Here is a full version of Roubini's piece from the Financial Tiems
Latvia’s currency crisis is a rerun of Argentina’s
By Nouriel Roubini
June 10, 2009
After a recent failed public debt auction, the authorities in Latvia are desperately trying to prevent a depreciation of the currency, the lat. The country’s predicament is similar to the one that faced Argentina in 2000-01: a severe recession driven by global financial shocks, a sudden drying up of capital inflows and the need to reduce a large external deficit worsened by an unsustainable currency peg.
As in Argentina, the International Monetary Fund initially went along – somewhat uncomfortably – with the authorities’ strong preference for not letting the currency depreciate, in spite of its significant overvaluation. But a real exchange rate depreciation is necessary to restore the country’s competitiveness; in its absence, a painful adjustment of relative prices can occur only via deflation and a fall in nominal wages that will take too long and exacerbate the recession.
Draconian cuts in public spending will be required if Latvia is to improve the current account. But this is becoming politically unsustainable. And while fiscal consolidation is needed – as Argentina found in 2000-01 – it will make the recession more severe in the short run. So it is a self-defeating strategy as long as the currency remains overvalued.
Of course, as in Argentina, letting the currency depreciate would lead to massive negative balance-sheet effects. The large foreign liabilities of households, companies and banks are in foreign currency; the real value in local currency of such debts would increase sharply after a devaluation. Devaluation may therefore lead to default by many private sector agents – and as the country’s banks are local subsidiaries of Swedish banks, a financial meltdown in Latvia could prove damaging for its neighbours.
Nonetheless, devaluation seems unavoidable and the IMF programme – which ruled it out – is thus inherently flawed. The IMF or the European Union could increase financial support for Latvia but, as in Argentina, this would be throwing good money after bad. International resources are better used to mitigate the collateral damage of depreciation.
An introduction of the euro immediately after devaluation could help prevent the exchange rate from overshooting, although it would require the eurozone to admit a country that does not yet satisfy the formal criteria for membership. Euroisation after depreciation is a more credible strategy for Latvia than dollarisation would have been for Argentina, as Latvia was on its way to membership and its business cycle is highly correlated with that of the EU. Euroisation without depreciation will not work, as a real depreciation is necessary to restore competitiveness. Of course, any depreciation – with or without euroisation – will make many foreign currency debts unsustainable and will require a forced debt restructuring, as in the case of Argentina.
To minimise the risk of contagion, the best strategy may be: depreciate the currency, euroise after depreciation, restructure private foreign currency liabilities without a formal “default”, and augment the IMF plan to limit the financial fallout. It is a risky strategy but – as in Buenos Aires nine years ago – when plan A does not work it is time to move to plan B sooner rather than later. Delaying plan B would only cause a bigger blowout when the unavoidable currency crisis eventually occurs. It is to be hoped the lessons of Argentina in 2001 have been learnt.
Latvia’s authorities are trying desperately to prevent depreciation by intervening in the foreign exchange market. While the very thin interbank market slows down the rate at which domestic and foreign financial institutions can short the Latvian currency and put pressure on the central bank reserves, the country is bleeding forex reserves at an alarming rate. Only a miracle or some draconian and credible fiscal adjustment (that does not exacerbate the recession) could restore the peg’s credibility and lead to a growth recovery.
At this point, a currency and financial crisis is pretty much unavoidable; the issue is how to minimise the domestic and international costs of the needed change in the policy regime. As the experience with Argentina suggests, procrastinating will make the unavoidable crash – and the regional contagion – even more dramatic and costly.
The writer is a professor of economics at New York University’s Stern School of Business and chairman of RGE Monitor