Graph-in-grass

A boom in low quality mortgage lending in America triggered the Global Financial Crisis. It was a crisis of indebtedness which, courtesy of low interest rates, quantitative easing, government spending and bank bailouts, was resolved by the accumulation of even more debt.

As a result the world economy is more indebted today, in absolute terms and relative to GDP, than it was on the eve of the financial crisis. The stock of global debt has risen by 60% in the last ten years, far faster than global growth.

Yet debt levels vary too widely by country and sector to enable us to talk of a global debt bubble. Debt has risen in some countries, such as China, and fallen in others, including the US. Within countries some sectors, notably US banks, have shed debt or deleveraged and others, mainly Western governments, have raised borrowing.

Most Western governments are running much higher levels of debt than ten years ago. Relative to GDP, levels of UK government debt has more than doubled in the last ten years; the stock of US government debt has risen by 60%. Chinese government debt has also surged, albeit from lower levels. (The conspicuous exceptions, where government debt is falling, are Scandinavia and Germany).

The financial crisis triggered a massive clean-up of banks’ balance sheets, especially in the US and UK, where debt levels have fallen sharply. It’s a different story in Europe. There the process of deleveraging was stalled by the euro crisis. The European Central Bank stepped in to provide banks, especially in Italy and Spain, with cheap credit. As a result euro area financial institutions are more heavily indebted now than in 2007.

The cheap-money policies of recent years has lowered the return on safe assets, such as bank deposits. This has encouraged investors to move into riskier areas, including corporate debt, in search of higher returns. Non-financial corporates have taken advantage of this demand to restructure their balance sheet away from equity and towards cheaper debt finance. In the US, the euro area and China non-financial businesses are running higher levels of debt today than they were ten years ago. The UK is the exception. Its corporate sector has deleveraged and is now less indebted than those in the euro area and, indeed, China.

The debt burden for Western consumers has come down in the last ten years. This is especially true in the UK where tougher regulation and greater caution on the part of lenders has slowed annual growth in mortgage lending to low single digits. Together with consumers paying down debts the result has been a decline in UK consumer indebtedness to well below 2007 levels. The UK is roughly in the middle of the global league for consumer debt; above the US and Germany but below Australia, the Netherlands, Sweden and Denmark.

So while some sectors and countries have piled up debts, others have shed them. Asking whether global debt levels are too high is the wrong question. The right one is to ask which sectors and countries are most at risks.

Anyone who knows the source of the next financial crisis could become fabulously rich. Nobody has that prescience. But we’ll be keeping an eye on three areas this year: Chinese corporates, Italian banks and the use of leveraged corporate finance across the world. We look at each briefly below.

China’s overall debt-to-GDP ratio – for government, banks, consumers and corporates – has nearly doubled in the last ten years. At around 300% of GDP it is not far off US levels. The bulk of the growth has come from companies and consumers taking on debt, though government and banks have too. Much of the increase in borrowing has come from state-owned banks providing loans to state owned enterprises. China’s private sector has relied more on credit from the less well documented shadow banking sector.

Burgeoning debt has brought with it a misallocation of capital and created a lot of underused assets. Softening Chinese growth could hit asset prices and increase banks’ bad debts, reinforcing the slowdown. In these circumstances the authorities might balk at further monetary stimulus for fear of boosting already elevated levels of debt and bad loans.

The risks of a debt blow up in China are mitigated by three factors. Chinese corporate debt is mainly owed to state-owned banks which could be fairly readily bailed out. Capital controls reduce the risk of capital flight. And with most Chinese debt denominated in renminbi there’s less risk of a sharp devaluation sending financing costs through the roof, as has happened to many countries with high levels of foreign currency debt.

The second area of risk, and it’s hardly new, relates to Italy. Lacklustre growth in recent years has made it hard for Italy to shrink its mountain of government debt, which stands at 113% of GDP, well above the EU average. The cost of servicing that debt rose sharply last year as the country elected a populist coalition government committed to boosting public spending. With domestic banks and Italian households holding most government debt, higher bond yields pose a real risk to Italy’s banks. The ending of the ECB’s quantitative easing programme in December, which was an important source of capital, has added to the banks’ woes. Italian banks also have significant exposure to the Italian housing market, where prices are still falling.

The third area to watch is the leveraged loan market. Since the financial crisis, many companies have sought cheap financing through ‘leveraged loans’, that typically extend credit to less creditworthy, more indebted companies, usually without the kind of investor protection traditionally sought for such loans. The lenders tend to be a diverse mix of private and institutional investors on the lookout for higher yields in a low-interest-rate environment.

The leveraged loan market has doubled in size over the last ten years, overshadowing high-yield bonds as a source of financing for riskier businesses. But with global growth slowing, and growth in the developed world widely acknowledged to have peaked, investors are beginning to pull back from the market. But many worry that the next recession could bring about a string of corporate defaults that hit these lenders hard.

The US Federal Reserve, IMF and the Bank of International Settlements have all warned against a blowup. In 2017, former Fed Chair Janet Yellen noted - “if we have a downturn in the economy, there are a lot of firms that will go bankrupt, I think, because of this debt.” However, with a diverse group of private lenders exposed to this risk, most concede that while a correction would worsen a recession, it is unlikely to pose a systemic risk to the global financial system.

With luck the 2007-08 crisis will prove to be a once-in-a-lifetime event. Milder financial crises are more frequent events. The dotcom bust of the early 2000s wrought havoc in the US tech sector, hitting corporate investment and profits. But the resulting recession was shallow, short-lived and confined to the US. Unlike Lehman’s failure, in 2008, the bursting of the bubble in tech stocks did not send powerful shock waves through the world.

Systemic financial crises are hugely damaging. More localised financial busts, such as the dotcom collapse, could be seen as disciplining mechanisms – delivering a dose of reality to over exuberant markets, curbing the misallocation of capital and averting a bigger crisis in future. A global financial crisis, like 2007-08, is to be feared and resisted. In a dynamic economy smaller scale blow ups, where the damage is confined largely to the players, are necessary correctives to excess.