Commentary | 03 March 2015

How much debt is too much

How much debt is too much?

Stephen Grenville

Nikkei Report

3 March 2015

Please click here for the online text.

  • Stephen Grenville

How much debt is too much?

Stephen Grenville

Nikkei Report

3 March 2015

Please click here for the online text.

  • Stephen Grenville

Executive Summary

The 2008 global financial crisis was a dramatic demonstration that ill-considered debt causes major damage, affecting the entire global economy. If excessive national debt was the key problem around the world seven years ago, what has happened to debt levels since then? The short answer is that debt ratios, including private and public sector debt, have increased in all advanced economies, in some cases substantially. We do not seem to have fixed the problem. Are we heading for a repeat of the 2008 crisis?

McKinsey Global Institute has put together the figures, hoping to distill the answer from international comparisons. Gross global debt has grown by $57 trillion since 2007, raising the ratio to gross domestic product from 269% to 286%. The aggregate figures disguise outliers: Japanese debt is over five times gross domestic product, and Spain's debt is fourfold.

Government debt is responsible for much of the increase, boosted by the 2008 financial bailouts, fiscal stimulus programs in 2009 and the impact on national budgets of slow global economic recovery from the crisis. It is hard to argue that extra official debt was a mistake; these were necessary actions. A good case can be made that there has been too much budget austerity, with the feeble recovery being the result.

That said, it is also true that this is a heavy legacy: Reversing this rise in government debt would require Herculean budget austerity. Deleveraging would not only present a mighty political challenge but would further dampen the current feeble growth. For example, McKinsey estimates that halting the rise in Japan's official debt would require the budget to shift toward surplus to the tune of 4% of GDP. Spain would have to tighten its budget by nearly 5% of GDP.

If government debt has risen for understandable reasons, what about the private sector? Household debt has fallen in some of the economies that experienced problems in 2008 (the U.S., U.K., Ireland and Spain), but in part this is a result of default and rescheduling. Such temporary factors will not apply for long -- and do not apply elsewhere. In many other countries, household debt has risen inexorably.


Seven threats to sustainability

The report identifies seven economies where a combination of factors threatens sustainability. The four factors are the level and change of the debt/income ratio, the debt-servicing ratio and the change in housing prices. The "vulnerable seven" are the Netherlands, Australia, Sweden, Canada, Malaysia, Thailand and South Korea. It is worth noting that four of these are in the Asia-Pacific region.

In Australia, slow supply response has led to a dog-chasing-its-tail interaction between house prices and borrowing. Australians are accustomed to owning their own home and are ready to go into debt to do so. Interest rates are historically low, and a quarter-century of steady growth has given buyers confidence. In Malaysia, Thailand and South Korea, development of the financial sector has opened home ownership to a new cohort of borrowers. A sudden downturn (with rising unemployment) would shake household confidence and trim house prices, but none of these countries exhibits the sort of reckless lending that was prevalent in the U.S. and Ireland in 2008.

McKinsey's measure of unsustainability depends not just on the level of debt, but on the recent deterioration of the risk factors. Other countries have higher debt/income ratios (Denmark and Norway in particular, and even Singapore is higher than any of the "vulnerable seven"). But if a rapid rise in household debt is the warning signal, then even China -- where household debt is only 58% of income but has quadrupled since 2007 -- might cause some alarm bells to ring.

Why can some countries operate without apparent difficulty with debt ratios far in excess of normal? Why can Japan, for example, head McKinsey's ranking of debtors, and yet deleveraging is not a pressing policy priority? Why can Singapore -- successful and secure -- be No. 3 in the debt ranking without this causing serious concerns?

The answer is that debt is complex. Simple analytical ratios will be debatable for a single country and misleading in international comparison. This was demonstrated when the American academics Carmen Reinhart and Kenneth Rogoff pressed the panic button on government debt in 2010, claiming that there was a critical cut-off for sustainability, and that exceeding this level would sharply curtail growth. It turned out to be a false alarm. Their data did not support the claim.

Any simple debt rule will mislead (ignoring this basic truth was the main sin committed by Reinhart and Rogoff, rather than the careless use of data), but it is indisputable that debt levels worldwide are rising quickly, and that more debt creates vulnerabilities. We need to go behind the aggregate figures to examine the reasons for this rise and to ask where the greatest dangers lie.


Beginning of the debt story

First, some historical background: The upward trend in debt is largely explained by progressive deregulation of the financial sector since the 1980s. In most Western countries, more leverage was part-and-parcel of the process of financial sector development, which opened up the benefits of borrowing to a wider community. For example, American household debt has risen from 15% of income just after World War II to nearly 100% today because the financial sector now does a better job of meeting households' legitimate needs. Thus we should not be surprised about the growth of debt, as such. This is a transitional process, adjusting to the newly available opportunities to borrow.

