The Swedish central bank shored up its currency reserves by SEK100 bn last week. The move was widely interpreted as national preparation for a potential Latvian devaluation — Swedish banks having up to $75bn worth of exposure to Latvia, Estonia and Lithuania according to ING.
On Tuesday that market presumption can go one step further.
Bloomberg reports that Bengt Dennis, the former Swedish central bank governor and adviser to the Latvian government, told Swedish television on Monday night that the Baltic nation would have no choice but to go ahead with a devaluation. As the news agency quotes:
“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.
That is perhaps the boldest assertion so far by a related official that a Latvian devaluation may be imminent.
While a devaluation would hardly come as a surprise, the implications for Europe are still very great. Namely, the move would mark the first withdrawal from the European Exchange Rate Mechanism-II (ERM-II) since Great Britain’s in 1992. What’s more, Latvia’s four-year experiment with obliging to a euro currency band, and all the pain that went with it, will have come to nothing.
Just days ahead of a European Parliamentary election on June 6th, a devaluation would also not be very good publicity for the Brussels PR machine.
Yet, it seems, devaluation really is the only logical course of action. Among the bodies to have already urged the Latvian government to consider the move are the IMF. Back in April, Latvian prime minister let slip the international lender preferred devaluation of the Lat currency over any other course of action. The statement was the first official signal that there was a differing stance over the currency between the IMF and the Latvian government, which is still until today holding firm against a devaluation.
But as Lex points out in the FT on Tuesday, there’s only so much pain the Latvians can take:
The country ran up Europe’s biggest current account deficit in 2007 as inflation and spiralling wages whacked its competitiveness. Now, determination to maintain the peg and keep open possible euro entry is forcing an agonising economic adjustment. That could mean the economy contracting by a quarter or more, from peak to trough.
A survey by the Global Property Guide, meanwhile, reveals that Latvian property prices plunged the most in the world in the first quarter of 2009.
They describe the situation as follows:
AMAZING PRICE DECLINES IN LATVIA, DUBAI, AND SINGAPORE
Latvia is in surprisingly deep trouble. Average apartment prices in Riga declined an astonishing 50% over a year earlier, to €747 per square metre, with a 30% drop during the quarter. Latvia is in deep recession, with its economy contracting 18% in Q1 2009.
Devaluation would certainly help counter some of that effect. The great fear in Brussels, however, presumably is that if one country topples on the ERM-2 front, an unwelcome precedent might be set for others to follow. An even greater problem emerges when you consider that in many cases it was the promise of accelerated Eurozone entry that helped stave off currency collapses in stronger new member states like Poland and the Czech Republic back in October 2008.
Despite the above, the Latvian government on Monday still appeared stubbornly opposed to devaluation. A Reuters report said that while the government had redrawn its 2009 budget to foresee a 9 per cent deficit and an 18 per cent shrinkage in GDP, prime minister Valdis Dombrovskis was still of the opinion that more spending cuts were a better option to devaluation — the amended budget now includes a general public sector salary cut of 20 per cent and overall spending reductions of 40 per cent.
Of course it’s easy to understand why the Latvian government is keen to resist devaluation until the very last minute. The move would simply crucify the ruling party in the polls.
Related links:
Is Eastern Europe on the edge again? - FT Alphaville
The Eastern European carry-trade meltdown, reviewed - FT Alphaville
Estonia, nul points - FT Alphaville
Emerging market credit fundamentals deteriorating, S&P says - FT Alphaville
