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Monday, December 8, 2008

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

The IMF finally announced it's Latvia "bailout" plan on Friday. The plan involves lending about €1.7 billion ($2.4 billion) to Latvia to stabilise the currency and financial support while the government implements its economic adjustment plan. The loan, which will be in the form of a 27-month stand-by arrangement, is still subject to final approval by the IMF's Executive Board but is likely to be discussed before the end of this year under the Fund's fast-track emergency financing procedures, and it is not anticipated that there will be any last minute hitches (although I do imagine some eyebrow raising over the decision to support the continuation of the Lat peg). The Latvian government admits that some of the IMF economists involved in the negotiations advocated a devaluation of the lat as a way of ammeliorating the intense economic pain involved in the now inevitable economic adjustment. But the government in Riga stuck to its guns (supported by the Nordic banks who evidently had a lot to lose in the event of devaluation), arguing that the peg was a major credibility issue, and the cornerstone of their plan to adopt the euro in 2012.

"It (the programme) is centered on the authorities' objective of maintaining the current exchange rate peg, recognizing that this calls for extraordinarily strong domestic policies, with the support of a broad political and social consensus," said IMF Managing Director Dominique Strauss-Kahn.
In return for the loan the IMF have agreed a "strong package of policy measures" with the Latvian government and these will involve sharp cuts in public sector salaries, and a tight control on Latvian fiscal policy. The IMF have insisted on a substantial tightening of fiscal policy: the government is aiming for a headline fiscal deficit of less that 5 percent of GDP in 2009 (compared with a anticipated deficit of 12 percent of GDP in the absence of new measures) - to be reduced to 3% in 2010 (thus the Latvian economy will face not only tight effective monetary policy in 2010 - via the peg - but also a less accommodating fiscal environment, frankly it is hard to see where the stimulus to economic activity is going to come from here) . Structural reforms and wage reductions will also be implemented, led by the public sector, and VAT will be increased, all with the longer term objective of further strengthening Latvian competitiveness and facilitating the external adjustment. The problem is really how the Latvian population are going to eke it out in the shorter term.

"These strong policies justify the exceptional level of access to Fund resources—equivalent to around 1,200 percent of Latvia's quota in the IMF—and deserve the support of the international community," Strauss-Kahn said.
The loan from the IMF will be supplemented by financing from the European Union, the World Bank and several Nordic countries. The EU will provide a loan of €3.1 billion ($4.3 billion), the World Bank €400 million ($557.6 million), and several bilateral creditors [including Denmark, Estonia, Norway, and Sweden] will contribute as well, for a total package of €7.5 billion ($10.5 billion).

The stabilization program forecasts that the economy will contract 5 percent next year, the Finance Ministry said in a statement yesterday. Revenue is expected to fall by 912 million lati ($1.7 billion) next year and spending will be reduced by 420 million lati.

Strangely the IMF statement was not very explicit the key topic - the currency peg - in the sense that it was a little short on argumentation as to why it considered - despite its well known waryness about such approaches, and having got its fingers very badly burnt in Argentian in 2000 - that it would be best to continue this arrangement in the Latvian case, despite the Fund's strong emphasis on the need to current the large external balances which exist (see Current Account deficit in the chart below).

All we really know about the background to this decision is contained in the statement the IMF posted on its website on December 7:

Mr. Christoph Rosenberg, International Monetary Fund (IMF) Mission Chief, issued the following statement today in Riga :

"Following the IMF's statement on Latvia on November 21, 2008, good progress has been made towards a possible Fund-supported program for the country.In cooperation with the European Commission, some individual European governments, and regional and other multilateral institutions, we are working with the authorities on the design of a program that maintains Latvia's current exchange rate parity and band. This will require agreement on exceptionally strong domestic adjustment policies and sizeable external financing, as well as broad political consensus in Latvia In this context we welcome the commitment made today by the Latvian authorities. All participants are working to bring these program discussions to a rapid conclusion."

So there seems to have been a trade-off here, between the IMF agreeing (reluctantly I think, but this is pure conjecture since there is little real evidence either way) to accept the peg, and the Latvian government agreeing to exceptionally strong adjustment policies. But the question is: was this agreement a good one, and will the bailout work as planned? I think not, and below I will present my argumentation. But before I do, I think it important to point out that the kind of internal deflation process the Latvian government has just accepted is normally very difficult to implement, which is why economists tend to favour the devaluation approach.

Just how large the competitiveness issue is in Latvia's case can be guaged by looking at one common measure of competitiveness, what is known as the country's real effective exchange rate. The REER (or Relative price and cost indicators) aim to assess a country's price or cost competitiveness relative to its principal competitors in international markets. Changes in cost and price competitiveness depend not only on exchange rate movements but also on cost and price trends. The specific REER prepared by Eurostat for its Sustainable Development Indicators is deflated by nominal unit labour costs (total economy) against a panel of 36 countries (= EU27 + 9 other industrial countries: Australia, Canada, United States, Japan, Norway, New Zealand, Mexico, Switzerland, and Turkey). Double export weights are used to calculate the REERs, reflecting not only competition in the home markets of the various competitors, but also competition in export markets elsewhere. A rise in the index means a loss of competitiveness, and as we can see, Latvia has suffered a huge loss of competitiveness since 2005. There is a lot of "correcting" to do here.

The problems of loss of external competitiveness Latvia faces are not new, nor are they unique. Russia may be a lot larger than Latvia, and Russia may also have oil, but Russia's internal industrial core has become uncompetitive, and there is really only one sensible way of attacking this problem, and that is through devaluation, as Standard & Poor's Director of European Sovereign Ratings argues in the extract I cite below. One of the unfortunate side effects of the fact that currency policy has become almost a matter of national strategic importance in Latvia has been that the necessary open-minded discussion of the pros and cons of the situation has not been possible.
Accompanied by generous government spending, the credit boom also fueled inflation, which weighed on the competitiveness of Russia's noncommodity sector. As wage growth averaged nearly 30 percent over the last two years and the ruble-denominated cost of production rose, domestic manufacturers found it very difficult to compete with cheap high-quality imports. As a consequence, entrepreneurs logically avoided manufacturing and, instead, invested in much more profitable and more import-intensive sectors, such as banking, retail and construction.

