Europe – Page 15 – Chris Mallin Macro Perspectives

“Everyone has one…”

Spotlight on the UK 2 – balance sheets are at the heart of every economy

The key charts

From this (a simplified model of financial transactions)…

**I start simply with examples of three (of the four) core services provided by the financial system to households and corporates…**
Source: adapted from “Mapping the UK financial system”, Bank of England Quarterly Bulletin. 2015 Q2 article

To this (quantitative, objective and logical macro analysis)….

**…and arrive (in an accelerated fashion) at a highly quantitative, objective and logical analytical framework – “UK sectoral financial balances”**
Source: ONS; Haver; CMMP analysis

Introduction

This is the second in a series of posts in which I develop a consistent “balance sheet framework” for understanding the relationship between the banking sector and the wider economy. The first post presented a simple mapping of the UK economy and its financial system and highlighted the relatively large size of the UK financial system and the relatively volatile nature of its relationships with the UK economy. In this second post, I focus on:

the core services provided by the UK financial system
how these services produce a stock of contracts that can be represented by financial balance sheets that link different economic agents over time
how these balance sheets form the foundation of a highly quantitative, objective and logical analytical framework.

Summary

The UK financial system’s core services include making payments for goods and services, moving money from tomorrow to today (credit) and moving money from today to tomorrow (savings). The resulting “monetary circuit” facilitates the supply of goods and services and the subsequent consumption by households.

The core services also produce a stock of financial contracts that link different economic agents together over time. A fundamental principle of accounting is that for every financial asset there is an equal and offsetting financial liability. By definition, net financial wealth is therefore equal to the sum of financial assets less the sum of financial liabilities. If we take all the private sector financial assets and liabilities it is also a matter of logic that the sum of all the assets must equal the sum of all the liabilities.

The implication here is that for the private sector to accumulate net financial wealth it must be in the form of claims on another sector. In the case of a simple two sector economy, the net financial assets held by the private sector are exactly equal to the net financial liabilities of the government. The key message here is that in a two-sector economy, it is impossible for the public and private sectors to run surpluses at the same time. Of course, in reality these domestic sectors are also economically linked to foreign governments, firms and households, 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 two.

The three sectors described below – the domestic public sector, the domestic government sector and the ROW – can be treated as having income and savings flows over a given period (typically a quarter or a year). Extending the accounting principles described above any deficits run by one or more sectors must equal surpluses run by other sector(s). This leads to the key identity pioneered by the late Wynne Godley:

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

I analyse these trends for the key economic agents in the UK economy and their implications in more detail in my next post.

The core financial services

The core services of the UK’s (and any economy’s) financial system include:

Making payments for goods and services
Moving money from tomorrow to today (credit)
Moving money from today to tomorrow (savings)
(Managing risk – a core service but outside my analysis here)

By way of illustration, the diagram below depicts a series of transactions between six economic agents in a simplified (closed) domestic economy:

two households (the Smiths and the Khans)
two non-financial companies (Jane’s consumer durables and John’s commercial vehicles)
two financial institutions (a bank and a unit trust company/NBFI)

**The first key chart repeated: the core services of the financial system – payments, credit and savings**
*Source: adapted from “Mapping the UK financial system”, Bank of England Quarterly Bulletin. 2015 Q2 article*

The red arrows in this diagram represent a flow of money between each of the six economic agents. The yellow boxes show what was purchased with these funds (two non-financial assets, an apartment and a van ) and the pale blue boxes highlight the resulting financial assets. In turn:

Payments of goods and services: the Smiths buy an apartment from the Khans and Jane’s consumer durables buys a transport van from John’s commercial vehicles. The payments might be made directly in cash between the four parties, but are more likely to be made via banks’ payments systems. Note that, modern economies need efficient payment systems to enable agents to pay each other for goods and services. An economy based on a complex division of labour would be unable to thrive without an efficient payments system.
Moving money from tomorrow to today (credit): the Smiths finance the purchase of the Khan’s apartment via credit from the bank in the form of a mortgage. Jane’s company finances the purchase of the van by raising funds (selling shares) to the unit trust company. The financial system provides credit to both a household (HH) and a corporate (NFC) in this example.
Moving money from today to tomorrow (savings): the Khans saved the money they received from the Smiths by investing in an equity fund offered by the unit trust company, while John’s company put the proceeds of the sale into a bank account to pay wages and raw materials in the future. The financial system provides different forms of savings products to the HH and NFC in this example.

This simple example is, in effect, an alternative to the well-known economic concept of “the monetary circuit.”

The monetary circuit

**The main reason why people borrow in the UK is to purchase property!** **Breakdown of UK bank lending 1999-2019 (% total lending)**
Source: Bank of England; Haver; CMMP analysis

The monetary circuit concept argues that the purpose of a monetary economy is to facilitate the supply of goods and services and their subsequent consumption by households. Leave aside, for the moment, that the main reason for borrowing in the UK (and other developed markets) is the desire of HHs to purchase property (see graph above). With regards to production activities the main cause of borrowing is often that NFCs expect the demand for their goods and services to increase and therefore want to pre-finance production. In this scenario, the monetary circuit starts with expected demand which leads NFCs to pre-finance their 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. These flows are illustrated in the simplified monetary circuit framework diagram below.

**The simplified monetary circuit framework**
Source: Ehnts, D. MMT and European Macroeconomics. Routledge 2017

Foreshadowing a theme that I will return to in later posts, it is worth nothing the scenarios in which the monetary circulation described above fails:

Holders of deposits decide to uses them to repay outstanding loans
Holders of deposits are happy to hold rather than spend them (idle deposits)
Holders may transfer deposits to other forms of savings
Holders may use taxes to pay taxes

Of course, the decision to hold some form of excess deposits as a buffer against unforeseen circumstances is perfectly rational. Nevertheless with regards the monetary circuit and its main purpose – to facilitate production and consumption – there is a serious problem with hoarding/excess saving which has important implications for macro policy choices. More to follow on this theme in later posts…

Transactions to balance sheets

The three core services described above produce a stock of financial contracts that can be represented by financial balance sheets that, in turn, illustrate how different economic agents are linked together over time.

When the Smiths took out their mortgage from the bank in order to buy the Khan’s apartment, the bank provided them with the funds in exchange for a commitment from the Smiths to make repayments over time. In other words, the mortgage represents an asset for the bank and a liability for the Smiths and illustrates the connection between them. The diagram below illustrates the financial assets (yellow) and liabilities (blue) that result from each of the transactions above.

**Core services produce a stock of financial contracts that illustrate key linkages**
*Source: adapted from “Mapping the UK financial system”, Bank of England Quarterly Bulletin. 2015 Q2 article*

A fundamental principle of accounting is that for every financial asset there is an equal and off-setting financial liability. Hence, in this illustration, the Smith’s mortgage is a liability that is offset by an asset for the bank. Similarly, John’s commercial vehicles bank account is an asset that is offset by a liability for the bank.

Note, however, that while the assets and liabilities match each other, the associated future flows of money travel in the opposite direction to the flows of money created in the original transactions. The Smiths will have to repay their mortgage and the bank will have to provide funds if John’s commercial vehicles decides to withdraw money from its account. The physical assets shown in the earlier diagram are not included here as, unlike financial assets, they do not create an on-going relationship between the agents.

Note also the unique feature of banks in this relationship. They create deposits via lending not (as is commonly believed) the other way round. Of course, the bank needs to have liabilities to fund the lending but these do not have to be secured in advance of the loan being granted. The unique feature of banking is the fact that banks can simultaneously create loans and deposits and hence alter the quantity of money circulating in the economy. This is not the case for the unit trust company, which can only buy shares in Jane’s consumer durables by first securing an investment.

The key message at this stage is that balance sheets are at the very heart of the economy. The Bank of England has a balance sheet. The UK government has one, and as illustrated above UK banks, HHs and NFCs have balance sheets too. My balance sheet framework has the advantage of being both highly quantitative and objective since it focuses on transactions, debts, balance sheets and core accounting principles. It also allows me to follow the logic of the UK economy by monitoring the transaction records that show what is actually happening:

The stocks and flows of credits and debits
Who owes what to whom
Who the creditors are
Who the debtors are
How they came to have these roles

Financial net wealth/worth

**Financial assets and financial liabilities are unlikely to have the same value**
Source: ONS; Haver; CMMP analysis

In general, at any given point in time, it is unlikely that any individual or economic agent has financial assets and financial liabilities of the same value (see graph above). Since, any balance sheet has to balance, we need to create an equilibrium value by inserting the entry “net financial wealth” into the left hand side of the balance sheet. (This is merely convention and there is an argument that net wealth should be shown on the asset side of the balance sheet with an inverted sign, as it is claim of the owner against the balance sheet).

