Global debt levels have reached a new record of around $US200 trillion including public and private debt. It’s a perfect time for me to write a headline shrieking, “There’s a debt bomb and so the global economy is about to turn for the worse!”
As good as that would be for getting attention, it takes a truism - as most downturns start when debt is at a record and are made worse by high debt - and infers an outcome that’s not so reliable as to timing.
It is true that debt levels are at a record high. Countries with very high gross debt to GDP include Japan, Belgium, Canada, Portugal and Greece. These are among the developed countries that have seen a rise in public debt.
Germany, Brazil, India and Russia have relatively low debt. Australia does not rank highly in total debt, having world-beating household debt, but low public & corporate debt.
Emerging countries tend to have relatively lower debt, but rising private debt needs to be allowed for, particularly in China, where corporate debt is high relative to GDP.
So, what should market watchers be keeping an eye on then? Key signs to watch include a broad-based surge in debt along with signs of excess such as overinvestment, rapid broad-based gains in asset prices and surging inflation and interest rates.
Instead of taking an alarmist viewpoint, I am approaching the rising debt to GDP levels from the following perspective:
Seven reasons not to be too alarmed about record debt:
1) Debt has been rising since it was invented
This partly reflects greater ease of access to debt over time. So that it has reached record levels does not necessarily mean it’s a debt bomb about to explode.
2) Comparing debt and income is like comparing apples and oranges
I like to remind people that debt is a stock and income is a flow. Suppose an economy starts with $100 of debt and $100 in assets and in year 1 produces $100 of income and each year it grows 5%, consumes 80% of its income and saves 20% which is recycled as debt and invested in assets.
At the end of year 1, its debt to income ratio will be 120%, but by the end of year 5 it will be 173%. But assuming its assets rise in line with debt its debt to asset ratio will remain flat at 100%. So the very act of saving and investing creates debt and rising debt to income ratios.
China is a classic example of this where it borrows from itself. It saves 46% of GDP and this saving is largely recycled through banks and results in strong debt growth. But this is largely matched by an expansion in productive assets. The solution for China is to spend more, save less and recycle more of its savings via investments like equity.
3) Rise in private debt in the emerging world is offset by higher growth potential
Compared with developed countries, emerging markets have higher growth potential. Of course, the main problem emerging countries face is that they borrow a lot in US dollars and either a sharp rise in the $US or a loss of confidence by foreign investors can cause a problem. This is currently a concern as the $US is up 7% from its low earlier this year.
4) Debt interest burdens are low, in many cases falling
This is as more expensive, long maturity, older debt rolls off. And given the long maturity of much of the debt in advanced countries it will take time for higher bond yields to feed through to interest payments. In Australia, interest payments as a share of household disposable income are at their lowest since 2003, and are down by a third from their 2008 high. There is no sign of significant debt servicing problems globally or in Australia.
5) Most of the post-GFC rise in debt in developed countries is public
This is reassuring as governments can tax and print money. Japan is most at risk here, given its high level of public debt, but borrows from itself. And even if Japanese interest rates rise sharply (which is unlikely with the BoJ keeping zero 10-year bond yields with little sign of a rise), 40% of Japanese Government bonds are held by the BoJ so higher interest payments will simply go back to the Government.
6) Global interest rate hikes should be gradual
The US Federal Reserve has been raising rates slowly, and the ECB, Bank of Japan and RBA are all a long way from raising rates. What’s more, central banks know that with higher debt to income ratios they don’t need to raise rates as much to have an impact on inflation or growth as in the past.
7) Debt alone is rarely a shock to economies
Broader signs of excess such as overinvestment, rapid broad-based gains in asset prices and surging inflation and interest rates are usually required and these aren’t evident
on a generalised basis. But these are the things to watch.
History tells us that the next major crisis will involve debt problems of some sort. But just because global debt is at record levels and that global interest rates and bond yields have bottomed, does not mean a crisis is imminent.
For investors, debt levels are something to remain alert too – but in the absence of excess in the form of booming investment levels, surging inflation and much higher interest rates, for example, there is no need to be alarmed just yet.
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