Time for new solutions to Italy’s structural problems
The key chart
Trends in private and public sector net lending/borrowing over the past decade (Source: ECB; CMMP)
The key message
With the yield on Italian 10Y government bonds rising to 3.37% (+251bp YTD), attention is focusing again on the net borrowing of the Italian government and the government debt ratio (172% GDP).
This is entirely consistent with conventional macroeconomic thinking that continues to ignore private debt while seeing public debt as a problem. It is also mistaken.
A key theme of CMMP analysis is that, “private debt causes crisis – public debt (to some extent) ends them” (Professor Steve Keen, June 2021). Italy, of course, stands out as being one of only four developed market economies that has household (HH) and corporate (NFC) debt ratios well below the maximum threshold levels above which the BIS believes that debt becomes a constraint on future growth.
Not only does Italy not have a private sector debt problem, some of the economy’s key challenges stem from a lack of private sector borrowing and investment, not from too much. Consider:
The Italian private sector has been a consistent (and growing) net lender over the past decade. Instead of borrowing money to invest, HHs and NFCs have been saving/disinvesting. The outstanding stock of NFC debt at end 3Q21 was below the level recorded in 3Q09, for example.
The net savings of the private sector have been running at 1.5-3.0x the size of the net borrowings of the government. Instead of funding the fiscal stimulus required to close Italy’s deflationary gap, un-borrowed private sector savings have leaked out of the economy.
“Austerity” and future fiscal consolidation have not/will not solve either of these fundamental challenges. Domestic sector imbalances leave the Italian economy increasingly reliant of running current account surpluses. The structural challenges of excess savings and insufficient private sector investment remain.
The fact that un-borrowed savings in countries experiencing private sector deleveraging are able to leak into other bond markets, restricting governments from funding stimulus measures, reflects a structural flaw in the Eurozone. In 2012, Richard Koo, the Japanese economist and global expert on balance sheet recessions, proposed applying different risk weights to domestic and foreign government bonds as a partial solution.
Perhaps the time for new and imaginative solutions to Italy’s sector imbalances is at hand, once again…
Attenzione!
Top 10 government debt ratios, ranked by size (Source: BIS; CMMP)
With the yield on Italian 10Y government bonds rising to 3.37% (+251bp YTD), attention is focusing once again on the net borrowing of the Italian government and the government debt ratio (which is the third highest in the world at 172% GDP). This is entirely consistent with conventional macroeconomic thinking that continues to ignore private debt while seeing public debt as a problem. It is also mistaken.
HH and NFC debt ratios for BIS advanced economies (Source: BIS; CMMP)
A key theme of CMMP analysis is that, “private debt causes crisis – public debt (to some extent) ends them” (Professor Steve Keen, June 2021). Italy, of course, stands out as being one of only four developed market economies that has HH and NFC debt ratios well below the maximum threshold levels above which the BIS believes that debt becomes a constraint on future growth (see chart above).
According to the latest BIS statistics, Italy’s HH and NFC debt ratios are only 44% GDP and 73% GDP respectively. This compares with average debt ratios in the euro area of 61% GDP and 111% GDP (EA in the chart above) and BIS threshold levels of 85% GDP and 90% GDP respectively (red lines in chart above).
Not only does Italy not have a private sector debt problem, some of the economy’s key problems stem from a lack of private sector borrowing and investment, not from too much.
Net lending of Italy’s private sector over the past decade (Source: ECB; CMMP)
The Italian private sector been a consistent (and growing) net lender over the past decade (see chart above). Instead of borrowing money to invest, HHs and NFCs have been saving/disinvesting (see chart below). NFC debt of €1,277bn at the end of 3Q21 was below the €1,305bn recorded at the end of 3Q2009, for example. Over the same period, HH debt has increased by only 1.3% CAGR from €660bn to €764bn.
Trends in HH and NFC debt and debt ratios since 2009 (Source: BIS; CMMP)
The net savings of the private sector have been running at 1.5-3.0x the size of the net borrowings of the government. Instead of funding the fiscal stimulus required to close Italy’s deflationary gap, un-borrowed private sector savings have leaked out of the economy.
Trend in private sector net lending versus public sector net borrowing (Source: ECB; CMMP)
“Austerity” and potential future fiscal consolidation have not/will not solve either of these fundamental challenges. Domestic sector imbalances leave the Italian economy increasingly reliant of running current account surpluses with the RoW (see chart below). The structural challenges of excess savings and insufficient private sector investment remain.
Trends in Italian net sector balances (EURbn) (Source: ECB; CMMP)
In “The escape from balance sheet recession and the QE trap”, Richard Koo, the Japanese economist and leading authority on balance sheet recessions, highlighted the structural flaw in the Eurozone that allowed un-borrowed savings in countries experiencing private sector deleveraging to flee to other bond markets, preventing domestic governments from issuing debt to fund stimulus measures.
As far back as 2012, Koo proposed applying different risk weights to domestic and foreign government bonds. He suggested that, “The relatively minor regulatory change of attaching different risk weights to holdings of domestic versus foreign government bonds would go a long way toward reducing pro-cyclical and destabilising flows among government bond markets.”
Perhaps the time for new and imaginative solutions to Italy’s sector imbalances is at hand, once again…
Please note that the summary comments and charts above are abstracts from more detailed analysis that is available separately.
In “August snippets – Part 1”, I highlighted the importance of disciplined investment frameworks. In this second snippet, I revisit the foundations of my CMMP Analysis framework. I start by describing how I combine three different time perspectives into a consistent investment thesis (“three pillars”). I then explain how the core banking services (payments, credit and savings) link different economic agents over time to form an important fourth pillar – financial sector balances. Finally, I present examples of how these four pillars combine to deliver deep insights into policy options and responses.
The central theme is my belief that the true value in analysing developments in the financial sector lies less in considering investments in banks but more in understanding the implications of the relationship between banks and the wider economy for corporate strategy, investment decisions and asset allocation.
