A very interesting analysis on the Latvia situation is brought to us by Eduardo Levy-Yeyati, Director and Head of Emerging Markets Strategy at Barclays Capital on Monday via the VoxEu.org platform.
The author argues the country’s best bet for economic salvation will be through contained devaluation, because “internal depreciation” via fiscal policy, wage cuts and price deflation is likely to prove too painful. What’s more, the matter of bank deposits is likely to force matters this way in the end anyway, says Levy-Yeyati.
What’s interesting about such concern over bank deposits is that most analysts so far have viewed them as the country’s only saving grace. Unlike Argentina there has not yet been a run domestic accounts.
But according to Levy-Yeyati, while that might very well be the case, what’s clear is that local deposits are in the process of being changed into foreign currencies. Foreign deposits meanwhile are declining altogether. As he states:
Deposits: Depositors typically hedge the mounting currency risk first by “dollarising” bank deposits and, when devaluation is perceived as a bank solvency problem, by withdrawing to purchase foreign exchange. It is the second, more drastic avenue that can ultimately break the bank (if the central bank limits the provision of liquidity to face the deposit run) or the peg (if the central bank assists the private bank, injecting liquidity that ultimately goes against central bank reserves). Local deposits stabilised with the IMF deal (slowed down, in the case of nationalised domestic bank Parex, by monthly withdrawal limits similar to the “corralito” imposed in Argentina 2001) but continued to switch into foreign exchange deposits. By contrast, foreign deposits continue to fall.
This can be seen in the following chart:
If the trend accelerates, it could prove the unmaking of the currency peg, pushing the country firmly Argentina-wards in terms of economic crises. But the risk with forced devaluation this way, as the author points out, is overshooting to a new valuation level that goes beyond even Latvia’s worst devaluation fears as the “dollarisation” (or euroisation in this case) force is unleashed.
Nevertheless, this, argues Levy-Yeyati, is still preferable to clinging desperately onto the peg, as at least it opens the door to a quicker recovery. The best option would be some sort of compromise made up of part eurorisation, part managed float. As the author explains:
A strategy halfway between euroisation and floating — a contained devaluation that preserves Latvia’s ERM II status — falls short by most accounts, but it is nonetheless the most likely to broker a compromise between all relevant players (the Lats, the EU, the IMF, Sweden). The natural way to implement this would be a negotiated one-off 15%-30% realignment of the central parity preserving the ECB commitment to intervene at the bounds, and the time table for euro adoption, accompanied by the widening of the current +-1% band to the ERM standard +-15%. True, it’s hard to find successful contained devaluations under a currency run in recent economic history. But there are more things at stake in the Latvian peg — even a devalued one — than just a nominal anchor, which makes this strategy, if not a sure cure, at least a viable therapy.
Doing nothing, however, seems not to be a wise option.
Related links:
Is Latvia the new Argentina? - VoxEu.org
Latvia - more parallels with Argentina - FT Alphaville
Crisis averted; Latvian central bank buys euros - FT Alphaville
Latvian bond failure begins - FT Alphaville
