The Markets’ Worst Kept Secret

by James Gruber

Lashing central bankers
The math of debt
Dreaded reform
Risk of another debt bust?

Here’s what your stockbroker and the media aren’t telling you: the world is more indebted now than it was at the height of the financial bubble in 2007. That’s right. Despite the extraordinary government intervention of the past six years. Despite continuing optimism of a recovery. Despite the reassuring words of central bankers. We’re worse off in debt terms.

From this, there are several inevitable conclusions that will be discussed in depth in this piece:

1. The policies pursued since the financial crisis haven’t worked. Otherwise, debt to GDP ratios would be decreasing, not increasing.

2. Interest rates can’t rise above GDP rates, otherwise debt to GDP ratios will climb further. If they do, you can expect more money printing, budget cuts and tax rises.

3. That means low interest rates are likely to stay for many, many years. It’s the only way to bring the debt down to more sustainable levels.

4. The startling thing about the past six years is the almost total lack of reform to fix the problems which led to the 2008 debt bust. It’s ironic that a paragon of communism, China, may well be the one to soon lead the way on substantive capitalist reforms.

5. Emerging markets, including my neighbourhood of Asia, may be better off than the developed world when it comes to debt, but rising asset and commodity prices have papered over several problems. And these problems are now coming to light.

6. Debt crises happen because incomes can’t support the servicing of the debt any longer. If there is any drop-off in economic growth, a 2008 re-run could well be around the corner. That’s not trying to be dramatic; it’s just the way the math pans out.

Lashing central bankers
It’s been surreal to watch news of Detroit’s bankruptcy this week. Once the bastion of a thriving American automobile industry, the city is now on its knees. Meanwhile, U.S. stock market indices are hitting all-time highs. Compare and contrast…

But it’s also been fascinating to see the commentary around the bankruptcy. Much of this commentary blamed a sharply declining population for the crisis and a host of other reasons. Less mentioned though was the real reason for the bankruptcy: Detroit simply spent far more than earned. And it went deeper into debt to finance the spending, until it could no more.

It’s not entirely surprising that this has been largely overlooked and that Detroit is being treated as an isolated case. That’s what politicians in the U.S. and across the developed world want you to believe. That debt isn’t a big deal and that they can help their cities and countries grow their way out of indebtedness, but they just need a bit more time to achieve this.

However, a recent report by the Bank Of International Settlements (BIS) – often referred to as the central banks’ bank – shows how difficult this task will be. The BIS annual report outlines, in a clear and often confronting way, the realities of the world’s indebtedness and how current money printing and low interest policies won’t fix the problems emanating from 2008. The BIS has credibility as it was one of the very few institutions to warn of excesses in the lead up to the financial crisis. I can’t recommend the report highly enough.

Let’s have a look at some of the report’s key passages. First, the BIS details the extent of the world’s debt problem. It says total debt in large developed market and emerging market countries is now 20% higher as a percentage of GDP than in 2007. In total, the debt in these countries is US$33 trillion higher than back then. Almost none of the countries that it monitors are better off than 2007 in debt to GDP terms.

The BIS describes the level of debt as clearly unsustainable. The primary reason is that studies have repeatedly shown that once debt to GDP rises above 80%, it retards economic growth. Obviously, if money is being spent on servicing debt, then there’s less to spend on investment etc. Most developed market economies now have debt to GDP levels exceeding 100%.

The BIS says governments need to quickly get their balance sheets in order and does some math to prove why. It says current long-term bond yields for major advanced economies are around 2%, well below the average of the two decades leading up to the crisis of 6%.

If yields were to rise just 300 basis points across the maturity spectrum (and still be below average), the losses would be enormous. Under this scenario, holders of U.S. Treasury securities would lose more than US$1 trillion dollars, or almost 8% of U.S. GDP. The losses for holders of debt in France, Italy, Japan and the U.K. would range from 15% to 35% of GDP.

Being the primary holders of this debt, banks would be the biggest losers and ultimately such losses would pose risks for the entire financial system.

The BIS doesn’t let emerging countries off the hook either. It suggests that while debt may be lower in these countries, they’ve benefited from rising asset and commodity prices, which are unlikely to be sustainable. And therefore caution is warranted here too.

But now we get to the juicy bit where the BIS calls the extraordinary policies of developed market central banks into question. For a conservative institution such as the BIS, the language is nothing short of scathing:

“What central bank accommodation has done during the recovery is to borrow time – time for balance sheet repair, time for fiscal consolidation, and time for reforms to restore productivity growth. But the time has not been well used, as continued low interest rates and unconventional policies have made it easy for the private sector to postpone deleveraging, easy for the government to finance deficits, and easy for the authorities to delay needed reforms in the real economy and in the financial system. After all, cheap money makes it easier to borrow than to save, easier to spend than to tax, easier to remain the same than to change.”

And then this:

“Governments hope that if they wait, the economy will grow, driving down the ratio of debt to GDP. And politicians hope that if they wait, incomes and profits will start to grow again, making the reform of labour and product markets less urgent. But waiting will not make things any easier, particularly as public support and patience erode.”

