Summary

In 2021, the global and Lithuanian economies recovered from the COVID-19 pandemic and grew sharply. However, as a result of high inflation and the consequences of Russia’s war against Ukraine, Lithuania’s economy will face challenges in 2022. In 2021, the global and Lithuanian economies grew by 6.1% and 4.8% respectively. The post-pandemic recovery was driven by business adaptation to the new operational conditions, successful vaccination, lifting of mobility and social distancing restrictions, and expansionary fiscal and monetary policies. In 2021, unemployment in Lithuania decreased from 8.8% to 6.6% and reached its pre-pandemic level, while wages after tax increased by 9.4%. It should be noted, however, that annual inflation increased rapidly, reaching 10.7% at the end of 2021 and 18.5% in May 2022. In 2022, economic growth is expected to slow down in Lithuania, mainly due to high inflation, a contraction in trade with Belarus, Russia and Ukraine, continuing disruptions in supply chains, and the recent deterioration in business and household expectations. This will adversely affect the financial condition of some companies and households.

As uncertainty eased during the pandemic, banks’ profits in Lithuania grew in 2021, while the quality of loans and the resilience of banks improved, which will help banks to withstand the risks of the war. The condition of the companies most affected by the pandemic improved, leading to a decline in non-performing loans across banks in the country in 2021 to one of the lowest levels in the EU. Banks’ profits also grew and returned to pre-pandemic levels, allowing banks to expand their lending volumes or build up capital buffers. While concentration of bank assets is still the second highest in the EU, risk appetite grew in 2021 and credit institutions’ active lending to households and businesses increased, leading to a rise in loan portfolios and a decline in interest rates. However, rising inflation and Russia’s war against Ukraine have heightened uncertainty, which may cause borrowers’ situation to deteriorate and bank lending to become more precautionary. Banks in Lithuania still have large capital buffers and are ready to withstand even greater losses than under the adverse scenario (in case of economic contraction by approximately 7.5%).

In 2021, lending for house purchase continued to grow rapidly, and loans for consumption and businesses recovered following the pandemic. In 2021, the housing loan portfolio reached its highest annual growth rate since 2009, which was driven by increased demand for housing during the pandemic. Moreover, amid easing pandemic constraints and improving household expectations, demand for consumer credit recovered, with the portfolio of consumer loans approaching pre-pandemic levels by the end of 2021. As the epidemiological situation and business expectations improved, the state reduced the amount of financial support for companies, while banks became more active in providing financing to businesses. Demand for business investment increased in 2021, with financing being mainly provided to the real estate (RE) operations, trade, and manufacturing sectors, which grew markedly. After the largest contraction in the EU in the first year of the pandemic, the portfolio of loans to non-financial corporations in nominal terms returned to pre-pandemic levels in early 2022.

In 2021, the housing market was heating up: as demand exceeded supply, prices picked up at an ever-faster pace, affordability decreased after a long break, and indications of house price overvaluation appeared, thus increasing the risk of a price correction. There was a significant increase in housing demand in 2021 that resulted in historically high sales, driven by residents’ desire for more spacious housing, strong wage and savings growth, house price increases and fears of inflation. Although more construction permits than ever were issued in Lithuania in 2021, there are significant obstacles to obtaining construction permits in Vilnius. At the same time, the number of homes being built grew only moderately and the number of completed homes declined, leaving housing supply lagging behind the increased demand. Due to supply-demand imbalance and rising construction costs, the annual growth rate of house prices accelerated in 2021, reaching between 21% and 26% in March 2022. According to the Bank of Lithuania, house prices became overestimated by about 9% and housing affordability deteriorated. The increase in housing supply is increasingly constrained by scarcity of building raw materials and rapid increases in construction costs, which may exacerbate supply and demand imbalances and accelerate house price growth. Such rapid price growth is unsustainable and leads to an increasing systemic risk to the country’s financial stability — the emergence of imbalances in the housing market increases the likelihood of a sudden price correction that could turn into insolvency of borrowers, losses for the banking sector, declining lending volumes and slowing economic development.

Russia’s war against Ukraine could negatively affect Lithuanian credit institutions through secondary channels, such as cyberattacks and potentially increasing losses for credit institutions due to the shrinking volume of trade with the war-affected states, rising energy and raw material prices, and deteriorating consumer and business expectations. The transport, construction, manufacturing, energy, and agriculture sectors have the closest trade ties with Belarus, Russia and Ukraine, and it is therefore likely that their profits will suffer the most from trade disruptions and the increase in prices of energy and raw materials. At the same time, rising inflation also has a negative impact on the financial situation of households and companies in a wider range of sectors, which worsens their expectations and may lead to a fall in aggregate demand. These factors may impair the ability of households and businesses to meet their financial obligations, which would result in losses for credit institutions. Finally, because of Lithuania’s political support for Ukraine, hostile states can carry out cyberattacks against Lithuanian credit institutions, which could lead to the withdrawal of deposits. However, the banking sector remains highly liquid and would be able to withstand a 41% fall in deposits.

Due to high inflation and possible interest rate hikes, vulnerable households and businesses may have difficulty in making loan payments, but credit institutions would withstand potential losses. The rapid rise in prices reduces households’ disposable income and corporate profits, resulting in lower funds available to meet loan obligations. In addition, the ECB is increasingly likely to raise its key interest rate in 2022 for the first time in a decade to reduce inflation in the euro area, which will increase loan payments for households and businesses and make new borrowing less attractive. With less available funds and increasing monthly loan payments, the financial situation of some households and businesses could deteriorate, which may lead to losses for credit institutions. On the other hand, the impact of this risk is mitigated by the significant increase in household savings during the pandemic and the large capital buffers of credit institutions that would enable them to withstand even significant losses.

The transition to a climate-neutral economy remains a challenge for Lithuania’s financial system, as well as a possible correction of imbalances in Sweden, with the Swedish capital banks making up a significant share of the banking sector’s assets and lending in Lithuania. As a result of the transition to a climate-neutral economy, manufacturing and transport sectors, which are major polluters and whose loan portfolio accounts for a quarter of Lithuania’s total corporate loan portfolio, will face new regulation and changing consumer behaviour. As a result of these processes, firms from these sectors may face a decrease in competitiveness and profits or even an increase in bankruptcies in the long term, while credit institutions may suffer losses due to an increase in non-performing loans. Imbalances related to the housing market in Sweden remains one of the challenges for Lithuania’s financial system. While household indebtedness and house prices in Sweden reach historical peaks, a more significant economic downturn or an interest rate hike could amplify household insolvency or lead to a correction of house prices. This would cause significant losses to parent banks and could therefore also result in the worsening of financing conditions in Lithuania. Moreover, should Swedish banks decide to curb lending in the Baltic region owing to increased risk, this could result in a slowdown in economic growth and a correction in the real estate market due to weaker demand in Lithuania.

Rapid growth in the fintech sector can pose challenges to the financial system in the long term, thus it is important to increase its maturity in terms of risk and business management. The growing fintech sector contributes to fostering innovation and increasing efficiency and accessibility of financial services in Lithuania. However, the low maturity of the fintech sector also poses related risks. One of them is the risk of money laundering and terrorist financing (ML/TF), which could harm the reputation of the state and of financial institutions established in the country. Moreover, fintech firms are more vulnerable to cyberattacks, and a successfully conducted cyberattack could increase distrust not only of the affected financial institution but also of other market participants. In order to avoid these risks, it is important to increase the maturity of the fintech sector, and the Bank of Lithuania is actively contributing to this goal.

The Bank of Lithuania continues to actively implement measures in order to support financial stability and, in response to the overheating of the housing market, it tightened the down payment requirement and set a 2% sectoral systemic risk buffer (SRB) rate for the housing loan portfolio. As of 1 February 2022, a tightened down payment requirement of at least 30% of the housing value has been applied for the second and subsequent housing loans in order to reduce the riskiness of such loans and to limit investment transactions that are financed with loans. The Bank of Lithuania also decided to apply the 2% sectoral SRB rate to the housing loan portfolio of credit institutions, which entered into force on 1 July 2022. This measure aims to increase the resilience of credit institutions, given the increased risk of overheating of the housing market. The Bank of Lithuania is assessing developments within the financial system and stands ready to introduce, if necessary, additional measures to ensure financial stability.

Dalintis:

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1.The financial system and its outlook

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1.1.Financial market and economic developments

The global economy recovered in 2021 from the recession caused by the COVID-19 pandemic, although GDP growth is expected to slow in 2022, reflecting rising inflation and Russia’s invasion of Ukraine. As estimated by the IMF in April 2022, the global economy grew by 6.1% in 2021 and such growth was broadly in line with the projection for the beginning of 2021. At the same time, GDP growth in the US and the euro area expanded at a similar pace: 5.7% and 5.3% respectively. The recovery was mainly driven by firms which adapted to the pandemic, successful vaccination programmes and the associated significant easing of COVID-19-related mobility and social distancing restrictions, as well as expansionary fiscal and monetary policies in advanced economies. These factors had a positive impact on household consumption and international trade in 2021, although the pick-up in economic growth was constrained by the pronounced disruptions in global supply chains. Ongoing supply chain constraints, together with Russia’s invasion of Ukraine at the beginning of the year and the related sanctions (see Table 1), will speed up energy and commodity price increases and pose higher challenges regarding dependence on Russian energy in the euro area countries. As a result, according to the IMF projections, global growth will slow down to 3.6% in 2022 and to 3.7% and 2.8% in the US and the euro area respectively.

