Chapter

II Structure and Size of the Financial Systems

Author(s):
Niamh Sheridan, Alfred Schipke, Susan George, and Christian Beddies
Published Date:
January 2004
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In channeling savings to investment, the financial system contributes to economic performance through mobilizing savings and allocating them efficiently, mitigating market imperfections, and promoting good corporate governance control. In this vein, the following section focuses on the state of development of the financial systems in the Baltics and the role of both bank-based financial intermediation and that of capital markets in allocating financial resources and attempts to identify potential obstacles that may hamper the sound functioning of the financial system and its future growth. This section also provides the background for the discussion of issues related to small open economies more generally.

Financial Intermediation

The Banking Systems

The financial systems in the Baltic states are heavily bank based. Despite its pivotal role, the banking sector is still small relative to the size of the economy in each country. In mid-2003, total banking assets as a share of GDP were about 80 percent in Estonia, 90 percent in Latvia, but only 34 percent in Lithuania. By comparison, the average size of the euro area banking systems was over 265 percent of GDP. Banking in the Baltics closely resembles the Western European model of universal banks that offer a broad range of services. Foreign entry has contributed to an upgrading of banking operations, growing trust by clients, and overall stability.

Compared with the beginning of the transition process a decade ago, the banking sectors in the Baltic states have undergone major changes. After regaining independence, the mono-bank system of the Soviet era was broken up into a two-tier banking system, consisting of the central bank and commercial banks. The elimination of this mono-bank system was quickly followed by a rapid expansion of the banking sector through a large number of new entries.

Initially, the strategy of the authorities was to increase competition and to bring down interest rates by granting licenses liberally with little regard to prudential requirements and supervision.4 Like other transition countries, the Baltics experienced banking crises during the transition process. In addition to the large amounts of bad debts inherited from the old regime, a key factor contributing to these crises was a lack of familiarity on the part of banks and enterprises with the functioning of a market economy. Bank ownership in the early days of transition was largely vested in the state, as was the ownership structure of their clients. As a result, lending practices often lacked financial or economic rationale. At the same time, banking supervision and regulation was still in its infancy, so bankers, who were inexperienced themselves, generally had little guidance from regulators. Especially after the banking crises, however, lending practices became more conservative.5

Over the last couple of years, the banking systems in the Baltics have benefited from substantial restructuring and consolidation partly in conjunction with foreign entry. In Estonia, the number of credit institutions dropped to 7 by mid-2003 from 42 in 1992. Although the consolidation had already begun prior to 1998, the Russian crisis that year accelerated the process.6 Above 80 percent of the banking capital is held by Swedish conglomerates, and foreign ownership in controlling banking assets rose to 90 percent from just above 2 percent. Ownership is also highly concentrated; the top five banks (C5) account for 99 percent of the assets, and, of these, the top three (C3) control 90 percent of banking assets.

The Latvian banking system differs somewhat from the ones in Estonia and Lithuania. Although the number of banks dropped significantly in the aftermath of the 1995 banking crisis, the number of operating banks in mid-2003 was still 22—down from 56 in 1994. The Latvian banking crisis was quite sizable because one of the banks, Bank Baltija—which accounted for 30 percent of the deposit base—had to be closed. The accumulated net loss of the bank amounted to about 8 percent of GDP. Successive improvements in banking legislation and regulation ensured that the Russian crisis of 1998 had only a limited impact on the Latvian banking system. While it seems remarkable that so many banks have been able to survive in a comparatively small country, past banking problems in Russia and other Commonwealth of Independent States (CIS) countries (Latvia has traditionally had closer ties to Russia than its Baltic neighbors) have facilitated the evolution of a segmented banking system: resident business, nonresident business, and a combination of the two. As a result, only a few banks—albeit large ones—focus exclusively on servicing the domestic market. More recently, however, even the more niche-oriented banks servicing nonresidents have also started to turn to domestic clients. In general, however, Latvia has emerged as somewhat of a financial center for the region. Foreign ownership, on the other hand, is less pronounced. In mid-2003, about 52 percent of the banking capital was owned by foreigners from Germany, Sweden, Estonia, the United States, and elsewhere. The structure of foreign ownership is therefore substantially more diverse than in Estonia. State ownership still accounts for about 4 percent of capital.7 The top five banks account for 65 percent of the assets, while the top three control 52 percent of banking assets.

