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Debt and Opportunity

The world is deep in a flood tide of debt. Do we care, and what can we do about it? Read on to find out.

The rise in global debt
More than eight years since the 2008 global financial crisis started, the world seems to be drowning in debt. Global economic growth, meanwhile, remains anemic. Some economists attribute this situation to the high levels of debt, reasoning that they have been preventing economies from realizing their full potential because governments, businesses and households have been devoting significant resources to debt servicing — resources that otherwise would have been available for productive activities.

Global debt was on a steep rise before the crisis and continued growing after it. The McKinsey Global Institute estimates that, by mid-2015, the world's debt stood at $204 trillion — $68 trillion (or 50%) higher than it had been in 2007, and $121 trillion (or 145%) higher than in 2000. Governments, businesses and households all contributed to the increase (see Exhibit 1). Emerging economies alone contributed 47% to the growth in global debt since 2007, with China playing a leading role.

What is more, global debt has been growing faster than the world's economy. As of mid-2015, it stood at 294% of global gross domestic product (GDP), up 25 percentage points (pp) since the end of 2007 and 48 pp since the end of 2000.

Exhibit1

Should we be concerned?
Based on historical experience, we should be. Debt accumulations are historically associated with slower future GDP growth, systemic instability and economic and financial-system vulnerability. The faster the debt build-up, the worse the ensuing contraction has been. In the years leading up to the global financial crisis, major advanced economies saw household debt spiral upward to unsustainable levels along with housing prices, until real estate collapsed and domestic spending slowed.

From this point on, several years since the end of the financial crisis, we should expect lower future economic growth, as we are already experiencing, and perhaps another credit crisis down the road.

The economic slowdown following debt accumulation is well understood by those familiar with the aftermath of the lending booms in the U.S. in the 2000s and Japan in the 1980s, and research findings corroborate it. When demand in an economy relies too much on credit, debt rises until servicing it becomes a burden that diverts resources away from spending and investment, and the economy slows down. To relieve itself of this burden, the economy must commit additional resources to reduce the stock of debt, which may cause a contraction. What is more, weak demand leads to disinflation or even deflation, which, in turn, triggers easier monetary policy, currency depreciation and increased banking-system vulnerability to crises.

However, since debt overhangs have often happened during or after deep recessions, wars or other crises, it is unclear whether anemic or negative growth can all be blamed on high debt. Historically, a few accumulations were large enough to cause systemic shocks, with long-lasting effects, globally. Others ended badly, with disorderly sovereign defaults often accompanied by economic and political instability. Some reversed slowly (through sustained economic growth, inflation or financial repression—including very low interest rates to make debt servicing easier), and others reversed quickly (through decisive actions, including restructurings).

Deleverage, or manage the debt and its growth trends?
Deleveraging has been happening since the 2008 global financial crisis, albeit not evenly or at a uniform pace. The critical question is whether deleveraging at any cost, or managing debt, is the right goal. Could it be that high debt levels do not matter as much as we fear? What if debt has become a structural element of the modern global economy, with its deep financial markets, sophisticated risk management tools and steadily declining interest rates to historically low levels that make debt servicing as easy as it has ever been?

• Businesses: Financial institutions have been deleveraging, mostly due to regulation and tighter capital standards. This has made the sector more stable, but has also restricted the availability of credit to households and businesses. The decline in corporate bank lending has been somewhat offset by an increase in non-bank credit. Nonfinancial corporations started deleveraging but, in the current environment of low or negative interest rates, a rebalancing to a lower cost-of-capital equilibrium seems to be taking place through increased bond issuance accompanied by stock buybacks. This may be indicating a shift in firms' capital structure toward more debt and less equity in the U.S., Japan and, to a lesser degree, Europe — which could be indicative of capital market efficiency and deepening. The equity market seems to approve of the shift, rewarding investors in firms that have been buying back their stock. Among proposals to better manage the growth in corporate debt is reducing or phasing out the tax deductibility of interest, coupled with reductions in marginal rates and other potential adjustments.

