Surely, the pressure has only piled on since I last wrote about this only a few days ago (see links above). The Financial Times' blog Alphaville in this case personified by Izabella Kaminska has steadily been supplying us with the latest on the unravelling in Latvia. A particularly good piece hammers down the point that it is not only freelance bloggers such as yours truly who are questioning the Baltic (Latvian) currency peg but also, now, most professional analysts close to the situation. This is a called a market discourse and although the commitment to maintain status quo may be there one cannot make the waters go back.

However and to be fair to all parties it does seem as if the Latvian authorities got the best of the discourse this week if, that is, being the last one to shout constitutes an upper hand in this case. Consequently, both the central bank and the premier minister Valdis Dombrovkis issued strong statements to suggest that the peg will hold simply because Latvia is committed to seeing this correction through.

Latvian Prime Minister Valdis Dombrovkis pledged to push through budget cuts and ensure the inflow of international loan payments as speculation grows the Baltic state may devalue, threatening the economy of Sweden. “These rumors and speculations should finally be stopped” about the devaluation of the lats, Dombrovskis, 37, said in an interview with Latvian Independent Television today. The currency will not be devalued, he said, and the country will pass budget cuts needed to get the next tranche of money.

This is of course all well and good, but one has the distinct feeling that all this merely constitutes the inevitable last launches before the opponent finally lands the kidney blow to send you crushing into the canvas.

In terms of a more thorough look at the Latvian situation which goes beyond the immediate plethora of market jitter you could do a lot worse than visit Edward's latest post on this issue. As he sets out pointing towards, overnight interbank rates rose to a record of 20% this week and it suggest more than anything the stress being levied on the system.

Another particular issue Edward deals with is the risk of contagion and essentially fallout from a devaluation in Latvia. Certainly, this is an important question in itself but I also agree with Edward [1] in the sense that the immediate plunge in other CEE currencies not to mention the Swedish Krona following a Latvian devaluation is not really the main issue here.

For the record, I see no decoupling and a Latvian devaluation would clearly force others to do the same, most notably I would think Lithuania and Estonia. As for the ripple effects towards the entire CEE edifice, they are likely to be substantial although not necessarily catastrophic. The real issue we need to understand I think is that that IMF program has problems and that this will become clearer and clearer as we move forward. Edward points to one very important data point in the form of a real effective exchange rate where numbers have just been published in 2008 format.

This gives a very clear image of the amount of down scaling the Baltics, and indeed many of the Eastern European Economies, need. It is important to understand that there is a level effect and relative effect here in the sense that one thing is to correct relative to one's own past level, and quite another to correct relative to others. Consequently, this is a chronic problem all across Eastern Europe and thus everybody has to correct. In this sense, the IMF are submitting those with pegged exchange rates to a dose of "medicine" which is simply too strong and which the domestic "system" cannot muster.

So, my feeling is that all this goes beyond whatever effect currency speculation would have in the wake of a Latvian devaluation/default. There are clear signs that the "exit strategy" from this crisis is not working and it is next to scandalous that the IMF/EU do not realize that while these countries certainly need a strong dose of "stick" to get themselves on the right track we need to ensure that they are not obliterated over the course of the next year. I mean, this talk about Euro adoption in 2012 is just so silly and counterproductive since who the heck knows where we are in 2012. Who knows, for example, where the Eurozone itself is in 2012. Really, I cannot stress enough how these road maps of convergence need to be rethought since there has been a structural break. We need a new plan and one which factors in the change in environment.

Moreover, I think we have established by now that the Eurozone is no magic potion and in fact faces a series of very severe tests on Spain, Italy not to mention the mental crush it will be when Germany does not recover because I can tell you; in terms of domestic demand she won't.  Basically as I see it, the option has always been to "let the CEE in", but that would also take a much stronger coordination on the fiscal side and essentially joint European financing through Euro bonds. At the moment, this is far to big a step for the gents in Frankfurt and Brussels to consider.

So, no decoupling in an immediate devaluation context, but more importantly, I tend to look at this more structurally than a simple question of how much the e.g. Forint and Leu will fall in the context of a Latvian devaluation.

