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It's gloomy in the Baltics.
The three Baltic Sea-hugging neighbors Latvia, Lithuania and Estonia face an uphill struggle to resuscitate their economies, mired in recession or headed there, rein in their current-account deficits and maintain their currency pegs.
Moody's Investors Service placed the bond ratings of Estonia and Lithuania on review for possible downgrade Tuesday, citing severe deterioration in the regional macroeconomic environment.
Analysts said a downgrade was likely.
"Possible? It's a no-brainer," said Win Thin, senior currency strategist at Brown Brothers Harriman & Co. in New York. "The ratings agencies have been overly generous with Eastern Europe, particularly the Baltics."
Within the emerging-markets universe, Eastern Europe is the region most vulnerable to economic and financial risk. Within the region, the Baltic countries stand out as particularly fragile.
"We believe the currency pegs in the Baltics and Bulgaria are likely to come under increasing pressure this year, and that devaluation is a likely outcome for one of them -- Latvia appears to be the weakest weak link -- which in turn would likely set off a chain reaction in the other pegs," Thin said.
"[T]he outlook for the Baltics is nothing short of horrific."
— Neil Shearing, Capital Economics
Latvia is in such bad shape that it was forced to secure a $2.35 billion loan from the International Monetary Fund in December, though IMF aid is no panacea. The economy contracted by 10.5% year-on-year in the fourth quarter of 2008, significantly worse than analysts had anticipated.
Latvian GDP collapse?
Latvia's recession is rooted in its massive current-account deficit, which is indicative of an overvalued real exchange rate, said Neil Shearing, an economist at Capital Economics in London specializing in what's being called emerging Europe, in a note to clients Wednesday.
"Latvia's decision not to devalue its currency raises the prospect of a sustained period of deflation and deep recession, with output falling by a massive 20% over the next couple of years," Shearing said.
An adjustment in the economy could come either through devaluation of the Latvian currency or through a fall in Latvian wages and prices.
Latvia persuaded the IMF that it should keep its currency peg, arguing that devaluation would cause an explosion in debt defaults because of the high number of loans denominated in foreign currencies.
Assuming that Latvia's currency peg against the euro holds, output could fall by 15% this year and another 5% next year, Shearing said. It is also possible that the currency peg could collapse, as was the case in Peru and Venezuela in the late 1980s.
"If Latvia were to follow a similar path, real GDP may contract by 20% this year, although growth could return to trend within two or three years," Shearing said. "What's more, it seems likely that currency boards in Estonia and Lithuania would also collapse. Either way, the outlook for the Baltics is nothing short of horrific."
Downgrades looming
Moody's Investors Service said Tuesday that it might downgrade Estonia's A1 foreign- and local-currency bond ratings as well as Lithuania's A2 foreign- and local-currency ratings.
The primary reason for the potential downgrades is "the severe deterioration in the global and regional macroeconomic environment, which has hit the Baltic countries especially hard," said Kenneth Orchard, a vice president and senior analyst in Moody's Sovereign Risk Group.
"The ongoing decline in economic activity and the shortage of liquidity in the region have led to an adverse feedback loop, whereby declining asset prices are reducing confidence and further weakening the broader economy," Orchard said in a statement.
Estonia's economic recession, which began in 2008, is expected to be deep and protracted, according to Moody's. Its current-account deficit will likely shrink to the low single digits in 2009 from around 18% of GDP in 2007, the agency estimates.
The Estonian government entered the recession with significant assets and almost no debt. As a result, it has been much less affected by the problems in the capital markets than Latvia or Lithuania, Moody's said.
Estonia could adopt the euro as early as 2011, which could provide "a needed boost to confidence," according to the ratings agency.
As for Lithuania, Moody's expects a recession there in 2009 and 2010 that could be the worst since the transition following the collapse of the Soviet Union.
"Given the scale of the 'boom' and expected 'bust' in the Lithuanian economy, it seems probable that the government will need to provide some form of financial support to locally-owned banks," Orchard said.
The Lithuanian government may be forced to negotiate extraordinary loans from the IMF and the European Union if the economic situation worsens more than expected, or if the degree of liquidity in the international capital markets deteriorates further, according to Moody's.
Polya Lesova is a New York-based reporter for MarketWatch.
