Marshall Auerback here.  I want to add a few thoughts on the situation in Latvia which Ed has highlighted on several occasions. His allusion to Argentina to describe the situation in the Baltics last July was on the money. I have a solution here out of the Argentine playbook.

In Latvia, the neo-liberal insanity continues.  The EU and IMF have told the government to borrow foreign currency to stabilize the exchange rate to help real estate debtors pay the foreign-currency mortgages taken out from Swedish and other banks to fuel its property bubble, raise taxes, and sharply cut back public spending on education, health care and other basic needs to “absorb” income. Higher taxes are to lower import demand and also domestic prices, as if this automatically will make output more competitive in export markets.

But Latvia doesn’t produce much to export. The Baltic States have not put in place much production capacity since gaining independence in 1991. Latvia, like other post-Soviet economies, has scant domestic output to export. Industry throughout the former Soviet Union was torn up and scrapped in the 1990s. (Welcome to victorious finance capitalism, Western-style.) What they had was real estate and public infrastructure free of debt – and hence, available to be pledged as collateral for loans to finance their imports. Ever since its independence from Russia in 1991, Latvia has paid for its imported consumer goods and other purchases by borrowing mortgage credit in foreign currency from Scandinavian and other banks. The effect has been one of the world’s biggest property bubbles – in an economy with no means of breaking even except by loading down its real estate with more and more debt. In practice the loans took the form of mortgage borrowing from foreign banks to finance a real estate bubble – and their import dependency on foreign suppliers.

So instead of helping it and other post-Soviet nations develop self-reliant economies, the West has viewed them as economic oysters to be broken up to indebt them in order to extract interest charges and capital gains, leaving them empty shells.

The sad part about this whole episode is that Latvia’s problems could be fixed over a weekend. Here’s what I would do:

1. Drop the peg to the euro, which functionally acts like an gold standard external constraint.
2. Don’t answer the phone when the foreign creditors call the government.
3. Have the banks declared insolvent, convert their external debt to equity, and then have them reopen that way on Monday with full deposit insurance guaranteed in the now free floating local currency.
4. Enact a 0% rate policy (use fiscal policy to regulate demand going forward).
5. Offer a local currency minimum wage job that includes healthcare to anyone willing and able to work as was done in Argentina after the Kirchner regime repudiated the IMF’s toxic package of debt repayment.

Full employment and economic prosperity would come in no time at all.

The last line is the key.  Improve employment and aggregate incomes and demand follows – as does creditWORTHINESS.  At the final stage, credit will follow.

Even a banker can figure that one out.

Related posts:

• China is set up for a big fall
• China issues bonds to “promote the RMB in neighbouring countries”
• Bloomberg talks Eastern Europe as Latvia downgraded
• Latvia as the new Argentina redux
• China can handle collapse of speculative inflows

The following is my translation of a much-discussed article that appeared in Swedish daily Svenska Dagbladet at the weekend.  This information was being withheld from the public and leaked at an inopportune moment.

Note that the Swedish government has secretly been preparing the banks for financial Armageddon, encouraging Swedbank into a rights issue which arguably was conducted under fraudulent pretenses – very reminiscent of Bank of America’s shareholder vote for the merger with Merrill Lynch.  In August, I asked “Why is Swedbank doing a second rights issue?.” Now we know.

This is the kind of thing that topples governments.

Secret meeting on the crisis in Latvian

Finance Minister Anders Borg has had secret talks with the major Swedish banks and warned of a near economic collapse in Latvia, Svenska Dagbladet has learned. A nightmare scenario for Swedbank and SEB.

Yesterday Anders Borg issued a stark warning to the Latvian Government that it must take its financial problems seriously.

The promised cuts must be implemented when the new Latvian budget is presented in late October, according to Finance Minister.

The international community’s patience is very limited, stressed Anders Borg at the summit of European finance ministers in Gothenburg where he hosts as the finance minister in Presidency.

His statement came after recent reports from Latvia on political divisions in the ongoing budget negotiations.

But for Swedish bank heads, Borg’s move came as no surprise. According to several independent sources, Anders Borg, over the last few weeks, has contacted the senior management of major banks and warned them of an acute political crisis in Latvia. This in turn can lead to both a devaluation and eventually a default. It is a kind of national bankruptcy, similar to what hit Iceland last fall.

In secret talks with Swedish banks, Anders Borg explained the growing pressure that exists within the International Monetary Fund (IMF) to force Latvia into a devaluation.

A collapse in Latvia would have serious implications for several major Swedish banks. With a devaluation the already high loan losses would explode overnight, especially because many Latvians have loans in euro, which would become significantly more expensive.

Swedbank has up to today lent 61 billion kroner to Latvian individuals and businesses. The figure for SEB is 40 billion, while Nordea has 30 billion in loans.

For Swedbank a possible devaluation would come at an especially poor time. The bank is currently in the middle of a second rights issue in which shareholders have been asked to put up 15 billion.

CEO Michael Wolf’s message to shareholders and customers has repeatedly been that the money would be used for offensive investments. To then have to deal with a severe national bankruptcy in one of its major markets and see new issue money disappear into a black hole would be a severe blow to the bank’s credibility.

That a serious crisis approaches in Latvia has already been flagged by Anders Borg in the budget he presented a few weeks ago. On page 99 he writes:

"Since it is difficult to safely assess Latvia’s ability to pay and with conditions for recovery, one cannot completely exclude the risk of a major default."

The background to the current situation is a crash in the Baltic economies. Latvia is just the worst hit. This year, the country’s GDP is to shrink by as much as 18 percent.

This led to a rescue package cobbled together at Christmas last year. The International Monetary Fund (IMF), the EU and the Nordic countries decided on payments totaling SEK 80 billion, of which Sweden accounts for 7 billion.

An essential condition for aid money, however, is that Latvia implement substantial cuts in order to get the economy in balance.

This means wage cuts for state employees in over 15 percent, including hospital closures and major tax increases.

In July of last year Latvia went to reduce their spending for next year’s budget by more than 7.5 billion crowns.  It opened the door to  a further one billion disbursements from the IMF and the EU.

But then, the domestic political situation deteriorated. The previous Latvian government fell in February and since then the country has been governed by a coalition of five parties. The Prime Minister is Valdis Dombrovskis.  Next year come elections again.

Two of the parties in this five-party coalition have now objected to the previously announced savings of 7.5 billion. Some want to go back on parts of the promise and believe that a reasonable savings is instead about 4 billion kroner.

The goal to save 500 million lats (7.5 billion kroner) is practically impossible to achieve without eliminating several parts of the economy, Vents Armands Krauklis from the influential Liberal Party, which sits in the government coalition, said the day before yesterday.

24 hours later came the response from the EU.

"Latvia does not have much room for maneuver; It must fulfill its letter-of intent," said Anders Borg yesterday in Gothenburg to the news agency Direkt.

Original Source

Hemligt möte om lettisk kris – Svenska Dagblaget

Also see my August post, “Zombie banks Scandinavian edition and the threat of too big to fail.” This problem looms even larger now.

Update 7 Oct 2009: minor translation corrections were made resulting from reader suggestion.

Related posts:

• Transferring Swedish bank risk onto Latvian taxpayers
• Sweden: competitive auto bailouts begin with Saab and Volvo
• Estonia and Latvia: headed for the rails
• Earnings results at Swedish banks show large writedowns in Baltics
• Violence erupts in Latvia

Today, Moody’s warned that Iceland, Latvia and Hungary were stabilizing but that their economies remained fragile. The problem is high debt levels, which is restraining consumer spending. Recovery in the Eurozone has been the main aid to stabilization, the report said. Absent this support, the outlook is considerably worse.

Moody’s re-affirmed Iceland and Hungary’s ratings of Baa1 and Latvia’s of Baa3, one notch above junk. But, Moody’s refused to remove its negative outlook to the countries’ credit ratings.

