Republic of Serbia: Selected Issues

High capital inflows and rising vulnerabilities underscore the importance of a comprehensive approach to ensuring stability. Standard balance sheet indicators mask a substantial build-up of exposures to exchange rate, maturity, and rollover risks. Household balance sheet risks originate from currency mismatches owing to credit euroization. The fiscal balance has a strong and significant impact on the current account in Serbia. The model is broadly able to reproduce recent economic and policy developments in Serbia. The analysis indicates that privatization can result in sizable fiscal savings.

Abstract

High capital inflows and rising vulnerabilities underscore the importance of a comprehensive approach to ensuring stability. Standard balance sheet indicators mask a substantial build-up of exposures to exchange rate, maturity, and rollover risks. Household balance sheet risks originate from currency mismatches owing to credit euroization. The fiscal balance has a strong and significant impact on the current account in Serbia. The model is broadly able to reproduce recent economic and policy developments in Serbia. The analysis indicates that privatization can result in sizable fiscal savings.

III. Household Credit14

Objective: Assess macro-financial vulnerabilities related to household credit growth.

Main findings: Household balance sheet risks originate from currency mismatches due to credit euroization, which in turn is an indirect credit risk for banks. However, the overall level of household credit is still low and buffers have been installed through prudential measures.

Policy implications: Financial vulnerabilities are on the rise and are amplifying macro imbalances. Ensuring financial stability will entail further strengthening of prudential regulation accompanied by supportive macroeconomic policies.

A. Introduction

34. Rapid credit growth in emerging European economies has ushered a spirited debate as to whether this catching-up process has ramifications for financial stability. Notably, the share of private sector credit allocated to the household sector has grown significantly in most emerging European countries, including Serbia. Balancing the benefits of access to finance for households while tackling the sustainability of increasing vulnerabilities, has become a key policy challenge.15 This paper analyzes the vulnerabilities related to household credit growth in Serbia, while providing a cross-country perspective on key policy questions related to macro-prudential concerns, balance sheet mismatches, impact of credit euroization, and the framework and effectiveness of policies.

B. Background

35. Serbia has been a late riser in financial deepening among the emerging European economies (Figures 1 and 2). The overall level of private sector credit is lower than in most of its European peers, at about 10 percent of GDP as of end-2006. The pace of growth of total private sector credit in Serbia, however, has been one of the highest among its peers over the past six years.

Figure 1.
Figure 1.

Selected Household Credit, 2006

(Percent of GDP)

Citation: IMF Staff Country Reports 2008, 055; 10.5089/9781451834901.002.A003

Source: IMF staff estimates.
Figure 2.
Figure 2.

Selected Household Credit, 2006

(Percent of total private sector credit)

Citation: IMF Staff Country Reports 2008, 055; 10.5089/9781451834901.002.A003

36. Household credit has been the main driver of credit expansion in Serbia, having risen from a marginal share in 2000 to 11.7 percent of GDP as of September 2007 (Figure 3). Over the same period, its share in total private sector credit has more than quadrupled to 41 percent. Consumer loans account for about 58 percent of total household credit in Serbia, and while the share of mortgages is low at about 27 percent as of September 2007, it is growing rapidly (Figure 4). With a relatively young market, the most important product is cash credit—uncollateralized general purpose consumer loans—although the recent prudential measures aim at stemming its growth. Most household loans carry variable interest rates and are denominated in or indexed to foreign exchange.

Figure 3.
Figure 3.

Serbia: Household Credits, 2002-07

Citation: IMF Staff Country Reports 2008, 055; 10.5089/9781451834901.002.A003

Source: NBS.
Figure 4.
Figure 4.

Serbia: Components of Household Credit, September 2007

(percent)

Citation: IMF Staff Country Reports 2008, 055; 10.5089/9781451834901.002.A003

Key Issues

37. The rapid growth in household credit in Serbia reflects a combination of factors related to economic convergence and financial deepening. This is in line with the empirical evidence indicating a positive relationship between the household credit-to-GDP ratio and per capita income for most emerging European economies (Figure 5). Expectations of sustained growth—linked to EU convergence—and financial liberalization can lead more households to borrow against future income growth. Lower long-term interest rates and a decline in inflation may have also stimulated the demand for and supply of credit. Furthermore, foreign banks, which dominate the Serbian market, have aggressively focused on increasing market share in consumer finance which offers higher margins. Cross-border capital flows, facilitated by these banks, have augmented the availability of funds to finance household credit in Serbia.

