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Wednesday, January 28, 2009

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

The IMF Senior Regional Representative For Central Europe and the Baltics, Christoph Rosenberg, recently took me to task on RGE Monitor about my Latvian devaluation proposal (as did RGE's own Mary Stokes), and I would like now to take a closer look at some of the points they raise.

In the first place, I would like to say that I obviously regard both Chrisoph and Mary as excellent economists, and I was in no way refering to them when I said that arguing in favour of sticking to the present currency peg constitutes trying to justify “virtually the unjustifiable” according to “the implicit consensus among thinking economists.” I do still hold that the consensus is with me, but that certainly does not mean I regard those who differ from me as "unthinking", and certainly hope I didn't give the impression that I was. And with that little "mea culpa", let combat begin.

And what better way to do this than by looking at Christoph's own arguments, (see below, and I hope I am being fair), although before I actually get into this part, let me "fast forward" to what I see as the three central issues involved: the timing and duration of the correction (that we all agree is needed), the role of Latvia's special demographics, and the distribution of the impact of the eventual debt restructuring between external stakeholders (the EU fiscal structure and the foreign banks) and Latvian state finances.

V Shaped or U Shaped?

As I see it, some of the force of Christoph and Mary's argument lies in the idea that there is little possibility of Latvia being able to succesfully carry out a V shaped correction at the present time due to the hostile global environment, thus it is better (my words not theirs') for Latvia to "mark time" to some extent between now and (say) 2012 (when possibly the external environment will be returning to some sort of normality, again my feeling, not theirs), and I understand the force of this point, I really do, it's just that I don't think Latvia's social fabric will be able to withstand the sort of pressure it is going to be put under (and Edward Harrison has already highlighted this part, as I have in my longer post on the difficulties associated with introducing generalised wage reductions). The IMF report on the Stand-By Arrangement stresses time and again that political consensus is vital to carrying through the proposed "fixed-peg correction", and yet it seems as if we are already running into difficulties on this front.

Also, and to try to keep this simple and as non-technical as possible, we are simply dealing here with trade offs, trade offs between the accumulation of bankruptcy and non-performing loans on the one hand, and the attraction of new FDI for manufacturing industry and getting growth through exports moving on the other. The trick is to get the balance right.

Now the U shaped recovery puts greater weight on the former, while the V shape one puts it on the latter, and I think the choice is as simple as that really. But I would also add in a further factor (to be explored a little more below), and this is the cost of waiting (there is always a cost to waiting) in terms of the demographic transition Latvia is living through (I am thinking about both out-migration and the impact of population ageing and Latvia's declining potential labour force). I suspect that part of the difference between us lies in the fact that Christoph and I attach different values to the cost of waiting in the Latvian case, and the roots of this difference lie, at least in part, on the differing theoretical frameworks we are using. To be blunt, I do not live in what I consider to be the rather timeless and abstract world of neo-classical steady-state growth and convergence theory (for all of which we have precious little meaningful empirical evidence across the EU27), but in the real historical time of ageing and shrinking populations, non-linear growth trajectories and windows of opportunity.

Latvia has between now and 2020 to get rich before it gets starts to accumulate so many age-dependency-related on-costs that it may, if it doesn't put in a well-founded spurt now, quite simply never close the gap. So Latvia is living in real historical time, and not an abstract theoretical one, and in the former, if you don't seize the opportunities you are offered with both hands, then you may well simply end up as tyre rubber on the highway of history, enjoying momentary fame only to end up as a historical irrelevance. So although history doesn't simply keep repeating itself in a simple circular (or Poincaréan) fashion, tragedy is always tragedy, whether it is the first, second, third or nth time round.

But perhaps "marking time" isn't really a fair analogy either, since obviously Christoph feels that the time in question can be put to good use - implementing structural reforms, rewriting the bankruptcy law to make debt restructuring easier, reducing wages and prices, etc, etc - but my worry is that all this will take place against a strongly contractionary atmosphere, with strong reductions not only in real GDP but also in nominal GDP - I mean if we are talking about a 5% plus contraction in real GDP, and (let's say, just as an example) a 3% reduction in the general price level, then we are talking about a drop of about 8% in the nominal value of GDP in 2009, and about another very large one in 2010, so let's be clear, these are contractions of a large order of magnitude (not far off the US 1930 - 33 ones) and my most serious doubt is about the ability of the Latvian social consensus to hold together through this, especially if there is no visible improvement in general conditions as a result. You need some sort of carrot, and not just good will.

