Category Archives: Debt

China’s credit expansion in perspective

28 Friday Dec 2018

Posted by in Debt, EM

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There seem to be three aspects of the recent debate about China’s private credit build-up:

1) Is it excessive? Yes, but it is not extreme.

2) Has it been misallocated? Probably yes, but not necessarily more than in other countries now or in earlier stages of development.

3) How will the authorities handle the inevitable credit burst? That remains to be seen, but due to its unique political system, China seems to be more in control than other countries which have undergone a similar fate Question is whether this control will result in a positive outcome.

China’s recent credit build-up is indeed big: its recent private credit-to-GDP gap (a BIS indicator measuring the speed of credit creation now relative to its long-term trend) is currently the largest in the world. 

China’s credit build-up seems to have accelerated especially so after the great financial crisis in 2008. 

However, private credit creation growth in China reached a top (using four quarters MA of the credit gap as an indicator) sometimes in 2015 and has been decreasing since then. 


Indeed, China’s absolute private credit to GDP ratio is nowhere near some other countries’ extremes. 

It is the corporate sector which has levered… 

…with households still relatively unlevered. 

And of the corporate sector, most of the debt is concentrated in the SOEs. Finally, its government sector is unlevered,  leaving the total (private + public) credit to GDP even lower relative to majority of other countries. 

 

Bottom line is, China seems to have a lot of credit space left, giving it some room for “a beautiful deleveraging”.

The fact that most of the credit is in CNY gives a lot of flexibility of how that deleveraging is done – on China’s own terms (there is some foreign currency debt but a lot of it is either matched by corporate foreign currency assets or covered by the country’s own FX reserves).

Having travelled extensively throughout the whole country, I can confirm that there are ghost cities but the state of the overall infrastructure, pretty much everywhere, is first class, probably on par, or even better than most of continental Europe while putting US/UK infrastructure to shame. Having travelled also through all of Central Asia and after spending a month in the Philippines and now in Malaysia, I can also attest that the alternative, not spending so much on infrastructure, is infinitely worse.

So, by investing in real estate and infrastructure projects, and given its large population which is emerging from decades of under-development, is China misallocating more capital relative to:

  • the developed world, particularly, UK and US, where since the 1980s majority of credit created was against existing (unproductive) assets like residential real estate and financial assets for speculative purposes, leaving current infrastructure in a crumbling state? That’s in sharp contrast to the period between WW2 and the 1980s when credit was allocated to the production of goods and services and infrastructure projects like the interstate highway system in the US (a period more comparative to China’s developments now, and one largely heralded as the golden stage of economic growth).
  •  the developing world, which similar to China now is also in need of massive infrastructure development but instead national capital has been syphoned off to offshore wealth centres? Yes, there has been private capital outflow from China as well but it would have been much bigger had the capital account not remained closed.

It would take time before we know for sure whether the decisions Chinese leaders are making are beneficial for the country or not. It is fairly likely, though, that this credit expansion is not sustainable. Should this boom be followed by a bust, we could be fairly certain that the situation would be carefully managed by the authorities, unhindered by either hostile domestic political opposition, like in the majority of the democratic Western world or by foreign creditors, like in the majority of the developing world.

How would they handle it? If history is any guide, they did a pretty good job both during the Asian crisis in 1997/98 and the great financial crisis of 2008. Third time lucky?

I expect the authorities to continue building up the social safety net – pension and health care system – alongside expanding and improving the financial assets universe. They could simultaneously deflate the real estate bubble, by starving it of additional capital and inflate financial assets by encouraging diversification into them. Unlike, developed world countries where household wealth generally collapses during crises, Chinese households could come out unscathed from this as they are unlevered. In addition, any losses on their real estate portfolio could be offset by gains in their financial assets portfolio. Finally, with the right social safety net in place, they would also feel more secure for their future than before and therefore welcome such an outcome.

 

Note: All data used above is from BIS

What is the optimal central bank balance sheet size?

16 Thursday Nov 2017

Posted by in Debt, Monetary Policy, Questions

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Answer: Depends on the size of the overall financial system balance sheet and whether it is deleveraging/leveraging.

This is a follow up on a previous post addressing the rationale for a continued increase of the major central banks’ balance sheet barring a sudden rise in the ‘private’ banks’ balance sheets.

