The latest offering from George “Minsky Moment” Magnus, senior adviser at UBS in London, focuses on that dismal word, “deleveraging”, which he describes as a “rare but significant influence over the course of the economic cycle”.
The deleveraging phenomenon tends to be self-reinforcing, and characterised by a protracted work-out of balance sheet repairs. Understood this way, it provides some conclusions about the deleveraging process, says Magnus:
First, it has to run its course, and time in this context is measured in years, not months or quarters.
Second, it may or may not induce a deep economic downturn, but it is most likely to be protracted, giving rise to 2-3 years (or more) of significantly below-trend growth in which unemployment will rise and capacity use decline. While it may be punctuated by quarters of positive GDP growth, “this does not mean recovery is at hand”.
Third, it is accompanied by a deflation in asset prices as contraction in debt and asset liquidation reinforce one another.
Fourth, market-determined outcomes are possible but generally seen as “sufficiently unpleasant as to warrant intervention and regulation by governments and central banks”, and often by a creeping or sudden “socialisation” of assets or institutions.
To date, significant developments have included liquidity provision with expanded collateral, and, in the US, a strong signal about the low likelihood of systemic risk, and the beginning of mortgage rescue legislation. Most probably, the next year or so will see an expansion of these efforts to include also proposals for the purchase of some asset-backed securities, possibly even state-sponsored recapitalisation of lenders.
Essentially, says Magnus, deleveraging unleashes two strong deflationary forces: the restructuring of banks’ balance sheets (with its attendant recapitalisation, “de-risking” and balance sheet shrinkage), and the restructuring of over-borrowed household or corporate balance sheets.
From a macroeconomic perspective, these processes and forces are what make this downturn different and are indispensable to the understanding of current monetary policy issues, especially the recent abrupt changes in the forward discounting of policy tightening and the rise in bond yields
From now, he says, we must deal with “the complication of living in a bifurcated world”, where advanced economies face a deleveraging with little or slow GDP growth but a probable erosion of headline inflation over the next 1-2 years, and where emerging countries have to address rising inflation (core or headline distinctions are less relevant) with tighter credit policies.
The upshot, in his view: slower global growth over the next 2-3 years – but the degree to which inflation becomes more serious is, in the first instance, down to emerging market credit and exchange rate policy choices.
On bank deleveraging: The process of recapitalisation is under way but has further to go, believes Magnus. The shrinkage and “de-risking” of balance sheets in an environment of greater credit risk, rising loan-loss provisions, dysfunctional wholesale funding, and greater regulation will be “neither easy not quick”.
Instead of negative loan growth in the worst affected sectors, it’s possible that bank assets as a whole could decline. At the very least, he says, bank assets and bank credit to GDP ratios – particularly in respect of the US, UK, Japan, France and Germany – are set to decline.
In any event, the main conclusion is that favourable factors aside, banks will have to raise more capital over the coming 18 months and shrink their balance sheets. In one example, the banks team considered the balance sheet impact of 1% increase in Tier 1 capital ratios in 2009, again assuming no new capital injections. The result is that iIn their universe of US banks, risk-weighted assets would have to shrink by roughly $646bn – or by 10 per cent, from $6.36trn to $5.72trn. For global banks covered, the percent decline is comparable, from $34.1trn to $30.6trn.
On the other main deflationary force, household de-leveraging: Despite a large accumulation in net wealth in the last several years, mostly house price-related, deleveraging crises always land households in opposite circumstances, notes Magnus. “The (mortgage) debt on their balance sheet is fixed, the (housing) assets aren’t, and creditors become more restrictive and pressing”.
The adjustment is all the more important because of the close relationships between real house price trends and consumer spending, in particular in the light of the sharp rise in personal sector indebtedness in many countries over the last 10-15 years.
Given this, and now restricted or closed access to credit and its higher cost, the most likely result of a sustained decline in real house prices will be a marked change in household savings behaviour. We have seen this in the banking and real estate crises in the US in the 1980s, Scandinavia and the UK in the 1990s – and it looks as though a repeat performance is due now, especially but not only in the US and UK.
Well then, have a nice day.