Download Resilience Preparing for the payback

Resilience
Reprinted from Resilience: A journal of strategy and risk
Preparing for
the payback
By Craig Scalise
www.pwc.com/resilience
Preparing for the payback By Craig Scalise
Could the intense focus on Europe’s sovereign debt crisis be obscuring a
bigger question: Are we entering an era of global debt unwinding? In this
third article in our Eurozone series, the collective government, corporate
and household drive to back the surfeit of debt could create highly
disruptive challenges for many businesses worldwide in areas ranging
from higher taxes and dips in demand to inflation, devaluation and asset
price instability. Companies should think about how to curtail the
upheaval and adapt their businesses to a thriftier era.
Around the world, developed
economies have amassed government
debts rivalling levels not seen since
the end of World War II.1 These debts
could cause a drag on the countries’
growth that lasts for decades,
potentially cutting nearly a quarter of
their economies.2 The public sector
isn’t alone. Corporate and household
debts, combined with government
debt, have nearly doubled as a
proportion of GDP since 1980, rising
to over 300% for developed
economies.3 High debt across
multiple sectors can increase risks to
growth and financial stability.4
As the payoff gathers pace, debt
unwinding could have severe and
unpredictable impacts on the global
economy, reshaping the business
environment for years to come. In
this article, we look at how
companies can develop a proactive
and effective response.
Trigger to unwind
Debt itself isn’t necessarily a problem.
At sustainable levels, debt can
strengthen an economy by providing
more freedom for people to consume,
opportunities for businesses to invest
and means for governments to
provide services and manage crises.
But when it gets out of hand it
becomes a problem. Recent analyses
suggest government, corporate or
household debt levels above 90% of
GDP are excessive—debts over this
level can reduce growth—while debt
levels above 60% are in the danger
zone.5 Using these benchmarks,
Figure 1 highlights how G10
countries as a whole have excessive
government and corporate debts. In
contrast, emerging market debt
seems generally under control for
now.
1- Carmen Reinhart and Kenneth Rogoff, ‘Too Much Debt Means the Economy Can’t Grow’, bloomberg.com, July 14, 2011.
2- Carmen Reinhart, Vincent Reinhart and Kenneth Rogoff, ‘Debt Overhangs: Past and Present’, National Bureau of Economic Research, Working Paper
18015,April 2012, p. 21.
3- Stephen Cecchetti, M S Mohanty and Fabrizio Zampolli, ‘The real effects of debt’, Bank for International Settlements Working Paper, No. 352, September
2011, p. 5.
4- Global Financial Stability Report—’The Quest for Lasting Stability’, International Monetary Fund, April 2012, p. 4.
5- T he Bank for International Settlements determined that economic growth declines when government debt is above 85% of GDP, corporate debt is above
90%, or household debt is above 85%. The analysis states that healthy debt levels, which provide buffers, are well below these limits (Cecchetti, Mohanty
and Zampolli, p. 1). An appropriate buffer can be estimated by the 1997 Growth and Stability Pact, which European Union member states negotiated to set
the government debt ceiling at 60% of GDP. Based on this, for illustrative purposes considering each form of debt, 60% of GDP is selected as the threshold
for entering the debt danger zone, and 90% is selected as the threshold for excessive debt.
14 I Resilience: Winning with risk Figure 1: Advanced economies: Troubling debt across sectors
Debt % of GDP (2011)
1. Reducing debt
120
100
Excessive
80
Danger zone
60
40
20
0
Options for reducing corporate
debt are often quite narrow and
vary by country. In many cases,
businesses can consider buying
back debt if they’re liquid enough
or exchanging debt for equity if
dilution is tolerable. Defaulting on
corporate debt through
bankruptcy or writedowns may be
an option in extreme
circumstances.
2.Strategy
Government*
Corporate**
Household***
Business leaders should identify
possible scenarios and prepare
contingency plans. The scenarios
should be used to ensure strategy
is effective under long-term slow
growth and volatility. Strategy
also needs to be able to withstand
the implications of knock-on or
even unintended consequences
such as high inflation, competitive
devaluations or trade wars. It
should account for how
government budget cuts impact a
business directly or through
customers that sell to
governments. All the while, it is
important to consider how
competitors might respond.
Examples could include a rush to
invest in and hence overcrowding
in faster-growing emerging
markets.
