Deleveraging is the process by which a company, household, sector or economy as a whole reduces its level of debt. This process involves reducing the proportion of debt to assets or income, often by repaying loans or selling assets to generate cash. Deleveraging generally occurs after a period of excessive debt or when economic conditions change, making debt management riskier or more costly.
Why is deleveraging important?
Deleveraging is essential to restore financial stability, as high levels of debt can lead to economic vulnerability, particularly if interest rates rise or growth slows. Excessive indebtedness can impair an entity’s ability to repay its debts, increasing the risk of default or bankruptcy.
Here are a few reasons why deleveraging is a key strategy:
- Reducing financial risks: When debts become too large, they expose an entity to increased financial risks. Deleveraging reduces these risks by easing repayment obligations, which can stabilize cash flows and improve financial health.
- Strengthening economic stability: on an economy-wide scale, widespread deleveraging can prevent financial crises. After the 2008 crisis, for example, many companies and banks had to reduce their debt levels to avoid a prolonged economic collapse.
- Improved credit ratings: A company or country in a deleveraging situation may see its creditworthiness and credit rating improve, lowering borrowing costs in the future.
Deleveraging mechanisms
Deleveraging can be achieved in several ways:
- Debt repayment: The most common method is to repay existing debts through generated profits, excess cash flow or the sale of assets. This directly reduces the level of debt relative to assets.
- Reduce spending: Companies, households or governments can cut back on spending to free up extra cash to pay down debt more quickly.
- Debt renegotiation or restructuring: In certain cases, entities can renegotiate the terms of their loans, either by extending the repayment period or by reducing interest rates, thereby lightening the debt burden without having to repay the borrowed capital immediately.
- Capital increase: Companies can issue new shares or seek investors to raise funds to repay debt, thereby reducing their leverage.
Deleveraging on a macroeconomic scale
Deleveraging can also occur on a large scale, affecting an entire economy or sector. This phenomenon often follows a financial crisis or a period of overindebtedness. For example, after the global financial crisis of 2008, many companies, financial institutions and households began a process of deleveraging to restore their financial health.
However, large-scale deleveraging can have negative short-term macroeconomic effects, such as:
- Slower economic growth: When many economic players simultaneously reduce their debt, they restrict spending and investment, which can slow growth. This can lead to a period of stagnation or recession, often referred to as a “deleveraging recession”.
- Deflation: Widespread deleveraging can lead to a drop in demand, exerting deflationary pressure on asset prices and consumer goods. This drop in demand can exacerbate economic difficulties.
- Vicious circle of deleveraging: If companies and households sell assets to reduce their debts, falling asset prices can lead to further losses, forcing other entities to sell, and so on, in a domino effect.
Historical example: the 2008 financial crisis
A classic example of deleveraging is the 2008 financial crisis. Prior to the crisis, banks, companies and households had taken on excessive debt, particularly in the real estate sector. When the real estate bubble burst and the credit crunch hit, many economic players were forced to deleverage rapidly.
Banks had to sell assets to shore up their balance sheets, businesses cut back on investment, and households curbed spending to pay off their mortgages. This led to a prolonged global economic slowdown, as deleveraging had a deflationary effect and reduced demand in the economy.
