Debt Deleveraging And The Low Growth Equilibrium
BMI View: Five years after the global financial crisis, the UK economy is still as overleveraged as ever. Although we believe that high leverage in the banking sector does not necessarily present an imminent risk, we are concerned with the anaemic pace of deleveraging among households, which are the driving force of the economy. We argue that without a turnaround in property prices or income growth, the Bank of England will be unable to raise interest rates over the foreseeable future. Moreover, the UK economy is at risk of being trapped in a high-debt, low-growth equilibrium.
It is no secret that the UK economy is one of the most overleveraged in the world and, as a consequence, has woefully underperformed during the global economic recovery. Moreover, the trajectory of the deleveraging cycle is increasingly diverging from some of its peers. In the US, freewheeling capitalism has engendered a socioeconomic model which has allowed the deleveraging process to be more of a 'slash and burn' type adjustment, with aggressive housing foreclosures and limited safety nets accelerating the process of debt normalisation through default. Meanwhile, in the UK, a comprehensive social safety net, record low interest rates and structural rigidities in the property market which have prevented a sharper collapse in house prices, have contributed to a new low-growth, high debt equilibrium which has zombified the economy.
Back in 2010 we attempted to measure the UK's total debt stock, which is a particularly arduous task given the difficulty in deciding which liabilities should be included in the final estimate. The debt levels of the household and government sectors are fairly straightforward to measure and typically constitute loans for the former and loans and bonds for the latter. It is more difficult arriving a figure for the banking sector given the role played by derivatives, which we have omitted given that across the industry they are essentially zero sum on the balance sheet. The figure which we have arrived at is roughly in line with other estimates that we have seen and tells a compelling story of the state of leverage in the UK.
|Hitting A Plateau|
|UK - Total Debt Stock, % of GDP|
As the left hand chart above shows, the total stock of debt in the UK has levelled off at around 500% of GDP. The unstacked chart on the right hand side clearly shows a sharp rise in government and financial corporation indebtedness, alongside a gradual improvement in the household and non-financial corporation sector. Although there caveats, which we discuss below, the debt load is mammoth whichever way you look at it.
The cross-sector dynamics are further reflected in our construction of the UK flow of funds, which uses data from the Office for National Statistics' Economic Accounts. The chart shows the net borrowing position across sectors which together sum zero. Therefore, by holding the rest of the world constant, if the private sector is borrowing, the public sector is saving. There is clearly a sharp reversal in the household sector from being a net borrower to a net saver, which has been offset by a sharp rise in government borrowing. The non-financial corporate sector remains a net saver, which is evident by the sharp rise in cash held on firms' balance sheets. Meanwhile, financial corporations have become net borrowers, which is perhaps unsurprising given the access to extremely cheap liquidity from the Bank of England.
|Government Offsetting Household Deleveraging|
|UK - Flow Of Funds, Rolling 4-Quarter % of GDP|
How then do we interpret the deleveraging cycle?
We would argue that the dynamics of household deleveraging are the most important. While it is true that the banking sector is considerably leveraged, the industry is truly global and will always be outsized relative to the UK economy, as is the case in Switzerland. Indeed, UK-based banks are fully integrated with the global economy as a result of far-reaching trading and investment activities and as such, the footprint on the domestic economy is perhaps not as significant as some expect. With London set to remain one of the world's leading financial sectors, and with global output continuing to expand, bank balance sheets will remain large relative to the UK economy. Provided that the British taxpayer is not left on the hook for the failure of more banks that are 'too big to fail' (additional bailouts would likely require a coordinated international effort) and assuming that investment activity is eventually ringfenced from the retail operations, the risk posed to the UK economy by the banking sector should be reduced somewhat. Moreover, if UK banks remain unwilling to extend credit to the private sector, foreign entrants could fill the gap and mitigate the impact on the broader economy of bank recapitalisation. We are not arguing that the UK banking sector is not systemically important, but rather that any systemic crisis would have a global rather than just local impact.
