Chapter

Chapter 2. Indebtedness and Deleveraging in the Euro Area

Author(s):
Petya Koeva Brooks, and Mahmood Pradhan
Published Date:
October 2015
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Author(s)
Fabian Bornhorst and Marta Ruiz-Arranz 

High debt in the euro area is weighing on growth. Countries that experienced a rapid increase in private sector debt in the run-up to the global financial crisis of 2008–09 have had worse economic outcomes—some are still in the middle of deep recessions, and their medium-term growth outlooks are weak.

Balance sheet adjustment in the euro area at the current juncture may prove more challenging than in other regions or in other episodes in the past. The simultaneous deleveraging of the public and private sectors in some countries appears increasingly daunting. And a fragmented financial sector with its own balance sheet problems amplifies the effect of private sector balance sheet stress on economic outcomes. Furthermore, the significant heterogeneity across countries in the euro area suggests that a one-size policy mix is unlikely to fit all. Countries in need of adjustment may be constrained by a common monetary and exchange rate policy, leaving them little space to maneuver. Finally, simultaneous deleveraging in several euro area members can lead to negative spillover effects, further amplifying the negative impact of country-specific deleveraging on economic activity.

This chapter evaluates indebtedness in the euro area and its implications for growth. It asks the following questions: Why does private sector indebtedness matter for growth? In which euro area countries is private sector indebtedness and leverage high? What do we know from past deleveraging experiences and what lessons can be drawn for the euro area? The next section of this chapter outlines how balance sheet stress can arise from high indebtedness and discusses the feedback loops at play across sectors. The third section takes stock of indebtedness across the euro area, identifying vulnerabilities across sectors and countries. The fourth section looks at historical episodes to gauge the extent of deleveraging that can be expected and the macroeconomic environment that supported previous deleveraging episodes. It also presents econometric evidence linking high debt in the private and public sector to growth outcomes. The fifth section offers policy considerations for the euro area.

Why Debt Matters

This section discusses balance sheet stress analysis and diagnosis.

Balance Sheet Stress

Indebted private sector agents are more susceptible to reacting to sudden asset price shocks or increased volatility. Large and sudden drops or swings in asset prices (for example, houses or equities) can cause balance sheet stress in an environment of high debt, because liabilities remain unchanged as the valuation of assets falls or fluctuates. High debt makes agents more vulnerable to sudden changes in macroeconomic conditions (interest rates and growth), while changing financing conditions make debt more difficult to roll over. Households and firms start focusing on repaying debt and strengthening their balance sheets (for example, by improving equity ratios or building liquidity buffers), while life-cycle consumption smoothing or expected returns on investment become secondary. This shift in behavior depresses demand and creates self-reinforcing feedback loops across sectors.

Thus, declines in asset prices have economy-wide consequences. Falling asset prices go beyond one sector of the economy because they affect both borrowers and creditors. For example, falling house prices reduce household wealth, decrease the value of collateral held by banks, increase nonperforming loans, and, when weak banks require public support, ultimately affect the public sector’s balance sheet. Public finances are also affected by lower tax revenue derived from transactions in this asset (for example, stamp duties). Likewise, equity prices not only determine a firm’s valuation (raising the cost of capital) and increase financial vulnerabilities such as the debt-to-equity ratio, but they also determine the value of households’ financial assets.

Feedback loops exacerbate downturns, particularly in cases of simultaneous deleveraging of the private, financial, and public sectors (Figure 2.1). The impact of asset price shocks has secondary effects. Faced with the need to repair balance sheets, agents give more importance to debt reduction than to profit maximization, which reduces economic activity and, in turn, exacerbates the initial drop in asset prices. Managing deleveraging becomes particularly challenging when all sectors of the economy, including the public and the financial sectors, deleverage simultaneously. This deleveraging can depress activity further because no sector is able to expand its balance sheet, even temporarily. The following feedback loops can be at play in a balance sheet recession with a weak financial sector:

  • Indebted households that need to repair their balance sheets consume and invest less, reducing firms’ profitability and the public sector’s tax revenue.
  • Firms faced with a slump in household demand begin to reduce their debt burdens by increasing margins, reducing wage costs, and scaling back investment. These actions, in turn, feed into lower household income through lower wages and higher unemployment, and into lower tax revenues.
  • The government’s own consolidation effort requires higher taxes and lower spending, which reduces households’ disposable income—exacerbating households’ debt-servicing capacity and firm profitability. In turn, public balance sheet weakness limits the scope for further assistance to the financial sector (for example, through bank recapitalizations).
  • The banking sector—faced with increasing nonperforming loans from households and firms and high exposure to a potentially weak sovereign—sees its capital being eroded. To rebuild its capital position, it tightens lending standards and increases lending rates, thereby depressing demand for investment and consumption loans.

