The Bank of Latvia recently increased the lat refinancing rate by 0.5 percent in order to keep the Latvian economy from overheating.
This decision will make loans in lats - already more expensive than borrowings in other major currencies - even more expensive for consumers. But will this interest rate hike help to subdue rising inflation in the country? We don't think so, as the effect of the central bank's action is just too limited.
There are at least three reasons for the recent decision of the Bank of Latvia: The sweeping growth of the economy over the last few years, which has started triggering inflation;
Latvia's entry into the European Union (where prices for many products and services are noticeably higher), which is already having an inflationary effect on prices;
The Bank of Latvia's obvious concern about the explosive growth of consumer and mortgage lending (mainly due to lower interest rates), which in turn may also overheat and lead to a burst.
In our opinion, the latest activities of the Bank of Latvia will not have a significant impact on the lending market and Latvian interest rates. Historically, a substantial portion of loans in Latvia has been issued in other currencies - i.e., U.S. dollars and euros. Interest rates on loans in these currencies are considerable lower than those for lat-denominated loans - in euros by over 2 percent and in U.S. dollars by over 3 percent.
In general, further growth of loans in dollars and euros is hampered by currency risk, which many Latvian borrowers are hesitant to take upon themselves. Higher interest rates in lats will facilitate more interest in foreign currency-denominated loans, especially in euros, since beginning in 2005 the lat will be pegged to the euro. In a few years it will be completely replaced by the euro.
This means that long-term loans issued today in lats will have to be repaid in euros anyway. This is why we offer Rietumu Banka's clients to take longer term loans in euros in order to benefit from the favorable interest-rate difference compared with that of lat-denominated loans, while at the same time taking on very limited - if any - currency risk.
It should be noted that in the medium-term perspective we are also expecting an increase of basic rates in euros and U.S. dollars due to the start of a new cycle of economic growth in Europe and the United States. However, even with this forecast in mind, loans in euros will be cheaper than lat-denominated loans for the next few years. Loans in U.S. dollars, though the most attractively priced today, carry significant currency risk, which will become even higher after the lat is pegged to euro. o
Leonid Alshansky is head of the analytical division of the investment management
department at Rietumu Banka.