Euro Area Policies: Selected Issues

This Selected Issues paper on Euro Area Policies 2013 Article IV Consultation highlights the monetary transmission mechanism and monetary policies. The European Central Bank has announced the Outright Monetary Transactions framework to address severe distortions in sovereign bond markets and safeguard monetary transmission. The cost of unsecured bond issuance remains elevated for both core and periphery banks, but there is a growing divergence between the two, driven mainly by rising periphery spreads. Weak growth and high levels of private balance sheet debt in the periphery are weighing on the health of bank balance sheets.

Abstract

This Selected Issues paper on Euro Area Policies 2013 Article IV Consultation highlights the monetary transmission mechanism and monetary policies. The European Central Bank has announced the Outright Monetary Transactions framework to address severe distortions in sovereign bond markets and safeguard monetary transmission. The cost of unsecured bond issuance remains elevated for both core and periphery banks, but there is a growing divergence between the two, driven mainly by rising periphery spreads. Weak growth and high levels of private balance sheet debt in the periphery are weighing on the health of bank balance sheets.

Indebtedness and Deleveraging in the Euro Area1

High private and public sector debt is holding back growth in the euro area. Simultaneous deleveraging across all sectors represents an immense challenge. Negative feedback loops between high debt and a weak financial sector are constraining economic growth and credit conditions. Policies that directly support the workout of bad debt in the financial and private sectors in the euro area could yield important benefits. The negative impact of private sector deleveraging on growth could be further reduced through a more supportive policy mix.

A. Motivation and Introduction

1. 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 outlook is weak.

2. 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 sector 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, there is significant heterogeneity across countries in the euro area, suggesting 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 for maneuver. Finally, simultaneous deleveraging in several euro area members can lead to negative spillovers effects, further amplifying the negative impact of a country-specific deleveraging on economic activity.

3. This paper evaluates indebtedness in the euro area and its implications for growth. We ask the following questions: (i) Why does private sector indebtedness matter for growth? (ii) In which euro area countries is private sector indebtedness and leverage high? and (iii) What do we know from past experiences of deleveraging and what lessons can we draw for the euro area? Section B outlines how balance sheet stress can rise from high indebtedness, and discusses the feedback loops at play across sectors. Section C takes stock of indebtedness across the euro area, identifying vulnerabilities across sectors and countries. Section D looks at historical episodes to gauge the extent of deleveraging that can be expected and the macroeconomic environment that supported previous deleveraging episodes. The section also presents econometric evidence linking high debt in the private and public sector to growth outcomes. Section E offers policy considerations for the euro area, while section F concludes.

B. Why Debt Matters

Balance Sheet Stress

4. Indebted private sector agents are more susceptible to react to sudden asset price shocks or increased volatility. Large and sudden drops or swings in asset prices (e.g., houses or equity) can cause balance sheet stress in a context 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 it more difficult to roll over debt. Households and firms start focusing on repaying debt and strengthening their balance sheets (e.g., through improving equity ratios, building liquidity buffers), while life-cycle consumption smoothing or expected returns on investment become secondary. This shift in behavior depresses demand and creates self enforcing feedback loops across sectors.

5. In that context, declines in asset prices have economy-wide consequences. Falling asset prices go beyond one sector of the economy, as they impact both borrowers and creditors. For example, falling house prices reduce household wealth, decrease the value of collateral held by banks, increase non-performing loans, and, when weak banks require public support, ultimately impact the public sector’s balance sheet. Public finances are also impacted by lower tax revenue derived from transactions in this asset (e.g., stamp duties). Likewise, equity prices not only determine a firms’ 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 (equity and shares).

6. Feedback loops exacerbate downturns, in particular in cases of simultaneous deleveraging of the private, financial, and public sector (Figure 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 over 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 sector, deleverage simultaneously. This can depress activity further as 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 sheet 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 the debt burden by increasing margins, reducing wage costs and scaling back investment. This, in turn, feeds 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 the households’ debt servicing capacity and firm profitability. In turn, public balance sheet weakness limits the scope for further assistance to the financial sector (e.g., bank recapitalizations)

  • The banking sector—faced with increasing non-performing loans from households and firms, and a 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, in turn depressing demand for investment and consumption loans.

Figure 1.
Figure 1.