Type of sanctions	Russia	Belarus
Individual	The EU and the US froze assets and imposed restrictive measures on individuals and economic entities.
Financial	The EU banned trading of Russian shares and Russian capital; The Central Bank of Russia’s reserves held in EU jurisdictions were frozen. Seven Russian banks were separated from the SWIFT system, four of which had their assets frozen. The provision of high-value crypto-asset services to Russian entities was prohibited. Sales of financial assets denominated in the currency of any EU Member State to Russia were prohibited.	The reserves of the Central Bank of Belarus held in EU jurisdictions were frozen. Three Belarussian banks were disconnected from the SWIFT system.  Sales of financial assets denominated in the currency of any EU Member State to Belarus were prohibited.
Energy	The US banned Russian oil, natural gas and coal imports.	The EU prohibited trade in mineral fuel.
Transport	The EU and the US banned exports of goods in the aviation and space industry. The EU and the US closed their airspace. It was prohibited to undertake activities (except for transportation of basic goods) in the EU territory. Russian-flagged ships were prohibited from entering EU ports (except for transportation of basic goods).	Belarusian companies were prohibited from using EU airports. It was prohibited to undertake activities within the EU territory (except for transportation of basic goods).
Technology	The EU banned the exports of dual-use goods and technologies, such as semi-conductors, and goods that can be applied in the defence industry.
Visa policies	In the EU, a restricted scheme for granting loans to investors or golden passports was introduced.	The EU and the US tightened the issuance of visas to Belarusian state officials.
Trade and goods	The EU banned steel imports from Russia. The EU and the US banned the exports of luxury goods. The target export bans amounting to EUR 10 billion in the areas where Russia is vulnerable due to goods supplied by the EU (e.g. quantum computers, advanced semi-conductors, sensitive machinery, transport equipment and chemical products).	The EU introduced a ban on tobacco products, bituminous materials and gaseous hydrocarbons, potassium chloride products, wood, cement, iron, steel and rubber products.

In 2021, Lithuania’s economy fully recovered after the COVID-19 pandemic, and the financial situation of its population improved; however, higher inflation will weigh on it in 2022. In 2021, Lithuania’s GDP grew 4.8%, i.e. somewhat lower than expected at the beginning of 2021. GDP growth was curbed by persistent supply chain disruptions in the second half of last year, labour shortages, and increased inflationary pressures, slowing down the development of Lithuania’s economy. These factors, together with the high comparative base (in 2020 Lithuania’s GDP contraction was one of the smallest in all EU countries), determined that Lithuania’s economy grew at a slower pace than in the EU and other Baltic States. The declining unemployment rate (from 8.6% to 6.6% in 2021) and the rapid increase in wages (9.4% per year) are expected to result in an improvement in the financial situation of Lithuania’s population, while a significant increase in the saving ratio during the pandemic should help meet future challenges. Consumer expectations returned to the pre-pandemic levels in mid-2021 as the economy recovered but started to deteriorate in the second half of 2021 and in early 2022, against the background of stronger inflation growth and the onset of the war in Ukraine. The strong increase in inflation (by 18.5% in May 2022, see Chart 1, right-hand panel) is expected to weigh on households’ real income growth in 2022 (an estimated nominal increase of 10.7% in 2022), together with their financial situation (for more details, see Section 2.3).

According to March 2022 projections, Lithuania’s economy will experience a significant slowdown in 2022, while inflation picks up.

Dalintis:

The consequences of Russia’s war against Ukraine will cause a slowdown in economic growth in 2022, mitigated by the flexibility of Lithuania’s energy imports and measures aimed at reducing the impact of energy prices. The economic sanctions imposed on Russia and Belarus and a shock due to Russia’s aggression against Ukraine led to a decline in Lithuania’s trade with these countries, while the prices of energy and other commodities and materials are rising. Trade with China is likely to be restricted so supply chain disruptions in Lithuania will continue. The slowdown in 2022 will also be driven by a slowdown in real consumption growth driven by higher inflation. As a result, Lithuania’s economy was projected to decrease (by 2.7%) or suffer a recession (1.2%) in 2022, should trade with Russia and Belarus come to a full halt, thus further reducing demand from other countries. Nevertheless, the flexibility of energy imports had already allowed Lithuania to cut gas and crude oil imports from Russia in April 2022, accounting for the bulk of imports from this country. The fiscal measures adopted by the Lithuanian government in April 2022 to mitigate the impact of inflation will improve the financial situation of residents. They increase the non-taxable income level and pensions and compensate for part of the rise in the prices of gas and electricity.

Global and Lithuanian financial markets experienced rapid growth in 2021 as the economic recovery progressed. However, a stronger-than-expected increase in inflation, the associated expectations of a more rapid rise in key interest rates, and Russia’s war against Ukraine led to a pronounce decline in stock markets and a rise in bond yields. Major stock indices in the US, the euro area and Lithuania rose by 26.9%, 20.8% and 18.3% respectively in 2021. The historically strong stock price increases were supported by the stimulus measures adopted by governments and central banks (in the form of fiscal stimulus and asset purchase programmes led by central banks), significant increases in household savings, and well-anchored expectations of future economic recovery. However, financial market sentiment started to prevail in early 2022. After hitting the ten-year low of 0.2% in August 2021, investment-grade euro area corporate bond yields increased significantly to stand at 1.5% in April 2022, i.e. 0.5 percentage points more than the 10-year average, which also translated into a marked increase in the cost of financing for enterprises within a short period of time. Borrowing conditions among European banks also tightened, supported by interest rate growth expectations, but still remain favourable. In early January 2022, the 6-month EURIBOR rose by 18 basis points to the beginning of April, reaching historically low levels, while market participants’ expectations of an increase in the ECB base interest rate also rose significantly (for more details, see Section 2.3). Stock prices in the US, the euro area, and Lithuania decreased by 4.9%, 9.4% and 7.4% respectively between the beginning of 2022 and April. It should be noted, however, that they are still at historical highs, and the rapidly rising inflation and related interest rate growth expectations, as well as Russia’s war against Ukraine, are accompanied by the higher risks of further stock and bond price corrections that may have negative repercussions on the global economy (for more details, see Section 2.3).

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1.2.Banking sector developments

High levels of capital and liquidity will help banks to withstand potential economic difficulties and losses as the condition of borrowers worsens due to the consequences of Russia’s war against Ukraine (for details, see Section 2.1). The results of stress testing show that banks are prepared to withstand even severe shocks and, under the adverse scenario, should GDP contract by 6.5%, meet their capital requirements in a prudent manner (for more details, see Section 4.1). However, banking sector concentration remains high — the second highest in the EU — although the concentration index has been slowly declining due to increased competition in recent years. High concentration of the banking sector increases the dependence of the sector on individual banks, and the insolvency of one of the major banks might have a significant impact on the financial system.

Most performance indicators of banks operating in Lithuania have been improving and are still among the best across the EU.

Dalintis:

As deposits increased and lending remained subdued, banks’ costs of negative interest rates rose, dampening the stronger growth in banks’ profits. Deposits of the private non-financial sector with banks increased as much as 42% over the past two years, while the portfolio of loans to the private non-financial sector increased by only 9% in the corresponding period, despite the strong re-acceleration of lending in 2021 (for more details, see Section 1.3). This development led to a still historically low loan-to-deposit ratio (see Chart 3, left-hand panel), while the share of funds held with the central bank increased by 13 percentage points since 2019, to 36% of total assets. Interest expenses paid for funds held with the central bank and other credit institutions subject to negative interest rates (which have increased by 160% since 2019) went up accordingly and amounted to EUR 68 million, accounting for the largest share (69%) of total interest expenses. With negative interest rates, central banks aim to encourage euro area banks to lend more actively, thereby offsetting the negative interest expenses. As central banks globally and in Europe tighten monetary policy, interest rates may start rising, leading to a reduction in these costs over the longer term (for details, see Section 2.3).

Banks’ profit returned to pre-pandemic levels owing to improvements in the quality of loans and increases in fee and commission income, but deposit growth, which was faster than crediting, put negative pressure on the growth of net interest income and profits.

