Latvia: Effects of a Failed Bond Auction

On June 3, the Latvian government failed to auction any of its 50 million lati ($100.7 million) of bonds, managing to sell only about 2.75 million lati ($5.5 million) worth of 30-day bonds the following day, which is raising fears that European emerging markets will have to struggle to raise capital for their rising debt. The effects of the failed auctions were felt across emerging Europe, with Hungarian, Polish and Czech currencies all losing value in investor anticipation that they too may face difficulty financing their debt. Meanwhile, shares in two major Swedish banks with heavy exposure to the Baltic States — Swedbank and SEB — declined on fears that a devaluation of currency in the Baltics would increase the amount of nonperforming loans on their books in the region. Speculation that the Latvian government could no longer support the peg of its currency the lat to the euro — part of the European Exchange Rate Mechanism that is supposed to bring Latvia into the eurozone — caused investors to shun the latest auction. Receiving no money at a bond auction is extremely rare (auctions are considered a failure whenever they receive less than 100 percent of the intended loan) and, as far as we at STRATFOR know, a first for a European country; however, the fact that Latvia was the first to achieve this feat is not at all surprising. The Latvian economy is, to put it bluntly, in shambles. Gross domestic product (GDP) is forecast to decline by over 13 percent in 2009, a figure reminiscent of GDP destruction during the Great Depression. In the first quarter of 2009, the GDP declined by almost 20 percent compared to the same period in 2008. Economic crisis forced the prime minister to resign in February following rioting and social unrest. The country has received a 7.5 billion euro ($10.6 billion) loan from the International Monetary Fund (IMF) and the European Union — although the second tranche of the loan is contingent on Riga getting a handle on its growing budget deficit. Devaluation fears, which undermined the auction in the first place, have risen again as a result of the spectacular failure. Devaluation can lead to loan defaults as many consumers and corporations in Latvia become incapable of servicing their foreign currency denominated loans. This is a particularly worrisome scenario for Swedish banks, which are exposed to the Baltic region, to the tune of 19 percent of Swedish GDP. With its export-dependent economy, Sweden is already suffering severely from the current recession because of collapsed global demand, with a GDP projected to contract by 5 percent in 2009. The failed auction in Latvia is only one more example of a European-wide problem that goes beyond emerging Europe and countries with banking exposure in the region. Countries across the Continent are facing serious declines in budget revenue while they are trying to stimulate their economies with government spending and shore up their banking systems with recapitalization and banking guarantees. These efforts mean ballooning budget deficits and mounting public debt. Particularly sharp increases in spending are occurring in the United Kingdom (where public debt has gone from 52 percent of GDP in 2008 to 68.4 percent in 2009), Ireland (from 43.2 percent to 61.2 percent) and Spain (from 39.5 percent to 50.8 percent). The pain is being felt not only by emerging-market economies. Auctioning debt is a great way to raise funds because, instead of talking to one or two large investors (usually banks), a government can have various investors compete to buy its debt, thus decreasing the yield that it has to pay on its bonds. This increased competition results in a lower price that the country has to pay to service its debt. However, auctions are now failing across Europe and not just for egregiously troubled emerging-market economies like Latvia's. Thus far, auctions also have failed (though none as spectacularly as Latvia's) or have been canceled or suspended in Spain, the Czech Republic, Slovakia, Sweden, Hungary, the United Kingdom and even Germany, whose bonds are used as a benchmark of quality in Europe. Because the recession is global, European countries are not just competing with each other for investors but also with the rest of the world, including the United States, whose treasury debt is usually a haven for investors seeking safety during a recession. As a result, European countries may find it difficult to attract investment, and failure to sell off all debt in a bond auction will likely become more common. The point of a bond auction, however, is to have greater investor demand for debt then there is actual debt, so as to lower the cost of debt service. With low appeal, countries may have to turn to loan syndications, in which they can negotiate bond yields with a few banks at a time. In those cases, however, banks have the upper hand and can negotiate interest rates that are much higher, thus making debt servicing much more costly. The United Kingdom has already switched to syndicated bond sales — an unusual move for a country that had, until now, relied almost exclusively on auctions to finance its debt. However, with the United Kingdom suffering its first auction failure in March, it does not want any more embarrassing public notices that would make it unable to attract investors to its debt. And the problem with auctions is that their failures are very public. Countries like Latvia, however, may not find any takers — in particular, any banks willing to service its debt — even through higher cost syndication. This may mean that, for countries most affected by the recession in emerging Europe — particularly the Baltic States and the Balkans — another round of IMF lending may be in order.