The Wall Street Journal reported:

"These three countries are the only ones whose government ratings have experienced multiple downgrades over the past two years," says Kenneth Orchard, vice president in Moody’s sovereign-risk group. The ratings of these countries still carry negative outlooks, signaling the possibility of further downgrades in the next 12 to 18 months.

As I mentioned in my last post, it is the debt that is holding these countries back. The report states:

The domestic sides of the economies remain weak as households and corporates struggle with elevated debt levels, the aftermath of housing bubbles in the cases of Latvia and Iceland, and weak banking sectors that are unable or unwilling to extend credit.

As a result, the FX Team at brown Brothers Harriman think these countries are over-rated. In a note released today Win Thin said:

All three of these countries saw improvements in their sovereign risk profiles this past quarter, but all three still remain overrated.  Our model puts Iceland at B, Hungary at BB, and Latvia at B.  Moody’s has always been too generous with its Eastern European ratings, and we have to question why all three remain investment grade still…

All three are also likely to contract in 2010, so the stresses on their economies and their social fabric won’t be going away anytime soon.  Downgrade risks are likely to persist for these three well into next year, as well as for Estonia and Lithuania.

I can’t help but see this as yet another data point demonstrating that this whole house of cards is being stitched together via fiscal and monetary stimulus. Absent this stimulus, the U.S., the U.K., the Eurozone, Japan, and China would all relapse into recession, dragging weaker economies like Latvia or Spain deeper into Depression.

Watch for any signs of premature policy normalization in the the Eurozone or the U.S. as a prelude to a double-dip. The silver lining here is that Moody’s also upgraded Brazil to investment grade today, showing that the emerging markets outside of eastern Europe are doing quite well (story here).

Related posts:

• Hungary cut to a notch above junk by S&P
• More trouble in the Baltics as S&P downgrades
• Baltics: Fitch downgrade and more downgrades to come
• A bearish view on Eastern Europe
• The EU promises to bail out eurozone members

Both Latvia’s and Estonia’s debt ratings were downgraded by Standard and Poors.  Estonia was cut from A to A-, while Latvia was cut to BB+ to BB – its considered high yield securities aka junk bonds. This should come as no surprise as both countries have been in the news due to severe economic dislocations as they attempt to maintain currency pegs in the face of a severe debt deleveraging.

Latvia has been having severe difficulties getting its IMF monies disbursed due to the lack of fiscal belt tightening. Just today Latvia released dreadful economic news with statistics revealing a19.6% fall in gross domestic product. As macabre as the figures were, they were better than analyst expectations of a 22% fall. Nonetheless, S&P has decided to use this backdrop as an occasion to downgrade the country’s debt along with northern neighbour Estonia.

Win Thin, an analyst at Brown Brothers Harriman, had this to say about the downgrades (emphasis added):

Somehow, Lithuania escaped this time but it should have been cut from the current BBB, as we rate it BB- vs. actual BBB/A3/BBB.  The only surprise to us was that the downgrades weren’t deeper, as we see eventual junk status (below BBB-) for all three.  As we noted in our most recent FX quarterly, the ratings agencies have been overly generous with Eastern Europe, particularly the Baltics.  Our sovereign rating model puts Estonia at a BB/Ba2/BB rating, way below actual ratings of A-/A1/BBB+.  For Latvia, we rate it B- vs. actual BB/Baa3/BB+.  Others that are overrated in the region include Bulgaria (we rate it BB vs. actual BBB/Baa3/BBB-), Hungary (we rate it BB- vs. actual BBB-/Baa1/BBB, and Romania (we rate it BB vs. actual BB+/Baa3/BB+).

We fully expect Estonia, Lithuania, and Bulgaria to follow Latvia and Romania into IMF programs.  Our negative view on the Baltics still underscores our bearish calls on SEK given the high levels of Swedish banking exposure to the region, and helps explain why SEK was the worst performer today vs. USD and EUR… Just look at Latvia.  It just reported Q2 GDP as contracting 19.6% y/y vs. an 18% drop in Q1.  The banking regulator has reported that all overdue loans rose to 23.5% of total loans in June...  Those numbers will only get worse, as we see little relief in sight for the economy…

The long and short of it is: expect more pain in Latvia and Estonia, but also across Eastern Europe as well. As the global recovery seems to within reach, particularly in emerging markets, expect Eastern Europe to underperform.

Sources

Brown Brothers Harriman FX Team

Related posts:

• Baltics: Fitch downgrade and more downgrades to come
• Moody’s: Iceland, Latvia and Hungary in “fragile stabilization”
• A bearish view on Eastern Europe
• Hungary cut to a notch above junk by S&P
• CDS contracts and the implosion of several Eastern European economies

Earnings season is upon us and the Swedish banks have begun reporting earnings. Their results have seen huge writedowns that demonstrate large and continued exposure to souring loans in the Baltics.

Handelsbanken and Nordea reported today. Despite the writedowns, you do get the sense that things are going better than expected as the banks beat expectations. Nordea even raised its guidance. But SEB and Swedbank, major lenders to the Baltics, are still on the ropes as previous earnings from those banks attest.

Nordea

The Danish daily Berlingske Tidene calls the first six months of 2009 “one of the best in Nordea’s history.” It notes that “despite the crisis atmosphere net income was almost a record, and management will need to revise full-year guidance upwards.”  Net income was 616 million Euros against expectations of only 421 million. That’s pretty spectacular.

But what about loans to the Baltics? Berlingske Tidene reports.

Impaired loans in the Baltic region as a whole – including both non-performing and performing – have run up to 418 million Euros, equivalent to 550 basis points of total loans and receivables.

The total writedowns for the Baltic countries was 202 million Euros…

Long story short, Nordea faces the same problems with loans in the Baltics that JPMorgan faces with credit cards and residential property in the U.S. i.e. rising losses.  In both cases, these losses have been offset by large profits due to a favorable interest rate environment.  Whether this continues is the question.

Handelsbanken

It was the same story at Handelsbanken, with the company bating expectations. The bank reported an operating profit of 3.445 billion krona, which was slightly more than last year and well above the 2.924 billion krona consensus. The Swedish krona is trading at 7.69 to the dollar, so we’re talking about $450 million in profit.

Loan losses were up to 939 million krona from 571 million last year. There was no initial report of exposure to the Baltics as Handelsbanken was not one of the biggest lenders amongst the Swedish banks. All in all, this was a good report.

SEB

SEB reported yesterday and they showed a large loss of 193 million krona, compared to the 2.8 billion profit of 2008.  This huge swing is due to large credit losses, he majority of it in the Baltics. SEB had 3.6 billion krona in credit losses, 74% of which came from the Baltics.  This forced them to write down 2.4 billion in loans in the Baltics and Russia.

The contrast is striking and its all due to the reckless lending in the Baltics.  Expect more of the same going forward.

Swedbank

Swedbank is the other big lender in the Baltics with SEB.  SO they had dismal earnings as well in a report from last Thursday.  The FT reports:

Swedbank, the largest lender in the Baltics, posted net losses of SKr2.01bn ($257m), compared with net profits of SKr3.6bn a year earlier.

It was the bank’s second consecutive quarterly loss and much worse than the SKr1.27bn deficit forecast by analysts.

Loan losses soared from SKr423m a year ago to SKr6.67bn, with about two-thirds of the amount in the Baltics and a third in Ukraine.

In response, the bank said it planned to reduce staff by 3,600, about 16 per cent of its workforce, by this time next year, with most of the cutbacks in the Baltic states.

Shares were up on the announcement, but I expect more of the same going forward.  Whether Swedbank needs more capital remains to be seen.

