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.
To help address these questions, the McKinsey Global Institute 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 analyzed 45 historic episodes of deleveraging, in which an economy significantly reduced its total debt-to-GDP ratio, that have occurred since 1930.
This 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.
Debt deleveraging is a multi-year event and that we are in the early stages of this deleveraging cycle.
Market reactions are widely out of proportion to the real problems…recent events are a disturbing comment on the power of fear…brave people will make a fortune buying in these days, and then we’ll all wonder what the scare was about. Right now the U.S. financial markets are trading very much out of fear and not any fundamentals.
The current debt crisis cannot be solved by mere declarations from official authorities. The debt crisis began with the decline of the housing market in 2006 and is continuing to this day. Phase I involved the transfer of private debt to sovereign debt by means of massive monetary and fiscal stimulus that has led to statistical economic recovery that remains anemic by historical standards. The problems that emerged with the Dubai crisis heralded the beginning of a sovereign debt crisis and phase ll—the transfer of weak sovereign debt to relatively stronger sovereign debt. The problem is that total debt is not reduced, but keeps getting shifted from weaker to stronger entities. Overall debt is too huge to ever be paid off and the relatively stronger nations will run out of ammunition long before the crisis is resolved.
The only long-term solution is a deleveraging of global debt, a process that cannot be solved with a magic wand waved by central bankers and prime ministers. It is a process that will take many years and will be accompanied by slow growth, numerous recessions and financial turmoil. The weaker European nations are already going on austerity, and there is more to come. Greece will have to undergo severe budget cuts without the benefit of an independent monetary policy or the ability to devalue its currency. Spain is cutting its budget by $18 billion and Italy by $15 billion. The UK, too, had announced major reductions in healthcare, IT and civil service. This will lead to a sharp slowdown or recession in Europe with negative implications for the rest of the world at a time when the U.S. economy is still fragile and China is trying to restrain a major housing boom. The entire globe is in danger of becoming like Japan, which is still struggling after two decades of monetary and fiscal stimulus—and Japan was operating within a global economy was still robust during most of its time of trouble.
In that kind of financial and economic climate it is hard to conclude that the stock market is cheap or that it is oversold on anything other than the very short-term. Most major stock market bottoms have occurred with the S&P 500 selling at 20% or more under its 200-day moving average. The index sold at 28% under its 200-day average at the 2002 bottom and 26% under at the 2009 bottom. Even at the recent lows the market was only 6% under its 200-day average. In addition sentiment is nowhere near as gloomy as it usually gets at major lows. The Investors’ Intelligence Survey show 29% of participants bearish as opposed to 50% or more at most of the past significant bottoms.
Valuation metrics, too, do not indicate that investors are really fearful at current levels with the S&P 500 selling at slightly over 17 times trailing smoothed reported earnings. At major past market bottoms the P/E was below 10. In fact the P/E was below 10 at some point in 17 of the last 60 years going back to 1950. If anything, the current P/E is more indicative of complacency rather than fear. As we have stated many times “it’s all about debt” and the deleveraging process has a long way to go.
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