This Selected Economic Issues paper for Bosnia and Herzegovina reports that output, exports, and incomes have increased and inflation has stabilized. New modern banking laws have been passed in both entities, and the banking sector has been almost completely privatized, with the majority of assets now under foreign ownership. The reforms to the central bank and to the banking system have been aimed to secure stability and to build an efficient financial system.

Abstract

This Selected Economic Issues paper for Bosnia and Herzegovina reports that output, exports, and incomes have increased and inflation has stabilized. New modern banking laws have been passed in both entities, and the banking sector has been almost completely privatized, with the majority of assets now under foreign ownership. The reforms to the central bank and to the banking system have been aimed to secure stability and to build an efficient financial system.

III. International Experience with Credit Booms and Large Current Account Deficits1

A. Introduction

1. While Bosnia and Herzegovina’s output has been recovering since 1995 and inflation is low, major macroeconomic imbalances have emerged. The external current account deficit stands, according to staff estimates, at about 17 percent of GDP in 2004, and closer to 24 percent of GDP according to official estimates. The deficit is the result of strong import growth. Meanwhile, bank credit to non-government, relative to GDP, has increased by over 20 percentage points in three years. In that time, it has grown almost 120 percent.

2. In an international context, these imbalances and trends are unusual. This chapter summarizes the international experience with large external deficits and fast credit growth since 1970, including among transition area and currency board countries. It draws some conclusions for Bosnia and Herzegovina from that international experience.

B. Background

3. The Bosnian current account deficit, according to staff estimates, has remained well above 10 percent of GDP since 2000, peaking at almost 22 percent in 2002. The deficit appears to be mostly financed by non-debt creating inflows, including capital transfers as one form of remittances and donor support, so the external debt-to-GDP ratio is estimated to be falling. On the other hand, errors and omissions are large and rising, signaling significant measurement error in either the current or capital account or both.

4. The domestic counterparts to Bosnia and Herzegovina’s external imbalance are notable. National savings have fallen from about 8 percent of GDP in 2000 to about 3 percent in 2004. But public consumption has not contributed to this decline. The overall deficit of the general government has fallen from about 7 percent of GDP in 2000 to less than 1 percent in 2004. Instead, private sector consumption has expanded by more than 10 percent of GDP since 2000. Alongside, investment spending has stagnated at about 20 percent of GDP for four years.

Figure 1.
Figure 1.

Balance of Payments Developments, 2000-04

(In percent of GDP)

Citation: IMF Staff Country Reports 2005, 198; 10.5089/9781451977783.002.A003

Sources: Authorities and Fund staff estimates.

5. The consumption boom has been bank-financed. Bank credit to non-government, relative to GDP, has increased by over 20 percentage points in 2001–04. Most of the new loans have gone to private households for reconstruction and consumption purposes—with the ratio of bank credit to households rising by 14 percentage points of GDP since 2001. Credit to non-households accounts for most of the remaining one percentage point increase, as bank credit to the government sectors has changed only marginally. This reflects many factors, including the strong restructuring of the banking sector (see Chapter 2 for details).

6. Are Bosnia and Herzegovina’s credit boom and external deficits unusual in international experience and what are the implications of this comparison? The remainder of the chapter explores these issues.

Figure 2.
Figure 2.

Bank Credit to Non-Government, 2001-04

(Eop. stocks; as percent of GDP)

Citation: IMF Staff Country Reports 2005, 198; 10.5089/9781451977783.002.A003

Sources: Authorities and Fund staff estimates.

C. International Comparisons

Credit booms

7. The 1970s saw many episodes of financial and currency instability associated with prior credit booms.2 And there is evidence that these were more frequent and marked in the case of fixed exchange rate regimes.3

8. What is the link, in international experience, between banking instability and rapid credit growth? To examine this question, we used Caprio and Klingebiel’s 2003 data set to identify periods of banking sector instability—defined as much or all of the capital of the entire banking system being exhausted—in many countries. They report 117 such banking crises that occurred in 93 countries since the late 1970s. We then matched this data with the behavior of the private sector credit-to-GDP ratio for 140 countries over the same period. For this, we defined a credit boom as a three-year period during which the private sector credit-to-GDP ratio jumped by a cumulative 10 percentage points or more. The private sector credit-to-GDP ratio was calculated based on the Fund’s IFS and WEO data.

