The key chart

Introduction

I began this series of five posts by stating that:

“the true value in analysing developments in the financial sector lies less in considering investments in developed market banks – they have been lousy LT investments – but more in understanding the implications of the relationship between the banking sector and the wider economy for corporate strategy, investment decisions and asset allocation.”

Over the next three posts, I presented a consistent, “balance sheet framework” for understanding this relationship and applied it to the UK economy and the three core sectors within the private sector – Financial Institutions (FIs), Households (HHs) and Non-Financial Corporations (NFCs).

I chose the UK economy deliberately to reflect the relatively large size of the UK financial system, and the relatively volatile nature of its relationship with the economy. Of course, the framework is applicable to any economy and my conclusion here will make reference to similar analysis for the euro area, and Germany specifically. More analysis of sector balances in Europe will follow soon.

The UK faces large and persistent sector imbalances and is increasingly reliant on the “rest of the world” (ROW) as a net lender.

At the end of 3Q19, the UK private and public sectors were running net financial deficits of -3.4% and -2.0% GDP respectively. These were offset by the ROW’s net financial surplus of 5.4%.

The key (OBR) assumptions behind the policy of fiscal tightening were that a move towards a public sector surplus would be accompanied by a narrowing of the ROWs net financial surplus and a widening of the private sector net financial deficit including high levels of borrowing. The first assumption proved wrong and the second only partially correct.

The 2020 OBR forecasts published in March will shed light on the government’s current assumptions but in the meantime I see downside risks to consumption and UK GDP growth and to further fiscal consolidation.

UK spotlights 1-4 in review

“Lousy LT investments, but…”

In “Lousy LT investments, but…” I presented a mapping exercise for the UK economy and its financial system. The key message was that a distinguishing feature of the UK economy was the relatively large size (and hence potential impact) of the money sector and the volatile nature of its relationship with the wider economy.

“Everyone has one…”

In “Everyone has one…”, I focused on the core services provided by the UK financial system (payments, credit and savings), how these services produce a stock of contracts that can be represented by financial balance sheets that link different economic agents over time, and how these balance sheets form the foundation of a highly quantitative, objective and logical analytical framework. This post built up to the key identity pioneered by the late Wynne Godley that states that:

Domestic private balance + domestic government balance + foreign balance = zero.

“Poised to disappoint”

In “Poised to disappoint…”, I highlighted the dominant role that UK households play in economic activity (FCE/GDP) and bank lending (the desire to buy properties) and their important role as investors in financial and non-financial assets. The key message was that while the HH was typically a net saver, the sector has been funding recent consumption by dramatically reducing its savings rate and accumulation of net financial assets (but not by increasing debt ratios). With real growth in disposable income slowing and the savings rate close to historic lows, I suggested that risks to UK growth lay to the downside and at odds with (past) government forecasts.

“Alternative investments”

In “Alternative investments”, I described the key economic roles of the NFC sector and explained that its (typical) requirement to borrow in financial markets in order to invest in non-financial assets meant that NFCs represent an important alternative investment vehicle for other sectors – offering stakes in their earnings (dividends) or interest payments in their debt. I concluded by asking that if NFCs widened their deficits further in order to fund investment, which sector will be increasing its surplus as an offset?

Imbalances and dependencies

Roles and balance sheets revisited

To re-cap, FIs, HHs and NFCs – the three core “economic groups” comprising the UK private sector – have distinct economic roles. In fulfilling these roles, they produce a stock of contracts that can be represented by financial balance sheets. These balance sheets link each group together (directly and indirectly) and form a highly quantitative, objective and logical analytical framework. A fundamental principle of accounting is that for every financial asset there is an equal and offsetting financial liability. In other words, if we take all of the financial assets and financial liabilities it is a matter of logic that the sum of the financial assets must equal the sum of the financial liabilities.

An important implication of this analysis is that for the private sector to accumulate net financial wealth (financial assets minus financial liabilities) it must be in the form of claims on another sector. In the simplified case of a two sector economy, the net financial assets held by the private sector are exactly equal to the net financial liabilities of the government. In this case, it is impossible for the private and public sectors to run surpluses at the same time.

