Boom and recession in Latviasince year 1999:The role of the banking sector

Author:Girts Vidrusks

Msc in Finance & International Business

Adviser:Morten Balling

2010
Abstract

This paper analyzes the severe economic consequences of the financial and economic crisis in Latvia which started in 2008. Given a few factors that have played leading role to deepen the recession the research focuses on studying economic and financial imbalances through the prism of the banking sector.

Banking development is studied to show that there is evidence in past with similar problems. The events in 1995 had severe economic consequences that should have been assessed by current banks Back then, banks deafulted because they had over supplied their borrowers with cheap capital that they were not capable to put to an efficient use give their stage of development.

Theoretical part of the research focuses on financial and economic growth relationship and mainly uses the framework by Ross Levine. Here a group of financial development functions are discussed. Unlike what widely recognized theories state, I find that there is evidence that an imbalanced transition economy has its own unique factors that are much more important in shaping the interaction between financial sector and sustainable economic growth. These functions are analyzed in Latvia case also.

Forward financial data are used to create regression model based on previous studies. The aim of the model is to show that the short term consumption was mostly stimulated by the growth in bank lending as contrasted to sustainable investment which got somewhat less attention.

At the end banks expansionary policies were analyzed that dramatically worsened the effect of the global financial crisis for Latvia. The analysis is based on banks annual reports and authors person interview with bank sector representatives.

Table of Contents

1Introduction

2Development of the banking sector

2.1History of banks in Latvia since 1990

2.2The development of the banking sector after 1999

2.2.1Number of banks

2.2.2Total Assets

2.2.3Loan Portfolio

2.2.4Asset Quality

2.3Regulation of the financial sector

2.4Parex Bank

3Economic development

3.1Gross Domestic Product

3.1.1Inflation

3.1.2Unemployment

3.1.3Government Role

3.1.4Role of Foreign trade

3.2The development of the real estate

4Finance and growth: theory

4.1Studies of financial development and economic growth

4.2Functions of Financial Institutions and implications for Latvia

4.2.1Producing information and allocating capital

4.2.2Monitoring firms and exerting corporate governance

4.2.3Risk amelioration

4.2.4Pooling of savings

4.2.5Easing exchange

4.3A brief overview of empirical studies

5Finance and growth: statistical analyses

5.1Modeling economic growth

5.2Results

6Strategic assessment of banking policies

6.1Lending strategies of the major banks in Latvia

6.2Individual approach to financial institution representatives

7Conclusions

8References

1Introduction

Latvia is among those few countries that 5 years ago was worshipped for having the fastest growth rates in Europe along with other Baltic countries: Estonia and Lithuania. The growth rates for the main economic indicators were truly unbelievable with a few years of above 10% GDP growth. The level of living increased even faster with real income growing at about 30% per year. To make life even better lending by banks was growing still faster, with a few years of close to 100% growth per annum. This all allowed people to acquire assets and consumer goods they did not have before and “improve” the standard of living in general.

However, now Latvia is well known for having been hit the most in the financial crisis that started in USA and from the economic crisis that followed. In fact Latvia has the largest GDP drop in the world in 2009 with more than an 18% hit. On top of that a real estate bubble burst with more than 70% loss in price in some segments. And to make life even sourer, a large part of the population had taken mortgage loans a few years earlier and is now left with debts that are much larger than the value of the underlying assets. Of course, many of those loan takers defaulted, thus losing their property and all previous payments.

There is no discussion weather Latvia could have avoided financial and economic crisis. Latvia is closely tied to international organizations and more importantly is dependent on foreign capital. Therefore the economic deterioration was only consistent to global tendencies. However, the largest question is why Latvia was hit so hard and what factors caused so large vulnerability. When comparing to countries with similar background such as Lithuania or Estonia, or even other European emerging countries, Latvia was most affected. Therefore it is important to assess those economic imbalances that made Latvia more vulnerable than any other country in the world.

The economic crisis in Latvia started in 2008 with the bailout of one of Latvia’s leading banks – Parex bank – who was also the largest bank with domestic capital in Baltic countries. Government took over the bank and was forced to inject large amounts of money into bank’s capital. This started Latvia’s negotiations with the International Monetary Fund (IMF) about an international financial aid.

Latvia is one of those transition countries where financial sector is comparably young, as it started to emerge only 20 years ago after reestablishing independence from the Soviet Union. Banking sector started on the grounds of state institutions but quickly went over to private hands and expanded very rapidly. In fact the development was very fast in mid 90’s and then again right before Latvia’s accession to EU. Total assets of all banks in Latvia grew from less than 3 BillEUR in 1999 to more than 33 Bill EUR in 2008. Mortgage loan portfolios for private persons in this period grow from 0.1 Bill EUR to 9 Bill EUR. Deposits, though lagging behind portfolio dynamics also grew very fast. The gap between loans and deposits was either borrowed by the international banks in Latvia from their mother companies or syndicated.

