Wednesday, August 29, 2007

On financial storms

There had been some comparisons between Latvia's economy now and that of East Asian countries (e.g. Thailand) before 1997 Asian financial crisis. In both cases, the country experienced very fast economic growth and had a big current account deficit (10% of GDP in 1996 Thailand, over 20% in Latvia now). As we now know, Thailand's boom ended with collapse of its currency, baht and a severe economic crisis in the following years. Similar things happened in several other Asian countries, shortly after Thailand.

What does this mean for Latvia? Discussions with Edward Hugh lead me to exploring what economists think about the causes of 1997 crisis in Thailand. In particular, it lead me to this paper by Paul Krugman, written a few years after 1997.

Interestingly, I can relate Krugman's theory to what has happened in Latvia over the last 10 years. Krugman develops a mathematical model of country's economy which leads to a conclusion that it can be in two stable states:
  • high-trust state in which investment takes place and banks lend money freely;
  • low-trust state in which domestic businesses are nearly bankcrupt and banks are unwilling to lend them money.
The low-trust state sounds very much like Latvia of mid-1990s in which credit was mostly unavailable. The high-trust state is Latvia of today. In 1997, a sequence of unfortunate events lead Thailand's financial system to collapse from the high-trust state into the low-trust state. The consequences were felt for a long time: in 2005, the average income in Thailand was less than in 1997.

The positive message from Krugman's paper is that crises of this form are not inevitable. They don't automatically happen once the current account deficit exceeds some magic number. Rather, current account deficit (and also large debt in foreign-currency, another similarity between Thailand'97 and Latvia'2007) are signs that the economy is vulnerable and might be less able to withstand a sequence of unfortunate events ("financial storm") pushing it into a downward spiral.

I've tried to think if such a financial storm could occur in Latvia now. I think no. There are some substantial differences between Thailand and Latvia. I will write on those in another post tomorrow but the most important one is that Bank of Latvia has the reserves to maintain the current exchange rate between the Latvian lat and EUR. (Thailand's crisis started with Baht plunging from 25 baht/dollar to 56 baht/dollar.)


Anonymous said...

If I remembr correctly, the Argentine government also has the dollar reserves to maintain the dollar parity in 2001. But the exchange rate and economy still collapsed. Why? Mainly because of the appreciating dollar and the real economy's inability to live with such a highly valued currency. With A current account deficit of 24% of GDP, I suspect Latvia faces the same fate. The country needs to export more, but its currency is pegged to a rapidly appreciating euro. I think this is unsustainable. Moreover, most of the capital need to finance the current account deficit is coming from other European banks. Surely the capacity of these banks to continue proviiiding credit on this scale has been eroded by the recent turmoil in credit markets? I thing the possibility of a severe and deep financial and economic slump in Latvia is very real.

Latvian abroad said...

Argentine in 2001 might actually be a good comparison. I think Latvia is not at that state yet. (The Argentine crisis was preceded by 1-2 year long downward spiral. Latvia is certainly vulnerable to a downward spiral of similar type, because of all the things you mentioned, but the spiral has not started yet.) Could Latvia get there in 2 years? It's possible, although I hope it won't happen.

Walter said...

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