Debt Hangover: Nonperforming Loans in Europe’s Emerging Economies

By Christoph Rosenberg and Christoph Klingen

Some hangovers take more than a good night’s sleep to get over. It’s been three years since the global economic crisis put an abrupt end to emerging Europe’s credit boom, but neither lenders nor borrowers are in much of a party mood. One key reason: many of the loans so readily dished out before the crisis have now gone sour.

Festering bad loans are a problem on many fronts:  banks, credit supply, economic growth, and people all suffer. Take Japan’s lost decade. There too, a credit boom ended in tears, new lending subsequently went from too much to too little, and a vicious cycle of credit squeeze, declining asset and collateral values, and economic paralysis followed.

In emerging Europe, the share of loans classified as nonperforming—many of them household mortgages—have exploded from 3 percent before the crisis to 13 percent at the peak. As can be seen in the chart below, levels in some parts of the Baltics and Balkans are already at par with previous financial crises elsewhere.

Tackling bad loans

Nobody wants this dire script to replay in emerging Europe. Policymakers, bankers, and international financial institutions therefore got together under the Vienna Initiative to identify ways to tackle nonperforming loans. A working group co-chaired by the IMF and World Bank just presented a report that analyzes the problem and offers a way out.

Our analysis finds evidence that nonperforming loans are indeed a serious drag on credit supply and economic growth. They drive up banks’ funding costs and interest margins, and at the same time drain their profits and capital. On the credit demand side, over-extended households and businesses are reluctant to consume and invest.

But can banks afford aggressive loan resolution, and would higher credit growth even be desirable in a region that just went through a massive credit bubble? The analysis provides comfort on both fronts: even if nonperforming loan resolution brought new losses to the fore, financial stability would not be undermined.  And despite the credit boom, the private sector’s debt-to-GDP ratio is still low in most countries, so a resumption of credit growth wouldn’t be a problem.

What’s holding things up?

If speedy loan resolution is in everyone’s interest, why is it not proceeding faster? The working group identified two key obstacles.

  • First, there is a collective action problem. Individual banks neglect the positive side effects that accrue from resolving these loans, including on collateral values. Unless their competitors do the same, they are not keen to book additional losses at a time when they face multiple regulatory and liquidity challenges elsewhere in Europe. Rather, banks might “extend and pretend”—roll over debt service in the hope that loans will become performing down the line.
  •  Second, moving bad loans off banks’ balance sheets, foreclosing on delinquent creditors, or seizing and selling collateral isn’t exactly easy in Europe’s emerging economies. Legal, judicial, tax, and regulatory systems are often poorly equipped to deal with insolvency and to facilitate efficient restructuring.

The best way to overcome the deadlock is a concerted push by policymakers, bankers, financial regulators and supervisors at the country level.

  • Banks should step up the work-out of these loans, often with help from their more experienced Western parent institutions. Writing down unrecoverable loans shouldn’t be a taboo. Local banking associations are well-placed to generate the momentum needed to overcome the first mover disadvantage we mentioned above.
  • Policymakers have a long to-do list, depending on each country’s circumstances. This includes creating—often from scratch—regimes for insolvency and out-of-court restructuring; designing tax regimes that don’t punish debt writedowns and loan-loss provisioning; and ensuring that bankruptcy courts have sufficient resources. The working group also identified some do-nots: governments should avoid heavy-handed  intervention such as extended foreclosure moratoria or mandated debt writedowns. Such measures backfire by undermining the payment culture and contractual environment—a deterrent for much needed new lending.
  • Financial supervisors need to step up pressure to accelerate the resolution of bad loans. Ever-greening, overvaluation of collateral, and underreporting must not be tolerated; adequate capitalization and provisioning needs to be ensured. Regulatory obstacles, such as constraints on banks to own real estate or establish special vehicles to manage these loans need to be removed. Finally, banks’ home and host country regulators should coordinate their actions closely.

The International Monetary Fund, World Bank, the European Bank for Reconstruction and Development, and the European Union can do their part by providing international coordination, such as under the Vienna Initiative, and technical assistance.

Emerging Europe’s debt hangover will not be cured by a good night’s sleep. But if all stakeholders work together, the recovery will be shorter and less painful.

5 Responses

  1. Europa für Heimwerker – eine Bastelanleitung:

    Many an idea proves to be breathtakingly ill-conceived. A bit of skepticism is suggested in particular by the fact that our cuddly Dutchmen are themselves have serious trouble getting their budget deficit below 3 percent of gross domestic product – something that Dutch finance ministers have indignantly demanded of others for years now. Back then, the Dutch economy was still booming. Now it is mired in recession, and suddenly there are even socialists there who are warning about overly hasty consolidation and rejecting Ms. Merkel’s fiscal pact, and rightly so.

    So it is also in Austria, with its similar monetary policy, where the government has not yet managed to incorporate the debt brake into the constitution; at present, it is simply a law that can be changed at any time. But still, they have a culture of stability there.

