Imagine, for a moment, you're ten years younger. It's 2006. The world economy is growing by 5.5% in real terms, fuelled by the push from the advanced economies (3.1%) and emerging economies (8.2%). Returning to 2016, the last 10 years have certainly left their mark. The advanced economies are scarcely growing by 2% and growth in the emerging economies, although still dynamic, has fallen to rates close to 4%. At the same time the world continues to take out debt: loans to companies and households have gone from 230% to 270% of GDP in the advanced economies and from 113% to 170% in the emerging. It therefore comes as no surprise that the relationship between growth and debt has raised a fundamental question: is debt necessary to revive growth or is it a burden that slows growth down?
The recent history of world debt can be divided into three volumes. In the first, between 2002 and 2008, the advanced economies accompanied their expansion with an increase in the private debt of households and companies, as can be seen in the second graph. This rise was due, at least partly,1 to monetary policies that were too lax, as well as to badly designed regulation. Moreover these factors also encouraged investors to take too much risk and led to resources being badly allocated among sectors. And this is where the second part of our story begins, with the outbreak of the financial crisis. To alleviate its impact on the economy, automatic fiscal stabilizers generated an increase in public debt, which had remained stable until then, also absorbing part of the private sector debt. In developed economies the private sector has gradually deleveraged since then, unlike the public sector which has continued to increase its debt amid doubts regarding the strength of the recovery.
The financial crisis also sowed the seed for the third and last part of our history of world debt, which has yet to come to a conclusion. The recession in advanced economies has led to an environment of low interest rates as central banks attempt to stimulate the economy, and also to low returns. Consequently, since the financial crisis capital has flowed towards emerging economies in search for better yields. Moreover, the accommodative monetary conditions in the advanced economies have been partly passed on to the emerging countries.2 Lastly, the high commodity prices recorded at the time gave the feeling of safety for loans to countries exporting these resources. All these elements created a context that encouraged debt in the emerging economies, reflected in the rise in total loans to the non-financial sector which went from 110% of GDP in 2008 to 170% in 2015, mainly due to the increase in debt among private firms and following a trend that shows no signs of stabilising.
Insofar as emerging debt is due to an environment of accommodative monetary policy in developed countries and high commodity prices, the change in scenario over the last few months with the start of interest rate hikes in the US and sharp falls in commodity prices could be a cause for concern regarding the sustainability of emerging debt. Several different aspects need to be considered in this respect: debt held in foreign currency, the concentration of debt in certain sectors and the returns from the investments financed by debt. As shown in the third graph, there has been a sharp rise in debt held in dollars since 2009. On the one hand, monetary normalisation in the US will push up both interest rates in advanced economies and also the value of the dollar, making credit conditions tougher in the emerging countries. On the other hand, a considerable number of emerging companies with debt in dollars also receive their income in dollars, reducing their exposure to the risk of exchange rate fluctuations. Countries such as China, South Korea and Singapore also have large reserves in the US currency. Moreover, a considerable share of the debt in dollars has long maturities.3 Nevertheless, studies carried out by the IMF and the BIS4 show that debt is concentrated in construction (particularly in China and Latin America) and in industries related to commodities. Moreover, new debt is also being concentrated in companies that already have a high level of debt. Lastly, as debt has risen in the emerging countries, the average profitability of companies has fallen, begging the question whether this debt is financing genuinely productive investments.
The history we have just reviewed reveals a financial cycle that interacts with the economic cycle. Economic expansion makes it easier for companies and households to take out debt in order to carry out investments and increase consumption, which stimulates activity, reinforces economic expansion and, once again, makes it easier to take out debt. This formed the basis of part of the growth in the developed economies up to 2007 and this is also partly fuelling the current growth in the emerging economies. However, if the investments financed with debt fail, this virtuous circle becomes vicious as the inability to repay debt leads to companies going out of business, pushes down demand and thereby causes a further wave of bankruptcies. Precisely to lessen the amplification of the economic cycle produced by the financial cycle, the experience of the advanced economies has led them to improve the regulation and supervision of the banking system. However, the increase in relative importance of the capital market as a source of financing raises doubts as to the capacity of these measures to stabilise the financial sector as a whole.5
As can be deduced from our analysis, developed and emerging countries are at different points in the cycle. On the one hand, the emerging economies are continuing to increase their debt at a fast pace and some factors raise doubts as to whether this new debt is actually sustainable. Given that this accumulation has been fuelled by the United States' lax monetary policy, the economic policy of the emerging economies should now be prepared to face tougher credit conditions that might lead to bankruptcies and put pressure on their currencies. Their economic policy must therefore be aimed at encouraging deleveraging in the private sector and limiting systemic risks. On the other hand, in advanced economies the rate of recovery (in general slower than expected) is generating intense debate regarding the role that should be played by monetary and fiscal policy.6 The levels of debt are still very high in spite of the private deleveraging carried out. Given this situation, greater stimulus from public demand or more accommodative monetary conditions could compromise debt sustainability. However, it is also true that more restrictive fiscal and monetary policies, a priori focused on speeding up the deleveraging process, could erode growth which is already very meagre and end up making it even more difficult to deleverage. Given this dilemma, it seems that the virtue will come from promoting supply-based reforms that help new productive sectors to develop while maintaining policies to support demand in the short term.
In summary, this discussion shows us that the disorderly interaction between the financial cycle and economic cycle has brought the advanced economies to a situation of high debt and moderate growth with economic policies that have little room to manoeuvre. This shows the importance of designing and implementing economic policies with a perspective that covers the whole economic cycle, reducing risks and building up buffers during the boom years to alleviate recessions.
Adrià Morron Salmeron
Macroeconomics Unit, Strategic Planning and Research Department, CaixaBank
1. An increase in the inequality in the distribution of income and wealth might also be one of the factors behind the rise in debt. See, for example, Rajan, R. (2010), Fault Lines, Princeton University Press.
2. Low interest rates in the US and Europe force emerging central banks to set lower interest rates to moderate the appreciation of their currencies.
3. See Caruana, J. (2016), «Credit, commodities and currencies», speech at the London School of Economics and Political Science, 5 February 2015.
4. Idem. and IMF, Global Financial Stability Report, Chapter 3, October 2015.
5. See the article «The banking sector after the crisis: more robust and stable?» and «Alternative channels to banking: the new challenge for financial stability», in this Dossier.
6. See the article «Financial instability, economic policy and the real economy: two opposing views», in this Dossier.