Major economies in for debt deleveraging

Several major economies are likely to face imminent deleveraging which will be a lengthy and painful process. This unwinding of unsustainable debt burdens will drag down their growth rates for years to come, said a study.

The spectre of deleveraging has been haunting the global economy since the credit crisis in 2008. So far, reality has been more benign, with economic growth recovering sooner than expected in some countries, even though the financial sector is still cleaning up its balance sheets and consumer demand remains weak.

New research from McKinsey Global Institute (MGI) says the deleveraging process may just be getting underway and would exert a significant drag on GDP growth. The study carried out in 10 mature and four emerging economies indicated that some sectors of the economies of five countries — Canada, South Korea, Spain, the United Kingdom and the United States — would very probably experience deleveraging.

Business executives too will face challenges: They may have to adapt to an environment where credit is tighter and costlier and consumer spending could be slower than prevailing trends over the medium term in countries where household debt has built up. The findings say growth may be stronger in emerging markets, which are far less leveraged than in mature ones. To cope, companies should build the potential impact of "pockets" of deleveraging into their market outlooks.

Overall, the corporate sectors in most countries entered the crisis with lower levels of leverage than they had at the start of the decade, with the exception of the commercial-real-estate subsector and companies acquired through leveraged buyouts. Both of those pockets of leverage have more than $1 trillion (Dh3.7trn) of debt, which will need to be refinanced in the coming years, suggesting difficulties ahead, it said.

According to Global Insight, US government debt will grow to 105 per cent of GDP by 2012 from 60 per cent in 2008; UK government debt to 91 per cent from 52 per cent; and Spanish government debt to 74 per cent from 47 per cent. This development could more than offset any deleveraging by the private sector. One implication is that Spain, the UK and the US might postpone deleveraging until after the crisis passes and growth in government debt is reined in. It is also likely that debt-to-GDP ratios will decline more slowly and over a longer period than the historical average, creating severe headwinds on economic growth.

While the crisis abruptly halted the growth of credit in many economies, the process of deleveraging is just starting. As of Q2 of 2009, the report found that total debt relative to GDP had fallen, and only slightly, in just a handful of countries. One reason for this has been the increase in government debt, which has offset declines in household sector debt. Current projections for rising government debt in some countries, such as the UK and the US, may preclude any significant deleveraging of the total economy over the next few years, it said.

Financial sector leverage, in contrast, has already fallen to the average historic levels prior to the crisis. "We find that in most countries, by the second quarter of 2009, the banking system had deleveraged to the point at which capital levels were at or above the average levels of the 15 years preceding the crisis. Whether more capital is needed in addition to what banks have now accumulated remains unknown. And given the possibility of economic-wide deleveraging going forward, any such measures to boost capital requirements should be phased in very cautiously over time to minimise the reduction of credit provision, it added.

The report said that financial crises were typically followed by deleveraging episodes that slowed GDP growth. "We cannot say for certain that deleveraging will occur today, we do know empirically that deleveraging has followed nearly every major financial crisis in the past half century. We find 45 episodes of deleveraging since the Great Depression in which the ratio of total debt relative to GDP fell and 32 of them followed a crisis."

The report suggested that policymakers could take several steps toward preventing future credit bubbles. First, history shows that policy makers can enable healthy deleveraging by supporting GDP growth through multiple channels. Many historic examples, from the US in the 1930s to Japan in 1997, show the danger of withdrawing support of the economy too soon. However, faced with large increases in public debt, many governments face an acutely difficult decision on how long to provide support and when to curtain public spending, it said.

Additionally, the report said that the right tools could have identified the unsustainable buildup of leverage in pockets of several economies in the years leading up to the crisis. Policymakers should work toward developing a robust system for tracking leverage at a granular level across countries and over time. Ideally, an international body should be tasked with collecting data from individual countries.

"Policymakers should revisit the numerous incentives for borrowing, especially in real estate markets. This includes tax breaks for mortgages and other policies because we observed high levels of household debt in Canada and the UK.

"Many governments provide subsidies and other programmes to encourage home ownership. And multiple policies provide tax advantages and other incentives that induce companies to issue debt rather than equity.

"Certainly, ample credit is needed for the growth of modern, developed economies but excessive borrowing, especially combined with loose lending standards, can cause serious harm to individual households, companies and the broader financial system. Therefore, as part of the longer term reform of the global financial system, it would be valuable to reassess incentives that may contribute to excessively high leverage," it added.

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