The Lithuanian banking system is somewhat less advanced than those of the other two Baltic countries. After the banking crisis in the mid-1990s and the indirect exposure from the Russian crisis (a sharp drop in output of minus 3.9 percent in 1999), bankers were reluctant to engage in credit activity. The crisis contributed, however, to the consolidation of Lithuania’s banking sector that included an aggressive restructuring both prior to and after privatization. The last state-owned bank, accounting for 10 percent of banking capital, was sold to a German bank early in 2002. Like its Baltic neighbors, Lithuania began with a large number of banks, peaking in 1993 with 27 banks. In the aftermath of the banking crisis in 1995, this number dropped sharply to 13, which is also the number of operating banks in 2003. Despite the large number of bankruptcies in Lithuania, the impact on the banking system was limited, given that the assets of the foiled banks made up only 5 percent of total banking assets. Credit to the private sector has taken off in the last year and a half, albeit from low levels. In mid-2003, loan growth was 40.5 percent year-on-year. Regarding foreign ownership, only 12 percent of bank capital is domestically owned. Concentration is also significant; the top five banks control 88 percent of the assets, while the top three account for about 77 percent of banking assets.

Foreign participation in the Baltic banking systems has played a crucial role in the restructuring process, albeit to different degrees, and has contributed significantly to the health of Baltic banks today. Foreign investors not only brought in urgently needed capital but also know-how and sound corporate governance practices, and have facilitated financial market integration with the West. The high degree of foreign ownership, however, also implies some risk. Nonetheless, the degree of monetization and particularly credit to the private sector—with the exception of Estonia—lags somewhat when compared with other EU accession countries (Figure 2.1). Lending to the nonfinancial private sector accounts for less than half of banking assets in the Baltics. In terms of sectoral distribution of credit, real estate lending has been gaining in importance—particularly in Estonia, where about 40 percent of loans outstanding in mid-2003 were secured by mortgages.8 Latvian banks, on the other hand, primarily fund the trade sector (21 percent), followed by manufacturing (16 percent). Lithuanian banks provide significant funding to trade and manufacturing (28 percent and 17 percent, respectively).

Figure 2.1.Monetization and Private Sector Credit in the Baltics, Selected EU Accession Countries, and the Euro Area, 2002

(In percent of GDP)

Sources: Economic Commission for Europe, Economic Survey of Europe 2002, International Financial Statistics; and IMF staff estimates.

1 Includes Czech Republic, Hungary, Poland, Slovak Republic, and Slovenia.

Foreign assets play an important role in the Baltic banking systems (Figure 2.2). In Latvia, particularly, about half of banks’ aggregate balance sheets comprises foreign assets, reflecting to a large extent business with nonresidents. Foreign currency-denominated lending to residents, however, is also very high, amounting to 82 percent of total loans in Estonia, 54 percent in Latvia, and 48 percent in Lithuania in mid-2003 (Table 2.1). At the same time, residents’ foreign currency deposits, as a share of total resident deposits, accounted for 26 percent, 41 percent, and 41 percent, respectively. Lithuania constitutes an interesting case in this regard because of the repegging of the litas from the dollar to the euro in February 2002. Many Lithuanian households and businesses continue to hold their deposits in dollars while the euro has appreciated substantially during 2002 and 2003.

Figure 2.2.Asset Composition in the Baltics and the Euro Area, 2002

(In percent of financial assets)

Sources: IMF International Financial Statistics; and IMF staff estimates.

