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Global Connections
October 16, 2012
What Deleveraging?
Bottom line: Most understand that deleveraging is expected to remain a major headwind for the global
economy for some time to come, as it is an inevitable consequence of over-leverage that marked the
decade prior to the Great Recession in 2008. However, perhaps less well appreciated is the fact that the
deleveraging process has not even begun. For most developed countries, overall leverage has actually
risen since 2008. Modest deleveraging in the financial and household sectors has been more than offset
by a sharp increase in government leverage. Specifically, since 2008, for every percent of GDP worth of
deleveraging by the private sector, the public sector debt has risen by 2.5% of GDP. If we assume that
the equilibrium level of private sector leverage is the average during 1990-2007, then to offset the
additional private sector deleveraging that will need to take place, public sector debt may need to rise by
72% of GDP, i.e., from the current 108% to 180% of GDP. Further, EM economies have continued to
see their decade-old credit cycles extend, partly as a result of hot money fuelled by the QE operations
conducted by six of the G7 central banks. It does seem to us that the developed world has very much
followed Japan’s path in avoiding deleveraging at all costs. The long-term risks of this policy path
marked by Keynesian stimulus are as clear as their short-term benefits, including a temporary boost to
asset prices. It is difficult to be sure how much longer a QE3-fuelled asset rally could last, but we remain
worried about the destiny of the global economy.
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What economic history tells us about deleveraging cycles. Most are familiar with the work by
Carmen Reinhart and Ken Rogoff („This Time Is Different: Eight Centuries of Financial Folly’), which
emphasizes the protracted and painful nature of post-crisis adjustments. On average, it took countries
23 years to recover from a deleveraging cycle, and per capita GDP fell, on average, by about a quarter.
The IMF has also done great work drawing a distinction between recessions that were accompanied by
financial crises versus the more „garden variety‟ types of recessions, i.e., ones triggered by monetary
tightening. The results are similar: recessions accompanied by banking or financial crises tended to last
longer and be deeper at the trough. Most recently, M. Schularick and A. Taylor (in „Fact-Checking
Financial Recessions’) examined the same issue and made an interesting observation: ‘(We looked) at
14 advanced economies over the past 140 years and (show) that larger credit booms during expansions
have been systematically associated with more severe and prolonged slumps. In short, credit bites back.
Measured against the historical benchmark, the recent US recovery has been far better than could have
been expected.‟ This is an interesting way of looking at the US recovery since the Great Recession,
mainly because it is precisely the opposite of how the Fed assesses the recovery. To the Fed, the
recovery has been sub-par, compared with most of the recoveries post-WWII. The Fed seems to reject
the historical pattern that banking crises and deleveraging tend to lead to protracted recoveries, and it is
in a hurry to artificially induce a quick normalization of the economy.
Overall leverage in DM at an historical high. Contrary to the popular presumption, total debt leverage
– defined as household debt, financial sector leverage, corporate debt, and government debt – has
actually increased in most developed countries since the Great Recession in 2008.
By Stephen L. Jen,
Managing Partner at SLJ Macro
Partners
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Global Connections – October 16, 2012
Source: McKinsey Global Institute and SLJ Macro Partners
Please see the chart above (using data from McKinsey Global Institute), on the total debt of selected
DM economies, as a percent of GDP.
Between 2008Q2 and 2012Q1, total debt-to-GDP ratio had risen in Japan (+40% of GDP), the UK
(+34%), Spain (+45%), France (+39%), Italy (+32%), Canada (+33%), Australia (+5%) and Germany
(+16%). Total debt-to-GDP ratio has remained relatively flat in the US (-0.8%). In every country in our
sample, the overall – private plus public – leverage either increased or remained flat during this period.
Averaging across the sample (GDP-weighted), the total debt-to-GDP ratio for the DM countries rose
from 226% of GDP to 318% by 2008Q2. This number has risen further, to 344% of GDP since then.
The chart below slices up the data by sectors.1 From 1990 to 2008, there was a sharp surge in financial
and household leverage in the developed countries in the sample. Corporate debt was relatively stable
during this period. Government debt also trended steadily higher during this period. However, since
2008, there has been a meaningful reversal in the trend of financial and HH debt, which is more than
offset by a further increase in government debt.
Source: McKinsey Global Institute and SLJ Macro Partners
1
GDP-weighted across the countries in our sample.
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Global Connections – October 16, 2012
We have the following thoughts.
