Thursday, July 05, 2007

Latvian housing bubble, part 3

Latvia is probably having a housing bubble now, with apartment prices having increased 61.2% in one year. This bubble has been largely fueled by money borrowed by Latvian banks from abroad. What will happen next?

Some people say that the housing prices in Latvia will only keep rising, since the average living conditions are worse than in Western Europe and there are so many people who would like a bigger apartment or house. True, but... the apartment purchases are typically financed by credits from banks and those credits are often financed by Latvian banks borrowing from abroad.

There are two possible events that could decrease the availability of credit (thus bringing down the housing prices):
  1. Increase in the interest rates;
  2. Stricter lending standards.
There is no signs of interest rates increasing but there are reports that Latvian banks are turning down mortgage applicants in larger numbers. An article today says that the amount of money issued in home loans in May was 20% less than in the first months of 2007.

Over the last months, there has been an increasing number of warning signs about Latvian economy. Articles in Latvian and international press, statements by Bank of Latvia. I suspect banks have reacted to that by pursuing more cautious credit policy. Latvian government is also trying to push banks in the same direction, by introducing stricter regulations on credit.

The last two months (May and June) have seen the first declines in housing prices, by 1% and 3.5%. A new report by Latio real estate company says that the number of housing sales has declined 15% in May (compared to April), due to lack of buyers who are willing/able to pay the requested prices. Some sellers are lowering prices, others are waiting.

The real estate companies say that 10-15% drop in prices is possible but they don't expect more than that. Developing...


Edward Hugh said...

Hi LA,

I just want to say thanks for doing this. It is really helpful, and I hope you will continue doing this as we move forward. As you say, at this point it is hard to see what is going to happen, but obviously there is going to be some sort of correction.

One point which came to me last night as I was having supper is that given the level of euro denominated mortgages (70% of total they say), the ECB is effectively doing the tightening in Latvia for you. So we should expect the same pattern as we are seeing in other EU countries who have had stong recent booms, like Spain, Ireland or Denmark. (Denmark isn't in the eurozone but the currency is effectively pegged to the euro, so there are some similarities here with Latvia on this front).

I am following Spain pretty closely (since I live there, or here), and Claus (Alpha Sources) is watching Denmark. There is a similar pattern across these countries but it is hard at this point to say where it will all go.

Speaking to people in banks here demand for mortgages in Spain has all but dried up now. One of the reasons why this is non-linear is that there is a "switch point". Previously people were rushing to get in before prices rose further, now people are holding back to see if they will fall.

One interesting point which is emerging are those who have been caught in the middle. Many people adopted the practice of not selling their old home before they had moved in to the new one they were building. This meant that the payments were out of phase, since people were buying up-front (ie before the new one was built). When prices were rising at 20% a year this made perfect sense. But now most of the people who were in this process can't sell their old homes, and they are having to pay a lot of interest (and increasing) on very large capital sums.

In some ways this could produce something similar to a stock market correction, since these people will have to "fold" their positions at some point by adjusting their asking prices downwards, if the volume of transactions produced was great enough this could trigger a substantial adjustment. At the end of the day all of this is about short term supply and demand and expectations.

"There is no signs of interest rates increasing but there are reports that Latvian banks are turning down mortgage applicants in larger numbers."

The other thing I was thinking about over supper was to do with this. What is going to happen to the peg if there is a substantial slowdown in Latvia? In the same way that the cb can't really raise rates now (due to the danger of precipitating even more capital inflows), it will be difficult to lower rates even if you move into recession, since you will soon have those ambitious carry-trade-oriented Japanese housewives (and others) moving in to work the interest rate advantage.

Basically, more than being driven by interest rates, people may want to "test" the resilience of the Latvian monetary authorities. If you anticipate an unwinding of the peg, then it will make perfect sense to go to Latvia and borrow in Lat and then park the money in (say) euro denominated instruments elsewhere. This is also a way of making the (for these people) desired result happen. Obviously the ECB and the Swedish banks would have to step in and guarantee liquidity, and there would be a battle of wills. But the big underlying question is, given the inflation we have seen, and are still to see given the time-lag in wages arriving to the PPI, just how long can they defend the peg?

At present only questions, but do please keep following all this, since I think it is going to be important.

Edward Hugh said...


I'm back again. Take a look at the charts Claus has prepared on Lithuania for this post. Stay in touch. Unfortunately it looks very much as if things are almost bound to happen now.

This is all happening so quickly.

And Poland is arriving fast in the outside lane.

Societies with these labour supply constraints just cannot grow so fast. The big danger is a "change in sentiment" from the banks and other investors towards the whole EU8. If that happened we would be in all sorts of problems.

Latvian abroad said...

Interesting... I knew the trends were similar for all the Baltics but didn't know the details about Lithuania. Well, their emigration rate to UK/Ireland is the highest in EU8 (after dividing by population it's about 1.5 times the Latvian rate, which is the 2nd highest).