Three perspectives – one strategy
As an investor, I combine three different time perspectives into a single investment strategy
My investment outlook at any point in time reflects the dynamic between them
My conviction reflects the extent to which they are aligned
Pillar 1: Long-term investment perspective
Example chart 1: growth trends in PSC illustrate how global finance is shifting East and towards emerging markets ($bn) (Source: BIS; CMMP analysis )
My LT investment perspective focuses on the key structural drivers that extend across multiple business cycles. Given my macro and monetary economic background, I begin by analysing the level, growth, affordability and structure of debt. These four features of global debt have direct implications for: economic growth; the supply and demand for credit; money, credit and business cycles; policy options; investment risks and asset allocation. My perspective here reflects my early professional career in Asia and experience of Japan’s balance sheet recession. The three central themes are (1) global finance continues to shift East and towards emerging markets, (2) high, “excess HH growth rates” in India and China remain a key sustainability risk, and (3) progress towards dealing with the debt overhang in Europe remains gradual and incomplete. The following four links provide examples of LT investment perspectives:
Example chart 2:China’s HH debt ratio continued to rise sharply in 1Q20 – too much, too soon? (Source: National Bureau of Statistics; CMMP analysis)
Pillar 2 – Medium-term investment perspective
Example chart 3: growth rates in M1 and private sector credit demonstrate robust relationships with the business cycle through time and have proved more reliable indicators of recessions risks than the shape of the yield curve (Source: ECB; CMMP analysis)
My MT investment perspective centres on: analysing money, credit and business cycles; the impact of bank behaviour on the wider economy; and the impact of macro and monetary dynamics on bank sector profitability. Growth rates in narrow money (M1) and private sector credit demonstrate robust relationships with the business cycle through time. My interest is in how these relationships can assist investment timing and asset allocation. My investment experience in Europe shapes my MT perspective, supported by detailed analysis provided by the ECB. A central MT theme here is the fact that monetary developments: (1) have proved a more reliable indicator of recession risks than the shape of the yield curve; and (2) provide important insights into the impact, drivers and timing of the Covid-19 pandemic on developed market economies. The following four links provide examples of my analysis of MT investment perspectives:
Example chart 4: headling figures mask a more nuanced message from monthly flow data (Source: ECB; CMMP analysis)
Pillar 3: Short-term investment perspective
Example chart 5: banks played catch up from May 2020, but what kind of rally was this and was it sustainable? (Source: FT; CMMP analysis)
My ST investment perspective focuses on trends in the key macro building blocks that affect industry value drivers, company earnings and profitability at different stages within specific cycles. This perspective is influences by my experience of running proprietary equity investments within a fixed-income environment at JP Morgan. This led me to reappraise the impact of different drivers of equity market returns. I was able to demonstrate the “proof of concept” of this approach when I returned to the sell-side in 2017 as Global Head of Banks Equity Research at HSBC, most notably when challenging the consensus investor positioning towards European banks in 3Q17. A central ST theme is the importance of macro-building blocks in determining sector profitability and investment returns. The following four links provide examples of ST investment perspectives:
Example chart 6: why it was correct to question the conviction behind the SX7E rally during 2Q20 (Source: FT, CMMP analysis)
Pillar 4 – Financial Sector Balances
Example chart 7: Financial sector balances (and MMT!) can be understood easily by starting with the core services provided by banks to HHs and NFCs (Source: Bank of England; CMMP analysis)
In January 2020, I presented a consistent, “balance sheet framework” for understanding the relationship between the financial sector and the wider economy and applied it to the UK. I chose the UK deliberately to reflect the relatively large size of the UK financial system and the relatively volatile nature of its relationship with the economy. I extended this analysis to the euro area later. I began by focusing on the core services provided by the financial system (payments, credit and savings), how these services produce a stock of financial balance sheets that link different economic agents over time, and how these balance sheets form the foundation of a highly quantitative, objective and logical analytical framework. Central themes here were the large and persistent sector imbalances in the UK, why the HH sector in the UK was poised to disappoint and why a major policy review was required in the euro area even before the full impact of the COVID-19 pandemic was felt. The following four links provide examples of FSB analysis:
Example chart 8: Pre-Covid, the UK faced large and persistent sector imbalances and was increaingly reliant on the RoW as a net lender (4Q sum, % GDP) (Source: ONS; CMMP analysis)
Policy analysis
Example chart 9: “Fuelling the FIRE” – split in EA lending over past twenty years between productive (COCO) and less productive (FIRE) based lending (% total loans) (Source: ECB; CMMP analysis)
These four pillars provide a solid foundation for analysing macroeconomic policy options and choices. Since September 2019, I have applied them to identifying the hidden risks in QE, to arguing why the EA was trapped by its debt overhang and out-dated policy rules, and to assessing the policy responses to the COVID-19 pandemic. Central themes have included: (1) the hidden risk that QE is fuelling the growth in FIRE-based lending with negative implications for leverage, growth, stability and income inequality; (2) why the gradual and incomplete progress towards dealing with Europe’s debt overhang matters; (3) why Madame Lagarde was correct to argue that the appropriate and required response to the current growth shock “should be fiscal, first and foremost”; and (4) how three myths from the past posed a threat to the future of the European project. The following four links provide examples of policy analysis:
Example chart 10: failing the “common sense test”. What was the point of running tight fiscal policies when the private sector was running persistent financial surpluses > 3% GDP (Source: ECB; CMMP analysis)
Please note that the summary comments and charts above are extracts from more detailed analysis that is available separately
May’s message from the UK money sector – risks from the HH sector
The key chart
The post COVID 19 outlook may be determined by the extent to which the dramatic increase in HH savings is forced or precautionary – financial sector balances provide important context here (£mn) Source: Bank of England; CMMP analysis
Summary of CMMP analysis
Households (HHs) play a dominant role in the UK economy – their consumption accounts for 63p in every pound of GDP and their borrowing accounts for 76p in every pound lent.
In this context, heightened uncertainty, debt repayments and a marked increase in savings represent clear and rising risks to the economy and to bank sector profitability.
The £26bn record increase in HH deposits in May (6x the 10-year average monthly flow) reflects extreme uncertainty. HHs are repaying loans, notably consumer credit which has fallen -25% (annualised) over the past three months and -3% YoY (the weakest rate since 1994).
Pre-COVID 19, HHs funded consumption by dramatically reducing savings…
…during COVID 19, the savings ratio jumped sharply from an 11-year low of 5.2% in 3Q19 to 8.6% in 1Q20 (in-line with its LT average)…
…Post-COVID 19, the key question is the extent to which these savings are “forced” (constraints on spending during lockdown) or “precautionary” (response to actual or possible unemployment) in the UK and in the euro area.
Financial sector balances provide important historic context here given that the UK economy was characterised by large and persistent sector imbalances previously. Increasing deposits and/or reducing loan liabilities are likely to be part of a structural shift towards higher levels of HH net lending/financial surpluses.
Financial flows may remain volatile but a sharp reversal with savings moving rapidly back into either consumption or investment appears unlikely given the UK’s starting position.
Look instead for further fiscal stimulus (eg, a temporary cut in VAT).
Please note that the summary comments above and the graphs below are extracts from more detailed analysis that is available separately.
