Is the fixed exchange rate regime sustainable?
Overview:
Latvia has experienced a massive economic boom in the last decade. This growth was facilitated by loose fiscal and monetary policies, huge capital inflows and a massive credit boom. This has led to serious economic imbalances: high inflation; inflated asset prices; a very large current account deficit; an overhang of short-term external debt and serious mismatches in the banking sector. The boom had already started to turn to bust in late 2007. The onset of the more severe phase of the global financial crisis from September has transformed a severe downturn/asset price adjustment into a potential threat to the fixed exchange rate regime and the stability of the banking sector. The approval of a large (EUR7 billion) international financial package helps but the sustainability of the exchange rate regime remains in question.
Recommendation:
The new economic program is centred on the maintenance of the fixed exchange rate regime despite evidence that the Lat is overvalued. The strategy of a sharp economic adjustment and swift adoption of the Euro may work and has strong support internationally but is nonetheless risky. Achieving a real exchange rate adjustment without moving the nominal exchange rate is difficult and will require sustained political support and no further negative shocks. We are therefore underweight on Latvian local and foreign currency assets.