UK ANALYST SEES LATVIAN DEVALUATION AS UNAVOIDABLE

UNCLAS LONDON 001321 SIPDIS E.O. 12958: N/A TAGS: EFIN ECON XH UK SUBJECT: UK ANALYST SEES LATVIAN DEVALUATION AS UNAVOIDABLE ¶1. (U) Summary: The Royal Bank of Scotland (RBS) foresees the devaluation of the Latvian currency as inevitable. RBS' Head of Central and Eastern Europe Middle East and Africa Research, Timothy Ash, told us on June 3 there is no way back for Latvia on the currency front. Ash maintained a move to devalue sooner vice later is better, particularly in an environment where the market is relatively risk-positive. RBS, house view is the current situation may provide an opportunity to use Latvia as a test case for the region getting off fixed exchange rate regimes. End Summary. ¶2. (U) Ash views the current Latvian central bank bleeding of foreign exchange reserves as unsustainable. In his June 2 Market Strategy report, he notes the Bank of Latvia has already intervened in recent weeks to defend the lat currency, and the resulting contraction in the monetary base has worsened domestic demand and public finances in the process. Though the current account is in surplus now, the budget deficit has spiraled out of control as revenues have collapsed. The original IMF program targeted a budget deficit of 4.9 percent of GDP, but the government appears to be now targeting a deficit of 9 percent of GDP, while European Commission (EC) forecasts warn of a deficit of 11 percent of GDP. If Latvia sustains its ratio of general government debt to GDP in excess of 50 percent into 2010, financing the debt will be difficult given that external and domestic markets appear closed to Latvia which leaves the country reliant on official financing, Ash stated in the Market Strategy report. In fact, on June 3 the Latvian treasury failed to sell any of its debt securities at an auction adding to the pressure to devalue. ¶3. (U) Ash acknowledges the mere fact that members of the current government have put out "feelers" over the options on the exchange rate regime front is a major worry, as it could spook depositors in the banking sector. While devaluation is not without costs, it would clear the air. Ash saw the decision to stabilize Latvian banks using IMF/EU funds as putting a "finger in a dyke" in the effort to prevent a domino-effect to other fixed exchange rate regimes in the region and to protect Western European, largely Swedish, banks. In hindsight, Ash finds that with the current pace of real GDP contraction and mounting fiscal problems in Latvia, a devaluation could not be much worse than the slow death being wreaked on the Latvian economy by fixed exchange rate orthodoxy. He foresees a potentially embarrassing scenario for Sweden if markets perceive Latvia,s real economy has been sacrificed for the stability of Swedish banks. Visit London's Classified Website: http://www.intelink.sgov.gov/wiki/Portal:Unit ed_Kingdom LeBaron