Chapter

2. Managing Rapid Financial Deepening in Emerging Europe

Author(s):
International Monetary Fund. European Dept.
Published Date:
November 2007
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Income convergence in emerging Europe has been accompanied by rapid financial deepening. Financial intermediaries have played a primary role in channeling capital flows into the region, benefiting consumers, producers, and investors alike. But the resulting high speed of convergence is engendering short-term risks and medium-term challenges. To ensure “safe driving” at considerable speed, and thus smooth convergence, policymakers will need to adopt a cautious approach. Faced with the uncertainties involved, reducing vulnerabilities and building buffers will be essential. Where convergence has been associated with large external imbalances, the challenge is to “prepare for the curve ahead,” which is to turn around these imbalances without painful adjustment. This will require that resources flow without hindrance to productive investments, particularly in the tradables sector. Policymakers will need to strengthen their financial systems and raise the flexibility of labor and capital markets.

For a number of years, the financial systems of Europe’s emerging economies have been playing a key role in these economies’ convergence and integration with advanced economies. Along with foreign direct investment (FDI), financial systems have been the principal conduits for the vast flow of capital into the region. Financial intermediaries have sparked in most recipient countries a rapid, if not blistering, pace of financial deepening.22

Rapid financial deepening has brought both benefits and risks to borrowers and investors. The benefits have come in the form of consumption smoothing, diversification, and risk sharing, but they have not accrued uniformly. The pace of financial deepening differs markedly across countries. And there are concerns that its speed is too high in some countries, posing risks to macroeconomic and financial stability.

Policymakers have struggled with the question of whether and how to manage fast-paced financial deepening. Some observers have taken the view that countries are on a one-way road to prosperity and that the risks pale in comparison to the benefits. Some, however, have interpreted the risks as high and rising, as evidenced by the swelling of imbalances. And those who have tried to slow capital inflows and credit expansions have been thwarted because the available policy options turned out to be either limited or ineffective.

Against this background, this chapter, after reviewing finance’s role in the convergence process, advocates a two-pronged approach to addressing the policy challenges associated with rapid financial deepening:

  • Driving safely at high speed. With policies having had limited success in slowing the speed of credit growth, policymakers need to focus on reducing vulnerabilities and building safety margins. Such caution is desirable because of uncertainty about the extent to which the observed pace of convergence is an equilibrium phenomenon. In addition, it provides a buffer against sudden shifts in market sentiment that may be unrelated to country fundamentals.

  • Preparing for the curve ahead. An often-overlooked aspect is that the ongoing convergence process will entail a fundamental reorientation of the economies involved. Protracted current account imbalances will have to change course, and resources will need to shift to productive investments, particularly in the tradables sector to help boost exports; otherwise, an abrupt correction or a prolonged period of slow growth may follow. Private sector agents will need to be aware that such a turnaround is inevitable. Policymakers would do well to focus on reforms that will facilitate the smooth rebalancing of the sources of growth.

Finance’s Role in Convergence

Capital Inflows and Financial Deepening

Convergence in emerging economies has been greatly helped by massive inflows of capital. Over the last two decades, it has become clear that the growth potential in these economies is very large. As the economies have opened up, and their financial systems have reached a basic threshold of development, investors have taken advantage by injecting capital, thereby accelerating the convergence process. Income levels have been catching up quickly, with the fastest progress observed in the Baltics, Bulgaria, and Romania (Figure 21), countries that started from low levels. Not surprisingly, these countries have also been experiencing the largest current account deficits in the region (Figure 22).

Figure 21.Convergence in Europe, 2000–06

Sources: Eurostat; and IMF staff calculations.

Note: In each period, income levels of individual countries are indexed so that the average of the EU-25 is normalized to 100. Income levels are based on purchasing power parity–adjusted income per capita data from Eurostat. The average speed of convergence is measured as the geometrically averaged change in the index over the period 2000–06. The sample consists of the EU-25, Croatia, Iceland, Macedonia FYR, Romania, Switzerland, and Turkey. Country names are abbreviated according to the ISO standard codes.

