By Aaron Eglitis
Feb. 23 (Bloomberg) --- Latvia, Estonia and Lithuania, facing a prolonged recession, say they will protect their currency pegs whatever the cost. That strategy may be as crippling as the alternative, economists say.
The three-nation Baltic region is in its deepest crisis since breaking from the Soviet Union in 1991. Latvia, which spent $1.26 billion in 11 weeks defending the lats last year, was forced to turn to an International Monetary Fund-led group for a $9.6 billion bailout. Its economy may contract 12 percent this year, while Estonian gross domestic product may shrink by as much as 9 percent and Lithuania’s GDP by 4.9 percent.
Latvian Premier Ivars Godmanis resigned on Feb. 20 and Lithuania’s two-month-old cabinet is struggling to win over a skeptical electorate after the two nations suffered the largest street riots since independence last month.
Keeping the peg “will likely mean a number of years of very low economic growth,” said Lars Christensen, chief economist at Danske Bank AS in Copenhagen. “Wages and prices will have to fall to reestablish competitiveness.”
Central bankers and government officials in the three countries, across the Baltic Sea from Sweden and Finland, say they will stick to their course toward adoption of the euro. The Lithuanian litas and the Estonian kroon entered the exchange-rate mechanism, the waiting room to join the euro, in 2004, just after the nations joined the European Union. The Latvian lats was linked in the mechanism a year later.
Confidence Loss?
Without the peg, authorities say, the three economies would be in worse shape.
Latvian central bank Governor Ilmars Rimsevics said on Feb. 13 that devaluing the lats would swell debt, cause a “tremendous” loss of confidence and prompt Estonia and Lithuania to follow suit. Estonian Deputy Central Bank Governor Marten Ross agreed in a Feb. 19 e-mail, saying banks and exporters would be hurt most.
“Devaluation would not solve any competition issues,” he said. “Devaluation would postpone reforming uncompetitive companies or would force smart and competitive employees to seek work outside Estonia.”
Last year’s currency support sent Latvia’s central bank reserves down 25 percent. The Lithuanian central bank’s foreign currency reserves have fallen 3.2 percent since August and Estonia’s reserves have fallen 5 percent to $3.4 billion.
Retaining Euro Peg
Latvia, the only of the three countries to have gotten a bailout, got a bad deal from the IMF, said New York University’s Nouriel Roubini. The terms retained the euro peg as long as the government reduced wages, raised taxes and slashed spending.
“The IMF made a mistake with the Latvia program of allowing them to keep the peg,” Roubini said in an interview on Feb. 4. “It doesn’t make any sense because the currency is overvalued.”
That view is shared by Paul Krugman, a Nobel prize-winning economist who in a Dec. 15 commentary in the New York Times warned that Latvia may become “the new Argentina.” That country had a currency board and saw its peso plunge even after receiving an IMF loan.
The Latvian government fell on Feb. 20 after members of Godmanis’s party said they lost confidence in his leadership, which was shaken after riots broke out on Jan. 13 in the capital Riga. Police arrested 106 people. Two days later in Lithuania, another 86 arrests were made after violence erupted in the capital, Vilnius.
Declining Polls
Two months after the government assumed power and introduced austerity measures, support for the Prime Minister Andrius Kubilius’s Homeland Union fell to 11.6 percent in January from 21 percent the previous month, a survey by Vilmorus for Lietuvos Rytas showed. The margin of error was 1.9 percent.
“Although the implementation of these tough measures could lead to a significant erosion in popular support, we think that their political cost will still be much smaller than the cost of a currency devaluation,” said Yarkin Cebeci, an economist at JPMorgan Chase & Co. in Istanbul.
Devaluation also may push corporations and mortgages into default: About 80 percent of total loans in Latvia and 84 percent in Estonia are in euros.
Latvia’s “banks and legal system are at this point not prepared for such a shock,” said Christoph Rosenberg, head of the IMF’s mission to the Baltic state, in a Jan. 6 opinion on the RGE Monitor, defending the agreement. “It’s questionable whether devaluation would quickly boost exports, given the global environment and the structure of its exports.”
‘Worry Less’
European countries with currency boards “have to worry less” about the global credit crisis than those with floating exchange rates, European Union Monetary Affairs Commissioner Joaquin Almunia told Eesti Paeevaleht in an interview.
“Regarding Estonia and other countries that use currency board systems, one has to say that a currency peg is a positive element,” Almunia was quoted as saying. “It ensures that the currency is stable, even in very volatile market conditions.”
Estonia is now considering wage cuts of 10 percent for state employees, excluding police and teachers. Latvia and Lithuania have already cut state public wages by 15 percent and 12 percent respectively.
“Essentially, it’ll be a political decision that the pain of holding these regimes is just too heavy a cross to bear,” said Timothy Ash, head of emerging-market economics at Royal Bank of Scotland Plc in London. “Their positions are just becoming more unsustainable because everyone around them is just letting their currencies adjust.”
To contact the reporter on this story: Aaron Eglitis in Riga at aeglitis@bloomberg.net
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