Financial stability in the EU new Member States, acceding and candidate countries

Rapid credit growth in the EU new Member States, acceding and candidate countries has raised the issue of financial stability in the region. This rapid credit growth has been accompanied by the deterioration in the current account balance and the large-scale distribution of foreign currency loans. In the first part of this study, we analyse the overall stability of the banking sector vis-à-vis the very rapid credit growth. Given the high share of foreign currency loans, we examine the exposure to exchange rate risk. We identify that the main vulnerability for the banking system stems from the open currency position held by fi nal borrowers (households and businesses). These economic agents are generally not hedged against exchange rate risk. In the event of a depreciation in the national currency, the banking system would therefore be exposed to an increase in payment defaults on foreign currency loans. We consider this to be “indirect” credit risk for the banking system. In the second part, we explore the likelihood of a currency crisis. We estimate an econometric model for the link between credit growth and the current account balance showing a significant negative relationship in these countries, i.e. a 1-percentage-point increase in credit flow as a percentage of GDP deteriorates the current account-to-GDP ratio by 0.5 percentage point. Consequently, excessively high credit growth would contribute to deteriorate the current account beyond a sustainable level and would increase the likelihood of a currency crisis. Currently, external vulnerability remains contained in the countries under review, though it has increased in most of them since 2000. Lastly, we implement causality tests to evaluate the nature of credit growth. When the causality detected indicates that credit growth fuels domestic demand, and not the opposite, this could be interpreted as a potential risk for the system insofar as strong credit growth may lead to excessive demand beyond that related to a simple catching-up process. For countries where this test is significant, a causal relationship from credit growth to domestic demand has been detected in Bulgaria, Estonia, Latvia and Poland. The causality detected in Croatia and Romania is heading in the opposite direction.