Figure 2.1Feedback Loops from Balance Sheet Effects

Note: NPLs = nonperforming loans.

Diagnosing Balance Sheet Stress

Gross debt matters, but so do other indicators. A sector’s indebtedness is a key variable driving balance sheet stress and the ability of the sector to absorb shocks. However, focusing exclusively on gross debt is not sufficient. The level of indebtedness a sector can sustain varies across countries according to initial conditions, including the characteristics of the housing market or the degree of intermediation provided by the banking sector. Although scaling debt to income is useful for gauging a sector’s capacity to service debt obligations, leverage ratios that link debt to assets are relevant for assessing debt in relation to a sector’s own balance sheet. Assets, including housing and financial wealth, can also be important buffers because they allow agents to draw down savings and they are relevant in assessing debt sustainability. More important, because debt stocks tend to change slowly, financial flows can be useful for detecting changes in behavior that signal balance sheet stress. Such signals would happen, for example, when agents revert to financial surplus and when their debt-service burdens become too high relative to income. Other considerations that may alter the implications of the debt overhang include the characteristics of the debt profile, such as the composition, redemption profile, and structure of the investor base.

Analysis of aggregate balance sheet data has its limitations. It cannot identify pockets of vulnerability that may exist within sectors, and abstracts from distributional aspects. For example, assets and liabilities could be concentrated in different subsets of the population, and conclusions from an aggregate perspective can be misleading. This chapter provides an overview of indebtedness in the euro area, but it also takes into account more detailed country- and sector-specific analyses made available in other studies (IMF 2012a, 2012c, 2013c, 2013f; ECB 2013a).

Indebtedness and Deleveraging in the Euro Area: Stylized Facts

This section discusses the debt levels for the euro area, the variation across countries, nonfinancial firms, households, financial sector, public debt, and economic outcomes of high debt.

The Euro Area Debt Level

Debt levels for the euro area as a whole are on par with those in the United States or the United Kingdom, but the deleveraging process has yet to translate into debt reduction (Figure 2.2). In the aggregate, household debt is lower than in the United States or the United Kingdom. Corporate debt appears to be higher in the euro area and the United Kingdom than in the United States, though important differences in the size of intercompany loans and trade credit complicate comparisons in levels.1 Government debt in the euro area is also at comparable levels, and increased less since 2003 than in the United States or the United Kingdom. The euro area also enjoys a comfortable net international investment position. Yet since 2009, the United States and the United Kingdom have seen reductions in household debt, and the United Kingdom has also experienced a reduction in corporate debt, whereas the deleveraging process in the euro area has not yet translated into an area-wide reduction in debt. Looking at flows in the euro area shows the private sector’s deleveraging effort, with firms and households in a contractionary net lending position vis-à-vis other sectors (Figure 2.3; ECB 2013a).

Figure 2.2Euro Area: Net Lending/Borrowing

(By sector, percent of GDP)

Source: European Central Bank.

Figure 2.3Indebtedness in the Euro Area, the United States, and the United Kingdom

Sources: European Central Bank; Haver Analytics; IMF International Financial Statistics; and IMF World Economic Outlook.

Note: Includes intercompany loans and trade credit, which can differ significantly across countries.

Variation across Countries

Indebtedness varies across countries and sectors (Figure 2.4). Since early in the first decade of the 2000s, private and public debt have increased most sharply in countries now under stress. Debt is particularly high in Ireland, Portugal, and Spain, where households, the nonfinancial corporate sector, and the government are all highly indebted compared with their euro area peers. In addition, a number of other countries have high debt in one or two sectors.2 And when all sectors are highly indebted, sizable net external liabilities have accumulated.

Figure 2.4Indebtedness across the Euro Area

Sources: European Central Bank; Haver Analytics; and IMF staff estimates.

Note: Data labels in the figure use International Organization for Standardization (ISO) country codes.

Nonfinancial Firms

This section focuses on the corporate debt and leverage, as well as corporate insolvencies and vulnerabilities.

Corporate debt and leverage

Corporate indebtedness and leverage have increased. Indebtedness of euro area firms increased substantially in the first decade of the Economic and Monetary Union (EMU), as a consequence of low real interest rates and prospects of high growth. Higher bank debt, combined with falling equity valuations, has boosted corporate leverage during the crisis, threatening debt sustainability. Although firms’ leverage ratios have more recently fallen, they remain elevated in a number of countries (Figure 2.5, panels 1 and 2). Firm-level data suggest that in some euro area economies up to 20 percent of corporate debt may not be sustainable (IMF 2013e).

