Stock traders on the floor of the exchange in São Paulo, Brazil: private credit is booming in many emerging market economies (photo: Mauricio Lima/AFP)

Low Growth, Inflation Hamper Debt Reduction

October 5, 2016

  • Global debt at record highs, rising
  • Two-thirds represents private sector liabilities
  • Fiscal policy can help facilitate private sector deleveraging

Global debt, currently at an all-time high, could thwart the fragile economic recovery, the IMF said today in the latest Fiscal Monitor.  

Reducing debt significantly will require fiscal policies that support economic activity, and facilitate the restructuring of private debt and the     cleanup of non-performing bank loans.

Global debt has continued increasing in the aftermath of the global financial crisis, reaching 225 percent of world GDP by the end of 2015 (see Chart 1). "Global debt is one of the major headwinds against growth in the world economy," said Vitor Gaspar, Director of the IMF's Fiscal Affairs Department.

About two-thirds, or close to $100 trillion, consists of private sector liabilities. Although not all countries are in the same phase of the debt cycle, the sheer size of the global debt raises the risks for an unprecedented deleveraging—a reduction of debt levels—that could hamper growth worldwide.

The October 2016 Fiscal Monitor examines the extent and makeup of global debt and uses a new database covering virtually the entire world to explore fiscal policy’s role in facilitating the adjustment needed to reduce debt to less risky, more manageable levels.

A diverse debt landscape

Private debt is high in advanced and a few systemically important emerging market economies, but trends have varied widely since 2008:

  • Advanced economies, the epicenter of the crisis, have deleveraged unevenly, and in many cases private debt has continued climbing. Public debt levels have also risen in these countries, partly as a result of their taking on private sector liabilities through bank bailouts.
  • Easy access to financing worldwide has led to a private credit boom in some emerging market economies, notably China.
  • In low-income countries, private and public debt levels have also risen, thanks to greater availability of and wider access to financial services, as well as improved market access, but debt-to-GDP ratios generally remain low.

It all comes back to growth

Deleveraging has so far proceeded slowly among highly indebted advanced economies, largely because of the current environment in which growth rates and inflation remain low. Deleveraging can make matters worse by putting a further drag on economic activity. High debt levels can slow the pace of economic recovery for a number of reasons.

First, high private debt levels increase the likelihood of financial crises, which are usually accompanied by deeper and more protracted economic slowdowns than those associated with normal recessions. The risks are not confined to private debt, as entering a financial crisis with high public debt levels exacerbates the effects of a financial crisis, more so in emerging markets than in advanced economies.

Second, excessive debt levels can weigh on an economy’s growth even in the absence of a financial crisis, as highly indebted borrowers ultimately reduce their investment and consumption.

Complementing fiscal with other policy levers

The evidence suggests that for a significant deleveraging to take place, restoring robust growth and returning to normal levels of inflation is necessary. So what to do in a world in which the room for policy action is constrained because either resources are limited or policy levers (such as interest rates) cannot move further? On the fiscal front, targeted interventions such as government-sponsored programs to help restructure private debt and public support for financial sector restructuring can be very effective in reducing the output losses generally associated with private debt deleveraging. The Fiscal Monitor looks at several case studies where these measures were used, underlying the importance of their design to ensure their success.

The simulations discussed in the report suggest that these types of interventions, if well designed, can be more powerful than standard fiscal stimuli, particularly when the weaknesses in banks result in inefficient credit rationing of solvent households and firms. Of course, these measures should be supported by strong frameworks for insolvency and bankruptcy and guided by strong governance principles to limit abuses and safeguard public funds.

But fiscal policy cannot solve the debt problem alone. Given the limited room for policy action noted earlier, it is imperative to exploit complementarities across different policy tools—including monetary, financial, and structural—to get more mileage out of any fiscal intervention.

Preventing excessive private debt

“It is important to have in place measures to prevent excessive debt buildups,” said Gaspar, particularly in emerging markets, where private sector leverage has increased rapidly over the last few years. The report makes three key recommendations:

  • Regulatory and supervisory policies should ensure that private debt levels are monitored and sustainable.

  • Fiscal policy should be countercyclical in upturns to create buffers for cushioning downturns.

  • Incentives in tax policy that encourage debt should be phased out to limit excessive leverage buildup.

The global financial crisis taught us that it is very easy to underestimate the risks associated with excessive private debt during upswings and underscored the cost of responding too slowly to a financial crisis. Fiscal policy can do more than it is currently the case to restore nominal growth, facilitate the necessary economic adjustment following a crisis, and build resilience in an economy to withstand future upheavals. However, it cannot do it alone; it has to be supported by complementary policies within credible frameworks.