An agreement by Estonia, Latvia and Lithuania to create a pan-Baltic capital market bodes well for the revival of plans for a European Union capital markets union, analysts say.
The plan will also go some way to reducing the overwhelming dominance of banks in lending markets in the Baltic countries by giving the small and medium-sized businesses that account for the bulk of economic activity in the region the opportunity to tap the bond markets.
The finance ministers of the three countries signed an agreement on Nov. 6, 2017, with the aim of strengthening and deepening their markets. One of the primary objectives of the project, which is backed by the European Bank for Reconstruction & Development, is to overcome the limitations the Baltic countries face due to their small size by creating a common market for covered bonds and structured products.
The pan-Baltic market forms part of the EU's plans to establish a capital markets union, or CMU, for the whole bloc by the end of 2019, rather than being a stand-alone project, according to Jacek Kubas, principal, local currency and capital markets development, at the EBRD.
"We are not creating a union within a union," he said.
A team of analysts at Scope Ratings led by John Opie called the agreement struck by the Baltic countries a "sign of progress" toward the completion of the EU capital markets project.
Progress on the wider European project has been slow and, at times, disjointed, since 2014, when EU President Jean-Claude Juncker promised in his maiden policy speech to create an EU-wide CMU. This was followed in 2015 by an action plan announced by the then-EU commissioner for financial stability, financial services and capital markets union, Jonathan Hill.
The U.K.'s vote in 2016 to leave the EU initially dealt a blow to the CMU plans as it raised questions about how such a union would function without the participation of the country with the biggest capital market. Following Hill's resignation in the wake of the Brexit vote, his successor, Valdis Dombrovskis, restated his commitment to developing the CMU but then overhauled the plan in mid-2017. This new plan included nine "priority actions" including a strategy for the development of local and regional capital markets within the EU and looking into the case for an EU-wide passport for financial technology activities.
The Baltic CMU will be an "inspiration" to other EU member states, Kubas said. "We hope that the Baltic capital markets union will demonstrate that even a tiny country can benefit from a capital markets union. A European capital markets union won't just be for large economies like France and Germany."
Small business benefit
One of the main outcomes of the Baltic CMU will be a wider range of financing choices for the small- and medium-sized businesses that account for the bulk of economic activity in the region, but have few options other than banks if they want to obtain debt, Kubas said.
SMEs generate 50% of economic output in the Baltic economies, while micro-enterprises (defined as businesses employing less than 10 people) contribute 21%, according to 2014 data from Eurostat, the EU's directorate for statistics. By comparison, SMEs generate 36% of growth in the EU 28 economies combined, with micro-enterprises contributing 21%.
Banks are the dominant source of financing for corporates of all sizes in the Baltic countries: in the three years to 2015, bank lending made up 93% of corporate debt, with the remaining 7% from bonds. By contrast, bank debt made up 76% of corporate debt in the EU as a whole during that period, with corporate bonds accounting for the remaining 24%, according to a report by the Association for Financial Markets in Europe (AFME) and New Financial, a think tank which believes that Europe needs deeper capital markets.
But credit supply from banks in the Baltics has been tight in the years following the 2008 global financial crisis, and this is often cited as a constraint on economic growth, according to the AFME/New Financial report. The banking industry is also "highly concentrated," according to Scope Ratings, with subsidiaries or branches of Nordic institutions dominating lending activity. Swedbank AS, the Estonian arm of Swedish lender Swedbank AB (publ) is the largest lender in the Baltic region by total assets.
However, banking industry insiders say they are happy about the prospect of a more diverse funding market:
"On [the] one hand the pan-Baltic capital market initiative could create certain competition for banks, but we welcome this competition and view it as healthy and needed, as it could foster even more broad-based economic growth," Sanda Liepina, chair of the Association of Commercial Banks of Latvia, said. "On the other hand the initiative could also create opportunities for banks to diversify their funding sources through issuing covered bonds and expanding into investment banking activities."
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