Financial Stability 2/2001

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3 Macroeconomic developments and credit risk

3.1 The macroeconomic environment
3.2 Credit developments
3.3 Credit risk associated with loans to the household sector
3.4 Credit risk associated with loans to the enterprise sector
Box:
Enterprise investment and financing

3.1 The macroeconomic environment⁴

Until this autumn, the turnaround in the world economy had only limited effects on the Norwegian economy and Norwegian banks. The downturn was primarily linked to the technology industry, which accounts for a small share of the Norwegian business sector compared with many other countries. Moreover, the Norwegian technology industry is not very export-oriented and has a limited degree of bank financing.

The terrorist attacks on the US have amplified the international downturn. The downturn will also be felt in Norway. The travel industry and airlines have already been affected by growing caution among businesses and households. The volume of traditional merchandise exports has fallen. The same applies to prices for important Norwegian export goods, such as fish and aluminium. Earnings and activity levels in many enterprises may decline markedly next year as a result of the downturn.

At the same time, labour shortages in public and private services are expected to persist. The public sector will generate an increased stimulus to the Norwegian economy in the years ahead. Households have a solid financial position and income growth is expected to be strong over the next few years, providing scope for continued growth in private consumption. An increase in vacation days and low growth in the labour force will result in weak growth in the labour supply. The rise in labour costs and the deterioration in profitability are therefore expected to continue. All in all, mainland GDP is projected to increase approximately in pace with growth in capacity over the next two years.

Table 3.1

The business sector will be facing structural challenges as a result of growing tendencies of a dichotomy in the economy. For several years, high growth in labour costs has contributed to weakening profitability. Continued pressures in the public sector and sheltered sectors of the economy are contributing to further shifts of economic resources from industries exposed to international competition.

This will also pose increasing challenges to the banking sector and may result in higher bank losses in the years ahead. This particularly applies to banks that have large loans to industries exposed to international competition.

In general, the scale of losses will depend on the adaptability of the Norwegian economy. The more easily production equipment, property and other fixed assets can be transferred to more profitable uses, the lower banks' losses will be as a result of adjustments. Banks that have large commitments to enterprises with fixed assets that are heavily tied to a specific activity will be most exposed to losses.

The adaptability of labour is also of considerable importance to banks. If those who become unemployed are swiftly hired by other enterprises, households will be able to maintain their income and debt-servicing capacity.

The scale of loan losses as a result of adjustments is not expected to be of a magnitude that will threaten the financial strength of the banking industry. The downside risk for Norwegian banks is largely associated with the depth of the downturn in the international economy, which will also weaken economic developments in Norway.

In addition to a sharp downturn, a pronounced fall in asset prices might threaten financial stability. These events often coincide in time. Equity markets have fallen sharply since peaking in spring 2000. However, the value of Norwegian households' shares and units in securities funds is limited (see Table 3.2). The fall in the value of households' holdings of equities and units in securities funds has thus far been more than offset by a further increase in housing wealth, which in general is far more important for households.

Table 3.2

The oil price is of particular importance to Norway. Projections for the Norwegian economy are based on an oil price that continues to generate high revenues. There is considerable uncertainty concerning future oil prices. A substantial fall will result in more sluggish economic developments in Norway even though lower oil prices will stimulate demand in our export markets. Investment activity in the petroleum sector and supplier industry will be reduced. Household expectations concerning their own finances may be reduced, with a fall in house prices and reduced consumption growth as a result.

Various risks that are facing the financial system are assessed in this report. Credit risk constitutes the largest potential for losses. A severe downturn in the economy would increase the probability that losses associated with several types of risk will occur at the same time.

3.2 Credit developments

Outstanding credit to the public in mainland Norway (households, non-financial enterprises and municipalities) has increased considerably since the mid-1990s. At the end of 1995, total outstanding credit from domestic and foreign sources to mainland Norway came to 128% of mainland GDP. At the end of the second quarter of 2001, this credit had increased to 163% of mainland GDP, or about NOK 1800 billion.

