Editor Pick – Is Eastern Europe at Risk of an Asian-style Banking Crisis?
S&P downgraded Latvia’s long-term sovereign rating from BBB+ to A- last week, citing the “increasing risk of a hard landing”.
With a current account deficit of 26% of GDP in Q4 2006 (the world’s highest) combined with runaway government spending and booming credit growth (78% in 2006), the Latvian economy looks dangerously close to overheating.
Following the negative ratings action on Latvia, attention has focused on the growing economic vulnerabilities in Eastern Europe and the other two Baltic countries. While these economies have not reached the same boiling point as Latvia, many are experiencing similarly fast credit growth and high current account deficits. Consequently, Danske Bank warned in March that several other Eastern European countries could be in line behind Latvia for negative ratings action.
…the prospects for credit ratings in the EU8+2 countries are somewhat less rosy than they have been in recent years. Latvia especially stands out as being in the danger zone for downgrades. Romania is also likely to face a downgrade. Furthermore, negative rating action should also be expected for Estonia, Lithuania, Bulgaria and Slovakia.
In a recent report on the rising risks in the Baltics, Fitch acknowledges the possibility that problems in Latvia could have a knock-on effect across Eastern Europe’s financial markets similar to what occurred in the Asian crisis.
Investors who lose money in Central and Eastern Europe or more specifically one Baltic country could look to close their positions across the Baltics, triggering a halt to or even an outflow of foreign funds from Baltic banks. This would be likely to lead to an abrupt slowdown in lending and consequently a severe correction in the growth rate, and, potentially, asset prices. “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.
Nevertheless, Fitch believes contagion risk from “direct” trade or financial linkages is very limited.
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