As I pointed out recently in the context of Latvia and the impending potential for a devaluation, there is a distinct risk of falling victim to the sin of crying wolf. Yet, as the plot inevitably thickens I am maintaining, as it were, my cry. There are two significant points to think about in the context of what we might call recent developments. First of all there is the news that the 2009 deficit envisaged in the budget before the Latvian parliament will amount to 9.2% of GDP - significantly higher than the original IMF agreed "limit" of 5%, and even well above the latest negotiating objective of the Dombrovskis government of 7%. Of course, this is just number salad but at the end of the day it is important because it determines whether and under what condition the IMF funded bailout packaged continues. The fact that Latvia reports a deficit of this magnitude almost amounts to throwing in the towel in my opinion, or at least it means that the playing field is now a different one when it comes to IMF funding. Finally, and in case you think that Latvia has not already cut spending just look at the following estimates for cuts in the public sector:
Taking into account that the budget amendments envisage steep spending cuts, the amendments must be passed immediately, so that the ministries and other government agencies know how much money they will be allotted from the budget this year, stressed the Finance Ministry.
It is planned that the Defense Ministry's budget will be reduced LVL 30.8 million, the budget of the Finance Ministry will be cut LVL 14 million, Interior Ministry - LVL 10.4 million, Education and Science Ministry - LVL 22.1 million, Agriculture Ministry - LVL 20.5 million, Transport Ministry - LVL 109.5 million, Welfare Ministry - LVL 7.2 million, Justice Ministry - LVL 7.4 million, Culture Ministry - LVL 15.9 million, Health Ministry - LVL 39.3 million, and Regional Development and Local Governments Ministry - LVL 10.8 million.
The initial demands would of course represent even deeper cuts and this is the main point in this case; just how much pain can you inflict under a fixed exchange rate before the dam breaks? As it appears, everyone has a breaking point and with e.g. property prices slumping 50% y-o-y in Q1 alone it is not difficult to see the boom-bust nature of Latvia's recent economic performance.
Another and very important part of the picture comes from the fact that it is not only the IMF who is footing the bill in Latvia. Consequently, and this is the case for all three Baltic economies, the expansion has effectively been characterised by the outsourcing of the financial sector to particularly Nordic banks' subsidiaries and most notably Swedish owned banks. This creates a large dilemma in the context of devaluation since most of the of the credit to corporates and households have been provided in Euros as a result of the so-called road map towards Euro entry which was perceived as a fait accompli. Recently, RGE analyst Mary Stokes explicitly tackles this question in the context of the entire CEE edifice. Stokes frames the issue neatly when she says:
The general idea is that these parent banks (as well as the CEE economies in which they operate) are likely to be collectively better off if they all continue to support their Eastern European subsidiaries. The problem, however, is they may not be individually incentivized to do so.
Stokes is initially positive in the sense that we won't see a large scale withdrawal of foreign banks from Eastern Europe citing recent evidence in the context of Romania, Hungary and Serbia where foreign banks have pledged to support their subsidiaries despite strong economic head-winds. However, she also makes a very important point when she coins the notion of the asymmetric prisoner's dilemma. What lies behind this term is the idea that because different foreign banks are exposed to a different degree in different parts of Eastern Europe with different economic fundamentals the idea of a common commitment across the board may be difficult.
One key ingredient here is of course, as Stokes notes via Fitch ratings, that the extent to which banks are exposed relative to their parent companies differ substantially. This is simply to say that while some banks are indeed able to shoulder the inevitable losses which will come in a CEE context, some are threatened on their life . Finally, there is the risk that if one bank decides to give up its support for the subsidiary and thus the domestic economic edifice in its current form, so will other banks do the same. On a macroeconomic level this would of course be tantamount to one economy deciding to devalue which would immediately, one would assume, force others to follow suit.
As you can probably tell by now I am getting closer to the topic at hand. Consequently, I believe that what is now materialising with Latvia as the main venue is exactly this asymmetric prisoner's dilemma that Mary is talking about.
Let us begin first with the simple and ominous sign that lending conditions in the Latvian interbank market have become increasingly tight recently. I already pointed to this in my previous post (see link above) where I noted how the Latvian central bank, through its currency board, has already spent over 500 million euros buying lats. Last week in particular was tough as Bloomberg reports how the central bank had to buy 95.4 million lati ($190.6 million) in order to protect the Lati from moving below its trading limit where it is only allowed to move 1% either way against the Euro (from a mid point). According to Bloomberg, such purchases have already caused the foreign exchange reserve to shrink by 38% between September 08 and April 09 alone.
Latvia’s overnight lending rate rose to a record today because of a shortage of lati on the market after central bank purchases of the currency and Treasury bill sales, said Andris Larins, an analyst at Nordea AB. Asking rates on the overnight Rigibor, the interbank lending market, rose to 14.2 percent after the central bank bought 95.4 million lati ($191.5 million) to support the currency last week. Treasury bill sales and higher interest rates on money the central bank charges to borrow also contributed, Larins said.
As can be seen, the effect from these operations have driven the interbank rate to its highest in more than 10 years as the central bank purchases are sucking up liquidity from the market. The main message here is that the shorter term rates are converging to the annual rate (click image for better viewing).
