Financing of the Economy

The report "Financing of the Economy 2024", the second analytical issue in this series by Latvijas Banka, offers a detailed assessment of access to lending and other financing sources in Latvia and analyses factors which have limited access to financing in Latvia over the past years. The report concludes that while some improvements have been noted since the previous report on financing the economy, there is still significant room for further progress.

Kārlis Vilerts, Head of the Research Division of Latvijas Banka and one of the report's authors, notes:
"A robust financial sector that ensures stable access to financing for companies and households is crucial for fostering healthy economic growth. The corporate lending segment shows little sign of positive change, while other lending segments, such as housing lending, are showing slight improvement. The markups on housing loans have decreased, though they remain at a high level. In 2018, households aiming to receive a loan for house purchase or construction were subject to a markup of roughly 2.4%, but in early 2024, the average markup stood at 1.6%."

The lower markups benefit not only those seeking a new loan, but also those who have already been granted loans, as they now have the opportunity to refinance their loans under more favourable conditions. This is particularly relevant in light of the regulatory amendments introduced at the beginning of 2024, which have substantially reduced the costs associated with refinancing housing loans.

Lending in Latvia remains sluggish

Latvijas Banka's analysis suggests that lending in Latvia remains sluggish, with loans to non-financial corporations and households accounting for only 27.5% of gross domestic product (GDP) in the first quarter of 2024. Beyond the cyclical factors and monetary policy tightening that hinder lending across the euro area, structural issues, such as the high lending rates and strict collateral requirements, further constrain lending in Latvia.

Lending rates remain among the highest in euro area

Lending rates in Latvia and the Baltic States overall remain among the highest in the euro area. This is particularly evident in the housing loan segment. In the first quarter of 2024, interest rates on housing loans in the Baltic States were 2 percentage points higher than the euro area average and well above the nearest followers.

This is partly due to the high share of loans with variable interest rates in the Baltic States. Elsewhere in the euro area, fixed interest rates – that remain unchanged for the term of the loan agreement or adjust less frequently, thereby protecting borrowers from fluctuations in short-term interest rates – are far more common.

Latvia should also seek solutions to broaden the range of interest rate fixation options and make them more attractive for borrowers. This would expand the range of loan options and allow borrowers to shield themselves from frequent changes in interest rates.

The corporate lending segment shows little sign of positive change

Interest rate markups have remained high and, combined with a large share of variable interest rate loans, have resulted in very high lending rates. To improve the lending conditions, competition in corporate lending must also be intensified, with one option being a reduction in loan refinancing costs.

For companies, loan refinancing costs include not only the fee for the new loan agreement (around 1% of the loan amount), but also a fee for early repayment (around 2% of the outstanding loan amount), and represent a significant burden, reducing the likelihood of refinancing.

Therefore, Latvijas Banka proposes to prohibit the fees for the early repayment of loans or for their refinancing with another lender.

Non-bank sector

The non-bank sector has become increasingly important in financing the economy. This is especially true for non-bank lenders which have increased their financing to both households and non-financial corporations.

Notably, the demand for these relatively costly loans has risen despite sustained improvements in the financial health of Latvian households and companies.

This testifies to the ability of these service providers to find a solution that seems acceptable to an increasing number of companies.

The non-bank sector has become increasingly important in financing the economy, and this is especially true for non-bank lenders

The economic shocks experienced over the past couple of years have thus far failed to leave a lasting impact on the financial situation of Latvian companies and their willingness to invest, despite there being some variation across sectors. Overall, the indicators of corporate financial health have remained stable, and the willingness of companies to invest continues to be solid. Looking ahead, lower interest rates and higher economic activity will further support the need to finance corporate investment.

At the same time, access to financing is constrained by the high cost of financing and stringent collateral requirements, which reduce corporate demand for bank loans and force them to rely on their own funds as well as other alternatives.

Lending outside Riga

The availability of financing across Latvian municipalities is very uneven. This is clearly shown by differences in housing lending. The amount of outstanding housing loans in Pieriga municipalities comes close to the euro area average. Meanwhile, in other regions of Latvia, lending activity remains very sluggish, accounting for no more than 10% of municipal GDP. This also applies to the State cities and municipalities with a high level of economic activity.

These disparities stem from several structural issues that hinder lending development in the housing market, including the widespread shadow economy, the gap between real estate valuations and construction costs, as well as various loan supply constraints (minimum amount, etc.).

To address these issues, a wide range of policy measures is needed, including reviewing regional lending support programmes which have already been discussed with AS Attīstības finanšu institūcija Altum, and reducing the state fee for registering property rights in the Land Register.

The report "Financing of the Economy 2023" prepared by Latvijas Banka offers a detailed assessment of lending and other financing sources in Latvia and analyses factors which have limited access to financing in Latvia over the past 10–15 years.

Kārlis Vilerts, Head of the Research Division of Latvijas Banka and one of the authors of the report, points out that robust access to financing is an important part of a healthy economy as it supports investment activity and so also economic growth. Having a financial system that functions well is consequently a key criterion that must be met to strengthen a country's economic development in the long run.

Lending activity is now a third of what it was at the time of the global financial crisis relative to the size of Latvia's economy, as outstanding loans amounted to nearly 90% of gross domestic product (GDP) back in 2011, whereas they stood at a mere 27.1% of GDP in the second quarter of 2023. The decline in the level of over-indebtedness following the global financial crisis was initially justified, but lending remained weak even despite the financial situation of households, companies and the government improving significantly. The reasons for the prolonged and substantial decline in lending volumes can be found on both the demand and supply sides of financing.

The report identifies both supply and demand side factors that are inhibiting lending.

The most important conclusion is that the decline in lending activity in the corporate segment comes more from the access to financing being limited than from companies being unwilling or unable to borrow. That the decrease in lending activity has been observed simultaneously with an improvement in the financial situation of companies points to the availability of loans having deteriorated.

The financial situation of households, together with their ability to take on new debt has improved considerably, but this has not been reflected in a significant expansion of lending for housing. There was much less activity in the construction of new housing than in Lithuania and Estonia. The reasons for this lie in several structural flaws, such as bureaucratic obstacles to the construction process and the relatively high lending rates and limited availability of loans in the regions of Latvia away from the capital.