Dalintis:

At the end of 2021, the share of loans with a significant increase in credit risk rose again after the expiration of government support measures for businesses and accelerating inflation, while Russia’s war against Ukraine further strengthened this trend and will contribute to the deteriorating quality of the loan portfolio. In the fourth quarter of 2021, the share of riskier borrowers increased again, especially in the corporate segment — the share of such loans increased by 1.4 percentage points to 10%. This increase may have reflected the expiry of government support to businesses (for more details, see Box 1) together with strong inflation rates, as well as rising construction and energy costs. In addition, banks increased provisioning for loans to construction and RE, energy supply, accommodation and catering, and support services companies. With the war, the share of non-performing loans increased slightly (from 1.7% to 1.8%) in the first quarter of 2021, while the share of loans with higher credit risk increased by 3 percentage points to 13%. The worse debtor assessment is also reported in the Bank of Lithuania quarterly bank surveys: from the end of 2021 banks started to give poorer assessments as to the developments in the financial standing of households and some companies, while the developments in the situation of companies engaged in manufacturing, transport, real estate and construction activities were negatively assessed in the first quarter of 2022. The share of loans to companies engaged in these activities subject to higher credit risk also increased (for details, see Section 2.1). If the share of non-performing loans increases significantly, the risk appetite, credit volumes and profitability of banks may decline. 

The share of non-performing loans decreased but remains higher in the accommodation and catering sector, while the share of loans with a significantly greater credit risk for banks went up at the end of 2021.

Dalintis:

Owing to the uncertainty triggered by Russia’s war against Ukraine, banks anticipate a tightening of their credit standards.

Dalintis:

Competition has increased, driven both by active lending by the major banks and by rapid credit provision by smaller banks, as suggested by improving concentration indicators. From mid-2020 onwards, more banks started to increase their lending volumes, while smaller market participants started to actively grant loans for house purchase and, accordingly, credit market concentration started to decline (see Chart 6, left-hand panel). Although the loan portfolio is still concentrated among the major banks, the flow of new loans has become more homogeneous among the market participants. The concentration of corporate loan flows in the corporate segment is similar to that observed in 2016, i.e. before the exit of the important corporate lender, Danske Bank A/S Lithuania branch, and the mergers of Nordea and DNB banks in the Baltic States. In turn, the concentration of flows in the housing loan segment is at its lowest since 2015 and below the 20-year average. Higher risk appetite and increased competition improved the access to finance for enterprises – based on the data of the Survey of Enterprises 2021, the share of rejected corporate loan applications decreased.

Competition in the credit market increased, contributing to lower banking sector concentration and banks’ lending rates.

Dalintis:

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1.3.Credit developments and indebtedness

Although the portfolio of loans granted by credit institutions grew more rapidly, the indebtedness of the private non-financial sector remained broadly unchanged.

Dalintis:

The increase in deposits during the pandemic was mainly supported by government support and declining investment but has recently been increasingly driven by growth in credit.

Dalintis:

The flow of new loans granted by credit institutions to non-financial corporations increased significantly, with the real estate, trade and manufacturing sectors receiving the largest share of credits.

Dalintis:

The recovery of credit institution lending was accompanied by a contraction in loans to other non-financial corporations, but debt securities and trade credit financing increased. Despite a significant increase in the flow of new loans granted by credit institutions in 2021, corporate funding from other non-bank sources also increased. Corporate liabilities to non-banks grew at a slightly slower pace than loans granted by credit institutions: in the course of the year, it increased by 8.5%, or EUR 2.9 billion. The main contribution came from a further rise in trade credit liabilities (EUR 1.2 billion, or 8%), debt securities (by EUR 0.6 billion, or 34%) and other amounts payable to non-financial corporations and households (EUR 1.2 billion, or 23%, see Chart 10, right-hand panel). On the other hand, the strong growth in short-term loans granted by other non-financial corporations in recent years started to contract, representing a decrease of 22% (or EUR 0.6 billion) at the end of 2021 compared with the previous year. Irrespective of this trend, liabilities to other non-financial corporations remain significant and account for 35% of their total financial liabilities. This means that the risks due to disruptions in the chain of mutual corporate debts remain relevant since other related enterprises might be affected by financial difficulties and failures of these companies to meet their obligations, which could cause credit losses for financial institutions. 

Lending to SMEs increased more rapidly in 2021, while corporate financing from other non-bank funding sources also increased.

Dalintis:

Strong lending for house purchase has led to a rapid expansion of the housing loan portfolio since 2020, as well as an increase in the share of riskier loans. Demand for new housing loans has been growing since 2020, supported by more favourable lending conditions, positive housing market outlook and higher savings, which made it easier for households to meet their down payment requirements. In March 2022, the annual growth rate of the portfolio of housing loans granted by credit institutions stood at 12.3%, one of the highest growth rates since 2009. The volume of new housing loans granted in the course of the year was 19.2% higher than a year ago and the value of loans granted increased even more rapidly (43.3%, see Chart 11, left-hand panel). This reflected not only an increase in activity in the housing loan segment, but also an increase in the average loan value. At the beginning of 2022, the latter amounted to EUR 81,000 (15% more than a year ago) and this could have been affected by the rise in house prices. As in the previous years, in 2021, slightly more than half (51.5%) of new housing loan agreements were signed in the Vilnius District, although housing loan portfolios increased across regions. Increased competition led to even more favourable lending conditions and an easing of standards in 2021: the average annual interest rate decreased by 0.2 percentage point to 2.1%, while the average DSTI and LTV ratios of newly issued housing loans increased slightly and fluctuated in a range of 28% and 78% respectively. In particular, the share of borrowers taking housing loans with a lower down payment and longer maturities has recently increased (for more details, see Section 2.2), but a slight tightening of lending standards has also been observed since the start of 2022.

In 2021, the flow of new consumer loans recovered from the contraction during the lockdown periods as the average loan value increased. Borrowing through P2P lending platforms generated greater interest as well. The easing of lockdown restrictions led to stronger household consumption and, therefore, demand for new consumer loans grew accordingly. Improvements in household expectations, the favourable cost of borrowing, and the increased need for this type of financing may have contributed to this development. In 2021, the value of new consumer loans granted by other consumer credit providers (non-credit institutions) amounted to EUR 481 million, i.e. 23.2% more than in the previous year, while the number of loans granted contracted by 15.7% (see Chart 11, right-hand panel). This shows an increase in the amount of household borrowing for consumption — the average amount of credit increased by 46% year on year, as well as the lengthening of the average maturity of loans by five months. It may have been influenced by rising prices, the desire to purchase more expensive items, and more favourable conditions to assume larger liabilities as a result of robust wage growth. In aggregate terms, the portfolio of loans granted by other consumer credit providers increased by 18.1% over the year, while the interest in peer-to-peer (P2P) lending platforms remained strong as well. In 2021, the volume of loans granted through P2P lending platforms increased by 21.9% and the total value of these loans increased by 49.2% year on year (i.e. nearly EUR 53 million). The provision of new MFI consumer loans was also more active: in March 2022, the annual flow of pure new loans increased by 59.2% year on year, reaching EUR 355 million. This led to the recovery of the portfolio of consumer and other loans granted by MFIs after the lockdown and in March 2022 it was 6.4% higher year on year. 

Activity in the housing loan segment remained robust and the contraction in lending for consumption during the pandemic recovered.

Dalintis:

Heightened uncertainty due to Russia’s aggression against Ukraine may affect further credit dynamics. The flow of new loans to the private non-financial sector may be dampened by the contraction in demand for new loans. This could be due to increased uncertainty, rising commodity prices, and increasing disruptions in supply chains, which might cause companies to postpone higher investment for the future, as well as more stringent lending standards, which could increase the share of rejected applications. According to the bank lending survey, a slight decline in demand of non-financial corporations for new loans is already observed in the first quarter of this year and has so far been mainly driven by the financing needs for working capital and capital investment (see Chart 12, left-hand panel). On the other hand, the flow of new loans for investment has not yet been significantly subdued, though the flows may so far reflect earlier projects planned and initiated (see Chart 12, right-hand panel). Business confidence indicators deteriorated significantly in March, which could lead to more cautious planning of new investments and lower demand for this type of financing. On the other hand, should liquidity needs increase, the demand for working capital could increase, which could partly amortise the decline in the flow of investment loans. Rising inflation and uncertainty over Russia’s war against Ukraine also weighed on household sentiment: in March, consumer confidence reached its lowest level since the first lockdown. According to the bank lending survey, demand for new housing and consumer credit stalled in the first quarter of this year. In the near term, banks expect a contraction in demand and a slight tightening of their lending standards. Further developments of household credit may be affected by a more cautious management of personal finances and more carefully thought-out assumption of new liabilities due to lower expectations.

Heightened uncertainty and worsened expectations may dampen the demand for new credit. 