Figure 5.
Figure 5.

Household Credit and Per Capita GDP in Emerging Europe, 2006

Citation: IMF Staff Country Reports 2008, 055; 10.5089/9781451834901.002.A003

Source: ECB.Note: EU13 countries include Austria, Belgium, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, Netherlands, Portugal, Slovenia and Spain.

38. Rapid household credit growth raises both macro and prudential concerns. Prudential concerns are related to the ability and resources of regulatory and supervisory authorities to comprehensively address the various sources of risk (e.g., balance sheet mismatches). The main challenges are posed by the rapid growth in household credit and the ability of foreign banks to raise alternative funding sources.

39. One macro implication of credit booms is the possibility of asset market, notably real estate market, imbalances. A combination of high demand for housing, enabled by a credit boom, and limited supply can inflate asset prices, thus increasing the consumers’ net worth. The latter could lower risk premia and—along the lines of Bernanke and Gertler (1989)—encourage greater leverage, thereby rendering households more exposed to asset price fluctuations (Ortalo-Magne and Rady, 2006). In many emerging European countries, house prices have experienced rapid growth and generated concerns of potential asset price inflation (Sirtaie and Skamenlos, 2007). In Serbia, the exemption from mandated reserve requirements for mortgage loans insured by the National Mortgage Insurance Company, has contributed to a sharp increase in housing loans, although the extent of housing price increases is difficult to fathom due to the lack of reliable data. Rising mortgage lending, notably in or indexed to foreign currency, albeit from a low base, creates vulnerability to a decline in house prices, higher price volatility, and exchange rate depreciation with potential downside risks to nonperforming loans.

40. Furthermore, rapid credit growth—enabled by large foreign inflows and expansionary domestic policies—also led to rising external deficits and vulnerabilities. Besides the large capital inflows, the high credit growth in Serbia was compounded by large wage increases of 20–30 percent in the public sector and fiscal relaxation during electoral cycles. These increased household income and encouraged even greater leverage. The resulting growth of aggregate demand outpaced supply, leading to a widening of the current account deficit (Figure 6). As discussed in chapter V, the importance of credit in explaining the rising current account deficit in Serbia is statistically significant.16

Figure 6.
Figure 6.

Serbia: Net Credit to Private Sector and Imports, 2007

(percent)

Citation: IMF Staff Country Reports 2008, 055; 10.5089/9781451834901.002.A003

Sources: NBS and IMF staff. estimates.

41. Despite the growing indebtedness, Serbian households appear to have a positive net worth.17 Deposit growth and other sources of income, such as remittances, have so far mitigated the rise in gross liabilities of the household sector. Moreover, the current debt servicing burden is relatively low, aided by prudential measures that limit monthly installments on household debt to 30 percent of net monthly income.

42. Nevertheless, Serbian households’ balance sheets appear to be exposed to risks originating from currency mismatches and interest rate exposure. Over 80 percent of loans to households are linked to foreign currencies (mainly euro and to a lesser extent the Swiss franc) and they largely carry variable interest rates (Figure 7). Even though households’ foreign-currency deposits are sizeable on aggregate, borrowers and savers may only partly overlap. As in many emerging markets, there is a concern that the consequences of a large depreciation may not be fully understood by unhedged borrowers.18 Thus, the rising exposure to exchange rate risks creates indirect credit risks for banks, which could face a sharp deterioration in asset quality if exchange rate risks were to materialize.

Figure 7.
Figure 7.

Credit Euroization, 2006

(percent of total credit)

Citation: IMF Staff Country Reports 2008, 055; 10.5089/9781451834901.002.A003

Source: WEO.

43. Tentative calculations by staff indicate that the exposure of Serbian banks to the household sector makes them vulnerable to sharp exchange rate shocks, albeit with some mitigating factors. A dinar depreciation in the order of 25 percent depreciation, for instance, could result in a decline in the capital-to-asset ratio of the banking sector from 19 percent to about 14½ percent. While such a shock would not make the risk-weighted capital adequacy fall below the minimum requirement of 12 percent, it could constrain banks’ ability to extent new credit, aggravating rollover and interest rate risks.19 These results, however, are to be treated with caution, as they are based on the banking system’s exposure to the household sector only. Similar calculations that include the entire foreign currency balance sheet position of the banks indicate a lower level of vulnerability. Nevertheless, the concern over a potential deterioration in asset quality and profitability from an exchange rate shock is compounded by the recent increase of household non-performing loans, although from a low base.20 That said, the net financial position of the banks and the low base of household credit allows the financial system to better withstand such shocks. Also, household assets, including mattress money, in foreign currency as well as foreign remittances could mitigate these concerns.

