GLOBAL DEBT A comprehensive insight into the world s largest bubble A CAPITALIST EXPLOITS REPORT
Whether you re an individual investor looking for high-quality research and information to help steer through increasingly treacherous markets, or an investment professional looking to provide clients with solid, expert analysis and ideas to do the same thing, this report will interest you. Maybe you re completely unfamiliar with financial markets and are just diving into them now. One thing is certain: we all face a complex and challenging investment landscape, and like it or not we re all deeply affected by what is taking place right now in the world s financial markets. It s happening under our noses, but most don t see it. It is without a doubt a crisis requiring any rational investors full attention. This report will provide some context with which to view some of the complex questions investor s today are forced to grapple with. What is taking place now in global markets is unprecedented in human history, which makes this an incredibly interesting time to be alive. It is also potentially very dangerous, and our hope is that this report provides you the context with which to make some intelligent decisions for your portfolio and indeed your life. 2
What Crisis Awaits? There is a scene in the movie Thelma and Louise where near the end, Thelma, played by Geena Davis and Louise, played by Susan Sarandon are being chased by law enforcement officers across the desert. Knowing that they have nowhere to turn to and not wishing to give themselves up they put their foot on the accelerator and floor it, thereby ensuring their own deaths as they drive straight off a cliff. It s an iconic movie, which sadly depicts accurately what Central Bankers today, having abandoned any modicum of responsibility, are doing as they drive the monetary car at full-speed towards a gaping ravine. Excessive accumulation of debt was at the very heart of the global financial crisis that ripped through the global economy crippling many of the world s largest financial institutions, and bringing many others to their knees. This debt accumulation was a direct result of easy monetary policies repeatedly enacted by successive Central Bankers in the developed world. The easy monetary policies have brought us successive bubbles, and with each collapsing bubble a new larger one has been created. It is a commonly used phrase that the Fed is the lender of last resort. The Fed, together in concert with global Central Banks has been lending as a matter of last resort to such an extent that the largest bubble of all now stands, giant and overbearing, above us all. That bubble is in the global debt markets. This is the backdrop through which we view today s global debt markets. It s a background and history of increasing Central Bank intervention, increasing regulation, increasing government oversight and unsurprisingly, increasing fragility. One would think that the lessons learned from the 2007 crash would be burning red hot in the minds of Central Bankers, and market participants, both private and public alike. One would think that massive de-leveraging would be de-rigueur. One would be horribly mistaken, as we re going to show you in this report. Argentina has defaulted again, and France has announced rather ceremoniously that they consider 60% of their debt to be illegal. The wheels are coming off. I m reminded of the famous quote in the book The Sun Also Rises, by Ernest Hemingway. How did you go bankrupt?, he writes. Two ways. Gradually then suddenly. Each successive crisis has been met with a re-inflation of an asset bubble. It hasn t been the same asset class, as the Central Banks don t have control over where the money flows, only that the 3
money does indeed flow. This is how we have experienced asset bubbles and re-bubbles and re-re-bubbles. This is the new normal, the way the world operates, and the danger to us is in thinking that this will last - that this is indeed the way things will be, as a matter of course. The disconnect between fundamentals and reality could not be more dramatic. Take for example the move by the ECB to take European interest rates negative as Europe s economies continue to falter and as government debt levels climb ever higher. If what we experienced in the Global Financial Crisis (GFC) was proportional to the level of debt in the system at the time, then expect the GFC of 2007-08 to look like a speed-bump on the way to a concrete barrier when compared with what s coming. This is not unsubstantiated opinion based on scare mongering, devil-prompted anti-keynesian, anti-krugman vitriol. This is a good old-fashioned review of the facts, as unpleasant as they are. I know that while history doesn t necessarily repeat, I m told that it rhymes. It s not all bad news While the developed world continues to gorge itself on debt, many of the Emerging Markets have not done so and are sporting far healthier balance sheets. In this report we lay out the blueprint behind a decision we made some 5 years ago. We made