But otherwise enjoy a post that breaks all the rules. I am loudly calling the likely collapse of a politically sensitive country. Its one of those circumstances when shouting fire can cause the tragedy. To some extent I take comfort in my low readership.
I promised when I started this blog to have a global focus. I haven’t mostly because the most interesting story around is what is happening in the US financial market. But I hope to remedy that in this post as I give you, dear readers, a financial tour of Sweden, Latvia, Estonia and Lithuania.
I shouldn’t shout this story – but it is such a good story I can’t resist. The title is a little sensational too – but not unfair.
Before I start I need to introduce you to a model of bank collapse.
The fixed currency model of bank collapse
First observation: banks intermediate the current account deficit
· Countries that run big current account deficits have banks with loan to deposit ratios above 130. (See Australia or New Zealand for examples.)
· Countries that run big current account surpluses have loan to deposit ratios of 70 or less. (See my post on 77 Bank for an example.)
· Another way of saying this is that banks in current account deficit countries are generally reliant on wholesale funding. [It’s the crisis in wholesale funding that is causing the problems in American banks now.]
Second observation: fixed exchange collapse with currency runs
When a country has a fixed exchange rate that is too high (evidenced by unsustainable current account deficits) they become subject to runs on the currency. This happens as follows:
· Some speculator (eg George Soros) shorts-sells the currency and buys whatever it is fixed to. They do this by borrowing the target currency or by withdrawing lending in the target currency.
· They then take the borrowed currency and give it to the central bank/currency board who swap the domestic currency for foreign reserves at the fixed exchange rates. In doing so they reduce domestic money supply causing short term interest rates to rise. If they do this enough they induce a recession (ugly). This creates pressure (political and otherwise) for a deviation.
· Alternatively the central banks sterilises the money supply change. However if they continue to do this they will run out of foreign currency reserves – and the fixed exchange rate collapses anyway.
Many a fixed currency has been broken this way. George Soros did it with the pound. Nameless speculators did it across Asia. The Mexican Peso and Argentine Peso both had fixed currency pegs that didn’t hold.
Third observation: a currency run results in the banks being de-funded.
· Given that most the lending in the “target currency” is to banks and the banks in current account deficit countries are generally dependent on wholesale funds – the run on the country causes funding pressure to banks.
· This funding pressure when it is particularly intense will cause those institutions most dependent on foreign currency to become illiquid and hence collapse. The currency crisis morphs into a run on bank wholesale funding.
Past currency crises have been associated with bank collapses. In Thailand (which was precisely to this model) the finance companies actually collapsed and the banks almost collapsed. In Korea both the banks and currency collapsed.
But you need to be really careful of countries with fixed exchange rates and huge, unsustainable current account deficits.
Never much fun shorting the banks in such countries
If you had picked the collapse of the Thai Banks you might have cleverly shorted the stocks. It would not have helped much. Suppose you shorted $100 worth of a Thai bank. It collapsed down 95% (corrections in the comments). So you had $95 in profit. The only problem is that you have the profit in the pre-crisis exchange rate. The currency also dropped almost 90%. So you were left with about $10 profit. That is fine-and-dandy but it is not much reward for effort of picking a system that is about to collapse.
You would of course be much better just shorting the currency – or shorting the ADRs of the target stock (the ADRs being priced in a hard currency).
The real exception is that if you find a bank in a hard currency that is totally exposed to the debacle country you can make a fortune. You can guess now that Swedbank is my bank. It is not the only one – but is very spectacular.
Current account deficits, fixed exchange rates and Eastern Europe
Eastern Europe is full of vulnerable currencies. Most of the countries have fixed their exchange rate to the Euro (hoping I guess for Euro membership at some stage) and have massive current account deficits.
Latvia is particularly bad. The exchange rate is pegged (as per this page from the central bank of Latvia). The current account is enormous, almost 25% of GDP. There is no doubt whatsoever this exchange rate is not sustainable. Not close.
Estonia is not much better. It too has a large current account deficit and its currency (the Kroon) is also fixed to the Euro.
