The Next Bubble
Following the financial crisis in 2008, central banks flooded financial markets around the globe with money in an effort to aid the economic recovery, spur economic growth, and recapitalize and deleverage the banking system. Central banks, such as the United States Federal Reserve, lowered interest rates from 5% to 0% and started purchasing assets in an effort to spark growth, increasing their balance sheet by 70%. Monetary easing continues around the globe to this day, and rates have been taken so low—in some cases even to negative rates—that countries now find themselves with strong incentives to borrow. Unless central banks in the U.S. and throughout the world raise interest rates, this negative trend toward further global indebtedness will not stop. In fact, because of this steady debt accumulation, many worry that a financial or debt crisis among one of the world’s major economies will explode into an international economic catastrophe.
Historically, debt has been linked to healthy economic growth. Whether it is government, household, or corporate, debt fuels growth by linking those who have capital with those who need to put capital to use. When an economy is weak, debt has the ability to stimulate growth. To sustain that growth, the amount of debt taken on must be carefully calculated, and can never exceed a debtor’s ability to pay back their obligation to their creditors. In a vacuum, debt could be kept at this equilibrium level. However, since central banks cut rates to zero in 2008, and after that into negative levels in Japan and the Eurozone, borrowing has spiked to unsustainable levels. Today all major economies maintain a higher level of borrowing to GDP than they did before the crisis.
Globally, debt has risen to $217 trillion, over double what it had been at the start of the century. Debt to GDP—a measure that indicates a country’s ability to produce and sell goods and services sufficient to pay back debts—has risen from 200% to 325% over the same period, indicating that borrowing has outpaced economic growth. Slow growth has continued since the crisis, making it extremely difficult to pay off debt. This slow growth, low rate environment has created a tremendous problem in which companies pay for their outstanding obligations by taking on more debt. Though the IMF doesn’t have a specific point at which it claims debt levels to be “dangerous,” it does note that 225% of global debt to GDP qualifies as such. As the IMF points out, this level of debt is unprecedented. The uncertainty created by this indebtedness has sparked both fear and profound apprehension around the globe that an economic collapse in one country will spread throughout the world. The biggest worry on this front is China.
As the second largest economy in the world and the largest emerging market, China is deeply embedded within the global economy as both a major producer and, more recently, as a consumer-driven economy. Just as in many cases around the globe, China’s debt level has quadrupled since 2007. This debt has been mostly domestic (debt held by banks), and used to finance real estate (a related but entirely different problem). Additionally alarming, China’s debt to GDP ratio has soared from 150% to 277% in the past ten years. Historically, this cumbersome increase in debt has been linked to financial busts or abrupt economic slowdowns. The high level of debt seen here isn’t the only problem, though; some of these loans are toxic.
In total, 5% of loans in China have been defaulted on recently. More alarmingly, out of a survey of 1,000 Chinese firms, 16% of them owed more in interest than they earned before taxes, leading to what could become a spiraling cycle of debt. This statistic not only points to the high level of debt in China but also to the ineffectiveness of borrowing at consistently spurring growth. In 2015, a small 2% devaluation in the Yuan disrupted global financial markets. Should this debt bubble we see among Chinese firms pop, initiating a larger debt crisis, financial markets throughout the world would be in utter disarray.
Because of China’s history of government intervention in the Chinese economy and financial markets, there is widespread speculation that President Xi Jinping will bail out Chinese banks if there is a financial crisis. If the government’s manipulation of China’s economy, financial markets, and currency is any indication—and their push to reassure the Chinese people that the recent slowdown in GDP growth is but a speed bump and not the beginning of a larger decline—it is clear that the Chinese government will do whatever it takes to maintain their GDP growth goal of 6.7%.
While the accumulation of debt in China is a major problem that needs to be addressed, it is not the only problem facing global markets and the economy. Artificially low interest rates have misallocated capital and distorted asset classes, causing investors to chase yield, thereby creating asset bubbles. Namely, the real estate market has been inflated in many economies around the world, as low rates give buyers access to cheap financing. This phenomenon is reminiscent of the crisis the United States experienced almost a decade ago, and merits immediate attention if we hope to avoid a similar period of economic downturn.
Equities have also rallied under these low interest rates—specifically dividend stocks, which investors now prefer over bonds in this low-rate environment because of their higher yield. Historically, investors purchased junk bonds in search of yield, but now that rates are so low that bonds produce only small amounts of yield, securities (like these dividend stocks) are the choice pick for investors. In adjusting their portfolios to own more of these dividend-paying stocks, however, investors arguably fail to take into account the valuation of the company whose stocks they are buying. Thus, company valuations have been inflated to the point that many companies are now valued higher than their profit margins suggest they should be. Low rates have similarly distorted the foreign exchange markets as investors chase yield, disrupting the efficient flow of capital and depleting profits from U.S. multinational corporations. Adding to these distortions, central banks around the globe have attempted to keep rates low to weaken their currencies and ensure the attractiveness of their exports. The weaker their currency, the cheaper their exports, the greater the profit they can accrue—at the expense of those who do not manipulate the value of their money.
Low rates and distorted financial markets have caused problems for financial institutions worldwide, such as pension funds, banks, insurers, and for individuals, such as savers and retirees like our parents and grandparents. Banks—which at their most basic level perform savings and loan operations—are having a difficult time with low rates due to the low net interest margin (the difference between what banks borrow and lend, i.e. their profit) that they create. When rates are higher, banks have higher net interest margins, thus increasing their profitability and ability to loan more to consumers and businesses, eventually aiding economic growth. Furthermore, retirees dependent on interest income have become unable to rely on the safe income stream that comes with investing in the debt market. Pension funds and insurers who are vitally dependent upon the revenue stream to fulfill obligations to their clients are forced to purchase other assets in search of the yield necessary to fulfill those obligations. This international low-rate environment has caused harsh problems for the financial institutions that companies and individuals depend on for economic benefit and daily sustenance.
One can never know exactly when a debt bubble will burst. It is for this reason that we must act now. Around the world, debt needs to be deleveraged to sustainable levels. Although debt is normally an incredibly efficient catalyst for growth, the enormous amount of monetary easing worldwide renders this conventional tool for growth ineffective. Low rates cannot be sustained any longer. They must be addressed immediately before we experience another global meltdown.
(Overhead picture by Carl Icahn)