Of course, in reality these domestic sectors are also linked economically to foreign FIs, NFCs, HHs and governments, collectively termed the “rest of the world” (ROW). Hence, the private sector can accumulate net financial assets equal to public sector liabilities, the ROW’s net liabilities or a combination of the two.

The private, public and ROW sectors can be treated as having income and savings flows over a given period. If a sector spends less than it earns it creates a budget surplus. Conversely, if it spends more that it earns it creates a budget deficit. A surplus represents a flow of savings that leads to an accumulation of financial assets while a deficit reduces net wealth. If a sector is running a deficit it must either reduce it stock of financial assets or it must issue more IOUs to offset the deficit. If the sector runs out of accumulated financial assets, it has no choice other than to increase its indebtedness over the period it is running the deficit. In contrast a sector that runs a budget deficit will be accumulating net financial assets. This surplus will take the form of financial claims on at least one other sector.

Implications for growth and policy

Applying this framework to the UK economy, I see large and persistent sector imbalances. Prior to the global financial crisis (GFC), the UK government ran an average net financial deficit of 2.5% GDP between September 1989 and September 2008. Of course, in the aftermath of the GFC, the private sector moved sharply into net financial surplus as one would expect. More surprisingly, given movements in real effective exchange rates, the ROW net financial surplus also remained high. The offset over this period was the widening of the government deficit to 10.4% which was an appropriate and necessary response to prevent a much deeper recession. Since December 2009, the average government net financial deficit has been 5.5% (ie more than double the pre-crisis average). This has been offset by private sector and RoW surpluses of 1.3% and 4.2% respectively.

I also see an increasing reliance on the RoW as a net lender to the UK economy. The key (OBR) assumptions behind the policy of fiscal tightening after the GFC were that the move towards a public sector financial surplus would be accompanied by a reduction in the ROWs net financial surpluses and a widening of the private sector’s net financial deficit driven by higher borrowing. The first assumption proved wrong and the second assumption on partly correct.

As at the end of 3Q19, the ROWs net financial surplus was 5.4% of GDP. This was offset by a narrow government deficit of 2.0% GDP and a wider private sector deficit of 3.4% GDP. Both the private and public sectors in the UK are running net financial deficits at the same time, something that can only happen is the ROW is running a compensating net financial surplus.

NFCs (and FIs) have increased their debt ratios slightly since 2015, but the HH sector debt ratio has remained stable. As discussed in “Poised to disappoint”, the HH sector has been funding consumption by slowing its rate of savings (sharply) and accumulation of net financial assets.

From this, I see risks to consumption and UK GDP and to further fiscal consolidation. High absolute levels of HH debt (% GDP) are constraining HH borrowing. Trends in disposable income and savings are, therefore, likely to be key factors driving HH consumption and growth in the UK. With real growth in disposable income disappointing and savings rates close to historic lows, the risks to UK growth from this analysis appear tilted to the downside.

Previous assumptions behind the policy of fiscal consolidation have already been revised to reflect the persistence of large RoW net financial surpluses. However, even the 2015 OBR forecasts that still assumed a narrowing of this surplus, required ambitious assumptions regarding the propensity of the private sector to increase their borrowing and financial deficits.

With larger than forecast ROW net financial surpluses, further fiscal consolidation requires even more private sector borrowing which I see as unlikely. The 2020 OBR forecasts published in March will shed light on the government’s forecasts but in the meantime, I see further risks to their previous assumptions.

What next? Europe…

In future posts, I will be analysing euro area economies through the same balance sheet framework. Dependency on the ROW is also relevant, but for very different reasons. In direct contrast to the UK trends described above, the German private and public sectors are both running net financial surpluses. These are offset by ROW net financial deficits.

The UK is dependent on ROW remaining net lenders, Germany is dependent on the ROW remaining net borrowers.

Please note that the summary comments above are extracts from more detailed analysis that is available separately

The key chart

Introduction

This is the fourth in a series of five posts in which I develop a consistent “balance sheet framework” for understanding the relationship between the banking sector and the wider economy and apply it to the UK. The focus here is on the non-financial corporations (NFCs) and their key economic role as:

• Producers of good and services
• Investors in non-financial assets (which leads to the future production of good and services)
• Borrowers (or lenders) in financial markets

Summary

The balance sheet framework allows each of these roles to be considered in the context of the relationship between NFCs and other sectors of the economy.

