Will Latvia's pitch for foreign banking business end in tears?

Cypriot banks that attracted huge foreign investment under dubious laws required a European bailout. As Latvia prepares to adopt the euro, similar worries have surfaced.

In less than two months, on Jan. 1, 2014, the small Baltic nation of Latvia will become the 18th member of the eurozone. It is an accomplishment to be proud of. Only the second post-Soviet state to achieve this status, Latvia reached this point after enduring the world financial crisis and the path of drastic austerity that followed.

But some in the EU are looking warily at the eurozone's newest member, noting its banking industry's striking similarities with those of another member, whose financial crash required a European and International Monetary Fund bailout this past spring: Cyprus.

Though it was a mélange of problems that led Cyprus' banking sector to disaster, Latvia's has similar issues, including its reliance on foreign deposits and attraction of dubious money from post Soviet states.

The Latvia banking scene also has a more numerous and varied set of players than is typical in the region, says Karsten Staehr, professor of international and public finance in the school of economics at Tallinn University of Technology in Estonia. “The Latvian banking system has always been much more diverse than Estonia’s, for instance. There are very many banks given the small size of the country and the banks have owners from Western Europe, Latvia, Russia and other ex-Soviet countries.”

And Latvia's banks have had a troubled history of both criminal ties and economic crisis, Dr. Staehr notes. “Latvia was once on the US list of countries not doing enough to combat money laundering. Parex bank collapsed during the global financial crisis and the government was not able to finance the rescue of the bank and therefore had to turn to the IMF and other lenders for help.”

Tax haven to be?

The passage of recent banking legislation designed to make Latvia more competitive and attractive to investors is also a source of concern.

The laws, which go into effect with adoption of the euro, put Latvia on a par with other EU countries regarded as tax havens. The EU average for corporate tax stands at 23.5 percent. Latvia’s, at 15 percent, is third lowest, after the 12.5 percent of both Ireland and Cyprus – whose banking sectors both collapsed in the financial crisis.

The new legal framework could also make Latvia a stopover for tax havens outside the EU like the Cayman Islands. This is because holding companies, concerns which hold stock for other companies, are not taxed for dividends and stock sales in Latvia, and as of next year will not owe tax on interest or licensing fees they pay to foreign companies.

This regime allows foreigners to park their money in Latvia and move it to third countries more cheaply than in other tax-friendly EU countries like the Netherlands, Cyprus, Ireland, and Malta.

Some analysts, however, see Latvia’s courting foreign deposits merely as a natural product of its geography and society.

“Yes, there are considerable foreign deposits in Latvia,” says Morten Hansen of the Stockholm School of Economics in Latvia’s capital Riga. “This kind of banking is a comparative advantage for the country: There is proximity to eastern markets and being inside the EU makes investment safer and comparatively well regulated. The Russian language is spoken and the business mentality of the east is understood.”

Luring investors

In fact, Latvia has gone to great lengths to attract foreign investment, including offering depositors of sufficient means the opportunity of residency – and thus the coveted Schengen visa that comes with it. That means these investors can live and travel freely in Europe, something highly valued by those from Russia and other post-Soviet states where standards of living are generally lower. A depositor or investor of 100,000 lati ($192,000) can be granted a five-year residency in Latvia, a scheme not held in universal esteem.

“This is a completely mistaken policy,” says Alf Vanags, director of the Baltic International Centre for Economic Policy in Riga. “It has encouraged property speculation and increased the price of real estate in the center of Riga."

Still, Mr. Vanags says, Latvia is not Cyprus. "I don’t see foreign deposits as a particular problem. It is of a totally different order than what was happening in Cyprus.”

Indeed, Latvia’s banking system is much less inflated than that of Cyprus during its crisis – and with deposits at 128 percent of GDP, much lower than the EU average of 359 percent of GDP. Whether the new tax incentives favoring foreign depositors will cause problems down the line is for now a matter of speculation.

“Is there some concern?” asks Hansen rhetorically. “I am quite sure that some – but certainly not all – of this money is dirty, but so it was in Cyprus, and so it is in Switzerland, Luxembourg, etc., etc. But I don't see any particular risk at the moment.”