EVT #6: Will this be the next crisis?

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Last week I briefly mentioned that Latvia was in trouble, as it was coming under speculative attacks designed to devalue its currency. This week, I'd like to talk some more on this subject because I think that this event has the potential to trigger a serious crisis with Europe-wide consequences .

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The story so far

As you may already know, after breaking free of the Soviet Union, Latvia (along with Lithuania and Estonia), enjoyed years of relentless growth as its economy was integrated into the European Union, and its currency was pegged (fixed) to the euro in preparation for monetary union and even closer economic integration.

One unintended consequence of the peg however, was a surge in foreign currency borrowing. This helped to boost consumption, and fuelled a housing bubble that rivalled the housing bubbles of Britain, Spain and Ireland.

Basically the fixed exchange rate meant that Latvian consumers could borrow cheaply in euros or Swiss francs without having to worry that the lats (the Latvian currency) would weaken, and increase the amount of money they owed. Unsurprisingly, they took full advantage of this cheap money - private external debt hit 130% of GDP at the end of last year.

As well as this orgy of consumption and borrowing, the fixed exchange rate also meant that goods produced abroad were suddenly affordable. In fact, they were both cheaper and of better quality than locally produced ones. As a result, Latvia's current account deficit hit 25% of GDP. To put that more simply, Latvia was consuming 25% more than it produced.

If Latvia had had a flexible exchange rate then the currency would have fallen in order to adjust these imbalances. Foreign imports would have become more expensive, allowing local producers to compete; borrowers would have taken out loans in the local currency with its higher interest rates; and exports would have become more competitive. However, the fixed exchange rate prevented any devaluation and so worsened these imbalances.

So why on earth would anyone run a fixed exchange rate? In its defense, a fixed rate helps keep inflation low and therefore helps to improve standards of living. As those who lived in South America in the 1980s can attest, inflation can have very painful consequences.

The result

However, Latvia's not having much fun either at the moment. The recession has hit the country incredibly hard. GDP shrank at a rate of 18% a year (yes 18%! And you thought we had it bad here in Britain with GDP down 4.1%!). This was simply because the fixed exchange rate led to a major loss of competitiveness, exacerbated by the depreciation of other eastern European currencies. On top of that, a couple of banks also collapsed under the weight of their bad loans.

Unemployment has hit 14% already and the public sector deficit is 10% of GDP. The currency has also come under speculative attacks, with people trying to sell the lats before a possible devaluation (something similar happened to the pound in 1992). The central bank has been forced to spend vast sums of its reserves to support the currency; last week alone it spent €240m (not a small amount for a country of this size).

The central bank's actions also have an unintended consequence. Because the central bank buys lat and sells foreign currency, the money supply shrinks in other words, lats are sucked out of the economy.

This is exactly the opposite of the quantitative easing policy operated by the Bank of England. It is basically reducing liquidity in the system, and therefore the economy is further weakened by the lack of credit.

The International Monetary Fund has already intervened and has granted a $2.4bn bailout package to try to stabilize the economy. Parliament has also done its part by cutting the budget deficit including a 20% cut in salaries for public employees.

What can happen now?

I see two scenarios. Both are linked to the exchange rate and both are ugly.

1) The exchange rate peg stays and the economy adjusts through deflation.

In this scenario, salaries and prices have to fall to a level where the economy becomes competitive again. As a result, we'd still see higher default rates on loans, as debt servicing costs would account for a larger share of income, and economic activity would shrink further while unemployment could rise further.

This scenario is basically the deflationary spiral that Gordon Brown has tried so hard to avoid. Imagine if your salary was cut by 20% and your mortgage and the prices you pay stayed the same. Not a pleasant idea, is it?

Past examples of this are very rare, simply because the population gets very very angry and a revolution generally follows. Argentina followed a similar pattern between 1999 and 2002 and we all know how that ended. It also occurred in the US between 1929 and 1933, and in Italy between 1926 and 1929 (I include Italy simply because my great granddad went bust and lost a large farm, a brick factory and a cheese-making plant in northern Italy when Mussolini decided to fix the exchange rate of the lira at 90 to the British pound, which back then was the leading currency).

That's the first scenario.

2) Latvia abandons the peg and the economy adjusts via the devaluation of the lats.

This scenario could be the less painful of the two, but it would have other nasty consequences. Lenders to Latvia would have to recognize losses straight away and default rates could still soar. Economic activity would restart as the economy regained competitiveness. Inflation would rise as the price of imports picked up, but unemployment may well fall. Something like this happened last year to the UK when the pound fell by 20% against all major currencies, which helped to soften the recession here.

What could be the consequences?

That sounds like a more attractive option for Latvia. But assuming that devaluation is the most likely scenario, the consequences could reach far beyond Latvia's tiny territory. The first hit would be Sweden because Swedish banks are the largest lenders to Latvia and the other Baltic states. Swedbank (Stockholm: SWED-A) and SEB Banken (Stockholm: SEBA) have made more than €33.7bn of loans to the Baltic states.

A devaluation might not be enough to bankrupt the Swedish banking system but it could still pose serious problems, and indeed the markets have already started to push the Swedish krona and the Swedish banks lower.