Six key charts
The £26bn record increase in HH deposits in May reflects extreme uncertainty levels (£mn) Source: Bank of England; CMMP analysisHHs are actively repaying loans…(£bn on LHS, % YoY on RHS) Source: Bank of England; CMMP analysis…notably in consumer credit (credit cards and other consumer loans) Source: Bank of England; CMMP analysisMixed messages from the mortgage market – HHs borrowed an additional £1bn in May after no growth in April (not shown here) but forward-looking approvals fell 66% on previous 6m average Source: Bank of England; CMMP analysisThe HH savings ratio has jumped from an 11-year low of 5.2% in 3Q19 to 8.6% in 1Q20 Source: ONS; CMMP analysisA structural shift to higher HH net financial surpluses would suggest that a rapid shift of savings back into consumption and investment is unlikely. Look for further, offsetting fiscal stimulus instead?(HH net financial surplus as % GDP) Source: ONS; CMPP analysis
At the time of writing (3 April 2020), more than one million people have been infected and more than 53 thousand have lost their lives in the Covid-19 pandemic. The euro area (EA) is one of the epicentres of this global crisis and faces huge human and economic costs.
Introduction
CMMP analysis can add little value to the debate over the human costs and the appropriate medical and social responses to the pandemic. It can add value to the economic and political debate, however, by applying its three core analytical frameworks – global debt dynamics; money credit and business cycles; and financial sector balances.
I begin by challenging three myths from the past two decades that: (1) painful structural reforms post-2000 were the main driver of Germany’s recovery and resurgent competitiveness; (2) existing fiscal frameworks (including the Stability and Growth Pact) are still relevant in 2020; and (3) “this crisis is primarily the hour of national economic policy” (Issing 2020).
Instead, I argue that: (1) the main reason why Germany’s fiscal deficits did not widen substantially after the collapse of the 2000 IT bubble was that ECB policy led to other countries experiencing asset bubbles, lost competitiveness (and a build-up of unsustainable debt); (2) asymmetric fiscal rules that are tough on deficits but weak on surpluses are inappropriate in the current situation; and (3) this is the time to re-establish coordinated, counter-cyclical fiscal policy across the EA.
EA governments have the opportunity to show that it’s not just the ECB that “will do whatever is needed”. More importantly, failure to acknowledge and debunk the myths of the past and to respond to this opportunity appropriately, risks immeasurable harm to the future of the European project.
Myth #1: The role of structural reforms
In 2000, the EA and Germany were hit hard by the collapse of the IT bubble (real GDP, YoY, country contribution to total growth) Source: ECB; Haver; CMMP analysis
Twenty years ago, the euro area (EA) experienced a sharp economic slowdown following the collapse of the IT bubble. The Germany economy was hit hard in the process, experiencing three consecutive quarters of negative growth (3Q01-1Q02). The domestic fiscal response was insufficient to counter the massive increase in savings by both the NFC and HH sectors.
Germany’s fiscal response was insufficient to counter the massive increase in private sector savings after the IT bubble burst (4Q sums, % GDP) Source: ECB; Haver; CMMP analysis
In short, Germany had become the second developed economy (after Japan) to experience a balance sheet recession in the post-war period (Koo, 2015). In response, important “Agenda 2010” structural reforms (pensions, labour market) were introduced between 1999 and 2005. This (painful) experience has shaped the enduring narrative about the requirement for similar reforms across Southern Europe.
Germany becomes the second developed market (after Japan) to experience a balance sheet recession with the private sector deleveraging despite lower rates (HH and NFC credit as % GDP, dotted lines indicate period of ECB rate cuts) Source: ECB; Haver; CMMP analysisIn response to weakness in the German economy, the ECB cut rates to a post-war low of 2% (lower than rates had been under the Bundesbank) Source: ECB; Haver; CMMP analysis
Unfortunately this narrative is incomplete and underplays the role of ECB policy at the time. In the face of German economic weakness, the ECB cut ST interest rates to 2% in 2003 – lower that they had ever been under the Bundesbank.
M3 growth expanded much faster in the EA (ex Germany) and led to corresponding increases in wages and prices. In contrast relative subdued M3 growth in Germany subdued wage and price inflation (nominal growth in M3 rebased to December 2000) Source: ECB; Haver; CMMP analysis
This had little impact on Germany where money supply, prices and wages continued to stagnate, as balance sheet recessions theorists predict.
Trends in unit labour costs show how other major EA economies lost competitiveness against Germany Source: ECB; Haver; CMMP analysis
The story was very different elsewhere in Europe. Other countries in the EA lost competitiveness against Germany, experienced unsustainable asset bubbles, and built up unsustainable levels of debt.
The cost of borrowing for Spanish HHs fell quickly in response to cuts in policy rates (% YoY) Source: ECB; Haver; CMMP analysisBut led to an unsustainable housing boom, collapse and balance sheet recession in Spain (residential property price rises, % YoY) Source: ECB; Haver; CMMP analysis
This brief historical summary is important because it falsifies the idea that recessions and the lack of competitiveness in Europe’s periphery are the results of “national idleness”. Instead, they occurred because Germany was unable to use fiscal stimulus to address its own severe balance sheet recession and ECB monetary policy was forced to pick up the slack, leading to asset bubbles across the EA and, when these bubbles burst in 2007, balance sheet recessions in periphery countries and ultimately the euro crisis.
Myth #2: Fiscal frameworks are still relevant
Too little, too late? Private sector deleveraging in the EA began later and has been more gradual than in the UK and the US (private sector debt as % GDP, dotted lines indicate timing of peak levels) Source: BIS; Haver; CMMP analysis
In February, before the full impact of the pandemic was becoming understood, I was arguing that the EA was still dealing with the legacy of these debt overhangs. Private sector debt levels were still high too high, money, credit and business cycles were significantly weaker than in past cycles and inflation remained well below target.
Collective fiscal policy “was” about as tight as at any poing in the past twenty years (4Q sum, % GDP) Source: ECB; Haver; CMMP analysis
In spite of this, the nations of the EA were collectively running a fiscal policy that was about as tight as at any period in the past twenty years. They were doing this at a time when the private sector was running persistent net financial surpluses. This policy mix failed a basic “common sense test” even before the wider impacts of the pandemic were emerging.
Failing the “common sense test”. What was the point of running a tight fiscal policy when the private sectors was running persistent financial surpluses above 3% of GDP (4Q sums, % GDP) Source: ECB; Haver; CMMP analysis
A key lesson from the German (and Japanese) experience is that the deflationary gap in economies facing debt overhangs is equal to the amount of private unborrowed savings. Balance sheet recession theorists argue that these “unborrowed savings (at a time of zero interest rates) are responsible for the weakness in the economy, and it is because the economy is so weak that fiscal stimulus is necessary” (Koo, 2015).
