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Does global debt now constitute a systemic risk?

With the world’s governments $63 trillion in debt with interest rates poised to rise, should we prepare for a major shock to the global economy? Cherry Reynard investigates

The world is in debt. The numbers are vast: governments have borrowed $63 trillion of which the US has the lion’s share (31.8%), Japan has a chunk (18.8%) and China has the next largest piece (7.9%). The UK has a relatively manageable 3.7% of the world’s government debt, behind France, Italy and even eternally prudent Germany.

An illustration of global debt by country. Source: World Economic Forum

An illustration of global debt by country. Source: World Economic Forum

https://www.weforum.org/agenda/2018/05/63-trillion-of-world-debt-in-one-visualization

This means relatively little in isolation: The US may have the most debt, but it also has the largest economy and relatively fast growth. Its debt to GDP ratio is currently 107%, dwarfed by that of Japan at an eye-watering 239%. China may have low government debt, but that is because its debt is largely concentrated in state-owned corporate entities that don’t appear on its books.

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At the same time, high debt is a problem for countries such as Argentina, where refinancing might be tricky but most developed countries can find ready buyers for their debt. Even Italy, the current sick man of Europe, managed to find buyers for its bonds in an auction at the end of May, which was over-subscribed.

Slouching tiger

When does debt matter? Much of the concern around global debt is focused on China. Debt in Chinese state-owned entities (such as banks) stands at 115% of GDP. That looks worrying, but Edward Smith, head of asset allocation research at Rathbones, suggests a more nuanced view: “There were a number of years when Chinese debt was growing at a faster pace than its economy. However, debt to GDP is never that informative about a country’s risk of moving into crisis. What is informative is the pace at which debt is being accumulated.” Rathbones looks at the credit to GDP gap, a metric that assesses how fast a country is growing its debt relative to its GDP.

“A few years ago, China was growing its debt very rapidly and it looked to be on the brink of a debt disaster, but this rate has been falling for a number of years. As such, we see China as much less of a risk.”

It helps that China is a vast creditor nation and that the debt is largely housed in state-owned organs. Erin Browne, head of asset allocation at UBS Asset Management says it is important to remember that this is a managed economy: “While the government continues to support the state-owned entities, there is an implicit backstop. The risk of a hard landing is very small and there is a lot of room to cut debt. The Chinese government has the monetary tools to intervene if necessary.”

Chinese debt seems to be on a leash

Chinese debt seems to be on a leash

The US government debt is also large, and about to get larger as Donald Trump’s tax cuts come into effect. The Congressional Budget Office has said the US budget deficit will surpass $1 trillion by 2020. Smith points out that that is even if US economic growth was an optimistic 3% for 10 years and there was no recession. The budget could still be 5% over GDP and that is on top of the structural deficit of $19 trillion.

These are big numbers, but the question is more whether people will continue to fund it. Smith believes this isn’t a problem: “If people continue to fund Japan, they will continue to fund the US. The problem is that it puts upward pressure on interest rates and that could expedite the next recession.”

David Jane, multi-asset manager at Miton feels similarly about household debt in the US. This has gone up in absolute terms but has improved as a proportion of overall household assets: “You would expect the amount of debt to rise as income and house prices go up.” Smith points to worrying household debt levels in countries such as Canada, Australia, South Korea and Hong Kong, but says that none of these would fundamentally destabilise the global economy.

Hot under the dollar

Emerging markets have been another area of concern. Worried economists have pointed out that aggregate debt in emerging markets is now higher than it was during the Asian crisis. Browne says: “Emerging markets have taken advantage of lower bond yields to take on debt. Eighty-five percent of hard currency debt is dollar-denominated and if the US dollar continues to rise that is a problem. It could materially increase the rollover risk. This is why emerging markets have sold off since the start of the year.”

Both Browne and Jane believe that there are clear risks for some of the smaller emerging markets. Jane says: “This has been one of the unintended consequences of quantitative easing. Countries such as Turkey, Venezuela, Argentina and even Brazil and Mexico at the margin, took advantage of low rates but now don’t have the money with which to pay it back.”

The ability of emerging markets to repay their debts may raise some eyebrows

The ability of emerging markets to repay their debts may raise some eyebrows

However, while it is problematic for the countries involved, it is not a systemic issue says Jane. “This is a normal process of financial markets. Some people made mistakes, but it’s not terminal for the world economy. Some people will lose money, particularly in emerging market corporates.”

The other key area of difficulty is in US corporates. Browne points out that borrowing in the US corporate sector is now at the same level it was during the last two recessions. This worries some more than others. Smith believes it may mean that the big employers in the US could be more sensitive to interest rate rises and therefore may need to cut back as interest rates shift, with a knock-on effect for employment levels.

Browne, in contrast, is less worried, saying that interest cover is reasonably solid: “Corporates have been financially responsible. They have debt structures that are much more manageable and roll overs are not bunched together.” She believes the one area of concern is in corporate loans. These are linked to Libor and therefore the cost will rise as rates rise. Many are ‘covenant-light’ and have low recovery rates. As the impact of corporate tax cuts eases, this may become a greater problem. She believes this may be as soon as 2020 or 2021.

However, to say there is no systemic crisis is not the same as saying there will be no disruption in bond markets. Jane says that a second debt crisis was always unlikely to come so soon after the first because policymakers have been laser-focused on avoiding it. However, he adds: “The real issue is what happens to the price of debt securities. The prices of a lot of assets could change materially in this new environment as investors start to expect a risk-based return on risk capital. German bond yields are at 0% ꟷ they are priced for no rational purpose.”

Bond pricing: No rational purpose?

Bond pricing: No rational purpose?

“There has been a lot of anomalous pricing that now needs to sort itself out. That is the real global debt worry. People will lose money. It won’t be sudden, but it could be prolonged. We see a 10 – 20 year gradual repricing if inflation comes back.”

There is higher debt in the global economy but most of it is at a sustainable level and policymakers have worked hard to ensure there is no systemic debt problem that could infect the whole financial system. However, that doesn’t mean that investors won’t lose money on certain assets as monetary policy conditions change. Fixed income markets have seen a lengthy bull market that may now take some time to unwind.

Cherry Reynard is an award winning financial journalist, who has written for the Financial Times, Forbes, Investors Chronicle, The Telegraph and Money Observer

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