As the ongoing Eurozone crisis illustrates, safely reducing debt and clearing the way for economic growth in the aftermath of the global credit bubble will take many years and involve difficult choices. Mature economies have only just begun deleveraging and the limited progress to date has been exclusively in their private sectors (households, corporations and financial institutions) – in most countries, government debt continues to rise. However, history shows that private sector deleveraging after a financial crisis can, under the right conditions, lead to renewed economic growth and then public sector debt reduction.
These are the principal conclusions of a new report from the McKinsey Global Institute (MGI), Debt and Deleveraging: Uneven progress on the path to growth. This research updates MGI’s report from January 2010 that examined the global credit bubble and looked at 32 historical episodes in which countries significantly reduced their debts – or deleveraged – after a financial crisis.
The new report revisits the world’s ten largest mature economies to see where they stand in the process of deleveraging, focusing in particular on the experience and outlook for the United States, United Kingdom, and Spain, three countries covering a range of deleveraging and growth challenges. It also examines the relevant lessons from history about how governments can support economic recovery amid deleveraging, and identifies six key markers business leaders can look for to monitor progress of specific countries.
The report concludes that the United States has seen the most rapid deleveraging among the major economies so far, and may be as little as two years from returning to more sustainable levels of private sector debt. Progress in the United Kingdom and Spain has been more limited, and those countries face a longer period of gradual debt reduction.
Commenting on the new report, Charles Roxburgh, London-based director of the McKinsey Global Institute, said: “In 2010 we considered how difficult and lengthy the deleveraging process can be, by analysing past deleveraging episodes. There are no quick fixes – and there may be more bumps in the road ahead. Understanding the interplay between deleveraging and growth can help policy makers and business leaders steer the proper course as their national economies continue to recover from the financial crisis.”
The report examines the conditions that Sweden, Finland, and other deleveraging economies achieved in the past to revive growth. Susan Lund, director of research for MGI based in Washington, DC.
“The countries that successfully reduced debt, such as Sweden and Finland, dealt decisively with the debt overhang, stabilised the banking sector, and enacted structural reforms to enable private sector investment and growth. They then went on to experience more than a decade of strong GDP growth – this is the good news. Countries that did not enact such reforms, such as Japan, have felt the lingering effects for the financial crisis for many years. The challenge for all countries will be to balance the need for debt reduction with the need to revive growth,” the report added.
Key findings include the deleveraging process has only just begun in most countries. Based on data up to Q2 2011, total debt has actually grown across the world’s ten largest mature economies since the 2008-09 financial crises, due mainly to rising government debt. Only three countries in the sample—the United States, Australia and South Korea—have seen the ratio of total debt to GDP decline.
The deleveraging episodes of Sweden and Finland in the 1990s are particularly relevant today. These nations both experienced credit bubbles and collapses, followed by recession, debt reduction and eventually a return to robust economic growth. The experience of these nations and other historical examples show two distinct phases of deleveraging. In the first phase, lasting several years, households, corporations, and financial institutions reduce debt significantly. While this happens, economic growth is negative or minimal and government debt rises. In the second phase of deleveraging, GDP growth rebounds and then government debt is gradually reduced over many years.
Today, the United States is most closely following the Nordic path towards deleveraging. Debt in the financial sector has fallen back to levels last seen in 2000, before the credit bubble, and the ratio of corporate debt relative to GDP has also fallen. US household debt has declined by $584 billion, or by 15 percentage points relative to income. This is more than in any other of the largest economies; at this rate US households could reach sustainable debt levels in two years or so.
Deleveraging in the United Kingdom and Spain is proceeding more slowly. In the United Kingdom, total debt relative to GDP has grown slightly, due to additional borrowing by both the government and the non-bank financial sector. UK households have reduced their debt relative to income by just 10 percentage points – and the absolute amount of UK household debt has actually increased slightly since 2008. In Spain, households have reduced debt relative to income by even less and corporations continue to carry the highest ratio of debt relative to GDP among the ten largest economies. It could take a longer time to finish an orderly deleveraging in the United Kingdom and Spain, and policy makers in these countries will need to adopt policies that enable deleveraging while creating the conditions for growth.
Reduce public debt, the United States has reached more of these milestones than other nations and is closest to moving into the second, growth phase of deleveraging. No single country has all the conditions in place to revive growth, however. In all deleveraging countries, the challenge in the next few years will be to find the correct balance between the need to reduce debt and the need to revive GDP growth. While there are clear patterns and markers of success to guide policy makers, there is no simple formula. Each nation has unique challenges.
Understanding the course of deleveraging will be of critical importance to business leaders. Overall growth in the time of deleveraging is likely to be restrained, but the pace of debt reduction varies across nations and sectors and from place to place within nations. This provides opportunities for businesses that take a granular approach to strategy and for executives who can overlay their own assessments of the impacts of deleveraging on general forecasts. For example, the report notes that businesses that can anticipate the course of deleveraging in specific markets can invest ahead of recovery in demand and gain share. The report examines several trends that are driven by deleveraging and will influence growth in coming years.