By now you probably know all you need to know about Too Large To Fail (Citigroup), Too Interconnected To Fail (AIG), and Too Many Potential Job Losses To Fail Before A New Administration Takes Office (GM). Almost all the bailout cases we have seen recently were some combination of the above and they generally shared the characteristic of being large relative to the US and perhaps global financial system. We have become accustomed to bailout increments in the hundreds of billions of dollars, and to periodically reassessing how many trillions have been committed by the Federal Reserve and others.
Today we received confirmation of something quite different: a bailout package for Latvia. Latvia is a small country (2.2m people) and it is receiving a loan of just $2.35bn from the IMF. The loan is obviously tiny compared with other bailouts (Citigroup received at least 10 times as much in November), but it is big in relation to Latvia’s economy – in IMF parlance, the loan is 1,200 percent (or 12x) Latvia’s quota. Quotas are based on the size of your economy, among other things, and it used to be that 3x quota was a big loan and 5x quota really raised eyebrows. (Iceland recently broke some records in this regard (official numbers here), and perhaps we are now in a brave new world where borrowing over 10x quota becomes more standard.)
We can scrutinize the full details of the program when it becomes public, but the press release already makes the key point quite clear,
The program is centered on maintaining Latvia’s exchange rate peg while recognizing that this calls for exceptionally strong domestic policies and substantial international financial assistance.
Latvia has laid claim in recent years to having the world’s most overvalued exchange rate, which is fixed (or pegged) against the euro. An overvalued exchange rate implies that you import more than you export, thus running a large current account deficit and needing a great deal of capital inflows. Latvia’s current account deficit peaked close to 25% of GDP (not a typo: twenty five percent), although it declined significantly over the past year. Capital inflows, of course, are sadly diminished in this environment and the country has consequently been losing reserves at an unsustainable rate (this is all in the IMF press release).
So Latvia will get a loan from the international community, via the IMF and through various bilateral add-ons, which will not require any adjustment of their exchange rate. This is good news for the Latvian private sector, which has borrowed heavily in euros and which would have great difficulty servicing its debts if there were to be a significant depreciation (i.e., what usually happens in this kind of situation.) But how is this possible?
It’s possible because Latvia is receiving an extraordinary level of support, a generous bailout by any measure – with what appear to be pretty easy conditions, i.e., not much of the “adjustment” that countries usually need to do when big credit booms end. Why would anyone do this for Latvia? The answer is (a) it is small, so this is not expensive, and (b) this (hopefully) prevents contagion to other emerging markets that have exchange rate pegs. Even if the risk of contagion is low, the cost of being extremely generous to Latvia is pocket change to the IMF’s shareholders. (Although do remember that over-generous and over-long support of exchange rate pegs can end in tears - see Mike Mussa’s book on Argentina for details.)
In effect, Latvia is Too Small To Fail. Or, if you prefer, Too Indebted In Foreign Currency To Devalue.