Leverage is a wonderful thing when it works in your favour. It enables development, amplifies returns and at times offers illusory periods of above-trend growth. Eventually, however, the effects of additional debt begin to fade and, on the margin, offer less and less benefit. Once a nation, company or individual gets to a point where potential incremental growth does not justify higher levels of indebtedness, repayments begin, and the rebalancing of leverage starts to limit economic prospects. Bermuda has benefited greatly over the last decade and a half from an explosion in credit, but I would argue that Bermuda has now hit this rebalancing point.

Since 1998, Bermuda dollar private sector credit (as measured by loans and advances held at Bermuda’s financial institutions) has grown at 7.3 percent per annum, from $1.8 billion to $4.9 billion, far outstripping the 4.1 percent rise in nominal GDP over the same period. Consequently, the total percentage of Bermuda dollar deposits lent by the banking sector has grown from only 81 percent in 1998 to 145 percent in 2012 as Bermuda banks started to lend more than the deposits on hand. As a result, domestic dollar private sector credit has grown from 58 percent to about 90 percent of GDP as of 2012.

Two of the main beneficiaries of the growth in debt and credit were the real estate and financial intermediation sectors which grew at a rate of 5.3 percent and 4.2 percent, respectively, since 1998, both outstripping overall economic growth of 4.1 percent during the period.

It is very evident that Bermuda has levered up. The average leverage of about 70 percent of GDP over this period is still much lower than our current level of about 90 percent of GDP. Since it is not likely that we will witness much higher nominal GDP, it is more likely that the numerator (debt level) is headed lower over time.

If we include gross public debt of $2.3 billion and unfunded pension and healthcare liabilities of $1.3 billion to total bank lending of $8.8 billion (includes lending outside of Bermuda), total indebtedness escalates to a level of $12.4 billion or 225 percent of GDP. We can also see from this chart, as in the rest of the world, private sector deleveraging has been made up for by an increase in public sector leverage.

If one is assessing the risk of indebtedness, the level alone is not very telling. We would need to compare this balance in relation to similar economies to see how Bermuda ranks in relative terms. The important near-term implication, however, is that as Bermuda tries to contain its escalation in debt, the reduction in leverage will likely act as another drag on potential growth. As mentioned previously, levering up helps accelerate growth and economic activity in good times. The deleveraging process, unfortunately, works in reverse. Bermuda’s excess debt created in the boom will need to be worked off. More specifically:

— Consumers in Bermuda have gradually started paying off debt. This is one major reason why the economic recovery in Bermuda has been elusive. Consumer deleveraging hurts interest-rate sensitive purchases like autos and housing. This helps to explain some of the rapid fall in auto sales in Bermuda and the very low level of sales activity in the real estate sector. The Bank of Butterfield’s recent press release on its 2013 earnings highlights the trend in private sector deleveraging. They note “prepayments and soft loan demand, which drove a decline in the loan portfolio”.

— Government liabilities can be reduced by a mix of higher taxes, lower expenditures, or lower entitlement benefits (including higher retirement ages). All these, of course, collectively lower and reduce the growth rate of real household disposable income relative to that of real GDP.

We have started to see a slowdown in the growth of credit in Bermuda. Sectors that benefited greatly from increased lending, such as banking and real estate, will likely start to see growth lower than overall economic activity. The process of deleveraging, or at the least a slowing rate of the growth in credit, will act as another headwind on the Bermuda economy. This is not the fault of the banks, it’s simply a cycle that can last many years.

Nathan Kowalski is the chief financial officer of Anchor Investment Management Ltd. The views expressed are his own.