DELEVERAGED EFFORTS HAVE STALLED TOO SOON / THE FINANCIAL TIMES MARKETS ( A MUST READ )

Deleveraging efforts have stalled too soon

By John Plender

Published: February 8 2011 15:11

Great financial crises are more often than not followed by episodes of debt reduction, or deleveraging – the proverbial hangover after the party.


When global imbalances have been a root cause of the financial disruption, that deleveraging needs to be accompanied by a rebalancing of the economies of surplus and deficit countries.


After a three decades long debt binge in the big deficit countries, the imperative is all too obvious in the horrendous headline numbers. Total public and private UK debt as a percentage of gross domestic product in 2008 was 469 per cent, which was higher even than in Japan, while the comparable number for the US was 296 per cent.


The figures are admittedly subject to heavy qualifications. The US figure goes up to 350 per cent of GDP if the financial sector’s asset backed securities are included.


The UK falls to 380 per cent if, as the McKinsey Global Institute does, you exclude offshore banking activities that have no impact on the performance of the British economy.


Or you can scare yourself silly by including off-balance sheet liabilities of the public sector such as unfunded pension liabilities.


The important point, though, is that despite the need to slash these debt mountains the deleveraging process in the US and, to a lesser extent the UK, appears to have stalled before it has even started to gather impetus.


Consider the following. Deleveraging made a start in the private sector, where the initial deflationary impact was offset by the public sector’s expansionary fiscal policy.


First, the banks started rebuilding their balance sheets. Then US savings as a percentage of disposable income rose from just under 2 per cent in the third quarter of 2007 when the credit crunch began to over 7 per cent in the second quarter of 2009 as households paid down debt. Yet that fell back to 5.3 per cent in December last year and there is growing anecdotal evidence that the corporate sector is stepping up investment plans, which will reduce its current high level of saving.


The trajectory has been similar in the UK where the savings ratio went from minus 1.3 per cent in the first quarter of 2008 to 7.5 per cent in the second quarter of 2009, only to fall back to 5 per cent in the third quarter of 2010. Meantime the Obama fiscal easing package in December puts back the day on which deleveraging comes to the US public sector.


Given that the big creditors, China, Japan and Germany, take no responsibility for their part in global imbalances and are all now tightening policy after loosening in the recession, this suggests that the imbalance story is back with a vengeance.


There will, of course, be continuing pockets of deleveraging. Banks continue to reduce their dependence on wholesale funding and will bolster capital further to address the requirements of Basel III.


There will be defaults in commercial property, which accounts for a vast chunk of corporate sector debt in the US and UK, and in the leveraged buyout area, as weaker borrowers are unable to refinance. The UK government, unlike the US, has donned a hair shirt.


When central banks start tightening again, the potential for default in residential property is huge, especially in the UK and Spain where much mortgage lending is at floating rates. Three decades of disinflation and declining interest rates have reduced the incidence of default to historically low levels. If the trend reverses, the debt burden will be painful. Household sector debt in the UK and Spain amounted to 101 per cent and 85 per cent of GDP respectively in 2008. These inflated levels are unprecedented.


Yet the key to debt sustainability ultimately lies in the public sector. Some suspect that inflation will be the mechanism for writing down debt in the US and UK, which borrow in their own currencies. Once again because memories of the inflationary 1970s are remote, it is easy to forget how quickly the rate might climb once recovery is more firmly established.


If investors refuse to roll over public sector debt and governments are forced to borrow from the banks, inflationary expectations can change fast. Even the US, with a very short average maturity of just four years on its government debt, could be vulnerable to refinancing risk with the debt on course to hit 100 per cent of GDP.


My feeling, though, is that the battle will be on Capitol Hill rather than in the markets, as Tea Party folk try to wreck President Obama’s re-election prospects by curbing the budget deficit.

If they succeed, the current account deficit will probably also come down sharply, causing global imbalances to shrink in a way that will cause maximum pain to the various creditor countries.

The writer is an FT columnist


Copyright The Financial Times Limited 2011.