Devaluation In Latvia: Why Not?

The IMF, which recently announced a $2.4 billion agreement with Latvia, has said the ailing Baltic country will not be required to give up its currency peg (the lat is currently pegged to the euro with a ±1% fluctuation band). This is quite an unusual move and is reportedly controversial even within the IMF.

Edward Hugh, Paul Krugman, and Edward Harrison, among others, have all argued strongly in favor of devaluation. I agree with most of their points and I even argued in a post back in May that fixed exchange rates in the Baltics played an important contributing factor in these countries’ build-up of massive imbalances (i.e. double-digit current-account deficits). Nevertheless, the case for devaluation is not so clear-cut.

Both Hugh and Krugman argue that high foreign-currency denominated lending (which accounts for over 85% of total lending in Latvia) is not a good reason to keep the currency peg. They rightly point out that mass defaults would occur whichever way Latvia adjusts – via devaluation or via a painful, drawn-out process of internal price deflation. Essentially, either adjustment path is going to result in mass defaults. So why shouldn’t Latvia take its medicine in one fell swoop – devaluation – and get it over with?

To examine why devaluation in Latvia’s case is not a clear-cut way to go, let’s look at 1) how a devaluation would affect financial stability in Latvia and beyond and 2) how it would affect export competitiveness.

With regard to financial stability, devaluation would generally be preferable to the painful, drawn-out process of internal deflation. The Ukraine, for example, was required to move away from its dollar peg and toward a more flexible exchange rate as part of the terms of its 16.5 billion IMF deal reached in November 2008.

As mentioned above, mass defaults will likely occur, regardless of whether Latvia chooses devaluation or internal deflation. But there may be a difference in timing.

Devaluation would lead to a wave of defaults occurring in a concentrated period. Internal deflation would also result in defaults, but they would likely be spread over a more protracted period.  In Latvia’s particular case and given the current global environment, there is reason to believe that opting for the more drawn-out internal adjustment route would result in less financial instability in Latvia and beyond.

Nordic banks dominate Latvia’s banking system, as well as Estonia’s and Lithuania’s. The Swedish banks Swedbank and SEB are particularly exposed (controlling around 40% of lending in Latvia and well over 50% of lending in the other two Baltics). These banks’ domination of the Baltic markets is such that they’ve been referred to, only somewhat in jest, as the de facto monetary authorities in these countries.

image001_512_18.png Latvia, on its own, makes up only a small proportion of these Swedish banks’ total lending and total operating profits. However, as mentioned by a number of analysts  (including Anders Aslund and Edward Hugh), a devaluation in Latvia is likely to trigger devaluations in its key trading partners – Estonia and probably Lithuania. So a devaluation in Latvia has to be considered in light of the fact that such a devaluation will start a chain reaction through neighboring Baltics.

That is, these Swedish banks would be dealing with a mass of defaults across Estonia, Latvia, and potentially Lithuania. This would really start to have an impact on financial stability in the region and in Sweden. This could even cause these Swedish banks to rethink their presence in the Baltics and withdraw from these markets, given the mass of defaults they would be hit with all at once. The departure of these banks from the Baltics would be a massive blow to financial stability and consequently, it would impede economic recovery in the Baltics, as these Swedish banks make up the bulk of these countries’ financial systems, as can be seen below.


Arguably, if the defaults occur over a more extended period of time (vs. in a more concentrated period via devaluation), these Swedish banks might better absorb losses and weather the storm. And by taking this path, Latvia may be insuring that these Nordic banks stick around and remain committed to the region.

Another danger is that the contagion effect could spread beyond the Baltics to the rest of Eastern Europe.  For example, investors might question the durability of the currency board in Bulgaria – another new EU entrant which has experienced similar imbalances to the Baltics and which is now starting to slow down. More broadly, the psychological impact of a devaluation in Latvia could cause investors to re-evaluate risk in the region, in general. This would have important implications, considering Eastern Europe is a region where current-account deficits are the norm, making them heavily dependent on continued external financing.

Beyond financial stability, the other major consideration in examining a Latvia devaluation is competitiveness. Will a devaluation in Latvia actually boost exports given the current global slowdown?

According to Edward Hugh, ‘exports are the name of the game’ and the only possible area for growth. But it’s unclear how much a devaluation would boost them, especially considering the struggling EU buys 80% of all Latvian exports.

More specifically, the other two Baltics (Estonia and Lithuania) are Latvia’s top trading partners, accounting for about 30% of its exports in 2007, followed by Germany, which took about 9%. As all these partners are in the midst of their own sharp downturns, it’s questionable how much a devaluation in Latvia would actually boost exports, especially since such a move would likely trigger competitive devaluations in neighboring Estonia and Lithuania, which are also struggling with sharp downturns and double-digit current-account deficits.

