Analytics, Economics, Inflation, Latvia

The British analysts points out that Latvia's decision not to devalue its currency raises the prospect of a sustained period of deflation and deep recession, writes LETA.

As Capital Economics points out, the current recession in Latvia has its roots in the country's massive current account deficit, which is indicative of an overvalued real exchange rate.

Economic theory suggests that two remedies to restore competitiveness – either a devaluation of Latvia's currency peg against the euro, or a fall in Latvia's wages and prices.

As part of the recent bailout package, Latvian policymakers persuaded the International Monetary Fund that the currency peg should stay. They argued, that a devaluation would lead to an explosion in debt defaults, given that a large chunk of the recent lending boom took place in foreign currency.

However, Latvia's chosen road means that the subsequent adjustment in the real economy will be long and painful. The government has already pledged to cut public sector wages by 15% and similar wage cuts in the public sector are likely to follow. Domestic demand looks set to contract by over 10% this year.

The Capital Economics analysts predict that prices could be falling at an annual pace of 5% by the end of this year, and will have a similar pace of decline in 2010. Sharper falls are possible. While maintaining of the lat's peg to the euro has avoided an immediate sharp rise in debt defaults, subsequent falls in prices will increase the real value of debt. As a result, default rates are still likely to rise significantly over the medium-term. Capital Economics estimates that more than 10% of loans could be bad by the end of the year, up from just 1% currently.

According to the experts, the short point is that regardless of the currency regime, the Latvian economy is staring into the abyss. If current trends continue, the analysts forecast a 15% contraction in output this year, and another five% next year.

Furthermore, growth may only turn positive in 2012, and is unlikely to return to its potential of around 4 to 5% much before 2014.

In total, output in Latvia could fall by more than 20% from peak to trough.

Capital Economics points out that an alternative scenario exists in which the currency peg collapses. In such a scenario, real GDP could contract by 20% this year, although growth could return to trend within two or three years.

The London analysts also point out that the currency boards in Estonia and Lithuania are also going to have serious problems.