## _wp07244 - References

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---

### Introduction — role of capital inflows and policy framing
- Massive private capital inflows, largely bank-intermediated, have played a key role in the convergence of emerging Europe to higher living standards.
- Benefits:
  - Faster consumption and investment, funding previously unaffordable projects, diversification and risk sharing via foreign banks and foreign direct investment.
- Risks and unevenness:
  - Extent and allocation of capital inflows differ markedly across countries.
  - Rapid inflows can create vulnerabilities to macroeconomic and financial stability, especially when risk appetite falls.
  - Policy responses (macroeconomic and prudential tightening) have had limited and constrained effectiveness, often restricted by exchange rate regime choices.
- Two-pronged policy strategy recommended:
  - Drive safely at high speed: reduce vulnerabilities and build buffers/safety margins given uncertainty about “speed limits”.
  - Prepare for the curve ahead: anticipate a fundamental reorientation (rebalancing of current account, shift of resources to tradables); emphasize flexible factor markets and strong financial systems.

### Stylized features of convergence (Section II)
- Capital flows and consumption smoothing:
  - Capital inflows enable agents to smooth consumption and fast-forward convergence; countries starting from lower income (e.g., the Baltics, Bulgaria, Romania) showed fastest convergence and the largest current account deficits.
  - Bank-intermediated credit expanded considerably (Table 1 covers country-level credit-to-GDP series over 2000–2006 for Bulgaria, Croatia, Czech Republic, Estonia, Hungary, Latvia, Lithuania, Poland, Romania, Russia, Serbia, Slovak Republic, Slovenia, Ukraine, Turkey).
- Diversification and risk sharing:
  - Financial globalization measured by ratio of total foreign assets and liabilities to GDP reached high levels in many emerging European countries (Figure 3).
  - Foreign banks and foreign direct investment provide risk capital and share downside risk.
- Shift toward nontradables:
  - Over 2000–06, credit to the nontradables sector more than doubled while credit to the tradable nonfinancial sector stagnated (Figure 4).
  - Household credit for housing tripled over 2000–06; consumer and other credit roughly doubled (Figure 5).
  - Two-stage convergence pattern:
    - Expansion stage: large capital inflows, growing current account deficit, spending accelerates; supply bottlenecks in nontradables push up relative price of nontradables and shift resources to nontradables.
    - Reorientation stage: gradual capacity build-up in nontradables, relative price falls, resources shift back to tradables to satisfy domestic demand and service foreign debt.

