Abstract
This Selected Issues paper for Bulgaria highlights that the rapid credit expansion has not raised significant financial stability issues, but has been a key factor in the sharp weakening of the external current account. Although the deficit has been mostly financed by foreign direct investment (FDI) inflows, deficits of this magnitude cannot be sustained as privatization inflows will dry up with the completion of the government’s privatization program. Concurrent with the surge in bank credit, the external current account has weakened, reaching a deficit of 8½ percent of GDP in 2003.
I. Bulgaria’S Credit Boom: Characteristics, Consequences, And Policy Options 1
A. Introduction
1. One of the most apparent economic developments in Bulgaria in recent years is a surge in bank credit. In the aftermath of the 1996/97 economic and financial crisis, credit growth was initially very subdued, reflecting low credit demand and risk-averse behavior by banks. The banking sector was completely restructured after the crisis, with virtually the entire banking system now in private hands and three-quarters foreign owned. As confidence returned, credit demand increased and banks began to lend again. While this catch-up process was initially very slow, the past two years have seen a dramatic acceleration.
2. The rapid credit expansion has not yet raised significant financial stability issues, but it has been a key factor in the sharp weakening of the external current account. Increased financial intermediation is welcome from a growth perspective, as it increases output and demand and raises efficiency, and so far, it has not led to a weakening of prudential indicators. Indeed, banks’ asset quality, liquidity, profitability, and capitalization remain very high. However, concurrent with the surge in bank credit, the external current account has weakened, reaching a deficit of 8½ percent of GDP in 2003, up from 5½ percent in 2002. While the deficit has been mostly financed by foreign direct investment (FDI) inflows in recent years, deficits of this magnitude cannot be sustained as privatization inflows will dry up with the completion of the government’s privatization program. Indeed, given reasonable assumptions on greenfield investment, the debt-stabilizing non-interest current account deficit amounts to about 7¼ percent of GDP.2
3. Credit growth is unlikely to slow substantially without measures to contain it. While banks’ loan portfolios will eventually grow in line with growth in funding sources, the banking system remains liquid in the aggregate, and able to fund sustained rapid credit expansion from abroad. Moreover, Bulgaria’s level of financial intermediation is still low and further catch-up is to be expected. For example, Cottarelli et al. (2003) estimate that the posttransition equilibrium level of the credit-to-GDP ratio for a country with Bulgaria’s fundamentals is about 50 percent, nearly twice the current level.
4. To the extent that credit growth is driving the external deficit, policies aimed at reducing bank lending growth—as part of a broader package of measures including tighter fiscal policy and structural reforms—are an appropriate response to these developments. While the levels of monetization and financial intermediation remain low compared with other countries in the region, there is a concern that the pace with which they have risen is not sustainable from a macroeconomic perspective. However, the currency board arrangement (CBA) and the open capital account strongly curtail monetary actions to reduce credit growth. Indeed, the efficacy of most measures on the credit side depends on the responsiveness of capital flows to domestic monetary conditions.
5. The objective of this chapter is to answer the following three questions:
What are the causes and characteristics of the credit boom? 3
What risks does it pose?
What policy options are available to dampen the boom?
B. Causes and Characteristics of the Credit Boom
Background and causes of the credit boom
6. Bulgaria suffered a severe economic and financial crisis in 1996-97. The activities of commercial banks were central to the crisis; for much longer than in most other transition countries, state-owned commercial banks remained instruments of government policy, administering soft loans to loss-making state-owned enterprises (SOEs). The banks were in turn refinanced by the central bank, which enabled rapid loan expansion to the new private sector as well. Thus, by end-1996, Bulgaria’s nongovernment sector credit-to-GDP ratio (hereafter, NGCR),4 at 60 percent (and briefly much higher), was higher than in most other Eastern European countries (Figure 1).5 With the unreformed SOEs making losses, nonperforming loans rose sharply, and, with the growing decapitalization of banks and a number of failed pyramid schemes, public confidence in the financial system evaporated in late 1995. Mass bank runs followed the exchange rate crisis in spring 1996. In the meantime, the health of the banking sector had reached new lows: in early 1996, 70 percent of outstanding loans were classified as nonperforming, and the negative net worth of the banking system was estimated at 10 percent of GDP. Bank lending ground to a halt, with the NGCR falling to 9 percent by end-1997, a precipitous drop of 50 percentage points from a year earlier.
Developments in Credit, 1996-2004
(in percent of GDP)
Citation: IMF Staff Country Reports 2004, 177; 10.5089/9781451804478.002.A001
Developments in Credit, 1996-2004
(in percent of GDP)
Citation: IMF Staff Country Reports 2004, 177; 10.5089/9781451804478.002.A001
Developments in Credit, 1996-2004
(in percent of GDP)
Citation: IMF Staff Country Reports 2004, 177; 10.5089/9781451804478.002.A001
7. The period after the crisis saw a gradual revival of commercial banking. Following the crisis, banks, now operating in a new regime and with different incentives, initially invested mostly in government securities, and generally maintained high cash balances. This risk-averse behavior in part reflected a lack of information (including too short a credit history) about prospective borrowers, doubts about contract enforcement, and the loss of a large client base as the CBA (with the prohibition to lend to banks and the government) had severed the close link between the banks and SOEs. Gradually, and aided by economic recovery, a return of confidence, strengthening of bank balance sheets, and privatization of state banks (in many cases to foreign investors), this risk averse behavior gave way to increased lending. At the same time, the legal, supervisory, and accounting framework banks were operating in was strengthened, laying the foundation for increased bank lending. The framework was strengthened by (i) expanding the regulatory powers of the Bulgarian National Bank (BNB); (ii) strengthening prudential regulations and supervision, including an increase in minimum capital adequacy requirements; (iii) increasing creditors’ rights; and (iv) introducing international accounting standards.
8. Since mid-2002, what had been a gradual revival of financial intermediation has turned into a credit boom. The postcrisis period witnessed a return of macroeconomic stability, robust real GDP growth (4¾ percent on average) and moderate inflation (Table 1). Against this favorable macroeconomic background, the NGCR rose by roughly 1½ percentage points (annual average) between end-1997 and end-2001 (Figure 2). Thereafter, credit growth accelerated, with the NGCR rising by 6 percentage points per year on average between end-2001 and end-2003, and by a further 2 percentage points in the first quarter of 2004 alone.
