Since 2000, the Lithuanian economy has flourished. With GDP growing on average 7% a year and salaries by 9.1% (reaching more than 15% in the past four years), this was an economic miracle. The jobless rate was low, the currency stable.
Much of this miracle could be attributed to the expansive lending enabled by a steady flow of relatively cheap money that Scandinavian banks supplied to their subsidiary banks in Lithuania. This process helped to change consumption habits, boosted living standards and created sheer optimism about the future.
The composition of financing flow has changed: from 2005 to 2008, the share of lending to financial services, industry and trade decreased by almost half, yet total lending increased. This was because lending to the private sector (both mortgages and consumer loans) and to real estate almost doubled and together accounted for 56.8% of the total lending portfolio at the end of 2008, compared with 30.4% at the end of 2004. That is understandable, because the possibility to consume immediately instead of saving and consuming later, was not accessible to the Lithuanian nation for most of the 20th century. Huge demand for new housing and a lack of modern commercial property made real estate the fastest growing sector in the local economy, and this had an indirect stimulus on other sectors.
Most of this credit expansion was provided by inflows of foreign money into Lithuanian banks. From 2005 to 2008, local credit growth was almost double local deposit growth. In this period, foreign parents, mostly Scandinavian, put about €9.8bn into the Lithuanian economy via their subsidiary banks, including more than €3bn each year in 2007 and 2008. Such a flow made it difficult for consumers to resist borrowing, with real estate prices rising at double-digit rates for the past few years, and banks eased lending standards.
Yet, in the recent financial turmoil, such a financing model and lending practices has had clear weaknesses. Almost at once, the freeze-up of international money markets cut off access to cheap money for Lithuanian banks and they needed to rely more on a local deposits market already under stress and facing high competition. Local interest rates skyrocketed, borrowers had difficulties servicing their loans and there was almost no possibility of accessing new credit in the way they used to. This is the time to learn how to borrow responsibly, to align optimism to economic realities – this will help the economy to move on.
The recent crisis will even out some of the discrepancies in the economy. Some of these were evident, such as low-skilled construction workers earning many times more than high-skilled professionals in other industries, as a result of the temporary spike in demand for such services. Some of these imbalances were more technical, such as broad macroeconomic concepts such as the current account deficit, which in the final quarter of 2008 contracted to 3.8% of GDP from as much as 13.5% of GDP one year earlier. Such adjustment reduces pressure on Lithuanian litas, the national currency, which is pegged to the euro.
Having sufficient coverage by foreign exchange reserves and with the current account deficit almost closed, this leaves the question of any currency devaluation more of a political issue. The damage done by such a move would probably hurt national wealth and the political will is therefore strong on this point. With 63% of loans in euros and 74% of local deposits in litas, devaluation would wipe out depositors’ value and make payments of loans unbearable, hurting the asset quality of Lithuanian banks.
Lending penetration in the Lithuanian economy is not as deep as it is in the country’s neighbours, and there is still a lot of room to expand. But more cool-headed demand, and stricter standards of lending are needed as pre-condition of economic recovery.