Friday, August 31, 2007

On financial storms, part 2

Click here for Part 1 of this post.

Just like East Asia in 1997, Latvia has very high current account deficit and a lot of credits in foreign currency (euro in Latvia now, dollars in East Asia in 1997). This lead to a devastating financial crisis in several Asian countries 1997. In this post, I will describe two reasons why (I think that) such crisis is unlikely in Latvia.

First, Bank of Latvia is well-prepared to defend to present exchange rate of 1euro=0.7 lats. In 1997 Thailand, the crisis started by exchange rate of Thai baht plunging from 25 baht/dollar to 56 baht/dollar. This put extreme pressure on people and businesses which had borrowed in dollars. Many of them went bankrupt because their baht incomes were worth much less dollars but the amounts of dollar loans were still the same.

As of July 2007, Bank of Latvia has the foreign currency reserves worth 5.1 bln US dollars. This is comparable with the amount of lats in circulation and Bank of Latvia should be able to maintain the present exchange rate even if people rush to exchange lats for euros.

Speculative attacks on currencies use borrowed money. If speculators want to crash the exchange rate of Thai baht, they borrow money in bahts and exchange it for dollars, until there is no party willing to exchange dollars for bahts. Then, the exchange rate falls. Eventually, some of borrowed money is exchanged back at a lower exchange rate to repay the loans. The rest is speculators' profit.

The problem with doing that in Latvia is borrowing a sufficiently large amount of lats. In more developed financial markets, one can easily borrow large amounts for speculative transactions. Latvia, however, has very little in terms of financial markets. The banking system is oriented towards everyday transactions and borrowing the lat equivalent of 5.1 bln US dollars for speculative purposes is between very hard and impossible.

The second distinction between Latvia now and East Asia in 1997 is the nature of foreign currency inflows. If foreign money is withdrawn from a country in a panic, that can trigger a financial crisis. Some investments are harder to withdraw than others. As Martin Wolf said, "factories do not walk" (if an investor has purchased a factory, it is difficult to sell it in a panic and leave the country with money). Foreign investment into Latvia has been more in shopping centres than in factories. However, shopping centres are about as unlikely to walk as factories.

For the last years, most of foreign currency inflows have been through Latvian banks borrowing money from abroad. This is more worrisome but a fair amount of this borrowing has been from Scandinavian banks that own the respective Latvian banks. As a result, Scandinavian banks are interested in stable long-term future for the Latvian banks and are less likely to withdraw their loans suddenly.

The third distinction is that financial markets have been less stormy in recent years and have tolerated much larger imbalances then before. This can, however, change anytime. But, based on first two distinctions, I'm optimistic about Latvia.

That being said, the Latvian boom of last few years will probably subside. To use an analogy from Asia, Hong Kong avoided a financial crash in 1997. Yet, a colleague from there tells me that there was a marked difference between pre-1997 Hong Kong (optimistic, flush in money for any reasonable project) and post-1997 (people squabbling over much smaller amounts of funding). There were people who had been abroad for a while, went back around 1997 and were quite disappointed with life there post-1997. And it's worse in the industries which boomed in 1997. For example, the salaries for Hong Kong construction workers now are half of what they were in 1997.

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