Managing Debt in an Overleveraged World
MILAN – What ever
happened to deleveraging? In the years since the 2008 global financial
crisis, austerity and balance-sheet repair have been the watchwords of
the global economy. And yet today, more than ever, debt is fueling
concern about growth prospects worldwide.
The McKinsey Global Institute, in a study
of post-crisis debt trends, notes that gross debt has increased about
$60 trillion – or 75% of global GDP – since 2008. China’s debt, for
example, has increased fourfold since 2007, and its debt-to-GDP ratio is
some 282% – higher than in many other major economies, including the
United States.
A global economy that
is levering up, while unable to generate enough aggregate demand to
achieve potential growth, is on a risky path. But to assess how risky, several factors must be considered.
First, one must
consider the composition of the debt across sectors (household,
government, non-financial corporate, and the financial sector). After
all, distress in these sectors has very different effects on the broader
economy.
As it turns out,
economies with similar and relatively high levels of gross debt relative
to GDP exhibit sharp differences when it comes to the composition of
the debt. Excessive household debt is particularly risky, because a
shock in the price of assets (especially real estate) translates quickly
into reduced consumption, as it weakens growth, employment, and
investment. Recovery from such a shock is a long process.
The second factor to
consider is nominal growth – that is, real growth plus inflation. Today,
real growth is subdued and may even be slowing, while inflation is
below target in most places, with some economies even facing the risk of
deflation. Because debt is a liability for borrowers and an asset for
creditors, these trends have divergent effects, increasing value for the
asset holder, while increasing the liability of the debtor. The problem
is that, in a low-growth environment, the probability of some form of
default rises considerably. In that case, nobody wins.
The third key factor
for assessing the risk of growing debt is monetary policy and interest
rates. Though no one knows exactly what a “normal” interest-rate
environment might look like in the post-crisis world, it is reasonable
to assume that it will not look like it does today, when many economies
are keeping rates near zero and some have even moved into negative
territory.
Sovereigns with high
and/or rising debt levels may find them sustainable now, given
aggressively accommodative monetary policy. Unfortunately, though such
accommodation cannot be sustained forever, today’s conditions are often
viewed as semi-permanent, creating the illusion of stability and
reducing the incentive to undertake difficult reforms that promote
future growth.
The final, and
arguably most important, factor shaping debt risk relates to investment.
Increasing debt to sustain current consumption, whether in the
household or government sector, is rightly viewed as an unsustainable
element of a growth pattern. Here, China’s case is instructive.
In a sense, the
frequent refrain that China’s debt is on an unsustainable path is true.
After all, high levels of debt increase vulnerability to negative
shocks. But, in another sense, this misses the point.
Many governments
nowadays are accumulating debt in order to buttress public or private
consumption. This approach, if overused, can amount to borrowing future
demand; in that case, it is clearly unsustainable. But, if used as a
transitional measure to help jump-start an economy or to provide a
buffer from negative demand shocks, such efforts can be highly
beneficial.
Moreover, in a
relatively high-growth economy, ostensibly high debt levels are not
necessarily a problem, as long as that debt is being used to fund
investments that either yield high returns or create assets worth more
than the debt. In the case of sovereign debt, the return on investment
can be viewed as the increment to future growth.
The good news is
that, in China, much of the accumulated leverage has indeed been used to
fund investment, which in principle creates assets that will augment
future growth. (Whether the results of the government’s recent decision
to increase the fiscal deficit to stimulate the economy follow this
long-term growth-enhancing pattern remains to be seen.)
The bad news is that
directed lending and the relaxation of credit standards in China,
particularly after the crisis, have led to investment in assets in real
estate and heavy industry with a value well below the cost of creating
them. The return on them is negative.
China’s so-called
debt problem is thus not really a debt problem, but an investment
problem. To address it, China must reform its investment and financial
systems, so that low- or negative-return investments are screened out
more reliably. That means tackling the mispricing of risk that results
from the government’s backing of the country’s state-owned banks (which
surely could not be allowed to fail).
Many developed
countries are also failing to invest in high-return assets, but for a
different reason: Their tight budgets and rising debts are preventing
them from investing much at all. As this weakens growth and reduces
inflation, the speed at which their sovereign-debt ratios can be reduced
declines considerably.
In order to spur
growth and employment, these economies must start paying closer
attention to the kind of debt they accumulate. If the debt is financing
growth-promoting investment, it may be a very good idea. If, however, it
is financing “current operations” and raising short-term aggregate
demand, it is highly risky.
Of course, the
situation is not cut and dried. The return to public investment is
affected by the presence or absence of complementary reforms, which vary
from country to country. And there is some potential for abuse, with
expenditures being misclassified as investments.
Yet, in an
environment of low long-term interest rates and deficient short-term
aggregate demand (which means there is little risk of crowding out the
private sector), it is a mistake not to relax fiscal constraints for
investment. In fact, the right kind of public investment would probably
spur more private-sector investment. Identifying such investment is
where today’s debt debate should be.
Michael Spence, a Nobel laureate in economics
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