Household debt and foreign currency borrowing in new member states of the EU
Ray Barrell E. Philip Davis
Tatiana FicAli Orazgani
National Institute of Economic and Social ResearchBrunel 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 growth of debt in the household sector
While credit growth is an essential element of the catching-up process in the NMS, excessive household indebtedness, especially if it is in foreign currency, may increase their susceptibility to a crisis and/or prolonged periods of slow economic growth as balance sheets are corrected
Objective
The objective of this paper is to
identify risks related to the evolution of debt in NMS and
derive implications for macroeconomic policy Rising household debt and foreign currency borrowing
– from the perspective of the 2008 global financial crisis
Outline
Household indebtedness in NMS: stylised facts
Quantitative assessment of the sustainability of debt
Qualitative discussion of risks arising from borrowing in foreign currencies
Conclusions
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
have recorded the fastest pace of debt growth
The Central European economies the debt to income ratios in
Poland, Hungary and the Czech Republic have been increasing relatively moderately
The Southern European countries 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
0.0
0.2
0.4
0.6
0.8
1.0
1.2
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
BG BL CR GE ES FR HU
IT LI LV PO RM SL
Debt drivers
The expansion of 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 of: GDP per capita, interest rates, house prices
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
Short run
)ln(21.0006.0)ln(64.091.5)2.9()2.2()9.7()1.8(
tttt PHLRGDPDEBT
)ln(15.0005.0)ln(77.024.0)2.5()8.1()7.7(
1)4.3(
1 tttttt PHLRGDPECTDEBTDEBT
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 HH debt to income ratio in the new member states
has largely evolved in line with its fundamentals GDP per capita, the long term interest rate and house prices
There is, however, some evidence of excessive debt growth in recent years in Estonia, and possibly the other Baltic economies and Hungary
Estonian residuals
-0.2
-0.15
-0.1
-0.05
0
0.05
0.1
0.15
0.2
19
97
19
98
19
99
20
00
20
01
20
02
20
03
20
04
20
05
20
06
20
07
Hungarian residuals
-0.06
-0.04
-0.02
0
0.02
0.04
0.06
0.08
19
97
19
99
20
01
20
03
20
05
20
07
What is the equlibrium level of debt?
The evolution of the debt to income ratio in line with its determinants - GDP per capita, interest rates and house prices - does not necessarily guarantee the sustainability of the debt growth
GDP per capita,interest rates, and house prices are subject to cycles and/or bubbles
=> We argue that the equilibrium level of debt should correspond to equilibrium levels of its determinants
Equilibrium levels of debt to income determinants House prices
Bubbles in house prices
GDP Cycles in GDP growth
Bubbles in house prices
Average annual growth of house prices in NMS and OMS
0
5
10
15
20
25
30
35
40
2000 2001 2002 2003 2004 2005 2006 2007
%
NMS OMS
peak
peak
There have been strong demand pressures on new member states’ housing markets, suggesting that house prices may exhibit bubble properties
This may have been supported by the scale of foreign ownership of banks and the degree of foreign currency borrowing by the personal sector
BL
CRHU
LI
LV
ES
PO
05
101520253035404550
0 20 40 60 80 100foreign currency borrowing of households
(as % of the total)
aver
age
annu
al h
ouse
pric
e gr
owth
200
0-20
007
BL
CRHU
LI
LV
ES
PO
05
101520253035404550
0 20 40 60 80 100foreign ownership of banks (%)
aver
age
annu
al h
ouse
pric
e gr
owth
200
0-20
007
The rough size of the house price bubble in Estonia
0
1
2
3
4
5
6
7
19
97
19
98
19
99
20
00
20
01
20
02
20
03
20
04
20
05
20
06
20
07
20
08
inde
x of
hou
se p
rices
House prices House prices with the bubble removed
GDP cycle Cycle-driven risks related to debt => nonperforming loans
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
Estonia
-3-2-1
01234
567
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
%
0
0.5
1
1.5
2
2.5
3
3.5
4
4.5
%
Output gap NPL
Hungary
-1.5
-1
-0.5
0
0.5
1
1.5
2
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
%
0
1
2
3
4
5
6
7
8
9
%
Output gap NPL
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
How to measure excessive indebtedness?
time
Debt to
income ratio
Source: own modification based on Kiss, Nagy, Vonnak, 2007
Absolute equilibrium
Sustainable convergence path
Fundamentals-based path
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 fundamentals-
based path which may be affected
by cycles and bubbles
Medium- and long term equilibriaHow sustainable is debt to income?
The Czech level of debtto income may have gradually reached the absolute equilibrium territory.
In Hungary the debt to income ratio has exceeded its sustainable convergence growth path.
