Wednesday, February 18, 2009

Looking for "Plan B" in the Baltics

The latest economic news out of eastern Europe is not just bad in itself. It underlines that the epicentre of the financial crisis has shifted from America very firmly to this side of the Atlantic.

Rapid devaluations of all the free floating currencies in Eastern Europe, irrespective of the policies or the circumstances that apply in any given country suggests a collapse of confidence that borders on the irrational. Meanwhile, the other European free floating currencies, such as the Swedish Krona or Sterling have also devalued. This leaves the countries that have fixed their currencies to the Euro zone, but have not yet adopted the single currency itself, looking very vulnerable.

Bulgaria, Estonia and Lithuania are all tied to the single currency through a system called a currency board, which means that none of the national currencies, respectively the Lev, Kroon and Litas are issued without a corresponding collateral of Euros in the reserves of the Central Bank. In theory, therefore there is no point in selling the national currency for Euros, since the reserves fully back the notes and coins in circulation. Meanwhile, the broader money measures are covered through the banking sector that created them. Given prudent policies by the government then, it should be in fact be essentially impossible to break the currency link.

The odd one out in the Baltic is Latvia which does not operate a currency board. Nevertheless, the Bank of Latvia maintains very high levels of reserves in order to back the currency- indeed at times the Bank of Latvia has claimed that they have over collateralized their currency. However, unlike Estonia and Lithuania, Latvia has had a significant domestic bank- Parex Banka- which got into difficulties and which, in common with banks across Europe has had to be rescued. This in turn required Latvia to seek the aid of the IMF in order to fund the rescue.

The consequence has been a growing scepticism of Latvia's ability to maintain its exchange rate, within the tight constraints of ERM II- the system that dictates the intervention points for the Bank of Latvia to buy and sell their currency in order to maintain a range no greater than +/- 1% of the central reference rate to the Euro, which is €1 = 0.702804 Latvian Lats.

As a Baltic Central Banker said to me only this week, if you fix the currency, then everything else in the economy has to be flexible. Yet in fact the policy that fixes the currency against the Euro is now, in the face of the rapid devaluation of all neighbouring currencies, actually forcing a rapid and very large real appreciation of the Baltic currencies against those of almost all their neighbours. The recession that was in any event headed towards a 10% fall in GDP now could end up even worse. We are seeing real wage cuts of 30% being imposed across the board, and this could be just the beginning.

Despite the fact that the Estonians especially have argued that they would lose much hard earned credibility by going down the path of devaluation, the fact is that maintaining the current rate of 15.67 Kroon to the Euro is essentially seeing a wholesale transfer of real Estonian wealth to the shareholders of the Swedish owned banks in the country. The massive cut in Estonian living standards which this implies is not something that a responsible policy maker should be contemplating, and yet both the central bank and the government continue to insist that there is no "Plan B".

The counter argument, put forward by the policy makers is "who benefits?" from a devaluation. The fact is that I am certainly not an advocate of a loose monetary policy: it has been a continuous soft option for the UK and in the end it has brought us inflation and eroded living standards over the longer term. Nevertheless these are exceptional times and by making a policy decision to devalue in an orderly way now, it at least buys some time for the Baltic economies to adjust to the increasingly deep economic crisis that is hammering into all of the European economies at the moment. The answer to that question posed by the Central Bankers is that the current policy now benefits only the mostly Swedish-owned Banks at the expense of the real wealth of every single Estonian citizen. By cutting relative costs in Estonia through devaluation, the economy will not have to endure the savage real cut in Estonian living standards that the currency board is now demanding.

That is a benefit well worth the swallowing of some pride at the loss of an economic virility symbol that is doing far more harm than good to the economic interests of Estonians.


Martin said...

The question is at what point will the speculators turn on the Euro. Tonight we here the EU spanking six countries for going over a 3% deficit and a statement that they will not support the currencies of non-euro members. The markets can smell fear. It's the Euro's turn next. £1=£1.25 by mid-march.

Cicero said...

Well an eleven Euro cent move is not that much in the great scheme of things at the moment, even over such a relatively short period. Arguably £1= €1.25 is about right and the current €1.14 is overstating Sterling's weakness. Still even $1.25 is a very long way from €1.52 which Sterling held even as recently as January 2007.

Anonymous said...

i am from Lithuania and can tell you that most people have long ago moved their savings into euros or gold. Devaluation would of cause cut the wages (measuring in euros) but it would cut all wages equally. Maintaining the peg cuts the wages unevenly (some people simply lose jobs). The losers of the devaluation would be swedish banks (because they lended alot of money in the baltics) so they are bribing local governments into keeping the peg and it is gonna last as long as possible

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