1

Growth of bank credit in central and eastern Europe:

housing markets and the role of foreign-owned banks

Dubravko MihaljekSenior EconomistBank for International Settlements

Presentation at the 12th Dubrovnik Economic Conference

Dubrovnik, 29-30 June 2006

The views expressed are those of the author and not necessarily those of the BIS.

2

Outline

1. Common trends in credit growth

2. Housing markets

3. Foreign-owned banks

4. Policy challenges

3

Rapid growth of bank credit to the private sector

Bank credit to the private sector, 2002-05

3835

38

34

17 1720

1315 14

36 6

4

40

33

38

0

100

200

300

400

500

600

700

SCG ROM LAT BUL ALB LIT EST TUR HUN BIH SVN HRV MAK SKA CZE POL EUR

-10

0

10

20

30

40

50

Nominal growth (cumulative, in percent) (lhs) Real growth (% per year, compound rate) (rhs)

Note: ALB=Albania, BIH=Bosnia-Herzegovina, BUL=Bulgaria, CZE=Czech Republic; EST=Estonia, EUR=Euro area; HRV=Croatia, HUN=Hungary, LAT=Latvia, LIT=Lithuania, MAK=Macedonia, POL=Poland, ROM=Romania, SCG=Serbia-Montenegro, SVK=Slovakia, SVN=Slovenia, TUR=Turkey.Sources: IMF, International Financial Statistics; national data; author's estimates.

4

Determinants of rapid credit growth in CEE

GDP and income growth, greater macro stability Financial deepening Global and regional factors (EU accession,

institutional reforms) Competition among banks Property markets in CEE/SEE started to develop

5

Macroeconomic setting (1)

5-6% growth on average since 2004 Main contribution from domestic demand (incl. investment)

Table 1 Real GDP growth in central and eastern Europe1

2003 2004 2005 2006

Average 4.7 6.2 5.7 5.6 New EU members 5.2 5.9 6.3 6.1 Non-EU countries 4.2 6.5 5.1 5.0 Memo: Euro area 0.7 2.0 1.3 2.1 1 Annual percentage changes.

Sources: European Commission, Economic Forecasts, Spring 2006; IMF, World Economic Outlook, April 2006.

6

Macroeconomic setting (2)

Inflation declining but still relatively high on average; overall, greater price stability

Table 2 Consumer price inflation in central and eastern Europe1

2003 2004 2005 2006

Average 5.0 4.9 4.7 3.8 New EU members 2.9 4.3 3.3 3.2 Non-EU countries 7.2 5.5 6.0 4.5 Memo: Euro area 2.1 2.1 2.2 2.2 1 Annual percentage changes.

Sources: European Commission, Economic Forecasts, Spring 2006; national data.

7

Macroeconomic setting (3)

Narrowing fiscal deficits (though still large in few countries); less crowding out of the private sector

Table 3 Fiscal balances in central and eastern Europe1

2003 2004 2005 2006

Average –3.3 –2.1 –1.5 –1.5 New EU members –3.0 –2.3 –1.8 –2.5 Non-EU countries –3.7 –1.9 –1.3 –0.5 Memo: Euro area –3.0 –2.8 –2.4 –2.4 1 Percent of GDP. Sources: European Commission, Economic Forecasts, Spring 2006; national data.

8

Determinants of credit growth: financial deepening (1)

Although increasing, levels of financial intermediation are still low, including in the new member states …

Bank credit as a percent of GDP

Sources: IMF; national data; author's estimates.

6

2510 11 11 12 10 4 5

7250

26

4734

46

14

45

24

42

55 31

26 28

1326

21119

0

20

40

60

80

100

1999 2004 1999 2004 1999 2004 1999 2004 1999 2004 1999 2004 1999 2004 1999 2004

CZ HU SI LV EE SK PL LT

Claims on central government Credit to the private sector

9

Financial deepening (2)

… and even more so in south-eastern Europe (except for Croatia)

Bank credit as a percent of GDP Bank credit as a percent of GDP

Sources: IMF; national data; author's estimates.

