Why 23 October could be a bad day for the euro
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MoneyWeek Editor
John Stepek Oct 06, 2009
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The Irish voted for the Lisbon Treaty with a hearty 'yes' on Friday.
They didn't have a lot of choice. Or at least, they felt they didn't. Ireland is in a deep hole right now. Apart from pretty-much bankrupt countries like Iceland, Ireland is the developed economy which has suffered the worst in the financial crisis. And the last thing the Irish felt like doing was embracing wholesale change, which might make things even worse.
Of course, things are going to be painful for Ireland either way. No one can wave a magic wand and make the recession go away. But at least the EU can breathe a sigh of relief at wiping out another threat to the European project.
The real threat to Europe lies elsewhere...
How Latvia ended up in such a mess
Few countries are having a tougher time in this recession than Ireland. Latvia is one of them.
The Latvian economy shrunk by 18.2% in the 12 months to June. In other words, the country's economy is now nearly a fifth smaller than it was just a year ago. That's a lot to lose.
How did it end up in this mess? Latvia is a member of the EU, but has its own currency, the lat, which is pegged to the euro. Basically, the country fell victim to the "euro convergence" trade during the good times. This was the assumption by investors that most countries in eastern Europe would end up joining the euro, so therefore you could treat their obscure and previously somewhat dubious currencies as basically being just as good as euros.
This led to lots of foreign-owned banks piling into these countries – in Latvia's case, it was Swedish banks – offering cheap finance denominated in euros, or Swiss francs. Loose money led to property and other asset bubbles. Then when the easy money days vanished, so did the prosperity. And just like in Ireland, when you ripped the property bubble away, what you were left with was an uncompetitive economy with too-high wages and too much reliance on an over-inflated property sector.
Meanwhile, with foreigners unwilling to lend any more money to the country, Latvia has already had to turn to the International Monetary Fund (IMF) for a bail-out. It is currently being propped up with loans from the IMF and the EU.
Latvia has to devalue the hard way
Normally, what would happen in such circumstances is that a country's currency would collapse – like Iceland's for example. But Latvia is defending its currency peg because it has its heart set on euro membership. That means that it has to devalue the hard way – wages and prices have to fall to make the country more competitive. On top of this, to secure further tranches of lending from the IMF, the country is having to meet tough austerity measures to show that it's serious about repaying its debts.
But as Ambrose Evans-Pritchard has regularly pointed out in The Telegraph, this route out of a crisis is painful. And it's not the sort of thing that populations put up with for long.
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Already, Latvia's governing coalition is falling out over the austerity measures. Last month, the government failed to push through a property tax raise which was a key aspect of the EU and IMF bailout conditions. Then at the weekend, the government announced it would make budget cuts of 225m lats, rather than the 275m expected. The IMF has asked for a total of 500m in cuts.
If it doesn't meet these conditions, and the IMF decides to pull the plug, then Latvia can't continue to defend its currency peg, and it will basically go bust. And if the IMF ever felt over a barrel because of the risk to the wider global economy, it certainly doesn't any more.
As Lars Christensen of Danske Bank tells Evans-Pritchard: "They [Latvia] don't seem to understand that the IMF and EU are willing to walk away now that the global economy has improved and spill-over risks have been reduced." The Swedish press yesterday were reporting that Swedish finance minister Anders Borg had been holding secret talks with Sweden's big banks, Swedbank and SEB, to "prepare them for the fallout," says Izabella Kaminska on FT Alphaville. Borg has already warned Latvia that "lenders' patience is wearing thin".
However, the IMF and EU shouldn't get too complacent. If Latvia goes, we could see other countries in the region abandon their pegs and devalue too. And as the Asian crisis showed us all in the Nineties, when one domino topples, you can never be quite sure where the chain reaction will actually end. The IMF reckons that of all the banks in the world, Europe's are the ones sitting on the biggest pile of undisclosed toxic debts. A crisis in Eastern Europe could be just the thing to bring that weakness to light.
Why 23 October could be a bad day for the euro
The Latvian government has to submit its budget proposal for 2010 to Parliament by 23 October. If it doesn't come up with a suitably austere package, then we'll soon find out whether Latvian devaluation will end up being a storm in a teacup, or the start of something much bigger.
What does that mean for investors? Well, as my colleague David Stevenson pointed out yesterday (How to profit from a rebound in the dollar), everyone is rather gloomy about prospects for the dollar right now. At the same time, investors seem somewhat complacent about prospects for the euro, particularly in light of the Irish 'yes' vote. It's another reason to believe the dollar is overdue a bounce while the euro is overvalued - and a crisis in Latvia could be just the catalyst.
Then of course, there's the threat to the wider global economy. The Federal Reserve always said that the subprime crisis was a small, easily-contained problem. They were wrong about that. Those who think Latvia's problems will be easily contained could be just as badly wrong.
That's another reason to be cautious about prospects for stock markets. As we've said for a while now, investors should be very picky when choosing stocks. We've favoured big blue-chip defensive plays for a while now, but I've just been reading about an interesting stock-picking method based on looking at research and development spending. I don't have space to go into it in detail right now, but I'll have more from the chap behind the method, Dr Mike Tubbs, later this week – keep an eye out for it.
Our recommended article for today
Virtually every class of asset is rising as one at the moment. And that's not healthy, says Merryn Somerset Webb. Because when markets turn, they will all fall together. But there is one exception.
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