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Saturday 19 Aug 2017 | 15:38 | SYDNEY
Saturday 19 Aug 2017 | 15:38 | SYDNEY

Debt ratio analysis gets too much credit

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COMMENTS

12 September 2011 16:11

Over-leveraging was clearly an important element in the 2008 global financial crisis. Does this mean residual balance sheet problems have to be whittled away over many years, with America and Europe repeating Japan's 'lost decade'?

The financial markets' alarmist focus on debt/income ratios would suggest this is the case. Interactive ready-reckoners of this ratio are widely available to highlight the issue, and the idea finds support from influential academic analysis of past crises. Reinhart and Rogoff identify inflection points which inhibit growth and trigger crises when government debt/income ratios approach 100%.

This has some intuitive plausibility: any ratio getting to 100% seems to be at a tipping point. But it is facile analysis. To start with, this ratio is difficult to calibrate, as it compares a flow (income) with a stock (debt). Other ratios will be more relevant in identifying vulnerabilities: the debt servicing ratio and gearing (debt to equity), for instance.

Just as important, we need to differentiate between sectors — households, corporates, banks and government. Households were the focus of post-GFC concerns in the US (and in Australia, where these issues were well covered by Ian Macfarlane in 2003). Over the past couple of decades, household debt-to-income in many advanced countries has more-or-less doubled.

This increase reflects two structural changes. As inflation was brought under control in the 1990s, interest rates fell and households had capacity to service more debt. Second, the financial sector was deregulated. No longer did you go cap-in-hand to your banker to get a loan, bringing hard evidence of years of joyless thrift.

Of course, deregulation opened up opportunities for over-leverage. But problems will be identified by detailed assessment, not by some simplistic aggregate ratio.

When US prime-time television was replete with ads urging NINJAs (no income, no jobs or assets) to borrow, problems were brewing. As well, honeymoon introductory interest rates confused borrowers about their servicing capacity, rising house prices offered the promise of easy profits, securitisation removed the lenders' responsibility to assess risk, the legal system allowed borrowers to walk away from their debts and government-backed lending agencies were eager to refinance almost without limit.

Taken together, this was a formula for the sub-prime disaster. To blame this on breaching some simple aggregate ratio is just poor analysis.

Japan demonstrates the inadequacy of debt/income ratios as a measure of country risk. Gross government debt to GDP has been twice the designated tipping point for decades. To assess debt, we need to know what counterpart assets the government holds, whether the debt is held domestically or by foreigners, what is the borrowing interest rate and whether the country is running a current account deficit which makes it vulnerable to sudden outflows.

When all these things are considered, Japan is sustainable and Greece, with a lower ratio, is not.

The financial system requires its own specific analysis. The critical ratio in 2008 was not debt/income, but debt/equity. The US financial system was highly leveraged, with many institutions holding only $1 of equity for $30 of debt. This was extreme, but not uncharacteristic of the financial sector everywhere. While the gearing made banks vulnerable, the more basic problem was that they lent to people who couldn't repay, backed by collateral which was grossly inadequate when housing prices fell. Even small losses extinguished banks' inadequate equity.

The knock-on problem demonstrated the classic Achilles' heel of all financial systems: when sentiment changes, the depositors demand their money back.

Japan did not experience its 'lost decade' just because debt/income was high. The key problem was a banking system weighed down by bad corporate lending. This problem was not addressed until 1999, nearly ten years into the lost decade. Nor is Greece experiencing its current problems just because its debt/income ratio is high. For a decade its grossly unsustainable fiscal position was facilitated by cheap funding made possible by Euro membership.

The debt ratio analysis fails to recognise that different countries got into trouble for different reasons. If the diagnosis differs between countries, so too does the prescription. The answer is not to put policy on hold waiting for debtors to grind down their debts by demand-sapping saving. Greek debt is unsustainable, and has to be largely written off. The knock-on effect for European bank balance sheets will require official assistance. The US needs a combination of short-term stimulus (which might include some measures of mortgage debt relief) and medium-term restoration of the fiscal position.

None of these countries will be helped by inflicting a long recession while balance sheets are gradually returned to some historical debt ratio. Nor do countries need to return to the repressed financial sectors that kept household debt ratios low. Larger, more complex balance sheets, with more assets and more liabilities, are sustainable for households and countries alike. Singapore and Switzerland have huge foreign liabilities, but also huge foreign assets.

Sophisticated financial sectors give households and governments enough rope to hang themselves. In the years leading up to 2008, the financial sector grew too big. It also did a poor job of intermediation, price discovery and risk management. This has to change. But simple rules-of-thumb are not much help in guiding this reform, or for avoiding prolonged recession.

Photo by Flickr user respres.

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