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Tuesday, June 30, 2009

Estonia's Neck Goes Into A Latvian-style Noose

Well, today is the 30 of June, and still no news from the IMF on releasing the next tranche of the Latvian loan. Perhaps this is one of the reasons why (via Ott Umelas at Bloomberg).

Estonia’s fiscal deficit under European Union terms more than doubled in the first quarter from a year earlier, indicating the Baltic country may not be able to adopt the euro in January 2011. The deficit, including social security and state and municipal spending, rose to 5.57 billion krooni ($502 million) from 2.06 billion krooni a year earlier, according to data published on the statistics office’s Web site today. The gap corresponds to 2.5 percent of gross domestic product, according to Bloomberg calculations based on the Finance Ministry’s forecast for Estonian GDP for 2009.

The first-quarter figure means the government will have to keep the deficit at 0.5 percent of GDP for the rest of the year to meet euro-entry criteria. Finance Minister Jurgen Ligi has said he sees no improvement in the economy before the third quarter. The minority Cabinet of Prime Minister Andrus Ansip has cut the 2009 budget deficit by 16 billion krooni, or 7.3 percent of GDP, in recent months to avoid depleting state reserves and keep the fiscal deficit at last year’s level of 3 percent of GDP, the same as the EU’s budget-deficit threshold. This would allow Estonia to adopt the euro in January 2011, the government’s main economic goal.

So why a "Latvian-style" noose? Because these countries have built for themselves a sort of "paradox of fiscal thrift" connundrum, whereby the more you cut, the more GDP falls, the more revenue rises, the more spending grows, the more the fiscal deficit goes up, the more you have to cut, and so on. In the end, as Kenneth Rogoff said yesterday, it simply becomes too painful. There seems no way Estonia can achieve a 3 percent deficit this year at this point. And remember what IMF First Deputy Managing Director John Lipsky said last week.

“If there is a solution it begins with macro policies,” Lipsky said. “No single exchange rates solution, or exchange regime represents a solution to these kinds of problems. What is important is that the currency regime is credible and coherent”.

Estonia now has no exit strategy, at least not to join the euro in 2011 it doesn't And then we have Lithuania and Bulgaria to think about. Basically, the ECB and the European Commission should never have drawn a line in the sand across the original Maastricht criteria. But it's too late for that now.

Monday, June 29, 2009

Are The IMF and The ECB Lining Up Against The EU Commission Over Latvia?

There was a very interesting and revealing press conference given by IMF First Deputy Managing Director John Lipsky and European Central Bank governing council member Christian Noyer in Paris on Thursday. Christian Noyer said that, in his opinion, Baltic countries like Latvia would not be helped by joining the single currency (the euro) prematurely.

"It's in the interest of candidate countries not to enter too early because it risks making the economic situation unbearable," Noyer said.
Lipsky, for his part stressed the region could not depend on any particular foreign exchange regime to shield it from the effects of the financial market crisis:

"If there is a solution it begins with macro policies," Lipsky said. "No single exchange rates solution, or exchange regime represents a solution to these kinds of problems. What is important is that the currency regime is credible and coherent".

Do I detect a shift in emphasis here? Certainly Latvia's currency regime is not credible (most external observers now consider devaluation inevitable), nor is it - in my opinion - coherent. And there has only been a deafening silence coming out from the IMF in recent days on the topic.

The EU finance ministers have decided to support maintenance of the peg, but that is hardly surprising, however, Swedish Prime Minister Fredrik Reinfeldt told Reuters, again rather revealingly, that "We think that a clear signal of support from the EU would help them to achieve support from the IMF." That is, the IMF is wavering, and the EU is putting pressure. This, approach, however, suffers from the flaw that it is hardly either coherent or convincing.

Now the Latvian parliament approved budget cuts of 500 mn Lati for the 2009 budget on June 16, a vote which lead the EU to decide to release the next 1.2 billion euro tranche of the emergency loan to Latvia. So why is the IMF still assessing the situation? Some draw consolance in the idea that the IMF’s share of the program is smaller - only 1.7 billion euro in comparison to the 3.1 billion which is coming from the European Commission. But this is to neglect the strategic role the IMF is playing in the whole process. If the IMF isn't leading, then what is it doing. Evidently, the fissures which may be developing between the Commission on the IMF approaches only serve to draw more attention to the complexity of the whole current EU economic and political architecture.

Latvia is a sovereign country, also member of the European Union. Looked at from one point of view, what was the IMF doing there in the first place. But once they have taken leading responsibility, it is not wise for the Commission to try to claw this back from them. After all, the whole process is supposedly intended to raise investor confidence, something which is hard to do if there is not unity of purpose.

Meanwhile liquidity conditions continue to remain tight, and Rigibor interest rates shot up again at the end of last week, following the termination of the summer solstice holiday.

The last official news we have said simply that the IMF would decide on the Latvian loan after June 26. Well we are now after June 26, and we are still none the wiser.

Meanwhile Latvian's continue to save, and outstanding private debt fell in May to 14,140.2 million Lats from 14,252,4 million Lats in April. They year on year change is now down to only 1.6%, and will more than likely turn negative in June, which means that, with the government also trying to save hard, continuing contraction is completely guaranteed without exports.

And today we have two additional pieces of relevant news. Firstly, and most interestingly, former IMF chief economist Kenneth Rogoff - now a Harvard University professor - has said the IMF made a mistake, and should never have allowed Latvia to keep the peg. (That is, he agrees with what Krugman and I have been arguing all along). The IMF, however, is still maintaining an apparent vow of silence on the whole situation, or so it seems, and have yet to pronounce. Hello, EU Commission, how can you lose your heads, when all around you are keeping theirs?

Latvia should devalue the lats to avoid a worsening of its economic crisis, said Kenneth Rogoff, a Harvard University professor and former chief economist at the International Monetary Fund, in an interview with Direkt. The IMF made the wrong decision when it allowed Latvia to keep its currency peg, Rogoff said in Visby, Sweden today, according to the Swedish news agency. While a quick devaluation would be best for Latvia, Rogoff doesn’t believe it will happen for a long time because the IMF and Europe will provide the Baltic nation with loans, Direkt reported. In a normal situation, Latvia would already have devalued the lats and defaulted on its debt, Rogoff said, according to the news agency. World leaders have decided no countries should be allowed to fail and Latvia is benefiting from that, he said.
Secondly Central bank governor Ilmars Rimsevics has given an interview to Reuters TV. He will go down with his ship, like every good Captain should, but there will be no lifeboats for the rest of you.

Latvia will stick to its currency peg and not devalue, even if the country fails to win further loans from the European Union and International Monetary Fund, its central bank governor said on Monday. "People who are expressing that (a devaluation is possible) lack some education and knowledge and I am sorry. There is absolutely nothing to do with devaluation in Latvia," he told Reuters at the Bank for International Settlements (BIS) meeting. "If the cuts (in the budget) won't be made, there would not be financing available, but that in no way would influence or affect the currency peg," Rimsevics added.
The European Central Bank also today urged urged Latvia to rethink plans to siphon off half of its central bank's profits to help rebuild the country's battered finances. Latvia's government plans to up the amount of central bank profits it takes, to 50 percent from the current 15 percent.