Figure 2.5Corporate Debt

Sources: European Central Bank; Haver Analytics; IMF staff calculations; Creditreform 2012; and IMF staff estimates.

Note: First observations for the Netherlands are 2005. Data labels in the figure use International Organization for Standardization (ISO) country codes.

Procyclical financial conditions are weighing on corporate balance sheets. Higher bank lending rates resulting from financial fragmentation are felt strongly in the bank-dependent small and medium-sized enterprise (SME) segment, which has a large share in value added. Lending conditions are tight, further reducing available financing for solvent firms.

Corporate insolvencies and vulnerabilities

Insolvencies have increased markedly where corporate debt is high (Figure 2.5, panels 3 and 4). In most crisis economies, the increase in insolvencies in the nontradables sector is somewhat higher than in the tradables sector, indicative of initial stages of economic rebalancing. This increase is noteworthy in view of the fact that, despite recent reforms, insolvency regimes in many euro area countries are generally lengthy and costly, and the recovery rate of claims is very low (Figure 2.6; World Bank 2013).

Figure 2.6Insolvency Regimes

Source: World Bank 2013.

Note: Data labels in the figure use International Organization for Standardization (ISO) country codes.

Pockets of vulnerability remain in the corporate sector. Although the overall level of indebtedness in some countries may not be alarmingly high, high debt increases the vulnerability of firms to changes in the business cycle, including interest rate fluctuations (ECB 2012). In addition, a confluence of other factors can make indebted firms more vulnerable. In Spain, corporate indebtedness problems are concentrated in the real estate and construction sectors, where firms are highly leveraged and very reliant on bank financing. However, firms in other sectors are also highly leveraged, making them vulnerable to interest rate and earnings shocks. In 2010, about a quarter of a sample of 7,000 firms were financially distressed (IMF 2012c). In Portugal, firm profitability is low, particularly for SMEs and micro-firms, which account for nearly two-thirds of corporate value added. As a result, the share of debt at risk is increasing, with 20 percent of firms in financial distress, concentrated in the nontradables sector (IMF 2013f). In Italy, the corporate debt-to-income burden is not particularly high, but leverage is high and the sector relies heavily on short-term bank financing, in particular in the important SME sector (IMF 2013c).

Households

This section focuses on the household debt and the housing boom including the buffers and vulnerabilities.

Household debt and the housing boom

The turn of the housing cycle triggered sector-wide deleveraging where real estate bubbles had driven debt up (Figure 2.7), especially in those countries where declining real interest rates and rapidly rising incomes encouraged households to contract debt. Mortgages represent the largest share of household debt in euro area countries (Cussen, O’Leary, and Smith 2012), and they have been the most significant drivers in the increase of household debt since the start of the euro. When the housing boom burst in 2007–08, households were left with high debt and overvalued assets, in particular in Ireland and Spain. Although the price adjustment has gone far in some countries (for example, Ireland), house prices remain high in some others (Spain, France, and the Netherlands).3 As house prices began to adjust, households moved from a financial deficit to a financial surplus position. In Ireland and Spain, for example, households have now begun to dispose of financial assets and repay debt, and have slashed the acquisition of nonfinancial assets (Box 2.1). Despite these efforts to repair balance sheets, household debt continued to increase until 2009. It has since started to decline in Ireland and, to a lesser extent, in Portugal and Spain.

Figure 2.7Household Debt

Sources: European Central Bank; and IMF staff estimates. Organisation for Economic Co-operation and Development; and IMF staff estimates.

Note: First observations for the Netherlands are 2005. Data labels in the figure use International Organization for Standardization (ISO) country codes. Long-term average since 2000 but varies with data availability.

Buffers and vulnerabilities

Household assets are important buffers, but 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, because households can dispose of assets to smooth consumption. However, in a depressed housing market with high owner-occupancy rates, disposing of housing wealth is often difficult. Indebted households have fewer liquid financial assets in countries such as Portugal, Spain, and Greece (Figure 2.8; ECB 2013b), although the sector as a whole has in many countries moved toward safe and liquid financial assets since the crisis (Cussen, O’Leary, and Smith 2012).

Figure 2.8Household Balance Sheets: Survey Results

Source: European Central Bank.

Note: Data labels in the figure use International Organization for Standardization (ISO) country codes.

