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Friday, July 24, 2009

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

Maintaining the peg also requires substantial political commitment. If this commitment were to falter, there is a risk that the execution of the difficult but necessary policies required under the authorities’ program could also weaken. However, all political parties are strongly committed to the exchange rate peg.
How the world changes in six months. The above lines come from the IMF "Republic of Latvia: Request for Stand-By Arrangement - Staff Report" of January 9 2009. But just today we can read in a Baltic newspaper:

"Reliable sources tell LETA that the International Monetary Fund (IMF) has stipulated that the loan agreement document must be signed by all ruling coalition parties in Latvia, thereby showing their resolve to implement it."
The reason the IMF are now so edgy is spelled out by Reuters Political Risk Correspondent Peter Apps:

A string of other countries are also facing stark cuts, and analysts say in many - like Latvia - domestic politics could well intervene as elected politicians are unwilling to face the political consequences of cuts demanded by the IMF and wider financial markets.
So what the IMF are evidently worried about is the possibility that some coalition members may support the agreed measures just long enough to get the payout, and then effectively disown them. This seems to be a far cry from the substantial political commitment that was earlier considered to be so essential to maintaining the peg.

And the issue goes well beyond Latvia, since as Apps points out, a string of other countries are in a similar if currently marginally better condition, including Bulgaria, Romania, Lithuanis and Hungary, all busily making cuts while coming to rely more and more on multilateral lenders.

So if there is no clear resolution to Latvia's growing dispute with the IMF, the European Union could end up facing a dilemma - whether to bail out troubled emerging European countries who won't make cuts or face the consequences of not doing so. As Lars Christensen, head of emerging markets research at Danske Bank in Copenhagen says:

"This could be a test case for Europe....In Latvia, it's domestic politics that really become the driver. The question is what the EU would do if the IMF walks away."
A good question.

In the above quoted IMF document, they also make the following point:
Correcting currency misalignment without nominal depreciation is extremely difficult, as experience from other currency board and fixed exchange rate countries continues to show. Large external financial support and sustained wage and fiscal discipline by both the private and public sectors are required. Failure could entail substantial reputational risks for both the authorities and international institutions.
The last sentance is important, failure could entail substantial reputational risks for the international institutions involved, in particular in this case for the IMF and the EU Commission. This loss of credibility should the peg eventually collapse in chaos is one of the considerations that lead some of us to argue strongly from the start against going down this road. But few would listen.

Beyond the immediate issues of the peg, there are also serious structural considerations which make this kind of "body-with-two-heads" approach less than desireable in delicate situations such as this. Even if all we have here is - as some would suggest - a soft-cop hard-cop duet, the policy of letting the EU Commission permanently play the role of soft cop is hardly desireable, especially for the message it will be sending to Southern Europe, where our improvised duo may soon find themselves once more forced into action. And especially also for financial markets where nervousness about the ability of Europe's complex institutional structure to handle the evident continuing weaknesses in the banking system is still highly evident. Leaving the impression that the EU itself is not able single handedly to deal with its own recalcitrant offspring is not exactly the best way to convince the sceptics.

Today's Latvia Roundup

The exact state of play in the negotiations with the IMF is still far from clear. Latvia's Prime Minister Valdis Dombrovskis said on Thursday that talks with the IMF were making progress on issues of pensions and taxes and results of the talks are expected early next week, but since we have been getting news like this for some days now it is hard to draw conclusions.

Izabella Kaminska at FT Alphaville thinks the analyst community is increasingly interpreting the deadlock as yet another (and possibly decisive) chink in the armour of Latvia’s euro-peg defence, citing in particular the latest research note from the RBC Capital Markets’ emerging markets team. While Capital Economics' Neil Shearing is even more explicit:

Relations between the IMF and Latvia are deteriorating quickly, raising the prospect that the loan programme that is vital to maintaining the country’s currency peg could collapse altogether..... with relations between both sides souring, and the pain in the real economy intensifying, it remains to be seen how long a new agreement will hold. Indeed, there is a growing risk that the programme could collapse altogether, which would spell the end of the currency peg and trigger a round of debt restructuring.
As for me, I agree with Neil, this situation has now become so unstable, while the internal devaluation is working so slowly, that the Fund really need to think about how to handle the damage containment issue. The crisis is far from over in the East and South of Europe, and the risk of a spark from this whole fiasco setting either Athens or Madrid alight is most certainly non-negligable. I advise all concerned to think very carefully at this point about the implications of what they are doing, for the sake of all our well-being. The Maginot line may still be far from broken, but a distant fortress on our outer defence ring may well be about to fall. Let's just learn the lessons shall we?


