In an earlier column (“The lessons from leveraging and pains of deleveraging,” March 10, 2008), before the global financial crisis had worsened and reached its nadir, the credit markets freezing abruptly in the fall of 2008, I dealt with the expected costs of deleveraging, the unwinding of the excessive global debt burdens, as the ultimate collateral damage from the crisis. Deleveraging was the also the major theme of the International Monetary Fund’s (IMF) October 2008 Global Financial Stability Report -- Financial Stress and Deleveraging Macro-Financial Implications and Policy.
Last week the McKinsey Global Institute (MGI) released a 94-page report, Debt and Deleveraging: The Global Credit Bubble and Its Economic Consequences, which throws more light on deleveraging and its costs. In the report, “debt” refers to outstanding debt (all credit market borrowing, including loans and fixed-income securities), measured across countries by the debt-to-GDP [gross domestic product] ratio; “leverage” refers to the debt-to-asset or debt-to-income ratios, measured differently across different sectors. The main argument of the report is that the aggregate debt-to-GDP ratio by itself is an inadequate leverage indicator. Leverage has to be viewed from multiple lenses, measured at different levels using different metrics, distinguishing among the household, financial, corporate and government sectors. The likelihood of deleveraging across the four sectors depends on their absolute leverage levels, debt and leverage growth rates and debt service capacities, as well as vulnerabilities to income, funding and interest rate shocks.
The report offers country and sector-specific analyses of the past, current and expected deleveraging trends in the global economy, focusing on 10 developed countries (Canada, France, Germany, Italy, Japan, South Korea, Spain, Switzerland, the UK and the US) and the BRIC emerging economies (Brazil, Russia, India, and China). It also analyzes 45 significant deleveraging episodes, 32 of them following a financial crisis, since 1930. A “significant” episode is either a case in which the total debt-to-GDP ratio declines for at least three years in a row by at least 10 percent, or in which the total nominal credit stock shrinks by at least 10 percent. The 45 episodes are classified into four archetypes: (1) belt-tightening episodes, during which credit grows more slowly than GDP for many years; (2) massive defaults; (3) high inflation; and (4) growing out of debt with very rapid real GDP growth. Although the first archetype, lasting on average six to seven years, is the most common, accounting for about half of all the episodes, Turkey’s single episode qualifies as one of the seven cases of massive default archetype, each of which followed a financial, mostly a currency, crisis. It was a total (private and public sector) leveraging episode during 1987-2003. The debt-to-GDP ratio started at an incredible 25.371 percent, by far the highest among all the cases, and ended at 92 percent. The second of the two appendices of the MGI study contains seven case studies -- from the US, the UK, Finland, Malaysia, Mexico, Argentina, and Spain -- that cover most of the four deleveraging archetypes. I wish it had included Turkey’s episode as a case study of massive default deleveraging in addition to those of Argentina and Mexico.
I will further my discussion in my column tomorrow by delving into the main findings of the report, prepared in light of data from 50 countries.
