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Thursday, May 28, 2009

Devaluation Imminent in the Baltics?

By Claus Vistesen: Copenhagen

Even when liars tell the truth, they are never believed. The liar will lie once, twice, and then perish when he tells the truth.

One thing which is certain at the moment is that the rumour mill is grinding hard and that it is very difficult to get a clear picture of what is going on. It is too cumbersome for me to go into the entire background here (I assume most of you are familiar with the Baltic and CEE situation), but if you want some background try this or this which will give you the opportunity to browse a myriad of articles. The situation is however pretty simple. Ever since it became clear that the Baltics was going to suffer not only a hard landing, but a veritable collapse on the back of the financial crisis one obvious question always was whether these economies could maintain the Euro peg throughout the correction process. So far the peg have held and the countries, as well as the IMF who have been called for aid, have been committed to the peg and thus the future entry in the Eurozone.

But this has come at a price and as international economics 101 tells us, the only way you can correct with a fixed exchange rate and an open external account is through deflation and a very sharp drainage of domestic capacity. And so it has come to pass that particularly in Latvia who has come under the receivership of the IMF the scew has been turned, (and turned and turned) and now the question is how much more can the public and the goverment take. In a recent article in the NYT the situation is well described as the Latvian government scrambles to meet ends on the IMF's pre-condition to continue funding the bailout programme.

One very significant indication that things are near its breaking point came when Central Bank Governor Ilmars Rimsevics launched the idea that, since the liquidity in Lati is being drained in order to keep the peg and because the cuts needed to abide by the IMF rules are immense, public employees might be submitted to receive their pay in "vouchers" in stead of actual Lati. As Edward points out, this is straight out of the vaults of the Argentian crisis' annals. This is one of the things you get with a peg maintained too tightly during a deflationary crisis. It deprives you from liquidity. Now, in some sense this all about the next installment of IMF funds of course and whether Latvia will (can) make the needed budget cuts to please the fund to such an extent that they will continue to slip the bailout checks in the mail.

Essentially, under the peg, the central bank has to buy Lati in the open market to maintain the peg since there is, naturally, a pressure on the peg as everybody want's euros. So, the central bank is forced to drain the economy from liquidity to maintain the peg in an environment where the economy is contracting at about 20% over the year. This is not fun and, as it were, not sustainable given the trajectory of these economies. In this sense devaluation is no cure but a simple prerequisite (and necessity) for the healing process to begin.

Even more significant it appears that the the foreign banks, so important in the Baltic story since they basically provided the liquidity inflows to fund the boom, are beginning to accept the basic point I, and others, have made so often before. This is the point that although a devaluation would entail default on a large batch of Euro denominated loans, this default would come in either case as a result of the utterly horrid contraction. In this sense it was very significant that the SEB Chief Executive Annika Falkengren pointed out;

"In total we would have the same size of credit losses, but (if there is no devaluation) they would be a little more regular and over a longer time frame," SEB Chief Executive Annika Falkengren told Swedish radio. "In the case of a devaluation they would be pretty much instantaneous."

This is important because one prerequisite for the peg to hold was always that the foreign banks explicity backed it since they pretty much finance the majority of the credit needed to hold these economies afloat and particularly so Latvia. Essentially, on the Swedish side of things it appears that they are pretty much treating this as over and done.

According to Dagens Industri' Torbjörn Becker, leader of the Eastern European Institute of the School, a devaluation is likely. "The alternative to a devaluation in Latvia is to wait until the reserve is drained and the economy will disappear into a black hole, " he told the DI. Torbjörn Becker believe that neighbors Estonia and Lithuania follow.

Moreover, the Riksbank just recently bolstered its foreign currency reserve with an amount equal to 100 mill SEK which can be interpreted as a precautionary measure to deal with a potential fallout in the Baltics.

The Executive Board of the Riksbank has decided to restore the level of the foreign currency reserve by borrowing the equivalent of SEK 100 billion. This needs to be done because the Riksbank has lent part of the foreign currency reserve to Swedish banks. We have also increased our commitments to other central banks and international organisations. The Riksbank needs to maintain its readiness to supply the Swedish banks with the liquidity required in foreign currency.

Finally, there is Danske Bank, aka Lars Christensen in the context of the CEE, who warns of a serious event risk in the Baltics in today's daily installment on emerging markets.

The event risk has risen sharply in the Baltic markets and we advise outmost caution. Yesterday, the Swedish central bank Riksbanken said it will increase its currency reserve by SEK 100 bn through a loan from the Swedish debt agency. Investors seem to believe that this is a buffer to deal with potential problems arising from the Baltic crisis.


