March 21, 2007
The economy’s dramatic expansion – 12 per cent in 2006 – has been at the expense of macroeconomic stability. Real wage growth has encouraged rampant domestic demand, exports are losing competitiveness, and the current account deficit has breached 20 per cent of gross domestic product. Meanwhile, high capital inflows have spurred unprecedented lending growth. Domestic credit to the private sector and non-bank public sector, just 18 per cent of GDP in 2000, is likely to exceed 100 per cent of GDP within the next two years, according to Standard & Poor’s.
The currency’s peg to the euro has provided the country with much-needed stability – after Russia’s 1998 default, most crucially – but has restricted the central bank’s ability to use monetary policy to reduce demand and inflation. It has also encouraged the credit boom by reducing borrowers’ exposure to foreign exchange risk. Moody’s says Latvia’s $20bn external debt equates to over 100 per cent of GDP, 43 per cent of it short-term and owed by the private sector.
Paradoxically, the nature of some of the cheap bank financing actually provides reassurance that the economy is not about to implode. Much of it is externally funded by loans to Latvian banks from their overseas parents – these are unlikely to be withdrawn even if servicing them becomes a problem. There are other comforting signs. Unlike in many Asian markets in 1997, Latvia’s banking system is reasonably transparent and well-supervised. In addition, the government has very little net debt, giving it some flexibility to help out if, say, the private sector was forced into widespread default in the event of a devaluation.
That said, although Latvia in 2007 may not be Thailand in 1997, there are worrying similarities. Maintaining a currency peg depends not just on economic fundamentals but, crucially, on confidence. After Thailand’s currency peg broke in 1997, its currency lost more than half its value in the following six months. Such an extreme precedent should remind the Latvian government that bolstering confidence has now become its main task.