Abstract: In this article, we analyzed China’s leverage issue, focusing on the level and structure of financial leverage and its relationship with financial risks. We found that the different trends between micro leverage ratios and macro leverage ratios mainly reflect the change of return on capital, which is in turn driven by the economic cycle. Our micro analysis based on the MM theorem shows that information and transaction costs, taxation, and incentive mechanisms (such as the soft budget constraint) are closely related to the leverage structure. Our macro analysis indicates that the investment-oriented growth pattern with high savings helps explain the high leverage ratio in China. Although high leverage may lead to systemic financial risks, the “crisis” thresholds are statistically unstable. We believe that the process of deleverage should be managed prudently, i.e., efforts should be made to avoid a liquidity crisis and a “debt-deflation” trap due to rapid deleveraging, and to avoid asset bubbles due to a rapid increase in leverage.

Full report ：WP No.20171 •Level and Structure of Leverage vs. Financial Stability Theory and Evidence.pdf