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Generational Dynamics Web Log for 11-Oct-2009
Latvia may be near financial collapse, as GDP falls 18% this year

Web Log - October, 2009

Latvia may be near financial collapse, as GDP falls 18% this year

October 23 will be a crucial day for Latvia and for Europe.

Like many countries (including the United States), Latvia went on a multi-year spending spree, borrowing money, and taking advantage of a huge real estate bubble. Now the credit crisis is hitting hard, and Latvia has to pay the price.

Northeastern Europe

Northeastern Europe

In the halcyon days of the credit and real estate bubbles, Latvia followed an especially pernicious form of credit abuse. Latvia has its own currency, the lat, and Latvia is in the European Union. Therefore, everyone assumed that Latvia would would soon adopt the euro currency (in fact, this is still the plan for 2013), and therefore everyone assumed that the lat was as good as the euro.

Thus, many European banks, especially those in Switzerland and Sweden, loaned enormous amounts of money at low interest rates (we call these "subprime loans" in America) to Latvian consumers and businesses, causing the credit and real estate bubbles to be especially large in Latvia. When the bubbles started popping, Latvia was hit very hard.

Latvia's gross domestic product (GDP) is down almost 20% from last year. Retail sales are down over 30%. Latvia’s government debt will rise to 61 percent of GDP by the end of 2011, compared with 20 percent at the end of last year. Real estate values have fallen 50%.

Latvia is no longer able to finance its debts by issuing bonds, which only creates more debt. They could devalue their currency, but that would violate the EU rules for joining the euro currency in 2013.

Instead, they've had to beg for help. No one would care very much about the Latvians, except for the fear that a Latvian default or currency devaluation would cause a chain reaction of defaults and devaluations throughout Eastern Europe, especially in Lithuania, Estonia, Poland, Hungary, Bulgaria and Romania.

So last spring, Sweden, the EU and the IMF agreed to bail out Latvia. They offered to provide a $12 billion loan to help Latvia get through the crisis. There were conditions, though. In order to get the loan Latvia would have to cut public spending by 500 million lats ($1 billion) per year.

Several months ago, the Latvian government agreed to cut 225 million lats from the budget and impose 100 million lats in tax increases, in partial compliance with these demands. Even with this partial compliance, salaries for public workers were cut by 40%, and many hospitals and schools were closed.

As I wrote two months ago in "Iceland begs for mercy as Europe turns the screws," the EU and the IMF are in no mood to be lenient to countries that get into trouble. So it's not surprising that they're demanding the full 500 million lats in budget cuts before any aid can be provided.

The Swedes are being particularly vociferous in demanding full Latvian compliance because Swedish banks are especially at risk. Riksbank, Sweden's central bank, and a chorus of top Swedish officials are warning Latvia that they can't simply ignore their previous agreements. "It is as though we are living in a completely different world," said Riksbank Governor Stefan Ingves.

There have been some recent developments that have raised concerns that a major crisis is brewing:

On September 17, the Latvian Parliament voted overwhelmingly (52-28) against a bill that would have provided for the remainder of the 500 million lat budget cuts demanded by the EU, the IMF and Sweden.
Insofar as this reflects a kind of "mini-rebellion" among the Latvian people to refuse to make any more cuts, it puts the entire bailout into doubt, and may mean that a currency devaluation and chain reaction effect is all but certain.
But its significance goes well beyond that. The unemployment rate among youth is already 31%, and concentrated among ethnic Russians. This is sure to revive old feelings from World War II, when Latvia was a battleground between the Nazis and the Russians, and after WW II, when Latvia was forced to become a Soviet state. Thus, social unrest becomes a big danger.

The EU, the IMF and Sweden have loudly proclaimed that Latvia MUST live up to the 500 million lat budget cut agreement before any aid can be provided. The Swedish government has apparently decided that an economic collapse in Latvia cannot be prevented, and have been preparing Swedish banks for that event.
The result of all this is that a compromise of some kind will be almost impossible to effect. With the lenders committed to one position, and the Latvian Parliament having overwhelmingly voted down further budget cuts, a crisis situation will be difficult to avoid.

Last week, Latvia's prime minister asked the Parliament for law changes that would limit the liability of single-home owners to the value of the collateral. With real estate prices having fallen 50%, this law would have a huge impact. If the value of a mortgaged home is less than the total amount due on the mortgage, then the amount of the mortgage would be reduced to the value of the home.
The Swedes are furious at this proposal, since it would mean that the assets carried on the books of Swedish banks would take a major tumble immediately.

There is a feeling in the financial community that the entire worldwide financial crisis is over, and that therefore there's no real need to bail out Latvia.

This illustrates the problem with the airheaded optimism that pervades today. It causes people to make wrong, sometimes disastrous decisions. When these decisions backfire, everyone is shocked, and the consequences can be enormous. That's why we say that the "Principle of Maximum Ruin" applies to today's financial marketplace.

Fear index -- 11-Oct-2008 to 11-Oct-2009 <font face=Arial size=-2>(Source: Marketpsych)</font>

Fear index -- 11-Oct-2008 to 11-Oct-2009 (Source: Marketpsych)

To see how complacent the financial community has become, take a look at the adjoining graph. Long-time readers of this web site may recall that in 2007 I occasionally discussed the "Marketpsych Fear Index." This index measures the anxiety of investors by examining media stories. They have a computerized methodology that counts words in financial stories to determine how anxious investors are.

As you can see, the anxiety level of investors has plummeted to the lowest level in over a year, and actually to the lowest level since early 2007, the start of the financial meltdown. The overconfidence is astonishing, as is the new stock market bubble we're seeing.

Most of these overconfident people in the investment and financial community probably couldn't even spell "Latvia," let alone find it on a map. If they could, they wouldn't be so complacent.

On October 23, the Latvian government must submit its budget proposal for 2010. The choices are appalling:

It can adopt further massive budget cuts, to meet the demands of Sweden, the EU and the IMF, risking social unrest as unemployed people lose their homes and can't pay heating bills in the extremely bitter winter; or, it can refuse to make more budget cuts, risking any chance of a bailout.

It can devalue the currency, giving up any hope of joining the euro currency in 2013, and possibly setting off a chain reaction of devaluations in eastern Europe; or, it can keep the currency as its fixed peg to the euro, causing even greater financial hardship to the Latvian people, risking further unrest.

It can implement its radical mortgage forgiveness law, infuriating its neighbors, causing numerous bank crises, and probably triggering copycat laws in other eastern European countries; or, it can drop the idea, and allow more people to lose their homes and their life savings.

All of these decisions have to be made by October 23. At that point we'll see if the Latvian situation fizzles, or if it triggers a major new financial crisis.

(Comments: For reader comments, questions and discussion, see the Latvia thread of the Generational Dynamics forum.) (11-Oct-2009) Permanent Link
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Generational Dynamics Web Log for 11-Oct-2009 Latvia may be near financial collapse, as GDP falls 18% this year

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Generational Dynamics Web Log for 11-Oct-2009
Latvia may be near financial collapse, as GDP falls 18% this year