Ambrose Evans Pritchard of the Telegraph may have written off Latvia on Monday with a scathing comparison to Argentina, but the country’s central bank is not taking the criticism lying down. In fact, as Reuters reports:
RIGA, June 15 (Reuters) – Latvia’s central bank said on Monday that it intervened last week to buy 160 million euros ($225.1 million), selling the local lat currency in a reversal of a trend of earlier weeks when it had to buy lats. The change in trend came after the lat last week firmed away from the weak end of its 1 percent fluctuation band against the euro and headed towards the strong end. The central bank, which announces its interventions on Monday for the previous week, including on Reuters page, had in the last week of May and first week June spent 372 million euros to buy lats and support the currency.
So, already the central bank is buying back the euros it sold only last week. Devaluation crisis averted?
Well not quite.
Much of the turnaround is down to renewed hopes that the second tranche of some €7.5bn in promised IMF-EU bailout funds (about €1.2bn) will make its way to the country soon. However, the fact remains, if the money doesn’t arrive by the summer, the country is still at effective risk of default. The country has already had to impose some very painful budget cuts. Collectively these amount to some $1bn, including a 10 per cent cut in pensions and a further 20 per cent reduction in public sector salaries — hardly symptomatic of an economy on the turnaround.
As BarCap observe in a recent note, the cuts are tantamount to an “internal” devaluation anyway — and it is here if anywhere the situation risks becoming explosive, Argentina-style.
Meanwhile, as the Baltic news agency BNS reported, Finance Minister Einars Repse believes that even with the budget cuts the budget deficit this year could be as much as 11.6 per cent of GDP.
There’s also the fact that due to years of low FX volatility the country has gathered a tremendous amount of foreign-exchange denominated debt. As Barclays rightly points out if the internal devaluation is to work the country must undergo a radical relative price adjustment.
Therein lies the real threat:
Instead, against the backdrop of a deep recession, the threats to the peg come rather from a sharp deterioration of bank asset quality (NPLs) that in turn could compromise the rollover of banks’ foreign liabilities, ignite a deposit run and ultimately create unbearable costs for the real economy through a pro-cyclical exchange rate defence (already visible in the form of liquidity shortages and higher interest rates).
Of course this will take a while to manifest. So far, depositors have proved remarkably resilient to negative news shocks, standing true to the lat all the way. But, as Barclays write:
Should conditions change, households can either hedge the mounting currency risk by fully “euro-izing” bank deposits or, when a devaluation is perceived as a bank solvency problem, withdraw to purchase FX.
Of course, the above can’t really happen overnight and in that sense Latvia is unlikely to become Iceland. However, any slant in the situation towards depositor panic, and the situation does risk spiralling out of control. Which leaves one course of obvious action to avert disaster: Immediate euro entry.
As Nouriel Roubini pointed out last week in an FT editorial (our emphasis):
An introduction of the euro immediately after devaluation could help prevent the exchange rate from overshooting, although it would require the eurozone to admit a country that does not yet satisfy the formal criteria for membership. Euroisation after depreciation is a more credible strategy for Latvia than dollarisation would have been for Argentina, as Latvia was on its way to membership and its business cycle is highly correlated with that of the EU. Euroisation without depreciation will not work, as a real depreciation is necessary to restore competitiveness.
Although even that won’t solve the problem of all those prospective bad loans. As Roubini concluded:
Of course, any depreciation — with or without euroisation — will make many foreign currency debts unsustainable and will require a forced debt restructuring, as in the case of Argentina.
Default control in that case becoming a top priority:
To minimise the risk of contagion, the best strategy may be: depreciate the currency, euroise after depreciation, restructure private foreign currency liabilities without a formal “default”, and augment the IMF plan to limit the financial fallout. It is a risky strategy but — as in Buenos Aires nine years ago — when plan A does not work it is time to move to plan B sooner rather than later. Delaying plan B would only cause a bigger blowout when the unavoidable currency crisis eventually occurs. It is to be hoped the lessons of Argentina in 2001 have been learnt.
All of which suggests in the end that it’s more the case of crisis delayed than averted for now. In Barclays’ eyes anyhow the probably paths for the crisis now look like this:
1) Maintaining the peg at current parity until EUR adoption in 2013. This remains the official strategy.
Probability: 30%. As laid out above, we think that defending the peg at current parities over a multi-year horizon seems difficult.
2) Collapse of the peg, including bank runs and massive overshoot of the LAT. Such an disorderly collapse of the peg cannot be entirely excluded given the existing tension. Experience with such crises suggests that they would involve an overshoot of the exchange rate way beyond equilibrium levels, and the temporary imposition of deposit freezes / bank holidays / capital controls.
Probability: 10%. In usual circumstances the risk of such a scenario would be much higher, but the relatively small size of Latvia’s economy (and thus the relatively small absolute financing needs) combined with the incentives of its powerful friends: 1) the EU, concerned about a region-wide crisis; 2) Sweden, aware that balance-sheet losses in Riga would be ultimately paid in Stockholm; and, 3) a super-sized IMF.
3) Orderly (20-30%, one-off) “re-alignment” of the peg. We think such a scenario may ultimately be the most likely outcome.
Probability: 60%. For the same reasons that we believe a “collapse” scenario has a low probability, we believe this scenario has a high one. We try to illustrate such a scenario in more detail below.
Related links:
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