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 2000-2001: 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.
Draconian cuts in public spending will be required if Latvia is to improve the current account. But this is becoming politically unsustainable. And while fiscal consolidation is needed – as Argentina found in 2000-2001 – it will make the recession more severe in the short run. So it is a self-defeating strategy as long as the currency remains overvalued.