Meanwhile, it’s unclear that cutting the relative price of Latvian exports – via devaluation – would actually boost demand. For example, wood in its many different forms – sawn wood, plywood, fuel wood – is Latvia’s top export, accounting for over 20% of total exports in 2007.  Given the worldwide slowdown in the construction and housing sectors, it’s unclear how much devaluation would actually stimulate demand for this resource.

In sum, a painful adjustment over time vs. sudden devaluation may be the lesser of two evils in Latvia’s case.

0 Responses to "Devaluation In Latvia: Why Not?"

  1. Anton Benjamins   December 29, 2008 at 10:49 am

    Well argued. I agree. But after the forests are cut and sold at discount prices, where then? I have been building a temple to the Latvian God Jahnis–the only such place in all of Eastern Europe–for the sake of Latvian self-consciousness and tourists, but with the number of tourists likely to decline sharply, I have a God (fortunately neither he nor I are in debt) who is but my “private property”. The self-consciousness of Latvians, of course, goes “pop”. May we survive 2009!

  2. Brian Shriver   December 29, 2008 at 10:19 pm

    Maintaining the peg makes it easier to repay current debts, but requires continuing to borrow more money to finance the trade deficit. Sooner or later credit limits will be reached and the peg will collapse.Better to devalue now and break the downward debt trajectory. If you’re in a hole, the first thing to do is to stop shoveling.If a country devalues its currency far enough, it will eventually achieve a trade surplus – even if its trading partners are also suffering. At that point, its financial position will stop deteriorating and start improving.

  3. Argentinian   December 30, 2008 at 7:57 am

    The resemblances with the situation of Argentina during the crisis of 2001 – 2002 are amazing: currency peg, massive foreign-currency debt, current account deficit and a sudden stop in lending.The IMF is once again using the same recipes and trying to prolong the unavoidable adjustment via devaluation. Eventually these countries will have to follow that road, unfortunately it will be later and even more indebted. Probably this $2.4 billion bail out would be more useful after the devaluation and not before it.I agree that exports will not boom in this context, but anyway devaluation will help to regain the external equilibrium.

  4. interested reader   December 30, 2008 at 10:41 am

    Very nice post, Mary. It made me rethink.

  5. Latwis   January 1, 2009 at 9:41 am

    Benjamins: I think I know your temple: it is in Vilzeni, right? I have sometimes wondered on the strangely coloured wooden pieces. Is it accessible by public?

  6. Latwis   January 1, 2009 at 10:31 am

    My problem regarding this post is following:SEB and Swedbank are indeed the de facto monetary authorites of Latvia. Their lending has created the bubble and they have profited nicely from it: see the profit figures above and notice from profit/loan value ratio that their margins have been quite good in the Baltics.Now when the bubble is bursting it would be only fair, if they would also bear the cost of the losses. I am afraid that by taking the IMF loan Latvians will do nothing but create opportunities for SEB and Swedbank to quitly wind down their positions in Latvia in order to minimize the impending currency risk. These banks are actually doing exactly that right now by not issuing new credit.So the end game may as well be that by the summer SEB and Swedbank will be off the hook, Latvians saddled with huge debt, lending still slow, monetary base therefore shrinking, budget contracting because monetary base shrinking due crredit contraction and due people swithcing off lati for currency fear, therefore tax base contracting and so in spiral. Argentina revisited.Then,like in Argentina, IMF will rethink the position and will not issue additional loans. It will be than that the hedge fund guys will try to strike but we Latvians will be out of ammunition and will surrender and devalue.So in my opinion this protraction solves nothing, except is morally wrong as it only helps the guilty.swedbank was named the most socially conscuious company in Latvia in 2007 for 4th year running. There is no such animal as fair-weather socially conscious company. It should show that it is socially consciuos by not moving away from Latvia when the weather turns bad. Since we have these Swedish banks as de facto monetary authorities, I also expect the Bank of Sweden to act as lender of last resort and print Swedish money to bail out the Swedish banks. That would be morally right.It is however true in Ms Stokes blog and wrong in Mr Harrisons blog that devaluation will not help exporters. Not by much. It is true that real exchange rate has gone up with the inflation, but I still do not think that lat is overvalued for export competitivness purposes as the excahneg rate is still very low. remember that we just passed the 1990 level in GDP (after the Washington Consensus Inspired Crash in 1990-1993), so the potential level in economy is far from reached. The exports this year are still 13% up. The problem is that people belived the peg too much and the lending in euros skyrocketed until it was not absorbable so it spilled out in inflation and imports and it is imports which are up by even more that is causing the problem.As I am not concerned about export competitiveness then the question remains: how to wind down imports. For that purpose a devaluation would be nice tool.If I were a governor of Bank of Latvia I would devalue by 15 per cent today, whilst still strong on reserves, wait a year and then revalue by 15 percent. By devaluing he will call on stop of imports and force SEB and Swedbank to keep their assets in Latvia for a year. I would also keep the currency board but print more lati and cover thus the budget deficit.By revaluing a year later he will stop the inflation and enter the Maastriht criteria.I would make explicit pledge not to save any more banks, but leave that job to monetary authorities in Sweden. They can not have the cake of nice profits coming in without facing up to downside.Note that I do not want to fleece the banks; let them live forever. But I also do not want to be saddled by tax because some swedes have made the wrong bets in the Baltics. Better devalue.What concerns estonia, they will be forced to devalue, too. But it will take some time before they will comprehend what has happened and will do so, so in the meanwhile we latvians will be able to exploit it by increasing the exports.However, none of the blogs here would discuss one-sided euroisation. Since export competetivness is not the issue, maybe we should do it? We still have the reserves of euros plenty. F*** the ECB rules.