Both enterprises and households have contributed to the sharp growth in credit (see Chart 3.1). Credit from domestic sources to enterprises, measured as a share of mainland GDP, rose from 38% at end-1995 to 53% at the end of the second quarter of 2001. For households, the equivalent share increased from 71% to 79%. Municipalities account for a relatively modest share of total domestic credit even though the rate of growth in municipal borrowing has been very high the past year.

Chart 3.1

The 12-month growth in credit to households came to 10.5% at end-September 2001 (see Chart 3.2). The rate of growth has been more than 10% for 18 months. The rate of growth in loans to enterprises has been very high in periods, but has slowed markedly the past year and is now lower than growth in credit to households. At end-September, the 12-month growth in credit to enterprises was 9.0%. Credit to municipalities grew by 15.8%.

Chart 3.2

3.3 Credit risk associated with loans to the household sector

Continued high growth in debt…

Household debt is still growing rapidly. One reason for this is the sharp rise in house prices (see Chart 3.3). Higher house prices result in increased borrowing requirements for house purchases. At the same time, the rise in house prices boosts the housing wealth of households, and hence their possibilities for borrowing, as dwellings are often used as collateral. This situation may lead to a price-credit spiral driven by expectations of a further rise in prices.

Chart 3.3

Debt has risen at a faster pace than disposable income since the third quarter of 1999. This will place increased demands on income growth in the period ahead. Loan repayments should generally be covered by disposable income. If borrowing is used to accumulate liquid wealth, it will be possible to use this when loans are to be repaid.

The household saving ratio has remained high for several years and increased further in 2000. Total gross fixed and financial investments were thus higher than borrowing in 2000. This means that an amount equivalent to all loans raised plus part of disposable income were used for fixed and financial investments. Households' fixed investment is generally equal to investment in new dwellings. The continued sharp rise in the number of housing starts in the first eight months of 2001 indicates that fixed investment has continued to increase this year. Gross investments in financial assets levelled off in the first half of 2001 at a little less than NOK 100 billion, measured as the sum of the last four quarters, after having increased sharply for several years.

Traditionally, banks have exercised caution in extending credit for investments in financial assets. The sharp rise in debt nevertheless appears to have been used to finance both fixed and financial investments. The explanation for this may be that households raise new loans or increase their loans on the basis of rising housing wealth and refrain from repaying loans when part of the increase in housing wealth is realised.

…but wealth is also increasing

Positive investments in fixed and financial assets in recent years have resulted in an increase in household wealth in the form of fixed and financial assets (see Chart 3.4).

Chart 3.4

Gross financial wealth increased at a particularly sharp rate after 1998. A large part of the increase in wealth reflects a higher market value for securities. The all-share index of the Oslo Stock Exchange fell by 23½% in the third quarter of this year. On the basis of the fall in value as a result of the drop in securities prices in autumn 1998, the decline this autumn may reduce the value of households' securities holdings by about NOK 30 billion.

Financial wealth is largely concentrated in high-income households: in 1999, 10% of households with the highest income accounted for more than 45% of households' total gross financial wealth. Debt is also unequally distributed among households, but to a lesser extent than gross financial wealth. Net financial wealth is therefore also unequally distributed. The unequal distribution is also evident when we look at different age groups (see Chart 3.6). Younger age groups have on average negative net financial wealth. The difference between younger and older age groups has widened over the past ten years.

Chart 3.5     Chart 3.6

All in all, households have accumulated net financial wealth of more than NOK 400 billion. Financial wealth, to the extent that it can be used when required, will serve as a buffer for servicing debt in the event of lower growth or a fall in income. If wealth is adjusted for insurance claims, which are not very liquid and cannot be used to the same extent if households should experience problems in servicing their debt, financial wealth is negative.

Reduced ability to withstand strong economic downturn

The sharp growth in household debt over the past two years has led to an increase in the debt burden (debt as a percentage of disposable income) (see Chart 3.7). Over the past six months, the debt burden has increased further, approximately in line with the projections in the baseline scenario in the previous report. The high level of borrowing also contributes to an increase in the interest burden (interest expenses as a percentage of cash income, i.e. disposable income before deducting gross interest expenses) (see Chart 3.8). The interest burden in the baseline scenario is somewhat lower than in the spring report as a result of some upward revisions in the estimates for growth in household disposable income in the period ahead.

