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Latvia: hold that peg!

 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.