Wage freezes Are more Palatable than Wage Cuts

Now it may seem strange to adduce arguments from evolutionary psychology (not Evolutionary Psychology, please note) in a debate about macro economic policy, but I do feel that years and years of evolution have left us with a kind of asymmetric bias which means while we definitely (always and everywhere) don't like to see our wages and salaries actually cut, we have much less resistance to them being eaten away by price inflation (again, this is the whole point of Keynes's little tract "How To Pay For The War" - its just that this war is an economic and not a military one). So politically, it is easier in principle to maintain consensus around a devaluation which followed by tight controls on income, than it is to cut people's salaries outright. Another example which illustrates my point here comes from the recent German experience, where real wage deflation was effected over a number of years (1995 - 2005), and export competitiveness restored, by maintaining a wage freeze, and getting people (during the most significant part of this process) to agree to work more hours for the same money. But to do this in Latvia you need to be able to expand output and add jobs, which is why devaluation is, in my opinion, highly desireable. You cannot expect people to work for the same money and longer hours, and agree to the chap working next to them being dispatched off to the employment offices, things just aren't that simple in the real world.

The bicycle is must easier to keep stable if you peddle forwards.

The Demographics Clinch It

So this brings me to the biggest problem I have to the whole U shaped correction idea in the Latvian context. I will readily agree with Christoph when he says that the Latvian labour force is extremely nimble, and indeed it is especially so when it comes to packing its bags and heading off in the direction of the frontier in search of work abroad. In fact it is so nimble that it manages to do this without the Latvian statistical office even noting that the people have gone, that's how nimble they are.

So this is the outcome I really fear most, the one which means that when Latvia does eventually start to recover, this recovery will only take place with a time lag, and in the wake of an expansion in some key West European (and especially Nordic) economies, which will mean that their will be another loss of workforce in the slipstream their take off will create, a loss which can become a very serious drag on future growth, and indeed may well restrict even further the inflation-free level of sustainable growth for the entire Latvian economy. The chart below, which compares the Irish and the Latvian wage distributions comes from an earlier period (and indeed was prepared by the IMF itself), but it does give some idea of the problem, since there is a clear wage slope running across Europe from east to West, and much needed Latvian workers have an unfortunate tendency of trying to climb their way up it.

(please click over image for better viewing)

So the situation envisaged in the "fixed-peg correction" - namely a period of negative economic growth and substantial wage contraction - will probably only produce yet another round of out-migration (although this time, in all probabity, it won't be to Ireland) which will in turn makes the domestic wage correction even more difficult to implement (another kind of 'vicious loop'). It is interesting to note that the IMF were raising this sort of issue with the Latvian authorities during the earlier overheating phase, but the Latvian solution (which prevailed at the time) was really to tolerate higher than desireable wage increases in order to disuade Latvians from leaving. So there is prior evidence that whatever the promises (and even, lets be generous, the good intentions) local governments find it very hard to stand in the path of their voters when these want social improvemnt, and indeed such vulnerability could come from the most compassionate and noble of motives, the problem is these are simply misplaced.

Debt Restructuring A key Problem

Here (see below) is the IMF Structural Roadmap as it appears in the latest report, and as can be seen, there is a heavy emphasis on the legislative changes needed to carry out the debt restructuring, which gives some idea of the important role this played in the decision making process.

• Cabinet of Ministers to adopt decision that reforms controls over budget execution (December 31, 2008).
• Adopt operational guidelines clarifying procedures for provision of emergency liquidity assistance (December 31, 2008).
• National Tripartite Co-operation Council will establish a Committee to Promote Wage Restraint (January 31, 2009).
• Review and, if necessary, revise regulations on emergency liquidity support (January 31, 2009)
• Complete focused examination of the banking system (March 31, 2009).
• Develop comprehensive debt restructuring strategy (April 30, 2009).
• Amend banking laws to give FCMC, BoL and Government powers to restore financial stability in case of systemic crisis (June 30, 2009).
• Adopt an amendment to the Budget and Financial Management law to strengthen financial responsibility, transparency and accountability (June 30, 2009).
• Amend insolvency law to facilitate orderly and efficient debt restructurings (June 30, 2009).