Now, Just two weeks ago I mentioned a plan by Swedbank and SEB to write down personal loans in Latvia, the hardest hit country in the Baltics, by 10% in exchange for a Latvian government guarantee against further losses (see Transferring Swedish bank risk onto Latvian taxpayers). It is unclear whether these writedowns were taken or even if this proposal has gotten a green light, especially given the problems Latvia is now having getting more money from the IMF.  But, clearly, this would mitigate any losses at Swedbank and SEB.

The difference in profitability between the four banks does show that the banking system in Sweden is doing just fine outside of the problems with Baltic exposure.  I take that as an encouraging economic sign in Sweden that may be indicative of other countries in Northern Europe as well.

Sources

Nordea overrasker positivt – Berlingske Tidene

Nordeas vinst klart över förväntan – Dagens Nyheter

Handelsbanken överträffar prognoser – Dagens Nyheter

Baltic exposure hits Swedish bank – BBC News

Related posts:

• Why is Swedbank doing a second rights issue?
• Estonia and Latvia: headed for the rails
• Event risk in the Baltics is critically high
• Transferring Swedish bank risk onto Latvian taxpayers
• European banks have hands out for more capital

This is my translation of an article from Dagens Nyheter, a Swedish daily.

Swedish banks are planning to write down Latvian personal loans by 10 percent. However, the proposal includes only a small part of the Latvia’s mountain of debt.

The criteria for qualifying for the program, as it stands right now, is quite strict. So there is nothing which will include a very large number of private individuals in Latvia, "said Swedbank Director Thomas Backteman to TT.

On Wednesday, Latvian Prime Minister Valdis Dombrovskis on Latvian radio told of new plans to support indebted individuals.

He said that the program is based on "a certain solidarity" from the banks in the country, which are to write down the debt of the people who qualify for assistance.

But according to Thomas Backteman, the proposal comes from the banks themselves. The Latvian Banking Association has been having a discussion with the Government of Latvia on a way to restructure of private debts.

The Bankers’ Association made a proposal to provide a moratorium, that is, a temporary deferral, in the case of payments on debts to private persons.

And for those who give this concession, the state will step in and guarantee the debt. “Then we will write down the debt by 10 percent," he says.

Swedbank and SEB are the two banks with the most loan customers in Latvia. Like SEB Swedbank estimates that the economic impact of the proposal will be small:

"Our current assessment is that only a small part of SEB’s loans to households would be covered," writes Elisabeth Lennhede, press officer at the bank, in an email to TT.

And even if the debts are written down, the program would probably also mean that banks would forgo a small part of the massive credit losses that are expected to arise in Latvia in the coming years.

That’s how it is, and above all, we get a guarantee, "says Thomas Backteman.

It sounds like a transfer of risk from Swedish banks to Latvian taxpayers if you asked me.

Lettiska skulder ska skrivas ned – Dagens Nyheter

Related posts:

• Earnings results at Swedish banks show large writedowns in Baltics
• Sweden prepares for financial collapse in Latvia and major bank losses at home
• Estonia and Latvia: headed for the rails
• Why is Swedbank doing a second rights issue?
• Lessons from Swedish bank resolution policy

I am not the only one who sees events in Latvia as a potential catalyst for further downside risk to the reflation trade.  Mary Stokes over at Nouriel Roubini’s site has a very readable post out on why we should be watching events in that tiny Baltic nation for potential signs of contagion elsewhere.  She notes:

The collapse of the Thai baht in July 1997 helped spark the Asian financial crisis. Could events in Latvia spawn a similar contagion? Eyes are focused on this small Baltic economy, amid growing talk of a devaluation, due to the potential for spillover effects into its fellow Baltics, Sweden and the broader Eastern European region.

Strong trade and financial linkages, not to mention similar macroeconomic vulnerabilities, mean a Latvian crisis would almost surely have knock-on effects on neighboring Estonia and Lithuania, as detailed in this RGE EconoMonitor post in early May. A Latvian crisis would also have negative spillover effects into Sweden via Swedish banks’ heavy exposure to the Baltic trio. The wildcard is how a Latvian crisis would affect the greater Central and Eastern European (CEE) region. Direct trade and financial linkages between Latvia and CEE economies, outside of the Baltics, are limited. Nevertheless, many of these countries – particularly Bulgaria and Romania – share similar macroeconomic vulnerabilities with Latvia, meaning a crisis there could ‘wake up’ investors to the potential for crises in the rest of the region.

Last July I was talking about the Baltics as the next Argentina, but it seems we are past that already now.  At present, the legitimate fear is ‘Latvia as the next Thailand.’  There’s a new meme for you.  While I am much more bullish about the reflation trade, I still harbour doubts, particularly when it comes to Eastern Europe. One of my ten predictions for 2009 was that Eastern Europe would infect the Eurozone and bring the European banking system to its knees (that was prediction #4 back in December).  I do think the situation is brighter.  Nevertheless, Eastern Europe is going to be a problem going forward and Latvia is merely the catalyst as Thailand was in Asia in 1997.

The broader CEE region has minimal trade and financial linkages with the Baltics. So the key channel of contagion between the Baltics and the broader CEE region would be via the ‘wake up channel’ – meaning a crisis in Latvia could serve as a wake-up call to investors, alerting them to similar vulnerabilities elsewhere. So far, the evidence suggests the rest of the CEE will not go unscathed if Latvia devalues, despite their limited linkages. For example, the recent sell-off in the Polish zloty and Hungarian forint was largely attributed to concerns over potential spillover effects from a Latvian crisis.

The full post is linked below.  But, I suggest you look over at FT Alphaville for more coverage on this situation.  They have run a number of good posts on both the Baltics and the CEE banking situations.  The guys over at A Fistful of Euros are on the case as well.

Back in May, Michael Robinson of the BBC released an amazing podcast that captures the situation in Latvia quite well – selling $3,000 flats for $200,000.  Nice!  In my view, this is probably the best on the ground look you will see by a journalist anywhere.  Listen to the podcast below.

BBC podcast below

Source

Is Eastern Europe on the Brink of an Asia-Style Crisis? – RGE Monitor

Related posts:

• A bearish view on Eastern Europe
• Bloomberg talks Eastern Europe as Latvia downgraded
• Violence erupts in Latvia
• More trouble in the Baltics as S&P downgrades
• Baltics: Fitch downgrade and more downgrades to come

This is the assessment of den Danske Bank as reported by Edward Hugh.  The last time I mentioned the Baltics was on May 12th in my post “A bearish view on Eastern Europe.”  I ended saying the Scandinavian banks’ exposure to the Baltics is just as worrying and should be the place to watch before we give a definitive all-clear.”  And that all-clear signal is far from coming.  In fact things seem to be reaching a critical state.

Here’s what den Danske Bank says:

The event risk has risen sharply in the Baltic markets and we advise utmost caution. Yesterday, the Swedish central bank Riksbanken said it will increase its currency reserve by SEK 100 bn through a loan from the Swedish debt agency. Investors seem to believe that this is a buffer to deal with potential problems arising from the Baltic crisis.

We should be watching these developments in Scandinavia and the Baltics because things have a way of metastasising in this globalized economy. Read more at the link below.

Source

Danske Bank Warn On The Baltics – Edward Hugh

see also Devaluation Imminent in the Baltics? by Claus Vistesen (notice the allusions to Argentina, a comparison I made last July.

Related posts:

• Estonia and Latvia: headed for the rails
• Earnings results at Swedish banks show large writedowns in Baltics
• Are the Baltics the new Argentina?
• Roubini’s RGE Monitor: Threat of ‘Asia-Style Crisis’ in Eastern Europe
• Foreign investors dump Danske Bank

This morning you may have read Gideon Rachman’s positive view on Hungary.  He said the panic is all but over and it looks like Hungry is going to get through this debt crisis.

