Global imbalances: Root cause of the debt supercycle
June 1, 2016
Throughout financial history, there have been periods when debt — including government, business, and consumer debt — would reach heights of proliferation and then recede. These debt cycles have been common. Even the concept of a debt supercycle, a period with more intense increases in private sector and government debt, has been identified and discussed since the 1960s.
We are in the midst of a debt supercycle, one that grew out of the ashes of the global financial crisis of 2008–2009 when debt was already extraordinarily high. This cycle is undoubtedly large, with worldwide debt by March 2016 reaching more than 300% of global gross domestic product (GDP), compared with 269% in 2007.* As managers of international sovereign bonds who analyze and think about these developments, we consider this debt cycle significant, and the size of the debt is certainly an important aspect. But what makes this supercycle different from its predecessors is one key factor: globalization.
Imbalances in the macroeconomic picture
Economies have become more globalized through the active trading of goods and services across increasing numbers of borders. The debt in this supercycle not only accumulated in a world economy of both developed and emerging market countries, but also against a backdrop of a more interconnected, global financial market. Underlying this globalization has been an expanding network of imbalances, or structural issues, in the macroeconomy.
These imbalances — a country or region with large fiscal deficits, excessive borrowing, financial institution balance sheet problems, and other issues — can look on the surface to be unique and self-contained. Yet sometimes, the problems that crop up in one country or region, even when they seem to be managed and dealt with, can appear to be contagious, and seemingly spread to other countries.
Think of the housing bubble in the United States that burst in 2007. Similar events with overbuilding and excessive borrowing repeated themselves in Ireland in 2010, and then in Spain in 2013. There are more contained situations. One example is Iceland, which plunged into a financial crisis in 2008 after the default of its three largest banks but had pulled itself free by 2011.
In general, however, globalization means that imbalances and structural issues in one place can have an impact on the whole. Over time, imbalances can drag down economic growth, build fiscal burdens that threaten to become overwhelming, or can misallocate human and financial capital.
The echoing effect of some imbalances
Particularly since the global financial crisis of 2008–2009, imbalances have cropped up in one spot after another, with government and financial leaders trying to address an individual situation, only to have another appear elsewhere. Probably the principal example of this can be found in the roots of the US subprime housing crisis.
That extreme event spilled over into a larger financial meltdown marked by the collapse of Lehman Brothers. These events were met with a variety of interventions from the government and policymakers, financial bailouts, the Dodd-Frank legislation, and the Federal Reserve’s quantitative easing programs.
Although the US was largely successful in addressing the issues of the financial crisis, the ink was barely dry on these efforts and initiatives when a series of debt crises emerged in Europe. Some occurred in rapid succession, some were very similar in nature, and other problems tended to reflect the issues of that particular country. While there have been numerous efforts to address them, some problems remain unresolved. A sampling of imbalance events include:
- Greece: The ongoing debt crisis in Greece has largely stemmed from its low retirement age and high pensions undermining its social welfare system, and from the government’s inability to handle them. The country is in the midst of its third bailout in five years. As part of the European Union (EU), Greece’s debt problems have affected the global financial system, but the EU is limited on political aspects.
- Ireland: In a roaring economy in the early 2000s, the Irish housing market surged with high prices and unchecked construction, only to have it crash amid a deep economic crisis. In this case, the debt crisis mainly grew out of the state guaranteeing the main Irish-based banks that had financed the property bubble. However, Ireland has made progress in dealing with the issues, and by 2013 was the first euro zone country to emerge from its bailout program.
- Italy: By 2011, as Greek debt crisis continued, the big fear in nearby countries such as Italy and Spain was contagion. This was fulfilled to a certain extent in Italy, not necessarily due to rampant government overspending, but because of its relatively weak economy and continuing structural unemployment. This in turn led to high borrowing costs and debt problems. Recently, Italy — as Spain and Portugal did in 2012 and 2014 — has turned to programs known as "bad banks." A bad bank is a corporate structure set up to handle legacy nonperforming loans (NPLs). By creating bad banks, bad loans can be separated from good assets in the rest of the banking system, thus helping to improve the economy.
Arguably, this collection of European debt problems has triggered additional layers of complexity to the debt supercycle imbalances. Part of this is due to the patchwork nature of similar symptoms developing at varying degrees. Another important factor is that these countries are tied together by the EU economically, but not politically.
Other imbalances: From systematically important, to isolated cases
Some countries have imbalances that may not necessarily lead to similar problems among their neighbors, but their economies are so systematically important to the global economy that the imbalances have an important impact. China, an economic powerhouse although still a developing market, certainly comes to mind. China has been working to overcome several imbalance issues, including overbuilding of real estate and infrastructure such as roads and airports, and too much leverage in their banking system.
