Financial Stability 2/2003

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2 Macroeconomic developments, households and enterprises

2.1 The macroeconomic environment
2.2 Households
2.3 The enterprise sector

Box:
- Effects of a fall in household consumption on the enterprise sector

2.1 The macroeconomic environment

Recent developments suggest that growth in the Norwegian economy is picking up. Seasonally adjusted mainland GDP growth was 0.3% in the second quarter of this year, while growth was marginally negative in the two preceding quarters (preliminary figures). The growth projections, as presented in the October Inflation Report, have been revised upwards somewhat since the May Financial Stability report (see Table 2.1). There are also signs of higher international growth.

Table 2.1

Norges Bank’s key rate has been reduced by 2.5 percentage points since the May report and by 4.5 percentage points since December 2002. The interest rate level is low from a historical perspective and price inflation is subdued. The narrowing of the interest rate differential between Norway and other countries has contributed to the depreciation of the krone (see Chart 1.4) and has improved competitiveness in the enterprise sector.

High cost inflation over several years and low global demand has adversely affected developments in the manufacturing sector. As a result, industries that supply services to the manufacturing sector have experienced a period of sluggish activity. In addition, the airline industry and the ICT sector have been restructuring. Enterprises that supply goods and services to households are enjoying solid growth, however. LFS (Labour Force Survey) unemployment has increased since the May report, but remained unchanged from the second to the third quarter of this year, at 4.6% seasonally adjusted. Industrial leaders’ expectations concerning economic developments improved in the third quarter of this year (see Chart 2.1).

Chart 2.1

Gross capital formation for mainland Norway continued to fall in the second quarter of this year. Service industries accounted for most of the fall. Manufacturing investment, which showed a marked contraction in the first quarter, showed a seasonally adjusted increase in the second quarter. Petroleum and pipeline investment expanded by 6.5% between the first and second quarter. Oil prices have edged down since the uncertainty surrounding the war in Iraq came to an end. In a historical context, oil prices remain high.

Household demand is on the rise, and private consumption rose by a seasonally adjusted 1.3% between the first and second quarter. Households are more optimistic about the future (see Chart 2.2). In particular, optimism concerning the national economy has picked up considerably from the low level prevailing earlier this year.

Chart 2.2

Developments in the Norwegian economy ahead partly depend on the strength and sustainability of the international upturn and developments in the krone exchange rate. There is a large measure of uncertainty associated with the rapid and pronounced reduction in interest rates. Private consumption is expected to be the driving force behind the economic upturn. This may in turn lead to higher employment. As capacity utilisation increases, business investment is expected to pick up.

Growth in total credit and credit from domestic sources has slowed somewhat since the previous report. Credit from foreign sources, which has fallen so far in 2003, is still contracting. In the statistics, credit from foreign sources only comprises credit to non-financial enterprises. Low growth in credit to enterprises and a weaker krone are the main factors behind decelerating growth in credit from foreign sources. In spite of somewhat lower credit growth, credit to mainland Norway as a percentage of mainland GDP is at a historically high level (see Chart 3). High house prices and a two-track economy, with strong household income growth on the one hand and weak corporate earnings on the other, have led to a marked divergence in credit developments between these sectors (see Chart 2.3).

Chart 2.3

2.2 Households

High debt growth in the household sector

Debt accumulation by the household sector has continued at a rapid rate. Twelve-month growth in household domestic debt has been about 10-11% over the past three years, and was 10.2% in September this year (see Chart 2.3). Twelve-month growth in household foreign-currency debt from domestic sources has slowed this year from the high growth rates recorded in 2002. The wide interest differential between Norway and other countries and the strong krone in 2002 generated considerable interest in such loans.

Unchanged net financial assets

Household gross financial assets increased in the second quarter of 2003 compared with the same quarter of 2002 (see Chart 2.4 and Table 2.2). Bank deposits and the value of equity holdings and insurance claims showed the strongest increase. Insurance claims are generally illiquid and cannot be drawn upon if households encounter payment problems. The liquid portion of their financial assets, gross financial assets less insurance claims, also increased. Household gross debt expanded at about the same pace as gross financial assets, leaving net financial assets virtually unchanged.

