Lucas Papademos: Financial structures, credit growth and house prices
in the new EU Member States - policy challenges on the road to the euro
Speech by Mr Lucas Papademos, Vice President of the European Central Bank, at the
Conference held by Latvijas Banka, Riga, 19 September 2005.
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I. Introduction
It is a great pleasure for me to speak at this conference organised by Latvijas Banka, in a
country that has played such an important role as a major trading centre in European history.
Initially, that role partly reflected its geographic location on one of the oldest trading routes in
Europe - the so-called "Route from the Vikings to the Greeks", which was used to trade,
among other things, Latvian amber - a route dating back to the times of the Ancient Greeks
and the Roman Empire. And then later, the city where we have gathered today, Riga,
became one of the most significant members of the Hanseatic League, which controlled
trade on the bustling Baltic Sea in the 14th and 15th centuries. Today, Latvia has a modern
and dynamic economy, again occupying an important position in European trade, having
achieved a remarkable transition towards a successful market economy after gaining
independence in 1991.
Trade and finance have always gone hand in hand. Therefore, it is no surprise that just as
the Latvian economy has undergone an impressive transformation, so too has the Latvian
financial system. Latvia has made substantial progress in the development of its financial
structure and has created the institutional and legal frameworks necessary to support a
market-oriented financial system.1 Today, its financial markets are developing rapidly in new
directions and are providing valuable services to both households and the corporate sector,
underpinning the functioning of a modern high-growth economy.
As I am addressing a distinguished audience with expert knowledge of the Latvian economy,
I consider it appropriate to take a broader and more comprehensive view, and look at the
development of the financial sector not only in Latvia, but in the new EU Member States as a
whole. After an overview of certain salient features characterising the financial structures of
these countries, I will concentrate on two issues that have recently received considerable
attention from both policy-makers and the media: strong credit growth and rapidly rising
house prices. This will bring me to the focal point of my remarks: the challenges arising from
these developments and the appropriate policy responses.
II. Features of the financial structures in the new Member States
Many of you have witnessed at first hand the remarkable transformation of the economies
and financial systems of the new Member States in Central and Eastern Europe over the
past decade. The convergence of the financial structures of these economies with those of
Western Europe has also been significant. The modernisation of a country's financial
structure - that is, of the whole set of financial markets, instruments and institutions - is of
crucial importance for actual and potential economic growth, and has received a lot of
attention from both academics and policy-makers.2 Financial structures differ from country to
country, reflecting the influence of various factors and of different traditions; but those
structures also change over time as the processes of economic development and financial
integration evolve. Looking at the financial structures of the new EU Member States today,
five key characteristics are apparent.
First, the overall degree of financial depth in the Central and Eastern European countries is
still lower than in the euro area. This applies in particular to financial intermediation by banks
and to the household sector. For example, bank financing represents a much smaller share
of GDP than in the euro area.3 It may be argued that if the low degree of financial
intermediation persists, this could impede the efficient channelling of savings to investment,
and that further financial reforms would therefore be needed.
Second, the capital markets in these countries remain relatively underdeveloped. As a result,
the issuance of quoted equity and debt securities by non-financial corporations in order to
finance their investments and operations is not as important as in the euro area. This may
come as a surprise, given that the stock markets in the new EU Member States have
experienced very strong and, indeed, accelerating growth over the past few years. The
average annual returns on equity in most of these countries have outperformed significantly
those of the stock markets in the euro area. On the one hand, the substantial increases in
equity prices in the new Member States may have reflected a rise in the fundamental values
of the shares. On the other hand, this development may also reflect supply constraints: the
limited issuance of new equity by firms and the relatively small number of companies listed.
For example, the share of the five biggest listed companies in total market capitalisation and
turnover is very high in most of the new EU Member States. Thus, since liquidity in these
markets is relatively low, price movements in a small number of companies might influence
to a relatively large extent the overall price level of the stock market.
Overall, financing through banks remains the dominant form of intermediation and a key
feature of the financial structure in the majority of the new Member States. That said, equity
financing has grown steadily over the past few years, even though the amount of corporate
funds raised through capital markets remains rather limited. Furthermore, financial account
data, which have been collected and compiled by the ECB in close collaboration with the
new Member States, indicate that, in terms of amounts outstanding, shares and other equity
are an important source of financing for non-financial corporations, mainly owing to the large
contribution of non-quoted equity. This form of equity financing, for example family capital
invested in small companies, also contributes to the large share of equity financing of euro
area non-financial corporations.4 For the six new Member States for which data on unquoted
equity is available, its share in total equity financing is 80% or more.
