Debt, Deleverage and Default: What Next?
London, UK - 26th January 2010, 01:35 GMT
Dear ATCA Open & Philanthropia Friends
[Please note that the views presented by individual contributors are not necessarily representative of the views of ATCA, which is neutral. ATCA conducts collective Socratic dialogue on global opportunities and threats.]
The relentless forces of debt, deleverage and default were set in motion by the financial market excesses of the last decade. This is hardly surprising, but the details are sobering.
Debt and Leverage
Debt grew rapidly after 2000 in most mature economies. The global boom during the decade to 2008 was greatly facilitated by taking on excessive debt via leverage. Enabled by the globalisation of banking and a period of unusually low interest rates and risk spreads, this largesse was the catalyst for the following:
. Explosion of the financial-services sector;
. Massive banking bonuses;
. Huge corporate-sector pay packets; and
. Rampant appreciation in prices across all asset classes.
Although growth in leverage during the 1990s and 2000s was a global phenomenon, by far the most rapid expansion came in the developed world, particularly the Anglo-Saxon countries and some members of the European Union. The phenomenon was also noticeable in a number of emerging market countries in Asia and Latin America. By 2008, several countries had higher levels of debt as a percentage of GDP than the United States. That growth in debt was accompanied by exceptional growth in a variety of economic metrics including:
. Executive compensation relative to that of average workers rose significantly; and
. Share price to earnings ratios rose dramatically.
In the middle of the last decade, it was often frustratingly difficult to get any data on leverage levels, since it was an issue on which precious few government policymakers, financial regulators and central banks focused. That was partly due to misplaced faith that financial innovation, particularly securitisation, had made debt less dangerous than before by spreading it around the entire economy and beyond.
The spectre of deleveraging has been haunting the global economy since the start of the financial crisis in late 2007, ie, The Great Unwind, and the subsequent collapse in world trade in late 2008, ie, The Great Reset. The resultant credit crunch put brakes on the rise in private-sector borrowing. Governments then stepped in by ramping up their deficits, via stimulus spending, in efforts to mitigate the economic slowdown. However, government debt addition is now running up against natural limits via:
. Fears that investors will start to balk at yet more issues of government debt without concrete plans to pay it back;
. Taxpayer concerns about how hitherto unbelievable levels of public-sector deficits will be paid for; and
. Who will do the paying?
We may have found ourselves encumbered by unsustainable debt burdens in the private and public sectors which could drag down GDP growth rates for years to come. This may end up being an atypical deleveraging cycle and may take more than double the usual cycle time of half a decade or more. Deleveraging has only just begun.
Story Until 2009
So far economic growth seems to have recovered sooner than expected in some countries. Even though the financial sector is still cleaning up its balance sheets and consumer demand remains weak, the financial markets are giving the major economies the benefit of the doubt. However, there has been relatively little deleveraging since the peak:
. Debt was hardly down in the US last year;
. Instead of deleveraging, debt grew again by double digits in Spain last year; and
. Debt shrank by double digits in the UK, but that came from a huge financial-sector deleveraging.
Alongside the limited rise in broker borrowing in the past decade, there was also a far more startling increase in "real economy" debt, particularly in the household and real estate sector. Since the crisis started, this "real economy" debt has declined a tiny bit, while financial sector leverage has fallen considerably. But since public debt has spiralled, gross leverage levels for most large nations have not fallen. In turn, that suggests if deleveraging is inevitable, most of it is still to come. From a historical perspective, this challenge is not entirely unprecedented. The UK and US have had considerable experience of slashing vast debt burdens before in the last two centuries.
As economies are unable to leverage any further by taking on more debt, it is natural that the process will begin to go into reverse. Even if governments manage to make up shortfalls in private-sector debt in the medium term, economies are still in for a rough ride.
Story in 2010 and Beyond
Now there are a number of signature signs on the ATCA radar which suggest that the deleveraging process may just be getting under way, exerting a significant drag on GDP growth. In a sicklier global economy, players are desperately trying to raise debt and to export their way out of trouble. When every government is struggling to increase borrowing, competition amongst them will drive up the cost of capital, with the weakest economies paying the highest price. The deleveraging process is likely to result in painful global economic contraction.
While ATCA cannot say for certain when deleveraging will gain momentum, we do know that deleveraging has followed nearly every major financial crisis in the past half-century. In the past, governments have tried to counter deleveraging by creating rapid growth through fiscal or monetary stimulus; exports via devaluation; or preparation for and participation in war. These alternatives are all extraordinarily challenging particularly when every government is trying to achieve the same result. Engineering an easy escape becomes a competitive sport. Growth is tough to achieve. Nation states face three unpalatable options: outright default; inflation; or severe belt-tightening in which private consumption and public spending are dramatically cut.
We welcome your thoughts, observations and views. To reflect further on this subject and others, please respond within Twitter, Facebook and LinkedIn's ATCA Open and related discussion platform of HQR. Should you wish to connect directly with real time Twitter feeds, please click as appropriate:
. ATCA Open
. mi2g Intelligence Unit
. Open HQR
. DK Matai