Chart 2.4     Table 2.2

House prices on the rise again

Higher housing wealth in the second quarter of this year compared with the same period one year earlier led to a an increase in total household net assets in the same period. After falling somewhat through the spring, house prices have shown a rising tendency again since the summer, reflecting the interest rate cuts through the year. Seasonally adjusted, monthly house price inflation has been positive since June and was 1.5% from September to October. The twelve-month rate of increase in house prices was 4.1% in October.

Turnover in the housing market was higher this year than in 2002. However, it takes longer, on average, to sell a dwelling. One explanation may be that dwellings that have been advertised for a long period are finally sold and therefore included in the turnover statistics. The number of households planning to move appears to be rising. The number of households planning to move in the coming three months was stable through last year and fell somewhat in the first six months of 2003. At the beginning of August, this indicator rose by about 80% compared with the beginning of April of this year, and reached its highest level since 1999. This indicates that turnover in the housing market may continue to rise ahead.

House price inflation and debt growth

The sharp rise in the value of dwellings in recent years is one of the main factors behind the marked growth in household debt. House prices have risen at a brisk pace since 1995 (see box p 12). Deflated by the building cost index, house prices are about 20% higher than the previous peak in 1987 (see Chart 2.5). Deflated by annual wage growth, house prices are marginally lower than in 1987.

Chart 2.5

In the May report, we pointed out that with the past rise in house prices, household debt may continue to rise even after a levelling off in house prices. Since only a portion of the housing stock changes hands each year, for a long period there will be dwellings that are sold at a higher price than the last time they were sold. As long as the loan-to-asset value ratio increases when a dwelling is sold and turnover is high, this will make a positive contribution to credit growth. Household debt in relation to housing wealth has increased somewhat (see Chart 2.6) but is nevertheless lower than it was at the beginning of the 1990s.

Chart 2.6

House price expectations have a considerable influence on debt accumulation. Some households may have postponed house purchase in anticipation of lower house prices. The fall in interest rates, combined with the recent rise in house prices and expectations of a further price rise, may lead to increased activity in the housing market. This may amplify the rise in house prices and lead to an acceleration in both household debt and housing wealth, making the sector more vulnerable to a fall in house prices. The extent to which households will have to make adjustments in response to such a situation will depend on their loan-to-asset value ratio (see Chapter 3) and their debt and interest burden.

Increase in fixed interest mortgages

Historically, fixed interest mortgages have been relatively limited in Norway. However, figures from the largest banks and the Banking, Insurance and Securities Commission show that the portion of fixed interest mortgages is rising. A survey conducted by the Savings Banks’ Association indicates that fixed interest mortgages account for 20% of the stock of loans to households.¹ Fixed interest mortgages may reflect households’ preference for predictable interest expenses. Fixed interest mortgages reduce households’ vulnerability to a rise in interest rates. At the same time, their interest expenses will not decline when floating interest rates fall.

Rising debt burden, but falling interest burden

The household debt burden, loan debt in relation to disposable income, increased in the first half of 2003 (see Chart 2.7). The debt burden of Norwegian households has risen markedly over the past years and is high in a Nordic and international context (see Chart 2.8). However, if household debt is measured as a percentage of financial assets and housing wealth, the picture is fairly similar to that of the other Nordic countries (see Chart 2.9). Danish households have a high level of financial assets, while Norwegian households have a high level of housing wealth.

Chart 2.7     Chart 2.8     Chart 2.9

Household interest burden, i.e. interest expenses after tax in relation to disposable income plus interest expenses, has declined this year (see Chart 2.10). In spite of the high rate of debt accumulation, the sharp fall in interest rates has contributed to the decline in interest expenses. The interest burden fell by 1 percentage point from the fourth quarter of 2002 to the third quarter of 2003. This has eased households’ debt servicing.

Chart 2.10

Debt is rising for households with a high interest burden

As mentioned earlier, there are wide differences in the interest burden of various groups of households. The income and wealth survey conducted by Statistics Norway for 2001 shows that households with an interest burden of over 20% account for a growing share of household debt. While households with a high interest burden accounted for 24% of household debt in 1998, their share increased to 40% in 2001. The largest increase of about 10 percentage points took place from 2000 to 2001.

