Bar set too high for Latvia

27 October 2009

Bar set too high for Latvia

In 1991 Argentina opted for an ultraliberal exchange rate policy under which the peso was valued at parity with the US dollar. What this meant in practice was that Argentina was giving up part of its sovereignty, with interest rates determined by the Fed, the US central bank in Washington, DC. In the first instance the new policy appeared to be working out well, but the strength of the dollar at the time made life ever more difficult for Argentine exporters. In 2001 Argentina ended up in deep crisis. The IMF responded by demanding and getting the implementation of draconian cuts, the aim being to maintain the link between peso and dollar. Yet the Argentine currency eventually collapsed, with the peso's value declining by 75%. The enormous price increases which followed led to an equally huge increase in poverty. Exports, however, recovered. The government was, moreover, able after this to stimulate the economy and break with the IMF. Spectacular recovery ensued..

Ewout Irrgang

Ewout IrrgangIn Europe, Latvia opted for a fixed exchange rate against the euro as a step towards its goal of adopting the single currency. The fixed exchange rate, and the prospect of eurozone membership, led initially to a massive influx of foreign capital. The economy grew so quickly that, together with Lithuania and Estonia, it provoked talk of the 'Baltic Tigers'. This growth was, however, entirely financed with borrowed money, most of it loaned from foreign banks. Latvia was spending far more abroad than it could pay for through exports. The credit crisis threatened to make the country into another Argentina, with the fixed exchange rate bringing about a currency collapse. The country was forced to go knocking on the doors of the IMF and the European Commission, which loaned it billions in order to maintain the fixed rate, but only on condition that wages were drastically cut so that fewer imports woyld be purchased. At the same time, falling wages and falling prices give Latvian exporters more opportunities. As a consequence, the Latvian economy has shrunk by 20%. But this is still insufficient.

The fixed exchange rate could be abandoned, which would mean a steep decline in the value of the country's currency, the Lat. This would make it easier for the Latvian economy to recover, as it would again offer more opportunities to exporters. Prices would rise substantially, but on the other hand far fewer or less severe cuts would be needed. Many Latvian mortgages are held, as was the case in Iceland, in euros. Steep decline in the value of the Lat would therefore lead to an equally steep rise in the mortgage burden. Most foreign banks would probably be forced by these circumstances to forgive a proportion of the Latvian mortgage debt. The Latvian government, equally, could force them to do this. Ending the fixed exchange rate would nevertheless lead to
widespread social misery, just as it did in Argentina in 2001. Yet the problems would probably be less severe than they would be were Latvia to maintain the link with the euro, which would make the ordinary Latvian still worse off.

Most foreign banks active in Latvia are Scandinavian. They have a great deal to lose from the decoupling of the Lat and the euro. Lithuania or Hungary, both of which have also taken out many loans from reckless foreign banks, may follow. What is more important for the European Commission and the IMF – the interests of international banking, or those of ordinary Latvians?

Ewout Irrgang is a Member of Parliament for the SP.

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