The time is over for cheap money :: Балтийский курс

The time is over for cheap money :: Балтийский курс

By Olga Pavuk, 12.11.2007.

In mid-September British citizens queued in order to withdraw their savings from the Northern Rock bank. The simple reason was that the bank made fortunes on cheap loans while facing problems returning debts on borrowed loans. For the fist time since 2005 real estate prices in the United Kingdom have dropped significantly. What is the situation with the bank loans in the Baltic States where mortgage lending has been growing for several years and housing prices have already started moving down?

Recent past

In order to understand the current lending market situation in Estonia, Latvia and Lithuania it is well worth to return some years back. Thus, in 1990s people were not fishing for loans and the real estate market remained stable. The price for 3-4 rooms apartment was around USD 12-30 thousand in Tallinn, 9-20 thousand USD in Riga and 20-40 thousand USD in Vilnius. Commercial banks complained about great shortages of funds in the national currency and interest rates on loans in USD and EUR were above 10%, in some banks as high as 22%.


According to Hansabanka survey, less than 5 per cent of Latvian population took bank loans in 2001, contrary to 98% in Sweden. However, the real estate prices had already started climbing up, slowly at first, but steadily. The banks started to introduce various types of loans: for young families, for young specialists, etc., with the aim of attracting additional customers. But the most important thing was that of a rather steep decline of mortgage rates, e.g. from 6-7 per cent to 10-11 per cent depending on the loan’s currency; the loan’s periods were between 10 to 40 years.


In January 2000 the Scandinavian banking group MeritaNordbanken Group announced its plans for expansion in the Baltic States by opening branches in Estonia, Latvia and Lithuania; the group was later renamed Nordea. Today no one remembers that the initiator of the reduction of the loan interest rates was Nordea Bank, which had just entered the Baltic market and was able to operate with credit resources in amounts incomparable with those available for the local banks. Paradoxically enough but today it is Nordea that suggests reducing wholesale banking activity warning at the same time about overheating risks in the Baltic economies.


Worries about the spread of the lending boom and the likely threats of overheating in economy have been voiced the Baltic States already since 2002. At that time the credit portfolio accounted for 61 per cent of the banking assets in Estonia, for 57 per cent in Lithuania and for 49 per cent in Latvia. The Bank of Estonia warned about precautionary measures against commercial banks. However, the banks themselves looked at the housing market with optimism and thought of the ways how to increase the mortgage lending. In 2002 there were 12 per cent of households with mortgage loans in Estonia and 7-8% in Latvia, while the average figure in Europe was 30-40% and even 50 per cent.


Lending grew faster since then: in 2003, on the eve of these states’ accession to the European Union the banks’ loan portfolio increased by 52,2 per cent in Latvia, by 38,4 in Estonia and by 37,5 per cent in Lithuania. Then it was the Bank of Latvia’s turn to produce warnings concerning the end of the low interest era and that of cheap credits by increasing in July 2004 the mandatory reserve requirement for commercial banks to 4 per cent. The banks responded by raising the loan rates; however nothing was done in order to prevent the borrowers buying apartments and houses the value of which were quickly increasing. Quite noteworthy that the financial experts already at that time started to talk about gradual lending decrease in the Baltic States.

Wrong prognoses

During 2005 lending in the Baltic States grew generally by 85 per cent (by 90 per cent in Latvia, 88 per cent in Lithuania and 75 per cent in Estonia) whereas an estimated 32 per cent growth was predicted for the period. We already provided the readers with our assessment of the problem in the last year’s BC issue (no. 38, 2006) as tough competition among foreign local banks’ owners for clients and mortgage borrowers increased.


In 2007 the pace of lending kept growing but at a slower rate (see: Table 1). In the first six months of this year lending in Latvia grew by 55 per cent as compared to the same period in 2006; in Estonia the growth was nearly 40 per cent and 29 per cent in Lithuania.


The real estate market responded to the growing demand and availability of loans by inadequate increase of prices for any type of housing, even quite shabby ones. The lending boom on the housing market was driven also by cheap consumer loans and available leasing services.