The breakdown of debt with a high interest burden on income deciles has also changed. Households with high income (decile 7-9) account for a larger proportion of debt with an interest burden of more than 20%. However, there has been a marked increase in debt with a high interest burden for low- and middle-income households (decile 1-6). If we assume that the debt breakdown by interest burden and income decile has remained unchanged from 2001 to the first half of 2003, NOK 159bn of debt will be attributable to households with a high interest burden and an income after tax of less than NOK 321 000 (decile 1-6) (see Chart 2.11). The comparable figure for 1998 was NOK 65bn.

Chart 2.11

In the May report, we pointed out that households with a high interest burden and low and middle income (decile 1-6) had limited financial reserves as measured by gross financial capital in relation to debt. As a result, these households were particularly vulnerable to debt servicing problems. The figures for 2001 indicate that their situation has improved (decile 1-6)² (see Chart 2.12). The improvement may also be partly attributable to shifts between the different income deciles between 2000 and 2001³. Financial reserves increased for all groups (with an interest burden under and over 20%) except for those with high income (see Chart 2.12 and 2.13). Bonds and equities account for a larger share of financial wealth among households with high income than for the other groups. The reduction in financial buffers for these households probably reflects the fall in equity prices between 2000 and 2001.

Chart 2.12     Chart 2.13

Developments ahead

Growth in household debt has been high for a long period. The projections for the next three years assume a gradual deceleration of debt growth, to the same level as growth in disposable income at end-2006. The projections are based on the technical assumption that interest rates will move in line with money market expectations. This implies that the debt burden will increase to a good 150% of disposable income in 2006 (see Chart 2.7). If debt continues to expand at the current rate, while disposable income remains at the same level as in the first alternative, the debt burden could increase to about 170% in just over three years. This is higher than the peak during the banking crisis at the beginning of the 1990s.

In the alternative with gradually decelerating credit growth, the interest burden will slow initially as a result of lower interest rates (see Chart 2.10). As the interest rate increases in line with the forward interest rate, household debt burden will rise, but will still be lower than the current level. In the alternative with high debt growth, debt is accumulated faster and is higher than in the first alternative. Interest expenses show a corresponding increase. At the beginning of the period, there is little difference between the interest burdens in the two alternatives. After the increase in interest rates in 2004, the debt burden becomes heavier. The interest burden therefore increases more than in the first alternative.

The marked interest rate reductions this year have made it easier in the short term for households to service their debt. The low interest rates are also contributing to higher employment and thus more favourable developments in disposable income. However, low interest rates may induce households to increase their borrowing from an already high level. When interest rates rise again, interest expenses will increase and the interest burden will become heavier. A consolidation in the household sector may have a negative impact on the enterprise sector (see box). If debt accumulation continues at the same rate, households, and in the next round enterprises, will become more vulnerable to negative economic disturbances.

2.3 The enterprise sector

Bankruptcy figures show signs of improvement

Sluggish developments in the Norwegian economy through 2002 and into 2003 contributed to a sharp rise in the number of bankruptcies (see Chart 2.14). In the first three quarters of 2003, 25% more bankruptcies were reported than in the same period in 2002. However, the number of bankruptcies fell from the second to the third quarter of this year. Many small entities with a low turnover have gone bankrupt. The third quarter of 2003 was the fourth consecutive quarter with a fall in total sales of entities that went bankrupt.

Chart 2.14

If the number of bankruptcies among limited companies is compared with the total number of limited companies, the rise in bankruptcies has slowed. The number of limited companies in the Register of Business Enterprises increased by 24% from 1995 to end-2002. The number of newly registered companies was highest in 1998, at just over 15 000 new companies, but has subsequently fallen, to just under 12 000 in 2002.