Table 2.1.Banking Indicators(In percent, unless otherwise indicated)
EstoniaLatviaLithuania
199920002001200220031199920002001200220031199920002001200220031
Capital adequacy
Capital adequacy—risk-weighted average16.113.214.415.314.616.414.314.213.112.617.416.315.714.814.7
Liquidity
Liquidity ratio58.364.472.557.551.964.166.765.562.166.045.449.748.042.042.2
Total reserves/total deposits28.125.414.514.416.618.916.314.513.66.814.911.38.68.48.5
Excess reserves/total reserves43.319.016.71.51.519.87.54.82.07.030.228.416.815.712.8
Asset quality
Nonperforming loans (in millions of domestic currency)792.0716.0590.0408.4508.158.054.046.041.943.3663.9595.7484.2461.4349.5
Nonperforming loans/total loans4.03.22.30.80.96.04.62.82.01.812.011.07.05.84.4
Loan-loss provisioning/gross loans4.42.62.11.00.94.03.01.71.51.54.53.72.61.10.9
Loan-loss provisioning/nonperforming loans118.381.491.7123.3106.779.374.180.495.5102.737.534.634.218.723.6
Profitability
Return on equity9.28.420.912.412.511.019.019.016.416.31.14.0–1.19.814.1
Return on assets1.51.22.71.61.51.02.01.51.51.40.10.4–0.11.01.6
Net interest margin4.64.74.13.83.54.33.63.13.65.35.33.94.1
Loans and deposits
Loans/deposits100.998.595.3102.4109.365.958.370.369.274.179.364.562.566.269.9
Loans/total assets56.659.259.561.264.743.440.347.348.150.253.046.649.952.853.1
Nonresident deposits as a share of total deposits16.916.014.313.111.346.951.351.954.352.98.98.212.617.519.5
Nominal interest rate spread4.53.95.43.73.58.47.56.44.65.08.28.36.65.03.4
Foreign currency deposits as a share of total deposits31.134.030.128.726.448.246.845.040.840.948.849.549.142.240.9
Foreign currency loans as a share of total loans76.177.978.782.681.952.351.356.353.753.761.666.860.651.148.1
Concentration
C392.091.091.090.090.349.851.052.852.951.974.183.581.977.676.6
C599.099.099.099.199.461.362.366.265.364.692.491.292.488.687.8
Memorandum Items(In percent of GDP)
Total assets28.733.548.075.680.250.462.071.885.189.126.029.032.033.433.8
Deposits (resident)22.526.130.139.340.617.320.623.327.028.415.918.721.222.020.6
Sources: Country authorities; BankScope;and IMF staff estimates.

Most recent data.

Sources: Country authorities; BankScope;and IMF staff estimates.

Most recent data.

In view of the strong presence of foreign owners, banks can close the funding gap through credit lines from their parent banks. But foreign currency lending has other drawbacks in that banks basically substitute foreign exchange risk for credit risk, if foreign currency loans are extended to unhedged borrowers. The highest risk is in Estonia due to the large amount of foreign currency-denominated lending to households. One might argue that, given Baltic countries’ successful implementation of their currency boards (Estonia and Lithuania) and Latvia’s fixed-rate system, the potential for adverse exchange rate movements is small, but the experience in other countries—particularly in Latin America—has shown that the balance sheet effects of adverse exchange rate movements can be quite large to both banks and corporations. Although the Baltic states have a credible exit strategy in the form of future EMU membership, a mutual agreement between the European Union and the Baltic states about the central parity still would have to be reached before the countries could join the ERM2. In general, while loan and deposit dollarization may not cause a crisis, it does have the potential to exacerbate one.

Banking performance in the Baltics has improved over the past few years, as evidenced by key banking indicators, although Lithuania still faces some difficulties. In view of Lithuania’s recent efforts to complete the privatization of the remaining state-held banking capital, however, it is likely that the banking sector will become more efficient, and profitability will improve in the region. Nonperforming loans have decreased significantly, profitability continues to be high by international standards, and banks appear to be well capitalized and liquid.9 A significant share of bank revenue is generated as a result of investments in securities, however, rather than through traditional lending to the real sector. The reason for this, on the one hand, is that foreign ownership contributed to more prudent lending behavior. On the other hand, the asset composition probably reflects a higher risk aversion in the aftermath of the Russian crisis, and there may also be a shortage of sufficiently viable projects. While net interest margins have come down in recent years, they are still quite high by international standards. Both the high-interest margins and relatively high profitability overall indicate that the large degree of concentration observed in the Baltic banking systems may in fact be hampering competition. With EU accession, however, competition is likely to increase and, as a result, profitability ratios are expected to fall, approaching those in Europe (Table 2.2).

Table 2.2Profitability in Selected European Countries, 2002
FinlandNetherlandsLuxembourgGermany
Return on equity10.2812.459.271.23
Return on asset0.740.680.430.06
Net interest margin2.301.350.881.54
Source: BankScope.
Source: BankScope.