Summary: We have been used to a small and relatively stable central bank balance sheet because before the 2008 financial crisis, the banking system balance sheet had been steadily growing. However, post the crisis, the banking system started deleveraging across the developed world. To avoid a continuation of the financial crisis, the central banks there had no choice but to leverage, i.e. increase their balance sheet.

Going forward, the size of the central bank balance sheet will be very much determined by what happens with the banking system balance sheet as a whole: if banks continue with the deleveraging, something which is more than likely given the plethora of financial regulations (Dodd-Frank, Basel III, MIFID2, FATCA, AMLD, AIFMD, CRS, etc.), the central bank may have to continue to expand its balance sheet or face another financial crisis.

Background

Since the 2008 financial crisis, to most economic observers, central banks have been increasing their balance sheets in order to facilitate easier economic conditions having exhausted their conventional means to do so. There is a strong debate among economists, investors and market practitioners, in general, about the effectiveness of such policies. I argue that the direct economic issues (growth, inflation) may have been of secondary importance to the reasoning behind the increased central bank balance sheets.

Central bankers’ primary objective may have been financial stability, including maintaining a stable rate of growth of the country’s total financial balance sheet. In that sense, some central banks’ balance sheet may need to grow even larger if the ‘private’ banking sector continues to deleverage.

On one hand, central banks’ balance sheets are unique in the sense that they act as the lender of last resort: they control, and, to a certain extent, regulate the money supply. That’s the conventional view of central banks. On the other hand, they are an integral part of the country’s financial sector, and, therefore, cannot be viewed in isolation.

The ‘private’ and central banks’ balance sheets are indeed linked together. We have been used to the former generally rising, especially so after the great financialization of the economy beginning in the 1980s. Therefore, we have taken it for granted that the central bank needs to just ‘sit back and relax’: there was no need for it to do any heavy lifting, i.e. the central bank’s balance sheet did not need to rise relative to GDP or to the whole financial sector’s balance sheet.

Since 2008, however, we have seen the private banking system heavily deleveraging in the US and EU. In Japan, the deleveraging actually started in the mid-1990s when the ‘private’ banking system’s balance sheet started shrinking relative to GDP. In order to maintain financial stability, the central banks in these respective countries needed to start to increase their balance sheet at a much faster pace than GDP and, more importantly, than the rate of deleveraging of the ‘private’ banking sector.

Japan

Even though it started properly leveraging (QE) only in the early 2000s, the Bank of Japan (BOJ)’s balance sheet started growing relative to GDP at the same time the domestic commercial banks’ balance sheet started deleveraging in the mid-1990s (see the chart on the right hand-side of the panel below). Nevertheless, the total financial system balance sheet (BOJ + the commercial banks) continued to decline between 1995 and 2007 (see the chart on the left-hand side of the panel below). The BOJ should have expanded its balance sheet much more back then.

Ironically, it was after the 2008 GFC that the domestic commercial banks’ balance sheet in Japan started growing again in line with also the BOJ’s balance sheet. As a result, the total financial system balance sheet also started growing. However, it took until 2016 for it to reach its previous peak from the mid-1990s. That was mostly thanks to the BOJ heavily increasing its balance sheet by starting to buy also private assets – corporate bonds, REITs, equities.

EU

Financial institutions in the Euro-area started deleveraging after the sovereign crisis in 2012 and since then have shed about 4Tn EUR in assets (Left-panel chart below). The European Central Bank’s (ECB) balance sheet, on the other hand, has increased by about 3Tn since the 2008 financial crisis with the majority of the increase happening after 2014 (Right-panel chart below).

Indeed, between 2011 and 2014, both the banking system’s and ECB’s balance sheets had been decreasing relative to EU-area GDP – a fact which substantially contributed to the prolonged negative effect of the sovereign crisis and kept European assets underperforming (Right-panel chart below). Since 2014, however, while the banking system balance sheets continued to decrease, the ECB balance sheet started to rise relative to GDP.

