By G. Sharmila
We have discussed rising global debt, including that of world household debt. The situation is becoming dire. However the good news is that there are ways to live with, and manage debt if governments are willing to listen.
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In previous articles, it has been established that nations rarely reduce total debt relative to their gross domestic product (GDP) and that debt ratios around the globe continue to rise. “There has been much discussion about the maximum level of public and private debt a country can sustain with no clear answer so far,” observed the McKinsey Global Institute (MGI) in its report Debt And (Not Much) Deleveraging.
“Learning to live safely with debt is critical not only for the advanced economies that today have unprecedented levels of debt, but also for developing economies. With a few exceptions, developing nations today have much lower ratios of debt to GDP than advanced economies. Nonetheless, they can learn from the mistakes made by advanced economies and create the policies necessary to safely manage debt,” MGI opined in its report.
While significant progress has been made since the 2008 crisis in making the global financial system more stable, MGI believes that opportunities still exist to further reduce the risk of financial crises through innovations to manage debt more effectively, avoid dangerous leverage, and decrease excess debt when necessary.
Innovating mortgage contracts
According to MGI, better risk-sharing features of household debt can make repayments more flexible when borrower circumstances or economic conditions change and avoid the costly option of default.
One approach, MGI said, is to include an insurance element in debt contracts, where automatic adjustments in repayment schedules are contingent upon specific events, such as job loss or indicators of economic recession and rising unemployment.
“However, many borrowers might be disinclined to pay for such insurance, particularly during boom times. In the interest of financial system stability, policy makers could, if they chose, create tax incentives for such mortgages.
“There are precedents for such flexibility in other types of debt contracts. For example, in the United Kingdom and Australia, student loan payments are capped at a certain percentage of the borrower’s income, so that payments rise along with incomes,” MGI explained.
Another approach MGI suggests is to introduce an equity-like element of risk sharing into a home purchase. For example, if home prices in the surrounding community decline below the purchase price of the home, the borrower’s payment is reduced by a similar percentage. When prices recover, the payments revert to the original rate and the lender is entitled to 5% of the capital gain when the borrower sells.
“The objective is to avoid foreclosure by automatically adjusting loan payments during tough economic conditions,” MGI commented on the measure.
Improving private-sector debt restructuring
MGI pointed out that sometimes default on debt is unavoidable, hence clear and efficient mechanisms for restructuring or discharging bad debt can minimise the damage of default to borrowers, lenders and the overall economy.
“For households, rules governing mortgage default or restructuring matter greatly. There are very different implications for non‑recourse loans (in which the lender cannot seize other assets or future income of the borrower) and recourse loans (in which the lender can),” noted MGI.
One option is recourse mortgages, which provide strong protections to creditors and make it very difficult for borrowers to walk away from their housing debt, which would put their other assets at risk.
“From an economic perspective, however, recourse loans have the unwanted effect of deepening recessions, by forcing struggling households to make loan payments even if it requires sharply reducing consumption,” MGI said.
Non‑recourse mortgages also have their drawbacks. “They may encourage borrowers to take on more debt — particularly during a housing boom — with the knowledge that they can walk away from the debt if necessary,” MGI explained.
“To counter the incentive to borrow too much, non‑recourse mortgages could be combined with conservative limits on loan-to-value ratios and countercyclical macroprudential rules to dampen new lending during credit booms,” MGI recommended.
Another option for debt restructuring is the “strip-down”, where the court orders a modification of the loan agreement to reduce servicing costs and avoid foreclosure. “While the strip-down has benefits, including reducing household indebtedness and reducing the effects of housing defaults on consumption, there are trade-offs. As in the mortgage innovations discussed above, stripdowns could cause lenders to reduce the supply of credit or raise its price,” MGI cautioned.
“For corporate debt, a clear, consistent, and expeditious bankruptcy system is essential to enable businesses to restructure and move ahead,” MGI explained. It added that while all countries have bankruptcy codes today on paper, refinements may be warranted in some countries to strengthen them protections for creditors.
Macroprudential tools to dampen credit cycles
A key challenge for policy makers is to protect their economies from the bad judgements of some borrowers and lenders without limiting the flow of debt to sustain healthy growth. “Applying macroprudential policies such as counter-cyclical reserve requirements on banks can help achieve this goal. This means assessing the systemic risk of lending decisions in addition to the risk to the individual lender (the more traditional microprudential view),” MGI said in its report.
It also recommended that regulators impose limits on loan-to-value ratios for mortgages that vary over time, becoming more stringent during periods of rising housing prices and looser during downturns.
“Other policies can discourage or prohibit certain types of risky mortgages, such as interest-only loans. And countercyclical measures can slow the pace of lending when debt is rising too rapidly by imposing higher capital requirements on banks,” MGI added.
Reduce tax incentives for debt
MGI highlighted that the explicit and implicit incentives that governments provide for real estate vary widely across countries, but they include tax deductibility of mortgage interest and preferential treatment of capital gains on residential properties.
It suggested that policy makers reconsider the mix of incentives provided for residential housing and balance the social goal of homeownership against other needs, such as investments in infrastructure, education, or research and development that would enhance the long-term productive capacity of the economy.
“Reducing or phasing out some of the incentives should be debated. The right answer will differ by country. While making such changes could be politically difficult, some countries have done so, such as the United Kingdom, which ended mortgage interest deductions,” MGI pointed out.
“Reforming the corporate tax code is even more politically fraught, with winners and losers to any policy change. Nonetheless, the tax incentives for corporations to issue debt could also be reconsidered to create a more level playing field between debt and equity financing,” MGI said.
