Ominous Clouds Over The Baltic States

This year we've been highlighting the tail risk associated with the Baltic economies for greater Europe, especially as it related to our long position in Sweden (via the etf EWD, which we sold on 6/1) due to Sweden's strong banking presence in the region. The economic forecasts for Estonia, Latvia, and Lithuania for this year and next are already the worst for all of Europe by far, yet last night's failed Latvian Treasury bill auction for 50 Million Lati ($100 Million) signals that the situation there has continued to deteriorate and,  without further international support and defined economic action from Latvia, the threat of default will increase and, in the worst case scenario domino through the region as Scandinavian lenders were forced to withdraw.

While we're cognizant of the relative GDP size of the Baltic states compared with their European peers-Latvia's economy is about 1/100 the size of Germany's on a good day -and, according to the Bank for International Settlements in Switzerland, Swedish Banks have about $75 Billion of loans to the Baltic states, i.e. not an insignificant sum.  

The Lati is currently pegged to the Euro with a trading band of 1%.  There's a mixed response from Swedish, Latvian and international officials on how to attack Latvia's ailing economy, which may contract 18% this year according to the country's Prime Minister Valdis Dombrovskis. One camp  would recommended that Latvia devalue its currency outside of the band to encourage exports and limit imports, thereby improving its trade balance while reducing the current account deficit. The tail risk would be excessive devaluation if a free(er) float was allowed, increasing the prospect of default.  Another camp believes that the band versus the Euro should be maintained, with the Swedish Krona taking the brunt of the devaluation until economic conditions and/or investor confidence improves. Already the Swedish Krona has fallen ~3.7% versus the Euro since June 1.

In response to the economic conditions Dombrovskis is planning to implement budget cuts through decreases in public wage and spending, standards imposed by the IMF and European Commission to receive the next tranche of loans from an original package of 7.5 Billion Euro, which the country began receiving in Q4 of last year.  The fund delayed a 200 Million-Euro transfer in March after the government failed to make budget cuts. The country cannot afford for this to happen again.

The Latvian central bank has bought some 1.3 Billion Lati since the beginning of 2008, which has contributed to a lack of local currency liquidity and to the lack of bids in the auction yesterday. Today the Lati was trading up after the Treasury bought the currency. 

While Sweden's Finance Minister Anders Borg said that his country can weather a "possible bank collapse, or nationalization, sparked by the economic collapse in the Baltic states" and the IMF is likely to grant the next tranche, the ailing performance of the Baltic states, many of which have been seriously hampered by declining appetite from their main trading partner, the Eurozone, creates an economic tail risk for Sweden in particular, and Europe should the flashlight be placed on the weaker emerging economies of Eastern Europe. 

We sold out of our position in Sweden from a technical perspective, believing in part that its YTD performance had run a bit ahead of itself (as compared with Germany for example) with global export demand still weak and its Baltic lending issue looming in the background. Sweden has a dynamic economy with a very strong financial system and currency, one that has traded historically (not on chart) in a tight range versus the Euro. We have a bullish bias on Sweden in the longer term.  

Matthew Hedrick

Analyst

Ominous Clouds Over The Baltic States - sweden