Latvia: hold that peg!

July 29, 2009

 Latvia’s currency peg to the euro has become a punchbag for economists convinced that the Baltic state is inflicting unnecessary pain on its citizens. But devaluation of the lat risks mass defaults by citizens and companies. Four-fifths of private loans are in euros, and large-scale default would cripple the banking system. The Swedish banks that have lent billions of euros in Latvia would also be vulnerable.

Latvian devaluation would unleash a chain reaction around the Baltic and beyond. Lithuania and Estonia would face huge pressure to follow, and the knock-on effect could hit Bulgaria, which also has a currency board, and put pressure on other central European currencies. Devaluation would wreck any early prospect of Latvia joining the euro zone, which the former Soviet republic sees as a safe haven of financial stability and political independence. 

Prices would be pushed up, but Latvia’s open, highly flexible economy would gain little, since it has few exports and little manufacturing base. The government would still have to slash spending and raise taxes to bring down a budget deficit set to hit 10 percent of gross domestic product this year.

Economists such as Nouriel Roubini and Paul Krugman have drawn a facile parallel between Latvia and Argentina in 2001, noting that the International Monetary Fund spent billions there to defend a currency peg that was overwhelmed by market forces. There are, however, key differences.

The lat is a little traded, illiquid currency, not subject to speculative financial flows or a sudden withdrawal of portfolio investment. The currency peg is backed by the European Union, which has paid the lion’s share of financial aid to Riga. It is the Latvian government and central bank, not Brussels, which decided to uphold the peg. Indeed, the central bank chose to keep the lat within a narrow band of one percent either side of a central euro rate, rather than the 15 percent range allowed by the EU’s exchange rate mechanism.

The government has so far kept a broad political consensus behind what amounts to an “internal devaluation”, cutting public sector pay by 40 percent this year and pensions by 10 percent. Prices have fallen and, after the balance of payments deficit peaked at 25 percent of GDP in the third quarter of 2007, the current account has turned positive and a modest surplus of 1.3 percent of GDP is expected this year.

The deflation medicine is ghastly but Latvians are taking it stoically. To change course now would cause Latvians greater pain, spread financial contagion and set back the extension of the euro zone for years. For what benefit?

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