Figure 22.Current Account Balances and Income Levels in Europe, 2006

Sources: Eurostat; and IMF staff calculations.

Note: In each period, income levels of individual countries are indexed so that the average of the EU-25 is normalized to 100. Income levels are based on purchasing-power-parity-based income per capita data from Eurostat. The sample consists of the EU-25, Croatia, Iceland, Macedonia FYR, Romania, Switzerland, and Turkey. Country names are abbreviated according to the ISO standard codes.

Conceptually, the quickest way to prosperity involves some degree of capital inflows (Figure 23). Where capital does not flow in—perhaps because lenders are worried about a country’s ability to repay—consumption and investment will grow more slowly. Savings will need to be set aside to fund the expansion, and higher interest rates will provide this incentive. Capital inflows fast-forward this process: consumption can accelerate more quickly and increase well before production rises.

Figure 23.Convergence with and without Capital Inflows

Source: IMF staff calculations.

Note: Cases with/without capital flows are represented by the blue/red lines. The productivity shock is the same for both cases. The time intervals are expressed in years. For simulation details, see Bems and Schellekens (2007).

Financial systems have played a vital role in intermediating the capital inflows into emerging Europe, quickening the pace of financial deepening. Initially, finance arrived in large quantities, with FDI providing the lion’s share. As financial development and bank consolidation progressed with the help of foreign investors, however, financial systems came to play a paramount role.

Financial deepening has been driven almost exclusively by the large expansion of bank-intermediated credit (Table 4). This expansion is, however, by no means uniform across countries, in part because starting points have differed. While the pace of financial deepening in the Baltics and the Balkans has been very fast, others, such as the Czech Republic and Poland, have experienced a much more subdued pace, at least until very recently.

Table 4.Credit to Nonfinancial Corporations and Households, 2000-06(Percent of GDP)
2000200120022003200420052006Average Yearly Change
Bulgaria14.916.321.428.541.450.162.16.7
Croatia49.952.463.666.770.183.596.67.8
Czech Republic34.231.133.234.538.545.01.8
Estonia28.530.433.037.648.167.495.49.6
Hungary35.635.536.342.945.650.855.62.9
Latvia19.525.831.840.651.170.893.110.5
Lithuania14.815.016.723.028.638.354.05.6
Poland24.325.326.528.226.928.834.71.5
Romania12.413.515.318.621.525.934.63.2
Russia15.718.820.924.827.430.633.62.6
Serbia12.014.914.418.123.324.32.1
Slovak Republic32.329.735.340.12.0
Slovenia44.446.949.051.754.967.476.94.6
Ukraine12.214.619.527.428.937.151.75.6
Turkey30.732.825.024.927.834.443.21.8
Sources: Bank for International Settlements; national authorities; and IMF staff calculations.Notes: Data include direct cross-border credit. Average yearly change is applied to the percentage point change in the credit-to-GDP ratio over the sample period of each country.

Financial Globalization and Risk

A striking aspect of the convergence in emerging Europe is that it has been taking place on the back of increasing financial globalization. Financial globalization has created vast opportunities for diversification and risk sharing, further enhancing finance’s role in convergence. The degree of financial globalization, as measured by the ratio of total foreign assets and liabilities to GDP, has reached high levels in many emerging European countries (Figure 24). Moreover, as illustrated in Figure 22, capital has been flowing from richer to poorer countries.

Figure 24.Share of Foreign Assets and Liabilities in GDP, 2005

(Percent)

Source: IMF, International Financial Statistics.

In this convergence process, diversification and risk sharing have materialized concretely through the operations of foreign banks and the inflow of FDI. In the search for higher profitability, foreign banks have diversified themselves by endowing affiliates abroad with large amounts of risk capital. This risk capital funds opportunities with higher returns. The risk-sharing nature of FDI is well known: FDI seeks to take advantage of upside profit potential, but also bears part of the downside risk.