a radical shift, moving much of our capital out of developed markets and into rapidly-growing Emerging and Frontier markets. We ve written extensively about this within the pages of http:// capitalistexploits.at/. Not only did we move much of our capital out of developed markets, but we moved it out of public markets into private markets and privately run companies. The markets I m talking about are markets where leverage is a fraction of that employed in many developed markets, markets which are growing as a result of less, not more regulation; less not more Central Bank interference; and less not more oversight. What grew out of this investment strategy was a small and exclusive syndicate of global investors and entrepreneurs that share our views, and now invest alongside us in private, curated opportunities, which we source globally. The group is known as Seraph. After reading this report if you want to know more about Seraph you will find our contact information at the end. To conclude this introduction let us say that debt is both the great enabler as well as the great destroyer of civilizations. We re of the strong opinion that it should not be taken lightly. 4
On with the facts then... Global debt trends According to the Bank for International Settlements (BIS) [1], global debt reached $100 trillion in mid-2013, having grown by 40% since the onset of the global financial crisis (from $70 trillion in mid-2007): FI = financial corporations; GG = general government; II = international institutions; NFI = non-financial corporations; NPISH = non-profit institutions serving households; TDS = total debt securities; EM = Emerging Markets (Brazil, China, Korea, Mexico, Poland, Russia, South Africa and Turkey). Source: [1]. Of the $100 trillion, $43 trillion has been issued domestically by governments an approximately 80% increase since 2007 when debt had reached such completely unsustainable levels as to bring us the GFC. 5
As you can see from the chart below the developed or advanced world economies have taken on completely unsustainable levels of debt, with virtually every major Western country gorging on ever increasing amounts of debt. The next chart shows us where the majority of this debt is coming from. 6
Central Bank balance sheets have quite simply exploded, thus promising us all a day of reckoning. When this day will come is the $64 million question. That it will come is no longer up for debate. While populist economists such as Paul Krugman are of the opinion that ever increasing debt is possible, we believe that history proves otherwise. The Wall Street Journal has compiled an interactive chart [2] of countries relative debt positions between 1990 and 2012. Below we show the starting and ending charts. The difference between the two I think speaks for itself. Source: [2]. Source: [2]. 7
The trend is unmistakable, and due to the sheer size of debt in many countries, it now appears virtually unstoppable. Certainly the political will to change course is not currently present. An IMF working paper [3] shows central government debt levels as a percentage of GDP in developed and emerging economies. It shows that advanced economies government debt is at levels not seen since immediately after World War 2, when countries (understandably) borrowed aggressively in order to rebuild their economies. Source: [3]. The working paper authors argue that, Total external debt is an important indicator because the boundaries between public and private debt can become blurred in a crisis. External private debt (particularly but not exclusively that of banks) is one of the forms of hidden debt that emerge out of the woodwork in a crisis. Just as bank balance sheets before the 2007 09 financial crisis did not reflect the true economic risk these institutions faced, official measures of public debt are typically a significant understatement of vulnerability. 8
It is therefore important to look at total (public+private) external debt. Here, the difference between developed and emerging economies is stark: as Emerging Markets have been deleveraging, advanced economies have done exactly the opposite, but at a much faster pace. Source: [3]. Taking private debt alone, the situation is similar. Source: [3]. 9
As mentioned in the prelude to this report, our personal wealth is largely invested in, and devoted to, private equity, much of it in Emerging and Frontier markets, where debt levels both private and public are fractions of those in the developed world. I m reminded of a famous rule of Warren Buffets: Rule No 1: Never lose money. Investing in economies and businesses which hold substantially less debt than their developed world counterparts, while experiencing growth rates many times those enjoyed in developed markets, goes a long, long way to reducing downside investment risk. In its recent Economic and Investment Outlook Report [4], Vanguard cautions readers about high government and private sector debt. The report presented the following heatmap to illustrate its point. Source: [4]. 10
