Transcript Household debt and foreign currency borrowing in new

Household debt and foreign
currency borrowing in new
member states of the EU
Ray Barrell
E. Philip Davis
Tatiana Fic
Ali Orazgani
National Institute of Economic and Social Research
Brunel University
National Bank of Poland
Motivation

Many new members of the EU

Poland, Hungary, Czech Republic, Slovakia, Slovenia, Estonia,
Latvia, Lithuania, Bulgaria, Romania
have been experiencing rapid debt growth in the
household sector


Credit growth is an essential – and natural - element of the catchingup process in the NMS
Excessive household indebtedness, especially if it is in foreign
currency, may, however, increase a country’s susceptibility to a crisis
To what extent did it matter
during the global financial crisis of 2008?

Objective

The objective of the paper is to

identify risks related to the evolution of debt in
NMS and
 derive implications for macroeconomic policy

Households’ borrowing: its scale and currency
composition – lessons of the global financial crisis of
2008
Outline
Household indebtedness in the NMS: stylised
facts
 Quantitative assessment of the sustainability of
debt
 Qualitative discussion of risks arising from
borrowing in foreign currencies
 Conclusions

 Lessons
of the crisis of 2008
Household indebtedness in NMS:
stylised facts
Stylised facts
New member states’ debt levels have been catching up
relatively rapidly with levels observed in the old members of
the EU
 The Baltics


1.2
1.0

The Central European economies

0.8
0.6
0.4

0.2
BL
CR
GE
ES
FR
IT
LI
LV
PO
RM
SL
HU
2008
2007
2006
2005
2004
2003
2002
2001
2000
1999
1998
1997
1995
1996
BG
the debt to income ratios in
Poland, Hungary and the
Czech Republic have been
increasing relatively
moderately
The Southern European countries

0.0
have recorded the fastest pace
of debt growth
the HH debt in Romania and
Bulgaria, although increasing,
has remained at low levels
which may be associated with
a relatively lower level of
financial development in these
countries
Debt drivers

The expansion of the household debt results from two
factors:
 the

convergence process
in which case the expanding indebtedness constitutes a necessary
element of the medium-, long term macroeconomic equilibrium
 short term borrowing trends
 driven by the business cycle or by autonomous factors such as
financial liberalisation linked to international competition or
foreign ownership of the banking system.
 These may result in credit booms, posing risks of overheating to the
economy and of financial instability in the downturn.
Quantitative assessment of
sustainability of debt in NMS
Qualitative assessment of debt
sustainability

3 steps
1. Estimate a model of debt

What does the debt to income ratio depend on?
2. Detemine the equilibrium level of debt

How do you measure the equilibrium?
3. Assess excessive indebtedness of households
In the short run
 In the medium run
 In the long run

The model of debt to income

The model
 defines the debt to income ratio as a function
 GDP per capita, interest rates, house prices
of:
 encompasses:
 selected new member states: Poland, Hungary, Czech Republic,
Estonia, Latvia and Lithuania
 major economies of the Euro Area as comparator countries:
Germany, France, Italy, Belgium and

is estimated: as a panel with fixed effects within error
correction framework (using annual data for 1996 -2007)

Long run
DEBT t   5.91 0.64 ln(GDPt )  0.006 LRt  0.21 ln( PH t )
( 8.1)

Short run
( 2.2 )
( 7.9 )
( 9.2 )
DEBT t  DEBT t 1  0.24 ECTt 1  0.77  ln(GDPt )  0.005 LRt  0.15  ln( PH t )
( 3.4 )
( 7.7 )
( 1.8 )
( 5.2 )
where:
DEBT - debt to personal income ratio, GPC – real GDP pc,
LR - long term interest rate, and PH - house prices
Model results
Residuals suggest the debt to income ratio in the new member
states has largely evolved in line with its fundamentals

There is, however, some evidence of excessive debt growth in
recent years in
Estonia, and possibly the other Baltic economies and
Hungary
Hungarian residuals
Estonian residuals
0.2
0.08
0.15
0.06
0.1
0.04
0.05
0.02
-0.1
-0.15
-0.2
-0.04
-0.06
2007
2005
2003
2001
-0.02
1999
0
1997
2007
2006
2005
2004
2003
2002
2001
-0.05
2000
0
1999


1998

GDP per capita, the long term interest rate and house prices
1997

What is the equlibrium level of debt?


