“Like many small countries, Latvia has struggled to attract outsiders’ attention,” says The Economist. “Now it is famous, and hating it.” The economy is being propped up by the International Monetary Fund (IMF) and the EU and is expected to shrink by a quarter by 2010. A devaluation of the currency, the lats, could spark a chain of currency slumps across eastern Europe reminiscent of the Asian crisis of the late 1990s.
Latvian growth rocketed as the private sector gorged on cheap credit from overseas. But when capital inflows ceased with the credit crunch, the bubble burst. And the downturn is being made worse by Latvia’s currency peg. It has tied the lats to the euro to qualify for entry into the single currency. But that means the currency cannot fall, and thereby boost growth via exports. So the government has to engineer a so-called ‘internal devaluation’ – prices and wages must fall for competitiveness to be restored. That involves painful austerity measures, a pre-requisite for more help from the IMF.
The upshot is that Latvia is being “crucified on its exchange rate peg”, as Ian Campbell puts it on Breakingviews. GDP is already on course to slump by a fifth this year and the IMF is now looking for almost $1bn of further budget cuts to lower the budget deficit to 7% of GDP. Unemployment has jumped from 6% to 17% in a year and public sector salaries are to be cut by 20%. A union leader has
already said it’s time to take to the streets, says Ambrose Evans-Pritchard in The Daily Telegraph.
There are virtually no examples of countries successfully undergoing the painful deflation imposed by internal devaluations, says Capital Economics. Argentina’s fixed rate collapsed amid riots in 2001, for instance. History shows that further rescue loans without devaluation just “add debt and draw out the agony”, says Evans-Pritchard.
A currency and financial crisis is “pretty much unavoidable”, says Nouriel Roubini in the FT. Delaying devaluation will just make the eventual crash and knock-on effect worse.
So Latvia is likely to devalue its currency eventually. Since 90% of loans in Latvia were made in euros, this implies a steep rise in bad loans as the value of the debt rockets. If the pegs in Estonia and Lithuania, who are in a similar mess, go too, Sweden’s banks – with $75bn of exposure to the Baltic region – would face “a thumping headache”, says Lex in the FT. Analysts reckon that Swedbank may need an injection of state equity if losses spiral amid devaluation, notes Robert Anderson in the FT.
Could other Baltic dominoes topple?
A Latvian devaluation would almost certainly put pressure on the Estonian, Lithuanian and Bulgarian currencies, all of which are pegged and look overvalued. And other currencies will also come under attack; during crises, “markets do not distinguish” between economies on the basis of fundamentals, says Capital Economics.
However, the Asian crisis shows that after the initial maelstrom, investors become more discriminating, so the Polish zloty and the Czech koruna might ultimately escape “relatively unscathed”, as these two economies look solid. But an Asia-style crisis scenario would fuel fears over banks’ exposure, “seriously endangering the recent thawing of global credit markets”, says Standard Chartered. The turmoil in eastern Europe is unlikely to be over just yet.