### Theoretical framework — model of finance and convergence (Section III)
- Model setup and uncertainty:
  - Small open economy with representative agent; three goods: tradable, nontradable, investment.
  - Convergence modeled as response to announcement of a future productivity improvement subject to uncertainty: good state G occurs with probability π, bad state B occurs with probability 1π−; uncertainty resolved in period two.
  - Borrowing/lending with constraints: incentive (collateral) constraints, individual rationality of lenders, and a solvency constraint capturing lenders’ risk-capital-to-asset ratio ω.
  - Strategic default possible on non-collateralized debt; collateral effectiveness captured by parameter φ with 01φ<<.
- Key functional forms and parameterization:
  - Unitary elasticity between tradable and nontradable; intertemporal elasticity captured by ρ with 1/ρ = 0.50.
  - Discount factor β = 0.96.
  - Expenditure weights: ε = 0.34 (tradables in consumption), γ = 0.44 (tradables in investment).
  - Capital income share α = 0.33.
  - Depreciation δ = 0.073.
  - Ratio of steady-state productivities TN AA = 1.10 (normalized).
  - Investment-output ratio targeted at 0.21.
  - Productivity shock: initial growth rate 3% with persistence 0.8, implying an eventual 16 percent increase in the level of productivity (same increase assumed in both sectors unless noted).
  - Labor adjustment cost parameter λ = 2; investment adjustment cost parameter η = 0.9 (benchmark).
- Equilibrium and dynamics:
  - Equilibrium characterized by sequences of prices p, w, q, h, r; consumption and assets cT, cN, k, b; sectoral plans and investment inputs consistent with first-order conditions and market clearing.
  - Transitional dynamics expressed relative to initial steady state, except interest rate (absolute percentages), current account balance (percent of output), and nontradable output share (percent of total).
- Three illustrative cases and implications:
  - Case 1 — Opening up to capital flows (no uncertainty; extremes φ = 0 and φ = +∞):
    - Autarky: domestic interest rate rises to equilibrate excess demand; consumption jumps immediately followed by gradual output and consumption rises; relative price of nontradables remains flat.
    - Open economy: domestic interest rate converges immediately to world rate; borrowing speeds convergence; prolonged current account deficits; two-stage dynamics with initial shift to nontradables then reorientation back to tradables.
    - Timing/path of productivity realization affects cross-sectoral swings; postponed productivity growth produces larger initial nontradables share and greater later contraction.
  - Case 2 — Alleviating credit constraints (price-sensitive collateral constraint binds):
    - Collateral constraint (binding case) specified as: 111 1 0 1 ttt t bqk φ α ++ + += + (as given in text).
    - Financial accelerator dynamics via capital price, collateral quantity, and borrowing:
      - First-stage acceleration: initial nonbinding constraint allows jump in capital-good price and stock.
      - Second-stage acceleration: gradual relaxation of collateral constraints via endogenous dynamics.
    - Tighter credit constraints slow convergence, produce smaller current account deficits, and reduce volatility in sectoral output and relative prices.
  - Case 3 — Uncertainty and risk sharing:
    - One-period uncertainty (resolved in period two) with probability π of good state; lenders’ risk tolerance captured by ω.
    - If ω = 0 (infinitely risk averse lender), solvency constraint binds and state-contingent interest rates may equal the world rate r in bad state (2Bα = r), limiting risk sharing.
    - If ω is large (risk-neutral lender), solvency constraint never binds and optimal risk sharing can provide perfect insurance from period two onward.
    - Uncertainty prompts more cautious initial behavior: more subdued current account deficits and consumption growth, smaller and more persistent relative price boom in nontradables.
    - With risk sharing (22 BG rαα <<), initial foreign borrowing rises and relative price increases are larger; risk sharing balances intertemporal smoothing and cross-state smoothing.

### Section III.C specific results (π=1; credit constraint threshold)
- For π=1. For φ > 0.34 , the credit constraint is not binding.
- Section III.C variations emphasize how risk appetite (parameter ώ) links to the current account deficit (first period after the shock) via Figure 10.
  - Investors are assumed risk neutral up to the point where losses exceed ώ percent of invested assets; beyond that point, investors become infinitely risk averse.
  - Model parameterizations referenced: one specification used π=0.5 and φ=+∞; elsewhere in Section III.C π=1 and φ=+∞ is used.

### Risk sharing, productivity, and factor flexibility (Section III.C continuations)
- Productivity, factor flexibility, and current account sustainability:
  - Larger productivity improvements are consistent with larger current account deficits (positively sloped model-simulation lines).
  - Factor market flexibility increases allowable borrowing for a given productivity improvement (solid line = high flexibility; dashed line = low flexibility).
  - Figure 11 model parameterization: λ=20 and η=0.3 for the solid line; λ=0.1 and η=0.97 for the dashed line. In addition, π=1 and φ=+∞.
- Breaking the speed limits — macro and financial consequences:
  - Core macro concerns: demand outstrips supply (overheating), loss of competitiveness, inflated asset prices, debt-service problems when exchange rates or asset prices adjust abruptly.
  - Financial sector amplifiers:
    - Financial accelerator via collateral-based lending increases price volatility (Kiyotaki and Moore, 1997); regional correlation between credit growth speed and house price growth (Figure 12).
    - Deterioration in lending standards can generate excessive household and corporate debt or exposures (e.g., foreign-currency liabilities, variable-rate lending). Emerging Europe shows large share of liabilities in foreign currency (Figure 13).
    - Overconfidence (e.g., prospects of adopting the euro or joining EU) can push prices above fundamentals (Figure 14).
    - Foreign bank contagion: concentration of international players creates common-lender contagion risks (Table 3). Strategic shifts by parent banks can amplify foreign-sourced shocks.
    - Sudden stops can severely affect consumption growth; Figure 16 simulations show significant consumption effects when sudden stops last 1 or 3 periods.
  - Sudden-stop simulation parameterization: π=0.5, φ=+∞; sudden stop defined as bt>=0 for t=3 or t=3,4,5, imposed one period after the initial productivity shock.

