The issue:Is Bulgaria's approach to credit growth appropriate?
In 2005, Bulgarians took loans totalling 2.5 billion leva, according to Bulgarian National Bank (BNB) records. This meant that the credit growth rate was about 32.9 per cent, slightly more than the limit set by BNB for the year, which was 30 per cent.

The sharpest increase was in housing loans, which rose by 101 per cent. By the end of 2005, Bulgarians owed 2.03 billion on housing loans. Consumer loans went up by 49 per cent.

According to BNB, the highest rate of increase was in the beginning of 2005, before a set of further restrictions on lending took effect. From April 2005, measures introduced included new rules on minimum obligatory reserves of banks, with penalties for banks that exceed lending growth limits.

Apart from a rate of lending that it considers too high, BNB is also worried by the quality of loans. The central is concerned that banks' criteria for granting loans are insufficiently strict.

BNB has predicted that in the first three months of 2006, credit growth will be about six per cent. If BNB's measures against credit growth prove effective, this year the figure will be no more than 20 per cent.

Concern about credit growth grew as an issue from about 2004.

One of the key sources of concern is what the loans are being used for.

Speaking at the February 2006 conference in Plovdiv on banking, BNB deputy governor Dimitar Kostov called on banks to less free with loans because consumers were using the borrowed money mainly to buy imported goods.

Apart from the obvious risk that a higher rate of borrowing means a higher risk of bad debts, the fact of using loans to buy imports has aggravated Bulgaria's foreign trade deficit, which last year added up to about $5 billion.

Speaking at the same conference, BNB deputy governor Emilia Milanova said that the consumer and mortgage loan-books of Bulgaria's 34 commercial banks continued to generate classified exposures at a faster rate than their commercial credit portfolios.This trend, first detected by BNB in 2005, tripled the number of suspect retail loans last year. Suspect mortgage loans rose from 2.34 per cent of the overall mortgage portfolio at the end of 2004 to 7.43 per cent at the end of 2005.

Milanova said that the trend was unacceptable because retail loans were treated as the lowest risk category under international banking standards, said Milanova. She said that the spike in bad retail loans was caused by Bulgarian banks being too busy competing for market share to assess properly the eligibility of prospective borrowers.
This year, BNB has again moved against credit growth, with new measures. Corporate bonds floated by domestic issuers will be recorded in the credit portfolio of the buyer bank to discourage the practice of banks purchasing bonds instead of extending a loan to a particular issuer. Another new rule will require that mortgage borrowers co-finance at least 50 per cent of the home purchase or else the lender will be required to provision double the standard amount.

The BNB will recommend to the banks to require that prospective borrowers have a disposable income of 100 leva a family member after the payment of the monthly loan installment.

In late 2005, non-performing loans were reported to amount to about 400 million leva, or 2.24 per cent of overall loans.

The International Monetary Fund has been a prime mover in urging Bulgaria to calm the loan market.

Speaking at the banking conference, IMF resident representative James Roaf said that the credit boom was putting limitations on the economy. Credit growth, with an increase in the budget deficit, put the economy at risk of instability, Roaf said.

A counterpoint to this is the report released in early 2006 by Standard & Poor's that held that Bulgaria's banking sector was now substantially more robust than during the financial crisis of 1996/97. The ratings agency, however, named management of the credit environment as a key factor in future assessment of the country's creditworthiness.

Some in the banking sector are chafing at the restrictions.

They argue that the views of the IMF and BNB are too cautious, and that credit growth in Bulgaria is not anomalous in comparison with similar economies elsewhere in Europe, and for that matter by eurozone standards.

At the Plovdiv conference, according to media reports, Post Bank chief executive Anthony Hasiotis expressed indignation at BNB continually tightening restrictions.
"Leave us alone and let us do our job," Hasiotis was quoted as saying.

Banking measures and the current account deficit
James Roaf, IMF Resident Representative in Bulgaria

Bulgaria currently faces a difficult macroeconomic policy challenge.

Since the introduction of the currency board, the country has enjoyed eight years of strong and steady growth, low inflation, improving living standards, and, in recent years, falling unemployment. At the same time, the confidence inspired by this performance, and the expectations for convergence with the EU, have been reflected in very strong growth of consumption and investment, fuelled by bank credit and investment flows from abroad. This has resulted in a major deterioration in Bulgaria's external current account deficit, which has increased from below six per cent of GDP in 2002 to about nine per cent of GDP in 2003 and 2004 and to almost 15 per cent of GDP in 2005.Significant current account deficits are of course common to other countries in the region, and indeed the kind of policies discussed below for Bulgaria are also being implemented in many other countries, in various forms and degrees depending on individual country needs. But the scale and speed of the current account deterioration has been especially pronounced in Bulgaria, and the currency board regime also means the authorities here are especially constrained in their possible policy responses. Given that a current account deficit reflects an excess of demand over supply, the advice of the IMF in this situation is to seek to moderate demand growth in the near term, while pursuing structural reforms to increase supply in the medium and longer term.

I focus below on the role of banking measures in demand management, but this should not be taken to mean that fiscal policy is any less important in this regard. Neither should it detract from the overriding importance of structural reform for the longer-term success of the Bulgarian economy. Successive governments will need to pursue an ambitious reform agenda in areas such as the business environment and rule of law, public administration and corruption, and education and the labour market, to ensure that Bulgaria can compete and thrive within the EU and, eventually, the euro area.

