Latvia struggles with currency weakness Lat’s movement has implications for emerging market currencies

NEW YORK (MarketWatch) — A year ago, a sell-off in the currency of Iceland, a North Atlantic island nation with a population of less than half a million, triggered a meltdown in emerging markets across the globe. There are growing signs that Latvia may be the nextIceland.

Speculation has been rising that the Baltic republic may soon have to devalue its currency, the lat, which is getting closer and closer to the low end of its narrow fluctuation band. The Bank of Latvia only allows the lat to trade in a 1% range against the euro.

In fact, the Latvian central bank confirmed that it has intervened in the market in the past two days by selling euros to support the local currency, according to Lars Christensen, senior analyst at Denmark’s Danske Bank. The lat breached the lower limit of the trading band on Friday.

Latvia’s domestic situation increasingly resembles that of Iceland last year – it has an overheated economy fueled by credit growth, soaring inflation and a huge current account deficit.

In fact, the country’s current account deficit, at 22% of gross domestic product, and inflation rate, running at 6.6%, were the highest in the European Union in 2006, according to Fitch Ratings.

“It’s not often that you see this sort of headline, but Latvia could be the one to watch if the recent weakness in emerging market currencies is to gather speed,” said Steve Barrow, chief currency strategist at Bear Stearns.

Scary numbers

The Latvian government is trying to restore confidence in the lat by playing down the devaluation risk. But global risk aversion, which is on the rise following the sell-off in the equity markets of the past several weeks, will keep the pressure on the lat and with it, on the riskier, and more volatile emerging market currencies.

With such a narrow trading band for the lat, and with some “scary” looking economic numbers, “it seems almost inevitable that something has to give,” Barrow said.

The ripple effect from a sharp slide in the lat could be significant. It was the sudden depreciation of the Thai currency, the baht, which triggered the Asian financial crisis in the late 1990s. And there was a similar domino effect from a sell-off in Iceland’s krona last year.

Emerging-market currencies fell sharply between February and June 2006 after an unexpected downgrade of Iceland’s outlook by Fitch. Fears of a global liquidity crunch forced investors to bail out of riskier investments.

The Latvian economy by any measure is quite small, said Danske Bank’s Christensen.

Still, “the Latvian story is extremely interesting in the sense that [it] should be a reminder to people about other countries with similar problems,” he said.

The current account deficit and debt liabilities make Latvia vulnerable to an increase in risk aversion because of its dependence on external financing.

Earlier this month, Fitch warned that the country looked most vulnerable to an “abrupt adjustment in capital and financial flows and slowdown in economic growth.”

Gloomy outlook

Overheating is another concern. The Latvian economy has enjoyed stellar growth in recent years, reaching an all-time high of 11.9% in 2006.

In February, credit agency Standard & Poor’s lowered its outlook for Latvia to negative from stable, citing “an escalated risk of a hard landing” if no corrective actions were taken. The economy is showing “clear signs of overheating,” said S&P.

In an attempt to cool the economy and rein in inflation, the Latvian central bank on Thursday raised its key interest rate by a half percentage point to 5.50%.

The bank admitted that the country faced problems. “Alongside Latvia’s rapid development, the economic imbalances have continued to worsen as suggested by the key macroeconomic indicators: persistently high inflation, large current account deficit, and rapidly growing external debt,” the central bank said in a statement.

“The rate hike will help reduce the pressures on the lat moderately,” said Danske’s Christensen. “But the risks still are considerable and more rate hikes might very well be needed if the lat weakens further.”

“If the narrow band is breached it will obviously be a massive blow to the credibility of the peg,” he said. “It is getting harder and harder to avoid a hard landing in the Latvian economy and we therefore continue to recommend strongly to hedge exposure to the Latvian markets.”

Contagion risk

The problem is that the danger doesn’t stop at Latvia’s borders. Its neighbors, Estonia, and Lithuania, are also showing signs of overheating, rising inflation, tightening labor markets, rapid credit growth and substantial current account deficits.

Eral Yilmaz, an analyst at Fitch, warned that a delay to euro adoption, along with weak economic conditions, is a constraint on rating upgrades for these three countries, collectively known as the Baltic Republics. A failure to address overheating could lead to negative rating actions.

“‘Psychological’ contagion, by which markets draw parallels between economic and financial trends across countries and react accordingly — as seen in the Asian crisis and the emerging-markets sell-off in May 2006 — is a risk in the Baltics,” Yilmaz said.

The situation in the Baltic States is “worrying,” agreed Katrin Robeck, economist at Moody’s

“Rapid credit growth paired with growing external account deficits could contribute to capital flight and currency depreciation,” she said.

“We’d be surprised if the current bout of weakness in many emerging market currencies were to end here,” said Bear’s Barrow. “There still seems to be plenty of bad news out there waiting to prolong the risk-reduction process. Much of [it] looks set to come from the U.S. subprime mortgage market.”

“One thing that there probably isn’t a debate about is that this market will get worse,” he said.

Most emerging market equities, bonds and currencies are trading at fairly rich valuations, said Danske’s Christensen.

Meanwhile, the ratings outlook for many of these economies is turning more negative.

On Thursday, Fitch downgraded Iceland’s foreign and local currency issuer default ratings, citing new data pointing to “a material deterioration in Iceland’s external balance sheet.”

If there were a devaluation of the lat, “the market is almost bound to see some contagion effects given that a number of other countries in the region have similar issues, involving large current account deficits and overheated economies,” said Bear’s Barrow.

“And, if this contagion spreads wide enough, it could certainly cast a pall over the emerging market landscape.”