A new IMF report illustrates that a large share of both advanced and emerging economies struggle with private debt overhangs. Excessive debt is a drag on growth and a risk for financial stability. Low nominal growth has hampered deleveraging and aggravates these dangers. Moreover, high public sector debt has reduced governments’ capacity to support private balance sheets and stabilize economic growth in future crises. Therefore, the lingering debt overhang provides a strong incentive for fiscal and monetary policies to work towards higher nominal GDP growth now.

IMF Fiscal Monitor, “Debt: Use it Wisely”, October 2016.

The post ties in with this sites’ lectures on government finance risks.

The below are excerpts from the report. Headings and some other cursive text has been added for context and convenience of reading.

The debt situation

“The global gross debt of the non-financial sector has more than doubled in nominal terms since the turn of the century, reaching USD152 trillion in 2015. About two-thirds of this debt consists of liabilities of the private sector…current debt levels, at 225% of world GDP are at an all-time high.”

Private debt overhang can be characterized as a situation in which a borrower’s debt service exceeds its future repayment capacity…For evaluating repayment capacity [one can] use the sustainability criterion… whereby private debt is assessed as sustainable whenever net worth follows a non-decreasing trend. Widening differences between actual and sustainable debt defined according to this methodology would signal possible deleveraging pressures in the future. Data for a sample of advanced economies suggest that private debt is high in some cases, even after assets are accounted for…The gap between actual and sustainable debt in the household sector that opened up during the boom has not yet been closed… In more than half the sample, non-financial corporations have increased their leverage relative to the period before the crisis.”

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A condensed history

“The genesis of the global debt overhang problem resides squarely within advanced economies’ private sector. Enabled by the globalization of banking and a period of easy access to credit, nonfinancial private debt increased by 35% of GDP in advanced economies in the six years leading up to the global financial crisis [in 2008]. The credit boom was not limited to the U.S. mortgage sector but was broad based…with more than half of the debt coming from households.”

After the start of the global financial crisis, public debt in advanced economies rose rapidly, while progress in private sector deleveraging was mixed. On average, private debt ratios in advanced economies reached a turning point in 2012, with the largest reductions since then registered in those countries that entered the crisis with high debt levels. In some cases, however, private debt has continued to accumulate at a fast pace—notably, Australia, Canada, and Singapore.”

“As private debt started to retrench, public debt picked up, increasing by 25 percent of GDP over 2008–15. The realization of contingent liabilities with respect to the private sector played an important role, accounting for about a quarter of the change…Only about one-third of advanced economies have made inroads in improving general government net financial worth since 2012 and, on average, these inroads have been small.”

“Meanwhile, easier financial conditions in the aftermath of the global financial crisis have led to a private debt boom in some emerging markets, particularly in the nonfinancial corporate sector. The surge was concentrated in a small number of emerging market…although this group includes large systemically important countries such as Brazil and China…The rise in private debt among these countries, at 38% of GDP on average, is of some concern, as it is similar in magnitude to that of advanced economies in the run-up to the [global financial] crisis.”

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The nominal growth problem

“Private sector deleveraging in advanced economies thus far has been much slower than previous successful experiences…The percentage reduction in private debt ratios so far has been only a third of historical precedents at this point in time, and private debt levels are significantly higher…Weak macroeconomic conditions have been the major factor impinging on deleveraging efforts in advanced economies…The current low-nominal- growth environment… is…setting the stage for a vicious feedback loop in which lower growth hampers deleveraging and the debt overhang exacerbates the slowdown.”

“Changes in debt-to-GDP ratios can be due to pure inertia imposed by the need to pay interest on the existing debt stock (which increases the ratio’s numerator) and nominal GDP growth (which increases its denominator). The balance of these two opposing forces is the so-called interest-growth differential (r–g). “

“Although the interest rate environment has been relatively benign…low nominal growth in advanced economies has resulted in positive interest-growth differentials, implying a cumulative increase in total debt over 2008–15. This…is… hindering deleveraging by households and non-financial corporations. As an illustration, even if the private sector in advanced economies had not issued any new debt since 2008 but had simply rolled over the outstanding stock of debt at that time, private sector debt ratios in those countries would have increased by 17% of GDP.”

“In the euro area…there is evidence that some European banks—burdened by high levels of impaired assets and a low-growth environment— may not be in a position to extend the necessary credit flows to sustain normal economic activity, contributing to a deeper economic slump. In addition, structural challenges have worsened the outlook for bank earnings in these countries, complicating the clean-up of balance sheets.”

The fiscal problem

“Empirical analysis shows that fiscal policy can significantly reduce the depth and duration of a financial recession associated with a private sector debt overhang. However, a government’s ability to play such a stabilizing role depends on the health of its fiscal position prior to the crisis, especially in emerging market economies… without government intervention, balance sheet repair often proceeds very slowly, because of coordination problems, market failures, and the inability of distressed banks to absorb losses.”

“General government balance sheets have… weakened, particularly in advanced economies…Low nominal growth accounts for close to 50 percent of the increase in the public debt ratio since the start of the global financial crisis…If financial repression follows, margins may be compressed and banks’ profitability will decline. All of this will ultimately result in inefficient credit rationing for creditworthy households and firms.”

“Entering a financial crisis with a weak fiscal position exacerbates the depth and duration of the ensuing recession, as the ability to conduct countercyclical fiscal policy is significantly curtailed in that case.”

“[A historical analysis] examines six deleveraging episodes in which fiscal policy was deployed as part of a policy package aimed at reducing private sector debt while minimizing the so-called deleveraging drag on output…All six countries implemented a fiscal stimulus…Expansionary macroeconomic policies and targeted fiscal interventions complemented and reinforced one another. To the extent that they did not work in sync, the recovery was frail…In most cases, early action geared toward bank recapitalization and corporate restructuring was instrumental in unclogging the economy’s credit system, encouraging write-downs, and minimizing output losses.”

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Ralph Sueppel is founder and director of SRSV Ltd, a research company dedicated to socially responsible macro trading strategies. He has worked in economics and finance for almost 25 years for investment banks, the European Central Bank and leading hedge funds. At present he is head of research and quantitative strategies at Macrosynergy Partners.