During the past five years, emerging markets have experienced a significant rise in the credit to the private sector. In the countries that have recently joined the European Union, however, borrowers have been suffering from a rather severe credit crunch. This paper shows that this anomaly can be attributed to the financial-integration effects following their joining the EU.
Until recently, academic research stressed the benefits of political integration with the EU for Emerging Europe, which is deemed to have enhanced institutional credibility in the new member countries, and provided easier access to bail-out institutions during the financial crisis of 2008.
This empirical study analyzes whether EU membership strengthens the role of foreign banks as a source of credit. If banks finance domestic credit expansions mainly domestically, e.g., via deposits, changes in cross-border financial inflows may not result in credit growth. In contrast, if banks finance domestic credit mainly via loans or deposits from foreign banks, domestic credit growth is more dependent on cross-border financial inflows.
The study suggests that political integration enhanced the dependence of domestic credit growth on external bank financing. Moreover, it is shown that although political integration benefitted the new EU members during the monetary boom, the increase in financial integration made these economies more vulnerable and dependent on external financing. The problems of the euro area institutions and the deleveraging of European banks, therefore, negatively affected credit conditions in the new EU members.
The policy lesson is that the EU’s economic and political institutions, e.g. the supervisory and regulatory framework or established bailout institutions, continue to the have, for good or ill, an impact on the new members of the EU via financial integration. Therefore, repairing the financial sector and improving the quality of monetary and financial institutions in the core European economies is important for the EU as a whole and not just for the euro area.