The resulting structural imbalances were well camouflaged by the extraordinary growth in energy and other commodity prices. For six straight years, the earnings from Russian oil and commodity exports on world markets have increased much faster than the cost of imports, offsetting the less flattering volume effects. From 2003 through this year, the cumulative difference between export and import price inflation in Russia was a fairly remarkable 74 percent. This put upward pressure on the ruble, encouraging borrowers to take loans in dollars or euros at negative real interest rates, under the assumption that the ruble would appreciate indefinitely. But it also provided an important source of financing.
Frank Gill, director of European sovereign ratings at Standard & Poor's in London, writing in the Moscow Times

So the Latvian competitiveness problem has become evident to everyone, and perhaps the best indication of the severity of the problem is the way that people almost laugh at the suggestion that Latvia must now live from exports (exports, what exports?, they say). However it is clear, and especially given the force of the agreed internal adjustment, that domestic demand is now dead as far forward as the eye can see as an effective driver of GDP growth, and, as can be seen in the chart below, exports are going to have a hard time of it, even after growth in other European countries picks up in 2010 (or whenever).

The competitiveness problem can be seen quite clearly in the above chart, as Latvian wage rises became detached from productivity improvements in the second half of 2005 and the rate of increase in exports shrank rapidly, while imports began to enter at a much faster rate. This process eventually itself in the first half of 2007, with import growth at first increasing rapidly, only to subsequently decline, giving in the process some positive increment to GDP from the net trade effect - as exports once more began to accelerate (creative destruction impact) even while imports fell through the floor. However as the external trade environment has darkened, even this expansion in exports has petered out, and inflation adjusted exports are currently hardly growing, and may even turn negative in the coming quarters. 2009 promises in any event to be a very hard year, but without a truly massive correction in relative prices there will be no recovery in 2010 either, and probably not in 2011. Remember, wages are now about to start falling, unemployment is about to start rising, and government expenditure is about to get pruned, so the only possible area for growth is external trade, and any inbound FDI that can be attracted to build productive capacity for exports. On top of which the correction in the current account deficit means that Latvians collectively - government, companies and households - are going to have to start saving, and a rise in net aggregate savings is basically tantamount to a brake on internal demand. So whichever way you look at it, exports are now the name of the game.

Why Keep The Peg?

Given all the problems that having the peg are likely to create, what then are the arguments for maintaining it? Well frankly, such arguments are hard to find at this point, in the sense that there are relatively few people, at least in the English language, who are willing to stick their neck out and try to justify what, in my humble opinion, is virtually the unjustifiable, and the implicit consensus among thinking economists would seem to be that this is a bad idea. The decision does, however, have its advocates, and Anders Aslund of the Peterson Institute has been bold enough to have a try, so, in the interests of balance and try and get some purchase on what the arguments might be, I am reproducing his argument in its entirety.
Why Latvia Should Not Devalue
by Anders Aslund December 9th, 2008

Latvia has a severe financial crisis, the preconditions for which have long been evident. A fixed exchange rate to the euro led to an excessive speculative influx of capital, boosting Latvia’s private foreign debt to 100 percent of GDP. Inflation soared to 16 percent, and the current account this year to 15 percent of GDP. Latvia’s budget has traditionally been almost in balance.

For most countries, devaluation would appear inevitable, and some argue that Latvia has to devalue its currency, the lat. But Latvia’s circumstances are peculiar, making the standard cure not only inappropriate but harmful. A severe wage and social expenditure freeze would be a better prescription, along the lines of a preliminary agreement on macroeconomic stabilization reached on December 8 among the Latvian government, the European Commission, the International Monetary Fund (IMF), and the Swedish government.

Now the questions are how much financing Latvia needs, who will give it, and on what conditions? The key outstanding issue has been whether Latvia should devalue or not. But given that Latvia—and Estonia—are experiencing high inflation with close to balanced budgets, devaluation is neither necessary nor desirable. A freeze of wages and social transfers would be preferable for both economic and political reasons.

First of all, thanks to Latvia’s limited GDP, $27 billion in 2007, sufficient international financing can be mobilized. The combination of IMF, EU, and Nordic funding should be sufficient.

Second, devaluation is likely to aggravate inflation and it could start a snowball effect of higher inflation and repeated devaluations. A devaluation would not be less than 20 percent and it would cause greater social and economic disruption.

Third, the great number of mortgages held in euros would force a massive blow-up of bad debt and mortgage defaults, which in turn would seriously harm the population, the housing sector, and the banking sector and thus the economy as a whole. Such a banking crisis is not necessary. One of the three big banks, Parex Bank, has already gone under, but the other two, the Swedish banks Swedbank and SEB, are strong enough to hold, if no devaluation occurs.

Fourth, Latvia’s main macroeconomic problem is inflation. Devaluation would initially aggravate inflation, while a wage and social expenditure freeze would sharply reduce inflation. High inflation has led to the excessive current account deficit. Latvia does not suffer from any structural terms of trade shock

Fifth, a freeze on wages and public expenditures would strengthen the budget, while devaluation is likely to lead to severe budget strains.

Sixth, the Latvian population seems politically committed to the fixed exchange rate, and it seems prepared to take a freeze of incomes and public expenditures, and if necessary even cuts. Therefore, devaluation could lead to undesirable and unwarranted political convulsions.

Finally, devaluation in Latvia would inevitably drag down Estonia as well, and all the effects would be doubled, while Estonia might hold its own without Latvian devaluation. Lithuania, which does not really have any serious financial problems, could also be harmed. I would have recommended that the Baltics abandon their fixed exchange rates a few years ago, but this is the wrong time to do so.

The argument I am making applies only to very small economies with basically sound economic policies. Russia and Ukraine are in a very different situation. Both suffer from major structural changes in terms of trade because of slumping commodity prices, and they should let their exchange rates float downward with their terms of trade.

The main arguments in favour of the peg would thus seem to be as follows:

1/ Latvia's situation is exceptional (is that also true of Bulgaria, Estonia and Lithuania?). It is hard to know what to make of this. Certainly the comparison with Ukraine and Russia does not seem appropriate, since these are ultimately competitor countries as far as manufacturing industry goes, and they are devaluing not because of their raw material exports (agriculture and energy) are too high, but because the price of the products from their manufacturing industries are too high due to all the earlier internal inflation, and the attempts to maintain the currency value via the controlled "corridor".