This is likely to lead to a fluid
strategy that’s different from the
past. Leadership should try to
instill a culture that supports
innovation and flexibility.
G10
Emerging markets
* Gross general government debt (SNA 2008 S13)
** Non-financial corporate debt (SNA 2008 S11)
*** Households and non-profit institutions serving households (SNA 2008 S14 + S15)
Source: Oxford Economics
Tightening the knot
Countries have worked their way
through high debts before. However,
today’s economic environment and
the widespread debts do not leave a
clear path forward.
Solutions to high debt usually begin
with growth—bolstering incomes
and tax bases to grow faster than the
debts. But developed countries are
stuck in slow growth. Indeed, studies
are showing that debts at their
current levels may be part of what’s
holding down the growth.6 So
pressure to act is mounting. These
debts leave little room to absorb
shocks in an increasingly volatile
world. Electorates are concerned
about future generations’ debt
burdens. Businesses are concerned
about drags on growth.
Countries across the world—and
sectors within the countries—will
likely be compelled to face debt
unwinding soon even if it means
making tough choices.
Taking action
Guiding the business through debt
unwinding begins with accepting less
control over circumstances, while
preparing to adapt to the
consequences. Key considerations
include how to pay down debts where
required. Businesses may also need
to rethink corporate strategy,
finances and operations to deal with
the impact on investment
and demand.
6- Carmen Reinhart, Vincent Reinhart and Kenneth Rogoff, p. 21. and Cecchetti, Mohanty and Zampolli, p. 1.
Resilience: Winning with risk I 15 3.Finance
Finance is at the heart of debt
unwinding exposure. Are there
assets concentrated in currencies
at risk of devaluation or hedging
techniques that would fail in high
volatility? Shocks like inflation
spikes need to be modelled in
detail to identify knock-on effects
that could disintegrate profits. Tax
increases around the world should
be considered. Portfolio
composition also needs to be
reviewed—by 2016, one-sixth of
once-safe sovereign debt is
expected to no longer be
considered safe.7
Figure 2: High debt rampant in leading advanced economies
Debt % of GDP (2011)
240
200
160
120
Excessive debt
80
Danger zone
40
0
Government*
4.Operations
Companies need to determine
which circumstances put their
income most at risk, and how they
can make up the revenue. What
resources should be moved to be
most productive in the face of
slow growth? Procurement can
assess solutions to currency
fluctuations that mismatch costs
and revenues. Even administrative
functions may need to prepare.
Some companies have found that
IT needs significant planning to
support payroll processes if the
Eurozone crisis causes currency
changes.
Once a business has taken stock of
possible debt unwinding scenarios
and their exposure to
consequences, it can form
contingency plans and test them
for workability.
Household***
Japan
France
Canada
Spain
Italy
US
UK
Germany
* Gross general government debt (SNA 2008 S13)
** Non-financial corporate debt (SNA 2008 S11)
*** Households and non-profit institutions serving households (SNA 2008 S14 + S15)
Source: Oxford Economics
How the debt may unwind
One of the most important areas of
the scenario planning outlined in the
strategy implications earlier is how a
particular government moves to
unwind debt. This is a controversial
area in which the approaches
advocated by different countries and
the politicians within them vary
significantly. Indeed, there may be
many changes of tack through the
unwinding, heightening the potential
for instability and disruption.
The question at the heart of these
policy deliberations is how to balance
growth and debt reduction. Any path
they choose will come with tradeoffs, uncertainty and risks.
7- Global Financial Stability Report—The Quest for Lasting Stability, p. xi.
16 I Resilience: Winning with risk Corporate**
Governments may reduce debt
aggressively if it’s primarily
structural. They’re likely to attack it
directly by raising taxes, lowering
spending or both. Japan has already
started down this route by doubling
its sales tax to 10%. European
countries are taking extraordinary
steps to reduce spending, and
austerity is on the table for many
developed countries with little
tolerance for tax increases.
Other common tactics for slashing
debt may be of limited use. Some
inflation could ease debt burdens, but
most countries will not accept
inflation high enough to put much of
a dent in their debt. Inflation is a
particularly weak prospect for
countries saddled with foreign debt,
relying on exports or holding
short-term debt that would require a
bigger inflation spike.8 There’s also
little room to reduce debts through
currency devaluation with so many
countries in similar positions.