While eliminating the deductibility of interest would effectively raise corporate tax rates, that move could be offset by a lower marginal rate, MGI said. It also suggested an alternative reform, one that allows corporations to deduct dividends from profits in calculating their corporate tax liabilities.
“This allowance might encourage companies to pay dividends rather than pursue share buybacks to boost stock prices. To avoid worsening fiscal deficits, this reform might be accompanied by other tax reforms to ensure the package is revenue neutral (although there would still be distributional effects),” MGI said.
A broader range of tools needed to resolve sovereign debt
According to MGI, for the most indebted governments of today, neither promoting economic growth nor pursuing fiscal austerity alone is a plausible solution for deleveraging, given the magnitude of change needed. A broader range of debt resolution mechanisms for governments may be needed, MGI said.
It added that when considering options for sovereign debt restructuring, it matters whether debt is held by external creditors (foreign parties) or domestic creditors, and whether the debt has been issued in local or foreign currencies.
“For restructuring external debt, one key difficulty may be the sheer number of creditors. Collective action clauses can aid governments in negotiating with bondholders and preventing a handful of creditors from derailing resolution or holding out for full repayment. However, current collective action clauses suffer from several weaknesses, and the IMF has proposed reforms to aid future government debt restructuring.One proposed reform is for creditors to vote on restructuring of all bond issues, rather than requiring separate votes on each issue,” MGI explained.
Meanwhile, for sovereign debt held primarily by internal creditors, governments could pursue more targeted measures to raise revenue to avoid debt restructuring. “For instance, taxes on wealth or large-scale asset sales could be considered as means to pay off debt. Pursuing any of these options could present political challenges. Historically, it has been rare for governments to restructure domestically held debt outright (although Argentina effectively did this when it broke the peso-dollar peg in 2002, resulting in a massive currency depreciation),” MGI said.
Furthermore, instead of getting central banks to cancel their government debt holdings (which is implausible), another option is to replace the government debt on the central bank’s balance sheet with a zero-coupon perpetual bond, MGI said.
“Although the market value of such a bond would be zero, central banks are not required to mark their assets to market. Still, any such move could create backlash in the markets and, in some countries, by policy makers. Therefore, a simpler but equivalent measure would be for central banks to simply hold the government debt they have accumulated in perpetuity and for the broader public to shift its focus to net debt rather than gross debt,” it explained further.
Improve data collection and debt monitoring
With a clear and timely understanding of how credit is being issued and used, MGI said, it is possible to identify emerging risks and act on them before they can trigger financial crises.
“In the age of big data it should be possible, for example, to develop granular, real-time data on the liabilities, assets, and incomes of individual borrowers. This will enable regulators and lenders to understand at a household or corporate level not only how much debt is being accumulated, but also how it is being used, and whether the borrower is still capable of repaying,” it explained.
MGI also recommended a creation of a central credit register that captures data about all loans over a certain value from various institutions, which has been used in Germany. “Both supervisory authorities and reporting institutions benefit tremendously from such a mechanism, with the regulators gaining a comprehensive overview of the status of large borrowers and the lenders benefiting from the ability to assess in real time the creditworthiness of their actual and potential clients.”
Such credit registers, MGI said, are used in a range of countries and, given today’s technology, this resource could be deployed more broadly (with proper privacy safeguards) to gather information on all sorts of credit.
Creating a healthy mix of bank and non-bank credit sources
At a time when banks remain constrained in their lending capacity, non‑bank credit can be an important resource for the economy, MGI pointed out.
It recommends that the first step be to further develop corporate bond markets, adding that more room exists for bond market development in Europe and emerging markets.
“To function effectively, such markets need a yield curve set by regular government bond issuance, ratings by independent agencies, an efficient bankruptcy system and laws to protect creditors, and demand from institutional investors. Private placements are the best way for smaller companies to issue bonds, allowing pension funds, insurers, and other institutions to provide credit to them directly,” MGI explained.
Secondly, “plain vanilla” securitisation needs to be encouraged. “Plain vanilla” securitisation involves a simple pass-through of pools of mortgage obligations into marketable securities, a practice that has been used by Fannie Mae and Freddie Mac in the United States for decades and has proven sustainable. In this form of securitisation, the underlying quality of loans is high and risks are diversified. All investors in the securitisation bear the same risk.
“The private sector can also perform securitisation, but with regulations to avoid the problem that arose before the crisis: pooling of poor quality loans and disguising underlying risks. National regulations on loan quality for securitisations could be developed,” MGI suggested.
Thirdly, MGI advocated strengthening reporting standards and monitoring of non-bank intermediaries. “While some non‑bank credit providers—such as finance and leasing companies, insurers, and government programs—have been around for years, new types of lenders continue to emerge, and their evolution should be monitored closely,” it emphasised.
Promote financial deepening in developing economies
Developing economies of today have significant funding needs to build infrastructure, housing, and their industrial bases. “As the wealth of these nations grows, there should be commensurate financial deepening, with broader access to more varied types of financing instruments and a broader range of financial institutions.
“This includes development of public capital markets for both equity and debt; housing finance and mortgage markets; pension funds and insurance companies to create demand in the market; and a range of other mutual funds and asset management options,” MGI suggested.
“There are additional requirements for effective financial markets: a sound legal system that offers efficient bankruptcy proceedings and protection of creditor and minority shareholder rights, a framework for transparent accounting and financial reporting, credit rating agencies for both businesses and households, and a robust set of financial market supervisors and regulators,” MGI added.
It is clear while no perfect solution exists to the global debt situation, some of the measures suggested by MGI can be adopted by governments worldwide to relieve their debt situation.
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