Latvia Defies the American Conventional Wisdom
For nearly a year, prominent American economists, such as Paul Krugman, Nouriel Roubini, and Kenneth Rogoff, have maintained that Latvia is just another Argentina (as Krugman has put it) and that it was only a matter of when, not whether, Latvia would be forced to devalue its currency. Well, despite these warnings, devaluation seems less rather than more likely. This conventional wisdom appears increasingly doubtful.
True, Latvia had incurred a huge current account deficit of 23 percent of GDP in 2006 and 2007, which led to the accumulation of a largely private debt of 136 percent of its GDP. Obviously, the Latvian lat had become overvalued.
The conventional wisdom argues that such large foreign imbalances can only be corrected through devaluation. The recent examples of such failed pegged exchange rates are Thailand, Indonesia, Malaysia, and South Korea in 1997–98, Russia in 1998, and Argentina in 2001. Yet many pegged exchange rates have survived severe crisis. That is especially true of small, open economies with limited financial sectors.
But conventional wisdom is not always a guide to the present. In the May issue of American Economic Review, Stanford economists Peter Blair Henry and Conrad Miller argue that Barbados has been economically more successful than Jamaica because Barbados pegged its exchange rate to the US dollar in 1975 and stuck to it. In 1991, Barbados experienced a serious current account crisis, and "the IMF recommended devaluation," but "the Barbadians resisted the recommendation," according to their paper. "Instead of devaluing, the government began a set of negotiations with employers, unions, and workers that culminated with a tripartite protocol on wages and prices in 1993," they write, in which "workers and unions assented to a one-time cut in real wages of about 9 percent….The fall in real wages helped restore external competitiveness and profitability….The economy recovered quickly." Unlike Barbados, Jamaica devalued repeatedly and ignored structural reforms.
There are many other examples. Slovakia has outperformed Hungary in the last decade, and their main difference is that Slovakia had a pegged exchange rate for long periods, while Hungary has had a floating rate. In 1982 Denmark pegged its krone to the Deutschmark. This peg that still holds helped Denmark start radical liberalizing reforms a decade before Sweden, which persistently devalued.
The conventional wisdom that devaluation is inevitable in a severe current account crisis is simply not correct. Barbados, Slovakia, and Denmark have shown that a peg can enforce economic discipline and facilitate structural reforms.
The goal of any country in this kind of economic distress is to reduce costs, which is best done directly by cutting salaries, prices, and public expenditures. Devaluation is a second-best solution if the government lacks the political strength to undertake direct cuts, because devaluation boosts the foreign debt burden of the country in crisis.
I went to Latvia last month to see for myself and I met many people of relevance. The leading policymakers are determined to resolve the crisis and to restart stalled structural reforms. Impressively, the government has cut public salaries in two rounds by 35 percent and pensions by 10 percent. This is more than Barbados did. The wage cuts have been approved by the trade unions and the parliament. Latvia, like Estonia and Lithuania, has an unusually flexible economy.
Thanks to cost cuts and reduced demand for imports, the current account turned positive as early as January 2009 and will clearly end so this year. At present, reserves correspond to about seven months of imports.
The Latvians want to maintain the peg to the euro to be able to adopt the euro as soon as possible. Latvia saw one single social protest last January. Since minor violence erupted, the organizers whom I met called off further demonstrations. The Latvians are a serious nation committed to their independence and economic success. After eight years of an average GDP growth of 9 percent, Latvians are prepared to endure quite a bit of suffering. This nation lost one quarter of its population in World War II through death, deportation, and emigration, which does not sound very Argentinean either.
It is close to impossible to speculate against the lat because the Latvian economy is so small, its financial sector so tiny, and lats are rarely used. Of all loans in the Latvian economy, 87 percent are made in euros. Currently, Latvia's international reserves are about $5.5 billion, almost equaling both the $1.65 billion of lats in circulation and total bank deposits in lats of $4.2 billion, which should be enough to guarantee stability.
Few other financial assets denominated in lats can be sold short. Total outstanding government bonds in lats are only $1.9 billion. The stock market is minuscule, with a daily turnover of a mere $20 million. Bankers in Riga told me that speculators offered 10 percent a month to speculate against the lat, but nobody wanted to lend to them because all the holders of lats are interested in its sustenance. A senior investment banker said that their customers only speculate through credit default swaps (CDS) to avoid counterparty risk. Even so, the CDS rate lingers around a moderate level of 600 basis points, compared with 5,000 basis points for Ukraine last February, which did not result in default either.
Latvia's ultimate difference from Argentina is that it is a member of the European Union, which together with the friendly Scandinavian governments has provided substantial emergency funding. They can easily and profitably lock any speculators in a bear trap. The euro is a good exit for the peg, and the European Union should expedite its adoption.
Latvia's only serious remaining financial problem is the budget deficit. Latvia has a strong tradition of nearly balanced budgets and minimal public debt, but the crisis has naturally undermined revenues and boosted social expenditures. Even after truly Herculean budget cuts, the Latvian government assesses its budget deficit at 9 percent of GDP, and the European Commission concurs, while the International Monetary Fund (IMF) believes that it might be as large as 15.5 percent of GDP.
The cause of this numerical disagreement is primarily that the IMF forecasts that GDP will fall by 18 percent this year, which was the actual decline during the extreme first quarter, but the consensus forecast, shared by the European Commission, is a decline of 13 percent.
The IMF has ended up in a highly undesirable situation. Its forecasts do not seem very likely, and it has no strong record as a forecaster in crises, as recoveries are often fast and sharp. In December 1998 the IMF expected Russia's GDP to fall by 8.9 percent in 1999, but it rose by 6.4 percent. Given the size of the Latvian cost adjustment, a more rapid than expected economic recovery is all too likely, especially as a small and open economy is governed by export demand.
While the likelihood of devaluation of the lat is slight, such a devaluation would probably be sharp if it occurred, because so few payments are made in lats, which are used for little but tax payments, public expenditures, and wage payments. An uncontrolled devaluation on a very thin market could easily be 50 percent, devastating Latvia's public finances, as the country's foreign debt would double to some 270 percent of GDP.
During a few days of the Latvian devaluation scare in early June, all floating Eastern European currencies fell a few percentage points. A minister of finance in the region told me that he thought that in case of a Latvian devaluation, these currencies would fall 15–20 percent and the currency boards of Estonia, Lithuania, and Bulgaria would collapse. Then, at least half a dozen major European banks would go under and Europe would face a spectacular banking crisis not hitherto seen. A Latvian devaluation could become as harmful for Europe as the bankruptcy of Austria's Kreditanstalt in 1931 or Lehman Brothers' collapse last September.
Nobody needs that, and many European policymakers understand this danger and are happy to bail out Latvia. Moreover, both the risk of Latvian devaluation and its potential consequences should decline over time. The IMF, on the contrary, seems confused in the turmoil. After concluding a standby agreement with Latvia last December, it has refused to issue a second, supposedly quarterly, tranche of some $300 million and it maintains a deafening public silence. On July 2 the European Union went ahead on its own, giving Latvia a second tranche of $1.7 billion. The Europeans are starting to wonder what the IMF is doing with its money.
Any failure of the IMF program for Latvia would weigh heavily on the IMF, but since it is already engaged so deeply in Latvia, it has little choice but to make this program a success.