As a result of that, the total balance sheet (ECB + financial institutions) has started to stabilize at these levels (Left-panel chart above). Nevertheless, it seems that the ECB is indeed repeating the BOJ error of taking its time to raise its balance sheet to support the deleveraging happening in the banking system. If that deleveraging continues, as is more likely than not on the back of continued regulation (Dodd-Frank, Basel III) and the pressure form fintech and now cryptocurrencies, the ECB will most likely also have to massively increase its purchases by adding private assets to the list, just like BOJ.

US

US total banking system assets (Fed + financial institutions) are unchanged since the 2008 financial crisis (Left-panel chart below). Even though, the financial system has indeed deleveraged by the order of $3Tn (Right-panel chart below), the Fed has made up by leveraging its balance sheet by about the same amount. In fact, this is the first time since WW2 when banks in the US have deleveraged.

However, most of the liquidity in the system since the mid-1990s has been generated in the shadow banking system (see here, for example). Therefore, for the US, I have compared the central bank’s balance sheet to total domestic liquidity (Charts below).

Total liquidity relative to GDP is still decreasing despite the efforts of the Fed to the contrary (Left-panel chart above). Except for the period between WW2 and 1957, there was only one other period when total domestic liquidity was decreasing – during the Savings and Loan crisis in the late 1980s.

Fed’s liquidity is now starting to slow down as well. This is a big risk if the banking system also continues to deleverage (Right-panel chart above).

Conclusion

BOJ, ECB, Fed balance sheets are much bigger relative to GDP and relative to where they were before the crisis on absolute levels, but relative to the total balance sheet of the financial system they are still quite small. If the ‘private’ banks continue to deleverage, the central banks’ share of the total balance sheet will continue to naturally rise even if they do not increase their balance sheet. The overall financial system will shrink as a result. However, the risk to the financial system is much bigger if the central banks also deleverage at the same time.

‘Mining’ for money is a ridiculous idea

03 Friday Nov 2017

Posted by in blockchain, Debt, Monetary Policy

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Martin Walker (FT Alphaville) touches upon an important aspect of the modern crypto money creation process: the ridiculous costs and unnecessary side effects of digital ‘mining’.

Bitcoin exemplifies our bizarre relationship with money through the ages stemming from our lack of understanding of what it is. It’s as if we are cursed to never come to terms with money’s functions and how they help us progress. Our problems started with us prioritizing the ‘store of value’ of value function of money over ‘medium of exchange’ and ‘unit of account’. For if money is expected to increase in value, it is much more likely to be hoarded than exchanged and thus it will eventually cease to be a reliable unit of account.  

From the very beginning of humankind, it has indeed been a constant one step forward, two steps back kind of dance with our faithful companion. Money originated as a ‘gift’= a debt of gratitude to our fellow tribal members who shared their luck of finding more food than they needed. When our memory (of ‘how much’ we owe whom) failed and disagreements became common, we created the first money ledger run by the first central authority (the tribe leader): lines in the sand of who ‘owes’ who.

From there on, it all went downhill for different reasons: huge, cumbersome stones; other stupid object; precious metals… There were some interruptions to this craziness: the time of the Roman republic, the first fiat money in China, the Italian city states creating the first modern ledger during the Renaissance. But generally speaking the crazy money mist always came back and deluded us in going to extremes (mining foreign lands, killing indigenous people, etc.) to obtain shiny objects and call them money.

Until it all ended in 1971 when Nixon pulled the US out of the Bretton Woods Agreement and fiat money became the norm globally. And now, in 2017, having reached an extraordinary level of human progress, once again the mist is descending in front of our eyes and we are thinking about going back to ‘mining’ for money?  

Plenty of liquidity but scarce money

05 Thursday Oct 2017

Posted by in blockchain, Debt, Monetary Policy, UBI

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“All the perplexities, confusion, and distress in America arise…from downright ignorance of the nature of coin, credit and circulation” John Adams in a letter to  Thomas Jefferson

1)We should have never ‘put together’ “store of value” and “medium of exchange”.    

2) If something has intrinsic value which is expected to go up in time, it will be hoarded and exchanged less often.

3)’Money’ is a “unit of account” which we ‘exchange’, in order to efficiently get the things we really need and want in life.

4)Inflation/Deflation are simply measures of whether ‘money’ is abundant or scarce relative to the economic activity we desire.

5)In the economic system we have created, purchasing power is gained either through paid work or through credit.