A more worrying development could be contagion. A devalued Latvian lats could attract speculators to bet on the devaluation of neighboring currencies like the Estonian kroon or the Lithuanian litas, or even of countries further afield that are pegged to the euro, such as the Hungarian forint or Bulgarian lev.

Devaluation in itself wouldn't be so terrible if debt were denominated in local currency and held by local investors for example, Italy and the UK devalued in 1992 without particular problems - but the fact that most of the debt taken out by these countries is denominated in euros and is held by foreign banks (Swedish, Austrian, French, Italian and German banks in particular) makes for a particular explosive mixture.

If a country devalues then its creditors would be forced to recognize the losses straight away. This would hammer their capital and raise the possibility of a second banking crisis, especially because total lending to eastern Europe is more than €200bn. Latvia is a small country and could be easily rescued, but if more countries run into trouble then the bill could be very expensive and could lead to in-fighting within the European union. Most of the countries I mentioned have the same problems as Latvia - overheated property markets, large current account deficits, hefty borrowings and fixed exchange rates.

An event of this magnitude would be sufficient to cause a sell-off in the stock markets, especially after the second-quarter rally. The mood would surely change and people would realize there is more pain to come.

There's also an extreme possibility which has a very very low chance of happening - but it's nevertheless worth mentioning and considering.

As you know, the Baltic states have a large Russian minority (as in Georgia) and Russia is keen to reassert its power and prove to the world that it's still a superpower. In extreme economic crises, populations tend to take to the streets (as happened in Argentina in 2001 or in Greece last year). This popular anger could easily be redirected towards the Russian minority - and as you can well imagine, this could provoke a Russian intervention in one of the former satellites.

This is a very remote possibility but such is the economic uncertainty that it should be kept in consideration. If anything like this happened I imagine that the European markets and the euro would plunge.

Finally if you are asking why UK and US banks are not exposed to this the answer is very simple frankly they had enough "crap" they could finance at home. They could lend on subprime , leveraged buy outs (subprime for private equity firms, basically), commercial property and so on. They didn't need to chase lending abroad, unlike their continental counterparts who had a surplus of savings at home and no one to lend it to.

The crucial question: how do we make money out of this?

We don't know exactly which way this situation will go, or exactly when Latvia's woes will reach crisis point. So for the moment, I'm just monitoring the potential ways to play the situation. But so you can get a handle on the thought processes involved in picking promising trades, here are some of the angles I'm looking at.

1) The easiest way would be to join the speculators and short the currencies of these countries. However this is pretty tough. Lats, kroon, litas and lev are thinly traded. Your best option could be the Hungarian forint as it's marginally more liquid. It might be worth checking with your spread betting account provider which markets you can trade in and what the conditions are. But be advised that the daily currency volatility is quite large and on top of that you bear the extra risk of the euro/GBP exchange rate which could move against you.

Timing here is crucial, so before opening the position, you'd have to wait for a day when the currency strengthens. And the more the Latvian authorities defend the peg the more it will cost you. There is also the risk that the IMF or the European union agree on a rescue package and the currency rallies against you, but this could be limited by the narrow trading band provided by the peg.

Overall, this is a very risky and potentially complicated way to play the fall-out, and I suspect there will be better ways to profit.

2) Another way to play it would be to wait for the extreme move and then buy the bounce as the effect could be far reaching. I suggest monitoring the Swedish krona plus the banking sector (Stockholm: SEBA) and (Stockholm: SWED A). If the Swedish krona loses value then you might look at buying exporters based in Sweden like Ericsson (Stockholm: ERICB) which would benefit from a cheaper currency.

3) I also found a couple of short exchange-traded funds (ETFs). But the trouble is that they replicate the MSCI index of main emerging market economies, which includes China, Brazil and so on. In fact, the index covers 26 emerging countries of which only five are in Eastern Europe, and none of the Baltic economies are included. This ETF could move if contagion happened and the mood on emerging markets changes but this play could be quite risky. The ticker is EUM or EEV for the ultra short version of the same ETF.

Conclusion

In my opinion the chances of a Latvian devaluation are quite high it's more a matter of when than a matter of if. The central bank could fight on for a few more months, especially if it gets help from Sweden or from Europe, but I don't think it will be able to maintain the peg.

Also contagion is far likelier than the market is pricing in. Generally when one weak economies goes the rest tend to follow - witness South East Asia in 1997, or Britain in 1992 when it followed Italy and devalued after five days. As this situation is quite complex I will monitor it for you in the next few weeks, and will also look for other ways to make money from this event.

I welcome your feedback - you can get in touch with me at eventstrader@f-s-p.co.uk.

Riccardo Marzi

PS And I'll also leave you with a thought. Latvia is a troubling situation, but it's a tiny country, on the periphery of the eurozone. But imagine what would happen if one of the PIGS (the weakest eurozone economies, Portugal, Italy, Greece and Spain Ireland is an honorary member) run into trouble? Sound far fetched?

Think again. They all had massive housing bubbles, and still have large public and private debts, troubled banking systems, current account deficits and most important of all falling competitiveness. But unlike Latvia and the other eastern European economies they can't devalue. They are all stuck with the euro. I will return to this subject and how we could take advantage of the upheaval that would arise - in the next few weeks.

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