RIGA - The latest International Monetary Fund World Economic Outlook report, released Oct. 1, calls for the recession in the Baltic countries to continue in 2010 with gross domestic product shrinking 3.7 percent after contracting 17.4 percent this year, reports Bloomberg. "Emerging Europe has been hit particularly hard by the weakening demand for exports and the drop in capital inflows," says the report.
Latvia's economy is suffering the second-worst contraction in the European Union and in December had to turn to a group, led by the EU and IMF, for a 7.5 billion euro loan to help support its finances. Latvia has committed to keep its fixed exchange rate and to cut public spending to rein in its budget deficit.
The IMF report notes that flexible exchange rates in Bulgaria and Romania have "acted as a shock absorber" in easing the crisis. The Polish economy, which has seen its currency depreciate, will probably grow 1 percent this year, with growth next year of 2.2 percent, the IMF said.
Latvia's GDP will continue falling in 2010 before stabilizing in the second half of 2010, then gradually resuming positive growth by the second half of 2011, says a report by Swedbank.
Discussions revolve around what policies the government should follow to stabilize the economy, and to get it moving again. Anders Aslund of the Peterson Institute of International Economics, who was in Riga on Oct. 1, said that Latvia's situation, which is frequently compared to that of Argentina in 2001, doesn't resemble the Latin country and that it should avoid devaluation, reports news agency LETA.
"These two countries are as different as the Argentine tango from Latvian song," he said. "If you have decided to stick to the policy then there is no need to change the policy. Moreover, it seems to me that the worst is over." Aslund, of course, is not one of the reported 18.3 percent unemployed in Latvia, according to the latest numbers from Eurostat. A projected sluggish recovery means the jobless face years of inactivity until the country stubbornly returns to pre-crisis employment levels.
The Latvian government's response to the crisis has been to cut government spending, slash public sector wages, while watching as private sector wages contract to restore competitiveness in export markets. "The lats has appreciated with respect to the euro and the dollar. Also, other Eastern European countries have seen devaluations recently. Under these conditions, how is the Latvian economy to compete if the peg is maintained?" says senior economist Jose Antonio Cordero in an e-mail to The Baltic Times.
Cordero, in a report published by the Washington, D.C.-based Center for Economic and Policy Research says that "Currency pegs have proven inadequate to deal with external shocks. They definitely contribute to stabilize inflation, and provide some sense of 'security' so more people can borrow in foreign currency (and lenders provide credit in foreign currency, after they have themselves borrowed that money abroad). The absence of a foreign exchange risk is definitely an invitation for foreign debt to grow."
This partly explains how Latvia's private sector was able to run up huge euro-currency liabilities during the boom years. Much of the private sector debt, of which 85 percent is owed in foreign currencies, was built up during Prime Minister Kalvitis' (People's Party) government. President of the Bank of Latvia Ilmars Rimsevics attributes the current problems to the irresponsible budget policies of the Kalvitis government, through its out-of-control budget spending and loan activities.
"Although there are some signs [today] of favorable activity within manufacturing, the recovery still lies very far away. Once output stops falling, there is still a long way before production actually increases, and, well, jobs are even farther away," says Cordero.
Latvia's second quarter current account balance surprised economists with a surplus of 14.2 percent of GDP. The goods and services balance was also positive for the first time since the second quarter of 1994. Despite the improvement, Cordero believes that "This was not for the right reasons: both imports and exports have gone downâ€¦ The Latvian economy is not becoming more competitive; it's just that the contraction [of the economy] is so huge that its capacity to import is crippled."
The IMF and the EU insist on the government maintaining fiscal restraint, though this tends to reinforce pro-cyclical trends, exacerbating the downturn. "Yes, the IMF has allowed a higher fiscal deficit, but this won't be enough in such a depressed economy that needs continuing foreign support to prevent the money supply to collapse."
"I would conclude that devaluation is still a possibility. Yes, it will have negative effects on the balance sheets of households and firms. But more heterodox measures could then be applied to protect Latvian institutions and people that would end up harmed by the devaluation. Argentina did it after the collapse of the currency board system, and the results prevented further losses," suggests Cordero.
To alleviate the negative effects devaluation would cause, the economist makes several recommendations. "Swedish banks exposed would be protected by the Swedish Central Bank. The Central Bank announced publicly that they have the capacity to cover the potential losses incurred by their commercial banks, coming as a result of an eventual devaluation. So, Latvia should not be worried about Nordic banks, who happily lent money excessively to Latvians on favorable conditions before the current crisis."
Part of the funds provided by the international lenders, now being used to support the currency, could be "redirected towards programs to help banks and borrowers deal with the potential consequences of devaluation. As expected, devaluation could [then] promote more rapid recovery, and this could, in turn, increase government revenue to deal with the fiscal deficit."
"Devaluation should be done in an orderly way, especially to mitigate the possibility of a panic. [Temporary] capital controls would help prevent a speculative attack, says Cordero.
With many arguing to stay the course to facilitate Latvia's early adoption of the euro, now targeted for 2014, Cordero counters that "With the lats appreciating against the major currencies, and with some other Eastern European countries devaluing, I would argue the lats is possibly [already] overvalued. The possible decline in wages resulting from the recession will not be enough to compensate for this overvaluation."