"What Happened to Deleveraging?"
Friday, February 6, 2015
Kudos to Richard Dobbs, Susan Lund, Jonathan Woetzel and Mina Mutafchieva, of the McKinsey Global Institute, for their comprehensive (136 page!) report: “Debt and (Not Much) Deleveraging.” Preferring to let quality research speak for itself, I’ve excerpted extensively:
“What Happened to Deleveraging? The global financial crisis of 2007–08 was sparked by the accumulation of excessive debt and leverage in many advanced economies, particularly in the household and financial sectors. After the September 2008 collapse of Lehman Brothers, governments took unprecedented actions to preserve the financial system. One reasonable expectation in the years following the crisis and the ensuing global recession was that actors across the economy would reduce their debts and deleverage. However, rather than declining, global debt has continued to increase. Total global debt rose by $57 trillion from the end of 2007 to the second quarter of 2014, reaching $199 trillion, or 286% of global GDP. Rising government debt in advanced economies explains one-third of the overall growth, as falling tax revenue and the costs of financial sector bailouts raised public sector borrowing. Growing debt of developing economies accounts for half of the growth. China’s total debt has quadrupled since 2007, reaching $28 trillion, accounting for 37% of growth in global debt.”
“Government debt has grown by $25 trillion since 2007, and will continue to rise in many countries, given current economic fundamentals… Government debt in advanced economies increased by $19 trillion between 2007 and the second quarter of 2014 and by $6 trillion in developing countries.”
“The value of corporate bonds outstanding globally has grown by $4.3 trillion since 2007, compared with $1.2 trillion from 2000 to 2007.”
“There are few indicators that the current trajectory of rising leverage will change, especially in light of diminishing expectations for economic growth. This calls into question basic assumptions about debt and deleveraging and the adequacy of the tools available to manage debt and avoid future crises.”
“It is clear that deleveraging is rare and that solutions are in short supply.”
“A large body of academic research shows that high debt is associated with slower GDP growth and higher risk of financial crises. Given the magnitude of the 2008 financial crisis, it is a surprise, then, that no major economies and only five developing economies have reduced the ratio of debt to GDP in the ‘real economy’ (households, non‑financial corporations, and governments, and excluding financial-sector debt). In contrast, 14 countries have increased their total debt-to-GDP ratios by more than 50 percentage points.”
“Developing economies have accounted for 47% of all the growth in global debt since 2007—and three quarters of new debt in the household and corporate sectors.”
The McKinsey report does a commendable job with Chinese data:
“Until recently, China’s unprecedented economic rise was not accompanied by a significant expansion in leverage. From 2000 to 2007, total debt grew only slightly faster than GDP, reaching 158% of GDP, a level in line with that of other developing economies. Since then, debt has risen rapidly. By the middle of 2014, China’s total debt had reached 282% of GDP, far exceeding the developing economy average and higher than some advanced economies, including Australia, the United States, Germany, and Canada. The Chinese economy has added $20.8 trillion of new debt since 2007, which represents more than one-third of global growth in debt. The largest driver of this growth has been borrowing by non‑financial corporations, including property developers. At 125% of GDP, China now has one of the highest levels of corporate debt in the world. Throughout history and across countries, rapid growth in debt has often been followed by financial crises. The question today is whether China will avoid this path and reduce credit growth in time, without unduly harming economic growth.”
“China’s household debt has nearly quadrupled, rising from $1 trillion in 2007 to $3.8 trillion in the second quarter of 2014… Since 2007, the stock of mortgages has grown by 21% per year.”
“We estimate that nearly half of the debt of Chinese households, corporations, and governments is directly or indirectly related to real estate, collectively worth as much as $9 trillion.”
“Property prices have risen by 60% since 2008 in 40 Chinese cities, and even more in Shanghai and Shenzhen.”
“Two particular aspects of China’s local government debt raise questions about risk: reliance on land sales and use of off-balance sheet local government financing vehicles. These financing vehicles fund infrastructure and other projects, using public land as collateral. By the second quarter of 2014, loans to local government financing vehicles had grown to $1.7 trillion, from $600 billion in 2007. In addition, local governments have begun to borrow via newer entities, which accounted for an additional $1.1 trillion of debt. Local governments use land sales to repay debt because of limitations in the municipal finance system… The ability of local government financing vehicles to repay their $1.7 trillion in loans is in question… In our analysis, we found that, in 2013, eight provinces were running fiscal deficits of at least 15% of revenue and that most provinces had debt-to-revenue ratios of more than 100%.”