C. Policy Developments and Lessons from Other Countries

44. In general, prudential regulation of household credits has to strike a balance between encouraging healthy growth of credit while minimizing potential economic distortions of regulatory compliance. Ensuring that minimum prudential standards in household lending are met and not circumvented is a key challenge in most emerging European countries. In particular, verification of income (especially foreign exchange income), loan-to-value and loan-to-income ratios, and maturity mismatches are key parameters for enforcement. A public information campaign on the risks of borrowing is beneficial. Regulators generally consider certain benchmarks, such as maximum loan-to-value ratios (70–80 percent), maximum debt-service/income ratios (35–40 percent for all household credits), a minimum repayment rate (10 percent of outstanding balance for credit cards) and a maximum credit card limit (equal to 3–4 months income). Strict assessment of real estate collateral is also important.

45. The NBS has recently implemented tighter prudential policies and continues to strengthen its regulatory and supervisory framework. The new regulations tightened foreign exchange exposure limits, increased capital requirements, broadened reserve requirements on foreign liabilities, and extended regulatory coverage to leasing companies (Box 1). Banking supervision has improved following the implementation of the new banking law in October, 2006. After the establishment of the Central Credit Registry in mid-2002, the NBS has launched public information campaigns on financial literacy that articulate the risks of borrowing.21 A wide range of material has been made available to bank customers drawing their attention to the risks involved in various banking products, including those denominated in, or linked to a foreign currency. The credit bureau has significantly enhanced the availability of credit information. Additionally, the monitoring of credit risk induced by foreign exchange risk will be improved and new rules for unhedged borrowers will be implemented. Banks have adopted the NBS’s framework for the analysis of borrowers’ exposure to exchange rate risks, although its implementation remains difficult. Capital regulation to regulate the management of market risks has been issued. A formal MOU has been signed with the national supervisors in Greece, while informal contact is being maintained with other relevant home supervisors. The Bank Supervision Department of the NBS is currently working on a strategy for the implementation of Basel II standards.

Serbia: Recent Prudential Measures to Manage Risk of Rapid Credit Growth

  • HH debt to income ratio: monthly installment cannot exceed 30% of net monthly income. This can go up to 50 percent including mortgages.

  • Maximum maturity of cash loans to households was lowered to 2 years.

  • Limit the minimum monthly repayment on revolving credit cards (5 percent) and maximum maturity of certain consumer loans (5 to 7 years).

  • A risk weight of 125 percent to be used in the calculation of risk-weighted assets that are FX or FX indexed loans if the borrower can’t rely on inflow in the same currency. Currently this is only for exposures exceeding dinars 10 million. In 2008, the minimum threshold will be lifted.

  • HH lending cap to be reduced from 200 percent of Tier I capital to 150 percent (from 2008). All mortgages are included in this calculation.

46. The tightening of prudential measures and strengthening of risk management of banks is in line with developments in several other emerging European countries. Many emerging European countries with a high degree of euroization are taking measures to tighten prudential regulations on foreign-exchange linked loans to households. These include higher/differentiated risk-weights on unhedged foreign currency loans (Croatia, Poland, and Slovakia), higher liquidity requirements (Croatia and Romania), and conducting more frequent stress tests (Czech Republic, Hungary and Poland). Some countries are even taking administrative measures, such as credit ceilings, as a last resort measure. There has been enhanced supervision of banks with foreign exchange lending (more frequent off-site and on- site inspections), especially the ones that are in a weaker position. Countries have also encouraged financial institutions to conduct public awareness campaigns to educate borrowers on the risks involved in foreign exchange lending (Hungary). Several central banks have pointed to the risks associated with mortgage loans in foreign currencies.

47. These measures, however, have shown mixed results in curbing credit growth, although they have generally strengthened the health of the financial system by building buffers. Credit growth, especially to households, remains strong in many emerging European countries, aided by foreign banks’ ability to obtain funds through rapid deposit growth and borrowing from abroad (including from parent banks). Circumvention of measures (administrative or prudential) by borrowers through direct foreign borrowing or from less supervised financial institutions (including through leasing and credit cards) have been common. For instance, in Croatia, direct credit controls led to circumvention and disintermediation, while in Estonia and Romania, increased financing from abroad continued to support strong credit growth. Administrative limits on bank credit have had some impact in Bulgaria but broader credit growth remained unabated. Nevertheless, countries like Ukraine and Bosnia saw some slowdown following tightening measures. In the case of Serbia, it remains to be seen whether the effectiveness of macro-prudential and supervisory policy measures will be durable.

