During the second half of the 1990s, deep economic and financial crises in Bulgaria, Romania, and Ukraine all but halted financial intermediation. Subsequently, prudent macroeconomic policies spurred a rebound in economic growth, especially growth of profits, and this recovery whetted the appetite for borrowing and improved banks’ perceptions of borrowers’ creditworthiness. The entry of reputable international banks, along with strengthened central bank regulatory and supervisory frameworks, restored domestic confidence in the banking sector, leading to a quick rise in deposits and pressure to find profitable asset placements. Capital poured in, primarily through the mostly foreignowned banking sector, in response to lower country risk premiums and improved business conditions. At the same time, sharply declining budget deficits and ample external budgetary financing limited government paper issuance.
Initially, banks remained risk-averse, maintaining high cash balances in all three countries while also, in Bulgaria, building up net foreign assets and, in Romania, investing mostly in government securities. This cautious approach stemmed from a lack of information (including short credit histories) about prospective domestic borrowers, doubts about contract enforcement, and the loss of a large client base, because state-owned enterprises were no longer deemed creditworthy without state guarantees. However, aided by economic recovery, a return of confidence, strengthened bank balance sheets, and privatization of state banks, the risk-averse behavior gradually gave way to increased domestic lending.
Increased financial intermediation is usually associated with an increase in economic growth, but rapid credit growth can also pose risks for macroeconomic and financial sector stability (see box). In emerging markets, credit booms typically result not in higher inflation but in current account deterioration and exchange rate appreciation. This has been the case in Bulgaria and Romania where, during the recent credit acceleration, the contribution of domestic demand to real GDP growth rose sharply whereas that of net exports turned negative. Consumer price inflation has remained relatively unaffected in both countries, with overheating so far largely manifested in widening trade deficits because of a rapid growth in imports.
In emerging markets, credit booms typically result not in higher inflation but in current account deterioration and exchange rate appreciation.
When financing constraints are eased, increased bank lending can stimulate higher investment and consumption, and, ultimately, help raise the standard of living. But a rapid increase in bank lending entails two broad risks: the emergence or worsening of macroeconomic imbalances (macro risk) and a deterioration in bank asset quality that can undermine financial sector stability (credit risk). These two risks, when they materialize, are typically mutually reinforcing, creating boom-bust cycles in credit and asset markets and large swings in macroeconomic fundamentals.
Macrorisk. Increased credit availability eases liquidity constraints on households and firms, leading to higher consumption and investment. Given short-run supply constraints, this will tend to exert upward pressure on prices and demand for foreign goods, and thus cause a deterioration in the trade balance. Left unchecked, a rapid increase in credit can boost domestic prices and wages—which at an unchanged or appreciating nominal exchange rate could reduce international competitiveness—and heighten external vulnerabilities. A sudden reversal in capital flows or other external shocks, as well as swift and drastic policy responses, which may become unavoidable, could trigger a hard landing—that is, rising interest rates, slowing growth, declining asset prices, and downward pressures on the exchange rate.
Creditrisk. Rapid credit growth can trigger banking sector distress through macroeconomic imbalances and deteriorating loan quality. If the rapid expansion of bank loans leads to large current account deficits and is accompanied by fiscal deficits and inflationary pressures, an economy becomes increasingly vulnerable to a hard landing. Whether this hard landing causes any distress for the banking sector will depend on the sector’s exposure to those risks and its financial buffers. Excessive risk taking may also damage loan quality. During booms, the quality of risk assessment may suffer because of the volume of new loans and the use of new loans to service existing debt. Risks may be underestimated because the assessments are based partly on the current strength of the economy and the rising values of underlying collateral. During busts, this cycle is reversed, magnifying the negative effects.