Household balance sheets are vulnerable to income uncertainty, further asset price corrections, and, down the road, interest rate increases. In most countries with high household debt, sustainability indicators such as debt-to-income ratios or debt-service-to-income ratios have deteriorated (Figure 2.8), owing to falling incomes, with young and low-income households particularly vulnerable. For example, in Spain, 22 percent of households are estimated to be vulnerable to stress, but the shares are much higher among poor and young households, where debt-service-to-income ratios can reach 80 percent. The main risk for Spain arises from a further adjustment of house prices and an increase in interest rates given that most mortgages are indexed to the Euro Interbank Offered Rate (IMF 2012c). In the Netherlands, house prices are still overvalued based on a range of metrics, and young cohorts would be especially vulnerable to a further drop in prices (IMF 2013d).

Box 2.1.The Savings Rate and Household Balance Sheets

The rise in the household saving rate during 2007–09 in many advanced economies can be explained by the sharp decline in asset prices and increase in fiscal deficits (Figure 2.1.1).1 The decrease in wealth associated with the decline in house and asset prices prompted households to decrease consumption and increase savings. In turn, the deterioration in the fiscal position had a strong positive impact on savings—partly reflecting Ricardian equivalence where the expectation of future tax increases drives households’ savings relative to their income today.

Figure 2.1.1Household Saving Rate

Sources: European Central Bank; and Haver Analytics.

Since 2009, the deteriorating macroeconomic environment, lower disposable incomes, and higher unemployment have caused a decline in household savings (Figure 2.1.2). Cyclical factors such as higher unemployment lowered the household saving rate as households ran down accumulated assets to smooth consumption. In fact, before the crisis, households were acquiring financial and nonfinancial assets, and at the same time incurring debt. Since the crisis, households have slashed their acquisition of nonfinancial assets and are repaying debt by disposing of financial assets. In sum, households may still be saving a similar fraction of their incomes, but they are doing so by reducing their wealth and investing less, with negative consequences for the broader economy.

Figure 2.1.2Financial Account Decomposition of the Household Saving Rate

Sources: European Central Bank; Haver Analytics; and IMF staff estimates.

1 Econometric results are based on a sample comprising Canada, France, Germany, Ireland, Italy, Japan, Spain, the United States, and the United Kingdom from 1980 through 2012. The correlates to explain household saving behavior include wealth, fiscal policy, interest rates, cyclical factors, and demographic factors (see IMF 2013b).

Financial Sector

In many euro area countries, highly leveraged financial sectors impair intermediation and burden the sovereign. In several economies banks had traditionally relied on wholesale funding, and built large exposures to sovereigns and the real estate market (IMF 2013a). The share of nonperforming loans (NPLs)—both from households and firms—has risen rapidly, increasing uncertainty about the quality of banks’ assets, and in turn increasing funding costs and driving share prices down (Figure 2.9). In a fragmented European financial market, such banks face an uphill battle to strengthen their capital positions so as to provision for NPLs, buffer their sovereign exposure, and meet new regulatory requirements.

Figure 2.9A Weak Financial Sector

Sources: IMF Financial Soundness Indicators.

Note: Data labels in the figure use International Organization for Standardization (ISO) country codes.

Public Debt and the Migration of Debt

Debt migration from the private to the public sector has played an important buffer role in the euro area. In the boom phase, the private sector, in particular financial firms, increased their indebtedness while governments were able to reduce debt. As the private sector entered the deleveraging cycle, debt migrated to the public sector—through bank recapitalization or debt-financed fiscal demand support—while other sectors moved to reduce their debt burdens (Figures 2.10 and 2.11). However, with savings being lower than investment across all sectors for a number of years, many economies accumulated sizable external debt (Figure 2.12).

Figure 2.10General Government Debt

(Percent of GDP)

Source: IMF World Economic Outlook.

Note: Data labels in the figure use International Organization for Standardization (ISO) country codes.

Figure 2.11Debt Migration

Source: Haver Analytics.

Note: Data labels in the figure use International Organization for Standardization (ISO) country codes.

Figure 2.12External Indebtedness: Net International Investment Position

(Percent of GDP)

Source: IMF International Financial Statistics.

Note: Data for France are for 2011. Data labels in the figure use International Organization for Standardization (ISO) country codes.

High Debt and Economic Outcomes

Balance sheet stress has been associated with weaker economic outcomes (Figure 2.13). In countries where private sector debt increased rapidly to a high level until 2007, growth outcomes have since been weaker. This association also holds for household debt and consumption, as well as for corporate debt and investment. Moreover, where the corporate sector was highly leveraged in 2007, the increase in unemployment since the crisis has been higher.4 Finally, a highly leveraged financial sector precrisis has also been associated with higher lending rates postcrisis, creating procyclical financial conditions. Looking ahead, fiscal policy is tightening most where private sector balance sheet stress was the highest, also creating procyclical fiscal conditions.