Especially, it is important to pay attention to the fact that the overnight rate has skyrocketed and even surpassed the annual rate. The overnight rate has risen 1352 basis points since the 21st of May and it indicates verly clearly how much stress and uncertainty is building up in the market. Essentially this is the effect Bear Stearns / Lehman had on the Libor back in the days where global interbank markets were freezing over. Moreover, I have from reliable sources that some banks are quoting overnight rates as high as 20% which suggests that things are moving fast at the moment.
But why all this fuss now then?
Well, it is worth remembering that it already began last week and as I pointed out above the larger than expected announced budget deficit cast serious doubt over the potential for future IMF funding. However, a more prominent reason is certainly that the Swedish banks and Swedish discourse in general have begun to turn strongly towards devaluation in Latvia as a sure thing. Last week, the Riksbank strengthened its foreign currency reserve with 100 million SEK, but more importantly SEB Chief Executive Annika Falkengren noted how the level of defaults would essentially be the same regardless of whether Latvia devalued or corrected through internal price deflation.
This kind of message from a Swedish bank executive is not without importance since it is, for a large part, Sweden that have financed the Baltic expansion through the heavy exposure of many Swedish banks in the Baltic economies. Up until now however, popular belief has held that since most of the loans having been offered by foreign banks were in Euros these banks would strongly reject devaluation as it would effectively eat up a large part of their balance sheet in one sweep. However, as many of us have pointed out these defaults would come anyway as a result of the sharp and essentially brutal deflationary correction. It is exactly this recognition which seems to have trickled down to Swedish bank officials.
As a consequence of this and, arguably, a host of other things Bengt Dennis, a former Swedish central bank governor and an adviser to the Latvian government was quoted this weekend as saying that a Latvian devaluation is a done deal. The only question would be when and how.
Bengt Dennis, the former Swedish central bank governor and an adviser to the Latvian government on how to cope with the economic crisis, said the Baltic country will need to devalue its currency. “No one knows if there will be a devaluation tomorrow or in a few months -- the timeframe is always uncertain -- but we have moved beyond the question of whether there will be a devaluation and should instead focus on how it will be carried out,” Dennis told Swedish state television SVT last night.
This is of course pretty unequivocal and indicates quite strongly how the end game is near. In essence, it is very obvious, I think, that the sentiment in Sweden has turned from one in which the desire to wait out the storm and take the losses gradually to one where there is a demand for closure and immediate quantification of the losses. This is significant since the longer markets believe that Swedish banks no longer explicitly support the peg, the closer we move towards a devaluation.
Clear signs of such sentiment comes from the publication of the Riksbank's Financial Stability Report out Tuesday where it is estimated how Swedish banks will lose as much as SEK 170 billion during 2009 and 2010 on loan losses. Now, it is impossible to say whether these estimates implicitly include a Latvian devaluation or not, but one thing is certain; the estimates have the Baltics written all over them and, if anything, the downside looms as a direct function of the potentially worsening situation in the Baltics. Add to this that the Swedish economy in general has endured an absolutely horrendous 6 months across Q4-08 and Q1-09 and it is not difficult to see from where the impetus to pull the plug in the Baltics could come from. Recent figures for GDP indicate how national output fell 6.5% over the year in Q1-09 which compares to an annual drop of 4.9% in Q4-08.
To add to the pressure it also appears that the political tension in Latvia is growing.
In the first instance there is of course the expected and almost obligatory refutation of Dennis' comments about the almost certainty of a devaluation.
I hereby announce that an opinion by Bengt Dennis, member of the High Level Advisors Working Group to the Government of Latvia, which he expressed today to the Bloomberg news agency about an inevitable devaluation of the Latvian national currency – lats – is not true, and should be evaluated as expert’s personal, individual opinion which has nothing to do with issues concerned in the first sitting of the High Level Working Group, as well as with the position of the Government of Latvia on overcoming the economic crisis.
This is of course all well and good, but the question is whether we can take this for granted as the "official" position. For starters, Bloomberg (linked above) quotes Justice minister Mareks Seglins for calling a debate about the potential gains and losses relative to a currency devaluation. This would indeed be something new in a Latvian context as a debate about the Lati's Euro peg hitherto has been stifled completely by the official backing of the Lati's value against the Euro. As people closer to the Baltic situation than me have pointed out, this may be a specific attempt to stir up things by Seglins since his party are bound to lose local elections come Saturday and may thus lose the majority in parliament.
A Done Deal Then?
Not quite, but it is impossible not to notice that some significant cracks have emerged. I think it is particularly important that Swedish stakeholders in the Baltic debacle now seem to favor "throwing in the towel" through a devaluation as it is assumed that it would amount to the same thing, in the end, as trying to keep things together. Of course, no one other than Latvia herself can choose to devalue, but the signs from Sweden are very important in the sense that the Swedish banks are paramount in keeping the economic edifice together. Moreover, there is the IMF where we do not yet know whether bailout funding will continue with the new estimate of 2009 budget deficit. My guess is that the IMF won't stand for it but then again, it would be wise to cut some slack if they have an interest in keeping the peg (which I am not sure it really wants).
I will end as I did last time with a general warning. At this point rumours will drive the discourse as much as real economic fundamentals and political decisions. However, it is difficult to deny that a devaluation in Latvia seems to be moving closer.
 - Incidentally and for all the complaints about me focusing too much on the similarities between the CEE, here is an example of differences. This is to say that when it comes to a high degree of event risk there are of course notable assymmetries. What I would like, however, to point out is that when it comes to the fundamentals and the underlying problems/causes of the crisis, the Eastern European countries are, in many cases, strikingly similar.