Andres Sutt. Credit growth in the Baltics: What's next?

East Capital Summit, 30 May 2007, Tallinn

Credit growth in the Baltics: What's next?

Andres Sutt

Presentation to the speech (pdf, 292 kB)

1. The role of the financial sector in economic development

Broadly speaking, the financial sector has three key functions in the economy:

- intermediation of funds from borrowers to lenders and from savers to investors;
- reducing transaction costs using economies of scale;
- monitoring and managing risks (asymmetric information, moral hazard).

As a result, a well-functioning financial sector contributes to growth by accumulation of savings and assistance to efficient allocation of capital. Economic growth, in turn, encourages financial development. When we compare the ratio of credit to GDP in economies at different stages of development, a strong positive relationship is evident between credit ratios and income levels. Estonia clearly belongs to the “bottom circle” of countries, indicating that our financial sector as well as the income level still has room to grow. Nevertheless, while our income level is comparable to that in Poland, our credit to private sector was nearly 80 percent of GDP in 2005, while that in Poland was around 30 percent. This, in my opinion, is an indication of favorable conditions for financial sector development in Estonia.

2. Preconditions for financial deepening in the Baltic countries

Elimination of factors of “financial repression” is not enough to create a solid basis for rapid and sustainable financial sector development. To use the words of a famous institutional economist Douglass C. North, the potential contribution of the financial sector to economic growth increasingly depends on the credible commitment of the state to ‘provide the public good of a set of rules and their enforcement designed to lower transaction costs’. Important factors in the Baltics include:

- economic openness;
- perception of political stability;
- solid and credibly enforced property rights and bankruptcy laws combined with an efficient judicial system;
- adaptability of the legal structure (to allow new kinds of contracts and institutions);
- good corporate governance in the financial sector;
- modern regulation and efficient supervision;
- information rules: disclosure requirements, financial transparency, etc.


Low capital accumulation with the resulting need for investments (and high expected returns) encouraged financial sector development. In the case of the Baltic countries, early openness and reforms leading to the process of EU accession provided the framework and incentives for important institutional improvements that facilitated economic growth. Average GDP growth in the Baltics (8% in 2001–2005) has not only been much higher than in the “old” EU Member States (1%) but also noticeably above the “new” Member States’ average (5%). The growth difference largely stems from the difference in productivity growth. Estonia’s openness to innovations (such as the Internet) and close ties with the Nordic countries facilitated investment in the financial sector.

3. The dynamics of banking sector development

There were major changes in the financial sector in the 1990s (starting from a state-owned monobank system which could not function in a market economy). However, the development of the financial sector really took off in late 1990s, when both structural and cyclical factors were at play. The Baltic countries established themselves as stable and fast-growing catching-up economies in the process of EU integration. The entrance of foreign financial institutions and benign global liquidity conditions fuelled credit growth with drastically wider and easier access to credit, favorable lending terms and new financial instruments.

The Baltic financial sector is bank-dominated and highly integrated with the Nordic banking sector. The share of foreign banks (as a percentage of total assets) in Estonia is the highest in the EU (nearly 100%). The entrance of foreign banks has been mutually beneficial. While the “home market” concept of the Nordic banks has made interest rate margins all but disappear in Estonia and Lithuania, the Baltic share in Swedbank’s and SEB’s profits is much higher than the respective share in asset allocation.

Credit growth has been remarkably rapid in all three Baltic countries. First it picked up in Estonia (where the April figure was 48%) and somewhat later in Latvia and Lithuania, where the rate of credit growth is currently at 60% and 40%, respectively. This has resulted in considerable accumulation of debt in all three countries. In Estonia and Latvia, the corporate sector debt to GDP ratio was already higher than the respective figure in Finland in 2006. However, household debt has still room to grow in all three Baltic countries.

Much of the capital intermediated by banks has flowed into the real estate sector and many analysts consider it an increasing risk. For instance, the share of real estate and related activities in the banks’ loan and leasing portfolio exceeds 50% in Estonia. Indeed, housing loans have been growing at an exceptionally fast pace over the past few years and this has led us at the Bank of Estonia to increase capital charges on mortgages and to increase reserve requirements as well as to take a recourse on moral suasion.

On the other hand, there are also factors that mitigate the risks associated with the concentration of investment in real estate. Investment in residential real estate can be seen as a natural part of the catching-up process. First of all, such investments are unavoidable as living standards catch up with more advanced economies. Housing conditions were relatively poor in all post-Soviet countries, whether we look at quantity (square meters per capita) or quality. More generally, there is a clear positive relationship between income and house prices. Furthermore, taking a housing loan has never been as easy and affordable as in recent years. From the lender’s point of view, housing loans are also relatively low-risk investments, as evidenced by the low rate of past-due loans in this sector and historical experience in other countries. In line with the current position in the economic cycle, the overall credit quality in the Baltic countries is remarkably high in international comparison.

4. What’s next: soft landing or a collision course?

There are first signs of stabilization in Estonia’s real estate and credit market, and I expect similar developments to take place in Latvia and Lithuania. These signs point to an increased probability for a soft landing, which will result in a slower but still robust growth rate of GDP for the next few years to come. The Bank of Estonia expects GDP growth to cool from 11.4% in 2006 to 8.4% in 2007 and 5.6% by 2009.

While the next few years will see a cooling down of credit growth, the role of credit in economic growth will remain considerable. The growth rate of housing loans is expected to stabilize, as a further extension of loan maturities is not likely, interest rates are on the rise, and the pool of potential borrowers has shrunken. In view of the competitive credit market, credit conditions are likely to remain relatively favorable for borrowers, provided that the economic environment as a whole is still considered reliable.

Of course, there are risks related to this relatively benign scenario. One of them is the possible “overshooting” by parent banks in the Nordic countries as a reaction to a reassessment of perceived risks in the economy at the time when the credit cycle turns. Another risk is that lending to some sectors may lead to a larger-than-expected deterioration of the credit quality if these market segments turn out to be less competitive than expected (even if the performance of the overall economy is relatively good). Therefore, at the turn of the cycle banks should exercise an extra degree of prudence. Tighter credit standards and better differentiation of borrowers according to their individual risk profile are advisable.

It is important that the policy makers too are well prepared for these risks. It is not only my personal opinion that policy makers in small and open economies, such as the Baltic countries, can support soft landing by fostering the flexibility of markets (product and labor markets, but also financial markets). The governments have an important role in macroeconomic stabilization by maintaining a prudent fiscal stance, as do the central banks by safeguarding a monetary system that anchors inflation expectations. It is also the task of the authorities to provide a sound and transparent institutional framework. For the financial sector, such a framework includes effective financial supervision. In view of the increasing integration of the financial markets, it is crucial to maintain close cooperation between the regulators and supervisors of the financial system as well as between the relevant authorities of home and host countries. In Estonia, both the domestic tripartite memorandum of understanding between the Ministry of Finance, Financial Supervisory Authority and the Bank of Estonia as well as the memorandum of understanding between the Baltic central banks and Sweden on management of financial crises in banks with cross-border subsidiaries or branches were signed in 2006.

5. The Baltic economies will remain an attractive investment location

In a longer term, investment and lending in Estonia and the other Baltic states will still be more profitable than in the “old” European Union member states. The Baltic countries will offer an attractive combination of a sound institutional and legal framework and relatively high returns. While the rate of the convergence in income and productivity levels of the Baltic countries with the more advanced EU economies has been outstanding, there is still a long way to go. Closing the gap – even at a fast pace – will still take more than a decade and will offer opportunities for growth.

Andres Sutt. Credit growth in the Baltics: What's next?