In a legal opinion published on its Web site on Monday, the ECB warned the move risked hurting Latvian central bank independence and wiping out funds designed to be a financial safety net for country's troubled banks. "The use of central bank financial resources may be counterproductive from the credibility point of view if confidence in the financial stability and independence of the National Central Bank is undermined," the ECB said.

"It is important to shield the rules related to the distribution of profits from third-party interests and to ensure a legal framework that provides a stable and long-term basis for the central bank's functioning."

One of the most crucial questions going forward is will the process of relative price adjustment, while still keeping the peg, be able to balance the economy, or will it turn out to be intolerable, thus leading nevertheless to devaluation in the end. Although wage growth and inflation are slowing, one could ask whether the adjustment is fast enough to enable Latvia to keep the currency pegged. Uncertainty about the answer is likely to keep the devaluation fears as well as the uncertainty in the FX and money markets alive in the future.
Annika Lindblad: Nordea

Well quite, this is one of the things I have been arguing all along, and now those who in theory support the maintenance of the peg begin to "worry" that the rate of price and wage decline may not be fast enough to maintain the peg. Wouldn't it have been better to have thought a little more about this, before embarking on what is evidently such a risky endeavour.

At the end of the day what we could really say here is, that in a bid to defend credibility, all credibility has now been lost, and things will only get worse from here on in. Tragedy has already repeated its self as tragedy, and now its about to become one of the sickest of all sick comedies. I think it's time to put a stop to the agony.

Saturday, June 20, 2009

Facebook Links

Quietly clicking my way through Bloomberg last Sunday afternoon, I came across this:

Facebook Members Register Names at 550 a Second

Facebook Inc., the world’s largest social-networking site, said members registered new user names at a rate of more than 550 a second after the company offered people the chance to claim a personalized Web address.

Facebook started accepted registrations at midnight New York time on a first-come, first-served basis. Within the first seven minutes, 345,000 people had claimed user names, said Larry Yu, a spokesman for Palo Alto, California-based Facebook. Within 15 minutes, 500,000 users had grabbed a name.

Mein Gott, I thought to myself, if 550 people a second are doing something, they can't all be wrong. So I immediately signed up. Actually, this isn't my first experience with social networking since I did try Orkut out some years back, but somehow I didn't quite get the point. Either I was missing something, or Orkut was. Now I think I've finally got it. Perhaps the technology has improved, or perhaps I have. As I said in one of my first postings:

Ok. This is just what I've always wanted really. A quick'n dirty personal blog. Here we go. Boy am I going to enjoy this.
Daniel Dresner once broke bloggers down into two groups, the "thinkers" and the "linkers". I probably would be immodest enough to suggest that most of my material falls into the first category (my postings are lo-o-o-ng, horribly long), but since I don't fit any mould, and Iam hard to typecast, I also have that hidden "linker" part, struggling within and desperate to come out. Which is why Facebook is just great.

In addition, on blogs like this I can probably only manage to post something worthwhile perhaps once or twice a month, and there is news everyday.

So, if you want some of that up to the minute "breaking" stuff, and are willing to submit yourself to a good dose of link spam, why not come on in and subscribe to my new state-of-the-art blog? You can either send me a friend request via FB, or mail me direct (you can find the mail on my Roubini Global page). Let's all go and take a long hard look at the future, you never know, it might just work.

Tuesday, June 16, 2009

Another Round in Latvia?

By Claus Vistesen: Copenhagen

I will forgive my readers if they think that my coverage of the recent debacle surrounding the potential for an imminent devaluation in Latvia has been a bit asymmetric. I mean, here I was; throwing fuel on the bonfire when it looked as if the cracks would make the edifice tumble and now as it seems that those cracks have been temporarily mended, I have gone silent. Well, not entirely then, and this post is thus to show that I actually do attempt to provide a balanced coverage.

Consequently, it seems as if the defences will hold in Latvia, but the apparent vote of confidence from the IMF and the EU commission and thus promises that the external loan financing will continue will not come for free. In order to make due on the loans the Latvian government is planning an unprecented range of spending cuts amounting to an astonishing 10% of the entire fiscal budget according to Bloomberg reporter Aaron Eglitis. These massive cuts include, among other things, a 10% pension reductions and a full fat 20% wage reductions for state employees. As prime minister Dombrovskis is quoted; these cuts should be more than enough to please the debtors in the form of the EU and, most notably, the IMF to whose mercy Latvia finds itself. One would surely hope for Dombrovskis that he is right.

And by all means, it does seem as if markets have been calmed so far [click on picture for better viewing].

As we can see overnight rates have fallen to much more comfortable levels the past few days and we have even had the news that the central bank were actually selling Lats in the open market in stead of its hitherto valiant efforts to maintain the peg, by sucking up domestic Lat liquidity pushing overnight rates up to a massive 100-200% according to a number of, I should say, unofficial reports. Medium term financing in the form of the 3 month and 6 month RIGIBOR remain elevated compared to last month, but so far the massive squeeze in short term financing seems to have abated. Overnight rates consequently fell from an officially reported high of 24.60% to 8% on the 15th of June and further down to a soothing 5% here on Tuesday.

Does it end here then? This seems to be the inevitable question we must ask ourselves.

I have my doubts. First of all, it is difficult to see the big difference here. The fundamentals still look anything but solid and the underlying weaknesses remain. As Edward noted recently in a thorough analysis of Latvia's long term economic potential, the crisis has long and deep roots which go beyond the question of default now or default later. More importantly however, Latvia has now effectively begun a great experiment to see whether it pays off to literally dismantle one's society with the aim to fulfill a distinctly narrow economic objective in the form of a fixed exchange rate. To add insult to injury, the peg itself is not the main goal. Eurozone membership is, and apart from the obvious question of whether such a membership would be a desirable outcome for Latvia at all, I have my serious doubt that we will ever get there.

But that is somwhat for the long term. In the short term, the horizon is still littered with uncertainty and I tend to agree with Danske Bank's Lars Christenses as he dryly notes:

“There really hasn’t been any fundamental change,” said Lars Christensen, head of emerging markets at Danske Bank A/S in Copenhagen. “The only thing that has changed is how long they can postpone a devaluation. The issues are still there, and what will happen when they need the next loan installment?”

This sounds about right to me and although it distinctly seems as if Latvian policy makers are determined to do whatever it takes, the costs will be immense and one has to wonder whether the fort will hold forever? I don't think it will.

Saturday, June 13, 2009

Lost In The Latvian Translation?

According to reports in the Baltic Course newspaper, Latvian Finance Minister Einars Repse (of the New Era party) is not against the strikes and rallies that are being organised in response to the proposed state budget cuts, he is, however, opposed to any violent protests and subsequent civil unrest.

Rallies and strikes are a good thing, but disturbances will not solve anything," Repse pointed out after a meeting with Latvian Free Trade Unions Association representatives today. As the finance minister explains, he realizes that "people are really concerned and desperate", however, damaging government buildings will not contribute to improving the situation in any way as repairing the buildings would have to be paid for with state budget money anyway.