### Empirical indicators and cross-country patterns (Section IV inputs)
- Speed of credit growth and house prices, 2002-2006 (Figure 12):
  - Speed of credit growth = annual percentage-point increase in credit-to-GDP ratio, averaged over 2002-2006; credit includes direct cross-border credit and refers to households and nonfinancial corporations.
- Share of foreign-currency loans in total loans, 2006 (Figure 13): wide cross-country variation highlighting currency-exposure risks.
- Asset share of foreign-owned banks, 2000 and 2005 (Figure 15): rising foreign ownership in many countries; average levels reported for 2000 and 2005.
- Table 3: Banks' exposure to emerging economies, 2006 (percent of total exposure) — country and source breakdowns reported, with aggregate “Rest of the world” shares reported (e.g., 49.6, 92.8, 88.7, 94.1, 95.3, 80.5, 88.3, 89.2 across listed banking-country columns).

### Reducing vulnerabilities and building buffers (short-term policy actions)
- Implemented measures (examples reported):
  - Macroeconomic tightening: raising interest rates; increasing reserve and liquidity requirements; reducing fiscal deficits or building surpluses.
  - Prudential and supervisory tightening; stepped-up monitoring of banks’ loan-granting standards.
  - Marginal reserve requirements on foreign borrowing in a few cases.
- Observed limitations:
  - Rapid credit growth persists in many countries despite tight fiscal policy (examples: Bulgaria and Estonia).
  - Rapid deposit growth or easy parent-bank funding limited the impact of domestic measures on bank funding costs.
  - Significant tightening of reserve requirements often had transitory effects as banks and borrowers circumvented controls (examples: Croatia and Latvia).
  - Controls that redirect borrowing abroad raise prudential concerns.
  - Capital controls are largely infeasible in EU member states and may not have lasting impact (International Monetary Fund, 2007).
- Recommended pragmatic focus: reduce vulnerabilities and build safety margins; strengthen or maintain:
  - Tightening macroeconomic policies:
    - Tighten fiscal policy to cool demand or avoid adding to demand pressures (example: the Baltics).
    - Eliminate fiscal incentives contributing to nontradables booms (example: Latvia).
    - Conduct incomes policies promoting wage restraint supported by productivity growth (example: Romania).
    - Tighten monetary policy (example: Ukraine).
    - Increase reserve requirements (example: Bulgaria).
  - Raising prudential standards:
    - Remove distortions in bank lending (risky sectoral allocations, unhedged currency borrowing, imprudent funding behavior, real estate bubbles).
    - Identify and raise bank-specific capital requirements where necessary.
    - Establish risk-based and forward-looking supervision (examples: Bulgaria, Latvia, Romania, and the Slovak Republic).
  - Upgrading supervisory cooperation and coordination:
    - Ensure adequate enforcement capacity, cross-border cooperation between home and host supervisors, and coordination among supervisors of nonbank financial institutions (examples: the Czech Republic, Estonia, Lithuania, Poland, and the Slovak Republic).
  - Enhancing risk disclosure:
    - Conduct public awareness campaigns and strengthen disclosure requirements of risk management and internal control policies and practices (examples: the Baltics, Croatia, Hungary, Poland, and the Slovak Republic).

### Medium-term challenge: reversing current account imbalances
- Key points:
  - Converging economies must service debt and eventually turn around current account imbalances.
  - Larger current account deficits amplify the rebalancing challenge; where inflows fueled a nontradables boom, production must reorient toward tradables.
  - Delivering on higher-productivity expectations is vital: if productivity expectations fail to materialize, rebalancing will be more difficult (Portugal example).
- Policy implication: equip economies and financial systems to support a turnaround—credit growth to households should slow in relative terms and more financial resources should flow to productive investments.

