I already pointed to this in my previous post (see link above) where I noted how the Latvian central bank, through its currency board, has already spent over 500 million euros buying lats. Last week in particular was tough as Bloomberg reports how the central bank had to buy 95.4 million lati ($190.6 million) in order to protect the Lati from moving below its trading limit where it is only allowed to move 1% either way against the Euro (from a mid point). According to Bloomberg, such purchases have already caused the foreign exchange reserve to shrink by 38% between September 08 and april 09 alone.

Latvia’s overnight lending rate rose to a record today because of a shortage of lati on the market after central bank purchases of the currency and Treasury bill sales, said Andris Larins, an analyst at Nordea AB. Asking rates on the overnight Rigibor, the interbank lending market, rose to 14.2 percent after the central bank bought 95.4 million lati ($191.5 million) to support the currency last week. Treasury bill sales and higher interest rates on money the central bank charges to borrow also contributed, Larins said.

As can be seen the effect from these operations are very as they have driven the interbank rate to its highest in more than 10 years as the central bank purchases are sucking up liquidity from the market. The main message here is that the shorter term rates are converging to the annual rate (click image for better viewing).

Especially, it is important to pay attention to the fact that the overnight rate has skyrocketed and even surpassed the annual rate. The overnight rate has risen 1352 basis points since the 21st of May and it indicates verly clearly how much stress and uncertainty which is building up in the market. Essentially this is the effect Bear Stearns/Lehmann had on the Libor back in the days where global interbank markets were freezing over. Moreover, I have from reliable sources that some banks are quoting overnight rates as high as 20% which suggests that things are moving fast at the moment.

But why all this fuss now then?

Well, it is worth remembering that it already began last week and as I pointed out above the larger than expected announced budget deficit cast serious doubt over the potential for future IMF funding. However, a more prominent reason is certainly that the Swedish banks and Swedish discourse in general have begun to turn strongly towards devaluation in Latvia as a sure thing. Last week, the Riksbank strengthened its foreign currency reserve with 100 million SEK, but more importantly SEB Chief Executive Annika Falkengren noted how the level of defaults would essentially be the same regardless of whether Latvia devalued or corrected through internal price deflation. This kind of message from a Swedish bank executive is not without importance since it is, for a large part, Sweden that have financed the Baltic expansion through the heavy exposure of many Swedish banks in the Baltic economies. Up until now however, popular belief has held that since most of the loans having been offered by foreign banks were in Euros these banks would strongly reject devaluation as it would effective eat up a large part of their balance sheet in one sweep. However, as many of us have pointed out these defaults would come anyway as a result of the sharp and essentially brutal deflationary correction. It is exactly this recognition which seems to have trickled down to Swedish bank officials.

As a consequence of this and, arguably, a host of other things Bengt Dennis, a former Swedish central bank governor and an adviser to the Latvian government was quoted this weekend of saying that a Latvian devaluation is a done deal. The only question would be when and how.

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.

This is of course pretty uequivocal and indicates quite strongly how the end game is near. In essence, it is very obvious I think that the sentiment in Sweden has turned from one in which the desire to wait out the storm and take the losses gradually to one where there is a demand for closure and immediate quantification of the losses. This is significant since the longer markets believe that Swedish banks no longer explicity support the peg, the closer we move towards a devaluation.

Clear signs of such sentiment comes from the publication of the Riksbank's Financial Stability Report out today where it is estimated how Swedish banks will lose as much as SEK 170 billion during 2009 and 2010 on loan losses. Now, it is impossible to say whether these estimates implicitly include a Latvian devaluation or not, but one thing is certain; the estimates have the Baltics written all over them and, if anything, the downside looms as a direct function of the potentially worsening situation in the Baltics. Add to this that the Swedish economy in general have endured an absolutely horrendous 6 months across Q4-08 and Q1-09 and it is not difficult to see from where the impetus to pull the plug in the Baltics could come from. Recent figures for GDP indicate how national output fell 6.5% over the year in Q1-09 which compares to an annual drop of 4.9% in Q4-08.

To add to the pressure it also appears that the political tensions in Latvia is growing.

In the first instance there is of course the expected and almost obligatory refutation of the Dennis' comments about the almost certainty of a devaluation.

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.

This is of course all well and good, but the question is whether we can take this for granted as the "official" position. For starters, Bloomberg (linked above) quotes Justice minister Mareks Seglins for calling a debate about the potential gains and losses relative to a currency devaluation. This would indeed be something new in a Latvian context as a debate about the Lati's Euro peg hitherto has been stifled completely by the official backing of the Lati's value against the Euro. As people closer to the Baltic situation than me have pointed out, this may a specific attempt to stir up things by Seglins since his party are bound to lose local elections come Saturday and may thus lose the majority in parliament.

A Done Deal Then?

Not quite, but it is impossible not to notice that some significant cracks have emerged. I think it is particularly important that Swedish stakeholders in the Baltic debacle now seem to favor "throwing in the towel" through a devaluation as it is assumed that it would amount to same thing, in the end, as trying to keep things together. Of course, no one other than Latvia herself can choose to devalue but the signs from Sweden are very important in the sense that the Swedish banks are paramount in keeping the economic edifice together. Moreover, there is the IMF where we do not yet know whether bailout funding will continue with the new estimate of 2009 budget deficit. My guess is that the IMF won't stand for it but then again, it would be wise to cut some slack if they have an interest in keeping the peg (which I am not it really wants).

I will end as I did last time with a general warning. At this point rumours will drive the discourse as much as real economic fundamentals and political decions. However, it is difficult to deny that a devaluation in Latvia seems to be moving closer.

---

[1] - Incidentally and for all the complaints about me focusing too much on the similarities between the CEE here is an example of differences. This is to say that when it comes to a high degree of event risk there are of course notable assymmetries. What I would like however to point out is that when it comes to the fundamentals and the underlying problems/courses of the crisis the Eastern European countries are, in many cases, strikingly similar.

Devaluation Imminent in the Baltics?

2009-05-28T11:43:00.000+02:00

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.

Danske Bank Warn On The Baltics

2009-05-28T10:56:00.001+02:00

Danske Bank has issued the following advice to investors:

The event risk has risen sharply in the Baltic markets and we advise utmost 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.

No comment.

The krona fell for a third day after the Riksbank announced the loan, and declined more than any of the 16 most-traded currencies against the dollar and the euro. Stefan Ingves, central bank governor, said in the statement that the financial crisis may be “prolonged”. Since the start of the financial crisis, Sweden has spent 100 billion kronor on swap agreements with Iceland, Estonia and Latvia and on dollar injections into Swedend's financial system.

Swedish banks have claims in Latvia, Lithuania and Estonia amounting to about $75 billion, according to ING Groep NV, with SEB, Swedbank and Nordea accounting for 53 percent of Latvia’s lending market. Sweden’s central bank raised the amount of euros available for the Latvian central bank to swap for lats to 500 million euros ($670 million) at the start of May. Latvia’s central bank first entered the swap agreement with both its Swedish and Danish counterparts to borrow as much as 500 million euros for lats last December. The Riksbank was to provide 375 million euros and the Danish central bank the remainder.

Latvia has already spent over 500 million euros buying lats this year to support the currency.

Earlier this week the New York Times Economix Blog said the following:

The jury is still out on whether Latvia can do what it takes to rebalance its budget and qualify for the bailout money it received from the International Monetary Fund and the European Union. Take a look at this analysis of Latvia’s situation from Danske Bank, which has consistently offered hard-headed – that is, pessimistic – views of the Baltic nations of Latvia, Lithuania and Estonia. (The bank was also far ahead in calling the disaster in Iceland.)

The most interesting aspect of the story, from a global perspective, was the notion that a default — even by a small country — could trigger a cascade of bad news at a time when the financial situation appears to be easing.

Let us just all hope that this last mentioned "notion" remains just that, "an interesting notion".

Meanwhile, Swedish media seem to be treating the devaluation as almost a "fait accompli" - those of you who don't speak Swedish can try putting this and this through your Google translator if you are interested.

Payment By "Voucher" In Latvia?

2009-05-26T14:38:00.000+02:00

This sounds like something straight from the Argentine history book. Yesterday someone left this comment on my Latvian Blog:

By the way, latest idea in Latvia is to issue vouchers as a substitute to LVL (thats in case Latvia doesnt get any money from IMF). So if you work in public sector, your salary partly will be paid in vouchers which you can use to buy food. And yes - it would also mean 'stable' LVL, at least on paper. I still don't really understand how it could possibly work in free capitalist economy. But it underlines how strong is the will to keep current LVL rate at any means, even if it means total collapse.

At the time I wasn't sure what to make of this, but then I saw that according to a report in the Latvian newspaper Diena, Central Bank Governor Ilmars Rimsevics visited the town of Liepaja on Friday, and told the astounded journalists assembeled there that: "The level of the expenditure shock we are receiving is so high that we can not cease to maintain this quantity of expenditure. So there is a shortage of funds, and we're forced to look at the different kinds of projects, which can help us provide for the foreseeable future. Taking into account that the money is not budgeted, it can be emitted in vouchers".

Rimsevics also gave an interview to the Russian-language newspaper Telegraf (published this morning) where he says more or less the same thing. Basically, the IMF are threatening to withold the next round of funding if the Latvian government does not move ahead with the agreed wave of budget cuts - which in some areas will be of up to 40%. Latvia received a 7.5 billion-euro bailout from the IMF and the European Commission last December. The agreement required Latvia to limit its budget shortfall to to 5 percent of gross domestic product. Since then, the economic outlook has turned far worse than anticipated and Prime Minister Valdis Dombrovskis's government is seeking approval to run a 7 percent deficit.

