Page 36 - Nuvama | IC Report 2023

• DE-GLOBALISATION • DEREGULATION • DEBT • DEMOGRAPHY • DEMOCRACY

Debt: Virtue or vice?

Over the last decade, debt was considered a sin. Corporates and financial institutions saddled with
debt have suffered severe stress and significant erosion of market value 2010s—a sharp contrast to
2000s when debt was a virtue and growth-enabler. So how does debt metamorphose from being a
virtue to a vice?
Economist Hyman Minsky’s work on financial instability is quite instructive in this regard. Minsky
argued there are three stages of debt:
• Stage 1 (Rational lending): This is typical of the early recovery phase. Banks are cautious, and
Stage of loans are made largely to borrowers that can service both principal and interest through internal
business cycle accruals. This is the most virtuous debt phase.
determines
whether debt is • Stage 2 (Exuberance): This is a phase when exuberance sets in. Growth outlook is strong and
a virtue or vice banks tend to lower lending standards. Loans are made to borrowers that can pay only interest,
but not necessarily the principal. During this stage, seeds of instability get sown. As Minsky puts
it, “Stability breeds instability”.
• Stage 3 (Irrational lending): In this phase, lending becomes speculative. Lenders extend loans
based on asset prices even though the underlying business may not generate enough revenue to
service interest, let alone principal. That is how debt turns into a vice. Even small changes in asset
prices hamper debt servicing, causing dominoes to fall. This is when financial instability risks kick-
in and a growth downturn amplifies.
In theory, while these stages are well defined, the lines between these stages are blurred. Besides, in
a capitalist world, financial system moves from one stage to the other quite fast. Hence, it is critical to
understand where we are in the debt cycle.

Exhibit 1:
Stages of
debt cycle Stage 1 Stage 2 Stage 3
Rational Exuberance Irrational
lending lending
Borrowers can Borrowers can Borrowers can service
service debt and service neither interest
interest interest nor principal

Source: Hyman Minsky’s work on financial instability, Nuvama Research

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