Leasing

In addition to bank financing, the Baltic states (in particular Estonia) have experienced a surge in lease financing, with leasing in some cases directly substituting for bank loans (Table 2.3). As discussed below, certain features of the Baltic economies make leasing an attractive alternative to traditional bank financing for both lessor and lessee. Since these features are likely to be shared by other transition economies and CIS countries, the trend toward lease financing might ultimately spread to other transition economies as well. The most common type of lease is the financial lease, which is the closest substitute for a bank loan, given that ownership of the asset being financed is transferred to the lease holder at the end of the leasing period. So-called operational leases, which are structured more like rental contracts, have been less important.

Table 2.3.Leasing Sector
EstoniaLatviaLithuania
199920002001200220032199920002001200220032199920002001200220032
Leasing and factoring16,78210,07813,97119,27121,493751412142783018491,3432,0962,558
In percent of GDP8.911.614.517.819.21.93.24.45.45.81.92.84.14.9
Leasing16,2909,22012,28416,89419,352701191792432685726801,1211,7482,128
In percent of GDP8.210.612.715.617.31.82.73.74.75.11.31.52.43.44.1
Leasing assets1,36,2909,22012,28416,89419,352701191792432685726801,1211,7482,128
Financial (in percent of total assets)62.552.346.340.945.895.782.979.476.797.995.395.495.093.8
Operational (in percent of total assets)23.721.722.623.820.34.35.28.211.02.14.74.65.06.2
Leasing assets by industry (in percent of total assets)
Motor vehicles (passenger, commercial, and other)49.044.140.239.339.952.150.148.351.451.657.649.344.843.847.4
Real estate20.520.119.526.625.45.314.816.213.814.86.820.118.717.717.5
Other430.635.840.334.134.842.635.135.434.733.635.630.636.438.635.1
Leasing portfolio by maturity (in percent of total assets)
Up to one year4.14.02.93.75.131.322.121.624.734.2
One to three years27.125.722.120.915.244.937.332.634.142.2
Three to five years45.594.651.245.143.316.830.231.926.112.2
Over five years23.220.723.830.336.46.910.313.915.111.4
Factoring1491.9858.91,687.12,376.42,141.035.221.334.035.433.7169.1222.0347.9429.5
In percent of GDP0.61.01.72.21.90.10.50.70.70.60.40.50.70.8
Memorandum Items:
GDP176,32787,23696,571108,024111,8623,8904,3484,8135,1955,46942,60844,69847,49850,67952,491
Leasing assets from bank-affiliated companies16,1349,13212,24716,73419,165
Source: Country authorities.

In millions of national currency.

First half of 2003.

For Estonia, total leasing assets include hire purchase contracts

Other includes machinery and equipment; ships, aircraft and railway equipment; data processing and communications, and so forth.

Source: Country authorities.

In millions of national currency.

First half of 2003.

For Estonia, total leasing assets include hire purchase contracts

Other includes machinery and equipment; ships, aircraft and railway equipment; data processing and communications, and so forth.

In Estonia, leasing activities amounted to 17.3 percent of GDP in mid-2003, representing about one-third of total credit to the private sector. About 25 percent of lease claims were used to purchase real estate on installment plans. The remaining 75 percent of leases were used to purchase movables; about half of these involved purchases of personal and commercial vehicles.10

While the leasing market in Latvia is smaller, it too is expanding rapidly—almost tripling in size between 1999 and mid-2003, by which time the stock of leased assets had exceeded 5 percent of GDP. More than three-fourths of these leases were financial leases, a much higher proportion than in Estonia. More than 50 percent of lease assets were used to purchase vehicles, while real estate leasing made up about 15 percent. The remaining lease contracts included leasing of machinery and equipment, airplanes and railway equipment, and data processing and communications equipment. Factoring is relatively insignificant, amounting to 0.6 percent of GDP in Latvia.

Although the leasing market in Lithuania has been growing fast, it is still the smallest among the Baltic states, with total assets accounting for 4.1 percent of GDP in mid-2003. The breakdown between cars and real estate is similar to that of Latvia. Almost 94 percent of these leasing assets are financial assets.

Several factors contribute to the significance of leasing in all of the Baltic states. The most important of these factors is related to how collateral is handled as well as the cost of repossessing assets in the case of nonpayment of loans. Although a lease contract operates in most respects like a debt contract, under a lease contract the title to the underlying property remains with the bank or the leasing company. This important legal difference in ownership makes leasing an attractive alternative to debt financing in economies where the actual cost of seizing collateral is high. In this respect, leasing—especially financial leases—is an efficient market response. The importance of leasing in the Baltics may presage the growth of this sector in other countries.

