V Summary and Conclusion

Niamh Sheridan, Alfred Schipke, Susan George, and Christian Beddies
Published Date:
January 2004
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The Baltic states are on the verge of joining the European Union. This event represents a mile-stone in the completion of the transition process in the three countries. During the past ten years of economic transformation, the allocation of savings and investment took place largely in the form of internally generated funds and through the employment of strategic investors in the privatization process. Associated with this were substantial improvements in efficiency, which contributed to the countries’ strong growth performance. Now that the transition is largely complete and the Baltic states have moved closer to the production possibility frontier, the continued, efficient allocation of savings and investment will have to rely more prominently on the financial system. This will also be one factor to ensure continued high rates of productivity growth. A positive relationship between the financial system development of a country and its economic growth has also been reflected in a growing body of literature.

Currently, the financial systems in all three countries are still largely bank based. Bond and equity markets play a negligible role in each of the financial systems. The capacity for intermediation—as measured by standard indicators, such as monetization and credit to the private sector—is still lower in the Baltics compared with the euro area average and with most other transition economies. Furthermore, the banking systems are highly concentrated and dominated by foreign ownership, especially in Estonia and Lithuania.

Latvia continues to have less foreign ownership and a larger number of banks relative to the size of the country, but the banking system is somewhat fragmented. While the larger banks focus on the domestic market, a number of smaller institutions are specialized and cater to nonresidents. This reflects Latvia’s strategy of serving as a financial center for CIS countries with weaker banking systems and as an intermediary between the East and the West.

Most indicators suggest that the banking systems in the Baltic countries are relatively strong and quite profitable with the exception of Lithuania, which completed the privatization of its banking system only in 2002. Nonetheless, there are some structural issues that could lead to problems. A large percentage of lending in Estonia takes place in foreign currency to unhedged borrowers. In Lithuania, the repegging of the currency from the U.S. dollar to the euro has not produced a corresponding change in the composition of foreign currency deposits.

Small open economies with underdeveloped financial systems can benefit substantially from foreign ownership. In the case of the Baltics, foreign ownership has improved the stability of the financial system and resulted in efficiency increases. The dominance of foreign ownership could pose some challenges, however. In Lithuania, and to a greater degree in Estonia, the banking systems are owned primarily by two Swedish parent banks. One of the key risks therefore is the transmission of a shock via the banking system to the Baltics. The likelihood of a credit crunch in the Baltics caused by the parent banks depends in turn on the lending exposure of those banks to the Swedish economy. It is the degree of diversification of the parent banks, rather than the presence of foreign banks per se, that could create risks for the Baltics. Analysis reveals that one of the two Swedish banks is highly exposed to the performance of the Swedish economy because a sizable share of its lending is to domestic borrowers. A sharp and prolonged downturn in Sweden could therefore lead to a credit crunch in Estonia and Lithuania via the Swedish banking system. An analysis of the stock prices of the Swedish parent bank and the share prices of the subsidiary, however, did not reveal any correlation. In the case of Estonia, the risks associated with a downturn in Sweden are compounded by the fact that Sweden is also Estonia’s second largest export market. A real shock originating in Sweden could be followed by a credit crunch, thereby hampering the ability of the financial system to smooth out real shocks.

Overall, however, the policy of the Baltic states to allow, and in some cases to encourage, foreign bank ownership has played a critical role in the establishment of a sound and stable banking system. Potential vulnerabilities of the Baltic banking systems to shocks from abroad are likely to be reduced as a result of further integration of Swedish banks with institutions in the rest of Europe. Future EU-driven mergers and acquisitions, for example, will lower such risks through a diversification of the lending portfolio of the parent banks.

