Central banks,economic statecraft and offshore banking: Comparing financial internationalization strategies in Latvia and Estonia

Peg to the Russian rouble in Latvia

The BoL became operational in 1990 as a branch of the Soviet Vnesekonombank, taking over currency exchange operations, which at the time were highly regulated across the Soviet Union due to exchange rate risks (Fleming et al., 1996; Fleming and Talley, 1996). However, the BoL leadership did not espouse the regulated approach of Moscow and instead opted for a radically unfettered approach. The BoL governor Repše saw unlimited foreign exchange from Russian roubles as part and parcel of the broader package of economic transition, where foreign exchange markets had to be fully liberalized even before setting up an independent CB (Repše, 1993). Unlike his Estonian counterpart, Repše deliberately rejected any CB role in providing currency exchange: ‘The BoL is unequivocally opposed to the monopolization of currency exchange. There is no serious basis for such an idea, as it is quite clear that closing of small currency exchange offices will increase black market operations’ (Lapsa and Saatčiane, 2008).

As a consequence of a decision by the BoL, as of January 1991, Latvia became the only post-Soviet state with unlimited convertibility between non-convertible Russian roubles and Western currencies (Laar, 2002). The BoL openly allied with the domestic entrepreneurs, delegating them the function of foreign exchange between convertible Western currencies and non-convertible Russian roubles. In April 1991, the BoL granted the first currency exchange licence in the former Soviet Union to Parex Bank, an established currency dealer facilitating a significant share of trade transactions from Russia and Ukraine. Riga was turned into the largest cash market in the former Soviet bloc, attracting huge amounts of rapidly inflating Russian roubles from all over the crumbling empire (Laar, 2002; Lainela and Sutela, 1994). As recalled by Valery Kargin, the co-founder of the Parex bank, the first and the largest player in the sector: ‘The process reached such a scale that sometimes we sent several cash-stuffed TU-134 aircraft a week to the Russian regions of Orenburg, Siberia, and don’t know where yet. We embarked the cash, and the plane took off with security men, cashiers and often the cash owners themselves’ (Kargins, 2005).

However, even if the massive financial inflows led to overheating of the Latvian economy – for example, in 1992, inflation reached almost a thousand percent – the Latvian CB continued to accept Russian roubles and converted them to ‘hard’ Western currencies. As argued by Governor Repše in June 1992: ‘We are ready to uncouple from the [Russian] rouble if … the Bank of Russia does not hold its ground [and devalue] … for now, there is no such threat. I hope that Russia will hold on’ (Saeima, 1992). However, the massive inflow of Russian roubles continued even after August 1992 when the BoL introduced differentiated exchange rates to accommodate for inflationary dynamics in the Russian rouble zone (Lainela and Sutela, 1994). It took as long as January 22, 1993, for the BoL to regain control of monetary policy by ‘cutting the naval string with the Soviet monetary system’, as retrospectively assessed by the BoL (Bitāns and Purviņš, 2005: 144–145). In February 1994, after an extended period of extremely tight monetary policy, the BoL decided to peg the Latvian currency to the IMF’s Special Drawing rights. Yet, the protracted integration into the Russian monetary system proved to be highly formative to Latvian non-residential banking. In 2005, the BoL acknowledged that Latvia’s emergence as an ‘important financial centre for international settlements of the former USSR republics…was facilitated by the liberal currency market and free currency convertibility’ (ibid. p. 152).

Rapid uncoupling from the Russian rouble in Estonia

In stark contrast with Latvia, the Estonian authorities preferred rapid separation from the Russian monetary system (Madariaga, 2017: 651–653; Raun, 2001: 24–25). An important role in shaping this determination was played by the Estonian 1992 banking crisis when Moscow froze foreign banking assets. This led to an emerging consensus between the BoE and the government that Estonia’s prosperity and growth could only be found by integration into the West (Fleming et al., 1996). As Ardo Hansson, a key architect of the Estonian monetary reforms and a subsequent BoE governor (2012–2019) told this author: ‘Losing that money in Russia, that was such a painful lesson, that you did not dare to go to that business again… I don’t know whether there was a fundamental vision [initially] other than a bias towards anything Western’ (Hansson, 2022).