Regarding the peg, there was an attempt to crash it in the described way a few months ago. It resulted in a major shortage of lats, pushing the short term interest rates from 5% to 10% in a few months. Graph here. The Bank of Latvia reacted by letting the rates stay high.

For now, it seems that the major party doing the tightening in Latvia is actually the 4 major Scandinavian-owned Latvian banks. Since they control 70% of mortgage market, their decisions have a lot of effect. They have helped the boom by lending loosely (more loosely then the leading locally-owned banks) and now they are cutting back.

Edward Hugh said...


"For now, it seems that the major party doing the tightening in Latvia is actually the 4 major Scandinavian-owned Latvian banks."

Thanks, yes, this is the picture I was getting. The Economist also has an article which might interest you. They say this:

"Aware of the dangers, the banks, mainly Swedish-owned, are reining in lending. Their share prices wobbled during a brief financial crisis in February. Prudent behaviour by the banks may amount to a monetary tightening on its own."

They mention the peg issue:

"A speculative attack on the lats may tempt some, but it is tricky to organise in Latvia's puny financial markets........If it does run off the road—for example, if it is forced to unpeg its currency—the main victims will be local borrowers and foreigners who have lent to them (in theory, but probably not in practice, Western banks could refuse to bail out local subsidiaries, even if their loan books shrivelled). Any crash in the Baltics is unlikely to affect outsiders' views of other regional economies. The likeliest route for contagion would be to next-door Estonia. It is also overheating, but its somewhat more responsible government has a modest budget surplus.

Basically we have to hope they are right here, since coming off the peg at this point could be really messy. (Incidentally, as I understand the situation Latvia doesn't have an important govt deficit, and the plan agreed back in March targeted at least a balanced budget, so I don't really know what they are on about with this comparison with Estonia). But then we need to think about this point in the BICEPS report:

"We see wage growth as feeding into producer prices after a lag of
approximately 15 months and this in turn feeds into export prices entailing a loss of

so even if wage inflation stops now, producer prices are set to rise for some time to come. It is hard to see how to handle the implications of this and stay on the peg, especially if there is a sharp slowdown in domestic demand, and Latvia needs to live more from exports.

I have a long standing gripe with the Economist - which goes from Japan to India - for the lack of importance they attach to the demographic component in growth, and this time again they do not let me down. They do note this though:

"So how to cool things down? For countries that can do it, keeping their interest rates above the euro's and letting their currencies appreciate helps. So does bringing in foreign workers from places such as Ukraine in order to reduce upward wage pressures. Slovakia is a prime example of how to pull off both tricks."

The thing is they just do not seem to see how general this whole problem may become. Look at the latest unemployment data from Poland. If the labour minister is at all right and unemployment drops below 10% this year this will be significant. This is happening very, very quickly. Poland at this rate would have what, two or three years of fast catch-up growth left before they hit the same wall. And the Ukraine clearly can't feed all the labour markets involved, and certainly not permanently.

The critical factor, IMHO, is when the financial markets wake up to this underlying reality. Then we can see contagion if things go the wrong way. Initial weak-spots are Hungary (as the Economist notes) - I am maintaining a Hungary blog - and Bulgaria, where really the labour market situation can hit very rapidly indeed due to the rate of population decline and the enormous emigration that has been going on, and then, as I say, the problem can hit Poland, as people start factoring-in the future implications.

If you want to speculate further, you could start to think about the implications of any major slowdown in Eastern Europe on Germany, which as I argue in the comments on this post, is very dependent on growth in Eastern Europe for growth in its own exports.

A lot can happen here. In part it depends on how quickly "sentiment" changes, the meme is starting to go the rounds. It isn't just the Economist, as you may have noticed, Claus linked to this piece yesterday in the FT. In the meantime we need to watch and wait.

Edward Hugh said...

Also, I just found this. It isn't clear what it means - it may be to do with money laundering or something - but it certainly won't help stabilise confidence in the banking system.

Latvian abroad said...

I think Economist is right about the Latvian currency peg being very hard to break.

The comparison with Estonia is probably a matter of perception. They've maintained balanced budgets for 15 years (and have widely advertized that as an example of their good policies), while Latvia hasn't. From a practical perspective, Latvia's deficits for last 5 years have been around 1% of GDP which is fairly close to having a balanced budget.

What happens if the "meme" keeps spreading? In short term, that could bring even more tightening by foreign-credit dependent Scandinavian owned banks.

The closure of accounts is probably money laundering related. The Latvian banking sector can be classified into 2 categories: the banks that lend Western money on domestic market (e.g. "Scandinavian 4" that I mentioned) and the banks that primarily serve non-resident (e.g. Russian) customers. Today's reports from Latvia is that AmEx actually closed accounts for 6 out of 10
Latvian banks (not all Latvian banks) and the "victims" are all from the second category.

Anonymous said...

Hello neighbor, I would like to exchange links with your blog. Here is the Estonian Housing Bubble blog. Sorry, currently provided in Russian only.

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