The horror scenario envisaged a Hungarian banking collapse that would ripple back into the rest of Europe and then around the world. Many EU banks have lent heavily in central Europe. Austrian banks are thought to have lent the equivalent of more than 70 per cent of their country’s gross domestic product to the region. This idea – perhaps combined with a folk memory that the Great Depression had something to do with the collapse of an Austrian bank – helped heighten the panic about Hungary.

But, having just visited Budapest, I can return with good news. The immediate crisis is over. There was a moment when there was a real fear of a bank run. One Hungarian financier is quite precise about the date: Friday, March 13. However, confidence just about held up, the moment passed and so has the threat of imminent collapse.

The unfolding of the Hungarian crisis now looks like a microcosm of the world crisis. Fear of financial collapse is gradually giving way to worries about an unprecedented contraction in the economy – with all the social and political consequences that could imply.

The Hungarian government has predicted that the country’s economy will shrink by 6 per cent this year. It has not performed that badly since 1945. Unemployment is rising and so is inflation, because of the fall in the Hungarian currency.

Hungary has no room for the kind of counter-cyclical Keynesianism that is being tried in the US and the UK. Nobody thinks the markets would tolerate huge fiscal deficits, so instead the government is cutting spending and raising taxes. State pensions were sliced by about 8 per cent last week. Sales tax has just been increased. And this is just the start of an austerity drive.

So, to recap what Rachman is saying, Hungary is looking pretty awful, but it could be worse. But, is that really true?  I’ll come at this question via Latvia and the troubles now ongoing there.  Yesterday, we learned that Latvia’s economy shrank 18% in the period from Q1 last year to Q1 2009.  This is a Great Depression scenario for Latvia.  But, the other Baltics, Estonia and Lithuania, are imploding as well.  For example, at the end of April, Lithuania reported a 12.6% drop in year-on-year GDP – not as bad as Latvia, but a Depression with a Capital ‘D” nonetheless.  I had asked in July if the Baltics were the next Argentina.  The answer is obviously, yes.

So what does this have to do with Hungary?  A lot. Western banks piled into the former Soviet bloc in Eastern Europe during this decade’s boom.  And with growth coming off the boil those bets are coming a cropper.  Certainly, things look much worse in Latvia than they do in Hungary.  Hence, the optimism from Rachman.  But, the guys at Brown Brothers Harriman are not onboard with the all clear call.  They have a bearish view on Eastern Europe. Here’s what they had to say regarding sovereign credits today:

Moody’s has been busy today, downgrading Ukraine to B2 from B1 and Kazakhstan to Baa1 from A2.  Interestingly, Moody’s damned Mexico with faint praise yesterday by saying that it couldn’t see Mexico losing its investment grade rating.  Of course, that doesn’t rule out downgrades from the current Baa1 rating, and we note S&P just put its BBB+ on negative outlook.  Our EM sovereign rating model puts Mexico at BBB-/Baa3, and so the case is strong for a downgrade.  However, Moody’s appears to be correct about Mexico hanging on to its investment grade rating.  Our model puts Kazakhstan at BB+/Ba1, and so significant downgrades are warranted.  Again, we are incredulous that Moody’s put it at A2 in the first place.  We also put Ukraine at B-/B3, and so another downgrade there is warranted.  Given how poor 2009 is shaping up to be in terms of growth, capital flows, etc., we believe the rating agencies will continue to downgrade the weaker EM credits into 2010.  And it’s not just EM that the agencies are going after, with Fitch today moving Greece’s outlook to negative from stable (Greece was already downgraded by S&P in 2009, with agencies cutting Ireland, Portugal, and Spain this year too).  We reprint below our ratings outlook that was in the latest quarterly, since these views still hold:

The Baltics:  Despite seeing some downgrades already, Estonia, Latvia, and Lithuania remain highly overrated.  All still face serious crisis risks in 2009, and it’s likely that the other two will eventually follow Latvia into an IMF program.  None of them deserves an investment grade rating, and we look for multiple downgrades in 2009.  Note that IMF programs did not prevent downgrades during the Asian crisis.

EMEA:  Most of the other countries in this group are facing significant downgrade risk this year too, though perhaps the Czech Republic slightly less so.  Hungary’s rating is the most out of line and faces the most downgrade risk in 2009, followed by Iceland, Bulgaria and Romania.  We believe Poland and South Africa face moderate downgrade risk.

You should notice that Hungary is an outlier in their analysis with significant downgrade risk.  So, it is not a case of all clear at all, not for the Baltics and not for Hungary either.  Edward Hugh at “A Fistful of Euros” have been chronicling these events. Read his posts on these events over the last two days:

• The Agony Continues – Latvian GDP Falls By 18%
• “Not All East The European Economies Are The Same”
• Non-performing Loans In Latvia

So, while the outlook is much improved, the risks are far from over.  With regard to the crisis in Eastern Europe, most people had been focused on Austrian banks and Central Europe (Hungary, Poland, Slovakia, Czech Republic).  I have written on this on a few occasions as well, even throwing in a vague reference to the Great Depression a post called, “1931.”  But, the Scandinavian banks’ exposure to the Baltics is just as worrying and should be the place to watch before we give a definitive all-clear.

Related posts:

• Hungary cut to a notch above junk by S&P
• Baltics: Fitch downgrade and more downgrades to come
• More trouble in the Baltics as S&P downgrades
• Roubini’s RGE Monitor: Threat of ‘Asia-Style Crisis’ in Eastern Europe
• Moody’s: Iceland, Latvia and Hungary in “fragile stabilization”

Today I saw two blurbs about Eastern Europe which I want to pull together with a bit of added commentary about the automakers in the U.S.  The first blurb had to do with the Baltics and their probable downgrade to junk by the ratings agencies.  This is what Win Thin, a Senior Currency Strategist at Brown Brothers Harriman had to say earlier today in a market commentary.

Fitch cut the outlook for Bulgaria’s BBB- rating to negative from stable. The agency cut Bulgaria to BBB- from BBB back in Nov. Fitch cited the deterioration in the global outlook along with Bulgaria’s high current account gap (25% of GDP in 2008!) and large external financing needs as factors behind the outlook cut. IMF is now looking for 3.5% contraction in GDP this year and 1% in 2010, and also sees a big decline in net capital inflows, both portfolio investment and FDI shrinking noticeably. Our sovereign ratings model rates Bulgaria at BB vs. actual BBB/Baa3/BBB-, and believe that a junk rating is only a matter of months away. Bulgaria is not the only one in the region facing downward ratings pressure, and we continue to express amazement that so many were given investment grade ratings in the first place. Looking ahead, we see the three Baltic nations all moving into junk territory (only Latvia is junk right now). Bulgaria pegs the lev against the euro, and so far it has held up. However, if the Baltics continue to deteriorate, we cannot rule out broken pegs for all four (Estonia, Latvia, Lithuania, and Bulgaria). To us, Eastern Europe now looks very much like Asia did back in 1997, and we all know what happened then.

I hope this argument sounds familiar because it is something I have been saying since last Summer (I also mentioned similar comments from BBH earlier this month.

Fine. But, then I saw a Blurb from Gillian Tett of the FT. She is the same Gillian Tett who wrote “Saving The Sun” a look at a Japanese bank restructuring in the aftermath of the lost decade in Japan. In this case, she was looking at a bank in Kazakhstan (for your cycling and cinema enthusiasts, this is home to Alexandre Vinikourov and Borat).

Here’s what she says:

As the financial crisis virus has swept around the globe in recent months, Kazakhstan’s banking sector has been engulfed in turmoil. This is not just creating a headache for the Kazakh government and Western creditors, but also highlighting issues about the credit derivatives market that extend well beyond those far-flung steppes.

Take the case of Morgan Stanley’s dealings with BTA, Kazakhstan’s largest bank. A few years ago, BTA – like many of its Eastern brethren – was an up-and-coming darling of the capital markets world, with investment bankers furiously competing to float its bonds, provide loans, and much else.

