# **Stress-Testing Croatian Households with Debt—Implications for Financial Stability**<sup>1</sup>

This paper assesses the financial stability risks that arise from the high debt levels accumulated by Croatian households in the pre-crisis period. As opposed to relying on banking sector data, this paper puts forward a methodology that uses household budget surveys (HBS). In particular, the vulnerability of indebted households to changes in economic conditions is explored. This includes shocks that impact only some households (or household members), such as the loss of income that arises as a result of becoming unemployed, as well as shocks that arise from changes to the terms in which loans have been extended. The latter includes changes in exchange rates and their impact on the debt service of foreign currency (or foreign currency linked) loans and changes in interest rates and their impact on the debt service of variable interest rate loans. The effect of these shocks on households’ vulnerability depends not only on the size of the shocks simulated, but also on the risk thresholds that are used to tag a household as vulnerable.

The use of HBS has limitations. To begin, they cover only a small subset of all households―0.2 percent. But the sampling methodology involved limits the concerns that arise from small samples. Another limitation is that the coverage of these surveys has some weak aspects. For example, while incomes, expenditures and household characteristics are covered in detail, information on financial assets is largely absent. But these limitations should be gauged against the alternative; namely, detailed loan-by-loan borrower information is lacking in macroeconomic data and this also hampers a thorough assessment of household vulnerability. Also, the lack of data on the stocks of household financial assets suggests that the risks identified in this paper are likely to be upper bounds to concerns about household over-indebtedness and its potential implications for financial stability. Finally, the use of HBS allows a distinction between households with and without debt and the characteristics of those that do hold debt, thus enabling an assessment of the impact of debt on aggregate economic activity (Albacete and Fessler, 2010).

The vulnerability exercises carried out highlight that low income households are particularly vulnerable. However, the financial distress of these households appears to precede the economic shocks that Croatian households might be going through as a result of the global financial crisis—what this paper refers to as _risk loans at origination_ . The economic shocks, be these through increased unemployment, changes in interest rates, or changes in exchange rates appear to have limited additionality in terms of new vulnerable households. That so many households are at risk at loan origination raises questions as to what banks know about their borrowers that is not captured in Croatia’s HBS—a subject to which the paper devotes some attention. The primary focus of this paper is, however, the impact of plausible crisis-related economic shocks on financial stability; i.e., new vulnerable households.

A second conclusion is that household debt is concentrated in few households and largely in upper income quintiles. In part this is because credit growth took place from low levels and was brought to an abrupt and early end by the financial crisis. For example, only 7 percent of all households in Croatia have mortgage debt; the equivalent figure for France, Germany, the UK,

> 1 This paper was prepared as background to a forthcoming World Bank (2011) report titled ―Golden Growth: Restoring the Lustre of the European Economic Model.‖ The views expressed are exclusively those of the authors and do not necessarily represent the views of the World Bank or the Executive Directors and the governments they represent. We wish to thank Sanja Madzarevic-Sujster for bringing to our attention the features of the Croatian HBS that serve to explain the high level of risk loans at origination, thus necessitating a distinction between level and change regarding household debt at risk. We also appreciate the comments received from Evan Kraft and Peter Mooslechner. Of course all remaining errors are our exclusive responsibility.

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