At the same time the Latvian central bank keeps having to buy the local currency (the Lat) to support the euro peg - last week the bank bought 6.4 million lati ($12 million), and this was the eighth consecutive week they have had to make such purchases. The longer it takes to reach agreement with the IMF - who are convinced that severe budget cuts will be expansionary in the short term (due to the improved confidence they will produce, see here), the more the bank will need to spend to counter those who are betting they will be forced to devalue.

The bank have now bought about 1.1 billion lati since September 2008, and such interventions have reduced Latvia’s foreign currency reserves by 36.7 percent compared with September last year. The flight to euros is also producing strong liquidity pressure inside the country, and the central bank cut its refinance rate to 4 percent on May 13, the second reduction so far this year, in an attempt to boost borrowing amid a liquidity squeeze and much harsher lending criteria. Basically, in order to keep lati in circulation, interest rates on the Rigibor, the local interbank lending market, have been driven up by 42 percent since 3 February to hit 13.7 percent on May 14 (for six-month loans). And this in an economy which shrank by 18 percent in the first quarter.

As I say at the start, all this - including the vouchers proposal - does now sound incredibly like Argentina, since issuing scrip money is exactly the kind of thing you get pushed into when you try unrealistically to hold a peg. It is the begininning of the end. The same thing, exactly, happened in Argentina, where they ran out of pesos and started to issue Patacónes, Lecops, Créditos, Argentinos and a myriad of other exotic bits and pieces of scrip. I give a bit of background on all this in this post on my Spanish blog, while Bloomberg's Aaron Eglitis has a useful summary of the general Latvian situation here.

SEB Accept Krugman's and My Point.

Currency devaluation in the Baltics would not lead to bigger loan losses for Swedish banks, the losses would simply come more quickly and be harder to deal with, according to SEB Chief Executive Annika Falkengren speaking in a radio interview on Saturday.

"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."

Now what was it Krugman and I were saying that everyone jumped down our throats for:

I’ve been saying this for a couple of weeks, but Edward Hugh has the goods.

Hugh puts his finger, in particular, on one gaping hole in the logic of the opponents of devaluation. We can’t devalue, they say, because the Latvian private sector has a lot of debts in euros, and a devaluation would make it very hard for borrowers to service those debts. As Hugh points out, the proposed alternative — sharp wage cuts, and basically a major domestic deflation — will also make it hard to service those debts. In fact, I’d be a bit more specific than Hugh: other things equal, a nominal devaluation and a real depreciation achieved through deflation should have exactly the same effect on debt service (unless some of the debt is in lats rather than euros, in which case devaluation would do less damage.)

Ms Falkengren has a very peculiar way of looking at things when it comes to analogies:

However, Falkengren said that devaluation without long term policies to get economies back on track was not a good option. "It's like peeing in your pants. It feels good, but only for a very short time," she said.

But essentially she is right, devaluation is not a solution, only a route to solutions. Long term structural reform is needed either way.

Non-performing Loans In Latvia

2009-05-12T16:40:00.000+02:00

This is all so tragic, and so foreseeable (viz, my original post here, for example).

Krguman on me:

"Hugh puts his finger, in particular, on one gaping hole in the logic of the opponents of devaluation. We can’t devalue, they say, because the Latvian private sector has a lot of debts in euros, and a devaluation would make it very hard for borrowers to service those debts. As Hugh points out, the proposed alternative — sharp wage cuts, and basically a major domestic deflation — will also make it hard to service those debts."

Krugman on himself:

"In fact, I’d be a bit more specific than Hugh: other things equal, a nominal devaluation and a real depreciation achieved through deflation should have exactly the same effect on debt service (unless some of the debt is in lats rather than euros, in which case devaluation would do less damage.)"

The Latvian Financial and Capital Markets Commission yesterday with numbers on domestic loans currently in arrears.

By the end of Q1 2009, loans in arrears in Latvia amounted to 20.5% of the aggregate loan portfolio of Latvian banks (up 5.5 percentage points from the end of 2008). The aggregate loan portfolio of the Latvian banks was worth LVL 16.4bn (approx. EUR 23bn) at the end of March 2009. Of the bank loans issued to households in Latvia, 22.1% were in arrears at the end of March 2009. Furthermore no less than 21% of mortgage loans were in arrears by March.

Danskebank on the Commission report:

We are quite concerned about the speed at which the non-performing loans are rising. Considering the gloomy outlook for the rest of 2009 NPLs are probably set to increase even more. We highlight that there is not a 1:1 relationship between NPLs and loan losses, but nevertheless these data cause us to believe that bank loan losses will go much higher than current levels – particularly in Latvia but also in the other countries.

And finally Krugman, who can speak for both of us here:

"This looks like events repeating themselves, the first time as tragedy, the second time as another tragedy."

Amen to that!

The Agony Continues - Latvian GDP Falls By 18%

2009-05-11T13:12:00.000+02:00

Latvia's economy shrank by nearly a fifth (year on year) in the first quarter, according to the latest flash estimate from the national statistics office. Obviously this is a dreadful state of affairs, and illustrates just how difficult the country's chosen adjustment path is proving to be.

Gross domestic product fell 18% year-on-year, and Statistics Latvia reported that the decline was broad-based, with manufacturing down 22%, retail trade down 25% and hotel and restaurant services output 34% lower from a year earlier. "The economic situation is of course very serious," Latvian Prime Minister Valdis Dombrovskis reportedly told a press conference in Stockholm, and who could disagree.

GDP fell by an annual 10.3% in the fourth quarter of 2008, while the economy contracted over the whole of 2008 by 4.6% following 10% growth in 2007. This is evidently what is meant by the expression "boom-bust".

The latest GDP numbers from Latvia suggest that the actual situation is in fact worse than the already pretty gloomy expectations. In many ways the “worst case” scenario for the medium term outlook for Latvia has now become a reality. Taking into account further tightening on the fiscal front the downturn could become even more pronounced in the coming quarters.

The weaknesses in the economy seem to be pretty broadly. The decline in both the manufacturing and the service sectors continued in Q1. The export sector has been contracting steadily, due both to slack global demand and uncompetitive domestic prices.

Industrial output was down by 23.4% in March, according to working day adjusted data from the statistics office. Manufacturing fell by 26.6%, electricity and gas supply by 14.1%, while mining and quarrying activity actually increased of 25%. The strongest reductions in industrial output were in textiles - down by 59.2%, in the manufacture of motor vehicles, trailers and semi-trailers – down by 52.9%, and in the manufacture of machinery and equipment - down by 47.2%.

Foreign trade has been dropping, and in March 2009 total trade turnover at current prices was 700.6 mln lats, up 8.3% (or 53.7 mln lats) on February, but down 29.7% (or 296.3 mln lats) on March 2008. Exports reached a low in January, and have climbed slightly since then.

Over the whole quarter trade was down by 32.7% (or 963.9 mln lats) over the first quarter of 2008. Exports fell by 26.0%, while imports were down year on year by a whopping 36.5%.

70.8% of Latvia’s March exports went European Union countries, and another 15.1% went to CIS countries. The principal export partners were Estonia (13.3% of total export), Lithuania (13.0%), Germany (10.2%), Russia (8.7%) and Sweden (7.2%). Since all five of these main trade partners are themselves in strong recessions at this point the outlook for improved exports (even were Latvia competitively priced) is not exactly promising at this point.

The drop in imports does, of course, mean that the trade deficit has been steadily improving (see chart below), which means that despite the drop in exports, net trade has actually been positive for GDP in the first quarter.

Price Inflation Still Far Too Strong

One of the key points in Latvia's "non-devaluation" strategy is to get the wage and price level down quickly. Since the only relief can come from exports as the global recovery starts to take shape it is important that as much of the internal deflation process should have been carried out by that point. However when we come to the reality it is important to note that progress has been slow, and far from satisfactory. The consumer price level was down in April by 0.4% with respect to March, but compared to April 2008, consumer prices had still increased by 6.2%. Obviously much of this inflation is already inbuilt, but in the absence of independent monetary policy it is obviously clear that the Latvian government should be doing more to speed this up, otherwise all this is going to take an eternity, the pain will be unendurable, and much of the structural damage well nigh permanent. The Latvian economy could look worse than the Florida coast after a hurricane has passed.

The only really bright spot is that the tradeable sector does seem to have responded rather more rapidly than the rest (as theory would predict) and export producer prices are now falling rapidly.

Company finances are strained, as internal demand is weak and financing conditions tough. In addition, the position of the Latvian consumers is difficult, as unemployment has shot up and wage growth has slowed. 2009 is likely to be a very difficult one for Latvia, and the government faces the twin challenge of both keeping the budget deficit within a limit accepted by the IMF in order to receive the rest of the emergency loan, and of breaking the back of the economic contraction which is currently spiralling away out of control.

Households are obviously also having a hard time, and incoming data on the rise of non performing loans in Latvia is becoming preoccupying. NPLs (loans that are more than 90 days overdue) as a proportion of the total rose to 7.8% in March (see chart below), and while this level is still not excessive, it is that rate of increase that causes concern.

Retail Sales In Freefall

Retail trade turnover was down in March by an astonishing 27.3%.

