COVER STORY • 9Confronting the Hazardsof Rising Private Sector
Leverage

By Adolfo Barajas

Benefits & Hazards of Private Sector Leverage
Leverage, the ability to borrow, is a double-edged sword. It canboost economic activity by allowing firms to invest in machinery to
expand their scale of production, or by allowing people to purchasehomes and cars or invest in education. During economic crises, it
can play a particularly important role, making it possible for firms
and households affected by sharp disruptions to their incomes tocontinue to make payments on essential items. In this way, leverage
can provide a bridge to an economic recovery.

The Benefits
Several decades of research have shown that, at themacroeconomic level, leverage by the private sector is indeed
associated with quantifiable benefits. As reviewed by Ross Levine(“Finance and Growth: Theory and Evidence” in Handbook of
Economic Growth: Philippe Aghion & Steven Durlauf (ed.), Elsevier,2005) and Alexander A. Popov (“Evidence on Finance and Economic
Growth” in Handbook of Finance and Development, Edward Elgar,
2018), studies have shown that countries that have a greater ratio ofprivate sector borrowing from the banking system to their GDP –also commonly referred to as the country’s financial depth – tend to
experience higher economic growth rates over long periods of time.
Delving deeper into the channels through which these effects
materialize, work by Raghuram G. Rajan and Luigi Zingales(“Financial Dependence and Growth”, American Economic Review,Vol. 88, No. 3, 1998) highlighted a crucial role played by private
borrowing: it helps to relax financing constraints on firms. That is, itallows the sectors and firms that naturally require greater funding
from outside sources to expand more rapidly. In addition, a broadgroup of studies uncovered benefits on other fronts, in particularfacilitating greater rates of capital accumulation, and lower inequality
and poverty rates.

Author Adolfo Barajas

a “too much finance” phenomenon, whereby countries at alreadyvery high levels of financial depth may actually experience a
reduction in long-run growth when they deepen further. This is partly
due to a greater propensity for financial instability when levels ofprivate sector borrowing are high and growing rapidly. As
documented by Moritz Schularick and Alan M. Taylor (“Credit Booms
Gone Bust: Monetary Policy, Leverage Cycles, and Financial Crises,
1870-2008”, American Economic Review, Vol. 102, 2012), while not
all such episodes – credit booms – result in financial distress orcrises, certainly most financial crises have been preceded by credit
booms. Particularly destabilizing, as Atif Mian, Amir Sufi, and Emil
Verner find (“Household Debt and Business Cycles Worldwide”,
Quarterly Journal of Economics, Vol. 132, 2017), are rapid increases
in borrowing by households. These episodes tend to produce aboom-bust cycle, whereby increased spending spurs greater
economic activity and feeds asset prices in the short run, but leaves
the economy more exposed to a severe downturn in activity or a
sharp correction in asset prices in the future.
In this article I discuss the two blade edges of private sector
leverage in the context of an almost uninterrupted buildup since theglobal financial crisis. Drawing on results from recent research by
our team in the International Monetary Fund (IMF), I argue that,
because facilitating borrowing was part of the policy package
pursued by many governments to provide support to their private
sectors during the Covid-19 crisis, a policy dilemma or tradeoff
emerges: the short-run benefits of these policies might be generated
at the cost of future financial stability risk. Our analysis implies thenthat policymakers should be aware of this tradeoff and stand ready toreverse the Covid-era policies when no longer needed. In addition,
we show that a particular set of tools – macroprudential policies –can be deployed early to lessen or even eliminate the tradeoff
between easing credit conditions today and increasing financial
stability risk tomorrow.

