Debt quality, not accumulation, threatens financial stability
In its latest financial stability report (October 2018), the IMF
warns against continued debt accumulation. The global debt mountain
has never been higher. However, a closer look at the data reveals
that it is mainly emerging markets that experienced a debt
explosion, with the problem concentrated in a number of countries.
Moreover, despite substantial growth in non-financial corporate
debt, productivity growth remains constrained in advanced economies.
Apparently, credit is insufficiently used to boost future growth.
Hence, rather than reducing credit provision to avoid financial
instability, credit quality should be monitored more intensively.
For several emerging markets, reducing absolute debt is essential to
avoid an uncontrollable further debt accumulation.
Absolute versus relative
In absolute terms, aggregate global debt increased substantially in
recent decades. However, when expressed in relative terms, namely as a
percentage of global GDP, talking about a global debt explosion since
the financial crisis is clearly exaggerated (Figure 1).
Figure 1 - Evolution of Global Debt (in % of GDP and TN USD)
During the last decade, debt went hand in hand with economic growth.
One can assume that credit growth contributed to economic growth by
boosting consumption and in particular investments. Distinguishing
between advanced and emerging economies teaches us that relative debt
growth was particularly strong in emerging markets. Conversely,
relative aggregated debt growth has actually been slightly negative
after the financial crisis in advanced economies (Figure 2).
Deleverage in the financial sector contributed substantially to this
trend, whereas other economic agents in western countries still
increased their indebtedness over the past 10 years.
Figure 2 - Evolution of Debt, Emerging Market vs Advanced Economies (% of GDP, GDP weighted averages)
In particular, non-financial corporate debt increased substantially.
In a period of gradual recovery after an economic downturn, growing
credit provision is no surprise. Corporate credit played a substantial
role in growing out of the financial crisis. As such, this trend is
not worrying, but rather reassuring. The corporate sector invested in
the future. However, debt accumulation should lead to improved growth
potential in the longer run. Otherwise, debt levels may become
unsustainable, in particular when the economy cools down or interest
rates rise. For advanced economies, productivity growth is an
essential driver of future potential growth. If one looks at the
evolution in productivity growth in advanced economies, the recent
evolution is very disappointing (Figure 3). Annual productivity growth
dropped to about 1%, far less than in the recent past and insufficient
to give a strong boost to economic growth. This is surprising in an
era of radical innovation in artificial intelligence and
digitalization. The latest technological trends have not translated
into higher productivity growth yet. This discrepancy between credit
growth and declining productivity growth raises questions about the
quality of credit provision from a macroeconomic perspective. Credit
provision is insufficiently focused on productivity enhancing
investments which is a crucial condition for debt sustainability in
the longer run. Hence, rather than calling for debt reduction in
advanced economies, it seems more appropriate to call for improved
credit quality. This may not be an easy task. Financial institutions
and their regulators do watch credit quality, because of its
importance for macroeconomic financial stability. However, the credit
quality control is based on financial parameters rather than on the
economic rationale of new investment projects. Ultimately what counts
for the financial sector is that loans are reimbursed. Hence the
macroeconomic perspective stands far away from the micro-level
reality. Bringing in a macroeconomic perspective in credit provision
policies would be economically wise, but practically hard to
implement. Nevertheless, it can and should become the focus in
Figure 3 - Productivity Growth (GDP per hour worked) (USD, 2010 PPPs, % change yoy)
Vigilance for emerging markets
While low productivity growth is a concern in advanced economies, other debt quality features matter for emerging markets. In particular, emerging markets’ vulnerability to foreign currencies and foreign interest rates are worrying. Various emerging markets are exposed to developments in the US economy. The combination of USD appreciation and increasing US long-term interest rates risks causing an upward pressure on the most indebted emerging markets. It is no surprise that Argentina and Turkey have been among the first victims, but undoubtedly more emerging economies will be affected as roughly a third of all debt maturing through 2021 is USD denominated. Despite growth enhancing effects of credit provision in emerging markets, these financial challenges call for a clear debt reduction in the most indebted emerging markets.
In sum, the global debt story is more nuanced than suggested by the
latest IMF report. Debt levels are at all-time highs but relative to
GDP, debt in advanced economies has slightly declined since the
financial crisis while that of emerging markets continues to increase.
The appropriate respective responses, therefore, should also be
nuanced. In advanced economies, the focus going forward should be on
credit quality and whether or not leverage is boosting future
potential growth. In emerging markets, as financial conditions
tighten, countries will need to focus on reducing macroeconomic
imbalances, including reducing their debt burdens.