Central Europe
Credit - Big Party, Big Hangover, Now What?
October 26, 2009

By Pasquale Diana | London

Credit-driven recession is playing according to script. In the years prior to the breakout of the recent crisis, double-digit credit growth across CEE was the norm, not the exception. While central banks and international organizations were concerned by the speed of lending growth, it was generally viewed as a natural by-product of ‘catching up' to richer EU neighbors, which had significantly higher credit to GDP ratios. The abrupt bursting of the credit bubble has shown that convergence may well still hold in the medium-to-long term, but there can be serious bumps along the road. While year-on-year credit growth has remained in positive territory everywhere in the region (except for the Baltics), this is the result of carryover effects from last year and the impact of FX weakness: local currency depreciation inflates the value of loans denominated in FX even if no new lending takes place. Looking at the statistics for new lending corrected for FX swings, credit growth is effectively almost zero in most countries.

Real estate prices collapse and current account deficits adjust as domestic demand plunges. The drought of new credit is having the expected effects. Real estate prices have fallen sharply, as the marginal buyer has disappeared and financing is problematic. Large current account deficits have shrunk dramatically and in some extreme cases (Baltics) are turning into surpluses. Consumption has weakened, especially in countries which have seen fiscal tightening as mandated by the IMF, as consumers had no way of borrowing against future income. Investment also contracted sharply, as bank loans were no longer available and reinvested earnings from similarly credit-constrained western parents also suffered. By and large, the countries which had the highest credit boom over recent years also suffered the most severe output losses.

Credit growth will resume as the recovery takes hold. But at what pace? As the global macro outlook improves, the economies of CEE will no doubt receive a boost. As our global team has highlighted in previous research, a resurgence in credit is historically not a pre-condition for the recovery to take place (see "Bigger than the Big 5", The Global Monetary Analyst, October 14, 2009). That said, when the recovery truly takes hold, credit and output are inextricably linked, with one reinforcing the other. This note focuses on what the outlook for credit growth will be in the coming years, and how it is likely to influence the overall economy.

Substantial slowdown in credit growth from the 2004-07 period. We see several reasons to expect credit growth to resume at a pace well below the one that prevailed in the pre-crisis boom period. The main reasons are:

•           Regulatory environment is changing. Local authorities, supported by the ECB, are likely to be much less complacent than in the past about credit dynamics. In most of the region, the proliferation of FX loans in CHF and EUR dramatically increased the FX risk run by unhedged borrowers, while at the same time reducing the efficacy of domestic monetary policy. As a result, inflation-targeting central banks were unable to focus on domestic CPI dynamics, but had to pay disproportionate attention to FX moves, because of their impact on financial stability and the quality of the loan book. A resumption of lending in local currency, rather than FX, would allow for a more ‘standard' monetary policy approach, in which the FX rate is important only insofar as it affects the CPI outlook. The recent change in tone by the NBH in Hungary is instructive: the bank now feels that it is appropriate to put in place much stricter LTV ratios for FX loans than HUF loans, in order to discourage the latter. Local banks have already stated opposition to these plans, arguing that they are too severe. If implemented, they would mean a severe shock to home affordability. Corporates, which are naturally hedged (their export revenues are in FX), should be relatively less affected.

•           FX borrowers more cautious. The recent episode taught a valuable lesson to unhedged FX borrowers (mostly households), namely that carry trades can go wrong. Even after the recent rally, the average monthly payment on a CHF mortgage taken out in Hungary in 2007-08 is up around 20% (CHF mortgage rates did not fall, despite the collapse in CHF Libor rates). Note that while the debt stock is still fairly low relative to its richer Western peers, the Hungarian debt service obligation is over 10% of disposable income according to the NBH, well above the EMU average.

•           Structural changes in funding profile. Our equity research colleagues (Ronny Rehn, Hadrien De Belle) believe that the CEE banking model is moving towards a more self-funded model. In other words, parent banks will not pour capital aggressively into their subsidiaries to the same extent as before, but will increasingly rely on local deposits. In addition, Ronny notes that there is a risk that increased co-operation among regulators might well curb cross-border loans (i.e., loans originated directly from abroad, to avoid local reserve requirements).

What does this all mean for the macro outlook? Our banking research colleagues think that in the post-crisis period credit growth could slow to one-third of the 30% pre-crisis growth rate across CEE. Clearly, some countries will be affected more severely (Bulgaria, Romania, Hungary), others less (Czech Republic, Poland). Below we sketch out what we think the main consequences for the economy will be.

•           Smaller equilibrium current account deficits, slower real estate market and construction activity. Over the recent period, current account deficits reached clearly unsustainable levels (15-25% of GDP in Baltics and Balkans, 7-8% in Hungary and Poland). Their rapid unwinding is bringing them towards zero very fast. When import flows recover and some FDI/portfolio inflows resume, deficits will widen again, but clearly nowhere near previous levels. Also, real estate bubbles will be harder to come by, as cheap funding will no longer be available. Moreover, construction activity will not continue to outpace GDP growth as it has done in dramatic fashion over the recent years in Romania and Bulgaria, among others.

•           More degrees of freedom for domestic monetary policy. It looks likely that the credit slowdown will affect mostly FX loans, which were the segment of the credit market which rose the fastest in 2004-08. The stock of FX loans will remain significant and central banks will never be able to ignore it altogether. At current maturities, it would take another 10-15 years to work off the stock of FX loans entirely. However, if more of the new borrowing takes place in local currency (so local rates become more relevant), at least monetary authorities will feel that policy is gaining greater traction at the margin and that FX is not the only channel via which policy can function.

•           Slower convergence dynamics, less benign outlook for regional FX. A thorough analysis of long-term convergence trends is beyond the scope of this piece. However, we think that cheap money, strong debt-financed FDI and fast banking inflows that prevailed in 2004-07 were a fortunate combination of events which is unlikely to repeat itself. In the extreme, a sudden disappearance of FX lending in the post-crisis world would imply an effective rate hike for, say, Hungarian borrowers of several hundreds basis points from the days of cheap CHF loans. Even if EUR funding was still available, rates would be around 200bp higher than in CHF. The NBH estimates that had the tighter rules on FX loans it now proposes been available five years ago, GDP growth would have been 0.5pp lower each year on average. While no simulations are available elsewhere, one can assume that the impact on countries which had real estate and construction booms (Bulgaria, Romania) would have been much larger.

In addition to less easy credit, we subscribe to the view that a lot of capital has been destroyed in this recession, and will probably not come back so quickly. Some projects which received financing in the good years should probably never have gone ahead. The heady growth rates of 2004-07 were probably a one-off, unlikely to be repeated in the coming years. It is instructive that a number of institutions and policymakers are buying into the idea that medium-term growth trends across the region are set to slow . Structural arguments strongly suggest that these economies will continue to outperform core EU, which is likely to experience a potential growth slowdown of its own. However, convergence will be slower, and it would be a mistake to assume that pre-crisis convergence trends will resume once this recession is over. The implication for currencies is that trend appreciation will be lower than previously expected, as nominal convergence will also take place more slowly than previously thought.

Bottom Line

We argue that even after the current crunch is over, credit will not be as generous as in the pre-Lehman world. We believe that a combination of tighter local regulation, better EU co-ordination among regulators and more risk-averse behavior by borrowers will likely result in a sharp drop in credit growth from the booming double-digit rates prevailing in 2004-07. The implications will be reduced likelihood of real estate bubbles, a diminished role for construction activity and overall slower trend GDP growth. Convergence dynamics to richer EU countries will still play out, but at a slower rate than previously assumed.

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