When markets were more agitated than they are today, one source of background worry was the Baltics. The countries went on a debt binge, borrowing heavily from Swedish banks. And while the amounts at issue are hardly earth-shaking by credit crisis standards, there is always the possibility that unexpected knock-on effects could lead to more serious consequences than now appear likely. Not that the impact is not meaninful to parties immediately involved, namely Sweden and Lativia.
John Hempton provided background earlier in the year:
Latvia and to a lesser extent Estonia and Lithuania had a massive and unsustainable current account deficit. That means they bought more from the rest of the world than they sold (just like America buys far more from China et al than they sell). The current account deficits (relative to GDP) was however much bigger in Latvia.
In a floating exchange rate regime this would usually be remedied by the currency falling dramatically, increasing the competitiveness of exports (and increasing the price of imports). The market provides a solution. With America this can’t happen because the Chinese fix their currency against the US dollar. In the Baltic States the currency is fixed against the Euro.Normally to fix the exchange rate a central banker needs to buy the currency that is tending weaker. They buy it and remove it from circulation. In so doing the reduce the money supply in the weaker currency causing interest rates to rise and a mild monetary deflation (increasing the competitiveness of local industry versus foreign competition) and hence over time remedying the current account deficit.
Unfortunately this monetary deflation causes a recession in the country with the naturally weaker currency. Ultimately that makes fixed rates unpopular in countries with chronic relative economic under-performance – because the populace doesn’t like more or less continuous mild recessions…
Now there is one exception…And that is if somebody cheaply finances your current account deficit ad-infinitum. Then you can have the nice strong currency and spend it and not have any domestic price pressure. Unfortunately you also wind up owing your foreign benefactors just way too much money.
The party has to end. And it can end quite sharply when the foreign benefactor becomes less willing to lend to you.
Foreign benefactors have just put the choke collar on Latvia. The government was unable to roll over its debt this week. From MarketWatch:
Latvia’s central bank warned Wednesday of “another wave of distrust” beginning to roll over the Baltic country, as the government received no bids for one of its three auctions for debt securities, heightening worries over its financial situation and the sustainability of its currency peg.
The Bank of Latvia, in an uncharacteristically dramatic statement for a central bank, said the lack of confidence can potentially bring higher interest rates and exacerbate conditions for entrepreneurs….
Latvia has been battling to emerge from a deep financial crisis. Sweden on Tuesday put pressure on the tiny Baltic nation to fulfill required spending cuts, threatening to withhold payments due at the turn of the year from a 7.5 billion euro rescue loan put together by Nordic countries.
Sweden, in other words, finds itself a major actor, along with the EU and the IMF, in negotiating a rescue package that extends new loans only if austerity measures are implemented.
But Latvia does not appear to be ready to accede to Sweden’s demands. The immediate cause for concern is that Latvia will simultaneously devalue its currency and provide a mechanism for its consumers to partially default on mortgages held by foreign banks. From another MarketWatch story:
The Baltic country is squabbling with Western — mostly Swedish — leaders over spending cuts, and it’s a very real possibility that the country may be forced to devalue its euro-pegged currency if emergency global funds don’t arrive.
Were Latvia to devalue, that would hit economies in neighboring countries like Lithuania, and Swedish banks would rack up additional losses on the loans they have made throughout the region.
The real nightmare scenario would be the Swedish banks then pulling down other European banks, and then triggering Credit Crunch: Part 2.
There is, of course, a long way before that unwieldy scenario comes to pass. Latvia hasn’t devalued — yet – and, even if it does, that doesn’t mean it would drag the Swedish banks under.
Latvia just had a $17 million bond auction fail, as in no bids. Which is understandable given the real possibility of a near-term devaluation.
The Guardian comments less than enthusiastically about the central bank’s idea of how to cut the Gordian knot, that of reducing mortgage borrowers’ liability en masse (deep principal mods, as we would call them here, on mortgages held by foreign banks):
The Latvian government was struggling to avert a financial meltdown today as ministers convened emergency talks with Scandinavian banks to discuss a bold and controversial plan to slash mortgage-holders’ liabilities to lenders.