Relating the same argument to inflation targets, when inflation and inflation expectations are below target and rates are zero or negative, fiscal policy should lead with an expansionary stance and monetary policy should cooperate by focusing on guaranteeing low interest rates for as long as needed.
Since, I wrote these comments, EA governments have responded with a series of emergency fiscal measures including immediate stimulus via spending and foregone revenues, deferrals of some revenue sources, and other liquidity provisions and guarantees. However, the scale of the responses varies widely and, most importantly, there has been a lack of common fiscal responses, even in the EA.
Before, turning to this issue in myth #3, I will highlight an important argument from my preferred sector balances approach and Wynne Godley’s core identity that states:
Domestic private balance + domestic government balance + foreign balance = zero
Germany was able to emerge from recession partly by boosting exports to EA countries who were growing more rapidly in the wake of the ECB rate cuts described earlier (total current account and current account with the rest of the EA, EUR billions) Source: Haver; CMMP analysis
Governments in low-debt countries often overlook that they have benefitted massively from membership of the single market and the ability to run large current account surpluses. Germany was able to emerge from its earlier recession by boosting exports to the rest of the EA where economies were responding (too quickly) to ECB rate cuts. Today, Dutch private and public sector deficits are offset by financial deficits run by the RoW.
Dutch private and public sector surpluses are offset by widening RoW financial deficits (4Q sums, % GDP) Source: ECB; Haver; CMMP analysis
Put simply, “asymmetric fiscal rules – tough on deficits, weak on surpluses – are quite inappropriate to the [current] macroeconomic situation” (Gentiloni, 2020).
Myth #3: This is the hour of national economic policy
The EA is one of the epicentres of the Covid-19 pandemic and faces huge human and economic costs. Non-essential services in major economies that account for one third of total output have been closed and the IMF estimates that each month’s closure equates to a 3% drop in annual GDP. The IMF concludes that, “a deep European recession this year is a foregone conclusion” and today’s PMI releases support that conclusion.
Policy makers have responded quickly with large monetary and fiscal expansions (including suspensions of previous fiscal rules and limits). Through its Pandemic Emergency Purchase Programme (PEPP) the ECB plans to buy €750 billion in addition bonds (on top of the previously announced €120bn purchases) and has removed country limits.
After the “lo spread” false start, the ECB announced bold PEPP action putting the onus on politicians to respend approrpriately (Italy 10Y bond yield minus German 10y bond yield, ppt) Source: Haver; CMMP analysis
Debate now centres on whether a further common and significant response is needed. Options under consideration include ESM credit lines (combined with OMT); so-called “corona bonds”, a EA Treasury, and one-off joint expenditures.
Once again, this debate has exposed divisions between “defensive hawks” and more “ambitious integrators”. The French, Italian and six other EA governments are proposing combining using the ESM with the issuance of corona bonds. The German government has a preference for exhausting other options first, while the Dutch government has not only stated that use of the ESM should be considered only as a last resort, it has also ruled out the option of issuing corona bonds.
The IMF argues that, “the determination of EA leaders to do what it takes to stabilise the Euro should not be understated.” The EU’s economic chief, Paolo Gentiloni, believes that “consensus is growing day by day that we need to face an extraordinary crisis with extraordinary tools.” Nonetheless the corona bond debate threatens to deepen the rift between EA capitals over how far and how fast the EA should harness common fiscal solutions to tackle the pending economic damage.
The future of the European project may rest on how this debate is resolved.
Please note that the summary comments above are extracts from more detailed analysis that is available separately.
Household net worth is at a new high driven by persisent financial surpluses post GFC combined with positive revaluation effects from housing and financial assets (multiple of disposable income) Source: ECB; Haver; CMMP analysis
Examining wealth effects
Households (HH) in the euro area (EA) have been running persistent financial surpluses of between 2-3% GDP since the GFC. I considered the implications of these trends for the choice of policy mix in previous posts (see “Policy reboot 2020”). In this post, I examine the implications for the resilience of HH consumption in the face of the Covid-19 crisis.
HHs have run persistent financial surpluses since the GFC leading to a build up of financial assets (% GDP, 4Q sum) Source: ECB; Haver; CMMP analysis
HH net wealth (HNW), the difference between the value of HH assets and liabilities, is an important determinant of private sector consumption. Given that HH consumption accounts for 54 cents in every EURO of GDP, it is also an important determinant of overall GDP growth in the EA.
Changes in wealth affect consumption in the short run as HH feel richer or poorer and become more or less confident. The level of HNW is also an important driver of long term consumption since, along with income from employment, it determines the amount of economic resources available to HHs.
Trend and breakdown (NFAs, FAs, FLs,) of HNW over the past twenty years (EURO trillion) Source: ECB; Haver; CMMP analysis
HNW hit a new high in absolute terms (€52trillion) and as a multiple of disposable income (7.2x) at the end of 3Q19. This included non-financial assets (NFAs) of €34trillion, largely in the form of housing, and financial assets (FAs) of €26trillion, netted off against financial liabilities (FLs) of €8trillion.
Breakdown of changes to HNW highlights the importance of revaluation gains in NFAs (change in Euro per capita) Source: ECB, Haver, CMMP analysis
The growth in HNW reflects not only the build-up of FAs, but also revaluation gains in these and other NFAs. As discussed in “Fuelling the Fire”, Quantitative Easing has stimulated asset prices and led to increased housing and financial wealth (see graphs above and below).
QE has stimulated asset prices and increased housing and financial wealth (changes in per capita terms by quarter and as rolling 4Q sums) Source: ECB; Haver, CMMP analysis
Revaluation gains of NFAs have been particularly important in Portugal, Greece, Spain, Germany and Austria. However, ECB estimates suggest that while residential property prices remain undervalued in Greece, they were overvalued by 12%, 16% and 18% in Portugal, Germany and Austria respectively even before the impact of Covid-19 as felt.
Property prices were over-valued even before the impact of Covid-19 (3Q19) Source: ECB; Haver; CMMP analysis
Potential revaluation losses on NFA will have a negative impact on HNW for obvious reasons, but their impact on future consumption (marginal propensity to consume) is more challenging to determine (and varies between micro and macro levels).