7)As long as companies earn a profit, they retain more ‘money’ than they distribute in wages and other payments, thus there is insufficient medium of exchange to meet the supply of goods.

7)Even if companies invest the profit in new projects, this only adds to the previous supply-demand imbalance unless new medium of exchange is added endogenously in the form of credit.

8)Advances in technology make the old paradigm of Work=Job=Income obsolete; purchasing power is lost.

9)Credit only makes the scarcity of ‘money’ more acute because new medium of exchange needs to be added just to pay the interest on the debt; a vicious cycle develops.

10)This credit/debt cycle also eventually comes to a natural end (2008); no more purchasing power can be added even endogenously.

11)If we want to keep the current economic system going, we need to find a new way of generating ‘purchasing power’.

12)But if the paradigm has shifted, normalization is meaningless; instead of going back to something that does not work, let’s look forward.

12)’Helicopter money’ has an, unjustifiably, bad reputation historically.

13)UBI is politically unfeasible to implement in a large country with open borders.

14)The problem with them in the past has been our lack of knowledge of existing economic activity, and thus our inability to disburse the right amount of purchasing power needed.

15)M≠PxT, so we invent V, in order to MxV=PxT

16) Both of them, however, are great ideas which need to be put in the context of our existing institutional framework.

17)The central bank opening its balance sheet (CBDC) to the public at large is the next step in monetary/fiscal policy.

18)Blockchain, as in a large, open, decentralized, distributed, real-time database of all economic transactions, is the digital equivalent of ‘GDP’ of the industrial era.

19)The Fisher’s equation above then takes the form of CBDC=Blockchain, ‘money’ matches economic activity.

What if central banks gave the QE money to the people?

03 Tuesday Oct 2017

Posted by in blockchain, Debt, Monetary Policy, Questions, UBI

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I would not be blindfolded by the fact that the US is trying to go back to ‘normal’ with the Fed on a rate-raising spree. ‘Normal’ changed a long time before 2008. You cannot go back to ‘normal’ with a broken monetary transmission mechanism. We can create all the money in the world but if it goes in the hands of the few, if it is subsequently ‘hoarded’ and if it cannot  reach the end consumer because Work≠Job≠Income (whether that is because of technology, globalization or whatever) or because the credit channel is closed (the end of the private debt super-cycle in 2008), the economy is not going to go anywhere. And if there is little demand because there are not enough mediums of exchange, aka money, circulating in the economy, optimizing production is a waste of time and resources.

Instead of focusing on going back to a ‘normal’ interest rate policy, a forward-looking central bank would be looking into the opportunity presented by the rise of the blockchain technology and the subsequent spread of digital cryptocurrencies. The latter are a direct response to the broken down monetary transmission mechanism: if the traditional mediums of exchange do not circulate in the economy, people are devising their own ways of exchanging goods and services.

The interest-rate cycle is something of the past now. If the financial crisis of 2008 did not make it obvious, perhaps, we have to wait for the next one, which would be here like clockwork as policy makers embark on the policy of ‘normalization’. But there is some hope that some central banks are looking into ways to introduce a digital currency of their own and opening their balance sheet to the public at large.

Back of the envelope calculation shows that if the money spent on buying financial  assets by the central banks of UK, US and Japan, was instead disbursed directly to the people, working wages would have risen substantially.

Between 2008 and 2016, central banks’ balance sheets have risen by 360% in the UK, 99% in the US and 280% in Japan.

Source: Bank of England, US Federal Reserve, Bank of Japan

At the same time, over this period, nominal wages have risen by only 14.8% in the UK, 18.4% in the US and actually fallen by 2.9% in Japan! In 2016, the average annual wage in the UK was GBP 34,142, in the US – USD 60,154 and in Japan – Yen 4,425,380.

Source: OECD

Japan is peculiar also because its working age population declined by 7.4%, while US’ and UK’s rose by 4.5% and 2.7%, respectively, during this period.

Source: OECD

I took the actual change in central bank balance sheets and divided it over the average working age population between 2008 and 2016. If this money could have been disbursed directly to the people, workers would have received a lump sum of GBP8,574, USD10,997, Yen4,430,424 over the period.

Let’s imagine that this lump sum was disbursed to the working age population at the end of 2016. Compared to 2008, their wages in 2016 would then have been higher by 44% (UK), 40% (US), 98% (Japan)!

