Risk assessment: the financial system is resilient to war and inflation effects, but the heating up of the housing market is a cause for concern
Lithuania’s financial system has successfully coped with the pandemic and is broadly resilient to the consequences of Russia’s war against Ukraine and the risks of prolonged high inflation and possible increase in interest rates. However, the heating up of the housing market is a cause for concern: as property prices continue to rise rapidly, there are more and more signs of overvaluation and unsustainable growth.
“As the global and European economies were climbing out of the economic pit caused by the pandemic, we found ourselves in a new phase of uncertainty due to Russia’s war against Ukraine. As a result, the Lithuanian financial system and the economy as a whole are facing significant challenges. The heating up of the housing market and the widening gap between housing supply and demand are also worrying,” says Gediminas Šimkus, Chairman of the Board of the Bank of Lithuania.
In its latest Financial Stability Review, the Bank of Lithuania identified three main risks to the country’s financial system.
Risks posed by Russia’s war against Ukraine. The commodity price shock and the substantial severance of trade links with countries affected by the war may make it difficult for some companies to repay loans. This could lead to losses for banks and negatively affect overall economic growth. The threat of cyberattacks has also increased because of the war. However, the Bank of Lithuania’s stress testing of banks under various adverse scenarios shows that the country’s banks are capable of withstanding much bigger shocks. Even in a particularly adverse scenario, if Lithuania’s GDP were to contract by 6.5% in 2022, banks would exceed their capital requirements with a large margin and withstand a decline in deposits of more than 40%.
Risks from prolonged high inflation and possible increase in interest rates. Vulnerable households and businesses might face problems making loan repayment contributions if high inflation persists and interest rates rise. However, according to the Bank of Lithuania, this risk is mitigated by the significant savings accumulated by households during the pandemic and the capital buffers of companies and banks. Moreover, higher interest rates will have a positive impact on financial stability in the long term as they will help to dampen inflation and cool down the real estate market.
Risk of potential overheating of the housing market. As housing prices, which have risen rapidly during the pandemic, begin to deviate from fundamentals, there are more and more signs of unsustainable real estate market development, ultimately leading to the increase in the risk of falling prices and consequent growth of losses. The Bank of Lithuania estimates that housing prices currently exceed the values based on fundamental factors, which include economic, income or population growth, by about 9%. The rapid price growth is mainly driven by a widening gap between housing demand and supply. During the pandemic, demand for housing increased significantly, while the supply of new housing remained almost unchanged and has even been falling recently. Furthermore, in the short term, the supply of new housing may be constrained by the increase in construction prices reflecting the rise in raw material prices, and by the possibility of building permits being granted.
Having assessed the potential risks, the Bank of Lithuania has already taken precautionary measures and tightened the down payment requirement for the second and subsequent housing loans and introduced the capital requirement of 2% for housing loan portfolios of banks. These measures will cool down the market of investment transactions with loans but will not directly affect the market for dwellings bought with own funds, which are most numerous. This necessitates additional measures affecting the whole market, the adoption and application of which requires decisions from other national authorities.
The Bank of Lithuania welcomes the ongoing discussion on the revision of the universal real estate tax pattern and is currently examining the submitted proposals. A properly calibrated real estate tax could reduce excess demand for housing and thus help balance the real estate market. According to the Bank of Lithuania, the real estate tax should be universal, without many exemptions to avoid the tax, it should be at a progressive rate and apply to the aggregate value of the real estate owned rather than to individual objects. Moreover, in the current context, ensuring a flexible and sufficient supply of housing is crucial.
Financial Stability Review is published by the Bank of Lithuania on an annual basis. Its purpose is to assess potential risks to the Lithuanian financial system and identify possibilities of addressing them.