The severe economic downturn due to Covid-19 will push economies around the world deeper into debt. The governments of many countries are borrowing heavily for fiscal stimulus packages to support growth and provide relief for vulnerable groups. At the same time, private companies and households may be forced to borrow more to survive the economic impact of Covid-19. In addition, the economic downturn challenges their capacity to service their existing debts. Therefore, despite widespread concerns about the current escalation of public debt and its sustainability, we should not lose sight of the potential risk from possible surges of private debt.

The pandemic threatens to force more households into debt.

This is especially true for developing economies in Asia, where private debt has grown faster than public debt in recent years, even prior to Covid-19. More specifically, while the GDP-weighted average public debt-to-GDP ratio of developing economies in Asia increased by around two-fifths from 2008 to 2017, private debt expanded by around two-thirds during the same period. There are significant differences in the pattern of public and private debt growth across sub-regions. For instance, the growth of private debt has been most pronounced in East and Southeast Asia.

Private debt consists of household debt and corporate debt – i.e. borrowing by households and companies. While both have contributed to the growth of private debt in the region, their relative contribution differs across countries. In the Republic of Korea and Thailand, for instance, the growth of the private debt is driven mainly by household debt expansion, while in some other economies—like Hong Kong, China and the People’s Republic of China—both household and corporate debt are contributing to private debt expansion.

Accumulation of private debt may not necessarily be a problem. Higher debt levels can reflect the development of the financial sector, which channels household savings to finance investment by firms. But too rapid or too large a debt buildup may contribute to excessive leverage in inefficient sectors, contributing to an overall deterioration in the quality of the debt. This is particularly true when there is abundant liquidity in the market. The deterioration, in turn, can threaten the health of banks and the financial systems by causing large amounts of non-performing loans.

To investigate this danger, we examined the relationship between private (and public) debt buildup on one hand and financial instability on the other. To capture financial instability, we use a measure of currency depreciation pressures. The underlying intuition is that as the debt level builds up, both domestic and foreign investors become more sensitive to vulnerabilities arising from weak fundamentals and pull their money out of the country, weakening the currency. For example, during the Asian financial crisis of 1998, several Asian countries suffered a sharp depreciation of their currencies.

The analysis, which uses a global sample of 59 economies and controls for key relevant factors that can affect the exchange rate, yielded some noteworthy findings. Overall, the analysis revealed that both private and public debt buildup exacerbates currency vulnerability or financial instability. Interestingly, the evidence of a significant effect on currency depreciation pressure is more robust and consistent for private debt than public debt.

Furthermore, the evidence indicates that excessive private debt buildup can be particularly harmful in emerging markets. The adverse effect of public debt buildup on exchange rate depreciation pressure is most pronounced during periods of broader financial stress such as the global financial crisis of 2008.

While leverage fosters sound economic activities and helps consumption smoothing, it poses a risk to financial stability when debt is allocated to unproductive sectors. The risk of debt quality deterioration increases when the economy is slowing down or contracting, as is happening now due to Covid-19.

Some developing Asian countries accumulated private debt during the post-global financial crisis era of global low interest rates. As such, Asian regulators and policy makers should not neglect prudential financial supervision and regulation even as they are preoccupied with the Covid-19 crisis. Structural policies can also contribute. For example, strengthening shareholder rights will improve corporate governance. This would help to improve the quality of private debt and reduce the risk of financial instability in the future.

This blog is based on analysis done by the authors for the Asian Development Outlook 2019 Update.

Authors:

Donghyun Park is Principal Economist, Economic Research and Regional Cooperation Department, ADB.

Arief Ramayandi is Senior Economist, Economic Research and Regional Cooperation Department, ADB.

Shu Tian is Economist, Economic Research and Regional Cooperation Department, ADB.