Marco E. Terrones
In several emerging market economies, credit has expanded rapidly in recent years. Although rapid credit expansions are often associated with financial deepening, favorable external financing conditions, or cyclical upturns, they frequently raise concerns because of the role of excessive credit expansions in some financial crises. What do credit booms look like? What are the macroeconomic effects of a credit boom? How is firms’ behavior affected by a credit boom? How should policymakers respond to a credit boom? This article surveys recent IMF research on these topics.
Credit booms are generally defined as periods of unusually sharp, above-trend expansions in real credit. More specifically, a credit expansion is identified as a boom if it exceeds some multiple of the standard deviation of a given country’s credit fluctuations around trend (Terrones, 2004; and Mendoza and Terrones, 2007). Alternatively, credit booms can be defined as episodes where the credit-to-GDP ratio deviates from its rolling trend, which uses information until the boom is identified, by a given factor (Gourinchas, Valdés, and Landerretche, 2001). The former definition seems to be superior to the latter because it allows real credit and real GDP to have different trends and cyclical properties, which is important if countries are undergoing a process of financial deepening. In addition, the use of a rolling trend, instead of a long-term trend, could affect the characterization of the boom by distorting its timing and duration.
Credit booms can be the result of various factors, such as explicit or implicit government guarantees, herding behavior by banks, information asymmetries, and agency problems. (Dell’Ariccia and Marquez (2006) show that as information asymmetries across banks decrease, banks loosen their lending standards and increase aggregate credit.) They can also be associated with hasty financial liberalization and large capital inflows, particularly in countries with weak prudential regulation and supervision. One important mechanism that could lead to a credit boom is the financial accelerator, by which shocks to asset prices are amplified through balance-sheet effects. For example, excessive optimism about future earnings could boost asset valuations and incomes, which would enhance the net worth of the households and firms that hold the assets and, in turn, increase their capacities to borrow and spend. Thus, the expansion phase of the credit boom is characterized by the leveraging of households and firms. (This is a key feature of the transmission mechanism emphasized in the literature on emerging market crises—see, for instance, Arellano and Mendoza, 2003.) This process may be unsustainable, however, and when the overly optimistic expectations are revised downward, asset prices and incomes fall, pushing the financial accelerator into reverse. These large and rapid changes in credit, which occur as the quality of funded projects declines and misperceptions about risk increase (Borio, Furfine, and Lowe, 2001), could often lead to crisis, particularly in countries with weak legal and financial institutions.
What do credit booms look like? Many countries around the world have experienced credit booms during the postwar period. These booms have the following characteristics (Mendoza and Terrones, 2007). First, they are synchronized and occur in bunches. (They are centered around “big events,” including the debt crisis, the exchange rate mechanism (ERM) crisis, and sudden stops.) This suggests that common influences in capital flows and financial liberalization played important roles. Second, the amplitude of credit booms is larger and more asymmetric (with downturns sharper than upswings) in developing countries than in industrial countries. Not surprisingly, credit booms in developing countries are associated with a higher incidence of crises (banking crises, currency crises, or sudden stops). Indeed, there is evidence that some credit booms have a significant effect on the likelihood of banking crises, especially when accompanied by current account deficits (Barajas, Dell’Ariccia, and Levchenko, 2007), and the probability of default (Segoviano, Goodhart, and Hofmann, 2006). (Kroszner, Laeven, and Klingebiel (2007) study the growth effects of banking crises. They find that during banking crises, sectors highly dependent on external finance experience greater contraction of value added in countries with deeper financial systems than in those with shallower ones.)
Credit booms generally coincide with large macroeconomic fluctuations, particularly in developing countries (Mendoza and Terrones, 2007). Real output, consumption, and investment rise above trend as credit expands, and fall—indeed, some countries have experienced outright recessions—as credit collapses. The output of nontradables and the real exchange rate both rise during the upswing of the boom and fall sharply during the downturn, and these effects are particularly important in developing countries. Finally, credit booms often end with current account reversals and collapses in the stock markets. Property price booms and busts have often been closely linked to credit booms—this link was particularly strong during the Asian crisis (Collyns and Senhadji, 2002).
