Too Small To Fail
The Weekly Standard, November 9, 2009
Independence Monument, Riga, Latvia, 2009 © Andrew Stuttaford
It's a measure of the tension of the times in which we live that Anders Borg, the finance minister of famously polite Sweden, has been going around threatening Latvia. Yes, Latvia. "The patience of the international community is," he growled on October 2, "very limited, and Latvia has little room to maneuver."
If it's rare for a Swede to lose his cool, it's astonishing that a small Baltic state (Latvia's population is just over 2.2 million) was the cause. But Latvia is in an economic mess that is extraordinarily deep (GDP will fall by nearly 19 percent this year), and the consequences have already spread far beyond its borders. Evidence that it was pushing back at those who have been trying to help is what triggered Borg's explosion--well, that, and the risk posed to three of Sweden's largest banks by their roughly 40 billion euros of Baltic exposure.
The story of the Latvian crisis is, if nothing else, proof of the old maxim that no good deed goes unpunished. While the underlying sources of the country's difficulties can be put down to the devastation of half a century of incarceration in the Soviet domain, the immediate cause can be found in one of the happier events in Latvian history: its 2004 admission, alongside the other Baltic states (Lithuania and Estonia), into the European Union.
The integration of large swaths of Eastern Europe into the wider European economy and, ultimately, the EU is something that even Euroskeptics concede has been a triumph: a fusion of enlightened self-interest, generosity, and strategic vision that has done much to smooth the path away from Soviet rule and Communist ways. Initial flows of capital lured to the region by the collapse of Communism were, as the 1990s progressed, supplemented by waves of investment attracted by the reassuring spectacle of former Soviet satellites rediscovering the pains and pleasures of the free market. The transformation was further accelerated by the prospect of eventual EU membership as a final guarantee that they would not slip back.
This was the way it worked in Hungary, Poland, and other former Warsaw Pact nations, and this was the way it eventually worked for the three Baltic states, the first former Soviet republics to apply for, and be accepted into, EU membership. Thus funds began flowing into Latvia, Lithuania, and Estonia almost as soon as they regained their independence--at a time when the prospect of losing it again to Brussels was still but a distant dream. Much of this money came from the neighboring Nordic countries attracted by an exciting local investment opportunity, historical connections (the Latvian capital, Riga, was once the largest city in greater Sweden), and a keen interest in avoiding the development of three turbulent post-Soviet slums in their backyard.
So far, so benign. But the onrush of Nordic cash overwhelmed the small and rickety enterprises typical of economies emerging from Communist rule. A huge part of the Baltic banking sector ended up in Nordic hands--roughly 70 percent of borrowing in Latvia is now sourced from banks controlled by foreign (primarily Nordic) institutions. What began as a change for the good (the Nordic-run institutions were better managed and capitalized than their local predecessors) degenerated into an unhealthy codependency as the banks financed an unsustainable boom on ultimately disastrous terms. By the time it was all over, they were essentially funding the current accounts of all three Baltic nations.
The bubbles began to inflate as EU membership loomed early this decade and ballooned after the three countries crossed the finish line. Too much money (and too much credit) was pouring into economies too small to absorb it productively, which triggered inflation, speculation, and a consumer binge. Overall government borrowing remained modest in each of the Baltic states, but debt racked up in the private sector--in Latvia it reached 130 percent of GDP in 2008. Imports were sucked into the region, and exporting industries were priced out. (Latvia's textile sector was 12 percent of the country's exports in the early 2000s; it is today only 5 percent.)
Alberta Iela, Riga, Latvia, 2009 © Andrew Stuttaford
As the Baltic economies roared (Latvia's GDP grew by 12 percent in 2006, and 10 percent in 2007), current account deficits soared (Latvia's peaked at some 25 percent in 2007). Fueling the inflationary fire still further, a number of EU countries (notably the U.K. and Ireland) waived the transitional period that has traditionally followed the accession of less-developed countries into the EU and opened up their labor markets to workers from the Baltic, attracting far more immigrants from the region than originally expected. That was good news for employers in London and Dublin, but it siphoned off talent back home, increasing already fierce upward pressure on wage rates and, incidentally, adding to the demographic anxieties of three small peoples that had--only just--succeeded in preserving their ethnic, cultural, and political identity after half a century of Moscow's best efforts to Russianize their countries. Not the least of the ironies facing the Baltic states is the way that their long overdue reintegration into the global economy could, by offering their best and brightest citizens better opportunities abroad, destroy the integrity and the essence of the nations they leave behind.
