Too much debt and too little financial discipline
Asia’s finance experts see both as harbingers of the next financial crisis
THE world is flushed with debt – right now nearly US$250 trillion, up 8% from a year ago. This level, according to the Institute of International Finance (IIF), is three times what it was two decades ago and relative to GDP, global debt exceeded 318%.
The biggest borrowers are the United States (125% of GDP), China (295%), eurozone (around 100%) and Japan (237%) – which together account for 67% of the world’s total household debt, 75% of corporate debt and nearly 80% of government debt.
Malaysia’s total debt ratio is 241%. The continuing rise in the level of debt – against a backdrop of tightening financial conditions, is a cause for concern. The shifts in government and financial sector debt since 2008 are consistent with quantitative easing (QE), where central banks buy back bonds held by banks and the market.
One standout change in recent times has been China, where its share of global debt rose from 4% in 2007 to 15% by 2016. These levels have significant implications for financial market stability and raises the risk of a crisis.
Here’s the problem – it’s difficult to say what level is too high (red line). In practice, scholars feel that debt to GDP ratio is not a really useful way to define the practical limit especially of state borrowing. After all, growing debt correlates with growing economies.
Debt can spark growth, but excessive debt can be a drag on economies. Savings, too, matter. So, does banks’ global net assets. Also, large debt loads can signal trouble if borrowers can’t service them. Indeed, since the 2007/08 financial crisis, borrowing has increased substantially, especially corporate debt in China, forex-denominated borrowing in emerging market economies (EMEs), and newly popular forms of debt among US households and millennials.
What’s worrisome is that global debt is about to be stressed: major central banks, which kept money cheap, are changing course. As the surge in growth fades, rising interest rates and the removal of stimulus measures are tightening financial conditions giving rise to increasing signs of strain in credit markets – early warning signals of a looming debt crisis. The danger comes from the unmanageability of rising accumulations of private and public debt.
Of late, IMF, OECD and BIS (Bank for International Settlement) have expressed real concern on the continued impact of rising aggregate debt levels. The Frankfurt meeting in October 2016 of Asean+3 and European Central Bank (ECB) focused particular attention on corporate debt and the need to be “watchful of corporate leverage in the region”.
After all, debt triggered the 2008 global financial crisis. Indeed, today, the room to respond to a similar event is more restricted from both a monetary and fiscal policy perspective. Further, the evolution of fiscal positions and rising government debt levels in EMEs are also driven by the decline in commodity prices, natural disasters and internal conflict. Let’s not forget that rising debt levels are reflected in global banks’ balance sheets. BIS data on the net international asset and liability positions of the banking sector indicates increasing systemic fragility, pointing to evidence of refinancing risks, in addition to existing foreign exchange and interest rate risks that had emerged prior to the Global Financial Crisis (GFC). While foreign exchange position and interest rate gaps can be hedged using derivatives (such as cross-currency or interest rate swaps), refinancing may become problematic were interest rates to rise suddenly, or if financial markets were subject to external shocks. Any flight to quality will see corporate credit spreads increase; that in turn will put pressure on corporate profitability as well as access to financing.
Drivers of rising debt include the lingering fiscal response to GFC. Corporations and household’s response to the low global interest rate environment has led to asset bubbles, encouraged share buybacks and promoted buoyant consumer spending. One concern is the propensity for some EMEs to finance domestic debt in offshore markets, leading to undue sensitivity to offshore market volatility and domestic currency depreciation. Collectively, these factors increase financial vulnerability leading to possible debt default, bursting of asset bubbles, and contagion, possibly to Asia.
Apart from rising debt, contagion could also arise due to other factors, including rising interest rates by the Fed, trade wars, rise in inflation, or a eurozone crisis linked to Italy. Many countries in Asia implemented measures to reduce vulnerability after GFC. For example, South Korea & some others introduced strict loan to value rules and household income requirements on mortgages, and strengthened prudential regulations on commercial banks. Still, concern remains in that these measures may not be enough should some of the global vulnerabilities start to play out.
ASFRC
The 33rd session of ASFRC (Asian Shadow Financial Regulatory Committee) on “Rising Debt and the Risk of a Financial Crisis in Asia” was hosted by the Jeffrey Cheah Institute on South-East Asia, Sunway University from Jan 19-21, 2019. ASFRC is a group of experts on financial markets and related policy issues in the Asia-Pacific region. They act: independently of the members’ affiliated institutions; meet twice a year to make policy recommendations on issues of topical interest in financial markets; and apply academic research findings to its policy recommendations. ASFRC is part of the global family of 6 Committees in the United States, Europe, Latin America, Australia and New Zealand and Japan. ASFRC was founded in 2004 and today comprises 24 members (I am a founder member) from 15 Asian nations.
To preserve financial stability and reduce the likelihood of a crisis in the near future, ASFRC suggested 5 improvements in Asia’s financial systems:
1. Macro-prudential policies, which were implemented after GFC, have been strengthened in some Asian countries; but these need to be strengthened further. However, the limitations and shortcomings of these policies also need to be better understood. For example, restrictions on real-estate lending ignore the source of bank financing, which may largely originate from non-core deposits and external wholesale funding markets over which central banks have little control. Such funding sources are subject to the whims of investor risk appetites.
2. Bank regulators in Asia should look more closely at increasing bank capital adequacy requirements beyond Basel III levels, as is currently being done in countries such as Switzerland and New Zealand.
