Latvia Devalues Economy, Spares Currency to Save Path to Euro – IMF Report: Economy to Shrink a Total 27 Percent

Nov. 6 (Bloomberg) — Electronics and clothing stores at the Galerijas Centrs in Riga’s old town fly banners offering discounts of as much as 50 percent.

Liga Kalnina isn’t buying. “Many friends have problems,” said the 28-year-old, whose salary was cut 25 percent in September. “They don’t have money now and they don’t know when they will.”

Their plight is part of Latvian authorities’ plan to save the Baltic country’s currency and economy, among the worst hit in Europe during the global crisis. By ratcheting down state wages and prodding companies to do the same, policy makers are betting the resulting plunge in consumer demand will curb inflation, bring it back in line with the euro countries, whose currency Latvia is trying to join.

Latvia’s inflation rate may turn to 1 percent deflation in October, according to the median survey of six economists, when the figures are released on Nov. 9. That would be the first annual deflation since the country split from the Soviet Union in 1991 and became a market economy. It compares with a rate of 17.9 percent in May 2008.

Prime Minister Valdis Dombrovskis and Central Bank Governor Ilmars Rimsevics are resisting pressure to drop the lats out of its 2 percent trading band with the euro because a devaluation would throw Latvia off the path to joining the common currency.

Devaluation Shock

They also argue that forcing thriftiness after years of record consumption beats the deeper shock of devaluation, avoids a wave of defaults in a country where about 90 percent of loans are denominated in euros and prevents the crisis from spreading to Swedish lenders and neighboring Estonia and Lithuania.

A 30 percent lats devaluation would put 44 percent of all loans into arrears over 90 days, the central bank said Oct. 1.

Dombrovskis told Parliament yesterday that a lats devaluation would mean the country “would lose the light at the end of the tunnel. We would not be able to implement the exit strategy: to join the euro zone in 2014.”

“If you think the Latvian lats will devalue then you could buy credit default swaps, short the Swedish krona and Hungarian forint as a proxy hedge or buy forward contracts on the lats euro rate,” said Bartosz Pawlowski, an emerging markets strategist at BNP Paribas in London. “If you think that the country won’t devalue, then you could sell forward contracts on the lats.” Those carry an interest rate of about 13 percent on 3-month contracts.

Cheap Loans

Latvia’s economy boomed after joining the EU in 2004 as cheap loans fueled a real-estate bubble and an appetite for imported goods. The current-account gap ballooned to 22.5 percent of gross domestic product in 2006 and 2007, the EU’s widest. It recorded a second-quarter surplus of 14.2 percent of GDP.

By December 2008, Latvia had turned to the European Commission and the International Monetary Fund for a 7.5 billion-euro ($11 billion) loan after Riga-based Parex Banka AS failed during a run on deposits.

“We are in the midst of a slow-burning pain,” said Morten Hansen, head of the economics department at the Stockholm School of Economics in Riga, and a supporter of the plan. “My biggest fear is how low the economy will go.”

Latvia’s strategy, called internal devaluation, is criticized by economists including Nouriel Roubini, the economist who predicted the global economic crisis. The New York University professor said in the Financial Times on June 10 that Latvia’s policy was a ‘self-defeating strategy” and that the country would have to devalue, as Argentina did in 2002.

More Time

Swedbank AB’s chief Baltic economist, Martins Kazaks, who opposes currency devaluation, said on Oct. 30 that Latvia’s internal devaluation was one-quarter complete.

The economy probably will shrink a total 27 percent from peak to trough, according to an IMF report. Indonesia, by comparison, shrank 19 percent from peak to trough during the Asian crisis of the late 1990s.

Consumer prices may fall a cumulative 8 percent through 2011, the IMF said. In September, retail sales slumped a record 30.9 percent, while the 19.7 percent September unemployment rate was the EU’s highest, according to Eurostat methodology.

“Everyone feels the crisis here,” said Inese Riezniece, a 29-year-old lawyer in Riga who lost half her income this year due to a law firm’s pay cuts and the loss of a second job. One relative moved to Canada, and Riezniece gave up her apartment to live with her brother.

Dumplings and Beer

At Pelmeni XL, a fast-food restaurant, Russian-style dumplings are on discount. The Latvija Balzams liquor store offers a half liter of Aldaris beer for one-third off.

Nils Muiznieks, a political science professor at the University of Latvia, said Latvians are looking to emigrate, rely on family and friends, sell possessions or work two jobs — a dim prospect with record unemployment.

Young people risk suffering the most because they never lived through communism, the transformation to a free-market system after 1991 or the bank crash of 1995, he said.

Kalnina, a procurement specialist, said at this time last year she was eyeing a brand-new PSA Peugeot Citroen car and planning her next vacation abroad. She now meets friends at home to save money.

“I didn’t think the crash would be so sudden,” she said. “I don’t plan anything any more.”

To contact the reporters on this story: Aaron Eglitis in Riga at aeglitis@bloomberg.netJames M. Gomez in Prague at jagomez@bloomberg.net

Last Updated: November 5, 2009 19:01 EST

Source: Bloomberg

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