Anonymous said...

I'm reading your older posts about lat devaluation and you mentioned that there is hugh percentage of euro denominated loans it latvia. but does it matter really? let me explain what i mean by that. if latvia gross foreign debt is 130% of GDP with or without euro denominated loans they would suffer a lot. with euro denominated loans first would suffer those who have taken them but after that and rise in non performing loans banks would also suffer. and in countries that don't have loans denominated in foreign currencies but do have big foreign debt, again are banks those that would be hurt, right? so basically it all comes to banks, isn't it?

Anonymous said...

Hi, somehow, I read and do not see that you say aanything new, just repeating what other people said... why your devaluation option should be good for any I can not follow.. in Hungary and Romany the IMF does not request anythiing comparable to Latvia, that's the problem.

Edward Hugh said...

Hello there,

"but does it matter really? let me explain what i mean by that. if latvia gross foreign debt is 130% of GDP "

I'm not really following your question. If a country has loans of 130% of GDP in foreign denominated debt, it doesn't matter whether they are in US dollars, euros, Swiss francs, or Japanese yen. But I doubt this is your question.

The loand could also be held by either households, companies or the government. Is your question does it matter which of these it is that has created the debt, and the answer is that no it doesn't, since at the end of the day the government, as we are seeing in Latvia, in order to maintain open international lines of credit, needs to take responsibility for debts entered into by its citizens if those citizens can't pay. This is simplifying things a bit, but basically it is like this.

Now.... the internediary in all this is normally the banks, since the unpaid loans end up with the banks, and modern countries need stable banking systems, so in the end the government needs to resolve the problem in the banks, as we are seeing now in the case of Parex in Latvia.

I hope that helps, but I am not sure it really answers your main question, becuase basically I am not sure I understand what it was.

Edward Hugh said...

Hi again,

"why your devaluation option should be good for any I can not follow.. in Hungary and Romany the IMF does not request anythiing comparable to Latvia, that's the problem."

Well, I think here everyone sees the problem they what to see, and that may also be part of the problem.

Devaluation is not an option, it is now inevitable. The internal devaluation has just been too slow. I think people are still arguing about whether you really need one, and whether Latvia is able to export anything etc. Too much talking, not enough decisive action, and your economy does goes down the plughole.

Devaluation was an option in November. It could have been done, and it could have been a 15% adjustment in the currency band. But Latvia's leaders didn't want that, and now what you have is a holy mess. So, as I say, one month sooner, or one month later, you will devalue.

At this moment we have to see whether an agreement with the IMF is possible or not.

What the IMF does (or doesn't do)in Hngary or Romania is a big topic, but I'm having trouble understanding how this is at the heart of the Latvian crisis?

Anonymous said...

Ed, let me try again. let's presume that country A has foreign debt of 130% of GDP and it's all in foreign denominated currencies. and let's presume it's all made by banks. and bank are lending it. but they are lending it in domestic currency not in euros. and there domestic loans are not indexed to euros. they are not protectics themselves from devaluation.
and there is other scenario: same, foreign debt( and in foreign currencies) but banks made euro denominated loans( and those indexed in euros).

now, devaluation comes and what happens? in both cases banks will be hit. in first case probably more, because they are the ones that will get it all, and in second example borrowers would be first, but because of many unpaid loans, banks will be hit hard too.

but country as a whole will be hit no matter how loans are denominated, isn't it?

and extra question. latvia and all other countries that have high percentage of euro denominated loans probably have high savings in euros too, right? wouln't that offset some of the losses of devaluation( altough i presume that those who save in euros are not the same who borrow in euros)

Edward Hugh said...

OK, now I get you better.

"and let's presume it's all made by banks. and bank are lending it. but they are lending it in domestic currency not in euros. and there domestic loans are not indexed to euros. they are not protectics themselves from devaluation."