**Financial assets minus financial liabilities = financial net worth. The example of UK HHs 2000-2018 (£ millions)**
Source: ONS; Haver; CMMP analysis

In the case of the UK, HHs had financial assets of £6.7trillion and financial liabilities of £1.9trillion at the end of 2018. In other words, their net financial worth was £4.7trillion. In contrast, NFCs had financial assets of £2.5trillion and financial liabilities of £5.6 trillion ie, net financial worth of minus £3.1trillion.

**Contrasting trends in HH and NFC financial net worth 2000-2018 (£ millions)**
Source: ONS; Haver; CMMP analysis

Implications for analysis

Returning to basic accounting principles, if we take all the private sector financial assets and liabilities it is a matter of logic that the sum of all the assets must equal the sum of all the liabilities. This means that the net wealth of the private sector would have to be zero if we include only private sector IOUs (assuming that the public sector is not holding any private sector debt.)

The implication here is that for the private sector to accumulate net financial wealth it must be in the form of claims on another sector. In the case of a simplified two sector economy compromising the private sector (HHs and NFCs) and the public sector (all levels of government), the private sector could accumulate “outside wealth” in the form of government currency and/or government ST bills and T bonds. Note that the private sector can only accumulate net financial assets if its spending is less than its income in a given period. In this example, these financial assets are government/public sector liabilities (currency, bills and bonds). The government liabilities arise when it is spending more that it is receives in the form of tax revenues. The resulting deficit accumulates to the stock of government debt which is equal to the private sector’s accumulation of financial wealth over the same period.

In the case of a simple two sector economy, the net financial assets held by the private sector are exactly equal to the net financial liabilities of the government. If a government runs a balanced budget where spending is equal to tax revenue, the private sectors net financial wealth will be zero as a result. If the government runs a budget surplus with spending less than tax receipts, the net financial wealth of the private sector will be negative. The key message here is that in a two-sector economy, it is impossible for the public and private sectors to run surpluses at the same time. (In future posts, I will show that this is exactly what is occurring in Germany in practice)

Of course, in reality these domestic sectors are also economically linked to foreign governments, firms and households, collectively termed the “rest of the world” (ROW). Hence, the domestic private sector is able to accumulate net claims against the ROW even if the domestic government is running a balanced budget. In this case the private sector’s accumulation of net financial assets is equal to the ROW’s issue of net financial liabilities, although in reality it is more likely that the private sector will accumulate net financial wealth combining both domestic and ROW liabilities.

Flows, stocks and sector balances

From an analysis perspective, the three sectors described here – the domestic public sector, the domestic government sector and the ROW – can be treated as having income and savings flows over a given period (typically a quarter or a year). If a sector spends less that it earns it creates a budget surplus. Conversely, if it spends more than 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 its 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 surplus will be accumulating net financial assets. This surplus will take the form of financial claims on at least one other sector. More details of how this works in practice will follow in later posts.

**The end game! A quantitative, objective and logical analytical framework. Quarterly sectoral balances for the UK (4Q MVA as % GDP)**
Source: ONS; Haver; CMMP analysis

Conclusion – “where the money flows, there too the future goes.”

Having started this post with the observation that every economic agent has a balance sheet it seems appropriate to conclude by returning to basic accounting principles. Following the original economic work of Wynne Godley, we know that if we sum the deficits run by one or more sectors this must equal the surpluses run by other sector(s). Hence, Godley’s key identity:

Domestic private balance + domestic government balance + foreign balance = 0

In my next post, I will analyse these trends for the key economic agents in the UK economy and their implications in more detail.

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

“Lousy LT investments, but…”

Spotlight on the UK 1- mapping the system

The key chart

“An ever-present feature of most people’s lives and a critical part of the economy” Bank of England, 2015

**“An ever-present feature” – the relative size of financial assets for the “real” and “money” sectors in the UK and EA (multiple of annual GDP)**
Source: ONS; ECB; Haver; CMMP analysis

Happy New Year

A central theme in CMMP analysis is 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 wider implications of the relationship between the banking sector and the wider economy for corporate strategy, investment decisions and asset allocation.

To begin 2020, I am publishing a series of posts in which I develop a consistent “balance sheet framework” for understanding this core relationship and apply it to the UK economy. The choice of the UK is deliberate, reflecting both the relatively large size of the UK financial system and the relatively volatile nature of its relationship with the UK economy (see the key chart above).

This first post presents a simple mapping exercise for the UK economy and its financial system.

Summary

Financial assets represent the largest segment of the UK’s £42 trillion national balance sheet, accounting for 75% of total assets at the end of 2018. The UK’s “money sector”, in turn, accounts for 68% of financial assets (compared to 58% in the EA), highlighting the important role of the sector in terms of absolute size. Within the money sector, MFIs remain the dominant players, but “other FIs” are playing an increasingly important role in both the UK and EA economies.

A key distinguishing feature of the UK economy is the relative size (and hence potential impact) of the money sector and the volatile nature of its relationship with the wider economy. The money sector’s financial assets rose from 6x GDP in 2000 to 15x GDP in 2008 and remain 10x GDP currently (3Q19). The unsurprising conclusion here, is that the UK’s financial system is “an ever-present feature of most people’s lives and a critical part of the economy” (Bank of England, 2015).

In my next post, I will develop this analysis by considering the core services provided by finance institutions and how they produce a stock of contracts that can be represented by financial balance sheets that link different economic agents together over time.

Lousy LT investments, but…

At various stages in my career, I have run top-rated bank equity research teams. In the face of LT bank under-performance throughout this experience, I have been struck by (1) the enduring, positive bias from sell-side analysts and (2) the scale and expense of the sell-side and buy-side resources dedicated to individual bank stock-picking.

**Lousy LT investments – UK, US and EA banks have significantly under-performed local markets** **(relative performance since 2004)**
Source: Haver; CMMP analysis

Over the past 15 years, UK banks have under-performed the FTSE 100 by 75%, US banks have under-performed the S&P 500 by 53% and EA banks have under-performed the SXXE by 58%. Yet, how many sell ratings have been published over this period?

In my view, the same (expensive) resources would be better applied to understanding the implications of the relationship between the banking sector (and even the wider economy and/or the impact of macro developments on banks’ future profitability and cash flows!). Returns here are likely to be more attractive, hence my focus at CMMP.

The UK’s national balance sheet

Financial assets represent the largest segment of the UK’s national balance sheet, accounting for 75% of total assets. At the end of 2018, the UK’s national balance sheet was £42 trillion, largely unchanged in terms of total size since 2016. Financial assets totaled £31 trillion (75% of the total) and non-financial assets – largely land and other fixed assets – totaled £11 trillion (25% of the total).

**The share of financial assets peaked in 2008 – breakdown of UK assets since 1995 (% total assets)**
Source: ONS; Haver; CMMP analysis

The share of financial assets rose in the build-up to the GFC to peak at 82% in 2008, but is currently similar to the level seen in 2000. The UK’s financial liabilities totaled £32 trillion at the end of 2018, resulting in a net worth of just over £10 trillion. As an aside, the 3% growth in the UK’s net worth in 2018 was the slowest rate of growth since 2012.

**UK’s net worth growing, but at the slowest rate since 2012 (£ trillions)**
Source: ONS; Haver; CMMP analysis

The role of the UK financial system

**The financial system accounts for the bulk of UK financial assets – growth in UK financial assets since 2000 showing split between the money and real sectors (£ millions)**
Source: ONS; Haver; CMMP analysis

The financial system, comprising MFIs, other FIs and insurance companies and pension funds (ICPFs), accounts for 68% of the UK’s financial assets compared with 58% in the Euro area (EA). At the end 2018, the financial assets of the UK financial system totaled £21 trillion a 7% CAGR since 1995. Of course, as can be seen in the graph below, this growth occurred up to 2008 (15% GAGR between 1995 and 2008) when the system’s financial assets peaked at almost £24 trillion, 11% higher than at the end of 2018. At the 2008 high point, the financial system or “money sector” accounted for 78% of the UK’s financial assets compared with 58% in 2000.

