Claudio Borio interview with Capital

Original quotes from interview with Mr Claudio Borio, Head of the Monetary and Economic Department of the BIS, with Capital, conducted by Mr Lukas Zdrzalek and published on 24 January 2019.

BIS speech  | 
24 January 2019

Mr. Borio, as only a few people have done, you warned against the financial crisis. Which difficulties in the world economy do you see nowadays?

Borio: It is ironic that debt levels, which were at the heart of the financial crisis, have continued to rise since then. The debt of households, governments and non-financial corporations accounted for 210 percent of global GDP in 2007, and it's now more than 240 percent.

Why has the world not been able to reduce debt after the financial crisis?

The reasons differ across countries. One common reason, of course, is that interest rates are still exceptionally low. Then, in some countries - those at the heart of the crisis - there has been some private sector deleveraging, notably by households. But government debt has risen, not least owing to depressed economic activity and efforts to cope with the banking problems.

Which countries are you thinking of?

Think, for instance, of Ireland, Spain and the United States. By contrast, in several countries less affected by the crisis, it is mainly private sector debt that has increased, as debt levels were generally lower at the start of the crisis and financial expansions continued. China is the most prominent example. There is a well-known self-reinforcing dynamic here.

Which role do the low rates play exactly?

Low rates may trigger an expansion of debt. It becomes easier to borrow, which leads to higher debt and higher asset and real estate prices. This induces further borrowing and risk-taking. At some point, this process reverses.

But does this mean central banks did too much?

One has to look at this in a much more nuanced way. It was absolutely necessary for central banks to pull out all the stops to stabilise their respective economies, and thus the world economy: that is what central banking is all about. By lowering rates, central banks helped to prevent the world from getting caught in a downward spiral. That is a point we have to give them credit for. And since the financial crisis, there have been huge central bank-led efforts to make the financial system more secure. Central banks have done a lot to ensure that the financial system can better cope with future economic weakness. Another big plus.


But central banks have not been properly supported by other policies. Governments did not do enough in terms of structural reforms. Indeed, central banks were overburdened. That is the main reason why rates are so low. Therefore, part of the problem we face today is that, consistent with their inflation mandate, central banks have kept interest rates unusually low for unusually long, creating potential financial stability vulnerabilities

The policies of central banks, however, do have side effects. You already warned against a debt trap. Are we already caught in that trap?

It is just too difficult to say. What I can say is that if debt levels increase further, it would become more difficult for central banks to raise rates again without creating problems. Principally, central banks should use good economic conditions to tighten monetary policy, preferably with a steady hand. Moreover, they should not be deterred by short-term market volatility as long as that volatility does not have a significant impact on the real economy.

You are worried by the US corporate debt market, why?

First of all, this market is interesting because it illustrates the developments I outlined earlier. In the US households, which were at the core of the crisis, decreased their debt while corporates, which were less affected, increased it. We are not the only ones who have warned about US corporate debt. We are worried, for example, about the market for leveraged loans -- loans given to highly indebted companies. This market has grown massively and has a volume of some USD 1.3 trillion.

But the US economy has grown massively since the crisis.

Importantly, covenants there have been weakening. In addition, we are concerned about the US triple BBB market, which now accounts for a large share of overall corporate debt. Companies with such a rating are still investment grade, so that institutional investors can still hold the debt. However, a triple BBB rating means that these companies are only just above "junk" status.

US bonds with a triple BBB rating already have a volume of $2.25 trillion and make up 75 percent of the US investment grade market, can this giant market cause a recession?

That's a big word, 'cause' a recession; I would rather say 'reflect' or 'contribute to' any recession. If the world economy slowed down substantially or if there was a recession, it is likely that the rating agencies would downgrade significant parts of this market to junk. That would widen credit spreads sharply. So, risk premia for corporates would rise. Corporates would have to pay higher rates for new money and some might even lose access to funding altogether. This would amplify market reactions.

What could trigger this dynamic?

Many investors are not allowed to hold junk bonds. So, they would have to sell, depressing prices and pushing up yields and hence companies' funding costs. So, sizeable downgrades would not only reflect a recession, but would also amplify it. This is a potential weakness in the world economy.

Investors are increasingly using passive investment vehicles like ETFs, which simply replicate a bond index. ETFs are very liquid investment vehicles as they can be quickly bought and sold on exchanges. How do these funds change the nature of bond markets?

Such ETFs are a part of an overall boom in asset management underpinned by very favourable conditions. In such a situation, investors often tend to take increasing risks. During a boom, market liquidity appears plentiful. This is the reason why many investors go into asset classes, such as parts of the corporate bond market, whose liquidity is particularly sensitive to market conditions. These investors are lured by the expectation of permanent liquidity. However, fair-weather liquidity disappears rapidly when the market runs into difficulties. Technicalities aside, this is how ETFs can exacerbate market dynamics.

One could argue that if there are problems in the corporate bond market, central banks could step in by printing more money to cushion any difficulties. How realistic is that?

Central banks would naturally respond if problems in this market threatened economic activity. However, the question is whether that would be enough. History suggests that it might not be. This is part of a broader issue: the nature of the business cycle has changed since the early 1980s. Until then, recessions were caused by central banks reacting to a sharp increase in inflation by tightening monetary policy. Since then, the origin of recessions has been in the financial sector, as unsustainable financial expansions have largely self-corrected with little change in inflation. That´s why we should pay particular attention to the financial sector.

What would happen if inflation increased more than it has done so far?

That´s an important question. Should inflation increase significantly more than expected, it would make things worse. Central banks would have to tighten monetary policy at the same time as the financial sector weakened. In such a case, central banks would have less room for manoeuvre, as they would have little choice.

The most important question is what are the consequences of a world full of debt. Some people think it will end with a huge crash.

A crash would not solve the problem. A crash would only lead to more debt, at least relative to GDP. But it need not happen. And, as noted, there are signs that debt levels have been stabilising.

But is there some way out of debt?

Of course. There are three possible ways, but only one and a half of them works. The first way out is higher inflation combined with interest rates that stay low - a form of financial repression. This combination would erode the value of outstanding debt, making it easier for borrowers to repay it. However, as history tells us, high inflation leads to lower growth. We've been there, we've seen that and we don't want to go back. A second way is to restructure debt. This would be painful, as investors would incur serious unexpected losses. Targeted restructuring can be a part of the answer, but only to a limited extent. The best way to get out of debt is stronger and more sustainable growth. Higher income would lead to a lower ratio of debt to GDP.

How can we spur such growth?

This is not easy and it works only if governments implement structural reforms. A typical example is promoting greater flexibility in the labour market, or more competition in the economy in general. Unfortunately, as the recovery from the crisis has taken hold, structural reforms have waned.