A Closer Look at 2007[1]
I used the Czech National Bank’s Financial Stability Report, 2007 to evaluate the Czech Republic’s financial status and resilience shortly before the crisis of September, 2008. My next step from here will be to create a glossary of terms I did not understand (bolded below), and to look at the Financial Stability Report for 2008.
Note: The 2007 Financial Stability Report was published in early 2008, thus many of the CNB predictions were made in the context of more recent developments.
“From the financial stability point of view, the development of the Czech economy in 2007 can be assessed as very successful, notwithstanding the shocks emanating from foreign financial markets. Despite a predicted moderation in economic growth, the current outlook for the next two years creates good conditions for maintaining the degree of financial stability already achieved. The main risks include a further deepening of the credit crisis in the advanced economies, a more pronounced slowdown in economic growth abroad and a continued very strong exchange rate of the koruna. These risks could slow net export growth, weaken domestic economic activity and, in turn, worsen the performance of the financial sector.”[2] Due to risk aversion and the credit crisis abroad, this will lead to tightened lending conditions in the Czech Republic. This is both a natural progression and desirable for financial stabilization.
As early as 2007, the Czech National Bank predicted a decline in financial stability in those countries directly affected by the credit crisis, a sharp decline in lending to the private sector in those countries, and a knock-off effect in other economies. The Czech koruna appreciated dramatically as a response to the credit crisis. This appreciation, combined with the decline of the euro brought concerns about net exports and the domestic economy’s welfare.
Risks in the financial sector as discussed in the previous year’s outlook report manifested in the US subprime mortgage crisis, “which gradually spilled over into other financial market segments and turned into [the] credit crisis in the first few months of 2008.” For this reason, one should expect a global downward outlook for the next two years, including a downward effect in the euro region, and likely a recession in the US.
The credit crisis will bring credit contraction in the US, and knock-off effects in other developed countries. “One of biggest risks over the next two years is a potential credit contraction in some advanced countries as problems with mortgage loans and related securities spread to other segments of the credit market. The major losses of some banks will lead to a decrease in the overall capital adequacy of banking sectors. The subsequent recapitalization of banks will negatively affect growth in lending to the private sector and economic growth.”
Central banks adopted monetary policy to respond to the turn in credit cycle. The Fed lowered monetary policy by 1.25% to 2%, and the ECB held their rate at 4%. The CNB increased its monetary policy rate by 0.25% a total of four times in 2007 to respond to inflationary pressures. Inflation is expected to return to target by the end of 2008, and interest rate to be stable for two years thereafter.
In the context of downward interest rates in main currencies, investors will seek out stable currencies such as the Czech koruna, putting upward pressure on the koruna. In the first phase of financial turbulence, the koruna appreciated due to investors’ shift away from the dollar towards the koruna, and domestic exporters’ sale of the euro in light of the appreciating koruna. The appreciation of the koruna combined with a decline in euro demand could have a significant negative effect on Czech economy through “deterioration in net export growth.”
Fiscal reforms[3] are impacting the behavior of economic agents and having varying effects on disposable income of households and corporations. The reform of public finances will cause volatile behavior of aggregate demand.
2008 will see slow growth in GDP and disposable income of households. The decrease in disposable income may hamper households’ ability to repay previous loans. “On the other hand, it may help to eliminate the excessively optimistic expectations which emerged at the peak of the cycle and supported a rapid rise in the indebtedness of households…”[4]
“The traditional macroeconomic sustainability indicators recorded strongly positive developments in 2007. The public budget deficit under ESA95 methodology fell to 1.6% of GDP and the ratio of public debt to GDP decreased to 28.7%. The current account deficit declined to 2.5% of GDP, while the surplus on the output balance increased.”[5]
Corporations (non-financial) maintained good financial conditions throughout 2007, but recorded a decrease in loans, which may indicate a future downturn in performance. Corporate credit risk remained low in 2007, but is expected to rise by 1 or 2% in 2008.
Koruna appreciation has so far had little effect on exporting-centered corporations’ credit risk. However, data analysis shows we can expect a higher credit default rate of exporting corporations due to their increased sensitivity to currency rates.