Measured by the total sales of the bankrupt enterprises, the percentage rise from the first three quarters of 2002 to the same period in 2003 was highest for the fishing and property management industries. Of the major industries, only property management shows an annualised increase compared with 2002 (see Chart 2.15). The total sales of small unincorporated firms that went bankrupt increased almost fivefold from the first three quarters of 2002 to the corresponding period in 2003, but still only accounted for 4% of the total sales of all bankrupt entities.

Chart 2.15

Lower interest and debt burden

Figures for interest and debt in relation to cash surplus are important indicators of enterprises’ debt servicing capacity. The cash surplus derives from ordinary operations and financial assets (capital income).

Debt and interest burdens have fallen by 20% and 33%, respectively, from 2002 to 2003 (projection), after rising since 1995 (see Chart 2.16). The reduction in interest rates has contributed to a substantial fall in both variables. At the same time, the increase in enterprise debt is low. If developments in the Norwegian economy are in line with the baseline scenario in Inflation Report 3/2003, the interest and debt burden will continue to fall in 2004.

Chart 2.16

Improved corporate profitability in 2002

Since the May report we have received annual reports for 2002 for limited companies. Overall, profitability improved from 2001 to 2002. Operating margins increased (see Annex Table 1). Pre-tax returns on total assets and equity rose, but are still low compared with the last ten years (see Chart 2.17). Average estimated interest on debt increased, but by less than the return on total assets, thereby contributing to a higher pre-tax return on equity.

Chart 2.17

Profitability in some industries deteriorated from 2001 to 2002 (Annex Table 1). Profitability in fish farming was very weak in 2002, with a negative operating margin, largely as a result of low salmon prices due to overproduction. Operating margins for telecommunications and IT were also negative in 2002. Profitability in the shipbuilding industry, measured in terms of return on total capital, deteriorated in 2002. However, profitability for large industries such as manufacturing, wholesale and retail trade and commercial services was positive from 2001 to 2002.

Cash surplus as a percentage of outstanding bank debt is a measure of debt servicing capacity. In 2002 this ratio showed a negative tendency for a number of industries (Annex Table 1). The situation in fish farming and IT, with a cash deficit in 2002, was the main source of concern.

The results for the first three quarters of 2003 for a selection of listed enterprises indicate that profitability in the enterprise sector is showing continued improvement.⁴

Stable equity ratio despite record high dividend level

The equity ratio of enterprises as a whole edged up marginally from 2001 to 2002 (Annex Table 2), but is lower than in the period 1996 – 2000 (Chart 2.17). Equity ratios were influenced by a record high dividend level in 2002. Allocations to dividends as a percentage of equity and dividends rose from 4% in 2000 to just over 7% in 2002. Dividend income was liable to tax in 2000, but this tax was abolished in 2001. The high dividend level in 2002 may be due to owners’ fear that tax on dividends will be reintroduced.

Bankruptcy probabilities and risk-weighted debt

Norges Bank’s bankruptcy prediction model predicts the probability of an enterprise going bankrupt within three years. Bankruptcy probabilities at end-2002 were at approximately the same level as in 2000 and 2001 for both the most vulnerable enterprises and the median enterprise (see Chart 2.18).

Chart 2.18

Bankruptcy probabilities are predicted on the basis of enterprises’ accounts for 2002, and therefore do not take account of developments so far in 2003. The substantial reduction in interest rates in the course of 2003 is having a positive effect on enterprises. We have predicted bankruptcy probabilities on the basis of Norges Banks’ projections for economic developments. Our projections indicate that bankruptcy probabilities will fall in the period 2003-2005.

In particular, enterprises with a high level of debt financing are noticing the direct effect of lower interest rates. However, a low interest rate does not necessarily preclude payment problems. To be able to service their debt, many enterprises are also dependent on improved underlying earnings. It may take some time before the risk for these enterprises falls.

Risk-weighted debt (bankruptcy probability multiplied by debt) can be used to explain financial institutions’ losses one year a head in time.⁵ Risk-weighted debt as a percentage of total debt expresses expected loss per krone of debt in the event of bankruptcy and no dividend. For enterprises as a whole, this ratio remained approximately unchanged in 2002 compared with the previous year (see Chart 2.19). The ratio increased for commercial services. In isolation, a reduction in bankruptcy probabilities after 2002 will contribute to reducing risk-weighted debt.