“The third element of risk to China’s financial stability comes from the growing volume of loans by non‑bank financial institutions—so-called shadow banking… By the second quarter of 2014, loans from these institutions reached $6.5 trillion, or 30% of total loans outstanding [‘and half of new lending’] to households, non‑financial corporations, and governments.”
“Most of the loans are for the property sector. The main vehicles in shadow banking include trust accounts, which promise wealthy investors high returns; wealth management products marketed to retail customers; entrusted loans made by companies to one another; and an array of financing companies, microcredit institutions, and informal lenders. Both trust accounts and wealth management products are often marketed by banks, creating a false impression that they are guaranteed.”
“Overall, non‑bank lending grew by 36% per year from 2007 to the second quarter of 2014, compared with 18% per year for bank lending. The rapid growth of shadow banking in China is in large part driven by the high demand for higher-yield investment products among Chinese investors. The People’s Bank of China sets the maximum rate that banks can offer on deposits, currently 3.3%...”
“The third potential risk in China is the growing debt accumulated in off-balance sheet local government financing vehicles, which are used to fund infrastructure (airports, bridges, subways, industrial parks), social housing, and other projects. Local governments rely on these off-balance sheet entities because they have limited taxing authority, must share revenue with the central government, and until recently have not been permitted to issue municipal bonds. Since China’s 2009 stimulus program, lending to local governments has surged, reaching $2.9 trillion.”
“Debt and (Not Much) Deleveraging” is loaded with data that should be quite alarming to global policymakers and market participants. It is not, however, “alarmist.” The report works to strike a balanced approach.
“One bright spot in our research is progress in financial-sector deleveraging. In the years prior to the crisis, the global financial system became ever more complex and interconnected. Credit intermediation chains become very long, involving multiple layers of securitization, high levels of leverage, and opaque distribution of risk. This was reflected in growing debt issued by financial institutions to fund their activities. Financial-sector debt grew from $20 trillion in 2000 to $37 trillion in 2007, or from 56% of global GDP to 71%. Much of this debt was in the so-called shadow banking system, whose vulnerability was starkly exposed by the financial crisis. It is a welcome sign, then, that financial-sector debt relative to GDP has declined in the United States and a few other crisis countries, and has stabilized in other advanced economies.”
As one might expect, the McKinsey report is tilted toward conventional thinking and economic doctrine. From my analytical perspective, it is short on critical Credit analysis. It is, understandably, bereft of Credit Theory. And there’s palpable complacency regarding the U.S. markets and economy. I take exception with some details of the analysis, not to be critical but only in the spirit of expanding what I see as crucial aspects of the ongoing “global government finance Bubble.”
“The financial sector has deleveraged.”
From a Credit analysis perspective, central bank balance sheets are fundamental to “the financial sector” and should be included in leverage calculations. As I’ve argued for several years now, deleveraging is a myth, albeit in the financial sector, real economy, securities markets or otherwise.
“Financial system leverage and complexity have declined since the crisis.”
I would counter that the unprecedented expansion in central bank Credit/leverage has created extreme complexity and uncertainty. Policymaking has been instrumental in fomenting epic divergences between inflating securities markets and disinflating real economy price dynamics.
The upshot has been unappreciated securities market leveraging and latent financial and economic fragilities. Never has finance (and analysis!) been as complex – not even close.
“The riskiest elements of shadow banking have declined since the crisis.”
This conventional viewpoint suffers from “fighting the last war” syndrome. The analysis focuses on the post-Bubble reduction of mortgage finance intermediation: “Securitization and structured credit instruments,” “Special-purpose vehicles and structured investment vehicles” (i.e. CMOs & CDOs), Credit default swaps, money market funds and repurchase agreements (repos). I saw no mention of record hedge fund industry assets or the explosive growth in the ETF (exchange-traded fund) complex. The issue of central bank-induced Trillions flowing into global risk markets was excluded. I believe the general implication of reduced speculative leveraging is flawed. Omitting discussion of potential market liquidity issues is a serious analytical shortcoming.
“New forms of non‑bank credit are growing rapidly but remain small… such as credit funds operated by hedge funds and other alternative asset managers. Assets in credit funds for a sample of eight alternative asset managers have more than doubled since 2009 and now exceed $400 billion.”
