More than three years went past since the European Union has increased by eight new member states from Central and Eastern Europe. Among them, especially the Baltic States have reached recently high economic growth rates. In particular Latvia, which recorded the highest one (11.9% in 2006) in the whole European Union. Having regained their independence in 1991, after the breakdown of the Soviet Union, the three Baltic States might have developed after a more than 10- year continuing transformation- process of their economies, through self- confident countries with interesting investment opportunities for foreign investors. Since the independence of the three Baltic States was restored, all three countries were driven to replace the centrally planned, socialist system, forced by the Soviet Union through a structure based system on free market principles. A continuing order of political and economical events during the last two decades, and the contemporaneous developments in the financial markets, as well as the banking and insurance sector of the three Baltic states, upcoming changes in the course of onward globalisation, and the broadening unification in financial market regulation led to serious changes and demonstrated important milestones to liberalised market principles. The descriptive literature, which supported the present minithesis, describes only short periods of the developments in the Baltic financial markets. Moreover, you will not find a kind of evaluation about all three Baltic States in comparison to each other over such a long time period.
There are no current statements, which conclude this whole development- period among the three Baltic states and there is no clear assessment whether the Baltic states` financial markets can be considered as integrated or not. Therefore, this minithesis serves as an attempt to answer this main question.
Table of Contents
1. Introduction
2. General Economic Situation in Estonia, Latvia and Lithuania
3. The Financial Markets in the Baltic States
3.1 The Financial Sector
3.1.1 The Commercial Banking Sector in the Baltic States
3.1.2 The Insurance Market in the Baltic States
3.2 Foreign Exchange & Money Market in the Baltic States
3.2.1 The Baltic States on their Way to own Currencies
3.2.2 Money Market & Exchange Rate Policy
3.3 The Credit Market in the Baltic States
3.3.1 Credit Growth and General Conditions
3.3.2 Latvia by Way of Example
3.4 The Capital Market in the Baltic States
3.4.1 Stock Exchanges and Stock Market Indices
3.4.2 The Securities Market in the Baltic States
4. First Years after the Breakdown of the Sovjet Monobank- System
4.1 Banking Crises between 1992 and 1995
4.2 The Russian Financial Crisis and its Effects on Baltic Economies
5. Financial Market Integration & Current Challenges in the Baltic Economies
5.1 Financial Market Integration& Recent EU Directives
5.2 Euro- Introduction
5.3 Critical View of Latvia`s Current Economic Problems
6. Conclusion
7. List of Figures and Tables
8. List of Literature
1. Introduction
More than three years went past since the European Union has increased by eight new member states from Central and Eastern Europe. Among them, especially the Baltic States have reached recently high economic growth rates. In particular Latvia, which recorded the highest one (11.9% in 2006) in the whole European Union. Having regained their independence in 1991, after the breakdown of the Soviet Union, the three Baltic States might have developed after a more than 10- year continuing transformation- process of their economies, through self- confident countries with interesting investment opportunities for foreign investors. Since the independence of the three Baltic States was restored, all three countries were driven to replace the centrally planned, socialist system, forced by the Soviet Union through a structure based system on free market principles.[1] A continuing order of political and economical events during the last two decades, and the contemporaneous developments in the financial markets, as well as the banking and insurance sector of the three Baltic states, upcoming changes in the course of onward globalisation, and the broadening unification in financial market regulation led to serious changes and demonstrated important milestones to liberalised market principles. The descriptive literature, which supported the present minithesis, describes only short periods of the developments in the Baltic financial markets. Moreover, you will not find a kind of evaluation about all three Baltic States in comparison to each other over such a long time period.
There are no current statements, which conclude this whole development- period among the three Baltic states and there is no clear assessment whether the Baltic states` financial markets can be considered as integrated or not. Therefore, this minithesis serves as an attempt to answer this main question.
As a first step the general economic situation in Estonia, Latvia and Lithuania will be considered to have a first impression of each country`s economic individualities.
The next step will be an analysis and comparison of the financial markets in all three economies, including the main steps in their individual developments. That means that the financial sector, including the banking sector and the insurance sector will be evaluated, as well as a critical consideration of the developments in the foreign exchange and money market, the credit market, and the capital market in each country. In the next chapter the issue will be addressed to some exceptional circumstances the financial markets in the Baltic States had to deal with, and how they were affected by these circumstances. The last chapter examines the consequences of the EU- enlargement and chances for the three economies. Particularly, upcoming changes because of the extending EU- financial market harmonisation and the resulting challenges for the Baltic States therof. High inflation rates and extremely high current account deficits in Latvia could also be a cause for concern. Is Latvia on the way to an “overheated” economy? Is the introduction of the euro again postponed? And how are the Baltic economies assessed at all? This discussion will complete the work finally.
