In 2000, the Clinton administration commissioned a secret report called Life After Debt. The federal government had managed to run a budget surplus every year since 1997, having failed to do so at all since Richard Nixon abandoned the gold standard in the 70s.
At the time, economists were projecting that the entire US public debt would be paid off by 2012. Life After Debt aimed to provide solutions to the problems that would come with eliminating debt entirely. Where would investors find a security free from default risk? How would the Federal Reserve control monetary policy? Which assets would the government buy to fund social security?
Of course, the US government never had to answer these questions. By the time the report had made its way into public hands in 2011, countries like the US, UK and Spain had seen their deficits balloon in response to the worst financial crisis since the Great Depression. Those already afflicted with enormous government debt, such as Japan, Greece and Italy, continued to borrow as their growth slowed.
Companies in emerging economies have also loaded up, and in China, bank loans have been funnelled to unprofitable state-owned companies which cannot afford to repay them, while the country’s runaway housing market now threatens to tank, risking widespread defaults.
Global debt is higher than it has ever been. The IMF announced in September that leverage had hit a record $152 trillion, or 225 per cent of global GDP. The figure certainly sounds ominous, but is another financial crisis around the corner?
In many respects, the figure is not a problem in itself. “The key question is not how large the debt is in absolute terms but whether it is sustainable,” writes Michael Pearce, global economist at Capital Economics. Indeed, while Federal Reserve Bank of New York data shows that US households held $12.6 trillion in debt at the end of 2016 – the highest since 2008 – American incomes, GDP and the country’s population have grown in the meantime. Indeed, household debt has fallen as a percentage of GDP in the US and the UK since the financial crisis.
Moreover, the financial crisis was caused by a conflagration of sub-prime mortgages, and lending restrictions to homeowners have been toughened considerably in the years since, with lower interest rates making it easier for those who can afford a mortgage to pay off the capital more quickly. Today’s concerns are different, and the risks aren’t so great.
Fears about the US car loans market have intensified in recent years, with $1.1 trillion outstanding at the end of 2015 – up 30 per cent from pre-crisis levels. But the interest on car loans as a share of disposable income remains below its financial crisis peak. And cars are very different assets to houses – repossessions can be done easily.
In fact, it is government borrowing which has accounted for the entire increase in debt ratios in the developed world since the financial crisis. Any questions about their creditworthiness are perhaps answered by investors’ insatiable appetite for government bonds, whose yields remain low.
Governments face little problem servicing their debts in the current climate. Interest rates remain at or near record lows in Europe, Japan, the UK, and the US, so debt costs little to service relative to national income. In other words, while national debt is high in the rich world, it is also affordable.
Along with Greece, Japan is the only developed country with unsustainable levels of debt, thinks Pearce, and even their situations aren’t hopeless. With its own currency and central bank, Japan always has the option of inflating away its debt through policies like “helicopter money”. Japan actually spends less servicing its public debt today (2 per cent of GDP) than it did in the 1980s, despite its debt having more than tripled as a percentage of GDP. Bound by the euro, Greece has no such luxury. But neither would investors be shocked if Greece’s creditors announced further debt restructuring.
However, if the rich world’s debt burden appears benign, no investor can know what legacy its unconventional monetary policy experiment will leave behind.
Europe finds itself caught between poor economic growth and an inability to retreat from QE. Non-performing loans worth more than €1 trillion remain on the balance sheets of the continent’s commercial banks, giving the European Central Bank little option but to keep up the pace of monetary easing. “The banks need cheap money to absorb these non-performing loans,” says Morgane Delledonne, fixed income strategist at ETF Securities. “Unwinding QE too early would cause a repricing of the credit risk, especially in the context of high political uncertainty, which would lead to a widening of the spread within the euro area and financial fragmentation.”
Moreover, as rich world central banks have bought bonds and equities, the prices of assets such as property have been distorted, and capital has probably been allocated inefficiently. “The canary in the mine could be when the banks become sufficiently well capitalised to lend more freely again,” says Iain Tait, partner at London & Capital. At such a point, inflated asset prices could be in for a big correction.
Unlike the developed world, public debt remains low in emerging economies, but firms have binged on credit to fund their growth.