2/ A severe wage and social expenditure freeze would be a better prescription than devaluation. Well they would be a good prescription, but they simply are not possible, since simply freezing things where we are won't work, the imbalances are too large, so we are talking about sharp reductions in wages and public spending (as nominal GDP goes sharply down, then even a 5% fiscal deficit will mean spending has to contract - by 420 million lati according to the budget forecast - although the IMF has agreed to a policy of protecting social expenditure as much as possible).

3/ Then there is the forex mortgage situation. This I agree is a major problem, as devaluation implies default, and an oncost for Sacndinavian banks. But if we are sending the entire Latvian population through all this simply to attempt to avoid defaults on mortgages we are making a mistake, since obviously the sharp rise in unemployment we can expect and the sharp fall in wages can have a similar impact. I mean, one way or another the REER (see above) is going back to the 2005 level, so the mortgages will be just as unaffordable, and in my view the best solution to this would be for the Scandinavian (and Italian - Unicredit) banks to take a haircut, and receive compensation via their domestic bank bailout programmes. This would be a much more equitable sharing of the costs of the forex lending programme having gone wrong. To take another example, Spain is not devaluing from the euro, yet a hefty round of mortgage defaults (and builder bankruptcies) is now expected. So it is really a case of default through one door, or default through the other one. Which way would you like to go, sir?

4/. That devaluation would provoke inflation. Well this is just the point, devaluation would only provoke significant inflation IF Latvia still didn't have an independent monetary policy (to restrain domestic demand), but since part of the reason for devaluation is precisely to recover control over monetary policy again, this argument seems to me not to be completely valid, and it seems to be forgetting the other problem, deflation, which is much more likely to become Latvia's real problem over the next two or three years. Trying to run some form of Quantitative Easing (which is the new "in" term for how best to handle monetary policy in the midst of a liquidity trap, which may well be where Latvia and several other CEE economies are now headed) without independent monetary policy is quite frankly, completely impossible. If we look at the chart for the producer price index I reproduce below, we will see that the PPI (which is normally regarded as an indicator of coming inflation) is no longer climbing, and seems set to start to come down., and this could easily be an early warning signal for forthcoming deflation.

5/. The Latvian population seems politically committed to the fixed exchange rate, and appears prepared to take a freeze of incomes and public expenditures. This may well be true, and is an impression I get when I look at some of the comments on my blog. Many Latvians (and citizens of other Baltic states) have accepted the peg as some indication of "post-independence" indication of national "seriousness", and that any stepping-back from it would be seen as some kind of defeat. I understand this view, but I think it is a mistake, since sometimes it is better to accept defeat in order to live to fight again another day. I think Latvian politicians are to some extent reacting to this kind of pressure, to some extent thinking about their own invested social capital, and to some extent under pressure from Nordic banks. In any event all three of these seem to have more influence than the rational arguments about the advisability of the peg. There is no doubt in my mind that the coming recession will be longer and deeper if the peg is maintained. Indeed I am almost certain that the attempt to sustain it will fail (and that we will see some kind of rerun of Argentina 2000 - in all three Baltic countries and Bulgaria) and really the sooner the population become aware of this the better. Basically what we witnessed in Argentia in 2000 was basically a process of growing battle fatigue and war weariness, as the population were asked to make one sacrifice after another in support of a policy which couldn't work, and only lasted as long as it could. The end product is that when the peg finally breaks the local population will be severely disillusioned, and the politicians will totally lack credibility, which is a sure recipe for chaos, as we saw in Argentina in 2001.

Indeed, if anything the position is arguably worse in Latvia at the present time, since the optimum conditions for a free and open debate about the alternatives aren't exactly in place at the moment it seems very hard to know what the population at large would decide if they had complete access to all the arguments.

6/. Finally, devaluation in Latvia would inevitably drag down Estonia as well. This is undoubtedly a consideration in the mind of the IMF (and Lithuania, and Bulgaria) but really all of this will have to be faced by all four countries sooner or later, especially since the only way out of their recession will be, as I am saying, through exports, and most of the other competitor countries (look even what is happening to the Polish zloty and the Czech Koruna as I write) will see the partities of their respective currencies well down on the euro as we enter the recovery.

Where Is Growth Now Going To Come From?

Basically the key argument for devaluation is that it is easier to manage an economy with a low level of inflation (please note I am saying low, very low, certainly below 2%, ask Ben Bernanke or the Japanese is you don't believe me) than it is to manage an economy which is in deflation freefall. The big danger in Latvia is not only that there can be a real (ie price adjusted) contraction in the economy of 5% in 2009 (or more, the economy is down 4.9% year on year in Q3 2008, and things are certainly going to get worse), but that this contraction may be accompanied by price deflation (ie actually falling wages and prices) which means nominal (current price) GDP would decrease by the size of the real contraction plus the fall in prices. Thus we could see a very large drop in nominal GDP in 2009 and 2010. If realised this would be a very difficult situation to handle, and I doubt the people currently taking policy decisions in Latvia are fully aware of the implications (although the IMF economists should know better). In particular the deflationary debt dynamics would be very hard to control, and again, especially without independent monetary policy.

It is important to remember that these loans which have been agreed to are simply that, loans, to guaranteee the external financial stability of the country during the forthcoming correction, but they do not, in and of themselves solve any of the real economy problems. And they will need to be repaid if they are used, and will nominal Latvian GDP heading down, the cost of repaying them effectively goes up in terms of real Lat earnings. This is what debt deflation means.

The International Monetary Fund on Friday said it now expects a net income of
about $11 million in fiscal year 2009, and not a shortfall of $294 million as
previously forecast, as more countries turn to it for rescue loans in a
deepening financial crisis. "The improved income outlook reflects new lending
activity that is estimated to generate additional fund income of about $247
million, assuming all disbursements under the recently approved arrangements are
made as scheduled," the IMF said. Since early November, the IMF has approved
rescue packages for Hungary, Iceland, Ukraine and Latvia as the global crisis
spreads to more emerging economies.

