Confronting the Hazards of Rising Leverage

IMF Blog, March 29, 2021

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Leverage—defined as the ability to borrow—can boost growth by enabling investment by firms and consumption by households, but high levels or rapid increases in leverage can create financial vulnerabilities and increase exposure to severe downturns or sharp asset price corrections.
During the COVID-19 pandemic, policymakers acted to ensure access to credit so firms and households could borrow to cushion the downturn; this helped limit layoffs and allowed households to continue spending on essentials such as rent, utilities, or groceries.
The core policy question: how to support the fledgling recovery without allowing an excessive buildup of leverage.

Leverage measured as the ratio of the stock of debt to GDP approximates an economy’s capacity to service its debt.
From 2010–19, global nonfinancial private sector leverage rose from 138 percent to 152 percent.
Leverage of firms reached a historical high of 91 percent of GDP.
Easy financial conditions after the global financial crisis of 2008–09 have been a key driver of rising leverage.
In response to the COVID-19 shock, borrowing increased further in both advanced and emerging market economies.
The decline in output contributed to higher debt-to-GDP ratios, and corporate leverage rose an additional 11 percentage points of GDP through to the third quarter of 2020.

Accommodative policies (cuts in policy rates and quantitative easing) reduced borrowing costs, supporting growth but also fueling increases in leverage.
Short-term effect: easing financial conditions provide a boost to economic activity.
Medium-term risk: easing is associated with a heightened risk of a sharp downturn starting at 7-8 quarters out.
The tradeoff is amplified during credit booms: the near-term boost is greater, and the medium-term downside risks are larger.
Policymakers must balance supporting recovery with avoiding excessive leverage buildup that could threaten financial stability later.

Macroprudential measures can tame buildups in nonfinancial sector leverage and help resolve or lessen the policy dilemma.
Evidence on specific tools and their effects:
- Tightening borrower-related tools (e.g., reducing the maximum loan-to-value ratio for mortgage borrowers) slows household leverage.
- Tightening liquidity regulations on banks (e.g., raising the minimum amount of liquid assets that must be held in proportion to total assets) slows firm leverage.
- Tightening foreign currency constraints on banks in emerging markets (e.g., limiting their open foreign currency positions) slows firm leverage.
Macroprudential tightening can mitigate downside risk to growth and alleviate the tradeoff between near-term support and medium-term risks.
Combining monetary policy loosening with concurrent macroprudential tightening can mostly contain medium-term downside risks to economic activity.

Timing is complex: broad tightening of financial conditions could hurt nascent recoveries, yet lags between activation and impact of macroprudential tools call for early action.
Limitations of current toolkits:
- In many advanced countries, the macroprudential toolkit is aimed solely at banks while credit provision is increasingly migrating toward nonbank financial institutions.
Policy implications:
- Swift, targeted tightening of macroprudential measures is recommended to address pockets of elevated vulnerabilities while avoiding general tightening of financial conditions.
- Policymakers need to urgently design new tools to address leverage beyond the banking system.

Source: Confronting the Hazards of Rising Leverage — Adolfo Barajas, Fabio Natalucci; March 29, 2021.