3. Crisis management and resolution procedures within Asia should be enhanced and preferably delegated to the Asean+3 Macroeconomic Research Office (Amro). Amro needs to continue developing its own independent capability to conduct effective regional macroeconomic surveillance so that it can better serve as the regional institution responsible for dealing adequately with a crisis. Regional surveillance through Amro should be strengthened.
4. Financial market participants need to better understand region-wide risk and to do so requires greater data definition, collection and sharing than currently.
5. Looking forward, initiatives to reduce dependence on the US dollar and promote regional financial market integration should be more actively pursued, including the use of local currency or a currency basket for the issuance of corporate bonds.
Lessons
Scholars in the United States and IMF have gathered clear empirical evidence pointing to credit growth as a powerful predictor of financial crisis. This evidence worries many today. Like Malaysia, ECB has called on eurozone governments to pay and pare down their debts. China, whose credit boom is one of the largest and longest in history is worried too. Among the majors, the Chinese, Japanese and eurozone economies have slackened significantly (Chinese GDP rose 6.6% in 2018, the slowest in 28 years). A crisis of some sort is likely, given that salient characteristics of a system liable to a crisis are already present – massive debt, high leverage, maturity mismatches, credit growth and opacity.
Authorities in China have sounded the alarm that “grey rhino” risks could threaten the economy and started to curb the debt surge by slowing down economic growth. China, fearing the risk of a crisis, has acted to prevent a more severe downturn later. Such concerns also play out in EMEs whose bond markets have grown tremendously over the past decade. Because of high & rising debt, currencies & bonds in EMEs such as Argentina, Turkey, Brazil and South Africa, have been dropped by investors who worry about their vulnerability to high inflations and large balance of payments & budget deficits.
IIF had estimated EMEs non-financial corporate debt to be 95% of GDP, against 90% in the advanced economies. However, the US is more sanguine. As the world’s most powerful nation with US$ as the reserve currency, its debt (Treasuries) is highly demanded as “safe haven” as well as “money” – regarded in Wall Street as an asset to hold, and among monetarists who regard the debt/GDP ratio as irrelevant since debt simply creates money. Highly indebted US corporates are of greater concern to investors. US businesses borrowed heavily to take advantage of ultralow rates driving corporate debt close to 50% of GDP. Rising debt relative to earnings has also downgraded rising volumes of US corporate bonds to junk. The same is happening in China. This trend can readily destabilise. While US household debt has started to fall since the crisis, such debt has grown rapidly in EMEs because of the rising middle-class, especially in China and India. Malaysia’s household debt ratio is already close to 85%. Investors worry that debt is now being curtailed in ways that hurt the economy. Banks are known to have retreated from cross-border and mortgage lending, making global finance less risky; but deals yet another blow on world trade and real estate development.
Of course, no one knows for certain when the next recession will come. Still, there is a clear and present danger. Many signs have emerged – the rising massive global debt is one of them. US equity markets are currently pricing-in a 60%-70% chance of a US recession within 12-18 months. High grade credit, frothy asset prices and falling Treasuries’ yields point to similar odds. What’s most worrisome is that ten years after the last crisis, valuable lessons from high debt & excessive leverage have not been learnt; instead, global debt ratio has since then been up 40 percentage points.
Today’s trajectory of geopolitics and finance look grim. Indeed, it’s beset with conditions, including unpredictable US politics, suggesting that the next global recession and financial crisis is already brewing. In the event such a crisis does occur, scholars lament that the tools available to policymakers will be constrained. Fiscal policy is hampered by higher public debt, but returning to unconventional monetary policies may be thwarted by the bloated balance sheets of central banks.
Bailouts will be run up against the inequality driven populist mood and less solvent sovereigns. Unlike a decade ago, once the next economic and financial downturn occurs, the policy tools available to reverse it will probably be less effective. That’s really worrisome.
What then are we to do
Heterodox schools of economic thought have long questioned the view that government spending must be paid for by taxes (or offsetting spending cuts). Orthodox thinking, however, have been more cautious. “Government spending must be paid for now or later” (Harvard Prof Barro; again: “a cut in today’s taxes must be matched by a corresponding increase in the present value of future taxes”).
However, today, government borrowing looks less scary than it used to. Fear of “crowding out” (i.e. government bonds lure capital that would otherwise finance more productive private projects) has given way to government borrowing “crowding in” new private investment. Public infrastructure spending might raise returns to private investment, generating more of it – that’s what’s really needed. Still, governments cannot borrow without limit. Whether or not creditors mind, governments can only throw so much cash at its citizens (we are not talking about corruption), before they exceed the nation’s productive capacity and pushes up prices bringing about runaway inflation.
We have in Malaysia today, a prime minister with an overdeveloped fear of public debt (nurtured in part by economists – certainly not by politicians!) so much so he recently set up a committee to reduce the government’s “RM1 trillion” debt (and liabilities) to a manageable level within 18 months.
Basis: research has shown that periods in which government debt exceeded 90% of GDP are associated with sustained slowdowns in economic growth. In a pinch, governments do have tools to manage unwieldy debt burdens. But this requires a strong political will to really do it?
Former banker, Harvard-educated economist and British Chartered Scientist, Tan Sri Lin See-Yan is the author of The Global Economy in Turbulent Times (Wiley, 2015) and Turbulence in Trying Times (Pearson, 2017). Feedback is most welcome.