lucas papademos : financial structures, credit growth and house prices in the new eu member states - policy challenges on the road to the euro speech by mr lucas papademos, vice president of the european central bank, at the conference held by latvijas banka, riga, 19 september 2005. * i. * * introduction it is a great pleasure for me to speak at this conference organised by latvijas banka, in a country that has played such an important role as a major trading centre in european history. initially, that role partly reflected its geographic location on one of the oldest trading routes in europe – the so - called “ route from the vikings to the greeks ”, which was used to trade, among other things, latvian amber – a route dating back to the times of the ancient greeks and the roman empire. and then later, the city where we have gathered today, riga, became one of the most significant members of the hanseatic league, which controlled trade on the bustling baltic sea in the 14th and 15th centuries. today, latvia has a modern and dynamic economy, again occupying an important position in european trade, having achieved a remarkable transition towards a successful market economy after gaining independence in 1991. trade and finance have always gone hand in hand. therefore, it is no surprise that just as the latvian economy has undergone an impressive transformation, so too has the latvian financial system. latvia has made substantial progress in the development of its financial structure and has created the institutional and legal frameworks necessary to support a market - oriented financial system. 1 today, its financial markets are developing rapidly in new directions and are providing valuable services to both households and the corporate sector, underpinning the functioning of a modern high - growth economy. as i am addressing a distinguished audience with expert knowledge of the latvian economy, i consider it appropriate to take a broader and more comprehensive view, and look at the development of the financial sector not only in latvia, but in the new eu member states as a whole. after an overview of certain salient features characterising the financial structures of these countries, i will concentrate on two issues that have recently received considerable attention from both policy - makers and the media : strong credit growth and rapidly rising house prices. this will bring me to the focal point of my remarks : the challenges arising from these developments and the appropriate policy responses. ii. features of the financial structures in the new member states many of you have witnessed at first hand the remarkable

transformation of the economies and financial systems of the new member states in central and eastern europe over the past decade. the convergence of the financial structures of these economies with those of western europe has also been significant. the modernisation of a country ’ s financial structure – that is, of the whole set of financial markets, instruments and institutions – is of crucial importance for actual and potential economic growth, and has received a lot of see european central bank, “ financial sectors in eu accession countries ”, july 2002. 1 / 7 attention from both academics and policy - makers. 2 financial structures differ from country to country, reflecting the influence of various factors and of different traditions ; but those structures also change over time as the processes of economic development and financial integration evolve. looking at the financial structures of the new eu member states today, five key characteristics are apparent. first, the overall degree of financial depth in the central and eastern european countries is still lower than in the euro area. this applies in particular to financial intermediation by banks and to the household sector. for example, bank financing represents a much smaller share of gdp than in the euro area. 3 it may be argued that if the low degree of financial intermediation persists, this could impede the efficient channelling of savings to investment, and that further financial reforms would therefore be needed. second, the capital markets in these countries remain relatively underdeveloped. as a result, the issuance of quoted equity and debt securities by non - financial corporations in order to finance their investments and operations is not as important as in the euro area. this may come as a surprise, given that the stock markets in the new eu member states have experienced very strong and, indeed, accelerating growth over the past few years. the average annual returns on equity in most of these countries have outperformed significantly those of the stock markets in the euro area. on the one hand, the substantial increases in equity prices in the new member states may have reflected a rise in the fundamental values of the shares. on the other hand, this development may also reflect supply constraints : the limited issuance of new equity by firms and the relatively small number of companies listed. for example, the share of the five biggest listed companies in total market capitalisation and turnover is very high in most of the new eu member states. thus, since liquidity in these markets is relatively low, price movements in a small number of companies might influence to a relatively large extent the overall