Do debt service costs affect macroeconomic and financial stability

Abstract

Excessive private sector debt can undermine economic stability. In this special feature, we propose the debt service ratio (DSR) as a measure of the financial constraints imposed by private sector indebtedness, and investigate its association with recessions and financial crises. We find that the DSR prior to economic slumps is related to the size of the subsequent output losses. Moreover, the DSR provides a very accurate early warning signal of impending systemic banking crises at horizons of up to one to two years in advance. We conclude that the DSR can serve as a useful supplementary indicator for the build-up of vulnerabilities in the real economy and financial sector.