"We have recently downgraded ourgrowth forecast for the Baltic States and now expect both Latvia andEstonia to enter recession this year. But at the same time there arefive good reasons to expect all three countries in the region tomaintain their currency pegs against the euro," Capital economistNeil Shearing said.
Shearing's five good reasons are:"First, they are small and open economies, which makes them ideallyplaced to benefit from the reduction in currency risk provided by afixed exchange rate.
"Second, the high share offoreign-currency denominated debt in all three economies means that adevaluation would have a disastrous impact on both household andcorporate balance sheets."
"Third, a currency devaluation wouldstoke inflation...Fourth, a move to a floating currency would notnecessarily provide protection from overheated and unbalanced growth.
"Finally, a devaluation could bepolitical suicide given that the currency boards are widely creditedwith providing the bedrock for the recent boom. Indeed, given thepotential for a disorderly sell-off, it would be brave of anygovernment to do anything but wholeheartedly back a country'scurrency peg."
Basically, that boils down to a beliefthat even if there was a chance that letting the currencies floatfreely might improve the situation, the possibility that things mightmove in the other direction is too great a risk for any politicalparty to take. While it would be nice to be credited with 'rescuing'the country from recession, no-one wants to be blamed for thatrecession if and when it hits.
In any case, Capital does not forsee adevaluation on the cardsm owing to the fact that all three currencyregimes are backed by adequate levels of foreign exchange reservesand are lightly traded.
"While the recession in the Balticscould be deep and protracted, we expect the region's currency pegsto stay in place," Shearing concludes.