SOLVING DELEVERAGING PUZZLE WILL CALM INVESTORS / THE FINANCIAL TIMES ( HIGHLY RECOMMENDED READING )

Solving deleveraging puzzle will calm investors


By Gillian Tett

Published: October 7 2010 17:31


Back in mid-2007 – or just before the credit bubble burst – some bankers formed an amateur rock band and played (rather badly) at a European securitisation conference. They christened the group “D’Leverage”, short for “da leverage” (think reggae). For back then nobody was thinking about the issue of deleveraging; the name thus seemed an amusing joke.


No longer. These days, as the International Monetary Fund and World Bank meetings start in Washington, the word “deleveraging” is haunting policymakers and investors. More specifically, three years after that D’Leverage performance, it is now crystal clear to everybody that debt levels were absurdly high during the credit boom.


What is not evident, however, is how much further that debt now needs to decline to produce any sense of normality. We do not know, in other words, how far along we are into this “deleveraging” process, nor what this might mean for growth or asset prices.


The current data on the issue looks mixed. In some respects – and in some sectors – there might seem to be reason for cheer. The latest capital markets monitor from the Institute of International Finance, published this week, reports a “sharp decline in the liabilities of the US shadow banking system this year”, amid “ongoing deleveraging – in particular by US households”.


Total liabilities of the shadow banks have dropped from almost $22,000bn two years ago, to nearer $17,000bn, or where it was five years ago. “Debt levels for US households, businesses and particularly financial institutions continue to decline” the IIF notes, as a proportion of gross domestic product, towards levels seen earlier in the last decade.


A separate recent report from Citi’s European credit team reinforces that point. This data also suggests that a sharp deleveraging has already occurred for banks. And in the non-banking corporate world, net debt to ebitda for S&P non financials is now running at around 140 per cent, down from 210 per cent at the peak in late 2008. For the EuroStoxx non-financials, the ratio has moved from around 230 per cent to 170 per cent.


If the pattern seen in earlier economic cycles were to play out, investors should welcome this news. With debt levels suitably reduced, banks and companies should now feel confident enough to start borrowing again – and thus raising investment, spending and so on. But that does not appear to be occurring: after cutting debt, companies are still (for the most part) sitting on vast piles of cash; so, it seems are households. Meanwhile banks are resolutely refusing to make large volumes of new loans.


Why? One reason may be that the household sector is still running a big debt burden by historical standards, and is beset by unemployment. Another is that regulatory uncertainty is sapping corporate nerves. However, the Citi team thinks the biggest issue is that rising public sector debt is undermining confidence too, or creating a climate of “fear”, as Alan Greenspan wrote in the FT yesterday. Most notably, even as the private sector has delivered, public debt has exploded.


Thus the total scale of leverage in the system – namely the sum of both non-financial public and private debt – has not fallen markedly in the last two years (in America, for example, it is now running at around 220 per cent, compared to 170 per cent at the start of the decade.). Hence, Citi argues, investors cannot expect a “normal cycle”; companies and consumers alike are too shell-shocked by the recent past – and so uncertain about how governments will deal with all that public debt in the future. The most likely path for the next few years therefore is one of sluggish growth at best.


To me, this seems an entirely reasonable projection. Having lived in Japan in the late 1990s, and seen what happens when companies and consumers become trapped in the psychology and dynamics of a “balance sheet recession”, as the Japanese economist Richard Koo calls it, the current patterns smell uncannily familiar.


However, the really big uncertainty is the political economy. Japan, in essence, has accepted a long period of private sector deleveraging and stagnant growth without much social upheaval. Whether voters in America or Europe will do the same, without either forcing their governments to resort to inflation or default, is crucially unclear.


Either way, the one thing that is evident is that there needs to be a lot more research and debate about deleveraging. Precisely because this issue was not on anyone’s radar screens three years ago – to a point where bankers could say “da leverage” and laugh – there is much about this dynamic that remains crucially uncertain. Little wonder that markets are so jittery, and emitting such contradictory signals between different asset classes.


Copyright The Financial Times Limited 2010.