Feedback Loops from Balance Sheet Effects

Citation: IMF Staff Country Reports 2013, 232; 10.5089/9781484347850.002.A003

Diagnosing Balance Sheet Stress

7. 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. But focusing exclusively on gross debt is not sufficient. The level of indebtedness a sector can sustain varies across countries with initial conditions, including the characteristics of the housing market or the degree of intermediation provided by the banking sector. While scaling debt to income is useful to gauge a sector’s capacity to service debt obligations, leverage ratios that link debt to assets are relevant to assess debt in relation to a sector’s own balance sheet. Assets, including housing and financial wealth, can also be important buffers as they allow agents to draw down savings and they are relevant in assessing debt sustainability. More importantly, because debt stocks tend to move slowly over time, financial flows can be useful to detect changes in behavior that signal balance sheet stress. This would happen for example when agents revert to financial surplus and when their debt service burden becomes 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.

8. 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 paper provides an overview of indebtedness in the euro area, but it also takes into account more detailed country and sector specific analysis made available in other studies.2

C. Indebtedness and Deleveraging in the Euro Area: Stylized Facts

The Euro Area Level

9. Debt levels for the euro area as a whole are at par with those in the U.S. or the U.K, but the deleveraging process has yet to translate into debt reduction (Figure 2). In the aggregate, household debt is lower than in the U.S. or the U.K. Corporate debt appears higher in the euro area and the U.K. than in the U.S., though important differences in the size of intercompany loans and trade credit complicate comparisons in levels.3 Government debt in the euro area is also at comparable levels, and increased less since 2003 than in the U.S. or the U.K. The euro area also enjoys a comfortable net international investment position. Yet, since 2009 the U.S. and the U.K. have seen a reduction in household debt, and the U.K. has also experienced a reduction in corporate debt, while 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 3, ECB 2013a).

Figure 2.
Figure 2.

Financial Surplus in the Euro Area

The private sector has increased its financial surplus

Citation: IMF Staff Country Reports 2013, 232; 10.5089/9781484347850.002.A003

Sources: ECB.
Figure 3.
Figure 3.

Indebtedness in the Euro Area, U.S. and the U.K.

Citation: IMF Staff Country Reports 2013, 232; 10.5089/9781484347850.002.A003

Variation Across Countries

10. Indebtedness varies across countries and sectors (Figure 4). Since the early 2000s, private and public debt increased most sharply in countries now under stress. Debt is particularly high in Ireland, Portugal, and Spain, where households, the non-financial corporate sector and the government are all highly indebted compared to their euro area peers. In addition, a number of other countries have high debt in one or two sectors.4 And when all sectors are highly indebted, sizeable net external liabilities have accumulated (Figure 12).

Figure 4.
Figure 4.

Indebtedness Across the Euro Area

Citation: IMF Staff Country Reports 2013, 232; 10.5089/9781484347850.002.A003

Non-financial Corporates

Corporate debt and leverage

11. Corporate indebtedness and leverage have increased. Indebtedness of euro area firms increased substantially in the first decade of EMU, on the back low real interest rates and prospects of high growth. Higher bank debt, combined with falling equity valuations, has boosted corporate leverage during the crises, threatening debt sustainability. While more recently firms’ leverage ratios have fallen they remain elevated in a number of countries (Figure 5). Firm level data suggests that in some euro area economies up to 20 percent of corporate debt may not be sustainable (IMF 2013c).

Figure 5.
Figure 5.

Corporate Debt

Citation: IMF Staff Country Reports 2013, 232; 10.5089/9781484347850.002.A003

12. Pro-cyclical 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 enterprises (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

13. Insolvencies have increased markedly where corporate debt is high (Figure 5). In most crisis economies, the increase in insolvencies in the non-tradables 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, costly, and the recovery rate of claims is very low (Figure 6 and World Bank (2013)).

Figure 6.
Figure 6.

Insolvency Regimes

Citation: IMF Staff Country Reports 2013, 232; 10.5089/9781484347850.002.A003

14. Pockets of vulnerabilities in the corporate sector. While the overall level of indebtedness in some countries may not be alarmingly high, high debt increases the vulnerability of corporates 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. But 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 was financially distressed (IMF 2012d). 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 non-tradable sector (IMF 2013d). 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 2013b).