### Fostering factor-market flexibility and improving financial infrastructure
- Factor-market flexibility:
  - Flexible labor and capital markets facilitate reallocating resources from nontradables to tradables (Figures 17 and 18 illustrate high- versus low-flexibility paths).
  - Labor market flexibility is particularly pressing: countries with rapid credit growth tend to have more rigid labor markets (Figure 19).
  - Risks of adopting advanced-economy-style generous welfare states too early: labor market rigidities associated with generous welfare can inhibit resource movement to tradables.
  - Flexibility is especially important where exchange rate flexibility is limited, since domestic factor prices (wages) must carry much adjustment.
- Financial infrastructure reforms:
  - Strengthen bankruptcy and insolvency laws to meet international best practice for creditor protection.
  - Improve corporate governance via legislative and enforcement changes.
  - Provide more and better credit information; foster development of credit registries.
  - Develop missing market segments to mobilize domestic savings: under safeguards, develop securitization and asset-backed securities markets.
  - Develop basic derivatives markets to deepen underlying securities markets and improve risk allocation.

### Conclusion and policy summary
- Finance and convergence have delivered substantial benefits to emerging Europe, accelerating convergence through capital inflows and financial deepening.
- Short-term risks: overheating, lax risk management, exposure to sudden reversals.
- Medium-term challenges: rebalancing large current account deficits when speed limits have been exceeded.
- Pragmatic policy directions:
  - Build buffers and reduce vulnerabilities via macroeconomic tightening, higher prudential standards, upgraded supervisory cooperation, and enhanced risk disclosure.
  - Prepare for reversal of external imbalances by strengthening factor-market flexibility and financial systems to support reorientation toward tradables.
- General equilibrium perspective recommendations:
  - Empirical assessments must be country-specific because speed limits vary across countries and over time.
  - Evaluate convergence speed using welfare metrics (not just growth) to account for risk.
  - Consider the entire convergence path; many economies are in the expansion stage but will enter the reorientation stage, which should shape current policy.

*Source — _wp07244 - References (IMF staff paper content provided).*

### References..............................................................................................................

### _wp07244 - References

### Introduction — role of capital inflows and policy framing
- Massive private capital inflows, largely bank-intermediated, have played a key role in the convergence of emerging Europe to higher living standards.
- Benefits: faster consumption and investment, funding previously unaffordable projects, diversification and risk sharing via foreign banks and foreign direct investment.
- Risks and unevenness:
  - Extent and allocation of capital inflows differ markedly across countries.
  - Rapid inflows can create vulnerabilities to macroeconomic and financial stability, especially when risk appetite falls.
  - Policy responses (macroeconomic and prudential tightening) have had limited and constrained effectiveness, often restricted by exchange rate regime choices.
- Two-pronged policy strategy recommended:
  - Drive safely at high speed: reduce vulnerabilities and build buffers/safety margins given uncertainty about “speed limits”.
  - Prepare for the curve ahead: anticipate a fundamental reorientation (rebalancing of current account, shift of resources to tradables); emphasize flexible factor markets and strong financial systems.

### Stylized features of convergence (Section II)
- Capital flows and consumption smoothing:
  - Capital inflows enable agents to smooth consumption and fast-forward convergence; countries starting from lower income (e.g., the Baltics, Bulgaria, Romania) showed fastest convergence and the largest current account deficits.
  - Bank-intermediated credit expanded considerably (Table 1 shows country-level credit-to-GDP series over 2000–2006; sample includes Bulgaria, Croatia, Czech Republic, Estonia, Hungary, Latvia, Lithuania, Poland, Romania, Russia, Serbia, Slovak Republic, Slovenia, Ukraine, Turkey).
- Diversification and risk sharing:
  - Financial globalization measured by ratio of total foreign assets and liabilities to GDP reached high levels in many emerging European countries (Figure 3).
  - Foreign banks and foreign direct investment provide risk capital and share downside risk.
- Shift toward nontradables:
  - Over 2000–06, credit to the nontradables sector more than doubled while credit to the tradable nonfinancial sector stagnated (Figure 4).
  - Household credit for housing tripled over 2000–06; consumer and other credit roughly doubled (Figure 5).
  - Two-stage convergence pattern:
    - Expansion stage: large capital inflows, growing current account deficit, spending accelerates; supply bottlenecks in nontradables push up relative price of nontradables and shift resources to nontradables.
    - Reorientation stage: gradual capacity build-up in nontradables, relative price falls, resources shift back to tradables to satisfy domestic demand and service foreign debt.

