Sweden and Italy averages 40 percent (EBRD and World Bank, 2011). Since in the worst case only 1 of every 10 households faces financial distress, this is unlikely to result in a drag on aggregate economic activity. Moreover, two-thirds of these households are at _risk at loan origination_ and, as discussed later, this results in an upward bias on household vulnerability.

On the whole, the risks to financial stability arising from household debt appear to be manageable despite Croatia’s large increase in household debt in the years preceding the financial crisis. To reach this conclusion, this paper begins by describing household debt developments over the past decade. It then presents a methodology to tag indebted households as vulnerable to financial distress and further stress tests the balance sheets of households to changes in economic conditions. The implications for financial stability are then discussed by assessing the impact of household debt problems on banks’ loan portfolio. Conclusions follow.

# **Developments in Household Debt**

Figure 1 shows developments in total household debt in the European region.<sup>2</sup> Worth noting is that household debt is, as would be expected, below the average for richer EU15 countries. Interestingly, debt levels are in line with those observed in the United States when this country had similar incomes per capita (in real PPP terms; household debt in the US was also about 2530 percent of GDP in the early 1960s). There are a few exceptions. Over-leveraged household balance sheets appear to be likely in Estonia, Latvia, and Croatia, and perhaps also in Montenegro, Bosnia and Herzegovina, and Ukraine; the last three countries mostly on account of their lower income levels. Although it would be best to benchmark household debt after controlling for country-specific structural characteristics, this is not possible owing to the lack of a long time series; thus the focus here only on income per capita comparisons as opposed to a benchmarking of household debt based on country-specific structural characteristics.

**Figure 1. Household Indebtedness across Emerging Europe (% GDP)**

<!-- Start of picture text --> EU10 EU Candidates EU Neighborhood<br>70 70 70<br>60 60 60<br>50 50 50<br>40 40 40<br>30 30 30<br>20 20 20<br>10 10 10<br>0 0 0<br>2000 2002 2004 2006 2008 2010 2000 2002 2004 2006 2008 2010 2000 2002 2004 2006 2008 2010<br>BGR CZE EST HUN LTU LVA ALB BIH HRV MKD ARM AZE BLR GEO<br>POL ROM SVK SVN EU15 MNE SRB TUR EU15 MDA UKR EU15<br><!-- End of picture text --> Source: EBRD Structural Change Indicators, European Credit Research Institute, and authors’ calculations. Note: Includes all types of household debt.

2 EU15 includes Austria, Belgium, Denmark, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, Netherlands, Portugal, Spain, Sweden, and United Kingdom. EU10 includes Bulgaria, Czech Republic, Estonia, Hungary, Latvia, Lithuania, Poland, Romania, Slovak Republic, and Slovenia. The candidate countries comprise the rest of the Balkans (Albania, Bosnia and Herzegovina, Croatia, Kosovo, FYR Macedonia, Montenegro, Serbia, and Turkey. The EU neighborhood covers Armenia, Azerbaijan, Belarus, Georgia, Moldova, and Ukraine.

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