(iii) an increase in the unemployment rate and thus a resulting loss in household income, and (iv) a scenario that combines these three shocks as independent events.<sup>8</sup> How is the size of individual shocks chosen? One could either set ad-hoc shocks or benchmark these based on a country’s own recent developments. With one exception, the latter approach is chosen; namely, the largest change in 2007-10 is calculated to specify the shocks to which households might be exposed—a change of 3.7 (domestic currency loans) and 3.3 (foreign currency loans) percentage points in variable interest rate loans, a change in the kuna-euro exchange rate of 4.6 percent and in the kuna-Swiss franc exchange rate of 31.4 percent, and an increase in unemployment of 6.0 percentage points (Figure 3). The rationale behind the choice of the largest changes and depreciation over the period is that, as mentioned in the introduction, the paper tries to reveal the maximum possible impact on households’ abilities to repay their debt.<sup>9</sup> In addition to the benchmark shocks based on the country’s developments, the impact of an arbitrary devaluation of 35 percent in the kuna-foreign currency rate is also explored. This arbitrary shock is calibrated using the experience of banking crises countries (Laeven and Valencia, 2008).

As to the thresholds used to tag a household as vulnerable, two approaches are possible: an arbitrary threshold or a financial margin threshold. The arbitrary threshold is measured as total debt service payments as a percent of disposable income and is calibrated based on work for advanced economies carried out by Johansson and Persson (2006). Specifically, this paper sets 35 percent as the threshold beyond which a household is considered to be vulnerable even though, a priori, households with high incomes should be able to devote a larger share of their income to debt service while maintaining subsistence consumption levels.<sup>10</sup>

**Figure 3. Size of Shocks in Croatia**

<!-- Start of picture text --> Panel A. Interest Rates Panel B. Exchange Rate Change Panel C. Unemployment Rates<br>12 % 8 13 % of Labor Force<br>12<br>3.7pp 7<br>10 4.6% 11 6.0pp<br>6 10<br>8 9<br>31.4%<br>5<br>8<br>6 3.3pp Domestic CurrencyForeign Currency 4 EURCHF 7<br>2007M1 2008M1 2009M1 2010M1 2010M12 2007M1 2008M1 2009M1 2010M1 2010M12 2007M1 2008M1 2009M1 2010M1 2010M12<br><!-- End of picture text --> Source: Croatian National Bank, Croatian Bureau of Statistics, and authors’ calculations.

> 8 As opposed to modeling unemployment based on an individual’s characteristics, it is assumed that the change in unemployment randomly affects employed household members. An alternative is to model the likelihood of becoming unemployed based on the characteristics of household members; to simplify the presentation, however, this alternative is not pursued.

> 9 It should be noted that, as in Figure 3, the period of time used to define the magnitude of each shock is different. This makes it difficult to compare the results across different scenarios; in fact, the probability of the individual shocks being considered is different. For example, it took a few months for an increase in the kuna-euro exchange rate of 4,6 percent, but the increase in the CHF-euro exchange rate of 31,4 percent took several years. In this regards, it would be more accurate to use shock variables defined in terms of standard deviations. But, as noted before, the goal is to consider the largest possible economic shock. 10 No doubt rich households might have higher consumption needs. The point, however, is that they are also more likely to be able to service their debts without falling into poverty.

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