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The Global Realities of Credit, Debt and Deleveraging

During the financial bubble ending in 2007, governments, corporations, and individuals took on debt to stay afloat. In the fourth quarter of 2007, global debt reached $142 trillion.

In the years that followed the bursting of the bubble, one would expect that debt would decrease. However, not only has deleveraging not happened, but global debt has actually grown by $57 trillion, as of the second quarter of 2014, to a total of $199 trillion.
The reason this matters is because high debt levels can not only stifle economic growth, but can also trigger another financial collapse.

According to a report by the McKinsey Global Institute (MGI), all of the world’s major economies now have higher levels of borrowing relative to GDP than they did in 2007.1 Overall, the ratio of debt-to-GDP has gone up by 17 percent.

In all 22 of the advanced economies in the study, debt-to-GDP ratios increased by as much as 50 percent. The average debt-to-GDP ratio in advanced economies is now 280 percent, compared to an average of 121 percent in developing countries.

In developing economies, government debt is to be expected because it is needed to build out infrastructure that is required for economic growth. Corporate debt is needed for business expansion, and household debt is a positive sign that more people are joining the consumer class and gaining access to credit. Nearly half - 47 percent - of the increase in global debt came from such countries.

Fortunately, corporate debt is not really a problem, since corporations are not highly leveraged. The issue of shadow banking has receded in the U.S. and many other economies, with the exception of China.

This means that there are three primary areas of risk arising from the high levels of debt according to MGI. The first risk is caused by the increase in global government debt.

Government debt has gone up by $25 trillion worldwide since 2007, with $19 trillion of the increase in advanced economies and the remaining $6 trillion in developing countries. In some cases, countries took on debt to stimulate the economy or to finance bailouts of troubled sectors.

The second risk is the increase in household debt in Northern Europe and some Asian countries.

Continued growth in global household debt is worrisome because the increase of household debt to unsustainable levels in the United States and other advanced economies triggered the financial crisis of the past decade. From 2000 to 2007, the ratio of household debt relative to income went up by one-third or more in the United States, the United Kingdom, Spain, Ireland, and Portugal.

Simultaneously, this increased household debt drove up housing prices. When housing prices started to decline and the financial crisis occurred, the struggle to keep up with this debt led to a sharp contraction in consumption and a deep recession.

Household debt has declined since the recession in only five advanced economies - primarily the ones that suffered the most from the last time household debt skyrocketed: the U.S., the UK, Ireland, Germany, and Spain. The most deleveraging has occurred in the U.S., which lowered consumer debt via mortgage loan defaults, and in Ireland, which used loan-modification programs.

In most other countries, however, household debt-to-income ratios are still climbing. In fact, according to MGI, Denmark, Norway, and the Netherlands now have household debt of more than 200 percent of income, and those countries - plus Australia, Sweden, and Canada - now have higher household debt ratios than the U.S. had at the peak of the credit bubble.

The third risk is caused by the increase in China’s debt.

China has quadrupled its debt, from $7.4 trillion to $28.2 trillion since 2007, which accounts for more than one-third of the increase in global debt. China’s debt as a share of GDP, at 282 percent, is greater than that of the United States or Germany.

According to MGI, “Three developments are potentially worrisome: Half of all loans are linked, directly or indirectly, to China’s overheated real-estate market; unregulated shadow banking accounts for nearly half of new lending; and the debt of many local governments is probably unsustainable.”

Shadow banking loans total $6.5 trillion and account for nearly one-third percent of China’s debt (excluding the financial sector) and half of new lending. Entrusted loans, in which one company lends money to another, elevate risk because the failure of one corporation could trigger a chain reaction that would take down other companies that hold its loans. Businesses as well as individuals use shadow loans to buy property, and because real-estate prices are looking frothy, there is a very real danger that a bursting housing bubble will expose the weaknesses of the unregulated and uninsured shadow banking system.

