Fiscal policy effects on non-performing loan formation

The fiscal situation in an economy may have a significant impact on the evolution of Non-Performing loans (NPLs). Austerity measures limit the loan servicing capacity of households and businesses (Perotti, 1996) whereas public borrowing accelerates markedly ahead of sovereign debt and banking crisis (Reinhart and Rogof, 2010). We empirically approach the effects of fiscal policy on NPLs employing a global data set for 31 countries covering a fifteen year period. We control also for other macroeconomic factors so as to quantify effects stemming from fiscal policy measures. We employ panel data methodologies since they provide us the means to deal with unobserved country heterogeneity when examining the determinants of asset quality. We also examine the one period ahead forecasting performance of our models in line with the cross sample panel data validating suggestions of Granger and Huang (1997). Our findings imply that, on a global level, when accounting for variables linked to macroeconomic performance such as GDP growth and the unemployment rate, fiscal pressure imposed on the economy, as measured by changes in the cyclically adjusted primary surplus, constitute important determinants of Non-Performing loan formation. Also our specifications provide efficient out-of-sample one-step ahead forecasts combining effectively unobserved country heterogeneity with observed macro and fiscal determinants. Our analysis could be of great interest to policymakers since the assessment of credit risk in the banking sector is a crucial element of macro-prudential policy. In this framework, besides strict macroeconomic performance metrics one should also take into account the fiscal framework when trying to explain the key drivers behind NPL evolution.