Households

Household debt and the housing boom

15. The turn of the housing cycle triggered sector-wide deleveraging where real estate bubbles had driven debt up (Figure 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 et al., 2012), and they have been the most significant driver in the increase of household debt since the start of the euro. When the housing boom burst around 2007-08, households were left with high debt and overvalued assets, in particular in Ireland and Spain. While the price adjustment has gone far in some countries (e.g., Ireland), house prices remain high in some others (e.g., Spain, France, Netherlands).5 As house prices started 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 financial assets and repay debt, and have slashed the acquisition of non-financial assets (Box 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 7.
Figure 7.

Household Debt

Citation: IMF Staff Country Reports 2013, 232; 10.5089/9781484347850.002.A003

Buffers and vulnerabilities

16. 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. But in a depressed housing market with high owner occupancy rates, disposing of housing wealth is often difficult. Indebted households have less liquid financial assets in periphery economies (Figure 8 and ECB (2013b)), although the sector as a whole has in many countries moved toward safe and liquid financial assets since the crisis (Cussen et al., 2012).

Figure 8.
Figure 8.

Household Balance Sheets – Survey Results

Citation: IMF Staff Country Reports 2013, 232; 10.5089/9781484347850.002.A003

17. Household balance sheets are vulnerable to income uncertainty, further asset price corrections, and, down the road, to interest rate increases. In most countries with high household debt, sustainability indicators such as debt-to-income, or debt service-to-income ratios have deteriorated (Figure 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 housing prices and an increase in interest rates, as most mortgages are indexed to the Euribor (IMF 2012d). In the Netherlands, house prices are still overvalued based on range of metrics, and young cohorts would be especially vulnerable to a further drop in prices (IMF 2013f).

Box. 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.1/ The decrease in wealth associated with the decline in housing and asset prices prompted households to lower 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 increase drives households’ savings relative to their income today.

Figure B1:
Figure B1:

Household Savings Rate

Citation: IMF Staff Country Reports 2013, 232; 10.5089/9781484347850.002.A003

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

Figure B2:
Figure B2:

Financial Account Decomposition of the Household Savings Rate

Citation: IMF Staff Country Reports 2013, 232; 10.5089/9781484347850.002.A003

1/ Econometric results are based on a sample comprising of Canada, France, Germany, Ireland, Italy, Japan, Spain, the U.S., and the U.K. from 1980-2012. The correlates to explain household saving behavior include wealth, fiscal policy, interest rates, cyclical factors, and demographic factors (see IMF 2013h).

Financial Sector

18. In many euro area countries, a highly leveraged financial sector impairs intermediation and burdens the sovereign. Many banks in periphery economies had traditionally relied on wholesale funding, and have built large exposures to sovereigns and the real estate market (IMF 2013g). The share of non-performing loans (NPLs)—both from households and corporates—has risen rapidly, increasing uncertainty surrounding the banks’ asset quality, and in turn increasing funding costs and driving share prices down (Figure 9). In a fragmented European financial market, such banks face an uphill battle to strengthen their capital position, so as to provision for NPLs, buffer their sovereign exposure, and meet new regulatory requirements.

Figure 9.
Figure 9.

A Weak Financial Sector

Citation: IMF Staff Country Reports 2013, 232; 10.5089/9781484347850.002.A003

Public Debt and the Migration of Debt

19. 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 corporates 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 burden (Figures 10 and 11). But with savings being lower than investment across all sectors for a number of years, many periphery economies accumulated sizeable external debt (Figure 12).

Figure 10.
Figure 10.

Sovereign Debt

General Government Debt

(percent of GDP)

Citation: IMF Staff Country Reports 2013, 232; 10.5089/9781484347850.002.A003

Sources: WEO.
Figure 11.
Figure 11.

Debt Migration

Citation: IMF Staff Country Reports 2013, 232; 10.5089/9781484347850.002.A003

Figure 12.
Figure 12.

External Indebtedness

Net International Investment Position

(percent of GDP)

Citation: IMF Staff Country Reports 2013, 232; 10.5089/9781484347850.002.A003

Sources: IFS.1/ Data for France is 2011.

High Debt and Economic Outcomes

20. Balance sheet stress has been associated with weaker economic outcomes (Figure 13). Where private sector debt increased rapidly to a high level until 2007, growth outcomes have been weaker since then. 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.6 Finally a highly leveraged financial sector pre-crisis has also been associated with higher lending rates post crisis, creating pro-cyclical financial conditions. Looking ahead, fiscal policy is tightening most where private sector balance sheet stress was the highest, creating pro-cyclical fiscal conditions.

Figure 13.
Figure 13.

