A quarterly magazine of the IMF

March 2006, Volume 43, Number 1

Going too Fast?
Paul Hilbers, Inci Otker-Robe, and Ceyla Pazarbaşıoğlu

Managing rapid credit growth in Central and Eastern Europe

Many of the Central and Eastern European (CEE) countries have recently experienced a rapid expansion of bank credit to the private sector. This process, already apparent at the beginning of the decade, has only become stronger. During 2000–04, credit increased by about 17 percent a year on average in real terms across the region. In 2004 alone, credit to the private sector increased by about 30–45 percent in real terms in 6 of the 15 countries. As a result, the ratio of private sector credit to GDP has also increased significantly in these countries, albeit generally from a low base.

Are these developments simply the result of a normal and expected "financial deepening," as the CEE countries continue their move toward fully developed market economies in an integrating Europe? In that case, credit growth would largely be absorbed by an increase in money demand without major macroeconomic consequences. On the demand side, the credit expansion is supported by higher income expectations, often related to these countries' (prospect of) accession to the European Union (EU). On the supply side, the credit surge has been facilitated by foreign financial institutions entering these markets with the objective of rapidly gaining market share. While these institutions often have only limited exposure to any particular country, they play a significant role in the local banking systems.

The expansion of credit from relatively low levels of financial intermediation would support this "catching up" hypothesis (see circle,
Chart 1). For example, Ukraine had a private sector credit ratio to GDP of about 8 percent in 1999 and has experienced an increase in real growth of private sector credit of almost 40 percent—along with countries like Bulgaria, Moldova, and Romania, which showed a rapid growth from low initial levels. Indeed, most of the CEE countries with the fastest growth in private sector credit had credit-to-GDP ratios below the group average of 22 percent (compared with an average for the original 15 EU member countries of over 100 percent).

The rapid credit expansion in these countries is not, however, danger free. Countries' experiences with financial distress remind us all too well that misperceptions about the evolution of risks and inappropriate (or lack of) policy responses can be costly. This article explores policymakers' options, ranging from the well-known monetary and fiscal ones to less discussed, but equally important, supervisory and prudential ones. The latter could be used to strengthen the resistance of the financial system to the adverse consequences of credit expansion.

Healthy or unhealthy?

Is the CEE credit boom worrisome? There is no unambiguous answer to the question of whether the rapid credit growth in these countries is a simple result of catching up, given that the structural changes that have affected these economies make it more complicated to calculate the "normal" level of credit. The key concern, however, is that the process of moving to a new equilibrium—the new normal level—may involve significant risks at both the macroeconomic and microeconomic levels.

On the macroeconomic front, rapid credit growth has contributed to a rise in imports and a widening of the current account deficits in most CEE countries. A continued deterioration in their external balances may increase the risk of speculation against these countries' currencies under the prevailing pegged or tightly managed exchange rate regimes. The low savings rates in most of the countries suggest they are highly dependent on the willingness of foreign investors to fund these deficits. The pattern is similar to experiences of other countries where (over) optimism about future earnings led to a boost in asset valuations and a surge in capital inflows that allowed firms and households to borrow and spend.

On the financial front, it is unclear whether the credit risk systems of banks in the CEE countries will be able to cope with a potential lending boom. In most countries, the prudential indicators do not suggest the banking system has significant vulnerabilities, but many indicators are "lagging," not "leading," ones. Moreover, for many, there are indications of a decline in capital adequacy and some increase in credit risks. Rapid credit growth—particularly in countries where the number of credit applications grows rapidly—has started to put a strain on banks' and bank supervisors' ability to assess risks. Banks' potential exposure to indirect foreign exchange risks may also have increased, since foreign currency–denominated lending represents a substantial proportion of total loans. Loans are increasingly being financed with liabilities other than deposits, as banks expand credit by changing the composition of their assets and by increasing external borrowing. A sharper-than-expected decline in interest margins resulting from stronger competition may decrease profitability and thereby increase the vulnerability of the banking system.

These macroeconomic and financial risks are closely interrelated. On the one hand, macroeconomic instability (inflation and/or external imbalances) may contribute to financial instability—particularly when banks and their borrowers are significantly exposed to interest rate and exchange rate risks. On the other hand, financial instability (a vulnerable financial system) may contribute to macroeconomic imbalances, as markets react by adjusting investment portfolios, including currency holdings. Thus, an appropriate policy response would generally need to include a combination of macroeconomic and prudential measures to tackle both types of risks.

Formulating a policy response

The starting point for a policymaker should be to determine the types of possible macroeconomic and financial stability risks associated with credit growth. This would involve monitoring and analyzing a breakdown of aggregate data in terms of the borrower's characteristics; the loan's purpose; its maturity and interest rate fixation period; currency denomination; and other relevant conditions, such as the availability of collateral and funding sources.

Without such a comprehensive assessment, it is difficult to determine whether an observed rate of credit growth is a cause for concern and how to react. The assessment should also incorporate macroeconomic, macroprudential, and structural factors, including the existence of macroeconomic imbalances, the soundness and strength of the financial system, the quality and effectiveness of supervision and regulation, the structure of the financial system, and the financial health of borrowers. It would be essential to have balance sheet information for household and corporate sectors. Armed with this information, policymakers can identify the key risks associated with credit growth (see Table 1) and assemble measures that will handle the interrelated macroeconomic and financial risks (see Chart 2).

