A lat to worry about (June 2009)

Rethinking Bretton Woods | Sat, Jun 20, 2009

Center of Concern staff Aldo Caliari is quoted in this analytical article appeared on the Financial Times, June 17 2009.

A lat to worry about

By Robert Anderson, Stefan Wagstyl and Jude Webber

Published: June 17 2009 03:00 | Last updated: June 17 2009 03:00

Inara Blumberga is at the centre of an unprecedented economic gamble. The librarian from the Latvian beach resort of Jurmula faces a big cut in her salary as the Baltic nation embarks on a risky plan to pull itself out of an economic crisis harsher than any other country in Europe is suffering.

With the backing of the International Monetary Fund and the European Union, Riga is hoping that if it can impose enough pain on the domestic economy, it will be able to maintain its exchange rate peg to the euro. That would allow it entry into the single currency zone within the next four years.

After months of dithering, the government last week put together a package of measures that will mean Ms Blumberga - who earns just 280 lats ($552, £337, €398) a month - along with hundreds of thousands of other public sector workers will suffer a 20 per cent pay cut. Even pensioners will see reductions of 10 per cent.

Latvia ran into trouble managing the unprecedented surge in credit-fuelled economic growth that rushed through central and eastern Europe, driven by EU enlargement and globalisation. As small, open economies, the Baltics were swamped with foreign loans, chiefly from Swedish banks, particularly in their overheated property markets. But while Estonia and Lithuania worked to slow the pace, Latvia's leaders ignored calls for restraint until it was too late.

The end came last autumn with a currency and banking crisis, which forced the government to go to an IMF/EU consortium for €7.5bn ($10.4bn, £6.3bn) in emergency aid. For now, the financial markets are giving Latvia the benefit of the doubt: fears of an immediate devaluation have eased since the 500m lat austerity package appeared to unlock the door to a €1.4bn slice of the pledged funds that had been withheld.

Nor have Latvians so far mounted the kind of violent protests that last winter helped bring down the previous government and paved the way for the emergence of the current centre-right coalition. As Ms Blumberga says stoically: "There won't be protests like in January, as you can achieve nothing. People hoped for something in January but no one expects anything now."

However, economists warn there are few precedents of a crisis-hit country successfully pulling itself out of trouble without devaluing the currency. Even Argentina, which has adopted one of the least conventional routes to recovery of recent years, devalued as part of its shake-out early this decade (see below). "What they are trying to do is, to the best of our knowledge, unprecedented in economic history," Rory MacFarquahar, an emerging markets expert at Goldman Sachs, says of the Latvians. "It is politically extremely painful and I don't know whether it is sustainable."

More is at stake than the fate of this EU country of 2.3m, which regained its independence from the Soviet Union in 1991. If Latvia succeeds, it would send a powerful signal that the ex-Communist countries, having endured the turmoil of that transformation, have the resilience to cope with the current global crisis.

But if Latvia fails, it could have a knock-on effect on other troubled economies in the region, particularly those with fixed exchange rates, such as Estonia, Lithuania and Bulgaria.

Around the globe, small and vulnerable countries are responding to the crisis with budget cuts. Unable to borrow their way out of trouble, as the US and the UK are trying to do, they are struggling to contain deficits by reducing public spending, including cutting pay bills by slashing government employee numbers. Some are resorting to radical measures. Iceland is preparing its biggest-ever budget overhaul. Lithuania is mulling introducing student fees. Estonia has postponed previously agreed increases in unemployment benefit. But no administration is going as far as Riga in cutting actual pay.

Under the IMF/EU rescue terms, Riga has pledged to keep its budget deficit to 5 per cent of gross domestic product. But with the economy contracting much faster than then forecast, the deficit could reach 12 per cent without remedial action. Even with the latest cuts, it will be 7 per cent, a figure that breaks the IMF's normal boundaries.

