# **Debt Overhang in Emerging Europe?**<sup>1</sup>

# **1. Introduction**

The aim of this background paper is to assess the extent to which debt overhang poses a constraint to economic activity in Emerging Europe, as the region emerges from the recent financial and economic crisis. The analysis covers the new member states of the EU (Bulgaria, Czech Republic, Estonia, Hungary, Latvia, Lithuania, Poland, Romania, Slovak Republic, and Slovenia) candidate and potential candidates of the EU (Albania, Bosnia and Herzegovina, Croatia, Macedonia, Serbia and Turkey) and Eastern Partnership countries (Armenia, Georgia, Moldova, Ukraine).

We take a broad view of debt overhang, analyzing both its macroeconomic and microeconomic dimensions. At the macroeconomic level, we examine how external and domestic sectoral balance sheets developed prior to and during the crisis. At the microeconomic level, we assess the distribution of debt across firms and households at the outset and during the crisis. We further examine the loan losses suffered by the banking sector during the crisis and how this may impact on their future lending.

In relation to our macroeconomic analysis, we find that the external imbalance problem for Emerging Europe has been in most cases more one of flows (high current account deficits in the pre-crisis years) rather than large stocks of external debt. A high reliance on equity funding means that net external debt is far lower than net external liabilities. In any event, current account deficits have narrowed quite rapidly in most countries over 2008-2010. In relation to domestic sectoral balance sheets, these have expanded quite rapidly but sectoral liabilities remain relatively low compared to advanced economies. However, the rapid expansion in credit does suggest that non-performing loans could be problematic, due to deterioration in loan quality during intense credit booms. Finally, with the important exception of Hungary, public debt levels remain relatively low in Emerging Europe. So long as the debts of other sectors are not socialized, the risk of sovereign debt crises in these countries seems low compared to many advanced economies.

At the microeconomic level, we first examine whether **debt overhang in the enterprise sector** may constrain future activity in the region. Using data from the EBRD 2009 Business Environment and Enterprise Performance Survey (BEEPS) we identify the share and type of firms which are highly leveraged in each country and assess what this may imply for corporate investment going forward out of the crisis. Comparing the share of highly leveraged firms by country to GDP contraction during the crisis we find that debt overhang is likely to pose a general threat to firm activity in only a limited number of the more advanced countries: Latvia,

> 1 Brown would like to thank Ralph De Haas and Franklin Steves (both EBRD) for sharing data and Karolin Kirschenmann for valuable research assistance; Lane thanks Peter McQuade for research assistance; we thank Juan Zalduendo for helpful feedback on an earlier draft. This paper was prepared as background to a forthcoming World Bank report titled “Golden Growth: Restoring the Lustre of the European Economic Model.” The views expressed in this paper are exclusively those of the authors and do not necessarily represent the views of the World Bank and its affiliated organizations or the Executive Directors of the World Bank and the governments they represent. All errors and omissions remain entirely the responsibility of the authors. The authors may be contacted by electronic email to <u>martin.brown@unisg.ch</u> (University of St. Gallen) and plane@tcd.ie (IIIS, Trinity College Dublin and CEPR).

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