Moreover, consumer loans are offered not only by banks but also by a number of various companies that have nothing to do with the status of the credit institutions. It can be seen through adds in the local press, billboards on the roads and numerous advertising booklets. According to DnB NORD Bank survey, as many as LVL 1.8 billion in free funds, i.e., about LVL 150 million monthly, have flowed to the Latvian real estate market alongside the banks’ mortgage loans since the beginning of 2007. This estimate is based on the reports made by the real estate companies which showed that about half of the housing acquired during the last year was made without using bank loans.

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Cure for inflation

Following the growth of prices for real estate and construction services, prices for consumer goods and services also stepped up in line with the appropriate notion of “creeping inflation”. As a result, various local and foreign experts from time to time and at regular intervals issued warnings about overheating of the Baltic economies, about a possible crises and even (how dreadful!) devaluation of the national currency (so far this has been said only about the Latvian lat).


Latvia was the first to show discontents, e.g. the government drew up the anti-inflation plan consisting of 30 items and started to implement it this July. One of the measures applied has been dealt with the loans’ procedures. Banks and other business entities (they have to follow the new rule, if the loan exceeds LVL 12.000) have to require from the potential borrower a certificate from the State Revenue Service or other national tax administration authorities which are authorized to confirm the client’s borrowing capacity and legality of his/her income. This requirement applies also to foreign borrowers.


Banks that issue loans using outside funds/resources were forced to implement these rules; therefore, as a consequence of this, the lending has somewhat decreased (see Table 2). But who is going to control other companies that offer loans based on their own resources? Supposedly it’s the responsibility of the State Revenue Service and the Center for Protection of Consumer Rights. They may approach the companies with the question: did you ask your clients to produce an SRS report about their income account? If not, they will impose a penalty. But they may never come. It is there that the failed banks’ mortgage borrowers have turned to.


As a result, the banks’ lending volumes have slowed down a little but the interest rates have been growing (see Table 3). Yet, this did not slow down the growth of consumer prices which was accompanied by surprisingly steep rise of wages. According to the Latvian Central Statistics Office, inflation in August reached a two-digit figure of 10.1% and wages grew nearly 32% in the second quarter of 2007 (as compared to the same period in 2006).


This September the Latvian government made several statements about the necessary measures for economic stabilization. It was even suggested to freeze salaries in the public sector for five (!) years. This will affect not only public service sector but the police force, the army, teachers and medical staff, as well. Doctors and nurses are threatening to hold strikes, demanding the promised pay rise and advising the government to think about cutting public expenditure by eliminating irrational spending such as “various grand projects, bonuses and privileges.” The Ministry of Culture strongly refuses to give up the construction project of a new National Library building, dubbed as the Palace of Light, as it is certain that the reduction of mortgage lending in Latvia will also slow down the growth in construction industry. In September the Cabinet of Ministers approved new draft regulations that will increase business trip allowances for public servants. The staff of the new Latvian president’s office demanded competitive salaries and a 40 per cent budget’s increase which would require additional funds. The country is in turmoil and this fuels people’s desire to spend the available cash right here and right now. The national economy minister has resigned in the outset.


It is mentioned only occasionally that Latvia should rather strive to increase exports, which fell steeply last year. In the first quarter of 2005 Latvian imports were twice as high as exports (in Lithuania and Estonia the difference was 1.4 times). After all, production of export goods and services has to be developed to solve this issue. But it will take a lot of efforts and it needs time. Who would do this? And where do we get the money? Investors are not actually standing in the line, and there are a growing number of reports about foreign companies leaving the region.


In Estonia, where inflation is somewhat lower than in Latvia, the need for radical anti-inflation methods was rejected this spring. The consumer price index in Estonia in March grew by 5,7 per cent on a year-to-year basis, which was the highest growth level since 2001.


But in September the Estonian finance minister announced that price growth could be curbed if Estonia avoided channeling surplus funds into consumption and investments. This could be accomplished by the budget policy instruments while planning the next year’s budget with a surplus by way of transferring a significant part of the expected profits to public saving funds. The minister believes that Estonia needs a comprehensive anti-inflation program and proposes to introduce tougher requirements to the issue of loans.

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Mortgage market’s freeze

Meanwhile the real estate market has been for several months already in a state of saturation anticipating changes. Quite a few estate property items have changed hands. Pessimists were speaking about the end of the boom on the real estate markets on the three Baltic States, first of all, in Estonia; others were talking about the decline in the industry which is likely to be heavy and long. Indeed, housing prices have started falling in all three Baltic States. Further price dynamics will depend to a large extent on a combination of factors such as macroeconomic environment and investors’ expectations and moods.


