Debt from A to Z
Historically, financial crises have had their roots in a build-up of excessive debt fuelled by exaggeratedly optimistic expectations as to the future growth outlook, amid a collective mis-assessment of risk. During the growth phase, economic agents tend to take on more debt, convinced that their future income streams will easily absorb borrowing taken out today, while rising valuations of assets offered as collateral make the underlying debt dynamic appear sustainable.
The reversal of expectations reveals the unsustainability of growth rooted in increasing financial imbalances and highlights clear cases of over-indebtedness. This can lead to a very rude awakening, with a phase of financial distress followed by a long and painful cleansing process. The 2008 crisis was no exception, with violent financial readjustments raising fears of a deflationary spiral reminiscent of the 1929 crisis, when reduced leverage and tumbling asset prices, confidence and economic activity all fed off each other.
Contrary to the received wisdom, and in spite of efforts to clean up balance sheets, the world today is still more heavily in debt than it was before the crisis, with the 2017 debt ratio reaching a new peak of over 242% of global GDP (excluding financial sector debt), up 40 percentage points (pp) relative to 2008 (1).
Debt has changed hands. While advanced economies have seen their debt ratios rise by 34 pp over the period to 274.5%, the structure of debt has changed over time. The private sector has tended to deleverage, especially where housing bubbles have burst, forcing households to tighten their belts. Conversely, governments have taken on fresh debt, resulting in an inevitable deterioration in public finances when the economic tide turns – a trend amplified in Europe by soaring interest rates resulting from the sovereign crisis and by sometimes costly bank bailouts, not to mention the unproductive nature of poorly calibrated Europe-wide austerity measures (the ‘austerity trap’).
Even with continued fiscal consolidation efforts finally bearing fruit, this edifice of debt persists, thanks to extremely low interest rates creating the illusion that debt trajectories are viable. As long as interest costs, which are a key influencer of spending growth, are rising less quickly than growth in the economic activity on which tax receipts depend, deficits can be absorbed painlessly, provided a modicum of discipline is maintained. However, a sudden uncontrolled rise in interest rates could quickly knock debt ratios off their supposedly sustainable trajectories.
Keeping interest rates very low for a long time has also added fuel to the fire. Emerging businesses have taken advantage of extremely favourable financial conditions on international capital markets to take out new borrowing, sometimes in hard currency, which makes the resulting debt vulnerable not only to interest rate rises but also to unforeseen exchange rate movements. This build-up of liabilities is mainly borne by China, whose debt has risen enormously quickly to reach 256% of GDP (versus 140% in 2008) – a historically high level for an emerging country at this stage of development. That being the case, we should not be blind to the risk of a financial hiccup. However, since this debt is in local currency and mostly held by Chinese savers and recycled in a closed loop (as in Japan), deleveraging appears less urgent and should be able to be spread out over time.
This rise in debt comes at a time when market valuations, also driven by low interest rates, look excessive, with the threat of a harsh correction if expectations shift dramatically. Central banks continue to manoeuvre, but have a tricky equation to solve. On the one hand, with the monetary emergency over, normalisation is now essential, both to resume balance sheet deleveraging and to deflate asset prices in an orderly fashion. On the other hand, the fragility of a financial system that has long been on life support through low interest rates means extreme caution is required, especially since markets have a tendency to take central banks hostage, with volatility spiking whenever the latter plan to siphon off fuel. Central banks must succeed in breaking free of this deterrent influence to continue working towards normalisation and avoid undermining their credibility.
(1) BIS, total credit statistics, décembre 2017