9. Prolonged credit booms increase the likelihood of a banking crisis. From the sample of 140 countries, 74 have had at least one episode of difficulties in the banking system as defined by Caprio and Klingebiel (2003). Of these 74, 22 countries experienced growth of private sector credit-to-GDP by more than 10 percentage points for three years preceding these events. These 22 countries account for almost 40 percent of the credit booms, indicating a high frequency of banking instability in countries with credit booms. Thus, in cases where growth of credit is rapid, the incidence of subsequent banking difficulties is high, albeit not inevitable.

10. The likelihood of a banking crisis following a credit boom seems to be somewhat higher in countries with greater financial depth to begin with. For the period 1990–2003, countries with private credit-to-GDP ratios of more than 25 percent account for about half of the sample of 140 countries but 75 percent of the 22 countries with both rapid credit growth and banking crisis. Accordingly, the other half of the sample countries with private sector-to-GDP ratios of less than 25 percent account for only one quarter of the crisis countries. Thus, in cases where financial depth is low initially, the likelihood of a credit boom will lead to banking difficulties may be lower, but remains significant.

11. What is the experience in the transition area? Most such countries had banking instability in the early-1990s, at the beginning of the transition process, before credit started to expand rapidly. Since then, however, credit has boomed in this group. But notwithstanding the recent vintage of these booms, already three episodes of banking sector difficulties have followed credit booms: namely Poland in 1993, Bulgaria in 1996, and the Slovak Republic in 1997.

Table 1.

Private Sector Credit-to-GDP (in percent), 1990-2003 in The Last Year of a Three-year Credit Boom and the First Year (shaded) of a Banking Crisis in Selected Transition Countries in the Region.

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12. Since most of these credit booms in the transition area are of recent vintage, it is not clear from the data if they presage banking difficulties. Broader international experience would suggest that this is the case if they continue, unless rapid credit booms in the transition context are somehow different from those elsewhere. This possibility cannot be determined from the available data. But given that Bosnia and Herzegovina is an outlier even among the transition countries, concerns would naturally be greater than those elsewhere in the transition area.

13. Bosnia and Herzegovina’s credit growth is, however, also an outlier among currency boards.4 There are several active currency board countries.5 Of these, only Bulgaria has, like Bosnia and Herzegovina, experienced rapid credit growth alongside an external deficit, but before it introduced the currency board. Hong Kong also experienced rapid credit growth from 1993–97, but alongside current account surpluses. The non-active currency boards of Argentina (1991–2001), Ireland (until 1979), and Malaysia (1967–73) all had credit growth below the threshold used in this chapter. The exception is Singapore (1967–73), where three-year credit-to-GDP growth exceeded a cumulative 10 percentage points during the last two years before the currency board was abandoned.

14. This summary of the international data confirms the main conclusions from the literature. Rapid credit growth is one of the most robust leading indicators for banking difficulties. Numerous studies have found that periods of significant and accelerating credit growth often preceded such events.6 The likelihood for banking difficulties to follow a lending boom is estimated to be as high as 20 percent, depending on the data set and methodology used. The high costs of a burst of a credit bubble are further described in IMF (April, 2004). The experience of the transition area is too recent, and generally has limited cases of high credit growth, for robust conclusions to be drawn for this narrow group of countries. But even within them, sustained credit growth is on a scale in Bosnia and Herzegovina that renders it an outlier, underscoring concerns there.

15. Recent empirical evidence also suggests that the exchange regime affects the probability of banking difficulties. More specifically, economies with rigid exchange rate regimes are more vulnerable to severe economic challenges (Rogoff, et al., 2004). In such cases, commercial banks have tended to underestimate currency risk in fixed exchange rate environments, funding domestic currency lending with foreign currency borrowing. Interestingly, banks in Bosnia and Herzegovina have not followed this route (see Chapter 2 for details).

16. But Bosnia and Herzegovina exhibits other characteristics which internationally have been associated with banking instability. International experience suggests that unsustainable macroeconomic policies (Argentina, 2001), wholesale liberalization in the absence of an appropriate and effective prudential regulatory framework (Chile, 1984), direct effects of fiscal difficulties on the domestic banking system (Argentina, 2001), contagion and spillovers (Argentina, 1995), terms of trade shocks and movements in real exchange rates (Venezuela, 1994), and political instability, unrest, and civil conflict can be associated with banking sector difficulties. Bosnia and Herzegovina exhibits some of these features to some degree—including unresolved excess government liabilities, fiscal pressures, and exposure to regional instability.7

Large external deficits

17. Bosnia and Herzegovina’s external deficit is unique. From a WEO sample of 180 countries, Nicaragua is alone in reporting a similar external deficit in 2003 and 2004. Moreover, except for Bosnia and Herzegovina, Jordan, and Lebanon, all other countries in the sample that reported annual current account deficit of more than 15 percent of GDP for at least 3 consecutive years since the mid-1980s are low-income countries, defined as PRGF-eligible, with structural balance of payments deficits.

