What if they held a bond auction and nobody came?
This is exactly what happened in Latvia a few weeks ago, as the country failed to receive a single bid for $16 million of debt, maturing in April 2010. In other words, investors were not willing to loan what amounts to international finance pocket change to a sovereign government for a measly 6-months.
Why? Because everyone expects that Latvia will devalue its currency; consequently, no one wants to be holding on to local assets there because the value of those assets will drop like rock once the Latvian government finally faces the music and devalues.
I talked about this in July “You Can profit from this countrys Devaluation ” after spending a great deal of time in the Baltics. Latvia’s currency, the lat, is pegged to the euro at very high rate– the agreement was made in 2004 when Latvia’s economy was growing very rapidly. At the time, the peg seemed reasonable.
Today, Latvia’s economy is collapsing 17% per year, and the central bank is running out of funds to intercede in the market. In order to maintain the peg, Latvia’s central bank has to buy lats and sell euro, essentially creating artificial demand for the lat. It can only do this for so long before it runs out of euro.
For months, it has been getting euro loans from rich European countries and supranational central banks. Each of these loans has been burned through as Latvia desperately tries to keep the peg alive. For the euro lenders, this is akin to buying bonds in GM… it’s a lost cause, and any new money you throw at it will surely be lost.
European governments have sternly warned politicians in Latvia that severe austerity measures had better be implemented if they want more loan money. Realistically, though, Latvia would have to eliminate entire divisions of its government and economy in order to meet the EU’s budget demands.
This is not likely to happen. Consequently, devaluation is looking more and more like the only remaining option.
The greatest fear of devaluation in Latvia is that locals who took out mortgages denominated in foreign currencies (because the interest rates were lower) would suddenly owe a hell of a lot more on the balance after devaluation.
For example, suppose someone took out a mortage of 100,000 at .7 lat = 1 euro. Latvians think, earn, and spend in lat, so the borrower would consider his mortgage to be 70,000 lat. If Latvia devalues to 1 euro = 1 lat, his mortgage balance in euro would stay the same (100,000 euro), but the equivalent would now be 100,000 lat.
Well… that would certainly make for a bad day. Imagine waking up one morning and owing another 40% on your mortgage when you already had negative equity to begin with!
Apparently, though, Latvia’s government has already thought this through this issue.
According to the Financial Times, Latvia’s legislature is taking steps to protect locals from the negative effects of a devaluation. Any overnight increase in mortgage principal as the result of devaluation, for example, will have to be assumed by the bank, not the Latvian borrower.
With such a populist, consumer-protection policy designed to cushion the blow of a devaluation already in the works, there is little remaining for Latvia’s government to do but devalue. It is not a question of if, but when… unless something truly miraculous happens, like Latvia wins the sovereign equivalent of the lottery.
Investment banks like Barclays and RBC are betting that Latvia will devalue 15% by the end of 2010. Sweden’s largest banks (which are the also the largest lenders in Latvia) are preparing for a devaluation scenario as well. They have to– devaluation in Latvia will hammer their balance sheets.
Swedbank, for example, has about 16% of its loan book in Latvia. When Latvia devalues, Swedbank’s equity will be hit hard and the stock price will suffer. In preparation, the bank conducted a $2.2 billion rights offering this month in order to cushion its balance sheet.
I still think shorting the banks is the best way to play this opportunity, but through carefully selected PUT options that limit risk exposure. If you directly short the stock, be prepared for a volatile run.
I think the market will also punish Sweden’s currency when devaluation occurs, so it would make sense to short the krona against the dollar, euro, and yen.
Let me know what you think about this strategy and if you have other ideas for how to profit.