Figure 2.13Balance Sheet Stress and Economic Activity

Sources: Organisation for Economic Co-operation and Development; IMF World Economic Outlook; IMF staff estimates; European Central Bank; and Haver Analytics.

Note: NFC = Nonfinancial corporation. Data labels in the figure use International Organization for Standardization (ISO) country codes.

Experience with Previous Deleveraging Episodes

This section discusses household deleveraging, corporate deleveraging, and the debt and growth nexus, including an econometric analysis.

Household Deleveraging

The magnitude of the post-2000 credit boom was unprecedented. A look at historical episodes can illustrate the scale of the present challenge. In the run-up to the crisis, the increase in household indebtedness in many advanced economies was, on average, 20 percentage points of GDP higher than in past credit cycles.5 As a result, the level of household debt and the need to deleverage became exceptionally large, compared with historical episodes.6

Household debt reduction has barely started (Figure 2.14). Most banking crises preceded by rapid credit expansions are followed by a protracted period of debt reduction (Tang and Upper 2010). Historical episodes suggest that the extent of deleveraging after the bust matches almost one-to-one the size of the debt built up during the boom period. That is, in most cases, household debt returned to the precredit boom level after a protracted period of deleveraging (lasting between 5 and 10 years). With household debt barely off its peak levels, the deleveraging process in euro area countries is expected to take many more years if debt is to return to the 2000 level. A notable contrast is the United States, which is two-thirds of the way back to the precrisis level (Figure 2.14).

Figure 2.14Household Deleveraging Episodes and Debt Reduction

Sources: Eurostat; Haver Analytics; national statistical agencies; IMF staff calculations; Organisation for Economic Co-operation and Development; and IMF World Economic Outlook.

Note: Data labels in the figure use International Organization for Standardization (ISO) country codes.

1 1970 for Canada, 1990 for Japan and Germany, 1980 for others.

2 September 2012, except for Ireland, Denmark, and Netherlands (June 2012) and Cyprus and Norway (end-2011).

In most historical episodes, household deleveraging was facilitated by higher inflation and an expansionary fiscal policy:

  • Most deleveraging episodes in the past were passive, in the sense that households did not actively pay down debt; instead, debt was eroded by inflation and income growth. The median contribution of inflation to the reduction in debt to disposable income was almost 70 percent in episodes associated with banking crises. The contribution of real income growth was about 25 percent, while the reduction in the stock of debt was small, except in Japan. In episodes without a banking crisis, the stock of debt even increased during the deleveraging period (Figure 2.14).
  • Fiscal policy was expansionary during the deleveraging period, supporting growth. The magnitude of the fiscal impulse varied across countries, but the cumulative impact was more than 10 percentage points in Sweden and almost 8 percentage points in Finland. The fiscal support was generally larger where deleveraging was the result of a banking crisis.

Projections suggest that the macroeconomic context this time will be more challenging. Euro area inflation is expected to undershoot the price stability objective. Therefore, the role of inflation in assisting the deleveraging process will be much more limited than in the past.7 Similarly, the contribution of growth in real disposable income is expected to be small, implying that deleveraging will have to rely more on paying down debt and, therefore, is likely to put additional stress on households. Likewise, fiscal policy will be less supportive of private sector deleveraging than in past episodes because public debt levels are significantly higher in most countries now than in the past. At the current juncture, market pressures and institutional factors constrain fiscal policy; the countercyclical role of public debt is projected to end in 2014 with a turn to primary surpluses in many countries (Figure 2.15).

Figure 2.15Fiscal Policy during Deleveraging Episodes

Sources: Eurostat; Haver Analytics; national statistical agencies; and IMF staff calculations.

Note: Data labels in the figure use International Organization for Standardization (ISO) country codes.

Corporate Deleveraging

Corporate debt levels are not much higher compared with the beginning of historical episodes of corporate deleveraging, but debt reduction has barely started. Although the levels of debt are comparable to previous episodes, the increase in corporate debt in the boom cycle was particularly large in Ireland and Spain, compared with historical episodes (Figure 2.16).8 Episodes of significant corporate deleveraging suggest that after large booms, an average of two-thirds of the increase in debt is subsequently reduced. In the euro area, corporate leverage has receded from the crisis peak in some countries, but debt-to-income ratios remain high.

Figure 2.16Corporate Deleveraging Episodes

Sources: Bank for International Settlements; Bruegel; European Central Bank; and IMF staff estimates.

Note: Data labels in the figure use International Organization for Standardization (ISO) country codes.

1 Historical episodes: Australia 1988–96; Japan 1989–97; United Kingdom 1990–96; Finland 1993–96; Norway 2000–05; Sweden 2001–04.

