The perils of private sector deleveraging in the Eurozone
This post was originally posted on Vox by Fabian Bornhorst, Marta Ruiz Arranz, 10 November 2013
Private and public debt in the Eurozone increased since the 2000s, and especially so in certain countries. This column presents evidence that high levels of private and public debt, together with deleveraging of all sectors, are especially harmful for economic growth. Private sector debt is more detrimental to growth than public sector debt. Therefore, policies aimed at reducing the private debt could yield important benefits.
High debt and the simultaneous deleveraging of firms, households, banks, and the public sector can weigh on growth through various channels. High debt increases private agents’ vulnerabilities to asset price shocks, financial volatility, and uncertainty. Faced with the need to strengthen and repair balance sheets, agents place more importance on debt reduction than on profit maximization, which reduces economic activity. This, in turn, exacerbates the initial drop in asset prices, and increases financial volatility. Economy-wide, self-enforcing negative feedback loops between highly-indebted private sectors, a weak financial sector, and a sovereign under stress constrain demand and credit conditions. Uncertainty about the private sector’s ability to service the high debt burden can raise questions about banks’ asset quality, and impair financial intermediation (Figure 1).
Figure 1. Feedback loops from balance-sheet effects
Debt levels in Eurozone crisis economies are high
Since the 2000s, private and public debt in the Eurozone increased most sharply in those countries that are now under stress. Debt is particularly high in Ireland, Portugal, and Spain, where households, firms, and the government are all highly indebted compared to their Eurozone peers (Figure 2). The levels of indebtedness and the associated challenges vary from country to country and across sectors (see Cuerpo et al. 2013, and Bornhorst and Ruiz-Arranz 2013). But generally speaking, in the non-financial corporate sector high leverage, low profitability, and bank dependence are particularly problematic for small and medium enterprises, and insolvencies have increased rapidly. In the household sector, the turn of the housing cycle has left many households with lower net worth, and young and low-income households in particular are vulnerable to further house price shocks. Despite low rates, debt servicing costs are high for indebted households. While household assets are important buffers, they are often illiquid. In Spain, for example, high levels of assets and low wealth dispersion—a result of high ownership rates—have been important mitigating factors. But in a depressed housing market with high owner occupancy rates, disposing of housing wealth is often difficult.
Figure 2. Indebtedness across the Eurozone
Historical episodes of deleveraging
We look at previous episodes of deleveraging and find that, historically, almost all of the run-up in household debt (during the boom period) tends to be reversed (Figure 3, see also Tang and Upper 2010). But in the Eurozone, where the boom was more pronounced, the reduction in debt-to-GDP ratios has barely started, despite the fact that the private sector has moved into a financial surplus position. Furthermore, most deleveraging episodes in the past were passive, in the sense that households did not actively pay down debt – it was instead eroded by nominal income growth. And fiscal policy was expansionary during past deleveraging episodes, supporting growth.
Because these factors cannot be expected to support the household deleveraging process in much of the Eurozone’s crisis economies, the adjustment is likely to be protracted and have to rely more on reductions in nominal debt.
Figure 3. Household deleveraging episodes
Is high private debt associated with lower growth?
While the debate about high public debt and growth remains open, a large body of research concludes that high public debt leads to higher interest rates and slower growth (e.g., Reinhart and Rogoff 2010, 2012, Kumar and Woo 2010, Cecchetti, Mohanty and Zampolli 2011, Baum, Checherita and Rother 2013). But far fewer studies have attempted to explore the impact of private sector debt on growth. Cecchetti, Mohanty and Zampolli (2011), for example, find that high corporate and household debt can also become a drag on growth. In a recent paper, against the background of high debt in the Eurozone, we present evidence that high private sector debt, paired with high public-sector debt, hampers growth (Bornhorst and Ruiz-Arranz 2013).
Our analysis – building on Cecchetti, Mohanty and Zampolli (2011) – suggests that the negative growth impact of debt in one sector depends on the level of indebtedness in the other sectors. When the three sectors – government, households, and corporate – have above-average debt levels, the negative growth impact of debt is highest (Figure 4). The results support the hypothesis that the confluence of debt in more than one sector exacerbates the negative feedback loops that arise in times of crisis. Therefore, headwinds are likely to be particularly strong in crisis countries where all sectors are highly indebted. The analysis also suggests that private sector debt may be more detrimental to growth than public-sector debt. Regressions identify a stronger and more statistically significant association between private sector debt and growth than between government debt and growth.