NFCs are responsible for a large share of economic activity in most advanced economies and their role as producers of goods and services is captured neatly in the “monetary circuit concept” which links NFCs, households (HHs) and banks together (see “Everyone has one…”, earlier this month).

Investment in non-financial assets (NFAs) is critical to ensuring that the capital used in this production process is in place. Unsurprisingly, therefore, NFAs represent an important part in NFC balance sheets. The shift in balance sheet structures back towards NFAs (since the GFC) is also an important indicator that NFCs believe that the returns from investing in productive assets will exceed the returns from financial assets. Productive fixed assets remain the largest segment of non-financial assets but the value of land is an increasingly important driver of the net worth of UK NFCs.

Financial assets are comprised mainly of equity, deposits and loans and their breakdown suggests a increased desire to hold liquid assets. Financial liabilities are dominated by equities, loans and (increasingly) pension fund liabilities.

Between 1999 and 2009, there was a shift away from equities in favour of debt financing that saw debt-equity ratios reach unsustainable levels (111%). The unsustainability of these trends was also reflected in the NFC debt ratio hitting a high of 113% GDP, well above the 90% BIS “maximum” threshold level. Since then the debt-equity ratio has fallen significantly (65%) and the debt ratio has fallen below the BIS average and threshold level (79% GDP).

Non-financial investments are the link between NFCs’ “real accounts” and their “financial accounts”. The NFC sector is typically a net borrower reflecting the fact that they are unable to generate savings that match their investment needs. The NFC sector moved into financial surplus after the GFC but since 1Q11, NFCs have funded investment firstly by reducing this surplus and, since 4Q12, by returning to net borrowing. In contrast to the UK HH sector, debt levels in the NFC sector suggest scope for an increase in borrowing. 

These dynamics highlight the final key role of NFCs in the economy – an investment vehicle for investors from other sectors. They offer stakes in their earnings (dividends) or interest payments on debt. The end result, which links directly back to the balance sheet framework, is that claims on NFCs can be found on the balance sheets of other sectors in the economy. Hence, the wider question is, if NFCs widen their deficits further in order to fund investment, which sector will be increasing its financial surplus as an offset? I will return to this question in the fifth and final post in this series.

Role 1: Producers of goods and services

NFCs are responsible for a large share of economic activity in most advanced economies and their role as producers of goods and services is captured neatly in the “monetary circuit concept” which links NFCs, households (HHs) and banks together. In short, this circuit starts with expected demand which leads NFCs to pre-finance production. NFCs pay their employees by a transfer of deposits at banks. These employees demand goods and services which (partially or otherwise) validates the NFCs expectations of future demand. The deposits of the firm will be replenished by the spending of households.

Role 2: Investors in non-financial assets

Investment in non-financial assets (NFAs) is critical to ensuring that the capital used in the production process to meet the demand for goods and services is in place. Put simply, to remain viable, NFCs need to invest in productive assets (gross fixed capital formation or GFCF in national accounts.) In the UK, GFCF typically accounts for just under 20% of annual GDP.

Unsurprisingly, therefore, NFAs represent an important part in NFC balance sheets. At the end of 2018, UK NFCs balance sheets totalled £6.4 trillion, comprising £3.9 trillion (61%) NFAs and £2.5 trillion (39%) financial assets (FAs).

Note the contrast here with the HH sector (see “Poised to disappoint”). The UK HH balance sheet has total assets of £12.2 trillion, spilt between £6.5 trillion (54%) of FAs and £5.6 trillion (46%) of NFAs. UK HHs are more exposed to FAs and these FAs, in turn, are larger than the total NFC balance sheets.

The current breakdown of NFC balance sheets indicates that they believe that the returns from investing in productive assets will exceed the returns from FAs. NFCs will invest where they believe returns are highest. If they feel that investing in fixed assets (machines, buildings) will bring significant returns to their owners, they will focus on the acquisition of NFAs. Conversely, if their expectations about the demand for goods and services are weak or declining, they may decide that they can earn better returns by directing funds towards FAs rather than NFAs.

In the mid-1990s, the breakdown of NFC balance sheets was 70%:30% between NFAs and FAs respectively, indicating relatively high expectation of returns from investing in NFAs to support future production. By 2008, however, the split had changed to 56%:44% respectively, highlighting changed expectations of returns between different asset classes. Since then the balance has shifted again with funds increasingly directed towards investment in real assets.

