Yesterday I talked about the demise of the Latvian economy and how it will foretell the future of California. Today I want to talk about the opportunity I see to profit from it.
I have seen the face of crisis before, both in the military and as a civilian. But rarely have I seen such a well-telegraphed money making opportunity to profit from crisis.
Sure, there are a lot of cheap assets in Latvia right now– the real estate and stock markets have lost 50% of their value in the last 12 months… but regardless, I would cross off Latvia as a place to invest for now, and here’s why:
Latvia’s government is flat broke. It turns out that their miraculous economic rates over the last several years were built on a mountain of debt on the back of domestic consumption… and as we have seen in the United States, consumption-driven, debt-laden growth is totally unsustainable.
During the boom years, Latvian politicians erroneously assumed that the gravy train would last forever and began feverishly expanding their domain. Tax revenues were high, government spending was even higher.
Today, with the economy in the tank, tax revenues have cratered to the point that Latvia’s Treasury Minister is about to start peddling for change.
Why does this matter? Because Latvia had the poor sense of signing up for the euro peg in 2004 at 0.702804 lats per euro. This means that the government no longer has control of its money supply and must artificially intervene in currency markets to defend the peg.
Defending the currency peg in this case involves buying and selling tens of millions of euro on the open market, effectively manipulating the price of euro in lats. There’s only one problem… Latvia’s bankrupt government doesn’t have any money to defend the peg.
That’s where the EU comes in. Old Europe has agreed to loan Latvia a few billion euro to stabilize its economy and defend the exchange rate. Could this generosity actually work?
Latvia is set to burn through several billion euros this year alone to finance its budget deficit. Add to that another billion or so to finance the country’s trade deficit, and a few hundred million in interest payments.
How much money does that leave to defend the currency peg? Not much.
And there’s just one more problem… the preponderance of lending activity in Latvia is dominated by a handful of Swedish banks who recognize that their loan default rates are about to soar thanks to the deteriorating economy.
When the EU’s loan proceeds make their way into Latvia’s economy, instead of underwriting new loans and recycling the funds, many Swedish banks appear to be shipping the euros back to Sweden in order to cover their expected losses.
Naturally, this will mop up any remaining funds, leaving Latvia without any ammunition to defend its currency peg.
My conclusion is simple– devaluation of the Latvian lat is absolutely inevitable. The more their politicians say that devaluation is not an option, the more I realize that it’s the only option.
The political consequences of not devaluing are potentially more catastrophic than the fiscal consequences. Latvians already took to the streets earlier this year and ousted the sitting government. The new government’s plan, full of 30% wage cuts and tax increases, is not going to go over well with this crowd.
Latvians want to devalue. They realize that prices are too high and consider devaluation to be like hitting the reset button on pricing. The government will not be able to ignore them for long, especially when its river of credit runs dry.
Tomorrow I’m going to talk about the way I plan on investing based on my conclusions… but of course, I would love to hear from you to see if anyone has any thoughts on how to play a Latvian devaluation (or argument to the contrary).