If wages could indeed ‘miraculously’ rise by almost half in the UK and US and almost double in Japan over this 8 year period, what are the chances that we would still be stuck around 2% inflation in the US and UK and around 0% in Japan? Where would GDP be?

This is a very simple exercise. Undoubtedly real life is much more complicated that this and it is rarely black and white. Moreover, this would have been a lump sum disbursement, a one-off boost to income, and not a permanent rise in wages. Consumer behavior in this case, Ricardian equivalence, etc., would have been very different from a situation with a permanent rise in wages.

However, instead of patting ourselves on the back that things could have been much worse had the central banks not backstopped the financial system by buying financial  assets, can we not also think how they could  have also been much better if we found a better use for the money miraculously created out of thin air? If we could create money out of thin air to boost financial asset prices, is it really not possible to devise a way whereby the consumer also gets a permanent rise in income? Can we have an adult conversation about the effects of such an experiment without resorting to the taboos of the past? Can we include people other than economists in this conversation?

The free market may be the best and most efficient optimization model available so far to us, but what if we are optimizing the wrong variable?

Who owns US corporate debt?

26 Tuesday Sep 2017

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This is Part Four of an exercise looking at how the ownership structure of major US assets has changed over the years. Part One (Equities). Part Two (Debt). Part Three (UST).

Source: Z1 Flow of Funds, US Federal Reserve

  • The largest holders of US corporate debt are foreign entities at 28.6% of all holdings. That’s up from less than 1% in the late 1940s.
  • The second largest holders are insurance companies at 25%. Even though their holdings have gone down from 44% in the 1940s, when they were also the largest holder by far, insurance companies seem to continue to play a dominant role in the US corporate debt market unlike so in equities or UST.
  • Mutual funds and pension funds come after at 18.6% and 10.8% respectively. Their roles have diverged since the mid-1980s with mutual funds relatively increasing, while pension funds relatively decreasing their holdings of US corporate debt.
  • Households were the second largest holder of US corporate debt in the 1940s at 31%. Today they are one of the smaller holders at 6.7%.

Source: Z1 Flow of Funds, US Federal Reserve

Who owns US Treasuries?

21 Thursday Sep 2017

Posted by in Debt, Questions

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Source: Z1 Flow of Funds, US Federal Reserve

2016

  • The biggest owner of US Treasuries (UST) are foreigners at 37.6% of total. Relative to other holders, their ownership actually peaked in 2008 at 44.2% and they have been net seller in the last two years.
  • The second biggest owner of UST is the Fed at 15.4%. If we add state and local governments to it, the government, as a whole owns, 20.6% of UST.
  • In the domestic sector, pension funds own the most at 14.5%, followed by mutual funds at 11% and households at 8.8%.

Over the years

Source: Z1 Flow of Funds, US Federal Reserve

  • The ownership of UST has changed significantly over the years. For example, at the start of the data in 1945, the financial sector (banks, broker-dealers, etc.) owned 41.9% of the total; in 2016 that had fallen down to 4.8%.
  • Households, the corporate sector and insurance companies have also substantially reduced their UST holdings over the years.
  • Mutual funds and pension funds, on the other hand, have increased them.
  • The elephant in the room, however, is the foreign sector, which in 1945 was the second smallest owner of UST (after mutual funds) at 1%. There was a big jump in foreign ownership in the 1970s and then starting in the mid-1990s.

T-Bills vs long dated US government securities

Source: Z1 Flow of Funds, US Federal Reserve

  • Majority of US government debt has historically been in long-dated instruments.
  • However, in the mid-1970s, there were about as many T-Bills as long-dated government paper. Nevertheless, over the last couple of years, the issuance of T-bills has declined to all-time low.

Who owns US debt?

19 Tuesday Sep 2017

Posted by in Debt, Questions

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…and how it is distributed

Source: Z1 Flow of Funds, US Federal Reserve

There was $41.3Tn of US debt in 2016 compared to $26.8Tn in 2006 and $12.4Tn in 1996.