To summarise the very extensive economic analysis in this area, the long-term housing effects on consumption are consistently weaker than those of financial wealth. Indeed, in a recent analysis of larger EA economies, the ECB concluded that, “Spain is the only large EA country for which consistently positive housing wealth effects have been estimated.”
HHs in the Netherlands, Belgium, Italy and France have higher gearing to changes in FA values Source: ECB; Haver; CMMP analysis
Significant heterogeneity exists in terms of the size and structure of HH financial assets. FAs are 2.2x the size of EA GDP on average, but above average in the Netherlands (3.6x), Belgium (3.0x), Italy (2.5x) and France (2.4x). Higher gearing to the value of financial assets in these economies is offset by the “absolute cushion” of higher per capita FA holdings in the Netherlands (€167k), Belgium (€121k) and France (€86k). However, in aggregate, Italian HHs have higher gearing than average but lower than average holdings of FAs per capita (€72k versus the EA average of €75k). Other Southern European economies also have smaller cushions in terms of FAs per capita – Greece (€25k), Portugal (€42k) and Spain (€50k).
Liquid assets are an important part of HH total FAs especially in Greece, Portugal, Austria, Germany and Spain. Source: ECB; Haver, CMMP analysis
FAs consist mainly of liquid assets (currency and deposits) and pension and life insurance-related assets. These assets account for 70% of total HH FAs with the remainder held in higher risk products including equity, debt and shares in investment funds. The share of higher risk assets has fallen from 40% pre-GFC to 30% currently suggesting that the negative impact of recent market falls may be less than after the GFC. In addition, HHs in Greece (59%), Portugal (44%), Austria (40%), Germany (40%) and Spain (39%) hold higher amount of their financial assets is liquid assets. However, on a per capita basis, the largest liquid holdings are in Belgium (€38k), Austria (€33k), Germany (€31k) and Ireland (€31k).
Conclusion
The stock of HH wealth in the EA has risen to new highs in absolute terms and as a multiple of disposable income and represents an important economic resource in the face of the Covid-19 crisis.
Revaluation gains of both NFA and FA assets have been important drivers of recent HNW growth, but both will turn sharply negative in the current environment. At the macro-level, long term housing effects on consumption difficult to measure but are consistently weaker than those of financial wealth (with the exception of Spain).
HHs in the Netherlands, Belgium, Italy and France have relatively high gearing to changes in the value of FAs, although with the exception of Italy this is offset by relatively high per capita holdings on FAs. HHs in Southern European economies typically have lower “cushions” in terms of per capital holdings of financial assets.
Since the GFC, there has been a de-risking of HNW holdings away from debt, equity and shares in investment funds in favour of liquid assets and pension and life insurance related assets. Lower risk assets now account for 70% of HH FAs. In addition, HHs in Greece, Portugal, Austria, Germany and Spain hold relatively high amounts of FAs in liquid assets. This suggests that the MPC from financial effects may be lower than after the GFC.
These conclusions come with the obvious caveat that the impact of changes in wealth on HH consumption differs substantially between countries, between NFAs and FAs and between HHs within the same country.
Please note that the summary comments above are extracts from more detailed analysis that is available separately
“A major policy shift to sustained fiscal loosening” – current OBR forecasts for the UK budget (solid line) compared with March 2019 forecasts (dotted line) as % GDP Source: OBR; CMMP analysis
A crucial week – part 1
On Wednesday 11 March 2020, the new UK Chancellor, Rishi Sunak announced the “largest sustained fiscal loosening since the pre-election Budget of March 1992” (OBR, 2020). Prior to the budget statement, the Bank of England also announced a package of measures – an unscheduled rate cut (to a historic low of 0.25%), the offer of cheap funding to banks, lowering banks’ capital buffers and expectations for banks to not increase dividends – in manner neatly described by the Chancellor as, “carefully designed to be complementary and to have maximum impact, consistent with our independent responsibilities.”
Government spending (% GDP) rising to late 1970s levels – a major shift Source: OBR; CMMP analysis
Viewed through my preferred financial sector balances approach (summarised in Wynne Godley’s identity below), the new budget addresses last year’s (partially) flawed assumptions behind the policy of fiscal tightening ie, that a move towards a public sector surplus would be accompanied by a narrowing of the RoW’s net financial surplus and a widening of the private sector’s net financial deficit including higher level of borrowing. Instead it incorporates a widening in the net financial surplus of the household sector – appropriate given the high level of UK HH debt and low level of UK HH savings – offset by a widening in the public sector deficit. The assumptions regarding the balances of the NFC and RoW sectors remain largely unchanged.
Domestic private balance + domestic government balance + foreign balance = zero
Wynne Godley
On a positive note, this appears a more balanced policy including an appropriate shift in responsibility away from the HH sector to the UK government. The co-ordination between fiscal and monetary policy is also a positive sign. Nonetheless, the Government’s gross financing requirement averages around £150 billion a year over the next five years, around half as much again as a share of GDP as in the five years prior to the financial crisis. Hence, the OBR concludes that, “public finances are more vulnerable to adverse inflation and interest rate surprises than they were.” On top of this, the reliance on the RoW as a net lender to the UK economy remains an additional and obvious risk.
Attention now turns to the ECB. As noted in “Are we there yet?” the EA is positioned better to ease fiscal policy than the UK but immediate risks remain that policy response may be limited. Watch this space, we are half way though a crucial week for UK and European policy makers.
The charts that matter
Last year’s (partially flawed) assumptions
Last year’s partially flawed assumptions expressed within the sector balances framework (% GDP) Source: OBR; CMMP analysis
“We expect the public sector deficit to narrow slightly, offset by a small narrowing in the rest of the world surplus. The corporate and household sector deficits are expected to remain broadly stable. The general profile of sector net lending is little changed from previous forecasts, although the size of the household sector deficit is slightly smaller than in our October forecast, consistent with an upward revision to our forecast for household saving. The size of the rest of the world surplus is slightly larger, reflecting the upward revision to our forecast of the current account deficit.” (OBR, 2019)
New versus old – the HH sector
HH sector is now expected to run wider net financial surpluses of between 1.3% and 1.6% of GDP Source: OBR; CMMP analysis
New versus old – the public sector (and the policy shift)
The end of austerity and a shift to sustained fiscal loosening (public sector net financial deficit as % GDP) Souce: OBR; CMMP analysis
New versus old – little change to NFC sector forecasts
NFC deficits are forecast to offset HH surpluses meaning that the private sector remains in deficit in aggregate (% GDP) Source: OBR; CMMP analysis
New versus old – still reliant on the RoW as a net lender
“Still very dependent” – the OBR assumes that the RoW will continue to run net financial surpluses of c.4% GDP over the forecast period (% GDP) Source: OBR, CMMP analysis
March 2020 forecasts expressed through sector balances
Widening HH surpluses offset by looser fiscal policy and widening NFC deficits (% GDP) Source: OBR; CMMP analysis
Conclusion
We are half way through a crucial week for UK and European policy makers. The first half saw a sustained loosening of fiscal policy by the new UK Chancellor, co-ordinated neatly with a package of measures from the Bank of England. This leaves a more balanced and appropriate policy mix.