I'm sure he can't have quite put it like this - if he did then a Finance Minister actually supporting strikes against his own measures would be a first, I think (what is happening in Latvia is surreal, but not this surreal, surely) - and that the question is a translation one, but still. It does illustrate the difficult position local politicians are being put in when it comes to defending the EU Commission and IMF inspired measures in the face of their own voters - as I already forecast it would be in my post The Long And Difficult Road To Wage Cuts As An Alternative To Devaluation back in January. More to the point is this, which is real enough:
Working pensioners' pensions will be slashed 70%, all other pensioners will see their pensions shrink by 10%. Also maternity and child care benefits will be cut by 10%.

Now, I know the aim is to bring prices down, but how can a country which is effectively dying for lack of children (post coming on this later) be actually cutting child allowances. Frankly I find this even harder to believe than the idea of a Finance Minister supporting strikes against his own policies. It is nevertheless true. Everything, I see, is possibile in Latvia, except, of course, devaluation.

Tuesday, June 9, 2009

Green Shoots In Germany, Estonia and Hungary?

Well, I am busying myself this morning scratching around looking for green shoots in Turkey. But even as I was digging for these I couldn't help notice this coming in over the radar from Germany, courtesy of Bloomberg:

German exports fell more than economists forecast in April as the global crisis restrained demand, keeping Europe’s largest economy mired in a recession. Sales abroad, adjusted for working days and seasonal changes, fell 4.8 percent from March, when they rose a revised 0.3 percent, the Federal Statistics Office in Wiesbaden said today. Economists expected a 0.1 percent decline in April, according to the median of 10 estimates in a Bloomberg News survey.
So German exports have not touched bottom yet - they are still falling. Since the German economy is export dependent, then this implies the obvious, the German economy is still contracting. I don't think anyone ever doubted this, but looking at the way some of the material has been presented recently, it wasn't always clear.

Indeed year on year, exports fell by 22.9%, the fastest rate so far, although since these annual stats are not working day corrected I wouldn't read too much into that just yet, since you really do need to average across March and April due to the Easter impact.

Another country where rather unsurprisingly we aren't seeing too many green shoots at the moment is Estonia, and only today the statistics office reported that exports decreased by 38% and imports by 41% (year on year) in April.

As a result the Estonian trade deficit rose for the second month running, and hit 1.8 billion kroons. So what we are seeing here is a distinct move in the wrong direction, on both counts.

We also learnt from the Estonian stats office today that GDP contracted by 15.1% (year on year) in the first three months of this year - a figure which was revised down from the earlier flash estimate of 15.6%.

Compared to the 4th quarter of last year, seasonally and working-day adjusted GDP decreased by 6.1% (more on all this in another post).

Finally on the green shoots front for today, we could note that Hungary's industrial production plummeted in April by 25.3% (year on year) according to working day adjusted data released by the stats office. This compares with a year on year contraction of 19.6% in March.

Month on month there was seasonally and working day adjusted drop of 5.1% in April, following 4.5% growth in March. So again, output is still falling, and no bottom has been reached.

This latest Hungarian data is particularly unpalatable following a number of reports which had been left open the possibility that the downturn in the Hungarian economy had ground to a halt, or at least staretd to decelerate. If industrial output shows similar weakness in other East European countries then this does not augur well for future German and eurozone output, since Hungary plays a significant role in the early stages of the European manufacturing production chain.

Sunday, June 7, 2009

Latvia - Devalue Now or Devalue Later?

The Latvian economy is certaily stuck in a hard and not especially pleasent place at the moment, and really one chart tells it all, since as we see above the local interbank overnight interest rates have been storming upwards and through the roof over the last two weeks. As a result of this unfortunate state of affairs the country has attained a higher profile in the international news media than most Latvians would ever have dreamt possible, or even, probably, considered desirable. Ever since Claus Vistesen's last post, my inbox hasn't stopped filling up with reports, analyses, forecasts etc. (apart from Claus, FT Alphaville's Izabella Kaminska has had a steady stream of posts - here, here, here and here - while RGE analyst Mary Stokes is a regular follower of the issues - and see again here for some thoughts on the contagion question).

The first issue that hits you is, can such a small country really be that important? The answer is, yes it can, and for a variety of reasons, although among these one is paramount, the so called "contagion" risk. As Danske Bank put it in their latest Emerging Markets Europe analysis:

Increasing concerns regarding a possible devaluation in Latvia yesterday spilled over into other countries in CEE. Although the direct link between the Baltic markets and others such as Poland, Hungary and Romania is very limited it is only natural that concerns over the situation in Baltic States triggers renewed concerns regarding the position in Central and Eastern Europe where many countries to a greater or lesser extent face problems similar to those in the Baltics. Those most at risk from negative spill-over effects are Latvia’s neighbours Estonia and Lithuania although we would expect contagion to affect countries in the region most like Latvia in terms of macroeconomic imbalancessuch as Romania and Bulgaria.
Personally, I think it possible that the immediate contagion risk may be being a little overdone at the present time. Certainly there will be immediate implications from any eventual Latvian devaluation for Baltic neighbours (and co-peggers) Estonia and Lithuania, and well as for more distant Bulgaria. A Latvian decion to break loose will, effectively, be the end of the road for the pegs, even if the unwinding may not necessarily be immediate. And beyond the Baltics and Bulgaria pressure will inevitably mount on other countries facing longer term economic and financial difficulties like Hungary and Romania (which may leave you asking just who exactly there is left inside the EU but outside the Euro - Poland and the Czech Republic to be precise), but my personal feeling is that while we may see everyone placed under stress we are unlikely to see dramatic short term "negative events". If I were looking for these it would rather be towards Russia I would be looking, and to the future path of oil prices, since if things were to go the wrong way on that front then the shock waves from Russia could easily destabilise all the rest of Central and Eastern Europe at one foul swoop.

But then, my relative lack of alarm on the contagion front stems from my perception of the present crisis in the East as less one of short term liquidity and balance of payments pressures, and more one of a longer term sustainability issues, given the relative poverty of the region when compared with West European neighbours, and the rapid population ageing and decline issues it is facing.

Ideological Lock-in?

Latvia is certainly hemmed in on all fronts at the moment, what with the 18% year on year GDP contraction registered in the first quarter, the projected 9.2% of GDP fiscal deficit for 2009 (if more cuts are not made), the rise of overnight interbank interest rates into the high teens, soaring credit default swap rates - Latvia's five-year credit default swap rose to a high of 721.1 basis points on Thursday - and almost vanishing Lati liquidity inside the country.

