November 9, 2015 by iMFdirect

by John Caparusso, Yingyuan Chen, Evan Papageorgiou and Shamir Tanna

Emerging markets have had a great run. The fifteen largest emerging market economies grew by 48% from 2009 to 2014, a period when the Group of Twenty economies collectively expanded by 6%.

How did emerging markets sustain this growth? In part, they drew upon bank lending to drive corporate credit expansion, strong earnings, and low defaults. This credit boom, combined with falling commodity prices and foreign currency borrowing, now leaves emerging market firms vulnerable and financial sectors under stress, as we discuss in the latest Global Financial Stability Report.

Credit booms and credit gaps often foreshadow severe bad debt cycles

Credit booms can feed the buildup of risks to the financial system—excess investment leading to surplus production capacity, deteriorating cash flow for corporates, rising default risk, and ultimately bank capital losses.  The credit gap, a measure of a country’s increase in borrowing (credit to GDP ratio) relative to its historical average, highlights vulnerable countries.

By the end of 2014, China, Thailand, Turkey, Brazil, and Indonesia all had credit gaps above 10%, a level often considered the benchmark for risky credit booms (Chart 1). China’s 25% credit gap places the country in the 5% highest credit gaps across emerging markets since the 1970s. This is consistent with other signs of strain:  the growth of opaque ‘shadow credit’ markets, and Chinese policymakers’ desire to limit financial market developments (for example, corporate defaults or volatility in equity and currency markets) that could trigger spillovers across the credit system.