The economic crisis was preceded not only with rapid development of the banking sector but also with imbalances in macro-economic indicators. Firstly, right before Latvia’s accession to EU inflation grew from the stabile level of 2-3% where it was for a few years to more than 6% for the next few years and then grew to more than 10% in 2007 and more than 15% in 2008. The current account deficit is another factor where Latvia had very large unsustainable misbalance. In 2006 exports exceeded imports by more than 100%. Besides the major part of imported goods and services were not related to technologies necessary for local companies but were rather consumer goods, starting with cars and luxury boats and ending with daily necessities such as food products and clothing. Another factor that must not be omitted is the government’s position to increase spending as much as possible. In fact during the “good years” government did not have a single year without budget deficit, regardless warnings by experts, including the president of the Bank of Latvia.

And finally the largest imbalance that Latvia had was related to housing market and construction sector. Both grew unbelievably for many years in a row. Prices on not renovated apartments in block houses grew from mere 437 EUR/m2 in 2003 to 1620 EUR/m2 in mid 2007 or 270% in less than 4 years. This caused a very large imbalance in Latvia’s economy as housing sector was both a source of very high income and a source of high yielding investments. In fact speculators kept prices growing while those in need of housing had no alternative but to buy at new prices facing a choice: to buy expensive today or even more expensive tomorrow. During the “good years” there was a rumor going in Riga, that half the city is actually uninhabited and is being kept on investors’ balance sheets for speculative purposes.

It is the purpose and the aim of this paper is to identify those imbalances that made Latvia so vulnerable to external and domestic shocks and to assess the role of banks. Indeed, much of the economic growth can be attributed to the vast amounts of cheap money that suddenly was accessible by everyone and predominantly originated from mother companies of the related banks in Latvia. Therefore it is important first to discuss the overall relationship between financial institutions and economic growth to argue that one can influence the other. And then I will study the effect of bank strategies on investments in sustainable economic growth and short term consumption.

Therefore within the scope of this paper there are a few questions that it should give answers to:

  1. Can history of Latvian Banking sector reveal experiences that could have been used to lessen the scope of the financial crisis?
  2. Are widely accepted theories on the level of financial development and economic growth applicable to Latvia and the booming economic environment in particular?
  3. Have banks stimulated sustainable economic growth through private lending and corporate retail sector?
  4. Can quotations from a sample of bank annual reports between 1999 and 2009 document a change in the risk aversion of Latvian bank managers in the period?

This study could be of particular use for economists and bank strategists in emerging countries where market imbalances exist as well as for experts in developed countries where it is more difficult to assess the set of macro-economic problems that is not relevant for developed markets. It could help to shape banking strategies in order to avoid own losses from systematic risks and to diversify those away in case any imbalances become significant. By doing so banks would help the economy to correct itself and lessen the size of the imbalance by pushing it in the opposite direction.

The main delimitation of this paper is the short period of time that can be observed. In particular for a sound econometric regression less than 10 years is too short a period of time to have a very strong model. In terms of scope I delimit this paper to examining the role of banks. Generally there is a popular view that there are three main factors that fostered recession. One is “banks”, which flooded the economy with cheap money and thus stimulated inefficient and often wasteful consumption and stimulated economic bubbles. The second is “government” which not only kept fueling the booming economy with growing spending during booming years, but also had the ability to control banks via regulations, capital requirements, and many more and therefore had the ability to make additional borrowing less feasible. And the third is current “account deficit”, which was actually a consequence of uncompetitive local producers, too strong currency, and more. I will focus on banks because I believe that few people that control most of the capital flows in Baltic countries and who represent five largest banks in Latvia have actually contributed most to the depth of the crisis.

I will structure my study in the following way. In part 2, I will study how banks in Latvia have developed throughout the last 20 years. I will pay some attention to history to show that there was already a banking crisis that could have helped in minimizing this one. I will also go through the main banking indicators and show their development. In part 3, I will summarize main economic implications as well as economic imbalances prior the crisis. I will also summarize main developments of the housing market. In Part 4, I will examine international theories on financial intermediaries and their impact on economic growth. I will also add to the discussion the unique case of Latvia and how it fits in those theories. In part 5, I will build an econometric model to study if banking indicators can explain the difference in investment growth and consumption growth and therefore show if lending has fostered sustainable economic growth or not. In part 6, I will summarize findings from banking annual statements and reviews to track the risk aversion of the upper management of leading banks in Latvia. I also have made a little survey to get a better understanding on how these banks position them. In part 7, I give my conclusions.