Macroeconomic policies. Managing rapid credit growth that threatens macroprudential stability has been a significant challenge for some of the CEE countries, because the set of available measures is limited by the countries' specific characteristics. Open capital accounts limit the ability of some countries, especially ones with pegged exchange rate regimes, to use monetary policy effectively, because increasing the interest rate tends to attract capital inflows that can further boost money and credit. The relatively high level of "euroization" also weakens monetary transmission mechanisms, making it difficult to influence lending and retail rates through changes in policy rates. Furthermore, in a number of CEE countries, where the fiscal position is already tight, the authorities may not have much room to resort to fiscal measures. Of course, when rapid credit growth is stimulated by inconsistencies or overly strong incentives stemming from macroeconomic or structural policies (for example, a monetary–exchange rate policy mix that creates perceptions of low exchange rate risks and, hence, incentives for excessive borrowing in foreign currencies; or generous fiscal incentives for mortgage loans), the first-best policy response should be to eliminate distortions and reduce incentives. Efforts should also be put into developing effective monetary instruments and eliminating obstacles to their transmission.

Prudential and supervisory policies. A key question is whether prudential and supervisory measures could substitute for monetary and fiscal policies in coping with rapid credit growth when traditional policy tools are not a viable option. In our view, prudential and supervisory measures should be used when there are financial stability risks or when there is room to bring a country's prudential and supervisory framework in line with international best practice. That said, there are limits to what prudential policies can do in the absence of prudent fiscal policies or if monetary or fiscal regimes create incentives that encourage credit growth. A piecemeal approach may lead to efforts to circumvent prudential measures by pushing the lending and borrowing activity offshore or to institutions that fall outside the regulatory framework. For this reason, prudential policies should be considered as part of a comprehensive package of measures to deal with rapid credit growth. Moreover, because such measures are meant to ensure sound lending practices and maintain the resilience of the banking system to adverse shocks, they should not be relaxed automatically when threats to macroeconomic stability subside.

The ability to further tighten prudential and supervisory policies varies across the CEE countries. In many of them, the frameworks have been strengthened (see Table 2), meaning there may be limited room for further tightening. Strengthening the capability of banks and supervisors to better assess and manage indirect exposure to foreign exchange risks is important—especially considering the large proportion of lending in foreign currency and limited information on the degree of hedging by borrowers in many of the CEE countries. Bosnia, Bulgaria, Croatia, Estonia, Romania, Serbia, and Ukraine have taken steps to tighten regulations and supervision, and Poland has pursued measures to both strengthen bank risk management and adjust capital requirements for foreign exchange risk.

Effective implementation of prudential and supervisory measures requires adequate enforcement capacity, cross-border supervisory cooperation and exchange of information, and effective coordination between supervisors of banks and nonbank financial institutions. It is essential to avoid loopholes that can be used for circumvention (for example, a shift away from bank lending to direct foreign borrowing or borrowing from less well regulated nonbank institutions). Similarly, creating an effective dialogue with home supervisors of foreign banks (for example, through bilateral or multilateral memorandums of understanding) will be critical in many of the CEE countries, where rapid credit growth is dominated by a group of foreign parent banks regulated and supervised by home-country authorities.

Administrative measures. A number of CEE countries, such as Bulgaria, Croatia, and Romania, have turned to administrative measures to deal with the rapid growth of credit. They have done this, for instance, by adopting marginal reserve requirements on excessive credit expansion or on banks' foreign borrowing (including from their parent banks). There can be merit to using such measures if, for example, there are significant macroeconomic and prudential risks that justify curbing the amount or growth of credit and if market participants fail to respond appropriately to changing risks and to other measures. However, authorities should consider administrative measures only as a last resort and on a temporary basis, because they often have unintended and undesirable side effects, including on the stability of the financial system that the measures are meant to protect.

Strengthening risk awareness. Where market participants may be pricing risks inadequately, it is essential to promote a good understanding of risk, including through public awareness campaigns against overborrowing and overlending, as Poland has done. This applies in particular to borrowing in foreign exchange, where foreign exchange risks for unhedged borrowers can easily translate into credit risks for the banks. Credit bureaus, as set up in Bulgaria and Romania, can help banks assess the quality of borrowers.

Limiting vulnerability

Rapid credit growth in the CEE countries reflects, at least in part, a process of catching up from low levels of financial intermediation to the higher levels that prevail elsewhere in Europe. However, even when moving to a new equilibrium, the process of credit expansion may become unbalanced and, if not well managed, involve significant risks. To reap the benefits of credit growth while countering these risks, authorities should have in place policies designed to limit the vulnerability of the real and financial sectors. A key element in assessing the vulnerabilities is to accelerate the building of comprehensive information systems that would enable regular monitoring and analysis of credit developments. Authorities need to continue strengthening the prudential and supervisory framework to increase the resilience of their financial systems to adverse consequences of credit growth. These measures, however, will be effective only when supported by a sound macroeconomic policy mix, effective cross-border supervisory coordination, and improved awareness of risk by the private sector.