www.variantperception.

com
01 June 09

Baltics Revisited
SO FAR

> Baltic countries were running large current account deficits, mainly funded by loans from foreign banks

> Overheating economies – driven by excessive capital inflows - fuelled inflation

> Baltic economies started to sharply slow, triggered by the global credit crisis

> Currency pegs to the euro are exacerbating the situation and devaluation, especially in Latvia, is growing in
likelihood

CURRENT SITUATION

> Current account deficits are now becoming surpluses as imports collapse

> Inflation is steeply contracting as demand withers

> The devastating correction in the Baltic economies has further to run, and may culminate in one or more
sovereign defaults in the region

> Contagion from a Baltic default may lead to defaults in the wider CEE region and further afield, as well as
having other unanticipated effects

STRATEGIES TO FOLLOW

> Continued strain will adversely effect credit spreads of Baltic countries’ government debt

> A currency devaluation in the region – which we see as most likely in Latvia - will likely cause great problems
to the banks who were most prolific lenders in the Baltic region. These banks are at best expected to
underperform, and at worst could be left insolvent

> Systemic risk will likely mean the economic sustainability of other economies in the CEE will come under
scrutiny, with the Balkan countries of Romania and Bulgaria looking obvious candidates

> In the event of a default in the Baltics, we would expect all CEE currencies and bonds to underperform.
HUF is a particular favourite to short (against USD rather than EUR)

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01 June 09

Distress in the Baltics remains a serious issue. Large current account

deficits, high inflation and excessive levels of borrowing in foreign
currencies are all characteristic of the Baltic countries, reminiscent of the
situations of Indonesia, Thailand and the Philippines et al prior to the Asian
crisis in the late 1990s. The deficits are becoming surpluses as imports
diminish, and inflation is easing as demand evaporates; however, there is no
guarantee that mere distress may not end up giving way to outright
catastrophe.

The recent GDP figures for the first quarter of this year, all in the region of 25-50% worse
than expected, are a testament to this:

Baltic GDPs

15

10

-5
Latvia (-18%)
-10 Lithuania (-12.6%)
Estonia (-15.6%)
-15

-20
Nov-03

Nov-04

Nov-05

Nov-06

Nov-07

Nov-08
Jul-03

Jul-04

Jul-05

Jul-06

Jul-07

Jul-08
Mar-03

Mar-04

Mar-05

Mar-06

Mar-07

Mar-08

Mar-09

Source: Bloomberg

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The IMF’s recent Global Financial Stability Report (GFSR) further illustrates the difficulties of
the Baltic countries with its calculations of their refinancing needs:

Source: Danske Bank

As can be seen, both Latvia and Estonia’s refinancing needs are almost 3.5 times their FX
reserves. Indeed, this is further emphasised by looking at their ratio of FX reserves to M2:

Baltic Ratio of M2 to FX Reserves (€)

4.50

4.00

3.50

3.00

2.50

Latvia
2.00
Lithuania
Estonia
1.50
Jan-00

Jul-00
Jan-01

Jul-01
Jan-02
Jul-02

Jan-03
Jul-03

Jan-04
Jul-04
Jan-05

Jul-05
Jan-06
Jul-06

Jan-07
Jul-07

Jan-08
Jul-08
Jan-09

Source: Bloomberg

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TIME TO (UN)PEG IT?

The three Baltic currencies are all pegged to the euro under the ERM2 regime. These pegs are
what is now impeding the necessary adjustments to make the Baltic economies more
competitive. If there is no currency devaluation, the natural place for this adjustment to take
place is through labour costs. However, as wages are difficult to push down, the adjustment in
the Baltic countries is continuing to take place through increasing unemployment:

Unemployment Rate (% )

15.2

13.2

11.2
Latvia
9.2 Lithuania
Estonia
7.2

5.2

3.2

1.2
Jan-03

Jan-04

Jan-05

Jan-06

Jan-07

Jan-08

Jan-09
May-03

Sep-03

May-04

Sep-04

May-05

Sep-05

May-06

Sep-06

May-07

Sep-07

May-08

Sep-08

Source: Bloomberg

The adjustment in Latvia will likely be the most painful. Unit labour costs there increased on
average 17.8% YoY between 2004 and 2008, compared to +8.9% in Estonia and -2.8% in
Lithuania, making Latvia’s currency the most overvalued on this basis. Adjustments for
Estonia should be less severe as its effective exchange rate has been helped to remain relatively
low, partly due to the decision of the currency board to deliberately undervalue the peg when it
was first introduced. Similarly the adjustment will be more muted for Lithuania, but this is
mainly because wage growth was more subdued in recent years, reflecting the country’s slower
growth, as well as its low productivity. (Lithuania has the unfortunate appellation of lowest
productivity growth-country in CEE.)

The original reason for the introduction of the currency pegs was to provide the fiscal
foundations and stability to help satisfy the Maastricht criteria essential for euro membership.
But the current parlous state of the Baltic nations’ finances and the reality that their
economies are in a collective stupor make it hard to see the rationale in retaining fixed
exchange rates; euro accession is now categorically not imminent. Who will be first to
realize they have little to lose by dropping the peg?