    • Dean Strautins   January 5, 2009 at 3:07 am

      Not a bad idea to devalue and then revalue the currency. Same could be done with social taxes to encourage employment.Australia provided funds for banks in Australia to issue loans to people and avoided the foolish purchase of toxic banks like Parex in Latvia.Decreasing the burning of money via city heating using imported gas is one fast way to decrease a drain on hard earn’t hard currency.

  7. Dean Strautins   January 5, 2009 at 2:55 am

    Interesting to question whether a devaluation would increase exports and also say that it would provoke devauations in Lithuania and Estonia. Other countries would only devalue in response if the exports from Latvia did improve as a result of the devauation.Therefore, the devaluation would work.Furthermore, since when is Latvia the leading economy in Europe? Russia is devaluing so why can’t Latvia devalue just like Russia and the UK?

  8. Neighbour   January 5, 2009 at 3:34 am

    The external analysts are discounting the flexibility of the Baltic economies. Baltics, while maintaining currency pegs, already successfully survived a couple of serious crises (banking crisis in the mid 90’s, Russian crisis in 1999) just to bounce back to strong growth after a year or so of slowdown. And we saw periods of strong economic growth and deflation in the recent past. Situation is not so rosy now, given the slowdown in the EU, but Latvia can still pull off this situation if they stick to prudent policies.

  9. Anonymous   January 5, 2009 at 9:32 am

    Whereas devaluation in Estonia or Lithuania might be a possibility if this were to happen in Latvia, it is not a given. The author of the post makes the fatal mistake that most “experts” seem to make and that is looking at the Baltics as one country. The three economies are indeed tied but one should look at their monetary policies over the years, economic development, etc and compare them to one another before starting such an analysis. If the Baltics “fall”, it will be because of such “experts” who try to convince the world (and investors) that the Baltics are one country and whatever happens in one will happen in others. This is unfortunate not only to Estonia and Lithuania but also to Latvia in the long run because it will be in Latvia’s interest that the current crisis will not repeat itself in its 2 neighbouring economies.Obviously the author of the original post is not aware that unlike Latvia, for example, Estonia has considerable reserves to fall back on which it accumulated over the years when it enjoyed economic growth and had budget surpluses for more than a decade.As to Swedish banks, as one of the commentators mentioned,they have enjoyed outrageous profits over the years in the Baltics. In fact, they are still profitable(according to them) despite defaults. Capital requirements are quite strict in Estonia to anticipate situations like we are in at the moment which is why banks are not entirely dried out and they have a safety net. However, if Swedish banks were to make losses, it would not even be a fraction of the profits they have made and an ethical thing to do would be to stick it out (which I believe they would anyway).Anyway, I would love to read an analysis from a person acquainted with the structure of economy, fiscal and monetary policies of the three countries, their similarities and differences and how they are tied to one another. Though I welcome the effort and interest towards the fate of Latvia, I would appreciate if some research would be made when approaching the subject.

  10. bsetser   January 5, 2009 at 9:52 pm

    Mary. Nice analysis. I would argue though that you are somewhat underestimating the impact of a devaluation on exports for two reasons:a) for commodities (like wood), a deval wouldn’t necessarily increase the volume of exports amid a global fall in demand, but it would tend to increase the local currency revenue exporters get from each unit of exports (every euro of revenue buys more local currency). this effect can be important. And you never know, a big enough devaluation might helps Latvia take market share from Findland and Sweden and Canada and others. Note that the SEK has depreciated v the euro over the past few months, and thus v Latvia.2/ Even if all the Balts trade heavily with each other, if they all depreciated v the euro, the SEK, the NOK and the ruble presumably they would gain a bit of market share in all of those large markets. For most small countries this is an important part of the dynamics that eventually produce recovery.that said, a devaluation requires a mortgage debt restructuring and the upfront realization of losses — otherwise the balance sheet effects dominate.b)