11 10 5 6

30 26

4 5

31 28

3757

46 45

12

37

2124

2120

2719 8 10

4 10

0

20

40

60

80

19

99

20

04

19

99

20

04

19

99

20

04

19

99

20

04

19

99

20

04

19

99

20

04

19

99

20

04

19

99

20

04

HR BH BG MK TR SCG RO AL

Claims on central government Credit to the private sector

10

Global and regional factors Rapid convergence of interest rates to euro area levels

11

Competition among banksNarrowing of intermediation margins

Representative commercial bank interest rates

Lending rate Deposit rate Interbank lending rate

End-20001 End-20051 End-20001 End-20051 End-20001 End-20051

Czech Republic 6.9 5.6 3.2 1.1 5.4 2.2

Hungary 12.7 8.0 9.5 5.5 12.3 6.5

Poland 20.9 6.2 15.0 2.5 19.4 4.6

Slovakia 13.4 6.7 6.9 2.3 8.1 3.1

Slovenia 15.8 7.7 10.1 3.1 12.2 4.0

Estonia 7.1 4.8 4.2 2.1 6.1 2.6

Latvia 13.2 5.5 4.4 2.5 8.7 2.5

Lithuania 11.3 5.8 3.4 1.5 5.4 3.1

Bulgaria 11.6 7.1 3.1 3.0 2.7 2.1

Croatia 10.8 11.1 3.5 1.7 4.5 4.4

Romania 53.2 15.7 32.4 4.2 49.1 5.2

Turkey … … 68.2 20.5 65.0 13.9

Average 16.1 7.7 13.7 4.2 16.6 4.5

Memo: Austria 4.4 3.6 2.2 2.2 4.9 2.5 1

Or the latest period available.

Sources: IMF; national data ; author’s estimates.

12

Housing markets in CEE

Housing supply limited in many regions Housing demand rising

• Domestic factors (income growth, housing finance, demographics)

• External demand for second homes in SEE (EU demographics, low interest rates)

• Investment demand (commercial property)

Risks of strong growth in property prices exist; policies to focus on the supply side

13

Development of property markets Key contribution of housing loans to credit growth

Table 2 Housing loans and private sector credit growth, 2003–05

Growth of private sector credit1 Contribution to growth of private sector credit2

Household Household

Countries

Corporate Total Housing

Con-sumer

Corporate Total Housing

Con-sumer

Bulgaria 28.7 63.3 114.8 51.5 50.5 49.5 17.3 32.1

Croatia 8.4 16.7 23.3 13.7 22.4 62.7 24.9 37.9

Czech Republic 11.1 32.3 39.6 23.3 10.7 89.3 69.9 19.4

Estonia 40.7 56.8 64.2 34.2 45.4 54.6 47.5 7.0

Hungary 12.3 28.5 26.1 44.2 40.8 59.2 43.9 15.8

Latvia 16.4 53.2 60.0 42.4 43.0 57.0 35.5 6.4

Lithuania 27.6 67.1 68.9 3.3 59.0 41.0 40.7 0.3

Romania 30.8 64.8 67.8 42.9 50.7 49.3 46.1 3.2 Serbia

25.2 61.4 … … 48.4 51.6 … …

Slovakia 3.7 35.4 34.9 15.6 27.0 73.0 51.7 15.2

Slovenia 40.0 105.0 … … 78.0 22.0 … …

Average 22.3 53.1 55.5 30.1 43.3 55.4 41.9 15.3

1 Annual growth rate of private sector credit (excluding credit to financial intermediaries), 2003–05; in percent. Data for 2005 are for the latest month available. 2 Percentage contribution to the annual growth rate of private sector credit; average for 2003–05 (for Slovakia, 2004–05). Based on monthly data.

Sources: Central banks; author’s estimates.

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Is rapid increase in property prices a concern?Growth of housing loans and house prices closely correlated

House prices and housing loans, 1997-051

(annual percentage changes)

y = 0.14x + 3.5

R2 = 0.20

-20

-10

0

10

20

30

40

50

-20 30 80 130 180

Housing loans

Ho

us

e p

ric

es

1 Annual percentage changes; data for Croatia, the Czech Republic, Estonia, Hungary, Lithuania and Poland.Sources: National data; author's estimates.

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House price increases: is there a bubble?