With worries over the Baltic situation on the rise there is a significant risk of negative spill-over to other markets in CEE. Therefore we see clear downside risk on the CEE currencies and a risk of a sharp sell-off in the CEE fixed income markets in the coming days. We especially see value in buying USD/HUF, but potentially also USD/PLN on an escalation of the Baltic crisis.

Basically, the way I see it is that there is only so much the currency boards can do and in Latvia's case, after having already spent over 500 million euros buying lats, I think we are moving steadily towards the end game. Of course, there is an obvious risk that I will perish further down the road with this one, but then again, so be it. It is imperative that investors and stakeholders entertain the possibility of a multiscale Baltic devaluation and, obviously, a sharp CEE sell off in the wake.


Anonymous said...

Hi Edward, I understand that bad blood exist between the CB and Finance ministry at the top level. One used to work for the other and now they completely despise each other as is evidenced in the voucher comments.

Raivo said...


If I'm reading the data correctly, in 2008 the share of people with an academic education (bachelor's, master's or doctor's degree) was 25.2% of the entire work force.

Anonymous said...

What is Baltic? There is no such country and there is no Baltic economy as separate system.

It is the same as to ask every day
"How Scandinavian economy is doing?"

At least people in these countries
feel that way.

Anonymous said...

All Sweden banks and Sampo Bank in Estonia have been profitable past years inc. 2008.

Those Sweden banks in Estonia are not subsidized pay taxpayers as in UK and USA.

Future losses are just predictions and it is now clear that banks are not good in forecasting business.

If you refer to often to opinions of banks, like Danske Bank, then it is more like to journalism not to analysis.

It may be fun for you, but in reality people problems in Latvia and Estonia are very serious.

Hynek Filip said...

I do not know whether Kristjan will agree, but I am somehow beginning to think that the "devaluation game" is beginning to be played according to other than purely macroeconomic rules.

Following the decision of the Riskbank to mobilize the staggering amount of SEK 100bn to support Swedish banks in case of devaluation, I personally believe that even the Swedes realised that there is no economic option but to devalue.

Yet, I do believe that there is a very strong argument against devaluation, and that is a political one. We should not forget that the three Baltic states are geographically as close to Russia as one can get, and that just about twenty years ago the three states were part of the Soviet Union.

If any of the three states is forced to devalue, it will most likely cause a very big and very sudden drop in living standards, and may as well result in overall frustration with the EU, the IMF and all things Western. Mind you, I am not at all sure that the Baltic people will begin to feel unhappy with the EU, but it may happen.

So what is the conclusion? I am inclined to believe that with Ukraine on the verge of collapse, Belarus under effective Kremlin control, Moldova completely forgotten and Bulgaria struggling, the West (US plus the EU) can not afford to allow anti-Western sentiments to gain ground in any formerly socialist CEE country, no matter what the cost.

Anonymous said...



Edward Hugh said...

Bloomberg this morning: Bengt Dennis, the former Swedish central bank governor and an adviser to the Latvian government on how to cope with the economic crisis, said the Baltic country will need to devalue its currency. “No one knows if there will be a devaluation tomorrow or in a few months -- the timeframe is always uncertain -- but we have moved beyond the question of whether there will be a devaluation and should instead focus on how it will be carried out,” Dennis told Swedish state television SVT last night.

Edward Hugh said...


"If you refer to often to opinions of banks, like Danske Bank, then it is more like to journalism not to analysis."

I don't agree. I think there are some very good economists working in banks or ratings agencies or as investment analysts. I would just mention Aninda Mitra who covers India for Moody's, Dominic Bryant (Chief European Economist for PNB Paribas) and Neil Shearing (who covers Eastern Europe for Capital Economics). Such people are not mere journalists, and are a lot better at their job than most of the people who have been working to advise the Baltic governments of late.

Of course, as in all walks of life, not everyone is a "crack", and there are plenty of second division players to be found, and especially in the East European context, but Lars Christensen at Danske Bank has consistently been among the "realists" on the Baltics, and his record speaks for itself.

Edward Hugh said...

"It may be fun for you, but in reality people problems in Latvia and Estonia are very serious."

Look, I appreciate this very, very much. I mean, it does not make me at all happy to see people suffer in this way, especially after such a long history of suffering.

I would obviously far rather the position in Eastern Europe was like India or Brazil, an evolving economic success story. But it isn't, and it is my job, as a scientist, to try and find out why. That is why I am here, and doing this.

Look. My son is a doctor. He once had to saw someone's leg off from the knee. Do you imagine that was "fun" for him? It wasn't? But doing it helped save the persons life. Try to think of it this way. You are running an experiment. Others will learn from what you do. For better or for worse that should be some consolation.

If only we had known then, what we know now.....