2. General Economic Situation in Estonia, Latvia and Lithuania
This chapter is dedicated to the general economic situation in all three Baltic States. Especially the economic growth (GDP), consumer- price growth, and the current account balances will be under review. The figures presented in the following table can also be considered as an indication for overheated economies, particularly in Latvia[2]:
illustration not visible in this excerpt
(table 1: Economic indicators of the Baltic states, 2005-2007; 2007-data is based on Hansabank data, May 2007)
The table shows that all three Baltic States had high economic growth rates, represented in their annual proportional % of GDP- growth. Latvia`s economy has had the highest growth rates among the three economies, with the highest one in 2006 (11.9 %). On the other hand, Latvia had also to “fight” high inflation rates (expressed in consumer price growth in table 1), which were the highest ones among the three states. This is also the main economic problem Latvia`s government has to deal with at the moment to avoid an overheating of its economy. Another problem is the current account balance deficit in Latvia. Estonia and Lithuania have problems too, but the situation is not as risky for the further development of their economies as it is currently in Latvia. All figures in table 1, which concern the year 2007 are based on forecasts, extracted from the “Hansabank Macro- Outlook 2007”.
Not only the figures in table 1 are important to know for having an imagination of the Baltic economies, but also unemployment rates are indicators for the economic development.
In the next table you can see that in there was an onward decrease in unemployment rates in all three Baltic States during the last five years[3]:
illustration not visible in this excerpt
(table 2: Harmonised unemployment level in Estonia, Latvia and Lithuania, 2002-2007; 2007 =forecast)
As can be seen in table 2, the unemployment rates in all three states are currently at rates around 5 percent, whereas Estonia has the lowest rates. This was a first impression of the main economic indicators to have an imagination of the current status quo in the Baltic economies. The next chapter is dedicated to their financial markets, the actual theme of this minithesis.
3. The Financial Markets in the Baltic States
In economics, the financial system consists of a set of markets and other institutions used for financial contracting and the exchange of assets and risks. This includes markets for stocks, bonds, derivatives, foreign exchange and precious metals. Operators in this system are institutions, like financial intermediaries (banks, insurance companies) and regulatory bodies.
In this chapter the financial markets of the Baltic states and their subtypes will be considered.
This includes also the market for foreign exchange and the money market, as well as the participating and intermediate institutions on these markets. A short view on the banking and insurance sector, the structure, past and current developments in the subtypes of the financial markets and a comparison between all three Baltic States will be the approach in this survey.
3.1 The Financial Sector
3.1.1 The Commercial Banking Sector in the Baltic States
In the early 1990`s the transformation process in the Baltic states led to structural crises in their banking sector. The new established banks after the breakdown of the Soviet Union were mainly state owned and suffered from risky loans. Moreover, they had not enough capital to offer new loans, which would have been important for the further transformation process. In addition there was a lack in management know-how and underdeveloped regulation processes in the commercial banking sector. Thus it was impossible to make further steps in the development. So they were forced to attract foreign investors for the further development of their banking sector and finally opened the banking sector to international competition. Foreign investors had to own a 50 %-share of such banks in the Baltic States. With 87% foreign investor-share Estonia has the highest one among all three states. The Baltic States are still of much interest as there is still potential for further growth and high profits.
In the following table foreign banks, which are engaged in the Baltic States are listed:
illustration not visible in this excerpt
(table 3: Foreign Banks in the Baltic states, 2002)
Other foreign banks as the Citigroup from the USA or banks from Austria, which are more present in other East- European states like Slovakia, Hungary, Czech Republic or Poland, are not engaged in the Baltic States. Especially Austrian banks are the largest banks in the Czech Republic, Slovakia, Hungary and Slovenia. The Baltic States are the primary aim of banks from Sweden. The Swedish Hansabank/Swedbank and the SEB are amongst the largest operating banks in the Baltic states.
3.1.2 The Insurance Market in the Baltic States
On the way to become welfare states since the collapse of socialism, the Baltic States were also forced to develop their insurance sector. All three states have a common past in terms of policy design. As an example, Latvia`s insurance sector is introduced in this chapter, because it might be too voluminous to state all three states` sectors individually as they have most things in common. Hence, only Latvia`s insurance sector is under consideration. Besides, the insurance sector of Latvia is compared to that of Germany for getting an image of the two dimensions between a developed sector and a rather developed sector.