Estonia is the Baltic leader in the process of real market decline, where the downward movement of the property industry is obvious. Latvia is the next with its real estate market started cooling down but not as much so far, while in Lithuania the activity and price growth on the real estate market have slowed down, however the decline has not yet been apparent.


Local analysts talk about price reduction with due sense of caution, mentioning 5-10 per cent. But there are reasons for a more visible decrease. There have been some cases when prices for houses in Riga, Tallinn and Jurmala have dropped by one-third from spring till autumn but these houses haven’t been sold. In Vilnius the growth of real estate prices has slowed down but it is too early to acknowledge the general price reduction.


Lithuanian real estate market experts point out that banks receive a growing number of applications for extension of the mortgage loan’s maturity. According to SEB Vilniaus bankas, the largest bank in Lithuania, over the last three years the average loan period for housing loans has increased from 18 years to 29 years. Some credit institutions are already offering loans for the period of 50 years. If previously people were afraid of remaining indebted for many years and preferred to tighten the belts at once, now they are realizing that it is better to be indebted for some extra years than to tie the belt too tight.


Those experts who share the optimistic view believe that prices for newly-built houses will keep growing in the Baltics due to growing construction costs, taxes and interest rates. In addition, the demand for housing still remains unsatisfied. Business people believe that there will always be demand for newly-built housing because people get married and divorced. For example, about 8-9 thousand of new apartments are needed in Riga annually, and 4,000 apartments are needed in Tallinn. “But it is not about how many apartments are needed, it is about how many people can afford to buy them,” say experts from the Estonian company Arco Vara.

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The banks’ position…

The time has gone when the position of a real estate property served as 100% collateral for receiving a bank loan. Due to the changes on the real estate market the credit institutions rather prefer cash and often an original business ideas and the business plan attached to a pledge.


Companies with original business ideas and good reputation will find it easier to obtain bank loans. Loans against a real estate collateral are losing their attraction in the eyes of credit institutions. Therefore it can be expected that a certain share of the banks will switch from retail loans to corporate financing.


Nevertheless, real estate property situated in the central part of the capital still represents a reliable asset. But its value is regarded presently as less stable, therefore banks assume too much risk when accepting real estate as the sole security for the loan, said Andris Vilks, Chief Economist of Latvia’s SEB Unibanka.


This connection is clearly demonstrated by changes in the mortgage loans’ share of the credit portfolios in the Latvian banks. At the beginning of this year mortgage loans accounted for 35,7 per cent of the total loan portfolio but by early August their share was already down to 32,2 per cent. Experts expect that the share of mortgage lending may drop below 30 per cent.


At the same time, Martins Kazaks, Chief Economist in Hansabanka, said that while the share of mortgage loans in the banks’ lending portfolio is decreasing, it still remains significant. Mr. Vilks agreed with this, adding that the banks had started improving their activity and developing their offer package in order to retain customers. Feeling the decline in lendings, the banks increased their offers to customers concerning investments in currency deposits and securities. This coincides with the government’s appeal to the population to spend less and make all possible savings for better times. The question is will the people listen and respond to such appeals being already frightened by various problems. The memories of the crises in the 1990s are still fresh in peoples’ mind.

Two possible options

The International Monetary Fund leaders can see some hope for the international economic system in the mortgage crisis, reported The Financial Times. Thus, Rodrigo de Rato says that the dramatic re-assessment of risks in financial markets should serve the medium-term stability trends in the global economy.


The Finnish Economic Research Institute (ETLA) forecasts seem quite optimistic among various generally gloomy forecasts. Thus ETLA expects the Baltic States to become the richest countries in the Eastern Europe by 2050. According to ETTA’s forecasts, Estonian and Lithuanian GDP per capita will reach 95 per cent of the EU-15 level by that time. The annual economic growth rate would then be 1.9 per cent in the Western countries and 3.7 per cent in Eastern Europe. The Finnish researchers pointed out that living standards in Slovenia, the Czech Republic and Estonia, which joined the EU in 2004, were already higher than in Portugal. The study of the Eastern European economies was commissioned by the Danish company Danske Capital. We shall be thankful to the Finns and the Danes for these kind assessments.

The Baltic Course 27, Autumn 2007