Another reason for the rapid development of the leasing market, especially with respect to operational leases, is that people are often faced with borrowing/liquidity constraints, reflecting the relatively low levels of income and wealth in these countries. Lease contracts executed in the Baltic countries entail a different payment structure than would a standard debt contract on a given underlying asset. These lease contracts, although classified as purchases by the lessee, have a lease term that is greater than 75 percent of the properties’ estimated economic life, with an option to buy for less than the market value. For example, leasing a car requires a lower payment up front, with a balloon payment coming due at the end of the term if the lessee decides to buy the car.

In the future, it is likely that leasing will continue to grow unless the cost of recovering collateral is reduced. As the leasing sector expands, however, regulation of these activities may become an increasingly crucial issue. Until now, leasing companies have been primarily bank subsidiaries, and hence are monitored through the supervision and regulation of the parent banks. A larger lease sector, however, that is not affiliated with banks would require explicit supervision and regulation of leasing to prevent regulatory arbitrage.

Insurance

While leasing is well developed, the insurance sector continues to be small in the Baltics (Table 2.4). It has been increasing steadily since 1993, however, and is likely to expand further in the future. Insurance company assets amounted to 5.4 percent of GDP in mid-2003 in Estonia, and about 2.5 percent of GDP in Latvia and Lithuania. The number of insurance companies has fallen because higher capital requirements resulted in the consolidation of the sector.11 Within the insurance industry, the life insurance sector is the least developed, accounting for about 20 percent of the total premium volume in Estonia and Lithuania, and much less in Latvia—close to 4 percent of total premiums. Recent legal changes, however, have helped stimulate growth in the life insurance sector in two of the Baltic states. In 1998, the Latvian government excluded payments made for employees’ life insurance premiums from social security taxes, while in 1997 Lithuania introduced tax allowances for long-term life insurance premiums. Similarly, nonlife insurance, primarily automobile insurance, is likely to see rapid growth in the immediate future as a result of compulsory motor insurance laws (third party liability) that have been passed in all three countries. Over the last couple of years, foreign investment has also played a significant role in helping the insurance sector to develop, reflecting the openness of the Baltic countries.

Table 2.4.Insurance Sector
EstoniaLatviaLithuania
199920002001200220031199920002001200220031199920002001200220031
Assets (in millions of U.S. dollars)106122138195241162174179212246187207237355430
Assets (in percent of GDP)2.22.42.52.55.42.42.52.42.42.61.81.92.02.32.5
Assets (in millions of national currency)1,6462,0562,4392,8993,298951071141261407498289491,1761,299
Life (in percent of total assets)24.732.237.941.141.524.724.425.025.622.97.412.018.622.724.0
Nonlife (in percent of total assets)75.367.862.158.958.574.177.374.974.477.192.688.081.477.376.0
Gross collected premiums (in millions of national currency)1,4171,6591,8222,1891,27795969710464439437478775444
Life (in percent of total premiums)15.318.319.520.418.97.13.93.64.13.77.510.314.416.021.3
Nonlife (in percent of total premiums)284.781.780.579.681.192.996.197.095.996.392.589.785.684.078.7
Foreign ownership (in percent of total assets)31.054.758.761.561.732.047.052.053.854.236.837.547.352.051.0
Memorandum Items:
GDP (in millions of national currency)76,32787,23696,571108,02457,2083,8904,3484,8135,1955,46942,60844,69847,49850,67952,491
Exchange rate, national currency/U.S. dollar, end of period15.616.817.714.913.70.60.60.60.60.64.04.04.03.33.0
Source: Country authorities

First half of 2003.

Includes reinsurance in Estonia.

Source: Country authorities

First half of 2003.

Includes reinsurance in Estonia.

Market-Based Finance

All three Baltic countries inherited the infrastructures of a banking system, but the capital markets have developed only over the past decade. As a result, the role of domestic capital markets as part of the financial system and as a means to allocate savings and investment has been very limited. To some extent, the monetary policy framework has contributed, at least initially, to the present state of development of the bond markets in the Baltics. Specifically, the Currency Board Arrangement (CBA) in Estonia and Lithuania and the peg in Latvia supported the deepening of foreign exchange markets and access to international markets. This, however, implied slower development of domestic markets. Developments would have been different had the Baltics opted to rely on domestic money as a nominal anchor instead of the exchange rate. In addition, foreign participation in the Baltic economies—which to a large extent reflects the past privatization process—has been significant, and financing has often come from parent companies through credit lines and foreign direct investments.

