RIGA - In an effort to kick start Latvia's sputtering economy back to growth, the currency is set to be devalued by at least 15 percent, but only at the end of 2010, say analysts at RBC Capital Markets and Barclays Capital, reports Bloomberg. Even though the government says it will reduce spending and raise revenue by the equivalent of 11 percent of GDP, the European Commission forecasts the fiscal deficit may grow to a record 10 percent this year, twice the initial 5 percent target set last year by international organizations that are extending a 7.5 billion euro lifeline to the country.
"Latvia may devalue its currency at any time as it just can't afford to cut its budget further," says London-based emerging market strategist at RBC Nigel Rendell. Latvia's Prime Minister Valdis Dombrovskis earlier this month said devaluation would harm personal savings and real incomes and increase the number of bad bank loans, 91 percent of which are in euros.
Investors are worried over the state of the country's finances, evidenced through the 6 percent October drop in the value of Latvian bonds maturing 2018; this would be the first monthly decline since February.
Many are betting on the Central Bank loosening the currency peg, as economic and social conditions worsen for Latvians. RBC market strategist Nigel Rendell looks for the lats to weaken by as much as 30 percent in the next six months.
Emerging-markets currency strategist at Barclays Capital Koon Chow believes that the currency is likely to devalue by 15 to 20 percent against the euro, and then trade within a band of plus or minus 15 percent to the new target. "There is a high probability that devaluation will happen, the difficulty is calling the right date for it," Chow said.
A controlled devaluation, similar to what Russia recently engineered, may also be under consideration. "Latvia and its bailout donors should consider a managed devaluation of the lats to protect the country's social services and support exports," says head of portfolio management at Pimco Europe Andrew Bosomworth. "Where there is a clear case of a real exchange rate misalignment and where there are efficiency and equality reasons to change the exchange rate regime in order to regain international competitiveness, devaluing is always an option."
Bosomworth says that "Done convincingly, with support from the ECB, EU and IMF, the shock wave across Central and Eastern Europe" can be prevented.
Devaluation would help make Latvian exports more competitive and revive an economy that three years ago had the fastest pace of growth in the European Union. Metal and wood products accounted for more than 30 percent of the country's exports. At the same time, depreciation would raise the cost of servicing the country's foreign debt, which is equivalent to 129 percent of gross domestic product, reports Fitch Ratings.
The fixed currency peg means Latvia was unable to weaken the lats to support exports last year, when the Polish zloty dropped 13 percent, and Iceland's krona plunged 46 percent. Poland, the EU's biggest eastern economy, was the only country in the region to avoid a recession this year. Belarus, also on IMF life-support, devalued its ruble in January. The lender in August urged the government to sell assets, curb lending and raise utility prices to cope with the crisis.
The three Baltic states lost international competitiveness because of "high domestic inflation and fixed nominal exchange rates," says Bosomworth. He notes that "The currency peg means everyone in the economy must bear the burden of foreign-currency debt taken on by a limited number of borrowers. Maintaining the peg at its current level also means resource allocation between the domestic and the export-oriented economy is inefficient.
Senior economist Jose Antonio Cordero earlier told The Baltic Times 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] overvaluedâ€¦ the decline in wages will not be enough to compensate for this overvaluation."
New York-based economist Juri Uustalu claims that it is practically impossible for Latvia to avoid devaluation, reports news wire bbn.ee. He notes that a recent IMF report regarding the dynamics of Latvia's foreign debt projections shows that, under some scenarios, liabilities will reach 200 percent of GDP. This leaves the impression that Latvia could never pay back such forced and unfair debt. This is going to resemble Argentina, whose debt was later reduced by about 66 percent and which was forced to devalue its currency 75 percent.
What is also interesting is the attitude of the Latvian government, he says. "It seems that Latvian politicians are still hiding from the truth and do not understand how serious it is. The IMF itself says politely that the vision of Latvia's government is optimistic and reflects the thinking 'let's hope that things will improve on their own.' But you know, they never do. The real estate bubble has caused an irreversible decline. Latvia's economy will return to the 2005 level only around 2015. What a lost decade."
Chief economist at Swedbank Martins Kazaks says that Latvia's GDP will contract by 25 percent by the middle of 2010, compared with the highest point it reached at the end of 2007.