Regarding integration into the Western economic system, the most consequential decision by the BoE was the introduction of a currency board which tied the Estonian kroon to a basket of Western currencies. If the Latvian rouble was initially a legal extension of the Russian rouble, the supply of Estonian kroon was strictly tied to the available Western currency reserves (Hansson and Sachs, 1994; Lainela and Sutela, 1994). Although viewed by the IMF as a step too far, the currency board served the Estonian authorities’ geo-economic objective to uncouple from Russia and, according to one insider, was a ‘realistic [solution], given our [limited] skills, education, and experience’ (Laar, 2002). Furthermore, the BoE’s swift introduction of the currency board was paired with the restrictions on the exchange of non-convertible Russian roubles, thus protecting the economy from a massive influx of Russian roubles from CIS and reducing the business opportunities for domestic bankers working with Russia. Estonia deliberately eschewed Latvia’s ‘very liberal’ approach with no limits on the exchange between the newly introduced currency and the Russian roubles (Laar, 2002, 2014). The BoE’s strict limits on the cash each Estonian resident could exchange effectively amounted to temporary capital controls. Ultimately, such restrictions directly stemmed from the hard constraint of the currency board, stipulating that new base money could be issued only with a corresponding increase in the convertible Western currencies (Fleming et al., 1996).

As Vahur Kraft, the CB governor between 1995 and 2005, explained to this author: ‘Only after some months, we liberated our capital control law, step by step. To a significant extent, such prudence was warranted by the currency board system, which imposed a hard constraint as to how much Estonian currency could be issued … There was a danger of speculative attacks against Estonian currency, and with capital controls, we avoided that’ (Kraft, 2022). This was confirmed to this author by Ardo Hansson: ‘When the banking [system] was set up in the rouble zone, your currency was … the base currency … and the risks came from dealing with Finish marks or dollars. However, the moment you did this rigid pegging to the DM, you drastically reduced all the risks looking at the West, and all the risks dealing with roubles suddenly accelerated. That alone encourages a lot of re-orientation’ (Hansson, 2022). In sum, the rapid introduction of a currency board against the backdrop of the 1992 banking crisis effectively helped the BoE to close off the economy to Russian roubles with far-reaching consequences on the development of the banking sector (Hirvensalo, 1994; Korhonen, 1996). During the 1990s, these interrelated decisions by the BoE effectively set Estonia on a markedly different financial development trajectory, nipping the emergence of domestically owned offshore finance in the bud.

Towards Latvia as a financial entrepôt

The idea of Latvia as a financial offshore was first put forward by the BoL governor Einars Repše (1991–2001). A physicist by training, Repše was a self-taught monetarist who believed in an open economy and conservative monetary policy leading to stable prices (Bohle and Greskovits, 2012). He explicitly aspired to turn Latvia into an international financial hub, modelled after Switzerland (Aslund, 2017; Bohle and Regan, 2022; Lainela and Sutela, 1994). Repše was closely allied with Ilmārs Rimšēvičs, his deputy governor (1992–2001) and successor (2001–2019) who executed and anchored the vision throughout the three post-socialist decades. As early as 1992, Rimšēvičs argued that ‘[i]f a financial system was created in Latvia that could serve both the East and the West, we would become another small Switzerland. That would be a huge achievement – this is how Latvia could rise’ (Latvijas Jaunatne, 1992). In their shared vision of Latvia as a financial bridge, the two central bankers openly allied with the domestic financial elites, building on the well-established practices of currency exchange in Riga in the 1980s (Kargins, 2005; Sommers, 2018; Sommers and Briskens, 2021). The BoL explicitly wanted to cultivate domestic financial capital, rather than attracting foreign investors. As Rimšēvičs argued at the time: ‘We must promote the development of the Latvian financial market in every possible way – but by relying on our forces. If we let foreign banks here, Latvian commercial banks could barely survive here’ (Latvijas Jaunatne, 1992).

In stark contrast with Estonia, the relations between the BoL and the Latvian governments remained tense throughout the 1990s. Although all post-transition governments of the 1990s espoused geopolitical neutrality to take advantage of the strategic location between the two geo-economic blocs (Austers, 2016: 212–218), the politicians remained hesitant about direct financial engagement with Russia. This was mostly due to prevailing ethnic nationalism, specifically, over such issues as the Soviet industrial and military legacy, citizenship, language, and rights of the Russian-speaking population more generally (EIHMANIS, 2019; Muižnieks, 2006). The dominance of such topics in the mainstream political agenda enabled the BoL to take a lead in the ‘quiet politics’ of financial governance (Culpepper, 2016), enabling it to proactively pursue its vision of non-residential financial services as a national development strategy (Aslund, 2017; Bohle and Regan, 2019).