Chart 3.7     Chart 3.8

A higher debt and interest burden has weakened the household sector's ability to withstand macroeconomic shocks which result in higher unemployment or a higher interest rate. With a sharp reduction in income, households will have to cut back on consumption and reduce debt. If households experience problems in repaying their debt, this may increase banks' losses on loans to households. Banks' losses may also increase if earnings in enterprises are reduced as a result of lower private consumption.

Developments in credit risk associated with loans to the household sector are thus closely related to general economic developments. The financial position of households influences the earnings potential of enterprises and hence credit risk associated with loans to enterprises. The economic outlook for households is favourable but more uncertain than it was six months ago. Credit risk is deemed to have increased further over the past six months. Both the debt and interest burden have continued to rise. Moreover, uncertainty about future developments has increased. All in all, credit risk is nevertheless still considered to be relatively low.

3.4 Credit risk associated with loans to the enterprise sector

Continued high debt growth, but signs of slowing…

Debt in the enterprise sector has increased considerably over the past 5-6 years following relatively moderate growth at the beginning of the upturn in the 1990s. Mainland enterprises in particular have accounted for the sharp increase in borrowing (see Chart 3.9). Gross loan debt in these enterprises has doubled since 1995, to a little more than NOK 600 billion.

Chart 3.9

The strong growth in debt is closely related to investment growth in enterprises. A steadily higher portion of debt in the enterprise sector is being used for investments in financial assets (see separate box). Fixed investment also rose sharply in the 1990s. Growth in fixed investment has slowed since 1995, while borrowing continued to increase up to the last part of 2000 (see Chart 3.10).

Chart 3.10

Growth rates for borrowing have slowed since November 2000. At end-September 2001, the 12-month growth in credit from banks came to 6.1% after having remained between 15 and 20% in the second half of 2000 and beginning of 2001. There are considerable differences across industries, which seem to underpin the impression of a dichotomy in the economy (see Chart 3.11). Sheltered industries, such as retail trade and services, are largely maintaining relatively high growth rates, while industries exposed to international competition, for example manufacturing, have sharply reduced credit growth this year.

Chart 3.11

Operating profits in non-financial enterprises, excluding oil and shipping, have shown far more moderate growth than changes in debt. The debt burden has thus increased and is now higher than it was at the end of the 1980s.

Slight increase in risk-weighted debt in 2000…

In spring 2001, Norges Bank developed a new credit risk model that predicts bankruptcy probabilities for enterprises as a function of, among other things, corporate earnings, liquidity and financial strength (equity ratio).⁵ According to the model, the bankruptcy probability of a typical enterprise (median enterprise) was approximately unchanged from 1999 to 2000 (see Chart 3.12).

Chart 3.12

The reduction in bankruptcy probability through the 1990s primarily reflects solid corporate earnings over several years. This contributed to improving enterprises' liquidity and equity ratio. A rising equity ratio indicates that a steadily smaller portion of corporate investment is debt-financed.

Despite a continued sharp rise in debt, risk-weighted long-term debt⁶ rose only marginally from 1999 to 2000. One reason for this is that the equity ratio increased in many enterprises in 2000. Moreover, enterprises with a high bankruptcy probability account for a steadily smaller share of long-term debt in the enterprise sector.

Risk-weighted debt increased in a number of industries in 2000 (see Chart 3.13 and 3.14). The fisheries industry, tourism, IT enterprises and the shipbuilding industry showed the sharpest increase. With the exception of the fisheries sector, these industries account for a small share of total risk-weighted debt. In isolation, the greatest cause of concern relates to the increase in risk-weighted debt in retail trade and property management, which are the two industries that have the most risk-weighted debt.

Chart 3.13     Chart 3.14

…and lower earnings

Weaker earnings are the first indication that enterprises are beginning to experience financial problems. A moderate decline does not increase bankruptcy risk to any extent. If the decline is considerable and persists, enterprises' liquidity and financial strength will come under pressure.