Greater risk sharing is, in principle, welfare improving and can further speed the convergence process. Uncertainty about the outcome is an integral part of this process, especially when current developments are driven by expected future gains in productivity and income levels. Financial globalization may allow for the transfer of risk to those most willing to bear it. Thus, from the point of view of borrowers, the opportunities for better risk sharing add to the attractiveness of foreign capital inflows and enlarge the current account deficit.

Two Stages of Convergence

How do the inflow of capital and the process of financial deepening allow economies to converge to higher income levels? It is useful to highlight—in a stylized manner—two stages that pose distinct policy challenges:

  • The expansion stage features large capital inflows, a growing current account deficit, and an acceleration in spending on tradable and nontradable goods. Whereas tradables can be easily imported from abroad, nontradables need to be produced locally, creating a bottleneck in the expansion stage. Excess demand will push up the relative price of nontradables, produce a real exchange rate appreciation, and result in a shift of resources to the nontradables sector.

  • Barring accidents, this is followed by a reorientation stage that is characterized by a rebalancing of the current account. Capacity in the nontradables sector would be built up gradually, dampening the price pressure. The relative price of nontradables would fall, and resources would shift back to the tradables sector. This sector will need to expand so that domestic demand can be satisfied and the foreign debt serviced.

Clearly, most emerging economies in Europe are still in the first—expansion—stage of convergence. This is evidenced by the still-large potential for catching up with the income levels of advanced economies. It is also evident because the ongoing financial deepening still benefits the nontradables sector disproportionately. For example, whereas over 2000–06 credit to the nonfinancial tradables sector stagnated, credit to the nontradables sector more than doubled (Figure 25). Similarly, over the same period, households saw a tripling in credit for housing purposes, whereas consumer credit and other types of credit roughly doubled (Figure 26).

Figure 25.Credit to Nonfinancial Corporations, 2000–06

Sources: National authorities; and IMF staff calculations.

Notes: Credit measures exclude direct credit from abroad. The sample of countries consists of Bulgaria, Croatia, the Czech Republic, Estonia, Hungary, Latvia, Lithuania, Poland, Romania, Russia, Serbia, the Slovak Republic, Slovenia, Ukraine, and Turkey.

Figure 26.Credit to Households, 2000–06

Sources: National authorities; and IMF staff calculations.

Note: Credit measures exclude direct credit from abroad. The sample of countries consists of Bulgaria, Croatia, the Czech Republic, Estonia, Hungary, Latvia, Lithuania, Poland, Romania, Russia, Serbia, the Slovak Republic, Slovenia, Ukraine, and Turkey.

Driving Safely at High Speed

What can be done to ensure the expansion stage goes smoothly and sets the country on a secure path to greater welfare and faster growth? Clearly, the faster convergence is, the more quickly benefits are realized; however, the more likely also that risks appear. The main challenge in the expansion stage will therefore be to “drive safely.” But what are the speed limits? Can one tell whether they are being broken? And, what can policymakers do about it?

Do We Know the Speed Limits?

Unsurprisingly, this question offers a fertile ground for debate (Demekas, 2007). The speed limits to the inflow of capital and financial deepening are not only hard to measure, they are also neither unique across countries nor fixed over time. Consider the following three important determinants:

  • Productivity gains. How bright is the future, really? This will matter much for the optimal speed limit. Greater future productivity will justify higher speed or, in other words, larger current account deficits. But larger deficits will also imply greater shifts in and out of the nontradables sector, producing larger swings in prices.

  • Factor market flexibility. How flexibly can an economy adapt itself to this bright future? Critical in this regard is the flexibility of labor and capital markets. Greater flexibility means greater compatibility with higher speed limits and larger imbalances.