In the second half, attention now focuses on the ECB and EA governments. The euro area is better placed than the UK to relax fiscal policy but the immediate risk remains that the policy response may be more limited. Watch this space.
Please note that the summary comments above are extracts from more detailed analysis that is available separately.
Time for a policy reboot – does it make sense to run tight fiscal policy (1) at this point in the cycle, and (2) when the private sector is running persistent financial surpluses? (4Q sums, % GDP) Source: ECB; Haver; CMMP analysis
Introduction
In my previous post, “Policy reboot 2020?” I suggested that, “progress towards dealing with the debt overhang in Europe remains gradual and incomplete”. This prompted two follow-up questions:
How do I monitor this progress within the Macro Perspectives framework?
Why does it matter?
In this post, I present eight graphs that are key to monitoring this progress:
Private sector debt ratios (PSDRs)
Costs of borrowing
Lending spreads versus policy rates
Growth in broad money (M3)
Growth in private sector credit
Money supply vs demand for credit dynamic
Inflation
Private sector net financial balances
Summary and implications
The eight graphs confirm that the EA is still dealing with the legacy of a debt overhang. Private sector debt levels are still too high, money, credit and business cycles are significantly weaker than in past cycles and inflation remains well below target.
In spite of this, the collective fiscal policy of EA nations is (1) about as tight as any period in the past twenty years and (2) is so at a time when the private sector is running persistent net financial surpluses (largely above 3% GDP since the GFC).
An important lesson from Japan’s experience of a balance sheet recession is that the deflationary gap in economies facing debt overhangs is equal to the amount of private unborrowed savings. These savings (at a time of zero rates) are responsible for weakness in the economy, and it is because the economy is so weak that fiscal stimulus is necessary (Koo, R. 2019).
Ironically, the EA is positioned better to ease fiscal policy than the UK (where both the private and public sector are running simultaneous financial deficits) but we are more likely to see fiscal stimulus in the latter (March 2020) than in the former.
It’s time for a policy reboot in the EA for 2020 and beyond.
Eight key charts
Key chart 1: Private sector debt ratios
Too little, too late? Private sector deleveraging in the EA began later and has been more gradual than in the UK and the US (private sector debt as % GDP) Source: BIS; Haver; CMMP analysis
The first chart illustrates twenty-year trends in private sector debt ratios (PSDR) – private sector debt as a percentage of GDP – for the UK, EA and US. The three vertical, dotted lines mark the point of peak PSDR for each economy. This is the standard starting point for analysing debt overhangs.
Private sector deleveraging began much later and has been more gradual in the EA than in both the US and the UK. The PSDR in the EA is now the highest among these three economies.
The US PSDR peaked first at 170% GDP in 3Q08, fell to a post-GFC low of 147% GDP in 3Q15 (co-incidentally the point when the EA PSDR peaked) and is currently 150% GDP
The UK PSDR peaked one quarter later (4Q08) at 194% GDP, fell to 160% GDP in 2Q15 and is currently 163%
The EA PSDR continued to rise after the GFC before peaking at 172% in 2Q15 and declining slightly to 166% currently
For reference, but not shown here, household (HH) and corporate (NFC) debt ratios (the two sub-sets behind these totals) differ across the three economies. In the EA, the NFC PSDR is 108% (above the BIS’ maximum threshold of 90%) but the HH PSDR is only 58%. In the UK and US these splits are 79%:84% (see “Poised to disappoint”) and 75%:75% respectively. In other words, the risks lie in different places in each economy.
Key chart 2: Cost of borrowing
The cost of borrowing for HH and NFCs has fallen sharply, reflecting relatively weak credit demand (composite costs %, nominal terms) Source: ECB; Haver; CMMP analysis
The second chart illustrates the ECB’s composite measures for HH and NFC cost of borrowing (in nominal terms). The cost of borrowing typically falls in periods of debt overhang, reflecting weak demand for credit.
Weak credit demand is reflected in the cost of borrowing for EA HHs and
NFCs falling sharply.
HH and NFC costs of borrowing both peaked in
3Q08 at 5.6% and 6.0% respectively
The HH cost of borrowing hit a new low in
December 2019 of 1.41%
The NFC cost of borrowing hit a low of 1.52% in
August 2019 and is currently 1.55%
For reference, costs of borrowing in real terms (shown here) remain low at 0.11% for HH and 0.25% for NFCs but above their October 2018 lows of -0.49% and -0.65% respectively.
Key chart 3: Spreads vs policy rates
Lending spreads at, or close to, post-GFC lows (composite cost minus MRR, ppt) Source: ECB, Haver, CMMP analysis
The third chart illustrates the spread between composite borrowing
rates and the ECB’s main refinancing rate (MRR). These spreads typically narrow
during periods of debt overhang.
Spreads between borrowing costs and the ECB’s main policy rate are at,
or slightly above, post-GFC lows.
HH spreads have declined from 2.97% in May 2009 to a new post-GFC low of 1.41%
NFC spreads have declined from 2.76% in May 2014 to 1.55% currently, slightly above their post-GFC low of 1.55%
Key chart 4: Growth in broad money (M3)
Growth in M3 has been steady since 2014 easing, but subdued in relation to past trends (% YoY) Source: ECB; Haver; CMMP analysis
The fourth chart illustrates the twenty-year trend in the growth of
broad money (M3). Broad money reflects the interaction between the banking
sector and the money-holding/real sector.
Growth rates in broad money have been stable since ECB easing in 2014
but subdued in comparison with previous cycles.
In December 2019, M3 grew by 5.0% YoY
Narrow money (M1) contributed growth of 5.3% which was offset by negative growth in short term marketable securities
For reference, the share of M1 within M3 has risen from 42% in December 2008 to a new high of 68%, despite the fact that HH overnight deposit rates are -1.25% in real terms.
Key chart 5: Private sector loan growth
Private sector credit growing at the fastest rate in the current cycle, but growth is subdued in relation to past cycles (% YoY) Source: ECB; Haver; CMMP analysis
The fifth chart illustrates YoY growth in private sector credit, the main counterpart to M3.
