Eastern Europe at a Tipping Point

I was just about to release the following post when I saw FT's Alphaville reports Latvia has been downgraded to "junk" by S&P. Here is the background I planned to release...

The Financial Ninja details:

"Latvia’s four-party coalition government, facing the steepest economic decline in the European Union and plunging public opinion ratings, resigned after two parties called for Prime Minister Ivars Godmanis to step down.

East Europe has been battered by the global financial crisis, which is curbing demand for their exports while shutting off credit and investment. Gross domestic product in Latvia, which has had 14 governments since breaking from Soviet rule in 1991, contracted 10.5 percent in the fourth quarter. The country followed Ukraine, Serbia and Hungary in seeking international aid when it lined up 7.5 billion euros ($9.5 billion) in loans from a group led by the IMF in December."

For those in the economic blogosphere, this isn't a surprise. John Hempton at Bronte Capital posted Hookers that Cost Too Much last summer, detailing the struggles Latvia was going to face, based on (you guessed it) the price of hookers:

When travel to Latvia opened up it was eye-popping for an awful lot of British lads. Here was a country where the women were Baltic Beauties – and poor. To the London lads this was bucks party heaven. It became more so when Ryan Air put on a Friday evening flight from London to Riga. Ryan Air even tried a Riga-Shannon route to service the Irish lads. The locals even got to classifying all Brits as Ryanair sex tourists as this club review shows.

Well due the crazy exchange rate the bucks parties got too expensive. I am not going to lead your round the internet to stories about over-priced hookers – but the bucks parties are moving to Prague. The Shannon-Riga flight has been cancelled. Ryan Air has recently announced a Friday night Birmingham to Prague flight.

This was just one example showing that the Latvian currency was too strong, but it allowed John to realize Latvia (and Eastern Europe in general) had all the makings for a severe recession:

Eastern Europe is full of vulnerable currencies. Most of the countries have fixed their exchange rate to the Euro (hoping I guess for Euro membership at some stage) and have massive current account deficits.

Latvia is particularly bad. The exchange rate is pegged (as per this page from the central bank of Latvia). The current account is enormous, almost 25% of GDP. There is no doubt whatsoever this exchange rate is not sustainable. Not close.

With a currency too strong, exports get crushed, but as of now they have been unable to devalue their currency due to pressure from European banks who have made huge amounts of Euro denominated loans to these eastern European countries (hence the widening of CDS spreads). A devaluation of their currency would mean the value of the loans skyrocket in local currencies, removing almost any possibility that they will be repaid. It seems we are now at the tipping point... that point when internal pressures become too strong, which is exactly what is happening now in Latvia. Back to the Financial Ninja:

Street violence is just street violence... until it isn't. This occurs when the people finally coalesce around a new leader and a new ideal. Then they unceremoniously overturn in it's entirety the old order... with all the chaos and violence that that entails.

"The deepening economic crisis has sparked the worst street violence since independence, when hundreds rioted in Riga’s old city, smashing windows and battling police after a peaceful anti- government demonstration of about 10,000 people on Jan. 13 had dissolved."