How Currency Devaluation Can Be A Bad Thing

Even as the dollar keeps hitting new daily lows, which continues being seen as a positive for the stock market, if not so positive for what little remains of world trade, not much has been said about the efforts by Latvia to do all it can to devalue its currency in the wake of a failed bond auction. The consequences are already metastasizing, as seen by the increasing volatility of related currencies, particularly the Swedish Krona which has been hit hard against the Euro on concerns of the country's exposure in Baltic states. Proposals by the Latvian government to rectify the lack of trust and to adopt a mortgage holder liability cap have not been met with enthusiasm. According to Commerzbank analysts any improvements attained from this, and other comparable devaluation approaches, would not achieve long-term goals and at best would result in short-term benefits. From Bloomberg:

A devaluation would still hit corporate loans and bring with it “a wave of insolvencies,” said Lutz Karpowitz and Antje Praefcke, Frankfurt-based currency strategists at Commerzbank. “Inflation would probably be even more difficult to get under control. The relief would be short-lived.”


The proposal by Prime Minister Valdis Dombrovskis on Oct. 6 to cap mortgage holders’ liability ignited speculation that the country’s authorities might be contemplating a currency devaluation by limiting the domestic losses that such a move would incur. Sweden’s krona dropped against the euro on concern the mortgage proposal may trigger bigger losses at the country’s banks, which dominate lending in the Baltic region.

With the EU, IMF and Sweden already very much pregnant in Latvia, compliments of a $11 billion bail out package, the fate of Latvia may be much more inversely aligned with that of the surging Euro than most expect. Ironically, a strong Euro is just what a weak Europe does not need, as already 20 of the bloc's 27 countries are projected to experiences budget deficits significantly above the Eurozone's statutory limit of 3% as seen in the graphic below:

And with the obvious implication that a regional devaluation would have adverse impacts for lender countries, the question becomes how long can a US-funded IMF (which in turns get its capital from foreign countries purchasing its bonds) avoid the dreaded contagion effect.

The Swedish banks that made euro-denominated mortgages would see foreclosures surge as fewer borrowers would be able to make payments. Latvia also would likely lose any chance of being allowed into the euro zone soon.

Yet one wonders just what is the tradeoff from a European perspective to keeping the Euro at such painfully high levels: with exports to the US becoming prohibitively expensive, and the possibility of a peripheral currency crisis looming, is the only benefit merely externalities to European capital markets courtesy of a surging US equity market? And the bigger question is how long before, finally, Europe realizes that relying on a US printing press, which in turn needs 100% backing from a stimulus heavy China, could prove dangerous to its health?