Thursday, 5 February 2015

The solo becomes a duet

The world economy is a bit like my early love life – long periods or inactivity and boredom interspersed with rare flashes of excitement.  Growing up in rural England with no Facebook, mobile phone, nor any natural ability to chat up girls made things pretty dull!  The same is true of the world economy - one minute we are in a world of dull stagnation and deflation and the next we are in mortal danger, thanks to Greece.

The excitement of a good riot

Right now we have the Germans and the Greeks to thank for this (unwelcome) moment of excitement. The Germans don’t have the good manners to either extend or write off the ridiculously large Greeks debts and the Greeks don’t have the humility to take orders from the Troika any longer. But why should the imminent default of the world 43rd largest economy cause such a rumble.  The default would add about $300bn of debt to other EuroZone members. Whilst $300bn is a lot of money it’s a drop in the ocean when compared to the overall debts in the developed world today – in fact it’s about 0.015% of the $200tn world's debt mountain.

The world’s debt can be categorised into four segments:
  1. Government debts – the difference between government spending and receipts - funded selling government bonds to the banks 
  2. Financial debts – leverage held by banks
  3. Corporate debts – Debts taken on by business funded by the banks
  4. Personal debts – Debts taken on by private individuals and funded by the banks
How the debt stack up
The common denominator is the banks; the systemic risk in our financial system comes from the leverage that the banks took on in the years 2000-2008, to fund massive levels of loans and derivative trading of junk grade assets associated with the housing market – mortgage backed securities.  The banks have been forced to deleverage over the last six years but there is still a huge amount of distressed debt in the system, Greek loans being a great example.  The second problem is that Governments have added hugely to the overall level of debt – some of this is from bailing out the banks (the TARP programme and the bailouts of Lloyds and RBS in the UK) but most of the increase comes from straight over spending – funding programmes that they can’t afford.  These two problems have meant that debt ratios in the developed economies have risen by 20 percentage points to 275pc of GDP since Lehmans went under – in other words the world is a more dangerous place than it was in the summer of 2008!  The problem about the Greek debt crisis is that it will put a lot more stress on both Government debt and banking debt.

The Bank of international Settlements (BIS), the only bank to forecast the crash, tell us that in addition to the increasing debt ratio credit spreads have fallen to wafer-thin levels and 40pc of syndicated loans are to sub-investment grade (junk) borrowers, a higher ratio than in 2007, with even fewer protection covenants for creditors.  Much of this credit boom has happened in the emerging markets who have succumbed to private credit booms of their own, partly as a spill-over from quantitative easing in the West.  As the BIS say  “Time and again, in both advanced and emerging market economies, seemingly strong bank balance sheets have turned out to mask unsuspected vulnerabilities that surface only after the financial boom has given way to bust.”  This inability to deal with distressed debts is costing us dearly.   Added to this pattern of serial forgiveness central banking policy has been easy during the up swings  aggressively loose and persistently during busts. This induces a downward bias in interest rates and an upward bias in debt levels, which in turn makes it hard to raise rates without damaging the economy – a debt trap.   If you look back of 30 years the level of interest rate required to create recovery has fallen from about 8% to today negative %.  The BIS go on to tell us that as “private and public debts continue to grow, the economy fails to climb onto a stronger sustainable path, and monetary and fiscal policies run out of ammunition. Over time, policies lose their effectiveness and may end up fostering the very conditions they seek to prevent".  We are obviously in a vicious circle.

There is now a unhelpful argument prevailing between the left and right.  On the left the economic problems are seen as a liquidity trap, requiring governments and central banks to feed in more and more credit – quantitative easing and public expenditure.  The BIS leads the charge on the debt trap side of the argument, which tells us that we need to continue the deleverage process to return to a world were banks are safe and interest rates are positive, but the BIS are a lone voice railing against the chant of all the main Central Banks. But there is something true and inspiring, like the perfect pitched voice of a single chorister, about their contrary take on the economic crisis – neatly summed up as -  “There is something strange about fighting debt by incentivising more debt."  But fear not the solo has become a duet as the most famous global management Consulting brand joins in on the side of debt reduction -

McKinsey’s survey of debt across 47 countries — illustrated in an FT interactive graphic — highlights how hopes that the turmoil of the past eight years would spur widespread “deleveraging” to safer levels of indebtedness were misplaced.   McKinsey go on to say that “This calls into question basic assumptions about debt and deleveraging and the adequacy of tools available to manage debt and avoid future crises.”  Hopefully the report will even up the debate among economists about what is an appropriate level of debt in an economy. McKinsey argues that high debt could constrain growth and create fresh financial vulnerabilities.

As the US and UK emerge from recession it is down to the Fed and the Bank of England to create a new order in which we “mend the roof while the sun is shining”.  These two venerable institutions must take a lead in raising rates, enforcing a real deleverage to restoring the banking sector to health and finally blow away the house of card that has been built on credit and weak banks.

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