Credit Growth and the CA Deficit

The following charts showing Latvia's deteriorating current account position and annual rates of credit growth come from The Global Financial Accelerator and the role of International Credit Agencies, a Paper presented to the International Conference of Commercial Bank Economists, Madrid, July 2007 by Carsten Valgreen, Chief Economist, Danske Bank







As Carsten says:

Latvia has successfully run a fixed exchange rate regime in recent years with the euro as the anchor. The fixed exchange rate regime has naturally diminished monetary policy’s ability to play a stabilising role in the economy. However, since 2005, the boom has accelerated and changed character. Increasingly it has been driven by the construction sector and the housing market, leading to extreme credit growth, rising inflation and above 25% wage growth.The fixed exchange rate regime has prevented the central bank from tightening monetary policy, and fiscal policy has not really been tightened either. Interestingly, external funding – which in theory should react to the overheating by tightening – has continued to be ample.

Partly this is because foreign banks own the largest banks in Latvia. These banks have continued to compete for market share in what is seen as a long-term growth market, by aggressively promoting credit. Foreign banking corporations fund a large part of Latvia’s current account deficit through their Latvian subsidiaries. Also, speculative funding in low rate foreign currencies has become widespread, cf. chart 4 above. Effectively this has led to a situation where the Latvian central bank had very little influence on credit extension in Latvia. Effectively foreign banks have extended credit in foreign currency to Latvian households and companies, keeping Latvian monetary policy and the central bank out of the loop. In spring 2007, this led to some pressure on the Latvian lati. This was partly ignited by Standard & Poor’s downgrade of Latvia’s sovereign debt. The central bank was forced to defend the currency by selling reserves. Partly this was also fuelled by Latvian politicians being seen to be postponing EMU entry, and by their unwillingness to tighten the fiscal reins. However, generally global markets have proved surprisingly complacent about the situation in Latvia, as is the case in Iceland.