Well, this is just it, isn't it. You have put your finger right on the heart of one of the big unspoken issues here. The banks would never dream of doing this. That would be to have unhedged exposure to currency risk. But they were prepared to (irresponsibly) encourage private households to take on just this risk by promoting loans in forex. This was very irresponsible (for the basic reason that they themselves think to do this is crazy), and in that sense I have absolutely no sympathy with them. I suppose they always imagined that in the event of "difficulty" the EU would bail them out, which happened, but now such issues are becoming so large all over Europe, that the EU itself may eventually need "bailing out". ie eventually there will need to be technical default typre restructuring in some places.

"wouldn't that offset some of the losses of devaluation( altough i presume that those who save in euros are not the same who borrow in euros)"

Well, yes, but only, as you say, to some extent, and for some people (who are not the same ones as those who borrowed).

But only partially, since the whole point about a current account deficit is that domestic saving doesn't cover borrowing needs. That why there is a deficit, and that's why you get foreign debt. So nationally, and on aggregate, you are losers rather than winners, not from devaluation, but from having borrowed unsustainably large quantities externally in the first place.

Anonymous said...

1. Devaluation in Latvia or in Estonia means immediately huge wave of foreclosures and losses to Sweden banks.
2. Devaluation does not help to sustain or increase export in shot term, there is just no demand. Other
economies are in crisis too.

Devaluation could help if crisis were limited to Latvia or Estonia. But it is not. Would you recommend devaluation to some other countries too? For example to USA with their 50% budget deficit?

You see, there is not known simple neoclassical textbook solution to the problem. It seems you tend to underestimate the roll of financial sector and depth in economy, which is quite typical to mainstream economists.

Edward Hugh said...

Hello Anonymous,

"Would you recommend devaluation to some other countries too? For example to USA with their 50% budget deficit? "

Obviously you are quoute right, the problem is a very large one. The United States has in fact devalued quite substantially against the euro since the start of the century.

You are sort of wrong on one detail though. The US problem is not the fiscal deficit. They are a rich country, and can run this temporarily (although the deficit is more like 13% not 50%, wherever did you get that number). The problem is the Current Account deficit, which they are now closing via devaluation. The euro area, which is centred on Germany - which of course had a huge current account surplus - is thus being revalued upwards.

This is the biggest problem for the CEE countries with high earlier internal inflation and pegs to the euro.

Basically I agree with you, the problem is global, but you can't surely be suggesting that the poor people of Latvia should simply sit back and watch their economy collapse while we wait to find a solution to the US-China trade imbalance?

Anyway, thank you for your contribution.

Anonymous said...

Hi Edward!

Some countries had pretty big depreciation like poland for example but it didn't cause significant inflation as many people thought it would. is poland exception or we can expect same things in other countries?

Edward Hugh said...

Hello anonymous,

"is poland exception or we can expect same things in other countries?"

No, look, my opinion is the basic envirnoment we are living in globally is disinflationary/deflationary. This is due to the collapse in world trade, fall in global demand and massive capacity overhang. This isn't going to go away overnight.

If you notice nearly all the developed economies have interest rates near to zero and some version of quantitative easing. This also applies to Slovakia and Slovenia, but the rest of the CEE are having difficulties of one kind or another.

Essentially Poland and the Czech Republic kep control of their monetary policy, and allowed their currencies to rise against the euro to take some of the heat out of their inflation during the boom. Now they devalue into the slump, helping to avoid deflation.

Inflation isn't the problem now, deflation is.

So the problem in the east now goes well beyond all those countries who peg to the euro like the Baltics, Bulgaria and Croatia. Countries like Hungary, Romania, Russia, Ukraine etc have big problems since they also tried to "manipulate" their currencies during the boom , with the result that their citizens or corporates (Russian case) took on forex loans, and this is what has caused the trap.

The CR and Poland had minimal forex lending since by floating their currencies they were able to contain inflation, and maintain low interest rates, the comination of which two discouraged forex borrowing.

So it is low inflation, and low forex borrowing that is the key to health, and of course all those people who sat back and watch the bonfire grow in the Baltics and allowed this stupidity to arise, and now the ones who are most adamant that devaluation would be "madness". They were wrong the first time, and now they are wrong the second. Will they ever learn? I hope so one day.

Anonymous said...

yes, but can import oriented country that plans to devaluate expect low inflation and not significant one? no matter deflationary forces are driving world right now. they cannot adjust that quickly and in many areas small countries don't have domestic alternative. so if they devaluate currency, price of imported oil would be higher, price of steel, price or any other neccesary product would go up, wouldn't it?

