Voices advocating a devaluation in Latvia appear to be growing by the minute. Equally so is the chorus comparing the recent spate of affairs to a major crossing of the Rubicon for the country.
Here, for example, is the latest view from Timothy Ash, head of emerging European Research, at RBS:
We sense that a similar Rubicon was crossed this week in Latvia when the prior cross party support for the exchange rate peg was finally broken with a former PM calling for a currency correction; just a year back a local economist was arrested for uttering doubts over the durability of the fixed exchange rate regime. Indeed, calls for a currency correction are now reaching a creshendo [sic] with a member of the cabinet going off-message with a call for a debate over the benefits of a devaluation. In a fixed exchange regime it’s united we stand, united we fall, so the fact that members of the current government feel the need to put out “feelers” over the options on the FX front is a major worry.
The obvious concern is that this just spooks depositors in the banking sector, leading to a weight of conversions out of Lats; the Bank of Latvia has racked up intervention over the past few weeks in defence of the LAT. This just makes their position more difficult in the real economy by contracting the monetary base, deflating domestic demand still further and worsening the recession and public finances in the process; they are in an acute vicious cycle.
But as Ash writes, the realisation that the current strategy is not working and that the taste of the medicine might be much worse than the symptoms of the disease is finally dawning. He concludes (emphasis FT Alphaville’s):
Net-net though, and whatever your view of fixed exchange rate versus floating regimes, the current status quo is clearly unsustainable, with local rates up thru 100%, and the Bank of Latvia bleeding FX reserves. Time is clearly running out. While devaluation is not without costs, it would clear the air, and in a trade off with the current huge pace of real GDP contraction/mounting fiscal problems surely cannot be much worse than the slow death being wreaked on the Latvian economy by fixed exchange rate orthodoxy.
Meanwhile, the analysts over at Variant Perception think it’s definitely more a question of when rather than if devaluation takes place. They base this notion on the fact that currency pegs are only exacerbating the current situation, which they compare to that faced by Indonesia, Thailand and the Philippines prior to the Asian crisis.
What’s more, the team writes that the original factors justifying currency pegs as part of the Maastricht criteria are now mostly obsolete (their emphasis):
The original reason for the introduction of the currency pegs was to provide the fiscal foundations and stability to help satisfy the Maastricht criteria essential for euro membership. But the current parlous state of the Baltic nations’ finances and the reality that their economies are in a collective stupor make it hard to see the rationale in retaining fixed exchange rates; euro accession is now categorically not imminent. Who will be first to realize they have little to lose by dropping the peg?
Mounting urgency for imminent action is highlighted, Variant say, by the Latvian prime minister’s admission earlier in March that any further delay in IMF assistance could well mean the country faces ‘bankruptcy’, and so would have to default on its outstanding debt.
To give you some idea of Latvia’s liabilities here, in a report issued earlier in May Fitch estimated the country has maturing debt in 2009 equal to 320 per cent of its current forex reserves.
If reports we first came across at A fistful of Euros are to be believed, a public-sector voucher payment plan is already underway in an attempt to limit some of Latvia’s hefty expenditure rate and help stave off a default.
And Variant offers some weight to the voucher story by saying:
And in a latest twist, there is evidence that public sector workers in Latvia are being paid partly in vouchers redeemable for food. According to the Central Bank governor, Ilmars Rimsevics, who spoke on Friday, “The level of the expenditure shock is so high that we cannot cease to maintain this level of expenditure. So there is a shortage of funds, and we’re forced to look at the different kinds of projects, which [we] can provide for the foreseeable future. Taking into account that the money is not budgeted, it can be omitted (sic) in vouchers”. It is this partial removal of the Lati from circulation that is causing the Rigibor interbank rate to rise, as can be seen on the next chart.
Meanwhile,over at A fistful of Euros, the voucher story led emerging markets specialist Edward Hugh to apply some not-so-spurious Argentina parallels to the whole scenario (our emphasis):
As I say at the start, all this – including the vouchers proposal – does now sound incredibly like Argentina, since issuing scrip money is exactly the kind of thing you get pushed into when you try unrealistically to hold a peg. It is the begininning of the end. The same thing, exactly, happened in Argentina, where they ran out of pesos and started to issue Patacónes, Lecops, Créditos,Argentinos and a myriad of other exotic bits and pieces of scrip. I give a bit of background on all this in this post on my Spanish blog, while Bloomberg’s Aaron Eglitis has a useful summary of the general Latvian situation here.
But what’s really worth noting is Variant’s observation that while the Rigibor interbank rate is markedly higher than the respective Vilibior and Talibor rates, there is no equal distinction in the sovereign CDS market.
The cost of insuring Latvian government debt against default remains virtually the same as that for Estonia and Lithuania, suggesting just one thing — ripe fears of further contagion. If based on precedent, Variant point out this is a sound market conclusion; the work of Reinhart & Rogoff in “This time is different” certainly suggests countries don’t tend to default alone.
They explain:
Specifically, despite the continued widening in Latvian interbank rates, Latvian CDS so far do not appear to be reflecting the concomitant risk-premium one might expect, suggesting a mispricing, or that the market is pricing the risk of default in the Baltic countries as if they had a correlation of 1, ie if one goes, they all go.
On the plus side, however, the country that defaults first is usually the one that recovers first. This presents some incentive for Latvia to go down the default route instead, say Variant. The consequences of currency devaluation, meanwhile, are seen as largely ‘cathartic’ but with violent short-term convulsions:
Hardest hit would be the foreign lenders — mainly Swedish banks — who would find the value of their loan assets decimated. In the shortterm, this may exacerbate the financial crisis as the credit supplied across the Baltic region, mainly by the same now beleaguered lenders, suddenly dries up. Some of the banks involved may be left insolvent.
Related links:
Waiting for Latvia to devalue – FT Alphaville
Is Eastern Europe on the edge again? – FT Alphaville
The Eastern European carry-trade meltdown, reviewed – FT Alphaville
Estonia, nul points - FT Alphaville