Latvia: Is This It For The Lat?
For several months now, I have run with the view for a devaluation of the Baltic and Bulgarian currencies. The core scenario has always been that such a move would likely not take place until end-2009/early 2010, but today we got a taste of just how acute the risks are of a much quicker and disorderly process. After key government advisors and ministers in Riga openly discussed the prospects of a devaluation, Latvian interbank, deposit and debt markets went haywire. Considering that it remains illegal in Latvia to undermine the confidence in the currency, such talk was a major break of government policy. The rapid deterioration of local capital market conditions in Latvia was a particularly negative signal that confidence in the economy is on tenterhooks and as a result, the potential for a run on the currency is incredibly high. To be sure, BMI is sticking to its core view for a devaluation, but now the risks are that it could happen far sooner than the end-2009 forecast we have currently set.
Riga Overnight Interbank Offer Rate
Of course, there are far greater implications beyond the Baltic states of a Latvian devaluation. Indeed, the macroeconomic weakness of the Baltics in particular has the potential to fundamentally undermine foreign investor confidence in the entirety of Central and Eastern Europe (CEE). As such, the failure of the Latvian currency peg would certainly prompt similar devaluations in Estonia and Lithuania, which in turn could prompt a new round of capital flight from CEE. This would not only put the brakes on the rally in the region’s markets but could even be the catalyst for the next down leg in a longer run bear market.
June 3rd, 2009 at 5:28 pm
What would be the immediate implications of a devalued lat on highly leveraged Latvian households? I believe the bulk of private sector loans is in foreign currency. This would surely mean serious deterioration of asset quality.
I know that Scandinavian banks are particularly exposed to the Baltic region. Could we see some financial contagion towards the Scandinavian economies in case of a devaluation?
June 4th, 2009 at 8:19 am
Absolutely, the contagion impact could be enormous depending on the scale of the devaluation. Take a look at SEK/EUR… the sharp sell off yesterday was directly correlated to the Latvian news. The only reason why the Baltics have not devalued already is because of the euro-denominated debt held by the majority of leveraged households in the country. This is why when the devaluation occurs, I would expect it to coincide with some sort of financing programme to protect FX-denominated debt holders. This will most likely have to be sponsored by a multilateral institution such as the EU/IMF.
June 4th, 2009 at 11:55 am
Dear Sir,
regarding your phrase “Considering that it remains illegal in Latvia to undermine the confidence in the currency”… How is this ‘crime’ defined, and how is this enforced?
Secondly, will not Latvian households lose a lot of their wealth? Will this not lead to protests, a la Argentina in 2001?
June 4th, 2009 at 12:07 pm
Hi Roger. It is a criminal offense in Latvia to spread ‘untrue’ or ‘false’ information about the country’s financial system. As far as I know, no one has actually been convicted of this crime in the past decade, though economist Dmitrijis Smirnovs was arrested and questioned for two days in December 2008 for being overly pessimistic about the stability of the country’s banks and currency pegs. Other commentators and even celebrities have received questioning from state security over jokes or negative comments about the economy. In short, you likely won’t actually be convicted under this law, but you can expect some serious scrutiny if you question the solvency of banks or the stability of the currency pegs.
Yes, Latvians will lose a great deal of their wealth, but its going to happen regardless of whether the peg goes. If they maintain the peg, Latvia will simply have to unwind the vast external debt holdings and current account deficits in even more painful ways: slashing employment and wages. Political risks will be high, but Latvia will not be alone in this regard across Europe.