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World Economic Outlook: Why we should be concerned about credit booms

Author(s):
International Monetary Fund. External Relations Dept.
Published Date:
June 2004
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Credit to the private sector has expanded rapidly in several emerging market countries over the past two years. While credit growth is generally associated with improving economic conditions and with the expansion and increasing sophistication of services offered by banks and other financial institutions (a process known as financial deepening), excessive credit growth has raised concern because of its role in previous financial crises. Based on findings in the April 2004 World Economic Outlook, Marco Terrones of the IMF’s Research Department explains why we should be concerned about credit booms and what policymakers can do to control them.

Credit booms are periods of unusually sharp expansions in credit that eventually collapse because they become unsustainable. They should not be confused with periods of strong credit expansion—often associated with financial deepening in emerging market countries—which can help spur economic growth.

Because lenders are uncertain about the creditworthiness of borrowers, they usually require some sort of collateral—such as real estate or equipment—thereby setting in motion a mechanism known as the “financial accelerator” (see box, page 175). This mechanism can result in credit booms. Indeed, the experience of the 28 emerging market countries included in the WEO study corroborates the importance of the financial accelerator.

What do credit booms look like?

The WEO team found that credit booms are associated with a cyclical upturn followed by a sharp downturn in economic activity. This suggests that credit booms have strong negative effects on the economy; indeed, in the worst cases they are associated with serious recessions (see Chart 1). The team also found that credit booms are associated with a rapid increase and subsequent fall in the price of nontradables (goods or services that cannot easily be exported, such as haircuts) relative to tradables (goods or services that can easily be exported, such as grain or television sets) (see Chart 2). Despite this, credit booms do not have a major effect on inflation—partly because most emerging market countries have very open economies, which helps keep price pressures at bay through increased competition. This suggests that rising domestic demand is vented mainly through a weakening of the current account and an appreciating exchange rate. Therefore, maintaining price stability—particularly for countries that have adopted an inflation-targeting framework—might not in itself help prevent a credit boom or bust. Finally, the WEO team found that banks lend more to the private sector and borrow more abroad during credit booms.

Besides these observations, credit booms in emerging market countries typically:

  • are less common than episodes of rapid credit growth (defined as periods when average real credit growth exceed 17 percent over three years). This reflects the fact that some countries are able to sustain rapid credit growth as their banking systems mature and expand their services.

  • take place simultaneously in many countries. This suggests that capital flows and financial liberalization play an important role. Credit booms are more likely to occur when capital inflows are large: two-thirds of the credit booms observed in the 28 emerging market economies happened during periods of large capital inflows. In contrast, only one-third of the periods characterized by rapid yet sustainable credit growth are associated with high capital inflows.

  • are associated with banking and currency crises. About 75 percent of credit booms in emerging market countries were associated with banking crises, while 85 percent were associated with currency crises.

  • often coincide with either consumption or investment booms and, to a lesser extent, with output booms (see Charts 3 and 4).

Note: A credit expansion in a given country is identified as a boom if it exceeds the standard deviation of that country’s credit fluctuations around its Hodrick-Prescott trend by a factor of 1.75. t denotes the year the credit boom started.

Data: IMF, International Financial Statistics; Penn World Tables; World Bank, World Development Indicators; national authority publications; and IMF staff calculations

The financial accelerator

The financial accelerator may help explain why credit booms occur. Too much optimism about future earnings boosts asset valuations (such as the price of stocks or real estate), thereby enhancing the net worth of firms that hold the assets. This, in turn, increases a firm’s ability to borrow and spend. However, this process is ultimately unsustainable. When it becomes clear that a firm is unable to satisfy expectations, its earnings forecast is revised down, thereby depressing asset prices and pushing the financial accelerator into reverse.

Coping with credit booms

Credit booms pose significant risks for emerging market countries because they are often followed by sharp economic downturns and financial crises. But credit booms are not easy to identify, leaving policymakers with the difficult choice of either reining in a credit expansion before it becomes obvious that it is unsustainable or letting the boom continue and risking a serious crisis. Policymakers should be most concerned if a rapid credit expansion is accompanied by other telltale signs of growing macroeconomic, financial, and corporate imbalances.

What should policymakers do if they detect signs that a credit boom is developing? They could consider one or more of the following actions:

  • Improveoversightofthebankingsystem. Credit booms often involve a shift toward private credit, the quality of which is often worse than is evident when the loan was first made. To stem the tide of bad loans, bank supervisors should tighten the enforcement of capital adequacy requirements. A stricter monitoring of bank borrowing may also be warranted. In some cases, bank supervisors may also wish to reduce incentives for short-term external borrowing.

  • Increasethescrutinyof corporateborrowing. As credit booms are usually associated with rapid increases in corporate leverage, firms and their accounting practices may need closer oversight to determine whether they satisfy disclosure requirements.

  • Tightenmacroeconomicpoliciesevenwheninflationissubdued. A credit boom is typically accompanied by an unsustainable surge in domestic demand that is then followed by a severe contraction, so it may be appropriate to restrain credit growth by tightening monetary policy.

To reduce the risk of future credit booms, policymakers in emerging market countries should also strive to improve the quality of their institutions. Credit booms are less frequent and—when they do occur—less costly in industrial countries, which usually have a stronger institutional framework. Priorities should include strengthening the framework for formulating macroeconomic policies, improving regulation and supervision of the financial sector (to encourage prudent risk management), increasing the transparency of the corporate sector, and improving the quality of statistics. Such efforts would not only help preempt credit booms, but would also foster financial development and economic growth.

Note: A credit expansion in a given country is identified as a boom if it exceeds the standard deviation of that country’s credit fluctuations around its Hodrick-Prescott trend by a factor of 1.75. t denotes the year the credit boom started.

Data: IMF, International Financial Statistics; Penn World Tables; World Bank, World Development Indicators; national authority publications; and IMF staff calculations

Copies of the April 2004 World Economic Outlook are available for $49.00 ($46.00 for academics) each from IMF Publications Services. See page 168 for ordering information. The full text of the WEO is also available on the IMF’s website (www.imf.org).

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