Firm-level data show striking patterns consistent with those observed during macro credit booms (Mendoza and Terrones, 2007). In particular, firm leverage (i.e., the ratio of total debt to market value, or of total debt to book value) increases significantly during the buildup phase of the credit boom and is followed by rapid deleveraging during its ending phase. In contrast, firm profitability (measured by the gross return on assets) and external financing (as measured by the Rajan-Zingales coefficient) peak earlier than the credit boom and collapse when the boom reaches its peak. Since the non-tradable sector is more dependent than the tradable sector on external financing, it is not surprising to observe larger swings in the former in leverage and the Rajan-Zingales coefficient. The consistency between firm-level data and macro credit booms—in contrast to studies where these associations have not been established—is evidence supporting the definition of credit booms based on real credit.
Dealing with credit booms is a challenging task for economic policymakers because of the difficulties involved in distinguishing episodes of rapid credit growth from full-blown credit booms. The recent episode of rapid credit growth in the transition economies of Central and Eastern Europe highlights the difficulties in identifying credit booms in countries with short histories as market economies and low initial levels of financial deepening.
For instance, Cottarelli, Dell’Ariccia, and Vladkova-Hollar (2003) conclude that although the rapid credit expansion in some of these countries seems consistent with a process of financial deepening, credit booms could not be ruled out there. Similarly, Hilbers and others (2005) find that although the rapid credit expansion in these countries is consistent with a catching-up process, the macroeconomic implications of rapid credit growth (particularly, increasing inflation and continued deterioration of the current account) entail important risks. Additionally, Duenwald, Gueorguiev, and Schaechter (2005) find that recent credit expansion in Bulgaria, Romania, and Ukraine has been excessive.
What should policymakers do if the preponderance of the evidence suggests that there is a significant risk of a credit boom developing? They should conduct a detailed assessment of the characteristics of the credit boom, including its sources, sectoral composition, and the extent of currency mismatches (see Hilbers and others, 2005). They should also evaluate the soundness of the financial sector and the quality of financial regulation and supervision. Based on these analyses, policymakers could consider implementing various policy measures if credit is deemed excessive. First, macro-economic policies could be tightened, even when inflation is quiescent (Terrones, 2004). In particular, policymakers could try to restrain credit growth by tightening monetary policy. Second, prudential and supervisory policies should be upgraded whenever possible. These measures, however, should be justified only by prudential considerations (Hilbers and others, 2005). Third, scrutiny of corporate and household borrowing and the monitoring of risks could be intensified. In particular, the monitoring of lending in foreign currency to unhedged borrowers should be a priority. Fourth, if the source of the credit boom is external financing, adoption of temporary administrative measures should be carefully considered. Fifth, and finally, all explicit and implicit government guarantees and fiscal distortions that result in overborrowing or overlending should be eliminated.
More generally, to reduce the potential risk of future credit booms, policymakers should strive to improve institutional frameworks, including their countries’ legal systems. In particular, measures to develop financial markets and improve corporate governance and transparency are needed. (Bruno and Claessens (2007) examine how corporate governance and countries’ regulatory regimes affect company valuation. They find evidence that corporate governance increases valuation, particularly for companies that rely more heavily on external financing.) Also, financial systems should increasingly rely on arm’s-length transactions while minimizing the risk of financial instability. The recent experience of the advanced economies suggests that this is likely to happen as a result of deregulation, technological advances, and financial globalization (see Lall, Cardarelli, and Tytell, 2006). These efforts will not only serve to reduce the likelihood of a credit boom but also help to foster economic growth.
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BorioClaudioCraigFurfine and PhilipLowe2001“Procyclicality of the Financial System and Financial Stability: Issues and Policy Options,”BIS Paper No. 1 (Basel: Bank for International Settlements).
BrunoValentina and StijnClaessens2007“Corporate Governance and Regulation: Can There Be Too Much of a Good Thing?” CEPR Discussion Paper No. 6108 (London: Center for Economic Policy Research).
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KrosznerRandall S.LucLaeven and DanielaKlingebiel2007“Banking Crises, Financial Dependence, and Growth,”Journal of Financial EconomicsVol. 84 (April) pp. 187–228.
LallSubirRobertoCardarelli and IrinaTytell2006“How Do Financial Systems Affect Economic Cycles?” World Economic Outlook September (Washington: International Monetary Fund)Chapter IV pp. 105–38.
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TerronesMarco E.2004“Are Credit Booms in Emerging Markets a Concern?”World Economic OutlookApril (Washington: International Monetary Fund) Chapter IV pp. 147–66.