Instruments

In terms of instruments, in 2016 total US debt was split as follows: 38.7% was in US Treasuries (UST), 29.3% was in US Corporates (USC), 20.6% was in Government Sponsored Agencies (GSA), 9.3% was in Municipal Bonds (Munis) and 2.6% was in Open Market Paper (OMP)

Source: Z1 Flow of Funds, US Federal Reserve

US Treasuries issuance as a % of total reached its all-time low in 2008 at 20%; the high was 1945 at 86%. There was a drastic reduction is US Treasuries issuance in the 1990s as Clinton’s administration decided to eliminate the US budget deficit. US Treasuries issuance picked up significantly after the 2008 financial crisis and almost doubled as a % of total by 2016.

Source: Z1 Flow of Funds, US Federal Reserve

US corporate issuance, on the hand reached an all-time high in 2007 at 36%; the all-time low was 1945 at 9%. Between 1999 and 2010 there were more US corporates bonds issued than US Treasuries.

Source: Z1 Flow of Funds, US Federal Reserve

Sectors

In terms of sectors, the largest owner of US debt is the US financial domestic sector at almost 60% of total, followed by the Rest of the World (RoW) at 26%, and the US nonfinancial domestic sector at 14%. Both domestic sectors have declined at the expense of the foreign sector as globalization spread after the mid-1990s.

Source: Z1 Flow of Funds, US Federal Reserve

The biggest holder of US debt in 2016 were indeed foreigners, followed by mutual funds, banks and households. While foreigners’ holdings are close to an all-time high, both banks’ and households’ holdings of US debt are at an all-time low.

Between 2008 and 2016, Fed’s holdings increased by almost x10 (1.6% to 10.2%). The rest of the government’s holdings however halved from 9% to 4.5%. Households and banks both reduced their holdings while foreigners increased them.

Source: Z1 Flow of Funds, US Federal Reserve

Margin call

12 Tuesday Sep 2017

Posted by in Debt, Quotes

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“So, you think we might have put a few people out of business today. That it’s all for naught. You’ve been doing that every day for almost forty years Sam. And if this is all for naught then so is everything out there. It’s just money; it’s made up. Pieces of paper with pictures on it so we don’t have to kill each other just to get something to eat. It’s not wrong. And it’s certainly no different today than it’s ever been. 1637, 1797, 1819, 37, 57, 84, 1901, 07, 29, 1937, 1974, 1987-Jesus, didn’t that fuck up me up good-92, 97, 2000 and whatever we want to call this. It’s all just the same thing over and over; we can’t help ourselves. And you and I can’t control it, or stop it, or even slow it. Or even ever-so-slightly alter it. We just react. And we make a lot money if we get it right. And we get left by the side of the side of the road if we get it wrong. And there have always been and there always will be the same percentage of winners and losers. Happy foxes and sad sacks. Fat cats and starving dogs in this world. Yeah, there may be more of us today than there’s ever been. But the percentages-they stay exactly the same.” John Tuld in Margin Call

Source: NYSE. Leverage is calculated as the following ratio: NYSE firms debit balances in margin accounts (or margin debt)/ (NYSE free credit balances in cash accounts + credit balances in margin accounts)

Are stocks overvalued? This is the longest stock bull market without a X% drop since XXXX (input your own numbers; they are meaningless, anyway)…  Sure, you must know your history and you must know your valuations. That’s the minimum when it comes to investing money. But none of them provides an edge. History is a pattern recognition puzzle, and, nowadays, as long as you provide the right inputs, even a simple algo would be able to sort it out. Valuation, on the hand, is just simple math. But again, you need the right variables. Knowing what to include and what to omit is tough but it is what would make a difference.

There is one thing, however, which I think beats all other ‘basic’ variables when it comes to figuring out the turning points in investment trends. I think that is leverage. Leverage matters especially in situations like we have today with stocks hitting all time highs and smart people questioning the sustainability of this long bull market. The thing is, we believe history and valuations provide the answers but it is a mind trick – we get the impression they do because that’s what we have been told and because it looks like this… but only in hindsight.

The market, however, can go down on anything that scares people if leverage is high. And it would not be one particular thing: everyone might have a different reason to sell. It could be a geo political event or it could be even something personal. But the underlying reason for selling would be the same – they had to sell!