The Bond Markets

In general, the development of markets for government debt is closely linked to the fiscal stance during the transition process. In addition, a growing nonbank financial sector, particularly through institutional investors such as insurance companies and pension and investment funds, typically leads to an increase in the demand for marketable securities.12 As discussed in greater detail below, bond markets can constitute an important supplement to bank lending. In addition, a well-functioning market for government debt can serve as a platform for the development of private sector debt markets and provide key information about market expectations.

After a decade of transition, domestic bond markets in the Baltics remain fairly underdeveloped and are dominated by government securities, with the exception of Estonia (Table 2.5 and Figure 2.3). A sizable portion of total bonds outstanding are in turn international rather than domestic issues, i.e., eurobonds; again, except for Estonia, private issues in international markets are very small (Figure 2.4).

Table 2.5.Bond Market Indicators(In percent of GDP, unless otherwise indicated)
EstoniaLatviaLithuania
199920002001200219992000200120021999200020012002
Market capitalization14.04.04.03.03.45.95.75.83.03.04.05.5
Turnover (in percent of market capitalization)227.082.079.0136.83.3150.6169.765.990.761.950.849.6
Government securities0.00.41.53.45.95.35.34.35.25.05.2
Eurobonds1.33.53.15.25.66.88.79.110.2
Yield (in percent)4.06.75.64.53.17.77.05.13.3
Yield spread
(in basis points)40.9183.594.167.741.1289.6240.1120.353.6
Corporate debt securities0.70.50.00.70.40.50.90.30.40.6
Sources: National stock exchanges; Datastream; and IMF staff estimates.

For Latvia, only nominal values of market capitalization and turnover are available.

Sources: National stock exchanges; Datastream; and IMF staff estimates.

For Latvia, only nominal values of market capitalization and turnover are available.

Figure 2.3.Primary Market Issues by Sector, 2002

(In millions of euros)

Source: European Central Bank.

Figure 2.4.Bond Issues in International Markets by Sector, 1995–2003

(Cumulative, in millions of U.S. dollars)

Source: Capital Data Loanware and Bondware.

During the period 1991–2003, cumulative international bond issues as a share of 1991–2002 GDP amounted to 3.0 percent in Estonia, 1.9 percent in Lithuania, and 0.7 percent in Latvia. Hungary, by way of comparison, issued bonds in international markets equivalent to 4.1 percent of its GDP over the same period.13 With minimal private issues in Latvia and Lithuania, companies still rely to a large extent on internally generated funds or bank credits to finance ongoing and new investment projects.

While, overall, emerging market financing in international bonds dropped substantially in 2002 compared with the previous year, bond spreads remain favorable, and both Estonia (in 2002) and Lithuania (in 2002 and 2003) have successfully launched eurobonds.

The total stock of debt outstanding as a share of GDP in EU countries was 123 percent on average at the end of 2002, while the comparable figure for accession countries was 35 percent.14 Notwithstanding the overall small size of the Baltic debt markets, the relative importance of the government debt market varies significantly across the Baltics.15 As pointed out above, government securities dominate the debt markets in Lithuania and Latvia. At end-2002, government debt accounted for 90–95 percent of the market in both countries. In Estonia, on the other hand, government securities only accounted for some 50 percent of the market.

In Estonia, government debt securities have not been the driving force of corporate debt market development or, more broadly, of capital market development (Figure 2.5). This is partly due to prudent fiscal policies during most of the transition period, which generated relatively small amounts of debt. Nonetheless, the fixed income market is gaining in importance as an alternative source of financing for marketable companies and local governments. At end-2002 about 57 percent of securities issued by corporations and financial institutions were short term, while 100 percent of government securities have a maturity between one and ten years. Only 1.7 percent of securities were traded through the stock exchange. The Estonian government issued its first eurobond in June 2002 to refinance more costly World Bank loans, to test market sentiment toward Estonia, and to change the currency composition of the debt.16 Both primary and secondary market activity has been declining in recent years.

Figure 2.5.Stock of Debt Securities by Issuing Sector, End-2002

(In percent)

Source: European Central Bank.