At the end of day, this is a question of swallowing those camels and accepting the idea that the current solution being applied is out of touch with reality. Essentially, I don't think the parties involved quite understand the structural damage many of the CEE, and Latvia in particular, have suffered. As per usual I am implicitly referring to the importance of factoring in demographics but then again; it is absolutely amazing that none of the presumed experts here have not added this variable to the equation yet. As Edward says towards the end in his entry ...

That is, the simple fact of the matter is that there is no exit strategy. The programme simply doesn't work. It is "over determined", since whichever way you look at it, there is always one more problem than there is solution. Gentlemen. I think its time to give up. Honourably, but to give up. Come on out of the bunker, white flags and hands in the air will not be called for. There's a world out here waiting for you, it's on your side, and there will be a tomorrow.

I couldn't have put it much better myself, I really couldn't.

---

[1] - There is a surprise :)

The year-ago level was about normal. In an economic boom, Dirk Van Dijk points out that capacity utilization gets up to about 85%, and historically a level of 75% indicates a very severe recession. We are in uncharted territory.

When looking at the global macro backdrop for industrial production and machinery orders amid weaker U.S consumption, we expect a continued slowdown in capital spending.

OPPORTUNITIES

While the credit crunch and slower economic growth dampens private sector spending, fiscal expenditures appear ready to play a counter-cyclical role. China announced a rather large stimulus package in November.

Also, the U.S Congress passed a stimulus package that President Obama signed on Tuesday, February 17, 2009. The bill contains money that will flow into infrastructure spending. The only issue is the timeframe of the spending. For example, according to CBO estimates, of the $27.5 billion in the budget for highway spending (Title XII - Transportation and Housing and Urban Development Highway Construction), $9.625 billion will be spent by the end of FY2010. This equates to 35% in the first two (FY) years and the remaining portion realized through the (FY) years 2011-2016.

Amid the current global economic slowdown, there may be a silver lining. Central bankers have gone from raising interest rates and fighting inflation to slashing rates and flooding the system with liquidity. Specifically, the U.S Federal Reserve has engaged in quantitative easing (QE). In March, the FED announced it would spend over $1 trillion to buy mortgages-backed securities, agency debt and Treasury securities. In our view, these monetary conditions have helped to put a bid into commodity prices. We would become more constructive on commodity stocks, such as Freeport McMoRan (FCX), on signs reflation measures were sustainable into 2010.

WEAKNESSES

We remain cautious on the U.S residential construction (& related) space. In our view, there is still too much existing and new home inventory to justify a new up-cycle in starts, which partially impacts the order flow of machinery companies that sell or lease equipment to the homebuilders. On the demand side, the combination of a weaker U.S labor market and the recent rise in mortgage rates (although from historically low levels) does not appear to add to the pool of available homebuyers.Zacks Investment Research

The year-ago level was about normal. In an economic boom, Dirk Van Dijk points out that capacity utilization gets up to about 85%, and historically a level of 75% indicates a very severe recession. We are in uncharted territory.

When looking at the global macro backdrop for industrial production and machinery orders amid weaker U.S consumption, we expect a continued slowdown in capital spending.

OPPORTUNITIES

While the credit crunch and slower economic growth dampens private sector spending, fiscal expenditures appear ready to play a counter-cyclical role. China announced a rather large stimulus package in November.

Also, the U.S Congress passed a stimulus package that President Obama signed on Tuesday, February 17, 2009. The bill contains money that will flow into infrastructure spending. The only issue is the timeframe of the spending. For example, according to CBO estimates, of the $27.5 billion in the budget for highway spending (Title XII - Transportation and Housing and Urban Development Highway Construction), $9.625 billion will be spent by the end of FY2010. This equates to 35% in the first two (FY) years and the remaining portion realized through the (FY) years 2011-2016.

Amid the current global economic slowdown, there may be a silver lining. Central bankers have gone from raising interest rates and fighting inflation to slashing rates and flooding the system with liquidity. Specifically, the U.S Federal Reserve has engaged in quantitative easing (QE). In March, the FED announced it would spend over $1 trillion to buy mortgages-backed securities, agency debt and Treasury securities. In our view, these monetary conditions have helped to put a bid into commodity prices. We would become more constructive on commodity stocks, such as Freeport McMoRan (FCX), on signs reflation measures were sustainable into 2010.

