by Anders Aslund, Peterson Institute for International Economics
Op-ed in the Moscow Times
June 24, 2009
© Moscow Times
Nobel Laureate economist Paul Krugman has stated that "Latvia is just another Argentina" that has to devalue its currency to escape from its financial crisis. Similarly, the Russian financial crisis in 1998 points to devaluation as a suitable solution. But Latvia's situation is very different.
The common feature in these three crises was the pegged or fixed exchange rate, which attracted excessive currency inflows leading to inordinately high levels of foreign debt. But the similarities end there.
I just visited Riga during the height of the crisis, but the city looks perfectly normal. No social suffering is apparent, although some restaurant prices have fallen and a few big construction projects have stopped. Latvia suffered from overheating as inflation peaked at 18 percent in 2008. The high cost-level rendered Latvia noncompetitive, and its imports rose more than its exports, leading to a current account deficit of no less than 23 percent of gross domestic product in 2006 and 2007. By contrast, Russia's current account was not negative even in 1998, when the oil price fell to $10 per barrel.
Both countries had a problem with foreign debt, but Latvia's is far greater, currently at 136 percent of GDP and rising with its falling economic output. Latvia's debt is largely private because its budgets have been close to being balanced, while Russia's foreign debt was public and was caused by a persistent budget deficit of 9 percent of GDP.
Their economic experiences could not have differed more. In 1998 Russia had gone through many years of declining GDP, while Latvia has boomed with an average annual growth of 9 percent from 2000 to 2007. Latvia is an open, highly flexible market economy, whereas Russia's market economy is strangled by red tape. The international setting is also at variance. Latvia has been a member of the European Union since 2004, and its exit strategy from its peg is to adopt the euro, hopefully in 2012.
In short, Russia suffered from an excessive budget deficit, whereas Latvia's problem was overheating. It needs to reduce its cost level and inflation while securing sufficient international funds to refinance its private foreign debt. Different problems and settings call for different solutions.
Russia solved its public-finance problem in an idiosyncratic fashion. Although it had no problems with competitiveness, it devalued. This devaluation, which shocked the elite, made it politically possible to cut public expenditures by 10 percent of GDP. As a result, the budget swung into surplus from 2000. Rather than mobilizing international financing, Russia defaulted on its domestic treasury bills. It saved $60 billion in public payments and got away with it because of the poor legal regulation of the GKOs. Thanks to an extremely low exchange rate, Russia experienced an instant export boom, although the oil price stayed relatively low until 2003.
Latvia has already mobilized huge international financing of $10 billion, more than one-third of its GDP. These funds come from three sources: the International Monetary Fund (IMF), the European Union, and individual European countries, mainly its Scandinavian neighbors. Latvia has been able to mobilize these unprecedented large funds because of its stellar economic policies. Therefore, it can finance its foreign debt as long as it complies with the IMF's fiscal conditions.
Originally, Latvia had hoped to adopt the euro in 2007. It has fulfilled the Maastricht criteria on a budget deficit of less than 3 percent of GDP. Its public debt is minimal, and it has fixed its exchange rate to the euro. Its only problem was inflation, which was persistently more than 6 percent a year from 2004—when Latvia entered the European Union—while it had to fall below 3 percent a year. With a fixed exchange rate, the government had minimal tools to control inflation before the crisis.
If Latvia does not devalue, it can easily get its inflation under control. Latvia has already dealt with its excessive costs. The Latvian government has cut public wages by 20 percent and it is about to cut them by another 20 percent. It has also decided to cut public pensions by 10 percent. Private employers are following suit. Unemployment has risen to 11 percent, about as high as in Russia.
Latvia's current account has actually turned into surplus from January this year. Prices are already falling. The adoption of the euro in 2012 becomes realistic only if the budget deficit is checked, and with the euro Latvia will have a strong insurance against future currency crises.
The remaining problem is the budget deficit, which has been caused by the crisis. As GDP fell by 18 percent in the first quarter of 2009, state revenues are plunging. The Latvian government has just prescribed the cure: a cut in public expenditure of a moderate 4 percent of GDP. This is far less than the 10 percent of GDP Russia had to endure in 1998 and 1999, leaving the country with public expenditures as large as they were in 2007.
Even after these cuts, the IMF forecasts that Latvia's budget deficit in 2009 will be 7 percent of GDP, but that is based on the prediction that GDP will fall by 18 percent for the year as a whole. Yet no forecasts are reliable during acute crises. The recovery might be as sudden as the fall. At the end of 1998, the IMF predicted that Russia's GDP would fall by 8.9 percent in 1999. In reality, it grew by 6.4 percent. Latvia can make a similar turnaround, because it suffers only from a standard balance of payments crisis.
Latvia has no reason to devalue. By standing firm, the government can finally force necessary structural reforms of its post-Soviet public sector with far too many teachers (one teacher for every six students) and hospital beds. Countries ranging from Denmark to Barbados have reformed thanks to maintaining pegged exchange rates.
If Latvia devalued, by contrast, the exchange rate of the lat would plummet, as few payments are made in lats. Latvians and firms with incomes in lats and mortgages in euros would default, and the banks would take huge losses. A big devaluation would boost inflation, and the euro would disappear beyond the horizon. Nobody needs that. The political support for the government's austerity policy is amazingly strong. The recent budget and salary cuts were adopted by a majority of 63 percent of the parliament. Only two big businessmen favor devaluation.
Fortunately for Latvia, it is difficult to speculate against the lat. Financial markets are too thin, and Latvia's currency reserves of $3.5 billion suffice for five months of imports. If the IMF and the European Union approve a second tranche of their loan program for Latvia, the country is likely to successfully sort out its financial crisis.
Op-ed: What Kiev's Democratic Turn Means for Moscow February 25, 2014
Op-ed: Russia Is Losing Sources of Economic Growth January 22, 2014
Op-ed: Putin Without Putinism February 8, 2012
Policy Brief 11-20: The United States Should Establish Permanent Normal Trade Relations with Russia November 2011
Book: Russia after the Global Economic Crisis May 2010
Book: The Russia Balance Sheet April 2009
Policy Brief 09-6: Pressing the "Reset Button" on US-Russia Relations March 2009
Paper: The Russian Economy: More than Just Energy? April 2009
Testimony: US-Russia Economic Relationship: Implications of the Yukos Affair October 17, 2007
Paper: Russia's WTO Accession November 21, 2006