Chart 2.19

Default probabilities decline

According to Moody’s KMV model, the probability of large, unlisted enterprises defaulting on their debt obligations is somewhat lower now than in the spring (see Chart 2.20). The fall has been largest for the 75 percentile enterprise (the median of the 50% weakest enterprises). The main reason for the lower default probabilities is the rise in equity prices, which according to the KMV model contributes to increasing the value of enterprises’ assets.

Chart 2.20

The default probability for the median enterprise in all the large Nordic countries is lower than it was this spring (see Chart 2.21). The decline has been most pronounced in Norway and Sweden, which are also the countries with the highest default probabilities.

Chart 2.21

Continued uncertainty associated with property companies

Property companies have higher debt financing than other enterprises, and the property industry is also the largest recipient of bank loans (Annex Table 1). In 2002, the increase in estimated interest for property companies coincided with a fall in return on total assets (see Chart 2.22). This contributed to a reduction in the pre-tax return on equity. Return on equity has been falling since 1999. The fall in interest rates this year has contributed to reducing the interest burden and thereby boosting the debt servicing capacity of property companies. Property companies with a large share of floating rate loans or a short lock-in period for fixed rate loans have benefited most from the fall in interest rates. Figures for listed property companies indicate that the interest rate lock-in period varies widely across companies. The average lock-in period for these companies varies from 1 to 5 years.

Chart 2.22

Property companies are affected by developments in various markets. Developments in the market for rental of office buildings are the main cause for concern. In February 2003, the percentage of vacant office space in Oslo, Asker and Bærum was about 10%, an increase of 5 percentage points on the previous year according to Eiendomsspar’s annual survey. This high vacancy rate appears to have remained steady. The value of office buildings has moved on a negative trend, and rental prices for office premises have continued to fall (see Chart 2.23). The effect of falling rental prices depends on the duration of the rental contracts. Only expiring contracts will be renewed at a lower rental price. However, existing rental contracts may also be renegotiated to reflect lower rental prices. Property companies in the hotel sector are exposed to a fall in the number of overnight stays. This number fell by 4% in the first 9 months of 2003 compared with the same period in 2002.

Chart 2.23

During the first 9 months of 2003, the area of completed premises and building starts for service sectors decreased by 23% and 13%, respectively, compared with the same period in 2002. Growth in the supply of commercial property is therefore declining, which in isolation may contribute to curbing the fall in rental prices and property values.

Share prices for listed property companies have moved on a positive trend since the May report (see Chart 2.24). However, the rise in prices is weaker than the benchmark index (OSEBX) on the Oslo Stock Exchange. In recent years, share prices for listed property companies have fluctuated less than the OSEBX. Listed property companies are more active than the property business as a whole in renting out retail premises, a market segment that has developed favourably.

Chart 2.24

Developments ahead

The fall in interest rates in 2003 has substantially reduced the debt and interest burden of the enterprise sector. As a result, many enterprises can service their debt even with low operating revenues. With increased growth in the Norwegian economy, enterprises’ underlying earnings will also improve.

The weak profitability of property companies, coupled with the substantial debt in this sector, is cause for concern. Our estimate for expected loss per krone of debt in this sector in 2002 is approximately unchanged from 2001 to 2002 (Chart 2.19). The estimate for expected loss per krone of debt in the sector commercial services, which represents an important share of the demand side for property companies, rose in 2002. On the other hand, the decline in interest rates in 2003 has contributed to reducing enterprises’ interest burden, thereby boosting their debt servicing capacity in the short term. On balance we assess the risk associated with parts of the property industry as relatively high, and unchanged from our assessment in the May report.

Enterprises in some industries, such as fish farming and commercial services, are still financially vulnerable. For the enterprise sector as a whole, the estimate for expected loss per krone of debt, based on accounts for 2002, remained roughly unchanged. The fall in interest rates has contributed to strengthening enterprise profitability in 2003. Although financial vulnerability varies across industries, on balance we assess overall risk as moderate, and somewhat lower than six months ago, if we disregard certain segments of the property industry.