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

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.

What’s the Matter with Latvia?

Once an investor darling, Latvia’s booming, double-digit growth earlier this decade was accompanied by massive imbalances – a current-account deficit approaching 25% of GDP (among the world’s widest) and an external debt load that peaked at over 140% of GDP. T he correction in these imbalances would have been challenging under any circumstances, but the global financial crisis and consequent drying up of capital inflows have raised the likelihood of a full-blown balance of payments crisis. Latvia’s currency, the Lat (LVL), is pegged to the euro within a ±1% fluctuation band, and such pegs do not tend to survive harsh economic adjustments like that now underway. In countries with flexible exchange rates, domestic demand does not have to bear the full brunt of correction in external imbalances as currency depreciation can shoulder some of the burden.

Latvia’s economy is currently on life support. Although agreement was reached in December on a € 7.5 billion (US$ 10.4 billion) IMF and EU-led rescue package, the government is now forecasting an 18% contraction in growth in 2009 , making it one of the world’s fastest shrinking economies. The immediate focus is on whether Latvia will receive the € 1.7 billion (US$ 2.4 billion) installment of its loan package due in late June. The key stumbling block is Latvia’s ability to meet the 5% of GDP budget deficit limit laid out in the loan terms. The problem is not that Latvia’s government has been spending recklessly. Rather, the issue is that the drop-off in Latvian growth has been so precipitous, far beyond that envisioned when the loan agreement was signed just six months ago, that extreme fiscal belt-tightening is now required to meet the loan terms. A 5% GDP contraction was assumed in the original agreement, as compared to the 18% now forecast.

Latvia has been going to agonizing extremes to make the June payout happen, dramatically slashing public sector salaries. More spending cuts are in the works. As Prime Minister Dombrovskis has pointed out, these belt-tightening measures will likely trigger an even deeper recession. Even with the cuts, Latvia’s budget deficit is still expected to come in above the limit, and it remains unclear whether the IMF and European Commission are willing to relax the loan conditions. As RGE Monitor warned in early May: if Latvia does not receive the latest tranche of its IMF-led loan, the country will likely be facing a double whammy of default and devaluation.

Signs suggest that even with the June payout, Latvia may not avert devaluation. On June 3, the government failed to find any takers for the LVL 50 mm (US$ 101 mm) in bonds it was hoping to sell. While government officials still speak out adamantly against devaluation, many commentators now see devaluation as inevitable. A former prime minister has called for a 30% devaluation, and Bengt Dennis – a former Swedish centr al banker who now advises Latvia – recently said devaluation is unavoidable. At the same time, Latvia’s central bank has been burning through its foreign reserves in its efforts to maintain the currency peg. From a peak of around US$ 6.6 billion in mid-2008, foreign reserves had plunged to US$ 4.1 billion at the end of May.

Why Hasn’t Latvia Already Devalued?

A key part of Latvia’s motivation in keeping its peg was its desire to adopt the euro early next decade. That euro adoption goal, however, increasingly looks like wishful thinking given the current economic woes. Some have argued that Latvia is clinging to its currency peg to avoid mass defaults, due to the high level of foreign currency-denominated lending there (around 90% of total loans). However, as RGE Monitor argued in December , mass defaults will occur, regardless of whether Latvia devalues or adjusts via internal deflation. The key difference is that devaluation will likely lead to a more rapid wave of defaults over a shorter period of time, which could magnify stress on the banking system.

Potential for Contagion

Among the numerous reasons the IMF’s senior representative for Central Europe and the Baltics, Christoph Rosenberg, gave in January for supporting Latvia in its desire to maintain the peg was the idea that a devaluation in Latvia would have far-reaching effects beyond this small Baltic country. “[D]evaluation in Latvia would have severe regional contagion effects, especially given the fragile global funding environment. The spillovers could well go beyond pressures on countries with fixed exchange rate in the Baltics and South-East Europe. For example, market confidence in foreign banks invested in the Baltics and similar countries would likely be affected, with implications for their ability to access wholesale financing.”

Estonia and Lithuania

Strong trade and financial linkages, not to mention similar macroeconomic vulnerabilities, mean a Latvian crisis would almost surely spread to Estonia and Lithuania’s economies. Latvia’s fellow Baltics are its top trading partners. Meanwhile, the same Swedish banks that dominate Latvia’s banking sy stem also dominate those in Estonia and Lithuania, providing another channel for contagion. Latvia is the weakest link of the three, having built up the largest imbalances. Nevertheless, the other two Baltics also experienced booming growth earlier this decade, along with double-digit current-account deficits, and all three are in the midst of severe recessions. Most importantly, Estonia and Lithuania also have currency pegs to the euro, and Latvia’s struggles are raising questions about the sustainability of their fixed exchange rates.