Compared to February sales decreased by 2.6% on a seasonally adjusted basis. Compared to the last quarter of 2008 retail sales decreased by 14.1% in Q1, while compared Q1 2008 there was a 24.5% drop.

Unemployment Also Up Sharply

Obviously one of the factors driving the increase in non-performing loans is the rapid rise in unemployment. In fact, as elsewhere the rate of increase eased in April, but still the rate of unemployment rose to 11% and the numbers unemplyed to over 120,000, according to the latest data from the State Employment Agency.

At the present time the government is working towards a deficit of 7% of GDP, above the 5% initially agreed to with the IMF. According to the Prime Minister discussions with the IMF about allowing a larger deficit are ongoing. Maintaining the deficit within the 5% of GDP limit is turning out to be increasingly difficult as the economy has contracted much more sharply than anyone anticipated.

According to Latvian economy Economy Minister Artis Kampars the economy has now reached the bottom and on the point of recovery. Kampars said this in an interview with LNT television. Asked about the gross domestic product decrease of 18% in the first quarter, Kampars said that it was logical and expected, but the GDP will start increasing later on this year.

He also said that regardless of the significant fall in the GDP, the government is not planning to revise the budget amendments, which are based on a 12% GDP drop.

Basically this whole view could not be farther from the truth, since the worst is yet to come, even if this may not be in terms of ever stronger rates of contraction. 18% is we have to hope "unrepeatable", as a year on year figure, and the contraction in the future may well be slower. But this is not what matters. The hardship of the Latvian people will undoubtedly increase, as will what is called the level of "distress" when it comes to paying loans. I see no recovery on the horizon, and even though the rate of contraction will almost certainly decline, positive growth is a long time away, and it would be a brave person who was willing to forcast any sort of growth in any quarter before we hit 2011.

Worst of all, the government, the European Commission and the IMF seem to have no exit strategy here. Like the Vietnam war, this recession may prove to have been a lot easier to get into than it was to get out of. Hanging on in the hope of a euro entry which may never be possible is no strategy. Those who didn't want to devalue got the Latvian people into all this, now perhaps they can explain to them how to get out, since the answer isn't obvious, as budget cut upon budget cut only feeds the contraction, which feeds the unemployment, which feeds the rise in non performing loans which feeds the bailouts which feeds the need for more spending and more cuts in services and staffing, which feeds the contraction and so on.

We need to break the circle, or are we just, like Dicken's Mr Mikawber simply going to hang around and wait for something or other to turn up? And if we are, then I'd be firmly locking and bolting the back door, since all those able bright young and educated people will be sneaking off elsewhere as soon as recovery starts up across Europe, and they won't be coming back, and then we really will be in a pickle, won't we? Or are we hoping they will be like his wife Emma, who let her maxim be "I will never desert Mr. Micawber!"

The Latvian Cat Is Out Of The Bag

2009-03-26T12:54:00.000+01:00

Reuters this morning:

The International Monetary Fund (IMF) would back a devaluation in Latvia, but the government, central bank and European Commission are against, the prime minister was quoted on Thursday as saying. It was the first clear statement by a policy maker about a differing stance between the IMF and Latvia and its other lenders over the currency, though the Fund has warned that keeping the currency peg during a sharp downturn would be tough. "The International Monetary Fund has no objection to a devaluation of the lat, but the European Commission, Bank of Latvia (central bank) and the government do not support this solution," Baltic news agency BNS quoted Prime Minister Valdis Dombrovskis as telling a meeting of regional journalists.

and Nordea flash comment:

According to Latvian Prime Minister Valdis Dombrovskis the IMF has no objection to a devaluation of LVL. However, he continues that the European commission, Bank of Latvia and the government are against devaluation. IMF's opinion counts as Latvia is asking the fund for a permission to increase the budget deficit to 7% of the GDP from the agreed 5%. Latvian economic contraction has been worse than expected. Getting out of the woods requires that competitiveness must be improved. This can be done by external or internal devaluation. IMF's stance highlights the risk of external devaluation. However, it is not a done deal since the political opposition is very hard. Some 90% of the Latvian loans are in foreign currency and hence external devaluation would affect most Latvian households and companies. Ongoing discussion emphasizes the importance of hedging the Baltic FX risk. If Latvia gives up, speculation that the other Baltic countries follow, increases.

This was always like this, and even though Ambrose Evans Pritchard glossed it all up a bit by talking about secret IMF documents that had been leaked, the information was always freely available in this report of the IMF website:

A change in the peg is strongly opposed by the Latvian authorities and by the EU institutions, and thus would undermine program ownership. The quasicurrency board has been an anchor of macroeconomic stability for more than 15 years, was able to withstand the 1998 Russian crisis, and commands popular and political support. Any change in regime would cause significant economic, social and political disruption.

The authorities and staff examined the merits of alternative exchange rate regimes. A widening of the exchange rate band to ±15 percent (as permitted under ERM2; currently Latvia has unilaterally adopted a ±1 percent band) would result in a larger initial output decline, since adverse balance sheet effects would reduce domestic demand. However, competitiveness would improve more quickly, reducing the current account deficit and fostering a more rapid economic recovery. The case for changing the parity would be stronger if it could be accompanied by immediate euro adoption. Technically, this would address many of the risks described above, and give Latvia deeper access to capital markets. With its negligible public sector debt, the government would also find it easier to borrow in euros on international capital markets. However, the EU authorities have firmly ruled out this option, given its inconsistency with the Maastricht Treaty and the precedents it would set for other potential euro area entrants.

So the only real news that Valdis Dombrovskis seems to be announcing today is that the central bank the Latvian government, the EU Commission, the ECB (and possibly) the Nordic Banks are the explicit villains of the piece.

Personally I am very sorry that we are now coming to what may turn out to be a "disordely" resolution of the four East European pegs, since I think it didn't have to be like this, as I have argued in:

Why The IMF's Decision To Agree A Lavian Bailout Programme Without Devaluation Is A Mistake

Why Latvia Needs To Devalue Soon - A Reply To Christoph Rosenberg

Why You Need Devaluation - An Open Letter To The People Of Estonia

Devaluation, Euro Membership And Loan Defaults - Some Thoughts For My Critics

Basically, if we go back to my last post on toxicity, and look at the causal chain:

Financial Crisis -> Real Economy Crisis -> Political Crisis

we can see that it is the political crisis which ultimately breaks the loop. Without the devaluation Latvia is stuck in a self reinforcing contraction where budget cuts slow the economy further and make necessary further cuts, while all the time more and more toxic assets are created, faster than you can borrow the money to clean them up (you know, the ball of negative energy that feeds on itself).

Update Dombrovskis "Corrects" Himself

According to the latest out of Reuters Riga Latvian Prime Minister Valdis Dombrovskis clarified later this morning (Thursday) that the International Monetary Fund was not currently seeking a devaluation of the lat currency. Speaking to reporters at the talks he is holding with IMF representatives, Dombrovskis said his earlier words were a "historical review" of negotiations last year with the IMF. "The current agreement of an unchanged exchange rate remains in force," he told reporters. Of course, no one doubted it. But still........

How Not To Manage Eastern Europe's Financial Crisis (Part 1)

2009-03-04T20:53:00.000+01:00

"Saying that the situation is the same for all central and eastern European states, I don't see that......you cannot compare the dire situation in Hungary with that of other countries."
Angela Merkel, Brussels, Sunday

"Happy families are all alike; every unhappy family is unhappy in its own way"
Tolstoy

In Europe, leaders rejected pleas for a comprehensive rescue plan for troubled East European economies, promising instead to provide “case-by-case” support. That means a slow dribble of funds, with no chance of reversing the downward spiral.
Paul Krugman

Bank regulators from Bulgaria, the Czech Republic, Poland, Romania and Slovakia met today and issued a joint statement, ostensibly to reduce the some of the impact of what they term "alarmist comments" from the Austrian government about how the regional banking system is now in such a precarious state that it requires urgent action at EU level to prevent meltdown. The Austrian government are, of course, concerned about the impact of any meltdown on their own banking system. The result of this "reassuring statement" can be seen in the chart below (10 years, HUF vs Euro).

Within minutes of the joint statement Hungary's currency plummeted to an all-time low against the euro and to a 6.5-yr low versus the US dollar. In fact the HUF rapidly depreciated to 312 per euro from 307.50 before climbing back in later trading to 310. And the reason for this swift reaction? Hungary was not invited to join the statement. As the forint plunged, Hungary 's banking regulator hurriedly signed up to the statement, blaming the original omission on a communications mess-up, but the damage was already done.

“Each of the CEE Member States has its own specific economic and financial situation and these countries do not constitute a homogenous region. It is thus important first to distinguish between the EU Member States and the non-EU countries and also to clarify issues specific to particular countries or particular banking groups."

Well this just takes us back to Tolstoy, each of them have their own specific problems, but the underlying reality is that they all face problems, and are vulnerable, each in their own way.

Hungary's economic fundamentals are clearly much weaker than those to be found in the Czech Republic and Poland as things stand, but what about Bulgaria and Romania? And the Czech Republic and Poland are about to have a pretty hard time of it as a result of their export dependence on the West, and Poland has the unwinding of the zloty options scandal still to hit the front pages. So there is plenty of food for thought here before throwing Hungary to the wolves. A default in Hungary could very easily lead to contagion elsewhere, and then the impact in the West is very hard to foresee. We should not be playing round with lighted matches right next to our fireworks stock. "Hey, it's dark in here" and then "boom".