House prices1

2001 2002 2003 2004 2005

Czech Republic 14.7 22.0 19.4 –2.5 …

Hungary … 4.8 10.9 9.2 0.9

Poland –1.6 –9.5 12.3 … …

Croatia –4.4 0.7 2.4 13.2 22.5

Estonia 34.0 30.7 14.0 28.0 21.3

Lithuania 24.0 10.1 18.3 10.1 45.3 1 Annual percentage changes. Data refer mainly to house prices in urban centres.

Sources: Central banks; real estate firms; author’s estimates.

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Role of foreign-owned banks in credit expansion

Impact on credit expansion – not as obvious as it seems Impact on credit allocation and bank efficiency – on the

whole positive Macroeconomic effects – some undesirable

consequences

• Credit expansion funded by external borrowing

• Foreign currency lending

• Risk of overheating

• Rising household indebtedness and widening external imbalances

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Impact of foreign-owned banks on credit expansion

Not as obvious as it seems

Foreign-owned banks and credit growth in CEE, 1997, 2000 and 2004

y = 0.075x + 25.02R2 = 0.023

0

10

20

30

40

50

60

70

0 10 20 30 40 50 60 70 80 90 100

Market share of foreign-owned banks (% of total banking sector assets)

Pri

vate

se

cto

r cr

ed

it a

s %

of G

DP

Sources: Bank Austria - Creditanstalt; author's estimates.

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Impact of foreign-owned banks on credit allocation

Composition of bank lending has improved

Composition of commercial bank lending1

Government2 Corporate Household

1999 2003 2004 1999 2003 2004 1999 2003 2004

Bulgaria 21 8 –3 65 67 70 14 25 33 Croatia 21 8 8 65 68 42 14 25 50

Czech Rep. 6 31 25 83 45 45 12 25 30

Estonia 3 6 4 71 52 50 26 43 45

Hungary 43 13 9 49 57 57 8 30 32

Latvia 11 10 9 76 63 59 13 28 32

Lithuania 29 20 4 62 63 70 8 17 26

Poland 5 6 7 62 53 46 33 31 46

Romania 35 9 5 62 68 68 3 23 27

Slovakia 29 49 49 64 37 34 7 14 17

Slovenia 22 22 22 52 57 55 26 21 23

Turkey 3 4 4 86 76 71 11 20 25

Average 19 16 12 66 59 56 15 25 32

Euro area … 11 11 … 41 41 ... 48 49 1 In percent of total credit, excluding interbank credit and credit to non-bank financial institutions. End of period or for 2004, latest available period. 2 Net claims on government for most countries.

Sources: Central banks; IMF; author’s estimates.

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Impact of foreign-owned banks on bank efficiency (1)

Prudential indicators have strengthened

Prudential indicators (in percent)

Non-performing

loans2

Capital adequacy3

Loan-loss provisions4

Return on equity

Return on assets

Countries

1999 2004 1999 2004 2000 2004 1999 2004 1999 2004

Average 16.5 6.8 20.3 16.9 58.5 63.6 –0.7 14.7 –0.1 1.4

High share of foreign banks7

14.9 3.8 22.2 14.2 59.9 56.8 8.6 17.8 1.1 1.5

Lower share of foreign banks8

17.9 9.5 18.7 19.4 56.8 69.4 13.7 14.5 1.4 1.6

Memo: Austria 1.7 1.5 13.9 14.7 … … 6.9 9.3 0.3 1.5 2 As percent of total loans. 3 Risk-weighted capital-asset ratios. 4 Ratio of bank provisions for loan losses to non-performing loans. 7 Average for the countries with a share of foreign bank ownership higher than or equal to 70% of total banking sector assets. 8 Average for the countries with a share of foreign bank ownership lower than 70% of total banking sector assets.

Sources: Central banks; IMF; author’s estimates.

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Impact of foreign-owned banks on bank efficiency (2)

Less interest income, more fee income

21

Impact of foreign-owned banks on bank efficiency (3)

Lower operating costs

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Macroeconomic effects (1)Clear role of cross-border loan flows in credit expansionBut household indebtedness generally low

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Macroeconomic effects (2)Foreign currency lending – risk of currency mismatches

Foreign currency deposits and loans, 2005Shere in total private sector deposits/loans, in percent

48

82

49

65

48

31

5248

77

52

72

15

72

28

0

10

20

30

40

50

60

70

80

90

BG HR RO SCG BH AL MK

FX deposits

FX loans

Source: Central banks.