In Latvia, the central government is the major issuer of debt. In contrast to Estonia, the Latvian government issued securities in excess of fiscal needs to help establish the domestic bond market and promote long-term financing in domestic currency. Nonetheless, corporate issues are still dormant, and issues by financial institutions continue to be insignificant as well. Both primary and secondary market activity was and remains dominated by government debt, although the share of debt of financial institutions that was traded in the secondary market increased to 18 percent in 2002 from zero in 1999. About 91 percent of the trades in securities were conducted via the over-the-counter market, while the remaining 9 percent were traded via the stock exchange. Nonetheless, with the listing of government securities at the Riga Stock Exchange (RSE) in 1999, stock exchange trading has gained in importance. In terms of maturity, about 7 percent of government securities outstanding at end-2002 were short term, while the remaining stock of securities had maturities between one and ten years (Figure 2.6). Since early 2003, the maximum maturity for domestic currency bonds is ten years. Securities of corporations, representing only 0.2 percent of total at end-2002, were exclusively long term, while 8.7 percent of the securities of financial institutions, representing 10.2 percent of the total, had a maturity of less than a year.

Figure 2.6.Original Maturity Structure of Debt Securities, 2002

(In percent)

Source: European Central Bank.

In terms of size, the Lithuanian debt market exceeded that of both of its Baltic neighbors. As in Latvia, government securities dominate the market, accounting for about 96 percent of the total at end-2002. Securities issued by corporations amounted to 4 percent of the total stock of securities at end-2002. Thus, primary market activity was driven by the borrowing needs of the government. Secondary market activity increased slightly between 1999 and 2002 but consisted mainly of trade in government securities. About 7.4 percent of the stock of securities at end-2002 had a maturity of less than a year, with the remainder being up to ten years. Corporate debt securities, on the other hand, are concentrated in the one to five-year maturity bracket (about 97 percent).

Equity Markets

Equity markets as a source of financing are still in their infancy in the Baltic states (Figure 2.7 and Box 2.1). In the mid-1990s, however, all three countries attempted to develop their equity markets. The initial push for development coincided with the 1995 banking crises in Latvia and Lithuania. The authorities’ objective was to diversify the sources of financing in order to allow enterprises access to funds even when bank lending dried up. It was also thought that well-developed equity markets were needed to allow companies to raise non-debt creating financing. Finally, it was believed that the creation of incorporated companies would improve corporate governance and therefore encourage companies to operate more efficiently.

Figure 2.7.Equity Markets, 1997–20031

Sources: Stock exchange websites, country authorities, World Federation of Exchanges, and the European Central Bank.

1Most recent data of 2003.

The factor that initially boosted the development of equity markets was privatization. In line with other transition economies, the Baltic states used either voucher privatization or the sale of assets to strategic investors to transfer ownership to the private sector. Both approaches had a positive, albeit temporary, impact on the stock market: a rapid increase in listings and active trading early on, but markets soon became illiquid, and companies began delisting. Moreover, turnover fell as the number of shareholders decreased, and ownership structures became more concentrated. Lithuania relied almost exclusively on voucher privatization, with the intention of ensuring ownership diversification.17 This strategy, which continued until 1995, was also consistent with the government’s goal of preventing the sale of assets to foreigners. Voucher privatization was used to sell off land, housing, and small and medium-sized enterprises that were state owned. The result, however, was that a relatively small group of insiders became owners and often resisted extensive enterprise restructuring.

While the initial impact of privatization was positive in that it allowed the stock exchange to get off the ground, the subsequent effect has been limited. Of some 50 percent of the 1,200 privatized companies that were initially listed and registered with the Lithuanian Securities Commission, only a few were actively traded on the National Stock Exchange of Lithuania (NSEL). More than 500 of the companies that were not traded or traded infrequently were ultimately delisted or reorganized into private, limited companies. Furthermore, a number of large companies were delisted after strategic investors bought out the remaining minority shareholders. Vilnius Bank, for example, which previously was the most actively traded company on the NSEL, was delisted when SEB (its Swedish majority owner) bought the remaining shares.18 By mid-2003, the number of listed companies had fallen to 37, of which only 8 were on the primary official list. The same development occurred with respect to the investment funds. Of the 200 investment funds that were created during voucher privatization, only 11 are still in existence. Given that the investment funds held shares in only a few companies each, they effectively became holding companies. Today, of the 11 funds that still exist, only one (Invalda) is listed on the NSEL (Box 2.1).