The Debt and Growth Nexus

The debate about the relationship between 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 (among others, Kumar and Woo 2010; Reinhart and Rogoff 2010; Reinhart, Reinhart, and Rogoff 2012; Cecchetti, Mohanty, and Zampolli 2011; Baum, Checherita-Westphal, and Rother 2012). Some of these studies find that high debt levels (greater than 80–90 percent of GDP) have a negative effect on growth. High debt also makes public finances more vulnerable because it constrains government’s ability to engage in countercyclical policies. An opposing school of thought argues that weak growth causes high debt and not the other way around. Panizza and Presbitero (2012) reject the hypothesis that high debt causes lower growth. Herdon, Ash, and Pollin (2013) challenge the findings of the influential papers by Reinhart and Rogoff, which argue that there is a threshold effect whereby debt greater than 90 percent of GDP leads to dramatically worse growth outcomes.

Fewer studies have attempted to quantify the impact of private sector debt on growth. A notable exception is Cecchetti, Mohanty, and Zampolli (2011), who find that corporate debt greater than 90 percent of GDP and household debt greater than 85 percent of GDP become a drag on growth. IMF (2012b) concludes that recessions that are preceded by a run-up in household debt tend to be more severe and protracted. This section looks at growth performance in previous household deleveraging episodes and presents econometric evidence of the way in which high private sector debt hampers growth.

Historical experience suggests that household deleveraging in the euro area will continue to weigh on growth. Average annual real GDP and consumption growth were about 1.5 percent lower during the deleveraging period than in the preceding period. The growth underperformance is not found to be higher in those countries where household deleveraging was also associated with a banking crisis (Figure 2.17). Although history is not destiny and the number of historical episodes to draw lessons from is limited, the analysis above suggests that headwinds from high debt and deleveraging are likely to persist.

Figure 2.17Historical Growth and Consumption Underperformance

Sources: Haver Analytics; and IMF staff calculations.

Note: Data labels in the figure use International Organization for Standardization (ISO) country codes.

Econometric Analysis

An econometric analysis suggests that the negative growth impact of debt in one sector depends on the level of indebtedness in the other sectors (Figure 2.18).9 When the three sectors—government, households, and firms—have above-average debt levels, the negative growth impact of debt is highest. 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 countries where all sectors are highly indebted.

Figure 2.18The Impact of High Debt on Growth

Source: IMF staff estimates; see main text and Annex 2.1 for details.

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.

  • High corporate debt and household debt are associated with negative growth even if either one is the only sector indebted in the economy. The negative impact becomes larger the higher the number of sectors with high debt. In particular, a 10 percentage point increase in the corporate debt-to-GDP ratio beyond the 98 percent average level is associated with a subsequent reduction in average annual growth of between 7 and 11 basis points, depending on whether the other sectors are highly indebted. Similarly, a 10 percentage point increase in the household debt-to-GDP ratio beyond the 48 percent average level is associated with a subsequent reduction in average annual growth of between 8 and13 basis points.
  • High public debt is negatively associated with growth only when both the household and corporate sectors are also indebted. In this case, a 10 percentage point increase in the government debt-to-GDP ratio beyond the 73 percent of GDP average level is associated with a 6 basis point reduction in subsequent average annual growth. In contrast, when only the government is indebted or only one additional sector has high debt, the relationship becomes not statistically significant.

Policy Options

This section focuses on dealing with high debt in the euro area, targeted policies, and how policy mix and structural policies help support private sector deleveraging.

Dealing with High Debt in the Euro Area

Experience suggests that decisive and properly sequenced policy actions can support deleveraging. Where private sector deleveraging is more advanced (for example, in the United States), measures were taken early on to strengthen the 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 about asset quality. These processes were supported by appropriate legislation and institutions. Historical debt-restructuring episodes also show that policies can help facilitate the deleveraging process, including through government-sponsored programs, direct government purchases of distressed assets, and the use of asset management companies to resolve distressed assets. In all such cases, the sequencing and country-specific circumstances are important (Laryea 2010). Two successful cases of household debt restructuring are the U.S. Home Owners Loan Corporation Program in 1933 and the experience in Iceland in the recent crisis.

Targeted Policies

Progress toward improving insolvency frameworks in the euro area could help, but it has so far been uneven. Reforming insolvency frameworks takes time, and effective implementation is often most difficult but key to success. A number of countries have moved to strengthen insolvency frameworks and institutions (Liu and Rosenberg 2013) including Austria, Germany, Greece, Ireland, Italy, Portugal, and Spain. Despite this progress, however, procedures are not widely used and the insolvency regimes remain inefficient and costly in many countries (Figure 2.6). National insolvency regimes may need to be made more effective by, for example, facilitating out-of-court settlements, reducing time for insolvency proceedings, and providing more flexibility to deal with personal or corporate bankruptcy. Stronger institutions—experienced judges and insolvency administrators—would also help support insolvency processes. In many cases, the stigma associated with bankruptcy also needs to be overcome.