### Theoretical framework — model of finance and convergence (Section III)
- Model setup:
  - Small open economy with a representative agent; three goods: tradable, nontradable, investment.
  - Convergence modeled as response to announcement of a future productivity improvement subject to uncertainty: good state G occurs with probability π, bad state B occurs with probability 1π−; uncertainty resolved in period two.
  - Borrowing/lending with contractual constraints: incentive (collateral) constraints, individual rationality of lenders, and a solvency constraint capturing lenders’ risk-capital-to-asset ratio ω.
  - Strategic default possible on non-collateralized debt; collateral effectiveness captured by parameter φ with 01φ<<.
- Key functional forms and parameterization (preserve exact values):
  - Consumer utility: unitary elasticity between tradable and nontradable; intertemporal elasticity captured by ρ with 1/ρ = 0.50.
  - Discount factor β = 0.96.
  - Expenditure weights: ε = 0.34 (tradables in consumption), γ = 0.44 (tradables in investment).
  - Capital income share α = 0.33.
  - Depreciation δ = 0.073.
  - Ratio of steady-state productivities TN AA = 1.10 (normalized).
  - Investment-output ratio targeted at 0.21.
  - Productivity shock: initial growth rate 3% with persistence 0.8, implying an eventual 16 percent increase in the level of productivity (same increase assumed in both sectors unless noted).
  - Labor adjustment cost parameter λ = 2; investment adjustment cost parameter η = 0.9 (benchmark).
- Equilibrium and dynamics:
  - Equilibrium characterized by sequences of prices p, w, q, h, r; consumption and assets cT, cN, k, b; sectoral plans and investment inputs consistent with first-order conditions and market clearing.
  - Transitional dynamics expressed relative to initial steady state, except interest rate (absolute percentages), current account balance (percent of output), and nontradable output share (percent of total).
- Three illustrative cases and key implications:
  - Case 1 — Opening up to capital flows (no uncertainty, extremes of credit constraint φ = 0 [autarky] and φ = +∞ [fully open]):
    - Autarky: domestic interest rate rises to equilibrate excess demand; consumption jumps immediately followed by gradual output and consumption rises; no major cross-sectoral dynamics; relative price of nontradables remains flat.
    - Open economy: domestic interest rate converges immediately to world rate; borrowing speeds convergence in consumption and output; prolonged current account deficits common; two-stage dynamics emerge with an initial shift to nontradables then a reorientation back to tradables as foreign debt repayment becomes dominant.
    - Timing/path of productivity realization affects cross-sectoral swings; postponed productivity growth produces larger initial nontradables share and greater later contraction.
  - Case 2 — Alleviating credit constraints (price-sensitive collateral constraint binds):
    - Collateral constraint equation (binding case): 111 1 0 1 ttt t bqk φ α ++ + += + (as specified in text).
    - Financial accelerator dynamics through interactions among capital price, collateral quantity, and borrowing:
      - First-stage acceleration: initial nonbinding constraint allows jump in capital-good price and stock.
      - Second-stage acceleration: gradual relaxation of collateral constraints via endogenous dynamics.
    - Tighter credit constraints slow convergence, produce smaller current account deficits, and reduce volatility in sectoral output and relative prices.
  - Case 3 — Uncertainty and risk sharing:
    - One-period uncertainty (resolved in period two) with probability π of good state; lenders’ risk tolerance captured by ω:
      - If ω = 0 (infinitely risk averse lender), solvency constraint binds and state-contingent interest rates may equal the world rate r in bad state (2Bα = r), limiting risk sharing.
      - If ω is large (risk-neutral lender), solvency constraint never binds and optimal risk sharing can provide perfect insurance from period two onward.
    - Uncertainty prompts more cautious initial behavior: more subdued current account deficits and consumption growth, smaller and more persistent relative price boom in nontradables.
    - With risk sharing (22 BG rαα <<), initial foreign borrowing rises and relative price increases are larger; risk sharing balances intertemporal smoothing and cross-state smoothing.

