Long haul ahead for Europe PDF Print E-mail
Wednesday, 25 January 2012 00:00
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McKinsey research shows no country has managed to deleverage without GDP growth and inflation

At a time when Europe’s leaders are putting the final touches to the austerity pact they agreed to last December, it’s useful to take another look at the data and the history of countries that have successfully deleveraged their huge levels of debt, whether in the government or the private sector. With debt levels as high as 507% of GDP in the UK, 363% in Spain and 314% in Italy, there’s no doubt countries need to deleverage. But why did the problem really get concentrated, at least to begin with, in what the Germans disparagingly call the ClubMed countries? McKinsey Global Institute has just come out with a new report on debt and deleveraging (http://shar.es/f0LYe) that is a takeoff from an in-depth analysis two years ago of the 32 instances of debt reduction after the Great Depression—this report takes lessons from the earlier report and examines the 10 largest mature economies to see where they stand in the debt reduction game.

At the outset, the progress of debt-reduction has been poor—while private-sector debt has fallen by 2%, or $1.5 trillion from the 2008 peak, government debt has risen by 26% or $7.8 trillion. Debt ratios have fallen in just three countries, the US, South Korea and Australia. As a proportion of GDP, debt ratios are up 39 percentage points (ppt) in Japan since 2008 to Q2 2011 and 35 ppt in France.

The composition of debt varies widely across countries. Of Japan’s debt of 512% of GDP, government debt is 226% of GDP; in the case of the US’s debt of 279% of GDP, government debt to GDP is only 80%; the UK has the world’s highest proportion of financial institutions’ debt (at 219% of GDP, that’s higher than Japan’s 120%, the next-highest); at 67% of GDP, Japan’s household debt is below the average for mature economies (the figure is 87% for the US). But, and this is important, the overall level of debt is just one of the parameters that causes a crisis—apart from Ireland (debt levels of 663% of GDP), McKinsey points out, none of the countries associated with the eurozone crisis have high levels of overall debt (Greece’s 267% of GDP debt is far lower than the UK’s 507%). This, of course, is the point FT’s Martin Wolf has been making so persuasively for so long (http://on.ft.com/tiZpHc) when he concluded “this, then, is a balance of payments crisis.” McKinsey doesn’t put it quite so bluntly as Wolf’s “if the most powerful country in the eurozone refuses to recognise the nature of the crisis, the eurozone has no chance of either remedying it or preventing a recurrence”, but it provides enough data to make this abundantly clear.

Given their very different initial conditions, it is but natural that each successful deleverager has done so differently, but there are some useful patterns—McKinsey selects Sweden and Finland’s debt-reduction in the 1990s as reference countries to judge how today’s deleveragers are doing. Having done that, there are some interesting points. One, in the initial phase, private sector debt levels fall while those of government rise; as the economy grows, this causes government debt proportions to also fall off. This is critical: without the growth, debt levels do not fall off.

Sweden’s ratio of government debt to GDP fell from 84% in 1996 to 45% by 2008—about 28 ppt of the 39 ppt fall was due to a rise in real GDP and the rest was due to the rise in inflation. In the case of Finland, faster real GDP growth accounted for more than two-thirds of the fall and inflation took care of the rest. That’s a humbling thought for Angela Merkel and her band of non-merry men to chew on.

Of the countries studied—the US, UK, Spain and Japan—the US is doing the best and US households probably have just another two years of deleveraging to do before they’re back to their pre-2000 levels (that’s the beauty of the US—the sharply compressed adjustment time thanks to its ability to really take it on the chin). By mid-2011, McKinsey points out, the ratio of US financial sector debt to GDP had fallen to below where it was in 2000 (the collapse of Lehman, JPMorgan Chase’s purchase of Bear Stearns and the BoA-ML merger all contributed to this).

The UK, by contrast, has not even begun deleveraging—as a proportion of GDP, debt rose from 487% of GDP at Lehman-time to 507% in Q2 2011. Financial sector debt can rise even more thanks to a $359 billion exposure to troubled eurozone countries, but the larger point is the higher degree of forbearance shown by banks—UK’s mortgage problems, in other words, are only going to get a lot more serious. Spain has much lower levels of debt, but the big lesson is the near-doubling of corporate debt between 2000 and 2008 has meant there is little headroom for private-sector led growth.

There are many lessons to be drawn and you can read the report for all of them, but the most important one to be drawn from Japan’s lost decades is that with not enough attention paid to fixing banks’ balance sheets and neither the public nor private sector making the necessary structural changes to enable growth, debt has continued to rise, meaning the day of reckoning is yet to come.


Last Updated ( Thursday, 26 January 2012 01:38 )

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