But earlier this year, when funding dried up for Kazakh banks, BTA fell under the control of the government. Initially BTA wanted to keep servicing its loans, and its creditors, such as Morgan Stanley, appeared happy to play along.

But last week Morgan Stanley and another bank suddenly demanded repayment. BTA was unable to comply, and thus tipped into partial default. That sparked fury among some other creditors, and shocked some Kazakhs, who wondered why Morgan Stanley would have taken an action that seemed likely to create losses.

One clue to the US bank’s motives, though, can be seen on the official website of the International Swaps and Derivatives Association. One page reveals that just after calling in the loan, Morgan Stanley also asked ISDA to start formal proceedings to settle credit default swaps contracts written on BTA.

Does this sound familiar? No. Well, I did just mention earlier today that CDS contracts were going to be an impediment to a good workout at Chrysler and GM:

CDS insurance writers. Get ready for major pain. If bond holders are getting screwed, you know the companies who guaranteed credit default swaps (CDS) are not going to be very happy here. Question: are bond holders playing chicken because they have insurance? If so, you can consider the CDS writers another negotiating party that did not get a seat at the table and are going to be left holding the bag – a reason to want some major changes in how the CDS market is run.

Let me pull these threads together. If one thinks that a bankruptcy of a systemically important organization in any country can proceed normally without the potential for mischief, one had better read Tett’s account.

What’s more, in the case of Chrysler and GM, the complexity of a Chapter 11 bankruptcy will be very large. The Obama team says “three months and you’re done.” That ain’t gonna happen. United took three years. LTV took five and Delphi, the auto parts maker is still in bankruptcy 4 years later. So, lets get realistic here.

Bringing this full circle, we come back to Europe. And there, we have a problem, – specifically, because what has happened in Ukraine is going to happen in places like Bulgaria, Latvia, Lithuania or Estonia.

In my view, the events in the home of Borat and the possibilities in Eastern Europe or with the U.S. automakers present a good example why Warren Buffett calls derivatives financial weapons of mass destruction.

The credit default swap market needs regulation – and fast.

Source
Insight: Kazakh bank falls foul of CDS – Gillian Tett, Ft.com

Related posts:

• Eastern European economic growth to crater in 2009
• Baltics: Fitch downgrade and more downgrades to come
• More trouble in the Baltics as S&P downgrades
• Large bank loses $7.9 billion: CDS involved
• Ten eastern European countries now looking to IMF for bailouts

The first time I wrote about the Baltics was back in August in a post entitled, “Are the Baltics the new Argentina?.” Since then, things have gotten progressively worse and the Baltics are clearly in Depression with Latvia leading the way to the downside. The credit ratings agencies have caught on to this and Fitch is marking the countries down near and into junk territory with negative outlooks. Win Thin of Brown Brothers Harriman has a good read on what to make of this:

Fitch downgraded the Baltics and kept the outlooks at negative. Estonia was cut to BBB+ from A- Latvia was cut to BB+ from BBB-, and Lithuania was cut to BBB from BBB+. The only surprise to us was that the downgrades weren’t deeper, as we see eventual junk status (below BBB-) for all three. As we noted in our most recent FX quarterly, the ratings agencies have been overly generous with Eastern Europe, particularly the Baltics. Our sovereign rating model puts Estonia at a BB/Ba2/BB rating, way below actual ratings of A/A1/BBB+. For Lithuania, we rate it BB+ vs. actual BBB/A2/BBB. For Latvia, we rate it B+ vs. actual BB+/Baa1/BB+. Others that are overrated in the region include Bulgaria (we rate it BB- vs. actual BBB/Baa3/BBB-), Hungary (we rate it BB vs. actual BBB-/Baa1/BBB, and Romania (we rate it BB vs. actual BB+/Baa3/BB+).

By the way, we still expect Bulgaria, Estonia, and Lithuania to join the others in IMF programs this year. EMEA remains the weak link in emerging markets, as a glance at our vulnerability table will verify, and we continue to question the viability of the pegs in the Baltics and Bulgaria. Investors have turned more positive on EM in recent weeks, but are surely differentiating between the good (Brazil, China, etc.), the bad (South Africa, Turkey, etc.), and the ugly (Baltics, Bulgaria, Hungary, etc.). We cannot see investors piling back into the EM countries with the worst fundamentals even if the global crisis continues to abate.

Much worse is coming to Eastern Europe and the Baltics are the worst of the lot.  You should note that Sweden has significant exposure in the Baltics and downgrades there will weigh heavily on that country.  Marc Chandler of BBH also picks up this theme:

Austria and Belgium have a higher percentage of their GDP in Eastern European exposure than Sweden, but are protected to some extent by being in the eurozone. Sweden’s exposure is concentrated in the Baltics. It’s currency floats freely. The Fitch downgrade and negative outlook for the Baltics has seen the krona hit. The euro hit a high on of SEK10.9840 in response and this represents a new high on the month. The SEK11.00 is a important barrier, around where stops are thought to lie. The euro is moving above the 20 day moving average for the first time since March 11th. A break of SEK11.00 could see a quick move toward SEK11.10-SEK11.20.

Related posts:

• More trouble in the Baltics as S&P downgrades
• CDS contracts and the implosion of several Eastern European economies
• A bearish view on Eastern Europe
• Moody’s: Iceland, Latvia and Hungary in “fragile stabilization”
• Estonia and Latvia: headed for the rails

Yesterday, Latvia was downgraded to junk. Despite its diminutive size, this is a big deal. Fist, it is a harbinger of what is to come for the rest of Eastern Europe. But, more importantly, it is a signal that Western European banks lending in the former Soviet Bloc are overexposed and threatened by large loan losses. In a global economy in which European banks lend at home, but also have significant U.S. mortgage debt and Eastern European loan exposure, events in Latvia will have a snowball effect.

While the EU, IMF and World Bank are all busily drafting up crisis solutions, the videos below should give a little colour on what this means for the economy, credit and investing.

Related articles
Latvian debt is given junk status – BBC News

Related posts:

• EU planning 200 billion euro package for Eastern Europe
• Roubini’s RGE Monitor: Threat of ‘Asia-Style Crisis’ in Eastern Europe
• Bloomberg talks about the meltdown in Eastern Europe
• UBS does not see the need for panic over Eastern Europe
• A bearish view on Eastern Europe

As this deepest of recessions takes hold, an increasing number of countries are seeing outbreaks of civil unrest. First it was Greece. Later, we saw unrest in the Baltics in Riga and Vilnius. Now, Iceland is experiencing the same. These countries are amongst the hardest hit economies. Therefore, we should see these episodes as a harbinger of what is to come unless government can prevent this downturn from deepening.

Angry Icelandic protesters clashed with riot police as they called for a new government on Wednesday and the country’s prime minister said he had the support of his coalition partner.

Geir Haarde, Iceland prime minister, speaking after his limousine had been pelted with eggs and cans by demonstrators, said the government was ”fully functional”…..

Anti-government and central bank protests are now regular fixtures in the once-tranquil capital after sharp currency falls and the collapse of the financial system in October caused by billions of dollars of foreign debt being incurred by banks.

Television footage from channel RUV showed protesters banging on Mr Haarde’s black limousine and then pelting it with eggs outside the government building.

The vehicle managed to drive away after riot police arrived.

PARLIAMENT PROTESTS

The protest also left the government building splattered with eggs and paint. The demonstrators then moved off to parliament and by evening about 3,000 protesters had gathered to face riot police surrounding the Althing, hurling fire crackers at the building and chanting ”disqualified government”.

One demonstrator scaled the face of the parliament building, reaching a balcony from which he hung a sign reading ”Treason due to recklessness is still treason”.