### Policy challenges and implications (Section IV)
- Short-term risks (expansion stage) — “drive safely”:
  - Speed limits are not directly observable, vary across countries and over time. Central determinants of appropriate speed limits:
    - Productivity gains: brighter productivity prospects justify higher speeds but also larger price/resource shifts.
    - Factor market flexibility: more flexible labor and capital markets allow higher speed limits.
    - Financial development: more developed financial systems allow faster convergence (Figure 9 shows relation between index of financial development and maximum current account deficit; index refers to aggregate loan-to-value: aggregate credit over aggregate capital; variation due to liquidation cost parameter φ).
    - Risk appetite: greater willingness of foreign investors to provide risk capital increases scope for risk sharing and larger optimal capital inflows (Figure 10 relates risk sharing and current account).
- Medium-term challenges (reorientation stage) — “prepare for the curve”:
  - Protracted current account imbalances must reverse; resources must shift to tradables and productive investment to service foreign debt without abrupt correction.
  - Policies should foster flexible factor markets and resilient financial systems to facilitate sectoral reallocation and absorb shocks.
- Summary policy directions (implied by framework and analysis):
  - Build buffers and reduce vulnerabilities during expansion stage (macroprudential and fiscal/monetary prudence where feasible).
  - Enhance labor and capital market flexibility to reduce misallocation and enable smoother sectoral reallocation during reorientation.
  - Strengthen financial development and supervision to manage credit booms and mitigate amplification via collateral channels (parameters φ and ω central to collateral effectiveness and lenders’ risk tolerance).
  - Consider the role of lender risk appetite in amplifying or dampening flows and tailor prudential settings accordingly.

*Italic: Source — _wp07244 - References (IMF staff paper content provided).*

### Section III.C, with π=1. For φ > 0.34 , the credit constraint is not binding.

### _wp07244 - Section III.C, with π=1. For φ > 0.34 , the credit constraint is not binding.

### Risk sharing, risk appetite, and the current account
- Figure 10 links an index of risk appetite (varied with parameter ώ) to the current account deficit (first period after the shock).
- Investors are assumed risk neutral up to the point where losses exceed ώ percent of invested assets; beyond that point, investors become infinitely risk averse.
- Model parameterization referenced in Section III.C: in one specification π=0.5 and φ=+∞ (noting that elsewhere in this Section π=1 and φ=+∞ is used).

### Productivity, factor flexibility, and current account sustainability
- Conceptual finding: larger productivity improvements are consistent with larger current account deficits (positively sloped model-simulation lines).
- Factor market flexibility increases the allowable borrowing for a given productivity improvement (solid line = high flexibility; dashed line = low flexibility).
- Figure 11 empirical note:
  - Empirical data: annual geometric average growth rate in total factor productivity over 2000-2005 and maximum CA deficit to GDP ratio over 2000-2005.
  - Simulated data: productivity growth occurs in first period after the shock.
  - Model parameterization for Figure 11: λ=20 and η=0.3 for the solid line; λ=0.1 and η=0.97 for the dashed line. In addition, π=1 and φ=+∞.

### Breaking the speed limits — macroeconomic and financial sector consequences
- Core macro concerns when “speed limits” are broken:
  - Demand outstrips supply, putting excessive pressure on prices and wages and causing overheating.
  - Overheating can lead to loss of competitiveness and inflated asset prices.
  - Debt-service problems may arise when exchange rates or asset prices adjust abruptly.
- Financial sector channels that exacerbate vulnerabilities:
  - Financial accelerator: collateral-based lending can create feedback between lending and asset prices, increasing price volatility (Kiyotaki and Moore, 1997). Regional comparisons show correlation between credit growth speed and house price growth (Figure 12).
  - Deterioration in lending standards as institutions compete, potentially generating excessive household and corporate debt or exposures (e.g., foreign-currency liabilities, variable-rate lending). Emerging Europe concern: large share of liabilities in foreign currency (Figure 13).
  - Overconfidence can fuel boom-and-bust cycles; optimistic expectations (e.g., prospects of adopting the euro or joining EU) can push prices above fundamentals (Figure 14).
  - Foreign bank contagion: foreign bank presence contributed to credit availability but concentrated international players create common-lender contagion risks (Table 3). Strategic shifts by parent banks can amplify foreign-sourced shocks.
  - Sudden changes in market sentiment (sudden stops) can severely affect consumption growth; Figure 16 simulations show significant consumption effects when sudden stops last 1 or 3 periods.
- Model parameterization referenced for sudden-stop simulations: π=0.5, φ=+∞; sudden stop defined as bt>=0 for t=3 or t=3,4,5, imposed one period after the initial productivity shock.