Yesterday it was Latvia's turn, and the cost of protecting against a Latvian default (Latvia is the first European Union member priced at so- called distressed levels) rose to a record following the announcement that the unemployement level rose from 8.3% in December to 9.5% in January, the highest level in nearly nine years. In fact credit-default swaps linked to Latvia increased nine basis points to an all-time high of 1,109 basis points, according to CMA Datavision in London. The cost is above the 1,000 level, breached last week, that investors consider distressed, and is now about 270 basis points above contracts linked to Lithuania, the next-highest EU member.

So two countries are being systematically detached here - Latvia and Hungary - and statements by EU leaders are unwittingly aiding and abetting the process. But we should all remember, after they have eaten Latvia and Hungary for breakfast, the financial markets will undoubtedly chew on other luckless countries over lunch (Romania's Q4 GDP data was out today, and it was a shocker, and S&P have already said they are "closely monitoring" the situation), before perhaps moving on to bigger game for supper.

And we should remember here, no one is too big to fall, and I have already been warning about the gravity of Germany's situation, with a rapidly ageing population, a hefty bank bailout of its own to swallow, and total export dependence for GDP growth. Final data from Markit economics out today showed that Germany's composite PMI fell to 36.3 in February from 38.0 in January. That was the lowest level registered since the series began in January 1998. And it means that the German economy - which is highly interlocked with the whole of Eastern Europe (Austria holds the finance and Germany the industrial exposure) - is certainly contracting more rapidly in the first quarter of this year than it was in the last quarter of 2008, and may well contract in whole year 2009 by something in the order of 5%. So maybe someone over there in Germany should be reading the poem you will see below aloud to "our Angela" right now (Oh, and if you don't speak German, you can find a translation here).

Als die Nazis die Kommunisten holten,
habe ich geschwiegen;
ich war ja kein Kommunist.
Als sie die Sozialdemokraten einsperrten,
habe ich geschwiegen;
ich war ja kein Sozialdemokrat.

Als sie die Gewerkschafter holten,
habe ich nicht protestiert;
ich war ja kein Gewerkschafter.

Als sie die Juden holten,
habe ich geschwiegen;
ich war ja kein Jude.

Als sie mich holten,
gab es keinen mehr, der protestieren konnte.

What Last Weekend's EU Summit Did And Did Not Achieve

2009-03-04T20:51:00.000+01:00

Well reading the press on Monday morning it would have been fairly easy to reach the conclusion that nothing really happened yesterday in Brussels, and that a great opportunity was lost. The latter may finally be true, but the former most certainly is not.

Let's look first at what was not decided on Sunday. The leaders of the 27 member countries in the European Union most certainly did not vote to back a proposal from Hungarian Prime Minister Ferenc Gyurcsany for a 180-billion-euro ($228 billion) aid package for central and eastern Europe. They did not back it because it was not even seriously on the agenda at this point. These people move slowly and we need to talk them throught one step at a time. So what was on the agenda. EU bonds for one, and accelerated euro membership for the East for a second. And once we have the EU bonds firmly in place, then that will be the time to decide how we might use the extra shooting power they will bring us (boosting the ECB balance sheet would be one serious option they should consider, see forthcoming post from me and Claus Vistesen). That is when the emergency blood transfusion Gyurcsany was rooting for might come into play, but on this, as on so many items, the details of how we do what we do as well as the "what we do" will become important, so the moves we do take need to be well thought out, and systematic, they need to get to the roots of the problem, and not simply respond to problems on a piecemeal, reactive basis.

As Paul Krugman puts it "In Europe, leaders rejected pleas for a comprehensive rescue plan for troubled East European economies, promising instead to provide “case-by-case” support. That means a slow dribble of funds, with no chance of reversing the downward spiral." Amen to that!

But let's look at little bit deeper at what has been decided, or if you prefer, at what has been floated, and may be "decided" at the next meet up. Well for one, we have promised not to be protectionist, and for another, The World Bank, The European Bank for Reconstruction and Development (EBRD) and The European Investment Bank (EIB) have launched a two-year plan to lend up to 24.5 billion euros ($31.2 billion) in Central and Eastern Europe. This sounds a bit like trying to drain an Ocean with a teaspoon, and it is, so predictably the financial markets were not too impressed, expecially when they learned that not much of what was promised was going to be new money (as opposed to theacceleration of existing commitments), and especially when we take this sum and compare it with the likely quantities which are needed to "take the bull by the horms". EBRD President Thomas Mirow (who is more likely to give a low side estimate than a high side one) recentlly told the French newspaper Le Figaro that in his view Eastern European banks could need some $150 billion in recapitalisation and $200 billion in refinancing to stave off the risk of a banking failure in the region. At least.

"(It) sounds like a lot of money, but when (commercial) banks have lent Eastern Europe about 1.7 trillion dollars, 25 billion is peanuts," said Nigel Rendell, emerging markets strategist at Royal Bank of Canada in London. "Ultimately we will have to get a much bigger package and a coordinated response from the IMF, the European Union and maybe the G7."

So let's now move on to the positive side of the balance sheet, since as we know our leaders are a slowish bunch when it comes to grasping what is actually going on here, and an even slower group when it comes to acting on that knowledge once it has been acquired. The biggest plus to come out of last weekend's thrash is most definitely the fact that the idea of accelerating membership of the eurozone for the Eastern countries has now started to gain traction, if with no-one else then at least with Luxembourg Prime Minister (and Finance Minister, he is a busy man) Jean-Claude Juncker, aka "Mr Euro", who was quoted by Reuters on his way into the meeting saying he did not expect any early change to accession criteria for the single currency.

"I don't think we can change the accession criteria to the euro overnight. This is not feasible," Juncker told reporters as he arrived for a summit where non-euro eastern countries are due to call for accession procedures to be accelerated after their local currencies have taken a hammering on markets.

While in the news conference following the meeting he said that there was now a consensus that the two-year stability test required for a currency of a country hoping to join the euro zone should be discussed.

"I can understand that there may be a slight question mark over the condition that one needs to be member of the monetary system (ERM2) for two years, we will discuss this calmly," Juncker told a news conference after a meeting of EU leaders.

So something actually went on during the meeting, even if we are largely left guessing about what. Angela Merkel also left a similar impression that movement was taking place. "There are requests to enter ERM 2 faster," Merkel is quoted as saying. "We can have a look at that."

Now I have already spelt out at some length why I think the Eastern Countries should be offered accelerated membership of the eurozone forthwith (see this post) as has Wolfgang Munchau (in this FT article here).

The Economist, in a relatively sensible leader which I have already referred to, divides the Eastern countries into three groups. Firstly there are those countries that are a long way from joining the EU, such as Ukraine, Turkey and Serbia. As the Economist points out, while it would be foolhardy practically and hard-hearted ethically to simply stand back and watch, European institutions are pretty limited in what they can do apart from offereing some timely financial help or some sound institutional advice, and it is entirely appropriate that the main burden of pulling these countries back from the brink should fall on the International Monetary Fund.

Then there are those East and Central European Countries who are themselves members of the Union, and here it is the EU that must take the leading role. A first group of these is constituted by the Baltic trio (Estonia, Latvia and Lithuania) and Bulgaria, who have currencies which are effectively tied to the euro, either through currency boards, or pegged exchange rates. Simply abandoning these pegs without euro support would both bankrupt the large chunks of their economies that have borrowed in euros and deal a huge psychological blow to public confidence in the whole idea of independent statehood. Yet devalue they must (either via internal deflation, or by an outright breaking of the peg) and either road is what Jimmy Cliff would have called a hard one to travel. As the Economist itself suggests, these countries have suffered the most painful part of being in the euro zone—the inability to devalue and regain competitiveness—without getting the most substantial benefits of participation, so although none of them will meet the Maastricht treaty’s criteria for euro entry any time soon (and since they are tiny - the Baltics have a population of barely 7m, and Bulgaria is hardly bigger), letting them directly adopt the euro ought not to set an unwelcome precedent for others and should certainly not damage confidence in the single currency (any more than it already is, that is).

On the other hand unilateral adoption of the euro is a rather more difficult issue for the third group of countries, those who are EU members, are not in the eurozone and have floating exchange rates: the Czech Republic, Hungary, Poland and Romania. None of these is here and now, tomorrow, ready for the tough discipline of a single currency that rules out any future devaluation, and they are large enough collectively (around 80 million) that their premature entry could expose the euro to more turbulence than it already has on its plate. But so could simply leaving the situation as is, since if these economies enter a sharp contraction (more on this in a coming post) then the loan defaults are only going to present similar problems for the eurozone banking system as their currencies slide. The big vulnerability for Western Europe from the Polish, Hungarian and Romanian economies, arises from the large volume of Euro and CHF denominated debt taken on by firms and households, mainly from foreign-owned banks. As the Economist puts it "what once seemed a canny convergence play now looks like a barmy risk, for both the borrowers and the banks, chiefly Italian and Austrian, that lent to them".

So we now have several EU leaders opening the door for the first time to the possibility of fast-track membership of the eurozone. As we have seen German Chancellor Angela Merkel said after the summit that we "could consider" accelerating the candidacy process, French President Nicolas Sarkozy said that "the debate is open", and Luxembourg Prime Minister Jean-Claude Juncker, who heads the Eurogroup of eurozone finance ministers, said he was willing "to calmly discuss" such a possibility. So the debate is open. When will the next meeting be? On Sunday I hope. A week in all this is a very long time for reflection in this hectic world. We need proposals, and concrete ones for how to move forward here. Especially since at the present time all our attentions seem to be focusing on the East, and there is also the South and the West (the UK and Ireland) to think about. Perhaps our leaders will be able to make time from their crowded agendas for a series of mid-week meetings on this topic.