When economies overheat, real estate prices tend to boil over, and so it was all over the Baltic. In Latvia, house prices jumped by (on some estimates) 300 percent between 2004 and 2007. Never a healthy phenomenon, the real estate bubble had an extra malignant aspect in the Baltics as most of the mortgage lending (a chunk of it distinctly subprime) that financed it was denominated in euros--not yet the Baltic countries' currency. Back in 2004 when Latvia, Lithuania, and Estonia signed up for the EU they took a seat in the waiting room for the monetary union. They were in a strong position to satisfy the Maastricht preconditions for adoption of the euro (subdued inflation, low levels of government debt, and well-managed public spending), and all three local currencies--the Latvian lats, the Estonian kroon, and the Lithuanian litas--had been pegged to the euro by 2005. Forecasts that they would be replaced by Brussels' money in 2008 did not seem out of line. Borrowing in euros looked like the smart thing to do. Euro interest rates were well below those charged for borrowing in lati, krooni, and litai and, with the adoption of the EU's single currency purportedly just around the corner, there was not supposed to be much in the way of foreign exchange risk. International (mainly Nordic) banks keen to minimize their exposure to the small illiquid Baltic currencies were only too happy to oblige: Some 80 percent of all private borrowing in the Baltic countries is in euros.
But the cash that cascaded into the Baltic countries pushed up their inflation rates to levels far in excess of the Maastricht criteria. In Latvia inflation peaked at nearly 18 percent in May 2008--up from 6.2 percent in 2004 and the 2 percent range between 2000-03. Drawn in by the prospect of near-term Baltic adoption of the euro, the flood of new money has perversely done a great deal to delay that switch (the latest predictions cluster at around 2011 for Estonia, 2012-13 for Lithuania, and, fingers crossed, 2014 for Latvia, although the IMF recently suggested that the latter date will slip still further). Foreign exchange risk was back.
And so were tough times. The inevitable bust arrived, gathering pace at roughly the same time as international financial markets were freezing up in 2008, an unhappy coincidence that made bad things worse as the (already slowing) foreign capital inflows that had done so much to sustain the boom came to an abrupt halt. To get an idea of the scale of the disaster that has struck, Latvian retail sales are running at 70 percent of 2008, the nation's real estate prices are down some two-thirds from their levels of two years before, and industrial production slumped 18 percent between June 2008 and June 2009.
The textbook response to this type of boom-and-bust would be a drastic devaluation of the currency to slash the cost of exports, discourage imports, and bring burgeoning current account deficits under some degree of control. If textbooks aren't sufficiently persuasive, markets can usually be expected to help out, and, sure enough, the lats came under strong pressure in June. But the sparse market in Baltic currencies gives them considerable protection against speculative attack. It's almost impossible to short thinly traded lati, krooni, or litai to the extent it would take to break their pegs to the euro. The fact that Estonia, Lithuania, and Latvia all operate currency board systems (in Latvia's case de facto rather than de jure) under which their monetary base is essentially backed up by gold and foreign exchange reserves means it would take an almost complete collapse in domestic confidence to trigger a run on the currency.
Of the three Baltic currencies, the lats has come under the most pressure (the economic and political fundamentals are weaker in Latvia than in Estonia or Lithuania, and the Latvian central bank had to spend around 1 billion euros to defend the currency in June). Yet the Latvian authorities continue to believe that now is not the time for devaluation. Latvian central bankers told me in August that depreciating the currency is simply not the answer to the country's predicament, and they make a good case. Devaluations work best in economies where a good portion of demand can be satisfied domestically, where the export sector has a high value-added component (i.e., not textiles and the like), and when the global economy is in good shape. None of these descriptions applies to the Baltic states or the world in 2009.
