Loaded With Debt

Call me old-fashioned

Being an old FART economist (that is old, Fat And Really Tired), I remember a time when weak currencies, low rates, high debts and fiscal and external deficits were considered a bad thing.

– A thing of the past, it seems. Wherever I turn these days, there are calls for lower rates, stronger liquidity, more public expenditures; higher deficits – More stimuli! And it’s not just from the MMT-crowd[1], but traditionally quite conservative economists and even central bankers are now calling for massive fiscal expansions and ever-expanding monetary policy measures. For two of the world’s most important economies, this is what the overall economic policy stance looks like (beginning with monetary policy):

Macrobond moment: These two charts could be used to both highlight: (1) an imbalanced economic policy mix, and; (2) a need for stronger international coordination of economic policy.

What the two charts above demonstrate is that while the Federal Reserve (FED), conducts a mildly restrictive monetary policy, the Trump-administration is firing away (and, from what we gather, even more is in the pipe). In the Euro Area, the situation is completely the reverse with a mildly restrictive (looking at primary balances) fiscal policy being counteracted by an interest rate gap we should see only every 50 years or so (sigma is currently below -3).

On balance, thus, we should be able to conclude that economic policy is fittingly supportive, but the policy mixes could (perhaps) be improved on. Outside of these economic mammoths, economic policy is by and large a reflection, and a high degree of economic stimuli is omni-present.

And I get it, I think. Lower rates are (at least on the margin) conducive to higher consumption and investments and, likewise, it is plausible that higher net public expenditures increase both private incomes and consumption.

But it also has other effects.

Yes, debt ratios are rising – in some cases, like China, quite dramatically. I find this especially interesting as China is still, by and large, importing the monetary policy stance from the US with the help of a semi-fixed exchange rate. It’s also somewhat confounding to see how overall debt ratios in the Euro Area and the US have been quite stable throughout the years following the global financial crisis (GFC), despite the quite dramatic waxing and waning of economic policy and the stark differences in the economic policy mix.

However, if we look only at non-financial corporates, i.e., if we exclude government debt, the patterns change, and both the US and Euro Area demonstrate a clear upward trend. For emerging markets in general and China in particular, the rise is considerably more pronounced.

By now, I’m guessing you’re expecting me to say this can’t continue. But I won’t. I am, nonetheless, profoundly unsure about how to really weigh these increases in indebtedness, especially considering that most analysts today feel we should do so much more, with whatever policy tools at our disposal.

However, and you can call me old-fashioned, what I do believe is that returns from whatever investments these debts belong to must earn decent returns, enough to cover both amortizations and (real) interest rates. For public investments (or deficits) finding the right measure of return is of course more difficult, but if we use recent GDP- and/or productivity growth as one performance measure, I think we can agree that it is not very impressive (albeit sufficient to continue the financial repression we have embarked on post-GFC).

Note: When studying the chart above, remember there is of course also a cyclical aspect of RoEs. Unfortunately, I couldn’t find any comparable data in the Macrobond base-package, so I’m using data from one of our add-on databases.

For the corporate sector, it is somewhat easier to find a more adequate performance measure. Since 2010, the corporate debt ratio has risen by around ten percentage points (p.p.) in both the US and the Euro Area (~developed markets), but without a considerably higher return to show for it. To the contrary, RoEs are considerably lower post-crisis than pre-crisis, which (at least) implies a corporate sector becoming more sensitive to economic/financial disturbances (what happens if/when economic policy turns neutral, or we experience a new severe crisis?).

In Emerging Markets (~China), the corporate debt ratio has risen far more than 20 p.p. since the GFC and RoE has simultaneously been on a slippery slope. In fact, despite having a higher debt ratio (and inherently having more volatile cash flows) than developed markets, emerging markets have failed to produce a higher RoE than DMs any time since 2013, which is definitely not a sustainable situation. – We can either look forward to a stark profitability improvement in emerging markets or fear an unwelcome realignment of debt levels.

Can’t inflation take care of it, you wonder? – To some extent, I’m sure it can. But unfortunately, believing they were on a new growth trajectory, many EMEs (not least China) opted to increase FX-denominated (mainly USD) debt by about 4 trillion USD, which is around ¼ of the total increase in non-financial corporate debt.

Macrobond moment: Today, I have used a lot of BIS-data, and it really is a treasure trove for detailed, yet harmonized cross-country financial data.

Thus, while it is close to impossible to decide – ex ante – if debts are too high, I firmly believe that public as well as private investments need to yield sufficiently to at least cover for amortization and (real) interest rate costs. With fast-growing EMEs posting even faster debt growth and rapidly falling returns, I must admit to feeling a tad worried.

What’s more, considering renewed calls in developed countries for fiscal policy to step in where private demand has failed, the apparent failure of investments to catapult growth and earnings even in EMEs makes me wonder if us developed nations will really be so much more successful. How an expensive bet will be we willing to make?

[1] Speaking of which: Can someone please point me to a paper on the “MMT-model”, I want to understand the assumptions and logics in a single, coherent, framework.

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