Selected Macroeconomic Indicators, 1999-2003
Selected Macroeconomic Indicators, 1999-2003
| 1999 | 2000 | 2001 | 2002 | 2003 | |
|---|---|---|---|---|---|
| Real GDP (percent change) | 2.3 | 5.4 | 4.1 | 4.9 | 4.3 |
| CPI Inflation (average) | 2.6 | 10.4 | 7.5 | 5.8 | 2.3 |
| CPI Inflation (end of period) | 7.0 | 11.4 | 4.8 | 3.8 | 5.6 |
| Credit-to-GDP ratio (end of period) | 11.8 | 12.2 | 14.5 | 19.0 | 26.4 |
| Broad Money (in percent of GDP) | 31.7 | 36.8 | 41.7 | 42.9 | 48.1 |
| Current Account (in percent of GDP) | -4.8 | -5.6 | -7.3 | -5.6 | -8.5 |
Selected Macroeconomic Indicators, 1999-2003
| 1999 | 2000 | 2001 | 2002 | 2003 | |
|---|---|---|---|---|---|
| Real GDP (percent change) | 2.3 | 5.4 | 4.1 | 4.9 | 4.3 |
| CPI Inflation (average) | 2.6 | 10.4 | 7.5 | 5.8 | 2.3 |
| CPI Inflation (end of period) | 7.0 | 11.4 | 4.8 | 3.8 | 5.6 |
| Credit-to-GDP ratio (end of period) | 11.8 | 12.2 | 14.5 | 19.0 | 26.4 |
| Broad Money (in percent of GDP) | 31.7 | 36.8 | 41.7 | 42.9 | 48.1 |
| Current Account (in percent of GDP) | -4.8 | -5.6 | -7.3 | -5.6 | -8.5 |
Change in Credit-to-GDP Ratio, 1998-2003
(from previous year, in percentage points)
Citation: IMF Staff Country Reports 2004, 177; 10.5089/9781451804478.002.A001
Change in Credit-to-GDP Ratio, 1998-2003
(from previous year, in percentage points)
Citation: IMF Staff Country Reports 2004, 177; 10.5089/9781451804478.002.A001
Change in Credit-to-GDP Ratio, 1998-2003
(from previous year, in percentage points)
Citation: IMF Staff Country Reports 2004, 177; 10.5089/9781451804478.002.A001
9. Bulgaria’s credit growth is broadly comparable to other countries that have experienced or are experiencing credit booms (Figure 3). Cottarelli et al. (2003) classify Bulgaria among the “early birds”—along with Croatia, Estonia, Hungary, Latvia, Poland, and Slovenia—having bank credit to the nongovernment sector rising for at least five years at an annual average rate exceeding 1½ percentage points of GDP. More recent credit developments in Bulgaria would classify the country more appropriately as a “fast riser.”
Change in Credit-to-GDP Ratio, 1998-2003
(from previous year, in percentage points)
Citation: IMF Staff Country Reports 2004, 177; 10.5089/9781451804478.002.A001
Source: Bulgarian National Bank, National Statistical Institute, WEO, and staff estimates.Change in Credit-to-GDP Ratio, 1998-2003
(from previous year, in percentage points)
Citation: IMF Staff Country Reports 2004, 177; 10.5089/9781451804478.002.A001
Source: Bulgarian National Bank, National Statistical Institute, WEO, and staff estimates.Change in Credit-to-GDP Ratio, 1998-2003
(from previous year, in percentage points)
Citation: IMF Staff Country Reports 2004, 177; 10.5089/9781451804478.002.A001
Source: Bulgarian National Bank, National Statistical Institute, WEO, and staff estimates.10. The boom reflects a mix of supply- and demand-side factors. In broad terms, the credit boom reflects a catching-up from depressed levels of post-crisis bank lending, and is thus part of a process of financial deepening. More specifically:
Banks’ ability to fund loan expansion has been boosted by strong capital inflows, partly through the banking system, amid high global liquidity, low interest rates, and increased confidence associated with Bulgaria’s prospective EU accession.
The newly privatized banks were keen to boost profitability and market share. With high capital adequacy ratios, banks managed to increase profitability by shifting the composition of their assets towards loans. This more aggressive stance on the part of the banks has been actively encouraged by their foreign parents. Many of the banks’ foreign owners are domiciled in less profitable markets, so parents have encouraged their subsidiaries to pursue aggressive loan portfolio expansion to improve consolidated results. With most banks pursuing this strategy, there has been a race between banks to maintain market share, which contributed to the acceleration of credit.
The greater supply of credit has been matched by increased demand from both businesses and households (Figure 4). For the former, a newfound confidence in Bulgaria’s future—prompted in part by strong EU accession prospects—boosted investment intentions and demand for credit. Consumer and mortgage credit has taken off partly because the banks offered new products, and partly because household demand for durables and real estate increased from previously depressed levels as they have felt more confident in their ability to service debt. These developments are reflected in real sector indicators, with private consumption and fixed investment growing rapidly last year (Table 2).
Finally, an additional factor explaining the credit boom may be crowding-in: bank credit to the public sector has declined substantially (Figure 4), reflecting low general government fiscal deficits and the privatization of nonfinancial public corporations.
