June 5 (Reuters) - Latvia's government has dismissed mounting
rumours it may have to devalue its lat currency to prevent a
financial crisis that could drive the country into bankruptcy
and send shockwaves across central and eastern Europe.
Speculation it may abandon its currency board regime and
lower the value of the lat versus the euro has hammered the
stocks of the Swedish banks that have financed an explosion in
growth in the Baltics for much of this decade.
It has also hit currencies, such as the forint in Hungary,
which, like Latvia, grabbed a multi-billion dollar lifeline to
stave off national bankruptcy, and raised questions over the
financial stability of the European Union's eastern wing.
Following are some implications of Latvia keeping its peg,
as its prime minister has said it will do, and of any move to
revalue the lat currency at a weaker level against the euro.
IF LATVIA MAINTAINS THE PEG:
- Latvia wants to keep the peg to maintain the value of its
economy and allow Latvians to repay loans taken in foreign
currencies at the same currency rate at which they borrowed.
That would help Swedish banks like Swedbank <SWEDa.ST>,
which have lent the Baltics billions of euros in foreign
currencies, bankrolling growth rates of more than 10 percent.
But it also requires huge cuts to public spending -- the
government plans to slash as much as 40 percent across the board
-- to reduce domestic demand and depress wages in what
economists call an internal devaluation.
That would ensure the country can cover its large foreign
liabilities due to high imports and prevent what would amount to
national bankruptcy.
But it could also foment resentment among Latvians as state
wages are cut and if the state failed to live up to promises to
maintain pensions. The country has already experienced its worst
riots since the fall of communism this year.
- Despite falling domestic wages and prices, some economists
say keeping the peg continues to make Latvia uncompetitive after
a likely economic contraction of more than 18 percent this year.
In this scenario, the economy is set to take years to resume
solid growth and catch up to the level it had reached in 2007.
IF LATVIA DEVALUES:
- Making the lat cheaper would make it much easier for
Latvia to recover from its massive economic contraction.
But it would also make it much more expensive for Latvians
to repay foreign currency loans, which could hammer the Swedish
banks. Analysts say non-performing loans could jump.
"Plausible estimates are in the region of 25 percent against
the euro. This would have significant implications for the real
economy. With nearly 90 percent of loans made in euros, the
value of debt (and so debt-servicing costs) would rise sharply,"
wrote Neil Shearing, of Capital Economics.
"Bad debt could quickly reach 25 percent of total loans.
Meanwhile concerns about deflation would quickly turn to
inflation fears, as import prices rise. We think headline
inflation could hit 10 percent to 15 percent next year (compared
with -5 percent if the peg stays)."
- Another immediate question would be whether the
devaluation would be to a new peg or to a floating rate, with
analysts seeing the peg more likely.
A floating rate with Latvia staying in the minimum two-year
ERM-2 waiting room for the euro would require the European
Central Bank to intervene to keep the lat within the regime's
required plus/minus 15 percent range.
If it was a new peg and less than 15 percent cheaper, Latvia
could still possibly stay in ERM-2, although rules on the
acceptable levels of devaluation are vague. If more than 15
percent, it would have to start the euro probation period anew.
- It could put pressure on other countries. Bank UBS said it
expected any devaluation to be ringfenced by an accord with the
European Union and the IMF to limit damage to other eastern and
western EU countries. But it said regional contagion may spread
to other Baltic states, Bulgaria, Romania or Hungary.
- Finally, if Latvia drops the peg, with IMF approval,
despite it having been a central strategy for the IMF programme
there, it would inject an element of uncertainty in the rest of
the Fund's bailout projects in central and Eastern Europe.
The question investors could ask is, if the Fund allowed
Latvia to essentially raise default risk on loans owed to
Swedish banks, could it also change tactics on other measures in
countries like Ukraine or Hungary, endangering investment?
And after the Fund asked western banks with big subsidiaries
in eastern Europe to commit to continue financing their units in
those countries, why would banks like Unicredit or Raiffeisen,
with heavy exposure in IMF bailout states, continue to do that?
(Reporting by Michael Winfrey; editing by Stephen Nisbet)