In Ukraine, macroeconomic imbalances have been driven by different shocks. In recent years, it has experienced large current account surpluses reflecting strong export commodity prices and an undervalued currency. With most of the terms-of-trade gains going to high-saving groups (a reflection of the ownership structure of Ukraine’s economy, including the export sector), the impact on domestic demand and inflationary pressures remained subdued through mid-2004. A subsequent pickup of inflationary pressures can be attributed mainly to expansionary fiscal policy, emerging capacity bottlenecks, rapidly rising wages and pensions, and an accommodative monetary policy stance.
Risks of financial sector distress are highest in Ukraine. The level of credit in all three countries is still much below that of many prominent crisis countries, but the speed of credit expansion in Bulgaria and Ukraine has reached levels comparable to theirs. However, institutional and structural factors put the banking systems in Bulgaria and Romania on a much stronger footing than Ukraine’s. The large share of foreign ownership and relatively strong prudential indicators also suggest that the banking systems in Bulgaria and Romania are relatively well shielded from shocks. In contrast, it is unclear whether Ukrainian banks could withstand a deterioration in credit quality: the buildup of cushions, in the form of capital and provisions, has not kept pace with the rapid credit expansion, and bank profitability in Ukraine has remained much lower than in most other transition economies. In all three countries, credit risk through exchange rate exposure is a concern, given the large shares of often unhedged foreign currency loans.
Putting on the brakes
How should policymakers respond to a credit boom? How can they determine whether credit is expanding too quickly? If it is found to be growing too quickly, should the policy response focus on offsetting the effects of the boom or moderating the boom itself?
In principle, policymakers can target an equilibrium level of credit, but such a calculation does not provide any guidance on how rapidly a country should move to that level. In Bulgaria, the gap between the estimated and the actual equilibrium ratios of credit to GDP has been narrowing very rapidly: in 2001, before the credit boom came into full swing, the credit-to-GDP ratio was 14½ percent, and by the end of 2004 it had reached about 35½ percent. Thus, the credit-to-GDP ratio rose by an average of about 7 percentage points a year—a pace that has been associated with banking crises in other countries. In Romania and Ukraine, the credit-to-GDP ratio has risen more slowly, averaging 2½ and 4¼ percentage points a year, respectively, during the same period.
The menu of policy responses depends on the country’s monetary and/or exchange rate policy framework and its institutional setting. With a fixed exchange rate regime, traditional monetary policy tools (changes in interest rates, open market operations) are ineffective, particularly in countries with open capital accounts. In such a setting, efforts to drain liquidity from the domestic banking system to reduce funding sources will be frustrated. As long as returns on lending remain high, nonbank or cross-border flows will quickly replenish funding sources.
The Bulgarian, Romanian, and Ukrainian authorities have taken different approaches to offset and moderate rapid credit growth. With limited monetary tools at their disposal, policymakers in Bulgaria and Romania have tightened fiscal policy to offset the sizeable increase in private sector consumption and investment. Nevertheless, sharply larger external current account deficits—though largely financed by foreign direct investment inflows—have generated concerns about external vulnerability, and the need to persevere with tight fiscal policies remains. In contrast, in Ukraine, where the predominant concerns are loan quality and banking sector stability—rather than macroeconomic imbalances—policymakers have used bank regulatory and supervisory measures to strengthen banks’ resilience to shocks.
Will further measures be needed? Probably so. Bulgaria and Romania are likely to continue to emphasize tighter macroeconomic policies, while supervisors will need to remain vigilant to ensure continued financial sector health, particularly because credit may be diverted to less supervised channels. In Ukraine, stronger prudential and supervisory policies will remain at the heart of efforts to reduce financial vulnerabilities.
Copies of IMF Working Paper No. 05/128, Too Much of a Good Thing? Credit Booms in Transition Economies: The Cases of Bulgaria, Romania, and Ukraine, by Christoph Duenwald, Nikolay Gueorguiev, and Andrea Schaechter, are available for $15.00 each from IMF Publication Services. Please see page 16 for ordering details. The full text is also available on the IMF’s website (http://www.imf.org).