And while the leaders dither, the markets react, and as Bloomberg reports the dollar surges as everyone seeks a safe haven during the coming storm.

The dollar rose to the highest level since April 2006 against the currencies of six major U.S. trading partners.... and .... The euro dropped to a one-week low against the greenback as European Union leaders vetoed Hungary’s proposal for 180 billion euros ($227 billion) of loans to former communist economies in eastern Europe. The Swedish krona fell to a record versus the euro on speculation the Baltic region’s borrowers may default, and the Hungarian forint and Polish zloty tumbled.

The Hungarian forint led eastern European currencies lower today, falling 3.1 percent to 243.86, while Poland’s zloty lost 3 percent to 3.7796. The forint fell to a 6 1/2-year low of 246.32 on Feb. 17 as Moody’s Investors Service said it may cut the ratings of several banks with units in eastern Europe. The zloty touched 3.9151 the next day, the weakest since May 2004.

EU leaders spurned Hungary’s request for aid at a summit in Brussels yesterday. Growth in Poland, the biggest eastern European economy, will slow to 2 percent, the slackest pace since 2002, the European Commission forecasts.

Latvia Downgraded To "Junk" By S&P

2009-02-24T18:04:00.000+01:00

And the Swedish Krona clearly didn't like the news.

Standard & Poor's Ratings Services today said it had lowered its sovereign credit ratings on the Republic of Latvia to 'BB+/B' from 'BBB-/A-3' and removed the ratings from CreditWatch negative, where they were placed on Nov. 10, 2008. The outlook is negative.......

We believe the necessary process of private sector deleveraging is likely to continue over several years, during which time real incomes will decline, testing Latvia's commitment to both its exchange rate regime and its obligations under the EUR7.5 billion assistance program from the IMF, EU, and other official lenders. The adjustment is made more difficult as external demand for Latvia's key exports continues to decline."

The negative outlook reflects the likelihood of a further downgrade later this year or in 2010 if we believe the government is wavering from its economic agenda in a manner that intensifies currency pressures and risks delays in disbursements from official creditors. If the Latvian financial sector retains access to international markets at reasonable cost, economic prospects brighten on the basis of improved competitiveness, fiscal targets are met, and the near-term prospect for Eurozone entry improves, the ratings could stabilize at the current level.

Standard & Poor's also said it had placed its 'A/A-1' sovereign credit ratings on the Republic of Estonia, and its 'BBB+/A-2' ratings on the Republic of Lithuania, on CreditWatch with negative implications. Which means that both of these may be up for downgrades in the not too distant future.

The IMF are about to withdraw to base camp to observe developments from afar, although it is possible that they have laid out their "conditions" for the incoming government, but since they have no effective "interlocutor" it is not clear whether these conditions are going to be completely acceptable or not at this point. Christoph Rosenberg, IMF mission chief to Latvia, issued the following statement today in Riga:

"The program supported by the IMF, the EU, and other bilateral and multinational donors is meant to sustain policies that will put Latvia back on a sustainable path, not particular political parties or coalitions. As long as appropriate policies are in place, such support will continue.

As IMF Managing Director Dominique Strauss-Kahn has said, the IMF will continue its technical work with the Latvian authorities. The IMF mission currently in Riga for the first review of the program has, jointly with a technical team from the European Commission, made a lot of progress in identifying issues that need to be addressed.

The IMF mission will return to Washington at the end of this week and continue its work with the authorities from there. It will be ready to return to Riga and continue the discussions after a new government has taken office."

While EU Economy and Finance Commissioner Joaquin Almunia seems to be hinting that the EU may be "readying up" intervention. Well, if that isn't what he's doing then I am at a total loss to understand what he is up to.

The European Union could have to bail out a member state in financial trouble but such a move is unlikely, especially among countries in the euro zone, EU economic chief Joaquin Almunia said on Monday.

States such as Hungary and Latvia have received assistance from the EU, and other countries within the 27-member bloc might need a financial support programme, said Almunia, who is European economic and monetary affairs commissioner.

"You can't rule out that a country outside the euro currency might come to need this assistance," he said during an economic conference in Madrid. "We don't think we'll get to this position."

Almunia said euro zone countries were better off and less likely to need EU help. "With the euro zone the position is not the same, either in terms of public debt, foreign debt or the ability to react to this recession," Almunia said.

And the cost of Baltic country CDS not surprisingly shot straight up:

The cost of insuring Latvian sovereign debt for five years rose on Tuesday by more than 30 basis points after Standard & Poor's cut the country's sovereign rating to junk.

Five-year credit default swaps (CDS) for Latvia were quoted at a mid-price of 977.4 basis points, according to CMA DataVision, up from their Monday close of 943.7 bps. Five-year CDS for Lithuania hit a record high of 861.7 bps after the S&P move, compared with Monday's 831 bps. For Estonia, five-year CDS rose to 733 from 730.7 bps.

Below is a chart for Latvia's 10-year Eurobond (quoted yield to maturity) maturing on 5 March 2018, it is now trading some 700 bps in the mid (755 in the bid) over the closest (by maturity) German bund. Apart from noting today's market reaction it is possible to see how the spread, after settling down following the IMF-lead deal, has now opened right up again to the level of the previous October highs.

Moody's Investors Service also said today that it can no longer rule out a Lithuanian currency devaluation, although it was at pains to point out that this was not its central scenario. In the course of its annual ratings review Moody's said the following:

"Even though the net benefits of abandoning the currency board would probably be negative, a devaluation can no longer be ruled out in the current environment, but this is not Moody's central scenario,"

Last week Brown Brothers Harriman & Co. warned that Latvia’s weakening economy might force the government to ease its policy of managing the lats, spurring all three Baltic currencies to break their pegs by mid-year producing a fall of anything up to 50 percent to the euro.

“Latvia stands out as the weakest of the three because its external debt is very high and it’s got a big current-account deficit,” said Win Thin, New York-based senior currency strategist at the oldest privately-owned U.S. bank. “The contagion between the three is so strong that if Latvia broke the others wouldn’t be able to resist.”

Standard and Poor's also issued a more general warning today about the parlous state of many of the Eastern economies. In a report titled "Market Dislocation Exposes Vulnerability Of Eastern European Economies," published yesterday the agency stated that the resilience of Eastern European economies seems to be crumbling under the weight of high foreign currency debt and the potential reprioritization of lending among foreign banks.

"The financial crisis that started to hit developed economies after August 2007 did not immediately affect East European economies," said Jean-Michel Six, Standard & Poor's chief economist for Europe. "In fact, through the first half of 2008 their economic prospects still appeared resilient. But in the second half of 2008, the effects of the crisis started to filter through the region and are now gathering momentum."

In particular S&P's singled out the Baltics, Hungary, Romania and Bulgaria as especially vulnerable.

The Baltic states (Estonia, Latvia, and Lithuania), Bulgaria, Hungary, and Romania. For this group the level of economic vulnerability is high. The Baltic states face significant external financing requirements that make them highly vulnerable to a cut-off in capital flows. Each maintains a currency board (except for Latvia), and the pegs to which their currencies are linked remain under heavy pressure, as they have since the middle of last year. Bulgaria's main vulnerability, meanwhile, remains its massive current account deficit. As foreign financing becomes much tighter, the Bulgarian economy is likely to experience a painful period of adjustment in 2009 and 2010, with GDP growing about 1% this year and close to 2% in 2010, and a negative growth scenario cannot be excluded. A similar rationale applies to Hungary, where we expect GDP to decline by 2.5% this year before experiencing a mild recovery of 0.5% in 2010. Romania, once one of the economic high-fliers, is also poised to slow sharply in 2009. After an impressive 7.3% in 2008, we believe GDP growth will plummet to 0.8% this year.

Fitch Worried By The Impact Of Political Turmoil On The IMF Loan

2009-02-24T13:32:00.000+01:00

Fitch Ratings warned this morning that the collapse of Latvia’s government at the end of last week materially increases risks to the IMF-lead bailout plan since the agreed budget cuts may now be delayed.

“Fitch believed that a failure to maintain budget controls could delay the disbursement of international funds to Latvia, and lead to renewed pressure on Latvia’s currency,”.

The government collapse comes at a very delicate time, since an IMF mission is currently visiting, and growth (or should I say contraction) forecasts now suugest the contraction will be deeper than anticipated which will evidently mean further budget cuts. Latvia’s Finance and Economy ministries now estimate that the economy will contract 12 percent this year, revised from an earlier projection for a 5 percent reduction in gross domestic product. Latvia agreed to keep its budget deficit at 5 percent of GDP as part of its 7.5 billion euro bailout deal.

“A protracted delay in forming a new government or new elections could, however, delay the implementation of austerity measures and make it harder to keep the budget in line with objectives,” Fitch said in the statement. “This, in turn, could affect the disbursement of loans from the IMF and others.”

Fitch currently rates Latvian debt at BBB-, one level above junk, and “believes a failure of the IMF program would increase pressure on the domestic banking system and the currency peg, putting negative pressure on the country’s rating.”