D. Elements of a Way Forward

48. Despite low levels of consumer credit, its rapid growth raises vulnerabilities. The concerns over high credit growth are mitigated by a relatively low level of consumer indebtedness, the tight prudential stance of the NBS, and a perception that the majority of Serbian banks, which are in foreign ownership, would likely receive support from their parent offices in times of distress.22 That said, the potential under-pricing of risk by foreign banks pursuing aggressive market share targets could lead to pressures on their balance sheet. Further risks stem from a sudden stop in capital flows, especially if the tight global credit conditions persist and/or domestic political issues remain unresolved. Moreover, the rising external vulnerabilities may pose substantial risks to households’ balance sheets.23 Therefore, the authorities are well advised to continue to take measures to prevent excessive build-up of risks in the household and financial sectors through an appropriate mix of macro and prudential policies.

49. In general, policies should be designed to safeguard macroeconomic and financial sector stability. Managing macroeconomic risks and reducing the probability of financial distress, while increasing the resilience to adverse shocks by building buffers, is critical. Indeed, prudential policies have been effective in countries if accompanied by macroeconomic policies including structural reforms. The operating environment for bank lending to households should ensure sound lending practices with high origination standards (e.g., through conservative loan-to-value, debt-service to income and loan-to-income ratios). Administrative controls can generally be circumvented, at least beyond the short term, and should therefore be used judiciously (Hilbers and others, 2005). In developing prudential measures, potential disintermediation needs to be taken into account, as well as the fact that the laws and judicial systems in many emerging countries often provide relatively strong protection to borrowers, resulting in time-consuming, expensive, or ineffective foreclosure and enforcement of creditors’ rights, and a weak credit culture.

50. Strengthening financial sector surveillance could be enabled by widening the information base to better assess the characteristics of debtors. Most mature market countries, and increasingly more emerging countries, undertake a more detailed analysis of household balance sheets using micro-level data from household surveys to assess household debt sustainability (as, e.g., in Hungary). The central bank could augment the information collected by the Credit Bureau with asset side data (e.g., on real estate prices from the National Mortgage Insurance Corporation) of households, thereby broadening the scope of the overall data analysis.

51. Finally, ensuring financial stability will entail close monitoring of banks’ risk management and their resilience to shocks. Despite significant progress, continuing to build supervisory capacity in a fast growing industry will be critical. To this end, the work of the NBS’ new financial stability unit that would conduct stress tests would help Serbia better prepare for systemic risks. Furthermore, the NBS, along with the Bankers’ Association has to continue to raise the risk awareness of borrowers. Strengthening the dialogue between home and foreign supervisors, to facilitate cross-border supervisory arrangements and crisis management, is another important area in an environment that is dominated by foreign banks. Alongside, the NBS has to continuously monitor banks’ liquidity in foreign exchange, in which it cannot act as a lender of last resort. In the medium term, a well-developed capital market could help diversify the financial system and improve the efficacy of monetary policy transmission in a highly euroized economy.

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14

Prepared by Mangal Goswami (MCM).

15

See IMF (2006), chapter II, for a more detailed discussion on this topic.

16

See also Kraft (2006) who finds that an increase of 1 percentage point of GDP in the flow of household credit is associated with 0.57 percentage point of GDP deterioration in the trade balance in the case of Croatia.

17

Household leverage data for Serbia is limited, and is constrained by the lack of comprehensive asset data (other than bank deposits). Tentative estimates, provided by Sorsa (2007), however, suggest that Serbian households have positive net worth, albeit declining.

18

See the April 2006 Report on Financial Stability of the Central Bank of Hungary.

19

The exchange rate sensitivity test was conducted only on the foreign currency denominated/indexed household portfolio of assets and liabilities.

20

A survey of the nine largest banks revealed a 43 percent increase in non-performing household loans during the first half of 2007, although the household NPL ratio was still low at 4.4 percent in June 2007. While the overall NPL ratio of these nine banks reached 10.4 percent in June, it was 3.5 percent after accounting for provisions.

23

See Chapter I.

Republic of Serbia: Selected Issues
Author: International Monetary Fund