Ilmārs Rimšēvičs: Standing firm against manipulations with Lats' exchange
rate
Article by Mr Ilmārs Rimšēvičs, Governor of the Bank of Latvia, published in the daily Diena on
16 February 2007.
* * *
Economists are currently discussing ways to improve the ability to compete of the Latvian
economy and they are right to do so because it is being undermined by high inflation. Morten
Hansen from the Riga School of Economics has also devoted this issue a great deal of
thought, sharing some of his insights with the readers of the newspaper Diena (10 February).
The Latvian economy is still the fastest growing economy in the European Union and that should make
us happy because our standard of living is raised. The downside, from the macroeconomic
perspective, is that the speed at which we are traveling can be compared to driving at 200 kilometers
an hour, because it is accompanied by high inflation, record high prevalence of imports over exports
(current account deficit), decreased ability to compete, a fast growing foreign debt. For quite a while
now, the main problem of the Latvian economy has been the overly high domestic demand that
exceeds supply; the economists call it "overheating" of the economy. The budget deficit is also too
high for this juncture in our economic development: we are not saving for the moment when the pace
of the economy will abate. Estonia, where the situation is very similar, last year recorded a budget
surplus of 3% of GDP.) If we fail to have a firm grip on the steering wheel and we dismiss the danger
of driving too fast, our breakneck speed can land us in a ditch!
We can only regret that Mr. Hansen has not applied his theoretician's savvy to come to the aid of the
Latvian economic policy makers: to specify the list of tasks that would allow the excessively rapid
development to slow down so that Latvia would continue to develop in the long term with a yearly
growth of 6-7% instead of running the danger of overheating as is obvious from the estimates of the
last quarter of last year. It would have been wonderful if Mr. Hansen had made use of his teaching
skills, which involve the ability to get things across with ease, to remind us that in the marathon
distances - in our case, approximating the level of European standard of living - sprinter's tactics are
of no use.
In such a list, there would be tasks that produce immediate results along with ones where the results
would be seen after several years. As a Scandinavian, Mr. Hansen could have reminded us, inter alia
of the unpleasant consequences - price adjustments - after the real estate bubble burst in the Nordic
countries at the beginning of the 1990s He could have reasonably suggested that the government
agenda should include a surplus budget sooner than is currently planned and a balanced budget as
early as 2008 instead of 2009-2010. By way of illustration, he could have shown the real possibilities
for slowing down the growth rate of lending, one of the drivers of high inflation, as they have been
used in other EU member states, including Ireland. Mr. Hansen could surely have talked about the
promotion of exports and strengthening of domestic competition, including increasing the number of
small and medium businesses and augmenting their efficiency as essential for the stability of the
economy and currency. Finally, he could have discussed restructuring Latvian exports to the
advantage of goods and services with a higher value added, which would have a strong beneficial
impact on the ability to compete.
Instead, the economist has regrettably chosen another route: to play with fire in the pages of Diena
and to frighten the population of Latvia. As a solution for the loss of ability to compete he offers
devaluing the lats, i.e. reducing its value. His pronouncements have not gone unnoticed in the public
space and for that reason I will henceforth outline the central bank's position on this issue. The loss of
ability to compete is a factor that is unequivocally detrimental to the Latvian economy: we are in full
agreement here, yet I categorically oppose his suggestion that devaluation would be the right
medicine here. It would be poison!
What consequences would devaluing the lats produce? Reducing the value of the lats would drive the
prices up even more and everybody would be affected. Imported goods, raw materials, energy would
all become more expensive. The potential relief to entrepreneurs would thus be short lived or
nonexistent. The rise in the standard of living would become more remote because the value of
savings in lats would decrease accordingly. In addition - and this is of crucial importance - confidence
in the lats as a payment and savings instrument, which has taken years to build, would disastrously
diminish both in Latvia and abroad.
About 75% of the loans granted to Latvian households are in euro whereas the income is in lats.
Should the lats be devalued, the burden on those loan recipients whose liabilities are in euro but
income in lats would increase dramatically: it would take more money to buy a euro. Anyone who
speculates, albeit theoretically, about devaluation of the lats, should be aware that it would lead to a
dead-end.
Whereas foreign experts keep devaluation in mind as an instrument that can be applied if necessary to
restore the ability to compete, my opponent goes much further than that: he claims that devaluing the
lats is unavoidable under the conditions of excessive inflation and loss of ability to compete. On the
contrary: a stable and unchangeable lats exchange rate in under such conditions serves and will
continue to serve as an automatic stabilizing and inflation-suppressing factor. I would also like to
remind any hotheads that only the Bank of Latvia can make the decision to devalue: not the
government. During my tenure as the chief officer of the Bank of Latvia it will not happen. On 31
January, the foreign currency reserves of the Bank of Latvia amounted to 2.4 billion lats. The Bank's
foreign reserves exceed the amount of lats in circulation and thus we would be quite ready and able to
exchange even the entire amount of lats in circulation for foreign currency in accordance with the
exchange rate as set by the Bank. Mr. Hansen is fully aware of this.
In conclusion, I would like to express confidence that the discussion about balanced development of
the Latvian economy in the long term will continue and that the set of measures that will be undertaken
in March under the auspices of the minister of finance and aimed slowing down inflation will prove
successful.