The insurance sector is also one of the supporting pillars in developed economies. In Germany, where the insurance sector has already existed since the 17th century, insurance is nowadays essential for the working of its national economy, whereas in Latvia this sector is still emerging after the breakdown of the Soviet Union about more than 16 years ago. For example Germany`s insurance supervisory agency pointed out, that the gross domestic product (GDP) was about € 2138.2 bn. in 2005 and its insurance sector produced in the same period a capital appropriation of about € 1009.0 bn. for the national economy. That was a ratio of approximately 47 per cent. Latvia in comparison had only a ratio of 1.57 per cent in 2005. In addition to that, it is possible to identify the trend of people`s investment behaviour in products for risk coverage and consequently the trends in the development in the insurance sector, respectively in the economy as a whole. For instance, this was done when both countries` national statistical offices evaluated the so-called insurance density in their annual survey in 2005. Thus Germany had an amount to be invested of 2031 € per head within one year and Latvia only 67.8 lats, which is 91.62€ per head. As might be noticed, there is still potential for development in Latvia`s insurance sector to become an important pillar for its national economy as in Germany.
3.2 Foreign Exchange & Money Market in the Baltic States
3.2.1 The Baltic States on their Way to own Currencies
On their way to own currencies the Baltic states and the foreign exchange market is considered first. The foreign exchange market is a so called “platform” for the international currency trade. Currency Trading is the world` s largest market with an average daily trade volume of about USD 2-2.5 trillion. Up to the onward postulation of their independence, the Baltic states` monetary policy was (if there was any) the monopoly of Moscow.
On the way to the entire statehood of the three Baltic states the main suggestion on the way to their own currencies was presented by economists of the Soviet Union, who presented a plan for the introduction of the so called “convertible ruble”. This was supposed to be done in a way of experiment in the regions of the Soviet Union, which wished to get the status of a special economic zone. Gradually, the idea of the introduction of own currencies in all Baltic states began to express the intention of them for an independent statehood.
The idea of the Baltic states` own currency was officially accepted in the spring and summer 1989 by the economic autonomy concepts, adopted by the supreme councils of Estonia, Latvia and Lithuania.
One example of the officially published wording, here by Latvia, was the following:
“The Latvian SSR has control over banking and the circulation of money, including the introduction of Latvia`s own currency and determining its exchange rate against other currencies, including the ruble as the common currency of the Soviet Union”[4]
The corollary of such documents, respectively wordings, which were published in Estonia and Lithuania too, and the idea of the “local” currency were also included in the first banking laws of the Baltic states. As an example the law of the Bank of Lithuania (adopted on 13 February 1990) among other mentions a hypothetical Lithuanian currency, the sole right of the Bank of Lithuania to issue it and its obligation to inform the public of the banknotes to be issued. This constituted the first courageous step of the Baltic countries for their target to get currencies of their own. On one hand, the countries who wanted to have their own currencies did not even exist in those days, but on the other hand they believed that it would be possible to launch a two-tier monetary system with local currencies, being freely convertible into foreign currencies. That is to say, the ruble was not freely convertible. The progressive motion of such ideas could only be supported by a way known as “dollarisation”, but this was not imaginable in those days. In addition, the knowledge about monetary matters was very scarce in all three Baltic states. The next step in the currency introduction was connected with the so- called transition parliaments, elected in 1990. These were the first non- Soviet governments and after regaining independence the first logical step into new self-confidence was to introduce an independent monetary system and own currencies. At that time there existed a lot of scenarios, which were suggested for the introduction of the national currencies. For example the restoration of the 1940 currencies ( based on the 1940- exchange rates and gold reserves) or adopting the currency of some foreign country ( In Estonia, the finnish markka, for example).
Discussions about future monetary reforms were also going on outside the Baltic states, e. g. in Germany, Travemünde (at a symposium) where four different strategies were discussed[5]:
1. “Laissez-faire- model”, where the market itself is allowed to choose the most suitable from among several currencies, circulating simultaneously
2. the introduction of the classical national currencies
3. the introduction of the currency with a fixed exchange rate, supported by the central bank s currency interventions
4. the Baltic Monetary Union
In addition, the currency board as one possible model of the future monetary system was suggested there. But at that time none of the three Baltic states were able to introduce their own national currency. In the monetary reforms of all three states the stage of the interim and permanent money had been distinguished. All three states had preliminary interim currencies in a given transition period. In Latvia rublis & lats and in Lithuania talonas & litas were an interim money stage. In Estonia too, where it was the so-called Soviet ruble and the purchasing power of it was cosiderably lower than in the rest of the Soviet Union, because of the legalisation of the hidden inflation. E.g. in Estonia consumer prices increased by an average of 35.5 times as compared to the end of 1998; In Latvia the increase was 19.2 times and in Lithuania 16.1 times.[6] The encouraging of dollarisation was another target in Estonias main monetary policy in the early 1990`s. Creating an alternative foreign currency circulation and attracting foreign currency into Estonia was one further strategy. Therefore Estonia worked out a special “Dollarisation-Program” in 1991, which was in conflict with the official foreign currency regulations of the Soviet Union. The coupon-like Lithuanian talonas as a parallel currency was introduced on 1 May 1992 and Latvia introduced its so-called Latvian ruble or rublis on 7 May 1992. The exchange rate of both currencies was 1:1 against the Soviet ruble.
