The policy options open to major economies, including China, to reduce debt, before another global crisis hits
Pedestrians crossing in Tokyo. Quantitative easing stopped a debt implosion, but its initial success enabled politicians to avoid structural reforms, The result was slower growth from declining productivity, even as companies and governments continued to borrow. In short, we are in a debt trap!
ALL of us are worried about growing global debt as a precursor to another round of crises. After the last global financial crisis, 2007-2009, global debt rose to more than US$200 trillion or US$27,000 for each person in the world.
Since 2.8 billion or nearly 40% live on US$2 per day, there is no way that the debt can ever be repaid. The bulk of debt owed by governments, banks and companies will be repaid by creating more debt.
If we are happy to create money, we should be happy to create more debt. Right?
Wrong. The right question is not the size of the debt or liability, but where is the net asset? Individually, we can always repay the debt if we spend less than what we earn, or invested in an asset that generates sufficient income to pay the interest.
Collectively, the government can always borrow to repay, because it can always tax to repay, if not principal, at least on the interest. Countries only get into trouble when they owe foreigners and cannot raise enough foreign exchange to repay their debt.
Charles Goodhart, Emeritus Professor at London School of Economics and one of the foremost thinkers on money and banking has written a series of important articles for Morgan Stanley, analysing the current debt crisis.
The reason we ended up with more debt than ever is due to three factors since 1970 – the willingness of the financial sector to lend, the increase in global savings relative to investment and the demand for safe assets. Professor Goodhart attributed the structural increase in savings to favourable demographics in the last forty years – particularly as emerging markets like China increased their savings from growth in their labour force that engaged in international trade.
The increase in savings relative to investments created a global savings glut, which meant lower real interest rates.
The willingness of emerging markets to park their excess savings in advanced countries in the form of official reserves and the banks willing to extend credit at lower interest rates created the boom in financialisation. Lower interest rates encouraged speculative activity (funded by debt) rather than investments in long-term productive projects.
When the bust occurred, the advanced central banks wanted to avoid a debt implosion and added to the bubble by lowering interest rates and flooded the markets with short-term liquidity.
The quantitative easing (QE) stopped the widening of the crisis, but its initial success enabled politicians to avoid taking tough action in structural reforms. The result was further slower growth from declining productivity, even as companies and governments continued to borrow, affordable only at near zero interest rates. In short, we are in a debt trap – more debt, little growth.
Central banks charged with reviving growth using only monetary policy are now actively using negative interest rates and desperate enough to think about helicopter money.
Negative interest rates as a policy tool was invented by small countries like Sweden and Switzerland to discourage large capital inflows that created excessive currency appreciation.
But for the eurozone and Japan to try that would actually destroy their banks’ profitability, which is why bank shares dropped after these were introduced. If banks think they will lose money, they will cut back lending to the real sector further, negating the objective of QE to stimulate growth. Banks receiving QE funds faced the double prospect of being punished for taking credit risks and also the need to increase both capital and liquidity due to the tighter bank regulations.
Helicopter money is not about central bankers jumping out of helicopters to atone for their mistakes, but about central bank financing a massive increase in fiscal expenditure – truly monetary creation on a large scale. If this happens, watch out for a rise in gold prices.
Prof Goodhart has carefully analysed the three options for deleverging or getting out of the debt trap. The first is to deleverge by swapping debt for equity, being tried by China.
This is feasible when the country is a net lender and both borrowers and lenders are state-owned entities. The second option is to use inflation to reduce the real value of debt. As the recent experience showed, getting inflation even up to target was tough to achieve.
The third option is to address collateral by inducing lenders and borrowers to renegotiate their debt or make the debt permanent. This is both painful and difficult and is unlikely to be adopted unless other options are tried.
In my view, the true result of the Bank of Japan’s negative interest rates is a tax on the older generation, because they are the ones not spending.
Japan tried Keynesian fiscal spending, which failed to sustain growth but created a huge debt overhang.
The Japanese older generation and the corporate sector keeps on saving because they are worried about the future, not surprising given an aging population and sluggish demand for exports.
So if you can’t increase the inflation tax, or corporate taxation to reduce the fiscal debt, use negative interest rates to reduce the value of savings of retirees and the corporate sector. Only Japanese savers would not revolt under such inequity.
For countries that have net savings and large public assets, like China, there is a fourth option to get out of the debt trap, and that is to re-write the national balance sheet. Most foreign analysts who worry about China’s debt overhang forget that after three decades of growth, the Chinese state has also accummulated net assets (net of all liabilities) equivalent to 166% of GDP.
That can be injected as equity into the overleveraged enterprises and banks if and only if the governance and return on assets can be improved under better management.
In the short-run, a clean-up of the over-leveraged enterprise sector and local government debt, embedded in the official and shadow banking system, will help sustain long-run stable growth. How to do this technically will be explained in the next article.
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