### Empirical indicators and cross-country patterns
- Speed of credit growth and house prices, 2002-2006 (Figure 12):
  - Speed of credit growth = annual percentage-point increase in credit-to-GDP ratio, averaged over 2002-2006; credit includes direct cross-border credit and refers to households and nonfinancial corporations.
- Share of foreign-currency loans in total loans, 2006 (Figure 13): shows wide cross-country variation and highlights currency-exposure risks.
- Asset share of foreign-owned banks, 2000 and 2005 (Figure 15): documents rising foreign ownership in many countries, with average levels reported for 2000 and 2005.
- Table 3: Banks' exposure to emerging economies, 2006 (percent of total exposure) — country and source breakdowns reported, with aggregate “Rest of the world” shares reported (e.g., 49.6, 92.8, 88.7, 94.1, 95.3, 80.5, 88.3, 89.2 across listed banking-country columns).

### Reducing vulnerabilities and building buffers (short-term policy actions)
- Implemented measures (examples reported):
  - Macroeconomic tightening: raising interest rates; increasing reserve and liquidity requirements; reducing fiscal deficits or building surpluses.
  - Prudential and supervisory tightening; stepped-up monitoring of banks’ loan-granting standards.
  - Marginal reserve requirements on foreign borrowing in a few cases.
- Observed limitations of these measures:
  - Rapid credit growth persists in many countries despite tight fiscal policy (examples: Bulgaria and Estonia).
  - Rapid deposit growth or easy parent-bank funding limited the impact of domestic measures on bank funding costs.
  - Significant tightening of reserve requirements often had transitory effects as banks and borrowers circumvented controls (examples: Croatia and Latvia).
  - Controls that redirect borrowing abroad raise prudential concerns.
  - Literature and IMF note: capital controls are largely infeasible in EU member states and may not have lasting impact (International Monetary Fund, 2007).
- Recommended pragmatic focus: reduce vulnerabilities and build safety margins, preparing for worse-case scenarios. Strengthen or maintain:
  - Tightening macroeconomic policies:
    - Tighten fiscal policy to cool demand or avoid adding to demand pressures (example: the Baltics).
    - Eliminate fiscal incentives contributing to nontradables booms (example: Latvia).
    - Conduct incomes policies promoting wage restraint supported by productivity growth (example: Romania).
    - Tighten monetary policy (example: Ukraine).
    - Increase reserve requirements (example: Bulgaria).
  - Raising prudential standards:
    - Remove distortions in bank lending (risky sectoral allocations, unhedged currency borrowing, imprudent funding behavior, real estate bubbles).
    - Identify and raise bank-specific capital requirements where necessary.
    - Establish risk-based and forward-looking supervision (examples: Bulgaria, Latvia, Romania, and the Slovak Republic).
  - Upgrading supervisory cooperation and coordination:
    - Ensure adequate enforcement capacity, cross-border cooperation between home and host supervisors, and coordination among supervisors of nonbank financial institutions (examples: the Czech Republic, Estonia, Lithuania, Poland, and the Slovak Republic).
  - Enhancing risk disclosure:
    - Conduct public awareness campaigns and strengthen disclosure requirements of risk management and internal control policies and practices (examples: the Baltics, Croatia, Hungary, Poland, and the Slovak Republic).

### Medium-term challenge: reversing current account imbalances
- Key points:
  - Converging economies must service debt and eventually turn around current account imbalances.
  - Larger current account deficits amplify the rebalancing challenge; where inflows fueled a nontradables boom, production must reorient toward tradables.
  - Delivering on higher-productivity expectations is vital: if productivity expectations fail to materialize, rebalancing will be more difficult (Portugal example).
- Policy implication: equip economies and financial systems to support a turnaround—credit growth to households should slow in relative terms and more financial resources should flow to productive investments.

### Fostering factor-market flexibility
- Flexible labor and capital markets facilitate reallocating resources from nontradables to tradables (Figures 17 and 18 illustrate high- versus low-flexibility paths).
- Labor market flexibility is particularly pressing: countries with rapid credit growth tend to have more rigid labor markets (Figure 19).
- Risks of adopting advanced-economy-style generous welfare states too early: labor market rigidities associated with generous welfare can inhibit resource movement to tradables.
- Flexibility is especially important where exchange rate flexibility is limited, since domestic factor prices (wages) must carry much adjustment.