Balance Sheet Stress and Economic Activity

Citation: IMF Staff Country Reports 2013, 232; 10.5089/9781484347850.002.A003

D. Experience with Previous Deleveraging Episodes

Household Deleveraging

21. The magnitude of the post-2000 credit boom was unprecedented. A look at historical precedents 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 other credit cycles in the past.7 As a result, the level of household debt today and the need to deleverage is exceptionally large, compared to historical episodes.8

22. Household debt reduction has barely started. 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 pre-credit boom level after a protracted period of deleveraging (lasting between 5 and 10 years). With household debts barely off their 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 exception is the US, which is two-thirds of the way through the pre-crisis level (Figure 14).

Figure 14.
Figure 14.

Household Deleveraging Episodes

Citation: IMF Staff Country Reports 2013, 232; 10.5089/9781484347850.002.A003

23. 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; it was instead 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 a banking crisis. The contribution of real income growth was about a quarter, while the reduction in the stock of debt was small, except for Japan. In episodes without a banking crisis, the stock of debt even increased during the deleveraging period (Figure 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 over 10 percentage points in Sweden and almost 8 percentage point in Finland. The fiscal support was generally larger where deleveraging was the result of a banking crisis.

24. Projections suggest that the macroeconomic context this time around will be more challenging. Euro area inflation is expected to undershoot the price stability objective. In that context, the role of inflation in assisting the deleveraging process will be much more limited than in the past.9 Similarly, the contribution of growth in real disposable income is expected to be small. This implies 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 15).

Figure 15.
Figure 15.

Fiscal Policy During Deleveraging Episodes

Citation: IMF Staff Country Reports 2013, 232; 10.5089/9781484347850.002.A003

Corporate Deleveraging

25. Corporate debt levels are not much higher compared to the beginning of historic episodes of corporate deleveraging, but debt reduction has barely started. While 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 to historic episodes (Figure 16).10 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 16.
Figure 16.

Corporate Deleveraging Episodes

Corporate Deleveraging Episodes

(Corporate debt, percent of GDP)

Citation: IMF Staff Country Reports 2013, 232; 10.5089/9781484347850.002.A003

Sources: BIS, ECB, Bruegel, IMF Staff estimates.2/ Historic episodes: JP 89-97, UK 90-96, AU 88-96, FI 93-96, NO 00-05, SE 01-04.

The Debt and Growth Nexus

26. The debate about the relation between high public debt and growth remains very much open. A large body of research concludes that high public debt leads to higher interest rates and slower growth.11 Some of these studies find that high debt levels (above 80-90 percent of GDP) have a negative effect on growth. High debt also makes public finances more vulnerable because it constraints 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, once they tackled the causality issue. More recently, Herdon et al. (2013) have challenged the findings of the influential papers by Reinhart and Rogoff, which argued that there is a threshold effect whereby debt above 90 percent of GDP leads to dramatically worse growth outcomes.

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

28. Historical experience suggests that household deleveraging in the euro area will continue to weigh down 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 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 17.
Figure 17.

Historical Growth and Consumption Underperformance

Citation: IMF Staff Country Reports 2013, 232; 10.5089/9781484347850.002.A003

Econometric Analysis

29. 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 18).12 When the three sectors—government, households, and corporate—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 some periphery countries, where all sectors are highly indebted.

Figure 18.
Figure 18.

The Impact of High Debt on Growth

The Impact of High Debt on Growth

(by sector and indebtedness of other sectors, estimated coefficient)

Citation: IMF Staff Country Reports 2013, 232; 10.5089/9781484347850.002.A003

Sources: Staff estimates, see main text and Annex 1 for details.

30. 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 they are 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 between 7-11 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 between 8-13 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.

E. Policy Options

Dealing with High Debt in the Euro Area

31. Experience suggests that decisive and properly sequenced policy actions can support deleveraging. Where private sector deleveraging is more advanced (e.g., U.S.), 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. 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 (see Laryea, 2010). Two successful cases of household debt restructuring are the US Home Owners Loan Corporation Program in 1933 and the experience in Iceland in the recent crisis.

Targeted Policies

32. Progress on improving insolvency frameworks in the euro area could help, but it has so far been uneven. Reforms to insolvency frameworks take time, and effective implementation is often most difficult but 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 (Figure 8). National insolvency regimes 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. 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.

33. Debt restructuring comes at high costs. Debt re-profiling, 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 work out 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.