But over and beyond the immediate concerns, and contagion risk Latvia is currently a test-bed for a number of issues with implications which extend well beyond the borders of this small Baltic country. In particular three questions stand out.

a) The rather counter intuitive idea - which I call the new orthodoxy in this post - that even during strong recessions a fiscal contraction could turn out to be expansionary, if it signals a long term determination towards fiscal rectitude. The IMF put the idea thus:
In emerging market countries with debt overhangs, the “Keynesian” effect of fiscal adjustment is likely to be outweighed by “non-Keynesian” effects related to expectations and credibility. Non- Keynesian effects have to do with the offsetting response of private saving to policy-related changes in public saving. In particular, if fiscal adjustment credibly signals improved public sector solvency, a fiscal contraction could turn out to be expansionary, as private consumption rises based on the view that future tax hikes will be smaller than previously envisaged.
IMF - Hungary, Request for Stand-By Arrangement, November 4, 2008
b) The idea of "internal devaluation" as a viable strategy for carrying out a substantial correction in relative wages and prices for a country with a currency peg and large balance sheet exposure to foreign exchange loans. Now it may well be that currency peggars are likely soon to become an extinct species, given the difficulties they tend to produce when such pegs unwind, but the Baltic countries may still be considered as test cases for others who don't (for whatever reason) have an independent currency and thus a serviceable monetary policy. Countries like Ireland and Spain, for example, who are facing a sharp correction, but being inside the eurozone currency area have no local currency of their own to devalue and are hence now destined to follow a similar path to the one being pioneered in the Baltics.

c) The idea that structural reforms can - in the context of a country with long term low fertility, declining working age populations and rising elderly dependency ratios - free up sufficient growth potential to offset the underlying population dynamic and, as the IMF put it in the above citation, credibly signal the possibility of future public sector solvency.

So Latvia is at the heart of a massive experiment, of the kind which lead me to lament on my about page that "Economists hitherto have tried hard enough and often enough to change the world, the real difficulty however is to understand it." Since the question I cannot help asking myself in the Latvian context is: to what extent do we really understand what we are doing here?

The thing is, all of the above mentioned theories - "internal devaluation", "stimulatory fiscal tightening" and structural reforms to offset declining working age population - sound splendid enough, but are the the theories themselves actually valid? How do we test them? And do the measures adopted on the basis of "believing" in them actually work? And are there sufficient grounds for accepting both the validity of the thoeries and the efficacy of measures based on them to ask for sacrifice on the scale that is currently being demanded from the Latvian people? And do we have any consensually agreed benchmarks which would enable us to decide whether the measures are working? Do we indeed - and by "we" here I mean the EU Commission and the IMF - have any inspectable performance indicators against which to measure progress?

Certainly, for every inch of success that is painfully clawed forward (the positive CA balance, for example), we seem to be constantly thrown back a yard by a host of additional problems (the growing fiscal deficit issue, etc), and not for the first time, we - the economists - find ourselves playing with fire, when we, of course, aren't the ones who risk getting burnt in the process!

Plethora Of Statements.

Both the European Commission and InternationalMonetary Fund (IMF) have been busying themselves over the last week making extensive statements on Latvia's 2009 budget amendment process - which is, after all - what lies at the heart of the issue. What has been notably absent however in all these public declarations, is any indication about when exactly the much needed money will arrive. And this is not a request for information simply at the convenience of Latvian lawmakers, it is the sort of information market participants badly need to receive in order to take the kind of decisions which would bring the situation more back under control for the Latvian authorities, and meantime the ambiguity continues.

European Economic andMonetary Affairs Commissioner Joaquín Almunia said in his prepared statement he believes the new budgetary proposals to be a step in the right direction. But how much of a step are they, since he also stressed that more was still needed to contain the rapid increase in the budget deficit. So again, just how much more is needed, and are Latvia's politicians capable of delivering? Or is the pain simply too much to stand?

"Sadly, the economic recession is proving more severe than expected inLatvia
bringing hardship for many and increasing the deficit to higherlevels than
expected. Latvia needs to reduce the deficit in asustainable way with
significant budgetary and structural measures,although I acknowledge that the
original fiscal targets in thegovernment's economic program are no longer within
reach. I alsounderstand there are limits on how much the deficit can be reduced
toallow some breathing space for the economy and for the people ofLatvia,
especially the sections of population most in need. I takenote that the
authorities want to control government debt and maintaintheir exchange rate peg.
The supplementary budget presented this weekis a first step. The Commission
wants to support government's efforts.I am looking forward to seeing additional
steps adopted during the second reading of the budget, as announced by the

On the other hand, Caroline Atkinson, the IMF's director of external relations, restricted herself to saying the fund agrees with the comments made by Joaquin Almunia to the effect that the supplementary budget presented by the government this week represents an initial move in the right direction. "The government's budget is a first step, and there is more work to be done," she said. Again, how much more work?

When directly asked the key question as to whether the IMF would support a depegging of the lat from the euro, she simply stated that the fund hasn't changed its stance. "We have commented before that the situation is challenging and that there is a need for action, and I think the authorities have stressed the importance of controlling the government debt and deficits and maintaining the peg," she said. That is to say, the Fund's position is that on this topic the government decides. On the other hand, with Latvia's financial and currency markets coming under increasingly evident stress, and Prime Minister Valdis Dombrovskis saying the country needs the second portion of the loan by early next week, the Fund remains meticulously silent on when exactly the next tranche will be paid, and on what it would take for them to release the money. Of course, negotiating in public is not the most desireable of things, but then having hoardes of market participants speculating on what you might be saying isn't exactly a comfortable situation either.

Marek Belka, head of the European Department at the International Monetary Fund, also limited himself on Friday to saying Latvia may need to make further spending cuts as well as increase taxes if it is to stabilize the economy.

The Latvian central bank, for its part, noting all the emphasis on "the government decides" side, and obviously not wanting to be forgotten, issued, for its part, a statement openly defending the currency peg, and warning of "dire losses" for Latvian citizens should the currency be devalued. The bank effectively ticked off public officials and advised them to be more careful what they say when speaking and the national currency and its stability in future. It also took the unusual step of underlining that the central bank was an independent institution, and is the only body empowered to take decisions about changing the currency rate. This was notable, as it could be seen as suggesting that someone else thought they had the ability to take such decisions, and it could also be read as a warning to anyone tempted to think they had such powers.

Meantime the recession goes on, and on.........

Industrial Output Stabilises

Latvian industrial output was in fact up in April over March - by 4.8% on a seasonally adjusted basis. Mining and quarrying were up by 1.8%, manufacturing by 5%, and electricity and gas by 4.6%. Some sectors were up sharply, clothing output, for example, rose 14.6%, pharmaceuticals by 11.6%, and chemicals by 9.7%. On the other hand electrical equipment was down on March by 19.5%, while other transport equipment (defined as ships and boats, railway locomotives and rolling stock) was down 13.2%. Such stabilisation was consistent with what we have been seeing in other countries, and at this point does not enable us to draw and longer term conclusions.

As a result of the improvement in April the year on year output drop fell to 16.9% (after adjustment for calendar effects). The fall was thus weaker than the 23.4% year on year drop in
March and a 24.2% one in February.

The core of the problem is exports, since with domestic demand now sunk into a deep hole, and fiscal austerity the "ordre du jour", exports are the only hope for growth. I mean, this is evident from a simple formula:

Changes in GDP = Changes in private domestic demand + changes in government spending + changes in the net trade impact (exports minus imports)

Clearly Latvia's economy is not condemned simply to shrink forever, but it can come to rest at quite a low level, and for it to rebound something needs to drive growth. What I am arguing is, other things being equal, and relative prices being right, that a combination of new investment for greenfield sites directed to axports (which is a plus for private domestic demand) plus the exports themselves could provide the stimulus which starst to turn the motor over. Devaluation is half of the answer here, with the other half coming from having a responsible government, a serious reform programme which encourages confidence in the country and economic and political stability. End all the speculation which surrounds the continuation of the currency peg would be one way to move forward on the second half of the agenda.