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BUDGETING FOR THE WORST

As the table below shows, none of the Baltic countries’ government finances are in a fit state
to convincingly satisfy the Maastricht Treaty prescript of a budget deficit under 3%:

Budget Deficits
Latvia Lithuania Estonia
(as a % of GDP)
2001 -2.1 -3.6 -0.1
2002 -2.3 -1.9 0.3
2003 -1.6 -1.3 1.7
2004 -1 -1.5 1.7
2005 -0.4 -0.5 1.5
2006 -0.5 -0.6 2.9
2007 -0.4 -0.2 2.7
2008 -4 -3.2 -3
Source: Eurostat, Bloomberg

Estonia had looked the most likely to meet the Treaty conditions first due it to having the
most innovative and dynamic economy as well as the smallest domestic banking sector of the
three countries. However, just very recently, the Estonian government (following in the
footsteps of Latvia), collapsed as the administration was punished for trying to make the
substantial budget cuts necessary in order to comply with Maastricht. So, even for Estonia, it
will take some time before common-currency adoption is economically and politically feasible.

Latvia is the first of the Baltics to have requested funding from the IMF. Even then, all has
not been plain sailing. The latest instalment is still being held up as Latvia has been unwilling
to comply with some of the austerity measures prescribed by the IMF as conditions for the
loan. The financial distress continues to build, leading the Latvian PM to say any further delay
in IMF assistance could well mean the country faces ‘bankruptcy’, and so will have to default
on its outstanding debt:

Source: Danske Bank

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01 June 09

And in a latest twist, there is evidence that public sector workers in Latvia are being paid partly
in vouchers redeemable for food. According to the Central Bank governor, Ilmars Rimsevics,
who spoke on Friday, “The level of the expenditure shock is so high that we cannot cease to
maintain this level of expenditure. So there is a shortage of funds, and we’re forced to look at
the different kinds of projects, which [we] can provide for the foreseeable future. Taking into
account that the money is not budgeted, it can be omitted (sic) in vouchers”. It is this partial
removal of the Lati from circulation that is causing the Rigibor interbank rate to rise, as can be
seen on the next chart.

STRESS IN LATVIA AND IMPLICATIONS OF A SOVEREIGN DEFAULT

Credit spreads remain elevated, with the Lithuanian and Estonian interbank spreads stabilizing
at a still historically high level, while Latvian spreads continue to widen:

Baltic Interbank Rates over 3m Euribor

1100

900
3m Rigibor (Latvia)
3m Vilibior (Lithuania)
700
3m Talibor (Estonia)

500

300

100

-100
J un-07

J un-08
A pr-07

A ug-07

Oc t-07

Dec-07

Feb-08

A pr-08

A ug-08

Oc t-08

Dec-08

Feb-09

A pr-09

Source: Bloomberg

Despite this, and the other distinctions between the three countries, the market does not
appear to be differentiating much when it comes to the risk of a sovereign default. The cost of
insuring Latvian government debt has decreased to just over half from the peak reached earlier
this year, virtually the same as for Estonia and Lithuania:

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Source: Bloomberg

So should the worst occur, what would be the effect of a government default in the Baltics?

It is likely the other Baltic countries would be the first and hardest hit. Aside from the
systemic market-risk resulting in all three countries being viewed as structurally very similar (as
exemplified by the CDS chart above), the Baltic countries are dependent on one another from
a trade perspective, most significantly Latvia:

Inter-Baltic Trade, Exports as a % of Total (2006)

30%

25%

Estonia
20% Lithuania
Latvia
15%

10%

5%

0%
Latvia Lithuania Estonia

Source: emporikitrade.com

Swedish banks are heavily involved in the region, accounting for almost half the lending which,
according to Danske Bank, is equivalent to 20% of Swedish GDP. Fine perhaps in the salad
days of pre-2007, but a real and growing concern when non-performing loans in the region are
at 3% and are projected to exceed 10%. This high concentration of lenders not only means a

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country default would be very damaging to only a few banks (Swedbank, SEB and Nordea
specifically), there would also be devastating secondary effects as credit rapidly dries up in the
non-defaulting Baltic countries, damaging their economies further.

The lending has left the Swedish banks heavily exposed to the currency pegs. Many of the
loans made were in local currency (lats, litas or kroons), but banks borrowed from their parents
mainly in euros. If the peg was dropped, this would leave a gaping mismatch between the
assets and liabilities of these banks, perhaps leaving them insolvent. Latvia is having the most
trouble defending its currency, its reserves having dropped almost 40% since last September,
and a recent survey for Baltics Business News had 4 out of 5 respondents believing Latvia
would have to devalue ‘soon’. Torbjörn Becker, leader of the Eastern European Institute of
the School, thinks a Latvian devaluation is likely: “The alternative to a devaluation in Latvia is
to wait until the reserve is drained and the economy will disappear into a black hole”. He
believes then that Estonia and Lithuania would follow in dropping their pegs.

