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

• Pages: 174-175

Page 174

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

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

What do credit booms look like?

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

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

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

- take place simultaneously in...