The BIS recommends urgent, broad-based reforms which principally involve cutting back on regulation to allow high-productivity sectors to flourish and for growth to return. It also says households need to makes further cuts to their debts while governments also need to get their balance sheets in order. And regulators need to make sure banks have the capital to absorb any risk of potential losses of the type mentioned above.

The math of debt
It’s worth elaborating on why the current path appears unsustainable, as the BIS alludes too. Put simply, debt is a promise to deliver money. If debt rises faster than money and income, it can do this for a while but there comes a cut-off point when you can’t service the debt. When that happens, you have to cut back on the debt, or deleverage in economic parlance.

There are four ways to deleverage:

1. You can transfer money (Germany transfers money to Cyprus)

2. You can write down the debt. Note though, that one country’s debt is another’s asset.

3. You can cut back on the debt. These days, that’s looked down upon and consequently called austerity.

4. You can print money to cover the debt.

Since 2008, we have seen countries employ all four of these methods.

But the real key is to make sure that interest rates remain below GDP rates. If that happens, debt to GDP levels will gradually fall. If not, they’ll inevitably rise. So say bond yields rise to the post war average of 6% in the U.S., and interest rates increase to comparative levels, nominal GDP would have to be above 6% for debt to GDP levels to decline.

If you understand this, then you’ll realise that talk of “tapering” in the U.S. is likely a load of baloney. Real U.S. GDP growth is expected to be close to 1% in the second quarter, with inflation at around 1.1%, resulting in nominal GDP growth of 2.1%. Many expect this nominal GDP to rise to +3% over the next 12 months. But even at those levels, bond yields can’t be allowed to rise much further (with 10-year yields at close to 2.5%). Otherwise, debt to GDP ratios will rise, impeding future growth and making budget cuts, tax rises and more money printing inevitable.

If the U.S. does taper and bond yields there rise, this would put upward pressure on bond yields in Europe. With GDP growth near zero and still exorbitant debt levels, higher bond yields would quickly crush the Eurozone. 

This is why central banks can’t allow higher bond yields and interest rates. Of course, central banks don’t control long-term bond yields; markets do. If central banks want low bond yields, markets will comply until they don’t. That is until they don’t trust that the current strategies of central banks are working. Given that investors are still enamoured with the every word and hint of Ben Bernanke and his ilk, it would seem that the time when bond markets do turn ugly is still a way off.

Dreaded reform
As the BIS points out though, reform is also critical to better economic growth for the developed world and lower debt burdens. On this front, it’s amazing how little restructuring has actually occurred in the U.S. and Europe.

In the U.S. for instance, can you name one piece of significant reform which has reduced regulation and led to growth in new prospective sectors? I can’t, but maybe I’ve missed something.

The trend of the U.S. results season seems to bear this out. U.S. banks have killed it, while many other sectors such as tech haven’t. It’s hardly surprising that current policies are benefiting banks at the expense of the real economy. After all, not only did banks get massive bailouts in 2008 but they’ve been given almost free money from the Federal Reserve via QE ever since. The banking sector is not back to 2007 levels but it’s gradually getting there. Who would have thought this would happen just six years after the biggest debt bust in more than 70 years?

It’s somewhat ironic that instead of the U.S. or Europe, it’s Asia which may be about to lead the way on the reform front. Late on Friday, China announced that it would scrap controls on lending rates and let banks price their loans by themselves. This means cash-strapped companies may have access to cheaper loans. This cheaper credit could further spur the current debt bubble. But the move is likely to have an adverse impact on the profitability of the state-owned banks, thereby making them more reluctant to lend.

It’s expected that the move will foreshadow a later, more important policy to remove controls on deposit rates. Higher deposit rates would increase household income and go some way towards the government’s goal to increase consumption and re-balance the economy.

These financial reforms are likely to be only a small part of a plethora of reforms that China will announce over the next 3 months. As I’ve said previously, I think investors are underestimating the pragmatism of the new leadership and their willingness to take short-term pain to reap later benefits. It won’t be enough to prevent a serious economic downturn but it bodes well for the long-term. The one risk to this scenario is if growth slows enough for unemployment to rise. If that happens, stimulus may again become the got-to tool at the expense of reform. But we’re nowhere near that point yet.

Japan is the other country which may go through with some significant reform. This weekend’s parliamentary elections should solidify Shinzo Abe’s power and give him the platform to pursue more deep-seated reforms. However, the big question remains whether any reform can prevent the country from being overwhelmed by its enormous debt. I’m in the minority suggesting that the debt is simply too large and reform will do little to prevent Japan from going insolvent, if it isn’t already.

Risk of another debt bust?
Which brings me to the key conclusion of this piece. That is, it’s hard to see the U.S, Europe, Japan and other developed world countries implementing reform in time to prevent their debts from rising further and possibly imploding. In other words, many of the fears of the BIS may well come true.

That may sound pessimistic and, to some, melodramatic. But the reality is that little has been done in the past six years to restructure economies and cut debt ie. learning the lessons of 2008. Because we’ve partially recovered from that traumatic period, that’s led to complacency. All the while, the debt that caused the bust in the first place has compounded and threatens to undo the world again.

Let’s hope it doesn’t come to that.

And that’s all for this week.

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