WEAKNESSES

We remain cautious on the U.S residential construction (& related) space. In our view, there is still too much existing and new home inventory to justify a new up-cycle in starts, which partially impacts the order flow of machinery companies that sell or lease equipment to the homebuilders. On the demand side, the combination of a weaker U.S labor market and the recent rise in mortgage rates (although from historically low levels) does not appear to add to the pool of available homebuyers.Zacks Investment Research

One thing which is certain at the moment is that the rumour mill is grinding hard and that it is very difficult to get a clear picture of what is going on. It is too cumbersome for me to go into the entire background here (I assume most of you are familiar with the Baltic and CEE situation), but if you want some background try this or this which will give you the opportunity to browse a myriad of articles. The situation is however pretty simple. Ever since it became clear that the Baltics was going to suffer not only a hard landing, but a veritable collapse on the back of the financial crisis one obvious question always was whether these economies could maintain the Euro peg throughout the correction process. So far the peg have held and the countries, as well as the IMF who have been called for aid, have been committed to the peg and thus the future entry in the Eurozone.

But this has come at a price and as international economics 101 tells us, the only way you can correct with a fixed exchange rate and an open external account is through deflation and a very sharp drainage of domestic capacity. And so it has come to pass that particularly in Latvia who has come under the receivership of the IMF the scew has been turned, (and turned and turned) and now the question is how much more can the public and the goverment take. In a recent article in the NYT the situation is well described as the Latvian government scrambles to meet ends on the IMF's pre-condition to continue funding the bailout programme.

One very significant indication that things are near its breaking point came when Central Bank Governor Ilmars Rimsevics launched the idea that, since the liquidity in Lati is being drained in order to keep the peg and because the cuts needed to abide by the IMF rules are immense, public employees might be submitted to receive their pay in "vouchers" in stead of actual Lati. As Edward points out, this is straight out of the vaults of the Argentian crisis' annals. This is one of the things you get with a peg maintained too tightly during a deflationary crisis. It deprives you from liquidity. Now, in some sense this all about the next installment of IMF funds of course and whether Latvia will (can) make the needed budget cuts to please the fund to such an extent that they will continue to slip the bailout checks in the mail.

Essentially, under the peg, the central bank has to buy Lati in the open market to maintain the peg since there is, naturally, a pressure on the peg as everybody want's euros. So, the central bank is forced to drain the economy from liquidity to maintain the peg in an environment where the economy is contracting at about 20% over the year. This is not fun and, as it were, not sustainable given the trajectory of these economies. In this sense devaluation is no cure but a simple prerequisite (and necessity) for the healing process to begin.

Even more significant it appears that the the foreign banks, so important in the Baltic story since they basically provided the liquidity inflows to fund the boom, are beginning to accept the basic point I, and others, have made so often before. This is the point that although a devaluation would entail default on a large batch of Euro denominated loans, this default would come in either case as a result of the utterly horrid contraction and the unsustainable builup of credit. In this sense it was very significant that the SEB Chief Executive Annika Falkengren pointed out;

"In total we would have the same size of credit losses, but (if there is no devaluation) they would be a little more regular and over a longer time frame," SEB Chief Executive Annika Falkengren told Swedish radio. "In the case of a devaluation they would be pretty much instantaneous."

This is important because one prerequisite for the peg to hold was always that the foreign banks explicity backed it since they pretty much finance the majority of the credit needed to hold these economies afloat and particularly so Latvia. Essentially, on the Swedish side of things it appears that they are pretty much treating this as over and done.

According to Dagens Industri' Torbjörn Becker, leader of the Eastern European Institute of the School, a devaluation is likely. "The alternative to a devaluation in Latvia is to wait until the reserve is drained and the economy will disappear into a black hole, " he told the DI. Torbjörn Becker believe that neighbors Estonia and Lithuania follow.

Moreover, the Riksbank just recently bolstered its foreign currency reserve with an amount equal to 100 mill SEK which can be interpreted as a precautionary measure to deal with a potential fallout in the Baltics.

The Executive Board of the Riksbank has decided to restore the level of the foreign currency reserve by borrowing the equivalent of SEK 100 billion. This needs to be done because the Riksbank has lent part of the foreign currency reserve to Swedish banks. We have also increased our commitments to other central banks and international organisations. The Riksbank needs to maintain its readiness to supply the Swedish banks with the liquidity required in foreign currency.