With these options limited, debtfocused governments are likely to
look at less conventional measures.
Outright default or renegotiation is
unlikely among developed countries
that prize their reputations and credit
ratings. Incremental measures are
more likely. Countries with large
public sectors may privatise state
enterprises. Another candidate is
closing tax loopholes and clamping
down on evasion; the UK has been
taking effective measures to reduce
evasion, but findings show that the
2009–10 cost of fraud to the
government was still GBP 20 billion.9
Debt-focused governments face the
risk that their tactics as a whole will
dampen growth, possibly even to the
point of recession. The tactics can
also increase volatility if
policymakers do not fully grasp the
consequences of unprecedented debt
unwinding.
may hold tax rates and spending
steady while increasing liquidity and
focusing on competitiveness. A risk
with this approach is that it may
increase inflation while missing both
targets—failing to jumpstart the
economies while letting the debt
burdens grow.
In contrast, governments that believe
their debt is largely cyclical may try
to accelerate growth now through
lowered taxes and/or increased
spending so they can address higher
debt later. Lowering interest rates
may also be an option, but alreadylow rates may call for unconventional
measures that are not as vetted,
including quantitative easing, and
increase risks like inflation.
Governments can also look to
measures that bolster
competitiveness, like easing labour
laws and supporting innovation. A
risk is that this focus may be selfdefeating if higher debts weaken
growth, either directly or by eroding
confidence in the economy. This
scenario could leave little to show
other than inflation and yet higher
debts.
Prolonged challenge
These scenarios foreshadow an era of
debt unwinding that would challenge
the business environment for years to
come. In past episodes, which tended
to be less complicated, countries
experienced weak growth while
unwinding household debt for up to
10 years10 or government debt for
more than 20 years.11 Other countries
that trade with the deleveraging
economies could feel the effects.12
Businesses need to take stock of their
exposures and be prepared to
respond to the consequences of
prolonged debt unwinding.
A third option for governments is to
split their attention between the two
targets, but they’d have a limited
arsenal for doing so. These countries
Craig Scalise is a Senior Macroeconomic Research Fellow in PwC’s Thought
Leadership Institute. Previously, Scalise was a director in PwC’s client
services and performed economic analysis for multinational companies.
Scalise earned an MBA in finance and organisational quality and a PhD
in business economics from the University of Chicago. He has authored a
book published by the Singapore University Press that analyses intellectual
property policy, and the ‘Entrepreneurial Energy—Its Creation and Capture’
series published by Problems and Perspectives in Management. Scalise has
also taught at the University of South Carolina.
89101112-
Carmen M. Reinhart and Kenneth S. Rogoff, This Time is Different—Eight Centuries of Financial Folly, Princeton University Press, 2009, p. 111.
National Fraud Authority, Annual Fraud Indicator, March 2012, p. 11.
Global Financial Stability Report - The Quest for Lasting Stability, p.13.
Carmen Reinhart, Vincent Reinhart and Kenneth Rogoff, p. 20.
China, for example, is exposed to indebted economies through its exports, 44% of which went to the European Union, US and Japan in 2011 (National
Bureau of Statistics of China, Statistical Communiqué on the 2011 National Economic and Social Development, February 22, 2012).
Resilience: Winning with risk I 17 Resilience
Reprinted from Resilience: A journal of strategy and risk
Publishers
Dennis Chesley
Global Risk Consulting Leader
PwC US
Miles Everson
US Advisory Financial Services Leader
PwC US
Executive Editors
Robert G. Eccles
Professor of Management Practice
Harvard Business School
Christopher Michaelson
Director, Strategy and Risk Institute, PwC Global Advisory
Associate Professor, University of St. Thomas Opus College of Business
Managing Editor
Rania Adwan
+1 (646) 471 5116
[email protected]
PwC US
Production Editor
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+1 (646) 471 1102
[email protected]
PwC US
Juan Pujadas
Vice Chairman, Global Advisory Services
PricewaterhouseCoopers International Ltd.
[email protected]
+1 646 471 4000
Author
Craig Scalise
PwC US
[email protected]
+1 (312) 298 2270
Special thanks to the following parties for their production and editorial assistance:
John Ashworth, Chris Barbee, Lisa Cockette, Ashley Hislop, Angela Lang, Sarah McQuaid, Roxana Opris,
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