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Latvia’s Economic Collapse: 2 Ways To Play The Baltic Region’s Financial Firestorm

|Includes: EWD, iShares MSCI Austria Capped ETF (EWO)

by Marc Lichtenfeld, Senior Analyst, Smart Profits Report

Back in February, I wrote about an impending crisis in Eastern Europe.

In my column, I mentioned that if Eastern Europe begins to head downhill, we could see a domino effect, with the contagion spreading very quickly.

Yesterday, the first domino may have fallen, courtesy of debt-laden Latvia. The country attempted to raise $100 million by selling debt securities. But there were no takers.

Let me repeat that. Latvia didn’t raise one measly dollar. That is staggering.

So why should we even care about this tiny Baltic country whose population is equivalent to that of Houston?

Simple. Because these things ripple across borders. Here’s what it means for the rest of Europe - and how to play it…

The Little Guys Need A Bailout, Too

In March, we noted the prospect of Latvia going bankrupt by this month. And as a result of Latvia’s failed auction, the currencies of other Eastern European countries such as Hungary, Poland and the Czech Republic were pounded.

With Latvia’s economy expected to contract 18% this year, the European Union and International Monetary Fund are reportedly considering a 7.5 billion euro ($10.6 billion) loan package to Latvia to help stem the crisis.

But that’s only if Latvia continues to peg its currency (the lat) to the euro and slashes government spending. However, there’s already been talk of a sharp devaluation of the lat.

To Devalue Or Not To Devalue?

If Latvia doesn’t devalue its currency: Sure, it might get the loans, but government services will be slashed and the debt crisis will remain. One third of the nation’s teachers have already been fired.

If Latvia devalues its currency: The country will have an easier time paying its debts. But citizens will see their buying power crushed and the country won’t get the help it needs from the EU and IMF.

Not only that, if the lat is devalued, there’s a good chance that the currencies of other eastern bloc nations like Romania, Bulgaria, and Lithuania would follow suit.

In turn, that could affect other countries like Poland and the Czech Republic. And Western European banks would be severely impacted.

The 1.3 Trillion-Euro Domino Effect

As mentioned in my February column, there are many banks all across Europe that have exposure to Eastern Europe.

In fact, Western European banks have 1.3 trillion euros ($1.8 trillion) worth of exposure to the region.

And the usually conservative Swedes are particularly vulnerable to a fallout from the Baltic states, with their banks having $75 billion at risk. So if governments devalue their currencies, banks that have outstanding loans in those countries will suffer devastating losses because the money that is repaid to them will be worth far less that what was originally lent out.

As I mentioned in my previous column, this could cause a flight to safety into the U.S. dollar. Here are two ways to play that trend…

Two Ways To Play The Eastern European Meltdown

~ iShares MSCI Sweden Index (AMEX: EWD): As I mentioned, Sweden’s banks are heavily exposed to Eastern Europe, so this is one country collectively holding its breath. This ETF tracks the price and yield performance of Swedish shares on the Stockholm Stock Exchange, and in addition to the serious pressure it faces from Eastern Europe, EWD also bounced over 70% from its lows and is due for a correction. You can short EWD or buy put options on it.

~ iShares MSCI Austria Index (AMEX: EWO): Like Sweden, Austrian banks also have a lot of exposure to Eastern Europe’s woes. And like EWD, this ETF seeks to replicate the performance of Austrian shares that trade on the Vienna Stock Exchange. EWO has doubled from its lows just three months ago and you can short it or buy put options if you want to play the downside.

For more on Europe’s woes, be sure to check out the recent column from my colleague (and one of my favorite Europeans) Martin Denholm.

Marc Lichtenfeld

Disclosure: No positions