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News : International Last Updated: Jan 20, 2010 - 7:48:25 AM


Rich countries face years of belt-tightening to reduce high debt levels; Deleveraging following crises lasts six to seven years on average
By Finfacts Team
Jan 19, 2010 - 5:04:38 AM

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Rich countries face years of  belt-tightening to reduce high debt levels, which will result in slow growth over much of the current decade, according to a new study. Deleveraging following crises are painful, lasting six to seven years on average, reducing the ratio of total debt to GDP (gross domestic product) by 25 percent.

McKinsey Global Institute (MGI), a research unit of the consulting firm, says the recent bursting of the great global credit bubble not only led to the first worldwide recession since the 1930s but also left an enormous burden of debt that now weighs on the prospects for recovery. Today, government and business leaders are facing the twin questions of how to prevent similar crises in the future and how to guide their economies through the looming and lengthy process of debt reduction, or deleveraging - - in which credit falls relative to the size of the economy.

To help address these questions, MGI launched a research effort to understand the growth of debt and leverage before the crisis in different countries, the economic consequences of deleveraging, and the practical implications for policy makers, financial regulators, and business executives. In the course of the research, MGI created an extensive fact base on debt and leverage in each sector of ten mature economies and four emerging economies. In addition, MGI analysed 45 historic episodes of deleveraging ranging from the US Great Depression to Argentina (2002 to present) today, in which an economy significantly reduced its total debt-to-GDP ratio, that have occurred since 1930.

The researchers found that with only one exception -  - Japan - - every major financial crisis was followed by a period of deleveraging.

Japan replaced private debt with a huge growth in public debt and its economy has spluttered for almost two decades.

Ratios of total debt to GDP (including debt owed by households, government, non-financial businesses and the financial industry) with America’s at just under 300%, lower than many others. However, apart from  Germany and Japan, most rich countries saw a huge rise over the past decade. The UK and Spain saw their total-debt ratios rise more than 150 percentage points apiece, to 469 per cent (380 per cent after adjusting for London's financial centre) and 342 per cent respectively.

 

The highest debt ratio in the report’s group of belt-tighteners in the historical analysis was 286 per cent in the UK after the second world war. Today more than half the rich countries in the McKinsey sample have debt of more than 300% of GDP. However, this time, the number of countries with simultaneous problems means that  quickly benefiting from an export boom for example, is not an easy option today.

The report has a brief reference to Ireland and its total debt ratio to GDP of 700 per cent figure, likely includes foreign banks in Dublin's offshore centre.

In Sept 2009, Ireland's private sector credit debt was at 290 per cent of GNP (gross national product); in that total, residential mortgage lending exceeded 100 per cent of GNP. The General Government Debt/GDP ratio was 64.5 per cent at end 2009, up from 44.1 per cent at end 2008. So Ireland is among the problem countries.

Irish household debt

McKinsey says total debt to GDP in itself is not a reliable guide to sustainability and the extent of deleveraging and the report looks within economies to see which sectors are carrying levels of debt that will likely have to be reduced in coming years.

It concludes that households in the US, Britain, Spain and to a lesser extent Canada and South Korea will shed debt. The commercial real-estate sectors in the US, UK and Spain will also be reducing debt levels. In Spain, parts of the the financial sector and some companies, particularly those in construction, will also likely be winding down debt.

Financial sectors have made progress in shedding debt but public and household sectors have yet to begin.

The historic episodes of deleveraging fit into one of four archetypes: 1) austerity or belt-tightening in which credit growth lags GDP growth for several years; 2) massive defaults; 3) high inflation and 4) growing out of debt caused by a very rapid GDP growth caused by a war effort, a "peace dividend" following a war, or an oil boom.

Irish private sector debt levels are among the highest in the developed world. Goodbody estimates that the private sector debt/GDP ratio will rise to 225% this year, was 86% a decade ago.

The rise in public debt and bank deleveraging will make it difficult for the global economy to return to past growth rates, European Central Bank Executive Board member Lorenzo Bini Smaghi said on Monday.

Bini Smaghi said he did not expect the global economy to return to its pre-crisis situation, as this had been unsustainable.

"I have the impression that many people, whether in the business sector, the financial markets, or in academic and political circles, think that the post-crisis world will be quite similar to the pre-crisis one in 2006-2007. In other words, they expect the economic recovery to bring us back to where we were before the crisis," he said.

"My feeling is that those who think like that are deluding themselves," he told Frankfurt's Chamber of Commerce and Industry.

Bini Smaghi said. said the pre-crisis situation was not in equilibrium. It was not sustainable. The crisis occurred precisely because the situation was unsustainable, both within certain countries and globally.

He said if the world economy were to return to the pre-crisis situation, within a short time span a new crisis would be likely to occur because the same imbalances that led to the crisis would build up again. Considering some recent developments and behaviour, and considering the way certain policies are being discussed and the thinking of some key players, such a scenario does not seem that unlikely.

"It is likely that a number of factors will weigh negatively on the economic outlook, making it difficult to achieve pre-crisis growth rates," Bini Smaghi said. A rise in unemployment and structural shifts in world demand and prices would also play a role, he said, referring to the construction and car industries.

Debt and Deleveraging; The Global Credit Bubble and its Economic Consequences (2MB pdf)

The McKinsey analysis adds new details to the picture of how leverage grew around the world before the crisis and how the process of reducing it could unfold. MGI finds that:

  • Leverage levels are still very high in some sectors of several countries—and this is a global problem, not just a U.S. one.

     
  • To assess the sustainability of leverage, one must take a granular view using multiple sector-specific metrics. The analysis has identified ten sectors within five economies that have a high likelihood of deleveraging.

     
  • Empirically, a long period of deleveraging nearly always follows a major financial crisis.

     
  • Deleveraging episodes are painful, lasting six to seven years on average and reducing the ratio of debt to GDP by 25 percent. GDP typically contracts during the first several years and then recovers.

     
  • If history is a guide, many years of debt reduction are expected in specific sectors of some of the world’s largest economies, and this process will exert a significant drag on GDP growth.

     
  • The right tools could have identified the unsustainable build-up of leverage in pockets of several economies in the years leading up to the crisis. Policy makers should work to develop a more robust system for tracking leverage at a granular level across countries and over time. One needs to look at specific metrics such as the growth of leverage, and the borrowers' ability to service debt if there is a disruption to income or rise in interest rates. MGI found that sufficiently granular data do not exist today.

     
  • MGI's analysis provides support for several of the current regulatory proposals, including improving the quality of bank capital through higher Core Tier I ratios, monitoring leverage as a proxy for asset bubbles, and creating better macro-prudential regulation to reduce systemic risk. However, the analysis raises questions about some aspects of the current regulatory agenda, such as limiting gross leverage ratios (which did not change appreciably in most banks).

     
  • Coping with pockets of deleveraging is also a challenge for business executives. The process portends a prolonged period in which credit is less available and more costly, altering the viability of some of business models and changing the attractiveness of different types of investments. In historic episodes, private investment was often quite low for the duration of deleveraging. Today, the household sectors of several countries have a high likelihood of deleveraging. If this happens, consumption growth will likely be slower than the precrisis trend, and spending patterns will shift. Consumer-facing businesses have already seen a shift in spending toward value-oriented goods and away from luxury goods, and this new pattern may persist while households repair their balance sheets. Business leaders will need flexibility to respond to such shifts.

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