While Sweden is not looking at a full-blown crisis, its strong financial linkages with the Baltics could dramatically cut in to the Nordic country’s growth prospects. Swedish banks have issued loans to Baltic borrowers equivalent to over 20% of Sweden’s GDP. According to Danske Bank, the loans could cost Sweden a total of anywhere from 2% to 6% of its GDP over several years, depending on how many Baltic borrowers default. Fitch Ratings recently used a number of stress test scenarios to examine Swedish banks’ ability to absorb losses in the Baltics and according to the results, Swedbank – one of Sweden’s largest banks – could be particularly affected. Nevertheless, Danske said in late May that all Swedish banks operating in the Baltics should remain solvent in a devaluation scenario. Some analysts have speculated that it may not be long before the Swedish state has to step in with direct financial assistance to help its banking sector.

Central and Eastern Europe (CEE)

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.

CEE countries are not a homogenous bloc. Bulgaria and Romania, in particular, share a similar boom-bust trajectory to that being played out in the Baltics. External imbalances in these five countries rivaled, and in some cases exceeded, the build-up of imbalances in pre-crisis Asia. For example, current account deficits in Southeast Asia from 1995-97 fell within the 3.0-8.5% of GDP range, whi le those in Romania, Bulgaria and the three Baltics were well over 10% of GDP in 2008. Like the Baltics, Bulgaria operates a fixed exchange rate system and a key concern is whether a Latvian crisis would shake confidence in Bulgaria’s currency board.

Romania and Hungary may have flexible exchange rates, but like Latvia, they have needed IMF-led rescue packages. If Latvia descends into crisis, it would highlight the fact that a rescue package, in and of itself, is not sufficient to avert economic meltdown.

Other countries in the region – Czech Republic, Poland, Slovakia – also built up imbalances in recent years and are in the midst of their own sharp slowdowns. Nevertheless, their imbalances never reached the same proportion as those in the Baltics and Balkans. Overall, their economies are in stronger positions to weather any contagion. Slovakia successfully entered the Eurozone earlier this year, while Poland qualified for a US$ 20.5 billion flexible credit line (FCL) from the IMF. An FCL is a precauti onary facility, available only to countries with very strong fundamentals, which can be drawn upon at any time and without meeting any specific conditions. Such a facility should help provide Poland with a bulwark against contagion.

Latvia’s woes are turning into a cautionary tale for other CEE countries vigorously pursuing euro adoption and could force a reassessment of the benefits. EU newcomers that have not yet adopted the euro are expected to participate in ERM II, a required currency stability test of at least two years for EMU hopefuls in which currencies are required to trade against the euro in a limited fluctuation band. A devaluation would force Latvia to start the challenging ERM II process anew.

Could a Latvian crisis affect the Eurozone?

If a balance-of-payments crisis occurs in the Baltics and it spills over into other Eastern European economies (please note that this is a big ‘if’), then the Eur ozone could be affected. The Eurozone’s exposure results from Western European banks’ heavy exposure to Eastern Europe, via subsidiaries, where they hold 60-90% market share (as a % of assets), depending on the country. Given the CEE’s strong financial linkages with Western Europe, the health of Eastern Europe’s economies and its banks could potentially afflict Western European banks, as detailed in this recent RGE EconoMonitor post.

8 Responses to "Is Eastern Europe on the Brink of an Asia-Style Crisis?"

  1. Anonymous   June 10, 2009 at 10:32 am

    It is impossible to see how the peg holds.—-Latvia money mkt freezing up, o/n rates at 100 pct* Reuters, Wednesday June 10 2009By Carolyn Cohn and Patrick LanninLONDON/RIGA, June 10 (Reuters) – A wave of interventions by the Latvian central bank to buy the lat currency and hold it within its peg to the euro has caused the local foreign exchange and money market to freeze up and interbank rates have shot up to 100 percent or more, dealers said on Wednesday.”No bank is making any lat offers,” said a trader at one Latvian bank.He said all banks wanted to keep hold of lats to meet reserve requirements due to the shortage of the currency, which central bank interventions have sucked out of the market.Reuters data showed banks’ reserve requirements at 738.5 million lats, with accrued excess reserves of 30.7 million lats. However, the trader said banks were keeping lats to themselves even with this small excess.There have been no price quotations in overnight and longer-term Latvian money markets on Reuters dealing terminals since Monday, as worries about a possible devaluation of the lat currency hit liquidity.The Rigibor interbank offered rate, fixed daily and based on contributions from seven banks, has been unchanged this week at 16.80/21.60 percent.But this price is not representative of the market.”The Rigibor rate is in no way a reflection of where interest rates would be if banks were forced to give out real interest rates,” said Lars Christensen, emerging markets analyst at Danske in Copenhagen. “They would then be at least 50-100 percent. The fact is there is no liquidity.”Another dealer said there was a small offshore lat market, where borrowing rates were being quoted at 150-250 percent.One bank, Nordea, is quoting overnight rates at 35/38.5 percent on its Reuters contributor page.Liquidity problems are also hitting the currency.”The only way to get liquidity is from the central bank and it has said it won’t give any,” the Latvian bank trader added.The euro/lat quotation on the Reuters conversational dealing system is sometimes going hours without updates.”That trade is frozen, almost nothing is going through,” said a trader.The lat currency has been hitting four-month highs against the euro this week on hopes that Latvian budget cuts will secure another tranche of funding from an international rescue package and stave off currency devaluation.Iceland suffered a similar seizing up in its currency and money market prices when its financial system and economy collapsed last year.Screen prices for currency markets in Ukraine, which has imposed capital controls on the hryvnia, are unreliable, analysts say. (Reporting by Carolyn Cohn and Sujata Rao in London and Patrick Lannin in Riga; editing by Stephen Nisbet)

