Deleveraging

Source: Wikipedia, the free encyclopedia.

At the

leverage ratio, or the percentage of debt in the balance sheet of a single economic entity, such as a household or a firm. It is the opposite of leveraging
, which is the practice of borrowing money to acquire assets and multiply gains and losses.

At the

GDP ratio in the national accounts. The deleveraging of an economy following a financial crisis has significant macro-economic consequences and is often associated with severe recessions
.

In microeconomics

The leverage ratio, measured as debt divided by equity, for investment bank Goldman Sachs from 2003-2012. The lower the ratio, the greater the ability of the firm to withstand losses.

While

assets and multiply gains in good times, it also leads to multiple losses in bad times. During a market downturn when the value of assets and income plummets, a highly leveraged borrower faces heavy losses due to his or her obligation to the service of high levels of debt. If the value of assets falls below the value of debt, the borrower then has a high risk to default. Deleveraging reduces the total amplification of market volatility on the borrower's balance sheet. It means giving up potential gains in good times, in exchange for lower risk of heavy loss and nasty default
in bad times.

However, precaution is not the most common reason for deleveraging. Deleveraging usually happens after a market downturn and hence is driven by the need to cover loss, which can deplete capital, build a less risky profile, or is required by nervous lenders to prevent default. In the last case, lenders lower the leverage offered by asking for a higher level of collateral and down payment. It is estimated that from 2006 to 2008, the average down payment required for a home buyer in the US increased from 5% to 25%, a decrease of leverage from 20 to 4.[1]

To deleverage, one needs to raise cash to pay debt, either from raising capital or selling assets or both. A bank, for example, can cut expenditure, sell

liquid assets, absorb off-balance-sheet structured investment vehicles and conduits, or allow its illiquid assets to run off at maturity
, which, however, can take a long time.

Deleveraging is frustrating and painful for

credit markets make it difficult to raise capital from public market. Private capital market is often no easier: equity holders usually have already incurred heavy losses themselves, bank/firm share
prices have fallen substantially and are expected to fall further, and the market expects the crisis to last for a considerable length of time. These factors can all contribute to hindering the sources of private capital and the effort of deleveraging.

In macroeconomics

U.S. households and financial businesses began de-leveraging in the years following the subprime mortgage crisis.

Deleveraging of an economy refers to the simultaneous reduction of leverage level in multiple

nominal GDP ratio of the economy. Almost every major financial crisis in modern history has been followed by a significant period of deleveraging, which lasts six to seven years on average. Moreover, the process of deleveraging usually begins a few years after the start of the financial crisis.[2]

As in January 2012, four years after the start of the

emerging economies in the world had just begun to go through a major period of deleveraging.[3] This is mainly because the continuing rising of government debt, due to the Great Recession, has been offsetting the deleveraging in the private sectors in many countries.[4]

Historical episodes of deleveraging

The McKinsey Global Institute defines a significant episode of deleveraging in an economy as one in which the ratio of total debt to GDP declines for at least three consecutive years and falls by 10 percent or more.[2] According to this definition, there have been 45 such episodes of deleveraging since 1930, including:

Based on this identification of deleveraging and Carmen Reinhart and Kenneth Rogoff’s definition for major episodes of financial crisis,[5] it is found that almost every major financial crisis during the period of study has been followed by a period of deleveraging.[2] After the 2008 financial crisis, economists expected deleveraging to occur globally. Instead the total debt in all nations combined increased by $57 trillion from 2007 to 2015 and government debt increased by $25 trillion. According to the McKinsey Global Institute, from 2007 to 2015, five developing nations and zero advanced ones reduced their debt-to-GDP ratio and 14 countries increased it by 50 percent or more. As of 2015, the ratio of debt to gross domestic product globally has increased by 17 percent after the crisis.[6]

Macro-deleveraging process

According to a McKinsey Global Institute report, there are four archetypes of deleveraging processes:[2]

  1. "Belt-tightening": this is the most common path of deleveraging for an economy. In order to increase net savings, an economy reduces spending and goes through a prolonged period of austerity.
  2. "High inflation": high inflation mechanically increases nominal GDP growth, thus reducing the debt to GDP ratio. E.g. Chile in 1984–91.
  3. "Massive default": this usually comes after a severe currency crisis. Stock of debt immediately decreases after massive private and public sector defaults.
  4. "Growing out of debt": if an economy experiences rapid (off-trend)
    real GDP
    growth, then its debt to GDP ratio will decrease naturally. E.g. US in 1938–43.

Macro-economic consequences of deleveraging

Massive deleveraging in corporate and financial sectors can have serious macro-economic consequences, such as triggering

GDP growth.[7][8]

In the

asset prices to collapse. The pressure of deflation
increases the real burden of debt and spreads loss further in the economy.

In addition to causing deflation pressure, firms and households deleveraging their

propensity to save. This is known as the paradox of thrift
.

Government regulation and fiscal policy

According to the theory of

business cycles. Deleveraging is responsible for the continuing fall in the prices of both physical capital and financial assets after the initial market downturn. It is part of the process that leads the economy to recession and the bottom of the leverage cycle
.

Therefore, some economists, including John Geanakoplos, strongly argue that the Federal Reserve should monitor and regulate the system-wide leverage level in the economy, limiting leverage in good times and encouraging higher levels of leverage in bad times, by extending lending facilities.[1][9] Moreover, it is more important to restrict leverage in ebullient times to prevent the crash from happening in the first place.[1]

In addition, in the face of massive private sector deleveraging,

government budget deficit
could seriously harm the stability and long-run prospect of the economy.

See also

References

  1. ^ a b c d [1], John Geanakoplos, The Leverage Cycle, Cowles Foundation, July 2009.
  2. ^ a b c d e f "Debt and deleveraging: The global credit bubble and its economic consequences". McKinsey Global Institute. January 2010. Retrieved January 14, 2016. {{cite journal}}: Cite journal requires |journal= (help)
  3. ^ [2], The Economist, Deleveraging: You ain't seen nothing yet, July 2011
  4. ^ [3] McKinsey Global Institute, Debt and deleveraging: Uneven progress on the path to growth, January 2012.
  5. ^ Carmen Reinhart and Kenneth Rogoff, This Time Is Different: Eight Centuries of Financial Folly, Princeton, NJ: Princeton University Press, 2009.
  6. ^ Dobbs, Richard; Lund, Susan; Woetzel, Jonathan; Mutafchieva, Mina (February 2015). "Debt and (not much) deleveraging". McKinsey Global Institute. Retrieved January 15, 2015. {{cite journal}}: Cite journal requires |journal= (help)
  7. ^ [4] "Assessing the private sector deleveraging dynamics," Quarterly Report on the Euro Area, 12(2013)1: 26-32.
  8. ^ [5] Cuerpo C., I. Drumond, J. Lendvai, P. Pontuch and R. Raciborski (2013), "Indebtedness, Deleveraging Dynamics and Macroeconomic Adjustment", European Economy, Economic Papers, 477 (April).
  9. doi:10.3386/w16337
    .
  10. ^ [6] Gauti B. Eggertsson and Paul Krugman, Debt, Deleveraging, and the Liquidity Trap: A Fisher-Minsky-Koo approach, preliminary draft, November, 2010.

External links

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