Edward Hugh said...

"no matter deflationary forces are driving world right now. they cannot adjust that quickly and in many areas small countries don't have domestic alternative."

Well, the point is basically if they cannot adjust quickly. ie they are infexible, they are basically in a very difficult situation, with pretty bleak prospects, and permanent IMF and EU support looming on the horizon.

These societies are ageing rapidly. The next ten years will be critical, and if they can't adapt, well, what can I say, inflation would be the least of their problems. Those countries - like Russia - who continue to have inflation even after devaluation are basically in a very big mess.

Edward Hugh said...

I mean the sad thing is, maybe some of these countries simply have no solution. Maybe we have to face up to this fact.

Anonymous said...

Thanks Edward,
well i don't see how can they adjust quickly if they don't have, for example, steel industry or alternatives for candies or computers, or detergents, if they import potatoes etc..
now, poland obviously didn't have this kind of problems. how come?

and secondly, is there in theory strong relation between devaluation/depreciation and inflation?

and finally, if they cannot adjust what percentage of extra inflation, would be caused by devaluation, in your opinion?

Edward Hugh said...

Hi again,

"and finally, if they cannot adjust what percentage of extra inflation, would be caused by devaluation, in your opinion?"

This is very hard to say. It would depend on institutional quality from one country to the next. Ukraine, for example, has massive devaluation and huge inflation, and still has high interest rates.

Basically I think there is virtually no solution here.

Hungary and Romania could devalue 30% and keep inflation under 5%, IMHO. But they would need to default on a large stack of forex loans, and this is why they don't in the short term. Finally, they will be forced to, since they can't simply watch the economies contract and contract.

Edward Hugh said...

The big question here is not what the inflation level would be in the countries concerned, but whether France and Germany would simply sit back and see the whole of Eastern Europe devalue against the Euro (while they also have to bail out Spain and Italy). In my view this is a political question, not an economic ones, and this is the true objection to Eastern devaluation, letting these societies become really export competitive. OTOH, for some of these societies it is export or die, so the issue has no easy answer.

I notice that Finnish people for example, tend to be quite critical of Sweden for these sort of reasons. Swedish prices are already in negative territory despite devaluation. But the Finnish attitude to Sweden is but a mild foretaste of what is in store for the east, when push really comes to shove.

The thing is, you can't hide poor institutional quality behind a currency peg. In the end the poor quality comes out in another way (inflation) and the issue only gets worse. Serious institutional restructuring and reform is the only real way forward, but the economies also need to get back to growth after all the damage that has been inflicted on them.

Anonymous said...

thanks again Ed. so what differentiates ukraine from romania and hungary ? its just institutional quality? and by that you mean that ukrainian central bank( and government) did their job, in terms of inflation, poorly?

Edward Hugh said...

Hi again,

"what differentiates ukraine from romania and hungary ?"

Basically no external agency exercises sovereignty over them. They have an IMF bailout, but since their politicians can play the between east and west game, the fund have limited leverage. The EU Commission have no power at all.

Ultimately, both Romania and Hungary will be run more and more from Brussels, and they will be forced to change. Or at least so I hope. Maybe I am too optimistic, but I would like to try. I think Ukraine has no way out. The political class is too internally powerful, and too divided.

Anonymous said...

About USA state budget deficit.
Your comment:"(although the deficit is more like 13% not 50%, wherever did you get that number)".

I got numbers from:
"WASHINGTON (Reuters. Fri Mar 20, 2009 ) - U.S. congressional budget experts on Friday offered a darker economic and budget outlook, which could complicate President Barack Obama's efforts to convince lawmakers to pass his $3.55 trillion budget plan for 2010.
The Congressional Budget Office forecast a record $1.8 trillion deficit for the fiscal year that ends September 30 under Obama's budget proposal -- or 13.1 percent of gross domestic product."

Please note that $1.8 trillion deficit is around 50% of the budget.

Of course they can just print money and devaluate dollar that way.

But is a competition in devaluations between countries a reasonable way out?

Edward Hugh said...

"About USA state budget deficit.
Your comment:"(although the deficit is more like 13% not 50%, wherever did you get that number)".

OK, now I understand what you were trying to say. But this is a very strange way of looking at things. The normal way of looking at the budget deficit is as a % of GDP, not as a percentage of the whole budget.