That, of course, leads to a deeper question. Will the growth of debt neatly adjust over time to a sustainable equilibrium level, with borrowers and lenders making well-based decisions on the safe and proper level of debt? In the early years of financial deregulation, this optimistic view was commonly held. The 2008 experience, however, demonstrated clearly that borrowers and lenders -- and the financial markets that bring them together -- have a very imperfect capacity to self-regulate a sensible debt level.

This should, perhaps, make us more sanguine about current debt levels. We are older and wiser, with better regulation of the financial sector. The excesses of the American sub-prime crisis, such as lending to borrowers characterized as NINJAs (no income, no job or assets), was not a necessary characteristic of the financial sector. As well, there were the specific characteristics of U.S. housing at the time -- over-building accompanied by an asset-price bubble.

At the same time, these sector-specific vulnerabilities interacted with a financial system that was over-leveraged, over-complex and over-confident. America's financial problems in 2008 came not from hugely excessive debt, but from foolish lending practices and Byzantine financial engineering. The crisis was a failure of prudential supervision and a misplaced faith in the self-regulating capacity of financial markets. We can do better in the future.

A proper assessment of borrowing risks would go deeper still, to understand the context and detail of transactions. Simple debt/income ratios will be misleading indicators of risk when borrowers have sound assets to match their debt. Governments that use their borrowing to fund useful infrastructure will be in a better position than those that borrow to fund pensions and welfare (or, for that matter, to rescue collapsing banks). High leverage based on real estate collateral should be safe unless there is an unsustainable asset-price boom. When the debt belongs to high-income borrowers, high debt-servicing ratios are sustainable. In short, inter-country comparisons are no more than a starting point in risk analysis.

Similarly, government debt has to be put in context. It is true that Japan would need to shift its budget dramatically towards surplus to get its stratospheric debt ratio down, but much of the debt is held by government institutions (including by the Bank of Japan) and most of the rest is held by stable domestic investors. Of course the debt cannot be allowed to rise endlessly. It will have to be addressed and ground down over time. Generational equity requires this, as does the vulnerability that high debt creates. This requires a consistent and credible medium-term plan, but not panic.


Lessons for emerging economies

For emerging economies, the lesson here is not to ban borrowing and revert to cash-flow limits on spending. Governments should see their finances as a balance sheet. Debt balanced by good infrastructure projects will not cause regrets.

The McKinsey report provides a specific example of the benefit of case-by-case analysis. China's experience refutes the idea that debt has to grow quickly in order to stimulate growth. In China's decades of double-digit economic growth before 2007, debt grew slowly and remained tiny. It has accelerated sharply in the slower-growth period since 2007 -- so rapidly as to raise universal concern. McKinsey identifies the main concerns as the debt binge of local government, the extent of the shadow banking sector and the reliance on housing collateral in a frothy overbuilt market.

Even though its total debt is not very high as a percentage of GDP in McKinsey's calculation, China is probably headed for an uncomfortable financial fall-out. Most countries have experienced some kind of financial crisis during the phase when the embryonic financial sector was growing fast to catch up with the real economy.

The issue is not whether China has potential financial problems; it is whether it can sort them out without a significant crisis. On the positive side, the biggest banks are state-owned, making any bailout easier. There are no foreign-debt concerns. The central government is not heavily indebted and could absorb substantial losses. There is still room for substantial urbanization and upgrading of the housing stock as incomes grow. On the negative side, local governments seem difficult to discipline. At some stage, the grossly abnormal pace of housing construction will have to slow dramatically as the stock of housing comes into line with the needs of the population. That will happen when the catch-up phase draws to an end.

Above all, the McKinsey report reminds us how little we know about the linkages between debt and economic performance. Japan operates with an apparently unsustainable level of government debt. Denmark functions successfully with mortgage debt three times the global average. Singapore is almost at the top of the debt list but is seen as a robust economy.

We do not have an analytic framework to explain these apparent anomalies. We know that more debt makes a country more vulnerable to cyclical excesses and disruptive reassessments, just as more international trade makes a country more vulnerable to the vicissitudes of global trade. But being able to borrow and lend ought to make the economy work better as it shifts purchasing power from those with no immediate spending requirements to those with productive opportunities. We do not know what a safe level of debt for governments or households might be, and if we did, we do not know how to enforce such limits while keeping the economy fully employed. Few of us saw the financial crisis coming in 2008. The one thing we know for sure is that we will not see the next crisis coming either.


Stephen Grenville, a former deputy governor and board member of the Reserve Bank of Australia, is a visiting fellow at the Lowy Institute for International Policy in Sydney and a consultant on financial issues in East Asia.