World Economy

Debt Binges Linked to Higher Risk of Banking Crisis

Debt Binges Linked to Higher Risk of Banking CrisisDebt Binges Linked to Higher Risk of Banking Crisis

Surges in household debt create short-lived bursts in economic growth that mask rising financial risks, including the threat of banking crises, the International Monetary Fund warned.

Larger ratios of household debt to gross domestic product typically generate faster growth and lower unemployment, the IMF said in a report released Tuesday. But those effects tend to reverse in three to five years, raising the risk of a banking crisis, said the Washington-based fund, Bloomberg reported.

Years of debt-driven economic activity tend to be followed by a period of instability and below-average growth in output and employment, the IMF said.

“There is a trade-off between the short-term benefits of rising household debt to growth and its medium-term costs to macroeconomic and financial stability,” the fund said in the report, part of the IMF’s Global Financial Stability Report, to be released in full on Oct. 11.

The IMF’s warning comes as central banks and financial regulators from Australia to Canada ponder how to drive economic gains without stoking already high levels of household debt built up amid years of ultra-low interest rates following the Great Recession.

After deleveraging in the aftermath of the 2007-2009 financial crisis, US household debt rose to a record $12.8 trillion in the second quarter, with modest increases in mortgage, auto and credit card debt.

Debt levels in both advanced economies and emerging markets have risen since the global financial crisis, the IMF found. Median debt-to-GDP levels surged from 52% to 63% in rich countries between 2008 and 2016, while increasing from 15% to 21% for emerging economies over the same period, according to the fund’s research.

To keep household borrowing under control, the IMF urged the use of so-called macroprudential policy tools, which use regulations to shape credit supply and demand. Demand-side measures can be highly effective, such as limits on loan-to-value ratios and the proportion of a person’s income used to service their debts.

Supply-side steps such as limits on bank credit growth and loan contract restrictions can also help, according to the fund.

The IMF said, “More specifically, our study found that a 5 percentage-point increase in the ratio of household debt to GDP over a three-year period forecasts a 1.25 percentage-point decline in inflation-adjusted growth three years in the future.

“Higher debt is associated with significantly higher unemployment up to four years ahead. And a one percentage point increase in debt raises the odds of a future banking crisis by about 1 percentage point.”

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