Productive fixed assets remain the largest segment of NFAs but the value of land is an increasingly important driver of the net worth of UK NFCs. NFAs comprise “produced assets” including fixed assets (building, machinery, IP) and inventories and “non-produced assets” (largely land). At the end of 2018, produced assets represented 57% of total NFAs and non-produced assets 43%. This compares with respective splits of 70%:30% in 2002 and 67%:33% in 2008. In other words, the value of land has played an increasingly important part in the net worth of UK NFCs.

Financial assets are comprised mainly of equity, deposits and loans, and their breakdown indicates a propensity to hold more liquid assets. At the end of 3Q 2019, NFC financial assets totalled £2.6 trillion, with equities of £1.2 trillion (47%), deposits of £745 billion (29%) and loans of £345 billion (13%). The breakdown of financial assets has remained relatively constant over the past twenty years, other than an increase in holdings of more liquid assets. Deposits currently account for 29% of total financial assets compared with 24% ten years ago and 21% twenty years ago.

Financial liabilities are dominated by equity, loans and (increasingly) pension fund liabilities. At the end of 3Q19, NFC financial liabilities totalled £6.2 trillion, with equity of £3.1 trillion (50%), loans of £1.4 trillion (22%) and pension fund liabilities of £1 trillion (16%).  

Between 1999 and 2009 there was a shift away from equities in favour of loans and debt financing. Balance sheet gearing rose sharply over the period. Using the ONS definition of outstanding debt (debt, loans and receivables) the aggregate NFC debt to equity ratio rose from 52% in September 1999 to 91% in September 2009 (below the March 2009 peak of 111%) before falling back to 65% at the end of September 2019.

The unsustainability of these trends was reflected in the NFC debt ratio over the same period. In September 1999, the NFC debt ratio was 84% GDP. By March 2009, this had risen to a high of 113% GDP. Since then the debt ratio has fallen back to 90% GDP.

Using the narrower BIS definition, it is noteworthy that the current NFC debt ratio of 79% (2Q19) is below the level of 95% for all reporting countries and, more importantly, below the 90% threshold that the BIS considers is the level of NFC debt above which debt becomes detrimental to future growth (see graph above).

Net financial worth – financial assets minus financial liabilities – hit a new low of £3.6 trillion in 3Q19. Interestingly, and coincidently, the net worth of UK HHs and NFCs hit new highs and new lows respectively in 3Q19.

Role 3: Borrowers in financial markets

Non-financial investments are the link between NFCs’ “real accounts” and their “financial accounts”. If NFCs are able to generate savings in excess of their non-financial needs, in a given period, they become net lenders or net financial investors. In contrast, if they are unable to generate savings that match their investment needs, they become net financial borrowers. The relevant balancing item is the net lending/net borrowing position. Non-financial investments can be financed through the use of internal funds (current and retained earnings) or by borrowing funds from other sectors.

To link this back to “Everyone has one”, in the event that NFCs require external funding, other sectors must be willing to provide them with funds.

The NFC sector is typically a net borrower reflecting the fact that they are unable to generate savings to match their investment needs. However, as in the HH sector, there were dramatic shifts in their position since the GFC. Since 1989, the UK NFC sector has run an average financial deficit equivalent to 0.5% of GDP. In response to the GFC, NFC increased their net savings from -2.6% GDP in June 2008 to 2.4% GDP in March 2011. This substantial negative shift equivalent to 5% of GDP occurred at exactly the same time as a similar shift in the HH sector. Since then, there has been a reversal of a similar scale to bring the current financial deficit to -2.1% GDP, below the LT average.

Since 1Q11, the NFC sector has been funding investment firstly, by reducing its financial surpluses and since 4Q12 by becoming a net financial borrower. Up until June 2015, UK NFCs were deleveraging. The debt ratio fell from 103% GDP to 87% GDP over the period and aggregate debt equity ratios fell from 77% to 69%. A complicating factor over this period has been the rise in NFC pension liabilities. In March 2011, pension fund liabilities were £339 billion accounting for 8% of total financial liabilities. By June 2015, they had risen to £748 billion accounting for 16% of total financial liabilities. Today, pension fund liabilities account for the same percentage (16%) of total liabilities.

