The nation of Latvia is quietly burning through its foreign reserves in order to stay pegged to the Euro. Once these reserves run out, CFP Contributor David Harris reports, its ‘game over’. Below, David discusses the potential for economic collapse in Latvia, and indeed it being a catalyst for a further fallout within European and specifically Swedish banks.

Latvia is on life support, but so will be a variety of its trading partners if things do not shape up soon.

Despite a €7.5 billion loan package announced last December, Latvia’s GDP is expected to contract by about 18% this year – the worst reduction in the EU and among the worst in the world.  Valdis Dombrovskis, the Prime Minister of Latvia, admitted his country faced bankruptcy this year, if the large €1.7 billion June installment were to be delayed.

Failing to produce budget cuts, Latvia did not receive its €200 million tranche in March.  One of the conditions of the package is that Latvia’s budget deficit cannot exceed 5% of its GDP.  But officials say that even if Latvia cut spending by 40%, it would still find itself with a 7% budget deficit.

Many suggest that Latvia should devalue its currency.  It is pegged to the EUR within a ±1% fluctuation band, which it has been able to maintain by tearing through its foreign reserves, which stood at USD $4.4 billion by the end of March, down from a pre-crisis peak of $6.6 billion.  Without IMF tranches, Latvia will continue to burn up its reserves, eventually enduring default and devaluation at the same time.

Latvia may have to maintain the peg: almost all of the lending to Latvia has been done in high-value foreign currency.  Latvia needs to use money of a competitive value, or else default on those loans.  After all, if Latvia’s currency shrunk by 50%, the loans would essentially double in value.

Latvia also keeps this exchange peg because it hopes to adopt the Euro.  This may be wishful thinking. 

If Latvia collapses, or is forced to devalue its currency, other trading partners and emerging markets will be rocked as well.

Estonia and Lithuania are Latvia’s top trading partners.  They are also pegged to the Euro.  Should Latvia collapse, those two countries will be forced to destroy their currencies to remain on an even keel, and will suffer an enormous loss of exports to Latvia.

Swedish banks dominate Latvia’s banking system, as well as the banking systems in Estonia and Lithuania.  Dead economies and currencies would wreak violence on the Swedish banks, SEB, Nordea, and Swedbank.  A Latvian collapse could create a domino effect that would wipe out 2-6% of Sweden’s GDP over several years.

Latvian officials have pleaded to have the IMF loan conditions modified to accommodate a 7% budget deficit, but so far, the IMF has not budged.  It may make sense for the IMF to cut its losses, but hopefully an agreement can be arranged before the region is faced with total collapse.  The world will know by the end of June.