Dalintis:

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1.4. Real estate market developments

The number of homes sold reached a historical peak in 2021, but market activity declined in the first months of 2022. As the pandemic hit the economy less than expected, the financial situation of households continued to improve (the average wage minus tax increased, on average, by 10.1% in 2021) and upon the change in households’ housing needs (e.g. due to spending more time at home), the residents’ interest in the purchase of homes reached a historical peak in 2021. This, combined with the so-called “spring effect”, when the housing market recovered from a slow-down at the start of the pandemic, led to a historically high number of homes sold in 2021. According to the Centre of Registers, a total of 55,000 homes were sold in Lithuania in 2021, a 22.2% increase compared with 2020 and 16.4% more than before the pandemic in 2019 (see Chart 13, left-hand panel). As the residents wanted to live in more spacious dwellings during the pandemic, house sales increased in 2021, being 26.5% and 35.2% higher than in 2020 and 2019 respectively. The volume of apartment sales in 2021 was 20.5% higher than in 2020 and 9.8% higher than in 2019. Legal persons also contributed to the increase in the number of housing units sold in 2021, accounting for 6% of the total housing acquired (1 percentage point more than in 2020). They were even more active in Vilnius as they purchased 9.5% of all homes sold in 2021 (3 percentage points more than in 2020). Amid the waning of the above-mentioned spring effect, increasing home prices, limited new housing supply and a consequent reduction in choice options, housing market activity has gradually contracted since the summer of 2021. According to more recent data, the first quarter of 2022 recorded a fall in sales volumes, which is common to the beginning of the year. The number of homes sold was 16% lower than the average over a quarter in 2021. Growing inflation and devaluing household savings provide incentives to residents to purchase homes earlier than planned, which could lead to a renewed increase in sales.

After the record in 2021, housing market activity and intentions to buy homes declined in the first quarter of 2022, while the supply of apartments in Vilnius remained limited.

Dalintis:

Although the number of building permits issued and under-construction housing units increased in 2021, the number of completed housing units decreased. Together with stronger demand for housing in 2021, there were also signs of improvement in housing supply, especially in the first half of the year. In 2021, the number of building permits issued in Lithuania was 29.7% higher than in 2020 and reached its historical peak, while legal persons acquired 40% more residential land plots than in 2020, possibly as part of the planning of the roll-out of new projects. In 2021, the number of under-construction housing units increased by 8.1% compared to 2020 but started to decline from mid-2021. The number of completed housing units declined by 21.1% since 2020, hitting its lowest level since 2017 (see Chart 14); thus, housing supply lagged behind the surge in demand and more market participants were noticing a lack of available apartments (see Chart 20). The supply of new housing in Vilnius grew extremely slowly. In 2021, the number of authorised, under-construction and completed homes in Vilnius decreased by 5.4%, 32.4% and 43.4% respectively.

Despite the high number of building permits issued in 2021, the increase in housing supply remained moderate.

Dalintis:

As housing demand outpaced supply, house price growth in 2021 reached its highest level since the financial crisis. House price growth started to accelerate in 2021 and stood at 19.8% to 23.9% in December 2021, its highest rate since 2007-2008 (see Chart 15). The rapid price growth is recorded across Lithuania; according to Statistics Lithuania, house prices in Vilnius rose by 20.5% year on year in the fourth quarter of 2021, whereas in the remaining territory of the country they were 19.2% higher. Based on the more recent data provided by the Bank of Lithuania and the market participant UAB OBER-HAUS real estate (hereinafter – Ober-Haus), the rate of price growth continued to rise in April 2022, reaching 21.4–27.2%.

Increasing house price growth outpaced the growth rate of wages, while higher inflation further pushed wages down and reduced housing affordability. Housing affordability improved over the decade, with house selling prices rising by 77% between the first quarter of 2010 and the fourth quarter of 2020; meanwhile, the average wage after taxes increased by 111%. While wages continued to rise strongly in 2021, reaching an annual average growth of 10.1%, house price growth accelerated further, to 16% on average. With house price growth overpassing nominal wage growth and high inflation leading to slower or even negative real income growth, it becomes increasingly difficult for households to keep up with the rapid house price growth and to save more for house purchases. The worsening housing affordability is reflected in the pronounced rebound in the house price-to-income ratio throughout 2021 (see Chart 15). Looking at nominal income, in the fourth quarter of 2021, the house price-to-income ratio stood close to the levels observed in the 2018-2019 period. In terms of real household income, the deterioration in affordability was even more pronounced and in the fourth quarter of 2021 stood at its lowest level since 2008.

House price growth has been the fastest since the financial crisis, surpassing wage growth, and therefore, the housing affordability indicator is worsening.

Dalintis:

Rent price growth is slower than that of selling prices but may start to accelerate in the near term.

Dalintis:

Rapid increases in construction prices may continue to put upward pressure on house prices. From the beginning of 2021, there has been a marked rise in the prices of residential building construction, mostly driven by the supply chain disruptions and rapid increases in the prices of construction materials due to a shortage of raw materials. In March 2022, the total annual growth rates of residential building construction prices and construction materials were at historical peaks, standing at 19.2% and 24.4% respectively (see Chart 17). As construction materials have become more expensive and this has caused an increase in the cost of new housing, if housing demand remains high, part of the increase in the construction price level could be passed on to the selling price of the housing, so that even if the supply of new housing increased, there would be a further rise in price pressures (for more details, see Section 2.2).

A strong rise in the prices of construction materials led to rapid increases in the cost of construction of residential buildings.

Dalintis:

The large share of imports of construction materials from Belarus, Russia and Ukraine may lead to a further rise in construction prices. Wood and articles of wood imported from Belarus, Russia and Ukraine accounted for 47% of total imports of these materials in 2021 (see Table 2), equalling the same share of imports of iron and steel and articles from these metals. The removal of both Belarusian and Russian elements and disruptions to trade with Ukraine as a result of the war will result in purchases from other suppliers at a potentially higher price and the duration of the supply of materials will be prolonged. This is likely to lead to continued strong growth in construction prices and limit the number of housing units under construction.

(percentages)

Parties	Wood and articles of wood	Articles of stone, plaster, cement, or similar materials	Iron and steel	Articles of iron or steel	Aluminium and articles thereof
Belarus	25.1	11.8	11.0	4.2	10.7
Russia	15.6	8.3	20.7	4.3	3.0
Ukraine	6.0	1.8	4.5	2.1	0.4
Total	46.7	21.8	36.2	10.6	14.1

Activity in the commercial real estate market rebounded noticeably in 2021 with the economic recovery and low interest rates prevailing. With stable economic growth, demand for commercial real estate premises increased as well, and the supply of commercial premises was therefore gradually increased by real estate developers, which had remained resilient in the construction projects during the pandemic: the supply of office, retail and storage premises in Vilnius increased by 8.9%, 10.7% and 2.8% respectively. There were also marked increases in commercial real estate demand, from both tenants and investors. As the pandemic eased, the number of office rental contracts in Vilnius concluded in 2021 went up by almost one-third (31%) compared with the average of five years, while the volume of investment transactions increased by 61% on average as investors searched for yield (see Chart 18). Investments in commercial real estate went in different directions, however; more active residential real estate purchases stood out, while the amount of funds invested in other segments remained largely unchanged. In the first quarter of 2022, investor activity in Lithuania decreased significantly, with the volume of investment transactions decreasing by 39.8%. The start of Russia’s war against Ukraine and the resulting sanctions on Russia and Belarus may further reduce demand for commercial real estate (in particular storage premises). On the other hand, an ongoing increase in the supply of commercial real estate may be hampered by rising construction costs, economic uncertainty and supply chain disruptions. 

The volume of commercial real estate transactions contracted noticeably at the beginning of 2022.

Dalintis:

The lack of storage premises may fade away due to the restrictions on the trade with Russia and Belarus. The shortage of storage premises remains common to all major cities: in March 2022, the shortage of such premises in Vilnius, Kaunas and Klaipėda was indicated by 46%, 80% and 50% of the surveyed respondents who assessed the commercial RE markets in these cities, respectively. However, after the onset of Russia’s war against Ukraine, the share of real estate market participants who believed that there was a shortage of storage premises in Vilnius decreased by 34 percentage points. A contraction in international trade volumes and re-exports from Lithuania due to the entry into force of the sanctions against Russia and Belarus is also likely to lead to a drop in demand for storage premises over time. Should the volume of international trade shrink markedly in Lithuania, a surplus of storage premises may arise. As a result, real estate developers carrying out the storage premises construction projects would suffer significant losses as a result of higher construction costs as inflation climbs and the occupancy rate of the premises is lower than planned at the start of the projects. 

While imbalances in the market for office and trade premises related to excess supply narrowed, Russia’s war against Ukraine may have reduced the shortage of warehouses in Vilnius.