  • Financial development. How financially developed is the economy to begin with? Europe’s emerging economies still differ significantly from its advanced economies in terms of financial regulation, supervision, and infrastructure. Where further reforms are warranted, convergence and financial deepening will accelerate. However, the speed of financial deepening needs to remain commensurate with the degree of financial development. For example, in the absence of sound arrangements for the liquidation of collateral, a speedy expansion of credit may generate unnecessary systemic risks (Schellekens, 2000).

Theory provides only qualitative guidance. Nonetheless, Figure 27 is suggestive. Conceptually, larger current account deficits are consistent with larger productivity improvements (the positively sloped lines, generated from model simulations), and flexibility in the labor and capital markets allows for greater latitude in borrowing from abroad for a given productivity improvement (the blue versus the red line). Introducing actual data into the figure illustrates that whether the current account deficits are too high depends on a host of factors. If factor flexibility were low (the red line), all countries would appear to be speeding. Conversely, if factor markets were highly flexible (the blue line), all of them would appear to be crawling. Thus, speed limits are largely unknowable, but increasing productivity and the flexibility of factor markets are key to strengthening the sustainability of the current account.

Figure 27.Productivity, Flexibility, and the Current Account

Source: IMF staff calculations and simulations.

Note: Empirical data: annual geometric average growth rate in total factor productivity over 2000–05 and maximum current account deficit to GDP ratio over 2000–05. Simulated data: shock consists of a persistent increase in productivity growth. For simulation details, see Bems and Schellekens (2007).

Breaking the Speed Limits

When driving becomes unsafe, policymakers have an unmistakable role to intervene. Indeed, if the speed limits are being broken, fast convergence and rapid financial deepening give rise to a litany of concerns that must be addressed. And, the financial sector may exacerbate these concerns. In this regard, the policy challenges faced in Latvia provide an interesting case study (Box 6).

Box 6.Addressing Financial Speeding in Latvia

Latvia, perhaps more than other recent EU entrants, has enjoyed very rapid convergence in income levels over the past decade. Closer integration of goods, capital, and labor markets in the rest of Europe has created favorable investment opportunities and spurred large inflows of foreign financing. Consequently, capital and technology stocks have risen, and new employment opportunities have emerged—both in Latvia and abroad.

But fast credit and wage growth have recently caused Latvia to diverge from a balanced and sustainable growth path. Overheating has intensified, driving the current account to a record deficit and magnifying external indebtedness. Rapid credit growth in euros has left large currency mismatches on the balance sheets of households and corporates. Procyclical macroeconomic and prudential policies have aggravated such trends.

Heavy borrowing for real estate have led to the diversion of resources to the nontradables sector to the detriment of competitiveness (first and second figures). This skewed pattern of development reflects the undertaxation of real estate relative to other sectors and a perception by banks that mortgage lending is less risky than lending to manufacturing. Real estate’s attractiveness as a saving vehicle has been reinforced by negative real interest rates, the absence of alternative saving to match instruments, and—until recently—sustained rapid increases in housing prices, all of which have reinforced perceptions of a one-way bet. Latvia’s small size and limited workforce have impeded the establishment of large export-oriented manufacturing projects.

Returning to a balanced growth path will require efforts to curb domestic spending and wage growth:

  • Avoiding a procyclical fiscal policy would help directly. By signaling the government’s concern about widening imbalances, it would also dampen overly optimistic private sector expectations.

  • Efforts to curtail lending and improve the risk profile of new credit would help mitigate macroeconomic and financial stability risks. The issuance of loans only on the basis of legally documented income, the establishment of a comprehensive register for all loans, and a minimum 10 percent down payment requirement will support these objectives.

Developments in Real House Prices

Source: Latio real estate broker.

Note: Deflated by Harmonized Iindex of Consumer Prices; 2002:Q1 = 100.

Household Mortgages in Latvia and Selected Countries

(Percent of GDP)

Sources: Latvian authorities; European Mortgage Federation; Eurostat; and IMF staff calculations.

Note: Household mortgages are for 2006 unless otherwise indicated.