The scheme could mean billions in losses for the big Swedish banks most exposed by the small Baltic state’s financial and economic crisis.
Valdis Dombrovskis, the embattled Latvian prime minister, said he was confident he could get his proposal through the parliament in Riga, but was still examining the legal implications of the scheme. But the powerful Latvian central bank delivered an unusually blunt attack on the prime minister, saying that his budget and bank policies were feeding a fresh “wave of distrust” towards the small and highly vulnerable state.
Banking sources in Riga warned that the radical proposal on mortgages, which could see borrowers repaying only a fraction of their loan, would backfire, deterring foreign investment, bringing already low bank lending to a complete standstill and wrecking international confidence in Latvia.
Dombrovskis said the foreign banks, which hold controlling stakes over 90% of the Latvian banking sector, shared the blame for the crisis and would also have to share the costs. “Some balance has to be found between the interests of borrowers and the interests of lenders,” the prime minister told the Guardian. “The real incomes of people are diminishing and it is getting more difficult to repay loans.”
Dombrovskis’s surprise proposal came amid growing international concern about Latvia after he revealed plans to cut public spending next year by only half the level agreed with international creditors earlier this year as part of a €7.5bn (£6.9bn) rescue package put together by the EU, the IMF and the Nordic countries. Sweden, currently chairing the EU, reacted by threatening to withhold more than €1bn in credit scheduled for next year.
The FT also weighted in:
The finance ministry denied there had been any weakening in commitment to Latvia’s currency peg with the euro amid a renewed round of speculation that the country would be forced to devalue the lat.
Riga announced tentative plans on Tuesday to cap the amount that banks would be allowed to collect from mortgage holders in a move that analysts said would make it easier for Latvia to devalue.
This has revived concern among international investors about the heavy exposure of Nordic banks to the Baltic region and the risk of contagion if devaluation in Latvia forced other eastern European countries with fixed exchange rates to follow suit.
The Latvian proposals would allow banks to collect only the current value of a property rather than the original value of the mortgage, insulating homeowners from the 70 per cent drop in property prices since their peak.
The move would remove one of the biggest obstacles to devaluation by ensuring that holders of euro-denominated loans, which account for about 80 per cent of mortgages in Latvia, would not face a sharp increase in debts if the peg with the euro was broken.
When a country starts denying that it is going to devalue, it is almost inevitable that it winds up doing just that.
On the surface, the Latvian crisis appears far too small to trigger another round of upheaval. But it could serve to reveal how weak European banks really are. They entered the crisis with lower equity levels than their US peers, and the biggest have just as sizable derivatives exposures. When you add to that the fact that they have realized even fewer of their losses than the US banks, a seemingly minor eruption like Latvia could serve to reveal that the banking emperors across the pond are wearing no clothes. While the odds of Latvia precipitating a larger set of problems are low, they are not zero.
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Funny, it reminds me of 2007, when subprime was a small problem, not susceptible to derail the economy. The rest of the market was healthy.
Sure…
Subprime had connected exposures, something I discuss in my book, the topic has not been well covered, amazingly. That does not appear to be the case with Latvia, but who knows….
Classic Hempton post on Latvia, notice the date.
http://brontecapital.blogspot.com/2008/07/hookers-that-cost-too-much-flash-german.html
Learn the mechanics of a currency run- very colorful descriptions and reasoning.
I know that it happens, but I truly cannot understand why a consumer would take out major debt in a currency that he/she doesn’t also receive as income. It makes sense for a company with income in multiple currencies to use it as a hedge against exchange rate volatility, but that doesn’t apply to a consumer. I assume it has something to do with interest or exchange rates, but would someone mind explaining why it looked like a good idea?
Exactly, interest rates on mortgages were lot lower in Euros than in local currency. Same thing happened all over Eastern Europe, i.e. in Poland huge chunks of mortgages were sold in Swiss Franks…
It’s pretty simple. If you had taken it in the local currency in some East European countries, your interest rate would have been around 10%. In swiss francs, it would have been only 2%.
