Nicholas Watson in Prague -

Though the Latvian prime minister repeated Friday, June 5 that there would be no devaluation of the local currency, there is a growing debate over whether a Rubicon has been crossed and a break of the lat's peg against the euro, after months of speculation, is now a certainty.

Prime Minister Valdis Dombrovskis was forced to issue a strong statement against a devaluation and slapped down the former Swedish central bank governor Bengt Dennis, who told Swedish television channel STV on the prior Monday evening that devaluation of the lat was inevitable. "We have moved beyond the question of whether there will be a devaluation and should instead focus on how it will be carried out," Dennis said.

Sweden's stake in this issue is that his country's banks have been heavy investors in the Baltics, the provider of many of the euro-denominated loans that Latvians, Estonians and Lithuanians have gorged on to buy houses, cars and consumer goods over the past few years as the region's economies boomed. But with the crisis bringing that growth to a juddering halt and pushing it into reverse - Latvia's economy is expected to contract by a staggering 18% this year - those banks now find themselves between a rock and hard place. Many of those borrowers are losing their jobs as the countries can't devalue their currencies to increase their competitiveness; at the same time, any devaluation would hurt people's ability repay their euro loans.

"We have just to put this talk (about a devaluation) to one side," PM Dombrovskis told newswires. "I think this is a situation that will go over and when we have agreement with international lenders the market will also calm down."

Variant Perception, a macroeconomic analysis consultancy, says that devaluation would ultimately be cathartic, but the short-term convulsions would be violent. "Hardest hit would be the foreign lenders - mainly Swedish banks - who would find the value of their loan assets decimated. In the short term, this may exacerbate the financial crisis as the credit supplied across the Baltic region, mainly by the same now beleaguered lenders, suddenly dries up. Some of the banks involved may be left insolvent."

Instead of devaluation, the Latvian government is pushing parliament to back budget cuts, which it argues would secure a further €1.2bn tranche of the €7.5bn loan it agreed with the International Monetary Fund (IMF) and European Union (EU) last year and allow the country to meet the budget-deficit criterion to adopt the euro in 2012 or 2013, which would solve many of the problems at a stroke. However, the budget deficit is spiralling out of control as the crisis causes budget revenues to collapse. The original IMF programme targeted a budget deficit of 4.9% of GDP, but the government appears to be now targeting a deficit of over 9% of GDP and European Commission forecasts warn of a deficit in excess of 11%.

The IMF is currently in Riga assessing the conditions and will wrap up its visit on June 5. And with a growing number of politicians and economists now arguing that a devaluation of the currency would be less painful in the long run than keeping it, there's growing speculation that the impetus behind such a move has become irresistible. "Remembering back to the big currency corrections, Russia in 1998, the abolition of the crawling peg in Turkey in 2001, and Iceland in 2008, often momentum/pressure builds over a number of months until a critical point of no return, a Rubicon, is reached and crossed," Tim Ash of Royal Bank of Scotland writes in a note. "In Russia in 1998 it was the failure of the agreement on an IMF programme reached in July 1998 to turn market sentiment. When the market continued selling despite the appearance of the seventh cavalry or Cossacks on the horizon in the form of a big ticket IMF programme, you just knew it was a case of dos svidanya for the heavily managed exchange rate regime as then was. We sense that a similar Rubicon was crossed this week in Latvia when the prior cross-party support for the exchange rate peg was finally broken with a former prime minister calling for a currency correction; just a year back a local economist was arrested for daring to utter doubts over the durability of the fixed exchange rate regime, so not sure what fate awaits the latest critic of the fixed exchange rate regime."

Assuming Latvia does finally call time on its currency peg, the next questions are: what happens to the Swedish banks? And what happens to the region's other currency pegs?

Swedish sauna

Swedish banks have issued loans equivalent to roughly 20% of Sweden's GDP to the Baltics; Swedbank and SEB jointly control between 50-75% of bank lending market in each Baltic country. On June 2, Sweden's central bank, the Riksbank, said it expected loan losses in 2009 and 2010 at major Swedish banks to total SEK170bn (€15.8bn), with just under 40% of these losses expected to stem from the banks' operations in the Baltics and the rest of Central and Eastern Europe. Swedish bank shares and the Swedish crown have dived on worries about the exposure to Baltic markets, while overnight interest rates, Rigibor, neared a record 16% on June 3. By way of comparison it was 3.92% a year ago to the day.

In late May, the Riksbank said it was boosting foreign currency reserves to enable it to lend to Swedish banks if needed, a measure which analysts linked to the Baltic situation. The Economist Intelligence Unit says, "it may not be too long before the Swedish state has to step in with direct financial support."

Swedish banks-€™ Baltic market share as of Sep 2008

Ash notes that it was a Swedish voice, a former Riksbank governor no less, who raised the "D" word so forcefully, implying that an important decision there has already been taken. "For Sweden, developments in the Baltics could prove embarrassing if the line is pushed that the Latvian real economy is in effect being sacrificed in the best interests of Sweden's banks. After all, a devaluation in Latvia would see [non-performing loans] rise, but it would be Swedish banks, not the Latvian government, which would be expected to pick up the tab of recapitalising local subsidiaries," says Ash. "Our growing sense now is that the emerging official 'external' and perhaps emerging domestic official view is now that the current hard lats strategy is simply not working, and that 'Plan B' may in fact be less unpalatable especially if the knock-on effects to other markets can be limited."

Those knock-on effects centre on what will happen to the currency pegs in other countries of the region: Bulgaria, Estonia and Lithuania.

"The relative shallowness of financial markets makes Estonia and Lithuania arguably less vulnerable to contagion. Nonetheless, if Latvia devalues, we believe both countries are likely to follow suit eventually. After all, they suffer the same fundamental problem of an overvalued real exchange rate and a weaker lat would simply exacerbate competitiveness issues," says Neil Shearing, emerging market economist at Capital Economics.

Analysts generally agree that the peg in Lithuania is at most risk, as its economy displays to nearly the same degree many of the same imbalances and weaknesses as Latvia's. But Oliver Weeks and Alina Slyusarchuk of Morgan Stanley see Estonia in a different light and say the country is still on course for adopting the euro in 2011, as it's closer than the other Baltics to meeting the Maastricht criteria. Nevertheless, they acknowledge that a Latvian devaluation before Estonia achieves euro entry would have a negative impact, implying that a Latvian devaluation could derail Estonia's euro adoption goal.

Further afield, a devaluation in Latvia could lead investors to question the durability of Bulgaria's currency board. "The big wildcard is how a Latvian default/devaluation would affect the greater CEE region. Direct trade and financial linkages between the Baltics and other CEE economies are limited. Nevertheless, many of these countries - particularly Bulgaria and Romania - share similar macroeconomic vulnerabilities to Latvia, meaning a crisis there could 'wake up' investors to the potential for crises in the rest of the CEE region," says Mary Stokes of RGE Monitor.

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