**A game of two “halves” – the growth in money sector financial assets occurred before 2008 (£ trillions)**
Source: ONS; Haver; CMMP analysis

Monetary financial institutions – the Central Bank, deposit taking FIs and money-market funds – represent the largest sub-sector within UK financial services. At the end of 3Q19, the assets of UK MFIs totaled £12.6 trillion or 53% of total money sector financial assets. The assets of other FIs and ICPFs were £6.3 trillion (27%) and £4.8 trillion (20%) respectively as shown in the diagram below which illustrates the financial assets and liabilities of the domestic sectors in the UK economy. I will be returning to the differences in financial net worth (financial assets minus financial liabilities) across the different economic sectors in subsequent posts.

**Financial sector balance sheets for the domestic sectors of the UK economy as at the end of 2Q19**
Source: ONS; Haver; CMMP analysis

The rise of “other FIs”

Other FIs are playing an increasing important role in both the UK and EA economies. This sub-sector comprises non-money market funds (investment trusts, unit trusts and other collective investment schemes whose investment fund shares or units are not close substitutes for deposits), other financial intermediaries (eg, security and derivative dealers, finance leasing companies, venture and development capital companies, and export and import financing companies), financial auxiliaries (insurance brokers, investment advisers, fund managers and payment institutions) and captive financial institutions (holding companies and SPVs) and money lenders.

**Other FIs gaining market share at the expense of ICPFs – breakdown of UK money sector financial assets (% total assets) since 2000**
Source: ONS; Haver; CMMP analysis

UK other FIs have increased their share of the money sector’s financial assets from 19% in 2000 to 27% at the end of 2Q19. This has been at the expense of ICPFs who have seen their share fall from 32% to 20% over the same period. A similar, if more muted trend, has also occurred in the EA where the share of other FIs has risen from 25% of money sector financial assets in 2000 to 30% at the end of 2Q19. In this case, however, this has been at the expense of EA MFIs who have seen their share fall from 61% to 56% over the same period.

**The rise of other FIs is a Europe-wide trend – market share of total money sector financial assets for the UK and EA other FIs (% total financial assets)**
Source: ONS; ECB; Haver; CMMP analysis

The UK’s key distinguishing feature

**One of the UK’s distinguishing features – the size (and its variability) of the UK money sector’s financial assets (as a multiple of annual GDP)**
Source: ONS; ECB, Haver; CMMP analysis

A key distinguishing feature of the UK economy is the relative size (and potential impact) of the money sector and the volatile nature of its relationship with the wider economy. In September 2000, the UK’s money sector’s financial assets were 6x larger than GDP. This compares with a multiple of 4x in the EA. By December 2008, the same ratio had risen to 15x GDP in the UK but only 6x in the EA. Since then, the UK’s ratio has fallen back to, a still very large, 10x GDP while the EA’s ratio has risen more steadily to 7x.

**Contrasting trends between the relative size in the real and money sectors’ financial assets (multiple of annual GDP)**
Source: ONS; ECB; Haver; CMMP analysis

In contrast, the relationship between the size of the “real economy’s” financial assets and GDP has been more stable. In 2000, the UK real economy’s financial assets were 4x larger than GDP. At the end of 2008, this ratio was also 4x and is only 5x currently. In the EA, the same ratio rose from 4x in 2000 to 6x in 2008 before falling back to 5x currently.

In other words, the ratio of the size of real economy’s financial assets to GDP is much lower and more stable in both the UK and the EA. However, it is much larger for the money sector and, equally importantly, more volatile in the case of the UK.

Conclusion

The unsurprising conclusion of this first post, is that the UK’s financial system is “an ever-present feature of most people’s lives and a critical part of the economy” (Bank of England, 2015). In my next post, I will develop this analysis by considering the core services provided by finance institutions and how these services produce a stock of contracts that can be represented by financial balance sheets that illustrate how different economic agents are linked together over time.

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

“Fading recession risks?”

A short update from the Euro Area monetary sector

The key chart

**Real growth in M1 (leading indicator), HH credit (coincident indicator) and NFC credit (lagging indicator) continue to move away from levels associated with recession risks in the Euro Area**
Source: ECB; Haver; CMMP analysis

The message from October’s data

Monetary indicators continue to move away from levels associated with recession risks in the Euro Area.

**Leading indicator: Growth in real M1 has rebounded and is at the highest level since October 2017**
Source: ECB; Haver; CMMP analysis

Narrow money (M1) grew 8.4% in nominal terms in October, up from 7.9% in September. In real terms, M1 grew 7.6% which is the fastest rate of real growth since October 2017 (8.0%) and compares with a real growth rate of only 4.7% in January this year. Given the leading indicator qualities of trends in real M1, this data supports the narrative that recession fears in the Euro Area have been overdone.

**Coincident indicator: Real growth in HH credit at its highest level since April 2008**
Source: ECB; Haver; CMMP analysis

Households and corporates are also increasing their borrowing at the fastest rates in the current cycle. HH credit (a co-incident indicator) grew 3.5% in nominal terms and 2.8% in real terms, the fastest rate of real growth since April 2008. NFC credit (a lagging indicator) grew at 3.8% in nominal terms and 3.1% in real terms. The real growth was marginally below the level of 3.2% recorded in August 2019, but again these rates are the highest real growth rates since June 2009.

**Lagging indicator: Real NFC growth at/close to its highest level since June 2009**
Source: ECB; Haver; CMMP analysis

Of course, credit growth remains relative subdued in relation to LT trends and concentrated geographically (HH in France, Germany, Benelux and Italy; NFC is France, Germany and Austria) and the demand for credit continues to lag the supply of money which indicates that the Euro Area has still to recover fully from the debt overhang (see graph below).

**Don’t get carried away – the demand for credit from the private sector (PSC) still lags the supply of money. The Euro Area continues to suffer from a deficiency in the demand for credit.**
Source: ECB; Haver; CMMP analysis

A simple conclusion

Nonetheless, the message from October is simple: current monetary trends remain inconsistent with recession fears in the Euro Area

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

“The ECB’s missing chart”

The FSR is suitably cautious, but misses a key chart

The key (missing) chart

Are ECB policies fuelling growth in less productive FIRE-based lending at the expense of productive COCO-based lending (% total loans)? What are the implications for leverage, growth, stability and income inequality?
Source: ECB; Haver; CMMP analysis

Summary

The ECB published its November 2019 Financial Stability Review (FSR) this week with a suitably cautious outlook for financial stability, economic growth, and banking sector profitability in the euro area (EA).

The analysis is as insightful and thorough as usual and supports many of my current views. However, it “falls short” in one key respect – the FSR presents its analysis through the traditional household (HH) versus corporate (NFC) framework, rather than through the increasingly more relevant COCO versus FIRE-based credit framework.

The risk here is that it underplays the hidden risks in QE, namely that the majority of credit in the EA is directed into “unproductive” FIRE-based credit rather than more “productive” COCO-based credit. As such, current policies to support/stimulate credit demand have potentially negative (if unintended) implications for leverage, growth, stability and income inequality.

Key messages from the FSR (Nov 2019)

The FSR states that the “the euro area financial stability outlook remains challenging“. It highlights four key issues:

Signs of asset mispricing suggest potential for future correction
Lingering private and public sector debt sustainability concerns
Growing challenges from cyclical headwinds to bank sector profitability (“75% of EA significant banks have ROE < 8%”)
Increased risk-taking by nonbanks may pose risks to capital market financing

In mitigation, the FSR notes that: (1) euro area banks are adequately capitalised with a 14.2% CET1 ratio; and (2) all Euro Area countries have activated macroprudential measures. Nonetheless, it concludes that “more active use of macroprudential policies could be appropriate to contain vulnerabilities“.

The FSR argues that the economic outlook has deteriorated and that growth is expected to remain subdued for longer, with risks tilted to the downside. It also concludes that “while the banking sector is resilient to near-term risks, challenges from a more subdued profitability outlook remain“. Four headwinds facing banks are cited: eroding interest margins; slightly higher costs of risk; high cost inefficiencies, and plateauing capital positioning.

I have covered many of these factors in recent posts including:

The ECB’s framework

The FSR presents its analysis of the HH and NFC sector separately. The HH sector is discussed in Section 1.3 (Euro area household resilience supported by low interest rates) and the NFC sector in Section 1.4 (Emerging pockets of corporate sector vulnerability).