However, when the Latvian economy was flooded with inflationary Russian currency as a result of the ‘no-limits’ convertibility of the Russian rouble (Bitāns and Purviņš, 2005: 144), the BoL’s approach, including the shadowing of the Russian rouble and favouritism towards the domestic financiers, was openly questioned by the Godmanis government (Saeima, 1992). The transcripts of the Latvian Supreme Council debates between June and October 1992 – the crucial period of the Latvian monetary reform – reveal fierce clashes between the CB governor Repše on the one hand, and Prime Minister Godmanis, who threatened to curtain the CB’s power by establishing a state development bank. According to Godmanis, such an institution would supposedly not only be more responsive to the credit needs of the economy but also take over the function of foreign exchange, which at the time had been fully delegated to private actors, such as Parex (ibid). In sum, in pursuing its vision of a financial entrepôt, the BoL directly built on the established business practices by domestic financiers, while keeping the elected government at arm’s length.

Towards foreign-owned banking in Estonia

In stark contrast to Latvia, in Estonia, the financial reform process was guided by the vision of increasing Western ownership, which then would help the economy as a whole. As a former BoE governor explained to this author, from the start the Estonian strategy was to attract foreign capital: ‘The BoE played a major role in that [process], first inviting international and multi-national institutions to the market, and later private banks came on their own’ (Kraft, 2022). Unlike Latvia, the Estonian monetary reform of 1992 was adopted by consensus between the BoE and the Laar government which closely cooperated both regarding the development of a strategic vision as well as its technical implementation. As recalled by Ardo Hansson, the BoE and government officials worked shoulder-to-shoulder, although the ‘technical capacity and expertise mostly came from the CB’: ‘At the time, I was an advisor to [the Prime Minister] Tiit Vähi, and it was purely about monetary reform, although the main work was more with [the governor of Eesti Pank] Siim Kallas. I was officially in Toompea, with the government, but the daily activities of preparing for the monetary reform were still at Eesti Pank’ (ERR, 2021). In an interview with this author, Hanson confirms: ‘It was quite consensual in the sense that it depended on few people who happened to get along reasonably well … everybody was pulling in the same direction’ (Hansson, 2022). Such unity was key to withstand the economic pressures and social grievances due to the rapid introduction of a currency board. As recalled by the then PM Laar, the societal pressures against the authorities included ‘attempts to topple the government using all kinds of methods … stand-off in the parliament … and demonstrations by incited pensioners in front of the parliament building’ (Laar, 2002). However, the BoE was able to withstand these pressures due to the shared consensus with the Laar government in power (Aslund, 2007; Bohle and Greskovits, 2012).

In addition, the Latvian and Estonian approaches markedly differed regarding their relationship with the domestically owned banks and their relationship with Russia. If the BoL openly cooperated with the established domestic financiers profiting from the exchange of Russian roubles, the Estonian authorities acted against such domestic financial interests. After the 1992 banking crisis (see above), PM Laar and the BoE governor Siim Kallas made it clear that the state would not bail out the collapsing banks which had engaged in high-risk operations, most notoriously, with Russia (Fleming et al., 1996; Laar, 2002; Madariaga, 2017). As noted by Prime Minister Laar, the state authorities pursued a ‘politically motivated resistance … against the influx of Russian capital’, stepping up regulatory standards and making financial transactions with the CIS countries increasingly difficult (Laar, 2002; Sõrg et al., 2004). Subsequently, the BoE significantly consolidated the banking sector, and the total number of banks in Estonia diminished from 43 in 1992 to 23 in 1993 (Lainela and Sutela, 1994). As demonstrated in the following section, the BoL then sought to improve the financial governance standards through rapidly increasing foreign ownership. According to a retrospective account by the Estonian Ministry of Foreign Affairs (2009): ‘With harsh measures, the government made it abundantly clear that Russia’s dirty money was not welcome in Estonia. After a few attempts, this was understood’ (Ministry of Foreign Affairs, 2009).

Selective regulation in Latvia

The 1992 Commercial Bank Law specified a few prudential regulations over six pages, providing full discretion to the BoL (Hansson and Tombak, 2011). In 1995, the BoL supervised as many as 79 licenced credit institutions, including 63 commercial banks. Many of them engaged in Ponzi schemes promising depositors an annual interest above 100%; others specialized in funnelling wealth from the CIS (Bank of Latvia, 1996; Bitāns and Purviņš, 2005; Hallagan, 1997a). The light-touch regulatory framework was hardly enforced, if at all. As early as the mid-1990s, the BoL noted that although the banking regulations were in line with EU directives, they ‘did not have the force of law’ (Bank of Latvia, 1996: 27).

