Why Low Investments and Lending are Not the Only Factors Holding Back Latvia’s Growth and Convergence with Europe

Indisputable – economic growth and rapid convergence with the level of European prosperity require investments, which are too low in Latvia. Investments are financed by lending, which is also at a very low level. Loans are issued by banks. You can immediately think that the banks are to blame for the low investments and the country’s backwardness. However, it must be said that such a conclusion is hasty. In our argumentation, we will take as a basis the annual survey of companies conducted by the European Investment Bank (EIB), the purpose of which is to find out the driving forces and barriers to investment in European, including Latvian, companies.

In the 2022 survey conducted by the EIB, it was found that only 62% of companies invested in Latvia in the reporting year, while in Europe, Estonia and Lithuania this proportion was around 80%. This echoes the observations in the macroeconomic data – low corporate investments compared to the gross domestic product have been visible for years. Why do we invest so little? Does the availability of credit play a decisive role in the investment decision? And what to expect next?

The EIB survey shows that out of all Latvian companies that made investments, about half of the companies used even a small part of external financing, and this mostly (71% of cases) came from banks. These results are very similar to the average results of Europe and Lithuania, while in Estonia alone, a third of companies use external financing when investing, of which only half comes from banks. If we look at the amount of investment, on average, 72% of the total amount is financed by Latvian companies from internal resources, 27% – relying on external (including bank) financing, and 1% – on loans from group companies. In this respect, it must be said again that we are very similar to Europe and Lithuania, while Estonians finance a larger amount of investment from internal resources.

Two main conclusions emerge from these EIB survey data. The first – bank financing, although important, is by no means the only type of investment financing. Mostly companies in Europe and the Baltics finance their development from internal resources.

It is important to note that Latvian companies do not stand out against the European and Baltic background with a particularly small share of external financing in investments. So, despite the faster dynamics of lending in Europe and the neighboring countries, it is not the case that companies finance a much larger part of their investments by borrowing. On the contrary – in Estonia, which according to macroeconomic data invests much more than Latvia, a significantly smaller number of companies rely on bank financing when making investments. This leads to the second important conclusion – if the share of bank financing in the investment financing of Latvian companies is not significantly smaller than elsewhere, then the main obstacle to investment is hardly the much-cited lending.

The EIB survey shows that there are indeed many more companies in Latvia (15.6%) than in Europe (6.2%) that have not had access to external (including bank) financing. In Lithuania, this indicator has been much higher than in Latvia in recent years, but in Estonia it is only slightly above the European level.

More about the reasons why financing is not available for a relatively larger part of Latvian companies has already been discussed many times, so we will not address it in detail in this article. But one of the most important factors is definitely the weak financial situation of companies. Only 66% of companies had positive equity in 2021, and only 57% – positive operating profit, but both of these basic requirements to be able to take a loan are met by an even smaller percentage of companies. In Lithuania and Estonia, the picture is much better – positive equity was recorded in 83% and 97% of companies, respectively, while positive operating profit was in 67% and 65% of companies.

Therefore, external financing is not available for a relatively large part of Latvian companies – this undeniably does not help to promote investments. However, a very important question is how big a role the availability of external financing plays in the decision to invest or not. In the 2022 EIB survey, 67% of Latvian companies mentioned the lack of access to finance as a long-term obstacle to making investments (see picture). This is not little nowadays, and is much more than the average in Europe, Estonia and Lithuania. However, the availability of finance “lives at the bottom” in the list of investment obstacles discussed in the survey. Uncertainty about the future is mentioned as the main long-term factor that discourages investments both in Latvia and in Europe. Almost 90% of Latvian companies cite the lack of qualified labor as an obstacle to making investments. Last year, the issue of energy prices was also very relevant, however, in the future, this will most likely recede from the top of the list of the most important investment obstacles.

It should be mentioned that in both Estonia and Lithuania all investment barriers, not only the lack of access to finance, are perceived as less restrictive. The biggest difference with the neighbors is in business regulation and tax policy, which in the perception of entrepreneurs in the rest of the Baltics hinders investments significantly less than in Latvia. It may be that the neighbors are simply incorrigible optimists, or we are huge pessimists. But there is also a high possibility that these results indicate that the business environment in the rest of the Baltics is more favorable for investments on a much wider scale than just in terms of financing, which is also ultimately reflected in faster growth. This is also unfortunately indicated by Latvia’s low place in various business environment attractiveness indices, as well as the poor result in the recently published index of the Foreign Investors Council on the investment environment in Latvia.

What is important for investments in the short term?

Moving from long-term to short-term factors, the main driver of private investment is the phase of the business cycle in which the economy is located. In years of rapid growth, companies and citizens live with optimism about the future, they have a desire to invest. On the other hand, in a stagnant economy, or even in a recession, it is clear that everyone tries to take care of their financial security and stability rather than taking new risks when investing.

Some recent statements by politicians and organizations lead us to believe that we will be able to pull the economy out of the slowness caused by the war and the cost of living by calling on banks to rapidly increase lending “tomorrow until noon”. And here wishes do not go together with real possibilities. First of all, the ECB’s policy in the form of high and rising interest rates, which has already resulted in a contraction of lending in the euro area, provides a strong counterweight to lending. Second, the reality of the business cycle in terms of demand must be taken into account. In the conditions of low growth, uncertain future and high risks, we can hardly expect a rapid increase in the demand for loans. Thirdly, the business cycle also affects the supply side – banks must maintain the principle of a responsible lender, which in such times can mean appropriate caution in granting loans. But the good news is that these difficult times will also pass, and the business cycle will begin to rise.

What’s next?

Banks are interested in the rapid and balanced development of the Latvian economy, because it is good for banking business. Banks want to lend – this is the task of banks and the basis of business. Much has already been said that while lending has indeed been extremely sluggish throughout the post-2009 crisis, from the banks’ perspective it has a much better chance of growing in the next business cycle. The Financial Industry Association has also highlighted the priority directions in which banks currently see the greatest lending potential. It is important that borrowers also have desire, courage and ambition. But what business surveys show is that the most important prerequisite for a sustained investment boom is to improve the business environment as a whole.

Of course, everything in the economy is connected – the increase in lending will also be reflected in the increase in investments. However, it should be understood that faster lending by itself will not reduce the other investment barriers mentioned by entrepreneurs. The uncertainty that companies cite as the biggest obstacle is not only related to external demand and geopolitics, things we can’t do much about. Uncertainty is also an internal problem of Latvia. The stability and predictability of legislation and tax policy related to business matters here. We need a clear vision of the country, where we will hire a high-quality and healthy workforce in the future, an understanding of what kind of energy policy we can count on in the long term, etc. In the context of the business environment, there is also a lot of talk about the need to reduce bureaucratic obstacles, administrative burdens and, quite simply, to trust entrepreneurs more.

Similar to how lost keys in a dark park tend to be looked for not where they fell, but under the lamp, we also try to “find” the culprit of missing investments where the “bad” person to blame is clear. On the other hand, for example, disorganized company balance sheets, a high share of the shadow economy, a lack of qualified and healthy workforce, excessive bureaucracy are ungrateful culprits, because problems that have been known for years and have been allowed for years have no quick solutions.

Faster investments, as well as faster lending, are necessary for a strong and growing Latvian economy. These goals definitely go hand in hand – by supporting and encouraging one, we will help both grow. In summary, we would like to say that in many ways, lending is rather the “brother in trouble” of investment, than the main culprit of the lack of investment in Latvia.