- Sweet Spot Found in Longest Maturities as Inflation Falls: Credit Markets (Bloomberg) - Europe's Rescue for Greece Brings Euro to New Normal (Bloomberg) - Inflation at 44-Year Low (Wall Street Journal)
...the depth of the recession and the difficulty of recovery are attributable in large part to the decision to maintain the country's overvalued fixed exchange rate.
Mark Weisbrot and Rebecca Ray, on Latvia's economy
FX Trading - Forget Latvia, I'm told.
After my Tuesday note on Latvia, I received two very informative emails pointing out my errors, omissions, etc. ... as well as some additional noteworthy tidbits about the Baltics. I'll get to those reader responses in a second.
First , the commodity currencies are getting trounced this week.
Second, I chose to discuss Latvia and point out its undertakings because I figured a decent number of you would somewhat identify with the situation ... since Latvia was on the radar screens of global investors a few times over the course of last year, impacting the global risk environment.
But I was not clear enough when I discussed the devaluation of the Latvian lat. It was an internal devaluation that Latvia undertook - cutting wages and prices - and not a devaluation of the nominal exchange rate; both are aimed at restoring competitiveness. It is argued that only a regular devaluation of the exchange rate can efficiently achieve the desired adjustment in the economy. And with my chart comparing LVLUSD and EURUSD, I then assumed Latvia had some flexibility in their fixed peg to the euro, with which they could somewhat use to manage their exchange rate; wrong.
Here's a quick note from Torbjorn Becker to give you some background on the Latvian economic dynamics influencing their devaluation decisions:
Basically the fixed exchange rate in combination with an over enthusiastic private sector and lax fiscal policy created a situation where there were large inflation differentials between Latvia and euro countries and thus interest rate differentials between lats and euro denominated loans. In real terms, anyone who borrowed in euro and invested in real lats assets got paid to do so [...] This fueled a bubble that for as long as it lasted made lats returns on euro borrowing even more irresistible. A rapid build up of foreign debt resulted [...] It should be noted that this was rational from a borrowers perspective as long as the exchange rate was fixed and banks supplied credit.
With that I'll kick it over to our first reader, L.G., from Riga, Latvia:
Dear Mr. Crooks, I live in Riga, have invested in real estate here since 1998, and find your analysis wrong on several levels: 1. Badly implemented austerity applied only to wage-earners, but not to real estate owners, has caused a demographic implosion, with huge numbers of people, especially young people, to leave to work abroad. Ever seen a recovery with an imploding population? 2. There's austerity with no structural reform on the bureaucratic-fiscal side. The tax system is as irrationally arbitrary for the unprivileged and for the not well-connected as ever. The government breaks its own contracts on land sales and small businesses have to report to the revenue service once a month, as ever. 3. The Lat hasn't been devalued against the euro. The exchange rate is fixed. Internal devaluation has produced no real growth in foreign investment because the country is as uncompetitive as ever compared to Lithuania and Estonia. 4. The Slesers-Skele oligarchy running the Saema (parliament) which freezes out competing businesses and guarantees itself sweetheart deals and govt contracts is in full control. The supposedly independent anti corruption prosecutor Loskutovs was fired and his assistant forced to resign. A Swedish investor tried for 5 years to open cafe barges on the riverfront in order to develop the tourism business, but couldn't get the license. Slesers did the deal for this summer's tourism season at a sweetheart rental rate of 2.5 Lats/m2 per year. Latvia is the mafia with a flag, but without the old Soviet style repression, the violence of Sicily or Calabria or the blockage of activist investors in publicly traded companies you'll find in Japan. Not exactly a recipe for growth. There are institutional and political impediments to applying your easy formulas here which you can't possibly understand without lowering the altitude from which you apply them enough to see what's happening on the ground.
So when I was trying to make the point that austerity measures and reining in government excesses can actually be a good thing, maybe Latvia wasn't the best example to use. Our next reader helped expand on that idea, pointing out that Estonia should be the Baltic model from which we take economic/fiscal pointers.
Take it away, I.M. ...
Hello! * Regarding Latvia. Latvia is not a good example of austerity measures and reasonable behaviour. If you want a real good example, look at Latvia´s northern neighbour Estonia. Actually Estonia gets rewarded for internal devaluation (decline in wages) and other austerity measures and probably will join Eurozone 2011. European Commission has given green light for Estonian Eurozone entry (http://ec.europa.eu/economy_finance/articles/eu_economic_situation/2010-05-12-convergence_report_2010_en.htm), this is considered one of the most important Yes from Europe. Let´s see what Ecofin decides on its June and July meetings (http://euro.eesti.ee/EU/Prod/Euroveeb/application/controllers/handleSessions.jsp?lang=en&oid=8152). But after European Commission´s yes we can say that Estonia probably will join Eurozone next year. Latvia (and on lesser extent Lithuania) is just a failed Baltic country. Austerity measures were forced by IMF, EU and Swedish officials. Contrary to Estonia who entered recession with considerable amount of reserves and extremely low public debt levels. If you want examples from Baltic region, you should take Latvia as a bad example and Estonia as a good example. * Regarding currency movements and currency devaluations in Baltics Don´t get fooled by USD/EEK, USD/LVL or USD/LTL price movements. In general they are all movements of USD/EUR because all these local currencies are in ERM II (http://en.wikipedia.org/wiki/European_Exchange_Rate_Mechanism) and pegged to Euro. Although a currency in ERM II is allowed to float within a range of ±15% with respect to a central rate against the euro, Baltic currencies are not floating at all. All Baltic countries have nominal band of 15% but Estonia and Lithuania keep actual band at 0 and only Latvia allows its currency to move a little (1%). ...
So there is no currency devaluations in fact, there is only plunge in exchange rate of Euro.
Alright, alright. Uncle. Uncle! The Latvian lat is fixed to the euro; not just kind of fixed - really fixed. Got it.
As to Estonia, it seems that country has it together. One commentator says of Estonia, By the time it joins [the Monetary Union], Estonia will probably be the only country to meet the Maastricht criteria.
But I ask: if they've been fiscally responsible and successful at their own internal devaluation-type measures, to keep from letting the pegged exchange rate rule their competitiveness, why do they wish to become a member of the monetary union?
Latvia, which isn't exactly the model of useful reform and austerity that I made it out to be on Tuesday, is said to be risking a longer period of economic misery by maintaining their overvalued fixed exchange rate. Apparently, because of their exposure in foreign-denominated loans, regular exchange rate devaluation wouldn't be as painless as would be hoped. So maybe that's a short-term obstacle that nobody wants to confront.
But still, can changes not be made to work towards real devaluation? Otherwise, they'll be stuck with the uncompetitiveness issue for a long time. And that's not going to work any wonders for their economy.
Estonia, who's revealed that they're going to be focusing their efforts on fortifying and building their export economy, should be careful with this exchange rate stuff. Perhaps they seek credibility, as any small economy would.
But the euro? I mean, how incredible can you get?
John Ross Crooks III
Black Swan Capital