Good debt, bad debt

A healthy amount of credit growth is vital to support economic growth, but too much debt can drag on growth and/or cause financial distress. Globally, overall debt levels have increased significantly over the past several decades as 30 years of falling interest rates in developed markets have made it more sensible and less costly to incur debt. Using the US 10-year Treasury yield as a proxy, interest rates peaked at 15.8 per cent in 1981, following the 1970s oil embargo and inflation spike, before falling to historic lows of roughly 1.5 per cent today.

So while the stockpile of debt has grown, the cost of servicing each new unit of that debt has fallen substantially. While there were other reasons for increased debt creation, including credit growth that followed increased innovation, and optimism about future growth prospects, there is much empirical research that supports the idea that low interest rates just create more debt.

For emerging markets, the picture is more complex. Many of these countries have financial systems that are less mature. The banking system and bond markets are less developed, and access to credit has historically been limited and informal. As these economies reach adolescence, we would expect debt to increase as a natural and healthy amount of financial deepening happens. However, debt levels have recently been growing a bit too quickly, as the global search for yield encourages corporate debt issuance in emerging markets.

Low rates, innovation and optimism about future growth prospects are some of the main reasons for this dramatic increase in debt levels, along with financial deepening. What is more, some of this debt creation was useful, and some was not.

It is important to remember that debt can be used in many different ways. All debt, like all dietary fat, is not created equal. While common nutritional guidelines told us that fat is bad, and should not be a large part of any diet, we now know that there are healthy fats and unhealthy fats.

Debt can be used in many different ways

Healthy fats – from nuts, avocados and olive oil, for example – support cellular function, fuel the metabolism and are vital for the body. Unhealthy fats – from fried food, meat and butter – tax the body, can clog arteries in your heart and in large quantities, lead to a range of health problems down the road.

In the same way, we can think about two kinds of debt: productive and unproductive. For what purpose is the person, business or government using the money? Is it going to enhance productivity or merely serve to increase spending? Productive debt is like the healthy kind of fat; it can be used to fuel growth and support real economic activity. When a company borrows money to expand its factories, for example, it leads to an increase in employment and output. Another example is a consumer taking out a car loan for a much-needed vehicle to drive to and from work.

In contrast, unproductive debt is like unhealthy fat: undeniably enjoyable in the moment and seemingly harmless, but with a range of potential repercussions further down the line. For example, excessive credit card debt that pushes a consumer’s spending beyond sustainable levels, or a company borrowing, in part, just to repay existing debt obligations. That said, we would expect companies to take advantage of this low-rate environment to strategically refinance their debt obligations, something we have seen since rates fell so dramatically. And at the extreme, useless forms of debt can be used to prop up ‘zombie’ companies, or to roll over non-performing loans.

Nandini Ramakrishnan is a global market strategist at JP Morgan Asset Management