The key factor for the UK economy is the health of the UK consumer, which contributes three-quarters of national spending. Therefore, we believe that the state of household deleveraging will provide significant clues as to the magnitude and direction of economic growth going forward. In nominal terms household loans have plateaued at around GBP1.46trn. However, nominal GDP growth has allowed the debt burden to ease from the peak of 103% of GDP in Q309 to around 95% today. Given that the economy has effectively flatlined over the past six quarters, it is inflation which has been the driving force behind this deleveraging.
|The Low Growth Equilibrium|
|UK - Labour Productivity, Income & Household Debt, % chg y-o-y|
A stable equilibrium requires nominal debt growth to be equal to or lower than nominal income growth, which in turn should be equal to productivity growth. If the first condition is not satisfied, debt rises relative to income and, if unabated, eventually hits an inflexion point where further increases in debt cannot be sustained. The second condition requires equality between growth in incomes and productivity. Income growth persistently exceeding productivity growth is inflationary. Conversely, if productivity growth consistently exceeds income growth, capital owners take a larger share of profits and workers account for a smaller proportion of economic output, which is deflationary. In this respect, we believe that the following chart is particularly interesting. During the credit bubble, debt grew at a much faster rate than incomes and productivity. A major inflexion point has now clearly been reached, with debt, income and productivity growth converging at a low rate. This goes some way to reinforce our view that the economy has got stuck in a high-debt, low growth equilibrium. Monetary expansion by the Bank of England, which has crushed the yield curve, has pinned down borrowing costs and effectively locked in this equilibrium for the foreseeable future.
A Rough Framework For Understanding Household Debt Dynamics
The standard sovereign debt sustainability framework is underpinned by real GDP growth, inflation, the primary fiscal balance and interest rate costs. In essence, some combination of robust growth, moderate inflation, low interest rates and a healthy primary balance contribute to a sustainable sovereign debt trajectory. In the case of the UK where the public finances are in a mess and the economy is treading water, much of the heavy lifting is being done by inflation and the Bank of England's asset purchase program, which has allowed nominal GDP growth to exceed interest costs.
Although the data is not as consistent for the household sector as it is at the government level, we can nonetheless use the sovereign debt sustainability framework to consider the impact of incomes, saving and interest rates on the trajectory of household debt. It should be noted at this point that the majority of household loans are accounted for by secured lending - effectively mortgages - and that wealth is largely tied up in property. As the chart below shows, the interest rate on secured lending (the standard variable rate) has long exceeded the rate of growth in nominal incomes (we have excluded bonuses from this measure owing to the volatility of the series, but it makes little difference to the overall conclusions), and households have been net borrowers for the best part of a decade. However, mortgagors have been able to rely on rapid growth in property prices during the last economic cycle, which have increased equity values and made it relatively easy to service loans. With property prices now falling and interest costs still exceeding nominal income growth, households have been forced to save more.
|BoE Bank Rate Will Remain Anchored|
|UK - Household Debt, Income, Savings & Mortgage Rate|
The increase in saving is similarly reflected in the next chart which shows housing equity withdrawal, both in nominal terms and as a percent of post-tax income. Periods of negative equity withdrawal (effectively paying down mortgages) have coincided with the last five recessions and, as of the third quarter of 2012, remains deep in the red.
|The Mortgage Mountain|
|UK - Household Equity Withdrawal & Recessionary Periods|
As we stated above, consumers are the driving force of the economy and household wealth is tied up largely in property. This gives rise to two key conclusions. First, the Bank of England's asset purchase programme will continue to have limited impact on economic growth. Although monetary expansion has generated wealth by pushing up equity values, this wealth effect accrues largely to the financial and corporate sectors. There is some gain to household wealth through rising pension portfolios, but on the whole the impact is limited unless it simulates property prices or alleviates mortgage service costs (mortgage providers have lowered rates, but the spread versus the bank rate has widened). Second, a major correction in property prices would be particularly damaging for the broader economy. Therefore, with nominal income growth unlikely to pick up substantially and household indebtedness still high, the Bank of England will be unable to raise interest rates for many years to come. In the meantime, consumer spending, and by extension economic growth, will continue to suffer.