Finally, there is Danske Bank, aka Lars Christensen in the context of the CEE, who warns of a serious event risk in the Baltics in today's daily installment on emerging markets.

The event risk has risen sharply in the Baltic markets and we advise outmost caution. Yesterday, the Swedish central bank Riksbanken said it will increase its currency reserve by SEK 100 bn through a loan from the Swedish debt agency. Investors seem to believe that this is a buffer to deal with potential problems arising from the Baltic crisis.

(...)

With worries over the Baltic situation on the rise there is a significant risk of negative spill-over to other markets in CEE. Therefore we see clear downside risk on the CEE currencies and a risk of a sharp sell-off in the CEE fixed income markets in the coming days. We especially see value in buying USD/HUF, but potentially also USD/PLN on an escalation of the Baltic crisis.

Basically, the way I see it is that there is only so much the currency boards can do and in Latvia's case, after having already spent over 500 million euros buying lats, I think we are moving steadily towards the end game. Of course, there is an obvious risk that I will perish further down the road with this one, but then again, so be it. It is imperative that investors and stakeholders entertain the possibility of a multiscale Baltic devaluation and, obviously, a sharp CEE sell off in the wake.

Towards a Common European Answer?

As I mentioned last week, Q4 was an absolute horror story in terms of European data with an aggregate Eurozone contraction of qoq GDP standing at -1.5% as well as cartoonish numbers from Eastern Europe. Unfortunately, the abyss does not seem to be any less daunting one week later and if anything, it seems that the chasm may have widened. Consider for example that Ukraine's economy contracted a full 20% yoy as measured by, an adimittedly dodgy, monthly GDP estimate. It should come as little surprise that the country is now being put into spotlight for a potential sovereign default. At least, the latest brief on Eastern Europe by Danske Bank goes a long way to convince me that the end may soon come for Ukraine. Not only do we have considerable insecurity about the proposed IMF package negotiated earlier this year, the rating agencies are also naturally on high alert. Here is Danske;

The ratings agency Standard & Poor's this week warned Ukraine it could face another ratings cut, saying it distrusted Ukraines ability to implement a crucial IMF deal. The agency said it could cut Ukraine's B foreign currency rating and B-plus local currency rating by one or more notches.

Hence Ukraine's commitment to adjust is wavering against a backdrop of contracting growth, es-pecially in the manufacturing sector (industrial production dropped an exorbitant 34.1% y/y in January), and the upcoming presidential elections in January 2010. Recently an IMF mission failed to sign off on a first review of Ukraine's performances under the USD 16.4bn IMF pro-gramme during a recent visit, sparking fears of non-implementation. Ukraine says it may approach other countries including Russia for additional financial help.

 

Yep, it does not sound good and the prospect of Ukraine betting on the whims of Mother Russia certainly cannot be accommodative for foreign investors' willingness to finance the ballooning current account deficit (well, they aren't of course which is also why the Hryvnia is collapsing).

Further afield in the context of Eastern Europe it seems as people are finally waking up to the fact that the unfolding mess will need a common European response. There are of course obvious political reasons for this, but also in economic ones since if something is not done to stop the whirlwind it is likely that the European banking sector will get dragged down too due to their exposure to Eastern European economies. Edward simply notes that we should let the east into the Eurozone now as well as he has forcefully argued why we need a common EU bond scheme to get to heart of the problem with the widening of financing conditions for Eurozone economies. And don't for a minute think that EU bonds to help Italy et al. issue bonds to pay to clean up the mess has nothing to do with the CEE. Basically, contagion works in mysterious ways sometimes and with the amount of direct exposure of European banks to Eastern Europe sovereign debt ratings and spreads could easily be hit by this.  Today, FT's correspondent Munchau chimes in with a similar point. Once again, I think it is important to point out that if we let things go their own way, the whole European economic system is at risk. This view is further given life by Morgan Stanley in their recent installment on the Polish economy which, as the biggest CE economy, is also riddled with the same weaknesses as its peers. I would especially note the following bit which is a general and important point ...