After years of the fastest growth in the EU, Riga now foresees the economy shrinking 18 per cent this year, the bloc's worst recession. The outlook for 2010 and beyond depends on the economies of western Europe and Russia, Latvia's main trading partners. Without dramatic improvements in the pan-European economy, Riga seems set for further rounds of tax increases and spending cuts to keep the deficit down and convince the IMF to continue its support and qualify for eurozone membership by the government's 2013 target date. "The government wants to feed the cow less and milk her more often," says one bank chief executive. Reaching for an even more pessimistic metaphor, he adds: "In a swamp there is no bottom."

Landmark property developments such as the twin Panorama Plaza towers on the road between Riga and the airport stand all but empty and shopping malls look forlorn. House prices fell by one-third last year, insolvencies are up and banks are repossessing more mortgaged properties and leased cars. "Business is in hibernation," says Gunnar Ljungdahl, who chairs the Swedish chamber of commerce in Riga.

In these circumstances, many governments devalue to spread some of the costs to foreign creditors and to boost the economy by making exports - which include wood products - more competitive. IMF officials have indicated that the organisation was divided over the wisdom of defending the lat's peg but was finally persuaded by pressure from Riga's EU partners as well as the Latvian government's own refusal to contemplate devaluation.

Latvia sees the currency peg as the linchpin of its economic policies. It helped drive down inflation and is the route to euro entry. Latvia's governments have often been weak but have always defended the peg and supported the powerful central bank, where both the prime minister and finance minister used to serve. "For Latvia the peg is the last pillar of trust," says Henrik Hololei, an Estonian cabinet head at the European Commission.

Also, Latvian officials argue that in a small economy, where 60 per cent of export value is in imported content, devaluation will not do much except encourage inflation. With some 90 per cent of all loans in euros, they add, it could bankrupt tens of thousands of companies and individuals. But the price of avoiding devaluation will be huge economic, social and political strains. Valdis Dombrovskis, prime minister, admits his main challenge now is "to preserve the social peace".

Some opposition politicians predict a rough autumn as unemployment rises from 11 per cent today to a forecast 20 per cent and those jobless for more than a few months find their benefits reduced to just 30 lats a month. Trade unions are planning a demonstration for tomorrow. The crisis could also exacerbate tensions between the majority and ethnic Russians, who comprise about 30 per cent of the population and sometimes hanker for closer ties with Moscow. Harmony Centre - a coalition seen by the other parties as pro-ethnic Russian - made strong gains in this month's European parliamentary elections. Top spot went to Alfreds Rubiks, a former Riga mayor, who says: "Our government backs this budget but people do not."

Yet most Latvians appear resigned to cuts. Many make light of today's hardship compared to the Soviet era or the tough post-Communist transition. After years of big pay rises, some are reconciled to making sacrifices. Ivars Godmanis, a former prime minister, says survival will depend on the government and the people huddling together like "penguins".

These survival instincts will now be tested. Independent economists doubt whether Riga's great gamble will work even with IMF/EU backing. Morgan Stanley analysts say: "Devaluation is inevitable and obviously getting closer." Even the IMF is unsure, warning that "correcting currency misalignment without nominal depreciation is extremely difficult".

If Latvia's stabilisation plan fails, the repercussions would be widespread. First, investors would question the strength of other fixed currency regimes, starting with Latvia's Baltic neighbours. Estonia, with a fiscal reserve accumulated in good years, is in a stronger position than Lithuania. But both are enacting austerity budgets in the face of forecast GDP declines this year of around 15 per cent. Further afield, Bulgaria insists it can maintain its fixed exchange rate without IMF support. But its socialist government faces a drubbing in elections due next month.

Elsewhere in the region, countries with floating exchange rates, including Poland, the Czech Republic and Hungary, have seen their currencies hit by market turmoil over Latvia. "We have seen the risk of contagion is still there," says Andras Simor, Hungarian central bank governor.

The brunt of any losses would be borne by Sweden's banks, whose Baltic assets amount to $80bn, or 16 per cent of Swedish GDP. In an extreme scenario, Baltic credit losses would reach 34 per cent of loans for Swedbank and SEB, the two biggest, which the national regulator has warned to reinforce their capital reserves.