Debt growth in Estonia has exceeded not only its sustainable convergence path, but also what the absolute equilibrium level would suggest
0.0
0.2
0.4
0.6
0.8
1.0
1.2
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
Absolute equilibriumDebt to income in the Czech R.Czech convergence path
Probably (highly) unsustainablein Estonia
Relatively unsustainable in Hungary
Probably sustainablein the Czech Republic
0.0
0.2
0.4
0.6
0.8
1.0
1.2
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
Absolute equilibriumDebt to income in HungaryHungarian convergence path
0.0
0.2
0.4
0.6
0.8
1.0
1.2
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
absolute equilibriumDebt to income in Estonia
Estonian convergence path
Sustainability of debt: summary 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 riskDeviation from the
absolute eq. path
Medium term riskDeviation from the
convergence path
Short term riskDeviation from the model path
Estonia high high high+ serious risks of a bubble in
house prices
Latvia low high serious risks of a bubble in house prices
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.
Key factors behind the growing share of borrowing in foreign currencies are rising integration of new member states’ financial markets with their Western European
counterparts rising demand for capital resulting from the convergence processes favourable interest rate differential availability of foreign funding expectations of EMU adherence
Foreign currency lending to HH to GDP
0.00
0.05
0.10
0.15
0.20
0.25
0.30
0.35
0.40
0.45
ES LV LI HU RM PO BL SL SR CR
2004 2005 2006 2007 2008
Foreign currency borrowing
0
20
40
60
80
1002005
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 BL HU PO RO SL CR SR
%
Euro Other Non domestic Domestic
The highest level of borrowing in foreign currencies is found in the Baltic countries. The composition of the foreign currency borrowing is biased towards euro
The Central European borrowers (in Hungary and Poland) tend also to borrow in other currencies (and the Swiss Franc in particular)
In the Slovak and Czech Republics foreign currency borrowing is almost completely absent
Foreign currency borrowing
Risks of borrowing in foreign currencies can be exacerbated – or mitigated – by currency regimes within which countries operate and their sustainability
Economies with a floating exchange rate and larger shares of borrowing in foreign currency are exposed to more serious risks BL
CR
HU
LI
LV
SLPO
ES
SR
RM
0
0.1
0.2
0.3
0.4
0.5
0.6
0.7
0.8
0.9
0 0.5 1 1.5 2 2.5 3 3.5 4 4.5 5
standard deviation of effective exchange rate
shar
e of
loan
s de
nom
inat
ed in
fore
ign
curr
ency
Estonian, Latvian and Lithuanian borrowers are sheltered by currency board or peg to the euro (and most of the foreign currency borrowing is denominated in euro)
However, there may exist risks of realignment
Borrowers in free float countries Poland, Hungary, Czech Republic and Romania may face relatively substantial exchange rate risks.
Regime Country
EMU Slovenia Slovakia
Peg to the Euro Latvia Floating exchange rate Czech Republic Poland Hungary Romania
Currency Board Bulgaria Estonia Lithuania (countries in italics fix the central exchange rate)
Conclusions
Conclusions
We have shown that debt-income ratios in new member states of Central and Eastern Europe have evolved broadly in line with fundamentals and can be regarded as sustainable in the long term Nevertheless, there are potential risks from overindebtedness in some
of these countries, notably Estonia, and possibly other Baltic economies, and Hungary (in the medium and short term)
Even in other countries whose debt-income ratios appear sustainable, there remain risks related to high levels of foreign currency debt. The degree of risk links also to the exchange rate regime, and suggests particular risks for borrowers in floating-rate Hungary and possibly Romania. Devaluation of currencies pegged to the euro would put borrowers in these countries at serious risk
Rising debt and foreign currency borrowing in NMS through the lenses of the 2008 crisis
Did the rising ratio of debt to GDP exacerbate the impact of the global financial crisis on NMS economies? Yes: Baltic states: ES, LV, LI No: Central European economies
Large credit booms (2005-2008) leading
to imbalances in the housing market and serious
overheating of the Baltic economies added to
the severity of the recession they have experienced
(“hard landing”) => the greater the imbalance
the harder the adjustment -12
-10
-8
-6
-4
-2
0
2
4
6
8
LT EE LV
T-4 T-3 T-2 T-1 T
Rising debt and foreign currency borrowing in NMS through the lenses of the 2008 crisis
Did the large share of foreign currency borrowing exacerbate the impact of the global financial crisis on NMS economies? Yes: Central European economies: PO, HU, RM No but serious risks: Baltic economies
Depreciation of the PO, HU, RM currencies put borrowers at serious risks:PO HU RM
EUR: 14.4% 11.5% 6.8 2008Q318.7% 11.8% 11.9% 2008Q4
CHF: 20.4% 17.4% 12.5% 2008Q320.7% 13.7% 13.8% 2008Q4
There was a wave of speculation on devaluation of the Baltic currencies, and the Latvian lat especially.