Do you have any special reason for adopting this methodological procedure? Frankly, I'm not sure it adds anything.

Well, as you say, Obama is attacking the crisis, and it does seem they can print money, since they issue debt in their own currency, and there are plenty of people in China and elsewhere who are eager to buy.

Naturally the dollar will be devalued more. You can see the euro is now rising, since Germany has a large Current Account surplus, this is natural.

The USD was overvalued. This was obvious from the size of the current account deficit they were running, and obviously they don't want deflation (or internal devaluation) and they have the ability to avoid it (as do the Czech Republic and Poland nearer to home). Obviously the people with ridiculously overvalued currencies who can't do anything about it get irritated at this point. But as I say, the CR proves even a fairly small state can avoid getting sucked into the quicksand.

If being to small was a problem, then maybe it would have been better to have established a Baltic Federation rather than three very small states.

For the good of the global economy the US is going to have to export more, and run a surplus, and pay down the debt, and there is just no way around that. If this means a high euro and a devalued dollar, then so be it. People should have though more about this kind of situation at the time of setting the currency up. Now is a little late to turn back. We wanted to be the alternative reserve currency, well now we have it, along with all the problems that go with this status.

Hynek Filip said...

Anonymous, the CR may actually be a very good precedent for the Baltics.

During 1H 2008, the koruna appreciated to a point where it was apparently grossly overvalued (at the top of the hype, the dollar cost about 14 korunas). At that time, one could import almost anything from the US and got it cheaper than anywhere in the CR.

Now, between September 2008 and March 2009, the koruna was left to depreciate drastically, from 14 CZK/USD to some 23 CZK/USD.

Interestingly enough, such a precipitous drop caused no negative reaction amongst the general public, the most probable reason being that the koruna has been weak for such a long time that any exchange rate below 25 CZK/USD is seen as "just fine".

Now, since March the koruna has been slowly gaining strength again and trades at 17.8 CZK/USD as of this morning.

The morale of the story is that even if the lat is let to depreciate, the depreciation need not be permanent. The koruna lost more than 50% against the dollar, but gained more than half of the losses back in a relatively very short time.

My point would be that a sustainable LVL exchange rate may not, at the end of the day, be so far remote from the current peg. What seems to be unsustainable is the peg itself, so it would seem rather advisable to get rid of it at the earliest convenience.

Marek said...

Lithuania - so far the best performing in the Baltic trio - collapsed in Q2 2009 by 22% y/y.

Industrial production 20%, retail 28% down.

This opens rather scary prospects on Latvian and Estonian Q2 results, I would say...

Anonymous said...

Hi all, just to ask really why such a small country as Latvia matters?.. It does not matter at all, but analysts start writting about Latvia which they can not (don't want) to writte about big important countries, e.g. US, Spain, Italy... so the problem is not Latvia at all..

Edward Hugh said...

Hello anonymous,

"Hi all, just to ask really why such a small country as Latvia matters?.. "

Good question, thanks for asking. Well it matters in a number of ways actually. In the first place, every country matters to its citizens, and the main readers of this blog are people living in the Baltics.

Secondly, what happens in Latvia can be seen as a harbinger of things to come in other parts of the CEE, including in some ways Russia, due to the regions common and near unique demographic legacy. I certainly started to try to understand what was happening in Latvia mid way through 2007, when I saw the kind of wage inflation which was going on. This intitial analysis certainly helped me understand the dynamic, and then apply to other countries which enabled me to some extent to see what was coming. Small countries are to some extent microcosms. I called the Baltics the "canary in the coalmine".

Secondly it matters becuase of the attempt to apply internal devaluation. Since many countries in the eurozone no longer have their own currency to devalue, and since the loss of competitiveness has been massive in some cases, the methodologies developed will need to be applied elsewhere, which is why it really is a pity they are making such a hash of this. The EU will hardly be able to say "look at Latvia, now this is what you need to do".

But the biggest reason everyone is watching Latvia at the moment is because of the contagion risk. In my opinion the crisis in the east is going to jump to the south. There are two possibilities. If Latvia devalues, the ricochet can easily reach Spain. This, I think is the most likely route. However, if for some reason Bulgaria goes first, then the fire can jump to Greece through the banking system, and then from Greece across the rest of Southern Europe.