The IMF, which recently announced a $2.4 billion agreement with Latvia, has said the ailing Baltic country will not be required to give up its currency peg (the lat is currently pegged to the euro with a ±1% fluctuation band). This is quite an unusual move and is reportedly controversial even within the IMF.
Edward Hugh, Paul Krugman, and Edward Harrison, among others, have all argued strongly in favor of devaluation. I agree with most of their points and I even argued in a post back in May that fixed exchange rates in the Baltics played an important contributing factor in these countries’ build-up of massive imbalances (i.e. double-digit current-account deficits). Nevertheless, the case for devaluation is not so clear-cut.
Both Hugh and Krugman argue that high foreign-currency denominated lending (which accounts for over 85% of total lending in Latvia) is not a good reason to keep the currency peg. They rightly point out that mass defaults would occur whichever way Latvia adjusts – via devaluation or via a painful, drawn-out process of internal price deflation. Essentially, either adjustment path is going to result in mass defaults. So why shouldn’t Latvia take its medicine in one fell swoop – devaluation – and get it over with?
To examine why devaluation in Latvia’s case is not a clear-cut way to go, let’s look at 1) how a devaluation would affect financial stability in Latvia and beyond and 2) how it would affect export competitiveness.
With regard to financial stability, devaluation would generally be preferable to the painful, drawn-out process of internal deflation. The Ukraine, for example, was required to move away from its dollar peg and toward a more flexible exchange rate as part of the terms of its 16.5 billion IMF deal reached in November 2008.
As mentioned above, mass defaults will likely occur, regardless of whether Latvia chooses devaluation or internal deflation. But there may be a difference in timing.
Devaluation would lead to a wave of defaults occurring in a concentrated period. Internal deflation would also result in defaults, but they would likely be spread over a more protracted period. In Latvia’s particular case and given the current global environment, there is reason to believe that opting for the more drawn-out internal adjustment route would result in less financial instability in Latvia and beyond.
Nordic banks dominate Latvia’s banking system, as well as Estonia’s and Lithuania’s. The Swedish banks Swedbank and SEB are particularly exposed (controlling around 40% of lending in Latvia and well over 50% of lending in the other two Baltics). These banks’ domination of the Baltic markets is such that they’ve been referred to, only somewhat in jest, as the de facto monetary authorities in these countries.
Latvia, on its own, makes up only a small proportion of these Swedish banks’ total lending and total operating profits. However, as mentioned by a number of analysts (including Anders Aslund and Edward Hugh), a devaluation in Latvia is likely to trigger devaluations in its key trading partners – Estonia and probably Lithuania. So a devaluation in Latvia has to be considered in light of the fact that such a devaluation will start a chain reaction through neighboring Baltics.
That is, these Swedish banks would be dealing with a mass of defaults across Estonia, Latvia, and potentially Lithuania. This would really start to have an impact on financial stability in the region and in Sweden. This could even cause these Swedish banks to rethink their presence in the Baltics and withdraw from these markets, given the mass of defaults they would be hit with all at once. The departure of these banks from the Baltics would be a massive blow to financial stability and consequently, it would impede economic recovery in the Baltics, as these Swedish banks make up the bulk of these countries’ financial systems, as can be seen below.
Arguably, if the defaults occur over a more extended period of time (vs. in a more concentrated period via devaluation), these Swedish banks might better absorb losses and weather the storm. And by taking this path, Latvia may be insuring that these Nordic banks stick around and remain committed to the region.
Another danger is that the contagion effect could spread beyond the Baltics to the rest of Eastern Europe. For example, investors might question the durability of the currency board in Bulgaria – another new EU entrant which has experienced similar imbalances to the Baltics and which is now starting to slow down. More broadly, the psychological impact of a devaluation in Latvia could cause investors to re-evaluate risk in the region, in general. This would have important implications, considering Eastern Europe is a region where current-account deficits are the norm, making them heavily dependent on continued external financing.
Beyond financial stability, the other major consideration in examining a Latvia devaluation is competitiveness. Will a devaluation in Latvia actually boost exports given the current global slowdown?
According to Edward Hugh, ‘exports are the name of the game’ and the only possible area for growth. But it’s unclear how much a devaluation would boost them, especially considering the struggling EU buys 80% of all Latvian exports.
More specifically, the other two Baltics (Estonia and Lithuania) are Latvia’s top trading partners, accounting for about 30% of its exports in 2007, followed by Germany, which took about 9%. As all these partners are in the midst of their own sharp downturns, it’s questionable how much a devaluation in Latvia would actually boost exports, especially since such a move would likely trigger competitive devaluations in neighboring Estonia and Lithuania, which are also struggling with sharp downturns and double-digit current-account deficits.
Meanwhile, it’s unclear that cutting the relative price of Latvian exports – via devaluation – would actually boost demand. For example, wood in its many different forms – sawn wood, plywood, fuel wood – is Latvia’s top export, accounting for over 20% of total exports in 2007. Given the worldwide slowdown in the construction and housing sectors, it’s unclear how much devaluation would actually stimulate demand for this resource.
In sum, a painful adjustment over time vs. sudden devaluation may be the lesser of two evils in Latvia’s case.