Gideon Rachman has a pretty gloomy piece in the Financial Times on the lousy state of affairs in the Baltics. Short story, like a lot of places, they went on a monster debt bender and now have an awful hangover.
Rachman suggests that Baltic woes could blow back and hurt Europe’s recovery. The trigger would be if they drop their currency pegs, which would almost certainly lead to defaults on external debt (as if that isn’t in the cards, regardless). On paper, given the small size of the economies involved, that may seem like a bit of a stretch, particularly since the banks most at risk are in Sweden. Peculiarly, he does not mention the dimensions of the danger, as in size of economies, possible banking losses, who might eat them. nor does he articulate what I think is the real vulnerability.
The open question is how fragile are Europe’s banks now? They ran on even lower equity levels than US banks, ate a lot of bad US paper, and depend on national regimes for backstops. In the Netherlands, Switzerland, and Germany, the banking sectors are too large for their governments to credibly back them up. Of course, Deutshce Bank has been very loudly insisting that it is fine, to the point where one wonders whether the lady doth protest too much.
The point here is a bit different that what Rachman mentions, or perhaps he regards it as implicit. It might not take that much for Eurobanks to look pretty wobbly again. The Baltics plus another worse than expected development (Chinese stock market downdraft? Swine flu looking like a real risk for the winter?) might be enough to have serious knock-on effects,
From the Financial Times:
A writer who projects emotions on to the weather is guilty of the “pathetic fallacy”. But, at the risk of sounding both pathetic and fallacious, it was entirely appropriate that the sky darkened and the thunder cracked as I approached the office of the Latvian prime minister in Riga last week. The gloomy atmosphere reflected the dark mood in a small, embattled country of 2.2m people. While business headlines in the rest of the world speak of clearing skies and rays of sunshine, the Baltic states are still in the midst of a howling economic gale.
Despite the region’s small size, the intensifying crisis in the Baltics cannot be treated as a freakish local squall of little concern to outsiders. Bank failures or plunging currencies in the three Baltic nations – Latvia, Lithuania and Estonia – could threaten the fragile prospect of recovery in the rest of Europe. These countries also sit on one of the world’s most sensitive political fault-lines. They are the European Union’s frontier states, bordering Russia.
The economic downturns in the region are shocking. Last week, Lithuania announced that its economy had shrunk by 22.4 per cent, at an annual rate, during the second quarter of 2009. Latvia and Estonia are likely to record similar falls when they announce their figures. Dalia Grybauskaite, the Lithuanian president, told me last week that her country might have to apply to the International Monetary Fund for a loan. Latvia has already trodden that path. Last week it agreed its second loan in eight months from the IMF and the EU.
The injection of cash is the good news. The bad news is that, in return for shoring up state finances, the new IMF deal will require the Latvian government to impose yet more pain on its suffering population. Public-sector wages have already been cut by about a third this year. Pensions have been sliced. Now the IMF requires Latvia to cut another 10 per cent from the state budget this autumn.
So far, the population has treated the downturn with remarkable equanimity…But the government has good reason to fear a winter of discontent. Unemployment benefits last just nine months in Latvia. Many Latvians lost their jobs at the beginning of this year – and will lose their income from the state this autumn. Officially, unemployment is 11 per cent, unofficially it is 16 per cent and rising fast. Heating bills also shoot up in the cold Latvian winter. Cutting police pay by 30 per cent in such circumstances seems slightly foolhardy.
It would be easier if the Latvian government could point to some prospect that things will eventually improve. But the country seems to be locked into a downward spiral. Property prices – which a few years ago made flats in Riga pricier than apartments in much richer western European cities – have collapsed. The banks will not lend. Jobs are going, wages are falling, the government is cutting.
With no hint of a domestic revival, the Balts have to pray for a revival in the world economy. But the Russians and the Germans are not buying. “Our export markets on both sides are closed,” says Ms Grybauskaite.
One way to ease the pressure might be to devalue local currencies and so boost exports. But the Baltic states are all grimly hanging on to their “pegs” – fixed exchange rates with the euro. In Latvia about two-thirds of private loans have been taken out in euros. The government fears that devaluation would bankrupt many citizens. But wage cuts could simply provide an alternative route to bankruptcy.
Latvia’s paymasters – the EU and the IMF – seem divided. The IMF has been open to the idea of scrapping the peg. Brussels is firmly against, fearing that it would trigger currency instability, bank failures and competitive devaluations across the EU.
The Latvian and Lithuanian governments are adamant that they will not devalue. That is what all governments in their position always say – right up until the moment when the dreaded decision is made. Their reluctance is not simply to do with economic risk. The Balts also worry that if they devalue, they might come to look like second-class members of the European club – a dangerous position for countries that were part of the Soviet Union less than a generation ago.
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They will have to devalue. The only question is whether they will devalue before they default or after.
"Latvia’s paymasters – the EU and the IMF – seem divided. The IMF has been open to the idea of scrapping the peg. Brussels is firmly against, fearing that it would trigger currency instability, bank failures and competitive devaluations across the EU."
hahahaha, this is a joke. everyone in the eu is so afraid of the devaluation of the lat. this guy makes it sound like the euro is pegged to the lat, not the other way around. and what is his projected devaluation of the gbp that would follow?
hahahaha, this is a joke. everyone in the eu is so afraid of the devaluation of the lat. this guy makes it sound like the euro is pegged to the lat, not the other way around. and what is his projected devaluation of the gbp that would follow?