Household debt increased by one-third in 2007, reaching over CZK 800 billion, supported mostly by loans for house purchase. The increase in debt is accompanied by a decrease in savings rate, to 5.1%. Despite these negative changes, these rates are low compared to the Western European average and are expected to turn around in 2008.
Over indebted households, particularly those whose income is not rising as quickly as household prices, could face serious problems in the case of adverse macroeconomic developments.
“The shocks on the advanced financial markets manifested themselves in declining prices of a whole range of risky assets and rising volatility on equity, bond and foreign exchange markets. However, the domestic interbank money market remained fully operational and interest rates there were affected mostly by expected changes in CNB monetary policy. The Czech financial markets responded to developments in global financial markets similarly as during corrections in previous years. Share prices went down in line with the falls in foreign stock markets, while bond yields initially declined slightly and then stabilized.”
In Q1 of 2008, the global financial crisis put upward pressure on the Czech koruna risk premium due to increased sales of government bonds by foreign investors. “The interbank market also recorded a very modest increase in the credit risk premium and a decline in market liquidity.” The Czech banking sector responded with increased credit rates for only riskier credit segments.
Risky trends in housing as discussed in the 2006 Financial Stability Report continued in 2007. Housing prices continued to rise; there are indicators that the market is overheating, with Prague as the riskiest region. Rent returns are decreasing, making property purchases financed by mortgage loans more risky.
Housing completions increased in 2007, but a saturation of the flat market cannot be ruled out. Although stress tests have confirmed banks’ current resilience, tightened credit standards with regards to property development sector was an appropriate measure to the increased risks in this sector.
The financial crisis has had little impact on the Czech financial sector. Evidence of this is in the continued stability in the CERTIS interbank payment system and SKD short-term bond settlement system, and aided by a rise in use of the intraday credit by CERTIS participants.
The Czech financial sector saw high returns on assets and equity, setting the stage for future financial stability, assuming that a large percentage of returns are kept in the form of equity capital. Depth of financial intermediation increased significantly in 2007 (as measured by the ratio of financial assets to GDP). This reflects a rise in financial institutions’ assets accompanied by a growth in bank loans.
Characteristics of the Czech housing loan market make it less susceptible to credit risk and a crisis similar to that of the subprime mortgage crisis in the US. This includes in particular good collateralization of mortgage loans with property. “Given the favorable phase of the business cycle and the high credit growth in 2007, the loan default rate still probably undervalues the magnitude of the banking portfolio credit risk to some degree.
High rates of client deposits have helped maintain financial stability and prevent against “drying up of market liquidity”. Although, credit growth has exceeded deposit growth, and this trend will likely continue, requiring a response from banks with changes in balance-sheet liquidity management. Only banks with a strong deposit foundation will be resilient to changes in the financial market.
Implementation of Basel II and the changeover to new prudential rules in July 2007 was a significant challenge for the banking sector. Due to these changes, there was a decline in regulatory capital requirements. A rise in default from corporations and households in 2008 is likely; “this would imply some increase in the regulatory capital requirements in the period ahead.”
Insurance and pension scheme saw continued growth in 2007. However, asset price volatility and increased cost of intermediating new contracts may have an adverse effect in insurance companies and pension funds’ performance. Fund shareholders can protect against this risk through increased capital.
The financial sector has continued to show resilience to the market, credit, and some aforementioned risks. However, an extreme macroeconomic development impacting interest rates, the exchange rate, and GDP growth could require “capital injections” to maintain capital adequacy in the financial sector.
[1] Czech National Bank, Financial Stability Report, 2007. Available from http://www.cnb.cz/m2export/sites/www.cnb.cz/en/financial_stability/fs_reports/fsr_2007/FSR_2007.pdf
[3] Reference unclear to me. Were these domestic or global reforms?
[4] Although the 2006 FSR addressed the problem of excessive optimism, I am skeptical of this prediction. A look into the 2008 report may present a different assessment.
[5] There has been a lot of discussion of debt as a percentage of GDP, particularly under the context of the 2010 budget and where that will leave the Czech Republic. I understand that an increasing deficit should be avoided, but I still do not grasp all the subtleties and implications of varying debt percentages.
