Rumors surrounding devaluation are spreading. Not surprisingly – when the governor of the country's central bank declares such a possibility and the prime minister says the opposite and advises the banker to stick to his own business (which does, by the way, include the exchange rate policy), the situation is bound to raise questions. And the scary word 'devaluation' begins to take root in people's minds.
It is indeed a scary word. As Olga Pavuk wrote in her recent article in the Russian-language daily Chas, "any discussion of lat devaluation coming from the president of the central bank or the prime minister should be taken as an alarm signal."
People fear devaluation for one main reason. It seems to signify a reverse of the traditional Latvian exchange rate policy going back to time immemorial.
More precisely, to May 1992, when the Latvian ruble first made an appearance in the minds of central bankers, and then in our wallets. Ever since the central bank in general and its charismatic governor, Einars Repse, in particular have been trying to assure the public of the lat's stability, raising the noble goal of keeping the Latvian currency steady almost to the cult level.
In reality, devaluation does not have to mean a U-turn in the central bank's policy. The lat, reduced in its value, is unlikely to go into free float. It will probably still be pegged to the SDR basket, or find a new benchmark in the euro. The Bank of Latvia will not readily forego its policy of the lat's stability. If it ain't broke, don't fix it, and the policy that won Repse his second term as the central bank's president definitely isn't broke.
Why did the talks of devaluation surface at all? The economic crisis in Russia is the answer. Starting from July 1998, Latvian net foreign assets have been falling steadily, in April 1999 reaching no more than 70 percent of their peak level at the end of June 1998, which was then 604 million lats ($1.02 billion).
This is the direct result of increasing the trade deficit, for which the Russian crisis is greatly responsible. Exports to the CIS in March 1999 were a quarter of June 1998 exports; imports fell slightly, but not nearly as much.
Apart from the increasing trade deficit, the statistics hint at possible struggles for the lat's stability. The amount of total cash in circulation fell from November to December 1998 and from March to April this year, which is likely to mean that the central bank is buying up lats, using up its foreign currency reserve to keep the domestic currency at the same level.
Both trends mean that the pressure on the central bank's foreign reserves is mounting. In March 1999 the amount of cash in circulation exceeded the lat value of the bank's net foreign assets, for the first time in five years, breaking the bank's tradition to back up every lat in circulation by a lat's value of foreign currency in reserves.
The situation may be cured by devaluation or reducing the value of a lat in relation to foreign currency. What exactly will this step bring?
First of all, it will ease the pressure on our foreign reserves. It may also change our balance of payments from vulgar red to noble black. More realistically, a figure in red (currently more than 11 percent of GDP) may diminish, making it if not less vulgar, then less burdensome economically.
Presumably we will switch to domestically produced goods and services, and foreign companies will switch to Latvian goods as imports priced in lats will become more expensive and exports priced in foreign currencies cheaper. Our industry will flourish, and investors, inspired by Latvian progress, will come running to our country (with money, of course). This is the theory.
What about the practice? The depreciation of the Russian ruble, the unintentional reduction of the currency's value in relation to other currencies, did cause some degree of revival in Russian industry, but as we all remember, it also caused a great deal of pain. Depreciation of South Asian currencies had a similar effect. What will Latvia have to pay for all the wonderful gains devaluation allegedly brings?
First of all, devaluation is not the same as depreciation. When a currency plunges as a country goes bankrupt or its banking system collapses, and both investors and currency speculators lose the last bit of confidence and start selling the currency, the process is quite different from cautious and deliberate central bank actions. A currency crash is a sign of economic weakness, a timely and controlled devaluation is of thoughtful economic policy.
Of course the real picture is unlikely to be as rosy as the theory tells us. There are many real life barriers to prevent it from coming true. Firms are often bound by long term contracts so the changes in import and export volumes will only come through after a time lag. Also price is not the only determinant of demand. Many of us do not buy the cheapest product on the market knowing that a more expensive one may last longer, taste better or have a more fashionable label attached to it.
In any case, devaluation will not make Latvian balance of payments worse even if it does not make it better by as much as we would like.
Devaluation may also get out of control if the Bank of Latvia is unable or unwilling to use its foreign currency reserve to sustain the inevitable speculators' pressure. It is very tempting to sell the currency which is bound to go down in value. Then the situation will resemble a 'currency crash' more than a 'timely and controlled devaluation.'
Considering the bank's devotion to a stable lat and the amount of foreign reserves it still has at its disposal, such a development is none too likely.
It is up to Repse and Kristopans to decide whether the lat has to be devalued. But if they decide so, a major economic disaster is very unlikely, and there are gains to be expected – at a certain cost in foreign currency.
Whoever pays the money takes the risk.