Third, in the new EU Member States we observe a significant degree of foreign involvement
in the financial sector in terms of ownership, financing and investment. This is particularly
visible in the banking sector, which is predominantly under foreign ownership in practically all
of those countries. But it also extends beyond that. For example, a substantial share of
government and enterprise financing comes from abroad and many major firms are listed on
stock exchanges outside these countries.
Fourth, most new EU Member States have experienced significant consolidation in the
number of financial institutions, particularly banks. This process has contributed to the
soundness and stability of these countries' banking sectors. Consolidation has also affected
stock markets. For example, the three Baltic stock markets recently merged with the
Scandinavian OMX markets and use a common trading platform.
Finally, it is clear that in several new Member States, further improvements in the legal
frameworks and market infrastructures may be needed in order to establish more transparent
and efficient financial markets. This also applies to the greater transparency of counterparties
in financial transactions, which would undoubtedly promote the further integration of these
countries' financial markets with those in the euro area.
From this overview, it is evident that, despite the significant progress made in previous years,
the convergence process of the financial structures of the new EU Member States with those
of the euro area is not yet complete. I will come back to this issue - and how we see the road
ahead for the new Member States - later. At this stage, allow me to address two issues that
are very topical for both the Latvian economy and several other new Member States: strong
credit growth and rapidly rising house prices.
III. Credit growth
Let me start, on the question of credit markets, by pointing to three characteristic facts. First,
dynamic credit growth to the private sector can be observed in a number of the new EU
Member States, well above the average rate in the euro area. The growth of credit to the
private sector has been especially strong in the Baltic countries and Hungary, where it has
reached annual rates of between 30% and 50% in recent years. In other countries, such as
the Czech Republic and Slovakia, the rate of credit growth to the private sector has been
more moderate, but has picked up recently, while in Poland it has slowed down considerably,
following peaks reached around the turn of the decade. Second, credit-to-GDP ratios in
Central and Eastern European countries still remain well below the euro area level. Third,
credit expansion has, in most of these countries, been financed by both domestic and
external sources. In the early stages of credit expansion, a rise in domestic savings, partly
reflecting increased confidence in banking systems and the overall financial deepening of
these economies, was a particularly important source of banks' financing. Subsequently, as
interest rates have declined and the propensity to consume has increased, banks have
progressively relied more on external sources.
Looking at the sectoral breakdown of credit growth, it is fairly clear that the main driver of
credit dynamics has been loans to households - largely in the form of mortgage lending.
Intense competition in this market segment has encouraged banks to substantially expand
their lending to households. By contrast, bank credit growth to the corporate sector has
lagged behind. This can be partly explained by the fact that an important share of investment
by the non-financial corporate sector has been financed by retained earnings and foreign
capital, including credit from banks in other countries and foreign direct investment.
Another striking - and potentially worrying - feature of credit growth in some of the new
Member States is the high share of foreign currency-denominated loans. These loans are
mostly euro-denominated, although loans in other currencies have also been gaining in
importance recently. They have typically been granted to non-financial corporations, though
also to households in the Baltic countries and Poland. Borrowing in foreign currency has
been driven by lower borrowing costs and stimulated by the financial liberalisation in some
countries prior to EU entry. The majority of foreign currency loans are held by larger
multinational firms, which generate the greater part of their revenues in foreign currency, and
can therefore also be considered as a hedging instrument. In general, borrowing in foreign
currency has been more widespread in countries with fixed exchange rate regimes or
exchange rate targets, particularly the Baltic countries. Nevertheless, the external net liability
position of the banking sectors of most Central and Eastern European countries continues to
be limited, with the exception of Estonia and Latvia, where the external net liability positions
reached levels corresponding to 23% and 17% of GDP respectively at the end of 2004.
IV. House prices
As you are well aware from the Latvian experience, rapid credit growth has gone hand in
hand with strong increases in house prices, especially in certain segments of the housing
market, such as apartments in major cities. That said, the picture is quite diverse across
countries, and it is difficult to discern general patterns. Some countries, including the Baltic
countries, have experienced double-digit increases in house prices, whereas in others, for
example the Czech Republic, house price developments have been more moderate. In
general, however, house prices in many new Member States have risen more strongly in
recent years than the average in the euro area, albeit admittedly from a much lower base.
Moreover, housing construction is picking up throughout the region, reflecting buoyant
housing demand. Of course, property prices have also increased at a fast pace over the past
few years in several euro area countries, as well as in other countries around the world,
notably the United States and the United Kingdom. So this phenomenon is not characteristic
only of the new EU Member States.