The Hazards

Rising Leverage, Before & During the Covid-19
CrisisThe other edge of the sword is that leverage may pose hazards aswell. Its positive impacts may evaporate or even reverse at very highlevels or when its growth is particularly rapid. Researchers such as
Jean-Louis Arcand, Enrico Berkes, and Ugo Panizza (“Too Much
Finance”, Journal of Economic Growth, 20 (2), 2015) have identified

During the decade following the global financial crisis and leading
up to the outbreak of Covid-19, leverage in the nonfinancial private
sector – comprising households and nonfinancial firms – had been
increasing steadily in many countries. We use a broader definition ofleverage than the financial depth measure described above, as we

44 Japan SPOTLIGHT • November / December 2021

https://www.jef.or.jp/journal/

CHART 1

Private nonfinancial sector leverage, by country group
1. Nonfinancial Corporate Leverage: Debt-to-GDP Ratio, 2001:Q1–
2020:Q4 (Percent)120

2. Household Leverage: Debt-to-GDP Ratio, 2001:Q1–
2020:Q4 (Percent)
90

90

60

60
Advanced economies
Emerging markets
Global30

02001:1

2004:1

2007:1

2010:1

2013:1

2016:130

02001:1

2019:1

3. Nonfinancial Corporations: Decomposition of the Debt-to-GDP Ratio
Increase from 2019:Q4 to 2020:Q4 (Percentage points)

6

10

5

2007:1

2010:1

2013:1

2016:1

2019:1

4

6

3

4

2

2

1

0

0

-2
-4

2004:1

4. Household Sector: Decomposition of the Debt-to-GDP Ratio
Increase from 2019:Q4 to 2020:Q4 (Percentage points)

128Advanced economies
Emerging markets
GlobalGlobalContribution of debt

AE
Contribution of GDP

EM
Leverage increase-1

GlobalAE

EM

Contribution of debt

Contribution of GDP

Leverage increase

Notes: The figure includes 27 advanced economies (AEs) and 25 emerging markets (EMs). Leverage is measured as the ratio of debt to GDP. Global, AE, and EM leverage are measured as
the ratio of aggregate debt to aggregate GDP across different country groups. Nonfinancial corporate debt figures are nonconsolidated.

Sources: Institute of International Finance; and “Loose Financial Conditions, Rising Leverage, and Risks to Macro-Financial Stability” by Adolfo Barajas, Woon Gyu Choi, Ken Zhi Gan, Pierre
Guérin, Samuel S. Mann, Manchun Wang and Yizhi Xu (IMF Working Paper WP/21/222, 2021)

include bond issuance in addition to bank credit received, and also
scale it by the country’s GDP to approximate the economy’s capacity
to service this debt. As Panels 1 and 2 of Chart 1 show, from 2010 to2019 global leverage of the nonfinancial private sector rose from138% to 152%, with leverage of firms reaching a historical high of
91% of GDP.
More recently, amid the sharp contraction in economic activity
brought on by lockdowns and social distancing practices during theCovid-19 pandemic, policymakers took actions to ensure that firms
and households could continue to access credit markets and borrow
to cushion the downturn. Many firms managed to limit the numberof workers they had to lay off. And cash-strapped households could
continue to spend on necessary items such as rent, utilities, or
groceries.
As a result, leverage increased even further. Panels 3 and 4 ofChart 1 show that during 2020 nonfinancial firms increased theirleverage by over 8 percentage points, to just over 100% of GDP,
while households increased theirs by 4 percentage points of GDP, to64.5% of GDP. The figure also highlights the diverging phases of theeconomic cycle between advanced economies (AEs) and emerging
market economies (EMs). With a nascent recovery in AEs, thedecomposition of the change in the ratio into changes in the amountof debt (numerator) and GDP (denominator) reveals that the increase
was driven solely by additional debt taken on by the private sector inthese countries, as GDP had a negative contribution. For EMs, thecontinuing depressed economic activity through the last quarter of2020 meant that GDP was responsible for about 60% of the increasein the leverage ratio for nonfinancial firms and almost 90% forhouseholds. But debt levels increased for both AEs and EMs.

