IMF Imposes New Conditions On Latvia

Izabella Kaminska at FT Alphaville has the story (via Reuters):

The International Monetary Fund has put forward new, difficult conditions for Latvia to receive further loans, the prime minister said on Wednesday in a further sign the Fund is being tougher than the European Commission.

It isn't clear at this point what these conditions are. Rumour has it they may be an end to the flat income tax, or a hike in VAT. A hike in VAT would be more hari-kiri, since this would again hit consumption AND would boost inflation at a time when they are trying to deflate to carry through an internal currency correction. It also isn't clear whether this is a serious attempt to add new conditions (which I find unlikely, given how advanced the distemper is) or whether this is a way for the IMF to get themselves off the hook (ie leave the EU Commission to stew in its own juice) without having a public and potentially damaging break with the EU. The IMF need to find some sort of exit strategy I think (since Latvia evidently at this point doesn't have one), or it risks losing its own credibility if it puts a seal of approval (by granting the next tranche) on something which most external specialists now think could end up in a very messy grande finale. Argentina ghosts are stalking the corridors in Washington, not because of the similarities between the two countries (they are, at the end of the day pretty different), but because of the way giving a final "kiss of death" loan to a country can ultimately come back and haunt you.

Update One

The local Latvian news agency is saying that if Latvia and the IMF do not sign the new agreement by Friday, Latvia may not see the next chunk of the IMF loan and it could jeopardize the further funding from the EC. This could be brinksmanship, but even brinkmanship can go badly wrong if the other party can't concede. And who is the other party here? Latvia or the EU Commission, since they already said they are happy with progress. What a muddle!

Update Two - Thursday Afternoon

Bloomberg's Aaron Eglitis reports this afternoon that Friday may in fact not be any kind of deadline. He quotes Caroline Atkinson, head of external relations at the IMF, in Washington, to the effect that the head of the IMF mission in Riga is returning to Washington this weekend as scheduled, while the mission itself would “continue its work.” This suggests there will be no final decision this week. She also said there was “broad consensus among all the parties involved” about the goals for Latvia, declining to go into specifics.

Rumourology has it that the IMF wants the government to become more effective in revenue collection, with the fear that the current contraction may be so strong due to the fact that part of the economy is disappearing back into a "grey area" as a backdrop. Various proposals are being floated around, but perhaps it would be better to wait for some concrete information before speculating about this.

Latvian central bank Governor Ilmars Rimsevics has also been holding a press conference in Riga today, and he took the opportunity to suggest that the country’s budget deficit was likely to grow to between 9.5 percent and 10 percent this year. If this is the case, then this would obviously put Latvia outside the 60% gross debt to GDP criteria by 2010, which would make euro membership as an exit strategy non viable over the relevant horizon in my view. Just a long shot, but maybe that is what they are all arguing about. The EU clearly has to offer the four peggars more in the way of a carrot, although they themselves need to remember - looking over at Slovakia and Slovenia - that mere euro membership is no panacea to cure all ills.

The IMF/EU Commission Rift On Latvia Seems To Be Deepening

Two weeks ago I drew attention to a revealing press conference given by IMF First Deputy Managing Director John Lipsky and European Central Bank governing council member Christian Noyer where it seemed a rather different posture was being taken on the Latvian question than that which is being transmitted from Brussels. Then P O'Neill found a message on Twitter which suggested the topic of the Latvian budget had been unexpectedly added to the EcoFin agenda.

Today Bloomberg report that Barclays Capital’s chief economist for emerging Europe Christian Keller thinks that the IMF's posture of continuing to withhold funds even after the approval of the spending cuts “signaled that the rift between the IMF and EU has widened” .

Now I don't want to see connections were there are none, but it is a coincidence that Christian Keller works for the same Barclays capital whose Head of Emerging Markets Strategy Eduardo Levy-Yeyati recently published a lengthy analysis on the influential Is Latvia the new Argentina? - where he argued that: "The strategy of engineering an “internal” depreciation under a peg in Latvia (via contractionary fiscal policy, wage cuts and price deflation) implicit in the IMF program is proving too painful, if not self-defeating as in the 2001 collapse of Argentina’s currency board"

Now the publication of this article was interesting since Eduardo Levy-Yayati is not just any old economist. Previous to joining Barclays Capital, as his Voxeu biography informs us, he was

"a Senior Financial Sector Advisor for Latin America & the Caribbean at The World Bank. Previously, a Senior Research Associate at the Inter-American Development Bank, the Director of Monetary and Financial Policies and Chief Economist for the Central Bank of Argentina, and the Director of the Center for Financial Research and Professor of Economics and Finance at Universidad Torcuato Di Tella. He has also worked as consultant for the IMF, the World Bank, the Inter-American Development Bank, the Japan Bank for International Cooperation, among many public and private institutions. His research on emerging markets banking and finance has been published extensively in top international economic journals. "

That is, Señor Levy-Yayati is an extremely experienced economist, an old Argentina hand, and enjoys some considerable influence over emerging markets issues in Washington. So was the appearance of the article in Voxeu at the end of June totally coincidental? He certainly is experienced enough to know what he is doing in these matters. And was it also a coincidence that only a week later former chief economist at the International Monetary Fund Ken Rogoff - surely another person who knows perfectly well what he is doing - gave an interview where he said that "Latvia should devalue the lats to avoid a worsening of its economic crisis" and that "the IMF made the wrong decision when it allowed Latvia to keep its currency peg"?

