• Home ::
• Fundamental ::
• Market View ::
• New Europe Weekly

• Send
• Print
• Add To
• Rss

New Europe Weekly

439f6b12-adac-4270-8e8a-f4efc8b82f67

1

0

Latvian devaluation fears

Fri, Jun 5 2009, 07:54 GMT
by Lars Christensen

Danske Bank A/S

Over the last couple of weeks, fears over a possible devaluation of the Latvian lat have escalated. This has led to a sharp spurt in money market rates, not just in Latvia, but also Estonia and Lithuania. Furthermore, markets are clearly nervous that a possible devaluation in Latvia could spark trouble in other Central and Eastern European markets, which, to a larger or lesser degree, have similar economic imbalances to Latvia.

Why are the markets increasingly pricing in a risk of devaluation in Latvia? In our view the renewed devaluation fears have to be seen in light of both worsening Latvian news flow, and news out of Stockholm. There is little doubt that the very sharp drop in economic activity in Latvia – with GDP down 18% y/y in Q1 – has sparked a debate both inside and outside Latvia as to whether maintaining a peg against the euro is the right policy. This week the IMF is expected to finalise its mission to Riga, after which it will announce whether the fund will pay the next instalment on Latvia’s IMF loans, or whether the money will be withheld because the government has failed to make the budget adjustment needed to fulfil the terms in the Standby agreement.

However, the biggest change in market perception of the Latvian situation was not sparked by news out of Riga, but rather by news out of Stockholm. Most important last week was the Riksbanken announcing that it would increase its currency reserves by SEK 100bn. Market participants view this as the Riksbanken’s attempt to build a “buffer” against potential problems for the Swedish banking sector stemming from the Baltic crisis.

Former Riksbank head, Bengt Dennis, prompted further speculation of a possible devaluation when he said in an interview with Swedish TV this week that it was not a question of whether or not there would be a devaluation in Latvia, but rather when. Bengt Dennis is highly influential both in Sweden and Latvia – he was central bank governor in 1992 when Sweden was famously forced to give up its fixed exchange rate policy and he is an official advisor to the Latvian government.

Given the news flow out of Riga and Stockholm over the last two weeks, it is no surprise to us that markets now fear a Latvian devaluation more than any time before, and that the situation is becoming increasingly unsustainable. We are crossing our fingers that whatever decision the policy makers in Riga make in the coming weeks, that it will be for the long term benefit of the Latvian economy.

• Download full New Europe Weekly with charts

Published on  Fri, Jun 5 2009, 08:18 GMT