I will continue with the issue I started to discuss on Monday. Today's question is: Why does rapid credit expansion has the potential to pose the risk of a significant monetary policy problem? In a study published in 1996, J. Frankel and A. Rose analyses monetary crises in developing countries for the period between 1971 and 1992.  One common characteristic for a hundred countries is that domestic credit volume expands rapidly. A new study in this topic is conducted by Barajas et al. They point out that more than half of the banking crises they analyzed were preceded by a period of rapid credit expansion.

The main motive behind these findings are: As things turn positive along with rapid economic expansion, risk perception of financial institutions decrease compared to periods of slow growth. The belief that things will always go well gains prominence. Financial institutions rush in to get a share from the credit market. Rapid credit expansion results in that institutions and individuals receiving the credit are not assessed sufficiently. This way, non-performing credit ratio goes up.

The most recent example is doubtlessly from the USA:  The close connection between the global crisis and the mortgage housing credit market of the USA is now known to everyone. In the period from 2002 and 2006 mortgage housing credit volume in the US rises rapidly: annual rises in credits is double-digit for each year over the period. Considering the inflation rate in the USA, we come up with a quite high real credit expansion. An example from Turkey can be also given: Banks' marketing credit cards in streets and shopping malls after the 2001 crisis and especially after 2003. On Monday, I talked about an announcement Central Bank published in 2004. The Bank called the regulatory and supervisory authority to take measures against the adverse outcomes to be created by rapid credit expansion. Before this were also announcements drawing attention to the dangers of dizzying rise in the number of credit card users.

Consequently, rapid credit expansion poses a potential danger considering monetary policy. If the regulation and supervision in the financial system is not solid, rapid credit expansion implies a future crisis in the financial system. We know closely from our recent experience what this means concerning the economy. In such a milieu, central banks are forced to act as fire brigades.  In this sense rapid credit expansion is dangerous considering monetary policy. Besides, there is the danger that appears within the period of rapid credit expansion. This danger is of course related with inflation. Rapid credit expansion might lead to consumption boom providing corporate sector with an environment where profit rates can be improved more easily. Rises in prices accelerate.

So, what can central banks do in the event of a credit expansion? A problem arises just at the beginning: At what pace credit expansion is rapid? Is it 5 points above inflation rate; or 10 or 35? What if a credit expansion we consider rapid in fact does pose any risk for the financial system? Assume that you overcome this challenge and decided that the things are not on track in the credit market? Then what would you do?

And the referred articles. First: J. Frankel, and A. Rose, 1996. Currency Crashes in Emerging Markets: An Empirical Treatment, Journal of International Economics, 41, 351-366. Second article: A. Barajas, G. Dell'Ariccia and A. Levchenko, 2007. Credit Booms: The Good, the Bad, and the Ugly, unpublished study, Washington, DC: IMF.

This commentary was published in Radikal daily on 22.10.2009