**Robust or subdued? Nominal HH credit growth is much lower than in past cycles (%YoY) and concentrated geographically (France, Germany, Benelux)**
Source: ECH; Haver; CMMP analysis

In summary, the FSR describes HH lending as “robust, with continued divergence across countries and types of loans”, HH indebtedness stable (with considerable heterogeneity across EA countries) and risks to HH debt sustainability contained. My comments:

HH credit is growing at the fastest rate in the current cycle (3.4% nominal and 2.6% real YoY growth) but rather than robust, I would describe this growth as relatively subdued especially in relation to historic cycles
As noted in previous posts, and illustrated in the graph above, HH growth is concentrated in Germany, France and the Benelux
In “Debt dynamics in the developed world” I agreed with the conclusion that excess credit growth risks in developed economies were relatively contained (and limited largely to non-EA countries such as Norway, Switzerland, Canada and Sweden, see graph below).

**CMMP analysis shows that HH sector growth risks are relatively low (HH RGF versus HH debt ratio)**…
Source: BIS; Haver; CMMP analysis

**…as are HH affordability risks in the Euro Area in contrast to Norway, Canada and Sweden (HH DSR as at end 1Q19 and deviations from LT average)**
Source: BIS; Haver; CMMP analysis

In the NFC sector, the FSR highlights the deceleration in corporate profits, along with increases in external financing and slightly elevated corporate indebtedness, but suggests that risks are offset by favourable financing conditions and large liquidity buffers.

**NFC debt levels remain above the average for BIS reporting countries and the BIS maximum threshold**
Source: BIS; Haver; CMMP analysis

**CMMP analysis shows that only Italy, Greece and Germany (among large EA economies) have NFC debt levels below the BIS maximum threshold**
Source: BIS; Haver; CMMP analysis

I would suggest that this underestimates risks in this sector:

The NFC debt ratio (% GDP) is currently 105% in the EA, above the 94% average for all BIS reporting countries and the BIS maximum threshold level of 90%
At the country level, only Italy, Germany and Greece have NFC debt ratios below the BIS threshold
My analysis also highlights relative high “growth” and “affordability” risks in the French NFC sector.

**France is among the four economies that have seen the fastest rates of “excess NFC credit growth” despite having high levels of NFC (% GDP)**…
Source: ECB; Haver; CMMP analysis

**…while also displaying relatively high levels of NFC affordability risk (NFC DSR as at end 1Q19 versus deviation from LT average)**
Source: BIS; Haver; CMMP analysis

An alternative framework

In September, I presented an alternative framework for analysing global debt dynamics. I argued that, in its broadest sense, lending can be split into two distinct types: lending to support productive enterprise; and lending to finance the sale and purchase of existing assets. The former includes lending to NFCs and HH consumer credit, referred collectively here as “COCO”-based lending (COrporate and COnsumer). The latter includes loans to non-bank financial institutions (NBFIs) and HH mortgage or real estate debt, referred to collectively as “FIRE”-lending (FInancials and Real Estate).

**EA lending is increasingly directed towards less productive FIRE-based lending (% total lending) which now accounts for 55% of total loans**
Source: ECB; Haver; CMMP analysis

In short, COCO-based lending typically supports production and income formation, while FIRE-based lending typically supports capital gains through higher asset prices. Lending in any economy will involve a balance between these different forms, but to repeat the key point from September: a shift from COCO-based lending to FIRE-based lending reflects different borrower motivations and different levels of risks to financial stability.

**Only three of the large EA economies have COCO-based lending above (Greece, Austria) or equal to (Italy) FIRE-based lending (% total loans)**
Source: ECB; Haver; CMMP analysis

Over the past twenty years, FIRE-based lending has increased from 48% of total loans to 55% as at the end of September 2019. The current level represents the highest share of FIRE-based lending. Only three of the large EA economies have COCO-based lending above or equal to FIRE-based lending: Greece; Austria, and Italy.

Why does this matter?

The hidden risk in QE is that the ECB is “Fuelling the FIRE” with potentially negative implications for leverage, growth, financial stability and income inequality in the Euro Area.

Leverage: while COCO-based lending increases absolute debt levels, it also increases incomes (albeit with a lag), hence overall debt levels need not rise as a consequence. In contrast, FIRE-based lending increases debt and may increase asset prices but does not increase the purchasing power of the economy as a whole. Hence, it is likely to result in high levels of leverage
Growth: similarly, COCO-based lending supports economic growth both by increasing the value-add from final goods and services (“output”) and an increase in profits and wages (“income”). In contrast, FIRE-based lending typically only affects GDP growth indirectly
Stability: the returns from FIRE-based lending (investment returns, commercial and HH property prices etc) are typically more volatile that returns from COCO-based lending and may affect the solvency of lenders and borrowers. The FSR notes that house prices rose faster than GDP in 1H19 and highlights signs of overvaluation, which now exceeds 7% on average, “but with a high degree of cross-country heterogeneity” (see graphs below)
Inequality: the returns from FIRE-based lending are typically concentrated in higher-income segments of the populations, with any subsequent wealth-effects increasing income inequality.

EA house prices have risen faster than GDP in 1H19 and are estimated to be overvalued by 7%
Source: ECH; Haver; CMMP analysis

**Residential property prices are estimated to be overvalued in all large EA economies (and in the UK) with the exceptions of Italy and Ireland**
Source: ECH; Haver; CMMP analysis

Conclusion

The FSR’s outlook for financial stability, economic growth and bank sector profitability is in-line with the views expressed in my recent posts (albeit with some differences in emphasis). However, the hidden risks associated with the ECB’s unorthodox monetary policy are potentially understated, in my view.

The alternative framework presented here, that draws the distinction between productive COCO-based lending and unproductive/less-productive FIRE-based lending, provides a clearer perspective of these risks.

The on-going shift in the balance of lending in the Euro Area has negative implications for leverage, economic growth, financial stability and income inequality.

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

“Macro building blocks revisited”

SX7E – relief rally or genuine recovery?

The key chart

The SX7E index of leading European banks has rallied strongly and outperformed the EURO STOXX index since the August 2019 low (graph illustrates relative performance based on average monthly prices). Is this merely a relief rally or the start of a sustained recovery?
Source: Haver; CMMP analysis

Summary

In early September 2019, I outlined the five key “macro building blocks” that drive bank sector profitability and share price performance (see “Macro building blocks matter”– look at the SX7E). I highlighted how they had weakened significantly during 2019, and noted how this had been accompanied by poor absolute and relative performance of the SX7E index of leading European banks over the previous twelve months.

Since then, the SX7E index has risen 26% from its 15 August low of 77 to a recent high of 97, before falling back to 93 currently (6% lower than 12 months ago). In this short update, I consider this performance in the context of my macro building block framework to ask: is this a relief rally or the start of a period of sustained recovery and share price outperformance?

Macro building blocks recap

In developed economies, I focus primarily on five key “macro building blocks” that drive bank sector profitability and share price performance:

growth in real GDP
growth in private sector credit
the level of ST rates
the level of LT rates
the shape of the yield curve

Net interest income – the main value driver for most banks – has a positive relationship with GDP, the level of rates and the shape of the yield curve. The level of ST rates is more important for banks in “floating rates” economies and market segments. In contrast, the slope of the yield curve is more important for banks in “fixed rate” economies and market segments.

**Variable rate lending as %age of total new loans in the EU**
Source: ECB; Haver; CMMP analysis

In the Euro Area, 63% of new loans to HHs and NFCs are based on variable rates but only 18% of mortgages (down from 58% in November 2004). This means that EA banks are affected by both the level of ST rates and the slope of the yield curve.

**Variable rate lending as %age of total EA mortgages**
Source: ECH; Haver; CMMP analysis

Non-interest income – the second key value driver – has a positive relationship with GDP but a negative relationship with the level of ST rates, while provisions have a negative relationship with GDP and a positive relationship with the level of ST rates.

Building blocks revisited

**Real GDP growth in the EA has slowed below the average rate over the past twenty years (% YoY)**
Source: ECB; Haver; CMMP analysis

Real GDP growth has slowed from the recent high of 3.0% (4Q17) to 1.1% (3Q19), the weakest rate of growth since 4Q13 and below the region’s twenty year average of 1.4%. All of the major Euro Area economies are growing below their LT averages with the exception of Spain and Portugal.