When discussing trends in house prices, it is important to keep in mind a number of specific
features of the housing markets of the new Member States. I am thinking in particular of the
generally high - and still rising - degree of owner-occupancy or the fact that institutional
arrangements associated with more developed housing markets, such as the legal
framework, the easy transfer of property, the different types of available insurance, good
valuation methods or alternative forms of mortgage finance, are still in a rather embryonic
stage in some countries. This may explain why the volume of transactions relative to the total
housing stock is still relatively limited in many new Member States. That said, it is a positive
development that in several countries considerable efforts are being made to improve the
institutional arrangements and the financial services on offer.
How can we explain the observed house price developments? Very favourable financing
conditions and perceptions among households that house prices are likely to continue to rise
in the future have contributed significantly to strong housing demand. The supply side of the
housing market, as recently suggested by indicators such as building permits granted and
the number of housing completions, has partly and gradually responded to the strong price
signals. If the supply of new houses continues to increase, this will alleviate some pressure
on the market and contribute to a moderation in house price increases.
V. Policy challenges
From this tour d'horizon of the salient features of financial structures and, in particular, of
credit and housing markets, I see a number of pertinent policy questions arising: How should
we assess the risks to financial stability that may be associated with these developments and
market characteristics? What are the main challenges for policy-makers, that is, for
governments, central banks and supervisory authorities? What are the issues to watch out
for concerning the evolution of financial structures in the years to come? Let me provide
some answers to these questions.
I shall start with the potential implications of rapid credit growth and strong increases in
housing prices for financial stability in the new EU Member States. Strong credit expansion
can be a cause for concern, not least because banking crises have often been preceded by
episodes of excessive credit growth. This statement is supported by theoretical arguments
and extensive empirical research. That said, I should stress that a banking crisis is not the
inevitable consequence of an episode of excessive credit expansion. However, a number of
theoretical explanations have been put forward to elucidate why credit booms are associated
with a higher probability of banking distress, notably the procyclicality of bank lending
behaviour. Risks may be underestimated during the expansionary phase of the credit cycle,
thereby resulting in a lowering of credit standards and of the average "quality" of borrowers.
This may lead to higher credit losses when the next economic downturn occurs. Risks may
also be underestimated as a consequence of the so-called "financial accelerator"
mechanism, whereby over-optimism about future returns may boost asset valuations and
thus firms' net worth, which then feeds back into higher investment and credit demand and a
further increase in asset prices.
So much for the theory: what should be our concern in the specific circumstances of the new
Member States? First, there is a danger that rapid credit expansion may strain banks' ability
to monitor and assess risks properly. This is especially relevant for the new Member States,
where banks' credit risk assessment is burdened by measurement difficulties in forecasting
potential future credit losses, owing to the lack of sufficiently long credit histories. This
problem may be even more pronounced in the case of market segments that were previously
underserviced, such as households and small and medium-sized enterprises. Second, the
relative importance of foreign currency lending for the domestic private sector in some
countries may have increased the vulnerability of households and unhedged
non-financial corporations to adverse exchange rate movements. Third, since mortgage loan
contracts in several new Member States typically have floating interest rates, rising interest
rates would have a negative impact on households' debt-servicing ability in those countries.
Furthermore, since mortgage lending has been the major growth area in most new Member
States, the evolution of house prices - as mentioned before - is, of course, a relevant factor
which requires careful monitoring. The upward trend in real estate prices can be expected to
continue over the medium and longer term, partly as a result of the gradual convergence with
price levels in the "old" EU Member States. However, it would be comforting to think that
such a "natural" development would not result in excessive and unsustainable house price
increases. In this respect, it would be useful to monitor the extent to which strong mortgage
lending and house price increases may lead to mortgage equity withdrawals, which in turn
may stimulate consumption even more and thus fuel further GDP and credit growth.
When assessing the balance of risks to financial stability, a number of mitigating factors
should also be taken into account. To begin with, credit risk should be contained, because
the ratio of the debt-servicing burden of firms and households relative to income is still
considerably lower than in the euro area. Moreover, a favourable growth outlook and
improving prospects for household disposable income which are associated with the
catching-up process, and the current low interest rate environment, are likely to make it
easier for private sector borrowers to service their debts. In addition, the improved
profitability of banks in most new Member States has helped them to maintain a solid capital
base, which should also improve their shock-absorbing capacity. Finally, the ratio of
non-performing loans to total loans has, in most countries, decreased or remained at a low
level over the past few years. Let me stress, however, that banks' asset-quality indicators are
typically backward-looking. Since risks may build up during the boom phase, a deterioration
in credit quality may become visible only with a significant time lag if general economic
conditions worsen. As most new Member States have been enjoying relatively high rates of
economic growth in recent years, the resilience of loan portfolios to negative output shocks
remains untested until now.
