Latvia’s credit rating has been cut to “junk” status by Standard & Poor’s, reflecting growing fears that its €7.5bn ($9.6bn, £6.6bn) IMF-led rescue package could unravel.
S&P cut Latvia’s rating to BB+ with a negative outlook and also put neighbouring Lithuania and Estonia on creditwatch negative. Latvia is the second European Union state to receive junk level status after Romania.
“The downgrade of Latvia reflects what we consider is a worsening external outlook and the associated implementation risks on the government’s ambitious economic program,” said Eileen Zhang, S&P’s credit analyst.
The worsening outlook in the Baltic states and the rest of central and eastern Europe could have serious repercussions for western European banks that have invested there.
In a worst case scenario, Austrian banks face losses of up to 11 per cent of GDP, Swedish banks of 6 per cent and Belgian banks of 3.5 per cent, Danske Bank estimated in a research note published on Tuesday.
S&P’s downgrade will deepen Latvia’s financial problems and could complicate ongoing talks with creditors of Parex Banka, whose liquidity crisis in November forced the government to seek IMF assistance in the first place.
On Tuesday Latvian credit default swaps – a measure of market perceptions of credit risk – jumped more than 30 basis points to 978 basis points.
Latvia’s government collapsed last week, raising doubts over whether the country will remain committed to its IMF-approved austerity programme and its exchange rate peg to the euro as it sinks into the worst recession in the European Union.
Latvia’s bubble burst last year when foreign banks stopped funding a consumer and real estate boom, leaving the country saddled with huge gross private sector foreign debts.
The Latvian economy is now expected to contract by 12 per cent this year, compared to the 5 per cent predicted in the austerity plan in December. To keep to the IMF plan, any new government will have to make further cuts in public spending, deepening the recession.
Instead a new government might decide to abandon the IMF plan and the lat’s currency peg to the euro.
Throughout eastern Europe a Latvian devaluation would affect risk perceptions and could destabilise several other countries with large macro-economic imbalances, particularly Bulgaria and Romania.
Closer to home, neighbouring Estonia and Lithuania would almost certainly be forced to abandon their currency boards. Both are already rushing to slash public spending in order to avoid having to seek their own IMF programmes to fund their budget deficits. “If one collides they’re all going to follow each other,” says Nigel Rendell of RBC Capital Markets.
Swedbank and SEB, the Swedish banks that dominate the Baltic banking sectors, would face huge losses in the event of devaluations. Shares in both banks fell on Tuesday and the Swedish krona slipped to a new low against the euro.
Both banks have already had to seek help from the state and their shareholders to boost their capital as loan losses mount. In a devaluation they would suffer a large hit on the value of their assets and would need further recapitalisation.