The European Commission revised down its 2019e, 2020e and 2021e GDP forecasts recently to 1.1%, 1.2% and 1.2% respectively. The latest ECB forecasts are the same for 2019e and 2020e, but they see growth returning to the LT trend of 1.4% by 2021e. These forecasts are consistent with monetary sector indicators (see “Look beyond the yield curve II”)

**Twenty year trends in EA private sector credit (%YoY, 3M MVA)**
Source: ECB; Haver; CMMP analysis

**Current growth rates in EA corporate and household credit (% YoY)**
Source: ECB; Haver; CMMP analysis

On a more positive note, private sector credit growth remains at/close to the highest level in the current cycle. The 3m MVA of PSC, NFC and HH YoY credit growth were 3.7%, 4.0% and 3.4% in September 2019. However, these growth rates remain subdued in relation to past cycles, concentrated geographically and increasingly directed towards less productive segments (see “Fuelling the Fire – the hidden risks of QE)

ST rates (EONIA) locked at the base of the ECB’s corridor (MLR – deposit facility rate)
Source: ECB; Haver; CMMP analysis

ST rates remain locked at the base of the ECB’s corridor (-0.46%) and the Governing Council “now expects the key ECB interest rates to remain at their present or lower levels until it has seen the inflation outlook robustly converge to a level sufficiently close to, but below, 2%”. This is negative for net interest margins in those countries (Austria, Italy, Portugal and Spain) and market segments (NFC lending) that are characterised by floating rate lending

**Euro Area 10Y bond yields remain in negative territory**
Source: Haver; CMMP analysis

LT rates have recovered from their lows but remain in negative territory. Ten year bond yields have recovered from the August lows of -0.71% to -0.26%, but are 49bp lower than at the start of the year.

**The 10Y-3M yield curve is no longer inverted**
Source: Haver; CMMP analysis

The EA yield curve has steepened 42bp from its recent inverted low (-0.28%) and moved back into positive territory at 0.14%. This is still 40bp flatter than at the start of the year which has negative consequences for net interest margins in countries (Belgium, France, Germany and the Netherlands) and market segments (HH lending) that are more exposed to fixed rate lending.

**Spread between interest rate on new EA HH loans and 3M Euribor**
Source: ECB; Haver; CMMP analysis

**Spread between interest rate on new EA NFC loans and 3M Euribor**
Source: ECB; Haver; CMMP analysis

Negative ST rates and flat yield curves are compounded by on-going price competition. On-going narrowing of spreads has been a key feature of the HH sector. Over the past twelve months the spread on new HH loans has fallen 24bp from 2.13% to 1.89%. In contrast, the spread on new NFC loans has remained relatively constant at 1.77%.

Sustained recovery?

European banks continue to generate a lot of noise but little overall direction. The recent rally in the SX7E index is consistent with less negative bond yields and the end of the period of yield curve inversion. Nonetheless, current macro building blocks are not sufficient to support a sustained recovery in banking sector profitability across the region, in my view.

**Relative performance of SX7E versus SXXE over past twenty years (average monthly prices)**
Source: Haver; CMMP analysis

The purpose of this website is not to make investment recommendations (and ignores valuation), but my analysis suggests that the recent rally in European banks share prices represents a relatively ST relief rally rather than a period of sustained recovery and outperformance.

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

“Debt dynamics in the developed world”

The developed world continues to deleverage but risks remain

The key chart

**Only Italy, Austria, Greece, Germany and the US have NFC and HH debt ratios (% GDP, 1Q19) below BIS “maximum threshold” levels (dotted red lines)**
Source: BIS; Haver; CMMP analysis

Summary

The developed world continues to deleverage. This process has already led to dramatic shift in the structure of global private sector debt (see “The Changing Face of Global Debt”). With private sector debt levels still “too high” in the developed world, this trend is set to continue.

Risks associated with excess credit growth in the developed world are lower than in past cycles and remain concentrated by economy (Sweden, Switzerland, Canada and France) and by sector (NFC credit more than HH credit). Despite lower borrowing costs, affordability risks are still evident is both the NFC (Canada, France) and HH sectors (Norway, Canada, and Sweden).

Progress in dealing with the debt overhang in the Euro Area remains slow and incomplete. Long term secular challenges of subdued GDP, money supply and credit growth persist while unorthodox monetary policy measures risk fuelling further demand for less-productive “FIRE-based” lending with negative implications or leverage, growth, stability and income inequality (see “ Fuelling the FIRE” – the hidden risk in QE).

Trends in DM debt ratios

Aggregate private sector debt ratios for the Euro Area, and the BIS sample of advanced and emerging economies (% GDP) – the developed world continues to deleverage while the emerging world plays “catch-up”
Source: BIS; Haver, CMMP analysis

The developed world continues to deleverage. Private sector credit as a percentage of GDP has fallen from a peak of 181% in 3Q09 to 162% at the end of the 1Q19. This has involved a (relatively gradual) process of “passive deleveraging” where the stock of outstanding debt rises but at a slower rate than nominal GDP.

The process of deleveraging in the Euro Area started later. Private sector credit as a percentage of GDP peaked at 172% in 1Q15 and has fallen to 162% at the end of 1Q19, in-line with the average for the BIS’ sample of advanced economies.

**The outstanding stock of debt continues to rise ($ billion) but at a slower rate than nominal GDP**
Source: BIS; Haver; CMMP analysis

This process has led to a dramatic shift in the structure of global debt. In 1Q00, the advanced world accounted for 90% of global private sector credit, with advanced economies excluding the Euro Area accounting for 70% and the Euro Area 20%. Emerging markets accounted for only 10% of global private sector credit with 7% from emerging markets excluding China and 3% from China.

**The changing face of global debt (% GDP) – shifting East and towards emerging markets**
Source: BIS; Haver; CMMP analysis

At the end of 1Q19, the advanced world’s share of global debt had fallen to 64% (advanced economies ex Euro Area 47%, Euro Area 18%) while the emerging markets share has increased to 36% (EM ex China 12%, China 24%).

Where are we now?

**The key chart repeated. The Netherlands, Sweden, Norway, Canada, Switzerland and Denmark have** **NFC and HH debt ratios (% GDP, 1Q19) above BIS threshold levels (dotted red lines)**
*Source: BIS; Haver; CMMP analysis*

With debt levels remaining “too high” in the advanced world this trend is likely to continue. The BIS considers corporate (NFC) and household (HH) debt ratios of 90% and 85% respectively to be maximum thresholds above which debt becomes a constraint on future growth.

In our sample of advanced economies, only Greece, Germany, Italy, Austria and the US have debt ratios below these thresholds in both sectors. In contrast both NFC and HH debt levels are above the BIS thresholds in the Netherlands, Sweden, Norway, Switzerland, Denmark and Canada. NFC debt ratios remain above the threshold in Ireland, Belgium, France, Portugal and Spain and while the UK has “excess” HH debt. In short, progress towards dealing with high levels of private sector debt remains incomplete.

Associated risks

Private sector growth risks

**The highest rates of “excess credit growth” (3-year RGF 1Q19) have occurred in economies where PSC debt levels are already high: Switzerland, Sweden, Canada, France**
Source: BIS; Haver; CMMP analysis

Risks associated with “excess credit growth” in developed markets are lower than in past cycles. I introduced my Relative Growth Factor analysis in “Sustainable debt dynamics – Asia private sector credit”. In short, this simple framework compares the relative growth in credit versus GDP (3 year CAGR) with the level of debt penetration in a given economy.

**Among the high risk economies, Canada has seen the most obvious adjustment (trends in 3-year RGFs since March 2002)**
Source: BIS; Haver; CMMP analysis

In terms of total private sector debt, the highest “growth risks” can be seen in Sweden, Switzerland, Canada and France. Private sector credit in each of these economies has outstripped GDP growth on a CAGR basis over the past three years despite relatively high levels of private sector debt. Canada has made the most obvious adjustment among this sample of relatively high risk economies with the RGF falling from over 4% two years ago to 1.8% currently.

NFC sector growth risks

In the NFC sector, the highest risks can be observed in Switzerland, Sweden, Canada and France. RGFs for these for these economies were 3.9%, 3.0%, 2.7% and 1.8% respectively, despite NFC debt levels that are well above the BIS threshold. As above, Canada’s rate of excess NFC credit growth is slowing in contrast to trends in Switzerland and Sweden.