Private sector credit is growing at the fastest rate in the current
cycle but also remains subdued in relation to past cycles and highly
concentrated geographically (Germany and France).
Private sector credit grew 3.7% YoY in December
2019 (3m MVA) above the average growth rate of 3.5%
Germany and France together contributed 2.8% of
the 3.7% growth in HH credit and 2.6% of the 3.2% growth in NFC credit in 2019
Key chart 6: Money supply vs credit demand
The gap between the supply of money and the demand for credit has started to widen again, indicating an on-going deficiency in credit demand Source: ECB; Haver; CMMP analysis
The sixth chart – one of my favourite charts – illustrates the gap between the supply of money (M3) and the demand for credit by the private sector. In typical cycles, monetary aggregates and their counterparts move together. Money supply indicates how much money is available for use by the private sector. Private sector credit indicates how much the private sector is borrowing.
The gap between the growth in the supply of money and the demand for
credit indicates on-going deficiency in credit demand in the EA.
Since 4Q11, broad money and private sector credit trends have diverged with gaps peaking in 3Q12 and 1Q15
The gap narrowed up to September 2018 but has widened out again recently
Key chart 7: Inflation
Inflation persistently below the ECB 2% target during 2019 (% YoY) Source: ECB; Haver; CMMP analysis
The seventh chart ilustrates the twenty-year trend in inflation (HICP) plotted against the ECB’s current inflation target. Again, inflation rates tend to much lower in periods of debt overhang.
Inflation remained below the ECB’s target throughout 2019 and finished
the year at 1.3%
Inflation ended 2019 at 1.3%, below the ECB’s target of 2%
Key chart 8: Private sector financial balance
The private sector is running a net financial surplus in spite of negative/low rates (4Q sums, % GDP) Source: ECB; Haver; CMMP analysis
The eighth, and final chart, illustrates trends in the private sector’s net financial surplus. In this analysis, 4Q sums are compared with GDP.
Finally, the private sector (in aggregate) is running a financial surplus in spite of negative/very low policy rates – a very strong indication that the economy is still suffering from a debt overhang
In aggregate, the EA private sector is running a
net financial surplus equivalent to 3.1% of GDP (3Q19) at a time when deposit
rates are negative (average -0.9% during 3Q19)
Why does this matter?
…Fiscal rules should be designed to favor counter-cyclical fiscal policies. Nevertheless, despite various amendments to strengthen the counter-cyclical features of the [EA] rules, the outcomes have been mainly pro-cyclical.
IMF, Fiscal rules in the euro area and lessons from other monetary unions, 2019
The EA is still dealing with the legacy of a debt overhang. Private sector debt levels are still too high, money, credit and business cycles are significantly weaker than in past cycles and inflation remains well below target.
Does this make sense #1? Collective fiscal policy is about as tight as at any point in past twenty years (Government net financial deficit, 4Q sum, % GDP) Source: ECB; Haver; CMMP analysis
In spite of all of this, the nations of the EA are collectively running a fiscal policy that is about as tight as at any period in the past twenty years. They are also doing this at a time when the private sector is running persistent net financial surpluses. Clearly, these developments fail a basic “common sense test”.
Does this make sense #2. The key chart again – what is the logic of running a tight policy when the private sector is running persistent surpluses (largely above 3% GDP) Source: ECB; Haver; CMMP analysis
Its worth noting that fiscal policy rules in the EA, including the Stability and Growth Pact, were created without reference to the private saving and for an economic environment that no longer exists (eg, positive rates, high inflation, government mismanagement etc.).
Are current rules still fit for purpose – government deficit/surplus as % GDP (y axis) plotted against government debt as % GDP (x axis)? Red lines indicate current SGP rules, green line indicates a balanced budget. These rules were designed for a different type of recession and constrain appropriate policy responses today Source: ECB; Haver; CMMP analysis
Leaving aside, the weak track record of adherence to these rules by member states, the obvious question is whether these rules remain relevant and whether the current policy mix is appropriate?
An important lesson from the experience of Japan’s balance sheet recession is that the deflationary gap in economies facing debt overhangs is equal to the amount of private unborrowed savings. Balance sheet recession theorists, such as Richard Koo, argue that these, “unborrowed savings (at a time of zero interest rates) are responsible for the weakness in the economy, and it is because the economy is so weak that fiscal stimulus is necessary”.
Relating the same argument to inflation targets, when inflation and inflation expectations are below target and rates are zero or negative, fiscal policy should lead with an expansionary stance and monetary policy should cooperate by focusing on guaranteeing low interest rates for as long as needed.
The UK is not as well positioned as the EA to relax fiscal policy – the UK private and public sectors are running simultanous deficits – but we are more likely to see UK fiscal easing first, in the March 2020 budget (4Q sums, % GDP) Source: ONS; Haver; CMMP analysis
Ironically, the EU is positioned better to relax fiscal policy than the UK (where both the private and public sector are running simultaneous deficits) but we are more likely to see fiscal easing in the latter (March 20202 budget) before the former.
In short, it is time for a policy reboot in the EA for 2020 and beyond.
Please note that the summary comments above are extracts from more detailed analysis that is available separately.
The EA remains trapped by PS debt levels and outdated policy rules
The key chart
Slowing GDP growth confirms the need for a major policy reboot (% YoY) Source: ECB; Haver; CMMP analysis
Summary
Today’s 4Q19 GDP data confirms that the euro area (EA) is growing at its slowest rate since the ECB introduced expansionary measures in June 2014 (0.1% QoQ, 0.9% YoY).
The region remains trapped by its debt overhang and out-dated policy rules – a major policy reboot is long overdue.
Progress towards dealing with the debt overhang in Europe remains gradual and incomplete. The EA continues to display the characteristics of a “private sector balance sheet-driven” slowdown rather than a “structural slowdown”. In this context, it is unsurprising that unorthodox monetary policy measures (1) have been only partially successful, at best, and (2) have unintended, negative consequences for growth, leverage, financial stability and income inequality.
Financial sector balances send clear message about the causes of the slowdown (4Q sum, % GDP) Source: ECB; Haver; CMMP analysis
Last month, I introduced my balance sheet framework and applied it to the UK economy. There are two key messages from this framework that are applicable to the current EA situation:
When the private sector is running a financial surplus in spite of negative/very low policy and deposit rates (see graph above), this is a strong indication that the economy is still suffering from a debt overhang
Fiscal space, like debt sustainability, is at its core a flow concept, not a stock concept (see graph below)
Following from this (and deliberately simplifying a complex policy debate), when growth, inflation and inflation expectations are below target and when interest rates are already zero or negative, fiscal policy should lead with an expansionary stance and monetary policy should cooperate by guaranteeing low interest rates for as long as needed. In short, this is a very different economic context to the one that existed when the current fiscal policy rules were chosen.
