A Measured View of the Debt Crisis

Edward Chancellor, the financial historian now working for Jeremy Grantham's fund management company, has done more than anyone to illuminate the imminence and consequences of the global debt crisis. In his most recent White Paper on the subject, he picks a measured path through the thickets of what soveriegn debt problems mean for economies and for investors. Among the key points I picked out from his eight page study are these:


1. Rapid increases in sovereign debt don't have to lead to default or high inflation, although more often than not they do. One classic example is Britain after the Napoleonic wars. More recent examples, we know, include Sweden, Finland, and Canada in the 1990s. Swedish gross government debt fell from a peak of 84% of Swedish GDP to below 45% within three years.

2. Inflation and/or currency debasement is however more often than not the way out. It is politically more convenient and generally the easier option. Sometimes, when things have really deteriorated, it is the only option. Because repaying debt rewards the wealthy at the expense of the poor, devaluing the currency is, to borrow a phrase from Keynes, “the line of least resistance… it is, so to speak, nature’s remedy, which comes into silent operation when the body politic has shrunk from curing itself.”

3. The biggest problem today is that many countries today have very large structural budget deficits that cannot be fixed as readily as Britain was able to solve its Napoleonic war debt. The largest structural deficits, according to the Bank for International Settlements, are in the UK (10% of GDP), US, Ireland and Japan. What is more, these calculations exclude both the growing burden of unfunded liabilities such as pension and healthcare costs, which as we all know are enormous, and the bank guarantees given during the recent crisis.

4. A further problem is that large proportions of the outstanding debt of the worst affected countries are held by foreign investors. For Ireland, the Netherlands, Spain and France, the figure is around 60%. In the case of the USA, it is nearly 50%. In the case of the UK, it is around a third. This matters because, if you are looking for comfort from historical experience, in those cases where excessive levels of debt have been successfully reduced to more normal levels, most of the debt has been held domestically, reducing the risk of destabilising capital outflows and/or currency collapses.

Chancellor makes the valid point that it is easy, but wrong, to extrapolate naively from the cases of Japan (since 1989) and the Club Med countries in Europe (today) to argue that a calamitous debt implosion is likely or imminent in every heavily indebted country. The Club Med countries, Spain, Greece and Portugal, for example have specific problems, such as a lack of competitiveness ( exacerbated by their membership of the eurozone), which put them in a different category to the UK and United States. Fiscal retrenchment is already underway in the UK and other countries and may yet, if combined with renewed economic growth, produce an acceptable outcome.

There are simply too many unknown variables to make a definitive forecast of how the sovereign debt crisis will play out possible. The risk of policy errors remains high. Nobodyknows whether the political will to make painful but necessary decisions will hold. In 19th century Britain, when both wealth and political power were concentrated in the hands of a small landed minority, the owners of the debt had fewer qualms about imposing rising unemployment and poverty on the majority to safeguard the value of their debt.

For investors, the important message from Chancellor's analysis is that owning bonds of indebted countries at current prices can only make sense if you are convinced that the worst outcome is where we are heading. In his words, "under only one condition – that the world follows Japan’s experience of prolonged deflation – do they offer any chance of a reasonable return. But this is not the only possible future. For other outcomes, long-dated government bonds offer a limited upside with a potentially uncapped downside. As investors, such asymmetric pay-off profiles don’t appeal to us".

To which I would only add: nor me. Until or unless it appears that the extreme deflationary case is coming to fruition, which is not impossible, but a low probability outcome, I would judge, the safer bet is still that inflation is coming our way. When it does happen, history suggests, it can happen very quickly. How much and how soon are the unknowns. A copy of the White Paper is attached. Recommended.
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Pricking China’s Bubble Won’t Be Easy

I share the view of my friend and colleague Edward Chancellor, the financial historian now working for Jeremy Grantham at GMO,  that it will take more than one interest rate rise by the Chinese authorities in order to prick the blatant bubble that is developing in Chinese real estate and the less obvious one that may be developing in the Chinese stock market. You may find it interesting to compare Edward’s view in his latest Financial Times column with that of Angus Tulloch (posted at the weekend) and the interview with Anthony Bolton that I expect to post tomorrow. What happens in China matters because what the authorities do there is most likely to be echoed before long by their slower moving Western counterparts.