### Improving financial infrastructure
- Essential reforms to channel finance to productive investment:
  - Strengthen bankruptcy and insolvency laws to meet international best practice for creditor protection.
  - Improve corporate governance via legislative and enforcement changes.
  - Provide more and better credit information; foster development of credit registries.
  - Develop missing market segments to mobilize domestic savings: under safeguards, develop securitization and asset-backed securities markets.
  - Develop basic derivatives markets to deepen underlying securities markets and improve risk allocation.

### Conclusion and policy summary
- Finance and convergence have delivered substantial benefits to emerging Europe, accelerating convergence through capital inflows and financial deepening.
- However, short-term risks (overheating, lax risk management, exposure to sudden reversals) and medium-term challenges (rebalancing large current account deficits) have emerged where speed limits may have been exceeded.
- Pragmatic directions for policymakers:
  - Build buffers and reduce vulnerabilities via macroeconomic tightening, higher prudential standards, upgraded supervisory cooperation, and enhanced risk disclosure.
  - Prepare for reversal of external imbalances by strengthening factor-market flexibility and financial systems to support reorientation toward tradables.
- General equilibrium perspective recommendations:
  - Empirical assessments must be country-specific because speed limits vary across countries and over time.
  - Evaluate convergence speed using welfare metrics (not just growth) to account for risk.
  - Consider the entire convergence path; many economies are in the expansion stage but will enter the reorientation stage, which should shape current policy.

*Source: IMF staff — Section III.C and related figures and tables in the provided content unit.*

### REFERENCES

### _wp07244 - REFERENCES

### Cited works
- Bems, R., and K. Jonsson Hartelius, 2006, “Trade Deficits in the Baltic States: How Long Will the Party Last?” Review of Economic Dynamics 9, pp. 179-209.  
- Demekas, D., 2007, “Are European Emerging Markets Different?” in Emerging Markets: Any Lessons for Southeastern Europe? Proceedings of OeNB Workshops No. 12 (Vienna, Oesterreichische Nationalbank).  
- Égert, M., 2007, “Determinants of House Price Dynamics in Central and Eastern Europe,” in Focus on European Economic Integration 1/07 (Vienna: Oesterreichische Nationalbank).  
- Fernandez de Cordoba, G., and T. Kehoe, 2000, ”Capital Flows and Real Exchange Rate Fluctuations Following Spain’s Entry into the European Community,” Journal of International Economics 51, pp.49-78.  
- Hilbers, P., İ. Ötker-Robe, and C. Pazarbasioğlu, 2007, “Analysis of and Policy Responses to Rapid Credit Growth,” in Rapid Credit Growth in Central and Eastern Europe: Endless Boom or Early Warning? ed. by C. Enoch and I. Otker-Robe (New York: Palgrave Macmillan; and Washington: International Monetary Fund).  
- International Monetary Fund, 2007, “Reaping the Benefits of Financial Globalization,” IMF Discussion Paper (Washington: International Monetary Fund). Available via the Internet: www.imf.org/external/np/res/docs/2007/0607.htm.  
- Kiyotaki, N. and J. Moore, 1997, “Credit Cycles,” Journal of Political Economy, Vol. 105, pp. 211-48.  
- Lucas, R. E. and E. C. Prescott, 1971, “Investment under Uncertainty,” Econometrica, 39, pp. 659-81.  
- Schellekens, P., 2000, “Costly Collateral and the Public Supply of Liquidity,” IMF Working Paper 00/125 (Washington: International Monetary Fund). Available via the Internet: www.imf.org/external/pubs/ft/wp/2000/wp00125.pdf.

### Key topics covered by the references
- Trade deficits and external imbalances in the Baltic States.  
- Characteristics and policy considerations for European emerging markets and Southeastern Europe.  
- Determinants and dynamics of house prices in Central and Eastern Europe.  
- Capital flows and real exchange rate fluctuations associated with EU accession (Spain case).  
- Analysis of rapid credit growth and policy responses in Central and Eastern Europe.  
- Broader implications of financial globalization.  
- Theoretical foundations on credit cycles and investment under uncertainty.  
- Issues of collateral costs and public liquidity supply.

*Source: _wp07244 - REFERENCES*

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/wp/2007/_wp07244.pdf_