After a recent failed public debt auction, the authorities in Latvia are desperately trying to prevent a depreciation of the currency, the lat. The country’s predicament is similar to the one that faced Argentina in 2000-01: a severe recession driven by global financial shocks, a sudden drying up of capital inflows and the need to reduce a large external deficit worsened by an unsustainable currency peg. 

As in Argentina, the International Monetary Fund initially went along – somewhat uncomfortably – with the authorities’ strong preference for not letting the currency depreciate, in spite of its significant overvaluation. But a real exchange rate depreciation is necessary to restore the country’s competitiveness; in its absence, a painful adjustment of relative prices can occur only via deflation and a fall in nominal wages that will take too long and exacerbate the recession.