The alternative approach being pursued by Latvia is an "internal devaluation" (Lithuania and Estonia have taken a similar tack) designed to rebuild its international competitiveness by purging the inflationary excesses of recent years and, while it's at it, restore badly needed fiscal and budgetary balance--in other words to generate some of the positive effects of a devaluation without abandoning the currency peg. If most countries are trying to reflate their way out of the current economic crisis, Latvia is doing the opposite. Public sector pay is slated to be reduced by as much as 40 percent (though actual cuts appear to have been less so far) as part of a budgetary squeeze that has included the closing of hospitals and schools (admittedly Latvia was oversupplied with both) and sharp reductions in both welfare payments and pensions--payments that weren't generous in the first place. Adding to the misery: Taxes are being increased. As economic cures go, this is about as tough as it is possible to get, and it has already yielded some tentatively positive results. Latvian inflation has been brought to its knees (in September it was running at 0.1 percent), the trade deficit has shrunk dramatically, and the current account is back in surplus (14 percent of GDP in the second quarter).
Advocates of a conventional devaluation retort that any signs of improvement are merely symptoms of an economy where all demand has been crushed and will stay crushed for quite some time. This is not, they argue, the sort of recovery that will persuade the nation's best and brightest to stay at home once the broader European economy has improved enough to resume hiring. Nor will it attract the new capital that Latvia so badly needs, capital that will only be further deterred as the "hopeless" defense of the peg perpetuates uncertainty over the currency's future while underpinning a real effective exchange rate that continues to rise.
Such arguments are too pessimistic--though only just--and they also fail to address the implications of all those foreign currency loans. Repaying them is already difficult within the context of a devastated real estate market and collapsing economy. Increasing the outstanding balances by 30 percent (the percentage generally thought to be by how much the lats would have to be devalued) would generate Sisyphean agony and drive domestic demand even deeper into the hole. Complicating matters still further is the fact that the affected borrowers are drawn disproportionately from the ranks of the young (many older Latvians remain ensconced in the properties they received gratis in the post-Soviet privatizations), the enterprising, and the upwardly mobile, who are the main hope of any lasting revival. (Undoubtedly a good number of them are also to be found in Latvia's governing class. Unsurprisingly they are not that keen to devalue. Would you vote yourself into bankruptcy?)
Crucially it was the harsh medicine of the internal devaluation that secured the international financial support without which Latvia's economy might have already collapsed. The country's key lenders have so far shown themselves willing to assist in propping up the Latvian currency. It's not hard to guess why, despite some rumored disagreements within the lending consortium, this strategy prevailed. The Swedish banks most heavily involved in the Baltic have all made substantial provisions against lending losses in the region (and raised major amounts of capital to replace what has been lost), but neither they nor the Swedish state that has effectively underwritten them would welcome the massive additional hit to balance sheets that would follow a devaluation of the lats--particularly as it would likely trigger devaluations (and further losses) in Lithuania and Estonia. There's also a clear risk (although less than there was a few months ago) of a domino effect--Baltic devaluations pressuring other vulnerable Eastern European currencies with the potential for extremely unpleasant implications for Western banks exposed in the former Soviet empire. To give just one example of what could be at stake, earlier this year outstanding loans by Austrian banks to Eastern Europe were reported to amount to roughly 75 percent of Austria's GDP.
It's this fear of wider contagion that largely explains the willingness of the multinational group that includes the EU, the IMF, the World Bank, and, of course, the Nordic countries to lend Latvia 7.5 billion euros (and that's before counting the indirect help Latvia has received, including critically, Sweden's support for its banks). In the wake of last year's global financial meltdown, those few billions may seem like chump change, but they represent a huge sum for Latvia (whose GDP stood at around 22 billion euros in 2008). For once, the country is benefiting from the size of its economy: It's simply too small to fail. In absolute terms a bailout of Latvia (or for that matter, any of the Baltic countries) does not involve that much money. If such a rescue can stave off catastrophe elsewhere it will be a bargain. Who needs a Baltic Lehman?