The Latvia statistics office have yet to give us detailed data for Q1 GDP, but they initially reported that the 18% annual decline was broad-based, with manufacturing down 22%, retail trade down 25% and hotel and restaurant services output 34% lower (all from a year earlier). "The economic situation is of course very serious," Latvian Prime Minister Valdis Dombrovskis reportedly told a press conference in Stockholm recently, and who could disagree.

Latvian exports are also well down, falling 23% year on year in March, an improvement on the 29% drop in February, but still substantial. Going by the April industrial output numbers we could expect a further improvement in April too, nonetheless far, far more will be needed to start to turn this situation around.

In fact, Latvia still ran a goods trade deficit of just under 400 million Lati in the first three months of the year, down significantly from the 650 million Lati in the last three months of 2008, but still large, especially since GDP is shrinking fast.

Lavia's current account has however improved spectacularly, and was back in surplus (although only marginally) as of January this year according to central bank data. This transformation is entirely logical and anticipated (even if the speed of the correction was not), since Latvia is now about to become a net saver, with a current account surplus, and with an economy which is driven by exports, which at the end of the day is what the whole devaluation debate is all about.

In fact, the headline current account surplus number is a bit illusory, since it has been produced by a combination of two factors, neither of which are totally desireable in and of themselves. This is why we could say that the surplus is a forced one, and that Latvia is being forced to become a net saver. In the first place there is the improvement in the goods trade deficit, which as I say, is more produced by a the fall in imports (which follows the decline in domestic spending power and living standards) than it is by any improvement in exports (which have of course been falling):

And secondly we have movement in the income balance, from deficit to surplus, and this, ironically, is produced by the fact that the internal collapse in economic activity means that the income return on Latvian investments (equities, profitability of enterprises etc) has dropped much more than the return on investments made by Latvians outside the country (where things may also be bad, but not as bad as they are in Latvia). Thus ironically, Latvian's who have had the foresight to borrow funds from the Latvian branches of Swedish banks to invest in economic activities in Sweden may well be faring rather better than those very banks themselves who lent money to be used in Latvia.

Retail Sales

Apart from the drop in imports, perhaps the best short term indicator of the contraction which is taking place in internal demand is to be found in the retail sales numbers. These were actually up slightly in March compared to March - by 0.3%, on a constant price seasonally adjusted basis. The improvement was largely in the sale of food products, which increased by 2.7% on the month, while sales of non-food product fell by 1.1%.

Compared to April 2008 however sales were down by 29.6% (working day adjusted, constant price data), following a 27.3% fall in March. Since April last year seems to have been the peak month, we can expect the annual drops to reduce, although the actual level of sales may well keep falling (see chart below).

Apart from the credit crunch and the consequent difficulty in borrowing money, the other factor which is producing the slump in retail sales is the dramatic rise in unemployment, which according to Eurostat data has surged from a low of 6.1% in April 2008 to the present 17.4%. And it continues to rise.

The Eurostat numbers are rather different from the Latvian Labour Board ones, since the latter is based on a different methodology (and is thus not part of any "sinister conspiracy" to hide the facts - for a full discussion of the issues involved see my recent post on the same issue in Spain), but if you compare the charts, the undelying trend is evidently similar, a sharp upward climb.

Restoring Competitiveness

The principal conclusion we can draw from all this then is that it would be foolish to expect any recovery in economic activity to come from Latvian domestic demand, and this problem will only be added to by the impact of debt deflation on houseowners who, according to Global Property Guide, have just seen their properties fall at the fastest rate anywhere on the planet - it wasn't that long ago that Latvia and Estonia were leading everyone up - with prices down by 50% year on year in the first quarter, and the drop over the last quarter of 2008 being an incredible 30%.

So we need to look to exports. But this is where we hit a problem, since all the inflation which took place during the boom side of the boom-bust have made Latvian prices and industries totally uncompetitive when it comes to its main trading partners. If we look at the latest Real Effective Exchange Rate Data (curiously enough released by Eurostat last Friday), it should not surprise us to learn that the worst loss in competitiveness occured in 2008.

The above chart compares Finland and Latvia, and gives us an idea of just how much competitiveness the Latvian economy has lost since the index was set in 1999. In fact the graphs are even more interesting, since we can see that there was a period - between 2002 and 2005 - when, despite the fact that living standards were rising, productivity was rising faster, and Latvia actually improved its competitiveness vis-a-vis Finland. It is that earlier dynamic which now need to be recovered.

But as we can see from the sharp upward rise the the Latvian REER post 2006, the structural damage has been substantial, and this large scale of the correction needed makes the "internal devaluation" path - even if it were working, and even if markets were accepting it, which in neither case is true - particularly onerous. Prime Minister Dombrovskis himself estimated only last week that any devaluation would need to be of the order of 30% (and looking at the chart it is hard to disagree), and this is already much larger than the 15% "adjustment" in the trading band the IMF were considering during the original loan negotiations.

Ideally improvements in competitiveness can be achieved in two ways, through productivity enhancements which can be attained via structural reforms, and through changes in the wage and price level. Unfortunately the former needs time to work, and time is now absolutely something Latvia hasn't got, with the recession biting deeper by the day, and the markets hot on the heels of the government. So we need the wage and price correction. Well, people have supposedly been working on this for some six months or so now, so just how far have we got? Let's take a look.

Well, if we look at average gross wages and salaries, they fell 1st quarter of 2009 by 6.2% over the last quarter, but when compared with the first quarter of 2008 they are still up - by 3.5%. Of course, given the rise in unemployment the actual volume of wages and salaries paid is down even more - by 10.9% on the year, and by 17.2% over the last quarter. But this is a dop in living standards produced by the recession, and not a fall in unit labour costs.

In fact, according to data from the Latvian Statistics Office, the level of gross wages and salaries has so far only fallen back to the level of August 2008. This contrasts with a lot of anecdotal evidence I have been receiving in comments which speak of far larger reductions, but there you are, that is what the data says.

But restoring competiveness via internal devaluation is about reducing wages and prices in like measure, it is not simply about reducing wage costs, since slashing wages without reducing prices is only to cut living standards, and this in and of itself serves no evident purpose, and indeed causes untold hardship.So how are things going with prices?

Well, not much better. According to the statistics office, as compared to March, the average consumer price level in April was down by 0.4%. The average prices of goods decreased by 0.3%, but compared to April 2008, consumer prices still increased, and were up by 6.2%. In fact both the general and the core idexes (by core I mean ex energy, food, alchohol and tobacco) were still above the January level, so on the consumer prices front we have yet to take even the first step into attacking the loss of competitiveness reflected in the 2008 REER.

What about producer (or factory gate) prices then? Well, here the situation is a bit better, since as compared to March, April producer prices were down by 0.9%, while as compared to April producer prices fell by 2.6% (the first month of year on year drop). In the case of export prices, the situation was even better, since these were down by 9% year on year in April. In fact in both cases (domestic and export) prices have been falling since last July, which is hardly surprising since energy costs (which were a major component in the recent producer price spike) have fallen sharply. And remember, what interests us here is competitiveness, and energy prices have been falling everywhere. What Latvia needs is to improve its relative prices vis a vis its main reference markets.

