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. Last Updated: 07/27/2016

Latvia Gives Investors Deja Vu and the Jitters

WARSAW -- Latvia is giving some emerging market investors a sense of deja vu.

A year ago when tiny Iceland's economy went into a skid, it was a wake-up call for traders who chased high yields around the globe with little regard for economic risks.

Now another small red-hot economy in Europe's cold north is in the spotlight, and again markets are taking a hard look at its peers for signs of trouble brewing elsewhere.

The verdict is that many show similar worrying symptoms -- an unsustainable pace of growth fuelled by booming consumption and credit, high foreign debt, surging wages, current account deficits topping 10 percent of gross domestic product and low currency reserves.

"The situation in Latvia bears a striking similarity to that in Iceland last year, only we would argue that Latvia is more exposed," said Tim Ash, an economist at Bear Stearns.

Danske Bank analyzed 11 "vulnerability indicators" for Eastern Europe's 10 European Union members and put Latvia and its neighbors, Estonia and Lithuania, as well as Romania and Bulgaria, in the red danger zone.

The booming Slovak economy got a yellow warning light.

The only countries ranked as safe were Slovenia, the sole 2004 EU entrant that has already joined the euro zone, plus the region's three biggest economies -- and reform laggards -- Poland, the Czech Republic and Hungary.

"Looking at the Central and Eastern European map, it becomes clear that overheating seems to be close to the norm these days," Danske said.

The big difference from last year is that the potential for market fallout now looks much less obvious.

Reaction to Iceland's rating downgrade was swift and direct. Its crown and stocks fell, hitting carry traders who borrow in low-interest currencies, such as the yen, to invest in high-yielding assets and sending ripples through markets as far away as New Zealand.

In contrast, Latvia's rating outlook downgrade by Standard & Poor's last week provoked only some weakening of the lat currency and devaluation rumors, swiftly denied by Riga.

Analysts say portfolio investors' minimal exposure to the Baltics and the local authorities' determination to defend their fixed currency board regimes -- central to their plans to join the euro zone -- limit the risk of a full-blown currency crisis.

Instead, the biggest risk is that without markets acting as a safety valve, and with authorities refusing to cool growth through fiscal tightening, imbalances will continue to build up and lead to a crash landing.

"Free-floating regimes prevent such big imbalances," says Michal Dybula, an economist at BNP Paribas in Warsaw. "With fixed pegs, you get a sharp adjustment in economic activity that is much more painful for ordinary people."

The World Bank painted such a worst-case scenario for the Baltics in its January report on Eastern Europe's EU members: "Continued rapid domestic demand growth and widening current account deficits can result in a sudden loss of confidence resulting in banks pulling out, a sharp correction in asset markets and a collapse of growth."

Such a hard landing may, but does not have to, lead to a financial crisis. Economists cite the case of Portugal, where a credit-driven boom in the run-up to euro zone entry in 1999 was followed by years of stagnation and sluggish growth but no banking crisis or market turmoil.

Some analysts say speculators may take aim at Romania, Eastern Europe's fourth-largest economy, rather than try to break currency pegs maintained by the Baltics and Bulgaria, which jointly account for just 0.5 percent of the EU's GDP.

They say Romania also shows some signs of overheating and that its authorities are reluctant to tighten policy, concerned the free-floating leu could gain too much.

"Romania has a high current account deficit, a credit boom and a central bank quite uncomfortable with a strong currency," said Lucy Bethell, a strategist at Royal Bank of Scotland.

"If you are a speculative investor, you probably want to punish a currency where authorities won't stand in the way."

But some analysts say instead of a targeted speculative attack, a "seasonal" spring emerging markets pull-back may be a more likely scenario.

"A mini crisis in Latvia might just be a spark for a broader emerging markets correction -- the now almost annual emerging markets spring correction?" said Bear Stearns' Ash.