But will this support buy enough time for the internal devaluation to work? Talking to Latvian civil servants, it is impossible to miss their unease about what may happen when the bleak Baltic winter descends on a population struggling through economic disaster. Nobody has forgotten the rioting in Riga (and in Lithuania) in January, the low point of a fraught few months that also saw the collapse of Latvia's sitting government. While there was a reasonable level of confidence amongst those to whom I spoke that the social net will hold, a winter of discontent may be difficult to avoid as benefits ratchet down (unemployment benefits fall sharply after five months on the dole and are then eliminated altogether after nine months--although the unemployed remain eligible for other forms of assistance), savings evaporate, and jobs remain scarce. Unemployment now stands at 18 percent, a devastating number in a climate of deteriorating welfare support. There are indications that the economy's fall is slowing (GDP is currently forecast to decline by a mere 4 percent next year), but what few green shoots there are have sprouted too late to make much difference this winter.
Adding to the worries is the fear that the country's economic woes will be used by the ever more revanchist Kremlin to foment discontent among the roughly 30 percent of the population that is of ethnic Russian descent. Maddening symbols of lost empire, and small enough to bully, Latvia and Estonia have long been placed amongst Russia's worst enemies by Vladimir Putin. He may be unable to resist the temptation to make their problems worse.
The Latvian government's strategy appears to be to hang on grimly and hope that the global economy recovers quickly and strongly enough to pull a sensibly deflated Latvia out of the mire and into hailing distance of the allegedly (that's a debate for another time) safe haven of eurozone membership. So far this tough approach enjoys at least a degree of grudging popular support. Some two-thirds of Latvians are thought to support the defense of a currency that is a symbol of both hard-won independence and the ability of ordinary Latvians to build a better future for themselves. They have seen their savings wiped out twice in the last 20 years, first by the Soviet implosion (and the chaos that accompanied it) and then again, after painful rebuilding, by a massive banking crisis in the mid-1990s. Devaluation would look all too much like round three. Latvian officials also put a great deal of faith in the country's flexible labor markets and the resilience of a people with recent memories of times far, far harder than now. Latvians will know, I was repeatedly told, how to cope.
Maybe, but all attempts to measure public opinion are guesswork--bedeviled by societal division (ethnic Latvians and ethnic Russians often see matters in very different ways) and the fact that Latvia's political parties are often little more than collections of a few friends or co-conspirators, sustained by self-interest, shared ethnic identity, and passing eddies of voter enthusiasm. They are bad at reflecting public opinion and worse at shaping it. If overall living conditions deteriorate badly this winter, there may be no one able to speak honestly to the nation or for its concerns. That's not a recipe for social peace.
There will be parliamentary elections next year and the uncertainty about the degree of support the internal devaluation will continue to enjoy helps explain September's unexpected failure of the governing coalition to pass all elements of the austere 2010 budget that was a condition for the continued support of Latvia's international lenders. This was the failure that so angered Anders Borg in early October. His mood will not have been improved by the market tremors that followed both his comments and subsequent press reports in Sweden that he had told Swedish banks to prepare themselves for the worst.
It's difficult to imagine that he would have been cheered up by the almost simultaneous revelation that the Latvian government was contemplating measures limiting the liability of homeowners to their lenders, a move that would have serious implications for a number of Sweden's banks. This proposal may have been an unsubtle attempt to pressure the Swedes into agreeing to go a little easier on the 2010 budget, but, with the furor it stirred up, it backfired. Its most controversial element--the idea that it would have retrospective effect--has been withdrawn, and the budget hiccup has been resolved with a Latvian climb-down. But these spats were a reminder that the realities that define this uncomfortable situation continue to hold true: Latvia is still both highly vulnerable and too small to fail, the codependent relationship between Sweden's banks and their Latvian borrowers continues to be both intact and unhappy, and the durability and extent of popular support for Latvia's harsh economic medicine remains an unknowable, unnerving mystery.
It's going to be a long winter.