Change in Credit-to-GDP Ratio by Borrower, 1998-2003
(from previous year, in percentage points)
Citation: IMF Staff Country Reports 2004, 177; 10.5089/9781451804478.002.A001
Change in Credit-to-GDP Ratio by Borrower, 1998-2003
(from previous year, in percentage points)
Citation: IMF Staff Country Reports 2004, 177; 10.5089/9781451804478.002.A001
Change in Credit-to-GDP Ratio by Borrower, 1998-2003
(from previous year, in percentage points)
Citation: IMF Staff Country Reports 2004, 177; 10.5089/9781451804478.002.A001
Contribution to Real GDP Growth, 1999-2003
Contribution to Real GDP Growth, 1999-2003
| 1999 | 2000 | 2001 | 2002 | 2003 | ||
|---|---|---|---|---|---|---|
| (In percent) | ||||||
| Real GDP | 2.3 | 5.4 | 4.1 | 4.9 | 4.3 | |
| Final consumption | 7.3 | 5.0 | 3.8 | 3.2 | 5.7 | |
| Private consumption | 6.5 | 3.1 | 3.6 | 2.5 | 4.4 | |
| Public consumption | 0.8 | 1.9 | 0.2 | 0.7 | 1.3 | |
| Gross capital formation | 1.7 | 2.3 | 3.7 | 0.9 | 3.2 | |
| Net exports | -6.7 | -2.0 | -3.5 | 0.8 | -4.6 | |
| Exports of goods and services | -2.4 | 7.4 | 5.6 | 3.9 | 4.3 | |
| Imports of goods and services | -4.3 | -9.4 | -9.0 | -3.1 | -8.9 | |
| Memorandum items | ||||||
| Share of domestic demand in nominal GDP | 105.8 | 105.4 | 107.6 | 106.6 | 109.8 | |
| Share of net exports in nominal GDP | -5.8 | -5.4 | -7.6 | -6.6 | -9.8 | |
| Nominal GDP (in millions of leva) | 23,790 | 26,753 | 29,709 | 32,335 | 34,410 | |
Contribution to Real GDP Growth, 1999-2003
| 1999 | 2000 | 2001 | 2002 | 2003 | ||
|---|---|---|---|---|---|---|
| (In percent) | ||||||
| Real GDP | 2.3 | 5.4 | 4.1 | 4.9 | 4.3 | |
| Final consumption | 7.3 | 5.0 | 3.8 | 3.2 | 5.7 | |
| Private consumption | 6.5 | 3.1 | 3.6 | 2.5 | 4.4 | |
| Public consumption | 0.8 | 1.9 | 0.2 | 0.7 | 1.3 | |
| Gross capital formation | 1.7 | 2.3 | 3.7 | 0.9 | 3.2 | |
| Net exports | -6.7 | -2.0 | -3.5 | 0.8 | -4.6 | |
| Exports of goods and services | -2.4 | 7.4 | 5.6 | 3.9 | 4.3 | |
| Imports of goods and services | -4.3 | -9.4 | -9.0 | -3.1 | -8.9 | |
| Memorandum items | ||||||
| Share of domestic demand in nominal GDP | 105.8 | 105.4 | 107.6 | 106.6 | 109.8 | |
| Share of net exports in nominal GDP | -5.8 | -5.4 | -7.6 | -6.6 | -9.8 | |
| Nominal GDP (in millions of leva) | 23,790 | 26,753 | 29,709 | 32,335 | 34,410 | |
11. The sustained decline in real lending rates suggests that demand for credit is still catching up with ample supply. While nominal rates have stabilized in recent months, both short- and long-term real lending rates fell in 2003 (Figure 5). The implied yield curve has remained broadly stable. The spread between lending and deposit rates has fallen, but at around 950 basis points it remains very high.6
Real Lending Rates, 1998-2003
(in BGN, percent, weighted period average)
Citation: IMF Staff Country Reports 2004, 177; 10.5089/9781451804478.002.A001
Real Lending Rates, 1998-2003
(in BGN, percent, weighted period average)
Citation: IMF Staff Country Reports 2004, 177; 10.5089/9781451804478.002.A001
Real Lending Rates, 1998-2003
(in BGN, percent, weighted period average)
Citation: IMF Staff Country Reports 2004, 177; 10.5089/9781451804478.002.A001
12. Banks have funded the expansion of credit through three main channels (Figure 6): (i) deposit growth has been relatively quick, owing to reintermediation and improved confidence; (ii) a reduction of foreign assets abroad, reflecting low global interest rates; and, more recently, (iii) borrowing from abroad (increasing foreign liabilities). While the first has led to a dramatic rise of the credit-to-deposit ratio, from 53 percent at end-2001 to 84 percent at end-2003, the latter two have resulted in a very sharp drop in banks’ net foreign assets. To a lesser extent, additional capital—either from the parent bank or through issuance of subordinated debt—has also been a source, but only for banks whose capital adequacy ratios were near the regulatory minimum of 12 percent.
Sources of Credit Expansion, 2001-2004
Citation: IMF Staff Country Reports 2004, 177; 10.5089/9781451804478.002.A001
Source: Bulgarian National Bank and staff estimates.Sources of Credit Expansion, 2001-2004
Citation: IMF Staff Country Reports 2004, 177; 10.5089/9781451804478.002.A001
Source: Bulgarian National Bank and staff estimates.Sources of Credit Expansion, 2001-2004
Citation: IMF Staff Country Reports 2004, 177; 10.5089/9781451804478.002.A001
Source: Bulgarian National Bank and staff estimates.Characteristics of the credit boom
13. As noted, in the post-crisis period, bank credit to the nongovernment sector initially rose gradually, but accelerated after 2001 (Figure 7 and Table 3). The largest contributor to the average annual 6 percentage point increase in the NGCR in 2002–03 was the nonfinancial corporate sector with 3¾ percentage points. The average increase in the NGCR for households amounted to about 2 percentage points, while that for nonfinancial public corporations remained unchanged (after having dropped by 3¾ percentage point a year on average in 1998–2001). The 2002–03 pick-up in growth was concentrated in medium- and long-term credit, which rose on average by 5 percentage points of GDP per year.7 Finally, while domestic and foreign currency credit were equal contributors to credit growth in the later period, the contribution of foreign currency credit rose dramatically in this period relative to the earlier period. There are a number of other noteworthy trends:
Changes in Credit-to-GDP Ratio, 2001-2004
(in percentage points of GDP, year-on-year)
Citation: IMF Staff Country Reports 2004, 177; 10.5089/9781451804478.002.A001
Sources: Bulgarian National Bank and staff estimates.Changes in Credit-to-GDP Ratio, 2001-2004
(in percentage points of GDP, year-on-year)
Citation: IMF Staff Country Reports 2004, 177; 10.5089/9781451804478.002.A001
Sources: Bulgarian National Bank and staff estimates.Changes in Credit-to-GDP Ratio, 2001-2004
(in percentage points of GDP, year-on-year)
Citation: IMF Staff Country Reports 2004, 177; 10.5089/9781451804478.002.A001
Sources: Bulgarian National Bank and staff estimates.Change in Credit-to-GDP Ratio
Relative to end-2003.
