In any market economy, fiscal and monetary policies are key to macroeconomic management. But the transmission of the effects of these policies is mediated to different degrees by the financial sector.

Hence, the role that the financial sector plays and the effects macroeconomic policies have, would depend on financial policies, and their impact on financial structure and behaviour.

Thus, we should expect that the transition from interventionist to more liberalised regimes in late-industrialising countries would affect the manner of, and the extent to which, macroeconomic policy serves to stimulate growth.

One effect of this transition is well known. Since neoliberal fiscal policy opts for tax forbearance to incentivise the private sector and simultaneously aims at fiscal consolidation, it results in a decline in debt-financed public expenditure as a ratio of GDP.

Prior to ‘fiscal reform’, even in economies where the tax-to-GDP ratio is lower than average, governments sustain a reasonable level of public expenditure by resorting to borrowing.

‘Deficit-financed’ spending is not limited voluntarily, but only when the resulting accumulation of excess liquidity results in inflation in sectors (like agriculture) that are supply constrained.

The central bank is therefore required to lend on demand to the government opting for debt-financed spending.

Moreover, in some countries, of which India is a leading example, the government pre-empts resources mobilised by the financial sector by getting banks (through the statutory liquidity ratio) and nationalised insurance companies to mandatorily invest a part of their funds in government bonds.

Since financial liberalisation subjects banks and other financial institutions to increased competition, this use of the financial sector as a source for privileged government borrowing is inevitably dropped. The government borrows less, and borrows from an ‘open market’. This has important consequences for macroeconomic and financial policy.

First, with government borrowing restricted, monetary policy by a central bank independent of fiscal dominance becomes the preferred means of macroeconomic management.

Second, the financial sector’s role in promoting growth takes a whole new turn, with lending to the private sector becoming the means to stimulating demand. In a deregulated environment debt-financed private spending substitutes for the role of debt finance public spending in more interventionist regimes.

Third, this role is facilitated by substantially increased liquidity infusion by the ‘independent’ central bank that helps sustain a credit boom which drives private debt financed spending.

Home truths The so-called sub-prime crisis in the US showed how this leads to an unsustainable explosion in debt, which provides a bubble on which the economy can ride for some length of time but finally bursts, with damaging consequences for the real economy.

The longer the duration for which the speculative bubble endures, the more severe the crisis that follows.

Not surprisingly, lending for housing is an important target for the speculative credit boom in most contexts. Globally, a significant component of the process of financial expansion and an important site for financial innovation has been the housing finance or mortgage market.

The reasons for this are obvious. In most contexts, individuals or families would like to own a house if it can be afforded. Given the relative costs of housing within the desired asset basket of a household, it constitutes one among the larger investments or the single largest investment that many households ever make.

Given the life-span or durability of that investment and its liquidity characteristics, this is an asset that is most eligible for debt financing, since foreclosures due to default can in most circumstances be followed by easy liquidation to compensate the lender.

That being said, it is also true that other forms of private lending in general and consumer lending in particular have been quite important as well.

Bad debts Consider the overall structure of lending to the private non-financial sector in India, for example. Through the 1990s, outstanding debt to the private non-financial sector in the country was around 30 per cent of GDP. But when the post-liberalisation boom occurred starting in the early 2000s, this figure rose sharply to touch 50 per cent by 2007 and 60 per cent by end 2015 (Chart 1).

What is noteworthy is that while initially this credit boom involved retail lending to households in the private sector, especially for housing, by 2007 fears that the credit boom would come to an end led to a decline and subsequent stagnation in credit to households. The outstanding debt of households fell from about 10.5 per cent of GDP in 2007 to 9 per cent by 2010 and has since fluctuated around that level.

However, after 2007 bank lending to the private corporate sector, including lending for infrastructural projects that involves major maturity and liquidity mismatches, has increased substantially. The result has been a rapid accumulation of bad debt of even the public sector banks, leading to large losses and fears of insolvency in some cases. This experience is different from that in China and South Korea (Chart 2&3). In China, outstanding debt of the private non-financial sector rose from 70 per cent of GDP at the end of 1985 to a little more than 115 per cent by 2008 (Chart 2). Then over the next seven years to 2015, when financial liberalisation was intensified, it shot up to more than 200 per cent. In this period household debt rose from 19 to 38 per cent of GDP. Debt to the private non-financial sector other than households also obviously rose sharply.

Weak links

What were more or less sequential developments in India, occurred simultaneously in China. But there too the overall rise in private debt has resulted in increased default and rising financial fragility.

Finally, the South Korean example is telling. Ever since the early 1960s, bank lending to the private corporate sector in Korea was much higher than in many countries with extremely high debt-to- equity ratios. As South Korean industry lost competitiveness and many of its chaebols moved abroad, banks that were primed to lend shifted in favour of real estate and stock markets with the hope of sustaining their profitability. But that made it vulnerable to the crisis in 1997. And when that crisis occurred both the debt-burdened private corporate sector and banks over-exposed to them took a big hit.

But this did not end the lending boom. Increased lending to the household sector resulted in an increase in the ratio of household debt to GDP from around 50 per cent in 2000 to 86 per cent in 2015.

That is, South Korea’s halting recovery from the crisis was driven by debt to the household sector, which touched 150 per cent of household disposable income by 2013.

The danger of massive default on such debt, which could have precipitated another major crisis, forced the government to step in and set up an 800 billion won fund to buy distressed household debt from the banking sector at a discount and restructure or write off a significant part of that debt.

In sum, across Asia the shift to reliance on debt-financed private expenditure for growth under liberalisation has created an environment prone to crisis. The recent fears of the effects of large defaults on private corporate debt in India are an instance of that disease.

Related Topics
comment COMMENT NOW