Baltic Blues

From the Economist last week:

Europe's fastest-growing economies hit choppy waters


DEVALUATION would be horribly painful and solve nothing. That is Latvia's defence, as its inflation rate and current-account deficit soar, and speculators hover over its pegged exchange rate. On paper, the small Baltic economy looks nastily exposed, as, to a lesser extent, do its neighbours Lithuania and Estonia (see chart). All three have overheating economies and fixed exchange rates: a risky mix. Some fear the region could be eastern Europe's Achilles heel.

Latvia is in the worst situation. Year-on-year inflation in September was a whopping 11.4%; the current-account deficit over a fifth of GDP. Bank lending, much of it in foreign currencies, has soared, creating a property bubble in the capital, Riga. Overheating has hurt competitiveness. To some the national currency, the lat, looks like the likeliest casualty.

Latvia's position was not helped when Jürgen Stark, a board member of the European Central Bank, said earlier this month that ex-communist countries wanting to join the euro zone faced “substantial challenges”, banker-speak for “forget it”; Lorenzo Bini Smaghi, another ECB board member, publicly questioned the ability of these countries to keep inflation under control while maintaining fixed exchange rates, a stance that means adopting what is de facto the euro zone's monetary policy.

Yet a devaluation is far from inevitable. The Latvian banking system is largely foreign-owned. If overstretched borrowers start to default, that will hurt shareholders abroad, mainly in Sweden, not the stability of the whole financial system. If scared banks rein in lending and construction companies go bust, that would help produce a much-needed soft(ish) landing. Indeed, that may already be under way. Furthermore, speculating against thinly traded currencies is tricky. It may also be pointless: the Latvian central bank has enough reserves to redeem every lat in circulation, and more besides. And as Jon Harrison of Dresdner Kleinwort, a bank, points out, Latvia has little foreign debt and a strong credit rating. It could borrow in euros to ease a local credit squeeze.

The problem for Latvia is the lack of monetary-policy levers. The currency peg means it cannot raise interest rates. Even when banks cut back on their lending, other financial entities, such as leasing companies, can fill the gap. That leaves only fiscal policy; yet the government, an uninspired coalition stronger on business practice than economic theory, has shied away from the big surplus that might slow the economy and reassure outsiders. The 2008 budget foresees a surplus of only 1%, rising to 1.5% in 2010. Outsiders think 3% would be a good start.

A forced devaluation in Latvia would be ruinous for the middle class—at least for those who stayed to experience it. Tens of thousands of Latvians have gone to work abroad already. Any gain in nominal competitiveness might well be counterbalanced by an even tighter labour market.

Estonia and Lithuania would be at risk if Latvia did devalue. But elsewhere, a crunch in the Baltics would be more spectacular than significant. The combined GDP of the three Baltic economies is barely 1% of the euro zone's. Their plight might worsen wobbles in Kazakhstan, say, but most other ex-communist countries would weather the storm. The main change would be in the mood music. When liquidity was plentiful, lending in eastern Europe looked like a source of easy profit. Now the region's bottlenecked economies and lacklustre governments stand more harshly exposed.