I am citing the above Reuters report, not as a criticism of the IMF - they are simply doing their job as best they can, and under very difficult circumstances - but to remind people that the IMF is effectively a bank, and these are loans, and interest is paid, and there are no "freebees" here, and definitely no "free lunches" - not even in the newly established Latvian soup kitchens.

So we should ask ourselves where growth is going to come from - the growth that will now be needed to repay the capital and interest on these loans. Certainly not from household consumption if we look at the chart below, or from government consumption given the restraint on public spending. The private consumption position can only deteriorate as wages fall and unemployment rises.

Not from manufacturing industry in the short term (until prices correct, and the external recovery starts), and again look at the chart.

And finally don't expect an investment driven recovery (again see chart) until the demand for Latvian exports picks up, and it becomes attractive to start expansing capacity.

Basically I feel the biggest condemnation which can be made of the package which has been announced is that it doesn't seem to contain one single policy for stimulating the economy, and stimulation and a return to growth is what Latvia badly needs by now.

And the worst case scenario outcome of the way all this is being handled (and the issue that actually concerns me the most) is the possibility that young people decide to start migrating out of the country again, in order seek a new future and to start sending money home to help their families confront the difficult circumstances. Since Latvia's population is already declining this would be the cruelest cut of all, and one would have to then ask just what kind of future really awaits this unfortunate country?


Anonymous said...

I live in Riga and the choices our government has made are puzzling me no less than you, from what I read. I generally share your sentiments.

The best arguments I've found for not devaluing the lat so far is virtually bailing out the Swedish bank short term interests in our country. Their lobby is so powerful that sound policy comes second to euro denominated mortgage default risks. That's one explanation but it entails a sort of a "screw the banks or screw 2.27 million people" logic. Also it is valid only if one is sure that the crisis will be over quite soon.

So I think that this actually isn't the reason behind actions we're seeing. My best guess is that the government, the IMF and the other lenders know very well that we will devalue before taking too much of that loan as the global economy continues to worsen. The purpose of this extraordinary arrangement is rather to give confidence to the markets that everything is still hanging on with the developing EU countries and the Swedish banks. This would pay off big time if the global economy recovers quickly. Latvia is simply being extraordinarily neighborly and helpful.

P.S. I also don't believe that there is some kind of a strong sentiment for protecting the peg at all costs. Latvians are happy to give the government a free ride on tough policies as you can see from the half-hearted 60 people protests in response to 25% wage reductions, 15% cuts in municipality spending, no stimulus to the economy whatsoever and other extreme measures like raising the VAT on many products from 5% to 21%. See, how calm, peace loving and intelligent the Latvians are?

What do you think about my explanation? It'd be interesting to read.

Edward Hugh said...

Hello, and thanks for a thoughtful comment.

"What do you think about my explanation?"

Well I think this is a complex situation, and I think a lot of factors all came together in the decision. I think pressure from the other countries on pegs - via the EU perhaps - must have played a part, as would pressure from the governments of the countries with the Nordic banks, since they would have to include the lossses in their own national bank bailouts - an outcome which I think would be fair, since these banks obviously aided and abetted the boom bust by facilitating the lending, which they did not simply to be nice but to create business. They evidently didn't really know what they were doing, and they - and not the Latvian people - should pay for this to some extent.

"So I think that this actually isn't the reason behind actions we're seeing."

So yes, I think this is part - but not all of it. Also, if Bulgaria has to come off its peg, then Austrian and Italian banks will have to fork out, as will their governments.

But I also think that the idea of entering the eurozone in 2012 is seen by the politicians as some kind of national salvation plan, and they don't understand enough economics to realise that what really matters is the exchange rate at which you enter, as Germany found out to its cost during the early years.

They also don't understand enough to realise that the euro is a currency union, and not a state federation, which means basically that there is no fiscal support. If you want fiscal support then you need to *fuse* with another state - like Sweden for example - and really, given the fact that your country is ageing rapidly without much in the way of accumulated national savings to pay for the retirement and health system, this, rather than independence would have been a better strategy when you came out of the USSR in the early 1990s. But this is all water under the bridge now, and Latvia will have to sink or swim on its own resources.

I mean, as far as I am concerned it is already deeply significant that the East European EU member bailouts are coming from the IMF and not the EU itself. This is an implicit admission that the EU already has enough on its hands with the potential problems looming in Southern Europe, and just does not have the spare capacity to help Eastern Europe that much in any meaningful way.

This is already an indicator of what to expect if you do manage to join in 2012.

"My best guess is that the government, the IMF and the other lenders know very well that we will devalue before taking too much of that loan as the global economy continues to worsen."

Well, if they do know that they are being extraordinarily irresponsible. Basically, I agree with you on the future. 2009 is going to be extraordinarily difficult all round. We can see some sort of recovery in 2010, but it won't be what we had before, since credit will be much more constrained, and everyone will be looking to export and not run CA deficits - including the US, the UK, Spain etc. So the issue is where all the customers are going to come from to buy all these exports. None of this is going to be as easy at it seems, which is basically why I think the IMF decision is such a bad one.

Have a merry xmas despite everything though.


Anonymous said...

As I understand the IMF is only giving about 22.7% of the 7.5 G€ loan. The rest comes from the World bank, The EU (41.3%) and the Nordic countries. The ECB was actually the first one to help us with a 500 M€ loan and other standard support available to the EU members. Also, being part of the Eurozone would actually increase the available aid as is shown by Denmark and other countries reconsidering joining the monetary union in light of the crisis. This is where I disagree the most with you saying "just a monetary union".

We surely wan't to join the Eurozone ASAP but in theory we could adopt the euro any time we want. The entire currency in circulation is backed up by euro reserves. As I've read, all it takes is courage and political support from Poland among other countries. As of now there are at least 6 countries/territories using the euro without formal agreements.

I'm still surprised by how little economic stimulus has been planned. Much of that aid money could end up being used to support the currency and refinance older debt. Only stimulus I've hear of is actually decreasing the income tax by 2% and providing co-financing to EU funds. The net tax burden is being increased though. At least on the people. There's some decrease on the businesses because of that personal income tax cut I mentioned.

The first syndicated loan repayments for Parex are due in January or February. That's where we'll take a dip in the loan money. Then there'll be the budget deficit. It suggests to me that devaluation is planned as the real aid to current account crisis, albeit unofficially.

