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

1
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

2
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

3
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

4
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

5
Household indebtedness in NMS stylised facts
6
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

7
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.

8
Quantitative assessment of sustainability of debt
in NMS
9
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

10
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
11
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

12
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
• gt We argue that the equilibrium level of debt
  should correspond to equilibrium levels of its
  determinants

13
Equilibrium levels of debt to income determinants

• House prices
• Bubbles in house prices
• GDP
• Cycles in GDP growth

14
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
15
GDP cycle

• Cycle-driven risks related to debt gt
  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

16
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

17
How to measure 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 fundamentals-
• based 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
18
Medium- and long term equilibria How
sustainable is debt to income?
Probably (highly) unsustainable in Estonia
Relatively unsustainable in Hungary
Probably sustainable in the Czech Republic
The Czech level of debt to 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
19
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 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 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
20
Qualitative discussion of risks arising from
borrowing in foreign currencies
21
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

22
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
23
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

24
Conclusions
25
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

26
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) gt the greater the imbalance
• the harder the adjustment

27
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.