Thought 1. Keynesian stimulus and ‘Fiscal Cliff
’. The chart above should help investors
visualize the magnitude of the increase in the leverage of the public sector, relative to the de-leveraging
of the private sector. Modest deleveraging in the financial and the household sectors has been more
than offset by a sharp increase in government leverage. Specifically, since 2008, for every percent of
GDP worth of deleveraging by the private sector, the public sector debt has risen by 2.5% of GDP. If we
assume that the equilibrium level of private sector leverage is the average during 1990-2007, then to
offset the additional private sector deleveraging that will need to take place, public sector debt may need
to rise by 72% of GDP, i.e., from the current 108% to 180% of GDP. There are intense debates on
fiscal austerity in Europe and the US. At the IMF-WB Annual Meetings in Tokyo this week, the IMF MD
Lagarde and the German Finance Minister Schäuble have clashed on whether Europe should persevere
with fiscal austerity, in light of the downside surprises to output growth in some European countries. In
the US, the same debate will almost certainly intensify in the months ahead. First, fiscal stimulus should
be seen not only in the context of it being a temporary support for aggregate demand, but also as an
offsetting measure against de-leveraging. Public sector debt arguably is easier to finance than private
sector debt, in some situations and up to a point. Second, fiscal stimulus is arguably less efficient than
demand fuelled by private credit, if the ultimate goal is to stimulate demand. Economic growth in the
developed world is slower, despite the fact that overall leverage has risen at a faster pace since 2008,
and, it has taken 2.5 units of public debt to replace 1.0 unit of private debt. This suggests a deficit in the
efficiency of economic activities financed by the public sector, compared with the private sector. Third,
as a follow-on from the first point above, is what the threshold of market tolerance is for public debt. In
Japan, the markets continue to tolerate public debt that is more than 200% of GDP. Could the
developed countries in our sample tolerate 180% of GDP? Only time will tell. While „Fiscal cliff (FC) 1‟
may be avoided if there are political compromises in the US, there will be further rounds of „FC‟, with
„FC-infinity‟ being the ultimate cliff.
Thought 2. Following Japan’s footsteps. More than two decades following the bursting of their equity,
housing, and investment bubbles, Japan‟s total leverage is at the highest point in history: at close to 500
percent of GDP, up from around 360 percent of GDP in 1990. Every year in the past two decades,
demand stimulus has taken precedence over fiscal prudence. Public debt is now more than 200 percent
of GDP, and continues to rise. The worrying trend is that, it seems, most other developed countries in
the sample appear to be following Japan‟s footsteps. The UK‟s total debt, for example, has also reached
around 500 percent of GDP, having risen from around 210 percent in 1990. Thus, since 1990, the rise in
total leverage in the UK has been more dramatic in the UK than in Japan. Despite countries refuting the
obvious parallels between the current predicament and what Japan faced in the last two decades, the
fact is that much of the Developed West seems to be following Japan‟s policy footsteps by buying time
to avoid the consequences of private sector deleveraging. The experiences of Japan should offer
important lessons for the rest of the developed world, in our view.
Thought 3. Extended credit cycle in EM. QE enables credit expansions, and helps slow down the
speed of private sector deleveraging. There are a few important side-effects that we have pointed out
previously. One of them is that the Fed‟s QE operations indirectly help fuel the already over-extended
credit cycles in EM. The chart below shows how the private sector debt-to-GDP ratios had risen steadily
up to 2008, and the rise in this ratio has actually accelerated further since then. Not only is the credit
cycle in EM economies likely to be long-in-the-tooth, but the underlying quality of the cycle may have
deteriorated. Prior to 2008, capital had been „pulled‟ into EM due to the perceived superior fundamentals
of EM. However, post-2008, capital has been „pushed‟ out of DM into EM because six of the G7 central
banks have been conducting unconventional easing policies. Capital „pushed‟ into EM is, in our opinion,
of inferior quality than that „pulled‟ into EM, especially when much of DM is decelerating: „high-beta‟
economies, i.e., economies that are leveraged to the US and Europe, cannot also be financial safe
havens, in our opinion. We don‟t know how much longer QE operations will fuel the EM‟s credit cycles,
but we suspect many EM central banks are as worried as we are about this type of capital inflow and its
consequential impact on credit. China, for one, wants no part of this. Foreign capital inflows in the past
decade have been an important support for China‟s property prices. Since the PBOC‟s currency
interventions are not fully sterilized (roughly around half of the inflows in recent years were sterilized), 2
capital inflows have eased the monetary conditions in China and helped fuel its most prominent bubble.