In contrast to the UK HH sector, NFCs have scope to increase their borrowing. Debt ratios are below the BIS threshold and debt servicing ratios are below their long term average. Indeed, real NFC growth is now at the highest level recorded in the current (mini) credit cycle.

Conclusion

These dynamics highlight the final key role of NFCs in the economy – an investment vehicle for investors from other sectors. They offer stakes in their earnings (dividends) or interest payments on debt. The end result, which links directly back to the balance sheet framework, is that claims on NFCs can be found on the balance sheets of other sectors in the economy.

Hence, the wider question is, if NFCs widen their deficits further in order to fund investment, which sector will be increasing its financial surplus as an offset? I will return to this question in the fifth and final post in this series.

Please note that the summary comments above are abstracts from more detailed analysis that is available separately

Introduction

This is the third in a serious of posts in which I develop a consistent “balance sheet framework” for understanding the relationship between the banking sector and the wider economy and apply it to the UK.

I have chosen to focus on households (HH) in this first, “sector-themed” post, to reflect the dominant role that they play in UK economic activity (FCE / GDP) and UK bank lending (the desire to buy properties).

Three key charts

Summary

HHs play a dominant role in the UK economy and in the demand for credit – 65p in every pound of UK GDP is related directly to HH consumption, and 78p in every pound lent is borrowed by HHs.

UK HHs are also important investors in financial and non-financial assets (largely property), with balance sheets skewed towards financial assets. Financial assets, comprising mainly of pensions, deposits and equities, are just over 3x the size of annual GDP. Financial liabilities are, unsurprisingly, mainly mortgage loans. Net financial worth – financial assets minus financial liabilities – hit a new high in 3Q19 and provides support for future consumption and welfare over the medium term.

The HH sector is typically a net saver/net lender in the UK (and other developed economies) but dramatic two-way shifts since the GFC have left financial surpluses well below historic averages (see first key chart above).

• HHs have been funding consumption by slowing their rate of savings and accumulation of net financial assets
• After a period of deleveraging post GFC, HH debt levels have stabilised (around the maximum BIS threshold level) but debt servicing costs remain low, highlighting HHs’ sensitivity /risk to a normalisation in interest rates
• The two periods of declining net financial surpluses – 4Q92-2Q06 and 2Q10-3Q18 – reflect different combined trends in savings and/or HH borrowing

In the immediate future, trends in disposable income and savings are likely to be key factors driving HH consumption and, therefore, GDP growth in the UK. With real growth in disposable income slowing and the savings rate close to historic lows, the risks to UK growth from this analysis appear tilted to the downside, and at odds with the (now out-dated) OBR forecasts and assumptions.

Why start with HHs?

HHs play a dominant role in the UK economy and in the demand for credit. HHs drive GDP growth via consumption (directly), and through government consumption on their behalf (indirectly). In 3Q19, HH consumption accounted for 65% of UK GDP, plus another 17% if government consumption on behalf of HHs is included. In other words, 65p (or 82p) in every pound of UK GDP is related directly (and indirectly) to HH consumption. For comparison, HH consumption accounts for 54% of GDP across the euro area.

The desire to buy properties is also the main driver of UK private sector credit demand. As of November 2019, total HH lending and HH lending for property purchases accounted for 78% and 69% of total UK private sector credit respectively. As can be seen from the graphs above and below, both factors have been enduring features of the UK economy and banking sectors.

HH balance sheets

UK HH are also important investors in financial and non-financial assets, with balance sheets skewed towards financial assets. At the end of 2018, the aggregate, UK HH balance sheet totalled £12.2 trillion, comprising financial assets of £6.5 trillion (54%) and non-financial assets of £5.6 trillion (46%). The breakdown of total assets had shifted from 65%:35% respectively in 1999 to 50%:50% respectively in 2007 before shifting back towards financial assets after the GFC.

Financial assets are comprised mainly of pension assets, deposits and equities. At the end of 3Q 2019, HH financial assets totaled £7.3 trillion, with pensions (insurance and guarantees) of £4.2 trillion (57% total financial assets), deposits of £1.7 trillion (24%) and equities of £1.1 trillion (15%). The breakdown of HH financial assets has been broadly similar over the past two decades albeit with a shift towards deposits and away from equities. Since 2000, HH financial assets have averaged 3x the size of annual GDP. At the end of 3Q19, this ratio had risen above this average to 3.3x GDP.