I have to say that I am really rather surprised at a numberof the things I found on reading the IMF report in detail. In particular I discovered that the true size of the 2009 annual fiscal deficit is going to be 17.3% and not the "mere" 4.9% that appears in the final budget accounts. This is not a problem of "massaging" (I am not suggesting that) but a by-product of the cost of bank restructuring - which involves recapitalisation and the acquisition of "troubled assets" - and these costs, under the new accounting rules, are classified as held to maturity, and not marked to market in terms of their valuation, nor, under the present convention do such liabilities appear as part of the headline fiscal deficit number.

Nonethless Latvia's gross public debt is now set to rise, and dramatically. It is set to go up from 8.3% of GDP in 2007, to 14.3% in 2008 and to an estimated 46% in 2010. And this is all basically to pay for the bank bailout (which is estimated by the IMF to be likely to cost of $1.868 billon in 2009) and not in order to address issues in the broader economic crisis.

The worrying part of all this is that if we don't get the best case scenario, and find ourselves, for example) not with a U- but with an L- shaped non-recovery, then this debt to GDP (and indeed even the annual fiscal deficit itself) may start to head above the EU 60% and 3% rules in 2011 or 2012, thus putting in jeopardy the IMF's own exit strategy for Latvia of eurozone membership. The IMF themselves go to some length to point out that the best case outcome critically depends on maintaining a political will which (as we are starting to see) may not be so strong as they were lead to believe at the time of making the agreement.

The problem is that Latvia, apart from the internal credit boom, and the consequent housing bust and real economy contraction which follows (and which all three Baltic states "enjoyed" actually stands out from its Baltic peers in that it also became something of an offshore financial centre during the boom years. That is to say, there are shades of the Iceland or UK problem in the Latvian situation. I quote the IMF document:

"Finally, standard debt sustainability analysis may not capture all of Latvia's characteristics, given its dependence on foreign bank borrowing for credit intermediation and its role as an offshore financial centre. First, Latvia's net foreign debt is much lower (around 70 percent of GDP), as it reinvests many of the non-resident deposits in assets overseas. The value and liquidity of these assets then becomes key. Second, much of its foreign borrowing is backed by domestic assets. Thus external debt sustainability will depend on whether these assets recover value and will be able to generate future returns to service the debt."

As I read it, this means that Latvia is a miniture version of Iceland or the UK, and that as well as a macro consumption boom/bust disaster there is a non-domestic-loan recovery problem inside the banking system of some magnitude. As the IMF itself says the value and liquidity of Latvia's overseas assets is one of the "keys" to the problem. The other "key" depends on whether or not domestic assets recover their earlier value, an outcome which given even the internal price deflation strategy proposed by the IMF seems fairly unlikely, at least over the relevant time horizon.

The bank restructuring component is so expensive largely because the Latvian owned Parex bank (assets equivalent to more than 20% of GDP) was taken over by the government following a run on deposits and the consequent need to avoid default on the 775 million euros ($1 billion) of syndicated credits due in 2009. In fact the problems at Parex were one of the main reasons Latvia went to the IMF and EU for financial help in the first place - since in theory the issuers of the syndicated credit had the right to demand repayment of the debt immediately following a change in ownership at the bank, and the government needed the institutional support to be able to renegotiate and rollover the debt.

As a result the Latvian authorities have been able to issue guarantee for the refinancing of isyndicated loans of EUR775 million due in 2009 (EUR275 million in February and EUR500 million in June). The credit ratings agencies, and in particular Fitch, believe that in the current global economic climate a rapid future sale of the bank difficult and that the government will have increasing difficulty in the future refinancing the syndicated loans. Moreover, the risk of further deposit withdrawals from Parex bank, especially by non-residents, will continue despite the effective nationalisation of the bank.

The new Parex chairman Nils Melngailis was quoted recently as saying that the bank's value was anywhere between 2 lats ($3.65), the price the state paid to buy out the two previous owners, and 600 million euros.