Debt restructuring comes at high costs. Debt reprofiling, debt restructuring, or debt default in the private sector and financial sector can reduce private sector indebtedness, with overall macroeconomic benefits. Indeed, when creditor seniority is respected and common principles are applied, the workout of bad debt can catalyze new economic activity. But debt restructuring also comes at the cost of damaging creditor-debtor relations, imposing losses on other agents, and creating moral hazard.

Policies can help guide this restructuring process, thereby mitigating its costs. Repairing the financial sector is, however, essential to addressing the balance sheet problems in the corporate and household sectors.

  • Strengthening bank balance sheets and working out NPLs is a precondition to policy effectiveness. The workout of private debt requires adequate provisioning and capital buffers in the banking system to absorb losses. Only then will banks have incentives to restructure their exposures to distressed borrowers. This process could further be helped by providing tax incentives (or removing tax disincentives) for debt write-offs. Policies to encourage debt write-offs and help facilitate the transfer of nonperforming assets to new owners would also support the repair of bank balance sheets. A pan-European backstop for solvent banks would help break the negative feedback loop between banks and sovereigns and reduce fragmentation. Overall, a cleanup of banks’ balance sheets would strengthen the banking system and help credit flow.
  • Debt restructuring in the corporate sector could further be supported by making more use of debt-equity swaps and out-of-court procedures to support the early rescue of viable firms. Asset management companies, either private or with some government participation, could help accelerate the restructuring of corporate debt, while taking weak assets off banks’ balance sheets (Laryea 2010).
  • In the household sector, direct debt-service support (for example, through guarantees or deferred interest) can help vulnerable households avoid bankruptcy in the face of unemployment while minimizing moral hazard. Government-sponsored programs can also encourage banks to reschedule household debt (Laeven and Laryea 2009). Wealth encumbrance could be modified where needed by, for example, easing mortgage payments for highly indebted, low-income households whose property has been foreclosed. Personal insolvency frameworks should be geared toward facilitating a fresh start for financially responsible individuals.

Policy Mix and Structural Policies

A measured pace of fiscal adjustment and monetary policy actions to reduce fragmentation would further facilitate balance sheet adjustment. Countercyclical fiscal policy is effective in balance sheet recessions, but debt sustainability and market access considerations constrain its use. However, getting the pace of consolidation right is essential. Monetary policy should aim to address the impairments to the normal transmission of the monetary policy stance, which would help reduce corporate and household borrowing costs, especially in countries with a large debt overhang.

Structural policies could also help support private sector deleveraging or mitigate its impact. For example, facilitating the substitution away from bank to nonbank financing by developing capital markets could reduce the reliance of firms on bank financing. And labor market reforms could increase firms’ flexibility to absorb demand shocks, through an adjustment in working hours and pay rather than through labor shedding.

Conclusion

Balance sheet adjustment in the euro area is an uphill battle at the current juncture. In other deleveraging episodes, high nominal and real growth, exchange rate depreciation, and monetary easing have supported balance sheet adjustments. For many euro area economies, however, the policy space is much more constrained: exchange rate devaluations can only happen internally, and if successful, will put downward pressure on prices. The real growth outlook is weak throughout the region and beyond. Finally, because the monetary transmission mechanism is impaired, monetary easing is not effective in lowering interest rates, and a fragmented financial sector amplifies the negative effects of protracted private sector deleveraging.

An accelerated cleanup of private and financial sector balance sheets can help avoid a protracted period of stagnation. Delays and resistance to working out nonperforming loans in the banking system and lengthy procedures for personal and corporate bankruptcies increase uncertainty about 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 considered.

Annex 2.1. Econometric Analysis

The econometric analysis in this chapter builds on Cecchetti, Mohanty, and Zampolli (2011), who use a data set on debt levels for a group of 18 OECD countries, based primarily on flow-of-funds data. The paper uses data for the period 1980–2006; however, since the authors had compiled data through 2009, this analysis uses the full sample.