**Contrasting trends between NFC sector risks in Canada versus Switzerland and Sweden**
Source: BIS; Haver; CMMP analysis

HH sector growth risks

In the HH sector, RGF analysis suggest that the highest risks are in Norway, Switzerland, Canada, Norway (and the UK). RGFs in these economies were 1.3%, 1.1%, 0.7% and 0.4% respectively. In other words, excess HH credit growth risk is lower than in the NFC sector. Furthermore, the rates of excess HH credit growth in each of these economies is lower than in the recent past, especially in Norway and Canada.

**Rapid adjustments in Norway and Canada among relatively high HH sector growth risk economies**
Source: BIS; Haver; CMMP analysis

Affordability risks

Despite lower borrowing costs, affordability risks remain. BIS debt service ratios (DSR) provide, “important information about the interactions between debt and the real economy, as they measure the amount of income used for interest payments and amortisations.” (BIS, 2017). The perspective provided by DSRs complements the analysis of debt ratios above but differs in the sense that they provide a “flow-to-flow” comparison ie, the debt service payments divided by the flow of income. In the accompanying charts, DSR ratios for private sector, corporate and household credit are plotted against the deviation from their respective long term averages.

**Canada and France display the highest NFC affordability risk levels (1Q19 DSR versus LT average)**
Source: BIS; Haver; CMMP analysis

NFC affordability risks are highest in Canada and France. Debt service ratios (57% and 55% respectively) are not only high in absolute terms but they also illustrate the highest deviations from their respective long-term averages (47% and 49% respectively). In the HH sector, the highest affordability risks are seen in Norway, Canada and Sweden, although the level of risk is lower than in the NFC sector.

**Norway, Canada and Sweden display the highest HH sector affordability risk (albeit lower than in the NFC sector)**
Source: BIS; Haver; CMMP analysis

Implications for the Euro Area

Progress in dealing with the debt overhang in the Euro Area remains slow and incomplete. Long term secular challenges of subdued GDP, money supply and credit growth persist. The European Commission recently revised its 2019 forecast down by -0.1ppt to 1.1% and its 2020 and 2012 forecasts down by -0.2ppt to 1.2% in both years, with these forecasts relying on “the strength of more domestically-oriented sectors.

**Subdued Euro Area growth forecast to continue (% YoY)**
Source: European Commission; Haver; CMMP analysis

Growth in broad money (5.5%) and private sector credit (3.7%) in September remains positive in relation to recent trends but relative subdued in relation to past cycles. Furthermore, the renewed widening in the gap between the growth in the supply of money and the demand from credit (-1.8%) indicates that the Euro Area continues to face the challenge of deficiency in the demand for credit.

**Gap between growth in supply of money and demand for credit illustrates the fundamental problem – a deficiency in credit demand across the Euro Area (% YoY, 3m MVA)**
Source: ECB; Haver; CMMP analysis

This has on-going implications for policy choices. Unorthodox monetary policy measures risk fuelling further demand for less-productive “FIRE-based” lending with negative implications or leverage, growth, stability and income inequality (see “ Fuelling the FIRE” – the hidden risk in QE).

**“Fuelling the FIRE” – split in EA lending over the past twenty years between productive (COCO) and less productive (FIRE) based lending (% total lending)**
Source: ECB; Haver; CMMP analysis

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

“The changing face of global debt”

Global finance continues to shift to the East and towards emerging markets making it unrecognisable from the industry that existed twenty years ago

The key chart

**The changing face of global debt (% of total PSC) – shifting East and towards emerging markets**
Source: BIS; Haver; CMMP analysis

Summary

In this post, I summarise my analysis of the latest Bank of International Settlement (BIS) Quarterly Review with respect to level and trends in global debt and global debt ratios. The key points are:

The level of global debt hit a new high of $183 trillion in 1Q19
Global debt ratios – debt expressed as a percentage of GDP – have rebounded since 3Q18, but remain below peak 1Q18 levels.
Deleveraging continues, however, in all sectors across the Euro Area
Emerging markets remain the most dynamic segment of global finance, accounting for 36% of total private sector credit compared to only 10% two decades ago
China remains the main driver of this growth, accounting for 24% of global PSC, but the misallocation of credit towards SOEs continues
Global finance continues to shift East and towards emerging markets making it unrecognisable from the industry that existed twenty years
Further research analyses (1) whether current trends are sustainable and (2) the associated investment risks.

A new high for global debt levels

**The level and breakdown of global debt between governments, corporates (NFC) and households (HH)**
Source: BIS; Haver; CMMP analysis

The level of global debt hit a new high of $183 trillion at the end of 1Q19. Corporate (NFC) credit is the largest sub-segment (39% of total) at $72 trillion. Government debt is the second largest sub-segment (35% of total) at $65 trillion, while household credit is the smallest sub-segment (25% of total) at $47 trillion.

Aggregating NFC and HH credit together, private sector credit totals $118 trillion or 65% of total global debt, down from 70% at the end of 2008. The shift in the balance of total debt from the private sector to government debt since the GFC reflects a shift from HH to government debt. In 2008, the split of total debt between HH, NFC and government debt was 31%, 39% and 30%. Today, the split it is 25%, 39%, 35% (1Q19).

**The level and breakdown of global debt between the government and the private sector (PSC)**
Source: BIS; Haver; CMMP analysis

Leverage is also rising again…

**Trends in total global debt and global debt ratios**
Source: BIS; Haver; CMMP analysis

Global debt ratios – debt expressed as a percentage of GDP – have risen for two consecutive quarters (an end to recent deleveraging trends) but remain below peak 1Q18 levels. The outstanding stock of global debt across all sectors fell between 1Q18 and 3Q18 before rebounding in 4Q18 and 1Q19. Debt ratios have rebounded but remain below peak levels.

Viewed over a twelve month period, we can observe different forms of deleveraging in action. In the HH and government sectors the absolute stock of debt has risen (to new highs) over the past twelve months but at a slower rate than the growth in nominal GDP. This represents a passive form of deleveraging as the debt ratio declines despite the stock rising in absolute terms. In contrast, the absolute level of NFC debt in 1Q19 ($72 trillion) is slightly below the level recorded in 1Q18 ($73 trillion). Hence the fall in the NFC debt ratio from 97% to 94% over the twelve months represents a mild form of active deleveraging.

**Despite the recent rebound, the NFC sector has seen a mild form of active deleveraging over the past twelve months**
Source: BIS; Haver; CMMP analysis

Recent developments provide some support for the concept of debt thresholds ie, the level of debt above which debt becomes a drag on growth. The BIS estimate that this threshold in 90% for the NFC sector and 85% for the HH and government sectors. At the end of 1Q2019, NFC debt stood above this threshold at 94%, government debt was just below at 84%, while HH debt was well below at 60%. In short, the different form of deleveraging in the NFC sector described above reflects the fact that NFC debt ratios remain too high and above the BIS thresholds.

…except in the Euro Area

**Private sector credit in the Euro Area is slightly lower now ($21 trillion) than in 3Q09 ($22 trillion)**
Source: BIS; Haver; CMMP analysis

However, gradual deleveraging continues in all sectors in the Euro Area. Interestingly, Euro Area deleveraging began first in the HH sector where debt ratios peaked at 64% in 4Q12. As elsewhere, this has been a passive form of deleveraging where the absolute stock of HH debt rises (to a new peak level in 1Q19) at a slower rate that the growth in nominal GDP. Total, PSC, NFC and government debt levels peaked later (1Q15) and have involved both passive and active forms of deleveraging. The stock of total debt reached new highs at the end of 1Q19 in total and in the PSC and HH sectors. In contrast, it is falling in the NFC and government sector where deleveraging is in its active form and where debt ratios of 105% and 98% remain above their respective BIS threshold levels.

**On-going deleveraging in the Euro Area depresses global debt ratios – but progress is slow due to the type of deleveraging involved**
Source: BIS; Haver; CMMP analysis

Emerging market dynamism…

**Trends in global debt with breakdown between advanced and emerging markets**
Source: BIS; Haver; CMMP analysis

Emerging markets remain the most dynamic segment of global finance, accounting for 36% of total private sector credit compared to only 10% two decades ago. Emerging market PSC totalled $42 trillion at the end of 1Q19 a rise of 225% over the past ten years or a CAGR of 12% per annum. Of this, NFC credit totalled $30 trillion (71% total PSC) and HH credit totalled $12 trillion (29% total PSC). NFC credit is typically larger than HH credit in emerging markets due to their relative stage in industry development. For reference the split between NFC and HH credit in advanced economies is currently 55% and 45% respectively.

