What really drives a boom-bust cycle in the modern global economy?, asks Rachel Layne in the Working Knowledge from Harvard University, who seems to seek an answer in a new study from the NBER that analyzes in depth data from 115 countries and shows that it is not always about household debt, but rather rising corporate debt may be the clearest warning that a fiscal crisis is coming.
It turns out that in recent years, experts have focused on housing and household debt for good reason: In the US, a collapse in home lending triggered the deep financial crisis of 2008. “But in the decade since then, the focus on household debt may mean that policymakers are overlooking an even more important signal of a potential widespread crisis: “Corporate credit quality and growth”explains Victoria Ivashina, professor at Harvard Business School and co-author of the study ““Corporate debt, boom-bust cycles, and financial crises” alongside Ebnem Kalemli-Özcan, Luc Laeven and Karsten Müller.
The analysis concludes that Corporate debt accounted for two-thirds of credit growth in the three years preceding the financial crises, recessions and depressions from 1940 to 2014. Once a boom cycle begins to bust, it is corporate debt that accounts for the vast majority of defaulted loans. Moreover, corporate debt is a drag on recovery, as it is restored more slowly than household debt. Once banks are forced to deal with such a load of unpaid debt, historically, the consequences are amplified, notes Ivashina in WK. “This tells us that The great financial crisis in the United States is a totally atypical case”he explains. “Only in 2007 and 2008 did we see that the largest share of non-performing loans came from households in the United States. And even then, you can see that losses from businesses were also substantial.” The results suggest that corporate debt expansions can provide important insights into the risk of future economic crises and deserve further scrutiny by policymakers, economists and regulators. The study comes after years of persistent inflation and rising interest rates, and amid close scrutiny of the state of the economy.
Data “unprecedented in breadth and scope”
Layne notes that the authors used recently released data from the Global Credit Project to analyze the impact of corporate debt in more than 100 advanced and emerging economies on the credit booms that typically precede financial crises.
The data overlaps with 87 systemic financial crises, including: the Scandinavian crises of the early 1990s; the Mexican tequila crisis of 1994; the Asian financial crises of 1996 and 1997; the Argentine crisis of 2001; and the Eurozone crisis of 2009 and 2010.
The authors analyzed the data in depth by industry, focusing on lending to: Agriculture, manufacturing, retail and wholesale trade, which are more important in developing countries; Construction, finance and household credit, which is more important in richer countries; and Companies that offer loans but are not subject to the same strict rules as banks, including leasing or financing companies, insurers and pension funds. The analyses form a body of research that looks at data “unprecedented in its breadth and scope,” the researchers write.
Understanding the role of leverage
The authors measure changes in the credit-to-GDP ratio, tracking corporate credit alongside GDP growth. “Overall, a single standard deviation increase in that ratio predicts a 3.6 percentage point increase in the probability of a financial crisis occurring,” Layne notes. In this regard, he notes that when commercial loans are backed by real estate, the alarm bells ring even louder: “Each one standard deviation increase in real estate-backed corporate credit relative to GDP is linked to a 3.7 percentage point increase in the probability of a crisis over the next three years.”
The study shows that a subsequent recovery may take longer to develop once the financial crisis abates if trade credit is the driving force of an economic crisis. In the case of commercial debt backed by real estate collateral, non-performing loans increase by more than 81% once the crisis hits. “When defaults occur in the commercial sector, banks’ balance sheets are harmed. And we show that, for example, there is an escalation of non-performing loans,” says Ivashina. “Once banks’ balance sheets are damaged, all sorts of consequences arise. For example, banks are less likely to lend.”
Debt: It’s not the same for everyone
Of course, not all countries and sectors relied so heavily on land and buildings to secure debt. Using a measure of the share of real estate collateral in five countries, the research concludes that:
- 84% of current loans in the construction and real estate sectors are backed by real estate.
- In transport and communications, that figure drops to 29%.
- The US economy behaves markedly differently: only 6% and 4%, respectively, in those two spheres are supported by the real estate sector.
Important signs for a possible future crisis
The authors therefore recommend that policymakers monitor firms’ lending behaviour more closely. The results also raise the question of whether there should be limits on firms’ leverage ratios, similar to the standards for household lending. And regulators should pay particular attention to loans that rely on real estate as collateral, even in industries other than real estate. “Our goal is not to say that household lending is not important. It clearly is,” Ivashina says, but rather to say that “Our goal is simply to push back against this narrative that somehow, after World War II, in a world where current household debt determines everything, everything else is relatively inconsequential in macroeconomic terms.”
Source: Ambito
