Debt Levels: Have we Learned the Lessons of 2008?
In this regular biweekly column, Les Nemethy of Central European corporate finance firm Euro-Phoenix questions whether the world really has learned from the last financial crisis.
Total global debt levels have reached a whopping USD 247 trillion as of 2018, up from USD 164 tln in January 2009, the time of the last financial crisis. That’s up from 213% to 318% of global GDP, according to the Institute of International Finance
One of the most basic principles of finance is that leverage is always correlated to risk. Hence systemic risk in the global financial system is considerably higher today than it was in 2008. That’s not to say that a recession or depression will happen tomorrow. But it does mean that the global economy is less able to withstand shock, should one arise.
Financial shocks can come from unexpected places. In 2008, the financial shock came from subprime debt. It was like the spark that set off the tinder keg. Before 2008, most people hadn’t heard of subprime debt, and to the best of my knowledge, no economist had predicted that this could trigger a financial crisis.
It is not possible to predict the origin of the next financial crisis. It might be triggered by the current trade war, loss of confidence in a particular government, a war, the failure of a financial institution, or a combination of the above. Or it might come from a totally unexpected area. Whatever the source of the shock, the higher the levels of debt, the more likely that there will be conflagration and contagion.
Because there is likelier to be conflagration and contagion at those pressure points of the global economy where debt levels are highest, for the remainder of this article I will focus on breaking down global debt, to identify places where risk is greatest.
Corporate debt has increased fastest (from 79% to 92% of global GDP), while government debt has also grown healthily (from 62% to 84%), from 2008 to 2018. Only household debt has been moderate (falling from 66% to 59%) over the same period, according to McKinsey Global Institute - Visualizing global debt.
And yet, in 2008, the general conclusion was that debt levels were way too high, and should be paid down in order to make the world a more stable place. Instead, governments and corporations have continued to pile on debt. They have not learned the lesson of 2008. We’ll now examine government, corporate and household debt in more detail.
As the chart below demonstrates, it is the Japanese and Chinese governments that have piled on the most debt, although the Chinese debt levels started from a much lower base in 2008:.
You might say that a government can never go bankrupt; they can always print more money. But a government may default where debt is denominated in foreign currencies. The likelier scenario is that, in the event of a crisis, governments will need to pay significantly higher interest rates to sell bonds. The U.S. Government currently pays about 8% of its budget to service debt, according to thebalance.com, and this is with extremely low interest rates. What if the U.S. Government had to triple its cost of servicing treasuries during a recession, when tax revenues are falling? Ouch!
Here again, China has been among the most profligate, with the European Union also showing healthy increases in debt, according to McKinsey Global Institute.
It should be borne in mind that the Chinese economy has been the fastest growing major economy in the world, more than doubling over the 2008-2018 period, to become the largest economy in the world on a Purchasing Power Parity basis, so the fact that Chinese corporate debt has increased by more than 50% relative to GDP points to a truly staggering level of debt growth with Chinese corporations. This is particularly worrying where state-owned banks are lending to state-owned corporations, as well as lightly regulated non-bank financial institutions accounting for so much lending.
Much of corporate bonds are low grade: the BBB bond market in the United States has exploded as it represented nearly 50% of the total corporate bond market in September 2018, versus 35% in 2006, says tortoiseadvisors.com.
According to Fitch Ratings, USD 500 billion of U.S. bonds are just one downgrade away from junk bonds. If downgraded, this would create major losses for investors, potentially creating a vicious circle of them withdrawing funds from the bond market, further driving up interest rates, etc.
Household debt has generally been decreasing in most economies of the world, with the dramatic exception of China (which, once again, started with a relatively low base in 2008).
Nevertheless, there are certain segments of household debt that still provide cause for concern. For example, according to the Federal Reserve, student loans represent roughly USD 1.5 tln in the States, and have more than doubled since 2008. It is now the second-largest category of consumer debt outstanding, after mortgages. According to the U.S. Department of Education and studies of Judith Scott-Clayton, associate professor at Columbia University, every year more than a million people default on their student loans and approximately 40% of borrowers are expected to default on their student loans by 2023.
In conclusion, it seems that most governments and corporations have not learned the lessons of the 2008 financial crisis. (Perhaps most households have.) This creates a virtual certainty that there will be another financial crisis; the only questions are when, and whether the next recession could be more severe than the one in 2008?
Les Nemethy is CEO of Euro-Phoenix (www.europhoenix.com), a Central European corporate finance firm, author of Business Exit Planning (www.businessexitplanningbook.com) and a former president of the American Chamber of Commerce in Hungary.
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