The European Central Bank is also worried and has lent Sweden €3bn to guard against its banks' Baltic exposure. As the Commission's Mr Hololei says: "Many countries in the region are dependent on how Latvia will get out of the crisis."

'Countries can default and the world doesn't end'

Cut off from international capital markets and still tens of billions of dollars in arrears with public and private creditors, Argentina has been a financial pariah since its 2001-02 crash led the country to take drastic measures to right itself - involving a $95bn debt default.

The country remains out in the cold because of its refusal to return to International Monetary Fund scrutiny of its public accounts, even after paying off its $9.5bn debts to the lender in one fell swoop in 2006.

But now, the global financial crisis has given respectable developed economies fighting with high debt, ballooning spending and lower international confidence a taste of what it feels like to be Argentina. In turn, the Latin American maverick is suddenly being viewed as a test bed for ways to restore stability.

As worldwide recession bites, countries struggling to meet tough deficit limits and spending cuts the Fund has imposed on them as a condition of bailing them out are trying to assess whether Argentina's go-it-alone stance works out any better than the fiscal medicine they are being ordered to swallow.

"I wouldn't be so quick to say that there is no alternative to the IMF," says Aldo Caliari at the Center of Concern, a Washington think-tank. He praises the exchange rate targeting and demand-led model that have been features of Argentine policy under Néstor Kirchner in 2003-07 and since then under the presidency of his wife Cristina Fernández, which led to six years of growth averaging 8.5 per cent in Argentina's rebound from its crash.

In its transition out of chaos, Buenos Aires adopted a devalued exchange rate, kept real wages low, froze public sector tariffs and introduced a web of energy, transport and food subsidies. Together this was dubbed a "heterodox" approach, as opposed to the orthodoxy preached by the IMF.

Argentina's experience, as that of other countries struggling now, reveals that "in times of crisis, you'll do what's necessary to survive", says Mario Blejer, a former IMF official who headed the Argentine central bank for the turbulent first half of 2002. With governments worldwide seeking creative ways to combat the crisis - such as the US Federal Reserve buying government bonds - the eccentric has almost become the conventional, he adds. "I don't know what is heterodox any more."

Indeed, the Argentine crisis showed that "countries can default and the world doesn't end", says a senior official at one multilateral lender. Ecuador, for instance, defaulted on $3.9bn of debt last year.

But Argentina has failed to move on by creating stable conditions for investment. As countries worldwide seek to emerge from recession, they will face the same challenges to improve competitiveness by boosting infrastructure, education, technology and labour productivity - tests that Argentina has so far failed.

Furthermore, it has settled neither with private creditors, which rejected a debt restructuring in 2005 and whose legal action has barred it from tapping international markets, nor with the Paris Club of western creditor nations. Argentina last year promised to pay off its $6.7bn Paris Club arrears using central bank reserves, but that plan was buried by the international crisis.

Since the default the government has, moreover, clung to the excuse of economic emergency to give it leeway to pursue its policies. That essentially allows Argentina to break contracts if necessary - alienating investors, who class it alongside Venezuela, Ecuador and Bolivia as the "bad boys" of South America.

The problems are hardly easing. They include higher-than-expected capital flight as savers take dollars abroad, and decelerating tax revenues - which according to Luís Secco, an analyst, mean Argentina is living way beyond its means. For every peso the state earns in taxes, it is now spending 1.8 pesos, he says.

Mr Caliari adds: "The government cannot rest on its laurels. It needs to be more cautious about spending. Heterodox doesn't mean you can ignore economic realities." The high outlays reflect a pre-election spending spree as Ms Fernández fights to retain a majority in Congress on June 28. The mid-term polls are being portrayed by the government as a referendum on its economic model: a choice between more of the high growth Argentines have become used to and a return to the chaos of previous years, when poverty and unemployment soared.

"It isn't important at this stage to have a programme or financial arrangement with the Fund," says Mr Blejer. "But it is important to slowly normalise international financial relations to gain access back to capital markets and improve the flow from other multilaterals."

Copyright The Financial Times Limited 2009