“The extent of the recession and economic pain from the austerity measures being felt by the country increase the risk of a popular backlash and could thwart the sustained implementation of the IMF program,” Fitch said.

Let The East Into The Eurozone Now!

2009-02-22T21:16:00.000+01:00

“It’s 20 years after Europe was united in 1989 – what a tragedy if you allow Europe to split again.”
Robert Zoellick, World Bank president, in an interview with the Financial Times

(Click On Image To View Video)

World Bank president, Robert Zoellick, made a call this week - in an interview with the Financial Times - for a European Union-led and co-ordinated global support programme for the economies of Central and Eastern Europe. I agree wholeheartedly, and even if I have, reluctantly, to accept the point made last week by our Economy & Finance Commissioner Joaquin Almunia that our pockets, though deep, are certainly not bottomless (and thus it is probably beyond our means right now to rescue the non-EU Eastern states), I still feel we should make good on our responsibilities to those who are EU members, and to do so by opening the doors of the Eurozone to those who wish to join. Since this proposal is fairly radical, the justification that follows will be lengthy.

This is not a view I have arrived at lightly, but looking at the extent of the problem we now have before us, a problem which is growing by the day, and taking into account the fact that the origins of the economic crisis in the East must surely rest (at least in part) in the decision to make euro participation a condition for EU membership for these countries (a possibility which was subsequently withdrawn in the critical moment, when the going started to turn rough), and then assessing the risk to the Western European banking system which would be posed by simply sitting back and watching it all happen, I think this move is not only the least damaging of the policies we can now follow, it is the in effect the only viable path left to us if we are to keep the eurozone as an integral entity together.

If this proposal were accepted a new set of membership criteria would need to be drawn up, of course, but the underlying principle would have to be one of offering the certainty of entry as guaranteed forthwith, for those who chose to accept. Rules were made to be broken, and nothing should be so inflexible - not even the Maastricht eurozone membership criteria - that it cannot be ammended as circumstances dictate. And at this point even the undertaking that this - like the long awaited US Stimulus programme - was on the table, would be sufficient to provide immediate, and much needed relief. Flirting with doing nothing here is, in my opinion, flirting with disaster, both in the East and in the West.

Existing Maastricht Criteria

Convergence criteria (also known as the Maastricht criteria) are the criteria for European Union member states to enter the third stage of European Economic and Monetary Union (EMU) and adopt the euro. The four main criteria are based on Article 121(1) of the European Community Treaty. Those member countries who are to adopt the euro need to meet certain criteria.

1. Inflation rate: No more than 1.5 percentage points higher than the three lowest inflation member states of the EU.

2. Government finance:

Annual government deficit: The ratio of the annual government deficit to gross domestic product (GDP) must not exceed 3% at the end of the preceding fiscal year. If not, it is at least required to reach a level close to 3%. Only exceptional and temporary excesses would be granted for exceptional cases.

Government debt: The ratio of gross government debt to GDP must not exceed 60% at the end of the preceding fiscal year. Even if the target cannot be achieved due to the specific conditions, the ratio must have sufficiently diminished and must be approaching the reference value at a satisfactory pace.

3. Exchange rate: Applicant countries should have joined the exchange-rate mechanism (ERM II) under the European Monetary System (EMS) for 2 consecutive years and should not have devaluated its currency during the period.

4. Long-term interest rates: The nominal long-term interest rate must not be more than two percentage points higher than in the three lowest inflation member states.

The Dimensions Of The Problem

European governments, the European Union and international financial organizations need to act fast on risks stemming form banks’ exposure in the eastern part of the continent to avert an escalation of the credit crisis, Nomura Holdings Inc. said. East European countries are struggling to refinance foreign- currency loans taken out by borrowers during years of prosperity through 2007, when economic growth averaged at more than 5 percent. The International Monetary Fund, which has bailed out Latvia, Hungary, Serbia, Ukraine and Belarus, warned on Jan. 28 that bank losses may widen as “shocks are transmitted between mature and emerging market banking systems.” “Swift action is needed to restore confidence and prevent trouble” to financial and economic stability in the euro region and emerging Europe, said Peter Attard Montalto, an emerging markets economist at Nomura International in London. “Any move should be quick. The situation has begun to decline more rapidly since the end of last year and there is risk that any action may come too late.”
Bloomberg

Robert Zoellick is far from being a lone voice in the wilderness about the current level of risk to the coutries in the East, and indeed precisely those EU banks who have been most active in emerging Europe are now busily trying to convince EU regulators, the European Central Bank and Brussels itself to coordinate new measures to counter the impact of the financial crisis confronting the region. The problem in the East certainly now adds a new dimesion to the problems facing us here in Europe, since West European governments are now being simultaneously hit on a number of fronts, and the situation is become more complicated by the day.

In the first place most West European economies are now either in or near recession, and their domestic banking systems are, to either a greater or a lesser extent, struggling. The West European states are thus, by and large, already feeling stress on their own sovereign borrowing capacities. But, with greater or lesser effectiveness, these countries are still able to increase their debt, even if sometimes the surge in borrowing is very dramatic, as in the case of Ireland, which will see gross debt/GDP shooting up from 24.8% in 2007 to a projected 68.2% in 2010 (EU January 2009 Forecast).

The situation in Eastern Europe is very different, and their economies and credit ratings evidently can't support such dramatic increases in their debt levels. Thus, in the case of those countries with a significant home banking presence, like Latvia's Parex, or Hungary's OTP, the support of external organisations (the IMF, the World Bank, the EU) becomes rapidly necessary when the bank concerned starts to have liquidity problems. But as a result of the consequent bailout the debt to GDP ratio starts to rise in a way which then places even subsequent eurozone membership in jeopardy. Latvia's Debt/GDP is, for example set to rise from around 12% of GDP in 2007 to over 55% in 2010. With a 10% plus GDP contraction already in the works for 2009, it is clear that Latvia's debt to GDP will rise beyond the critical 60% level. Hungary's debt/GDP is already above, and rising. If we don't do something soon, these two countries at least are being launched off towards sovereign default.

But the other half of this particular and peculiar coin turns up again in a rather unexpected way, and that is in the form of those West European banks who have subsidiaries in CEE countries, and who find now themselves faced, not with bailouts, but with ever rising default rates. This difficulty evidently and inevitably then works its way back upstream to the parent bank, and to the home state national debt, as the bank almost inevitably needs to seek support from one West European government, or another (in fact Unicredit, which has difficulty getting money from an already cash-strapped Italian government is talking of applying for support from the Austrian government via its Austrian subsidiary).

Austria is, in fact, a very good case in point here, since, as Finance Minister Josef Proell recently indicated, the country had some 230 billion euros of debt outstanding in Eastern Europe, equivalent to around 70 percent of Austria's GDP. The Austrian daily "Der Standard" have also reported the analysts view that a failure rate of 10 percent in Eastern Europe's debt repayments could lead to serious difficulties for Austria's financial sector. And this is no hypothetical "what if" type problem since the European Bank for Reconstruction and Development (EBRD) has estimated Eastern Europe's bad debts could go over 10 percent and could even reach 20 percent in the course of the current crisis. Underlining the mounting concern in Austria, Proell tried last week to convince EU finance ministers to provide 150 billion euros is support to CEE economies as a first step in trying to contain the growing wave of defaults.

The total quantity of debt outstanding is hard to put a precise number on, but the Bank for International Settlements estimated that, as of last September, more than $1.25 trillion had been leant by eurozone banks, and if you add in U.K., Swedish and Swiss bank liabilities the number rises to $1.45 trillion.

Western Europeean banks have a very important market share in the East, ranging from a low of 65 percent in Poland to almost 100 percent in the Czech Republic. This basically means two things, that the region's businesses and consumers are extraordinarily dependent on uninterrupted capital inflows from the West, and that some West European banking systems are extremely sensitive to rising default rates in the East. Of course the problem goes beyond the EU's borders, and while EU bank market shares in the Community of Independent States is rather less significant than in the EU12, due to the still substantial domestic ownership which exists there, exposure to defaults is not unimportant, especially in Ukraine, Kazakhstan and, of course, in Russia itself. Further, there is South East Europe to think about, and countries like Serbia and Croatia.

Large Banks Take The Initiative

Getting near to desperation, some of the largest banks involved - Italy's UniCredit and Banca Intesa, Austria's Raiffeisen International and Erste Group Bank, France's Societe Generale and Belgium's KBC - have launched a common initiative to try to lobby for an EU wide solution to the problem.

UniCredit is the largest lender in Poland and Bulgaria, while Erste is number one in Romania, Slovakia and the Czech Republic, with KBC occupying the position in Hungary, Intesa in Serbia, and Raiffeisen in Russia and Ukraine. Hungary's OTP Bank, emerging Europe's number 5 lender and the largest one in its home country, does not formally belong to the group. On the other hand OTP is actively looking for support.

OTP Bank Nyrt., Hungary’s biggest bank, said it’s in talks over a “role” for the European Bank for Reconstruction and Development, as it announced a 97 percent drop in fourth-quarter profit and “substantial” job cuts. As well as a possible EBRD involvement, OTP may also seek funds from Hungary’s emergency loan package from the International Monetary Fund, the European Union and the World Bank to “better serve the economy,” Chairman and Chief Executive Officer Sandor Csanyi said at a press conference in Budapest today. “There’s a chance the EBRD will assume a role in OTP, but I must stress that we plan no issue of new shares,” he said. OTP “doesn’t need to be saved,” Csanyi added.