Money Supply Problems

One indicator of the degree of stress which the Latvian economy is currently experiencing is the way in which bank lending (which fuelled the earlier boom) is now falling across the board. Year on year the numbers are still in positive territory, but the annual lending growth rate is steadily heading for zero - it decelerated to 4.3% in April (of which lending to non-financial corporations fell to a 9.2% growth rate while lending to households was down to 1.3% year on year). But month on month lending is contracting, and has been so doing since October. Loans to resident financial institutions, non-financial corporations and households contracted by 115.9 million lats or 0.8% in April alone.

Commercial credit and mortgage lending are both falling (by 3.4% and 0.8% respectively) and the negative momentum continues.

Money supply data show a similar tendency, even if in April M3 increased by 67.4 million lats and M2 by 63.6 million lats over March. Nevertheless the annual rate of decline in both measures of money supply continued to accelerate (to 8.2% and 8.1% respectively).

M1 - which consists of currency in circulation + checkable deposits (checking deposits, officially called demand deposits, and other deposits that work like checking deposits) + traveler's checks (ie assets that can be used to pay for a good or service or to repay debt) - has been falling now since December 2007.

Net foreign assets held by the Bank of Latvia fell by 218.7 million lats in April. According to the central bank the decrease in foreign reserves was a result of Bank of Latvia interventions (selling euro) and a reduction in foreign currency deposit held by the government as it drew down what remained of the last tranche of the international loan. Latvia has now spent about 503 million euros buying lats so far this year to support the currency. The bank had previously spent about 1 billion euros in 11 weeks last year defending the currency prior to the 7.5 billion-euro IMF-lead bailout.

Reserves had to some extent been boosted by currency swaps made available by the Swedish and Danish central banks. Indeed only in May Sweden’s central bank raised the amount of euros available for its Latvian counterpart to swap for lats to 500 million euros and extended the term of the agreement. The swap agreement dates back to last December, and allowed the Latvian central bank to borrow up to 500 million euros for lats. Under the original agreement the Riksbank was to provide 375 million euros and the Danish cb 125 million euros. However, according to the most recent statement from Swedish Finance Minister Anders Borg the Swedish government have now decided: so far and no further (see below).

Deteriorating Liquidity Conditions

As noted at the start of this post, Latvia is now suffering from a major Lat liquidity squeeze. And the shortage of lati on the internal market lifted has steadily been lifting interbank rates. One indication of the shortage was the inability of Latvia’s Treasury during the week to sell bills at a first auction at which 50 million lati (35 million euros) were offered. The Treasury did finally manage to sell a much smaller quantity (2.75 million lats - 4 million euros) . The problem is not one of price (yield) but of liquidity - there is simply a shortage of lati in the system overall as those who have the local currency sell and buy euros to protect against possible devaluation.

The lack of liquidity pushed Latvian interbank lending rates to their highest levels on record on Friday as the central bank removed lati from the market in an attempt to stem speculation. The six-month Rigibor rate rose to 16.00 percent. The three-month rate rose to 17.92 percent while the overnight rate rose to 19.6 percent. Obviously with levels like this devaluation becomes inevitable, but as Dombrovskis stresses: “This was a momentary situation and the moment when we have an agreement with the international lenders the market will calm down,” - for the time being at least. The critical question at this point is not whether a new agreement with the EU and the IMF is possible (it surely is), but rather whether it is worth the effort, since the government may well be in a situation were it is forced to agree to a series of extremely painful cuts only to find itself in the very same position three or six months from now.

Deficit Connundrum

As we can see, the Latvian people are being asked to make a bet in support of an economic idea, the idea (as presented above) that a fiscal contraction under present circumstances could turn out to be expansionary. Personally I am absolutely not convinced of the validity of this argument. What will convince lenders and investors to return to Latvia is:

a) a convincing commitment to structural reform and fiscal rigour in the longer term
b) a serious adjustment in relative wages and prices which converts Latvia once more into an attractive destination for export oriented investments.

At the present time we have the worst of both worlds here, since all the government's time, energy and attention is being focused on short term fiscal objectives, while the rate of price adjustment is far too slow. That is, the existing programme is NOT working, and I find myself wondering, do the IMF representatives have performance criteria, and if so what are they? And are these (assuming they exist) being in any way fulfilled, since the only visible positive outcome at this point is the recovery of a current account surplus, but if this is being achieved at the price of generating a massive fiscal deficit, then it is hard, really, to cry victory.

The general government consolidated budget showed a deficit of 190.8 million lats in April, with an accumulated deficit since the start of the year of 332.8 million lats). According to the central bank, the deterioration in the general government consolidated budget was largely the result is two processes: a) a revenue fall of 24.7%; and b) an increase in expenditure of 15.9%. Tax revenues were sharply down in all tax groups, with corporate income tax, VAT and personal income tax revenues dropping most (by 84.9%, 26.9% and 15.5% respectively).

The expenditure surge was primarily fuelled by payments of subsidies and grants which expanded by 70.3%. Rising expenditure for social benefits (by 26.2%) and the growth in interest expense (84.7%) were other significant contributors. General government gross debt increased by 143.2 million lats in April (to 3 119.0 million lats).

The consensus is that the current budget as agreed in a first reading before Latvia’s parliament last week implies a deficit of 9.2% of gross domestic product. It is anticipated that spending will be cut further via ammendments in the second reading scheduled for June 17 and that these should be sufficient to obtain additional disbursements from the European Commission and the International Monetary Fund. The question is not really (at this point) whether the Latvian parliament will pass the ammendments, but whether Latvia can hang out that long in the absence of stronger verbal and substantive support, and whether the measures if implemented will have the anticipated results.

On the latter point, as I have already indicated, I am extremely sceptical, and on the former, as we have seen statements from both the EU and the IMF have been much softer than might have been hoped for, while one leading ally (the Swedish banks and government) have now taken a much more ambiguous stance.

Swedish Finance Minister Anders Borg described the situation in Latvia as “markedly worrisome” in a statement on the Swedish government website at the end of last week. However, when it came to practical measures Borg was a lot less forthcoming, limiting himself to stating that Sweden would not offer Latvia any additional bilateral loan over and above the current contribution to the international bailout, adding the in his opinion the most important step forward was a show of determination by the government to rein in the budget gap. “They have to show that they have control over their public finances”. It is of the “utmost importance” that Latvia take “concrete and well-defined” additional measures to limit its public deficit to ensure that the IMF and the European Commission resume loan payment, he told reporters last week.

Swedbank, the largest bank in the Baltic states, has also stressed that they are fully prepared for a possible currency devaluation in Latvia. “We feel comfortable about our action preparedness regardless of which way the Latvian government chooses to go,” Chief Executive Officer Michael Wolf wrote in a statement published on the bank’s Website last week. As he also indicates, he gets the main point about the debt default problem:

“It’s not given that an external devaluation, over a longer period of time, will lead to larger credit losses for the banks,” Swedbank said. “But an external devaluation would give bigger credit losses during a shorter period of time as it directly hits the payment capacity for the many customers who have loans in euros.”
So What Happens Next?

Well , this is very hard to say, but certainly the omens - and especially Friday's Rigibor overnight reading - do not look good.