Dalintis:

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1.5. Developments in the non-bank financial sector

With the growth trends prevailing in financial markets, the value of Lithuanian pension and investment funds and holdings of assets grew rapidly in 2021, yet it had negative consequences of the asset price correction that started in early 2022. In 2021, second pillar Lithuanian pension funds earned the highest average annual return on the total life of pension funds in Lithuania (21.0%), while their managed assets increased by 31.4% to reach EUR 5.9 billion in December 2021. In the course of the year, the assets managed by third pillar pension funds increased by 32.8% to stand at EUR 221.8 million in December 2021, compared with an average annual return of 13.8%. In December 2021, the total assets managed by Lithuanian pension funds accounted for 9.7% of the total assets of the financial system, while this share remained unchanged over the year. In line with the growth trend prevailing in equity and RE markets, the assets of Lithuanian investment funds also grew rapidly, increasing by 40.3% year on year to EUR 1.6 billion in December 2021. The value of units issued by investment real estate funds amounted to EUR 990 million in February 2022 (46% of the total value of all investment fund units and 19% of the total value of commercial real estate loans). The strongest growth in the value of equity investment and pension funds was observed: the average value of a fund unit in such funds increased by 22.3–32.7% in 2021. However, such strong growth in return is likely to be less sustainable: at the beginning of 2022, the assets of Lithuanian investment funds investing in equity decreased by 11.2%, whereas assets of pension funds declined by 1.8%. In the event that asset revaluation — which had been observed in early 2022 as a result of Russia’s war against Ukraine and market expectations of a withdrawal of expansionary monetary policy by advanced central banks – were to increase and spread to other asset classes, the strong growth in Lithuanian pension and investment fund assets so far could slow down or even start declining. This would be particularly reflected in the investment fund segment, as the growth of assets of second pillar pension funds is significantly supported by mandatory contributions and government premiums.

The growing crypto-asset market has also led to increasing interest on the part of Lithuania’s households in this investment.

Dalintis:

In 2021, the electronic money institution (EMI) and payment institution (PI) sector in Lithuania continued to grow rapidly. Based on the unaudited data, the income of EMIs and PIs, which are the core of the Lithuanian fintech sector, amounted to EUR 504 million, 3.5 times more than a year ago, representing 53% of interest, fee, and commission income generated by banks in the respective period. The total amount of payment transactions was more than EUR 194 billion, which was 3.8 times larger than in the previous year. The number of licences issued to EMIs and PIs also increased, standing at 141 (6.8% more than a year earlier) at the end of 2021, yet one of these institutions had completed their year-long period without meeting their own capital requirements. In general, the market for EMIs and PIs is relatively young, and given its rapid expansion (as there are new market participants and the number of customers and volume of processed transactions is growing), it is important to ensure its maturity and prevent potential risks for the financial system as a whole (for more details, see Box 2).

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2.Risks to the financial system

Dalintis:

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2.1. Risks posed by Russia’s war against Ukraine

Russia’s war launched against Ukraine in late February 2022 significantly changed the geopolitical environment, while the direct impact of sanctions, rising energy, commodity and food prices, changing expectations, heightened uncertainty and cyberattacks may have a negative influence on the stability of Lithuania’s financial system. Although there is little direct link between Lithuania’s economic and financial system and the countries affected by the war, namely Russia, Belarus and Ukraine, the impact on the Lithuanian financial system could be amplified through secondary channels. First, it could worsen the situation of firms with links to these countries, or of companies that are more vulnerable to energy, commodity and food price increases or simply affected by the overall sluggish demand from export markets, thereby making it difficult for firms to meet their financial obligations. Second, Lithuanian financial institutions might be adversely affected due to an increased likelihood of cyberattacks and residents’ rapid withdrawal of deposits. Third, war-induced uncertainty and sanctions have shaken up financial markets significantly and may further increase risk premia and debt servicing costs. Finally, if consumer confidence deteriorated and buyers retreated from the housing market, the current price overvaluation could lead to a correction of house prices. 

As a result of Russia’s war in Ukraine, the West adopted sanctions against Russia and Belarus, with the financial, transport and energy sectors being the most affected. The first packages of sanctions were targeted at the financial sector: the assets of sanctioned persons, banks and the central bank were frozen and seven Russian banks were disconnected from the SWIFT system (see Table 1 in Section 1.1). Lithuania’s banking sector was not significantly affected by these sanctions, while a number of banks and other financial institutions themselves decided not to serve Russian and Belarussian customers and not to execute payment orders to those countries. These decisions are particularly detrimental to those Lithuanian businesses that have trade relations with the sanctioned countries, as companies may face difficulties when paying their customers. The sanctions have particularly adverse effects on the transport sector, with the market in Belarus being of particular importance for Lithuanian Railways and seaport. For some of these companies, these markets were also important for the provision of road transportation, storage and other transportation services. The decision not to import oil and gas from Russia by some Western countries, including Lithuania, will most likely affect Lithuania’s energy sector, which needs to look for new import markets at higher prices but has been unable to increase prices accordingly for consumers.

Energy prices increased significantly in response to Russia’s invasion of Ukraine.

Dalintis:

Export volumes of Lithuanian goods to Russia are not large and, in general, trade with Russia has been declining since Crimea’s annexation.

Dalintis:

Due to growing war-induced uncertainty or decreasing confidence in the Lithuanian financial system due to activities of hostile countries, financial institutions could be adversely affected by the rapid withdrawal of deposits. The increased volatility of deposits was observed during the first days of the war through 3 March, when deposits declined by EUR 585 million (2%) compared to 25 February. However, deposit growth had been already recorded on 4 March and, at the beginning of April, deposit growth turned positive (see Chart 23, right-hand panel). Due to the heightened concerns about the war and the desire of residents to increase their cash reserves, there was a shortage of cash at automated teller machines (ATMs), with a further EUR 562 million being distributed to banks between 24 and 25 February, but the situation quickly stabilised. There was an increase in cross-border transfers and a decrease in the TARGET2 balance, the latter being more significant than the cash withdrawals from ATMs. Despite these developments, banks continued to display particularly high liquidity ratios — in most banks, their liquidity coverage ratio was above 200%, and in all banks, the liquidity coverage ratio significantly exceeded 100%. The decline in deposits could be more significant if the war was to spread or if confidence in the Lithuanian financial system weakened as a result of activity of hostile countries. However, banks now demonstrate great resilience to liquidity shocks: the liquidity test shows that banks are able to withstand a 43% decline in deposits (for more details, see Section 4.2).

The heightened uncertainty at the beginning of the war led to a short-term reduction in bank deposits, but the direct links of the banking sector to the countries affected by the war are insignificant.

Dalintis:

The insolvency of large companies operating in the areas that are most affected by the war would have the largest impact on banks. Lithuanian financial institutions have granted loans to 21 large companies operating in areas that are more sensitive to the war (see Chart 24, right-hand panel) with a total portfolio of EUR 1 billion (approximately 12% of the corporate loan portfolio). It should be noted that, in terms of the economic activity of companies, the structure of the loan portfolios of the banks operating in Lithuania is similar, and the majority of large companies were granted loans from several credit institutions. On the one hand, such diversification in the event of insolvency reduces the amount of loss per bank. On the other hand, given the high concentration of the sector, in the event of insolvency of several large companies, banks with a similar portfolio structure and the same customers may amplify the shock to the financial system.

Loans to companies engaged in war-sensitive economic activities represent about one-third of the corporate loan portfolio, some of which are concentrated in large companies.

Dalintis:

High liquidity makes Lithuanian companies more resilient to war risks. However, bank loan portfolios already showed the signs of increased credit risk in the first quarter of 2022.

Dalintis:

Rising energy, food and commodity prices and slower economic developments will also affect companies with no direct links to Russia, while the sanctions and the search for new suppliers will put additional pressure on supply chains. This will create new challenges for Lithuanian companies that have recently been burdened by supply chain disruptions caused by the pandemic, rising labour costs and labour shortages. The war launched by Russia against Ukraine also has negative effects on the economies of other trading partners, therefore, Lithuania’s export demand is expected to weaken and investment to decline amid heightened uncertainty. A rapid increase in inter-firm liabilities (i.e. more than one-third of the total financial liabilities of all companies) in recent years could induce disruptions to payments between firms during a financially challenging period and make it more difficult for them to meet other financial obligations. High inflation also reduces the purchasing power of households and their ability to save, which in turn results in the deteriorating financial situation of households and may amplify the burden of current financial liabilities, especially in the light of the recently robust lending to households (for more details, see Section 2.3).

War-induced uncertainty and sanctions shook up financial markets significantly, yet the shock for the shares of Lithuanian companies was not higher than that for the corporate shares in other European countries. The war negatively affected the stock indices in Europe: while the impact was less pronounced than that on Russian shares (the trade in which had been suspended), Lithuanian and European corporate stock indices fell by about 12%, owing to heightened uncertainty in the region during the first week of the war, but have since returned to the pre-war levels (see Chart 26, left-hand panel). Confidence in US corporate stocks was higher than in European corporate stocks, with the S&P 500 index having grown early in the war. It should be noted that the relationships between Russia and the entities whose securities are listed in AB Nasdaq Vilnius Stock Exchange are negligible, but the war strongly affected the shares of the companies that have links with Russia. There is a particularly marked decline in the shares of the European banks operating in Russia (since they are most vulnerable to the sanctions): for example, the share prices of Raiffeisen Bank dropped by around 60%, similar to those of the largest sanctioned Russian bank Sberbank. By contrast, investor confidence in banks operating in Lithuania continued to be good: the shares of AB Šiaulių bankas, the single Lithuanian bank listed on the Stock Exchange, and the parent banks of Swedbank, AB and AB SEB bankas, also declined less than the overall European stock index (see Chart 26, central panel). Overall, as the stock exchange in Lithuania is relatively undeveloped and relevant for only a few companies, the direct impact of market corrections for large financial institutions is limited. However, the Lithuanian financial system could be affected owing to deteriorating expectations in the region and existing linkages between major foreign capital banks and parent institutions (for more details, see Section 3.1).

