Latvia as the new Argentina redux

Has Paul Krugman been reading my stuff? He is certainly thinking like me regarding emerging market risk. He has a post today talking about Latvia as the new Argentina. He says:

I’ve been saying this for a couple of weeks, but Edward Hugh has the goods.

Hugh puts his finger, in particular, on one gaping hole in the logic of the opponents of devaluation. We can’t devalue, they say, because the Latvian private sector has a lot of debts in euros, and a devaluation would make it very hard for borrowers to service those debts. As Hugh points out, the proposed alternative — sharp wage cuts, and basically a major domestic deflation — will also make it hard to service those debts. In fact, I’d be a bit more specific than Hugh: other things equal, a nominal devaluation and a real depreciation achieved through deflation should have exactly the same effect on debt service (unless some of the debt is in lats rather than euros, in which case devaluation would do less damage.)

This looks like events repeating themselves, the first time as tragedy, the second time as another tragedy.

For those of you who have been reading my stuff regularly, I made a similar argument back in July in my post “Are the Baltics the new Argentina?“:

The Baltics are looking a lot like Argentina was before it collapsed at the beginning of the decade: fixed exchange rate, large current account deficit, significant foreign bank lending, overheating economy turning to bust.

This combination is a toxic mix that will certainly end in the disaster it did for Argentina. I have a vivid memory of being in Buenos Aires when workers were rioting in the streets, knocking over cars and setting them on fire. Foreign banks were littered with Graffiti, including the word “ratas,” scrawled across them. Many banks were shut down and closed and too many bank I could see had armed guards with submachine guns out front to protect them. I can’t say this same disastrous scenario awaits the Baltics, but things could get pretty dicey there in any event…

The Baltics have a lot of hot money invested in their economies as much of the lending growth came on the back of foreign financial investment. When distress hits, one should expect a giant sucking noise from foreigners repatriating funds. This will leave the Baltics subject to credit deflation just as the economy is entering recession.

When one adds the slow economy and the high inflation to a fixed exchange rate and high current account deficits it says: the Baltics do not have the appropriate fiscal and monetary policy for a fixed exchange rate.

One of two things must give: the exchange rate peg or the economy. In Argentina, it was both.

Make sure you read Edward Hugh’s analysis sourced below. It shows that the IMF has made a big mistake in NOT correcting the exchange rate disaster in Latvia.  As you can tell from my post in July, all of this was readily apparent months ago.  Don’t let anyone tell you otherwise.

With Hungary and the Ukraine also taking money from the IMF, the other Baltics in deep trouble and many more countries in peril, I fully expect Eastern Europe to be a problem. And for banks in Germany, Austria, Denmark and Sweden, loaded to the nines with loan exposure there, that spells massive credit writedowns and loan losses. Get ready.  It will happen.

Sources
Latvia is the new Argentina (slightly wonkish) – Paul Krugman
Why The IMF’s Decision To Agree A Lavian Bailout Programme Without Devaluation Is A Mistake – A Fistful of Euros