The immediate challenge is how to influence the level of demand in the economy. The private sector is the source of the excess demand, but under the currency board the Bulgarian authorities lack the standard tools of monetary and exchange rate policy with which they could affect private sector behaviour. Fiscal policy is available as a lever, but here there is the constraint that Bulgaria has already been running a very responsible fiscal policy for a number of years, reducing concerns about fiscal sustainability. There are political limits to how much further fiscal tightening could be implemented, compared to the budget surpluses of about two per cent of GDP already achieved in 2004 and 2005.

In these circumstances the government and central bank have decided, with the support of the IMF, to take a balanced approach. First, the fiscal surplus is to be increased to at least three per cent of GDP in 2006. Second, measures are being taken in one area where the authorities do have a degree of control over private sector activity, which is the banking sector. In the past few years, bank lending has risen at breakneck speed, with credit stocks growing at up to 50 per cent a year in 2003 and 2004, albeit from a low initial base. This expansion of banking activity has provided enormous benefits to the country, allowing businesses to take advantage of investment opportunities and households to borrow for homes, cars, and other goods. But the very fast pace at which lending has grown has contributed to import growth and a larger current account deficit, adding to macroeconomic vulnerability, and has also raised prudential concerns about banks' ability to manage their growing portfolios. It is important to note that banking sector prudential indicators do not presently show any signs of a dangerous deterioration. But a rising portfolio of fresh loans and buoyant economic growth tend to improve these indicators, and if there were any incipient problems they would be expected to show up only later. So it pays to be particularly vigilant when banks are expanding rapidly.

Over the past two years, Bulgarian National Bank has therefore taken a range of prudential measures which would both reinforce bank soundness and moderate the growth of credit. These include intensifying supervisory activity; strengthening reserve, provisioning and capital requirements; expanding the credit registry; and most recently issuing guidelines to banks to ensure households have sufficient disposable income remaining after debt service. These measures mean that the Bulgarian banking sector now has some of the most stringent regulatory requirements in the world, which reinforces confidence that banks are able to withstand any shocks that might hit the system.

But despite these actions, at the beginning of 2005 bank credit was still not showing convincing signs of slowing down. BNB therefore introduced more direct controls on bank lending, under which penalty reserve requirements are imposed on banks whose loan portfolios grow in excess of fixed quarterly limits. These ceilings succeeded in bringing credit growth down to about 30 per cent in 2005, with about 17? per cent growth expected this year. The credit ceilings have proven the most controversial of the measures taken by the BNB, and have drawn a range of comments from members of the banking community and others. I will try to address some of the main lines of criticism here.

First, many contend that the credit ceilings are easily circumvented and lead to distortions. This is a fair comment. Under free capital mobility, squeezing bank lending is likely to lead borrowers to choose different channels of finance. The activities of leasing companies and other finance institutions outside the domestic banking sector have grown rapidly. Retailers provide direct financing to consumers. Some companies are able to borrow directly from abroad. Some banks are able to pass clients and loans up to their foreign headquarters. Banks may be able to set up special legal structures to take loans off their balance sheets, leaving room for increased lending. However, the key question here is not whether banking measures are perfect, but whether they are worthwhile despite their imperfections. Ways around such measures usually take some time to develop, so typically one expects them to be effective at first, but to gradually lose effectiveness as tools of demand management over time. So they should be seen as temporary measures, intended to meet a temporary economic need. And from the perspective of banking soundness, which has been the principal concern of the BNB, the credit ceilings have been very effective in reducing the speed at which bank portfolios expand, and in reducing the prudential risks that arise from that.

Second, many complain that the credit ceilings are anti-competitive. This too is a well-grounded criticism: the measures tend to imply that all banks should grow at the same rate, rather than competing for market share. But an analogy may be useful here. In motor racing, when there is a temporary problem such as oil on the track, the organisers may put out a "pace car" behind which the racers must stay in line, without overtaking each other, until the oil is cleaned up and the racing is resumed. Does this mean that a motor race is uncompetitive? Similarly the present credit controls can be seen as a temporary interference in the market, put in place for good reason during a period of heightened risk.

Third, there is the concern that reducing the availability of bank credit will harm economic growth, particularly by denying investors and businesses needed sources of finance. Here it is important to remember that these are only ceilings on credit growth, not any kind of ban on lending altogether. The ceilings may be lower than banks would have planned themselves, but they are not low in macroeconomic terms. The credit growth expected for 2006 corresponds to a flow of new lending equivalent to seven per cent of GDP, and in addition many other channels of finance outside the domestic banking system will be available, as discussed above.

To conclude, the combination of a large current account deficit and a rigid currency board regime puts Bulgaria in a complicated situation. The country needs to pursue fiscal consolidation, despite the absence of immediate concerns about the sustainability of the public finances. And it needs to pursue controls on bank lending, despite the absence of a significant deterioration in bank credit portfolios - and in the knowledge that such controls suffer from a number of imperfections. This may seem a strange conjunction at first sight, but from a macroeconomic perspective these are the appropriate and pragmatic policies to follow. The IMF - along with other institutions and commentators - commends the Government and central bank for the commitment to macroeconomic stability that they demonstrate with this approach.