Estonia’s economy is also suffering the effects. The current account deficit never got quite so bad in Estonia – but it not pretty.
Lithuania is a little better – maybe only marginally more unsustainable than the United States.
Manifestations of the Baltic madness
Argentina in the days of the fixed peso was a party for the middle class. The middle was the main beneficiary of the fixed currency – and when it was over the middle class rioted.
A similar party is visible in the streets of Riga. Mercedes are everywhere. Bentley has opened a dealership. However this ignores my favourite take on Riga. It’s the rise and fall of the bucks parties…
When travel to Latvia opened up it was eye-popping for an awful lot of British lads. Here was a country where the women were Baltic Beauties – and poor. To the London lads this was bucks party heaven. It became more so when Ryan Air put on a Friday evening flight from London to Riga. Ryan Air even tried a Riga-Shannon route to service the Irish lads. The locals even got to classifying all Brits as Ryanair sex tourists as this club review shows.
Well due the crazy exchange rate the bucks parties got too expensive. I am not going to lead your round the internet to stories about over-priced hookers – but the bucks parties are moving to Prague. The Shannon-Riga flight has been cancelled. Ryan Air has recently announced a Friday night Birmingham to Prague flight.
Manifestations of the Baltic Madness in bank balance sheets
The largest Baltic bank is Hansabank – a wholly owned subsidiary of Swedbank. The last Swedbank annual report contains this fascinating summary table:
For the currency challenged – there are about 6 Swedish Kroner to the USD.
The deposits are 102 billion kroner, loans 177 billion. That is a loan to deposit ratio of 174%. That would be pretty high for a country – but it turns out that Swedbank (via Hansa) gets 177% by having a massive deposit share – as seen in the following table:
In Lithuania the loan to deposit ratio looks sensible. In Estonia – despite a 62% deposit share and only a 49% lending share the loan deposit ratio is 163 percent. In Latvia the loan deposit ratio is a 176%.
The observant amongst you might have noticed that the loan to deposit ratio in the two tables doesn’t match. I can’t work out why either…
Whatever Hansa Bank is very wholesale funded. This can be seen in Hansa’s balance sheet (from the English Language version of Hansa’s annual report).
Again for the currency challenged there are 0.45 Lati to the USD.
The key observation here is that deposits are 1.7 billion Lati and loans are 4.2 billion. The loan to deposit ratio is 244 percent.
Again the observant will notice that this ratio is different to Swedbank’s annual report – suggesting that when talking to analysts Swedbank seems to think that a lot of wholesale funding in Latvia is deposits. Other than that (cynical) line I have no explanation.
The main source of funding is in the line: due to financial institutions. There is 2.7 billion Lati due to financial institutions.
Fortunately Hansa Bank tells us more about that. Here is a table from the Hansabank annual report about the money due to financial institutions…
So now we can see it. Swedbank funds the Latvian current account deficit. It funds it in Euro.
So what happens next?
Well if the Lati devalues (as would seem inevitable) then Hansa Bank has to pay Euro to Swedbank – and as its assets are in Lati it would be insolvent.
If the Lati doesn’t devalue its only because people (ie Swedbank) are prepared to continue to fund it. This is not pretty at all. All in Hansa owes Swedbank over 30 billion Swedish Kroner – all denominated in Euro and which can’t be paid. The equity capital of Hansa (roughly 7 billion Swedish Kroner) is also going to default.
This is a very big problem for Swedbank. Swedbank’s equity is 68 billion SEK – but 20 billion is intangibles. Swedbank is probably solvent at the end of this – but only just. Swedbank will (at best) lose its independence. Swedbank is in turn wholesale funded – and the chance of it becoming Swedish Government property is not low.
Having lent that much to a country with a phoney fixed exchange rate in a currency they can’t print – Swedbank management deserve it. Bad things happen to bad banks and this is a bad bank.
I wrote this post before SwedBank's great looking 2Q results. They made it all work - by lending even more to the Baltics. Latvian deposits are actually falling despite high inflation and rapid (but declining) loan growth.
I used to think Swedbank would probably survive. I now think it probably goes to zero.