The Baltic states' housing bubble was an economic bubble involving major cities in Estonia, Latvia and Lithuania.Kallakmaa-Kapsta, Angelika, (2007), Factors influencing developments in the real estate market, Bank of Estonia, Kroon and Economy, http://www.eestipank.ee/en/publication/kroon-economy/2007/no-2-2007Kallakmaa, A. Before and After the Boom : Changes in the Estonian Housing Market. The three Baltic countries had enjoyed a relatively strong economic growth between 2000 and 2006, and the real estate sectors had performed well since 2000. In fact, in between 2005Q1 and 2007Q1, the official house price index for Estonia, Latvia and Lithuania recorded a sharp jump of 104.6%, 134.3% and 106.7%. By comparison, the official house price index for Euro Area increased by 11.8% for a similar time period.
The housing price correction had begun in Estonia by mid-2007 followed by Latvia and Lithuania in mid-2008. Subsequently, Latvia and Estonia experienced recession by first half of 2008, while Lithuania had experienced a slowdown in its economy by the first half of 2008.Servaas, D.; Elena, F.; Gabriele, G.; and Alessandro, T.(July 2010)The Tale of the Baltics: Experiences, Challenges Ahead and Main Lessons. European Commission The situation worsened after the 2008 financial crisis, sending the entire region into a full-blown recession. All three countries experienced recession by 2009.
The increase of credit supply to private sectors was largely to be blamed for the housing bubble in the Baltic states, due to the availability of financing from foreign lenders (predominantly Scandinavian banks). Domestic banks (notably Parex Bank, a national bank in Latvia) were largely reliant on rolling their foreign loans (denominated in Euro) with large exposure to the real estate sector.Lina, B.; and Daniel, K.(December 2012)Real Estate Price Dynamics, Housing Finance and Related Macro-prudential Tools in the Baltics. European Commission The condition was further worsened due to the absence of loan-to-value ratio as well as negative real interest rate which spurred speculators to drive the market housing demand higher. The credit supply was then deteriorated at the peak of the boom as both foreign and domestic banks tightened lending standards due to the higher credit risk in the region. Subsequently, real estate market were dragged down, further deteriorate credit quality, forced banks to further tighten lending standards.
The severity of the crisis differed from one to another; with Latvia was the hardest hit by the crisis. Latvia applied for balance of payments support from International Monetary Fund, the European Union and regional members in November 2008 in order to strengthen the fiscal situation following the bail out of Parex Bank (largest bank in Latvia).Kristina, M.; and Liva, Z.(2013)Economic Miracle in the Baltic States: An Exemplary Way to Growth?. Jacques Delors Institute Lithuania experienced lesser impact from the crisis compared to Latvia, as it adopted significant austerity measures and more stimulus measurements compared to the both Baltic states. Nevertheless, public sector wage faced cuts as well as lesser social benefits.European Commission (2010)Assessment of the Action Taken By Lithuania and Romania. Communication to the Council Estonia, on the other hand, saw the public sector wages and benefits slashed in order to improve the budget balance in preparation for the adoption of euro.Kattel, R. and Raudla, R.(2013).The Baltic Republics and the Crisis of 2008-2011. Europe-Asia Studies
Background The economy in the Baltic states had been among the fastest growing in the European Area following the collapse of the Soviet Union as well as the recession due to 1998 Russian financial crisis. To minimize its dependence on Russia, the Baltic states opted to integrate closer to the Western Europe. By early 2000, the Baltic states' economy had begun to grow, to some extent higher than some of its Euro Area counterparts. Following the EU accession of Estonia, Latvia, and Lithuania in 2004, the period in between 2005 and 2007 witnessed an overheated economy of the three Baltic states. A combination of growth above potential, high inflation and far widening of the current account deficit were singled out as causes behind the overheating economy in the Baltic states.Lamine, B. (2008) Estonia: Overheating and Sectoral Dynamics.ECFIN Country Focus A credit boom in addition to bullish real estate investment spurred by foreign banks (predominantly Scandinavian Banks) worsened the scenario. All these factors led to a housing bubble in the Baltic states, piloting the real estate sector beyond sustainable.