Both currencies were at first circulating parallel with the Soviet ruble and various foreign currencies. This introduction became later the first stage of the gradual monetary reform of those two Baltic states, while this introduction was initially considered to overcome the shortage of cash in both countries. From the beginning of the year 1993 the rublis began step by step to strengthen against foreign currencies. Moreover, not only the rublis, also the talonas did not have a quite good quality in their banknotes and they were easy to counterfeit. Then the money was transferred into the Latvian lats and the Lithuanian litas. In Estonia the croon had been already introduced and Estonia was then detached from the ruble zone.
Kroon
The monetary reform in Estonia began on 20 June 1992 and the backdated monetary reform of the German Western Zones and their originated reform played an important role in the 1992 reform in Estonia. The exhange rate was as follows: 10 rubles = 1 kroon
The monetary reform removed the rubles from circulation. Estonias new currency, the kroon was pegged to the German mark under the currency board system and the exchange rate was set at 1DEM = 8 kroons. To built up the collateral behind the kroon, pre- war gold deposits returned to Estonia by Western banks before the monetary reform. Estonia received 11.3 tonnes of gold in total in 1992-1993. As well Latvia received 7 tonnes of gold, frozen in 1940, and Lithuania 6 tonnes of gold. The fixed exchange rate for the EEK to EUR, which was introduced on 28th June in 2004 when Lithuania joined beside Estonia as one of the first candidates for the EMU (European Monetary Union) the ERM II is:
1 EEK = 0.06390 EUR, respectively 1 EUR= 15.65000 EEK.
Lats
In Latvia, the Bank of Latvia issued a new 1,000 rublis denomination, which corresponded to a 5 lats banknote, the rate of exchange thus being 200:1. A short time period before the introduction of the lats, the exchange rate of the dollar plunged from 170 rublis per dollar to 100-120 rublis per dollar. In Estonia, the extremely high exchange rate of rublis into lats was seen as the correct decision.
Historically seen, this was not the first time that Latvia adopted a two-step monetary reform process. Already in 1922, when the lats had replaced the latvian ruble.
On February 1994 the lats was informally and through interventions on the part of the central bank, pegged against the IMF (International Monetary Fund) currency unit SDR at the rate 1 SDR = 0.7997 lats. The fixed exchange rate for the LVL to EUR, which was introduced on 2nd May, 2005 when Latvia joined the ERM II (Exchange Rate Mechanism) is as follows:
1 LVL = 1.42219 EUR, respectively 1 EUR= 0.70314 LVL.
Litas
In Lithuania the transition from the talonas to the Lithuanian litas was concluded in August 1993. The exchange rate was 100:1 and from 1st April 1994, Lithuania pegged the floating litas to the US- Dollar under the currency board system at an exchange rate of 1 USD =4 litas.
In Estonia the fixed exchange rate against the German mark and the currency board system was to stabilise the monetary system, whereas the fixed exchange rate in Lithuania was rather a goal by itself. The fixed exchange rate for the LTL to EUR, which was introduced on 28th June in 2004 when Lithuania joined as one of the first candidates for the EMU (European Monetary Union) the ERM II is: 1 LTL = 0.28962 EUR, respectively 1 EUR= 3.45280 LTL.
3.2.2 Money Market & Exchange Rate Policy
The major differences in the money markets of Estonia, Latvia and Lithuania may appear to be the interest rates of the commercial banks and the different levels of cash and foreign exchange on the market.
In a first step Latvia and the current monetary policy of the Bank of Latvia will be considered. The main given fact by the Bank of Latvia in their monetary policy is that the lats is pegged to the euro (EUR), in an analogous way the lats was pegged to the SDR currency basket more than 10 years ago. This is the first step to the future introduction of the common currency. One important criterion is that a currency should be pegged to the euro and in addition it should not fluctuate too much in advance to the deadline for the Euro- introduction. The same conditions have to be kept by Latvia and Estonia, but this will be shown later in another chapter, where the Euro- introduction and the current problems will be discussed. With regard to a comparison in current money market conditions, as interest rates, respectively refinancing rates and the money supply in all three Baltic states, you will find a table below where current important financial data is represented.
