Fresh reports from two leading western financial institutions highlight Latvia's vulnerability if a global credit squeeze were to ensue in the near future.
"The rise in borrowing costs following this summer's credit crunch will probably have the beneficial effect on cooling some of the region's most overheated economies," the European Bank for Reconstruction and Development wrote in its annual Transition Report.
The bank warned that a sharp rise in borrowing costs or a prolonged inability to borrow on international capital markets would have more drastic consequences for some countries. "Countries with high external funding needs may experience a stronger than expected economic downturn," the bank said, adding the Baltic states and Kazakhstan as the most vulnerable.
Deutsche Bank analysts have suggested liquidity and funding risks have increased across Eastern Europe in recent months.
"Borrowing costs have risen across the region. The Kazakh, Russian and Latvian banking sectors are the most vulnerable to funding and liquidity problems. In these countries the volumes of deposits do not assure sufficient funding of the ongoing lending boom," the bank's analysts said.
"In Latvia, domestically owned institutions are most vulnerable to funding and liquidity problems, especially to a potential flight to quality by deposits towards foreign-owned banks... A hard landing would hit all banks as they are heavily exposed to an overheating housing market (50 percent of total loans connected to real estate)," Deutsche Bank said.
"The strong reliance on external funding puts the key policy tools to engineer a soft landing into the hands of the managers of the largest Nordic banks present in the country. As neither a hard landing nor a continued overheating economy is in their own interest, we expect them to slow down credit growth to some 30 percent year-on-year," the analysts say in their comment.
Although the Latvian market's liquidity has decreased since July as a result of the global credit crunch, it is still significantly higher than during the Russian crisis in 1998 and has not reached critical levels yet, the bank said.