I will excerpt much of Mr. Caruana’s speech (bold added)
Globally, debt – of households, non-financial corporates and governments combined – has risen from around 210% of GDP at the end of 2007 to around 235% of GDP according to the latest available figures in 2014. That’s a rise of more than 20 percentage points in the course of just over six years. The increase has been faster in emerging market economies, albeit from a lower initial level, but debt has risen in advanced economies as well.
Not surprisingly, I find myself agreeing with the question posed in the title of a recent Geneva Report – “Deleveraging? What deleveraging?” – though not necessarily with all the policy conclusions drawn by the authors.
Today I would like to share with you a few thoughts about debt and its consequences. I will first take stock of where we are by highlighting a few additional figures on debt and sharing some observations on why the current pattern and dynamics of borrowing do not seem to fully reflect the performance of economically sound functions. I will then reflect on the consequences of higher debt levels. I am tempted to call this section “Debt trouble comes in threes”, paraphrasing the saying “Trouble comes in threes”. In other words, trouble usually doesn’t come alone
Taking stock
How is the 20 percentage point increase in global debt divided between the private and the public sector?
In advanced economies, government debt has risen by close to 40 percentage points of GDP since end-2007 to over 110% of GDP, while private sector debt has fallen by about 10 percentage points.
In emerging market economies, the picture is reversed, with private sector debt growing by more than 40 points during the same period to over 120% of GDP, while government debt has risen only slightly.
The total debt levels in emerging market economies are mostly still significantly lower than those in advanced economies.
In other words, despite a damaging global financial crisis that resulted from excessive leverage, and despite the deleveraging of specific sectors, there really has been little or no deleveraging in aggregate. Some countries – for example, the United States, the United Kingdom and Spain – have managed to reduce excessive household debt since the crisis, but their government debt has increased substantially. Others, especially among the emerging market economies, have kept public sector borrowing largely under control, but borrowing by their firms and households has run rampant
To continue…
The figures I have cited so far refer to the debt taken on by end borrowers. By contrast, leverage among major banks – at least when measured in relation to their equity – has declined since 2007. In particular, banks worldwide have become better capitalised, thanks to stronger regulation and market discipline.
And from a global perspective, aggregate cross-border bank lending, largely driven by the banks most affected by the crisis, has been relatively subdued since then, although it has shown some signs of growth in the past year. These cross-border banking flows are useful for channelling savings to countries that need resources for investment, but research has found that historically they tend to amplify domestic credit booms and busts – on both the upside and the downside. So, given the initial conditions, cross-border banking flows “taking a breather” may on balance be good news – especially since it has stopped adding fuel to those countries that have been experiencing financial booms.
My comment the BIS understands how capital flows are HARDLY the cause of boom bust cycles which are internally generated. Capital or cross border flows only AMPLIFIES on it, as foreign money (mostly financed by carry trades) piggybacks on sentiment in both directions: stampeding inflows during manias, flight during panics.
That said, we see that, at the same time, international bond issuance has hit record highs, especially for emerging market corporates. This development requires some attention.
Let me emphasise that debt, by itself, is not necessarily bad. It performs a useful, indeed vital, economic function. To quote from a 2011 BIS Working Paper by Cecchetti, Mohanty and Zampolli:
“Finance is one of the building blocks of modern society, spurring economies to grow […] individuals can consume even without current income. With debt, businesses can invest when their sales would otherwise not allow it. And, when they are able to borrow, fiscal authorities can play their role in stabilising the macroeconomy.” The authors’ empirical analysis supports the view that, at moderate levels, debt enhances growth, but beyond a certain threshold it becomes a drag on growth – very much in the spirit of the findings by Reinhart and Rogoff as well as some other authors.
My comment: there are productive debt and there are unproductive debt, democratization of debt via zero bound encourages accumulation of unproductive debt.
Mr Caruana’s example: household debt...
In many emerging market economies, the increasing debt stocks reflect, at least in part, progress in the development of their financial systems. Financial deepening contributes to economic well-being and to lower financial and macroeconomic volatility. As more households and businesses gain access to credit, this gives them greater flexibility to smooth out their consumption and to make long-term investments.
In practice, however, debt is often used in ways that don’t seem to correspond to economically sound functions. For example, in some of the countries that were hit hard by the financial crisis, households have tended to extract equity from their homes in good times while paying down their debts in bad times. In other words, the availability of housing finance has reinforced the economic cycle, instead of smoothing it. And a recent study by the Swedish central bank found that, despite high levels of household debt in that country, roughly four out of 10 borrowers are not reducing or amortising their debts.
Mr Caruana’s example Corporate debt…
Corporate borrowers also tend to be procyclical – paying down debt in recessions and borrowing to buy back shares during an upswing. The present cycle seems to be no exception. Corporations in advanced economies hoarded cash during the crisis, and more recently they have been issuing debt in order to buy back shares or to fund leveraged acquisitions. Meanwhile, in many economies, high corporate profitability is not being matched by spending on real investments.
While some governments have been able to use fiscal policy to counteract demand shortfalls in the aftermath of the crisis, their ability to perform this stabilising function has sooner or later become constrained by the high debt accumulated during the crisis (or even before). The result has been adverse debt dynamics – despite record low interest rates – with government debt stocks not yet returning to a clearly sustainable path. And some countries, especially on the European periphery, have even been forced to cut spending during the downturn.
Three types of debt trouble…
What are some of the implications of excessive debt? In my introduction, I said that the debt trouble comes in threes. At the origin is the build-up of financial imbalances that leads to excessive credit growth. What are the three types of trouble? The first and the most obvious: the build-up of financial imbalances risks a future financial crisis, an impaired financial sector and a debt overhang.