The notion that the euro area (mostly made up of Western European countries) can just ignore the issues ongoing in Eastern Europe is fundamentally flawed, in our view, for at least two reasons. First, Austrian (mainly), but also German, Italian and French banks have lent aggressively in the region, and have an interest in ensuring that CEE can see through the current downturn. Second, the trade linkages between the euro area and Central and Eastern Europe have expanded significantly over the recent years: the euro area now runs a €50 billion annual trade surplus with the CEE (CE + Baltics + Bulgaria), by our calculations.

Alas, how many times have I not hoped that Trichet and his fellow chums in Frankfurt would pay just a little bit attention to the unfolding tragedy to the East. So far, they have stayed firmly in the Ivory Tower, but I reckon that this will change.

And don't think for a minute that the clock is not ticking. Last week also brought the news that the Latvian government has chosen to resign. Now, apart from likely confirming Manuel Alvarez-Rivera's prediction that Latvia is headed for an early election it also brings up the question of where exactly that political stability and will the IMF called for in connection to their policy of maintaining the peg is. My feeling is that the IMF has its credibility firmly on the line here, and one has to wonder how this idea about the policies demanding a strong political consensus fits together with what we are observing.

And the going is getting increasingly tough in key areas;

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.”

One has to wonder why there is such asymmetry with respect to the economies in Eastern Europe? I mean, Ukraine and Russia has been devaluing like there is no tomorrow and also the Forint has taken a solid beating. Even though the two former might be outside the IMF's definition of political will and stability I think we should remember two things; one is that the economies who are now devaluing in nominal terms will be Baltics' main competitors for exports and secondly, the adverse effect of balloning debt and bankruptcies will also ensue in the context of deflation to restore competitiveness. No easy solutions here, but if the Baltics are not accepted de-facto into the Eurozone I still hold that they will need to devalue.

The coming week will be interesting not least in relation to how European leaders respond to the realization that this now actually, and without doubt, demands a solution in which nations just as banks may need to be bailed out.

Getting to the Heart of the Matter on the Global Economy

Leaving the travails of the Eurozone and her Eastern brethren for a minute I was also positively surprised by a couple of well put points by two of the big boys in relation to economic punditry. Let us begin with Martin Wolf writing about the lessons to be derived from Japan in a world of balance sheet deflation . Now, the first thing to dispense is obviously what a balance sheet recession is [1]. Well, the term originates from from economist Richard Koo and basically advocates that in situations like this, a strong fiscal stimulus is the most effective remedy. I tend to agree here, but I will leave that discussion for. Rather, I would like to turn the attention to one of Wolf's last remarks with respect to summing up the global situation (emphasis added);

It is, for this reason [see the article], fanciful to imagine a swift and strong return to global growth. Where is the demand to come from? From over-indebted western consumers? Hardly. From emerging country consumers? Unlikely. From fiscal expansion? Up to a point. But this still looks too weak and too unbalanced, with much coming from the US. China is helping, but the eurozone and Japan seem paralysed, while most emerging economies cannot now risk aggressive action.

Where indeed Mr. Wolf where indeed. Regular and perceptive readers will know that this is one of my main hobby horses in the context of the global economy. In fact, as recent as two months I, sort of, took the same Wolf to task on his piece on global imbalances in which he argued that credit worthy surplus nations should put into place measures to expand domestic demand. As I pointed out at the time this may be easier said than done especially because there are underlying structural reasons as to why surplus nations cannot easily ramp up demand to suck up excess global capacity. I am happy to see Wolf framing the situation as he does here because it means, in my humble opinion, that it brings us one step closer to the understanding of what the heck is going on here.

Adding to the choir Paul Krugman also joins in on Koo and Wolf and apart from the standard fiddle about the importance of fiscal policy (which I agree with, remember) Krugman also makes another point. Quite simply, Krugman points towards the well known fact that whatever recovery Japan has had since 2000 it has been all about exports (and foreign asset income); and at the end we get this:

And needless to say, we can’t all export ourselves out of a global slump.

So, how does this end?

Needless to say I cannot answer the last bit, but I do think that we are making progress here since apart from a poor little graduate student (in applied economics of all atrocities) some of the big ones are making some crucial points about what exactly the underlying structural dynamics are here (hint: demographics!) Here is to hoping that the thinking is being stimulated across the board.

[1] For some wonkish background on balance sheet recessions and where it comes from, Oxonomics has some further info here.