If all this is correct, then my guess is that we could even be eventually looking at the possibility of a Latvian sovereign default. I mean, personally speaking, I am pretty sure the medicine the IMF are administering just won't work (for the reasons I am putting forward) and that things will deteriorate. But sovereign default something I would never have imagined before I started digging a bit deeper into the whole situation. And the IMF should seriously be thinking about this. Latvia's level of public debt was previously very low, and then whooosh. Fitch seem to share this view, since they have maintained their negative outlook following last November's downgrade.

Fitch Ratings has today downgraded the Republic ofLatvia's long-term foreign currency Issuer Default Rating (IDR)to 'BBB-' (BBB minus) from 'BBB', Long-term local currency IDRto 'BBB' from 'BBB+' and Country Ceiling to 'A-' (A minus) from'A'. The Short-term foreign currency IDR is affirmed at 'F3'.In addition, Fitch has placed Latvia's sovereign ratings onRating Watch Negative (RWN).

Soon enough Latvia will have to face all the on-costs of pensions, health etc for the growing numbers of old people as the median age rises (see chart above). Claus Vistesen and I are busily trying to "calibrate" things here, since notionally Latvia's median age is a lot younger (41) than that of Japan, Italy or Germany (43). But then, on the other hand, Latvians live on average ten years less. So people stop working earlier, and since the really large health care costs are during the last 5 years of life, and this doesn't change substantially if those involved are between 65 and 70 or between 80 and 85. So there is an ageing "calibration" issue here - one which non of the multilateral agencies involved have yet taken on board as far as I can see. Also we need to move the saving and borrowing age ranges around a bit when we come to think about the life cycle (to adjust for shorter working lives etc).

And this "just where is all the money from the loans going" issue is a much bigger question than simply a Latvian one. The IMF original loan to Hungary, for example, included HUF 600 billion (about 20% of the total loan) to be allocated to bank bailout plans, 50% of which was earmarked for capital injections while the other 50% was to be used for state guarantees for commercial banks. The government later boosted this HUF 300 billion guarantee fund to HUF 1,500 billion, however today it has been announced that more of the IMF loan facility may be used to back loans right up to the 1,500 billion HUF level - which surely gives us an indication of the severity of the problems they are having. But what concerns us here is that as a result of these and other measures Hungarian debt to GDP is now projected to rise (Januarry 2009 EU Commission forecast) from approximately 65% in 2009 to 79% in 2010, and of course there can be downside (or if you prefer, upside) on this. So both Hungary and Latvia look dead set to me to receive further credit downgrades, downgrades which will only serve to materially worsen the situation. And thus there is a considerable danger of a self-perpetuating downward spiral, especially if due to the weighting towards the bank problems the present package of measures simply don't work. People are vastly overestimating the power of longer term structural reforms in the context of such a sharp downturn. All very troubling.

Deflation A Problem?

Also, there is another fundamental reason for devaluation, and that is the ability to regain control over an independent monetary policy, since handling a sharp and sudden deflationary shock may well be much harder with a fixed-wheel lock-in to the ECB benchmark rate. Ben Bernanke himself gave us a good example of how the sort of debt deflation process to which Latvia is going to be subjected works in practice, and why it is so dangerous in a modern economic context) in an early paper he wrote on Japan.

To take an admittedly extreme case, suppose that the borrower’s loan (taken out prior to 1992) was still outstanding in 1999 , and that at loan initiation he had expected a 2.5% annual rate of increase in the GDP deflator and a 5% annual rate of increase in land prices. Then by 1999 the real value of his principal obligation would be 22% higher, and the real value of his collateral some 42% lower, then he anticipated when he took out the loan. These adverse balance-sheet effects would certainly impede the borrower’s access to new credit and hence his ability to consume or make new investments. The lender, faced with a non-performing loan and the associated loss in financial capital, might also find her ability to make new loans to be adversely affected. This example illustrates why one might want to consider indicators other than the current real interest rate—-for example, the cumulative gap between the actual and the expected price level—-in assessing the effects of monetary policy. It also illustrates why zero inflation or mild deflation is potentially more dangerous in the modern environment than it was, say, in the classical gold standard era. The modern economy makes much heavier use of credit, especially longer term. Further, unlike the earlier period, rising prices are the norm and are reflected in nominal-interest-rate setting to a much greater degree. Although deflation was often associated with weak business conditions in the nineteenth century, the evidence favors the view that deflation or even zero inflation is far more dangerous today than it was a hundred years ago.

