Rising debt: is it a problem?

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If all households, companies and governments were to add up all their debt, they would need a calculator that can show lots of digits. Global debt currently stands at around 258,000,000,000,000 ($258,000 billion). This figure was revealed in the latest report (Q1 2020) by the Institute of International Finance (the 'central bank of central banks'). What's more, the mountain of debt keeps on growing every day. This trend is nothing new. A marked increase could already be seen well before the coronavirus pandemic and the financial crisis, with the debt mountain tripling over the last 20 years.

So, do we need to worry about these rising debt levels? The answer is not a clear yes or no. First of all, there are different kinds of debt, and there are several other factors to consider. The actual amount is important of course, but so is the debt-to-GDP ratio, the total amount of money in circulation, the identity of the debtor (creditworthiness) and creditor, the applicable interest rate, any budget deficits or surpluses, the purpose the debt is being used for (borrowing for investment is not the same as borrowing for consumption or for paying out retirement pensions) and so on.

A different view of debt

The general perception of debt has also changed somewhat. Being in debt is no longer "abnormal". Low interest rates have been around now for the past 10 years, but rather than using those low interest rates to reduce the burden of debt, many governments, companies and households have actually taken that opportunity to borrow even more. You can even buy a fridge on credit nowadays. That was unheard of in this country 25 years ago.

When will this peak?

Can the debt ratio go up even further? Of course it can. If central banks continue to buy debt, interest rates remain low and governments, companies and households don't experience any difficulties (re)financing their debt, debt can continue to rise for a long time to come. However, the higher this mountain of debt becomes, the more vulnerable it will be to any shocks.

According to the latest data from the Institute of International Finance (Q1 2020), the global debt ratio is 331% of global GDP. This debt is the equivalent of the total monetary value of all goods and services produced worldwide during approximately 3.3 years. That represents an increase of 49 percentage points compared to 2007, just before the financial crisis broke out.

Know the numbers

What does this mean for you as an investor? It means that you should do your homework before making any investment decisions. Although the central banks' efforts after 2008 were a necessity to keep the economy afloat, their support policies have resulted in many zombie companies. Zombie companies generate enough profit to cover their running costs and interest payments, but they do not experience enough growth to repay their principal in the long term.

In normal circumstances, zombie companies would go bankrupt or be pushed out by stronger competitors after a while. Due to the current low interest rates, however, these companies keep getting more money to refinance their debt. They are surviving by the grace of low interest rates, patient lenders and the new government stimulus policies in response to the coronavirus crisis.

"Rising debt is a point of concern for every investor. It is important that investors bear the evolution of a company's debt ratios in mind. You should keep a close eye on how the debt is developing in relation to the equity, how the annual interest payments are evolving in relation to the operating profit and whether the refinancing efforts with banks or debtors are going well. If an orange flag comes up for one of these issues, it is best to make your approach a little more cautious."

Geert Van Herck, Chief Strategist KEYPRIVATE

How many zombie companies are there?

A 2018 paper published by the Bank of International Settlements (the body overseeing central banks) examined data from 14 financial markets, including the US, Japan, Australia, Germany and Italy. This showed that 12% of listed companies can be classified as zombie companies.

Although these are the most recent scientific figures, we can assume that the coronavirus crisis has pushed up the share of zombie companies even more. As an investor, it is therefore important to keep an eye on these companies, and to exclude them from your portfolio (unless you are aiming for a higher return based on the risk you are taking). When these companies eventually do go under, the shareholder value will shrink away. You can follow a strategy of active stock picking that focuses on strong balance sheets and/or clear growth development. You can also go for an actively managed investment fund and have the fund manager handle all the calculations for you.

This article does not contain any investment advice or recommendation, nor a financial analysis. Nothing in this article may be construed as information with a contractual value of any sort whatsoever. This article is intended for information only and does not constitute in any way a commercialization of financial products. Keytrade Bank cannot be held liable for any decision made based on the information contained in this article, nor for its use by third parties. Every investment entails risks such as a possible loss of capital. Before investing in financial instruments, please inform yourself properly and read carefully the document "Overview of the principal characteristics and risks of financial instruments" that you can find in the Document centre.

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