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Household debt and foreign currency borrowing in new member states of the EU Ray 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 n Many new members of the EU n Poland, Hungary, Czech Republic, Slovakia, Motivation n Many new members of the EU n Poland, Hungary, Czech Republic, Slovakia, Slovenia, Estonia, Latvia, Lithuania, Bulgaria, Romania have been experiencing rapid debt growth in the household sector n n 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? n

Objective n The objective of the paper is to identify risks related to the Objective n The objective of the paper is to identify risks related to the evolution of debt in NMS and ¨ derive implications for macroeconomic policy ¨ n Households’ borrowing: its scale and currency composition – lessons of the global financial crisis of 2008

Outline Household indebtedness in the NMS: stylised facts n Quantitative assessment of the sustainability Outline Household indebtedness in the NMS: stylised facts n Quantitative assessment of the sustainability of debt n Qualitative discussion of risks arising from borrowing in foreign currencies n Conclusions n ¨ Lessons of the crisis of 2008

Household indebtedness in NMS: stylised facts Household indebtedness in NMS: stylised facts

Stylised facts n New member states’ debt levels have been catching up relatively rapidly Stylised facts n New member states’ debt levels have been catching up relatively rapidly with levels observed in the old members of the EU n The Baltics n n The Central European economies n n have recorded the fastest pace of debt growth the debt to income ratios in Poland, Hungary and the Czech Republic have been increasing relatively moderately The Southern European countries n 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 n The expansion of the household debt results from two factors: ¨ Debt drivers n The expansion of the household debt results from two factors: ¨ the n convergence process in which case the expanding indebtedness constitutes a necessary element of the medium-, long term macroeconomic equilibrium ¨ short term borrowing trends n driven by the business cycle or by autonomous factors such as financial liberalisation linked to international competition or foreign ownership of the banking system. n 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 Quantitative assessment of sustainability of debt in NMS

Qualitative assessment of debt sustainability n 3 steps 1. Estimate a model of debt Qualitative assessment of debt sustainability n 3 steps 1. Estimate a model of debt n What does the debt to income ratio depend on? 2. Detemine the equilibrium level of debt n How do you measure the equilibrium? 3. Assess excessive indebtedness of households In the short run n In the medium run n In the long run n

The model of debt to income n The model ¨ defines the debt to The model of debt to income n The model ¨ defines the debt to income ratio as a function n GDP per capita, interest rates, house prices of: ¨ encompasses: n selected new member states: Poland, Hungary, Czech Republic, Estonia, Latvia and Lithuania n 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) n Long run n Short run 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 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. 15 -0. 2 -0. 04 -0. 06 2007 2005 2003 2001 -0. 02 1999 0 1997 2006 2005 2004 2003 2002 2001 -0. 05 2000 0 1999 ¨ ¨ 1998 n GDP per capita, the long term interest rate and house prices 1997 n

What is the equlibrium level of debt? n n The evolution of debt to What is the equlibrium level of debt? n n 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 ¨ n 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 n Calculating the equilibrium level of debt requires Equilibrium level of debt to income n 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’ Bubbles in house prices There have been strong demand pressures on new member states’ housing markets, suggesting that house prices may exhibit bubble properties 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 n Cycle-driven risks related to debt => nonperforming loans n An increasing GDP cycle n Cycle-driven risks related to debt => nonperforming loans n 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 n Estimating the model of debt to income ratio ¨ for selected Excessive indebtedness n Estimating the model of debt to income ratio ¨ for selected NMS and ¨ major OMS n n 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 n The riskiness of the dynamics of debt can be assessed Measuring excessive indebtedness n The riskiness of the dynamics of debt can be assessed against: long term absolute equilibrium n characterising developed economies ¨ medium term sustainable convergence path n corresponding to the equilibrium level of fundamentals ¨ short term fundamentalsbased path n which may be affected by cycles and bubbles ¨ Debt to income ratio Absolute equilibrium 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 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 0. 8 0. 6 0. 4 0. 2 0. 0 0. 4 0. 2 2004 2005 2006 2007 2008 2000 2001 2002 2003 1995 1996 1997 1998 1999 0. 0 absolute equilibrium Debt to income in 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 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 n 3 types of risks Long term risks (debt to income Sustainability of debt n 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 Latvia low high Hungary low high Czech Republic low low Poland low low

Qualitative discussion of risks arising from borrowing in foreign currencies Qualitative discussion of risks arising from borrowing in foreign currencies

Foreign currency borrowing n The volume of borrowing in foreign currencies in new member Foreign currency borrowing n The volume of borrowing in foreign currencies in new member states has tended to rise over time The highest share of borrowing in foreign currencies (and predominantly in the euro) has been recorded in the Baltics. Central European borrowers (in Poland 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: ¨ ¨ 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 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 (%) n 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 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 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 ES 1. 2 SL BL 0. 8 SR CR 0. 6 LV HU PO RM 0. 4 0. 2 0 0 20 40 60 80 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)) 100 LI 1 ¨ Share of foreign capital in the banking system (%). ) Credit to deposit ratio n 100 Share of foreign currency borrowing (%) 90 SR CR 80 Expectations of EMU adherence ¨ Other RM ES LI LV PO 70 60 50 HU 40 30 SL 20 10 0 0 ¨ 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 and policy implications Lessons of the crisis of 2008

Conclusions n n n Over the period 1995 -2007 the ratio of debt to Conclusions n n n 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 n Lessons of the crisis of 2008 Risks related to the volume of debt Risks related to the currency structure of debt n n

Lessons of the crisis of 2008: Risks related to the volume of debt n Lessons of the crisis of 2008: Risks related to the volume of debt n 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 In the Baltic countries credit booms of 2005 -2008 generated imbalances in property markets and led to serious „overheating” of the Baltic economies. In effect, the recession, these countries experienced, has been very deep („hard landing” => the greater the imbalnace, the more painful the adjustment) ¨ 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 ¨ 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 Lessons of the crisis of 2008: Risks related to the currency composition of debt n 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 n Depreciation of Central European currencies (2008 Q 2) 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 n Effective exchange rate 2008 q 2=100

Thank you Thank you

Literature n The volume of household debt Barajas, Dell’Ariccia, Levchenko, 2007 ¨ Egert, Backe, Literature n The volume of household debt Barajas, Dell’Ariccia, Levchenko, 2007 ¨ Egert, Backe, Tumer, 2006 ¨ Kiss, Nagy, Vonnak, 2006 ¨ Cotarelli, Dell’Ariccia, Vladkova-Hollar, 2003 ¨ n The currency structure of household debt Cjabok, Hudecz, Tamasi, 2009 ¨ Rosenberg, Tripak, 2008 ¨ Basso, Calvo-Gonzalez, Jurgilas, 2007 ¨ Brzoza-Brzezina, Chmielewski, Niedźwiedzińska, 2007 ¨