The IMF cannot say what it really thinks for obvious reasons, but could we construe Levy-Yayati and Rogoff as thinking out loud on the funds behalf?

The clash between the two institutions (should such a clash exist) derives from “ideological differences” according to Keller. "The IMF is focused on economic questions such as the sustainability of the currency peg, the use of economic stimulus or the idea of fast-track euro adoption......The EU’s main concern is political, such as euro-adoption rules and the implementation of convergence programs".

This all rings pretty true, and it rings even truer when you note that the Latvian Prime Minister Valdis Dombrovskis said only last week that the country "may not need the IMF share of the financing". As Keller says, “The Latvia program has become a headache for the IMF.”

Postscript

Latvian foreign trade was down again in May, at 618.3 mln lats it was 4.2% (or 27.1 mln lats) lower than it was in April (no green shoot here) and 38.5% (or 387.6 mln lats) down on May last year, according to provisional data of Latvian Statistics Office. May exports were down 30.1% over May 2008, while imports were down an incredible 43.7%. Over the January – May period foreign trade was down by 35.4% on the same period in 2008. Exports were down by 27.7% and imports by 39.9%.






Industrial output fell back again in May over April, by 0.4% on a seasonally adjusted basis according to the statistics office. Year on year it was down 19.3%.





And domestic demand continues to weaken. Retail sales were down 0.48% in May over April, and 24.14% year on year, according to Eurostat data.





Latvia’s inflation rate fell to 3.4 percent in June, the lowest annual rate since October 2003, from 4.7 percent in May. Prices were down 0.5% on the month, but this is way too slow for the kind of internal devaluation process which is underway. At this rate the loss of GDP will be truly massive before the internal currency correction has taken place.

There were 206,000 people unemployed in Latvia in May, or 16.3 percent of the labour force, according to the latest Eurostat data. This is slightly down on earlier data, but since these results are survey based, and such rapid changes make it difficult to apply such methodologies, I don't think we need suspect any kind of "foul play". The rise is dramatic enough as it is, as can be seen in the chart below. This makes me wonder were we will be by mid 2010.




One area where the central bank has had some success has been in getting overnight interbank lending rates down again, and the overnight Rigibor is now back around 3% (13 July), but the 12 month rates are still very high (20.2% 13 July) which does suggest that while market participants are fairly sure the peg is safe in the short term, they are not at all convinced about what is going to happen in the longer term. And in this they seem to be making a valid judgement, since this is the situation at the time of writing.






Meatime Latvia's natality continues to suffer under the weight of the crisis, there were 1750 live births in May, down 15.3% on May 2008. Thus, not only are we playing with the countries short term future here, we are also putting the possibility of having a long term one at risk.




Where Is The Endgame?

When it comes to the short term dynamics of the looming currency crisis in Emerging Europe, one of the Baltic Three, probably Latvia, will most likely be the first to concede its peg, as Eduardo Levy-Yeyati says this is just too painful, and the loss of GDP which is taking place while the politicians are dithering is fearful.

But when Latvia does leave its peg, then others are almost bound to follow. Everything depends on whether the EU Commission and the IMF are proactive or limit themselves to a mere reactive, problem-containment role. If the Latvian currency realignment is done in an organised and systematic fashion, then it may, even at this late date, be a containable process. For this to happen the EU Commission have to stop playing with the politics of the situation, realise that the Maastricht criteria were not written in tablets of stone, and start to formulate a reasonable exit stratgey for all the Eastern members of the EU. They need, that is, to start thinking practical economics, the way the IMF now seem to be doing. The macro economics of this was always clear and straightforward.

But if the Latvian situation is simply left to fester, and the country falls into the grip of a growing political anarchy, then containment will be much more difficult, since panic will more than likely set in.

A similar situation pertains in Bulgaria (see my latest post on Bulgaria, since the similatities are evident). Absent a Latvian devaluation, it is not unthinkable that the Lev peg may be maintained in Bulgaria for another year or so. But if the Bulgarian authorities do go down this road, then we face the severe risk of a a further raggedy ending, since the problem is not one of sustaining the peg, but of restoring competitiveness and economic growth, and this is much more difficult without a formal devaluation. And if Bulgaria does go hurtling off that cliff on which it is currently perched, then just be damn careful it doesn't drag half of South Eastern Europe careering after it. The EU Commission need to begin to resolve this mess, and the need to begin now!

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.

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.