Notwithstanding the overall positive near-term outlook for financial stability in the new
Member States, potential risks implied by rapid credit growth call for continued vigilance by
national authorities. Reflecting these concerns, central banks and supervisory authorities
have taken several measures in response to rapid credit growth. The most commonly applied
measures can be classified under the category of "moral suasion". These include enhanced
central bank communication concerning the risks related to fast credit expansion, through
Financial Stability Reports or by other means, and recommendations made by prudential
supervisors aiming to increase banks' risk awareness. In some countries, the tightening of
monetary policy, for example in Latvia, and fiscal measures aiming to reduce the incentives
for borrowing, such as those introduced in Estonia, have also been used to moderate credit
growth. Nonetheless, these measures have not yet proved sufficient to moderate the pace of
credit growth in the Baltic countries, which has remained very high through the middle of
2005. Financial regulation and prudential supervision should therefore ensure that sound
asset quality is maintained. Furthermore, fiscal policy can also contribute to macroeconomic
stability and thus help to moderate volatility in financial markets.
Finally, let me address one issue that is somewhat "closer to home". Since robust bank credit
growth may continue in the period leading up to the accession of some new Member States
to the euro area and even in the years following the adoption of the euro, it is pertinent to
consider whether this could have a bearing on the euro area as a whole in the future. Given
the strong ownership and other links between euro area banks and banks in the new
Member States, it could be argued that there might be a risk transmission channel within the
EU. However, bearing in mind that banking sectors in new Member States represent a
relatively small fraction of the total assets of euro area banking groups, such a potential
contagion risk seems rather limited.
VI. The outlook for financial structures and the risks to financial stability
What is the outlook for financial structures and what are the potential risks to financial
stability in the coming years? Broadly speaking, the expected catching-up of the economies
of the new Member States in financial and real terms is likely to have two main implications
for their financial structures. First, it is expected to lead to a deepening of financial
intermediation and a further development of capital markets to levels comparable to those of
the euro area. Second, it is likely to promote an increased role for non-bank financial
intermediaries, such as pension funds and life insurance companies, whose presence is very
limited when compared with the euro area countries. As a result, financial sector balance
sheets are expected to expand substantially in most of the new Member States over the next
decade. Similarly, bond and stock markets are likely to develop significantly, along with life
insurance companies and pension funds. Against this background, a key policy challenge in
the new Member States is to safeguard the soundness of the banking system and the robust
and stable development of financial markets.
In fact, there are several potential stresses that could arise as financial systems expand,
especially in an environment of capital mobility and financial market integration. Experience
in a number of emerging market economies has shown that financial market exuberance can
drive risk premia on external debt and domestic financial instruments to levels lower than are
warranted by fundamentals. Under such circumstances, strong capital inflows, rapid credit
growth and buoyant asset prices may lead to episodes of sizeable real exchange rate
appreciation - with potentially serious repercussions for the real economy if expectations are
at some point not fulfilled. It is important to guard against such potential risks. After all - to
paraphrase slightly what Larry Summers once said - "the new finance is like a highway. It
gets you to where you are going better and faster, but the accidents may be worse."
VII. Concluding remarks
Let me conclude. Our review of the financial structures in the new Member States has
showed that substantial progress towards convergence with the euro area has been
achieved, but also that there is still a need to improve the financial infrastructure and to
strengthen the legal framework. I highlighted two major issues which are currently attracting
our attention in a number of Member States: robust credit growth and rapidly rising house
prices. While these developments could pose, in certain circumstances, significant risks to
financial stability, we see such risks as being rather modest at this juncture, bearing in mind
that the situation varies considerably from country to country. Nevertheless, it is important
that authorities and market participants be vigilant and take measures that can help to
reduce the likelihood of risks materialising and increase the resilience of the financial system.
To this end, the implementation of sound macroeconomic policies is key - particularly the
implementation of prudent fiscal policies that can contribute to moderating unsustainable
aggregate demand increases and contain large current account deficits. Fiscal measures
should also aim to eliminate tax distortions that can fuel property price dynamics. Moreover,
the further strengthening of supervisory mechanisms and practices and the enhancement of
the risk management methods employed by banks will help both to limit some potential risks
and to improve the shock-absorbing capacity of the financial system. What should be clear,
however, is that supervisory authorities cannot take financial stability for granted. The British
statesman and political theorist Edmund Burke once remarked that you can never plan the
future by the past. This is an observation that should not be forgotten, particularly in the fields
of financial stability and prudential supervision, and especially given the fact that the modern
financial history of the new Member States is still rather short.
Thank you very much for your attention.