By Edward Chancellor

Recent moves in Beijing to tighten lending conditions have spooked Chinese investors. Given that easy money fuels asset price bubbles, it is tempting to believe that the withdrawal of liquidity signals an imminent end to the good times. However, history suggests that once a boom has got going, it takes several sharp blows with the monetary cudgel to extinguish the speculators’ animal spirits.

Around the middle of January, Beijing made clear that it wanted to bring to a halt what one regulator described as a domestic lending “binge”. Admittedly, this declaration only took place after a pick-up of lending in the first two weeks of the year, which saw more than Rmb1,000bn (£90.7bn, €105bn, $146bn) of new loans originated. This rate of lending growth was some three times higher than last year’s already inflated levels.

Several banks have apparently been ordered to suspend all new loans. Credit Suisse reports that letters of credit have suddenly been withdrawn. “Mortgage lending has been virtually suspended,” claims the investment bank, “leading to a slowdown in property transactions”. The Shanghai Composite has swooned in sympathy.

This lending diktat coincides with other measures, including an increase in bank reserve requirements and stricter mortgage rules, to tighten credit conditions in China. Beijing apparently wants to control the various real estate bubbles that are popping up around the country. Home prices in the coastal regions were up more than 20 per cent in the last year. Despite low interest rates, new homebuyers in Beijing are spending up to 70 per cent of disposable income on servicing mortgages, says CLSA. High end property sales more than doubled in 2009, says the brokerage firm. A large portion of these purchases were made by investors.

The lack of affordable housing is fast becoming a political issue in the capital. A popular television drama, Snail House, which deals with the travails of “mortgage slaves”, has recently been taken off the air. Furthermore, inflation is picking up, hardly surprising given that the money supply growth approached 30 per cent towards the end of last year. In theory, tighter monetary conditions should raise the cost and limit the supply of credit, thereby helping to cool the financial markets. In practice, however, great booms tend to continue long after policy has become restrictive.

For example, the Federal Reserve raised interest rates in January 1928 with the intent of halting speculation on the Big Board. Despite this, US stocks rose by a further 70 per cent over the following 20 months before finally peaking in September 1929. The end of the tech bubble followed a similar course. Although the Fed Funds Rate was increased in June 1999, the Nasdaq nearly doubled over the following 10 months. Other stock market booms have likewise continued long after tightening commenced.

Real estate booms appear even less responsive to the initial tightening. In 1989, the Bank of Japan started a series of five hikes that saw interest rates climb from 4.75 per cent to 6 per cent. Although the Nikkei peaked towards the end of the year, Japanese commercial real estate continued rising until late 1990, by which time land prices had risen a further 45 per cent.

The recent US housing bubble also took a long while to cool. The Greenspan Fed raised rates in June 2004. Some 24 months and 16 rate rises later, US home prices finally ground to a halt. The S&P/Case-Shiller Composite Home Price index had climbed 25 per cent since the first rate increase.

The last time the Chinese authorities attempted to deflate an asset price bubble was in January 2007. At that time interest rates were raised, bank reserve requirements increased, and important officials spoke openly about the need to quell speculation. Several commentators anticipated an imminent collapse of the Chinese stock market, which had doubled over the previous year. The outcome was rather different. Over the following months the Shanghai Composite entered a period of exponential growth. The market finally peaked in October 2007 after five rate hikes and 13 increases in bank reserve requirements since the beginning of the year.

Experience suggests that recent tightening in Beijing is unlikely to mark the immediate demise of the frenzied Chinese real estate boom. Nevertheless, it brings that end one step closer.

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