Posted in Finance Articles, Total Reads: 841
, Published on 05 February 2016
As the dust settled over the financial crisis of 2008, the world went through the deepest and longest global recession since the end of World War II. In such a scenario, it was widely expected that economies across the world would deleverage & limit their exposure against such an episode in the future. Much to our collective surprise, debt has shown a strong growth in almost all countries, both in relative and absolute terms. Needless to say, this creates risks for the whole economic system, not least for individual countries.
Rising debt is a multifaceted issue. As global debt has gone up by $57 trillion since 2007, it becomes more and more difficult for countries to start the much needed deleveraging. One good news is that the financial sector has deleveraged as a result of the regulatory changes such as the Dodd-Frank Act to promote financial stability after 2008. Shadow banking has retreated, but new, non-bank sources of credit are emerging as big players in generating new debt. Household debt has been giving mixed signals. While it has gone down in major crisis-hit countries like the US, the UK, Spain & Ireland, it continues to grow in many other countries. Finally, the Chinese dragon has been gobbling up more and more debt, fueled by a real estate boom as well an extensive shadow banking system. Government debt has gone up by a huge margin as a result of national governments bailing out institutions hit by the financial crisis.
Given this scale of debt, it is prudent to say that the present solutions & traditional approaches to control debt may fall well short of the objective. Add to it the fact that the phenomenon of deleveraging is itself rare & has only been seen in a few countries like Sweden & Finland (aided by the export boom) in the 1990’s. Today, many large economies are trying to deleverage in an atmosphere of limited growth and low inflation, which make it even more difficult.
Let’s take a look at the present global scenario with the help of the following points:
• The governments are leveraged to the hilt due to years of using fiscal stimulus to combat the recession. Government debt has risen by $19 trillion between 2007 & 2014.
• Household debt has been rising in most countries except those mentioned above. Given that mortgages are the chief component in household debt, there is a strong correlation between rising real estate prices & household debt in any country. This means that policy makers have to be cautious with regard to sustainable debt growth in cities with high real estate prices.
• Financial sector debt has declined in the USA and has stabilized in other advanced economies. Complex financial instruments like collateralized debt obligations, credit default swaps, repurchase agreements, etc. have declined globally, as have the assets of off-balance sheet special-purpose vehicles that existed to securitize mortgages.
• Non-bank credit has been growing rapidly. With bank loans remaining constrained in the present & near future, non bank lending is likely to increasingly fund new growth.
• China’s rapidly rising debt after 2007 had rung alarm bells, but it was widely believed that China would be able to sustain its blitzkrieg growth, at least till 2017. The events of the past year & slowdown in Chinese demand has put paid to the fairy tale. The presence of multiple municipal special-purpose vehicles raising debt for infrastructure projects further exacerbates the situation. Residential real estate prices in Shanghai are now only about 10% lower than Paris or New York, which is a troubling signal of ballooning household debt. High interest shadow loans availed by many borrowers in China place them at an increasing risk of default.
How to combat the situation:
The growing debt has become a many-headed hydra for the global financial system. Conventional measures can have only limited success against such a monster. To minimize the risk of another crisis, effectively managing debt is of paramount importance for most countries, especially those with already high levels of debt-to-GDP ratio. The following ideas warrant a discussion when we talk about combating debt:
• Innovations in mortgage contracts such as mortgages which incorporate shared responsibility, i.e., loan payments reduce if property value falls below a certain level can be incorporated. In this system, the lender can be compensated by paying a share of the capital gain. Another way is that the homeowners purchase insurance to cover mortgage instalments in case of unemployment or other such unforeseen circumstances. With proper regulatory frameworks, such steps can bring stability to the mortgage industry.
• When firms default on loans, it causes disruption across the entire supply chain. There is a need to make this process less disruptive to the market. In this direction, non-recourse loans, which allow creditors to seize only the collateral, are widely used in the US. This ensures a swift resolution of debt defaults & resumption of normal consumption for the market. Such loans, coupled with regulations limiting excessive borrowing, can facilitate a more efficient system.