HH financial liabilities are dominated by mortgage loans, unsurprisingly. Financial liabilities totaled £2.0 trillion at the end of 3Q2019, with mortgage loans accounting for £1.4 trillion out of the total HH loans of £1.8 trillion. Again the breakdown of HH financial liabilities is little changed over the past two decades. Net financial worth – financial assets minus financial liabilities – hit a new high in 3Q2019 providing adequate MT support for future consumption and welfare.

HH sector financial flows

The analysis above has focused on stocks of financial assets and financial liabilities. I turn now to the flows (of income and savings) that accumulate into these stocks. Note that HH accumulation of net financial assets over the course of a year is only possible when spending is less than income over the same period. Put another way:

HH are net savers when savings – income minus consumption minus taxes – are higher than investment.

Note also, one of the key messages from “Everyone has one”, that if one sector is going to run a budget surplus, at least one other sector must run a budget deficit.

The HH sector is typically a net saver/net lender in the UK (and other developed economies) but dramatic two-way shifts since the GFC have left financial surpluses well below historic averages. Since 1989, the UK’s HH sector has run average financial surpluses equivalent to 3.8% of GDP (from a flow perspective). In response to the GFC, however, HHs increases their net savings from 2.6% of GDP in June 2008 to 6.9% of GDP in June 2010, a substantially negative shift equivalent to 4.3% of GDP. Since June 2012, HH have reduced their net surplus from 5.3% of GDP to a recent low of 0.0% in September 2018 and 1.1% currently. This trend reversal represented a substantially positive shift equivalent to 4.2% of GDP, in effect a mirror image of the trends immediately after the GFC.

HHs have been funding recent consumption by slowing their rate of savings/accumulation of net financial assets. Since early 2010, there have been two periods when UK HHs have reduced their savings significantly. The first occurred between March 2010 and March 2013 when HH savings fell from -41% from £37 billion to £22 billion and the second occurred between March 2015 and March 2017 when HH savings fell -61% from £35 billion to £14 billion. Between March 2010 and March 2017 the HH savings ratio fell from 13% to 4%, a thirty year low.

After a period of deleveraging post GFC, HH debt levels have stabilised (around the BIS maximum threshold level) but debt servicing costs remain low highlighting UK HHs’ sensitivity to changes in interest rates. The HH debt ratio is currently 86% of GDP compared with a high of 102% in March 2019. The BIS considers 85% to be the threshold level above which HH debt becomes a constraint on future growth.

While the debt ratio remains high, the HH debt service ratio of 8.9% is below the LT average of 10.1% and the September 2008 high of 12.3%. In other words, the risks associated with UK HH debt relate to the level of the debt rather than its affordability. They are reflected in (real) demand for credit remain very subdued.

The two periods where the accumulation of net financial assets by the HH sector has slowed dramatically have illustrated different drivers. In the first, between 4Q92 and 2Q06, the HH net surplus fell from 8.6% of GDP to –0.1% GDP (HH became slight net borrowers).

Over this period the HH debt ratio rose from 64% of GDP to 92% of GDP (see above) . At the same time, the HH savings ratio fell from 15% to 7% (see below). HH were increasing their borrowing and reducing their saving at the same time.

In the second, between 2Q10 and 3Q18, the HH net surplus fell from 6.9% of GDP to 0% of GDP. However, the HH debt ratio fell from 98% of GDP to 86% of GDP. In this second case, the main driver was the reduction in the HH savings rate from 13% to 6% (with a 3Q17 low of 4.0% described earlier).

Conclusion

In the immediate future, therefore, trends in disposable income and HH savings are likely to be key factors driving GDP growth. UK HHs appear to have little appetite for taking on more borrowing. With real growth in disposable income slowing and savings rate already at/close to historic lows, the risks to UK growth from this analysis appear tilted to the downside. My analysis and data challenges the assumptions in the last (now out-dated) OBS forecasts for the UK economy. I will return to this issue when the OBR updates its assumptions on UK sector balances in 1Q20.

Please note that the summary comments above are abstracts from more detailed analysis that is available separately