The scary facts behind us, let us now look at some of the main culprits, or players in this global, mammoth debt binge. United States As long as the U.S. Dollar is the primary international reserve currency, the U.S. government has an advantage of being able to print as much as it needs to settle its debt, both domestic and international. Not surprisingly, the U.S. debt has been rising over the past few decades, both in absolute terms and as a percentage of the country s GDP. Public debt The combined debt of the federal government and of local/state authorities has grown 11-fold in the past 30 years: from $1.4 trillion in 1982 to $15.3 trillion in 2013. With GDP having grown only 5-fold, the relative size of debt as a percentage of GDP has thus more than doubled from 42% to 91% within this period: Source: [25], [30]. The relative size of federal debt as a percentage of GDP is the highest since World War 2. Source: [29]. 11
This is where things get interesting. One could always ask the obvious question; how has this been sustained for this long already? The answer is to be found in the cost of capital. Although debt has risen versus GDP, interest payments as a percentage of GDP have remained relatively stable, as yields are at historic lows: Source: [21]. Holding interest rates low, and indeed pushing them ever lower has been at the forefront of Central Bank policy, enabling debt levels to continue rising while the cost of servicing said debt has remained stable or indeed fallen. In a normal functioning economy rising debt levels are typically associated with rising interest costs since the default risk rises with increased leverage. Clearly we are experiencing the exact opposite situation. It doesn t take a mathematical genius to see the problems in this Central Bank strategy, namely it s a problem of increasing fragility. It is a problem which Central Bankers of near perfect ignorance have time and again chosen to ignore, instead passing an ever expanding problem on to successive administrations; it s a problem to be solved in the future. The rationale behind this particular strategy is that growth will be achieved in the short term, which will then allow for a de-leveraging of debt to take place, all based on a healthy, resurgent economy. As is often the case with short term, emergency policies they are rarely short term, but rather enacted as policy, thereby increasing the risk to the system. The premise is that growth can be achieved by money printing, which if it were true Zimbabwe would be one of the most prosperous countries on earth! That Central Bankers are appointed not for competence, but allegiance, provides the answer to how we find ourselves in such a predicament. A more thorough discussion is required to understand Central Bank policy, the Federal Reserve, the ECB, the BOJ and numerous other culprits, but that is a discussion not intended for this report. In this report we are looking simply at the global debt build-up. 12
Now that we ve dealt with public debt let us move on to private debt Mortgage debt Mortgage debt is by far the largest component of household debt in the United States, representing about 70% of the total, as the following chart shows. Source: [31]. The next chart provides some more historical perspective. Total mortgage debt [5] 1 grew from $45 billion in 1949 to $13.2 trillion in Q4-2013, an almost 300-fold increase. All mortgage debt, including non-residential. Source: [20]. 1 All mortgage debt. 13
Similar to public debt, mortgage debt s relative size has grown, and although there has been a decline after the 2008 crisis, debt levels remain massively elevated by historical standards: Just as with public debt mentioned above, so too private households are enjoying historically low interest costs allowing for higher debt burdens to remain manageable. Source: based on data from [25] and [30]. As the chart above shows, consumer credit s share of GDP has not shown a similar decline in recent years, reflecting the rising balance of student loans (see below). The burden of mortgage payments had been rising steadily until the 2007-2008 crisis, with a significant decline since then, reflecting the decline in outstanding mortgage balances and their share of GDP. Seasonally adjusted data. Based on data from [24]. 14
Vanguard notes [4] the de-leveraging trend among U.S. households, estimating that, Although this debt may not reach more sustainable levels of 60% 70% of GDP until 2016 or so, lower interest rates to service it combined with rising stock and home values have substantially aided the transition to a passive de-leveraging phase of the cycle. Source: [28]. Given the long-term growth trend in consumer debt as a percentage of GDP (as shown in the chart above), it is probably logical to expect debt to rise once again, unless some far-reaching actions are taken to curb excessive lending and borrowing. 15