Thanks for the response and your blog in general! Have a merry xmas too!

Edward Hugh said...


"As I understand the IMF is only giving about 22.7% of the 7.5 G€ loan."

Yes, this is right. Which raises the question as to why the IMF is involved at all, if the percentage participation is so small?

I can think of two reasons. The first I have already explained, the resources of the EU are very strained at this point, all countries are at the upper limit of their fiscal deficit capacity, and they simply can't assume undertakings that they can't deliver on.

Basically there is a huge amount of downside in the pipeline, and especially in Southern Europe, which is all in the eurozone. So since they have to accept a balanced scenario, where you take into account the worst as well as the best that may happen, they know they just can't arrive to help the EU12 on a worst case scenario in Southern Europe.

So why didn't the IMF do more. Well there is this from Strauss Kahn in the first place.

"These strong policies justify the exceptional level of access to Fund resources—equivalent to around 1200 percent of Latvia's quota in the IMF—and deserve the support of the international community."

That is, proportionately Latvia is really getting a hell of a lot, and this may make all of this politically very delicate with other parts of the globe later. They can't give preference to Europe. Also, they have to imagine "downside", that is that the position of these and other countries can deteriorate, and that more money may be needed later, in which case IMF Funds at the present time are really quite restricted.

On the other hand the EU wants them involved for two reasons I think. In the first place the EU doesn't want to set a precedent that it can't live up to - namely that it will bail out the whole of an ageing and fragile EU12 (Latvia alone is, of course, no problem. The issue is what happens if Romania and Poland then join the queue. The slowdown and forex credit bust in both these countries is moving very rapidly at the present time).

Also, it is politically expedient for the IMF to play the "bad boy" role, and forec these harsh measures on the east. You will note that Brussels has been notably ineffective in pushing the Lisbon Agenda structural reforms through in the south of europe. Plus, if things go wrong, as everyone knows they might, it is the Fund and not Brussels that picks up the blame. That, basically, is what they are there for.

"We surely wan't to join the Eurozone ASAP but in theory we could adopt the euro any time we want. The entire currency in circulation is backed up by euro reserves. As I've read, all it takes is courage and political support from Poland among other countries."

I don't know who is propagating this idea, but it is most certainly FALSE. You can euro-ise, that is replace Lats in circulation with euros, Croatia isn't that far from this situation, and Ecuador (to give you a nice precedent) did this with dollars, but this wouldn't get you into the eurozone. In fact trying to force an entry in this way would produce the same kind of negative rejection effect that the Russians got for unilaterally recognising the separatist Georgian provinces. The IMF and the EU would never agree to this, and you are now effectively being governed by the IMF, in case you hadn't noticed. This is what an IMF programme means. You simply don't have full sovereignty anymore, till you pay off the debts, and leave the programme. So if I were you I would simply forget this idea.

You will be in the eurozone if and when the ECB and the EU Commission decide to invite you and not before, and I would say at this point that 2012 is a very early date to start talking about this given all that you are about to go through.

"Also, being part of the Eurozone would actually increase the available aid as is shown by Denmark and other countries reconsidering joining the monetary union in light of the crisis."

I don't follow the *logic* in this argument, that is I don't see why the fact that people in Denmark might now vote to join (which is not to any extent sure I don't think, but that doesn't matter) means that there is more aid available. It depends what we mean by aid. The Danish banks might welcome access to the ECB at this point, that is for sure, but look, here we need to make a distinction between liquidity and solvency.

This is a very hot topic right now in Spain, since we don't have a liquidity problem in the banking system (given access to ECB funding) but we may have a solvency problem in the banking sector which may well come to light if enough individuals default on their mortagages (say come 2011) and enough property developers and builders go bankrupt.

I have estimated the size of the default problem as between 300 and 500 billion euros, that is between 30% and 50% of Spanish GDP, and there is no way that Spain can handle this problem alone, yet the eurozone doesn't have a common fiscal pool, we aren't a Federated state like the US and there is no equivalent to the US Treasury.

The ECB can help out with the liquidity problem, as can the IMF with Latvia, but if you have a solvency problem, that is if you are quite simply facing national bankruptcy, which may well become the case if enough people leave, then the euro as such simply won't resolve this. Here is where the big problem lies.

If you are at all interested in what is happening in Southern Europe you could try this post on Unicredit (which is very important) and follow the argument back up the links, this one on Greece, and this one on Spain.

Basically I think that the eurozone is going to come under maximum stress around 2011, and I doubt 2012 will be a big year for new entrants, I really do.

Basically, if these programmes don't work, then the position of the countries in question is only going to deteriorate. I think we are in what they call an "evolving situation". In the case of Ukraine a Hungary the IMF may be creating a kind of new class of "economic protectorates" of people who come under the wings of the IMF and never leave. Bretton Woods was never intended for this, and I guess some new type of multilateral institution will need to be created to deal with the new reality, but there will be plenty of time to think and talk about all of that once we get out of the current crisis.

Anonymous said...

Dear all,
so far i saw 4 comments (2 of them posted by Hugh)and none of them appears to be written by local resident, but i may be wrong ... I also do not know if that is of any relevance, but it leaves the impression that none has the local "hands on" experience ...

Axing the wages and salaries is "de facto" devaluation, but not straight one - not a devaluation of currency. It is a devaluation of workforce/labour, which, according to Hugh, are the main obstacles for external competitiveness.

Well, I look at the export's graph (not the q/q growth, but nominal and real (how that?) monthly figures) and i may be blind, but cannot detect even the "technical" break-down on charts ... I look at Japan's export data today, and the Euro-zone New Industrial Orders, and the break-down is clear ... even, via the lens of (still in process?) devalued US dollar, the U.S. is clearly breaking down ... Well, the Latvian export figures may be mystery, alike Madoff's Ponzi? However, I do not see any real problem with Latvia's exports in nominal or real terms in charts (excluding the fact - what Latvia is really exporting? For sure, the official-doom excludes the Old-Riga sex industry :)). I do not know, and i would assume that nobody knows for sure in advance, but these stats from developed world suggest that exports will not be the driving force out of the global consumption bust ... So, i do have little confidence that export-led recovery may pull Latvia out of slump. Still, if yes, then global "competitive devaluations" (alike U.S., U.K., Russia in process ...) will destroy the existing framework for current foreign exchange anyway ...