• Households: To a large degree, consumer spending and residential investment were credit-financed before the crisis. Since it broke out, households in the U.S. and other advanced economies have been deleveraging. This is being done mainly through a rise in precautionary savings and paying down debt to weather the economic uncertainty. Delinquency write-offs and reduced credit availability for new mortgage, auto and credit card loans also played a significant role. In the emerging world, household debt has been rising at different rates across countries, with China leading the trend, but is still at modest levels relative to income.

Among proposals to improve stability of the home loan market are ones to encourage or require mortgage insurance and to change the tax deductibility of interest. This deductibility leads households to take larger mortgages. It mainly benefits high-income households, and contributed to unsustainable increases in home prices leading up to the crisis. Other proposals include flexible mortgage contracts, whereby lenders and homeowners share risks and rewards through economic and market cycles, and renegotiation, principal reduction and even forgiveness, in lieu of bankruptcy and foreclosure, for some types of consumer loans.

• Governments: Sovereign borrowing is generally on the rise, with governments typically taking on more debt since the crisis in order to spend or invest to stimulate their economies. Central bank borrowing to implement accommodative policies has been contributing to this debt buildup. In some regions, such as Southern Europe, attempts to address it included austerity policies, but the required "belt-tightening" exceeded the natural speed limit of fiscal consolidation and caused severe economic contractions in certain countries.

Oftentimes, defaults and/or restructurings are inevitable, and decisive action is generally the fastest way to deleverage and return to growth. Such episodes can be painful in the short run, forcing investors to take significant losses. However, if executed in a careful and orderly manner, a restructuring can lead to sustainable long-term economic growth and a rise in asset prices (see Exhibit 2). After the Brady Plan restructurings eliminated debt overhang in countries that had defaulted on commercial bank loans in the 1980s, investors responded with a wave of capital inflows to the relieved sovereigns. Their stock markets rallied, their economies benefitted from new investment and grew, and capital market access was restored.

img2

Sovereign debt crises might not happen, or could be more effectively addressed through better risk sharing, when debt service is made contingent upon countries' economic growth. Today's sovereign lenders and borrowers may draw lessons from the Spanish Empire of the 16th century (see feature box below). Higher coupons in expansions would allow investors to share in the prosperity, while a country's debt serviceability would be protected through lower coupons during recessions. GDP-linked warrants, offered by Argentina in 2005 and Greece in 2012, equity-like shares, offered by Singapore and proposed for the United States, and commodity-linked bonds for major producers such as Saudi Arabia (oil) or Chile (copper) are some of the instruments that have such features.

While credit fuels economic growth, there comes a point where rising debt can constrain expansion. This implies low expected returns and higher volatility for assets. Investors would be well advised to practice sound risk management and take the long-term view with portfolio positioning, since research evidence and experience indicate these trends play out over very long horizons. The benefits of deleveraging are most directly observable in cases where there has been quick and decisive resolution: Equity markets of countries that have just restructured their debt are very likely to rally in the short- to medium-term, as indicated in Exhibit 2. There are multiple reasons for this. Countries whose economies were stifled under heavy debt service are all of a sudden relieved from the burden and have at their disposal resources to pursue pro-growth activities. A portion of their resources comes from renewed access to debt markets, and this is also true for their corporations. The credit cycle affects equity returns, and attempts to time it may be informed by historical experience and other factors. Equity market underperformance has followed periods of rapid credit build-ups, especially in emerging economies, so this is a valuable metric to track and use as a guide for asset allocations in portfolios.

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The King of Sovereign Default
King Philip II (1527-1598) of Spain ruled for most of the second half of the 16th century over an empire spread across three continents, one of the largest and richest in history. His wealth and power did not prevent him from defaulting four times. Yet, his serial defaults on sovereign debt comparable to today's levels relative to the size of his empire's economy did not cause systemic problems or severe economic downturns. King Philip's bankers pooled risk through loan syndication, whereby many investors of small and medium-sized wealth participated in the lending. They also shared risk and reward with him by agreeing to debt service contingent on the evolving financial conditions of the crown. King Philip issued mostly short-term debt under flexible clauses— for example, making debt service contingent on the size and arrival date of the annual silver deliveries from the Americas. Lending to him was profitable, with average annual returns of 15% or more, even after factoring in his insolvencies.

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