**Emerging market debt accounts for 36% of total PSC versus only 10% twenty years ago**
Source: BIS; Haver; CMMP analysis

Debt ratios are catching up with the developed world and in some cases now exceed the BIS threshold levels too. PSC, HH and NFC debt levels reached 142%, 42% and 101% of GDP at the end of 1Q19 versus respective ratios of 162%, 89% and 72% respectively for advanced economies. Note that emerging NFC debt ratios currently exceed the BIS threshold but this reflects (1) the impact of China, which is discussed below, and (2) the fact that the BIS choses to include Hong Kong (NFC debt 222% of GDP) and Singapore (NFC debt 117% of GDP) in its sample of emerging economies.

**Playing “catch-up” – emerging market PS debt ratios (% GDP) are close to advanced economies’ levels**
Source: BIS; Haver; CMMP analysis

…driven by China

China remains the main driver of EM debt growth and now accounts for 24% of global private sector credit alone. PSC growth in China has grown 366% over the past ten years at a CAGR of 17% to reach $28 trillion at the end of 1Q19. Of this NFC credit was $21 trillion (74%) and HH credit was $7 trillion (26%), but it should be noted that China’s SOEs account for 68% of total NFC credit*.

Twenty years ago, China accounted from 3% of global debt and 31% of total EM debt. Today, these shares have risen to 24% and 67% respectively. China’s outstanding stock of debt exceeded the rest of EM in 3Q11.

**China leaves the rest of EM behind after 3Q11 (PSC % GDP)**
Source: BIS; Haver; CMMP analysis

The NFC debt ratio peaked at 163% of GDP in 1Q17 and fell to 152% in 4Q18 as the growth in NFC debt lagged growth in GDP. However, in the 1Q19, this ratio rose back to 155% and remains well above the BIS threshold of 90%.

*The supply of credit to (the more profitable) private sector NFCs remains constrained and well below the BIS threshold, highlighting the on-going misallocation of credit in the Chinese economy. Further analysis of China’s debt dynamics follows in future posts.

**China’s NFC debt ratio is rising again despite being well above the BIS threshold (90%) and levels seen in the RoW**
Source: BIS; Haver; CMMP analysis

Shifting East and towards EM

**Growth in global debt increasing driven the China and EM ($ trillions)**
Source: BIS; Haver; CMMP analysis

Global finance continues to shift to the East and towards emerging markets making it unrecognisable from the industry that existed twenty years. In March 2000, global debt was structured split between advanced economies ex Euro Area (70%), the Euro Area (20%), emerging markets ex China (7%) and China (3%). Today, those splits are 47%, 18%, 12% and 24% respectively. The face of global debt is changing dramatically.

My next research analyses (1) whether current trends are sustainable and (2) the investment risks associated with these trends

The changing face of global debt (% PSC debt outstanding)
Source: BIS; Haver; CMMP analysis

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

“Look beyond the yield curve II”

Monetary trends remain inconsistent with recession fears in the Euro Area

Messages from the money sector

**Narrow money (M1) and broad money (M3) growth accelerates in August 2019**
Source: ECB; Haver; CMMP

Earlier this month, I argued that (1) leading indicators were giving mixed messages about recession risks in the Euro Area; (2) that monetary indicators were comfortably above the levels the ECB associate with risks of recession; but (3) that the ECB was still expected to cut rates and to restart QE.

No surprises since then from the ECB. However, monetary indicators have moved even further away from levels associated with recession risks. Growth in real M1 (a leading indicator) accelerated in August, and real growth in household credit (a coincident indicator) and corporate credit (a lagging indicator) are at the highest levels in the current credit cycle. The message from the money sector in August is that current trends remain inconsistent with recession risks in the Euro Area.

No surprises from the ECB in September

The Deposit Facility Rate was cut from minus 0.4% to 0.5% in-line with expectations at this month’s meeting. The ECB also announced that it would restart buying €20bn of bonds per month until inflation hits its target of 2%. It also introduced a new “tiered” system of interest rates to reduce the cost to banks from negative rates (as discussed in “Power to the Borrowers”). No surprises here.

What are monetary developments telling us?

To recap, growth rates in real M1 and lending to the private sector demonstrate robust relationships with the business cycle through time. Real M1 tends to lead fluctuations in real GDP with an average lead time of four quarters. Real household (HH) credit growth tends to lead slightly (one quarter) or have a coincident relationship with real GDP. In contrast, real corporate (NFC) credit tends to lag fluctuations in real GDP with a lag of three quarters.

**Growth in real M1 (my preferred leading indicator) is rising well above the levels associated with recessions in the Euro Area (% YoY, 3m MVA)**
Source: ECB; Haver; CMMP calculations

Monetary indicators moved even further away from levels associated with recessions risks in August. Real M1, an alternative leading indicator with a stronger and more stable relationship with real GDP than the slope of the yield curve, grew 7.3% in August compared with 6.7% in July and 4.7% in January this year. This is the fastest rate of real growth in narrow money since January 2018.

**Growth in real HH credit (a leading/coincident indicator) is at the highest level in the current credit cycle (% YoY, 3m MVA)**
Source: ECB; Haver; CMMP calculations

**Nominal HH credit growth driven by France, Germany, Benelux and Italy – but remains subdued in relation to past cycles (%YoY)**
Source: ECB, Haver, CMMP calculations

Real HH credit (a leading/co-incident indicator) and Real NFC credit (a lagging indicator) grew at 2.4% and 3.3% respectively. In both cases, this was the fastest rate of growth in the current credit cycle. France (1.3%), Germany (1.2%), Benelux (0.3%) and Italy (0.2%) were the main contributors to HH credit growth (contributions here are in nominal terms).

**Growth in real NFC credit (a lagging indicator) is also at the highest level in the current credit cycle (% YoY, 3m MVA)**
Source: ECB; Haver, CMMP calculations

In the NFC sector, France (1.8%) and Germany (1.5%) were again the main country drivers, but Italy (-0.6%) and Spain (-0.2%) both made negative contributions to nominal Euro Area growth rates.

**Nominal growth in NFC credit still dominated by France and Germany while Spain and Italy make negative contributions (% YoY)**
Source: ECB; Haver; CMMP calculations

The message from the money sector in August is that current trends remain inconsistent with recession risks in the Euro Area. The domestic sectors are demonstrating resilience in contrast to the contraction seen in the more export-oriented manufacturing sectors. The latest trends remain supportive of current ECB and EC forecasts which point to a shallow recovery in growth in 2H19.

**Monetary trends are more supportive of current EC (and ECB) forecasts for a shallow recovery in growth (% YoY)**
Source: EC; Haver; CMMP

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

“Fuelling the FIRE” – the hidden risk in QE

The hidden risk in QE is that the ECB is fuelling the growth in FIRE-based lending with negative implications for leverage, growth, stability and income inequality

**“Fuelling the FIRE” – spilt in EA lending over past twenty years between productive (COCO) and less productive (FIRE) based lending (% total loans)**
Source: ECB; Haver; CMMP

How successful has the “Fourth Phase” of ECB monetary policy been?

**The (real) cost of borrowing for EA households (HH) and corporates (NFC) has declined since the Fourth Phase began in July 2014**
Source: ECB; Haver; CMMP

An important goal of the current “Fourth Phase” of ECB monetary policy is “to ensure that businesses and people should be able to borrow more and spend less to repay their debts”.

**“Shifting the balance of power” – trends in official (MMR), ST money market (3m Euribor) and household (HH) and corporate lending (NFC) rates since end May 2014 (change in bp)**
Source: ECB; Haver; CMMP

The ECB has achieved partial success here with private sector credit in the Euro Area now growing at the fastest rate in the current credit cycle (in nominal terms) thanks in part to lower borrowing costs.