You can even ignore the ever-popular gross domestic product (GDP).

Most of the indicators that the market relies on to forecast the future are worthless in this type of environment. The truth is the data coming out of the traditional economic indicators isn’t current. By the time it’s being reported, the information is already weeks or even months old.

If you want to know when the global slowdown that’s erased $28 trillion in wealth (so far) will finally reverse course, pay attention to the obscure Baltic Dry Index. And nothing else. Here’s why…

What Is The Baltic Dry Index?

Despite the name, the Baltic Dry Index has nothing to do with markets in Lithuania, Latvia or Estonia. Instead,…

``The effect of the financial crisis on the real economies of our main trading partners remained modest in the third quarter but will definitely increase,'' according to Martin Lindpere, an economist at the Estonian central bank. ``External demand is therefore expected to weaken in the coming quarters, and unfortunately, the contraction of the Estonian economy will accelerate.''

The central bank forecast suggests the Estonian economy may shrink between 1.8 percent and 2.7 percent this year, and between 2.1 percent and 4.5 percent next year. Really there is a high degree of uncertainty attached to next years forecast, since nobody is really sure at this point how bad things can get, either inside or outside the Baltics (Russia's economy is unwinding fast even as I write), or when exactly recovery will commence.

Quarter on quarter the economy contracted by 1%, following a revised 1.1% contraction in the second quarter.

All the signs are that the contraction may even accelerate in the fourth quarter. Estonian industrial output, which dropped 3.8 percent in September, has fallen in six of the seven months up to September, and looks almost certain to contract further in October-December . Likewise retail sales which have also been down for six of the past seven reported months.

More Trouble On The Way As The Currency Pegs Come Under Pressure


Lithuania, Latvia and Estonia mayall need to devalue their currencies over the next year as they seek to stave off a recession, according to a recent report from Bank of America Corp. With inflation still running at around three times the average rate across the 15-nation euro region and a slump in domestic demand that looks like it will be very hard to turn around amid the need to export may leave the Baltic states with little alternative but to abandon their currency pegs in the second half, on the view of David Hauner, a Bank of America strategist based in London.

``They will keep the pegs at the current exchange rates well into 2009, but reset the rates to devalue against the euro later, when markets have calmed,'' b Hauner said.

The Lithuanian litas and Estonian kroon have been little changed over the past three months based on their currency board systems that peg them to the euro at fixed rates. The Latvian lat is allowed to rise or fall 1 percent from a midpoint to the euro. The countries also participate in the European Union's exchange-rate mechanism, under which central banks must keep currencies within a 15 percent trading band against the euro.

Andres Sutt, deputy governor of the Estonian central bank, said the kroon's peg
to the euro will remain unchanged and that a devaluation would ``lack any
economic rationale.''

"The competitiveness of Estonian exporters has remained good; wage growth, inflation and loan growth have declined very rapidly, as has the current account deficit, lowering Estonia's dependence on external financing,'' Sutt said "The finances of banks operating here are also strong. All this characterizes the flexibility of the Estonian economy and its ability to adjust.''

In fact Estonia and Latvia continue to run a goods trade deficit, making it impossible to drive headline GDP growth from exports. Latvia's central bank Governor Ilmars Rimsevics also said ecently that "devaluation is an absolutely unrealistic scenario,'' while the Lithuanian central bank Governor Reinoldijus Sarkinas was cited by the Baltic News Service on August 19 as saying that the exchange-rate system "shouldn't change at all.''

Nonetheless the economic rationale for devaluation becomes more compelling by the day, as the Baltic countries if they are one day to enter the euro will need to do so at a much lower partity than the current one to be able to get growth in the longer term.

There are obviously two principal drawbacks to devaluation against the euro, the first of these is that foreign exchange debts will suddenly rise, and this is why the Baltic countries will undoubtedly need EU aid in sorting out the mess. Secondly there will be a delay in euro membership. Countries aiming to adopt the euro must spend at least two years in the Exchange Rate Mechanism, or ERM-2, to demonstrate the stability of their currency. Lithuania and Estonia began participating in the system in 2004, the same year they entered the European Union. Latvia joined a year later. If the Baltic countries devalue then the clock will need to be reset, but then again, eurozone entry with the economies in an economic slump (rather than a mere recession) does not seem to be an attractive proposition either. These economies will need time to get things straight again, so the delay in euro entry does not seem to be an inordinately large obstacle, in and of itself.

