We invite you to analyze the role of commercial banks in the Baltic economies before and during the crisis. The role of banks is best characterized by cash flows to and back Baltic economies generated by commercial banks. They provide loans to businesses, other entities, individuals, to households. The total volume of loans issued is regularly, every month, recorded and made publicly available on websites by the central banks of countries. Anyone can quickly assess the difference between domestic credit at the beginning and end of a certain period to measure the commercial banks’ financial injection into the economy during the selected period. Measuring the flow of credits according to the country’s gross domestic product might be convenient, which is also publicly available quarterly in the national statistics departments. In Fig. 1, we demonstrate the Lithuanian quarterly GDP relative annual growth (percent) since 1994 and compare it with the quarterly domestic credit growth as part of GDP measured quarterly.
Fig. 1. Lithuanian Quarterly Domestic Credit growth (blue) and Quarterly GDP annual growth (green) as a percent of GDP.
The impact of domestic credit on GDP has to be evident to everyone interested in economics. Nevertheless, so detailed quantitative relation observable in Lithuania from 2000 until now should cause surprise even for professionals. Such a coincidence can not be universal, whereas GDP growth depends on a significantly greater number of circumstances. Foreign direct investment, public investment, tax, and other business conditions are worth mentioning. However, the observed coincidence in the period considered exists and needs clarification. First, let us note here that GDP is measured at current prices and therefore expresses not only economic growth but also the extent of inflation. Even before the crisis, in the article Reasonable inflation (Dėsninga infliacija), we presented thoughts on economic growth and inflation in the Baltic states. So, the period before 2000 was marked by high GDP growth and high inflation due to the natural integration of new economies into the European economic space, in which the price level of all goods and services was much higher. At that time, inflation was also a hot topic of debate, and one can find our thoughts on the matter in the article The Baltic Paradox. By 2000, the prices of internationally traded goods and services leveled off with western, and the prices of local goods and services rose much more slowly as anchored to the slowly changing wages. The Russian crisis and the subsequent economic downturn also contributed to the end of inflationary processes. Baltic countries with a very low inflation rate, the national currencies tied with Euro, and a relatively lower wage level have become an excellent region for internationally active banks to employ free financial resources. That period coincided with the worldwide process of real estate appreciation, exhibiting the heating of the world economy due to the high money supply. Due to their geographical location, market futility, and lack of international marketing experience, Baltic countries struggled to attract foreign investment. Therefore, opening up new lines of credit has become practically the only natural growth resource. Some believe that the Baltic countries had to restrain using this resource, and central banks have had to limit the scope of credit and thus substantially reduce economic growth and inflation. In our view, only a more stringent selection of the areas of credit and projects could be meaningful and more strict control of budget expenses.
Fig. 2. Latvian Quarterly Domestic Credit growth (blue) and Quarterly GDP annual growth (red) as a percent of GDP.
Fig. 3. Estonian Quarterly Domestic Credit growth (blue) and Quarterly GDP annual growth (black) as a percent of GDP.
Latvian Domestic Credit and GDP growth coincide as well as Lithuanian does. One can clearly distinguish the noticeable acceleration of the recovery of GDP after the Russian crisis. It is also important to note that Latvia has achieved more than one and a half times the scale of domestic credit, giving rise to a higher GDP and price growth. Estonian domestic credit and GDP growth correlation are much less expressed. GDP after the crisis in Russia has recovered more quickly, but its response to the credit boom is significantly lower than that of Lithuania and Latvia. Full details of the differences require more profound analysis. Still, the data suggest that Estonia stands out by foreign direct investment (the neighborhood with Finland and its impact ) and tighter fiscal efficiency measures, which reduce their response to the credit boom. The most important finding of the analysis is that the economic development of the Baltic States during the period before the crisis was caused by the foreign banks’ credit policies. Since this was a decisive factor in the rapid economic growth, banks’ sudden and radical reaction to the global financial crisis has dealt a painful blow to the three countries. A sharp decline in the short term of credit flow has become a massive extraction of the financial resources of the Baltic states. It is evident that no economy, even the healthiest, would not withstand a financial shock of such size. Latvia has suffered from the change of 30% GDP financial inflow to the 10% GDP extraction of financial resources. Only the Lithuanian financial shock was slightly lower, but its impact on the economy is comparable.
We need an answer as to whether such a banking policy of foreign banks in the Baltic States is reasonable. The sharp GDP decline in 2008 followed a rapid change in banking policy. Banks’ losses related to customer insolvency could be much lower if domestic credit flow were smoother. Undoubtedly, the losses of Baltic economies due to the credit crunch are incomparable to the banks’ losses. As the financial crisis is a global phenomenon that is likely to avoid a loss was impossible. Still, losses in the Baltic countries could have been considerably reduced if the Scandinavian banks had acted like in the home countries. Today, the chances of survival seem plausible, but the Baltic countries must learn a lesson. The global financial order has not changed, and the new financial shocks may be repeated. It does not mean that all responsibility should be transferred to the banks. State as well by the tax and other legal means, has to direct the use of credits producing a return rather than current consumption. The pension system and other social guarantees may not be based on the temporary turnaround produced by consumption credits.
It is worth glancing at the adjacent Polish economy during the period since, formally speaking, there has not been recorded negative GDP growth. However, macroeconomic indicators are very closely related to the monetary policy, it is easier to say, to the currency, which is a unit of macroeconomic measurement. From our point of view, cross-comparison of changes in GDP when calculated in different currencies with considerable fluctuations can be misleading. The scientific approach requires that the units be uniform for comparison. It is easy to see that the fluctuations in the national currency may alleviate fluctuations in GDP. Still, whether smother numerical change reflects the actual macroeconomic developments is a serious issue. In Figure 4. we present the Polish domestic credit to GDP changes. There is an additional curve in black exhibiting GDP changes in Poland when GDP is converted into euros according to the quarterly average exchange rate of zloty.
Fig. 4. Polish Quarterly Domestic Credit growth (blue), Quarterly GDP annual growth (orange), and Quarterly GDP annual growth measured in Euros (black) as a percent of GDP.
The situation in Poland is different from the Baltic states in several ways. Although the correlation between domestic credit and GDP growth is also evident here, differences are much more expressed. The overall level of credit and its impact on the economy here is much lower. If in the Baltic states, Lithuania and Latvia, in particular, changes in credit go ahead of GDP, in Poland, GDP changes go ahead of domestic credit. It appears that creditors are more responsive to the overall economic change. GDP changes measured in the zloty are less volatile here: even in a deep worldwide crisis, only positive changes in GDP are observed in Poland. In our view, this phenomenon is deceptive. To compare with other states, one must use the same units of measurement. Changes in GDP, calculated in Euros, black line in Fig. 4., have similar fluctuations as in the Baltic states. Even more striking observation in Poland is around a critical period of 2003. The response of Poland to the global financial crisis looks as deep as in the Baltic States. Therefore, it is better to make reliable conclusions on the preferable exchange mechanism after recovery from the global financial crisis.
A much more comprehensive study of the global crisis’s impact on national economies is needed. Naturally, banking analysts are slow to explain the role of banks in emerging economies, and other professionals have to assess changes and offer prescriptions to countries on how to reduce the role of financial speculations and global financial instability.