What really drives boom-and-bust cycles in the modern global economy? A new paper from Harvard Business School, analyzing data from 115 countries, suggests it’s not always household debt. Instead, rising corporate debt may be the clearest warning of an impending financial crisis.
Experts have focused on housing and household debt, especially since the U.S. housing market collapse triggered the 2008 financial crisis. However, this focus might cause policymakers to overlook a more critical signal: corporate credit quality and growth.
Credit growth
The study found that corporate debt made up two-thirds of credit growth in the three years leading up to financial busts from 1940 to 2014. When a boom ends, it’s corporate debt that forms the bulk of unpaid loans.
Moreover, corporate debt slows down recovery, rebounding more slowly than household debt. Banks dealing with unpaid corporate loans face greater consequences.
“This shows that the U.S. financial crisis was an exception,” the researchers explain. “In 2007 and 2008, the majority of non-performing loans came from households in the U.S. Even then, corporate losses were significant.”
The findings suggest that corporate debt expansions give important clues about future economic crashes and need more attention from policymakers and economists. The paper comes amid persistent inflation and rising interest rates.
Impact of growing corporate debt
Using data from the Global Credit Project, the researchers studied the impact of corporate debt in over 100 advanced and emerging economies during credit booms that often precede financial crises.
The data covers 87 systemic financial crises, including:
- The Scandinavian crises of the early 1990s
- The Mexican tequila crisis of 1994
- The Asian financial crises of 1996 and 1997
- The Argentinian crisis of 2001
- The Eurozone crisis of 2009 and 2010
The authors examined lending by industry, focusing on:
- Agriculture, manufacturing, retail, and wholesale trade in developing countries
- Construction, finance, and household credit in wealthier countries
- Firms offering lending but not subject to strict banking rules, like leasing companies, insurers, and pension funds
They tracked changes in the credit-to-GDP ratio, linking corporate credit to GDP growth. A single standard deviation increase in this ratio predicts a 3.6 percentage point rise in the likelihood of a financial crisis.
Commercial lending backed by real estate is even riskier. Each standard deviation increase in real estate-backed corporate credit relative to GDP raises the crisis probability by 3.7 percentage points within three years.
Slower recovery
Recovery from a financial crisis can be slower if commercial credit drives the bust. Non-performing loans for commercial debt backed by real estate rise by over 81 percent during a crisis.
“Defaults in the commercial sector weaken bank balance sheets, leading to more non-performing loans,” the authors explain. “With weakened balance sheets, banks are less likely to lend.”
Countries and sectors vary in their reliance on real estate to secure debt. The research shows:
- 84 percent of loans in construction and real estate are backed by real estate.
- In transport and communication, that figure drops to 29 percent.
- The U.S. economy differs, with only 6 percent and 4 percent of loans in those sectors backed by real estate.
Policymakers should closely monitor firm credit behavior. The findings suggest limits on leverage ratios for firms, similar to standards for household loans, may be necessary.
Regulators should also watch loans that use real estate as collateral, even in non-real estate industries.
“Our goal is not to downplay household credit’s importance,” the authors conclude. “It’s to shift the narrative away from the idea that household debt drives everything and that other factors are less significant in macroeconomic terms.”
