Sense on Cents

Are all regions of the world improving? Will Asia lead the globe to greener pastures and brighter days? Well, if so, the trek through the fields will not be easy and we will encounter many storms along the way.

While Australia’s raising rates yesterday is an indication of an improving economy in that country, as one moves out of Asia into eastern Europe we encounter a decidedly different dynamic. Let’s revisit the ‘weakest link,’ that being Eastern Europe in general and the Baltic nation of Latvia specifically.

I initially addressed the economic weakness in this part of the world last February in writing, “The Weakest Link.” Today, we learn that Latvian Currency Scare Rattles Markets:

The Swedish krona and a range of eastern European currencies have tumbled as Latvia appears to edge closer to devaluing its currency.

In a re-run of the last major devaluation scare, Latvia failed to attract any bids for one of its treasury bill auctions earlier Wednesday. The country’s treasury received no bids for its offer to sell eight million lats ($16.7 million) of paper maturing in April 2010.

The poor auction results are the latest sign of economic stress in the Baltic nation, where the government is struggling to meet budget cuts required by the International Monetary Fund, the European Union and other bilateral lenders in return for aid.

The Swedish krona, linked to Latvia through Sweden’s large banking exposure to the country, tumbled as news of the failed auction emerged. The euro extended earlier gains to reach a peak at SEK10.3670 against the krona.

Meanwhile, Europe’s emerging market currencies, which often suffer from nerves over risk when Latvia’s problems intensify, also fell.

The euro soared to over HUF269 against the highly risk-sensitive Hungarian forint, from under HUF267 at the start of the day. The euro also swept to over PLN4.24 against the Polish zloty, from a low of PLN4.18.

The Turkish lira and, to a lesser degree, the Czech koruna, also weakened. The failed bond auction was “not good news,” said Nigel Rendell, a European emerging markets strategist at RBC Capital Markets in London.

“It has all the makings of the final chapter in the Latvian story,” he added. In credit markets, the cost of insuring Latvian sovereign debt against default continued to climb from recent levels, in a sign that investors are increasingly uncomfortable with the outlook for the country. Regional peers Lithuania and Estonia, which also peg their currencies to the euro, saw their swaps spreads widen.

Still, the debt and currency markets shouldn’t be overly troubled by Latvian devaluation risk, as the threat has been building for some time, and the global financial markets are now much more robust than they were several months ago.

“If they did devalue, there would be a selloff [in eastern European assets], but the impact would not be as severe as it would have been six to nine months ago,” said Mr. Rendell at RBC. “If we had big currency moves, I think people would buy them back,” he added.

Devaluation is also unlikely to catch the Swedish banks off guard. To brace for the potential onslaught of defaulting customers, both Swedbank AB and Skandinaviska Enskilda Banken AB have set up Baltic units to deal with problem loans and seized collateral.

While officials may care to discount the impact of a full blown devaluation of the Latvian currency, the interconnectedness of the global markets has proven to be more of a risk propellant rather than a risk mitigant. How so? The use of derivatives across currency and credit markets has been shown to be as much speculative in nature as pure hedging. In fact, there certainly are market participants who will benefit by a Latvian devaluation.

Can that devaluation, if it does occur, be well contained?

I’ll be watching.

LD

Related Sense on Cents Commentary

Let’s Cross the Pond and Revist the Weakest Link (May 23, 2009)