  • Additional financial regulatory measures would help induce banks to internalize systemic risks in real estate and currency markets. The financial regulator could intensify on-site inspections of large banks, ensuring credit risk models are tailored to the Latvian context.

Further efforts are needed to rebalance incentives for investment in the tradables sector:

  • Incentives for investment in real estate need to be scaled back. Recent increases in real estate taxation and plans for periodic reassessments of cadastral values are steps in the right direction. But, to be effective, enforcement of real estate–related taxation would need to be stepped up.

  • Through wage agreements, the public sector could demonstrate its understanding that wage growth should be kept in line with productivity growth. Similarly, social partners could secure a broad consensus for wage restraint.

  • More generally, shifting to higher-value-added products entails increasing employer involvement in setting education curriculums, and prioritizing EU structural funds to develop human resources, entrepreneurship, and innovation in traditional and new export sectors.

Note: The main author of this box is Gavin Gray.

Among the macroeconomic concerns, the significant problem is that breaking the speed limits leads to demand outstripping supply, putting excessive upward pressure on prices and wages and causing overheating. Monetary and fiscal policies are normally expected to be able to control these outcomes, but their effectiveness is limited in small economies facing strong capital flows. Hence, overheating can be associated with a loss of competitiveness and inflated asset prices. Subsequently, debt-service problems may arise when exchange rates or asset prices adjust, especially if they do so abruptly, as recent emerging market crises have illustrated.

The financial sector may exacerbate these vulnerabilities in several ways:

  • The financial sector can raise an economy’s volatility through the “financial accelerator” (Kiyotaki and Moore, 1997). Banks and financial institutions usually require collateral for lending. When asset prices rise, so do collateral values, thereby “accelerating” the capacity of borrowers to obtain credit. However, it may well be that the initial lending was behind the increase in the asset’s price in the first place. The upshot is that prices tend to be more volatile as a result of the interaction between lending and collateral values (Figure 28).

  • As financial institutions compete for market share, lending standards may deteriorate. Households and corporations could end up with too much debt, or with too much risk, for example by lending in foreign currency or exclusively at variable interest rates. This behavior played an important role in the subprime mortgage crisis in the United States. In emerging Europe, the main concern is the large share of liabilities outstanding in foreign currency (Figure 29).

  • Overconfidence may lay the groundwork for a boom-and-bust cycle. Overconfidence may arise in connection with the prospect of adopting the euro or joining the European Union. Borrowers and lenders may have inflated views about productivity and income. The financial sector may allow overoptimistic agents to borrow, driving prices above fundamental levels (Figure 30). However, if the expectations are not validated, the bust will be even bigger.

  • Foreign bank contagion raises additional concerns. Certainly, the significant presence of foreign banks (Figure 31) has increased the availability of credit, and promoted financial development and reform more generally. Indeed, support from well-capitalized parents makes banks less vulnerable to local financial conditions. Hence, foreign banks have also been credited with providing a degree of stability. Yet, the concentrated number of international players and the similarity of their activities expose emerging economies to common-lender contagion risks (Table 5). Changes in market sentiments or strategic shifts at the parent level could amplify the impact of foreign shocks on the host country and create ripple effects throughout the region.

Figure 28.Speed of Credit Growth and House Prices, 2002–06

Sources: Égert and Mihaljek (2007), Table 1; and IMF staff calculations.

Note: The speed of credit growth is defined as the annual percentage-point increase in the credit-to-GDP ratio, averaged over the period 2002-2006. Credit measure includes direct cross-border credit and refers to households and nonfinancial corporations.

Figure 29.Share of Foreign Currency Loans in Total Loans, 2006

(Percent)

Sources: European Central Bank; and national authorities.

Figure 30.Impact of Confidence on the Relative Price of Nontradables

(Percent)

Source: IMF staff simulations.

Note: Probability measure refers to the probability that a productivity increase is going to take place eventually. The increase in the relative price of nontradables occurs relative to initital pre-shock steady state values. For simulation details, see Bems and Schellekens (2007).

