When markets were more agitated than they are today, one source of background worry was the Baltics. The countries went on a debt binge, borrowing heavily from Swedish banks. And while the amounts at issue are hardly earth-shaking by credit crisis standards, there is always the possibility that unexpected knock-on effects could lead to more serious consequences than now appear likely. Not that the impact is not meaninful to parties immediately involved, namely Sweden and Lativia.

John Hempton provided background earlier in the year:

Latvia and to a lesser extent Estonia and Lithuania had a massive and unsustainable current account deficit. That means they bought more from the rest of the world than they sold (just like America buys far more from China et al than they sell). The current account deficits (relative to GDP) was however much bigger in Latvia.

In a floating exchange rate regime this would usually be remedied by the currency falling dramatically, increasing the competitiveness of exports (and increasing the price of imports). The market provides a solution. With America this can’t happen because the Chinese fix their currency against the US dollar. In the Baltic States the currency is fixed against the Euro. Normally to fix the exchange rate a central banker needs to buy the currency that is tending weaker. They buy it and remove it from circulation. In so doing the reduce the money supply in the weaker currency causing interest rates to rise and a mild monetary deflation (increasing the competitiveness of local industry versus foreign competition) and hence over time remedying the current account deficit. Unfortunately this monetary deflation causes a recession in the country with the naturally weaker currency. Ultimately that makes fixed rates unpopular in countries with chronic relative economic under-performance – because the populace doesn’t like more or less continuous mild recessions… Now there is one exception…And that is if somebody cheaply finances your current account deficit ad-infinitum. Then you can have the nice strong currency and spend it and not have any domestic price pressure. Unfortunately you also wind up owing your foreign benefactors just way too much money. The party has to end. And it can end quite sharply when the foreign benefactor becomes less willing to lend to you.

Foreign benefactors have just put the choke collar on Latvia. The government was unable to roll over its debt this week. From MarketWatch:

Latvia’s central bank warned Wednesday of “another wave of distrust” beginning to roll over the Baltic country, as the government received no bids for one of its three auctions for debt securities, heightening worries over its financial situation and the sustainability of its currency peg. The Bank of Latvia, in an uncharacteristically dramatic statement for a central bank, said the lack of confidence can potentially bring higher interest rates and exacerbate conditions for entrepreneurs…. Latvia has been battling to emerge from a deep financial crisis. Sweden on Tuesday put pressure on the tiny Baltic nation to fulfill required spending cuts, threatening to withhold payments due at the turn of the year from a 7.5 billion euro rescue loan put together by Nordic countries.

Sweden, in other words, finds itself a major actor, along with the EU and the IMF, in negotiating a rescue package that extends new loans only if austerity measures are implemented.

But Latvia does not appear to be ready to accede to Sweden’s demands. The immediate cause for concern is that Latvia will simultaneously devalue its currency and provide a mechanism for its consumers to partially default on mortgages held by foreign banks. From another MarketWatch story:

The Baltic country is squabbling with Western — mostly Swedish — leaders over spending cuts, and it’s a very real possibility that the country may be forced to devalue its euro-pegged currency if emergency global funds don’t arrive. Were Latvia to devalue, that would hit economies in neighboring countries like Lithuania, and Swedish banks would rack up additional losses on the loans they have made throughout the region. The real nightmare scenario would be the Swedish banks then pulling down other European banks, and then triggering Credit Crunch: Part 2. There is, of course, a long way before that unwieldy scenario comes to pass. Latvia hasn’t devalued — yet – and, even if it does, that doesn’t mean it would drag the Swedish banks under.

Latvia just had a $17 million bond auction fail, as in no bids. Which is understandable given the real possibility of a near-term devaluation.

The Guardian comments less than enthusiastically about the central bank’s idea of how to cut the Gordian knot, that of reducing mortgage borrowers’ liability en masse (deep principal mods, as we would call them here, on mortgages held by foreign banks):

The Latvian government was struggling to avert a financial meltdown today as ministers convened emergency talks with Scandinavian banks to discuss a bold and controversial plan to slash mortgage-holders’ liabilities to lenders. The scheme could mean billions in losses for the big Swedish banks most exposed by the small Baltic state’s financial and economic crisis. Valdis Dombrovskis, the embattled Latvian prime minister, said he was confident he could get his proposal through the parliament in Riga, but was still examining the legal implications of the scheme. But the powerful Latvian central bank delivered an unusually blunt attack on the prime minister, saying that his budget and bank policies were feeding a fresh “wave of distrust” towards the small and highly vulnerable state. Banking sources in Riga warned that the radical proposal on mortgages, which could see borrowers repaying only a fraction of their loan, would backfire, deterring foreign investment, bringing already low bank lending to a complete standstill and wrecking international confidence in Latvia. Dombrovskis said the foreign banks, which hold controlling stakes over 90% of the Latvian banking sector, shared the blame for the crisis and would also have to share the costs. “Some balance has to be found between the interests of borrowers and the interests of lenders,” the prime minister told the Guardian. “The real incomes of people are diminishing and it is getting more difficult to repay loans.” Dombrovskis’s surprise proposal came amid growing international concern about Latvia after he revealed plans to cut public spending next year by only half the level agreed with international creditors earlier this year as part of a €7.5bn (£6.9bn) rescue package put together by the EU, the IMF and the Nordic countries. Sweden, currently chairing the EU, reacted by threatening to withhold more than €1bn in credit scheduled for next year.

The FT also weighted in:

The finance ministry denied there had been any weakening in commitment to Latvia’s currency peg with the euro amid a renewed round of speculation that the country would be forced to devalue the lat. Riga announced tentative plans on Tuesday to cap the amount that banks would be allowed to collect from mortgage holders in a move that analysts said would make it easier for Latvia to devalue. This has revived concern among international investors about the heavy exposure of Nordic banks to the Baltic region and the risk of contagion if devaluation in Latvia forced other eastern European countries with fixed exchange rates to follow suit. The Latvian proposals would allow banks to collect only the current value of a property rather than the original value of the mortgage, insulating homeowners from the 70 per cent drop in property prices since their peak. The move would remove one of the biggest obstacles to devaluation by ensuring that holders of euro-denominated loans, which account for about 80 per cent of mortgages in Latvia, would not face a sharp increase in debts if the peg with the euro was broken.

When a country starts denying that it is going to devalue, it is almost inevitable that it winds up doing just that.

On the surface, the Latvian crisis appears far too small to trigger another round of upheaval. But it could serve to reveal how weak European banks really are. They entered the crisis with lower equity levels than their US peers, and the biggest have just as sizable derivatives exposures. When you add to that the fact that they have realized even fewer of their losses than the US banks, a seemingly minor eruption like Latvia could serve to reveal that the banking emperors across the pond are wearing no clothes. While the odds of Latvia precipitating a larger set of problems are low, they are not zero.