Student loans According to the Federal Reserve Bank of New York, Student loan debt is the only form of consumer debt that has grown since the peak of consumer debt in 2008, this represented 10% of total U.S. household debt in Q1-2014 (second largest debt type after mortgages). Student loan debt has grown to $1.25 trillion as of Q1-2014 [6], two-thirds of graduating students are carrying some form of debt [7], according to the CFA Magazine [8]. This is more than a 4-fold increase from less than $300 billion in 2004 [9]. The sharp rise in total student debt balance is evident in the chart below. Source: [9]. The sharp increase came as a result of compounding the rising number of borrowers by an increasing average loan size (+70% each between 2004 and 2012). Source: [9]. 16
To compound the problem, the share of delinquent student loans has been growing steadily during the past 10 years, with a sharp jump above 10% in 2012, as the following chart shows. Source: [31]. An article in the January/February 2014 issue of the CFA Magazine [8] made the following conclusions about the student debt market: The so-called higher education bubble may be near collapse, with private banks exiting the market. Changes in the higher education market likely will lead to structural changes as well as creative destruction. Student loan indebtedness may have systemic implications for investors, economic growth, and fiscal/monetary policy. In addition, the article reports that, The federal government is withholding money from the rapidly growing number of Social Security recipients who have fallen behind on federal student loans incurred to educate their children, quoting about 115,000 such cases in the most recent quarter, which was twice as many as in 2007. Once again a problem that is only exacerbated by existing policies, and for which the only real solution is a reduction in excessive borrowing. Obama s latest plan is not a solution. It will only add more weight to the camels back. 17
EU The EU s government debt had been following a downward trend (as percentage of GDP) until the crisis, which wiped out all progress, as government debt grew from the low of about 60% of GDP to almost 90% by the end of 2013. Source: [23]. The relative size of interest payments has declined over recent decades despite the recent growth in the relative size of debt. 18
The graphs below show the anomaly mentioned at the beginning of this report, namely declining interest costs for government debt. The graphs show France, Spain and Italy s 10yr yields declining to the lowest levels in history. 19 Source: [32].
There are no readily available consolidated statistics for the EU s private debt, but individual country charts clearly show a growing trend (in terms of percentage of GDP). Source: [22]. 20
Japan The Land of the Rising Sun is a prime example of excessive government debt growth, with a current debt/gdp ratio over 200% - well above any other developed country. With the Japanese economy stagnating for decades the debt burden has been growing since 1975. Source: [10]. Source: [27]. 21
Like other developed countries, growth in debt has not been associated with a similar rise of debt service cost as a percentage of GDP due to low interest rates. It s a coiled spring if ever there was one. Source: [10]. Source: [32]. As Global Financial Data notes, With an ageing population, no population growth, and low interest rates with savings absorbed by the government, it is difficult to see how Japan can ever return to any level of economic growth. Every country caught in the current financial crisis would be wise not to follow in Japan s footsteps. [10] 22
China Public debt EconoMonitor notes [11], Due to unreliable data and measurement problems, the exact level of [China s] debt remains unclear. Most estimates now put Chinese government (including local governments), corporate and household debt at around 200-250% of GDP, up from around 140-150% in 2008. The same source quotes China s National Audit Office as reporting the level of government debt, including local government debt, of about 55% of GDP (~US$5 trillion) 2, 60% above the 2010 level. At the same time, the article asserts that the debt of many stateowned enterprises, banks and other institutions is not included; with these, government debt is estimated at about 90% of GDP. Source: [26]. International Business Times notes [12] that the debt of China s local governments, Is not known, even by the central government, with analyst estimates putting it between 30% and 60% of China s GDP. Local government debt is being driven by excessively ambitious infrastructure and real estate projects, such as those announced by the Sichuan authorities in October 2013, which included, Three highways, five railroads and what would be the largest airport in West China, and whose value was reportedly ten times the fiscal revenues and double the province s GDP for the 2-year period during which the projects were to be implemented. Ghost cities are a typical example of China s wasted (and financed with debt) resources, in some cases with enough apartments to house the local population several times over. 2 Apparently, this includes $1.6 trillion in contingent obligations. Without these, government debt would equal about 39% of GDP. 23