Change in Credit-to-GDP Ratio
| Dec-98 | Dec-99 | Dec-00 | Dec-01 | Dec-02 | Dec-03 | Mar-04 1/ | ||
|---|---|---|---|---|---|---|---|---|
| (From previous year, in percentage points) | ||||||||
| Total | 1.1 | 1.6 | 0.4 | 2.3 | 4.5 | 7.3 | 2.0 | |
| By borrower | ||||||||
| Credits to nonfinancial public corporations | -1.4 | -0.9 | -1.0 | 0.0 | 0.1 | 0.0 | 0.0 | |
| Credits to nonfinancial private corporations | 1.3 | 2.4 | 1.3 | 1.5 | 3.3 | 4.3 | 1.3 | |
| Credits to households and NPISH | 1.2 | 0.1 | 0.1 | 0.8 | 1.1 | 3.0 | 0.7 | |
| By maturity | ||||||||
| ST | -0.5 | 0.3 | -0.2 | 0.6 | 1.2 | 0.6 | 0.6 | |
| o/w overdraft | 0.5 | 0.2 | 0.3 | 0.2 | 0.5 | 0.7 | 0.4 | |
| MLT | 2.0 | 1.4 | 1.1 | 2.0 | 3.4 | 6.8 | 1.4 | |
| Memo item: Overdue | -0.5 | -0.1 | -0.4 | -0.2 | -0.2 | -0.1 | 0.0 | |
| By currency | ||||||||
| Domestic | 1.8 | 0.9 | 0.8 | 1.5 | 1.7 | 4.1 | 0.8 | |
| Foreign | -0.7 | 0.7 | -0.3 | 0.8 | 2.8 | 3.3 | 1.2 | |
| Average 1998-2001 | Average 2002-2003 | Average 1998-2003 | ||||||
| Total | 1.4 | 5.9 | 2.9 | |||||
| By borrower | ||||||||
| Credits to nonfinancial public corporations | -0.8 | 0.1 | -0.5 | |||||
| Credits to nonfinancial private corporations | 1.6 | 3.8 | 2.4 | |||||
| Credits to households and NPISH | 0.5 | 2.1 | 1.1 | |||||
| By maturity | ||||||||
| ST | 0.0 | 0.9 | 0.3 | |||||
| o/w overdraft | 0.3 | 0.6 | 0.4 | |||||
| MLT | 1.6 | 5.1 | 2.8 | |||||
| Memo item: Overdue | -0.3 | -0.1 | -0.3 | |||||
| By currency | ||||||||
| Domestic | 1.2 | 2.9 | 1.8 | |||||
| Foreign | 0.1 | 3.0 | 1.1 | |||||
Relative to end-2003.
Change in Credit-to-GDP Ratio
| Dec-98 | Dec-99 | Dec-00 | Dec-01 | Dec-02 | Dec-03 | Mar-04 1/ | ||
|---|---|---|---|---|---|---|---|---|
| (From previous year, in percentage points) | ||||||||
| Total | 1.1 | 1.6 | 0.4 | 2.3 | 4.5 | 7.3 | 2.0 | |
| By borrower | ||||||||
| Credits to nonfinancial public corporations | -1.4 | -0.9 | -1.0 | 0.0 | 0.1 | 0.0 | 0.0 | |
| Credits to nonfinancial private corporations | 1.3 | 2.4 | 1.3 | 1.5 | 3.3 | 4.3 | 1.3 | |
| Credits to households and NPISH | 1.2 | 0.1 | 0.1 | 0.8 | 1.1 | 3.0 | 0.7 | |
| By maturity | ||||||||
| ST | -0.5 | 0.3 | -0.2 | 0.6 | 1.2 | 0.6 | 0.6 | |
| o/w overdraft | 0.5 | 0.2 | 0.3 | 0.2 | 0.5 | 0.7 | 0.4 | |
| MLT | 2.0 | 1.4 | 1.1 | 2.0 | 3.4 | 6.8 | 1.4 | |
| Memo item: Overdue | -0.5 | -0.1 | -0.4 | -0.2 | -0.2 | -0.1 | 0.0 | |
| By currency | ||||||||
| Domestic | 1.8 | 0.9 | 0.8 | 1.5 | 1.7 | 4.1 | 0.8 | |
| Foreign | -0.7 | 0.7 | -0.3 | 0.8 | 2.8 | 3.3 | 1.2 | |
| Average 1998-2001 | Average 2002-2003 | Average 1998-2003 | ||||||
| Total | 1.4 | 5.9 | 2.9 | |||||
| By borrower | ||||||||
| Credits to nonfinancial public corporations | -0.8 | 0.1 | -0.5 | |||||
| Credits to nonfinancial private corporations | 1.6 | 3.8 | 2.4 | |||||
| Credits to households and NPISH | 0.5 | 2.1 | 1.1 | |||||
| By maturity | ||||||||
| ST | 0.0 | 0.9 | 0.3 | |||||
| o/w overdraft | 0.3 | 0.6 | 0.4 | |||||
| MLT | 1.6 | 5.1 | 2.8 | |||||
| Memo item: Overdue | -0.3 | -0.1 | -0.3 | |||||
| By currency | ||||||||
| Domestic | 1.2 | 2.9 | 1.8 | |||||
| Foreign | 0.1 | 3.0 | 1.1 | |||||
Relative to end-2003.
The share of nonfinancial public corporations in nongovernment credit has declined sharply, from around 40 percent at end-1997 to 3½ percent at end-2001. Most of this decline occurred during 1998–2000, reflecting major progress in privatization and increased reluctance by the banks to lend to SOEs. Reflecting a slowdown in privatization, the share has not changed much since then, reaching 2½percent at end-2003. The relative shares of businesses and households have also shifted, with the household share rising relatively faster: at end-1997, the shares were about 56 percent and 5 percent, respectively, and at end-2001 they were 74½ percent and 21½ percent. Since end-2001, there has been a further change, with the share of private corporations falling to about 70 percent and households rising further to 27 percent. This trend has continued in the first quarter of 2004.
