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Definition of 'Deleverage'A company's attempt to decrease its financial leverage. The best way for a company to

delever is to immediately pay off any existing debt on its balance sheet. If it is unable to do

this, the company will be in significant risk of defaulting.

Companies will often take on excessive amounts of debt to initiate growth. However, usingleverage substantially increases the riskiness of the firm. If leverage does not further

growth as planned, the risk can become too much for the company to bear. In these

situations, all the firm can do is delever by paying off debt.

Any sign of deleverage shown by a company is a red flag to investors who require growth in

their companies.

Deleveraging is a process that is employed by financial institutions, businesses and governments to

reduce the amount offinancial leveragecurrently in place. This is usually accomplished by paying off

or otherwise reducing the amount of borrowed capital. The deleverage activity usually takes place

when the purpose for borrowing the capital does not result in the growth predicted and steps mustbe taken to minimize the negative impact.

One of the best examples of deleveraging is found in the business world. A company will often seek

to finance a growth project by borrowing capital from a bank or group of banks. This is often seen as

a wiser option than liquidating existing financial assets. The idea is that the growth project will begin

to operate at a profit within a projected period in time and eventually pay off the cost of the loan

without ever touching the core assets of the company.

If the growth project does not yield the anticipated results, the company must begin to undergo a

period of deleveraging. During this period, the company will take steps to pay off the loans

associated with the borrowed capital. This often means making use of the core assets of the

company in order to retire the debt. As a result, the overall value of the company is decreased rather

than increased by the attempt at growth.

DELEVERAGING AT MICRO LEVEL:At themicro-economiclevel, deleveraging refers to the reduction of theleverage ratio, or the percentage

ofdebtin thebalance sheetof a single economic entity, such as a household or a firm. It is the opposite

ofleveraging, which is the practice of borrowing money to acquire assets and multiply gains and losses.

DELEVERAGING AT MACRO LEVE:At themacro-economiclevel, deleveraging of an economy refers to the simultaneous reduction of debt levels

in multiple sectors, includingprivate sectorsand thegovernment sector. It is usually measured as a decline of

the total debt toGDPratio in thenational account. The deleveraging of an economy following afinancial

crisishas significant macro-economic consequences and is often associated with severerecessions.

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Macro-Deleveraging Process

According to theMcKinseyreport, there have been four archetypes of deleveraging processes:[2]

1. Belt-tightening: this is the most common path of deleveraging for an economy. In order to increase

net savings, an economy reduces spending and goes through a prolonged period ofausterity.

2. Highinflation: high inflation mechanically increases nominal GDP growth, thus reducing the debt to

GDP ratio. E.g.Chilein 1984-91.

3. Massivedefault: this usually comes after a severecurrency crisis. Stock of debt immediately

decreases after massive private and public sector defaults.

4. Growing out of debt: if an economy experiences rapid (off-trend)real GDPgrowth, then its debt to

GDP ratio will decrease naturally. E.g. US in 1938-43.

FACTORS WHICH AFFECT DELEVERAGING:

Macro-Economic Consequences

Massive deleveraging in corporate and financial sectors can have serious macro-economic consequences,

such as triggeringFisheriandebt deflationand slowingGDP growth.[6][7]

In thefinancial market, the need to deleverage causesfinancial intermediariesto shed assets and stop lending,

resulting in acredit crunchand tighterborrowing constraintfor business, especially the small to medium sized

enterprises. Many times, this process is accompanied by aflight to qualityby the lenders and investors as they

seek less risky investment. However, many otherwise sound firms could go out of business due to the denied

access to credit necessary for operation. Moreover, firms in distress are forced to sell assets quickly to raise

cash, causingasset pricesto collapse. The pressure ofdeflationincreases the real burden of debt and spreads

loss further in the economy.

In addition to causing deflation pressure, firms and households deleveraging theirbalance sheetoften increase

net savings by cutting expenditures sharply. Households lower consumption, and firms fire employees and halt

investment in new projects, causing unemployment rate to rise and even lower demand of assets. Empirically,

consumption and GDP often contracts during the first several years of deleveraging and then recovers,[2]which

in some cases cause a fall in total savings in the economy, despite the individuals' higherpropensity to save.

This is known as theparadox of thrift.

Government Regulation and Fiscal Policy

According to the theory ofleverage cycleofJohn Geanakoplosand originally byHyman Minsky, in the absence

of intervention,leveragebecomes too high inboomtimes and too low inbusttimes. As a result, asset prices

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become too high in boom times and too low in bad times, rather than correctly reflecting thefundamental

valueof assets.[1]

This recurring leveraging-deleveraging cycle is one of the most important amplifying

mechanism contributing to thecredit cyclesandbusiness cycles. Deleveraging is responsible for the continuing

fall in the prices of both physical capital and financial assets after the initial market downturn. It is part of the

process that leads the economy torecessionand the bottom of theleverage cycle.

Therefore, some economists, includingJohn Geanakoplos, strongly argue that theFederal Reserveshould

monitor and regulate the system-wide leverage level in the economy, limiting leverage in good times and

encouraging higher levels of leverage in bad times, by extending lending facilities.[1][8]

Moreover, it is more

important to restrict leverage in ebullient times to prevent the crash from happening in the first place.[1]

In addition, in the face of massive private sector deleveraging,monetary policyhas limited effect, because the

economy is likely to have been pushed up against the zero lower bound, wherereal interest rateis negative

butnominal interest ratecannot fall below zero. Some economists, such asPaul Krugman, have argued that in

this case,fiscal policyshould step in anddeficit-financed government spendingcan, at least in principle, help

avoid a sharp rise inunemploymentand the pressure ofdeflation, therefore facilitating the process of private

sector deleveraging and reducing the overall damage to the economy.[9]

Note that this comes at the expense of

higher government debt, which will compromise the overall deleveraging of the economy. This view is in

contrast with some other economists, who argue that a problem created by excessive debt cannot be ultimately

solved by running up more debt, because unsustainably highgovernment budget deficitcould seriously harm

the stability and long-run prospect of the economy.

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