“Everything needs to change, so that everything can stay the same” (‘Il Gattopardo’, Guiseppe Tomasi di Lampedusa). In other words, what is the context? The same event that happened 50 years ago might provide a totally different outcome now. If it was otherwise and life was linear, investing would have been too easy and life would have been too boring.

For example, history ‘changed’ in 1982 when rule 10B-18 was introduced providing ‘safe haven’ for US companies to buy back their own shares. Corporate buybacks were almost non-existent before. After this rule came into place, US corporates became the biggest buyers of US shares. The result has been negative net-issuance of US shares since at least 2000. Let me repeat that, the net supply of US shares (IPOs, etc. minus buybacks, etc.) has been negative for the last 17 years or so. How many people are taking this into account when they do their valuation analysis?

On the other hand, given how much the composition of stock indices has changed throughout time, how relevant is it to look at a time-series of index-based valuation variables?  Aren’t we comparing apples to oranges? Should US Steel, for example, trade at the same multiples as IBM, Apple, Amazon? I do not have answers to these questions. And even if I did, it would be irrelevant because what matters is what everyone else also thinks, and even if I knew what everyone else thinks, it would be still irrelevant because people do not always do the things they should be doing or thinking. But people always act when they do not have a choice.

When your broker calls you to post some extra margin, which you cannot do, you do not have a choice but to sell. But, don’t worry, this is not going to happen when stocks are hitting all-time highs. So, don’t get too excited about getting the top of the market even if you know what the leverage is. But knowing that the leverage is too high and that, maybe, just maybe, people do not have a choice, will help you sell AFTER the market has gone down 2%, 5%, 10%… Whatever that number is, whenever you think the ‘pain’ becomes unbearable. This is when the trend changes and the buy-on-dip guys get buried and it becomes sell-on-pops.

So, the trick is to measure the leverage or to at least to get an idea of how extended it is. One widely cited measure is the NYSE margin debt (the debit balances in margin accounts – chart below). I remember it was a compelling chart to look at in the summer of 2013 when margin debt was approaching the pre-2008 highs. But then it kept going and going, hitting new highs ever since… In the spring of 2015, after it had hit yet another high, it started dropping all the way until the beginning of 2016. And what happened to stocks? Nothing. Margin debt  is sitting on a new high even now but anyone shorting stocks using this measure of leverage has not done that well recently.

Source: NYSE

We can also look at the difference between the credit (+ cash) and debit balances of firms’ margin accounts on the NYSE. I call that net margin debt (chart below). That’s even more confusing as we can see the pre-2000 top but for some reason NYSE firms were in net credit (big negative spike) just before the Lehman Brothers bankruptcy. And again, since the summer of 2013 this measure of leverage has been hitting new highs.

Source: NYSE

Alternatively, we can look at the ratio between the two, or what I called, NYSE ‘Leverage’ (chart at the top of the post). This measure is approaching the highs reached at the peak of the Russia crisis and Dotcom crisis. Should we sell? How well would we have done if we followed this signal in 2008? Quite bad actually as this ratio hit the bottom the month before Lehman’s bankruptcy. But of course, 2008 was a ‘debt’ problem, not an ‘equity’ problem like 2000 was. Still US equities had a peak-to-trough decline of more than 50% back then. The bottom line is still that there was not much in the equity valuations and ‘nothing’ in equity accounts leverage that would have helped us predict such an outcome.

These charts above are not especially useful and would not have been much help in our investment decisions. That’s because even leverage has to be taken into context when looking at history. Because even if you have to post extra margin but you can still borrow at a reasonable rate (somewhere else) you might decide to choose the latter instead of selling. So, ceteris paribus, high leverage and high interest rates are the worst possible combination, but high leverage and low rates (the status quo since 2013 at least) means nothing.

Source: NYSE

Indeed, in the context of US interest rates, NYSE leverage actually looks reasonable, not too far from the lows post 2008 financial crisis (chart above). This is purely a function of how low rates have been in that period. Notice, for example, the high leverage throughout the 1990s when we also had a booming stock market. Which opens up another angle of thought. If rates do rise, as the base rate is indeed right now, then high leverage can quickly become a problem.

