Category: Europe

The key chart

The key message

The true value in analysing developments in global finance lies less in considering investments in banks’ equity and more in understanding the implications of the relationship between the money sector and the wider economy for macro policy, corporate strategy, investment decisions and asset allocation (see key chart above).

The 2022 “messages from the money sector” have taught us a great deal about macro policy (and its flaws), risks to financial stability and the transition from pandemic-economics to economic slowdown/recession in advanced economies.

Macro policy

Over the past twelve months, the money sector has reminded us that flawed macro thinking continues to drive macro policy in many advanced economies (lesson #1). The first flaw is to argue that governments (who enjoy monetary sovereignty) and households face the same spending and budgetary constraints. They do not. The second flaw is to largely ignore private sector debt. In a world that sees public debt as a problem but largely ignores private sector debt, it is common to overlook elevated private sector risks in Sweden, France, Korea, China and Canada (lesson #2). This is a mistake.

Financial stability risks

Among the sample of economies listed above, the banking sectors in China and Korea have the highest exposures to elevated private sector debt risks. Banks and investors share risks more equally in Sweden, France and Canada (lesson #3).

Rising levels of financial inequality are creating very real social, economic and political problems in many developed economies. Lower-income households have less flexibility to adjust their spending in response to rising prices and are less likely to have a cushion of savings to protect them. Does this justify sensational headlines about rising levels of consumer credit? Without playing down the genuine hardship that many are facing now, the answer is no (lesson #4).

Lower-income households hold relatively small shares of mortgage debt and consumer credit. Furthermore, a recovery in demand for consumer credit at the aggregate levels was a positive sign reflecting a normalisation of economic activity during 2022. This does not mean that complacency about rising NPLs is justified, however.

From pandemic-economics to economic slowdown/recession

Monetary cycles in the UK and EA have remained highly synchronised (despite Brexit) and pointed to a clear break from pandemic economics during 2022 (lesson #5).

Consumer credit is losing momentum, however, and sharply slowing real growth rates in money and credit point to slowdown/recession in 2023 (lesson #6).

The UK has already returned to the unsustainable world of pre-pandemic imbalances (lesson #7). The fact that this is an integral part of official forecasts returns us neatly to lesson #1 – flawed macro thinking drives current macro policy.

Thank you for reading and very best wishes for a very happy and healthy New Year

Seven lessons from the money sector in 2022

Lesson #1: flawed macro thinking drives macro policy

Over the past twelve months, the money sector has reminded us that flawed macro thinking continues to drive macro policy in many advanced economies.

The first flaw argues that currency issuers (e.g. governments who enjoy monetary sovereignty) and currency users (e.g. households) face the same spending and budgetary. The second flaw sees public sector debt as a problem but largely ignores private sector debt.

Jeremy Hunt, the latest Chancellor of the Exchequer in the UK, argued recently that, “Families up and down the country have to balance their accounts at home and we must do the same as a government.” He was following in the well-trodden footsteps of Thatcher, Cameron, Osbourne and Sunak before him. In the past, this rhetoric and mistaken belief set was used to justify austerity policies (which had well-documented, negative impacts on UK growth). Such arguments reflect a flawed understanding of how modern monetary systems work. They also ignore the fact that the correct fiscal response is the one that balances the economy not the budget.

Back in February 2022, France’s state auditor sounded the alarm about the impact of pandemic spending on France’s widening budget deficit and rising debt levels (see chart above). The auditor was factually correct to highlight the impact of pandemic spending on the government’s net borrowing but the analysis fell short in three important respects. First, the net borrowing of the French government was a necessary, timely and appropriate response to the scale of the private sector’s net lending/disinvestment. Second, while the outstanding stock of French government debt may be the fourth highest in the world, France ranks much lower in terms of government indebtedness. Third, from a risk and financial stability perspective, CMMP analysis is more concerned about France’s private sector debt dynamics, particularly in the corporate sector (see Lesson #2).

Lesson #2: its a mistake to ignore private debt

In a world that sees public debt as a problem but largely ignores private sector debt, it is common to overlook elevated private sector risks in Sweden, France, Korea, China and Canada. This is a mistake.

Why focus on Sweden, France, Korea, China and Canada?

First, their levels of private sector indebtedness exceed the “peak-bubble” level seen in Japan (214% GDP, 4Q94) and, in the cases of Sweden and France, the peak-bubble level seen in Spain (227% GDP, 2Q10) too. Potential warning sign #1.

Second, in contrast to other economies that exhibit high levels of private sector indebtedness (eg, the Netherlands, Denmark, and Norway) affordability risks are also elevated in these five highlighted economies. Their debt service ratios are not only high in absolute terms (>20% income), they are also elevated in relation to their respective 10-year, average affordability levels. Potential warning sign #2.

Note, finally, that among these five economies, Sweden, Korea and Canada have over-indebted NFC and HH sectors, while the risks in France and China relate more, but not exclusively, to their NFC sectors. When it comes to private sector debt dynamics, the world is far from a homogenous place.