There is now evidently a growing consensus among observers that some sort of devaluation is well nigh inevitable, with the only real question being when. Certainly the trading community seem to be anticipating such a move, and forward contracts now price the lat some 53 percent below its current spot rate of 0.7073. Bloomberg quote fund manager Paul McNamara , from Augustus Asset Managers, as stating that “There seems to be a reasonable market consensus that Latvia will devalue", and I think this is a fair view.

Caroline Atkinson, director of external relations for the IMF, limited herself to describing the economic situation as “challenging", adding that there was clearly "a need for action.” She also pointed out the need for flexibility, which could refer to the IMF and the budget limit, or could refer to felixility on the part of the government, given the fact "the authorities have stressed the importance of controlling the government debt and deficits in maintaining the peg."

The problem is not that the IMF and the ECB would cease to support the Latvian government if they choose to continue down their chosen path, the question is really will they be able to continue down their chosen path, and indeed does it any longer make sense for them to do so?

No Exit Strategy

During this whole process one thing has become abundantly clear from the IMF statements, for the Latvian government's chosen path to be viable, there needs to be an exit strategy. Really it is very well worthwhile everyone reading the recent interview with IMF Survey Magazine (end of May) given by the IMF’s new mission chief for Latvia, Mark Griffiths, and Christoph Rosenberg, advisor in the IMF’s European Department and coordinator of the IMF’s work in the three Baltic Republics, since it makes a number of things very clear.

Particularly of note are Rosenberg's insistence (which has been a constant on his part throughout the process) that ownership of the adjustment program rests with the Latvian government:

"Let me first stress that this is the authorities’ program—they have very strong ownership of the policies that underpin it."

and secondly, having a viable exit strategy is central to success.

"The alternative strategy—abandoning the peg—would also be associated with large economic short-term costs. That is clearly one reason why there is such a strong preference in Latvia for maintaining the peg. Latvia also has a clear exit strategy in place: meeting the Maastricht criteria and adopting the euro by 2012."

But really, we now need to ask, is this exit strategy still viable? Certainly on the current path it may be possible (on the back of very considerable sacrifices on the part of the Latvian people) to bring the deficit down below the 3% limit in 2011 (although whether the EU Commission and the ECB would regard this as a sustainable process is another issue), but what about the 60% gross debt to GDP ratio? In their April forecast the EU commission pencilled in debt to GDP at 50.1% in 2010 (up from 9.0 in 2007 and 19.5 in 2008). That is debt to GDP is rising very fast (indeed some might say exploding). At the same time this 2010 estimate, which already makes being within the 60% limit in 2011 a reasonably close call (too close for my comfort anyway) is based on GDP contractions in 2009 and 2010 of 13.1% and 3.2% respectively, and we already know that the contraction in 2009 will be significantly greater than the EU forecast.

But it is worse than this, since not only is GDP contracting, prices are also falling (in fact, under the "internal devaluation" scenario this is what we want). But what this means is that nominal (or current price) GDP will fall faster than real GDP, with consequent negative consequences for the debt to GDP ratio (since as GDP falls, the money value of the debt remains constant). In fact the more successful the price correction the higher short term debt to GDP will rise. At the present time the EU forecast GDP deflators of only minus 2.2% in 2009 and minus 3.6% in 2010. But as we have seen above, for growth to return to the Latvian economy prices need to correct by far more than this, and hence debt to GDP will inevitably rise more than forecast - either because prices don't correct fast enough, and hence GDP contracts more (worst case) or that they correct rapidly (but with negative consequences for debt to GDP. This looks suspiciously like a Maastricht lose-lose to me.

That is, the simple fact of the matter is that there is no exit strategy. The programme simply doesn't work. It is "overdetermined", since whichever way you look at it, there is always one more problem than there is solution. Gentlemen. I think its time to give up. Honourably, but to give up. Come on out of the bunker, white flags and hands in the air will not be called for. There's a world out here waiting for you, it's on your side, and there will be a tomorrow.

Tuesday, June 2, 2009

Update on the Potential for Devaluation in Latvia

As I pointed out recently in the context of Latvia and the impending potential for a devaluation there is a distinct risk of falling victim to the sin of crying wolf. Yet, as the plot inevitable thickens I am maintaining, as it were, my cry. There are two significant points to think about in the context of what we might call recent developments. First of all there is the news that the 2009 deficit envisaged in the budget before the Latvian parliament will amount to 9.2% of GDP - significantly higher than the original IMF agreed "limit" of 5%, and even well above the latest negotiating objective of the Dombrovskis government of 7%. Of course, this is just number salad but at the end of the day it is important because it determines whether and under what condition the IMF funded bailout packaged continues. The fact that Latvia reports a deficit of this magnitude almost amounts to throwing in towel in my opinion or at least it means that the playing field is now a different one when it comes to IMF funding. Finally, and in case you think that Latvia has not already cut spending just look at the following estimates for cuts in the public sector:

Taking into account that the budget amendments envisage steep spending cuts, the amendments must be passed immediately, so that the ministries and other government agencies know how much money they will be allotted from the budget this year, stressed the Finance Ministry.

It is planned that the Defense Ministry's budget will be reduced LVL 30.8 million, the budget of the Finance Ministry will be cut LVL 14 million, Interior Ministry - LVL 10.4 million, Education and Science Ministry - LVL 22.1 million, Agriculture Ministry - LVL 20.5 million, Transport Ministry - LVL 109.5 million, Welfare Ministry - LVL 7.2 million, Justice Ministry - LVL 7.4 million, Culture Ministry - LVL 15.9 million, Health Ministry - LVL 39.3 million, and Regional Development and Local Governments Ministry - LVL 10.8 million.

The initial demands would of course represent even deeper cuts and this is the main point in this case; just how much pain can you inflict under a fixed exchange rate before the dam breaks? As it appears, everyone has a breaking point and with e.g. property prices slumping 50% y-o-y in Q1 alone it is not difficult to see the boom-bust nature of Latvia's recent economic performance.

Another and very important part of the picture comes from the fact that it is not only the IMF who is footing the bill in Latvia. Consequently and this is the case for all three Baltic economies the expansion has effectively been characterised by the outsourcing of the financial sector to particularly Nordic banks' subsidiaries and most notably Swedish owned banks. This creates a large dilemma in the context of devaluation since most of the of the credit to corporates and households have been provided in Euros as result of the so-called road map towards Euro entry which was perceived as a fait accomplit. Recently, RGE analyst Mary Stokes explicitly tackles this question in the context of the entire CEE edifice. Mary frames the issue neatly when she says:

The general idea is that these parent banks (as well as the CEE economies in which they operate) are likely to be collectively better off if they all continue to support their Eastern European subsidiaries. The problem, however, is they may not be individually incentivized to do so.