Following the adjustments due to the war, the valuation of shares of Lithuanian banks remained similar to that of other European countries, although the growth of Lithuanian government bond yields was stronger than in Western Europe.

Dalintis:

Heightened uncertainty led to higher government bond yields, which will push up the state debt servicing costs. The rise in Central and Eastern European government bond yields, including Lithuania, has been more pronounced. Since 18 February, Lithuanian government bond yields rose by around 120 basis points (see Chart 26, right-hand panel). Against the background of a weaker outlook in Europe, the euro depreciated and the US dollar became stronger. Rising yields will push up the state’s debt servicing costs, while the depreciation of the euro may further burden Lithuania’s importers. Rising inflation, increasing bond yields and interest rates are recorded around the Western world, and sharp price corrections may lead to significant shocks in financial markets, as in 2009, resulting in an economic downturn and thus a decline in foreign demand, which would have a significant impact on Lithuania’s economy. 

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2.2. Risk of potential housing market overheating

In 2021, housing and credit market activity decoupled from the overall economic growth trends, signalling potential overheating of the housing market. Along with the strong rise in house prices and the number of sales, the value of housing acquired in 2021 was EUR 1 billion (40.7%) higher than in 2020, amounting to EUR 3.6 billion. This acceleration in the housing market led to a widening of the housing market’s gap vis-à-vis developments in the economy as a whole. Having fluctuated between 4% and 5% in 2016-2020, in the fourth quarter of 2021, the ratio of the value of purchased homes to GDP stood at 6.5%, i.e. 1.3 percentage points more than in the same period of the previous year and the most since the first quarter of 2008 (see Chart 28, left-hand panel). This increase in activity in the housing market was accompanied by a rise in lending for house purchases, which are increasingly affected by overly optimistic economic expectations and a low perceived level of credit risk (for more details, see Box 4). In 2021, the volume of housing loans granted increased by EUR 613 million (38.7%) compared to 2020, while in the fourth quarter of 2021 the ratio of the annual flow of new housing loans to GDP reached 4%, i.e. a year-on-year increase of 0.8 percentage point and the highest since the third quarter of 2009. Meanwhile, the value-to-GDP ratio of construction works carried out through the construction of new housing has remained broadly stable since 2019, amounting to 0.8% in 2021, indicating that housing supply increased much slower than demand. A sudden decoupling of housing sales and loan flows from the general economic trends increases the risk that activity in the housing market may become based on non-core factors and the housing market may become overheated.

In 2021, the value of purchased homes and the flow of new housing loans grew more rapidly than the economy as a whole, while house prices deviated from economic factor-based values.

Dalintis:

Although the share of borrowed funds did not increase in the total value of purchased housing, there was a rise in the volume of riskier loans. The number of houses purchased with a loan in 2021 accounted for 47.7% of the total value of housing units purchased (down by 3.1 percentage points compared to 2020), or one-third of the total number of purchased housing units (33.4%) (down 1.9 percentage points compared to 2020) (see Chart 28, right-hand panel). The non-increasing share of housing units purchased with a loan shows that the surge in lending for house purchases observed in 2021 is not the main source of financing of the observed larger number of sold houses. In the context of rapidly rising prices, house purchases are increasingly taking place with a lower down payment and longer maturity of the loan. The share of loans with a LTV rate of 80% or more (in other words a down payment of 20% and less) in the total flow of new housing loans was 43% in December 2021, i.e. a year-on-year increase of 6 percentage points (see Chart 29, left-hand panel). In order to reduce the average level of loan repayments, individuals assume liabilities for a longer term. The share of long-term loans (i.e. loans for 25 years or longer) accounted for 53.7% of all new housing loans in December 2021, i.e. a year-on-year increase of 3.7 percentage points. 

The share of housing loans in the total MFI loan portfolio increased, but the share of housing purchased with a mortgage loan slightly decreased in 2021.

Dalintis:

Resilience of households to potential housing market shocks is enhanced by the good financial condition of households. However, in the face of rapid house price increases and high inflation, the situation may worsen. The financial situation of households is more favourable: average wages after tax increased by an average of 10.1% in 2021, while financial assets of households exceeded their liabilities fourfold (429%) in the fourth quarter of 2021, with no significant change in the ratio over the year. In addition, Lithuania’s household indebtedness is one of the lowest in the euro area — according to the ECB, the household debt-to-GDP ratio in Lithuania stood at 24.1% in the third quarter of 2021 (see Chart 29, right-hand panel). The sound financial position of households makes them more resilient to an unexpected deterioration in their financial situation and reduces the likelihood that they will not be able to meet their financial obligations in the event of a correction of house prices. However, amid rapidly rising house prices, residents have to borrow even more and assume liabilities for a longer period of time, and expectations of further rapid price increases may induce people to make urgent, unreasonable decisions regarding house purchases. The prolonged high inflation could worsen the financial situation of households, due to stagnating or even declining real income, and a possible interest rate hike would lead to rising mortgage loan payments, as nearly all housing loans (97.6% in 2021) are granted at variable interest rates (for more details, see Section 2.3).

Loans close to the levels set by the RLR are somewhat on the rise recently, but Lithuania’s household indebtedness is low.

Dalintis:

In recent years, buyers purchasing homes as investment have contributed to the activity of the housing market, and a rapid withdrawal of such buyers could lead to a market correction. According to the latest real estate market participant survey carried out by the Bank of Lithuania, investors in Vilnius and Kaunas purchased 23% and 15% respectively of new apartments in the second half of 2021, i.e. respectively 2% and 20% less than in the first half of 2021, while, in Klaipėda, in the second half of 2021 investors purchased a fifth (20%) of new apartments, which was 10 percentage points more than in the first half of the year. The heightened uncertainty at the onset of Russia’s invasion of Ukraine may lead to a withdrawal of investors, and a sudden exit of investors comprising a relatively significant share of the housing market could lead to a correction in that market.

High inflation, combined with strong rental demand and price increases since the beginning of the war, may increase investor activity and lead to further unsustainable price growth. Rapidly rising inflation may again attract investors seeking to protect their savings against depreciation — according to a survey conducted by the Bank of Lithuania in 2021, 56% of households find real estate as the most attractive investment. Moreover, the strong inflow of refugees from Ukraine to Lithuania has shown signs of increasing demand for rented housing and accelerating rental price increases, which enhances the attractiveness of housing as an investment. An increase in investor activity would lead to a faster, unsustainable increase in house prices, based on the wish to earn money from the overheated housing market. To ensure the sustainable development of the housing market and limit the opportunities to purchase housing as an investment using borrowed funds, the Bank of Lithuania tightened its LTV requirement for second or subsequent housing loans to 70%, as from 1 February 2022 (for further details, see Chapter 5). Tax measures could also reduce the attractiveness of housing as an investment and introduce more sustainable development of the housing market (for more details, see Box 3).

When housing demand exceeds supply, the new challenges for construction firms imply slow supply increases and increasing supply-demand imbalances, which can lead to unsustainable growth in house prices. According to Statistics Lithuania, in 2021 the value of works carried out by construction companies during the construction of new housing stood at EUR 447 million, a 30% increase compared to 2020, which was particularly affected by the pandemic, and 11% more than in 2019. However, in 2021, construction prices were 8.7% higher than in 2019, making the real growth of the value of the construction works completed in 2021 stand only at 2.6%, compared to 2019. Shortages in housing supply were particularly noticeable in the Vilnius new housing market due to disruptions in the process of obtaining building permits. Taking into account the number of housing units sold, if no new housing is offered to the market, all of the housing currently for sale would be sold out in six months’ time (see Chart 30, left-hand panel). It is likely that supply increases will not materialise in the near term. The supply chain disruptions and shortages of construction materials caused by the pandemic and the deterioration of the situation since the onset of Russia’s war against Ukraine have increased the challenges faced by construction companies. Only around 15% of construction companies in the first quarter of 2022 stated that there were no restrictions on their activities, i.e. the lowest percentage since 2016 (see Chart 30, right-hand panel). During the period under review, one-fifth of construction companies reported lack of construction materials as a factor limiting operations of the construction sector, the largest number during the entire survey period since 2003. Meanwhile, household demand was buoyant — in the first quarter of 2022, only 14% of construction companies reported their activities being curbed by insufficient demand — the lowest share since 2007. As housing demand is still high and construction companies face new challenges that may be exacerbated by the start of the war, the slow increase in housing construction causes demand to grow further apart from supply, and consequently and higher house price growth. After demand and supply imbalances have built up, even if demand shrinks, price pressures may continue to persist as a result of limited supply.

The supply of new housing in Vilnius remains limited, with an increasing share of construction companies facing shortages of materials and equipment.