Real-estate prices have jumped by 60 percent in forty cities in China since 2008. It now costs only 10 percent more to live at a prime address in New York or Paris than it does in Shanghai.

But signs of a housing meltdown are beginning to emerge. Smaller cities now have 48 to 77 months of unsold housing inventory, while transaction volumes have already dropped throughout the country by 10 percent. A price correction would cripple China’s construction industry, which accounts for 15 percent of the country’s GDP.

It would also jeopardize local governments, which collectively owe nearly $3 trillion in loan obligations to the central government. One study found that 40 percent of local governments sell land in order to make loan payments. Another 20 percent take out new loans in order to make payments on older loans.

Based on this trend, we offer the following forecasts:

First, even if the housing bubble explodes in China, the reverberations will not trigger a collapse of the global economy.

MGI’s analysis shows that if real-estate prices plunge, China’s government could bail out the financial sector. Its dilemma going forward will be to keep debt from growing, while simultaneously trying to grow its consumer economy by encouraging its population to buy goods and homes they cannot necessarily afford.

Second, seven economies are in danger of a financial crisis caused by extremely high household debt.

Those countries, according to MGI, are the Netherlands, South Korea, Canada, Sweden, Australia, Malaysia, and Thailand. The remedies for this problem include offering flexible mortgage contracts to avoid foreclosures, establishing clearer personal bankruptcy rules, and implementing tighter lending standards.

Third, the soaring growth in government debt we’ve seen over the past decade is unlikely to end before 2020.

MGI looked at current primary fiscal balances, interest rates, inflation, and consensus real GDP growth projections and concluded that government debt-to-GDP ratios will continue rising over the next five years in the U.S., Japan, and European countries other than Germany, Ireland, and Greece. It is virtually impossible to deleverage when other economies are also deleveraging and when inflation is low and economic growth is sluggish. For six countries with among the highest debt levels - Spain, Japan, Portugal, France, Italy, and Finland - it would take at least a doubling of GDP growth beyond the current estimates to lower government debt-to-GDP ratios. Those governments may need to consider new policies, including asset sales, higher taxes on wealth, and more efficient debt-restructuring programs.

Fourth, the real solution is to unleash economic growth.

The problem is not necessarily too much debt, but rather too little growth in GDP and real household income.2 As we noted in the trend called Economic Growth in an Aging World in our March 2015 issue, the rate of global GDP growth is projected to decline from the historical trend of 3.6 percent over the past fifty years to just 2.1 percent for the next fifty years. Demographic trends - such as the aging of the Baby Boom generation and the dramatic drop in the global birth rate - have brought an end to the era in which the global economy could grow simply by expanding the number of people with jobs. From 1964 to 2014, employment grew by an average of 1.7 percent per year, but it is projected to plummet to 0.3 percent annually over the next fifty years. The only way to offset this drop is by growing productivity 80 percent faster than the already blistering pace of the past fifty years; that demands an increase from the current 1.8 percent to 3.3 percent. A previous study by the McKinsey Global Institute found that if companies and national governments were to adopt existing best practices, productivity growth could grow by 3 percent, while the rest of the productivity gains could come from innovations.3

References
1. McKinsey Global Institute, February 2015, “Debt and (Not Much) Deleveraging,” by Richard Dobbs, Susan Lund, Jonathan Woetzel, and Mina Mutafchieva. ⓒ 2015 McKinsey & Company. All rights reserved

http://www.mckinsey.com/insights/economic_studies/debt_and_not_much_deleveraging

https://www.aei.org/publication/is-debt-americas-greatest-economic-threat-heres-a-better-answer/

3. McKinsey Global Institute, January 2015, “Can Long-Term Global Growth Be Saved?” by James Manyika, Jonathan Woetzel, Richard Dobbs, Jaana Remes, Eric Labaye, and Andrew Jordan. ⓒ 2015 McKinsey & Company. All rights reserved.
http://www.mckinsey.com/insights/growth/can_long-term_global_growth_be_saved