How Latvia's debt problems mean a crisis for us all
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Associate Editor
David Stevenson Jun 05, 2009
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Latvia: not so very different from the UK
In the boom times, if you read a headline about the implosion of a relatively obscure Baltic Republic, you'd probably shrug and brew another cup of tea.
Not today. The news that Latvia has become the first EU country to face a sovereign debt crisis means you should pour yourself a rather stronger drink. This one bad apple could spoil the whole European financial barrel.
And when you hear bankers claiming a situation is under control, you really start worrying about how far the damage could spread…
Yesterday in London, it was quiet. The Bank of England base rate stayed unchanged at 0.5% and a little more new money was minted. And it was a similar story at the European Central Bank in Frankfurt – no change to euro rates either.
Yet over at the Riksbank in Stockholm, it's been panic stations. Latvia, just across the Baltic Sea, has been trying to raise cash to fund its surging public deficit. And it failed to raise a penny, or in Latvia's case, a 'lat', in its latest treasury auction.
Why? Latvia is in big trouble – its foreign debt needing re-funding this year is equal to 320% of GDP, says Fitch Ratings. And international investors didn't want to lend any more. If Latvia can't somehow cadge the money it needs, either the IMF – which is already imposing bailout terms - steps in, or the country goes bust.
How Latvia's crisis threatens Europe
What is so spooking the Swedes? Their banks have been very large lenders to the Latvians. The Riksbank reckons Sweden's Latvian loan losses could hit £14bn over the next two years.
Yet Stockholm's central bank has still said that its country's lenders "have sufficient capital to meet larger losses than this, and are well-capitalised in an international comparison".
But when the authorities – the Swedish Finance minister's been singing the same 'we can handle it' tune – tell us a problem's under control, usually it's time to worry. Remember US Fed chairman Bernanke's first guess on the US sub-prime problem "in the order of $50bn-$100bn"? Don't think so, Ben.
So what are the big risks building up in Latvia? The country wants to join the euro, but that's gone very much on the back burner. The economy is collapsing – GDP plunged an annualised 18% in this year's first quarter, the worst recession in the EU – so a crushing currency devaluation is much more likely. That's the only way to make the country's exports more competitive by reducing their cost to foreign buyers.
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Foreign exchange forward rates were yesterday indicating that the lat's value will more than halve against the euro within a year. That would massively hike Latvia's external debts – halving your exchange rate doubles your liabilities – and also the risk of the country defaulting. So Swedish bank losses could prove much higher than the Riksbank has said, which could threaten their own solvency.
Indeed, now Sweden "is preparing to nationalise its sick banks", says The Telegraph's Ambrose Evans Pritchard this morning, "raising fears that a string of Western European countries could face similar fallout from rising defaults in the former Communist bloc".
Investors therefore have three reasons to be worried.
The Latvians are not so different from us
Firstly, Latvia's woes reveal what happens when a country's debt millstone really drags it down. House prices have crashed 50%, says Evans-Pritchard, a third of the country's teachers are being fired and public salaries will be slashed by 35% to meet IMF demands.
Yet although Latvia's government spending shortfall as a percentage of GDP is high at 9.2%, it's not as bad as either the UK or the US. Both are heading for double-digit state deficits. And both have had recent brushes with rating agencies about their own credit scores being cut. If that happened, international confidence would wither and both would have to pay higher interest rates on their government bond issues to fund their state shortfalls. Maybe that looks a long way off. But as Latvia shows, the wheels can fall off fast. It certainly points to investors not holding gilts or US Treasury bonds.
The next credit disaster looms
Secondly, even if a Latvian bust won't nuke the whole system, it can still do serious damage. "Latvia has vast repercussions for the region", says Bartosz Pawlowski of BNP Paribas, "if the currency breaks in Latvia, it's likely to break in Estonia and Lithuania, perhaps Bulgaria, affecting other countries like Romania".
In other words, Europe's own sub-prime disaster is brewing. With £1.3 trillion of exposure to Eastern Europe, Western European banks are set to stack up enough losses to keep them in the recovery ward for years. That would cripple their ability to make future loans – and be very bad news for the eurozone, as well as the share prices of 'cyclical' stocks which need an economic rebound.
And thirdly, Eastern European investors beware. After big recent stock market rallies, several emerging market cheerleaders are very keen to sell their funds to you. But as Roger Guy of Gartmore tells Citywire, there are still big problems in Eastern European markets: "asset prices look quite overvalued in a lot of countries".
But he does believe there is "tremendous opportunity in defensive stocks" – those that don't need economies to improve to make money. As we pointed out yesterday: Six recession-beating stocks that still look good, that's where we'd much rather have our money right now, too.
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