It is difficult to be sure how much longer a QE3-fuelled asset rally could last, but we remain worried
about the destiny of the global economy.
2
Also, the sterilization costs of maintaining China‟s foreign reserves are very high, due to the negative carry of issuing domestic bonds to finance China‟s foreign bond holdings, which have low and falling yields.
We calculated that the implicit cost of carry for China to maintain its USD3.5 trillion worth of foreign reserves is in excess of USD100 billion a year.
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Global Connections – October 16, 2012
Source: Datastream and SLJ Macro Partners
Thought 4. The role of central banks. As pointed out by Reinhart and Rogoff, more than half of the
time during the decades after WWII, the Fed helped keep real interest rates negative in order to
gradually erode the real value of the large public debt the US had run up to finance WWII. In other
words, the US discharged its public debt more through out-sized nominal GDP growth than through
fiscal austerity or outright defaults. Similarly, financial repression, in the form of keeping the nominal and
real interest rates low, is generally-expected to be one of the main unspoken objectives of the Fed now,
to keep the real value of the US‟ public debt manageable. A challenge that central banks will face with
this strategy is, in contrast to the post-war period when much of the Developed West enjoyed a baby
boom, in the coming years, ageing will be the dominant demographic trend, which might not permit the
implicit transfer of wealth from the savers (retirees) to the debtors. The social tensions between the
young (who will need jobs) and the old (who will want to defend their savings) could escalate in the
period ahead.
Bottom line. We make the observation that total debt-to-GDP ratios in many major developed countries
have actually risen further since the Great Recession of 2008. Contrary to the popular presumption that
there has been broad-based deleveraging, the increase in public sector leverage has more than offset
the decline in private sector (households, banks, and industries) leverage. In other words, what we have
witnessed is a substitution of public debt for the de-leveraging that has taken place in the private sector.
It seems to us that many developed countries are following Japan‟s policy path. It is difficult to be sure
how much longer QE3-fuelled asset rally could last, but we remain worried about the destiny of the
global economy.
Stephen Jen is the managing partner at SLJ Macro Partners. Prior to establishing SLJ Macro Partners
in April 2011, Stephen was a Managing Director at BlueGold Capital (since May 2009), working as the
key risk-taker in currencies and as its macro strategist. Before BlueGold, Stephen was a Managing
Director at Morgan Stanley and, from October 1996 to April 2009, held various roles, including the
Global Head of Currency Research and the Chief Global Foreign Exchange and Emerging Markets
Strategist. Prior to Morgan Stanley, Stephen spent four years as an economist with the International
Monetary Fund (IMF) in Washington, D.C., covering economies in Eastern Europe and Asia. In addition,
Stephen was actively involved in the design of the IMF‟s framework for providing debt relief to highly
indebted countries. Stephen holds a PhD in Economics from the Massachusetts Institute of Technology,
with concentrations in International Economics and Monetary Economics. He also earned a BSc in
Electrical Engineering (summa cum laude) from the University of California at Irvine. Stephen was born
in Taipei, Taiwan, and now lives in London with his wife and two children.