When it comes to debt stock, the data still favors EM, but flow dynamics matter

09 Saturday Sep 2017

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In this post I am looking at debt sustainability, or the horizontal axis of the debt matrix presented here, using data from 36 countries of which 20 are developed markets (DM) and 16 are emerging markets (EM). Source: BIS

Total non-financial debt is composed of Private Debt and Government Debt. Private Debt can be further broken down between Households and Corporates.

Summary

  • In terms of total debt as a % of GDP, the most vulnerable 14 countries are all DM with Ireland (379%), Japan (371%) and Portugal (324%) taking the lead; on the other hand, the least vulnerable 13 are all EM with Indonesia (68%), Argentina (74%), and Mexico (82%) bringing in the rear. However, in terms of debt flow dynamics, EM has generally put on more debt after the 2008 financial crisis than DM.
  • We cannot see the latter development in the government debt picture. The 9 countries with the highest government debt to GDP are all DM, while the bottom 5 are all EM. In addition, the gap between DM and EM government debt since the 2008 debt crisis has widened (i.e. DM put on more government debt than EM).
  • But we can see that in the private debt picture. Yes, in terms of debt stock, the worst 7 countries are still all DM and the best 11 countries are all EM, but in terms of flows, the gap between DM and EM since the 2008 financial crisis has substantially narrowed – i.e., EM countries have accumulated substantially more private debt than DM countries.
  • The reason for that is EM private corporate debt, which has surpassed that of DM.
  • Nevertheless, if we strip the effect of China, the increase in EM corporate debt is not that dramatic.
  • There is one area in which EM private debt is still in much better shape than DM. That is household debt, where, in terms of stock, EM’s indebtedness is still half that of DM’s.

(Please click to enlarge for all chats in this post)

Details and charts

Total Debt

The worst indebted country is Ireland with its total debt as a % GDP doubling between 2008 (250%) and 2015 (500%), before settling in at 379%. There was a similar spike in indebtedness with most European countries in the top echelon of the above chart. Japan’s debt, on the other hand has been steadily increasing throughout the period.

The debt stock of the best EM countries is still several magnitudes less than that of the worst DM countries above. However, while DM’s overall debt levels have been more or less unchanged in the years after the crisis, EM has been putting on debt.

EM debt as a % GDP has increased from 140% (2009) to 185% (2016), while DM debt has been relatively stable at 265% of GDP.

Government Debt

Overall, EM debt stock as a % of GDP (46%) is more than half that of DM’s equivalent (98%).

And the gap has widened after the 2008 financial crisis, with DM government debt increasing while EM’s generally stable.

Private Debt

The latest private debt stock figures do not give us any additional information other than what we have already seen in total and government debt above: the most indebted countries being DM and the least EM.  The private non-financial debt service ratios confirm that as well (chart below).

However, the flow picture looks very different.

The gap between DM and EM private debt to GDP has substantially narrowed. If before the crisis, EM debt was less than half of DM debt (84% vs 176%), now they are almost on top of each other (138% vs 158%): EM has leveraged while DM has deleveraged.

(As per BIS, Credit-to-GDP gap is defined as the difference between the credit-to-GDP ratio and its long-term trend.)

After 2008, while DM has generally de-levered private debt at the expense of public debt, EM has levered private debt while public debt has remained the same. As a result, EM has levered while DM has de-levered. But where exactly has EM put on debt?

Both EM household and corporate debt have increased since the 2008 crisis but the bigger change is in the latter.

DM, on the other hand, has de-levered both household as well as corporate debt.

EM corporate debt surpassed DM corporate debt in 2014. However, if we strip the effect of China, the rest of EM’s corporate debt does not seem to have risen that much since 2008 (chart below).

In addition, EM households’ balance sheet still seems relatively much cleaner compared to DM’s (chart below).

The bottom line is that while DM’s debt stock is hitting extreme levels, EM’s still has room to grow. In addition, while all public and private debt levels are very high in DM, EM can in theory de-lever its corporate debt at the expense of either household debt or government debt and still keep its total debt level in check.

Conclusion: EM debt picture still looks generally healthier than DM’s equivalent. In fact, EM government debt dynamics have improved relative to DM’s after the 2008 financial crisis. The opposite has, however, happened in private debt dynamics. Nevertheless, despite worries of an increase in EM private debt indebtedness after 2008, this is mostly constrained to China’s corporate debt. EM household debt dynamics are also in much better shape than DM’s.