The empirical specification is derived from Solow’s neoclassical growth model, in which per capita income growth depends on the initial level of physical and human capital, the saving rate, the population growth rate, and technology. In addition to these standard regressors in the growth literature, measures of public and private sector debt are added to the specification to see whether they have an impact on growth independent of other determinants. Panel data regressions are estimated using country-specific and time-specific time effects as in the following equation:

in which

  • gi,t+1,t+k is the k-year forward average of annual real GDP per capita growth between years t + 1 and t + k. The analysis uses k = 5.
  • yi,t is the log of real per capital GDP at time t.
  • μi and γt are country-specific and time-specific dummies.
  • Xi,t includes gross saving as a share of GDP; population growth, number of years spent in secondary education as a proxy for the level of human capital, the age-dependency ratio, openness to trade measured by the sum of exports and imports to GDP, consumer price index inflation as a measure of macroeconomic stability, the ratio of liquid liabilities to GDP as a measure of financial development, and a dummy to control for banking crises.
  • Di,t includes, depending on the specification, the ratio of debt to GDP of the public sector, the private sector (household and corporate sector), or both, as well as interactions with dummy variables indicating whether the debt ratios are greater than a threshold level.

Least squares dummy variable (LSDV) estimation is used. The presence of a lagged dependent variable in the right-hand side (dynamic panel) implies that the estimates may be biased. However, it has not been proved that generalized method of moments or instrumental variables outperforms LSDV in small panels, such as the one this analysis uses (N = 18).

The analysis assesses whether the growth impact of high debt in one sector depends on the level of indebtedness in other sectors. Debt is considered to be “high” if it is above a certain threshold identified as the sample mean. The thresholds are 73 percent of GDP for public debt, 98 percent of GDP for corporate debt, and 48 percent of GDP for household debt. For instance, in the specification to estimate the impact of public debt on growth and its differential impact depending on the level of indebtedness in the private sector, the regressor α’Di,t becomes

in which Di,tP is the ratio of public debt to GDP, HP is a dummy variable taking the value of 1 if public debt is greater than the sample mean, HH is a dummy variable taking the value of 1 if household debt is greater than the sample mean, and HC is a dummy variable taking the value of 1 if corporate debt is greater than the sample mean. Given the above specification, α1 + α2 is the estimated impact of high public debt on growth when the household and corporate sectors are not highly indebted. Similarly, α1 + α2 + α3 is the estimated impact when the household sector, in addition to the public sector, is highly indebted. When all sectors are highly indebted, the estimated impact of government debt on growth is given by α1 + α2 + α3 + α4.

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This chapter is based on Euro Area Policies: Article IV 2013 Consultation—Selected Issues, “Indebtedness and Deleveraging in the Euro Area,” IMF Country Report 13/232, 2013.

1

See Cussen and O’Leary (2013) for a discussion of consolidated versus nonconsolidated corporate debt in the euro area.

2

See Cuerpo and others (2013) for an identification of countries currently facing private sector deleveraging pressures based on various indebtedness indicators. For an overview, see Buiter and Rahbari (2012) and McKinsey (2012).

3

A full assessment of house prices would have to go beyond affordability ratios (price-to-income and price-to-rent ratios) and include other fundamentals, including supply constraints (IMF 2012c, 2013d, 2013e).

4

In the euro area, high corporate debt is also associated with lower per capita GDP growth during the period 1999–2011 (ECB 2012).

5

Historical episodes include Canada (1979–84), Denmark (1987–94), Norway (1988–95), Sweden (1989–95), Finland (1989–97), the United Kingdom (1990–96), Germany (2000–11), and Japan (2001–11). In Finland, Japan, Norway, and Sweden, household deleveraging was associated with a banking crisis. These episodes were selected from among advanced economies that experienced a reduction in the household-debt-to-disposable-income ratio of more than 10 percentage points.

6

Historical experience offers one possible benchmark. Model-based approaches can also be used to derive optimal levels of leverage or indebtedness to gauge deleveraging needs (for example, Cuerpo and others 2013).

7

For a discussion of the role of inflation in assisting the deleveraging process, including its costs, see IMF Fiscal Monitor (April 2013).

8

Identification of historical corporate deleveraging episodes is based on Ruscher and Wolff (2012), who use the sector’s net lending and borrowing data as a marker, combined with indebtedness data from Cecchetti, Mohanty, and Zampolli (2011). The latter paper comprises episodes with significant debt reductions (10 percent of GDP or more), which, on average, lasted six years. A number of shorter episodes of corporate deleveraging identified by Ruscher and Wolff (2012) did not result in significant debt reductions.

9

See Annex 2.1 for details on the econometric analysis. Debt is considered to be “high” if it is greater than the mean value in the sample. The mean values are 73 percent of GDP for government debt, 48 percent of GDP for household debt, and 98 percent of GDP for corporate debt. The thresholds identified in Cecchetti, Mohanty, and Zampolli (2011) are also used as a robustness test. The main results hold, but the higher thresholds relative to the mean, particularly for household debt, imply that there are very few observations for which debt is high in all sectors at the same time.

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