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[email protected]
[email protected]
[email protected]
[email protected]
[email protected]
[email protected]
[email protected]
North America
Sales - North America
Adam Cherry - Head
Kahlil Adam, CFA
Flavia Stingelin, CFA
Carina Cassab Carreira
Europe, Middle East & Asia
Sales - Europe
Mark Fenton - Head
Aneli Gonzalez, CFA
Pedro Villa
Sales - Japan
Masafumi Nishimura
Sales - Hong Kong
Caio Galvão
Sales Trading - North America
Kevin Hard - Head
Eric Krall
Fernando Lasalvia
James Tallarico
Brad Marra
+813-3539-3856
[email protected]
+852-3657-2398
[email protected]
+1-212-710-6780
+1-212-710-6780
+1-212-710-6780
+1-212-710-6780
+1-212-710-6780
[email protected]
[email protected]
[email protected]
[email protected]
[email protected]
+55-11-3073-3657
+55-11-3073-3657
[email protected]
[email protected]
+55-11-3073-3310
+55-11-3073-3310
+55-11-3073-3310
+55-11-3073-3310
[email protected]
[email protected]
[email protected]
[email protected]
+55-11-3073-3340
+55-11-3073-3340
[email protected]
[email protected]
+55-11-3073-3211
+55-11-3073-3211
[email protected]
[email protected]
+55 11 3073-3110
+55-11-3073-3150
+55-11-3073-3145
+55-11-3073-3149
+55 11 3073-3297
[email protected]
[email protected]
[email protected]
[email protected]
[email protected]
Futures, Derivatives & Stock Lending
Carlos Maggioli - Head
+55-11-3073-3300
Futures Desk
Eduardo Barcellos - Head
Fabio Herdeiro
Alan Eira
Alexandre Rizzo
Celso Azem
José Dezene
Thierry Decoene
Hernan Livore
Bruno Giusti
Guilherme Michetti
+55-11-3073-3320
+55-11-3073-3320
+55-11-3073-3350
+55-11-3073-3350
+55-11-3073-3350
+55-11-3073-3350
+55-11-3073-3320
+55-11-3073-3320
+55-11-3073-3320
+55-11-3073-3320
[email protected] Commodities
Roberto Simonsen
Igor Petric
[email protected] Derivatives
[email protected] Fabiano V. Romano - Head
[email protected] Rafael Americo
[email protected] Marcio Caires
[email protected] Vinicius Alves de Pinho
[email protected] FX Spot
[email protected] Manoel Gimenez
[email protected] Haroldo Vasconcellos
[email protected] Stock Lending
[email protected] João Victor Caccese
Leandro Muniz
Private Banking Desk
Carlos Maggioli - Head
+55-11-3073-3300
[email protected]
Private Banking Sales - High
Felipe Beltrami - Head
Caio Felipe Zanardo Val
Marco Antônio Gomes
Natália Mônaco
+55 11 3073-3110
+55 11 3073-3292
+55 11 3073-3148
+55 11 3073-3297
[email protected]
[email protected]
[email protected]
[email protected]
Private Banking Sales - Ultra
Sergio Fonseca Rosa - Head
Edgard Claussen Vilela
Robinson Minetto
Frederico P. Bernardes
+55 11 3073-3110
+55 11 3073-3291
+55 11 3073-3290
+55 11 3073-3290
[email protected]
[email protected]
[email protected]
[email protected]
Private Banking Sales - Special
Marcelo Ferri - Head
Guilherme Rudge Simões
Patrick Kalim
Ricardo Guntovitch
Ricardo Julio Costa
Itaú Securities' Global Offices
SÃO PAULO
Itaú Corretora de Valores S.A
Av. Brigadeiro Faria Lima, 3400 - 10º Andar
São Paulo, SP, Brazil, 04538-132
NEW YORK
Itau BBA USA Securities Inc.
767 Fifth Avenue, 50th Floor
New York, NY 10153
LONDON
Itau BBA UK Securities Limited
The Broadgate Tower
20th Floor - 20 Primrose Street
London EC2A 2EW
HONG KONG
Itau Asia Securities Limited
TOKYO
Itau Asia Securities Limited Tokyo Branch
NBF Hibiya Bldg. 12F
1-1-7 Uchisaiwai-cho, Chiyoda-ku
Tokyo, 100-0011, Japan
DUBAI
Itau Middle East Limited
Al Fattan Currency House, Level 3
Dubai International Financial Centre (or DIFC)
PO Box 482 034
Regulated by the Securities and Futures Commission in Hong Kong
29/F, Two International Finance Centre
8 Finance Street - Central, Hong Kong
Itaú´s Complaints Officer (Ouvidoria Corporativa Itaú) may be contacted at 0800 570 0011 (calls from Brazil), on business days, from 9 a.m. to 6 p.m. (São Paulo, Brazil time) or P.O. BOX 67.600, Zip Code 03162-971.
The information herein is believed to be reliable but Itaú Corretora de Valores S.A. does not warrant its completeness or accuracy. Opinions and estimates constitute our judgment and are subject to change without notice. Banco Itaú S.A. may have a position from time to time. Past performance is not
indicative of future results.
This material is not intended as an offer or solicitation for purchase or sale of any financial instrument. This report is prepared by Itaú Corretora de Valores S.A. and distributed in the United States by Itau BBA USA Securities, Inc., and Itau BBA USA Securities, Inc. accepts responsibility for its contents
accordingly. Any US persons receiving this research and wishing to effect transactions in any security discussed herein should do so only with Itau BBA USA Securities, Inc. Analysts who are not CNPI only provide the team with technical support, not issuing personal opinions.