Indeed, signs of financial disturbance at Swedish Banks are beginning to emanate with the
Riksbank announcing on Wednesday it will borrow 100bn SEK from the National Debt Office
to restore its currency reserves. During the financial crisis the Riksbank had entered into swap
agreements with, amongst others, Iceland, Estonia and Latvia and this is evidence these have
been drawn upon heavily, reflecting the worsening funding problems in the Baltic countries.

Any Baltic default would also lead to downgrades towards the lower echelons of junk ratings
for the other nations, resulting in a significant increase to the cost of their funding. Fitch has
already cut Latvia to junk, and the other Baltic countries are on negative watch.

FURTHER CONTAGION

Countries don’t tend to default alone. The following chart illustrates the history of sovereign
defaults:

Source: Reinhart & Rogoff, “The Time is Different”, 2008

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As is clear, each lull is followed by a wave of defaults.

So if one of the Baltic countries were to default and history were to rhyme, where would the
markets be next likely to cast their cynical eye?

Two contenders are the Balkan countries, Romania and Bulgaria. Both have large external
deficits and significant refinancing needs (according to the IMF, Romania’s refinancing need
for 2009 is 127% of its GDP). Bulgaria had an extended property market that has just bust,
and Romania has already had to secure a €20bn IMF loan, with the usual austerity conditions
attached. Both have also just witnessed a precipitous fall in growth rates:

Balkan GDPs

11

-1

-3 Bulgaria (YoY)
Romania (QoQ)
-5

-7
Jun-04

Jun-05

Jun-06

Jun-07

Jun-08
Sep-04

Dec-04

Mar-05

Sep-05

Dec-05

Mar-06

Sep-06

Dec-06

Mar-07

Sep-07

Dec-07

Mar-08

Sep-08

Dec-08

Mar-09

Source: Bloomberg

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The cost of insuring both Romanian and Bulgarian government debt has stabilized, for now
anyway:

Source: Bloomberg

However, risk could be repriced very quickly. We will continue to closely monitor the
performance of the Balkan countries.

Contagion from a default would also negatively affect most if not all of the CEE currencies
and bonds. We would expect HUF, which we have discussed in previous reports, to
perform particularly poorly (and we would favour buying USDHUF over EURHUF as
a Baltic shock may bring focus back to European banks’ exposures to the region, and
thus be negative for EUR).

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01 June 09

FIRST ONE OUT’S THE WINNER

One final point worth making is that defaulting - for a country on the verge of it - is often,
paradoxically, not always a bad idea. If you have two countries, both of whose finances are in
a fractious state, and one decides to renege on its debt while the other struggles on and tries to
meet its commitments, then the former country is generally able to return to financial health
more quickly. They can start again and are able to get their economy back to a situation that
nurtures growth, while the non-defaulting country struggles on with the damaging spending
cuts and tax rises necessary to pay back their creditors. Markets have short memories, and
often misprice the risk of the defaulting country once it starts to borrow again. Argentina, for
one example, after its default in 2001/02, had to wait only 3 years for its cost of borrowing to
return to a level commensurate with a typical emerging market economy.

Argentine CDS (orange line) was on average only marginally higher than Brazilian and Turkish CDS,
despite it defaulting on its debt only a few years before

Source: Bloomberg

IN CONCLUSION

Severe stress remains in the Baltic countries, with Latvia looking the most fragile, due its
government finances, cost of funding, currency peg and export composition all less stable than
its neighbours; the market, however, seems not to distinguish too heavily between them.
Specifically, despite the continued widening in Latvian interbank rates, Latvian CDS
so far do not appear to be reflecting the concomitant risk-premium one might expect,
suggesting a mispricing, or that the market is pricing the risk of default in the Baltic
countries as if they had a correlation of 1, ie if one goes, they all go.

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Currency devaluation, which we see as most likely in Latvia, 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.

A sovereign default would be very damaging for all the Baltic countries, the primary vectors
being systemic risk and trade links. Also, should one or more of the Baltic nations default,
Estonia, with its innovativeness and its niche in windpower, and Latvia with its nascent foray
into biofuels, would both be likely to recover first (and not forgetting that whoever defaults on
their debt first may well have a head-start towards recovery). Sovereign defaults, however, if
history is a guide, rarely happen in isolation. Countries with similar structural imbalances to
the Baltics, like Romania and Bulgaria with their large external deficits, would likely come
under intense pressure, and may ultimately succumb to the ignominy of defaulting on their
debt. Contagion in the CEE would ensure currencies and debt across the region will
come under increasing pressure. We like shorting CEE currencies, particularly HUF,
but against the USD rather than EUR as a Baltic shock may bring focus back to
European banks’ exposures to the region, and thus be negative for EUR.

We will continue to monitor the situation and believe that if we see one sovereign
default in the Baltics (to which we ascribe a non-negligible probability), then we are
likely to see more in the remaining Baltic countries or the wider CEE region, and
perhaps beyond.

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