Spain, Ireland, Portugal, Italy, and Greece say hi.
I think the EU are more afraid of the precedent. This is the euro's first crisis. If someone else does it, it's much easier for the country that follows. Spain and Ireland suffered from the same items described for Latvia and Lithuania in regards to real estate popping, it's just they're members of the euro and therefore do not have the opportunity to reduce their peg while the Baltics do. Spain is projected to have 2010 unemployment of 22% for example, and cannot offer any sort of devaluation so that its currency reflects the Spanish economy instead of the German economy that it currently reflects.
Besides, are you really going to argue that if Latvian society fails because their currency is overvalued that the EU shrugging their shoulders doing nothing as they are currently doing is a good thing? What's the point of being a member of this group then if that's their end result? "With friends like you, who needs enemies?"
Centre for European Reform academic paper on the organization: http://www.cer.org.uk/pdf/essay_905.pdf
Europe’s achievement in creating the euro contributes to its soft power. During the recent financial turmoil, the currency has helped to insulate the countries that adopted it from wild exchange rate fluctuations. But the Europeans cannot yet regard the euro as an unqualified success. The economies of Southern Europe are not flexible enough to flourish in the eurozone. Their poor record on innovation, productivity, deregulation and the liberalisation of services has led to declining competitiveness and serious current account and budget deficits. The financial markets have some doubts about their long-term ability to stay in the eurozone. Greece looks like being the weakest link, and if its membership became an open question, the financial markets would quickly demand a massive premium for lending to other uncompetitive eurozone economies. To prevent the contagion spreading, the EU would bail out a government in serious difficulties – but it would not lend money without imposing painful conditions that politicians would find hard to swallow.
"everyone in the eu is so afraid of the devaluation of the lat. this guy makes it sound like the euro is pegged to the lat"
This is not what the article said. It said EU is concerned it could trigger other devaluations. As history indicates, triggers could be tiny relative to the events that follow.
EU has all the reason to worry. Euro is effectively pegged to every EU country's currency (or vice versa). Euro Union is unfortunate to have its first economic crisis a full blown depression caused by worldwide over-indebtedness. Things like that don't go away in 12 months. So if Baltics devalue it may give ideas to countries like Spain and Greece.
Baltic countries, however, are not typical. The have Russia next to them. All three countries considered themselves to had been occupied by Soviet Union. When Soviet Union failed, they immediately took off in the direction of Europe and removed/destroyed whatever reminders of Soviet times they had left. They were the only three countries which haven't joined CIS – a symbolical union of former soviet states.
It's no wonder that they fear and hate Russia very much. They'd like protection from it, both economical and military. Hence the desire to join Euro Union. The peg is their first step in that direction. I suspect their citizens will be willing to endure more suffering that most people expect. The questions is however, will it be enough, given the severity of the crisis.
Ryan,
i do not remember since when spain has not had unemployment rate of at least 9%.
"This is the euro's first crisis."
what are you referring to? the current global crisis or the baltic crisis? the baltic region has grown largely due to its overexposure to real estate. none has prospered by overinvesting in non-productive assets. swedish banks hold most of the mortgages, so it is a SEK, not an EUR crisis.
the EU is a economic block: no tarriffs, no duties, free flow of capital, currency stability only within the eurozone based on mutually accepted framework of budget deficit boundaries, debt to GDP ratio and others.
the EU is not a bailout block for naive blokes.
AN,
all floating EU currencies have more or less already devalued relative to the EUR. spain, greece, italy cannot devalue, they are eurozone members and to run a budget deficit in excess of 3% of GDP, they need permission from the EC.
and if not for any other reason, one has to appreciate the existence of the EUR just for the elimination of the 2-3% exchange rate tax extracted by banks on all crossborder commerce.
spain/ireland/greece account for 10% of EU's GDP, italy for another 15%, the baltics for 0.6% (after this year's contraction of 22%).
if you bother to look at numbers, you can get a good idea about the scale of the looming crisis. if you bother to study the EU's reaction to hungary's crisis last year or iceland's, you can get even a better idea.
and a side note, in case you do not know: the euro was intended to facilitate commerce and bring stability to the eurozone members. it is not a rival to the usd's status of reserve currency, it is not intended to be by design: there are constraints on the amount of debt eurozone countries can issue and it cannot accomodate current asian and arab savings without massive appreciation against the usd.
Ryan,
i do not remember since when spain has not had unemployment rate of at least 9%.
http://news.bbc.co.uk/2/hi/business/8016364.stm – April 24, 2009
Spain's unemployment rate hit 17.4% at the end of March [2009], figures have shown, with the jobless total now having doubled over the past 12 months.
I've seen projections that next year it will reach 22%.
what are you referring to? the current global crisis or the baltic crisis?
Crisis of currency. Not all of the members of the Eurozone are economic equals. Some are suffering more than others.
the EU is a economic block: no tarriffs, no duties, free flow of capital, currency stability only within the eurozone based on mutually accepted framework of budget deficit boundaries, debt to GDP ratio and others.
the EU is not a bailout block for naive blokes.
Right. For example, budgets deficits and debt to GDP ratios. So every country in the Eurozone right now is drastically cutting their public spending because they are taking in less tax revenue correct as people are making less money and companies are selling less?