At end-1997, short-term credit accounted for 50 percent of the total. By end-2001, this share had fallen to nearly 33 percent, and by end-2003 to about 25 percent. The corresponding gain was in the medium- and long-term category, which moved from around 16 percent at end-1997 to 72½ percent in 2003. The shift from short- to longer-term lending is a reflection of increased confidence of both creditors and debtors. In addition, the share of overdues in the total, which stood at 23 percent in 1997, has dropped to about 2 percent in 2003.
The relative shares of domestic and foreign currency credit have also shifted substantially. In 1997, foreign currency credit accounted for about 51½ percent of the total, and by 2001 this share had fallen to 35½ percent, a reflection of rising confidence in the lev. However, since then there has been a reversal of this trend, with the foreign currency share rising to 42½ percent by end-2003. It is likely that the latter reflected the relatively lower interest rate on euro-denominated loans.8
C. Consequences of the Credit Boom
The economic growth-financial intermediation nexus
14. An increase in the level of financial intermediation is associated with an increase in the long-run growth rate of the economy. The theoretical and empirical literature generally supports the view that financial sector development increases economic growth.9 There are various channels though which financial development can contribute to economic growth, including by collecting information and thereby improving the allocation of capital; risk sharing; and pooling savings and raising the efficiency of financial intermediation.
15. From a structural perspective, the increase in financial intermediation could therefore be considered beneficial. Bulgaria’s per capita GDP is still well below the average of Central and Eastern Europe. To the extent that financial deepening raises the country’s potential growth rate—through increases in the marginal productivity of capital and higher private savings—recent developments should in principle be welcome.
What are the risks?
16. While potentially beneficial, rapid financial deepening can carry with it risks (Box 1).10 The risks can be grouped into two broad categories: (i) prudential, i.e., overly rapid credit growth can threaten the stability of the financial system; and (ii) macroeconomic, i.e., rapid credit growth can lead to macroeconomic imbalances, both domestic and external.11 In the first group of risks, banks’ ability to manage risk typically declines as the volume of loans increases. As the number of borrowers rises (e.g., in the expansionary phase of the business cycle), banks may find it profitable to attract customers by reducing collateral requirements, trading off borrower quality for increased market share. This easing of lending standards may lead to a deterioration of banks’ portfolios, thus increasing the risk of financial instability.12 In the second group of risks, domestic risks relate to increased inflation of goods and asset prices. Typically, lending booms have been associated with rapid increases in asset prices, eventually leading to a financial bubble. A painful recession often follows the inevitable bursting of this bubble, as agents’ balance sheets are re-adjusted. External risks relate to a deterioration of the external current account, as the credit boom finances imports. To the extent that the wider external current account balance is not financed by inflows of foreign direct investment (FDI), gross external debt would tend to rise, increasing the country’s vulnerability to exogenous shocks. When credit spurs an import boom, the composition of imports will matter; if a large part of imports are investment goods that are used to increase the country’s export capacity, there may be fewer reasons for concern. In contrast, if credit finances primarily imports of consumer goods or investment in the nontradables sector, there may be more reasons for concern as this type of import boom is not self-financing.
Channels for Financial Intermediation
Increases in financial intermediation—lending booms being one manifestation—may occur due to various factors. According to Gourinchas et al. (2001), explicit or implicit bailout guarantees may spur lending as projects are priced under a “best possible scenario.” The pace of credit growth may also be affected by a poorly regulated financial market, a terms of trade shock that affects consumption or investment, or an inflow of capital from abroad due to external reasons.
Lending booms can be amplified by the “credit channel” of the economy. The financial accelerator model of Bernanke and Gertler (1990, 1995)—supplemented by a survey of empirical support in Bernanke, Gertler and Gilchrist (1996)—is generally used to explain this development. This model argues that credit market conditions amplify and propagate effects of initial monetary or real shocks, thus magnifying the volatility of macroeconomic variables. This approach rests on the assumption that the external finance premium—the difference in cost of funds raised externally by issuing equity or debt and internally by retaining earnings—varies inversely with the borrower’s net worth, his internal funds and collateral value of his illiquid assets. A boom in the real sector raises the net worth of the borrower, thus reducing his external finance premium and increasing his demand for loans. The subsequent increase in asset prices causes a further reduction of the borrower’s external finance premium (by increasing his net worth), and spurs further lending.
Within the financial accelerator model, the positive feedback can be easily reversed. A change in monetary policy or the real sector that increases the interest rate may—through the balance sheet channel (by reducing net worth) or the bank lending channel (by reducing credit)—increase the external finance premium of the borrower. As a result, his access to credit is reduced and, in addition, due to the fall in his net worth, his ability to service his debt may be compromised. In this case, through the negative feedback effect, the economy may face a recession.
17. Prudential risks do not appear to be an issue at present. Despite the rapid increase in lending, there is no evidence that the stability of Bulgaria’s financial system is currently threatened.13 Indeed, prudential indicators suggest a healthy banking system (Table 4), with low non-performing loans(NPLs), high capital adequacy (almost twice the required minimum of 12 percent), high liquidity, and strong profitability. Moreover, indicators for individual banks do not point to isolated systemic problems. Admittedly, these indicators tend to provide lagging signals of future problems; in particular, in a lending boom, the NPL ratio initially drops as the volume of loans (the denominator) rises. The deterioration in loan quality (the numerator) would tend to show up later. Nevertheless, it is important to monitor developments closely for any signs of deterioration.
Financial Soundness Indicators, 1999-2003
(In percent)
Non-performing loans including the watch, substandard, doubtful, and loss categories.
