No danger of 'new pegs for old'

Jul 08, 2008
By Mike Collier

LONDON - There's good news for currency-watchers in with a statement from Capital Economics – normally one of the more pessimistic assessors – saying that the region's currency pegs look secure for the next five years at least.

“We have recently downgraded our growth forecast for the Baltic States and now expect both Latvia and Estonia to enter recession this year. But at the same time there are five good reasons to expect all three countries in the region to maintain their currency pegs against the euro,” Capital economist Neil Shearing said.

Shearing's five good reasons are: “First, they are small and open economies, which makes them ideally placed to benefit from the reduction in currency risk provided by a fixed exchange rate.

“Second, the high share of foreign-currency denominated debt in all three economies means that a devaluation would have a disastrous impact on both household and corporate balance sheets.”

“Third, a currency devaluation would stoke inflation...Fourth, a move to a floating currency would not necessarily provide protection from overheated and unbalanced growth.

“Finally, a devaluation could be political suicide given that the currency boards are widely credited with providing the bedrock for the recent boom. Indeed, given the potential for a disorderly sell-off, it would be brave of any government to do anything but wholeheartedly back a country’s currency peg.”

Basically, that boils down to a belief that even if there was a chance that letting the currencies float freely might improve the situation, the possibility that things might move in the other direction is too great a risk for any political party to take. While it would be nice to be credited with 'rescuing' the country from recession, no-one wants to be blamed for that recession if and when it hits.

In any case, Capital does not forsee a devaluation on the cardsm owing to the fact that all three currency regimes are backed by adequate levels of foreign exchange reserves and are lightly traded.

“While the recession in the Baltics could be deep and protracted, we expect the region’s currency pegs to stay in place,” Shearing concludes.

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