Japan SPOTLIGHT • November / December 2021

45

CHART 2

Financial conditions & leverage
1. Nonfinancial Corporations: Within-Country Correlation
between Financial Conditions and a Future Change in Leverage
Interquartile

0.8

MedianInterquartile

0.5

Median

0.4

0.6

0.3

0.4

0.2

0.2
0.0

2. Households: Within-Country Correlation between Financial
Conditions and a Future Change in Leverage

0.1
AE

EM

FCI vs Future change in leverage over 12 quarters

0.0

AE

EM

FCI vs Future change in leverage over 12 quarters

Notes: The sample includes 19 advanced economies (AE) and 10 emerging markets (EMs) over the period 1996:Q1 – 2020:Q4. Panels 1 and 2 show the correlation of the negative of the
Financial Conditions Index (FCI) (that is, higher values indicate looser financial conditions) and changes in the debt-to-GDP ratio over the subsequent 12 quarters.

Sources: Institute of International Finance; and “Loose Financial Conditions, Rising Leverage, and Risks to Macro-Financial Stability” by Adolfo Barajas, Woon Gyu Choi, Ken Zhi Gan, Pierre
Guérin, Samuel S. Mann, Manchun Wang and Yizhi Xu (IMF Working Paper WP/21/222, 2021)

Key Factor in Leverage Buildup: Easy Financial
Conditions
Many factors can influence the capacity and willingness of theprivate sector to take on additional debt, such as fiscal performanceof the public sector, the rate of unemployment, and the speed ofaging of the population, but one in particular stands out: financial
conditions. These reflect the price that different private sector actors
in the economy assign to taking on additional financial risk. When
financial conditions are “loose” or “easy”, the price of risk is low,
whereas under “tight” financial conditions, risk taking is deemed
costly by the main players in markets involved in financialtransactions. Thus, one should expect that when financial conditions
are loose, firms and households have greater incentives and ability toborrow, and banks and purchasers of corporate bonds are also more
likely to provide the desired financing. In short, an easing of financial
conditions should result in greater private sector leverage.
This is verified by analysis undertaken by our team for Chapter 2of the April 2021 IMF Global Financial Stability Report (GFSR) anddescribed in detail in a recent paper (“Loose Financial Conditions,
Rising Leverage, and Risks to Macro-Financial Stability” by Adolfo
Barajas, Woon Gyu Choi, Ken Zhi Gan, Pierre Guérin, Samuel S.
Mann, Manchun Wang and Yizhi Xu, IMF Working Paper WP/21/222(Washington, D.C., 2021). We use a financial conditions index, or
FCI, constructed by the Monetary and Capital Markets Department of
the IMF as part of its continuous surveillance of financial
developments throughout the world. The FCI is a composite
measure, encompassing market data on real short-term interest
rates, equity prices, sovereign and corporate debt spreads, exchange
46 Japan SPOTLIGHT • November / December 2021

rates, and real house prices. It is calculated for each country, andthen can be aggregated into regional and global averages.
In Chart 2 we calculate the correlation between each country’s
financial conditions – a higher level denoting easier financial
conditions – and the growth of leverage over the subsequent 12
quarters, and show the average correlations as well as theinterquartile range over 19 AEs and 10 EMs. As illustrated, there is a
visible positive association for both groups of countries and for
nonfinancial firms as well as households. Our analysis further
reveals that this association holds for other time horizons, such as
eight or 16 quarters ahead, and when controlling for the other key
factors affecting leverage. Thus, the pre-Covid buildup in leverage ispartly explained by the easy financial conditions prevailing in mostcountries in the years following the global financial crisis, as is themore recent increase in leverage, amid financial conditions that
eased considerably after initially tightening sharply in the first quarterof 2020.