And it seems Lavia is now about to enter a sustained period of price and wage deflation (and thus loan to income inflation) with no monetary and no fiscal tools to attack the problem.

OK, Now for Christoph's points

1/ a devaluation in Latvia would have severe regional contagion effects. I think that on this point we are all in basic agreement. On my view, the EU and the IMF need a coherent common strategy to address the whole situation in the East (at least across those countries who form part of the EU), and I think we are rapidly getting past the point where problems can be dealt with on a piecemeal basis. I mean. clearly some of the points here post date our earlier debate, but part of the foundation of my initial argument was that the whole situation was at risk of becoming so serious that nothing less than a concerted regional initiative would have the credibility and the robustness to work. It may be that outright eurosisation of the entire group maybe the only viable way to go, but I need to argue this separately and substantially, so I will not go into this further here). But, be that as it may, the leading question is that even if eurosiation is to be contemplated, Latvia, Lithuania, Estonia and Bulgaria all need to come of their pegs and lower the parity at which they would enter, and even if the situation in each case is different, the problem is going to be the same, so my underlying point would be better to do this in a cordinated way, and indeed the decision by the Hungarian government to come off their band back in May could be seen as a first step in just this direction.

This is doubly the case since when we talk about regional consequences, we can also talk about the regional effects of a strong devaluation of the UK pound, the Swedish krona, the Russian ruble, the Ukrainian hryvnia, the Czech koruna, the Hungarian forint, and the Polish zloty. Basically the economies in all the aforementioned countries all face a similar problem - domestic demand is down and they need to export, and they are all addressing this by the application of a mixture of devaluation and price deflation, and basically I don't see why the Baltics should be so different, and why we (or at least the IMF, the WB and the EU) don't treat the three Baltic states as one single group here.

3/ Latvia’s preference for the peg is strongly supported by all foreign stakeholders, including the EU and its Nordic neighbors..........it seems unlikely that they will cut their losses and pull out, as Japanese banks did during the Asian crisis. Well, this is certainly the case, but it is not at all clear that these stakeholders could not be brought over to a devaluation strategy. There is currently a lively debate going on in Sweden about just how much responsibility the Swedish government and monetary authorities should accept in the context of what is happening in the Baltics (see here, and here), and more significantly, the Group Of Ten West European banks with most exposure to the CEE economies has started to lobby for an initiative from the ECB and the EU Commission to address the problem of the inevitable bank losses (since I take it we are agreed that the defaults will be no less on the internal deflation approach, and may well, as Krugman suggests, be greater as those who have borrowed in local currency are also forced into default).

4/ A devaluation would not significantly reduce Latvia’s external financing needs. I am not sure about this. Obviously a devaluation which was sharp enough to remove all further worries about future devaluations would take a lot of pressure off the country's reserves. The shrinkage in the CA deficit would also, as you say, help a little, as would the fact that internal saving would start to improve domestic liquidity.

While it would shrink the current account deficit further, private sector roll-over rates might not improve because the higher external debt to GDP ratio would likely result in credit agency downgrades to junk status and trigger the immediate repayment of most syndicated loans. I completely accept this point, but assume that the devaluation strategy would need to be accompanied by a loan restructuring package. Evidently this will be necessary in any event, on the devaluation variant they restructuring will come sooner, but against the difficulties this may present for a Latvian legal framework which is ill equipped to address the problems which will arise can be offset the advantages of getting all the bad news out of the way early.

5/ there are advantages to a U-shaped adjustment via factor price compression over the V-shaped recovery that is often associated with a devaluation.....Christoph makes the entirely valid point that Latvia’s banks (both domestic and foreign owned) and its legal system are at this point quite uprepared for the sort of stress a comprehensive debt restucturing process would put them under. By drawing the process of bankruptcies and nonperforming loan accumulation out a bit, Christoph argues, the authorities may well buy time to improve the country’s insolvency regime, strengthen banks’ capital base and allow private debt restructuring.

