Abstract

In only a decade after independence, the three Baltic states—Estonia, Latvia, and Lithuania—have transformed themselves into fully functioning, small open market economies that are on the verge of joining the European Union. The three Baltic states, jointly with the other seven accession countries of the first wave, will join the European Union in May 2004 and are expected to seek membership in the European Exchange Rate System (ERM2) shortly thereafter. Over the past decade, economic policies and developments in the three countries have been similar in many respects. All three have used the exchange rate as a nominal anchor to stabilize the economy and to impose fiscal discipline. Estonia and Lithuania chose a hard peg in the form of a currency board, while Latvia pegged its currency to a basket of currencies through an SDR peg. Although considered to be temporary arrangements until adoption of the euro, the respective exchange rate systems have served the countries well and withstood a number of shocks, the most extreme of which was the 1998 financial crisis in Russia.1

In only a decade after independence, the three Baltic states—Estonia, Latvia, and Lithuania—have transformed themselves into fully functioning, small open market economies that are on the verge of joining the European Union. The three Baltic states, jointly with the other seven accession countries of the first wave, will join the European Union in May 2004 and are expected to seek membership in the European Exchange Rate System (ERM2) shortly thereafter. Over the past decade, economic policies and developments in the three countries have been similar in many respects. All three have used the exchange rate as a nominal anchor to stabilize the economy and to impose fiscal discipline. Estonia and Lithuania chose a hard peg in the form of a currency board, while Latvia pegged its currency to a basket of currencies through an SDR peg. Although considered to be temporary arrangements until adoption of the euro, the respective exchange rate systems have served the countries well and withstood a number of shocks, the most extreme of which was the 1998 financial crisis in Russia.1

With the exception of a contraction in output at the very beginning of the transition period and a slowdown in economic activity in the aftermath of the Russian crisis—which led to a decline in output in Estonia and Lithuania—overall the Baltic states have experienced strong economic growth since independence. This strong performance has resulted from several factors: substantial increases in efficiency due to restructuring of the economy, including privatization; the attraction of foreign capital; and a stable macroeconomic environment.

Economic growth, in turn, went hand-in-hand with the rapid expansion of the financial sector. The path of financial sector development, however, was not always smooth and was interrupted by a number of banking crises. In Estonia, the first banking crisis emerged shortly after independence, while Latvia and Lithuania were faced with their banking crises in 1995. Estonia was confronted with a second banking crisis in 1997/98. These crises were largely related to the authorities’ strategy of developing the financial system by liberally granting licenses to new banks with relatively few prudential and regulatory safeguards. The objective of such a policy was to reduce lending rates and foster competition. The banking crises caused policymakers to focus more on financial sector stability, however, which led to the consolidation, restructuring, and implementation of more stringent prudential requirements and better supervision.2

The current structure of the financial system in the Baltic states is the outcome of past policies, the regulatory frameworks, and the level of development of the economies. In many respects, all three countries are confronted with similar challenges and questions that generally apply not only to these economies but to small open economies with nascent financial systems.3 Economic growth in the Baltics over the past decade was driven primarily by a reallocation of existing factors of production—that is, increases in efficiency due to the restructuring of the economy. To a large degree, the reallocation of resources relied less on the financial system and more on privatization-related investments—often in the form of strategic investors—and on firm, internally generated financing. Now that the economies are closer to their respective production possibility frontiers and privatization is almost completed, future sustained productivity growth will depend on how new technologies are adopted and on how scarce resources are allocated. To accomplish this growth, the financial system will play a more important role than in the past. Several issues and questions arise in this context.

  • Countries with less developed financial systems usually rely on the banking system for financial intermediation. Should such small open economies foster the development of their own domestic capital markets as a means of promoting growth, and if so how?

  • Should the government encourage—or be concerned about—a banking system that is owned primarily by foreigners? If so, how would economic shocks in the parent banks’ home countries affect their branches or subsidiaries in the small open economies?

  • In countries that pursue conservative fiscal policies and tend to balance their budgets over the cycle, thereby creating little or no debt, is there a role for government to actively foster the development of a domestic capital market?

  • As in many other parts of the world, the Baltic countries are faced with adverse demographic developments and have decided to move from a pay-as-you-go pension system to a three-pillar system that includes a fully funded, mandatory pension scheme. Although this reform is likely to have an impact on the development of capital markets, its exact nature will depend on the specific design of the pension system. Therefore, should small open economies impose investment restrictions to foster the development of local capital markets?

  • Does the small size of a country’s financial systems warrant regional alliances?

  • Small open economies might reasonably contemplate the integration of their financial systems into the system of a larger economy or a larger economic region. What are the implications of such a strategy, especially as they relate to the European Union (EU) and membership in the European Monetary Union (EMU)?

These questions are quite relevant for the Baltic states given that they are in many respects perfect examples of small open economies. This paper, therefore, analyzes the financial system in the Baltics and addresses some of the relevant issues. Section II provides a comprehensive overview of the structure and level of development of the financial system, discussing some of the unique characteristics of the Baltics, such as leasing; and comparing the structure of the Baltic financial systems to other EU accession countries and/or euro area averages, both of which serve as benchmarks.

Section III addresses some of the broader analytical questions raised above concerning how the financial system might be developed in the Baltics. In particular, current distortions of the financial system are analyzed, as well as the issue of whether or not the Baltics should move from an almost exclusively bank-based system to one that relies more on capital markets. The foundation for both improvements in financial intermediation, as well as the broadening and deepening of capital markets, depends to a large degree on corporate governance. Issues of corporate governance are addressed in this section, as are questions of regional integration. Estonia has begun to target balanced budgets over the business cycle, and Latvia and Lithuania may well follow suit. This suggests that the Baltics might find themselves in a situation similar to that of Hong Kong or Chile, both of whom issue government debt to foster the development of capital markets despite the fact that they run fiscal surpluses. This issue is discussed, as are the current efforts of the Baltic states to partly “privatize” their pension systems and the impact of these efforts on the financial system.

A unique characteristic of the Baltics is the percentage of banks that are owned by foreign institutions. Foreign ownership of financial institutions in turn is frequently credited with the improved stability of the financial systems in the Baltics. Foreign ownership can, however, involve risks. Such risks are addressed in Section IV, as are issues of EU accession. Section V concludes the paper.

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