CBA Analysis no. 5

Most new market economies in the New Europe are recording high GDP growth rates coupled with robust credit growth, mainly financed from cross-border sources. These developments, particularly pronounced in the Baltic countries and Southeastern Europe, has triggered reactions in economic policy making. Croatia is not an exception in this respect, although credit growth in the period 2004 – 2006 was lower than expected. This analysis provides a framework for an international comparison of paces of credit growth and includes a survey of regulatory responses in ten transition countries of the New Europe. It also presents a new method for calculating the cost of regulation index (the index of regulatory burden – IRO) which has increased due to regulatory responses to capital inflows and credit growth.

This analysis points to a disproportion between the growing cost of regulation of banking and the necessity for its reduction in the context of approximation to the EU. It shows that, if the cost of regulation remains high, the problem will not consist in the inability to comply with formal criteria of the European Monetary Union (such as the 2% obligatory reserve rate), but mostly in a fast reduction of the banks’ return on equity. This may bring about undesirable structural changes in credit markets and multiply rigidities in the system of monetary transmission. Due to such regulatory distortions, policy makers are increasingly less successful at controlling the pace of credit growth (although this success has always been limited). Fiscal adjustment is the only measure which may have a lasting impact in this respect.

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