Lesson #3: exposure of Chinese and Korean banks

Among the sample of economies listed above, the banking sectors in China and Korea have the highest exposures to elevated private sector debt risks. Banks and investors share risks more equally in Sweden, France and Canada.

In China, bank credit accounts for 84% of total private sector credit and the bank credit ratio of 184% GDP exceeds the peak-Spanish bank credit ratio of 168% GDP. Similarly, in Korea bank credit accounts for 73% of total private sector credit. The bank credit ratio of 161% GDP is slightly below the peak-Spain level but well above the peak-Japan level of 112%

In contrast, risks in Sweden, France and Canada are shared more equally between banks and investors (see chart above). Bank sector credit accounts for 51%, 50% and 49% of total private sector credit in Sweden, Canada and France respectively (reflecting the greater development of alternative sources of credit in advanced economies).This does not mean that banks are not exposed, however. The bank credit ratio in Sweden is 138% GDP, above the peak-Japan level. In France and Canada these ratios are the same or slightly below the peak-Japan level (112% GDP and 109% GDP respectively).

Lesson #4: the risks of rising financial inequality

Rising levels of financial inequality are creating very real social, economic and political problems in many developed economies. Lower-income households have less flexibility to adjust their spending in response to rising prices and are less likely to have a cushion of savings to protect them. Does this justify sensational headlines about rising levels of consumer credit? Without playing down the genuine hardship that many are facing now, the answer is no.

Lower-income households hold relatively small shares of mortgage and consumer credit in the UK and EA, for example. In the UK, the bottom-three income deciles account for 5% and 8% of the outstanding stock of mortgages and consumer credit respectively. Similarly in the euro area, the bottom-two income quintiles account for 13% of total household debt, albeit with significant variations at the country level. Furthermore, at the aggregate level, a recovery in demand for consumer credit is a positive sign reflecting a normalisation of economic activity rather than a sign of systemic stress/economic weakness.

This does not mean that complacency about rising NPLs is justified. According to the latest OBR forecasts, for example, the household debt servicing cost in the UK is set to rise from £60bn at the end of 4Q22 (3.8% of disposable income) to £107bn at the end of 4Q23 (6.6% of disposable income) and £125bn at the end of 4Q24 (7.5% of disposable income). Beyond that, the debt service ratio is assumed to stabilise at around 7.5% of disposable income. High but (perhaps conveniently?) below the 9.7% level seen at the time of the GFC.

Lesson #5: the break for pandemic-era economics

Monetary cycles in the UK and EA have remained highly synchronised (despite Brexit) and pointed to a clear break from pandemic economics during 2022.

Pandemic-era economics was characterised by a spikes in broad money driven by the hoarding of cash by HHs and NFCs, subdued credit demand and a record desynchronization of money and credit cycles.

Broad money growth has slowed from a peak of 15.4% to 5.6% in the UK and from a peak of 12.5% to 5.1% in the EA. HHs and NFCs have stopped hoarding cash, monthly consumer credit flows have recovered and money and credit cycles have re-synched with each other. Mortgage demand, the key driver of so-called FIRE-based lending is also slowing, notably in the EA.

Lesson #6: lower consumer momentum and slower growth

Consumer credit is losing momentum, however, and sharply slowing real growth rates in money and credit point to slowdown/recession in 2023.

Recall that in the face of falling real disposable incomes, HHs can either consume less, save less and/or borrow more – or a combination of these behaviours.

In relation to pre-COVID trends, US consumers repaid less consumer credit during the pandemic and have borrowed much more in the post-pandemic period than their UK and EA peers. Monthly flows of US consumer credit peaked at $45bn in March 2022 at 3x their pre-pandemic levels. According to the latest data release, they fell to $27bn in October 2022 but remain almost double pre-pandemic levels.

The messages from the respective money sectors is that downside risks to consumption remain more elevated in the EA and the UK where monthly consumer credit flows have already fallen back below pre-pandemic levels.

Real growth rates in M1, HH credit and NFC credit typically display leading, coincident and lagging relationships with real GDP. Each indicator is falling at an increasing rate in the UK and the EA. If historic relationships between these variables continue, this suggests a sharp deceleration in economic activity over the next quarters.

Lesson #7: the UK returns to the unsustainable pre-COVID world

The UK returned to the unsustainable world of pre-COVID economics with twin domestic sector deficits counterbalanced by significant current account deficits in 2022. The OBR expects these dynamics to continue throughout its forecast period to March 2028.

The good news for Jeremy Hunt, the Chancellor of the UK, is that the net financial deficit of the UK public sector is forecast to fall sharply and to trend to c2-3% of GDP throughout their forecast period. The bad news for UK households is that their net financial position is forecast to fall from its recent (and typical) surplus to sustained deficits of between 0.1% and 0.4% GDP. In short, the UK is set to become a nation of non-savers with households also spending more of their income on servicing their debt.

To return to the first lesson of 2022, the lack of appropriate health warnings and the implied structural shift in risk away from the public sector to the private sector here reflects either flaws in macro thinking and policy making and/or the heavy hand of reverse engineering. Neither are good news.

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