  2. Anonymous   June 10, 2009 at 9:18 pm

    CEE currencies extend gains on improved regional sentimentWed, Jun 10 2009, 09:16 GMTby KBC Market Research Desk are saying nearly something else, who has the true? The LAT is in trouble, or the trouble is gone? I am Hungarian and want it to know HUF will be much stronger then now (there are news in the local media it will reach 265 very soon from 280) or it will stay in the same levels?Thanks for your opinions!

  3. Brian Shriver   June 10, 2009 at 10:55 pm

    Excellent analysis. Any country that pegs its currency and runs a trade deficit should wake up!

  4. Anonymous   June 11, 2009 at 2:49 am

    Just for fun, let’s differentiate the not absolutely identical credit stories here (though the market, lusting for profitable overshoot, may ultimately refuse to do so)… Estonia went into the crisis with fiscal reserves equivalent to 12% of GDP. Estonia is running a 12m rolling services surplus of 8% of GDP. Estonia’s current account is already in surplus, with net FDI (which has dropped off significantly–unsurprisingly in the current environment) of 5% of GDP. Granted the current account surplus is the function of collapsed imports, itself the byproduct of withering domestic demand; no doubt real incomes are tumbling (from quite inflated levels however), the pie is shrinking (but it was far too large before, too much yeast in the past)….and the FDI may be primarily recapitalization funds from the Swedish parent banks. Even so, the only gross external financing needs left for Estonia is the stock of private sector external debt. There is NO public sector debt of any consequence. It is up to SEB and Swedbank to roll over the stock of private debt, and they show every inclination of continuing to do so. The optimists (there are some; they tend to live in Mumbai, Rio de Janeiro, or the outskirts of Barra-barra) tell me that the recovery in oil prices could perk up demand for Estonian exports in the Russian Federation.. In any case, the Swedish banks are stuck, so to speak and they enjoy the not modest backing of the Kingdom of Sweden…. Therefore at least consider the following, before scribbling off another small open economy’s obituary: Estonia, the export sector of which is less dependent on the other two Baltics, is not necessarily doomed to follow the same path as Latvia if the latter devalues. Yes I used the word if; yes, risks are rising, as fear feeds off of itself. But Mr. Roubini, ambulance chaser in chief of the global financial crisis, might want to make an effort to travel to Talinn and get a sense of the dynamics there before he gleefully scrawls an ‘X’ on their front doors…

    • Anonymous   June 13, 2009 at 3:47 pm

      A typical Estonian utopy – we are better because we are not Lavians. However, the reality with Estonia is even more unsustainable as with Latvia. The fall in Production in Estonia in April was -2,8% compared with March, on year-to-year basis the fall was -33,7%. In Latvia in April there was growth +4,8% compared with March, the year-to-year fall was -15,6%. Estonia is producing low quality mobile phones, Latvia – chemicals and pharmaceuticals which are much more stable during slumps.Source: problem of Latvia is the insolvency of its inflated financial sector because tiny Latvia has to take obligations for global PAREX bank which was important for Europa but unimportant for Latvia.

  5. Anonymous   June 11, 2009 at 4:43 am

    Is Roubini constructive on anything? Cinnamon buns for example? Or are those, too, previously overheated, now destined to deflate in a disorderly fashion leading to social discontent and painful defrosting?

  6. Anonymous   June 11, 2009 at 4:49 am

    It’s Stokes not Roubini. Stokes is stoking the Latvian pain… she hits all the key points though, while failing to mention that Latvia entered the crisis with public sector debt of 12% of GDP versus 60% plus for Argentina, plus with much better capitalized Swedish parent banks; the Swedes make far better au pairs than the Spaniards (or the Austrians). But the devaluation risk is clearly no joke. She might have taken the time though to speak about the dynamics of the internal devaluation process. After all my understanding is that nominal wages have come off 20% or so since end 2008. Correct me if I am wrong but that didn’t happen in Argentina? Of course this would accelerate the deterioration in the quality of the loan book, but that is where the Swedish au pair steps in to clean up the mess….

  7. Anonymous   June 11, 2009 at 4:52 am

    Mr. Shriver, is your point that the US is destined to fail since its currency is pegged (the dollar is essentially pegged to the dollar), and its running the largest current account deficit in the world? Where is the monetary flexibility if you cant devalue versus the Chinese? Forget Latvia, let’s talk Washington D.C. You dont see the US congress come up with 3% of GDP worth of budgetary cuts over a weekend the way the Lats have just done….