Figure 4. The impact of high debt on growth
Dealing with high private-sector debt in the Eurozone
Experience suggests that decisive and properly sequenced policy actions can support deleveraging. Where private sector deleveraging is more advanced (e.g., the US), measures were taken early on to strengthen balance sheets of financial institutions. Bank and private debt restructuring mechanisms have been used more widely, facilitating the workout of nonperforming loans and dispelling doubts over asset quality.
In the Eurozone, an accelerated clean-up of private and financial sector balance sheets can help avoid a protracted period of stagnation (see IMF, 2013). But delays and resistance to work out nonperforming loans in the banking system, and lengthy procedures for personal and corporate bankruptcies, increase uncertainty over the extent of the problem, and put further downward pressure on asset prices and firm performance. At the aggregate level, such feedback loops can trigger debt deflation dynamics. Therefore, in addition to providing a supportive macroeconomic environment, targeted policies to support the debt workout should be strengthened (see e.g., Laryea 2010 and Laeven and Lareya 2009).
- Repairing the financial sector is essential to address the balance sheet problems in the corporate and household sectors. The workout of private debt requires adequate provisioning and capital buffers in the banking system to absorb losses. A clean-up of banks’ balance sheet would strengthen the banking system and help credit flow (IMF 2013).
- Progress on improving insolvency frameworks in the Eurozone has so far been uneven. Reforms to insolvency frameworks take time, and effective implementation is often most difficult key to success. A number of countries have moved to strengthen insolvency frameworks and institutions (see Liu and Rosenberg 2013) including Austria, Germany, Greece, Ireland, Italy, Portugal, and Spain.
- But despite this progress, procedures are not widely used, and the insolvency regimes remain inefficient and costly in many countries. National insolvency regimes and institutions may need to be made more effective e.g., by facilitating out-of-court settlements, reducing time for insolvency proceedings and providing more flexibility to deal with personal or corporate bankruptcy. In many cases, the stigma associated with bankruptcy also needs to be overcome.
Authors’ note: The views expressed herein are those of the authors and should not be attributed to the IMF, its Executive Board, or its management.
Bornhorst, Fabian and Marta Ruiz-Arranz (2013), “Indebtedness and Deleveraging in the euro Area”, 2013 Article IV Consultation on euro Area Polices: Selected Issues Paper, Chapter 3, IMF Country Report No. 13/206 (Washington).
Buti, Marco and Pier Carlo Padoan (2013), “How to make Europe’s incipient recovery durable: End policy uncertainty”, VoxEU.org, September 12
Cecchetti, Stephen G, M S Mohanty and Fabrizio Zampolli (2011),“The Real Effects of Debt”, BIS Working Papers 352 (Basel).
Cuerpo, Carlos, Inês Drumond, Julia Lendvai, Peter Pontuch and Rafal Raciborski, (2013), “Indebtedness, Deleveraging Dynamics and Macroeconomic Adjustment”, European Economy, Economic Papers 477.
International Monetary Fund, 2013, Euro area Policies, IMF Country Report No. 13/202 (Washington).
Kumar, Manmohan S. and Jaejoon Woo (2010), “Public Debt and Growth”, International Monetary Fund Working Paper 10/174 (Washington).
Liu, Yan and Christoph B. Rosenberg, (2013), “Dealing with Private Debt Distress in the Wake of the European Financial Crisis: A Review of the Economics and Legal Toolbox.” International Monetary Fund Working Paper 13/44 (Washington).
Laeven, Luc and Thomas Laryea (2009), “Principles of Household Debt Restructuring”, International Monetary Fund Staff Discussion Note 09/15 (Washington).
Laryea, Thomas (2010), “Approaches to Corporate Debt Restructuring in the Wake of the Financial Crisis”, International Monetary Fund Staff Discussion Note 10/02(Washington).
Tang, Garry and Christian Upper (2010), “Debt Reduction After Crises”, in BIS Quarterly Review, September 2010, pp. 25-38 (Basel).
Reinhart, Carmen M. and Kenneth Rogoff (2010), “Growth in a Time of Debt”, American Economic Review: Papers and Proceedings 100, pp. 573-578.
Reinhart, Carmen M., Vincent R. Reinhart, and Kenneth Rogoff (2012), “Debt Overhangs Past and Present”, NBER Working Paper 18015 (Cambridge).