Last year, a report by the UN Conference on Trade and Development warned of a “deepening of the financial integration” between developed and emerging markets in recent decades, coupled with cheap credit which has flowed from the former to the latter. According to the Bank for International Settlements, the debt of non-financial corporations in these economies rose from $9 trillion at the end of 2008 to more than $25 trillion by the end of 2015. If US interest rates rise and the dollar stays strong, many worry that emerging market firms will default.
There are good reasons to think this won’t happen. According to Capital Economics, since 1990, any emerging market which has seen private debt increase by more than 30 per cent of GDP in 10 years has suffered a debt crisis. By this measure, China, Turkey, South Korea, Brazil and Russia look vulnerable. But a much greater of proportion of their debt is now owned by local investors and is denominated in their local currencies, so they are not as vulnerable to rising US interest rates or a stronger dollar as the East Asian Tigers were in 1997.
Sincere efforts are being made in many emerging markets to bring their private debt situation under control. Unlike in developed economies, their central banks have room to lower interest rates – and their governments to borrow – if a crisis hits. “Russia’s deleveraging has been spectacular in recent years,” says Sergey Dergachev, senior portfolio manager, emerging market debt at Union Investment. As a bond investor, Dergachev likes Russia and Turkey, despite their proportionally higher levels of foreign currency debt than other emerging markets.
China, however, is a different beast. While the US increased government spending and used QE to stimulate its economy during the financial crisis, China’s leaders lowered interest rates and bank reserve requirements, and used their grip on the country’s banking system to direct money to state-owned enterprises, which could build infrastructure projects to compensate for a global slump in demand.
Fearful that mass unemployment would inspire popular anger, the Communist Party kept the stimulus coming, causing its debt-to-GDP ratio to balloon from 150 per cent in 2008 to more than 250 per cent today. Corporate debt accounts for around 170 per cent of GDP.
The risk is that the debt on the balance sheets of these unprofitable state-owned firms account for a far greater proportion of China’s GDP than they produce, weighing on China’s economic growth. So integral is the Middle Kingdom to the rest of the global economy, its suffering would surely be everyone else’s.
However, some are quite relaxed about China’s corporate debt. Its creditors are not foreign after all, and the authorities are keen to manage the situation. Beijing controls both the indebted companies and the banks which have lent to them, so “there is no market dictating the pace of repayment,” says Andy Rothman, investment strategist at Matthews Asia.
Moreover, the People’s Bank of China has guided interest rates in the money market upwards to curb leverage, and recent PMI surveys indicate that China’s economy is growing more strongly. The government has even begun forcing ailing state-owned companies into performing debt-for-equity swaps.
But there are bubbles in China’s economy that the government might not be able to prevent bursting.
The debt in China’s overheated property market is a cause for concern, thinks Gerard Fitzpatrick, chief investment officer of fixed income at Russell Investments. After the stock market rout of 2015, investors rushed to buy property, leading to price growth in Tier 1 and Tier 2 cities of a whopping 25 per cent. But prices have started to fall, indicating that buyers may have overpaid and that China could be heading for a crisis.
The median deposit required to be approved for a mortgage in China is currently 25 per cent, lowered from 30 per cent in 2015 by the People’s Bank of China – still far higher than the 2 per cent required in the US prior to the sub-prime mortgage crisis. But debt service ratios in China are lower on household debt than corporate debt, so there is less ability to pay off interest.
Of course, China’s financial system is nowhere near as advanced as the US’s was before the sub-prime mortgage crisis. “Sub-prime assets found their way into the investment portfolios of Mom and Pop pretty quickly,” says Fitzpatrick. But the Chinese government has much less influence over the country’s household borrowing than its corporate borrowing. And it is not just regulated banks which have been doing the lending. China has an entire shadow banking system of asset managers and direct financing companies whose liabilities are unknown.
If the housing market collapses, however, it would be China’s banks which suffer, thinks Fitzpatrick, and that could be bad for all of us. “The property sector threatens Chinese banks, which account for a very high proportion of Chinese GDP. That’s where the systemic risk lies.”
This article appears in the latest edition of City AM's Money Magazine, released with the paper on Thursday 24 March.