Analytics, EU – Baltic States, Financial Services, Latvia, Lithuania

“It’s primarily a political issue” rather than a case of “running out of funding,” the bank’s London-based emerging markets economist David Hauner said at a press conference on July 8. “The adjustment the economy needs to undertake,” including wage cuts of about 30%, “is going to be politically very tough to sustain. We therefore think the government will reconsider keeping the exchange rate where it currently is.”

Speculation that the Baltic nation may be forced to scrap its fixed exchange-rate regime has grown in the past month, though the government and central bank have ruled out the move.

Prime Minister Valdis Dombrovskis has cut wages and spending to bolster competitiveness and rebalance the economy, rather than achieving those goals by allowing the lat to move freely. Latvia is a member of the pre-euro exchange-rate mechanism and defends a 1 percent band around a target rate to the euro.

Any devaluation will cause “a pronounced fallout” for other eastern European nations with fixed exchange-rate regimes, such as Estonia, Lithuania and Bulgaria, Hauner said.

In the case of a Latvian devaluation, the European Union and the International Monetary Fund “will need to provide very credible support packages for the other countries,” Hauner said. Bulgaria and Estonia are likely to be able to maintain their pegs, while Lithuania “is the second candidate” for devaluation, Hauner said.

Bulgaria, Lithuania and “possibly” Estonia will probably ask the IMF for a rescue package before the end of the year, Hauner said.