Chancellor Angela Merkel, while expressing support for the bank initiative, has stopped short of offering concrete assistance or suggesting measures beyond those which are already in place.

The president of the European Bank for Reconstruction and Development, Thomas Mirow, wrote in the Financial Times this week the bank proposals "deserve full support as a worsening crisis in emerging Europe will threaten Europe as a whole".

The Austrian government has already announced it is trying to raise support for a general European Union initiative to rescue the region’s banking system. The government has set aside 100 billion euros in cash and guarantees to stabilise its banking sector. Next in line in terms of exposure are Italy ($232 billion), Germany ($230 billion) and France ($175 billion).

Unicredit is publicly rather dismissive of the problem (as can be seen from the slide below which from a presentation they gave earlier this week, please click on image to see better), but Italian investors are far from convinced by their arguments, as witnessed by the fact that their stock has plunged 41 percent this year, and by the fact that they were forced to sell 2.98 billion euros in 50 year bonds this week to shore up their Tier I capital after investors only bought about 4.6 million shares, or 0.48 percent, from their most recent rights offer. UniCredit, which said last month it is considering asking for government assistance, has also been disposing of assets to raise money and it plans to pay shareholders their dividends in yet more shares. Nationalisation of banks to supply credit lines to the private sector is one hypothesis currently being studied by Silvio Berlusconi, according to a Financial Times report this morning.

(Click on image for better viewing)
The Austrian proposal includes funds from the European Investment Bank, the European Central Bank and the EU Cohesion Fund. The Austrian government has offered money of its own and has been urging Germany, France, Italy and Belgium as well as the EU itself to contribute. One feature, however, stands out in all of the proposals which have so far been advanced: they are loan based-support. What Soros calls the "tricky question" of fiscal allocation from Europe's richer member states has not so far been raised, but it will be, since it will have to be.

And of course, Austria's concern is far from being altruistic, as Austria's economy and sovereign debt stability depend on finding a solution. It is hardly surprising to learn that credit-default swaps linked to Austrian government debt soared this week - by 39 basis points to a record 225 - on concern the country will need to bail out the domestic banks itself as they report losses and writedowns linked to eastern European investments. Erste, which said last week that full-year profit probably slumped by almost 26 percent, is in talks with the government to get 2.7 billion euros ($3.4 billion) in state aid. RZB has asked for 1.75 billion euros.

The European Central Bank on the other hand, seems reluctant to extend emergency financial help to crisis-hit countries beyond the 16-country eurozone. The ECB did not have “a mandate to be a regional United Nations agency”, Yves Mersch, governor of Luxembourg’s central bank, recently told the Financial Times. Such comments reveal the level of resistance which exists within the ECB’s 22-strong governing council to the idea of offering financial support to countries outside the zone.

The ECB has so far offered loans to Hungary and Poland, but has attached what some consider to be excessively strong conditions on facilities allowing them to borrow up to 5billion and 10billion euros respectively. Mr Mersch, whose views are thought to be widely shared in the ECB, suggested the central bank was worried about setting precedents if it relaxed its stance on helping individual countries. While some euromembers might favour assisting nearby nations, “we must not forget that other people might be sensitive to different countries”.

Who Bails Out The West European Banks In The East?

Governments and EU officials are struggling to formulate a coherent response to the economic and financial turmoil that has started to engulf the eastern part of the old continent. EurActiv presents a round-up of national situations with contributions from its network. Leaders of EU countries from central and eastern Europe will meet on 1 March ahead of an extraordinary summit on the same day with the bloc's other members, it emerged on Thursday (19 January). Polish Prime Minister Donald Tusk has invited his counterparts from the Czech Republic, Slovakia, Slovenia, Romania, Bulgaria, Lithuania, Latvia and Estonia for the talks to ensure the 27-nation meeting on the financial crisis is not dominated by the interests of Western member states. See full Euractiv article on background.

The EU has so far provided emergency balance-of-payments assistance to two of the East European member states in difficulty - Hungary and Latvia, and EU ministers did agree in December to more than double the funding available for such emergency lending to 25 billion euros ( so far Hungary has been allocated 6.5 billion and Latvia 3.1 billion). It is also quite probable that such lending will now have to be extended to the two newest southeast European members, Romania and Bulgaria, since their ballooning current account deficits and dramatic credit crunches mean that they are steadily getting into more and more difficulty.

The core of the problem is that the East European economies enjoyed strong credit driven booms, which fuelled higher than desireable inflation and lead to strong foreign exchange loan borrowing which simply bloated current account deficits. Now capital flows into emerging Europe have dried up as the global financial crisis has raised investors' risk aversion and prompted them to dump emerging market assets, leaving foreign-owned banks as the only source of loans for companies and consumers.

Italy's UniCredit, the biggest lender in emerging Europe, warned at the end of January that there was a clear risk of the global credit crunch gripping the region. UniCredit board member Erich Hampel stated at a Euromoney conference in Vienna that the bank was committed to fund its subsidiaries in the CEE countries and would continue to lend, but at the same time made absolutely clear that in order to do this his bank would need government support, whether from Austria, or Poland, or Italy itself.

Hampel said Bank Austria would decide during the first quarter whether to tap the Austrian government's banking stability package for fresh equity. " he said. "Our budget is under discussion now and clearly assumes growth in lending and in funding to the East. "

And according to a report from the Austrian central bank the fact that a relatively small number of Western European groups - including three Austrian ones - own most of the banks in Central and Eastern Europe means that there is the risk of a "domino effect", implying the crisis would spread quickly from one country to another. "How capital flows into (emerging Europe) will develop depends on the financial strength of the parent groups and of the sister banks, and on whether the parents are willing and able to fund their subsidiaries," the bank's half-yearly Financial Stability Report said. "The risks to refinancing are increased by the danger of a domino effect, because a large part of the foreign capital in many countries comes from a relatively small number of Western European banks," .

"What we see is that the emerging European economies have lost all sources of funding but banking," said Deborah Revoltella, chief economist for central and eastern Europe of UniCredit, the region's biggest lender. The task to carry whole economies through a downturn comes at a time when parent banks already face a double challenge: a likely sharp rise in loan defaults at their eastern subsidiaries and more difficult and expensive refinancing for themselves. "The international banks cannot solve this situation," Revoltella said. "They can do their part, and it's fundamental that they do their part but we have to take care of the other sources of funding which are missing now."

And it isn't only Austria who is worried, since Greek central bank governor George Provopoulos warned Greek banks only last Tuesday against transferring funds from the country's bank package to the Balkans, where they have invested heavily.

Regional Risks

In our view GDP growth is like to be negative in all CEE countries this year. In those countries least affected by the crisis (i.e. Poland, the Czech Republic, Slovakia and Slovenia) GDP is like to drop at least 2-5%, while those countries worst affected (i.e. the Baltic States, Bulgaria, Romania and Ukraine) are likely to face double digit declines in GDP. In other words, in terms of expected output lost in the region this is as bad as or even worse than the Asian crisis of 1997-98.
Danskebank - CEE: This Looks Like Meltdown

The problem that the EU has in adressing the situation in the Eastern member states is that what we have on our hands is not only a banking crisis, there is also a strong credit crunch at work, one which is now having a severe impact on the real economies in the region. Most of the economies in the region are already in recession, and those that are not soon will be (I have intersperced a number of relevant graphs throughout this post which should give some general impression of what is happening). Thus these countries are all taking multiple hits at one and the same time.

1/ In the first place they have an economic contraction on their hands, in some cases becuase they are struggling with a steep decline of export demand from western Europe, in others because their externally financed credit boom has now come to a sharp and painful end.

2/. Most countries in the region have some form of foreign currency exposure, although at present this is largely household and corporate rather than sovereign. In a number of countries -notably Hungary, Romania, Bulgaria and the Baltics this is particularly onerous since most of the mortgages were taken out in euros or Swiss Francs, and the default risk is now rising as their economies either deflate (internal devaluation) or their currencies fall as part of the regional sell-off. The danger is that as the bailouts are implemented at local level this exposure is steadily transferred over to the sovereign level, creating a dangerous dynamic which can endanger future eurozone membership. States which default will be unlikely candidate members.

3/. These countries are also suffering the impact of significant asset writedowns, as those assets bought at very high prices during the boom - some at up to six times their book value - now have to be written down, further weighing on earnings and weakening financial and corporate balance sheets.

4/ Finally there is significant contagion risk. The comparatively small number of foreign lenders involved has lead IMF economists and the credit ratings agencies alike to repeatedly warn of how the risk that a seemingly isolated incident in one country may rapidly spread right across the region.

"I don't think it's an exaggeration to say that the whole banking sector and financial system (in the region) rests on the response of parent banks," said Neil Shearing, economist at Capital Economics. "If they withdraw funding it's not very difficult to see how there would be a very severe financial crisis sweeping across the region, and the whole region en masse would have to go to the IMF," he said.

Governments in the region have already taken what measures they can. Most increased deposit guarantees from 20,000 to 50,000 euros following the EU October Paris meeting. Lithuania went further and upped the limit to 100,000 euros, while Slovakia, Slovenia and Hungary all now offer unlimited protection. But this begs the question, who guarantees the government guarantees in the event they are called on.

So the problem has now become a very delicate one, since the banks want to maintain their presence in the region even while almost every factor imaginable is working against them. The latest such factor is the threat of credit downgrades for their core business in Western Europe, and Moody’s Investors Service warned only this week that some of Europe’s largest banks may be downgraded because of loans to eastern Europe, a warning which sent Italy's UniCredit to its lowest level in the Milan stock market in 12 years.

