1. 1 Growth of bank credit in central and eastern Europe: housing markets and the role of foreign-owned banks Dubravko Mihaljek Senior Economist Bank for International Settlements Presentation at the 12 th Dubrovnik Economic Conference Dubrovnik, 29-30 June 2006 The views expressed are those of the author and not necessarily those of the BIS.

2. 2 Outline 1. Common trends in credit growth 2. Housing markets 3. Foreign-owned banks 4. Policy challenges

3. 3 Rapid growth of bank credit to the private sector

4. 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. 5 Macroeconomic setting (1) 5-6% growth on average since 2004 Main contribution from domestic demand (incl. investment)

6. 6 Macroeconomic setting (2) Inflation declining but still relatively high on average; overall, greater price stability

7. 7 Macroeconomic setting (3) Narrowing fiscal deficits (though still large in few countries); less crowding out of the private sector

8. 8 Determinants of credit growth: financial deepening (1) Although increasing, levels of financial intermediation are still low, including in the new member states …

9. 9 Financial deepening (2) … and even more so in south-eastern Europe (except for Croatia)

10. 10 Global and regional factors Rapid convergence of interest rates to euro area levels

11. 11 Competition among banks Narrowing of intermediation margins Representative commercial bank interest rates Lending rate Deposit rate Interbank lending rate End-2000 1 End-2005 1 End-2000 1 End-2005 1 End-2000 1 End-2005 1 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 4.9 2.5 1 Or the latest period available. Sources: IMF; national data; author’s estimates.

12. 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. 13 Development of property markets Key contribution of housing loans to credit growth

14. 14 Is rapid increase in property prices a concern? Growth of housing loans and house prices closely correlated

15. 15 House price increases: is there a bubble?

16. 16 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

17. 17 Impact of foreign-owned banks on credit expansion Not as obvious as it seems

18. 18 Impact of foreign-owned banks on credit allocation Composition of bank lending has improved

19. 19 Impact of foreign-owned banks on bank efficiency (1) Prudential indicators have strengthened

20. 20 Impact of foreign-owned banks on bank efficiency (2) Less interest income, more fee income

21. 21 Impact of foreign-owned banks on bank efficiency (3) Lower operating costs

22. 22 Macroeconomic effects (1) Clear role of cross-border loan flows in credit expansion But household indebtedness generally low

23. 23 Macroeconomic effects (2) Foreign currency lending – risk of currency mismatches

24. 24 Macroeconomic effects – risk of overheating? GDP growth rates not far from potential Investment rates at or below long-term averages

25. 25 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)

26. 26 CA deficits for the most part due to higher investment

27. 27 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)

28. 28 Composition of capital flows is changing (2)

29. 29 Policy challenges Maintaining financial stability Avoiding risk of overheating Preventing property price bubbles Containing current account deficits

30. 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. 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. 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)