The volcanic island’s economy is expected to suffer a huge contraction this year while unemployment, once close to zero, is set to soar.

”People feel that it is incredible that after such a policy disaster that we faced last year, there has been no resignation, no minister, no one has resigned or responded, or taken responsibility for what happened,” said Gunnar Helgi Kristinsson, a political scientist at the University of Iceland.

Mr Kristinsson said there was a substantial likelihood the government would not survive the coming two weeks.

Source
Icelandic protesters clash with police – FT

Related posts:

• Baltics: Violence from an Argentina-style collapse
• Violence erupts in Latvia
• Where is the outrage?
• An Icelandic post-mortem
• Iceland: a cautionary tale for small nations

The riots on the streets of Vilnius and Riga in the Baltics are not being covered in the least in the U.S. media (Hat tip Ken). I believe they should because, as with Greece, the social unrest we are witnessing in those countries is the likely outcome of failed economic policies and depression. This was certainly the case during the Great Depression in the United States. While we are not seeing Argentina-level social unrest yet, these events are forerunners of a more ominous social climate.

Police used tear gas and rubber bullets Friday to disperse anti-government protesters who were throwing rocks and eggs at Lithuania’s Parliament.

The Interior Ministry said 15 people were injured, including four policeman. One protester lost a finger to a rubber bullet, police said. About a dozen windows on the Parliament building, in downtown Vilnius, were shattered.

Some 7,000 protesters had gathered outside Parliament on Friday morning to demonstrate against reforms aimed at easing the economic crisis. The violence started when police pushed away protesters who were demanding to see the parliamentary speaker.

By evening Vilnius was quiet. Police said more 82 people had been detained.

“According to police information, this is a well orchestrated action against Lithuania,” Prime Minister Andrius Kubilius told journalists.

“There are forces that are interested in destabilization and chaos in Lithuania, and they are using the public’s dismay over painful reforms to achieve their hostile plans,” Kubilius said, adding that police knew who was responsible.

Kubilius’ center-right coalition, in power less than two months, has been criticized for tax increases the government said were needed to shore up state finances. On Friday, Lithuania’s Finance Ministry announced it intended to borrow €1 billion (US$1.3 billion) from the European Investment Bank to plug a yawning budget gap. The Baltic country’s economy is expected to enter a recession this year.

Liucija Mukiene, a 63-year-old retiree, said the government was arrogant and corrupt.

“We are here today because this government is mocking us,” she said. “They taking away our last money and providing nothing. I am fed up with the lies, corruption and those grinning, fat faces behind the windows of Parliament.”

The clash echoes violent protests this week in Latvia and Bulgaria, and recent demonstrations in Greece, as a wave of discontent over economic woes, difficult reforms and government corruption sweeps through parts of Europe.

In Latvia, police detained more than 100 people Tuesday after protesters pelted police with rocks.

Source
Protesters clash with police in Lithuania – IHT Europe

Related articles
Baltic Protests Erupt as EU’s Worst Economies Shake – Bloomberg.com
Around 7,000 protest anti-crisis measures in Lithuanian capital – RIA Novosti
Thousands protest against government in Lithuania – Forbes.com

Related posts:

• Violence erupts in Latvia
• Violence erupts in Iceland
• Where is the outrage?
• More trouble in the Baltics as S&P downgrades
• Are the Baltics the new Argentina?

A friend living in Latvia wrote that he was “stunned by the chaos that broke out in Riga this evening.”  I had heard absolutely nothing about it until he told me.  Apparently, a peaceful protest outside Parliament turned bloody when the police started to crack down on protesters.  126 people were arrested. (Hat tip: Ken)

I looked for the story and found it on Bloomberg.

Latvian police detained 126 people after a peaceful protest by about 10,000 people calling for a referendum and elections turned into a riot, said Sigita Pildava, a police spokeswoman.

Police used pepper spray and batons to disperse protesters who had gathered in Riga’s old city, chanting “dissolve parliament,” and some crowd members broke windows in the Finance Ministry and a liquor store. A police car was set on fire, windows in the parliament were shattered and 28 people were injured, the Leta newswire reported.

The protest, organized by opposition political parties, trade unions and non-governmental organizations, called on the president to hold a referendum leading to new parliamentary elections less than a month after the country secured financial aid to bolster its economy.

Latvia received a 7.5 billion-euro ($9.9 billion) international aid package in December from a group led by the International Monetary Fund, the European Union and the Nordic countries. The Latvian economy contracted 4.6 percent in the third quarter from the same period a year earlier and the government took over the country’s second-biggest bank.

Needless to say, these are the types of things I expect to happen in the present fragile economic state — and the types of clashes we should try to avoid. Moreover, the Baltics and all of Eastern Europe have just seen a speculative frenzy collapse, so I expect to hear more about loan losses and economic downturn across the region. Latvia needs to depreciate its currency. That can definitely ease some of the pain. My hope is that leaders in the region will adopt the right policy prescriptions to minimize civil unrest like this.

Source
Latvia Protest Sparks Clashes Outside Parliament; 126 Detained – Bloomberg.com

Related posts:

• Baltics: Violence from an Argentina-style collapse
• Violence erupts in Iceland
• Iran: Ahmadinejad wins, violence erupts on the streets
• Where is the outrage?
• Tear gas and rubber bullets at G-20 Protests

The question on everyone’s mind in the emerging markets is who will blow up next. Arnab Das of Dresdner Kleinwort Benson takes a stab at answering that question. He targets the Baltics as the problem children and sees current account surplus nations in Asia as lest vulnerable. He also discusses his views on Russia.

Below is the video with him on CNBC giving forth his view.

Related posts:

• How Iceland collapsed
• Is Ireland the next Iceland?
• Violence erupts in Iceland
• Iceland fast tracked for EU membership
• Iceland: a cautionary tale for small nations

Has Paul Krugman been reading my stuff? He is certainly thinking like me regarding emerging market risk. He has a post today talking about Latvia as the new Argentina. He says:

I’ve been saying this for a couple of weeks, but Edward Hugh has the goods.

Hugh puts his finger, in particular, on one gaping hole in the logic of the opponents of devaluation. We can’t devalue, they say, because the Latvian private sector has a lot of debts in euros, and a devaluation would make it very hard for borrowers to service those debts. As Hugh points out, the proposed alternative — sharp wage cuts, and basically a major domestic deflation — will also make it hard to service those debts. In fact, I’d be a bit more specific than Hugh: other things equal, a nominal devaluation and a real depreciation achieved through deflation should have exactly the same effect on debt service (unless some of the debt is in lats rather than euros, in which case devaluation would do less damage.)

This looks like events repeating themselves, the first time as tragedy, the second time as another tragedy.

For those of you who have been reading my stuff regularly, I made a similar argument back in July in my post “Are the Baltics the new Argentina?“:

The Baltics are looking a lot like Argentina was before it collapsed at the beginning of the decade: fixed exchange rate, large current account deficit, significant foreign bank lending, overheating economy turning to bust.

This combination is a toxic mix that will certainly end in the disaster it did for Argentina. I have a vivid memory of being in Buenos Aires when workers were rioting in the streets, knocking over cars and setting them on fire. Foreign banks were littered with Graffiti, including the word “ratas,” scrawled across them. Many banks were shut down and closed and too many bank I could see had armed guards with submachine guns out front to protect them. I can’t say this same disastrous scenario awaits the Baltics, but things could get pretty dicey there in any event…

The Baltics have a lot of hot money invested in their economies as much of the lending growth came on the back of foreign financial investment. When distress hits, one should expect a giant sucking noise from foreigners repatriating funds. This will leave the Baltics subject to credit deflation just as the economy is entering recession.

When one adds the slow economy and the high inflation to a fixed exchange rate and high current account deficits it says: the Baltics do not have the appropriate fiscal and monetary policy for a fixed exchange rate.