So if you are buying a home and paying the mortgage in 15 years, financial cost would be 150% vs. 30% (very gross calculation). Even if Latvia, Poland or Hungary were to devalue, those foreign-currency mortgages still made sense.
Sorry, but the mortgages didn’t make sense. This is not just hindsight. It’s pretty safe to say that when you borrow, whether at 10% in your own currency or 2% in another currency, and there are many scenarios in which you would not be able to pay back the debt (whether because your income cannot service the debt or the currency moves against you), you’re probably not making a wise decision.
If the point isn’t abundantly clear, in your example, these borrowers couldn’t afford 150% in their own currency, and they couldn’t afford 30% in a currency appreciating against their own currency. The mortgages didn’t make sense.
It makes sense if the only number you look at is your monthly mortgage payment. In the world of ever-increasing real estate prices, ever-strenghtening domestic currency, why should one look at anything else? That was a sure bet (till it was not).
No one is saying those mortgages were for 100% of the house value. *That* would be absurd. Moreover, you must understand salaries are growing, and will be growing for the next decade, at rates over 10% in Central and Eastern Europe.
Plus, this scenario made sense because of everyone assumed that exchange rates would stay ‘fairly’ stable over time as most of these local currencies were pegged to Euros, in anticipation of joining the Euro monetary union in future. Once the governments were unable to defend the pegs (or decided not to) and local currencies started to depreciate last year your mortgage principal and interest payments were getting progressively bigger.
In this case, Latvia is still pegged to the Euro, the problem is that their GDP is projected to fall 17.5% this year and I think it fell lest year as well. With falling GDP comes falling income, meaning debts are harder to service. On top of this they had asset deflation in housing so those who bought near the top are severely underwater on the mortgage. This would be the case whether the loan was in Euros or Lats. The new problem is that if they devalue the loans will be even further underwater…to combat that they are proposing a law to revalue mortgages to reflect forgiveness of principle down to current fair market value…meaning big losses for the underwriting banks. Of course the banks will lose money anyway since the loans will default. Anyway, it is a story that is not new to any of us, the currency part is just another wrinkle to make something already really bad worse.
Those good wishing foreign commentators duly fail to mention, probably they just don’t know, that in the last 8 years foreign banks have profited from the tiny Baltic state in the amount of 12 billion dollars. It is quite huge from a 2.2 million nation. Now part of that money is to be put back into Latvia, insists Bank of Latvia, but Swedes and others resist. It is cheaper for them to hire lobbyists than to part with the money where they stole it and loose face in the process.
a current account deficit is not what any country elects to have. here is why:
1. if the country is WTO member, it has to open its borders.
2. if the local currency is pegged to a foreign currency, the interest rate is determined abroad.
3. if there are willing and irresponsible financiers of a consumer binge, bubbles will be blown.
in hindsight, the only way to prevent such crisis would have been massive tax hikes on income and property transactions. as you may imagine, tax hikes topple governments.
and what about the wonderful swedish failed bank resolution model? it seems those bankers just found another playground to play their old game.
Yves,
A couple of thoughts
The mess created by the Swedish banks (some, not all of them) in the Baltics demonstrates that it does not take that many years for a country to unlearn hard lessons of a recent past. Had the right conclusions been drawn from the 90s, taxpayers in Sweden and in the Baltics would not risk being called upon to make huge sacrifices to socialize banks’ losses.
Between Sweden’s financial crisis in the early 90s and the one we have now, the country also managed to squeeze in a tech bubble that was not insignificant. Furthermore, in addition to the current Baltic crisis, I believe that it is appropriate to add a local Swedish Private Equity bubble that has been under way for some time.
So, what we can learn from Sweden is that we never learn. The seducing power of the inflating bubble is so strong that other considerations become secondary. Let the debate on how to treat this manic depressive continue.