Dalintis:

An abrupt withdrawal of buyers could lead to a deterioration in the financial standing of construction and real estate companies, posing risks to financial stability which in the near term are exacerbated by rapidly rising construction prices and heightened uncertainty caused by the war. An increasing number of construction companies are facing financial difficulties: in March 2022, such an evaluation of their own situation was provided by a fifth of construction companies, the largest share of companies since the end of 2015. The rapid increase in construction prices also poses challenges for RE developers, as, according to market participants, up to 90% of the new apartments sold are still under construction. When the sale of still unfinished apartments is agreed upon in advance, in the context of higher construction prices, a number of RE developers may ask buyers to pay more, risking that buyers will not agree to terminate their reservation contracts or to incur higher construction costs for the developers themselves, thus potentially deteriorating their financial position. Heightened uncertainty due to Russia’s invasion of Ukraine also poses challenges for RE developers. Should housing buyers leave the market abruptly as a result of heightened uncertainty, a rapid rise in construction prices may result in a lack of liquid funds for developers to complete the already existing projects. A deterioration in the financial situation of construction and RE companies and the failure of companies to meet their obligations to housing buyers and credit institutions could lead to a housing market correction and pose risks to financial stability, as loans to these companies accounted for a third (33.6%) of the total MFI loan portfolio to non-financial corporations in the fourth quarter of 2021.

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2.3. Risks from high inflation and a possible increase in interest rates

Increasing consumption and supply chain disruptions during the pandemic led to a significant rise in inflation, which may get further prolonged owing to Russia’s war against Ukraine, impair the financial situation of companies and reduce the purchasing power of citizens. During the COVID-19 pandemic, active economic stimulus actions taken by central banks and governments worldwide and ample state support measures helped retain population employment and wage growth, thereby mitigating the economic shock.

Due to limited opportunities to consume during the lockdown period and wage increases, resident savings increased significantly. Over the same period, as a result of operational restrictions related to the pandemic and destocking of companies, the supply of goods and services dropped significantly, with supply disruptions from the long-established global supply chain at the start of the economic recovery after the initial pandemic shock. This led to strong commodity price increases in global commodity exchanges in the second half of 2021, resulted in shortages of goods and services and inflation that exceeded the medium-term inflation targets of central banks in the euro area and in a number of other advanced economies. The rise in energy prices was amplified by Russia’s war against Ukraine, which has the potential to disrupt global energy supply chains and further push up inflation. In May 2022, Lithuania’s annual inflation rate reached 18.5%, its highest level since 1996 and the second highest among EU countries. In addition to global contributions from energy and food commodity prices, the contribution of domestic factors affecting inflation in Lithuania has also strengthened, largely reflecting a stronger increase in service prices since mid-2021 associated mainly with domestic economic developments, which have been significantly affected by rapidly increasing wages.

Rising inflation had already started to adversely affect the financial situation of some Lithuanian companies even prior to the start of Russia’s war against Ukraine, which may worsen further as costs continue to increase. Since the beginning of 2022, the share of companies in Lithuania which reported, in the surveys conducted by Statistics Lithuania, that their activities were affected by financial difficulties has increased significantly. Higher inflation may have contributed significantly to this effect, as this share had risen even before the onset of Russia’s invasion of Ukraine and, according to the data reported in April 2022, fluctuated between 18% and 23%, exceeding the levels observed during the first lockdown (see Chart 31). The assessment of the financial situation of businesses in Lithuania in the first quarter of 2022 was one of the weakest in the EU countries: the financial situation was assessed worse only by Polish companies, while the share of companies facing financial difficulties in Lithuania exceeded the EU average by 14.5 percentage points. The rise in inflation has negative effects on the financial situation of companies — rising costs reduce the profitability of firms (in particular those with little negotiating power to pass on rising costs to buyers or who cannot compensate for them by increasing operational efficiency). At the same time, it may increase the likelihood of corporate defaults and reduce the availability of financing but may also have negative effects on the economy as a whole (e.g. higher unemployment and lower wage growth) via secondary effects. Nevertheless, the number of corporate bankruptcies has so far remained stable; although it exceeded its 2020-2021 level in March, the number of bankruptcies has remained one-fifth lower than in the pre-pandemic year 2019. In addition, liquid assets of non-financial corporations increased during the pandemic and may help companies to withstand significant economic shocks, while households with historically high savings may make them available to companies by consumption, thereby further strengthening their resilience.

The share of companies in financial difficulties significantly increased in early 2022, exceeding the levels observed during the first lockdown. 

 Dalintis:

At the same time, higher inflation weighs on the purchasing power of households and, if it continues, there would be a decline in consumption and a reduction in the possibility of more vulnerable households to repay their debts. The rise in prices of various products reduces household consumption and makes it more difficult for them to meet their financial liabilities as an increasing portion of income must be directed towards essential products. Therefore, the prolonged inflation has an adverse impact on households’ riskiness and financial stability and reduces their access to financing. Inflation mostly affects people with low incomes, as well as those who spend a higher share of their income on loan payments. On the other hand, the decline in the purchasing power of residents may also weigh on the production demand of Lithuanian companies, which would further worsen their financial situation. At the same time, inflation reduces the real value of outstanding loans, and as a result, the relative burden of the loan on residents who hold fixed-rate loans decreases.

In response to the rising inflation rate in the euro area, financial market participants assumed that the ECB would start raising the base interest rates already in 2022, while this increase in interest rates might have a negative impact on borrowers’ financial condition. Market participants’ expectations regarding EURIBOR interest rates, which are affected primarily by the ECB’s monetary policy decisions and how the changes in interest rates directly affect the loan repayment costs of the majority of borrowers, increased noticeably at the beginning of 2022. While the three-month EURIBOR was expected in December 2021 to turn positive in mid-2025, markets expect EURIBOR to reach the positive level already at the beginning of 2023 (see Chart 32, left-hand panel). Following its meeting in April 2022, the Governing Council of the ECB stated that the ECB’s asset purchase programme would be completed in the third quarter of 2022, paving the way for higher base interest rates in the second half of 2022. 

Expectations of a rise in base interest rates in the euro area have strengthened, and the example in Poland shows a similar rise in interest rates on loans in the context of base rate increases.

               Dalintis:

While a potential increase in interest rates would weigh on credit and economic growth prospects in the short term, reducing inflation and lower imbalances in the real estate market would have a positive effect on the economic and financial system in the long run. Higher interest rates would increase the cost of existing household financial liabilities and more expensive lending would dampen demand for new credit. Based on the calculations, a rise of 1 percentage point in interest rates on housing loans would result in an increase of EUR 44, or 14%, in the contribution of the average housing loan (see Table 3). Assigning a higher share of their income to loan payments would reduce the ability of households to allocate their income to consumption or repayment of their loans, thereby increasing the riskiness of household loans. A rise of 1 percentage point in interest rates would increase the probability of household insolvency by 0.077 percentage point (for more details, see Box 5). A similar situation would be observed in the corporate sector. The rising interest rates would dampen economic growth: according to econometric models, real GDP could be 0.96% lower due to the interest rate increase of 1 percentage point after one year, while the credit level would be 1.77% lower (see Table 4). It should be noted, however, that the resilience of households with housing loans to an interest rate shock is also enhanced by the fact that, since 2015, new housing loans were provided in the context of the income stress test of borrowers, with loans being granted only if the borrowers’ expenses for repayment do not exceed half of the income received, increasing the interest rates on housing loans to 5%. Moreover, in the long run, higher interest rates would reduce elevated inflation and the accumulated imbalances in Lithuania’s real estate market and, therefore, would have a positive effect on the country’s financial stability.

Increase of interest rates on housing loans, percentage points.	Housing loan interest rate, %	Monthly loan instalment, EUR	Change in the monthly loan instalment, EUR	Change in the monthly loan instalment, %
–	2.0	230	-	-
0.5	2.5	242	12	5
1.0	3.0	254	24	11
2.0	4.0	279	49	22
3.0	5.0	306	76	33

Impact of the interest rate shock on the economy				Impact of aggregate supply shock on the economy
Increase of interest rates, percentage points.	Real GDP, %	Inflation, %	Credit, %	Increase in inflation, percentage points	Real GDP, %	Credit, %	House prices, %
+0.5	-0.48	-0.48	-0.88	0.50	-0.39	-0.52	-1.07
+1.0	-0.96	-0.95	-1.77	1.0	-0.79	-1.05	-2.14
+2.0	-1.93	-1.91	-3.54	2.0	-1.57	-2.10	-4.27
+3.0	-2.89	-2.87	-5.30	3.0	-2.36	-3.14	-6.41

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3.Challenges to the financial system

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3.1.Challenges posed by a potential correction of imbalances in Sweden and changes in Swedish banks' lending policies in Lithuania

In Sweden, house prices and household indebtedness continued to increase, but the share of banks’ market-based funding somewhat decreased.