One of two things must give: the exchange rate peg or the economy. In Argentina, it was both.

Make sure you read Edward Hugh’s analysis sourced below. It shows that the IMF has made a big mistake in NOT correcting the exchange rate disaster in Latvia.  As you can tell from my post in July, all of this was readily apparent months ago.  Don’t let anyone tell you otherwise.

With Hungary and the Ukraine also taking money from the IMF, the other Baltics in deep trouble and many more countries in peril, I fully expect Eastern Europe to be a problem. And for banks in Germany, Austria, Denmark and Sweden, loaded to the nines with loan exposure there, that spells massive credit writedowns and loan losses. Get ready.  It will happen.

Sources
Latvia is the new Argentina (slightly wonkish) – Paul Krugman
Why The IMF’s Decision To Agree A Lavian Bailout Programme Without Devaluation Is A Mistake – A Fistful of Euros

Related posts:

• Are the Baltics the new Argentina?
• Event risk in the Baltics is critically high
• Latvia – the insanity continues
• Estonia and Latvia: headed for the rails
• The Euro and Baltic currency overvaluation

Last night an article by Niels Jensen of Absolute Return Partners caught my eye. In it, he made a very strong case for worrying about European bank exposure to emerging markets and its potential for creating systemic risk. I would like to share some highlights from this well-written piece and add a few thoughts of my own.

I have talked quite a bit about this problem in my blog in the past. Below are a few related articles. I am generally of the view that the crisis in the U.S. and Western Europe has been addressed sufficiently to provide a slow recovery. However, I am quite concerned of collateral damage from elsewhere bringing things to a head and precipitating a systemic problem. European bank lending to over-indebted emerging markets is tops on my list of worries.

Niels Jensen puts it quite well.

In the US, bank lending is already responding to Fed’s tactics. Total commercial and consumer bank lending has grown by an annualised rate of almost 50% in the last month and a half. Quite impressive in an economy which is supposedly in recession.

So far so good. The problem is, however, that the near meltdown has unleashed an asteroid storm of problems. Take Iceland. As most investors know by now, Iceland is in very serious trouble. According to at least one estimate, European banks stand to lose about $75 billion on Iceland – not exactly pocket change. And that is on a population the size of Coventry! Earlier this week, the Central Bank of Iceland raised the policy rate from 12% to 18%. Inflation is now running at about 16% and will undoubtedly peak at much higher levels. According to Danske Bank, expect it to hit 75% before things get better. That is ugly.

The canary in the coalmine

I have an increasingly uneasy feeling that Iceland is the canary in the coalmine. Hungary is struggling. So are Pakistan, Ukraine, Belarus, Romania and Argentina. Cristina Fernández de Kirchner, the President of Argentina, took everyone by surprise last week when she announced that the country’s private pension funds (about $26 billion) would be transferred into the state pension system. The official line is that she is aiming to protect the country’s pension funds from the global turmoil. Who is she kidding?

Now, the Federal Reserve Bank has decided to provide emergency loans to Mexico, Brazil, Singapore and South Korea. Not that long ago, it was Singapore (amongst others) which provided emergency funding to the ailing U.S. banking sector. If countries such as South Korea and Singapore require help from the outside, the state of affairs in other and less developed nations could be much worse than generally perceived.

This is the problem. There are any number of countries that are in jeopardy of imploding from a slowing economy, high debt and macro imbalances. The list extends from Asia to Eastern Europe to Latin America and beyond.

“So what?” you say. Well, not so fast. In a globalized economy, the interdependence of nations is a lot more than you might think. In fact, European banks have a lot of exposure to Emerging markets, having lent ridiculous sums over the past decade. Think of this as a 1980s Latin American debt problem writ-large.

European banks at risk
Worldwide cross-border lending now stands at $37 trillion with about $4.7 trillion going towards Eastern Europe, Latin America and emerging Asia. Cross-border lending by European and UK banks to emerging market countries accounts for 21% and 24% of respective GDPs compared to 4% for U.S. banks and 5% for Japanese banks (see chart 4). Europe has about $3.5 trillion of debt outstanding to emerging market countries whereas the U.S. has only about $500 billion on the line.

The country most exposed to emerging markets is Austria with total emerging market loans accounting for no less than 85% of the country’s GDP – most of it to Eastern Europe. Austrian banks have been aggressively pursuing opportunities in Eastern Europe for years. They have in fact been so aggressive that their total lending to the region (approximately $300 billion) exceeds the amount lent by Germany to Eastern Europe. Even more worryingly, Austrian banks are the largest holders of debt on Hungary and Ukraine – two of the most fragile economies on the old Soviet bloc. As an aside, when the global banking system collapsed in May 1931 in the midst of the Great Depression, it was a run on the Austrian banks which acted as a catalyst.

Italy is possibly in an even more dire condition. According to a recent article in The Daily Telegraph3, Italy’s public debt is now the third largest in the world, behind the U.S. and Japan. And, at 107% of GDP, it is almost twice the limit set by the Maastricht Treaty (so much for treaties!). Italy is also a big lender to Eastern Europe. Unicredit alone has about $130 billion of debt outstanding to Eastern European countries. Italy’s predicament is well recognised by fixed income investors. 10-year Italian government bonds now yield 1.08% more than their German sister bonds. The market is telling us that something rather unpleasant could happen to Italy. It is even possible that Italy could be forced to pull out of the euro, unless they can turn the ship around fairly quickly.

Meanwhile, UK banks are primarily exposed to emerging Asia and Latin America. Only Poland stands out in Eastern Europe as a major recipient of loans from UK banks and Poland is perhaps not up to its neck in problems the way Hungary and Ukraine are right now, but the situation is deteriorating there as well. Sweden is mostly exposed to the Baltic countries. The three Baltic countries owe a total of $123 billion, $83 billion of which originate from Sweden. Knowing that Latvian banks in particular have been rather innovative with the structure of their mortgage products (such as Yen based loans), would you sleep well if you were the credit officer of one of the major Swedish banks?

Spain is the Latin juggernaut

Spain is another worry. Contrary to popular belief, the U.S. is not the largest lender to Latin America – Spain is. Just under $1 trillion of cross-border debt is outstanding across Latin America. Only 17% of that comes from U.S. banks. Spanish banks, on the other hand, have more than 30% of the debt on their books. Let’s hope for Spain’s sake that Ms. Kirchner is telling the truth when she claims that the nationalisation of the private pension funds was done to protect them from the evils of this world. Somehow I doubt it.

The sharp rise in the value of the U.S. dollar and the Yen is not helping emerging market economies either. We do not know exactly what proportion of the $4.7 trillion of loans to emerging market countries are denominated in U.S. dollars and Yen respectively, but we suspect that it is a significant share. As long as the world is deleveraging, you should expect both currencies to continue to appreciate in value, as most carry trades have been based on either U.S. dollars or Yen. Meanwhile, some countries are putting up a brave fight (e.g. Hungary and Romania). However, as we learned in 1992, a wounded currency is like a bleeding torso in shark infested waters. You can rest assured that speculators will finish off the job. No central bank can win that battle.

One might argue that a devaluation of the Hungarian currency or a collapse of the Pakistani economy won’t really affect your portfolio, but that misses the point. It is the risk to an already wounded banking industry you have to worry about. And, as I have pointed out above, European banks are much more exposed to emerging market countries than their U.S. competitors.

And this is a big problem because European banks are undercapitalized. You might remember an article I wrote in June referencing a Citigroup study that said that European banks had a $400 billion capital shortfall. This shortfall has not disappeared. Arguably, it is much worse despite the many government bailouts in the intervening months because the losses have been much greater than anticipated.