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

  • Strengthening bank balance sheets and working out non-performing loans is a precondition. The work out 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 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 non-performing 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 clean-up of banks’ balance sheet 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 (AMCs), private or with some government participation, could help accelerate the restructuring of corporate debt, while taking weak assets off the banks’ balance sheet (see Laryea, 2010).

  • In the household sector, direct debt service support (e.g., 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 (see Laeven and Laryea, 2009. Wealth encumbrance could be modified where needed, for example, by easing mortgage payments for highly indebted, low income households whose property has been foreclosed. Personal insolvency frameworks should be geared towards facilitating a fresh start for financially responsible individuals.

Policy Mix and Structural Policies

35. 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. But getting the pace of consolidation right is essential. Monetary policy should aim at addressing the impairments to the normal transmission of the monetary policy stance. This would help reduce corporate and household borrowing costs, especially in the periphery.

36. Structural policies could also help to 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.

F. Conclusion

37. 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, put downward pressure on prices. The real growth outlook is weak throughout region and beyond. Finally, as the monetary transmission is impaired, monetary easing is not, at present, effective in lowering interest rates, and a fragmented financial sector amplifies the negative effects of protracted private sector deleveraging.

38. An accelerated clean-up of private and financial sector balance sheets can help avoid a protracted period of stagnation. 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 considered.

Annex. Econometric Analysis

Econometric analysis builds on Cechetti et al. (2011), which uses a new dataset on debt levels for a group of 18 OECD countries, based primarily on flow of funds data. The paper uses data over the period 1980-2006, but since the authors had compiled data through 2009, this analysis uses the full sample.

The empirical specification is derived from the neoclassical growth model of Solow, where per capita income growth depends on the initial level of physical and human capital, savings rate, population 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. More specifically:

gi,t+1,t+k=Øyi,t+βXi,t+αDi,t+μi+γt+εi,t,t+k

where:

  • 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;

  • μit 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 dependency ratio; openness to trade measured by the sum of exports and imports to GDP; CPI inflation as a measure to 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 public and/or private sector (household and corporate sector) as well as interactions with dummy variables indicating whether the debt ratios are above a threshold level.

Least squares (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 methods of moments (GMM) or instrumental variables (IV) outperforms LSDV in small size panels, like the one this analysis uses (N = 18).

The analysis tries to assess 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’s 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 αi,t becomes:

α1Di,tP+α2Di,tPHP+α3Di,tPHP+α4Di,tPHC

where Di,tP is the ratio of public debt to GDP, HP is a dummy variable taking the value of one if public debt is above the sample mean, HH is a dummy variable taking the value of one if household debt is above the sample mean, HC is a dummy variable taking the value of one if corporate debt is above 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 α1 + α2 + α3 + α4.

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1

Prepared by Fabian Bornhorst and Marta Ruiz Arranz.

3

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

4

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

5

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. See IMF 2012d, IMF 2013a, IMF 2013f.

6

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

7

Historical episodes include: Canada (1979-1984), Denmark (1987-1994), Germany (2000-11), UK (1990-96), Finland (1989-1997), Japan (2001-11), Norway (1988-1995), and Sweden (1989-95). In the last four, household deleveraging was associated with a banking crisis. These episodes were selected among advanced economies that experienced a reduction in the household debt-to-disposable income ratio of more than 10 percentage points.

8

Historical experience offers one possible benchmark. Model based approaches can also be employed to derive optimal levels of leverage or indebtedness to gauge deleveraging needs, see e.g., Cuerpo et al., 2013.

9

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

10

Identification of historic corporate deleveraging episodes is based on Ruscher and Wolff (2012), who use the sector’s net lending/borrowing data as a marker, combined with indebtedness data from Cecchetti et al. (2011). It comprises of episodes with a significant debt reduction (10 percent of GDP or more), which, on average, lasted 6 years. A number of shorter episodes of corporate deleveraging identified by Ruscher and Wolff (2012) did not result in a significant debt reduction.

11

Kumar and Woo (2010), Reinhart and Rogoff (2010, 2012), Cecchetti, Mohanty and Zampolli (2011), Baum, Checherita and Rother (2013), among others.

12

See Annex 1 for details on the econometric analysis. Debt is considered to be “high” if it is above 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 Cechetti et al. (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 when debt is high in all sectors at the same time.

Euro Area Policies: Selected Issues Paper
Author: International Monetary Fund. European Dept.