Baltic Currency-Peg Defense Cuts Reserves Amid Regional Slump

By Aaron Eglitis

Feb. 23 (Bloomberg) --- Latvia, Estonia and Lithuania, facing a prolonged recession, say they will protect their currency pegs whatever the cost. That strategy may be as crippling as the alternative, economists say.

The three-nation Baltic region is in its deepest crisis since breaking from the Soviet Union in 1991. Latvia, which spent $1.26 billion in 11 weeks defending the lats last year, was forced to turn to an International Monetary Fund-led group for a $9.6 billion bailout. Its economy may contract 12 percent this year, while Estonian gross domestic product may shrink by as much as 9 percent and Lithuania's GDP by 4.9 percent.

Latvian Premier Ivars Godmanis resigned on Feb. 20 and Lithuania's two-month-old cabinet is struggling to win over a skeptical electorate after the two nations suffered the largest street riots since independence last month.

Keeping the peg “will likely mean a number of years of very low economic growth,” said Lars Christensen, chief economist at Danske Bank AS in Copenhagen. “Wages and prices will have to fall to reestablish competitiveness.”

Central bankers and government officials in the three countries, across the Baltic Sea from Sweden and Finland, say they will stick to their course toward adoption of the euro. The exchange rates of the Lithuanian litas and the Estonian kroon were pegged to the euro in 2004, just after the nations joined the European Union. The Latvian lats was linked a year later.

Confidence Loss?

Without the peg, authorities say, the three economies would be in worse shape.

Latvian central bank Governor Ilmars Rimsevics said on Feb. 13 that devaluating the lats would swell debt, cause a “tremendous” loss of confidence and prompt Estonia and Lithuania to follow suit. Estonian Deputy Central Bank Governor Marten Ross agreed in a Feb. 19 e-mail, saying banks and exporters would be hurt most.

“Devaluation would not solve any competition issues,” he said. “Devaluation would postpone reforming uncompetitive companies or would force smart and competitive employees to seek work outside Estonia.”

Last year's currency support sent Latvia's central bank reserves down 25 percent. The Lithuanian central bank's foreign currency reserves have fallen 3.2 percent since August and Estonia's reserves have fallen 5 percent to $3.4 billion.

Retaining Euro Peg

Latvia, the only of the three countries to have gotten a bailout, got a bad deal from the IMF, said New York University's Nouriel Roubini. The terms retained the euro peg as long as the government reduced wages, raised taxes and slashed spending.

“The IMF made a mistake with the Latvia program of allowing them to keep the peg,” Roubini said in an interview on Feb. 4. “It doesn't make any sense because the currency is overvalued.”

That view is shared by Paul Krugman, a Nobel prize-winning economist who in a Dec. 15 commentary in the New York Times warned that Latvia may become “the new Argentina.” That country had a currency board and saw its peso plunge even after receiving an IMF loan.

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