Dalintis:

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3.2.Climate change challenges to financial stability

The resilience of the Lithuanian economy in the transition to a green economy is moderate, and increased investment in more sustainable business models by companies would further reduce the risk posed by the transitional period. According to an index composed by the World Bank, the resilience of the Lithuanian economy to the transition to a green economy was better than that of the most Central and Eastern European countries and it also slightly improved over two years (see Chart 34, left-hand panel). In recent years, Lithuanian companies and financial institutions have paid increasing attention to a more sustainable business model: there is a growing number of offers in banks to finance more sustainable products and projects, investment and pension funds focusing on green investment are emerging, and more and more companies are investing in green technologies. For example, according to the survey of non-financial corporates conducted by the Bank of Lithuania, the share of companies investing in green technologies in the first half of 2020 was 23%, and 27% in the first half of 2021. One way to finance the green transformation is to issue green bonds, but Lithuanian companies hardly use this option — there were no new issuances of green bonds in 2021. In general, green bonds are mainly issued by the government and its subordinate institutions, while the private sector has issued green bonds only once (see Chart 34, right-hand panel). 

The resilience of Lithuania’s economy in the transition to a green economy has improved in recent years.

Dalintis:

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4.Stress testing

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4.1.Bank solvency testing

(percentages)

Indicators	Actual indicator	Baseline scenario		Shock scenario		Severe shock scenario		Adverse scenario
	2021	2022	2023	2022	2023	2022	2023	2022	2023
GDP (annual change)	4.8	2.7	2.7	0.4	2.1	-1.2	1.5	-6.5	-1.0
Exports of goods and services (annual change)	14.1	5.2	1.9	3.8	3.1	3.0	3.9	-8.2	-0.9
Private consumption expenditure (annual change)	7.2	4.7	4.9	1.5	2.8	-0.8	1.1	-5.8	-1.0
Unemployment rate (annual average)	7.1	7.1	7.3	8.1	8.3	8.8	9.0	9.4	9.9
Wages (annual change)	10.5	10.7	7.7	5.6	3.7	2.2	1.1	-5.1	-1.3
Average annual inflation (based on HICP)	4.6	10.5	2.7	10.7	2.7	11.1	3.0	4.7	-1.3
RE price index (annual change)	16.0	14.2	8.7	4.8	2.3	-1.9	-3.7	-15.2	-2.3

Stress test results show that the banking sector is sufficiently capitalised and remains resilient to potential shocks (see Chart 35, left-hand panel). During 2022-2023 testing period, the banking sector would maintain high capital adequacy ratios (22.2%) under the baseline scenario. Under the shock and severe shock scenarios, there would only be a limited impact on banks’ capital positions. Under these scenarios, the weighted capital adequacy ratio would fall to 20.8% and 20.1%, respectively. Under the adverse scenario, which provides for an extremely severe economic shock, the capital held by the banking sector would be sufficient to meet the minimum capital requirements, including Pillar 2, with a margin. During the testing period, the adverse scenario would see the weighted capital adequacy ratio decline to 17%, while the gap from the baseline scenario would be -5.2 percentage points. Since the recent good profitability and macroprudential capital requirements have allowed banks to build up significant capital buffers, the capital depletion assessed during the stress testing does not address risks to the stability of the sector, allowing banks to withstand even a more severe economic shock than under the stress-testing scenarios. 

Under the adverse scenario, credit losses incurred by the banking sector in 2022-2023 would amount to around EUR 628.5 million, or approximately 4% of the total loan portfolio at the end of 2021 (losses on loans to non-financial corporations would amount to 8.6%, losses on household loans – 1.1% and household consumer loans – 3.7%). Between 2022 and 2023, as compared to 2020-2021, banks’ operating income could fall by around 11.5% under the adverse scenario. Compared to the baseline scenario, the decline in the capital adequacy ratio is mainly driven by increased credit risk losses and reduced net interest income (see Chart 35, right-hand panel). 

The banking sector is resilient to economic shocks. Credit risk losses on the loan portfolio are a major source of losses for banks.

Dalintis:

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4.2.Bank liquidity testing

The banking sector would overall be able to cover a 41.3% decrease in deposits with liquid assets; however, their liquidity situation varies (see Chart 36, right-hand panel). Results for individual banks fluctuate from 29.1% to 52.4%. For comparison: the largest monthly decline in deposits in the banking sector (6.2%) was recorded in October 2008, when depositors started to have doubts regarding the sustainability of one bank (deposits in the said bank dropped by 9.3%). Looking at individual banks, the largest decline in deposits over a month (28.7%) was registered in November 2008 in AB Parex banka (currently – AS Citadele banka Lithuanian branch), when its parent bank came into liquidity difficulties and the Government of Latvia had to provide it with financial support.

The banking sector would be able to cover a 41.3% decline in deposits.

Dalintis:

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5.Financial stability strengthening

Since 2014, the Bank of Lithuania has been given a macroprudential policy mandate, implementation of which improves the resilience of the financial system as a whole. The implementation of macroprudential policy enables early identification of threats to the financial system and the making of appropriate arrangements to manage those risks. In autumn 2021, the Bank of Lithuania reacted to the heating of the housing market by tightening the RLR and setting the sectoral SRB rate at 2% for the housing loan portfolio (see Chart 37).

The Bank of Lithuania reacted to the heating of the housing market by tightening the RLR for second and subsequent loans and setting the sectoral SRB rate at 2% for the housing loan portfolio.

Dalintis:

It should be noted that these changes are targeted — the requirement for a higher down payment will not affect the buyers of their first home, who will continue to be subject to the down payment requirement of 15%. Similarly, to take due account of situations where existing housing loans were taken a long time ago and most of them have already been repaid, an exception will apply to households with the outstanding amount of each earlier loan lower than 50% of the value of housing purchased using that loan. The second and subsequent housing loans of such households will be subject to the minimum down payment requirement of more than 15%.

Given the increase in the share of secondary loans in the flow of new housing loans between 2019 and 2021, it was decided to tighten the down payment requirement for second and subsequent housing loans, which entered into force on 1 February 2022. The new sectoral SRB is aimed at increasing the resilience of credit institutions to potential losses from deteriorating housing loan quality under the adverse scenario. 

Dalintis:

The buffer requirement will not apply to institutions with a housing loan portfolio comprising a very small share of the housing loan portfolio of the entire credit institution sector, i.e. below EUR 50 million, a figure which currently accounts for approximately 0.5% of total housing loans in Lithuania. Therefore, this requirement will not affect market participants whose impact on systemic risk in the housing market is negligible. On the basis of current data, the buffer will be applied to five institutions: AB SEB bankas, Swedbank, AB, AB Šiaulių bankas, the Lithuanian Central Credit Union and the United Central Credit Union groups. All of these institutions already have sufficient capital to meet the requirement when it comes into force. Since loans granted by foreign bank branches in Lithuania comprise approximately one-quarter of the housing loans in the country, the Bank of Lithuania applied to the ESRB, which, at the its request, issued a recommendation to other national competent authorities to recognise the sectoral SRB established by the Bank of Lithuania and to apply it to banks established in their jurisdictions with housing loan portfolios exceeding the materiality threshold mentioned above.

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Abbreviations

AB                    public limited company

CCyB                counter-cyclical capital buffer

CFPO                crowdfunding platform operators

CIU                   collective investment undertaking

CRD                  Capital Requirements Directive

CRR                  Capital Requirements Regulation

CU                    credit union

DSTI                 debt service-to-income

EBA                  European Banking Authority

EC                    European Commission

ECB                  European Central Bank

EMI                  electronic money institution

ESRB                European Systemic Risk Board

EU                    European Union

EURIBOR          Euro Interbank Offered Rate

Eurostat           Statistical Office of the European Union

Eurosystem      European Central Bank and euro area central banks

GDP                  gross domestic product

GHG                 greenhouse gas emissions

HICP                 Harmonised Index of Consumer Prices

IMF                   International Monetary Fund

LRDB                Loan Risk Database

LTV ratio           loan-to-value ratio

MFI                   monetary financial institution

ML/TF               money laundering and terrorist financing

P2P LPO            peer-to-peer lending platform operators

PI                     payment institution

RE                    real estate

RLR                  Responsible Lending Regulations

SB                    specialised bank

SME                  small and medium-sized enterprises

SRB                  systemic risk buffer

STI                   State Tax Inspectorate

Country codes

AT                                Austria

BE                                Belgium

BG                                Bulgaria

CY                                Cyprus

CZ                                Czech Republic 

DE                                Germany

DK                                Denmark         

EE                                Estonia

ES (in charts)                Spain

EU                                European Union

FI                                 Finland

FR                                France

GB                                Great Britain

GR                                Greece

HR                                Croatia

HU                                Hungary

IE                                 Ireland

IT                                 Italy

UK                                United Kingdom

US                                United States of America

LT                                 Lithuania

LU                                Luxembourg

LV                                Latvia

MT                                Malta

NL                                The Netherlands

NO                                Norway

PL                                 Poland

PT                                 Portugal

RO                                Romania

SE                                Sweden

SI                                 Slovenia

SK                                Slovakia