The 1994–1995 banking crisis questioned Latvia’s increasingly financialized economic model and the regulatory framework behind it (Fleming et al., 1996; Fleming and Talley, 1996). The anger of domestic depositors over the lost savings – mostly in Banka Baltija, the then-largest domestic bank – put pressure on the political class and constituted a ‘to be or not to be’ moment for the Latvian offshore finance sector (Austrālijas latvietis, 1995; Saeima, 1995). The BoL was hard-pressed to step up the regulatory framework which endangered the very survival of Latvia as a financial hub. Illustrating how high the stakes were in the mid-1990s, a prominent Latvian economist argued that ‘the hope of becoming a second Switzerland’ could only be saved if the favourable geographic monetary and cultural preconditions were complemented with ‘appropriate banking legislation and supervisory framework … ensuring the two main factors: security and confidentiality’ (Krastiņš, 1995).

However, in line with its vision of a financial hub, the BoL openly sided with the established domestic financiers. Its regulatory policies favoured the domestically owned banks serving non-resident depositors in the CIS countries. While significantly stepping up regulation for the ‘core’ banks serving households and businesses, the BoL hardly changed the regulation for ‘non-core’ banks that exported their services abroad (Fleming et al., 1996). Out of 39 banks that were allowed to operate, only 14 were allowed to accept domestic deposits, whereas the other 25 banks specialized in serving clients from the CIS states (Bank of Latvia, 1996). The 1998 Russian crisis – when Moscow’s debt moratorium imposed significant losses on the Latvian domestic banks holding Russian government debt ² – was another test for the BoL’s alliance with the domestic financial interests and its relations with Russia. Similar to the 1995 crisis, the BoL hesitated to act against the interests of domestic non-residential finance, which continued to grow in the following decades (Bowen and Galeotti, 2023; Pataccini, 2023).

Although the integration into the EU improved the regulatory standards overall (Bukovskis, 2022), the state authorities indirectly supported the sector through purposeful non-enforcement (Bowen and Galeotti, 2023; Dewey and Carlo, 2021). Having required establishing an independent financial regulator as part of the acquis (Eihmanis, 2019a), the EU constantly fell short of winding down the Latvian non-residential banking practices, including through the hard conditionality of the Balance-of-Payments programme and euro accession (Eglītis et al., 2014; OECD, 2015). It was only in the late-2010s as the United States leveraged its security guarantees vis-à-vis Latvia, when the Latvian authorities carried out comprehensive cleansing, effectively closing down the non-residential banking sector (Banka, 2023; Buckley, 2018; Meyer et al., 2018).

Conservative regulation in Estonia

From the early 1990s, the BoE pursued a more conservative regulatory policy than the BoL, demanding higher capital adequacy ratios and provisions against bad loans than required by international standards. After the 1992 banking crisis when Estonian assets were frozen by Moscow, the BoE became one of the ECE leaders in banking supervision and enforcement capabilities in line with the International Accounting Standards (IAS) (Bank of Estonia 1993, 1994, 1995, 1996; Kraft 2004). Bank supervision allowed the BoE to maintain a risk-averse supervisory approach throughout the 1990s (Spendzharova, 2014: 7–8). Throughout the 1990s, the BoE significantly increased the levels of foreign ownership, aiming to increase the governance standards and provide emergency financing in times of crisis (Hansson, 2022; Kraft, 2022; Spendzharova, 2014: 7). As the former CB governor Vahur Kraft (1995–2005) told this author, the BoE’s was deeply concerned that the Estonian domestic banks would fail and would have to be saved by the state. The BoE aimed to prevent such a scenario through increasing foreign ownership: ‘We at the CB had lots of meetings in international forums, at the IMF and the World Bank, EBRD where we invited foreign banks to Estonia. And the reason was better governance, clear ownership, and equity capital…This was a clear strategy’ (Kraft, 2022).

The 1998 Russian crisis and the debt moratorium further enforced the Estonian trajectory towards regulatory upgrading by attracting foreign financial capital. The consolidation of the domestic banking sector effectively upended Eesti Forekspank, the last major domestic outlet serving non-residents from Russia. After the takeover by the BoE, in 2000, the newly created Optiva Pank was sold to the Finish-based Sampo Bank and in 2007 acquired by Danske (Bruun & Hjejle, 2018). By the late 1990s, the Estonian banking sector was overwhelmingly foreign-owned, dominated by two Scandinavian banking groups – Foreningssparbanken (Swedbank) and Skandinavska Enskilda Banken (SEB) (Kraft, 2004; Sõrg et al., 2004).