Financial Soundness Indicators, 1999-2003
(In percent)
| 1999 | 2000 | 2001 | 2002 | 2003 | |
|---|---|---|---|---|---|
| Regulatory capital to risk-weighted assts | 41.8 | 35.6 | 31.1 | 25.2 | 22.0 |
| Nonperforming loans to total loans 1/ | 26.7 | 17.3 | 13.1 | 8.6 | 7.3 |
| NPLs net of provisions to capital | 7.0 | 2.5 | 2.4 | 2.7 | 3.1 |
| Return on assets | 2.7 | 3.1 | 2.9 | 2.1 | 2.4 |
| Return on equity | 18.8 | 22.5 | 22.0 | 16.4 | 21.7 |
| Liquid assets to total assets | 63.2 | 54.2 | 47.9 | 40.3 | 27.5 |
Non-performing loans including the watch, substandard, doubtful, and loss categories.
Financial Soundness Indicators, 1999-2003
(In percent)
| 1999 | 2000 | 2001 | 2002 | 2003 | |
|---|---|---|---|---|---|
| Regulatory capital to risk-weighted assts | 41.8 | 35.6 | 31.1 | 25.2 | 22.0 |
| Nonperforming loans to total loans 1/ | 26.7 | 17.3 | 13.1 | 8.6 | 7.3 |
| NPLs net of provisions to capital | 7.0 | 2.5 | 2.4 | 2.7 | 3.1 |
| Return on assets | 2.7 | 3.1 | 2.9 | 2.1 | 2.4 |
| Return on equity | 18.8 | 22.5 | 22.0 | 16.4 | 21.7 |
| Liquid assets to total assets | 63.2 | 54.2 | 47.9 | 40.3 | 27.5 |
Non-performing loans including the watch, substandard, doubtful, and loss categories.
18. There is, however, evidence of heightened macroeconomic risks (Box 2. While rapid credit growth has not been reflected in CPI inflation—the recent uptick largely reflects temporary factors related to food prices—real estate price inflation has accelerated since last year, coinciding with increased credit growth (Figure 8).14 While worth monitoring going forward, it may be premature to focus on this phenomenon at this time as it may be driven by fundamental factors, such as a catch-up to price levels prevailing in neighboring countries, or external interest in anticipation of EU accession.15 Of more concern is the weakening of the external current account which reflects a credit-induced import boom (Figure 9).16 The rise in imports has been relatively broadly based, with imports of raw materials, investment goods, and consumer goods all rising strongly.
Real Estate Price Index and CPI Index, 2001-03
(in percent change, year-on-year)
Citation: IMF Staff Country Reports 2004, 177; 10.5089/9781451804478.002.A001
Real Estate Price Index and CPI Index, 2001-03
(in percent change, year-on-year)
Citation: IMF Staff Country Reports 2004, 177; 10.5089/9781451804478.002.A001
Real Estate Price Index and CPI Index, 2001-03
(in percent change, year-on-year)
Citation: IMF Staff Country Reports 2004, 177; 10.5089/9781451804478.002.A001
Credit and Current Account Deficit to GDP Ratio,2001-03
(12-month cumulative change)
Citation: IMF Staff Country Reports 2004, 177; 10.5089/9781451804478.002.A001
Credit and Current Account Deficit to GDP Ratio,2001-03
(12-month cumulative change)
Citation: IMF Staff Country Reports 2004, 177; 10.5089/9781451804478.002.A001
Credit and Current Account Deficit to GDP Ratio,2001-03
(12-month cumulative change)
Citation: IMF Staff Country Reports 2004, 177; 10.5089/9781451804478.002.A001
Credit Growth and Current Account in Financial Programming
The analytics of the link between the current account and credit growth can be described in a simple financial programming model (based on Dornbusch 1980). The starting point is the observation that the current account (CA) represents a change in the net foreign asset position (NFA) of a country:
The right hand side encompasses all sectors of the economy—the central bank (NFACB), commercial banks (NFAB), the government (NFAG), and the nonbank private sector (NFANB). As the central bank is prevented by the currency board arrangement from issuing domestic credit, changes in the net foreign assets of the central bank have to equal changes in base money (H):
Any change in the reserves of the central bank is, thus, automatically translated to a change in the monetary base (as also described in Lewis (2002)).
For the consolidated banking system, the balance sheet identity can be written as:
where M2 is broad money and DC is domestic credit. Since total change in DC can be expressed as the sum of changes in domestic credit to the government and the nonbank public—
ΔDC = ΔDCG + ΔDCNG—and since any excess of expenditure of the government over tax revenue has to be financed by taking on more domestic credit or reducing its net foreign asset position—
This gives a link between the banking system’s net asset changes and the government’s deficit financing. Inserting the value for h NFAB in the current account equation gives:
The equation above links both fiscal policy and changes in credit to the nongovernment sector to the current account balance. For a given change in broad money, a higher fiscal deficit or an increase in credit to the nongovernment sector (that is not met by a decline in the net foreign assets of the nonbanking sector) leads to worsening of the current account. The equation further highlights the role played by currency-to-deposit ratios and reserve requirements in a currency board environment; for a given change in base money, changes in the currency-to-deposit ratio or the reserve requirement would bring about the required change in M2, which is then reflected in the current account.
19. Although there are mitigating factors, on balance, the weaker current account has increased macroeconomic risks. The current account deficit has been largely financed by FDI (82 percent coverage last year), and, combined with other capital inflows, international reserves have continued to rise. However, FDI is not without risks. Not only can it stop suddenly and even go into reverse, it may also represent investment in sectors that do not produce primarily for export. In the case of Bulgaria, as discussed in Chapter II, it is estimated that two-thirds of FDI went into the nontradables sector last year. In addition, even if it does not stop suddenly, privatization-related FDI is certain to dry up in a few years. If it is not replaced by other types of FDI, a continued high current account deficit would result in higher external debt and/or lower international reserves, increasing Bulgaria’s external vulnerability.17
D. Policy Options
20. It is likely that credit growth will moderate, even in the absence of measures, owing to a number of factors, including:
Some banks may become liquidity-constrained, reducing their ability to lend.
The share of loans in total assets has risen dramatically, and is bound to slow.
Credit growth has outstripped one of its key funding sources, deposits, resulting in a very sharp rise the credit-to-deposit ratio (see Figure 6). This may not continue.