One rather unique characteristic of the financial system in the Baltics is lease financing. In Estonia, lease financing amounts to about one-third of lending to the private sector. More recently, lease financing has also grown in importance in Latvia and Lithuania, albeit from a lower level. Financial leases are in effect a substitute for bank loans, because at the end of the lease, ownership of the asset is automatically transferred to the leaseholder. The substitution of leases for standard bank loans reflects the high transaction costs associated with the laws governing collateralized lending. Yet it also demonstrates how markets overcome inefficiencies, and given the similar shortcomings of collateralized lending in other transition economies, the trend in the Baltics might even be an example for those countries to follow. While lease financing per se does not represent a particular problem, the establishment of leasing companies outside of banks warrants a tightening of supervision. For the time being, however, the largest share of leasing takes place through bank-owned leasing companies.

After the international financial crises in the second half of the 1990s, it has been argued that over-reliance on bank credit implies certain risks and that the existence of a more diverse financial system—including a developed domestic capital market—could limit the impact of a crisis within a country because the private sector would be able to resort to alternative forms of financing. Some governments have therefore begun to encourage the development of domestic bond and equity markets. There are two ways to foster this development. The first is less contentious and focuses merely on eliminating existing distortions that favor bank financing over other forms of financing. In the case of the Baltic states, one of the major distortions comes from the tax system, which discriminates against nonbank financing by granting advantageous tax treatment for bank instruments, in effect making income from bank deposits tax free. Therefore, the first step toward fostering the development of capital markets should be through the elimination of existing distortions.

The other approach is more controversial and relates to active government policies to foster the development of a local capital market. One method focuses on developing an active market for government securities and establishing a yield curve even in cases where the public sector generates surpluses. The assumption of such an approach is that the development of a government bond market has positive externalities, which would, for example, make it easier for the private sector to price and therefore issue financial instruments. Hong Kong SAR and Singapore are among the countries that have pursued such a policy and both are somewhat similar to the Baltics in terms of openness, exchange rate system, and fiscal position. Latvia has also borrowed funds in excess of its financing needs to establish a benchmark yield curve. While such an approach might have positive externalities, it is unlikely that the size of the local markets in the Baltics would ensure sufficient liquidity to establish a yield curve over the entire maturity spectrum.

Another approach to fostering the development of local capital markets is through regulation, such as in the context of pension reform. The “privatization” of the Chilean pension system, for example, was associated with stringent investment restrictions, making investments in government securities mandatory. As a result, Chile’s pension reform contributed substantially to the development of its capital market, which in turn has been credited with the country’s relatively high growth performance. Similarly, the three Baltic states have embarked on pension reforms that are likely to increase investments in marketable securities. Based on current regulation, it is estimated that, in terms of the accumulation of pension fund assets after a four-year period, the largest impact would be in Estonia. While legislation in the three countries has converged, there are still differences with respect to investments abroad. Estonia has the most liberal approach, with no restrictions on foreign investments, while both Latvia and Lithuania have some restrictions. Again, given the size of the Baltics, developing local capital markets by restricting foreign investment is not the optimal means to accomplish social security reform. In this respect, Estonia’s approach would seem to be the most appropriate.

The lack of broad and deep capital markets in the Baltic states is related to the level of economic development, the absence of capital market infrastructure prior to the transition process a decade ago, and especially the small size of the countries. But, it is also a reflection of monetary policy framework in conjunction with the respective exchange rate systems. In particular, the currency board systems in Estonia and Lithuania have favored transactions in foreign exchange markets over those in traditional repo markets that would have contributed to the liquidity of the bond markets. Although equity markets, especially in Lithuania, experienced temporary surges as a result of mass privatization in the wake of the Russian crisis, stock markets in the Baltics are now limited to a few large companies.

Overall, the Baltic financial system has come a long way since the beginning of the transition process and is relatively well positioned to ensure that future economic growth is aided by an efficient allocation of savings and investment. Further EU integration will increase competition and efficiency. To what degree this will take place, however, will depend not only on policies in the Baltics but also on how and when the European Union itself will eliminate still-existing distortions and legal obstacles that have prevented capital markets and the EU banking systems from becoming fully integrated. The reform of EU capital markets, however, is ongoing.

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