Here’s where I see the biggest void: I believe “non-bank” securities-based finance is these days enormous and, on a global basis, actually much larger than 2007. Importantly, one of this Bubble cycle’s key sources of leverage goes unreported and unanalyzed. But I can’t fault McKinsey’s analysts. After all, central bankers appear oblivious to the proliferation of market-based leverage in global securities “carry trades” and derivatives markets.
“China’s challenge today is to enact reforms to deflate the growing credit and property bubbles, increase transparency and risk management throughout the financial system, and create efficient bankruptcy courts and other mechanisms to resolve bad debt without provoking instability or financial crises.”
Credit Analysis & Theory would argue the impossibility of deflating China’s “growing credit and property bubbles… without provoking instability or financial crises.” Chinese officials a few years back completely lost control of their Credit Bubble. Stating their intention to avoid Japan’s mistakes, they instead unleashed a historic Bubble that dwarfs their rival’s eighties’ excesses. “Debt and (Not Much) Deleveraging” doesn’t broach the subject of China’s endemic fraud and corruption. Yet resulting Credit system impairment and economic maladjustment ensure far-reaching additional risks and uncertainties that will surely manifest into acute instability and a precarious financial and economic mess.
To address a key issue from the report: “Whether China will avoid this path [Credit boom followed by financial crisis] and reduce credit growth in time, without unduly harming economic growth.” At this point, global policymakers and macro analysts have witnessed enough Credit Bubbles and busts to be alarmed by the prognosis.
A Friday afternoon Financial Times headline, “Greece is Just Part of the Global Debt Challenge”, provides a convenient segue to another interesting week in the markets. After closing last week at 14.80%, Greek five-year yields surged above 15.25% on Monday, before reversing course and sinking to 12.67% intraday Tuesday - before ending the week at 13.97%.
Markets were heartened by the more conciliatory tone adopted early in the week by Greek officials. General complacency that the EU and ECB would cave into pressure was challenged with the European Central Bank’s Wednesday afternoon surprise move to end the waiver on accepting high-risk Greek debt as loan collateral. The meeting between Greek and German Finance Ministers saw no narrowing of differences. And the market week ended with an S&P debt downgrade and less conciliatory language out of Athens. It will be an intriguing few weeks.
This week saw continued pressure on two key EM markets. The Brazilian real was slammed for 3.6%, trading to the low since 2004 (down 4.5% y-t-d). The Turkish lira lost 1.3% to a record low (down 5.6% y-t-d). Brazil’s local (real) 10-year yields surged 47 bps to 12.46%, with Brazil dollar yields up 13 bps to a six-week high 4.37%. It’s worth noting that the major Brazilian banks saw CDS prices increase, as unfolding corruption investigations moved closer to the major state-directed lenders. Petrobas’ stock was hit another 7% Friday on the (non-confidence inspiring) appointment of Banco do Brasil’s CEO to head the troubled company.
Turkey's lira yields jumped 49 bps to 7.51%, with 10-year dollar yields up 16 bps to 4.17%. Turkish stocks were slammed for 4.5%. The Shanghai Composite was hit for 4.2%. From Bloomberg: “China Sees Biggest Outflow of Capital Since at Least 1998.” Discerning analysts increasingly fear worsening Credit woes, deflation risk and Chinese currency devaluation. Yet the bulls want to interpret the PBOC’s move this week to reduce bank reserve requirements as the start of more aggressive Chinese stimulus measures.
At least for the week, the bulls were not dissuaded by China, EM travails or advancing Games of Chicken (Greece v EU; Russia v the West in Ukraine). Crude surged 8.5% on what appeared a decent short squeeze, while squeeze dynamics were in play as well in U.S. equities. The energy sector along with financials went fully into “rip your face off” squeeze mode. The Goldman Sachs most short index gained about 5% on the week.
But for the most part, it appeared more of the same: unstable markets levitated by the self-reinforcing momentum of speculative finance flowing into king dollar and U.S. markets. Friday’s payroll data provided added confirmation that the Fed is oh so far behind the curve.
At the same time, global developments embolden those believing that the Fed dare not even begin to normalize rates. Yet Friday trading did see five-year Treasury yields jump 18 bps.
The session saw the Utilities slammed 4.1% and the REITs hit for about 3%. Expanding divergences between the U.S. and global economies now foster heightened market instability for the beloved – and “Crowded Trade” - yield and income sectors.