• Considering the direct role of housing (real estate) bubbles & mortgage debts in financial crises, a case can be made for removal of tax-deductibility of the interest paid on housing loans. These sops benefit primarily the upper sections of the society, who avail larger mortgages to gain maximum tax benefits. This puts extra pressure on lenders. While this is difficult to do for corporate borrowers, policy makers could look into options that’d put debt & equity on comparable footing.
• Sovereign government debts have ballooned as a result of a sustained recession in the near past. Sovereign debt default is one of the most extreme situations that an economy can face. However, a broad range of options of debt restructuring are now available. For example, Greece just went for an EU-supported debt restructuring. In addition, focusing on net debt of a government (excluding debt owned by governmental agencies and central bank) can give a truer picture of the reality.
• Reporting & monitoring of debt related data is still patchy in many parts of the world. Governments as well as businesses can invest more on collection, analysis & monitoring of data regarding debt. Better microeconomic data gathering can be facilitated by investing in economic surveys. A central credit register can go a long way in collecting all data regarding commercial loans of a certain size. This can not only help the regulators, but also can be used to set policies.
• As a result of increasing regulatory pressures on banks, non-banking financial institutions can play an important role in supporting economic growth. NBFC’s & peer-to-peer lending have already begun to play an important role in Africa. With so many licenses being given to small finance banks by RBI, it is expected to play an increasing role in improving the availability of credit where traditional banking systems were not available till now.
• Financial systems in developing countries have been traditionally directed to the upper and parts of middle class of the society. The levels of sophistication of financial products has also been quite low. It is a known fact that developing countries need more credit to build infrastructure, set up businesses & cater to the housing needs of a population with growing disposable income. In this context, deepening of of the financial system is imperative in developing countries. This includes strengthening lending regulations, expanding financial disclosure rules, efficient insolvency laws, etc.
The above ideas are just some of the steps that can be taken to effectively manage rising debt levels across the world. These can help to mitigate the impacts of the bottoming out of short term debt cycle which happens every 8-10 years. It’s even more important due to the fact the global system has just started to recover from a deep recession. The US Federal Reserve has already started increasing interest rates, which will squeeze the money supply in the market.
To conclude, we have to say that the rate hike is just the easy part. The fact that even after the rate hike by ECB in 2011, inflation and growth failed to take off is a warning sign for the present situation. The Fed has promised 4 more rate hikes throughout this year. After ears of promises of hiking rates, it would be folly if they don’t follow through after declaring the hike. Such a move could send a bad signal to the market. On the other hand, given the market situations and the rising pressures from China, it is debatable if the market could absorb multiple rate hikes and still grow. The global market is dealing in dominos here & if even one of the dominos fall, it could mean financial chaos across global markets all over again.
This article has been authored by Shubham Chakraborty & Sidhant Mahipal from XLRI
1. Haver Analytics; national sources; World economic outlook, IMF; BIS; McKinsey Global Institute analysis
2. Robert J. Shiller et al., Continuous workout mortgages, NBER working paper number 17007, May 2011
3. Ibid. Atif Mian and Amir Sufi, House of debt, 2014
4. Anderson, Jonathan, Real economics vs. China economics (2014 version), Emerging Advisors Group, October 2014
5. Campbell, John Y., Stefano Giglio, and Parag Pathak, “Forced sales and house prices,” American Economic Review, volume 101, number 5, August 2011
6. Englund, Peter, “The Swedish banking crisis: Roots and consequences,” Oxford Review of Economic Policy, Volume 15, number 3, 1999
7. Holmstrom, Bengt, Understanding the role of debt in the financial system, Bank for International Settlements, BIS working paper number 479, January 2015
8. McKinsey Global Institute, Debt and deleveraging: The global credit bubble and its economic consequences, January 2010.
9. McKinsey Global Institute, Debt and (not much) deleveraging, February 2015
10. National Commission on the Causes of the Financial and Economic Crisis in the United States, The financial crisis: Inquiry report, January 2011
11. Shiller, Robert, The subprime solution: How today’s global financial crisis happened and what to do about it, Princeton University Press, 2008
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