Well, this is essentially the same set of issues as in argument 4. There are advantages in drawing out the bankruptcy process, but against these advantages need to be offset the problems posed by reform fatigue, as people are asked to sacrifice over a long period with no visible benefits to see for their effort. And there is no guarantee that the towel won't simply have to be thrown in at the end of the day on the U shaped recession, with a hasty devaluation being carried out, and the U being converted into a UL, with the bounce back only coming much later.

6/ it is questionable whether a devaluation would quickly boost exports, given the global environment and the structure of its exports. Re-orienting the economy towards tradables will require structural reforms which are envisaged in the program. Basically, I think we are back to the "waiting room" approach again here. Export lead growth is not really a credible option at the moment, so the argument goes, given that the external conditions are extremely unfavourable, and that Latvia's economy is dominated by non-tradeables, financial services and construction. All of this is undoubtedly true, but my argument is that you have to start somewhere, and may own view is that it is better to start tomorrow, rather than the day after, and I think the key to breaking the logjam is attracting greenfield site FDI, but to do this you need to get your operating costs down, and the V shape correction achieves this outcome quicker than the U shaped one.

7/ Latvia has a very flexible economy, especially a quite nimble labor market. Really I don't know what to make of this argument, since if this is the case, why was it not more evident during the years of dramatic wage inflation. Wage cuts of up to 25 percent do seem, as Christoph says, large, but so does the tripling of nominal wages between 2001-07 (doubling in real terms), and unless we get to grips with why all that happened in the first place (that is we take a good look at what may be the real Latvian capacity growth rate without inward migration) then I feel I remain unconvinced that we are suddenly about to see a newborn agility in the Latvian labour market. What I see are rather labour market rigidities, and a resistance to change.

Some analysts called for expanding inward migration to alleviate shortages and dampen wage pressures. However, policymakers generally considered that this would have the effect of replacing domestic low-cost workers with imported ones, thereby holding down wages and promoting further emigration. The government argues that rapid wage convergence with western Europe is needed to check emigration. - IMF Staff Report, 2006
Conclusions And Exit Strategy

So where does all this leave us? Well basically that what we have on our hands is one hell of a mess, and that here there are no easy solutions. Did anyone tell you we lived in an imperfect world? Well what is going on in Latvia is surely as good an illustration that you are likely to find that this is the indeed the case. There are no easy, quickfix, policy solutions, and I fully understand Christoph's dilemma, and the difficulty associated with decision taking in this case.

But, while nothing is guaranteed to work, some approaches may turn out to be better placed than others, and it is my considered opinion that the best way of addressing the Latvian problem is by trying to kick-start the economy via devaluation, and to then tackle the wage increase problem by explicitly opening Latvia's frontiers to external migrant labour (as, for example, the Czech Republic have, to some extent, done). Such devaluation, backed by imaginative enough greenfield site support from the government, could attract the FDI, and alongside it the migrants to provide the manpower for unskilled positions, with better educated Latvians being able to get involved in some of the higher value work. If something is not done to break the population vicious circle, and the meltdown in internal demand and property prices as young Latvians seek work elsewhere then the outcome is all too clear, although not for that any less tragic, as Krugman suggests.

Of course, some may wish to object at this point that devaluation has the same effect on wages as wage cuts do, and they would be right, but the point is the overall level of economic activity is greater on the V shaped approach (this was Keynes', and is today Bernanke's, basic insight). Latvian GDP is about to be thrown, from a period of trying to operate above capacity, to one where for an extended period of time it will operate below capacity. This can never be a good solution. On the V shaped recovery scenario the time path of GDP is higher, and the possibility of finding remunerative employment for each and every individual Latvian is to that extent greater. More idle resources will be put to work at a time when there is huge slack in the global system, and energy and material costs are at very low levels. Investment (building factories etc, buying machinery and equipment) simply couldn't be cheaper . Putting the resources to work to make this possible quite simply can't be a bad thing, or so I contend, and certainly not if the alternative may be sitting back and waiting till you have a sovereign default coming crashing in on top of you.

I see plenty of work for Latvian parliamentarians (passing much needed laws etc) in the current proposals but I see comparatively few initiatives which will keep the idle hands of Latvia's valuable human resource base from freezing over.