Following the standard transmission mechanism of monetary policy, the cut in official rates has fed through into money market interest rates (and expectations) and into the cost of borrowing for corporates (NFCs) and households (HHs) in the Euro Area. Since the end of May 2014, the MRR has fallen by 25bp, 3m Euribor by 69bp, and the composite cost of borrowing for NFCs and HHs by 123bp and 134bp respectively. This has represented an important shift in the balance of power from lenders/creditors to borrowers/debtors (see “Power to the Borrowers” – who are the winners from QE?). Private sector credit (PSC) stopped falling in March 2015 and is currently growing at 3.6%, the fastest nominal rate of growth in the current credit cycle.

The obvious caveats to this success story are the facts that current growth is (1) muted in relation to past cycles, and (2) limited geographically. Progress in emerging from the Euro Area’s debt overhang remains slow and incomplete. Economic cycles are shallower, money supply is subdued and credit demand is relatively week. These trends are entirely consistent with the “Balance Sheet Recession” concept and trends seen previously in Japan.

**Growth in HH lending is subdued in relation to past cycles and dominated by growth in Germany and France** (% YoY)
Source: ECB; Haver; CMMP

The current growth rate in PSC of 3.6% is well below the average of 8.3% in the decade between June 1999 and June 2009 and the peak growth of 11.7% reached in September 2016. Current growth is also dominated by Germany and France rather than broad based across the Euro Area. HH credit is growing 2.9% YoY (outstanding stock basis) of which France contributes 1.3%, Germany 1.2% and the Benelux 0.3%. Similarly, NFC credit is growing 3.1% YoY with Germany contributing 1.9% and France 1.6% while Spain, Italy, and Greece, Ireland and Portugal (GIP) all making negative contributions.

**Growth in NFC lending is also subdued in relation to past cycles and also dominated by Germany and France (% YoY)**
Source: ECB; Haver; CMMP

COCO versus FIRE – contrasting productive and unproductive credit

A less obvious, but more important, caveat is that the majority of Euro Area credit is now directed into “unproductive” FIRE-based credit rather than more “productive” COCO-based credit.

In the broadest sense, lending can be spilt into two distinct types: lending to support productive enterprise; and lending to finance the sale and purchase of existing assets. The former includes lending to NFCs and HH consumer credit, referred collectively here as “COCO” credit (COrporate and COnsumer). The latter includes loans to non-bank financial institutions (NBFIs) and HH mortgage or real estate debt, referred to collectively as “FIRE” credit (FInancials and Real Estate). Dirk Bezemer (www.privatedebtproject.org) neatly distinguishes between the productivity of these different forms of lending:

COCO-based lending typically supports production and income formation

CO: loans to NFCs are used to finance production which leads to sales revenues, wages paid, profits realised and economic expansion. Bezemer notes that these loans are used to realise future cash revenues from sales that land on the balance sheet of the borrower who can then repay the loan or safely roll it over. The key point here is that an increase in NFC debt will increase debt in the economy but it will also increase the income required to finance it

CO: consumer debt also supports productive enterprises since it drives demand for goods and services, hence helping NFCs to generate sales, profits and wages. It differs from NFC debt to the extent that HH take on an additional liability since the debt does not generate income. Hence the consumer debt is also positive but has a slightly higher risk to stability

**Share of total EA lending (%) accounted for by COCO-based lending (1999-2019)**
Source: ECB; Haver; CMMP

FIRE-based lending typically supports capital gains through higher asset prices

FI: loans to NBFIs (eg, pension funds, insurance companies) are used primarily to finance transactions in financial assets rather than to produce, sell or buy “real” output. This credit may lead to an increase in the price of financial assets but does not lead (directly) to income generated in the real economy

RE: mortgage or real estate lending is used to finance transactions in pre-existing assets rather than transactions in goods and services. Such lending typically generates asset gains as opposed to income (at least directly)

**Share of EA lending (%) accounted for by FIRE-based lending (1999-2019)**
Source: ECB; Haver; CMMP

Lending in any economy will involve a balance between these different forms, but the key point is that a shift from COCO-based lending to FIRE-based lending reflects different borrower motivations and different levels of risks to financial stability.

Over the past twenty years, FIRE-based lending has increased from 48% of total Euro Area loans to 55% as at June 2019. The current level represents a historic high. At the individual country level, the ECB has provided a breakdown on MFI balance sheets since December 2002. At the starting point of this data, COCO-based lending exceeded or equalled FIRE-based lending in six out of ten large Euro Area economies: Austria (73%:27%); Greece (73%: 48%); Italy (58%:42%); France (58%:42%); Spain (56%:44%) and Portugal (50%:50%).

As of June 2019, only three of the countries in this sample have COCO-based lending above or equal to FIRE-based lending: Austria and Greece (54%:46%) and Italy (50%:50%).

**As of July 2019, only three of the large EA economies have COCO-based lending above or equal to FIRE-based lending (% total lending)**
Source: ECB; Haver; CMMP

To what extent is QE fuelling the fire?

The shift towards these forms of credit pre-dates the introduction of QE in the Euro Area. As the data above suggests, this is part of a longer term trend. Indeed, at both the Euro Area level and the country level, the split between COCO-based and FIRE-based lending is broadly unchanged since both May 2014 and March 2015.

The shift is more noticeable since the end of the Global Financial Crisis however and may also reflect that NFC debt levels (expressed as a percentage of GDP) remain high and above the threshold levels that the BIS considers detrimental to future growth.

Nevertheless, the hidden risk in QE is that the ECB is “Fuelling the FIRE” with potentially negative implications for leverage, growth, financial stability and income inequality in the Euro Area.

As noted above, while COCO-based lending increases absolute debt levels, is also increases incomes (albeit with a lag), hence overall debt levels need not rise as a consequence. In contrast, FIRE-based lending increases debt and may increase asset prices but does not increase the purchasing power of the economy as a whole. Hence, it is likely to result in high levels of leverage.

Similarly, COCO-based lending supports economic growth both by increasing the value-add from final goods and services (“output”) and an increase in profits and wages (“income”). In contrast, FIRE-based lending typically only affects GDP growth indirectly.

From a stability perspective, the returns from FIRE-based lending (investment returns, commercial and HH property prices etc) are typically more volatile that returns from COCO-based lending and may affect the solvency of lenders and borrowers.

Finally, the return from FIRE-based lending are typically concentrated in higher-income segments of the populations, with any subsequent wealth-effects increasing income inequality.

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

“Power to the Borrowers” – who are the winners from QE?

Watch to see if the ECB introduces compensation measures for banks this week

**Trends in official ECB and ST money market rates (%)**
Source: ECB; Haver, CMMP

The ECB is widely expected to cut its deposit rate next week and to announce a restart of its QE (bond purchase programme) from October.

**QE in action – scale (EUR mn) and breakdown by instrument**
Source: ECB; Haver, CMMP

Previous non-standards monetary policy measures – the expanded asset purchase programme (APP), the introduction of negative deposit rates and the targeted longer-term refinancing operations (TLTROs) – all contributed to a steady and widespread decline in bank lending rates while narrowing their dispersion across countries in the Euro Area (EA).

**Falling (real) cost of borrowing for EA households and corporates**
Source: ECB; Haver; CMMP

Since the announcement of the credit easing package in early June 2014, lending rates have declined significantly more than market reference rates and policy rates.

In the household (HH) sector, EA lending rates have fallen 134bp since May 2014 compared with a 25bp reduction in the Main Refinancing Rate (MRR) and a 69bp reduction in 3M EURIBOR.

The largest contraction in HH lending rates have been seen in Portugal (-201bp), France (-175bp), Italy (-164bp) and Belgium (-156bp).

**Shifting the balance or power: cost of borrowing for households and corporates has fallen faster than ST money market and official rates (change in bp since end May 2014)**
Source: ECB; Haver; CMMP

In the corporate (NFC) sector, EA lending rates have fallen 123bp over the same period, with relatively large contractions in Portugal (-320bp), Spain (-193bp), and Italy (-192bp).

These trends are entirely consistent with the stated goal of the ECB to “ensure that businesses and people should be able to borrow more and spend less to repay their debt.” They also represent a clear shift in the balance of power from lenders to borrowers.

**Shifting balance of power reflected in underperformance of SX7E (leading EA banks) versus SXXE**
Source: Haver; CMMP

With 2Q19 results showing the negative impact of these trends on EA banks’ profitability levels (volume growth insufficient to compensate for spread erosion) and with EA banks’ share prices underperforming and trading at discounts to their tangible book value, the key question this week is not will the ECB cut rates and/or restart QE, but will they introduce measure to compensate banks for the obvious negative side effects of negative interest rates.

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