Other imbalance examples are more isolated situations, caused by internal problems or unique sets of factors, such as the Icelandic debt crisis mentioned earlier. Iceland may have looked very similar to other European imbalances, but in the end it was self-contained. Nonetheless, isolated examples still contribute to the overall debt problem because of globalization and interdependencies.
Examples of more self-contained situations include:
- Latin America: Pockets of debt imbalances in this region, such as countries defaulting on their debt, have reoccurred with some regularity since the 1980s. In fact, some countries still have Brady bonds outstanding. Brady bonds, named after former US Treasury Secretary Nicholas Brady, are dollar-denominated bonds issued by governments of developing countries. They were, created for the Latin American region in 1989 as a way to convert bank loans into new bonds after a default. This area is an example of how debt problems can be contained within a region because of the similar failures of governments to address underlying issues.
- Japan: With its aging population and nearly nonexistent growth, Japan has struggled with a difficult debt situation for more than two decades. As a relatively closed financial system, Japan’s problems have not spread beyond its borders. However, a ripple effect may result from recent efforts to try to address them, such as the so-called Abenomics policies advocated by Prime Minister Shinzo Abe (his economic policies are based on three principles of fiscal stimulus, monetary easing, and structural reform), and the country’s shift to negative interest rates.
Different sequences of events, at different times, can still add up
While each country or region may have its own sets of problems or factors leading to the imbalances, collectively they all contribute to the debt supercycle. This table outlines some of the underlying issues and the complexity of the imbalances, either past or still ongoing. They can surface in diverse groupings of countries or regions, not necessarily at the same time or to the same degree.
Imbalances cropping up
|Bank balance sheet mismanagement/shadow banking1
||US (Lehman Brothers collapse), Spain, Iceland
|Central government fiscal deficit – government spending
|Central government fiscal deficit – social welfare mismanagement
|Commodity demand collapse
||Brazil, Russia, Mexico, Chile, Organization of the Petroleum Exporting Countries (OPEC) countries
|Excessive housing price appreciation
||China, Spain, Ireland
|Housing market overbuilding
|Banking issues, legacy NPLs
|Mortgage financing and derivatives
||US (subprime mortgage crisis)2, Spain
|Rising household debt
|State-owned entities, privatization or reform
||China, Brazil, Greece
|Structural low inflation
||France, Italy, Spain
1Shadow banking refers to non-bank financial intermediaries that provide services similar to commercial banks but are outside normal financial regulations. Examples are money market funds, investment banks, and mortgage companies.
2The subprime mortgage crisis in the US was a nationwide banking emergency that coincided with the economic recession of 2008–2009. It was triggered by a sharp decline in housing prices, leading to mortgage delinquencies and foreclosures.
Addressing the problem
With so many imbalances in various places and with a variety of causes, the responses have also varied in kind. Cases like the US subprime debt crisis, and the subsequent global financial crisis, necessitated coordinated policy responses. In the EU, even without the benefit of political connections, there have been efforts to coordinate solutions to the drawn-out European debt crisis, including bailout programs from the International Monetary Fund and other entities.
Attempts to address the issues have included:
- Fiscal response from governments, such as coordinating bailouts, tackling government spending, and the like — however, in countries such as Greece, this has proved to be a continuing thorny problem
- Response from financial markets, which tends to occur more organically — for example, unprecedented conditions can lead to repricing or changes in sovereign credit, interest rate, or corporate credit risk
- Monetary policy responses from central banks — from quantitative easing to more unconventional tactics such as negative interest rates, monetary policy responses have become a growing factor in attempting to steer economies and ultimately the debt cycle.
Navigating the debt supercycle
Since the global financial crisis, the increased globalization of economies and financial markets has made more coordinated policy responses, such as from the central banks, something of a necessity to head off major international events such as an economic depression or a financial market meltdown. But are these policy responses to the imbalances working? We think the reasonable answer is that some are, but others may take longer or may not be effective at all.
That leads us to another question: Where are we in the debt supercycle, and what does it mean for investors of fixed income instruments attempting to navigate this period? A further look at the supercycle, what steps are being taken to resolve it, as well as implications for investors in this market, will be part of the next installment.
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*Source: McKinsey Global Institute, The Wall Street Journal
The views expressed represent the Manager's assessment of the market environment as of May 2016, and should not be considered a recommendation to buy, hold, or sell any security, and should not be relied on as research or investment advice. Views are subject to change without notice and may not reflect the Manager's views.
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