The leverage that builds up during the boom weakens balance sheets, which reduces borrowers’ capacity to repay and their resiliency to shocks. This vulnerability, in turn, magnifies creditors’ losses, amplifies market participants’ responses and contributes to generating market dynamics that are abrupt and non-linear.
Reliance on debt heightens sensitivity to declines in asset prices..
Relatively small declines in asset prices can force borrowers to cut back their activities, and in some cases default or reschedule their debts, which is costly for lenders and a potential drag on borrowers’ finances. We have seen this type of effect most recently in response to the sharp falls in house prices in countries such as the United States, Spain and Ireland. Similar adverse dynamics can occur if problems hit an overleveraged corporate sector, as several Asian economies learnt in the crises of the 1990s.
This excess sensitivity is just a symptom of the fact that leverage increases procyclicality. Small downside shocks to the economy become transformed, through various channels, into large ones. But the seeds of the problems that materialise in the bust are in fact sown during the boom. There, the procyclicality operates on the upside: borrowers can expand their balance sheets and take on risks too easily, pushing up asset prices and making it easier still to borrow more. The boom sets the stage for the subsequent bust.
Wow. Thoroughly the Austrian Business Cycle from the BIS’ perspective.
Now why emerging markets are faced with high credit risks…
History has taught us that large external debt is correlated with greater vulnerabilities and potentially sudden stops.Indeed, research at the BIS has found that when private sector credit-to-GDP ratios are significantly above their long-term trend, banking strains are likely to follow within three years. And right now, a number of emerging economies, as well as some advanced ones, have reached this point in the financial cycle.
And the subsequent debt overhang holds back growth. Households and firms seek to pay back what turn out to be excessive debt burdens, built on the illusory promise of permanent prosperity that the boom had fostered. Expansionary aggregate demand policies lose effectiveness. And, unless the financial sector is fixed quickly, it restricts and, more importantly, misallocates credit: reluctance to take losses keeps credit available for the weaker borrowers and curtails or makes it more expensive for the healthier ones. The damage caused by delayed balance sheet repair following the bust of the boom in Japan is well documented.
Tick tock tick tock.
The second, but less obvious, kind of trouble is that debt accumulation fosters misallocations of real resources.
The GDP and credit growth in the pre-crisis boom years were not evenly spread. They were concentrated disproportionately in specific sectors. For instance, in countries like Spain and Ireland, growth in the boom years was largely propelled by the construction sector as well as finance.
Leverage can distort investment decision-making, giving incentives to put resources into projects that promise quick, measurable returns, rather than into longer-term ventures with less certain but potentially more valuable rewards. Such incentives are arguably stronger when leverage is cheap.
The consequence of this association between debt accumulation and real resource misallocation is important. When boom turns to bust, the bloated sectors will have to shrink. Reviving growth in this kind of recession requires flexibility and capacity in the economy to reallocate resources efficiently from less productive to more productive sectors.
As I recently noted applied to the Philippines: A fifth major cost is that resources channeled to the bubble sectors are resources that should have been used by the market for real productive growth. Much of these resources are now awaiting reappraisal from the marketplace via a shift in consumer’s preferences which will render much of these misallocated capital as consumed capital.
Also: And since the current credit boom translates to intensive leveraging of the balance sheets of entities with access to the formal banking system and to the capital markets, the current BSP actions eventually shifts the risk equation from inflation to levered balance sheets…In short, there is concentration of credit risk from mostly heavily levered firms.
Third, financial booms mask deficiencies in the real economy.
Credit booms can act as a smokescreen. They tend to mask the sectoral misallocations that I just described, making it difficult to detect and prevent these misallocations in time. Boom times also tend to hide other slow-moving forms of deterioration in real growth potential. One such example is the trend decline in productivity growth in the advanced economies that started decades ago. Arresting this decline is crucial to achieving sustainable economic growth. Additional examples are adverse demographics and the secular decline of job reallocation rates. What appears fantastically harmonious on the way up thanks to the flattering effect of the credit-driven boom becomes cacophony and fragmentation on the way down
My comment: credit booms, which are seen by the public as this time is different, are illusory. The greater the boom, the more harrowing the crash. Let me paraphrase Newton’s third law of motion; for every boom, there is a near proportional and opposite bust.
Mr Caruana’s conclusion…
And so that’s why I said debt trouble comes in threes. The combination of these three types of debt-related phenomenon together with policies that neglect the power of financial cycles can give rise to serious risks in the long term. A sequence of such boom-bust cycles can sap strength from the global economy. And policies–fiscal, monetary and prudential –that do not lean sufficiently against the build-up of the financial booms but ease aggressively and persistently against the bust risk entrenching instability and chronic weakness: policy ammunition is progressively eroded while debt levels fail to adjust. A debt trap looms large.
Moving away from the debt-driven growth model of the last few decades is in my view essential in order for the global economy to truly recover from the crisis. This will require efforts from the public and the private sector alike to restore the resilience and reliability of the financial system. But no less importantly, it will require a rebalancing of economic policies so as to support greater flexibility and productivity in the real economy. In other words, a wider but country -specific reform agenda is needed.
Every crisis has been sown from the seeds of artificial booms. There is now way out now except to let the markets clear.
But the boom cannot continue indefinitely. There are two alternatives. Either the banks continue the credit expansion without restriction and thus cause constantly mounting price increases and an ever-growing orgy of speculation, which, as in all other cases of unlimited inflation, ends in a “crack-up boom” and in a collapse of the money and credit system. Or the banks stop before this point is reached, voluntarily renounce further credit expansion and thus bring about the crisis. The depression follows in both instances.—Ludwig von Mises
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