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breakingviews.comThe spectre of deleveraging haunts the financial markets. Rightly so, for the removal of credit from the global economy is a process which tends to feed on itself. That means that the credit crunch could easily turn into something much nastier.
Before the deleveraging came the leveraging. Take the US. The ratio of all sorts of debt to GDP rose from 160 per cent in 1975 to 342 per cent at the end the September 2007. Through to 2000, debt increased by 2.4 percentage points a year faster than GDP. But after the turn of the millennium, the excess of debt growth accelerated almost to 3.7 percentage points a year. The pattern was similar but less extreme in the eurozone, and similar but more extreme in the UK.
While it was happening, only a few sourpusses complained. Leverage, it was said, was a natural trend. As economies get richer, they have more need for debt-financed investments and debt-financed inventories. But lending grew much faster after 2000 than even the most gifted apologist could explain away.
It was a bubble, which has now been popped. And leverage has turned into deleverage.
In leverage, one thing leads to another. I can bid more for a house because my bank is willing to lend me more. The house price rises, giving the bank more confidence about lending me yet more. So I buy some shares or a new car.
Multiply that by a few hundred million borrowers and hey, presto: asset prices go up and GDP growth is high. Banks rejoiced. They set up off-balance sheet vehicles which piled on debt. Leveraged buyout groups borrowed to take companies private; hedge funds borrowed to invest in assets. And so on.
In deleveraging, too, one thing leads to another. Start with a bank that has lost a few billion on sub-prime mortgages. The bosses are likely to decide that troubled times call for higher capital ratios. That means calling lines of credit. Some borrowers are forced to sell assets, pulling down prices. The banks then look at the value of their collateral and think: “Oh my god, it’s not worth what we thought”. They then cut their credit again – giving another turn of the deleveraging screw.
This deleveraging won’t be confined to the US housing market. Wherever there’s been a debt mountain – other types of mortgages, credit cards, car loans, LBO loans – there could be a contraction of credit.
If the original debt fuelled consumption, deleveraging will feed into lower economic activity. If the original debt fuelled asset purchases, the consequence will be lower asset prices. In some cases, there could be a dual effect because lower asset prices can make people feel poorer and less willing to spend money. This is especially the case with people’s homes.
How far could the deleveraging go? Historical parallels are not very comforting. In Japan, private-sector debt increased five percentage points faster than GDP through most of 1980s and even faster at the end of the decade. Asset prices exploded. Private sector leverage started to fall in 1991. Despite massive government borrowing and five years of a near-zero interest rate on overnight borrowing, the prices of shares and real estate declined by 40-70 per cent.
The UK has a similar, although less dramatic, experience. House prices doubled in the five years up to 1990, as total loans increased at a rate six percentage points faster than GDP. Over the next five years, the ratio of loans to GDP shrunk by 10 per cent, and house prices also dropped by 10 per cent.
Politicians and central bankers, especially in the US, are alarmed by the rapid shift in direction. But there are limits to what they can do. Sharp cuts in interest rate may not be enough to make banks abandon their new-found caution in lending, especially if loan losses are rising.
Higher government deficits might not help either. In a deleveraging world, the government may borrow so much that riskier private sector borrowers find it hard to raise funds.
Whatever the government and the central banks do, the deleveraging snowball will reach the bottom of the mountain. Banks will start to see opportunities, and borrowers will become more courageous. But it could be a long and painful wait.
For further commentary visit www.breakingviews.com.
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