Banks’ foreign assets have fallen substantially, partly because of low foreign interest rates. With U.S. dollar interest rates likely to move higher, there will be less of an incentive to repatriate or borrow abroad. In any event, a minimum level of foreign assets is required for banks’ foreign operations, putting a ceiling on how much can be repatriated and some banks may reach exposure limits for their parent banks or other foreign lenders.
21. However, any deceleration in credit growth from these factors is unlikely to be substantial in the near term. Consequently, credit growth will need to be reduced to moderate domestic demand. Combined with reducing demand in the short run, economic policy needs to aim at strengthening supply in the medium to long run. Given Bulgaria’s policy framework, the following mix of policies could be considered:
Tightening fiscal policy. The authorities have already tightened their fiscal stance in response to the current account developments and are maintaining a prudent wage policy. However, a significant increase in government saving would be needed to fully offset the private saving-investment imbalance. A large additional fiscal tightening is difficult to justify, given that (i) the widening of the external imbalance is likely to partly reflect transition to a new equilibrium with increased financial intermediation that fiscal policy should not attempt to fully offset; (ii) fiscal policy is already prudent—the general government deficit has averaged only ¾ percent of GDP in recent years, and there are no evident fiscal sustainability problems; and (iii) there would be output costs to doing so, not to mention the political difficulty of such actions one year before parliamentary elections.
Reinvigorating structural reforms. Reforms are necessary to increase the economy’s productive potential, including export capacity. In the short run, there should be a focus on maintaining privatization inflows at a high level to satisfy external financing requirements. Beyond the short-term considerations, however, structural reforms are likely to have an impact—in the sense of stimulating a supply response—only with a considerable lag.
Reducing banking system liquidity. A tightening of reserve requirements and shifting of government deposits in commercial banks to the BNB—as the authorities are already doing—is likely to have an impact in the short run.18 However, given the open capital account and banks’ ability to borrow from abroad, further repatriate foreign assets, and access capital directly from their parents, the withdrawn liquidity might be replaced.19 The key question in this regard is how fast and to what extent it will be replaced; while the answer is uncertain, it is likely that market imperfections will prevent capital from being perfectly mobile in this case.
22. A number of other—somewhat more controversial—measures could be considered:
Regulatory and supervisory measures. The authorities have been implementing a strategy of phased supervisory measures to slow credit growth.20 So far, this strategy has not produced the hoped for reduction in credit growth. This is perhaps not surprising as supervisory measures aim to preserve bank asset quality. If, as a result of tighter prudential standards, banks lend less, this would be merely a by-product of such measures. The scope for further measures is limited by the fact that regulatory and supervisory practices already are at, or exceed, best international practice. However, one element in the BNB’s strategy—minimum liquid asset ratios—has not yet been implemented. A more stringent measure would be the imposition of credit ceilings.21 These types of measures, if implemented, should be considered temporary as they are distortionary and may impede bank competition.
Domestic bond issuance by the government. By selling domestic bonds—over and above rollover or deficit financing requirements—to commercial banks, the government could help soak up liquidity. This measure has the advantage of being more market based than some of the alternatives. However, there are disadvantages: such an operation (i) would amount to a quasi-monetary policy action that is not in conformity with the spirit of the CBA; and (ii) could be costly from a fiscal perspective, particularly if the banks are reluctant buyers of government paper (given that it is more lucrative to lend to the private sector).22 Nevertheless, this measure could be considered if credit growth remains at a very high level. More generally, the government’s debt management strategy can help develop the domestic securities market, which would provide banks (and private pension funds) with alternative investment opportunities.
Price-based controls on capital inflows. A measure of this nature should be considered only as a last resort. While potentially effective—Chile (and, more recently, Malaysia) being the oft-quoted examples—such a measure has several disadvantages: (i) the controls may eventually be circumvented; (ii) it may undermine financial market confidence; and (iii) capital controls tend to be distortionary (especially over the medium term).
E. Concluding Remarks
23. In many respects, the credit boom in Bulgaria is a welcome development. Increased financial intermediation will likely boost long-run economic growth and efficiency. From this perspective, the widening of the external current account deficit is partly a reflection of a transition to a new equilibrium characterized by greater financial intermediation and has alleviated financing constraints for investment and consumption. In addition, relatively rapid credit growth is likely to continue into the foreseeable future.
24. However, the recent pace of credit expansion has increased macroeconomic vulnerabilities. The large increase in private domestic demand and imports associated with the credit boom has resulted in a sharp widening of the external imbalance. While FDI inflows have mostly covered the growing deficit, this cannot be assured in the future. If FDI inflows were to slow significantly, a continued high current account deficit would increase external debt and/or lower international reserves. In such a case, financial markets could quickly change their hitherto benign view of Bulgaria’s prospects.
25. If the authorities want to reduce the external imbalance, credit growth should be lowered. Measures to reduce bank liquidity and prudent fiscal policy would contain domestic demand, while reinvigorated structural reform would boost the economy’s productive potential. Further measures, particularly on the credit side, may be needed if this strategy were to prove ineffective.
F. References
Bank for International Settlements, 2001, Marrying the Macro- and Microprudential Dimensions of Financial Stability (Basel).
Berg, Andrew, Eduardo Borensztein, and Catherine Pattillo, 2004, “Assessing Early Warnings Systems: How Have They Worked in Practice?” IMF Working Paper WP/04/52 (Washington: International Monetary Fund).
Bernanke, Ben, and Mark Gertler, 1990, “Financial Fragility and Economic Performance,” Quarterly Journal of Economics, Vol. 105 (February), pp. 87–114.
Bernanke, Ben, and Mark Gertler, 1995, “Inside the Black Box: The Credit Channel of Monetary Policy Transmission,” Journal of Economic Perspectives, Vol. 9 (Autumn), pp. 27–48.
Bernanke, Ben, and Mark Gertler, and Simon Gilchrist, 1996, “The Financial Accelerator and the Flight to Quality,” Review of Economics and Statistics, Vol. 78 (February), pp. 1–15.
