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

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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

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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 - PowerPoint PPT Presentation

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Page 1: 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 FicAli Orazgani

National Institute of Economic and Social ResearchBrunel University

National Bank of Poland

Page 2: Household debt and foreign currency borrowing in new member states of the EU

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

Page 3: Household debt and foreign currency borrowing in new member states of the EU

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

Page 4: Household debt and foreign currency borrowing in new member states of the EU

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

Page 5: Household debt and foreign currency borrowing in new member states of the EU

Household indebtedness in NMS:

stylised facts

Page 6: Household debt and foreign currency borrowing in new member states of the EU

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

Page 7: Household debt and foreign currency borrowing in new member states of the EU

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.

Page 8: Household debt and foreign currency borrowing in new member states of the EU

Quantitative assessment of sustainability of debt in NMS

Page 9: Household debt and foreign currency borrowing in new member states of the EU

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

Page 10: Household debt and foreign currency borrowing in new member states of the EU

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

Page 11: Household debt and foreign currency borrowing in new member states of the EU

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

Page 12: Household debt and foreign currency borrowing in new member states of the EU

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

Page 13: Household debt and foreign currency borrowing in new member states of the EU

Equilibrium levels of debt to income determinants House prices

Bubbles in house prices

GDP Cycles in GDP growth

Page 14: Household debt and foreign currency borrowing in new member states of the EU

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

Page 15: Household debt and foreign currency borrowing in new member states of the EU

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

Page 16: Household debt and foreign currency borrowing in new member states of the EU

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

Page 17: Household debt and foreign currency borrowing in new member states of the EU

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

Page 18: Household debt and foreign currency borrowing in new member states of the EU

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

Page 19: Household debt and foreign currency borrowing in new member states of the EU

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

Page 20: Household debt and foreign currency borrowing in new member states of the EU

Qualitative discussion of risks arising from borrowing

in foreign currencies

Page 21: Household debt and foreign currency borrowing in new member states of the EU

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

Page 22: Household debt and foreign currency borrowing in new member states of the EU

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

Page 23: Household debt and foreign currency borrowing in new member states of the EU

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)

Page 24: Household debt and foreign currency borrowing in new member states of the EU

Conclusions

Page 25: Household debt and foreign currency borrowing in new member states of the EU

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

Page 26: Household debt and foreign currency borrowing in new member states of the EU

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

Page 27: Household debt and foreign currency borrowing in new member states of the EU

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.