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New Europe Weekly

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Contagion − should we worry about it?

Fri, Jun 26 2009, 14:39 GMT
by Lars Christensen

Danske Bank A/S

The economic deterioration in Latvia and ongoing speculation that the Lat will be devalued have sparked discussions about whether we will see contagion from Latvia to other Baltic and CEE countries. Will the crisis in one country spark crisis in another?

In global economic history and the history of currency crises, there are examples of one country’s crisis spreading to other countries. Two notable examples of this are the ERM crisis in 1992-93, when we saw a currency crisis in many European countries; and during the Asian crisis when the devaluation of the Thai baht sparked devaluations in Malaysia, the Philippines, Indonesia and South Korea. However, there are also examples of currency crises that have not lead to any significant contagion. Here the Argentine crisis 2001-2 is a notable example – despite a very serious currency crisis in Argentina, widespread contagion to other countries in the region was avoided.

Overall, there are three main reasons why contagion could occur. First, a devaluation in one country has a direct impact on that country’s main trading partners, as the latter will see their competitiveness eroded by their neighbour’s devaluation, and this could put pressure on the trading partner’s currency. We note the Finnish devaluation in 1992 triggered devaluations in both Sweden and Norway. From this perspective it seems almost unavoidable that the Latvian devaluation would put enormous pressures on the pegs in the neighbouring Baltic countries Estonia and Lithuania due to the strong trade links between the three countries. However, it is important to stress that the trade links to other CEE countries like Poland or the Czech Republic are relatively limited, and there is therefore no reason to expect contagion to these countries via the trade channel.

The second “channel” of contagion is via financial linkages. This could clearly apply to the Baltic countries as they to a large extent share a common banking sector, as Nordic – mostly Swedish – banks own most banks in the Baltic States. Therefore, financial linkages are likely to lead to contagion from Latvia to the neighbouring Baltic countries. Furthermore, a spill over to Sweden looks likely, and in fact it seems that there has already been some contagion to the Swedish krona due to concerns over Latvia. Here again it is worth stressing that the financial linkages from the Baltic States to other CEE countries are limited and one should therefore not automatically expect a serious contagion to the rest of the region via financial linkages.

The third “channel” of contagion is significantly less direct and it is therefore much harder to assess its importance with regards to Latvia. This channel is what we could call a “lookalike” channel. Hence, in the event of a Latvian devaluation investors might start to focus on other countries that do not necessarily have strong trade or financial linkages to Latvia, but have similar macroeconomic problems. Here Bulgaria – which also operates a currency board regime like the Baltic States – clearly comes to mind, but also Romania, which is also struggling with the serious economic and financial bust after an unsustainable creditdriven boom.

Overall, we don’t believe that one can conclude that a potential devaluation in Latvia would automatically lead to devaluations in other Baltic and CEE countries, but it is hard to imagine it not putting tremendous pressure on the pegs in the other Baltic States. Whether we see contagion to other CEE countries is much harder to say, but most likely a Latvian devaluation would prompt investors to take a very good look at some of the most imbalanced economies in South East Europe, such as Romania and Bulgaria and possibly also Croatia and Serbia.

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Published on  Fri, Jun 26 2009, 14:44 GMT