Following a period of privatization and restructuring, commercial banks in Central and Eastern Europe and, more recently, in the Balkans have expanded rapidly their lending to the private sector. This paper studies whether these developments are consistent with a process of convergence and structural financial deepening by estimating an “equilibrium” level of the bank-credit-to-GDP ratio. It concluded that while there is no clear evidence that the recent increases in bank credit ratios is inconsistent with financial deepening, policy-makers will have to evaluate carefully its implications for macroeconomic developments and financial stability.
Since the second half of the 1990s, several countries in Central–Eastern Europe and the Balkans (CEB countries) have experienced sizable increases in domestic bank credit. For example, the cumulative growth of bank credit to the private sector (BCPS) in real terms in Bulgaria, Estonia, and Latvia was, respectively, 315%, 121%, and 304% during 1998–2002. While these rates are inflated by the initially low levels of credit stocks, the BCPS-to-GDP ratio (BCPS ratio) also increased fast (by 11%, 22%, and 17% points for the same three countries and period). More recently, BCPS has accelerated also in some Balkan countries where the transition process is less advanced. In 2002 BCPS in real terms rose by over 50% in Bosnia and Herzegovina (BH), and by 23% in Serbia and Montenegro (SM).1
These developments have raised the question of whether the fast pace of credit growth reflects a structural financial deepening that will benefit the real economy, or if instead, it represents a bubble-like credit boom detrimental to loan quality and banking system stability.2 Indeed, although in this region credit growth has not yet reached the pre-crisis excesses of some Asian countries, and in any case has not yet led to major macroeconomic imbalances, several observers have expressed concern for the effect that it may have for macroeconomic developments and financial stability.3
This question is important from a policy perspective and is essentially an empirical one. This paper tries to tackle it by estimating a model of the BCPS ratio based on a panel of non-transition developing and industrialized countries, and using its coefficients to evaluate the “equilibrium” level of the BCPS ratio for CEB countries. The idea is to compare the actual level of the BCPS ratio in the latter with what would be a “normal” level as assessed based on the experience of countries with similar fundamentals. In addition, the paper presents a few stylized facts to compare the growth rates of credit in CEB countries with those experienced by countries that eventually suffered from financial crises. In that context, the paper also examines the evolution of credit growth in each country by comparing the current rate with its structural component estimated by a non-linear trend.
The paper finds that, although rapid for industrial country standards, the growth of credit in CEB countries has been, up to 2002, below those of countries that ended up encountering a financial crisis. Furthermore, the evidence from our cross-country econometric exercise supports the idea that the recent credit growth in CEB countries is consistent with a convergence toward equilibrium. Indeed, the actual BCPS ratio in 2002 is above or around equilibrium for only BH, SM, and Croatia. In all other CEB countries, it is below its estimated equilibrium level.
However, this does not mean that policy makers should take a benign-neglect attitude towards the acceleration of credit growth. First, at a purely statistical level, our results are characterized by a wide margin of uncertainty, partly related to the “short history” of credit developments in CEB countries, partly to the fairly large standard errors of BCPS ratio models. Second, the macroeconomic and financial environment of CEB countries is such that continued credit growth, possibly at even faster rates, is likely in the years ahead (Cottarelli et al., 2003).
The paper proceeds as follows: Section 2 describes the evolution of bank credit in CEB countries and compares it with the experience of countries in which credit booms resulted in financial distress. Section 3 estimates a structural model of the BCPS ratio and an equilibrium level for the BCPS ratio in CEB countries. Section 4 concludes.
This paper finds no clear evidence that the increases in the BCPS ratio observed in many CEB countries up to 2002 are inconsistent with a “normal” financial deepening as these countries gradually converge towards financial structures similar to those of more mature market economies. For most of these countries the BCPS ratio was in 2002 still below the level that can be justified by their fundamentals. Moreover, the speed at which they are converging to their equilibrium does not seem abnormal, based on standard statistical tests aimed at identifying financial bubbles.
However, the absence of evidence of abnormal developments should not justify any form of benign neglect on the side of policy-makers. While we are relatively confident in stating that, in most countries, further increases in BCPS ratios could be explained by fundamentals (the differences between actual and equilibrium levels of the ratios are still large), the power of our statistical tests regarding the speed of convergence is inevitably low. These tests identify as abnormal sudden changes in the dynamics of BCPS ratios with respect to the recent past. They thus essentially focus on the acceleration of BCPS ratios, rather than on their speed. And while for many of the CEB countries the speed itself (the increase of the BCPS ratio per year) remains well below the speed observed in countries that were later hit by a financial crises (a few percentage points of GDP per year vs increases of the order of 5–10% points per year), in some CEB countries, or for some components of bank credit, much faster increases have been registered. Finally, while the analysis in this paper stops in 2002, fast credit growth has continued in many CEB countries also in 2003 and is, indeed, likely to continue in the years ahead. Thus, a close monitoring of developments in bank credit and a close assessment of their implications for macroeconomic and financial stability remains critical.
