Going too Fast?

• Author: Paul Hilbers, Inci Otker-Robe, and Ceyla Pazarbasioglu
• Position: Advisor in the IMF's European Department/Deputy Area Chief in the Monetary and Financial Systems Department/Division Chief in the International Capital Markets Department

Managing rapid credit growth in Central and Eastern Europe

Many of the Central and Eastern European (CEE) countries have recently experienced a rapid expansion of bank credit to the private sector. This process, already apparent at the beginning of the decade, has only become stronger. During 2000-04, credit increased by about 17 percent a year on average in real terms across the region. In 2004 alone, credit to the private sector increased by about 30-45 percent in real terms in 6 of the 15 countries. As a result, the ratio of private sector credit to GDP has also increased significantly in these countries, albeit generally from a low base.

Are these developments simply the result of a normal and expected "financial deepening," as the CEE countries continue their move toward fully developed market economies in an integrating Europe? In that case, credit growth would largely be absorbed by an increase in money demand without major macroeconomic consequences. On the demand side, the credit expansion is supported by higher income expectations, often related to these countries' (prospect of) accession to the European Union (EU). On the supply side, the credit surge has been facilitated by foreign financial institutions entering these markets with the objective of rapidly gaining market share. While these institutions often have only limited exposure to any particular country, they play a significant role in the local banking systems.

The expansion of credit from relatively low levels of financial intermediation would support this "catching up" hypothesis (see circle, Chart 1). For example, Ukraine had a private sector credit ratio to GDP of about 8 percent in 1999 and has experienced an increase in real growth of private sector credit of almost 40 percent-along with countries like Bulgaria, Moldova, and Romania, which showed a rapid growth from low initial levels. Indeed, most of the CEE countries with the fastest growth in private sector credit had credit-to-GDP ratios below the group average of 22 percent (compared with an average for the original 15 EU member countries of over 100 percent).

[ SEE THE GRAPHIC AT THE ATTACHED ]

The rapid credit expansion in these countries is not, however, danger free. Countries' experiences with financial distress remind us all too well that misperceptions about the evolution of risks and inappropriate (or lack of) policy responses can be costly. This article explores policymakers' options, ranging from the well-known monetary and fiscal ones to less discussed, but equally important, supervisory and prudential ones. The latter could be used to strengthen the resistance of the financial system to the adverse consequences of credit expansion.

Healthy or unhealthy?

Is the CEE credit boom worrisome? There is no unambiguous answer to the question of whether the rapid credit growth in these countries is a simple result of catching up, given that the structural changes that have affected these economies make it more complicated to calculate the "normal" level of credit. The key concern, however, is that the process of moving to a new equilibrium-the new normal level-may involve significant risks at...