Mary is initially positive in the sense that we won't see a large scale withdrawal of foreign banks from Eastern Europe citing recent evidence in the context of Romania, Hungary and Serbia where foreign banks have pledged to support their subsidiaries despite strong economic head-winds. However, she also makes a very important point when she coins the notion of the asymmetric prisoner's dilemma. What lies behind this term is the idea that because different foreign banks are exposed to a different degree in different parts of Eastern Europe with different economic fundamentals the idea of a common commitment across the board may be difficult. One key ingredient here is of course, as Mary notes via Fitch ratings, that the extent to which banks are exposed relative to their parent companies differ substantially. This is simply to say that while some banks are indeed able to shoulder the inevitable losses which will come in a CEE context, some are threatened on their life [1]. Finally, there is the risk that if one bank decide to give up its support for the subsidiary and thus the domestic economic edifice in its current form, so will other banks do the same. On a macroeconomic level this would of course be tantamount to one economy deciding to devalue which would immediately, one would assume, force others to follow suit.

As you can probably tell by now I am getting closer to the topic at hand. Consequently, I believe that what is now materialising with Latvia as the main venue is exactly this asymmetric prisoner's dilemma that Mary is talking about.

Let us begin first with the simple and ominous sign that lending conditions in the Latvian interbank market have become increasingly tight recently. I already pointed to this in my previous post (see link above) where I noted how the Latvian central bank, through its currency board, has already spent over 500 million euros buying lats. Last week in particular was tough as Bloomberg reports how the central bank had to buy 95.4 million lati ($190.6 million) in order to protect the Lati from moving below its trading limit where it is only allowed to move 1% either way against the Euro (from a mid point). According to Bloomberg, such purchases have already caused the foreign exchange reserve to shrink by 38% between September 08 and april 09 alone.

Latvia’s overnight lending rate rose to a record today because of a shortage of lati on the market after central bank purchases of the currency and Treasury bill sales, said Andris Larins, an analyst at Nordea AB. Asking rates on the overnight Rigibor, the interbank lending market, rose to 14.2 percent after the central bank bought 95.4 million lati ($191.5 million) to support the currency last week. Treasury bill sales and higher interest rates on money the central bank charges to borrow also contributed, Larins said.

As can be seen the effect from these operations are very as they have driven the interbank rate to its highest in more than 10 years as the central bank purchases are sucking up liquidity from the market. The main message here is that the shorter term rates are converging to the annual rate (click image for better viewing).

Especially, it is important to pay attention to the fact that the overnight rate has skyrocketed and even surpassed the annual rate. The overnight rate has risen 1352 basis points since the 21st of May and it indicates verly clearly how much stress and uncertainty which is building up in the market. Essentially this is the effect Bear Stearns/Lehmann had on the Libor back in the days where global interbank markets were freezing over. Moreover, I have from reliable sources that some banks are quoting overnight rates as high as 20% which suggests that things are moving fast at the moment.

But why all this fuss now then?

Well, it is worth remembering that it already began last week and as I pointed out above the larger than expected announced budget deficit cast serious doubt over the potential for future IMF funding. However, a more prominent reason is certainly that the Swedish banks and Swedish discourse in general have begun to turn strongly towards devaluation in Latvia as a sure thing. Last week, the Riksbank strengthened its foreign currency reserve with 100 million SEK, but more importantly SEB Chief Executive Annika Falkengren noted how the level of defaults would essentially be the same regardless of whether Latvia devalued or corrected through internal price deflation. This kind of message from a Swedish bank executive is not without importance since it is, for a large part, Sweden that have financed the Baltic expansion through the heavy exposure of many Swedish banks in the Baltic economies. Up until now however, popular belief has held that since most of the loans having been offered by foreign banks were in Euros these banks would strongly reject devaluation as it would effective eat up a large part of their balance sheet in one sweep. However, as many of us have pointed out these defaults would come anyway as a result of the sharp and essentially brutal deflationary correction. It is exactly this recognition which seems to have trickled down to Swedish bank officials.

As a consequence of this and, arguably, a host of other things Bengt Dennis, a former Swedish central bank governor and an adviser to the Latvian government was quoted this weekend of saying that a Latvian devaluation is a done deal. The only question would be when and how.

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.

This is of course pretty uequivocal and indicates quite strongly how the end game is near. In essence, it is very obvious I think that the sentiment in Sweden has turned from one in which the desire to wait out the storm and take the losses gradually to one where there is a demand for closure and immediate quantification of the losses. This is significant since the longer markets believe that Swedish banks no longer explicity support the peg, the closer we move towards a devaluation.

Clear signs of such sentiment comes from the publication of the Riksbank's Financial Stability Report out today where it is estimated how Swedish banks will lose as much as SEK 170 billion during 2009 and 2010 on loan losses. Now, it is impossible to say whether these estimates implicitly include a Latvian devaluation or not, but one thing is certain; the estimates have the Baltics written all over them and, if anything, the downside looms as a direct function of the potentially worsening situation in the Baltics. Add to this that the Swedish economy in general have endured an absolutely horrendous 6 months across Q4-08 and Q1-09 and it is not difficult to see from where the impetus to pull the plug in the Baltics could come from. Recent figures for GDP indicate how national output fell 6.5% over the year in Q1-09 which compares to an annual drop of 4.9% in Q4-08.

To add to the pressure it also appears that the political tensions in Latvia is growing.

In the first instance there is of course the expected and almost obligatory refutation of the Dennis' comments about the almost certainty of a devaluation.

I hereby announce that an opinion by Bengt Dennis, member of the High Level Advisors Working Group to the Government of Latvia, which he expressed today to the Bloomberg news agency about an inevitable devaluation of the Latvian national currency – lats – is not true, and should be evaluated as expert’s personal, individual opinion which has nothing to do with issues concerned in the first sitting of the High Level Working Group, as well as with the position of the Government of Latvia on overcoming the economic crisis.

This is of course all well and good, but the question is whether we can take this for granted as the "official" position. For starters, Bloomberg (linked above) quotes Justice minister Mareks Seglins for calling a debate about the potential gains and losses relative to a currency devaluation. This would indeed be something new in a Latvian context as a debate about the Lati's Euro peg hitherto has been stifled completely by the official backing of the Lati's value against the Euro. As people closer to the Baltic situation than me have pointed out, this may a specific attempt to stir up things by Seglins since his party are bound to lose local elections come Saturday and may thus lose the majority in parliament.

A Done Deal Then?

Not quite, but it is impossible not to notice that some significant cracks have emerged. I think it is particularly important that Swedish stakeholders in the Baltic debacle now seem to favor "throwing in the towel" through a devaluation as it is assumed that it would amount to same thing, in the end, as trying to keep things together. Of course, no one other than Latvia herself can choose to devalue but the signs from Sweden are very important in the sense that the Swedish banks are paramount in keeping the economic edifice together. Moreover, there is the IMF where we do not yet know whether bailout funding will continue with the new estimate of 2009 budget deficit. My guess is that the IMF won't stand for it but then again, it would be wise to cut some slack if they have an interest in keeping the peg (which I am not it really wants).

I will end as I did last time with a general warning. At this point rumours will drive the discourse as much as real economic fundamentals and political decions. However, it is difficult to deny that a devaluation in Latvia seems to be moving closer.


[1] - Incidentally and for all the complaints about me focusing too much on the similarities between the CEE here is an example of differences. This is to say that when it comes to a high degree of event risk there are of course notable assymmetries. What I would like however to point out is that when it comes to the fundamentals and the underlying problems/courses of the crisis the Eastern European countries are, in many cases, strikingly similar.