The Riksbank, the central bank of Sweden, said June 10 that it will borrow 3 billion euros ($4.2 billion) from the European Central Bank to preserve its foreign exchange reserves and attempt to guarantee financial stability. Sweden has sound economic fundamentals, but its European peers that have unsteady economies — such as Austria and Greece — will face tremendous difficulties from the economic problems that lie ahead.
Sweden's central bank, the Riksbank, announced June 10 that it will borrow 3 billion euros ($4.2 billion) from the European Central Bank (ECB) to shore up its foreign exchange reserves and ensure financial stability. On the same day, the country's Financial Supervisory Authority stated that Sweden would be able to handle the losses incurred by its major banks on loans made to the Baltic countries of Estonia, Latvia, and Lithuania, which are estimated at around $20 billion, over the next three years as long as the country remains financially prudent. These announcements come on the heels of the Baltic states — particularly Latvia's — deteriorating financial positions. (click image to enlarge) Sweden has been intimately linked to Estonia, Latvia and Lithuania ever since these former Soviet republics became independent countries and began their respective transitions into a market-based economic system. Because of its geographic proximity and historic involvement in the region (including territorial designs at various points in history), Stockholm was able to move first to capitalize on the region's transition to capitalism by getting a prime position in terms of overall foreign investment and specifically in the banking sector. Sweden's banks also moved on the region because they had a fair chance to compete with the German, U.K., Swiss and French banks in the Baltic States where they felt they had a competitive advantage. The strategy of Swedish banks operating in the Baltics, as for other Western banks operating in emerging Europe, was to use foreign currency lending (mainly in euros in the Baltics, but also Swiss francs in the Balkans and Central Europe) to offer consumer and corporate loans. This allowed consumers in the Baltics to borrow at a much lower interest rate than their domestic credit markets offered. This proved quite successful for Sweden as the Baltic countries experienced double-digit growth rates throughout the last decade fueled by booms in construction and consumer spending, all on the back of increased lending from Swedish banks. But such growth in the tiny Baltic countries has come crashing down in the midst of the ongoing economic recession. Those growth rates — which at one time were the highest in emerging Europe — have now reversed themselves to see contractions nearing 20 percent of gross domestic product (GDP). The bubble created by the credit glut for construction and real estate burst, and massive investor flight has caused the currencies of these countries to drop precipitously. Because an average of nearly 80 percent of the loans the Baltic countries took out were foreign currency loans (mostly from Swedish banks lending out in euros), any drops in the value of their domestic currencies would make it increasingly difficult to service these loans. This increases the likelihood of non-performing loans and thus poses risks for Swedish banks holding them. Latvia is the most egregious of the foreign currency-borrowing countries in Europe, with close to 90 percent of its borrowing exposed to foreign currency fluctuation. Because Latvia is often cited as the most at risk for a potential devaluation of its currency, forecasts of the potential effects of devaluation on its non-performing loan ratio are extremely dire. Indeed, Latvia has thus far been the most severely hit by the crisis and is the only Baltic state to have resorted to taking out a loan from the International Monetary Fund (IMF) (though Estonia and Lithuania may soon need to approach the IMF as well). Latvia's GDP has contracted by nearly 18 percent in the first quarter of 2009 year-on-year. While Latvia's numbers certainly are troubling, and potential devaluation is a harrowing possibility, this does not spell apocalypse for Sweden and its overexposed banks. Latvia is an extremely small economy (the entire GDP of the three Baltics combined was only $108 billion in 2008, while Sweden's was $485 billion). The total exposure of the Baltics to Sweden's banks only accounts for 8.5 percent of Swedish lending, of which only 2.5 percent (or roughly $22 billion) goes to Latvia. In addition, Sweden's relatively large economy is fundamentally sound, recording a budget surplus of 2.8 percent and relatively moderate (compared to its Western European neighbors) public debt of 40.7 percent of GDP in 2008. These figures are some of the best in the European Union, and — though they are certain to take a hit this year in the current financial climate — serve as a sign that Stockholm has room to maneuver in tackling its economic problems. That does not mean that Sweden is in the clear, as its export-driven economy faces many other challenges besides the overexposure to the Baltics, and drops in industrial production and further GDP contractions are very likely. This explains why Stockholm has gone to the ECB to borrow 3 billion euros ($4.2 billion) as a safety measure to shore up its currency reserves. Because Sweden is not in the eurozone (though is closely tied to the euro), it would benefit the country to have more euros on hand to strengthen the position of its banking system in the Baltics, where most lending was done in euros. The exposure to the region therefore does present a serious problem for Stockholm, particularly when combined with the overall effects of the recession, but it is a problem that can be overcome. There is, however, a bigger and more underlying problem that the entire European continent faces. The relationship between Sweden and the Baltics is only one example of the foreign currency-lending dynamic between an emerging European economy looking for credit and Western European banks looking for markets in which to be competitive. There are other countries — namely Austria and Greece — who are just as overexposed (if not more so) to emerging European economies. What is worse is that these countries are not nearly as prepared as the Swedes to handle the ensuing collapse. Austrian banks, which used their own geographic and historic ties to lend to credit-starved countries in Central Europe such as Hungary and Balkan states, are much more exposed to emerging European economies than Swedish banks. Austrian loans to the region are equivalent to 75 percent of Austria's GDP. Though Austria's economy, at $415 billion GDP, is smaller than Sweden's, the absolute value of its lending to emerging Europe is higher as well (at $300 billion, Austria's exposure is double Sweden's). Meanwhile, Greece extended foreign currency-fueled lending to the virgin credit markets of its Balkan neighbors. Though its banks are not nearly as exposed as those of Austria, at roughly 10 percent of GDP, Athens has extremely poor economic fundamentals to cope with the associated problems that lie ahead. So while Sweden is rightfully worried and starting to make the necessary steps to address these issues, Greece and Austria simply do not have the tools necessary to tackle these problems independently if they spread from the Baltic states to the Balkan and Central European countries that their banks are active in. Another factor that could exacerbate these problems is the fate of the currencies of emerging European countries. Latvia is only one example where its poor financial and economic position has raised fears that its currency will soon depreciate. The collapse of the lat, Latvia's currency, could spread investor doubt to the other Baltic States and from there to the Balkans and Central Europe. This would subsequently make it difficult for consumers and corporations who took out foreign currency loans to keep servicing them, creating a cascading crisis that not only impacts emerging Europe, but also Austria and Greece, which are both eurozone member states. These issues could and already have spilled over into the political and social spheres, with unrest and political change potentially sweeping across Europe.