Table 1: Key economic indicators for 2005–2007
Estonia Main economic indicators 2005 2006 2007GDP (real)10.511.27.1CPI average4.14.46.6Current account deficit (% of GDP)-10.3-15.5-17.4Foreign direct investment, net inflow (% of GDP)22.513.215.6Unemployment rate (%)7.95.94.7Gross wage (in €)555596784Real estate/construction/finance (% of GDP)10.6/8.6/3.610.4/9.9/4.010.3/10.7/4.0
Latvia Main economic indicators200520062007GDP (real)10.611.910.2CPI average6.76.610.1Current account deficit (% of GDP)-12.5-22.3-22.8Foreign direct investment, net inflow (% of GDP)5.18.59.4Unemployment rate (%)8.76.85.4Gross wage (in €)350430683Real estate/construction/finance (% of GDP)7.7/7.0/4.37.9/8.5/5.68.2/10.4/5.4
Lithuania Main economic indicators200520062007GDP (real)7.97.78.8CPI average2.73.85.7Current account deficit (% of GDP)-7.2-10.8-13.7Foreign direct investment, net inflow (% of GDP)4.66.85.9Unemployment rate (%)8.35.64.3Gross wage (in €)421459594Real estate/construction/finance (% of GDP)6.4/7.8/2.26.5/9.4/2.76.5/11.2/3.3 (Sources: Eurostat, World Bank)
Indicators of overheating economy in Baltic states: Unsustainable economic growth: All three Baltic states experienced very high market growth compared to the rest of Euro Area. The real GDP for Latvia achieved double digits for three consecutive years from 2005 and Estonia for two consecutive years from 2005. Even the real GDP for Lithuania from 2005 to 2007 is considered higher than the average growth in the Euro Area. Such high economic growth largely due to their measurement to attract foreign capital to their shore.Yoji, K.(September 2010)Economic Crisis in the Baltic States: Focussing on Latvia. Volume LV, July – September 2010 In Estonia, the amount of foreign direct investment (FDI) inflow hit as high as 22.5% of GDP and maintained the inflow in double digits up to 2007. Both Latvia and Lithuania managed to attract substantially high FDI to their shores though a much lesser share compared to Estonia. In all three Baltic states the majority FDI directly benefited the real estate and construction sectors. Unlike their preceding years, manufacturing sectors received far less than the real estate and construction sectors. Economists at the UniCredit Group opined the growth rate as consumption-led economic growth, with trade, finance, commercial services, real estate and construction fuelling the growth. Simultaneously, external imbalances became more worrying as the imports were growing twice as fast as the exports. Inflow of "hot money" abroad: The lion's share of investment flows came in the form of foreign credit, to a smaller extent in the form of foreign direct investments and portfolio investments. The degree of foreign ownership in Baltic banking is quite high, thus majority credit growth was largely financed by heavy borrowing of the biggest players in the lending market from the parent banks.Olga, E.(2010)Baltic States: Credit Crunch or Return to Equilibrium Level?. International Conference On Applied Economics Consequently, there is a sizeable inflow of debt (denominated in foreign currency) into the banking sector from parent banks to support the credit growth in the Baltic states. Throughout 2004–2007, total loans outstanding grew by 30-60% annually in the Baltic states with majority of loans granted to mortgage loans. Labour market tightening: Following the EU accession, many low-skilled workers, especially Latvian and Lithuanian, left their homes to emigrate to the United Kingdom and Republic of Ireland for better wages. The biggest impact was on the unemployment rate in the Baltic states. Estonia saw its unemployment rate fall from as high as 11.9% in 2001 to 4.7% in 2007.Pan European Institute (2009)Baltic Rim EconomiesIssue No 6,11-12-2009 The unemployment rate in Latvia was down from 12.1% in 2001 to 5.4% in 2007, while Lithuania's was from 17.4% in 2001 to 4.3% (Institute, 2009). As a result, the labour market became tight – which forced the nominal wages to rise in an accelerative manner for two successful years in Estonia, Latvia and Lithuania. Such a rise in the nominal wages actually fanned the inflation besides eroding the competitiveness of the affected Baltic states – due to a widening current account balance. Fiscal policy: In Estonia, the biggest issue lay on the current account deficit which was contributed by the rapid credit growth, which in return stimulated demands for importsFredrik, E.(2010)Baltic Economic Reforms: A Crisis Reviews of Baltic Economy Policy. European Centre for International Political Economy Working Paper The deficit was largely financed by a combination of FDI inflows, excessive borrowing by domestic bank from foreign parent banks, and an increase access to EU funds. On the positive side, Estonia was running on a surplus to enable the government to repay debts. In order for Estonia accession to the EU, Estonia had largely maintained a surplus till before the crisis, to fulfil the Maastricht Criteria of a budget deficit below 3% of the GDP. Thus, Estonia maintained the position as having the most stable public finances during the crisis. The situation in Latvia was far more worrying than its two neighbouring countries. By 2005, the International Monetary Fund (IMF) issued a caution to Latvia in order to minimize the economic risk from overheating.Janis, K.(2013)Study on the Economic and Social Situation in the Baltic States: LatviaEuropean Economic and Social Committee Latvia only responded by 2007 by clamping down on the credit market when inflation had skyrocketed to double digits. The scenario was further worsened due to its budgetary policy always having a deficit due to the incorrect assumption that the economy would always perform stronger than expected. In Lithuania, certain government policies caused much controversy in clamping down on the overheated economy. For instance, income tax incentives for individuals taking housing loans and an absence of a property tax appeared to lend support to credit and housing price growth.Raimondas, K.; Tomas, R.; Lietuvos, B.(2009)From Boom to Bust: Lessons from Lithuania "Red tape" among the highly bureaucratic central and municipal governments distorted the market supply and demand equilibrium for housing. During the economic overheating, the ruling democratic coalition reduced tax and increased government spending on social programmes. The wages for the public sector also stoked up the inflation rate, besides worsening the current account deficit.