Debtor's Prison

Greetings fellow inmates:

Last week the small Baltic country, Latvia, made headlines due to its continuing problems with both its economy and its currency. Primarily, the reason this case interests us here at DP is because the real underlying problem behind this brewing crisis is a massive external debt. The financial-economic linkages have proven to be extreme in Latvia, thus serving as a good test-case. Moreover, the ramifications of this looming crisis will extend far beyond Latvia’s borders as we’ll detail below.

As the story goes, Latvia and the other Baltic countries had experienced a fantastic growth in the years leading up to the GCC. From 2001 to 2007, real GDP in Latvia grew by an average 9%. Most of this growth was fuelled by strong capital inflows from Europe and elsewhere. In particular, there was an incredible growth in foreign-denominated debt. Interest rates in the local currency, the lat, were too high, prompting Latvians to take out mortgages and other loans in other currencies, notably the EUR, USD, CHF and JPY. Western banks were all too eager to lend to these new EU members, property and asset prices went through the roof; CPI inflation was 16% at the start of 2008, 10% at the end. The chart below gives you an idea of what a discrepancy there was between loans in EUR and Lats. Notice that the loan growth for EUR-denominated loans for households and corporations have slowed dramatically (and even more during 2009) from an annual growth of 50% to 10%.

As is well-known, the economic situation has taken a dramatic turn for the worst. As the GCC hit, Latvians found no more financing and the powerful economic-financial transmission channels have sent the economy into a tailspin. Cross-border bank funding was severely disrupted as Western banks pulled back, creating a vicious cycle of declining private sector debt and output declines. In the first quarter, GDP contracted by 18% annualized and house prices were down 50% from a year earlier, the biggest drop in the entire world. Unemployment is at 17%, according to Eurostat. One of the most representative indicators of the extreme imbalances in Latvia, and the Baltics in general, was their massive current account deficits, which hit double digits (as percent of GDP) every year since 2004. This means that the massive surge in foreign-denominated borrowing was being used to finance not only local property purchases, but also goods and services from other countries.

From a monetary perspective, we have also seen some much-to-be expected dramatic action in various aggregates. First we have a chart of components of M3. What first strikes us is the enormous numbers leading up to the GCC when deposits were growing at an annual 120%, at least in short-term deposits. In September, these numbers dropped precipitously to a 20% contraction. The Latvian Central Bank attributes some of this decline in rising interest rates for longer-term deposits. We believe this is also due to the compulsion of debt repayment as rolling the debt over became impossible.

Our hypothesis is supported by the following chart that compares the annual percentage changes in loans denominated in lats versus those denominated in EUR, the latter which saw sharp drops from close to 60% to close to 0% for households. This also corresponds with the drop in EUR-denominated lending we saw above.

Our point perhaps might be a moot one since it is a well agreed-upon point that massive external debt on top of large imbalances (ie: current account) are to blame for the economic tsunami facing Latvia at the moment. What we hoped to highlight however was how powerfully foreign-denominated debt, short-term deposits and purchasing power were interlinked.

Currently, Latvia is in a pickle with the IMF over its budget deficit and its defense of the peg to the EUR. As part of the $10bln bailout package Latvia procured from the IMF was the stipulation that Latvia would bring its budget deficit to 5% of GDP, as opposed to the current 9%. The necessary cuts would be draconian, with a third of country’s teachers being fired already and across-the-board public worker pay cuts of 35-40%. Even then the prospects of this barrier being met are slim; Latvia already fail to secure the March disbursement of the package due to this. Many analysts have opined that devaluing the currency (breaking the peg) would provide a quicker fix to the economy, by greatly boosting exports. To be sure, being forced to peg to the EUR under the Exchange Rate Mechanism (ERM) is like a straight-jacket on a crumbling economy with a depleted domestic demand. A quick devaluation of the lat would allow some economic recovery to take place through boosting exports. Latvian political figures have sent mixed signals, with the Premier Valdis Dombrovskis saying rumors about a devaluation should be terminated after earlier having admitted that the lat was probably overvalued versus the EUR by 30%. Expectations of a devaluation have been rampant in the marketplace, to the point that Latvia failed to sell a single bill at a $100m treasury auction. No one wanted Lats. Traders are betting that by the end of the year, lats will have dropped more than 50% versus the EUR. Fitch Ratings says that the foreign-denominated debt maturing in 2009 is 320% of foreign exchange reserves. We are in agreement with market indicators on the fact that a devaluation seems inevitable.

A few aspects complicate the view of a rosy recovery through devaluation however. For starters, breaking of the currency peg would be the first break from the European ERM since Great Britain bowed out of the EUR in 1992. A break of the peg in Latvia would almost certainly cause the other Baltic countries to also break the pegs and it would also severely strain currencies in Hungary, Poland, Bulgaria and Romania. Even more stable currencies, like the Swedish Krona, would be hard hit due to their huge exposure to this sour debt. Sweden alone has 40-50% market share in the Baltics. Western European banks have more than EUR1.3tr in exposure to the region, most of it in EUR- or other-denominated debt. As the local currencies crash, repayment of these foreign debts will become impossible for many debtors, causing a massive wave of defaults and bank losses. This could even be a brand-new sovereign debt crisis in the making as well.

Surely, this is something to watch closely in the coming weeks, we’ll keep you up to date on the progress of this brewing crisis. The takeaway we hope you take from this, once again, is the peril that lies in borrowing or lending too much. There is always a breaking point, and in many ways we have reached it, as individuals, corporations, nations and even as a planet.

May your capital be safe and your investments prosperous,

MAAA