Figure 31.Asset Share of Foreign-Owned Banks, 2000 and 2005

(Percent)

Sources: European Bank for Reconstruction and Development; and IMF staff calculations.

Table 5.Banks’ Exposure to Emerging Economies, 2006(Percent of total exposure)
AustriaBelgiumSwedenGermanyFranceItalyPortugalFinland
EU-1034.75.610.32.61.911.46.69.9
Bulgaria0.90.5
Czech Republic8.92.60.21.00.60.1
Estonia0.13.63.9
Hungary6.21.20.00.70.22.60.3
Latvia0.13.30.12.6
Lithuania0.12.90.13.2
Poland2.81.00.50.80.24.86.20.1
Romania8.70.50.40.8
Slovak Republic5.60.60.12.5
Slovenia2.20.20.10.10.1
Other emerging Europe14.61.00.41.71.27.01.00.5
Other emerging markets1.00.60.51.61.61.04.10.4
Rest of the world49.692.888.794.195.380.588.389.2
Source: Bank for International Settlements.

Reducing Vulnerabilities and Building Buffers

Faced with considerable uncertainties about speed limits but consensus about the potential cost of vulnerabilities, policymakers in most countries have taken concrete measures to address vulnerabilities. They have undertaken macroeconomic tightening: raising interest rates or reserve and liquidity requirements and reducing fiscal deficits or building up surpluses. Prudential and supervisory regulations have also been tightened, and monitoring has been stepped up to make sure banks uphold sound loan granting standards. In a few cases, marginal reserve requirements have been imposed on foreign borrowing (Hilbers, Ötker-Robe, and Pazarbasioglu, 2007).

While these measures have helped dampen credit growth, rapid credit growth remains a concern in most countries. Countries with relatively tight fiscal policies are still experiencing very large capital inflows and current account deficits (such as Bulgaria and Estonia). Rapid deposit growth or easy access to funding by the parent bank has limited any impact that policies might have had on banks’ cost of funds. Significantly tightening reserve requirements seems to have had at best a transitory impact on credit growth, as borrowers and banks have found ways to circumvent these controls (as has happened, for example, in Croatia and Latvia). Where controls result in direct borrowing from abroad, prudential concerns may arise. Finally, the literature shows that capital controls, apart from being largely infeasible in EU member states, may not make a lasting impact (International Monetary Fund, 2007c).

What else can be done? With the boom a reality and policies largely ineffective in stemming the tide, it will be key to focus efforts on further reducing vulnerabilities and building in safety margins. Policymakers will need to be pragmatic and take into account the worse-case scenario. Such an approach would be consistent with strengthening or maintaining the following measures (selective country examples where the IMF has advocated these measures are provided in parentheses):

  • Tightening macroeconomic policies: tightening fiscal policy, to cool off or not to add to existing demand pressures (the Baltics); eliminating fiscal incentives contributing to the nontradable boom (Latvia); conducting incomes policies that promote wage restraint supported by productivity growth (Romania); tightening monetary policies (Ukraine); and increasing reserve requirements (Bulgaria).

  • Raising prudential standards: directing prudential efforts to remove distortions in bank lending associated with, for example, risky sectoral allocations, unhedged currency borrowing, imprudent funding behavior by banks, or real estate bubbles; identifying bank-specific capital requirements and raising them where necessary; and establishing risk-based and forward-looking supervision (Bulgaria, Latvia, Romania, and the Slovak Republic).

  • Upgrading supervisory cooperation and coordination: guaranteeing the effective implementation of prudential and supervisory measures by ensuring an adequate enforcement capacity, cross-border cooperation between home and host supervisors, and coordination among supervisors of nonbank financial institutions to avoid loopholes (the Czech Republic, Estonia, Lithuania, Poland, and the Slovak Republic).

  • Enhancing risk disclosure: supporting a better disclosure and understanding of risks by conducting public awareness campaigns and strengthening market discipline for banks by tightening disclosure requirements of risk management and internal control policies and practices (the Baltics, Croatia, Hungary, Poland, and the Slovak Republic).