Let us be clear, of course there is no single clear "cure all" remedy here, but I think we need to say strongly that the earlier attempt to stem the migrant out-flow by being lax on the wage inflation front was to invite disaster (and the disaster of course came), whereas now, excessively compressing wages as the solution will have the impact which was previously feared.

Export Defeatism?

One of the biggest obstacles facing countries like Latvia at the present time (of course Latvia is far from being unique, Latvia is simply the "canary in the coalmine") is a kind of passive defeatism about exports. Of course, Christoph is completely right, the global environment coundn't be more unfavourable, but there really is plenty to be done, so why not keep warm during those long dark winters doing some of it. The EU Commission points out the problem in its latest forecast:

Exports are still dominated by commodity products and re exports, with only limited evidence of moving up the technology ladder. Hence, export revenues are exposed to volatile global commodity price developments (mainly prices of wood and metals). Furthermore, unfavourable real exchange rate developments (based e.g. on unit wage costs in manufacturing) had a negative effect on the external competitiveness of the economy. However, a recovery of exports in the first part of 2007 was driven by manufactured goods which stood at odds not only with the above described problems of the supply side, but also with the reportedly very low increase in manufacturing output in the same period. The overall conclusion on progress in strengthening the supply side is therefore mixed, but it can be concluded that the current domestic cost developments pose serious challenges to producers of tradeable goods and services. EU Commission, January 2009 Latvia Forecast

Finally Christoph has one additional point which really serves as a conclusion and a monument to all this, and that is the idea that Latvia has a clear exit strategy from its currency predicament: euro adoption.

As Christoph says, the Latvian authorities are determined to work to meet the Maastricht criteria in 2012. Certainly entering the euro zone will not do away - at a click of the finger - with the hard lifting necessary to address the competitiveness and high external debt problems (as he suggests in his avoiding the Portuguese trap article, and I go through in my Portugal Sustains post here). But it would offer support to a struggling Latvia and help bring back investor confidence. The point is, at which exchange rate should Latvia enter ERM2? Indeed, it is now apparent - if you read the IMF staff report on the standby arrangement, on their website, that they favoured an expansion of the band to 15% (which basically means 15% devaluation) and it was the EU itself who objected and pushed to retain the peg (see appendix below). It is not difficult to see the problems a Latvian devaluation might face in the light of the Parex related issues without direct euroisation (or EU fiscal support), but the thrust of my argument here has been that these difficulties (credit rating downgrades, sovereign default vulnerability) are going to come anyway. Indeed Latvia had its foreign-credit rating cut to Baa1 by Moodys on January 7 2009, the second such downgrade in three months, with the agency citing increased risks of a prolonged economic decline (read L shaped recession).

“The downgrade reflects the further intensification of the economic adjustment in Latvia since October 2008,” said Kenneth Orchard, an analyst with Moody’s, in the statement. “The economic downturn is now expected to be deeper and more prolonged than previously assumed.” The risk of a “disorderly correction” to economic imbalances remains even after securing the 7.5 billion-euro ($10.2 billion) international aid package. “Government borrowing will rise significantly over the next few years to smooth the adjustment and prevent a major economic crisis,”

Basically, the EU objected to the IMF proposal for emergency eurozone membership on the grounds that this would sat a precedent in other cases. But I really do feel that the Commission (and the ECB presumeably) are being ridiculously pig-headed here. We have an emergency on our hands, and exceptional measures are called for.

It is impossible for me to go here into all the issues involved in collective membership of the eurozone for the EU12 states that are not already in, but let me just say we need a substantial rethink allround, involving:

a) Issuing EU bonds to collectively fund bank bailouts across the Union (East and West)
b) Collective membership of the eurozone for those EU member states who want it
c) A new Lisbon Strategy and Stability and Growth Pact code involving much stricter conditions and stronger Commission powers and sanctions.

c) is the necessary and prior condition for giving consideration to (a) and (b) and not the other way round.

Finally, thank you, one and all, who have struggled forward and reached this point. In particular thank you for being so patient with my verbal largesse. I am trying to contain it, I really am.

Appendix: Extracts From IMF Staff Report On Latvian Request for Stand-By Arrangement

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.

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 (see below), 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.