18. Large deficits are often associated with exchange rate instability:

Table 2.

Current Account Deficits of more Than 15 percent of GDP for At Least Three Table 2: Consecutive Years (in percent) and Years of “Large Devaluations” (shaded areas), 1965-85 1/2/

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Excluding very small countries and countries with large FDI inflows during the years of large current account deficits.

Following Frankel and Rose (1996), a “Large devaluation” is defined as a depreciation of the annual average exchange rate against the U.S. dollar by more than two standard deviations of the the 20-year forward looking moving average exchange rate.

Table 2.

Current Account Deficits of more Than 15 percent of GDP for At Least Three Consecutive Years (in percent) and Years of “Large Devaluations” (shaded areas), 1965-85 1/2/

article image

Excluding very small countries and countries with large FDI inflows during the years of large current account deficits.

Following Frankel and Rose (1996), a “Large devaluation” is defined as a depreciation of the annual average exchange rate against the U.S. dollar by more than two standard deviations of the the 20-year forward looking moving average exchange rate.

19. This observation is again in line with the findings of the literature. Edwards (1989) and Kamin (1988) both show for their sample of countries that the current account was significantly different for the devaluers than for the control group.

20. Bosnia and Herzegovina’s current account deficit is also an outlier among active currency board countries. Few other countries have exceeded the 15-percent of GDP mark since 1990 or before. The group which has exeeded this mark largely comprises small island economies, notably the islands of the East Caribbean Currency Union (Antigua and Barbuda, Dominica, Grenada, St. Kitts and Nevis, St. Lucia, and St. Vincent and the Grenadines) which have sometimes even exceeded the 20-percent mark. The only other active currency board, in Brunei-Darussalam, has witnessed an annual average surplus of almost 60 percent of GDP since 1990.

21. None of the inactive currency boards exhibited high current account deficits either. Argentina’s annual average deficit was equal to 3 percent of GDP during the currency board years. Hong Kong has had an annual average surplus of about 4 percent of GDP since the introduction of the currency board in 1983. Ireland’s deficit was equal to 10 percent of GDP on average for the last ten years of its currency board era which ended in 1979. Malaysia’s current account balanced out during its currency board era. Only Singapore exited its 6-year currency board in 1973 with a current account deficit of 15 percent of GDP. The average over the 6-year period was 19 percent of GDP.

22. External imbalances are only one indicator of possible currency instability. Others include: poor export performance; financial sector instability; low or falling international reserves; rapid money and or credit growth; low real GDP growth; and domestic inflation, and fiscal deficits.8 Bosnia and Herzegovina scores well on some of these indicators, such as international reserves, inflation, the fiscal balance, and strong banks (see chapter 2). But others give some concern. While the fiscal balance is strong, it is structurally weak, with significant risks attached, GDP growth has slowed since the early 2000s, and bank credit is booming (see chapters 6 and 10).

D. Conclusion

23. Bosnia and Herzegovina’s credit boom and external deficit are remarkable—but not completely unique—in international experience. Countries elsewhere exhibiting these or similar characteristics have disproportionately, but not always, experienced subsequent periods of instability. On other dimensions of economic behavior which have been associated with volatility internationally, Bosnia and Herzegovina’s score is mixed. Even with due allowance for the likely underestimation of GDP, there would therefore seem to be good grounds to moderate credit growth and to lower the external imbalance in Bosnia and Herzegovina so as to underwrite the stability gained so far.9

References

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1

Prepared by Joerg Zeuner.

4

This comparison excludes the currency boards of Bermuda, Cayman Islands, Falkland Islands, Faroe Islands, and Gibraltar.

5

These comprise Bulgaria, Brunei-Darussalam, the East Carribbean Currency Union, Djibouti, Estonia, China, P.R.: Hong Kong, and Lithuania.

7

See Chapters 6 and 10.

8

See Kaminsky, Lizondo, and Reinhart (1998) for details.

9

See Chapter 5.