Preparing for the Curve Ahead

Reversing the Current Account Imbalances

Even if driving fast is safe, policymakers will need to take curves carefully to avoid accidents. Converging economies inevitably face the requirement to service their debt and turn around their current account imbalances (Figure 32). The larger the current account deficits, the greater this challenge will be. And the larger the extent to which the inflow of resources has fed the boom in nontradables, the greater the reorientation in the structure of production will have to be. Thus, tradable output will need to rise again relative to nontradable output.

Figure 32.Two Stages of Convergence

Source: IMF staff simulations.

Notes: Flexibility refers to capital and labor market flexibility. The time intervals are expressed in years. For simulation details, see Bems and Schellekens (2007).

An equally vital policy challenge will be to deliver on the expectations of higher productivity. It is on these expectations that consumption, investment, and borrowing decisions have been made. If they turn out to be invalid, the rebalancing of the current account and the reorientation of production will prove even more difficult and painful. Instructive in this regard is the experience of Portugal, which experienced a large credit boom on the back of expectations that failed to materialize (Box 7).

Box 7.Rapid Financial Deepening: Lessons from Portugal

Rapid financial deepening occurred in Portugal during the 1990s, when membership in the Exchange Rate Mechanism (ERM) and the prospect of euro adoption resulted in a sharp drop in risk premiums and interest rates. The resulting credit boom fueled a surge in domestic demand (first figure). With economic agents expecting permanently higher steady-state growth in monetary union, consumption and investment grew rapidly, housing and construction boomed, and income converged rapidly to the EU average (second figure). The corresponding decline in savings and rise in imports helped widen the current account deficit.

However, the anticipated high productivity growth did not materialize after Portugal adopted the euro in 1999. Consequently, domestic demand growth slowed and turned negative in 2002–03, as firms and households sought to work off the imbalances of the boom years. Cyclical difficulties were compounded by worrying structural developments, as productivity and competitiveness—whose weaknesses were masked by the boom—continued to flag. Real convergence shifted into reverse. In response to this challenging situation, the authorities have been taking decisive action to correct the imbalances accumulated during the 1990s.

Portugal’s boom and slump offer interesting lessons for Europe’s emerging economies, which are experiencing a phase of rapid financial deepening similar to Portugal’s a decade ago:

  • A painful adjustment period may ensue if expectations of future high productivity are not fulfilled and financial resources are not channeled into productive investment. During the second half of the 1990s, Portugal’s competitiveness declined, as wage growth outstripped productivity. With sticky downward wages and a relatively rigid labor market, reorienting resources to the competitive industries in the tradables sector became a daunting task, resulting in a period of slow growth.

  • Vulnerabilities to the financial system can arise when private sector indebtedness reaches unprecedented levels. The household and corporate debt levels in Portugal did not particularly stand out in Europe before the credit boom. However, by 2005, household debt as a percent of disposable income was the second-highest in the European Union, and corporate debt to GDP was also among the highest. These high debt levels can make the financial system vulnerable to credit risks if employment or interest rates evolve adversely. The need for balance sheet adjustment stemming from the high debt levels could also restrain domestic demand during the recovery.

  • Prudential policies play a paramount role. Rapid financial deepening makes it necessary to sharpen the focus on regulation and supervision conducive to the sound management of typically rising credit risks. Mounting private indebtedness and the concentration of credit in sectors such as real estate were key sources of risk for Portugal. In this regard, its financial system weathered the economic turmoil surprisingly well, helped by successful guidance from the Bank of Portugal.

  • Procyclical fiscal policy tends to be harmful. Fiscal policy would be expected to counter the booming demand associated with rapid financial deepening. But Portugal’s fiscal policy was mostly procyclical, thereby aggravating the amplitude of the boom. Furthermore, the lack of fiscal consolidation precluded fiscal expansion to help deal with the slump.