Some paragraphs, explaining the table and in addition the monetary policy of all three countries is discussed briefly.
illustration not visible in this excerpt
(table 4: Comparison of monetary indicators/interest rates in the Baltics)
* VILIBID - Vilnius Interbank Bid rate. Calculation and announcement of VILIBID was discontinued as of 01/01/2006.
All three countries and their current Interbank Offered Rates, respectively Interbank Bid Rates are mentioned above. As you can see there Latvia has at the moment the highest Interbank Offered Rate, the so- called RIGIBOR (Riga Interbank Offered Rate) at current data with 10.26 %, which represents the refinancing rate of the banks in Latvia.. Whereas Estonia offers the lowest rate of all three countries, at current data with 5.31%.
The lending rate in Lithuania in contrast is the lowest, at current data of 6.79% and further more Lithuania has the highest deposit rate (4.38%) for account deposits. All this data is considered in every country individually at their domestic currencies.
The main attention of the Bank of Latvia` s monetary policy lies on supporting the growth of the economy in the long run. Ensuring low and stable inflation rates and thus financial stability is for example one of the major tasks of the central bank in each country, not only in Latvia. Persuant to the “Law on the Bank of Latvia” the main task is just to maintain price stability by keeping the inflation rate low. After the EU-enlargement in 2004, when Latvia became member state (and by the time Latvia will become also member to the Economic and Monetary Union (EMU)), their task was particularly securing financial and economic stability in view of the common EU interests. Moreover, Latvia and the other Baltic states have to meet Maastricht convergence criteria to join the EMU, respectively the Euro Area.
As already mentioned, all three Baltic states hold a rather rigidly fixed exchange rate regime, where Estonia and Lithuania follow the currency board regime with the euro (EUR) and Latvia follows the quasi currency board with SDR. Latvia adopted the fixed exchange rate regime in February 1994, when the Latvian lat was pegged to the SDR- Basket of Currencies. This fixed peg has remained unchanged ever since. The Estonian monetary regime, where the Estonian kroon was pegged to the German mark in 1992, was unchanged until 1999 as the Estonian kroon was then pegged to the euro. To come back to the criterias which have to be fulfilled by the Baltic countries for joining the EMU, let us first have a view look at one example, here Latvia:
One of the convergence criteria is the participation in the Exchange Rate Mechanism II (ERM II) for two years, where Latvia joined already on May 2, 2005.
That means that, for at least two years with the introduction of the Euro in mind, the lats will have to be pegged to the euro, with the fluctuation margins of the lats exchange rate against the euro not exceeding more than +/-15% against the lats/euro peg rate.
To achieve the key objective central banks usually select a defined monetary policy strategy.
The Bank of Latvias strategy is the Exchange Rate Strategy, where the fluctuations of the national currency are limited within a definite range (in Latvia: +/- 1%) or the national currency is pegged to a single currency (in Latvia: the EUR). The external stability of the national currency is the target of Latvia`s central bank (E.g. the peg of the lats to the euro at 1 EUR = 0.702804 LVL). The Bank of Latvia has chosen this strategy, because a fixed exchange rate policy is one of the best possibilities to keep inflation low, stabilising the macroeconomic environment and increasing the trust in the own currency and macroeconomic policy of the central bank. Foreign trade plays an important role in such a small economy like Latvia and therefore the foreign exchange rate policy is very important, too.
[...]
[1] cp. Dr. Erika Sumilo, “Trade and Trade Policy Developments in the Baltic States after Regaining Independence,before joining EU“, University of Latvia,Riga (2006), p.2 et seq..
[2] cp.“The Baltic Outlook“, Macro-outlook (May 2007), Hansabank/Swedbank, p. 3-10.
[3] cp.“The Baltic Outlook“, Macro-outlook (May 2007), Hansabank/Swedbank, p. 3-10.
[4] cp. Kalev Kukk, “Five Years in the Monetary Development of the Baltic states: Differences & Similarities“, Bank of Estonia Bulletin 5 (1997), p.4 et seq..
[5] ibid.
[6] cp. Kalev Kukk, “Five Years in the Monetary Development of the Baltic states: Differences & Similarities“, Bank of Estonia Bulletin 5 (1997), p.4 et seq..
[7] cp. http://www.bank.lv.
[8] cp. http://www.lb.lt.
[9] cp. http://www.bankofestonia.info.
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