Latvia - (small) Lat devaluation on cards

Earlier this week heavily exposed to the Baltic region Swedbank reported its third straight quarterly loss. Swanbank also acknowledged that it was planning for a possible currency devaluation but said it’s seeing signs that credit quality in the Baltic region is beginning to stabilize. Indeed the worst may be over but its cleaver to prepare for devaluation in Latvia as the move would help country to recover faster and possibly would limit credit losses.

Just to give a brief characteristic of the country I should say that Latvia peg its currency just after the country won independence from the Soviet Union in 1991. In the recent past on the Latvia’s acceptance into the EU, the economy experienced a huge boom with the growth rates well above 10% per annum. The boom was driven by very strong credit growth financed by FDI inflow mainly into nontradable sectors ( real estate, retail and financial services). As time passes the imbalances built up. The wages went strongly up, the inflation level exceeds the EU level which further eroded the country competitiveness, current account gap top 25% of GDP in 2007.

There were several seeds of economic instability (bad mix policy – too loose fiscal policy combined with lack of monetary sovereignty) but among them most important was positive feedback mechanism from banking sector to private non-financial sector which fueled the housing bubble.

Simply credit growth was stimulating the home prices which were taken as collateral for loans. The more quickly the credit was flowing in the higher were the house prices. This process continues until the credit was unable to grow fast enough to further stimulate the house prices. At that time the private indebtedness top 125% of nominal GDP. (More detailed analysis of that process you may find in the previous post here or in Adrian and Shin paper ). The bad news is that this process works in reverse too (lower prices of homes lead to liquidation of loans which makes the decline more precipitous). In case of Latvia the credit bust was compressed in short time period which had catastrophic consequences on home prices. The figure below is a chart of home prices in capital of Latvia. Now the household’s holds negative equity as the home prices deflated but the nominal debt remained unchanged which suggest that more credit related loses lays ahead. As the households remains heavily indebt the recovery is likely to be very sluggish (L-type recovery is possible)

To get a better insight in situation I just implemented a simple balance sheet approach to Latvia. This analytical approach is different than ESA95 approach and it’s focused to examine balance sheet of the country and potential misalignments and vulnerabilities (more on that methodology here). In particular case of Latvia I focus on credit and currency misalignments so this is not a comprehensive approach. Figure 2 is a excel balance sheet of Government sector, Commercial banks sector and Private –non bank sector (click to enlarge the figure).

First observe that government indebtedness is low(ish) both in local and in foreign currencies. Second somehow modes net liability position of commercial banks masked the fact that the majority of the commercial bank assets consists around EUR 8.5bn (Lat12bn) in FX loans to the domestic nonbank sector. In words FX-risk of the banking system simply has been transferred in credit risk which was quite “natural“ as majority of the local banking sector assets are in foreign hands.

Without the coordinated IMF/EU/WB programs the country balance sheet gaps would not be sustainable would end up with currency crises. As I read IMF lead program as financing bridge to adopt euro (in 2012?) and extricate Latvia from currency risk. However this strategy is very difficult to implement as the government has to cut spending to meet the Maastricht criteria among dramatic economic downturn. In words this strategy is unlikely to win sustainable political support. But this is the minor problem. The major problem is fixing LAT to euro at too low level (maintaining overvaluation i.e. Portugal peg its currency too low to euro which had negative implication for the GDP growth). Latvia to repay the debt would need to increase the competiveness to be able to generate the current account surplus. Amid the crises the Latvian C/A deficit shrunk rapidly but this was achieved by collapse of domestic demand and import. Unfortunately amid weak external demand export also drop but leaser than import which ends up in small C/A surplus.

The easiest way to increase the country competitiveness would be allow currency to depreciate if not then the competitiveness may be raised by adjustment on the real side of economy (decreasing wages etc. which is rather painful process). In case of Latvia because of large FX misalignment devaluation is not a cost free solution but implemented orderly would increase the quality of the credit portfolio in the medium term as it would it would promote higher employment. The orderly devaluation would not necessarily jeopardize Latvian plan to join euro soon(ish) as in ERM2 mechanism currency can fluctuate -+15%. from the central parity. An orderly and small Lat devaluation seems to be a plausible solution.To make it orderly both banks and government has to be prepared. If the Swedbank is preparing for possible devaluation maybe Latvian government is preparing for devaluation too but this is only my interpretation and I may be wrong.