While Latvia’s central bank stands firm in the face of adversity singing a united chorus of “we shall not devalue, we shall not devalue,” all indications still remain that they will.
First proof of the inevitable comes in the form of the Latvian interbank overnight rate, which on Thursday soared to a fresh high of 12.80/16.80 per cent.
As the research arm of property advisers BH2 (who should know, seeing as Latvian property prices fell the most in the world in the first quarter of 2009) wrote in a report on Wednesday:
Raising overnight rates (as Latvia has done) is a desperate and ultimately counterproductive strategy. Whilst one cannot be sure whether devaluations will be coincident or staggered, none of the Baltic Three is in a position to avoid a currency reversal.
In terms of choreography Latvia is the most likely first mover. In the first instance Riga will announce that it was taking up its right within the ERM II to operate a 15% band around its central peg rate. This would of course see the lat move straight to its floor. For those who might see this as the end of things, we caution it will be just the start.
They go on:
The idea that the Baltic Three can accede to the euro in 2012 is quite frankly laughable. The reality is that their euro accession might never happen, with instead a new peg regime installed with an SDR anchor.
What’s more, they see the contagion factor spreading across the whole of emerging Europe when the whole thing does finally topple– in some way explain the sharp drops in non-ERM2 pegged currencies like the zloty and forint following Wednesday’s news that a Latvian bond-sale failed. As BH2 put it:
Currencies all across Emerging Europe are set to weaken, some from already depressed levels; with 25% a conservative forecast for the declines we expect for ERM II currencies, although we would not be surprised if the outcome was twice or even three times this. The whole of Emerging Europe will be drawn into this renewed crisis, from Poland and Bulgaria within the EU to Croatia and Serbia outside it. This assertion will seem at odds with the localised nature of recent currency weakness, and the calm which has followed. True, concerted financial help from outside and promises of thrift from within have combined to usher in a period of stability. Do not be drawn in by this.
As for those central bank assertions, do not be fooled they warn:
The reality is that the currencies of the Baltic Three cannot hold their current pegs indefinitely. Their authorities will claim they can. Experience tells us they cannot.
And here’s how BH2 foresees regional currencies finally settling against the euro following the inevitable currency shocks that arises:
Meanwhile, also joining “the Latvia will devalue” camp is Morgan Stanley. As Bloomberg reports, analyst MS Oliver Weeks believes the process is inevitable, although does concede it might not happen as quickly as some currently believe:
June 4 (Bloomberg) — A Latvian currency devaluation is inevitable, though probably not imminent, said Oliver Weeks, an emerging Europe economist at Morgan Stanley. Speculation that the Baltic nation may be forced to scrap its fixed exchange rate regime has intensified as the central bank stepped up its defense of the lats in the past two weeks and the government failed to sell any bills at auction yesterday.
There have been few signs of a run on banks by depositors in Latvia, which would trigger devaluation, London-based Weeks said in an e-mailed report today. The Riga-based central bank said today it will maintain the lats peg to the euro until the country adopts the single currency.
“We think that devaluation is inevitable and obviously getting closer,” Weeks said. Still, a devaluation “may not be quite as imminent as the market seems now to expect.”
But, perhaps, most interesting on Thursday were recent comments from European Economic and Monetary Affairs Commissioner Joaquin Almunia on the matter. In a statement on the Commission’s website he stated (our emphasis):
European Economic and Monetary Affairs Commissioner Joaquín Almunia believes that the new budgetary proposals are a step in the right direction and also appear to contain some welcome reforms, but more is needed to contain the increase in the budget deficit.
“Sadly, the economic recession is proving more severe than expected in Latvia bringing hardship for many and increasing the deficit to higher levels than expected. Latvia needs to reduce the deficit in a sustainable way with significant budgetary and structural measures, although I acknowledge that the original fiscal targets in the government’s economic program are no longer within reach.
I also understand there are limits on how much the deficit can be reduced to allow some breathing space for the economy and for the people of Latvia, especially the sections of population most in need. I take note that the authorities want to control government debt and maintain their exchange rate peg. The supplementary budget presented this week is 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 government,” said Commissioner Almunia.
Hmmm, whatever could he mean by “more is needed to contain the increase in the budget deficit”? Not that we mean to imply devaluation, but… as Barcap point out, there is possibly a way that Latvia could have its cake and eat it (eg. devalue and not fall out of the ERM2 either). Remember Latvia currently constricted to a 1 per cent band of its own doing, this is not the official ERM2 mandate. As Barcap explain:
The IMF and the EU will be very sensitive to the potential spillover effects any disorderly devaluation could have on the region. Both institutions may thus in the short run release another round of tranches in June (EUR 1.3bn altogether), which could help stabilize the situation for the moment. Official declarations are most likely to be made next week. There are several ways to go about a potential devaluation from there. One possible way could be to remove the unilateral +/-1% band that Latvia has declared unilaterally and let the LAT move to the +/-15% band under the ERM II mechanism (which it is part of since 2005). In this case, the ECB would have to intervene to support the band immediately and it could then discuss with the Latvians the need for a “realignment” of the central parity.
Of course, as BH2 point out, it’s the exit strategy that would be crucial here, and the risk is it may now be too late to move towards the 15 per cent band without unleashing negative forces that push the lat even further through that range. Certainly the lesson to be learnt according to BH2 is perhaps the Baltic states were too quick to confine themselves to the 1 per cent range in the first place? As they note:
As the Baltic Three prepared for their accession to the EU in April 2004 their uncompromising behaviour encouraged investors that entry would be seamless. Most notable was the confident strategy when joining the ERM II of fixing the lat, lita and kroon to unwavering euro pegs, rather than allow the 15% range allowable within the system. This was a clear statement to outside investors that it would not be long before all three acceded to Europe’s single currency, the target initially being 2008, albeit more recently being pushed out to 2012.
Related links:
Urgent message from the central bank of Latvia: ‘Do not disrespect us!‘ - FT Alphaville
Latvian bond failure begins - FT Alphaville
A Baltic quagmire, continued - FT Alphaville
Waiting for Latvia to devalue - FT Alphaville
Is Eastern Europe on the edge again? - FT Alphaville