    Something similarly racy can be said of Luxembourg. That country does have a central bank chief who assiduously calls for an interest rate hike at every hint of pre-inflation, which for the Bundesbank (German central bank) is essentially proof enough of a culture of stability. According to a study by the Market Economy Foundation (Stiftung Marktwirtschaft), however, that country has the second-highest explicit and implicit government debt in the euro area when measured in terms of GDP, and that would certainly be a point in favor of a representative from Spain, which has less debt.

    Now, Luxembourg should not be excluded from the ECB leadership ranks forever by virtue of being such a cute little microstate. But it is indeed curious that the reason seems to be that this man has a better Bundesbank-like ethos. There is no mention of that criterion in the treaty. Especially since the Luxembourg lawyer Yves Mersch is not a great economic thinker: He stands out most of all in terms of administrative experience. In a country that – speaking of tradition – did not even have a central bank until 1998, because it was in a monetary union with Belgium.

    Amid all the fervor, no one seems to notice that the vowed appointment of a Luxembourger conflicts with the equally popular-seeming idea that votes on the ECB board should henceforth be weighted according to the amount of money paid into the ESM (European Stability Mechanism) rescue fund, as was recently advocated by the Christian Democratic Union (CDU).

    True, whoever pays more should have more of a say. Numerocracy. But here’s the silly part: This could indeed give the Bundesbank a greater voice, but it would shrink our Luxembourg buddies to 0.25 percent in terms of votes. Which is not right for the purposes of the Bundesbank. Especially since, unfortunately, our other favorites do not come from what you would call huge countries either. The Dutch make up less than 6 percent of the ESM, the Austrians not quite 3 percent, and the Finns less than 2 percent. If votes are weighted, then Estonia – that model of stability – would crash onto the board with 0.19 percent. If you combine the entire acclaimed northern cultural sphere, the result is just under 38 percent on the ECB board – a little less than France and Italy. So maybe weighting isn’t such a good idea after all.

    Dangerous Tinkering

    All of this leaves the awkward impression that principles hold true only when they are used against others. In case of doubt, meanwhile, currency experts such as Mario Draghi or Jean-Claude Trichet possess more competence when it comes to monetary and stability policy than do many a German political appointee to the central bank boards.

    Indeed, it is not only in southern countries that Germany’s crisis managers have encountered little understanding since the crisis erupted. When the chancellor and the Bundesbank chief vote against aid, reject emergency intervention by central banks, and recommend brute austerity, the reaction is almost universal incomprehension. And it cannot be said that reality has since proved them right, as the Greek depression or the escalation of the crisis following the involvement of the private sector has shown. Ultimately the central banks did have to intervene in order to halt the disaster, at least for now.

    Perhaps it would be better to admit that simply employing big talk about a culture of stability and saying no to everything is not a very helpful approach. Rather, we should reexamine our own recommendations. By presenting more persuasive counterproposals, we could achieve much more than with the eternal lament about being disadvantaged or with the attempt to piece together a nice Europe for ourselves. With the right construction manual, we can build a stable edifice that will hopefully withstand wind and weather in the future and will not be held together by paint alone.
    Gisela Höfler

  2. Debt hangover: Big European banks are heavily loaded with tons of toxic assets. Neither the IMF nor any other agency has cared to find out the exact amount of dubious loans/mortgages. They are all working in unison to hoodwink the public. France, Germany, the U.K., Italy, Spain and many other EU members know this is the biggest problem of the financial crisis. So, I am asking to let me know the total amount of bad debts before going ahead with the ‘beating about the bush’ activity. Take only the French banks in particular. Will it be in the interest of the political leadership there to talk about the bad/irrecoverable debts at this juncture while the election season is in full swing?

    Almost all the big banks of the big EU countries come near to virtual ‘nakedness’ in a single day if the actual quantum of such loans/mortgages are ever revealed– much against our will though. And the less said about the quality of the two previous stress tests of about 91 banks the better.

    Surprisingly, some of these banks are declaring huge profits. How can it be possible to apply interest on dead loans, to avoid provisions for classified losses, to hide contingencies and to reduce the employment strength just to reflect positive results? The country Spain, for example, has over 23% unemployment — including around 50% unemployed youth population. Has anybody cared in this EU/IMF/ECB-led troika to know how many of those jobless have been relieved from banking circles?Also, there is much to be analyzed about the quality of management, regulatory systems and liquidity management in these 27 countries with particular reference to the euro zone.

    So, while performing the job of an analytical nature, you have to go deeper into the roots. No doubt it pains a casual reader to mention such absurdities, yet these are my personal observations. Please read it in the same spirit. I know I am not an expert. Thanks.

  3. They do not want the hangover and yet they still continue to feed the system that has caused it and will continue to cause it!

    Lending money is easy; paying it back is optional as the tax payers will bail the minority out if they default.

    The hard part is, stopping the system that encourages it!

  4. […] Blogging on the Fund’s website, IMF economists Christoph Rosenberg and Christoph Klingen say that three years after the global economic crisis ended emerging Europe’s credit boom,  many loans “so readily dished out before the crisis have now gone sour”. […]

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