Financial Stability Risk
Our analysis then turns to the potential financial stability risk ofrising private sector leverage. Following work of previous GFSRs andof Tobias Adrian, Nina Boyarchenko, and Domenico Giannone(“Vulnerable Growth”, American Economic Review, Vol. 109, 2019),
we adopt a particular perspective: Growth at Risk (GaR). Put simply,
GaR summarizes the possibility that economic activity may suffer asevere downturn, as the analysis focuses on the lower tail of the
distribution of future outcomes. GaR therefore provides a signal of
future financial distress, which is often the result of a buildup ofvulnerabilities that would require either a sharp correction in asset
prices or an abrupt deleveraging by the private sector. That is, if
leverage is indeed a source of vulnerability and therefore poses a
hazard for financial stability, this should show up as an intensified
downside risk to future economic activity.
We find this to be the case, in several ways. Chart 3 shows one ofour main results, the effect of an easing of financial conditions –which, as we saw, induces an increase in private sector leverage – on
GaR up to 12 quarters into the future. Note that GaR expresses thelower tail of the distribution of future economic growth outcomes;
therefore an increase means that downside risk is attenuated,
whereas a decrease implies that downside risk is accentuated. The
chart shows evidence of a tradeoff. Easing financial conditions tends
to provide a short-term boost to output as downside risk isattenuated in the first few quarters, but then at the cost of greater
downside risk starting around the seventh or eighth quarter.
Furthermore, the chart shows that this tradeoff is visibly more
pronounced during credit booms, that is, the near-term boost is
greater, while the medium-term downside risks are also larger.
Our analysis also finds that, regardless of their causes, upswings
in leverage of firms and households tend to be followed by increased

CHART 3

Amplification effects of credit
booms: impact of loosening financial
conditions on the 10th percentile ofoutput growth6

Credit boom
No credit boom

4
2
0
-2

1

2

3

4

5

6

7

8

9

10

11

12

-4
-6
Notes: The chart shows the 10th percentile impact of a one-standard-deviation easing in
the FCI on future year-on-year real GDP growth. A credit boom is defined as aperiod in which the eight-quarter change in private nonfinancial sector leverage ishigher than the top 3rd decile and financial conditions are looser than median in acountry. The control variables in all regressions include year-on-year real GDP
growth, inflation, and policy rate change (all one-period lagged), and country fixed
effects. Dashed lines indicate 90% confidence intervals based on standard errors
computed from bootstrapping.

Source: International Institute of Finance; Bank for International Settlements; and “Loose
Financial Conditions, Rising Leverage, and Risks to Macro-Financial Stability” by
Adolfo Barajas, Woon Gyu Choi, Ken Zhi Gan, Pierre Guérin, Samuel S. Mann,
Manchun Wang and Yizhi Xu (IMF Working Paper WP/21/222, 2021)

downside risk to economic activity, further evidence that sharpbuildups of private sector leverage can increase risks to financial
stability.

Policy Dilemma
Policymakers face a dilemma. Accommodative policies, such as
cuts in monetary policy rates in conjunction with quantitative easing
aimed at reducing firms’ and households’ borrowing costs, tend toresult in easier financial conditions which, in turn, spur a buildup in
private sector leverage. While such a buildup has been instrumental
in the short term to cushion the global economy from thedevastating impact of the pandemic, our results indicate that it canbe a vulnerability that poses a risk to financial stability further down
the road, particularly as the post-pandemic recovery takes hold.
For policymakers, the question becomes how to ensure that thefledgling recovery is not endangered, while at the same time
avoiding an excessive buildup of leverage that could have a sharp
contractionary effect on the economy in a few years’ time.

Macroprudential Policies Can Help
Our analysis suggests there are measures policymakers can taketo resolve, or at least lessen, this dilemma. Macroprudential policies– such as setting limits on borrower eligibility, raising minimum
capital or liquidity ratios for banks – can tame buildups in
nonfinancial sector leverage and help to attenuate downside risk tofuture economic activity.
We draw on an extensive IMF database documenting changes ineach of 17 macroprudential policy tools, available for up to 179
countries and from 1990 to 2018. By summarizing the tools into
seven categories, we are able to observe all actions that either
tighten or loosen tools in a particular category in a given quarter, andthen test whether these actions have had an impact on leveragebuildups or financial stability.
Our analysis shows that certain targeted macroprudential tools
can in fact arrest leverage buildups in different segments of theprivate sector. After countries tighten borrower-related tools (forexample, lowering the maximum loan-to-value ratio for mortgage
borrowers), we observe that leverage for households slows. When
policymakers tighten liquidity regulations on banks (for example,
raising the minimum amount of liquid assets that must be held inproportion to total assets), leverage of firms slows in response. And
when policymakers in emerging markets tighten foreign currency
constraints on banks (for example, limiting their open foreign
currency positions), leverage of firms slows down as well.
Importantly, macroprudential tightening can mitigate downside
Japan SPOTLIGHT • November / December 2021