But we didn't. That is the point.

"The Owl Minerva Flies Only After Dusk".

GWF Hegel

Edward Hugh said...


"What is Baltic? There is no such country and there is no Baltic economy as separate system. It is the same as to ask every day
"How Scandinavian economy is doing?""

Well, I understand your feelings, but I think it is a reasonably valid analytic tool.

I mean, I do think we talk about the Nordic (or Scandinavian) economies, since they have certain characteristics in common that make this useful. They are small open economies, pretty competitive, score well on institutional quality, are export driven, tend to run current account surpluses, and have welfare systems which have certain common characteristics which are widely recognised.

In particular they place great emphasis on gender equality, and offer very substantial support to those women who wish to have children. As a result, they tend to have near replacement fertility levels, and their economic systems are thuis a little more sustainable.

Baltic economies also have some discernable similar characteristics. All three have just been through a boom bust cycle. All three have low fertility and short male life expectancy. As a result when they try to grow they rapidly run out of labour supply, and have not yet implemented the kind of diversity programmes to be found in, say, the UK and Ireland which make their societies more friendly to migrant workers, thus helping overcome the birth deficiency.

As a result of the labour shortage their economies rapidly hit capacity limits and run into serious wage inflation as they try to expand. This whole problem will emerge again once growth does start to return, and probably with more intensity than ever, since your countries will surely lose permamently a lot of young educated people during the current depression ("L" shaped recovery). This is surely one of the prices you will pay for having been so stubborn about devaluation. But still, we all make our choices, and we all only get to live once.

The economies are small and open, but to date have run large trade and current account deficits. They all had housing booms which are now correcting, and they are all in metamorphosis to becoming export driven economies. People in these countries also tended to take out a large quantity of foreign currency denominated (euro) loans. I think that is sufficient in common structurally to use the analytic category "Baltic".

I mean, we also use the term "Central European" to refer to economies with some structural similarities like Poland, Hungary and the Czech Republic, and people don't seem to complain.

And analysts (not me) speak of the PIGS in Southern Europe (Portugal, Italy, Greece and Spain), which is really rather insulting (I am a "PIG", since I live in Barcelona), but I still think the category "Southern European Economies" - or if you insist "Club Mediterranean" - is a useful category, since there are quite a lot of things in common.

Or would you say that the people in the Baltics have less of a regional identity, and are less "solidaristic" with one another?

Anonymous said...

"Or would you say that the people in the Baltics have less of a regional identity, and are less "solidaristic" with one another?"
Yes, I would. There is almost no regional identity in Baltics. People
do not care much about other Baltic states. Culture and deep history are too different. For estonians Finland is more their region than Latvia.

Edward Hugh said...

Hello again,

"People do not care much about other Baltic states."

Well I feel that is a pity. I live in Spain, and I care about the Baltic states and about what happens to them.

"For estonians Finland is more their region than Latvia."

Well, as it happens I also care about what happens in Finland. I am European, you see, and more or less everything that is to do with Europe matters to me, even poor old Latvia.

And of course, the markets tend to treat the Baltics as one single entity. You may regret that, but it is nonetheless the case.

Actually, I am Catalan by adoption, and live in Spain, although people in Catalonia don't feel particularly Spanish, and prefer how they do things in Sweden amd Switzerland as far as I can see.

But as an economist these identitarian issues are secondary to me. Analytically the Baltic countries form an integral whole. You have conducted an experiment, and we must learn from this experiment for the benefit of others, who are yet to come. So they don't make the same errors, and all that.

Also, being all fairly small and fairly open economies, you do offer an ideal laboratory for research, and while that reality may or may not be to your liking, you surely cannot begrudge that others learn from your mistakes.

In particular here in Spain, where a very substantial internal devaluation is now unavoidable, your progress is being eagerly followed, since if you cannot manage to carry out the process in an orderly fashion there will be implications for the whole eurozone.

I, as you probably know, have my doubts, but I am willing to learn, and be proved wrong. For Spain's sake indeed, I hope I am wrong.

Edward Hugh said...

"So we do see now Estonian and Latvian economical activity (measured by GDP) back on the level of Q3 2005."

But this hasn't finished yet. It is just starting. The medicine is cut, cut, cut. And back in time we go. You have two more years of contraction out there in front of you, and with nominal GDP falling even faster. So we could get to the end of 2010 with GDP at around the 2003 levels (lets say). These are the 7 prime years in your growth history, and you will have gone nowhere, and you are both poorish countries, and the people will be loaded down with debts they did not have in 2003. These years are not coming back. They are irrevocably lost. The population dynamics of ageing and low growth will now steadily take over.

I call that not farce but tragedy. I don't know what you call it.