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Fears of Baltic contagion are threatening krona's health

FOLLOWING Eastern Europe&rsquo;s liberalisation in the early Nineties, the three Baltic states led the way in shifting towards an open market economy. They experienced stronger growth rates, lower unemployment and were more successful in bringing down inflation to manageable levels compared to the Central and Eastern Europe (CEE) countries.<br /><br />All three managed to peg their currencies to the euro and join the European exchange rate mechanism, a precursor to the single currency. <br /><br />But where this was once seen as a benefit and a sign of prosperity for the Baltic states, it has become their undoing. In trying to maintain the peg to the euro, the countries &ndash; Lativa, in particular &ndash; are using up valuable foreign exchange reserves, while GDP is shrinking by 20 per cent. But should they devalue, they run the risk of surging costs on foreign currency borrowings, an issue for many households which picked up euro-denominated loans in the good times, when the prospect of joining the euro was more of a reality than it is today. <br /><br />While the peg means that foreign exchnage traders cannot benefit directly from trading the Baltic currencies, the risk of contagion into Western and Eastern Europe opens up trading opportunities for forex investors. <br /><br />Sweden is a likely sufferer from contagion because Baltic countries have borrowed from its banks, leaving the country massively exposed whether Latvia devalues its currency &ndash; in which case the cost of loans would rise, increasing the chance of default &ndash; or plunges into wholesale collapse. <br /><br /><strong>CLOSEST TO COLLAPSE</strong><br />The EU and IMF are currently considering the best way to support Latvia, which is the closest to collapse of the three, but George Tchetvertakov, head of market research at Alpari UK, says that the EU would probably only give extra money on the condition of devaluation, which would create huge losses for European banks.<br /><br />The Swedish krona has fallen on the risk that banks could fail but this is more speculative than real, he says; no peg has been broken so far. There is the potential for a retracement of the losses in the krona if IMF intervention builds confidence, but with the chance that intervention is contingent on devaluation, the krona is likely to continue to suffer. <br /><br />The euro has not suffered as much because the European Central Bank is a much stronger body with more capacity to cushion any sort of fallout compared to the Swedish Riksbank. <br /><br /><strong>INSULATED DOLLAR</strong><br />Foreign exchange traders should look to go short in the short-term on the Swedish krona against the major currencies because of their liquidity. The pick of the pairs would be US dollar-krona because the US dollar is fairly well insulated against the risks posed by emerging Europe, whereas the banking sectors in both Switzerland and the Eurozone are thought to be at risk. <br /><br />The focus is certainly on the impact of a Latvian devaluation on Sweden, but Danske Bank analysts also see the potential of contagion into Eastern Europe. &ldquo;Therefore we see clear downside risk on the CEE currencies and especially see value in buying dollar-Hungarian forint, but potentially also dollar-Polish zloty on an escalation of the Baltic crisis.&rdquo; <br /><br />&ldquo;The prospect for Latvian budget cuts and a deal with the IMF might help the CEE markets. That said, event risk remains very high and we have a hard time seeing a serious comeback to the CEE currencies in the present environment,&rdquo; they write. <br /><br /><strong>MUSHROOMING DEFICIT</strong><br />Domestic fiscal troubles in the CEE will also mean that these countries&rsquo; currencies will struggle of their own accord. Merrill Lynch analysts note that expectations are improving for the CEE states, but activity is not and their fiscal deficits are &ldquo;mushrooming&rdquo;. <br /><br />But in the short-term it is the Swedish krona that will bear the major brunt of the impending collapse in the Baltic states.