The evolution of debt to income ratio in line with its
determinants - GDP per capita, interest rates and house prices does not necessarily guarantee the sustainability of debt growth
in the long run
GDP per capita,interest rates, and house prices are subject to
cycles and/or bubbles


If bubbles burst or cycles are reverted, the debtors are still left with large
amounts of debt to repay, so as to reduce the level of debt to income ratio
to a new equilibrium
We argue that the equilibrium level of debt should correspond
to equilibrium levels of its determinants
Equilibrium level of debt to income

Calculating the equilibrium level of debt
requires removing bubbles in house prices and
cycles in GDP

Bubbles in house prices result in significant
deviations from equilibrium. Once they burst an
immediate adjustment of households’ balance
sheets is not possible
 Cycles in GDP growth – overborrowing during an
upturn may result in an increased risk of
insolvency during a downturn
Bubbles in house prices
There have been strong demand pressures on new member states’ housing markets,
suggesting that house prices may exhibit bubble properties
Average annual growth of house prices
in NMS and OMS
The rough size of the house price
bubble in Estonia
peak
7
35
30
25
% 20
peak
10
6
5
4
3
2
1
House prices
2008
2007
2006
2005
2004
2003
2002
2001
2000
2000 2001 2002 2003 2004 2005 2006 2007
NMS
OMS
1999
0
1998
0
5
1997
15
index of house prices
40
House prices with the bubble removed
Countries reporting the highest growth of house prices have been Latvia, Lithuania and
Estonia (plus Bulgaria and Slovakia).
Over the period 2000-2007 the average growth rate of house prices in the new member states
significantly exceeded the average growth rate of house prices in the selected old members
of the EU. This can be partially attributed to fundamental factors, partially to a bubble.
GDP cycle
Cycle-driven risks related to debt => nonperforming loans
Hungary
Estonia
2
9
1.5
8
7
1
6
0.5
5
%
4
-0.5
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
0
2
-1
1
-1.5
0
Output gap

3
NPL
%
7
6
5
4
3
% 2
1
0
-1
-2
-3
4.5
4
3.5
3
2.5
2
%
1.5
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007

1
0.5
0
Output gap
NPL
An increasing level of such loans reflects either unwise lending or
deteriorating macroeconomic situation which would imply that shares
of bad loans in total loans increase
Excessive indebtedness

Estimating the model of debt to income ratio
 for
selected NMS and
 major OMS


and removing bubbles/cycles from debt determinants
(defining their equilibrium levels)
allows us to determine 3 types of risks related to
excessive debt:
 Short
run risks
 Medium run risks
 Long run risks
Measuring excessive indebtedness

The riskiness of the dynamics of debt can be assessed against:

long term absolute equilibrium
 characterising developed
economies
 medium term sustainable
convergence path
 corresponding to the
equilibrium
level of fundamentals
 short term fundamentalsbased path
 which may be affected
by cycles and bubbles
Absolute equilibrium
Debt
to
income
ratio
Sustainable
convergence path
Fundamentals-based path
time
Source: own modification based on Kiss, Nagy, Vonnak, 2007
Medium- and long term equilibria
How sustainable is debt to income?
Probably (highly) unsustainable
in Estonia
Probably sustainable
in the Czech Republic
Relatively unsustainable
in Hungary
1.2
1.0
1.0
1.0
0.8
0.8
0.8
0.6
0.6
0.6
0.4
0.4
0.2
0.2
0.0
0.0
0.4
0.2
2004
2005
2006
2007
2008
2003
2000
2001
2002
1995
1996
1997
1998
1999
0.0
absolute equilibrium
Debt to income in Estonia
Estonian convergence path
Debt growth in Estonia has
exceeded not only its sustainable
convergence path, but also what the
absolute equilibrium level would
suggest
Absolute equilibrium
Debt to income in Hungary
Hungarian convergence path
In Hungary the debt to income ratio
has exceeded its sustainable
convergence growth path.
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
1.2
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
1.2
Absolute equilibrium
Debt to income in the Czech R.
Czech convergence path
The Czech level of debt
to income may have gradually
reached the absolute equilibrium
territory.
Sustainability of debt

3 types of risks

Long term risks (debt to income ratio exceeds the absolute equilibrium)
 Medium term risks (debt to income exceeds the sustainable convergence path)
 Short term risks (debt to income exceeds the fundamentals-based path)
Country
Long term risk
Deviation from the
absolute eq. path
Medium term risk
Deviation from the
convergence path
Short term risk
Deviation from the model path
Estonia
high
high
high
Latvia
low
high
high
Hungary
low
high
high
Czech Republic
low
low
low
Poland
low
low
low
Qualitative discussion of
risks arising from borrowing
in foreign currencies
Foreign currency borrowing
The volume of borrowing in foreign currencies in new member states has
tended to rise over time
%
100
80
60
40
20
0
2005
2006
2007
2008
2005
2006
2007
2008
2005
2006
2007
2008
2005
2006
2007
2008
2005
2006
2007
2008
2005
2006
2007
2008
2005
2006
2007
2008
2005
2006
2007
2008
2005
2006
2007
2008
2005
2006
2007
2008

LV
ES
Li
Euro
The highest share of
borrowing in foreign
currencies (and
predominantly in the euro)
has been recorded in the
Baltics.
BL
Other
HU
PO
Non domestic
RO
SL
CR
SR
Domestic
Central European
borrowers (in Poland and
Hungary) have borrowed
also in other currencies
(and in particular in the
Swiss franc)
Borrowing in foreign
currencies in the Czech
Republic and Slovakia has
been practically absent.
Determinants of foreign currency
borrowing
Key factors behind borrowing in foreign currencies:


Interest rate differencial
LV
EE
70
60
LT
50
RO
HU
40
30
SL
PL
0.8
LV
ES
0.7
0.6
LI
0.5
RM
HU
0.4
0.3
PO
SL
BL
0.2
0.1
0
10
SR
CR
0
BG
20
share of loans denominated in foreign currency
0.9
90
80
Exchange rate volatility
Mini case study
Latvia
Mini case study
Czech Republic
Avg share of foreign borrowing 20052008 (%)

0.5
1
1.5
2
2.5
3
3.5
4
4.5
5
standard deviation of effective exchange rate
CZ
0
-2
0
SK

2
4
Avg interest rate differential 2005-2008 (pp)
6

In normal times – borrowers in countries with a free float are exposed
to a greater level of currency fluctuations – and more serious risks
In turbulent times – borrowers in countries with a fixed exchange rate
may be exposed to risks of devaluation
Determinants of foreign currency
borrowing
Key factors behind borrowing in foreign currencies:

The ratio of credits to deposits (if credit
demand exceeds available funds banks borrow
abroad)
Mini case study
Estonia
1.6
1.4

The rising integration of financial
markets (manifesting itself e.g. in the
presence of foreign banks (which may
affect the availability of credit in a
foreign currency))
ES
100
1.2
SL
LI
1
BL
0.8
SR
CR
0.6
Share of foreign capital in the banking
system (%).)
Credit to deposit ratio

LV
HU
PO
RM
0.4
0.2
0
0
20
40
60
80
100
Share of foreign currency borrowing (%)
90
SR
CR
80
Expectations of EMU adherence
 Other
RM
LV
PO
70
60
50
HU
40
30
SL
20
10
0
0

ES
LI
BL
Mini case study
Slovakia
20
40
60
80
100
Share of foreign currency borrowing (%)
Conclusions
and policy implications
Lessons of the crisis of 2008
Conclusions



Over the period 1995-2007 the ratio of debt to income in the
NMS increased - which can be regarded as a natural element
of the catching up process
In Estonia, Latvia, and Hungery, the debt growth was,
however, worryingly fast - which could increase the
susceptibility of these economies to a crisis. Moreover, the
share of borrowing in foreign currencies was exceptionally
high.
As the crisis came, these economies were exposed to
particularly high risks
 Lessons of the crisis of 2008
Risks related to the volume of debt
Risks related to the currency structure of debt


Lessons of the crisis of 2008:
Risks related to the volume of debt

Did the scale of households’ indebtedness contribute to the
deterioration of the macroeconomic situation in the NMS during
the crisis?
Growing disequilibria and the adjustment
10
In the Baltic countries credit booms
of 2005-2008 generated imbalances in property
5
markets and led to serious „overheating” of
the Baltic economies. In effect, the recession, these countries 0
experienced, has been very deep („hard landing” =>
-5
the greater the imbalnace, the more painful the adjustment)

EE
LT
LV
-10

Over the analysed period, debt growth
in the Central European economies was relatively
more balanced, and the recession – somewhat milder

The relative weight of the domestic shock
(resulting from the internal disequilibrium) and
that of the external shock (resulting from the
global crisis) – have been varying across countries
-15
-20
-25
2004
2005
2006
2007
2008
2009
Deviation of the GDP grpwth rate from its
1995-2009 average
Lessons of the crisis of 2008:
Risks related to the currency composition
of debt

Did the scale of borrowing in forreign currencies contribute to
the deterioration of the macroeconomic situation in the NMS
during the crisis?
Depreciation of the Central European currencies

Depreciation of Central European currencies
(2008Q2) put borrowers at serious risk
 The risk was partially offset by decreases in foreign
interest rates
The Baltic currencies were exposed to speculation
(and the Latvian Lat in particular, which, contagiously,
could have spread to the neighbouring countries):
 Although the devaluation could have improved
the Baltic countries’ competitiveness, the large share
of borrowign in euro, could have generated risks of
insolvency of households (and domestic banks
(plus their foreign parent banks)). It could have also
affected the credibility of the Baltic countries’ central
banks and their plans of adoption of the euro
 The above mentioned risks did not materialise

140
130
120
110
100
90
80
70
60
2006Q2
PO
2009Q2
2008Q2
2007Q2
HU
CR
RM
Effective exchange rate 2008q2=100
Thank you
Literature

The volume of household debt





Barajas, Dell’Ariccia, Levchenko, 2007
Egert, Backe, Tumer, 2006
Kiss, Nagy, Vonnak, 2006
Cotarelli, Dell’Ariccia, Vladkova-Hollar, 2003
The currency structure of household debt




Cjabok, Hudecz, Tamasi, 2009
Rosenberg, Tripak, 2008
Basso, Calvo-Gonzalez, Jurgilas, 2007
Brzoza-Brzezina, Chmielewski, Niedźwiedzińska, 2007