Submitted by Edward Harrison of the site Credit Writedowns.
I am not the only one who sees events in Latvia as a potential catalyst for further downside risk to the reflation trade. Mary Stokes over at Nouriel Roubini’s site has a very readable post out on why we should be watching events in that tiny Baltic nation for potential signs of contagion elsewhere. She notes:
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.
Last July I was talking about the Baltics as the next Argentina, but it seems we are past that already now. At present, the legitimate fear is ‘Latvia as the next Thailand.’ There’s a new meme for you. While I am much more bullish about the reflation trade, I still harbour doubts, particularly when it comes to Eastern Europe. One of my ten predictions for 2009 was that Eastern Europe would infect the Eurozone and bring the European banking system to its knees (that was prediction #4 back in December). I do think the situation is brighter. Nevertheless, Eastern Europe is going to be a problem going forward and Latvia is merely the catalyst as Thailand was in Asia in 1997.
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.
The full post is linked below. But, I suggest you look over at FT Alphaville for more coverage on this situation. They have run a number of good posts on both the Baltics and the CEE banking situations. The guys over at A Fistful of Euros are on the case as well.
Back in May, Michael Robinson of the BBC released an amazing podcast that captures the situation in Latvia quite well – selling $3,000 flats for $200,000. Nice! In my view, this is probably the best on the ground look you will see by a journalist anywhere. Listen to the podcast below.
Is Eastern Europe on the Brink of an Asia-Style Crisis? – RGE Monitor