If European banks were to suffer large losses in the emerging markets, we could have another panic on our hands, and this time no amount of government intervention would be able to forestall the inevitable bank runs and deleveraging. I recommend you read Niels’ piece. We need to sound the alarm on European banks because these institutions are in desperate need of more capital. If we wait until crisis hits to tackle this looming threat, it may be too late.

Source
When the Chickens Come Home to Roost – Niels Jensen

Related posts:

• A shift to Eastern Europe and emerging markets too
• Currency crisis is gathering storm
• Ten eastern European countries now looking to IMF for bailouts
• Quote of the day: Austrian banks
• Switzerland threatened with bankruptcy

Baltic currencies are overvalued, which has led to hot money flows and unsustainable levels of consumption. A crash is all but inevitable. The Baltics want in to the Euro, Estonia and Lithuania in particular. They are willing to sacrifice their economy on the altar of the Eurozone’s fixed exchange rates because the Euro is a political union as much as an economic one

This reminds me of 1992. Remember when the Pound was kicked out of the European exchange-rate mechanism (ERM)? Well, it was obvious from the start that the pound was overvalued. In 1989, Margaret Thatcher’s personal economic adviser risked an open dispute with Chancellor Nigel Lawson over the pound, ERM and fixed exchange rates.

The current crisis, long festering between Mrs. Thatcher and her Chancellor of the Exchequer, Nigel Lawson, exploded when her personal economic adviser, Sir Alan Walters, sent a now famous manuscript to The Financial Times of London – in lieu of granting it an interview about his personal life and views. The document, headed ”A Life Philosophy,” had been written for an obscure American journal, The American Economist, 18 months earlier; it has not yet been published.

In one devastating paragraph, Sir Alan declared: ”For more than 35 years I have been convinced that the various forms of pseudo-fixed exchange rates, dignified by various names such as crawling pegs, reference zones, etc., had only deleterious consequences – especially encouraging overvaluation and repression (on the part of dependent currencies such as sterling, the French franc, etc.) and massive capital flight or inflow when the ‘realignment’ was imminent, which would in turn give rise to proposals for more exchange controls and trade barriers.”

So he urged Britain to resist the pressures from Europe and ”the British establishment” to put the pound into the Exchange Rate Mechanism and instead to maintain its system of flexible exchange rates. ”So far,” he said, ”Mrs. Thatcher has concurred.”

-NY Times, 6 Nov 1989

Yet, the political desire for unity with the rest of Europe won the day — Margaret Thatcher’s government fell and paved the way for John Major and Britain’s europhiles. This pushed Britain into an unwise economic decision. The recession of the early 1990s was made all the more severe by the economic policies used by the UK government to defend the Pound’s overvalued peg.

So, here we are more than 15 years later with the same experiments in Euroland toward fixed exchange rates at unreasonable pegs. We have seen the Baltic States enter the Euro at unreasonably high exchange rates, causing their economies to overheat, risking a crash. Again, this was obvious from the start:

In its January report, the Bundesbank argued that the high current account deficits of east European countries could pose a risk if they were to enter the euro too fast. The Bundesbank said the problem is not the current account deficits themselves, which are normal for countries at this stage of economic development, but the impact of high current account deficits on the exchange rate. The biggest risk lies in the choice of a potentially wrong conversion rate when entering the euro. As we have seen in the case of Germany, which entered the euro with only a moderately overvalued exchange rate, it can take many years to correct such a mistake.
-FT, Wolfgang Munchau, 29 Jan 2006

While there is considerable difference between the three countries of Estonia, Latvia, and Lithuania, in general, things are destined to end badly for the Baltics. The countries would be advised to look after their economies first and politics second. A nasty recession in the UK after its unwise ERM experiment so put the British off to joining the Euro that they are still outside the Eurozone 15 years later. This is a lesson in history that Estonia and Lithuania both need to take seriously. An economic slump because of poor economic management will set their cases for the Euro back even further.

Related Posts
Estonia and Latvia: headed for the rails
Are the Baltics the new Argentina?

Related posts:

• Are the Baltics the new Argentina?
• Baltics: Fitch downgrade and more downgrades to come
• More trouble in the Baltics as S&P downgrades
• Iceland and the wonders of competitive currency devaluation
• Russia, sovereign debt defaults, and fiat currency

Late last month, I made a big to-do about the Baltics becoming the next Argentina. Well, part of that mess is unraveling as we speak. Estonia is in recession and Latvia is headed for recession.

Read my translation of a Dagens Nyheter article from Sweden. The Riksbank, Sweden’s Central Bank, has reason to worry about Swedish banking exposure to the Baltics and its effect as a drag on the Swedish economy. SEB and Swedbank have the most exposure.

Estonia: another EU country in recession

More and more countries are reporting a falling economy. Estonia is the second European country which has entered a recession.

Earlier, Denmark reported a negative GDP development. On Wednesday, it was Estonia’s turn. GDP declined by 1.4 percent in the second quarter compared with the same period last year.

There will be negative numbers even in the third and fourth quarter. Yes, we are in a recession, “said SEB economist Box Eire about the Estonian economy.

SEB, along with Swedbank, has a lot of banking activity in the Baltic countries. The GDP figure, which was weaker than expected, put pressure on the two banks’ stock prices, which were down over four percent each.

Even the Latvian economy is at a standstill. Year-on-year growth in the second quarter came in at +0.2 percent.

Notice that this is second quarter data and Q3-Q4 data should be even weaker. Writedowns for Swedish banks are coming.

For my U.S. and UK readers who could give a t%ss about the Baltics, know that these downturns are all inter-related. With the likes of Japan, South Africa, and the Baltics all separatly hitting the wall, it is obvious that there wil be some negative feedback for economies like the U.S. and the UK as well.

Source
Estland andra EU-landet i recession – Dagens Nyheter

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For those of you who actually care about anything international, there is an Emerging Markets crisis brewing right now in the Baltics. After reading posts from Alpha Sources, naked capitalism, Market Movers, and Bronte Capital on the subject, I started to think people actually cared about the tiny Baltics. So, let me add my two cents.

The Baltics are looking a lot like Argentina was before it collapsed at the beginning of the decade: fixed exchange rate, large current account deficit, significant foreign bank lending, overheating economy turning to bust.

This combination is a toxic mix that will certainly end in the disaster it did for Argentina. I have a vivid memory of being in Buenos Aires when workers were rioting in the streets, knocking over cars and setting them on fire. Foreign banks were littered with Graffiti, including the word “ratas,” scrawled across them. Many banks were shut down and closed and too many banks I could see had armed guards with submachine guns out front to protect them. I can’t say this same disastrous scenario awaits the Baltics, but things could get pretty dicey there in any event.

Claus Vistesen at Alpha Sources says:

As the Q1 GDP numbers came in for the Baltics I concluded that it was very likely that the region had entered a recession. In light of the proverbial definition of a recession as a consecutive quarter contraction it seems clear the Lithuania managed to smartly skirt the recession in H01 2008. As far as I can see at this point and from Eurostat’s data Estonia was the only one of the three Baltic economies that contracted in Q1 2008 (-0.5% and 0.1% for Latvia).

However and as ever before, the Baltics is increasingly getting stuck in stagflation and one of a particular sinister kind. In the case of the Baltics they may already be seeing the beginnings of a hard landing, whereas others continue to build up steam making it almost inevitable that they too will erupt at some point.

More to the point, the Baltics have a lot of hot money invested in their economies as much of the lending growth came on the back of foreign financial investment. When distress hits, one should expect a giant sucking noise from foreigners repatriating funds. This will leave the Baltics subject to credit deflation just as the economy is entering recession.

When one adds the slow economy and the high inflation to a fixed exchange rate and high current account deficits it says: the Baltics do not have the appropriate fiscal and monetary policy for a fixed exchange rate.

One of two things must give: the exchange rate peg or the economy. In Argentina, it was both.

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• Baltics: Violence from an Argentina-style collapse
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