However, balance-sheet effects would cause a sharp drop in domestic demand. The net foreign currency exposure of Latvia’s private sector is around 70 percent of GDP, with the corporate sector’s foreign currency open position roughly double that of the household sector’s. A 15 percent devaluation against the euro would increase private sector net foreign currency exposure by 11 percent of GDP, two thirds in the corporate sector and one third in the household sector. Mismatches between owners of foreign currency assets and liabilities suggest that devaluation may cause substantial redistribution effects. Private consumption would fall by around 6 percentage points due to negative wealth effect as net foreign debt increases, house prices decline, debt service costs increase, and consumer confidence deteriorates. Experience of other countries suggests that a devaluation of this magnitude would lead to a 5 percentage point decline in private sector investment.

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.


Anonymous said...

You mentioned possibility of default by Latvia. Taking into account Argentina's experience would not it be a sound strategy for Latvia to default at some point of the time? I assume that as soon as Latvia gets most of the money from EU, IMF and Nordics, it should default on the payments. It would give resources to restructure exporting sector. And would allow to restructure its obligations towards external financiers. What do you think of this?

Miacek said...

''my most serious doubt is about the ability of the Latvian social consensus to hold together through this, especially if there is no visible improvement in general conditions as a result.'' - a widespread social unrest is apparently already there, if we consider that according to a recent poll by Latvijas fakti, there are only two parties that would currently pass the 5% election threshold: pro-Russian Harmony Centre (just 9% support) and 'New era' (mere 5%). All current governing parties would get zero seats in Seima.


Edward Hugh said...

Hi Latvian,

"What do you think of this?"

I couldn't disagree more (in a friendly way) I'm afraid. I fear that this is what Iceland may be about to do. Basically such a move puts you beyond certain limits, and my feeling is that beyond there things get very very difficult. The big difference between Latvia and Argentina, Ecuador etc is the median age of the population. For what are basically quite technical reasons the age dependency problem you would have would be massive.

My advice is don't even think of doing this. And talk about "debt restructuring" not default, since while the two may be very similar, the latter expression puts the fear of god in a lot of people.

Basically, I think your government should have taken independent legal advice about how to restructure the whole Parex thing, and not simply taken into onto the public debt book, I'm not a specialist in this type of thing, but I am damn sure there are people out there who are.

So the way to do this is not default on the IMF, but change the bankruptcy law, using best and most favourable legal advice, remember you are a sovereign state, and offload - via restructuring - as much of the debt that your country doesn't deserve to have as quickly as possible. Once it is all on the government debt books any restructuring is a technical default.

Anonymous said...

Edward, it is Latvian again.

I have read most of your posts on Latvia and I do agree with most of your thoughts. I am myself a Latvian with the famous mortgage loan in euros. So it will hurt:).

Nevertheless my future scenario is on the pesimistic side. For Latvia to recover it needs to perform structural reforms. The yesterday memorandum of understanding between Ministry of Finance and European Commission was signed (http://www.fm.gov.lv/faili/bildes/preses_relizes/dok/MoU_ENG_versija.pdf). It has very generic requirements on structural reforms. The key of course is actual implementation of those reforms (it might not be a macro problem but is very important). Currently there are very few capable government officials who are capable of implementing those reforms. Long years of widespread corruption and division of government on basis of party affiliation have left government full of people with certain mindset. This mindset is focused on the doing what is good for themselves and party leaders. Even now in the government sector the main thinking is how to hide incomes and get through as much favorable expenses to compensate for their salary loss. There are no visible leaders in Latvia who have a capability to turn things around. In my opinion this is the main reason why Latvia most likely will default (or go into debt restructuring) on the government loans.

The key to solution is having as much pain as possible. It would force people out of existing paradigm and hopefully force new people into the politics. But as you have noted we have tight demographics. If we look at capable people who can actually turn things around, the situation is even tighter. It is all gloom and doom for me. But then I might be proved wrong...

Anonymous said...

Meanwhile the president of "Bank of Latvia" Ilmars Rimsevics told his opinion about devaluation in a public debate yesterday.
He said that "devaluation is a poison" and that "only pseudo-economists suggest Latvia to devalue".

I wonder what Krugman and others would say about this. :)