47

CHART 4

Macroprudential measures & downside risks to future growth
1. Impact of Macroprudential Tightening on the 10th Percentileof GDP Growth (Percentage points)
1

2. Impact of Loosening Financial Conditions on 10th Percentileof GDP Growth (with vs. without Macroprudential Tightening)(Percentage points)
3

Macroprudential tightening
No macroprudential tightening

2
0.5

0

-0.5

1
0
1

2

3

4

5

6

7

8

9

10

11

12

13

14

15

16

Quarters

1

2

3

4

5

6

7

8

9

10

11

12

13

14

15

16

-1
-2

Quarters

Notes: Panel 1 shows the effects of a net tightening event across the 17 types of macroprudential measures found in the IMF Integrated Macroprudential Policy database. Panel 2 shows theeffect of a one-unit loosening in the FCI. The “macroprudential tightening” regime contains all quarters with net macroprudential tightening in the past year. The dependent variable isthe year-over-year growth of real GDP over horizons of 1–16 quarters ahead. The control variables in all regressions are the change in the private nonfinancial sector leverage overthe past eight quarters, year-over-year GDP growth, and inflation. All the responses are estimated with county fixed effects using quantile local projections at the 10th percentile of thegrowth distributions. Dashed lines indicate 90% confidence intervals.

Source: International Institute of Finance; and “Loose Financial Conditions, Rising Leverage, and Risks to Macro-Financial Stability” by Adolfo Barajas, Woon Gyu Choi, Ken Zhi Gan, Pierre
Guérin, Samuel S. Mann, Manchun Wang and Yizhi Xu (IMF Working Paper WP/21/222, 2021)

risk to growth, thus alleviating the key policy tradeoff. In Chart 4 weshow the estimated impact of a macroprudential tightening on GaR
up to 16 quarters into the future. Panel 1 shows that, while there
may be a slight increase in downside risk in the near term, thepolicy’s strongest effects are to dampen downside risk in themedium term, beginning 10 quarters out. Panel 2 shows that whenpolicymakers loosen financial conditions – for example, undertaking
accommodative monetary policy – without taking macroprudential
policy actions, we observe the familiar short-to-long term tradeoff.
However, if they accommodate and also concurrently tighten
macroprudential tools, medium-term downside risks to economic
activity can be mostly contained.

When to Act
In the current context, charting a course for macroprudential
tightening is not straightforward and its timing should be tailored tocountries’ individual circumstances.
Many countries are experiencing a nascent recovery and broadtightening of financial conditions could hurt growth. Yet, given thelags that we detect between the activation of macroprudential tools
and their mitigating impact, early action is called for. In somecountries, the toolkit is also in its early stages of development and/or
has not been tested in practice. Moreover, even in the most advanced
countries, the toolkit is aimed solely at banks, while credit provision
48 Japan SPOTLIGHT • November / December 2021

to the private sector is increasingly migrating toward nonbank
financial institutions.
These considerations build a strong case for policymakers to
swiftly develop and tighten macroprudential measures to tackle
pockets of elevated vulnerabilities, while avoiding a generaltightening of financial conditions while the recovery is still in its
infancy. Policymakers will also need to urgently design new tools to
address leverage beyond the banking system.
Note: The views expressed herein are those of the author andshould not be attributed to the IMF, its Executive Board, or its
management.
© International Monetary Fund. This article is based on IMF
Working Paper 21/222, “Loose Financial Conditions, Rising
Leverage, and Risks to Macro-Financial Stability” and “Chapter Two”,
Global Financial Stability Report, April 2021.

Adolfo Barajas is a senior economist in the Global Financial Stability Analysis
Division of the Monetary and Capital Markets Department at the IMF, where his
primary responsibility is to work on analytical chapters for the IMF’s semiannual Global Financial Stability Report.