IMF undermines EU fight for Lativa peg

July 16, 2009

 Just when it looked as if Latvia’s currency peg to the euro had weathered the storm, the International Monetary Fund has raised fresh doubts by withholding funds for the Baltic European Union newcomer. 

 The IMF is right to demand a credible medium-term strategy for budget reform, but it would be wrong to risk contagion in eastern Europe by questioning the currency board. If one thing
could undermine the EU’s bid to avoid a wave of devaluations around the Baltic states, with knock-on effects for Swedish banks and potentially for central and eastern Europe, it is conspicuous differences between the IMF and Brussels.

Since the IMF has been publicly silent, the reasons for its reluctance to release 200 million euros in delayed funding can only be surmised. Latvian Prime Minister Valdis Dombrovskis said on Wednesday an IMF mission visiting Riga had posed new conditions for making the payment, and differed with the
European Commission over early euro entry for the lat. The IMF’s instinct when Latvia first called for help last November was to prescribe devaluation as part of its standard medicine for rescuing countries with a chronic balance of payments deficit. But both Latvia and Brussels objected,
arguing that the currency peg was a reform anchor key to market confidence, and that devaluation would not help the economy, since there were few exports to boost.

It is not clear that the IMF is still advocating devaluation. The signs are that it is demanding a firmer
commitment to tax hikes and budget reforms next year, including in such painful areas as health care, to make the currency peg sustainable.
Latvia has enough money from the EU, which released 1.2 billion euros last month after parliament adopted sweeping public spending and wage cuts, and from individual member states, notably Sweden, to do without the IMF tranche. But the Fund’s backing is important to give the programme credibility.

Economists such as Nouriel Roubini and Paul Krugman have compared Latvia’s plight to that of Argentina in 2000-01. They contend that imposing severe deflation inflicts greater pain and can only defer an inevitable devaluation.  The Latvian economy is set to contract by some 18 percent this year and public sector wages have been cut by 40 percent.   However, Latvia is not Argentina. A devaluation would have few trade benefits for a net importing country with little to sell. And it would hit the many households and companies that are highly indebted in foreign currency. It would also set back Latvia’s bid to join the euro zone, the main macroeconomic policy anchor, and risk triggering contagion across the region.

The cost to the EU (and the IMF) of a Latvian devaluation would likely be an order of magnitude greater than the price of supporting the currency peg. The population has responded resiliently and there is a broad consensus in parliament on continuing reforms.

The EU is governed by the rule of law and cannot simply waive its treaty criteria for Latvia to join the euro. If it did, other east European countries would beat down its door, and public support for the euro in Germany, the key member, would melt.

There may also be an element of good cop/bad cop at work. russels has strong political reasons for supporting Latvia, but the watchdogs of Washington have to demonstrate that their generous lending in the financial crisis has not weakened IMF conditionality, or made it a pushover for profligate

The IMF is used to unpopularity. But it would be unwise to risk being blamed for a collapse of Latvia’s currency peg.

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