Credit Growth

(Year-on-year percent change)

Sources: Portuguese authorities; and Eurostat.

Income Convergence and Current Account

Source: Eurostat.

Note: The main author of this box is Yuan Xiao.

With the credit-driven expansion of the nontradables sector a reality, and the rebalancing of growth toward exports an eventual necessity, the main issue is how to equip the economies and financial systems of emerging economies with the tools to support such a turnaround. Inevitably, the growth in credit to households will need to slow, in relative terms, and more financial resources will need to flow to productive investments. A key concern is that countries are not implementing sufficient reforms to facilitate these developments. Besides generally pursuing sound macroeconomic policies, bringing supervision and regulation in line with best practice, and avoiding microeconomic distortions, what else can policy makers do?

Fostering Flexibility

Flexible labor and capital markets are key to support the unencumbered flow of resources from nontradables to tradables (Figure 33). As Portugal’s experience exemplifies (Box 7), running large current account deficits is an undesirable proposition when factor markets lack sufficient flexibility.

Figure 33.Changing Composition of Production

Source: IMF staff simulations.

Notes: Flexibility refers to capital and labor market flexibility. The time intervals are expressed in years. For simulation details, see Bems and Schellekens (2007).

There is especially scope for improving labor market flexibility—a particularly pressing objective given that the countries where credit grew quickly also seem to have more rigid labor markets (Figure 34). Against this background, it would certainly be very risky for countries converging rapidly to advanced-economy income levels to also aspire to match the generosity of advanced-economy welfare states. The labor market rigidities often associated with a more generous welfare state may inhibit the smooth transition of resources to the tradables sector, thereby unnecessarily prolonging the reorientation phase.

Figure 34.Labor Market Rigidity and Speed of Credit Growth

Sources: World Bank, Doing Business Database; Bank for International Settlements; national authorities; and IMF staff calculations.

Notes: The rigidity-of-employment index is based on a 2006 survey capturing the difficulty of hiring and firing, and the rigidity in hours. The speed of credit growth is the annual percentage point increase in the credit-to-GDP ratio, averaged over the period 2001–06. “Credit” refers here to households and nonfinancial corporations, and includes direct cross-border credit. The sample consists of Bulgaria, Croatia, the Czech Republic, Estonia, Latvia, Hungary, Lithuania, Poland, Romania, Serbia, the Slovak Republic, Slovenia, Turkey, and Ukraine.

The need for flexible labor and capital markets is particularly important where exchange rate flexibility is limited. With such limited flexibility, domestic factor prices, in particular wages, will need to carry the burden of the price adjustment. Factor market flexibility may alleviate this burden by ensuring that labor and capital are sufficiently responsive to price signals.

Furthermore, the diversification of financial systems in emerging economies will make capital markets more flexible. As these economies catch up and integrate further with the advanced economies of Europe, the financing options provided by their financial systems will broaden. As noted in Chapter 1, more diversified financial systems are able to identify and support rapidly rising industries more quickly, which will improve the flexibility of capital markets.

Improving Financial Infrastructure

To allow financial systems to provide more resources to the corporate sector, building a supportive, enabling financial infrastructure will be essential, as discussed in detail in Chapter 3. Creditors need good protection, provided through strict enforcement of bankruptcy and insolvency laws that meet international best practice standards. Improving corporate governance is essential in a number of emerging economies, and will require changes in legislation and enforcement. In addition, providing more and better credit information will help financial institutions channel resources to the corporate sector. In this context, fostering the development of credit registries is crucial.

Other parts of the financial system need to be developed as well, especially to fill in missing market segments. This would benefit the mobilization of domestic savings and thereby help rebalance the current account. Under the proper safeguards noted in Chapter 1, the development of securitization and asset-backed securities markets continues to have an important role to play. The development of basic derivatives markets would also be critical in this respect, helping to deepen markets in underlying securities and better allocate risks.

See Decressin, Faruqee, and Fonteyne (2007).

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