Latvian housing bubble, part 2

As I mentioned in the previous post, Latvian real estate prices have increased 61.2% in one year. The most important reason behind that is, probably, the wider availability of bank credit in Latvia.

In 1990s, when I grew up in Latvia, it was fairly common to pay the entire amount upfront, when buying an apartment. The economy was fairly unstable and, if the banks issued credits for purchase of housing, the credits would be repayable in 5 years and would have quite high interest rates (20% or so? I no longer remember exactly). A friend of mine took one of those and then realized that the terms were so bad that he would have been better off if he had borrowed money from friends instead of the bank. This is largely why apartment used to cost 7000 or 20000 dollars those days.

With Latvian economy recovering from the post-Soviet slump and the outlook for the future becoming more certain, banks became more willing to issue long-term loans to their customers. Interest rates fell, 5 year loans were replaced by 15 year, then 30 year, than 40 year. When Latvia joined European Union, the interest rates fall to a level than was just slightly higher than in Western Europe. Latvia had gone from post-Soviet economic chaos to normalcy in just 10 years.

The speed at which credit became available was, however, much faster than the speed at which new apartments were built. And, so, the prices spiralled up. Also, since most Latvians don't have much savings, many of new loans (from 40% to 70%, depending on the bank) have been financed by borrowing from abroad. The foreign banks now saw Latvia as a part of European Union (rather than part of post-Soviet chaos) and were very willing to lend the money. The inflows of credits from foreign banks soon became comparable with the entire export revenue of Latvia:

• Latvian exports in 2006: 3.294 billions lats.
• Money borrowed abroad by Latvian banks in 2006:2.214 billion lats

In short term, this influx has been good for Latvian economy. Whenever someone buys an apartment with borrowed money, someone else gets the money by selling the same apartment. And that money is then spent in Latvia on goods and services, benefitting people who produce or sell those goods and services. Latvian economy has been growing 11% per year, average salaries are growing at about 30% per year. The tax revenues of the government are expected to grow 29.6% this year, which might mean that Latvian teachers will not be as underpaid as they used to be.

In longer term, it is not clear how long those trends will continue. Foreign banks might not be willing to issue new credits in so large amounts to Latvia forever. When the inflow of new credits into Latvia slows down, it can bring down the housing prices and, more generally, slow down the Latvian economy quite a bit.

Part 3 on real estate and Latvian economy coming in a few days...