Cottarelli, Carlo, Giovanni Dell’Ariccia and Ivanna Vladkova-Hollar, 2003, “Early Birds, Late Risers, and Sleeping Beauties: Bank Credit Growth to the Private Sector in Central and Eastern Europe and the Balkans,” IMF Working Paper WP/03/213 (Washington: International Monetary Fund).
Dell’Ariccia, Giovanni, and Robert Marquez, 2003, “Lending Booms and Lending Standards,” mimeo.
Dornbusch, Rudiger, 1980, Open Economy Macroeconomics (New York: Basic Books).
Goldstein, Morris, Graciela Kaminsky, and Carmen Reinhart, 2000, Assessing Financial Vulnerability: An Early Warning System for Emerging Markets (Washington: Institute for International Economics).
Gourinchas, Pierre-Olivier, Rodrigo Valdés, and Oscar Landerretche, 2001, “Lending Booms: Latin America and the World.” NBER Working Paper No. 8249 (Cambridge, Massachusetts: National Bureau of Economic Research).
International Monetary Fund, 2004, World Economic Outlook: Advancing Structural Reforms (Washington).
Kaminsky, Graciela, and Carmen Reinhart, 1999, “The Twin Crises: The Causes of banking and Balance-of-Payments Problems,” American Economic Review, Vol. 89 (June), pp. 473–500.
Levine, Ross, 2003, “Finance and Growth: Theory, Evidence, and Mechanisms,” mimeo.
Lewis, Mervyn K., 2002, “Currency Boards and Currency Arrangements in Transition Economies,” in Banking Reforms in South-East Europe, ed. by Zeljko Sevic (New York: Edward Elgar).
Organization for Economic Co-Operation and Development, 1999, OECD Economic Surveys—1998-99, Bulgaria (Paris).
Tornell, Aaron, and Frank Westermann, 2002, “Boom-Bust Cycles in Middle Income Countries: Facts and Explanation,” NBER Working Paper No. 9219 (Cambridge, Massachusetts: National Bureau of Economic Research).
Prepared by Christoph Duenwald and Bikas Joshi.
See Chapter II.
In this chapter, the term “credit boom” is not used in a technical sense, as sometimes defined in the literature. For instance, IMF (2004) identifies a credit boom as a credit expansion that exceeds a given threshold (equivalent to 1.75 times the standard deviation of the country’s average credit fluctuation around trend). Given this definition, the term “credit boom” does not apply to Bulgaria. However, such a threshold is fairly arbitrary—Gourinchas et al. (2001) and Tornell and Westermann (2002) use different methodologies to arrive at their samples of credit boom periods—and using the Hodrick-Prescott filter to arrive at a notional equilibrium credit ratio in a transition economy may be misleading given the frequent structural changes.
In the official credit statistics, the nongovernment sector includes the following types of borrowers: nonfinancial public corporations, nonfinancial private corporations, and households (including nonprofit institutions serving households, which comprise political and charitable organizations).
The Organization for Economic Co-Operation and Development (1999, p. 59) notes that, until 1996, “commercial credit was expanded to the nonfinancial sector in Bulgaria to a degree that was unprecedented relative to any other European transition economy.” It should be pointed out that private banks—the emergence of which was facilitated by soft entry regulations—were also actively extending credit at the time.
An important caveat here is that, given the hard peg, banks are limited in the extent to which they can raise rates. Also, given the CBA, banks can in principle face relatively high interest rate volatility. While volatility was indeed high in 1999-2001, the last two years have seen a reduction, a reflection of steadier capital flows.
The BNB uses the following maturity breakdown: less than one year, between one year and five years, and over five years. For the purposes of this chapter, the first category is shortterm credit, and the sum of the latter two is medium- and long-term credit. Overdrafts are assumed to be short-term credits.
The spread between lev and euro long-term interest rates averaged 335 basis points in 2003.
IMF (2004) provides a summary of the state of play in the literature; a more extensive discussion of both the theory and empirics regarding finance and growth can be found in Levine (2003).
While the probability of a credit boom leading to a banking crisis is low, Gourinchas et al. (2001) and Tornell and Westermann (2002) find that most banking crises are preceded by a credit boom.
The distinction between prudential and macroeconomic risks is made for expository purposes. The two types of risk may be causally linked: an episode of financial instability can quickly produce macroeconomic imbalances, while macroeconomic shocks can produce financial instability. The vicious spiral that may result is outlined in Kaminsky and Reinhart (1999).
A model consistent with these insights is presented in Dell’Ariccia and Marquez (2003).
Chapter IV summarizes the FSAP follow-up, including the results of banking system stress tests.
The index, available on a quarterly basis from the National Statistical Institute, measures the average price of one-, two-, and three-bedroom apartments in all administrative districts of the country.
In support of this contention, the increase in real estate prices is concentrated in large cities (such as Sofia and Plovdiv) and towns on the Black Sea coast.
A recent survey of early warning system models by Berg et al. (2004) reports widespread use of the current account as one of the predictive variables. For instance, Goldstein et al. (2000) find the current account deficit to be among the best indicators for predicting currency crises.
The Baltic countries are commonly cited as examples of why high current account deficits can be sustained. However, these countries were more advanced with structural reform and consequently attracted very high FDI inflows on a sustained basis.
The tightening of reserve requirements consists of the following two measures: (i) subjecting 50 percent of cash in vault to reserve requirements; and (ii) broadening the base of liabilities subject to reserve requirements by including deposits and securities above two years’ maturity and repos (excluding those of commercial banks), at a rate of 4 percent. Both measures could be tightened further by making all cash in vault subject to reserve requirements and subjecting longer-term liabilities to the full 8 percent reserve requirement rate. An actual increase in the reserve requirement rate is currently not being considered by the BNB as it goes in the opposite direction of EU harmonization.
Such an offset is more likely where banks are predominantly foreign owned, such as in Bulgaria.
See Chapter IV.
Other possible measures include dynamic provisioning, where additional provisions are set aside in lending booms, rather than in downturns when loan quality deteriorates. See for example Bank for International Settlements (2001).
It could be argued that the costs of reducing credit growth should not be borne by the public sector, but rather by the private sector which is the source of the imbalances.