What yea think?

Anonymous said...

Well, technical analysts would break my hands for looking at "technical break-down in charts" of export figures .. :) That would be also pervert for macro-economist :)

Edward Hugh said...

Hello Anonymous 2

I think I understand what you are trying to say. You are saying that since Latvian exports are still increasing (we don't know for how long) then the problem isn't exports. But if you look at GDP, then you will see that GDP is contracting, so the issue is that exports are not expanding fast enough to drive GDP into positive territory.

I mean basically economics isn't so hard. There are three factors which can lead to growth, households can spend more, the government can spend more, or people outside your country can buy more of what you are selling (exports). Some suggest what firms do also matters (investment), and it does, but at the end of the day investment is only to produce for end users, either at home or abroad, and so if the other three aren't consuming, you don't get invest ment, and hence look at the Gross Fixed Capital Formation chart for the last few quarters.

Now, in the Latvian case we know that households are going to consume less (since no one is going to lend them too much money, and for some time to come, and wages and salaries are going down), and we know that the government isn't going to be consuming too much, since they are going to try and balance the budget when revenue is declining (I mean the EU is going to chip in a bit, but then they already are, and we are contracting).

So structurally the only component which could be pushed up are exports.

Of course, you could say that this is impossible, maybe you are. But what this means is sitting back with folded arms and watching Latvian GDP contract and contract, and I would conjecture Latvian population decline even faster as young people can't stand the pressure.


You are also, I think, raising the question of where the hell the global recovery is going to come from, given that most developed economies are now overleveraged in terms of credit, and all need to live to some extent from exports. And how the hell is this going to be possible? And I would agree that this is a HUGE problem that we haven't even started to look at, since we are all still to busy trying to put the fire out before the house burns down completely, and don't have too much energy to think about what it will look like when we rebuild it.

But to move from saying that countries like the UK, and the US, and Spain etc, are all going to have problems to saying that it doesn't matter what Latvia does (an interesting type of fatalism this) since everyone is in a mess, so we will be in good company.

The problem is that Latvia is still a lot poorer than the US, Spain and the UK, so my guess is that the pain component will be comensurately higher.

I mean, even if the US, the UK and Spain have problems I still think there are things that people in Latvia can do to make their future a bit brighter, and I think it is better to do these things well, rather than badly. But then maybe I am being too Anglo Saxon here, and maybe their is a subtle Latvian way of looking at all this that I am simply missing.


"Dear all,
so far i saw 4 comments (2 of them posted by Hugh)and none of them appears to be written by local resident, but i may be wrong"

You are, this is the first line in the first comment.

"I live in Riga and the choices our government has made are puzzling me...."

Obviously Latvia is quite a surreal place :)

Edward Hugh said...


"What yea think?"

I have just re-read your comment and I think you have an excellent sense of humour, assuming you were excercising humour. In the Latvian case I am never exactly sure :)

"Still, if yes, then global "competitive devaluations" (alike U.S., U.K., Russia in process ...) will destroy the existing framework for current foreign exchange anyway ..."

I imagine you are referring here to what is known as Bretton Woods II, and I agree that this is going to the big issue when we get back to work, but people in Latvia need to try and eat work and live whether or not we find a satisfactory way of putting the global financial system back together again.

Incidentally if you look at the q.o.q export chart I am arguing that there is a technical break, and that it comes at the end of Q4 2005, before the huge credit bubble really got started.

Oh, look, this all started just after joining EMU, as Latvijas Banka put it:

"Latvia joined ERM II on May 2, 2005. ERM II means that, for at least two years prior to the introduction of the euro, the lats will have to be pegged to the euro, with the fluctuation margins of the lats exchange rate against the euro not exceeding +/-15% against the lats/euro peg rate."

This is very interesting, even if the evidence at this point is only coincidental, but it seems to me that it was having the euro anchor that really blew the whole thing up. Of course, if you like boom/busts.......

"The Bank of Latvia on December 30, 2004, has fixed the peg rate of the lats and the euro at 1 EUR = 0.702804 LVL, which took effect on January 1, 2005 in line with the government approved plan for Latvia's preparation for full-fledged membership in the Economic and Monetary Union (EMU)."

Anonymous said...

A simple question please: The article states:

"economy will contract 5 percent next year, the Finance Ministry said in a statement yesterday. Revenue is expected to fall by 912 million lati ($1.7 billion) next year "

Wiki says that the Latvian economy has revenues of approx $4 billion per year.

Would not the revenue fall represent a much larger than 5%percent of revenues? say 40% loss?


Anonymous said...

Hi, again ...

1. first anonymous appears to be lost in local conditions and seems to be seeking for outside assistance, so I am still unsure of being "native resident", probably a "tax resident" ...

2. as to export break-down in 2005 ... Well, if you dig deep enough, you will notice that the sharpest slow-down was for wood (and related) goods, that was due to winter-storm in January of 2005, which made big damage to forests (also in Scandinavia) and created over-supply of broken wood/timber, and depressed the prices in Europe afterwards ... In addition to the winter-storm, of course, the labour travelled to the West, credit boom ignited the local demand (also for wood that is used in construction) etc. Actually, if i look at the fact that wood was something like 40% of total exports in 2004, and has fallen to ca. 14% in October of 2008, secondly wood appears to be highly cyclical (for construction, furniture ... also pulp&paper..), so Latvia has come quite well around the wood demise ..
3. If i am right, then you can grow GDP by reducing the negative effect of net exports (imports are almost double of exports in Latvia) ... so I would probably more focus on domestic investments (in non-cyclical industries - consumer staples, healthcare & Pharma, local energy sources) that reduce imports?
4. Is it worth playing the wild card of currency, if you already do the devaluation of labour, ca 85% of borrowings are in foreign currency ... and there is high risk of global competitive devaluation (aka Bretton Woods II) later on?
5. I would seek for stabilization of the economy first, otherwise it appears to be in free fall on global scale ... and you should not touch the final consumption (you will destroy the domestic demand even more if you devalue local currency and have 85% of borrowings in foreign currency), as this exactly appears to be the problem now ... There is no guarantee that you will succeed with exports - do not forget the real risk of domestic protectionism (e.g., Smoot Hawley, see for more here by Yves Smith http://www.nakedcapitalism.com/2008/12/has-beggar-thy-neighbor-started.html ) when everyone realises that the only way to move forward are fiscal stimulus ... You will realize high tension already now between the south (PIGS countries) and central-north of EU, you have probably also noticed rounds of Italy probably assuming the exit for euro-zone, etc ...

