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How to Understand Leverage Ratio?

Author: Source: Date:2018-12-26

Deleveraging has dominated the discussion on China’s economic reform in the past year, while few asks when is the right moment to deleverage. Yu Yongding, Chinese Academy of Social Sciences academician and the People's Bank of China Monetary Policy Department former member emphasizes the importance to recognize the critical point to commence deleveraging effectively in order to avoid the outburst of financial crisis.

Yu led the audience through the subprime crisis in the US in 2008. When the asset price started to drop, financial institutions tend to sell their assets in order to deleverage. However, buyers may stop purchasing or financing for them under the circumstances, resulting in further drops of asset price. Nevertheless, the problem remains whether there is a red flag for leverage ratio. In general, we use 90% for non-financial entities, 85% for resident department, and 85% for public sector. But the reality usually alters. The national bond ratio was high in Japan in 1996. The Ministry of Finance and the Prime Minister decided to cut down on government expenditure, adopted austerity policy and increased taxes on consumption. In contrast to what was expected, the series of policies led to downturns in economic growth rate, lifting up leverage rate. The debt-to-GDP ratio was 91.2% in Japan in 1997, driving the policy circle rather anxious. But the ratio is now 250% and Japan is away from fiscal crisis. Yu recognizes that it is important to keep a close eye on leverage ratio, while highlighting that we are unable to decide on a red-flag leverage ratio.

Leaving the number aside, Yu continues to suggest on three measures to take after a financial crisis bursts out. With reference to the remedies taken by the US government, Yu points out that the first step is government intervention in capital market. US Treasury and the Federal Reserve both purchased MBS from financial institutions in order to stop the dive of asset prices. At the same time, central banks should lower interest rate and pump in liquidity. Besides, the government should help raise money for the problematic financial institutions through direct capital injection, debt-to-equity swap, takeover or even nationalization for the time being.

Moreover, Yu breaks down the factors that pile up the leverage ratio for corporates, including

 unrealistic goal of economic growth

 rise in capital-output ratio

 lowering corporate profitability

 excessively low percentage of equity financing in revenues

 high interest rate

 low CPI index

 high loan-to-investment ratio

The government’s effort to de-capacity, de-stock, deleverage, reduce corporate costs, and shore up weak spots have proved effective. The leverage ratio in China is stable now, according to Yu. Nevertheless, Yu suggests that the government should be cautious not to rush for quick and short-term results. Instead, he believes that the core rests in the pace and extent to deleverage. While the corporate is deleveraging, the public sector can add leverage to some extent. For instance, the government can invest more in R&D, equipment upgrade, provide better public goods and infrastructure. But Yu warns that

 we should not expect to complete infrastructure building overnight

 expansionary fiscal policy should not be the resolute but a contingent plan to mitigate the dive of economic growth and to win time for structural reform