The Latvian Cat Is Out Of The Bag

Reuters this morning:

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

and Nordea flash comment:

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

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

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

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

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

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

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

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

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

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

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

Financial Crisis -> Real Economy Crisis -> Political Crisis

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

Update Dombrovskis "Corrects" Himself

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