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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

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household debt and foreign currency borrowing in new member states of the eu

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
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-upprocess in the NMS, excessive household indebtedness, especially if it is in foreign currency, may increase their susceptibility to a crisisand/or prolonged periods of slow economic growth as balance sheets are corrected
objective
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
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
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
debt drivers
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.
qualitative assessment of debt sustainability
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 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

where:

DEBT - debt to personal income ratio, GPC – real GDP pc,

LR - long term interest rate, and PH - house prices

model results

Hungarian residuals

Estonian residuals

0.08

0.2

0.15

0.06

0.1

0.04

0.05

0.02

0

0

2005

2006

2007

2003

2004

1997

1998

1999

2000

2001

2002

-0.05

1997

1999

2001

2003

2005

2007

-0.02

-0.1

-0.04

-0.15

-0.06

-0.2

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
what is the equlibrium level of debt
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 correspondto equilibrium levels of its determinants

equilibrium levels of debt to income determinants
Equilibrium levels of debt to income determinants
  • House prices
    • Bubbles in house prices
  • GDP
    • Cycles in GDP growth
bubbles in h ouse price s

50

50

LV

LV

45

45

40

40

average annual house price growth

average annual house price growth

35

35

2000-20007

2000-20007

30

30

25

25

LI

LI

ES

ES

BL

BL

20

20

PO

PO

15

15

10

10

CR

CR

5

5

HU

HU

0

0

0

20

40

60

80

100

0

20

40

60

80

100

foreign currency borrowing of households

foreign ownership of banks (%)

(as % of the total)

Bubbles in house prices

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

gdp cycle
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
excessive indebtedness
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
How to measure excessive indebtedness?

Absolute equilibrium

Debt

to

income

ratio

Sustainable

convergence path

Fundamentals-based path

time

Source: own modification based on Kiss, Nagy, Vonnak, 2007

  • 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 equilibria how sustainable is debt to income

1.2

1.0

1.2

1.2

0.8

1.0

1.0

0.6

0.8

0.8

0.4

0.6

0.6

0.2

0.4

0.4

0.0

0.2

0.2

2007

2008

2006

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

0.0

0.0

Absolute equilibrium

2004

2005

2006

2007

2008

2002

2003

1995

1996

1997

1998

1999

2000

2001

Debt to income in the Czech R.

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

Czech convergence path

absolute equilibrium

Absolute equilibrium

Debt to income in Estonia

Debt to income in Hungary

Estonian convergence path

Hungarian convergence path

Medium- and long term equilibriaHow sustainable is debt to income?

Probably sustainable

in the Czech Republic

Probably (highly) unsustainable

in Estonia

Relatively unsustainable

in Hungary

Debt growth in Estonia has

exceeded not only its sustainable

convergence path, but also what the absolute equilibrium level would

suggest

In Hungary the debt to income ratio

has exceeded its sustainable

convergence growth path.

The Czech level of debt

to income may have gradually

reached the absolute equilibrium

territory.

sustainability of debt summary
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)
foreign currency borrowing
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 borrowing22
Foreign currency borrowing

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 borrowing23

0.9

LV

0.8

ES

0.7

0.6

LI

RM

0.5

share of loans denominated in foreign currency

HU

0.4

PO

0.3

SL

BL

0.2

0.1

SR

CR

0

0

0.5

1

1.5

2

2.5

3

3.5

4

4.5

5

standard deviation of effective exchange rate

Foreign currency borrowing
  • 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.
  • 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
conclusions25
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

8

6

4

2

0

LT

EE

LV

-2

-4

-6

-8

-10

-12

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 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

rising debt and foreign currency borrowing in nms through the lenses of the 2008 crisis27
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 2008Q3

18.7% 11.8% 11.9% 2008Q4

    • CHF: 20.4% 17.4% 12.5% 2008Q3

20.7% 13.7% 13.8% 2008Q4

  • There was a wave of speculation on devaluation of the Baltic currencies, and the Latvian lat especially.