Moody’s argues there will be “continuous downward rating pressure” in the region as a result of worsening asset quality and western banks’ reliance on short-term funding. UniCredit’s Bank Austria subsidiary earned almost half its pretax profit from eastern Europe in 2007, Raiffeisen International Bank-Holding almost 80 percent and Austria’s Erste Group Bank more than 60 percent, according to Moody’s.

“The most risky parts of the western European banks’ businesses are in eastern Europe and when you decide to cut risks, you cut back on the most risky assets first,” Lars Christensen, an analyst at Danske Bank A/S in Copenhagen, said by telephone today. “This could add further risk in the region as the economies there may face large current account deficits if funding from western European banks is withdrawn.”

As a result last Tuesday we saw a surge in the cost of protecting bank bonds from default, lead by Raiffeisen International Bank-Holding and UniCredit. Credit-default swaps on Vienna-based Raiffeisen climbed 26 basis points to a record 369 and those for UniCredit soared 23 basis points to an all-time high of 213, according to data from CMA Datavision in London. Credit-default swaps on Erste increased 24.5 to 307, Paris- based Societe Generale rose 6 to 116 and KBC in Brussels was unchanged at 240, according to CMA prices.

The rising cost of insuring against default by a “peripheral” European government is likely to weigh on the euro, according to Merrill Lynch & Co. “This remains an important background negative for the euro,” Steven Pearson, a strategist in London at Merrill Lynch, wrote in a note today. “European banking-sector exposure to Eastern Europe, often via foreign currency lending, is an additional euro negative story that is gaining air-time.” Emerging market central banks may move away from holding European government bonds in their reserves as widening yield spreads between debt of different euro-zone economies makes bonds more difficult to trade, Pearson said.

So Why Would The Euro Help?

Well, in the first place, four of the Eastern economies - Bulgaria, Latvia, Lithuania and Estonia, are effectively stuck, since their currencies are pegged to the Euro. They are in the unenviable position of being stuck between the proverbial rock and the hard place. They are now faced with US depression type economic slumps, and massive internal wage and price deflation all at the same time. Would Euro membership help? Well lets look at what the IMF said in their most recent report on the stand-by loan arrangement for Latvia.

Accelerated adoption of the euro at a depreciated exchange rate would deliver most of the benefits of widening the bands, but with fewer drawbacks. Unlike all other options for changing the exchange rate, the new (euro-entry) parity would not be subject to speculation.

By providing a stable nominal anchor and removing currency risk, euroization would boost confidence and be associated with less of an output decline than other options.Euroization with EU and ECB concurrence would also help address liquidity strains in the banking system. If Latvian banks could access ECB facilities, then those that are both solvent and hold adequate collateral could access sufficient liquidity. The increase in confidence should dampen concerns of resident depositors and also help stem non resident deposit outflows.

However, this policy option would not address solvency concerns and has been ruled out by the European authorities. If combined with a large upfront devaluation, there would be an immediate deterioration in private-sector solvency, which could slow recovery. Privatesector debt restructuring would likely be necessary. Finally, the European Union strongly objects to accelerated euro adoption, as this would be inconsistent with treaty obligations of member governments, so this option is infeasible.

Basically, devaluating the Lat and entering the euro directly was the IMF's preferred option for Latvia, "euroization with EU and ECB concurrence" was the second option, and keeping the peg and implementing massive internal deflation only the third. The problem was that the EU, in its wisdom felt euro adoption "would be inconsistent with treaty obligations of member governments" - as would I suppose bailing out Austria and Ireland be "inconsistent with treaty obligations of member governments under the Maastricht Treaty. Go tell it to the marines, is what I say!

And this is not just Latvia, but four entire countries (little ones, but still countries) that are effectively being thrown to the wolves here.

Downward Pressure On Currencies, Upward Pressure On Interest Rates

Nor is the position of those with floating currencies - Poland, Hungary, the Czech Republic and Romania - much better, since their currencies are now coming under substantial pressure, and as a result defaults are growing, defaults which will only work their way back upstream to the Western Countries whose banks will have to stand the losses.

At the same time, the risk of a sharper, 1997 Asian-style adjustment cannot be excluded, given the similarities between Asia before the eruption of the crisis there in 1997 and the situation in emerging Europe. Beyond any considerations about valuation, the FX market may overreact as it did during the Asian or Russian crises in 1997 & 1998. To halt the downward spiral of currency depreciation, a substantial rise in interest rates combined with a tight fiscal policy under an IMF programme could be necessary.
Murat Toprak & Gaelle Blanchard, Societe Generale

Obviously there is now a sense of urgency here, and the warning signs are everywhere, for those who know how to read them. According to Zbigniew Chlebowski, the chairman for the Polish ruling party’s parliamentary group speaking in an interview earlier this week, the Polish government has been in official talks with the European Central Bank over joining the pre-euro exchange-rate mechanism “for several days.” So consultations are getting to be fast and furious.

And Hungarian, Polish and Czech government debt, which has been among the highest rated in emerging markets, is now being downgraded by bondholders. Investors are currently demanding 20 basis points more yield to own Hungary’s bonds than similar-maturity Brazilian debt, which is rated four levels lower by Moody’s Investors Service, according JPMorgan bond indexes. The risk of Poland defaulting is currently running at about the same as Serbia, ranked six levels lower by Standard & Poor’s, based on credit-default swap prices, while Czech 10-year bonds yield the most compared with German bunds since 2001.

“Everybody is running for the door,” said Lars Christensen, head of emerging-market strategy at Danske Bank A/S in Copenhagen. “The markets have decided the central and eastern European region is the subprime area of Europe.”

The currencies of these currenciies are tumbling on investor concern the region’s economies are among the most vulnerable to the global credit crisis. Poland’s zloty has fallen 35 percent against the euro since August, the forint - which has fallen around 13% since the start of the year, and about 25% since last August -weakened to a record low of 309.71 this week. At the same time the Koruna hit the lowest level since 2005.

(Chart above - Polish Zloty vs Euro)

The zloty has risen - against the previous trend - by 3.2 percent this week, following a decision by the Finance Ministry to enter the market (on Wednesday) and started selling euros from European Union funds for zlotys. Prime Minister Donald Tusk said yesterday the currency must be defended “at any cost.” The Czech central bank stated it regards the buying and selling currencies to manage the koruna as an “exceptional” tool that it’s resisted using since 2002, with the implication that it may not be able to resist much longer, although interest rate hikes (as practised in Hungary) seem to be the more likely approach in the Czech Republic. Such gains as have been obtained for the zloty are likely to be short lived (intervention is a tool of desperation, not of strength, and rarely has any lasting effect) and they can hardly exhaust EU funding they badly need to spend on stimulus type projects in the face of the downturn defending the indefensible, as Russia has been learning to its cost in another context.

“It [currency intervention ]is for us an exceptional tool at our disposal,” Tomas Holub, head of its monetary policy department, said in a telephone interview today. “Of course it’s one of the potential tools, but so far no decision has been taken in this direction.”

After intervention the only real tool left is interest rate policy, and fear of further currency falls is now acting as a serious brake on monetary policy as the pace of economic contraction gathers speed in one country after another. “A lowering of interest rates at the current levels of the exchange rate is completely out of the debate,” Deputy Governor Miroslav Singer told E15 newspaper earlier this week. “The question is whether to raise, and by how much.”

Really the suggestion that all these countries simply traipse off to the IMF (one after the other) in search of help is shameful. There is simply no other word for it, shameful. As Oscar Wilde put it, losing one child may be an accident, but losing all your children, now that has to be negligence! Let them in, and let them in now, before the whole house of cards collapses on top of each and every one of us.

Postcript

This article is the second in a series of five I am in the process of writing on ways forward with Europe's financial and economic crisis.

The first was Why We Need EU Bonds.

Subsequent articles will deal with:

a) The need for Quantitative Easing In The Eurozone
b) What might a new Stability and Growth Pact look like?
c) Why as well as rewriting the banking regulations we also need to do something about Europe's demographic imbalances.

Update: The Danskebank View

With which I wholeheartedly agree.

This week the crisis in the CEE markets has intensified dramatically after the publication of a number of reports putting a negative focus on Western European banks exposure to the overly leveraged CEE economies. The crisis is clearly developing in an explosive fashion and there is a very clear risk of an Asian crisis style meltdown. The economies in the region are already in free fall, and at least one country Ukraine is dangerously close to sovereign default. Rapidly rising concerns have led policy makers across Europe to call for immediate action to avoid a dangerous collapse that potentially could spill into the euro zone. However, policy makers seem very divided on what to do in the current situation.

Earlier this week Lithuanian Prime Minister Andrius Kubilius called for coordinated action from the EU to try to solve the problems in CEE. Later in the week the World Banks president Robert Zoellick echoed Kubilius cry for help.

However, the EU Commission does not seem very excited about a coordinated effort to avoid meltdown. Rather Joaquín Almunia, EU monetary affairs commissioner, this week said that he would prefer a country-by-country approach to crisis management. In our view, a country-by-country approach to crisis management entails a number of risks, as there is a strong potential for contagion from one CEE country to another due to the significant integration in the financial sector across the region. Therefore, we think that there is urgent need for a more coordinated effort to stabilise the situation otherwise this crisis will drag out and uncertainty remain elevated for an extended period.