Do apologize for spelling, if any problems ...
what yea think?

Anonymous said...

I am the Anonymous 2nd, and will use the nickname of "Resident", as we get crowded and the issue of residents has no relevance :)

Anonymous said...


as i understand from what you write:

"economy (THIS SHOULD BE REAL GDP (REAL GROSS DOMSETIC PRODUCT) will contract 5 percent next year, the Finance Ministry said in a statement yesterday. Revenue (THIS SHOULD BE GOVERNMENT'S BUDGET REVENUE, NOT REAL GDP) is expected to fall by 912 million lati ($1.7 billion) next year "


Anonymous said...

well, and i think that Ministry of Finance (the Bloomberg shame aside) are optimists, still in denial of reality! I fear that unemployment will hit 15-20%, real GDP will contract double digit ...

Anonymous said...

I am an almost ex-pegist, (and Latvian tax payer) due to the special situation.

I fear that if Latvia had had a floating currency for longer, the government would have simply postponed hard choices for longer, and continued to distribute contracts to their friends and party members. It is only small compared to GDP, but applied economics is all about activity on the margins, and the margins of Latvia can be very dirty.

How to go forward? Well, I would not like to start from here :-)

But actually, do you have any suggestions for things that would stimulate exports? France and Germany have started technology investment programmes. Currently the political lobby seems to focus on agriculture and forestry, which is hardly at the top of the Lisbon agenda.

Thanks for yet another informative and enjoyable post. Merry Christmas,

Edward Hugh said...

Hello everyone,

I'll be back with some specific comments on what's being said soon, but at the present moment I'm deep into thinking about Ukraine's problems. And writing something up on Ukraine made me think about another problem that is going to be created by not devaluing now: the currency denomination of the loans. The IMF and the WB we imagine are lending in dollars, and the EU in euros. But if you borrow and then devalue, you have to pay back a lot more. Since I am convinced you will have to devalue eventually, it would be much better to do it before you take up the loans. Just look at what is happening to poor old Ukraine in the quote below. I mean the IMF seem to have it wrong both ways, by bending the stick too hard one way in Latvia (too rigid) and too far in the other in Ukraine (too flexible). Still, they do have a hard job, and surely have their work cut out at the moment.

Ukraine’s currency, down 50 percent against the dollar since June, may weaken another 24 percent as the International Monetary Fund restricts the former Soviet nation from halting the slide, Commerzbank AG says. “It’s like a freefall, a falling knife,” said Michael Ganske, head of emerging markets in London for Commerzbank, Germany’s second-biggest bank. “The central bank has limited ammunition and ability and willingness to support the currency.” The IMF’s $16.4 billion bailout package, agreed to last month, requires Ukraine to move toward a flexible exchange rate and prohibits reserves from falling more than 4 percent by yearend from about $32.8 billion now. While the pact permits intervention to stem “disorderly” swings, Ganske said such a decision “would be stupid.”

Edward Hugh said...

Here's the World Bank economic assessment for Ukraine. Unless anyone knows any better, as far as I can see we don't have this kind of document for Latvia yet.

Look at the table of key macro indicators on page 2, and the 2009 forecasts. -4% GDP, -14% consumption, -20.3% fixed investment, and -23.5 imports. And they only had a CA deficit of 6.9% in 2008. Latvia's correction is much bigger, and I don't know how you are going to "enforce" this kind of reduction in imports without changing the currency valuation. Or maybe you are, but the drop in living standards will be enormous.

Even after the devlaution they still project a 1.4% fall in exports, so we can see how hard everyone expects the external environment is going to be in 2009.

The WB still expect 13.6% inflation in Ukraine 2009, and this of course is the problem with devaluation, you need to keep a tight grip on inflation, totherwise you just lose it all, and you are back to where you started.

Edward Hugh said...

Hi Andris,

"economy will contract 5 percent next year, the Finance Ministry said in a statement yesterday. Revenue is expected to fall by 912 million lati ($1.7 billion) next year "

Well I think the Latvian resident has it right, and this number of $4 billion is a bit small. Still, we are talking about a drop of around 20%, which is much more than the contraction in the economy.

Some "wicked tongues" are of course suggesting that some of the earlier "whitening" process may be now going rapidly into reverse gear.

Edward Hugh said...

Hi David,

"But actually, do you have any suggestions for things that would stimulate exports? France and Germany have started technology investment programmes. Currently the political lobby seems to focus on agriculture and forestry, which is hardly at the top of the Lisbon agenda."

Well, I wouldn't be totally negative about agriculture and forestry, since of late they seem to have become the new value added product. What do I mean by this, well global demand for agricultural products (that is population increase plus increases in real GDP) has been rising much faster than capacity to supply, so, despite the current global recession, agricultural prices are rising structurally, and when things recover this can be an interesting area. But we are only talking about a small fraction of GDP, but even so increasing agricultural output by 2 percentage points of GDP would be no bad thing. I mean anything helps.

On exports generally, well we are all going to need to go back to talking about industry to some extent. Obviously everyone can't ramp up industry, or there is no one to buy, but a comparatively low wage economy like Latvia should be able to produce. There can't be any congenital reason why you can't.

You need to go out and attract the FDI which will start to become available as things recover. You have a low tax environment, now you are about to get a low wage one. You need the labour, of course, and to some extent you will need to pitch for migrants, but if you get all the prices right I don't see why Latvia shouldn't be able to attract investment to build factories, rather than attract money to build houses. Once you have the factories, and the people are earning wages, then they can buy the houses and pay for them, unless you get another sudden bout of land specualtion.

The big falacy was the idea of a services only economy, with the money coming not from Latvian savings but from the external wholesale money markets (or Nordic banks). This was always nonsense, its just that now people can see that.

There is no solution one way or another for tomorrow, we are talking about years here. But as I keep saying, better to do something than to do nothing.