Ironically, local governments bear 80% of all government expenditures, but have only about 40-50% of necessary revenues [13], and they are not allowed to borrow directly (since as far back as 1994, although a trial municipal bond program was launched in 2011), yet the central government has tasked them with supporting the economy through infrastructure projects [12]. As a result, local authorities have been using local-government financing vehicles (LGFVs) state-owned companies that borrow money from banks or through bonds. Herein lies one of the main risks: according to some estimates, LGFVs often borrow from shadow banks, which represent more than a third of the debt issued by traditional banks, and about half of China s GDP up from a quarter of GDP only five years ago. According to HSBC, The root cause of the problems associated with local government debt and shadow banking is the fact that a financial system dominated by banks can no longer cope with the demands of financing rapid urbanization. Notably, shadow banks do not comply with financial regulations and often demand shorter maturities and higher interest rates, putting the country s financial system on very shaky ground. In the words of a Societe Generale s analyst, Funding infrastructure projects with 10 percent-per-year interest rates and less than two years maturity looks dangerously like a Ponzi scheme for GDP creation. According to estimates by Nomura, more than half of LGFVs could have defaulted on their debt in 2012 without liquidity support from local governments. In addition, Morgan Stanley estimates [13] that a third of new local government borrowing is used to roll over existing debt, and that interest payments represent 17% of China s GDP. Private debt According to EconoMonitor [11], business and household debt grew by about 50% between 2008 and 2013 to 150-170% of GDP from 100-115%. Household debt doubled during this period from 20-30% to 40-50% of GDP, driven by rapidly rising home prices and general inflation. Morgan Stanley puts [13] the private debt level at 193% of GDP at the end of 2013 significantly higher than 115% of GDP in 2007. According to Pieter Bottelier [13], a senior adjunct professor at Johns Hopkins University s School of Advanced International Studies in Washington, D.C., China s corporate debt as percentage of GDP is at a relatively high level, and much of it is invested in real estate, making the economy vulnerable to a prolonged decline in property prices. According to a 2012 Bank of International Settlements ( BIS ) study [14] of national debt servicing ratios ( DSR ), DSRs above 20-25% often indicate heightened risk of a financial crisis. As EconoMonitor notes [11], Analysts have estimated that China s DSR may be around 30% of GDP (around 11% goes to interest payment and the rest to repaying principal), which is dangerously high. 24
Emerging Markets Though we talk about Emerging Markets as a whole, vast differences exist from country to country. As a whole Emerging Markets hold substantially less debt than their developed world counterparts. At the same time, their economies and banking systems are typically more fragile and susceptible to adverse capital flows than larger economies. Violent currency movements can affect emerging-market economies more rapidly than larger developed markets, as the Asian crisis of 1997 showed us. An IMF working paper [15] reports that Emerging Markets debt levels have been on a more sustainable level over the past decade than that of developed economies. Gross Debt Ratios in G20 Countries (PPP-Weighted Averages) Source: [15]. In an article on MarketWatch [16], Satyajit Das wrote in September 2013 that Emerging Market debts had risen by 10-30% since 2008, depending on the country, with Asian economies recording especially high growth rates. According to the article, a debt to GDP ratio of 150-200% is now common. At the same time, capital intensity of economic growth had doubled to $4-$8 of new debt per each $1 of additional GDP growth. According to Satyajit Das, consumer credit has grown too. In Thailand and Malaysia it reached 80% of GDP, Up sharply from levels in 2007. In Thailand, debt payments represent more than one-third of income. 25
One of the major problems for Emerging Market borrowers is hard-currency debts. These carry low interest rates but subject the borrowers to higher risk should their domestic currencies fall against the debt currency. Brazil for instance has dollar debt worth 12% of its GDP, Turkey 22%, India has foreign debt worth 20% of GDP. That being said, the overall levels of government debt are generally low (except in India and China), but government involvement with banks and industry increases their off-budget exposure. Recent years have seen a rise in non-performing loans. Satyajit Das reports that 12% of total assets in Indian state-owned banks are represented by either bad or restructured loans this is double the level of four years ago. In a blog post on the CFA Institute