2Development of the banking sector

A well functioning banking sector is a key element in the development of any market economy. Already in early 20th century Schumpeterargued that a well developed financial sector leaves a positive impact on the level of economic growth (Schumpeter, 1934). This study has been further elaborated by many scholars such as Levine Ross for example, who structured financial functions and explained how those foster processes that have positive ramifications on economic growth (Levine, 2005). A well developed banking sector is of even more importance for emerging markets where any substantial accumulated financial capitals are nonexistent or have been largely wasted in transition.

This is particularly the case of Latvia, which has experienced large denomination of its currency, hyperinflation of above thousand percent (Vaidere, 1999), many cases of fraud during privatization, leading to closing of largest manufacturing companies, and more. In fact, Latvia had the deepest recession among all other emerging post soviet republics leading to a 51% cumulative reduction in GDP over 6 years (Skapars, 2004). This all meant that Latvia, though independent, was suddenly facing new challenges of a new economic reality, with technologies designed for the old system and a labor force educated to function in that system. Needless to say that with this heritage Latvia was not competitive in free markets.

In order to efficiently reduce the economic gap between Latvia and the rest of the developed European economies, huge investments had to be made in economic sector, infrastructure, government sector, healthcare, and more. This could not have been possible without capital outside Latvia due to shortage of capital domestically and growing capital account deficit.

Even though not all of the foreign investment has originated through the banking sector, it is by far the largest supplier of financial resources and capital in Latvia and especially after Latvia became a full member of the European Union in 2005.

Before we move on to the economic crisis of 2008 and in particular the role of banks in magnifying its consequences, it is absolutely necessary to examine past a little deeper to understand that many aspects of current situation are not that unique and could have been avoided.

2.1History of banks in Latvia since 1990

One thing among many that marks the beginning of 1990’s noteworthy in the banking industry in Latvia is the exceptionally large rate of new banks being opened, especially after Bank of Latvia separated the functions of central bank and commercial banks in 1992 by giving the latter to private hands (Vaidere, 1999). In just four years after declaring independence the total number of commercial banks peaked at the level of 61 which is about double the level we have today (see Figure2.1).

Figure 2.1Total number of commercial banks in Latvia, 1990-2009

Source: Association of Latvian Commercial banks (ACBb)

In fact, the fast development of banking sector while other sectors being heavily under pressurefrom economic crisis is a noteworthy phenomenon in the history of emerging Latvia. It could be explained by the exceptionally advantageous geographic location for financial flows as well as by high capital concentration in the hands of foreign investors who invested in highly risky but extremely profitable ventures.

Year 1992 marks the beginning of a legislative framework for banks, which defines the role and functions of banks in Latvia and prescribes first regulations (laws “About Banks” and “About bank of Latvia” are signed).(Vaidere, 1999)

In large part due to finishing national currency reform and the strong policy of the Bank of Latvia in stabilizing Latvian lat, banks strengthened significantly in 1993. Banking capitals grew, product range widened and the payments system was advanced following western standards.

The development of state banks in 90’s was very difficult and their functioning was slower than private banks which grew very dynamically. However, the number of frauds in banking sector, and in particular in private banks, was growing and consequently more normative acts where written in January, 1993 to make banking regulations stricter, defining capital adequacy ratio and the size of reserves, regulating liquidity ratios, and setting limits to loans to single borrower (Jaunina, 2005).

This, however, did not efficiently stop individuals from exploiting banks leading to bankruptcies, expropriations, and lost savings of many customers. Many credit institutions had given deposits in local currency on very high rates, including 100%+ rates, in some instances betting on devaluation of the national currency (Jaunina, 2005). Some of these institutions had almost no equity thus making the situation explosive. Unsurprisingly many banks were closed or went bankrupt in 1993 – 1994without ever repaying their liabilities. The situation worsened dramatically when 4 major banks were closed, largest of those being the Bank of Baltic (in 1995). The total share of banking assets held by those 4 banks was 30%, while the share of private deposits reached 46% (Vaidere, 1999). Many lost their lifetime savings that were never retrieved; others withdrew their deposits from surviving banks thus only worsening the situation.

Many papers have been written on this banking crisis, examining and analyzing its reasons. Apart from weak legislative framework, weak regulation and enforcement, apart from extreme macroeconomic, social and political conditions, one reason seems very applicable to the banking crisis to come 13 years later. The banking sector was developing much faster than any other sectors fueled by both foreign capital and local deposits. The amount of money was simply too large for local companies to put it to an efficient use. This problem got fostered by the lack of competent bankers to assess the true risk of loans they had given and a large number of fraud cases from customers and bank owners. Especially large cases of fraud involved some bank owners who deliberately gave large irretrievable loans to friendly individuals or organizations.