ECB warns of risks involved in maintaining currency pegs

TALLINN - The Baltic states risk being pulled into another debt-fueled economic crisis if their governments fail to adhere to sufficiently strict measures to support their euro pegs, says the European Central Bank, reports Bloomberg. Latvia, Lithuania and Estonia are bogged down in a deep economic slump because the tight euro pegs led to easy credit, driving speculative asset bubbles.

The ECB report considers that the Baltic states tied their currencies firmly to the euro too early in the currency conversion cycle. These narrow currency bands added to pressure on fiscal policy to keep the economies away from imbalances, said the report. The need now is for the governments to maintain strict fiscal measures, to cut deficits, otherwise “the authorities in the Baltic states may not be able to prevent a renewed emergence of macro-economic imbalances and a repetition of the boom-bust cycle,” reported the ECB document from Nov. 17.

After EU accession in 2004, the three countries experienced a debtfueled expansion, sending wages up by as much as 85 percent, leaving their overheated economies vulnerable to the tightening credit conditions created by the global crisis. The Baltic central banks enforce tighter euro pegs than the 15 percent required by the euro’s exchange rate mechanism; Latvia sticks to a 1 percent band. “The experience of the Baltic states suggests that, for countries that have opted for pegging tightly their exchange rates, there is a significant risk that relatively low interest rates lead to excessive domestic borrowing and the emergence of asset price bubbles,” noted the ECB report. Since the global crisis started, the Baltic economies have contracted as much as 20 percent on an annual basis. Latvia’s GDP was down 19 percent last quarter, Estonia’s output fell 15.6 percent and Lithuania’s economy dropped 14.2 percent.

The region’s “adjustment is much sharper than in other central and eastern European EU member states that have allowed their exchange rates to fluctuate. The tight peg of the exchange rate of the Baltics has implied that these countries have lost significantly on competitiveness versus their neighboring countries,” says the report. Latvia, which is dependent on a 7.5 billion euro loan from a group led by the IMF to stay liquid, has promised to cut its budget deficit by 500 million lats (714 million euros) every year through 2012 to satisfy creditor demands. Latvia joined the ERM II in January 2005. Lithuania, which joined the ERM II in 2004, is working with budget cuts equivalent to 5 percent of GDP next year. Lithuania’s attempt to join the euro in 2007 was rejected because inflation exceeded EU limits. Estonia, which also entered the ERM II in 2004 and expects to adopt the euro in 2011, has cut its budget by 9 percent of GDP this year. The Baltic states are learning the hard way about boom-and-bust economic cycles.

Their cycle has been exacerbated by euro-denominated borrowing since joining the EU. This has forced central banks to stick more closely to their euro pegs, otherwise risk leaving households and businesses unable to service their euro-denominated debt. The ECB said the three countries will need to improve the regulation of their banking systems, including imposing restrictions on foreign currency lending. The countries also need to make their labor markets more competitive. Wage levels should be made more flexible, more resources should be targeted to export-oriented industries and competition in product markets must increase, says the bank. The ECB goes on to criticize the mechanisms for monitoring the progress of ERM countries on their way to euro adoption.

Tracking methods need to be more country specific with a view to preventing any regional contagion if currency pegs are considered to be under threat. “Surveillance procedures for countries participating in ERM II have been clearly deficient,” the report warned. The bank also said ERM central banks should make clear to market participants that unilateral euro pegs don’t rule out the option of revaluations or devaluations. “In countries with unilateral pegs or currency boards, it is crucial to communicate transparently to the public that, until the eventual adoption of the euro, exchange rate changes against the euro remain a possibility,” the bank said.