Estonia seem's to do outsourcing for Finland, anyone ever thought about Latvia outsourcing for Sweden (to pay for the bank flows), or am I miles off the mark here?

Edward Hugh said...

Hi again Resident,

"If i am right, then you can grow GDP by reducing the negative effect of net exports (imports are almost double of exports in Latvia) ... so I would probably more focus on domestic investments (in non-cyclical industries - consumer staples, healthcare & Pharma, local energy sources) that reduce imports?"

Well this is in the right ballpark I think, but you are a small (open???) economy, and there are things like economies of scale (and patents) so the rational solution to this puzzle would be to concentrate on some small segment here, and produce for the domestic market and for exports, and then trade some of the exports for some imports. Well, this is just basic Ricardo I suppose :).

But it is also Krugman new trade theory, which is appropriate since he has now taken an in Latvia.

I take your point (as I am saying) about the world not working as it should if we all go for exports, but it won't either if we all go for import substitution (aka protectionism Lite). Basically, what Latvia unfortunately has to do right now is practive import substitution via what we could call stomach substitution - that is placing air where previously there was physical substance (aka dropping living standards).

Devaluation or no devaluation doesn't change this, since it is simply swapping dropping imports by making them too expensive for dropping imports by making wages too low to pay for them. Which way would you like to be shot sir, with the Smith'n Wesson, or with the Colt. Or perhaps you would rather be pistol-whipped with the butt handle of either one of them (old soviet economic management school technique).

Anonymous said...

Hi Edward,
(this is also wonkish and in no particular logical order, by the way - i am not a "professional" economist... :))

well, there is no question that it has been a fundamental mistake to de facto fix the FX rate in such a narrow range and the all Krugman's working in full extent (destroyed local economy after the exit from USSR, and small, and quite open), adding up the easy access to foreign money (mainly via Scandi banks that made the same mistake in the early 1990-ties?), and promises of joining the euro-zone very soon ... made the illusion of fast catch-up to West so sweet!

Well, Scandinavia solved its crisis in 90ties (partly) by devaluing, but then there was no global consumption bust in works ....

I do not say either that Latvia should focus on "fixing" internal market only, it should go for exports too ... However, it is unfortunately very unclear what to focus on, assuming the current conditions (collapse of consumption, production, exports in double digits almost everywhere on global scale). You may simply make a costly (you would be running a competition among even desperate exporters... with much larger resources to promote themselves) mistake, by achieving too little ... just because there may be too many desperate exporters. Yea, and just imagine that Japan and Eurozone finally realize that they are "exploited" by US, UK, Russia etc. to go for global competitive devaluation ... In this context Latvia is in much more disadvantageous position vs e.g. US or UK that have no or very little foreign currency debt. Interestingly, but it seems that the consensus of CNY (Chinese yuan) appreciation vs USD is broken, too..?

As Krugman wrote: "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.)". Well, this is probably an accounting issue, but by deflating local cost factors you would save the equity capital on the balance sheets of Latvian corporate sector (not only banks)(unless they are not the same as a result of deflation), as devaluation (this would happen very fast) would increase the value of debt in foreign currency and reduce by that amount the equity ... Well, equity capital appears to be very expensive at moment? And may add up enough to compensate for the 15% local currency debt...

As to Krugman, he seems to be quite unsure that the Obama's "kiss" (ie. fiscal stimulus in 2009) is a guarantee for a sustained recovery in US thereafter, see here: http://economistsview.typepad.com/economistsview/2008/12/paul-krugman-li.html , but he is an advocate for fiscal stimulus ... so, he appears to prefer the "managed" (Keynes) approach to break the vicious cycle. At what cost?

I do not believe Latvia can make a managed devaluation on stand-alone basis - that would be rather a repeat of Ukraine (down 50% and not sure where the bottom/equilibrium is?).

Well, it is not clear to me - why the Latvian government has decided to borrow from IMF consortia, devalue the workforce instead of currency? But I would list following items:
1. Government suddenly realized that the revenue in government budget are falling rapidly due to local and global economy, so they needed to fill the gap, but that was not the most critical ..
2. if not the collapse of Parex bank, that will need ca 1.5-2.5 bln EUR from government to keep alive, and this came as a "slam dunk" to enter the emergency ...
3. i would say that rather fortunately, government was forced to ask IMF for funding, as government reforms were desperately needed ... (the politically unpopular reforms got new enemy, and abroad)
4. I still do not get - why the donors accepted the no devaluation scenario ... i do not know either, what the government has promised, but:

a) it may be due to current global conditions, as i list here ..
b)Sweden (other Scandi too) was actively promoting orderly solution, as this may be disorderly for Sweden/Scandi ... but Krugman may call his pal at Riksbank, he should have the answer. Let' s speculate - this is a rather temporary bailout of Scandi banks, and they will take the hit as global conditions stabilizes? Well, why Latvian taxpayer should pay that?
c) Labor deflation is certainly unfair to poor, but government, if i understand correctly, has promised, within the IMF consortia framework agreement, to keep the living standards of "very poor". But current solution favors the rich ...

Still, if the ERM2 agreement with ECB is in force, the ECB should support the +/-15% band ... and this should be used for "managed" floating vs EUR later on, as situation stabilizes ... just to make imports more risky, and promote local economy.

If you have smart people and good management, you would more likely achieve much more on your domestic soil currently - well, if you have them - smart people and management? So far the Latvian government rather appears on the opposite side of this wishful thinking. But if you assume you can manage that, it would be more effective in terms of available resources invested...

Actually, I wonder why the Latvian government has not contracted Krugman for good advise in exports and trade ...

... but Krugman's statement contains "unavoidable destiny" and ignores the "inability of humans to forecast" (although his track record is rather good :)). And the US has the right to use "managed" approach vs Latvia that does not deserve it ... The US approach may end in tears too http://www.nakedcapitalism.com/2008/12/martin-wolf-says-big-stimulus-programs.html, and depends on Sandy Feet, Chinese Communists and Japanese Desperate Housewives Investors accepting the US dollar AS IS, otherwise the global competitive devaluation will end in US peso, or US shekel, or US yuan? Assuming such background the new Argentina' s "another tragedy" will be not noticed and the damage for civilization will be less than Mad-Off Ponzi. Well, this is no fun, if comes true ...

What yea think?

Merry Christmas!