This is where the next debt crisis will come from
by Raul Elizalde - 2015-08-21
Many people are convinced that public debt is a main source of problems for any economy. This sentiment reached hysterical levels in the US in 2011, when even the chairman of the US Joint Chiefs of Staff, four-star Admiral Mike Mullen, called public debt the “biggest threat to national security.” Debt fights culminated in a government shutdown that stripped the US of its AAA rating. This repugnance to government debt remains unabated in many circles.
But proof that the uncontrolled growth of government debt leads to disaster is weak. The evidence, in fact, points in the other direction: economic and financial disasters precede, rather than follow, a surge of public debt.
Consider this: total net government debt in the US went from $5.1Tn in 2007 to $9.4Tn in 2010 – an increase of more than 80%. Why? Because entire business sectors, mostly financial, were at the brink of collapse and had to be bailed out by the government, which absorbed a vast amount of that debt. This was done directly, or indirectly by guaranteeing liabilities or injecting capital. It is easy to show that the size of US government market debt actually declined during the time when financial sector liabilities doubled. The government debt growth came later, and mirrored the latter’s decline.
The US is not alone in this. One example is Ireland, whose government debt stood at a mere 25% of GDP at the end of 2007, and later ballooned to 120% of GDP as the government guaranteed the liabilities of the banking system. A similar thing happened to Spain, which saw government debt explode from 36% to 100% of GDP in the same period. In both cases government debt declined while private debt grew until it became too large to handle. Eventually, the government was forced to take it over to prevent an economic collapse.
The lesson here is that huge run-ups in public debt levels are often a consequence of economic problems rather than a cause. The place to look for signs of future trouble is the private sector.
Unfortunately, by this measure the world seems to be in a much worse place today than before the financial crisis. Driven by historically low interest rates, private corporations have accumulated very large amounts of debt in the last few years, and much of it is in the form of corporate bonds.
Looking at the increase of non-financial corporate debt in the US, the current 4-year expansion is the largest and fastest on record. And in the last few decades, similar expansions were followed by large and damaging crises.
What makes matters worse is that this problem is not confined to the US. JP Morgan estimates that emerging-market private sector debt has increased by an “enormous” 33% of GDP since before the financial crisis (Financial Times, 8/11/2015). It seems quite likely that today’s emerging-market private debt will become government debt when the next crisis comes along.
One of the most worrisome changes is taking place in China, where, according to consulting firm McKinsey & Company, non-financial corporate debt has almost quadrupled from $3.4Tn to $12.5Tn from 2007 to 2014 (McKinsey Global Institute, February 2015). This represents a doubling of China’s corporate debt in relation to GDP.
It is not surprising that the global stock of private-sector is growing so rapidly everywhere. Interest rates have plummeted to their lowest levels in history, and in core markets like Germany they have actually become negative. This is a huge incentive to borrow.
This state of affairs is unlikely to last. Unless deflation – or disinflation – persists for far longer than anyone can imagine, interest rates will rise and the market price of debt will fall. This can trigger a large wave of selling, depending on the market’s perception of how fast rates can go up. Too many sellers and few buyers could lead to a new debt-related crisis.
This risk has not gone unnoticed. Prominent market participants have issued many warnings, but so far the general level of concern is very low. This is because few think that the Fed will embark in a serious tightening of monetary policy at a time when the US economy seems to be slowing down. While labor and housing are doing well, weak retail sales and falling industrial production, among other indicators, point to a softening of economic conditions.
Another argument against raising rates is that the US dollar is very strong and higher rates will make it even stronger – a fact that will negatively impact US businesses, which are generating a growing proportion of their revenue abroad.
There is also the fact that a stronger dollar will further depress the price of commodities, stoking deflation and worsening conditions in commodity-dependent markets in the developing world and in other countries like Australia and Russia. Surely the Fed does not want to spark a global currency-led crisis.
The market is probably right that interest rates are not likely to go up much anytime soon. But if the market is wrong, the consequences will be severe. Risks are not symmetric.
What to do? Trying to protect portfolios by diversifying holdings among various sectors will not help in a real crisis, because whenever panic strikes correlations go through the roof. The best course of action is to develop a plan for what to do if market conditions take a sharp turn for the worse. This means having pre-planned exit points to limit the damage and prevent over-reactions. It also means developing a plan for re-entry after the storm that triggered those exit points has passed.
It may well be that there is no crisis lurking just around the corner. We agree with the view that interest rates won’t go up soon, or much. But a private-debt related crisis can be triggered for other reasons, such as credit-quality concerns. And given its gigantic growth, it seems that conditions for a debt-led crisis are lining up better than at any time in recent years.
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