One other point, Sweden holds the EU Presidency as you point out. This means that Sweden’s finance minister presides over and drives the agenda on all pending EU affairs in the Council of Ministers, represents the EU externally in e.g. the IMF, runs Sweden’s finances and is involved hands on with the Baltic crisis. This A) creates risks for conflicts of interest and B) is too much for any single EU country to handle. With the Lisbon Treaty, a new positions as permanent EU Presidency will be created and hopefully improve this situation over time.
Swedish Lex,
Is it even possible to decouple deregulation of the finance industry from massive government subsidization of the finance industry, as Niall Ferguson posits in his paper Yves linked yesterday? As you point out, it seems like the finance industry, when deregulated, always seems to shipwreck itself. And its losses, though nominally “private,” always seem to find a way of migrating onto the public’s balance sheet.
So perhaps the underlying assumption upon which Ferguson’s argument is based—that banking losses be borne by the banks–is nothing but Utopian dreaming, either that or just sophistry.
I read Ferguson’s paper and very reluctantly had to agree with the Lenin quote. I agree with his assertion that the essential goal is to euthanize the TBTFs and, also, that there is a risk that this overriding goal “will vanish from sight as the number of [regulatory] proposals increases”. But while it is necessary to cut the TBTF’s down to size, I also think that it has become necessary to go further and assess what kind of financial system we want. In the same way that governments spend considerable amounts of efforts in analyzing, debating and defining energy policies (existing & future needs, externalities, affordability, services of general interest vs. areas of competition, etc.), this (latest) financial crisis should at least have as consequence that someone bothered to undertake a thorough inventory and assessment of it all. Actions in this area thus far are only touching the surface.
If it turns out that financial markets have to be administered valium and be kept under constant and close observation in order not to get dangerously ecstatic, so be it. This should not be too difficult to comprehend, but the fear of killing capitalism’s libido may well prevent the necessary catharsis.
You’re dealing with two separate issues here: deregulation on the one hand, and the possibility of banks bearing their own losses (which they have done quite frequently throughout history).
The difficulty with deregulation occurs when only one side of the equation is changed. Restrictions are lifted on banks, but public risk controls that by nature absorb the effects of bad banking decisions – such as, in our case, FDIC, and even the Fed itself – remain in place. You must understand that the problem vis a vis bailouts is systemic risk, and this is largely the creation of a past regulatory regime that bound banks together and backstopped them in an effort to remove uncertainty from consumers and bank customers, ie the public. This is the true Gordian knot. This kind of deregulation cannot work, and I believe there is a question of morality in employing it.
However, it is also “Utopian” to suggest that a speculative financial industry can be successfully regulated by an equally speculative governmental body. If history indicates anything here, it is the inability of regulation to counteract crisis, and the fact that government and the public are usually willing partners in the boom preceding the bust.
So it’s not a question of, can banks bear their losses. In any sustainable society, they must. The question is, how do we get there, from here?
Costard,
You certainly make some legitimate points.
I suppose my biggest beef with what you say has to do with your reading of history. I’m entirely too much a student of Veblen and other like-minded thinkers to believe any state ever existed that wasn’t a nanny state for rich people.
Take the US for example. As Jacques Barzun pointed out, in its early years the “Americans fought and cheated the Indian tribes on their borders and the southerners lived off the toil of 200,000 African slaves.”
Kevin Phillips then picks up the sordid tale. The great railroad fortunes, to pluck one example out of a long history of government largess that was lavished on rich people, were all built with government subsidies. As Phillips points out in Wealth and Democracy: Of the $23 million the Illinois Central had spent by 1857, most was raised from mortgages on the federal lands and only a sixth from shareholders, underscoring the centrality of the federal contributions.”
And so the pattern has continued, right on down to today, when the most flagrant abuse of the welfare state for the rich entails massive subsidies for the finance industry.
“What protects freedom is the division between governmental and economic power,” Hannah Arendt concludes in Crises of the Republic. “What protects us in the so-called ‘capitalist’ countries of the West is not capitalism,” she continues, “but a legal system that prevents the daydreams of big-business management of trespassing into the private sphere of its employees from coming true.”
