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Baltics take first step towards regional capital market

Recognising there is strength in numbers, Estonia, Latvia and Lithuania are joining together to created a pan-Baltic capital market, with covered bonds the first product planned. Michael Turner reports.
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The Baltic states of Estonia, Latvia and Lithuania are joining forces to create a joint capital market. The pan-Baltic project will not only boost the countries’ financial market capabilities but also support its banks by allowing them to sell covered bonds secured by mortgages from across the three countries – something that is currently not possible.

On November 6, the ministers of finance for Estonia, Latvia and Lithuania – with technical assistance from the European Commission and the European Bank of Reconstruction and Development (EBRD) – signed a memorandum of understanding (MoU) to begin work on the legal framework needed to create a pan-Baltic capital market, paving the way for future opportunities.  

Stronger together

“The three Baltic markets taken separately are quite small with limited resources,” says Aija Zitcere, director of Latvia’s financial markets policy department, the part of the Ministry of Finance responsible for implementing the plans. “With three together, we can achieve more.”

Covered bonds – highly rated debt printed by financial institutions that use another asset such as mortgages to act as security – are the first planned product to go on sale to investors as part of the initiative.

“Due to the size of the populations across the Baltics, and thus the mortgage market, it’s only when you put the mortgages of each country together that it will start to make sense,” says Jacek Kubas, principal in the EBRD’s local currency and capital markets division. “The aim is that banks will be able to pull mortgages from any of the Baltic jurisdictions to use as assets in a covered bond.”

Latvia’s residential mortgage market is one of Europe’s smallest, with just over €4bn outstanding by the end of 2016, according to credit rating agency Moody’s. Meanwhile, Lithuania and Estonia had about €14bn combined of outstanding residential mortgages at the end of 2016.

This means that, individually, the Baltic states each have a potential covered bond market that is tiny compared even to Hungary’s €14bn market, currently the smallest in Europe. A pan-Baltic covered bond market, however, would almost hit €18bn, putting the available asset pool size between Hungary and Slovakia.

International attention

Rating agency Moody’s says that, assuming the joint market goes ahead, Baltic banks will increasingly fund mortgages by issuing covered bonds, which typically have a five to 10-year maturity, rather than relying on uncommitted intragroup and short-term deposits for funding. “In Latvia, we see that banks mostly rely on parent company funding,” says Ms Zitcere. “The market situation has changed and there could be potential issues with that.” Nordic banks, in particular, have a large presence in the Baltics via local subsidiaries.

Internationally, there is likely to be plenty of demand from investors for a Baltic region covered bond. Lithuania and Latvia are already known to international buyers via their outstanding sovereign bonds, and foreign investors tend to consider the Baltic countries as one and the same when it comes to credit analysis.

“A Baltic capital market union as a brand will help to attract foreign investors,” says Sigitas Mitkus, Ms Zitcere’s counterpart in Lithuania’s finance ministry. “And this project will open up new financial instruments. It’s difficult to say how much [extra money could be raised each year], but I think that the situation will [get] better and better.”

Tackling hurdles

Nonetheless, challenges lay ahead for the finance ministries, starting with getting unified cross-border legislation in place. Laws need to be created for cross-border asset transfers, consumer rights and data protection, while avoiding unnecessarily increasing red tape by duplicating regulations.

“There is a need to have political will, and [there is] additional effort to make,” says Mr Mitkus, who did not see any major obstacles preventing the legal framework being created. “We have more similarities than differences.”

Yet, despite the optimism shared by all three ministries when they spoke to The Banker, there are some hurdles to clear. One potential issue is upcoming elections. Latvia is due to hold a parliamentary election by October 2018, while in 2019, Estonia follows suit and Lithuania picks a new president.

“There is always the political risk,” says Kaarel Eller, a lawyer in the financial markets policy department of Estonia’s Ministry of Finance. “It’s hard to say if the elections will make a difference, but if we do not go too much into [politically] sensitive areas such as pension funds, it should not affect the topics we need to agree on.”

A second issue is overcoming potential regional reticence to using a pan-Baltic capital market by both domestic borrowers and investors. “We need local markets to invest so it benefits our economy,” says Ms Zitcere, who notes that the capital market is still a novel route for domestic borrowers to raise money. “The financial market has been dependent on bank funding – we have many banks in Latvia and cheap credit. This has made capital markets less attractive for financing.”

Encouraging regional cross-border investment might be tricky, according to Mr Eller at Estonia’s finance ministry. “We have to manage expectations and have to be realistic,” he says. “One of the big challenges is the cultural and language barrier. There are always some inherent obstacles for investors, even just across one border.”

Useful foundations

There is already some groundwork that will stop the idea seeming entirely outlandish to Baltic investors. The three countries have a joint Nasdaq exchange, called Nasdaq Baltic, which has the same trading rules, market practices, trading system, joint trading lists, consistent indices and a single membership across the three countries.

However, while Nasdaq Baltic opens up the stock exchanges of each country to one another, it does not mitigate the scaling problems that borrowers from each individual state face in trying to tap international markets for funding. This is especially true for small and medium-sized enterprises (SMEs).

SMEs make up a huge part of the Baltic economy, with official statistics putting them at 99.8% of all enterprises, but access to capital markets is limited. “It is hard for them to attract capital markets funding because they are too small,” says Ms Zitcere.

The European Commission and EBRD are designing a financial instrument using the EU Structural Funds mechanism that will help SMEs cover potentially prohibitive costs, such as the price of listing.

“A combined capital market will increase [SME] access to capital markets,” says Mr Kubas at the EBRD. “An Estonian SME listing at Nasdaq Baltic will have access to investors from three Baltic states, and beyond, to buy their shares.”

Baltic ministries are also looking at ways to help shoulder some of the costs of capital markets access. According to Mr Mitkus, the Latvian finance ministry is, for example, working on a “special programme for SMEs, designed in such a way they could be supported by us providing listing support or research cover”.

As well as improving the availability of equity finance, all three ministries are looking to push into alternative funding for Baltic SMEs as part of the planned joint market. “We have new instruments such as crowdfunding and peer to peer,” says Mr Mitkus. “Our banking sector dominates the market, and creating alternative financing options is important.”

Plotting a course

To bring the Baltic capital market initiative to life, a steering committee of specialists from each ministry’s financial markets policy department is due to meet in the first quarter of 2018 – though there are unofficial conversations already under way. “We are talking informally,” says Mr Eller. “We see each other in Brussels often. There is much to say.”

As well as SME funding, the first meeting will focus on how to promote a pan-Baltic asset class and regulation. Everyone The Banker spoke to for this article believes the legal framework will be in place at some point in 2018, and almost everyone says the likely timeline for the first covered bond issue will be some time in 2019. Mr Mitkus even suggests joint covered bond and securitisation products could be expected by the end of 2018.

For now, it seems that the most important factor in seeing a Baltic capital market become a reality is maintaining the initial interest levels in the project. “We had the three ministries together in Brussels signing the MoU, so we now have political agreement at the highest level, but the momentum must keep moving forward,” says the EBRD’s Mr Kubas.

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