24

Macroeconomic effects – risk of overheating?GDP growth rates not far from potentialInvestment rates at or below long-term averages

Actual and potential growth rates in CEE

New member states

Potential growth

rate

Actual growth

rate 2001-05

EU candidates and aspirants

Potential growth

rate

Actual growth

rate 2001-05

Czech Republic 3.6 3.6 Bulgaria 4.9 4.9

Hungary 3.4 4.0 Croatia 4.9 4.4

Poland 3.9 3.0 Romania 5.3 5.7

Slovakia 5.0 4.9 Turkey 6.7 4.5

Slovenia 3.5 3.4

Albania 6.2 5.4

Estonia 7.2 7.6 Bosnia-Herzegovina 5.4 5.0

Latvia 8.1 8.1 Macedonia 3.4 1.4

Lithuania 6.5 7.6 Serbia-Montenegro 4.7 5.1

Sources: European Commission (2006); IMF, WEO, April 2006; author’s estimates.

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Is the widening of external deficits a concern?

CA deficits in CEE due to factors characteristic for the stage of development (income level, high capital building)

During 2000-03, the increase in deficits could be entirely explained by higher investment

But during 2004-05, ¼ of the increase in CA deficits was due to higher consumption (especially SK and RO)

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CA deficits for the most part due to higher investment

Table 5 Changes in external balances, investment and saving, 2004–051

Current account balance

Gross fixed capital

formation

Domestic saving

Budget balance

Average –0.6 1.4 0.8 1.8

Countries with wider CA deficit2

–3.1 2.4 –0.7 2.1

Countries with narrower CA deficit3

1.3 0.6 1.9 1.5

1 Cumulative changes during 2004 and 2005, in percentage points of GDP. 2 Bulgaria, Latvia, Lithuania, Romania, Slovakia, Slovenia, Turkey. 3 Albania, Bosnia and Herzegovina, Croatia, Czech Republic, Estonia, Hungary, Macedonia, Poland, Serbia and Montenegro.

Sources: European Commission, Economic Forecasts, Spring 2006; IMF, WEO, April 2006; author’s estimates.

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Other mitigating factors

Evidence of quick reversal of CA deficits without major growth slowdown (AL, BG, HR 2003-04; MK; SK 2002-03)

Consumer credit booms tend to be self-correcting (build-up of the stock of consumer durables tends to level off)

Purchasing power gains associated with RER appreciation were only used for additional consumption once the gains actually occurred, not in anticipation thereof (Deutsche Bundesbank DP 32/2005)

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Composition of capital flows is changing (2)

Composition of net capital flows (In percent of total net flows, average of country groups)

34

61

41

2 6

-14

12

4855 51

-14

18

4337

22

5 5 1121

43

2031

14

48

-40

-20

0

20

40

60

80

2003 2004 2005 2003 2004 2005 2003 2004 2005 2003 2004 2005

FDI Equity flows Bond issuance Cross-border bankloans

New member states

South-eastern Europe

Sources: IMF; author's estimates.

29

Policy challenges

Maintaining financial stability Avoiding risk of overheating Preventing property price bubbles Containing current account deficits

30

Factors complicating policy responses in CEE

Very small, very open economies Rapidly catching up with the EU (Balassa-Samuelson effect,

RER appreciation) Banking systems mostly foreign-owned

Strong capital inflows, easy global financing conditions

31

Policy responses so far

Raise interest rates – Romania, Slovakia Tighten prudential regulations – Baltics, Croatia Strengthen banking supervision – Baltics, Hungary, Slovakia,

Slovenia Moral suasion – Baltics, Croatia, Hungary Administrative measures (credit ceilings) – Bulgaria

32

Policy responses under consideration

Raise interest rates – there are limits to domestic interest rate policy with low global interest rates, fixed ERs, free capital flows, but global rates are now rising

Retain some capital controls (non-EU countries only) Allow capital outflows Clarify existing policies:

• focus on disinflation

• allow nominal ER to appreciate (managed and floating regimes)

Tighten fiscal policy (already tight in many countries)