Lithuania's ambition to be among the first countries in eastern Europe to adopt the common currency was thwarted in May 2006 as inflation accelerated. Estonia and Latvia were also forced to delay the changeover, and of course it has been this whole process of delay that put the spanner in the works and has lead to the whole boom bust cycle taking the form it has, as euro membership ebbed off into the distance.

``If your real exchange rate is overvalued, there are two options: either devalue, or accept a recession to make inflation fall relative to the trading partners,'' Hauner said. ``So the Baltics have the choice between a deep
recession or postponing euro-zone accession. I think they will choose the latter.''

``We've been in close touch with the Latvian authorities for the past week and those contacts are continuing. We hope to be able to adopt a decision fairly soon,'' Todd told journalists at a Brussels press conference today.

``We don't need the money now,'' said Edgars Vaikulis, a spokesman for Prime Minister Ivars Godmanis, yesterday. ``We are just in consultations,'' he said. Turning to the International Monetary Fund for support in the future was also a possibility, he said.

``I can't say that Latvia won't go to the IMF for help,'' he said. ``The IMF will come with conditions, and one of the basic conditions will be to cut the social budget. I'm completely against taking from the IMF, unless the state becomes bankrupt.''

``The economic downturn, which is already under way, is now likely to be more acute than previously anticipated and thus have a negative impact'' on both banks' asset quality ``in the near future,'' Moody's said.

``In the absence of substantial and timely international financial support, Latvia faces the likelihood of a severe financial and economic crisis and a further downgrade of its ratings,'' Eral Yilmaz, associate director for Fitch's sovereigns group in London, said in a statement.

``The effect of the financial crisis on the real economies of our main trading partners remained modest in the third quarter but will definitely increase,'' according to Martin Lindpere, an economist at the Estonian central bank. ``External demand is therefore expected to weaken in the coming quarters, and unfortunately, the contraction of the Estonian economy will accelerate.''

The central bank forecast suggests the Estonian economy may shrink between 1.8 percent and 2.7 percent this year, and between 2.1 percent and 4.5 percent next year. Really there is a high degree of uncertainty attached to next years forecast, since nobody is really sure at this point how bad things can get, either inside or outside the Baltics (Russia's economy is unwinding fast even as I write), or when exactly recovery will commence.

Quarter on quarter the economy contracted by 1%, following a revised 1.1% contraction in the second quarter.

All the signs are that the contraction may even accelerate in the fourth quarter. Estonian industrial output, which dropped 3.8 percent in September, has fallen in six of the seven months up to September, and looks almost certain to contract further in October-December . Likewise retail sales which have also been down for six of the past seven reported months.

More Trouble On The Way As The Currency Pegs Come Under Pressure


Lithuania, Latvia and Estonia mayall need to devalue their currencies over the next year as they seek to stave off a recession, according to a recent report from Bank of America Corp. With inflation still running at around three times the average rate across the 15-nation euro region and a slump in domestic demand that looks like it will be very hard to turn around amid the need to export may leave the Baltic states with little alternative but to abandon their currency pegs in the second half, on the view of David Hauner, a Bank of America strategist based in London.

``They will keep the pegs at the current exchange rates well into 2009, but reset the rates to devalue against the euro later, when markets have calmed,'' b Hauner said.

The Lithuanian litas and Estonian kroon have been little changed over the past three months based on their currency board systems that peg them to the euro at fixed rates. The Latvian lat is allowed to rise or fall 1 percent from a midpoint to the euro. The countries also participate in the European Union's exchange-rate mechanism, under which central banks must keep currencies within a 15 percent trading band against the euro.

Andres Sutt, deputy governor of the Estonian central bank, said the kroon's peg
to the euro will remain unchanged and that a devaluation would ``lack any
economic rationale.''

"The competitiveness of Estonian exporters has remained good; wage growth, inflation and loan growth have declined very rapidly, as has the current account deficit, lowering Estonia's dependence on external financing,'' Sutt said "The finances of banks operating here are also strong. All this characterizes the flexibility of the Estonian economy and its ability to adjust.''

In fact Estonia and Latvia continue to run a goods trade deficit, ma