In mid-2003, the Lithuanian stock market capitalization amounted to 4 percent of GDP. The exchange has been dominated by a few large companies such as the Lietuvos Telekomas, which alone represented more than 2 percent of GDP and 14 percent of the listed stock capitalization. The top five companies represent almost 60 percent of capitalization. With trading volumes at below 10 percent of capitalization, liquidity has been low.

Compared with Lithuania, both Estonia and Latvia have relied more on strategic investors in their privatization processes, using voucher privatization largely to sell off minority stakes after strategic investors had already acquired the majority of shares. Estonia (from early on in the transition process) and Latvia (from 1994) encouraged foreign participation, in particular sales of ownership stakes to Scandinavian enterprises and banks.19 Both countries did so by using fairly stringent tender processes that favored foreign companies over domestic ones, given that foreign entities had greater access to funds and expertise. Beginning in 1998, Lithuania also adopted the strategic investor approach, which was used to sell 60 percent of Lietuvos Telekomas; later, a public offering was used to sell most of the remaining shares. Since then, companies, including Mazeikiai Oil, GeoNafta, Vilnius, Savings and Agricultural Banks, and LISCO, have been privatized by strategic foreign investors.

The stock market in Latvia grew gradually, with market capitalization increasing to 10.8 percent of GDP in mid-2003 from 3 percent of GDP in 1996. Activity in the RSE began with the sale of a small number of stocks as a result of privatization-related initial public offerings. The subsequent listing of additional companies improved market capitalization and allowed the market to remain liquid. Recent activity has included mergers and acquisitions, such as the Swedish bank SEB’s purchase of the largest local bank Unibanka; the Danish insurance company Codan’s purchase of the local Balta company; and continuing privatization of the gas, telecom, oil, and shipping companies by foreigners. In mid-2003, the RSE had 61 companies listed and capitalization of about US$3 billion. Trading volume was about US$338 million (39 percent of stock market capitalization), after a dramatic fall from 2000 to 2001 due to delistings of two major companies and large block trades of a few major companies.

Estonia has the most developed stock market among the Baltic countries and from the beginning has clearly benefited from a few high-quality listings created through the initial public offerings of state-owned companies. Market capitalization of the Tallinn Stock Exchange (TSE) reached 20 percent of GDP in 1997, before the Asian and Russian crises subsequently reduced it to 11 percent of GDP. By 1999 the exchange had rebounded, with 23 companies listed and capitalization reaching 37 percent of GDP. In mid-2003, there were 14 companies listed, and capitalization was close to US$2 billion, or 38 percent of GDP. During 1997 and 1998, turnover reached frenzied peaks at about 160 percent of market capitalization as investors tried to exit the market in response to the twin crises. Since that time, however, turnover has returned to a relatively steady level of 14 percent of capitalization.

Box 2.1.Venture Capital

In advanced economies, a substantial portion of small enterprises are financed by venture capital. Venture capital financing is, however, largely absent in the Baltic states. Those funds that exist have support from Western governments or multilateral institutions, such as the European Bank for Reconstruction and Development (EBRD); Nordic financial institutions are another source of capital. Few of the venture funds that invest in the Baltics have a local presence, and financing of start-ups are negligible; instead the funds invest in existing businesses. Exits from investments tend to take place through private equity sales rather than initial public offerings. The lack of a developed venture capital market also implies that there is no secondary market for venture capital commitments. Market participants indicate that the development of venture capital is hampered by the negative experiences of investors during the last financial crisis, which has kept investors largely out of equities. In advanced countries such as the United States, the largest percentage of funding comes from pension funds; therefore, pension reform in the Baltic states is likely to boost the funds that will be available for venture capital. One of the main impediments, however, is the small size of the countries. To help address this issue, the EBRD has initiated the creation of a Baltic Venture Capital Association.

The above section describes the financial system in the Baltics and analyzes its strengths and weaknesses, revealing that financial intermediation remains somewhat underdeveloped, especially in Latvia and Lithuania, and that capital markets are still in their infancy in all three countries. Hence, the question arises whether further development of the financial systems is needed to ensure an efficient allocation of resources and high, sustainable growth rates.

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