website, Larry Cao, CFA notes [17] that quantitative easing in the developed economies and other external factors, coupled with low interest rates, were the primary reasons for the large inflow of cash into Emerging Markets debt, accounting for 60% of the increase in capital flows to Emerging Markets between 2009-2013. This has made Emerging Markets vulnerable to tapering measures in developed economies. At the same time, interest rates appear to be rising, which is likely to change the economic environment for Emerging Market debt in the near future. Corporate debt Business Insider quotes Nomura [18] estimates, according to which Emerging Market corporations have issued $400 billion in offshore debt since 2010, which represents 40% of total issuance. The chart below illustrates the sharp increase in debt issuance since the start of the 2007-2008 crisis: Source: [18]. 26
According to Nomura, This issuance is not captured in traditional country-level balance of payments statistics, which only measure debt issuance on a residency basis and not a nationality basis. In other words, the official statistics only measure a given corporation s debt issuance in the home country, and don t take into account offshore debt issued through overseas subsidiaries. Nomura analysts believe this hidden debt, Could pose a major risk for EMs in which currencies are rapidly declining against the dollar. Bloomberg quotes the IMF [19] saying that Emerging Market corporate debt tripled between 2009 and 2013 as a result of expansionary policies in developed countries, With debt levels in countries such as China, Hungary and Malaysia reaching or exceeding 100 percent of gross domestic product. A simulation model run by IMF, which assumes a 25% increase in borrowing costs combined with a 25% drop in corporate earnings across 15 Emerging Markets countries, suggests that emerging-market companies, with their $740 billion in foreign debt (35% of total), Could find it hard to service their obligations. Argentina, Turkey, India and Brazil are among the weakest economies in this regard. History Paints a Picture Before concluding this report I d like to present some examples of how large debt problems have been solved in recent history. Above we have the Greek 10-year bond yield, which as you can see was for some time sailing along smoothly at around a 5% yield, only for the wheels to come of the Greek government bond market with interest costs soaring to over 30%. The problem always gets solved, the question is only who is left holding the bag and who loses their shirt. When debts cannot be repaid you can rest assured that somebody will pay the price. 27
A well known example includes Argentina, a country which has a colourful history when it comes to fiscal policy. The above chart is not unlike the Greek one and shows how things appeared to be coasting along just fine, until it suddenly they weren t, and debt servicing costs soared. Russia A Template The Russian ruble crisis is we believe a wonderful template, which we ll spend a little time on. It portrays how things can go horribly wrong in a hurry, and how when the inevitable does in fact happen, it affects all market participants, not just those holding debt instruments in the given country. We d Like to show you the graph below, whilst highlighting the spike in the middle of the graph. This of course is the cost of debt blowing out like a well-timed geyser at Yellowstone National Park. 28
How Russia got to this point is worth reviewing. Let us take a meander down memory lane. Abbigail J. Chiodo and Michael T. Owyang have written a paper on the Russian Currency Crisis [33], which provides a very good anatomy of the crisis. April 1996 Negotiations with the Paris and London Clubs for repayment of Soviet debt begins. 1997 Trade surplus moving toward balance Inflation around 11% Oil selling at $23/barrel Analysts predict better credit ratings for Russia Russian banks increase foreign liabilities Real wages sagging Only 40% of workforce being paid fully and on time Public sector deficit high. September/October 1997 Negotiations with Paris and London Clubs completed. November 11, 1997 December 1997 February 1998 March 23, 1998 April 1998 April 24, 1998 Early May 1998 May 19, 1998 Mid May 1998 Asian Crisis causes a speculative attack on the ruble CBR defends the ruble losing $6 billion Year ends with 0.8% growth prices of oil and non ferrous metals begin to drop New tax code submitted to the Duma IMF funds requested Yeltsin fires entire government and appoints Keriyenko Continued requests for IMF funds Another speculative attack on the ruble. Duma finally confirms Keriyenko s appointment Dubinin warns government ministers of impending debt crisis, with reporters in the audience. Kiriyenko calls the Russian government Quite poor CBR increases lending rate from 30% to 50% and defends the ruble with $1 billion Lawrence Summers not granted audience with Kiriyenko Oil prices continue to decrease Oil and gas oligarchs advocate devaluation of ruble to increase value of their exports. 29