**Credit Growth and Financial Stability in the Czech Republic**<sup>**1**</sup>

# **1. Introduction**

During the first half of the 1990s, in the initial phase of the Czech Republic’s economic transition, the country’s banking sector operated with a relatively high credit–to–gross domestic product (GDP) ratio and with loan portfolios concentrated almost exclusively on the corporate sector. The deep banking crisis from 1997 to 1999 changed the banking sector dramatically, however. The sector went through noticeable downsizing and deleveraging as a significant amount of credit was written off the banks’ books. By the end of 2001 the banking sector had been restructured, and credit growth followed. Even though the credit-to-GDP ratio has remained reasonably low since then, a case can be made that the Czech economy experienced a credit boom nearly similar to those in other converging economies. The features and quality of the boom, however, were quite different. Among the differences were the facts that the growing portfolio of loans was financed from local deposits and that lending to the household sector was done in domestic currency only. Czech authorities did not resort to any supervisory or administrative measures to tame the credit boom, but its consequences were rather contained, and the banking sector was able to provide credit throughout crisis period without major disturbances. The basic explanation of this apparent puzzle is that the different qualities of the credit boom in the Czech Republic relative to other converging economies have been associated with tough macroeconomic policies and the environment that resulted from them. This paper attempts to explain how this scenario worked and what lessons could be taken from it for the future.

The paper is organized as follows. Section two describes the development of the Czech banking sector from the beginning of transition to the current post-crisis period. Section three reviews how the Czech National Bank (CNB), which has both monetary and supervisory authority, responded to credit growth in the pre-crisis years. Section four clarifies how CNB’s monetary policy and sustained nominal appreciation of the Czech koruna acted as key components of macroprudential policy in the Czech Republic. Section five focuses on the identification of the excessive credit in a converging economy. Section six addresses potential future challenges in taming a prospective credit boom and a number of other policy issues, and finally section seven offers conclusions.

# **2. The Czech Banking Sector and Its Credit Cycles**

The financial system in the Czech Republic went through boom and bust in the 1990s, associated with swings both in financial system structures and macroeconomic developments. The start of the country’s economic transition from socialism in 1991 and the subsequent privatization of the state-owned firms dramatically increased the demand for banking services, credit in particular. The group of four state-owned commercial banks that were built on the basis

> 1 This paper was supported by Czech National Bank Research Projects C1/09 and C5/11, and was prepared as background to a forthcoming World Bank report titled ―Golden Growth: Restoring the Lustre of the European Economic Model.‖ This paper represents the views of the authors and not necessarily those of the (i) Czech National Bank or its management, (ii) World Bank and its affiliated organizations, or (iii) the Executive Directors of the World Bank and the governments they represent. All errors and omissions remain entirely the responsibility of the authors. The authors can be reached by electronic email at jan.frait@cnb.cz, adam.gersl@cnb.cz, jakub.seidler@cnb.cz.

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