An enterprise normally uses 5-10 years to repay its long-term debt. It is therefore not unreasonable to assume that earnings after interest expenses and tax should amount to a minimum 10% of long-term debt if the enterprise is to be able to service its debt without major problems. In industries where enterprises generally have a longer maturity for debt (for example, property management), the earnings requirement each year will be lower than for the average industry. In 2000, total earnings in the enterprise sector came to 14.6% of total long-term debt, down from 15.7% in 1999. Earnings deteriorated in a number of industries from 1999 to 2000, and in 2000 were at a low level in relation to debt obligations in several industries.

The return on total assets (earnings as a percentage of total assets) was reduced from 1999 to 2000 in all the industries analysed. The reduction was greatest in IT enterprises, telecommunications, the shipbuilding industry and the fisheries sector. In 2000, the return on total assets varied from 1% in the telecommunications industry to about 11% in the construction sector and transport industry.

Small regional differences

Risk-weighted debt is largely concentrated in retail trade and property management in the most populated counties. However, the less populated counties increased their share of risk-weighted debt in 2000. Even though enterprises in some counties and industries have a relatively small share of total risk-weighted debt, some banks may be exposed.

Møre og Romsdal, Hordaland, Rogaland, Vest-Agder, Østfold, Vestfold and Telemark have a relatively large number of export-oriented industries. Enterprises in these counties may be particularly vulnerable in the event of an international downturn.

Risk-weighted debt has shown very similar developments in all counties since the end of the 1980s. This indicates that the potential for regional risk diversification is fairly limited. Charts 3.13 and 3.14 also indicate that there is little potential for risk diversification across industries in Norway.

Chart 3.13     Chart 3.14

Outlook for a further decline in earnings in 2001

Negative developments in the third quarter of this year, as well as the weak outlook for the remainder of the year, provide grounds for assuming that earnings will decline further in 2001. If earnings are reduced by 10%, and the high level of borrowing is maintained, earnings will on average amount to 11.8% of long-term debt at the end of the year, compared with 14.6% in 2000 (see Table 3.3). The situation will nevertheless be better than at the beginning of the 1990s when corporate earnings only came to 9.8% of long-term debt. Even if the level of earnings from 2000 is maintained, a number of industries at the end of 2001 will have earnings that are lower than 10% of long-term debt if the level of borrowing is maintained.

Table 3.3

Calculations made by KMV Corporation based on equity prices and accounts data show a considerable increase in the bankruptcy probability for unlisted enterprises in 2001 (see Chart 3.15). The increase has taken place in recent months. This demonstrates that enterprises' debt-servicing capacity is vulnerable to a fall in earnings. Bankruptcy probability has also increased sharply for listed non-financial enterprises in recent months.

Chart 3.15

According to figures from Dun & Bradstreet, the number of payment notations so far this year has increased in relation to the same period last year. This is an indication that a growing number of enterprises are beginning to experience financial problems. Due to changes in the data supply, it is difficult to quantify the actual increase.

Developments ahead

Generally sound liquidity and the high equity ratio at the end of 2000 imply that the enterprise sector as a whole is still fairly solid. The outlook ahead, however, is less favourable. This is reflected in developments in enterprises' debt and interest burden in the period ahead (see Chart 3.16 and 3.17). In the estimates, it is assumed that debt growth in mainland enterprises slows in the years ahead and that earnings decline in line with developments witnessed so far in 2001. This implies that the debt burden will remain high in the years ahead.

Chart 3.16     Chart 3.17

As a result of the strong increase in debt, enterprises must maintain high earnings in the years ahead to allow them to service their debt. Uncertainty concerning future economic developments has also increased. The risk of payment problems in enterprises and subsequent loan losses in banks is thus greater now than it was six months ago.

There is reason to be particularly aware of developments in industries that have a high risk-weighted debt and are also export-oriented. This particularly applies to the fisheries industry and fish farming as well as some manufacturing sectors (including metal goods and chemical products). The two industries with the highest share of risk-weighted debt, property management and retail trade, are to a lesser degree directly exposed to the international downturn. If the downturn extends over a longer period, these industries may also be affected to a sizeable extent. The risk of a deeper and more prolonged international downturn than currently envisaged does exist and the risk has increased in recent months. All in all, the risk associated with loans to mainland enterprises is considered to be higher than in the previous Financial Stability report.

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