Arendt was no fan of welfare for the rich, but she was likewise no fan of welfare for the poor. That’s why the Left despised her so much. Arendt saw no difference between the end-point of capitalism and the end-point of socialism. Socialism eventually evolves into what she called state socialism, which is what Soviet Russia had where governmental power overwhelms economic power. Capitalism eventually evolves into what she called state capitalism, which is what we have in the US today where economic power overwhelms governmental power. But at heart there’s no difference between the two, she said, “because we have here twins, each wearing a different hat.” Both entail the merging of governmental and economic power.
The trick is to keep governmental power separated from economic power. Arendt had some ideas about how that might be accomplished. But as you say, that’s all “speculative.”
In this case there’s really no beef… I agree with you. To rewrite Mises, politics is always and everywhere the manifestation of entrenched interests. This is why I’m skeptical of the perceived wisdom of government and “the people”, and why I don’t believe there is such a thing as disinterested regulation.
I would argue however that markets can only exist in a free society. Seen from this perspective, Arendt’s statement is a tautology. It was the growing freedom of the west that predated capitalism, and that made the capitalist superstructure possible. Markets are the natural outcome of people free to buy and sell. There is a profound difference between controlled societies (socialist, fascist, oligarchy, “crony capitalist” or otherwise) and classically capitalist societies. Talking of endpoints renders any human decision irrelevant… “in the long run we’re all dead”. There is nothing at all new about special interests, economic favoritism and a regimented economy. The originality of capitalist thought was that it put forth the idea that a society of free men will take care of itself, so long as it has certain protections, i.e. from violence and coercive behavior. I agree that we’ve never seen such a lightly governed society. The tendency for democracies is a bloated regime and a supernova of self-pillaging.
I think the short answer to you is, power is force. Force is always governmental, whatever the auspices of those who commit it. There is no power in a voluntary exchange. And there is no constraint to power, whoever has it, because no argument can withstand it. The only limit to force is where it meets a force in opposition. There is absolutely no way, in any circumstance, you might peacefully contain the state.
for a slightly different take, here is a longer version of a piece from michael hudson that ran in the FT in aug:
Swedish Les said “So, what we can learn from Sweden is that we never learn. The seducing power of the inflating bubble is so strong that other considerations become secondary”
I think thats spot on.
Yves, from what I can see, the situation in Latvia is very bad. The information I have available is showing major capital flight from Latvia over the last year. Companies doing business in Latvia appear to be expecting a full economic meltdown.
One other critical factor, however, is that the Scandinavian banks receive much of their funding through international markets, especially the money markets in the U.S. This crisis may in fact spread should a wave of panic centered on the Scandinavian banks hit the commercial paper market; that is a scenario that the authorities in Europe (and the U.S.) would have little control over.
The Latvian Prime Minister said: “The real incomes of people are diminishing and it is getting more difficult to repay loans.”
Gosh, that sounds a lot like what’s going on in the US.
This is all deja vu of the battle Kirchner had with Argentina’s creditors. I think that Sweden may learn, as Argentina’s creditors did, that lackiong some sort of “big stick” capability, creditors hold few trump cards.
This is all deja vu of the battle Kirchner had with Argentina’s creditors. I think that Sweden may learn, as Argentina’s creditors did, that lackiong some sort of “big stick” capability, creditors hold few trump cards.
Sweden hold a major trump card. Latvia wants to join EU to gain itself stability away from Russia. Countries coming into the EU have to be approved unanimously.
Sorry, not EU, but euro.
This will be a very enlightening episode on the EU in whole. Will they help their member state or cut their legs out from under them?
What people lose sight of here is that milions of Eastern and Central Europeans are working in Western Europe, thus they are being paid in those currencies.
Vinny G.
@ rj:
Latvia, along with much of Eastern and Central Europe have been EU member states for years. You must be thinking of “Eurozone” which is an entirely different thing.
Vinny G.