Playing dominoes

Alasdair Macleod – 5 June 2009

I cannot recall a government bond auction that attracted no bids at all, that is until Wednesday when Latvia tried to raise the equivalent of $100m in short-term debt in its own currency, the lat. Let us understand this: it was not a foreign currency offering, it was local. The Latvian central bank did not ask foreigners to lend it some money, but its own citizens, and perhaps anyone willing to accept the implicit guarantee of the euro peg. The funds must be intended for the government’s own spending rather than currency support. One can understand people passing up on the peg guarantee, but is there really no one in Latvia willing to lend its own government a little money? Overnight interest rates rocketed to over 100% on Thursday, which tells us something.

Latvia, as the Americans might say, is seriously bust. It has a 20% trade deficit and private sector external debt of 130% of GDP. The IMF estimates Latvia’s GDP will decline 12% this year, the worst of the three Baltic states. This decline assumes no financial implosion, an assumption that for some time has looked optimistic. This is a sub-prime borrower on a national scale.

Devaluation of the lat is a racing certainty, which will increase the burden of foreign currency liabilities. It will also fuel the developing economic collapse, by accelerating the debt burden. In common with the other EU states with pegged currencies, Latvia’s private sector has borrowed heavily in euros and Swiss francs. This foreign currency lending to the Baltics has doubled in the last three years, illustrating how speculative the credit bubble became. The collateral is now collapsing in value, and the misery for the borrowers is about to be compounded by devaluation.

The other countries pegged to the euro are:

  • Estonia, with external private sector debt of 80%, and a forecast GDP decline of 10% in 2009.
  • Lithuania, with external private sector debt of 135%, and a forecast GDP decline of 10% in 2009.
  • Bulgaria, with external private sector debt of 110%, but a forecast GDP decline of only 4% in 2009.

If Latvia is driven off its euro peg, Estonia Lithuania and probably Bulgaria will follow. Foreign bank exposure to these four countries is approximately $100bn.

There is a second group of European states that has some benefit from floating currencies, which includes Russia but excludes Turkey, and owes $700bn to foreign banks. Their currencies have fallen, and consequently their economic prospects are generally less stark that those of the Baltics. However, in spite of the currency risk, the private sector in these countries borrowed heavily in rising Euros and Swiss francs.

Lastly, Euroland owes $900bn on a cross-border basis. This obviously includes loans from banks in one euro state to customers in another as well lending from outside the region. Cross-border lending within Euroland is as much of an issue as lending to Latvia. A German bank lending to a Spanish business or bank is a German problem.

So the apparent inevitability of Latvia going bust has a domino-like potential to tip three other pegged currencies over. In turn this could knock over the rest of Eastern Europe, with disastrous consequences for European banks, who have done most of the lending. Within the euro-bloc, the similarities with Latvia’s situation will not be lost on creditors for Spain, Ireland and Portugal. The dominoes are $100bn, $700bn and $900bn.

The consequences of this combined assault on the bank balance sheets in the core of Euroland does not bear thinking about. We may also be about to find out the economic folly of a system that removes the flexibility of monetary management from the national level, yet leaves the liabilities there. How for example is Austria to guarantee the Austrian banks’ exposure to eastern Europe, when it amounts to multiples of Austria’s gross national product? Who will bail out Austria?

Europe’s private sector lending risks degenerating into a policy of everyone to look out for himself. Greece showed this by recently telling its banks to restrict further lending to the Balkans. Bearing in mind that Greek banks are owed €53bn by south-eastern European countries, this policy represents an interesting gamble: do you support your foreign debtors, or do you cut and run? If you cut and run, you bankrupt many of your Greek trading customers – which is why many of the Greek banks got involved in the Balkans in the first place – and you incur the wrath of your own creditors, who do not want the cross-border boat rocked.

The EU’s view on Latvia is consistent with these fears. It feels that devaluation of the lat will rock the boat; better to keep fingers crossed and hope the problem will go away. Deep down lies the fear this could be a laboratory test for a wider European problem.

The IMF has taken a different view, advising devaluation. So long as Euroland is paralysed by indecision, the IMF is more likely than Euroland to come up with the required financial support for Latvia, so its view will prevail in the terms imposed, if Latvia doesn’t collapse of its own accord.

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Alasdair started his career as a stockbroker in 1970 on the London Stock Exchange. In those days, trainees learned everything: from making the tea, to corporate finance, to evaluating and dealing in equities and bonds. They learned rapidly through experience about things as diverse as mining shares and general economics. It was excellent training, and within nine years Alasdair had risen to become senior partner of his firm. Subsequently, Alasdair held positions at director level in investment management, and worked as a mutual fund manager. He also worked at a bank in Guernsey as an executive director. For most of his 40 years in the finance industry, Alasdair has been de-mystifying macro-economic events for his investing clients. The accumulation of this experience has convinced him that unsound monetary policies are the most destructive weapon governments use against the common man. Accordingly, his mission is to educate and inform the public in layman’s terms what governments do with money and how to protect themselves from the consequences.

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