Germany’s private and public sectors are running simultaneous net financial surpluses in the face of slowing economic growth – does this make sense for Germany and/or the EA? Source: ECB; Haver; CMMP analysis
Unfortunately, despite strong and repeated calls for fiscal stimulus by the ECB, fiscal policy is only expected to be moderately supportive in 2020. Rules, designed to address different challenges at different times, are preventing stimulus in counties where policy makers would like to spend more (Italy, Spain) and national policy choices are limiting policy expansion in countries that have room for further stimulus (German, Netherlands). This is compounded by the lack of a central fiscal capacity at the euro area level that could strengthen the ability to deploy fiscal policy, complementing monetary policy, in case of significant euro area-wide downside dynamics (see https://www.imf.org/en/News/Articles/2020/01/28/sp012820-vitor-gaspar-fiscal-rules-in-europe ).
Are current fiscal rules still fit for purpose – government deficit/surplus as % GDP (y axis) plotted against government debt as % GDP (x axis)? These rules were designed for a different typ of recession and constrain required policy responses today. (Red lines indicate current rules) Source: ECB; Haver, CMMP analysis
Conclusion
Marco Perspectives frameworks illustrate why a major policy review that begins with differentiating between different types of recessions is required if the EA is to escape from the current debt and policy trap. The ECB has announced a review of monetary policy in the EA, but the need for a wider fiscal policy review/reboot appears more urgent, in my view.
I presented the investment implications of this analysis at “The 5th Global Independent Research Conference” in London earlier this month. Please contact me to dicusss these implications and for access to the detailed analysis behind the summary comments above.
Spotlight on the UK 5 – implications for growth and policy
The key chart
The UK faces large and persistent sector imbalances and is increasingly reliant on the ROW as a net lender (4Q sum, % GDP) Source: ONS; Haver; CMMP analysis
Introduction
I began this series of five posts by stating that:
“the true value in analysing developments in the financial sector lies less in considering investments in developed market banks – they have been lousy LT investments – but more in understanding the implications of the relationship between the banking sector and the wider economy for corporate strategy, investment decisions and asset allocation.”
Lousy LT investments – UK, US and EU banks have signficantly underperformed local markets (relative performance 2004-2019) Source: Haver; CMMP analysis
Over the next three posts, I presented a consistent, “balance sheet framework” for understanding this relationship and applied it to the UK economy and the three core sectors within the private sector – Financial Institutions (FIs), Households (HHs) and Non-Financial Corporations (NFCs).
I chose the UK economy deliberately to reflect the relatively large size of the UK financial system, and the relatively volatile nature of its relationship with the economy. Of course, the framework is applicable to any economy and my conclusion here will make reference to similar analysis for the euro area, and Germany specifically. More analysis of sector balances in Europe will follow soon.
The UK faces large and persistent sector imbalances and is increasingly reliant on the “rest of the world” (ROW) as a net lender.
At the end of 3Q19, the UK private and public sectors were running net financial deficits of -3.4% and -2.0% GDP respectively. These were offset by the ROW’s net financial surplus of 5.4%.
The key (OBR) assumptions behind the policy of fiscal tightening were that a move towards a public sector surplus would be accompanied by a narrowing of the ROWs net financial surplus and a widening of the private sector net financial deficit including high levels of borrowing. The first assumption proved wrong and the second only partially correct.
The 2020 OBR forecasts published in March will shed light on the government’s current assumptions but in the meantime I see downside risks to consumption and UK GDP growth and to further fiscal consolidation.
UK spotlights 1-4 in review
“Lousy LT investments, but…”
Contrasting trends between the relative sizes of the real and money sectors’ financial assets in the UK and euro area (multiple of GDP) Source: ONS; ECB; Haver; CMMP analysis
In “Lousy LT investments, but…” I presented a mapping exercise for the UK economy and its financial system. The key message was that a distinguishing feature of the UK economy was the relatively large size (and hence potential impact) of the money sector and the volatile nature of its relationship with the wider economy.
“Everyone has one…”
I started with examples of three (of the four) core services provided by the financial system to HHs and NFCs Source: adapted from “Mapping the UK financial system”, Bank of England Quarterly Bulletin 2015 Q2 article
In “Everyone has one…”, I focused on the core services provided by the UK financial system (payments, credit and savings), how these services produce a stock of contracts that can be represented by financial balance sheets that link different economic agents over time, and how these balance sheets form the foundation of a highly quantitative, objective and logical analytical framework. This post built up to the key identity pioneered by the late Wynne Godley that states that:
Over the past thirty years, there have been two (post-crises) phases when UK HHs have reduced their net financial savings dramatically (4Q sums, % GDP) Source: ONS; Haver; CMMP analysisBoth phases have been associated with declines in the absolute level of savings (£ millions, LH scale) and in the savings rate (%, RH scale)… Source: ONS; Haver; CMMP analysis… but only the first one was also associated with a signficant rise in HH leverage (HH debt as % GDP) Source: ONS; Haver; CMMP analysis
In “Poised to disappoint…”, I highlighted the dominant role that UK households play in economic activity (FCE/GDP) and bank lending (the desire to buy properties) and their important role as investors in financial and non-financial assets. The key message was that while the HH was typically a net saver, the sector has been funding recent consumption by dramatically reducing its savings rate and accumulation of net financial assets (but not by increasing debt ratios). With real growth in disposable income slowing and the savings rate close to historic lows, I suggested that risks to UK growth lay to the downside and at odds with (past) government forecasts.
“Alternative investments”
UK NFCs are typically net borrowers in financial markets ie, investment vehicles for other sectors in the balance sheet framework (4Q sum, % GDP) Source: ONS; Haver; CMMP analysis
In “Alternative investments”, I described the key economic roles of the NFC sector and explained that its (typical) requirement to borrow in financial markets in order to invest in non-financial assets meant that NFCs represent an important alternative investment vehicle for other sectors – offering stakes in their earnings (dividends) or interest payments in their debt. I concluded by asking that if NFCs widened their deficits further in order to fund investment, which sector will be increasing its surplus as an offset?
Imbalances and dependencies
The key chart repeated – The UK faces large and persistent sector imbalances and is increasingly reliant on the ROW as a net lender (4Q sum, % GDP) Source: ONS; Haver; CMMP analysis
Roles and balance sheets revisited
To re-cap, FIs, HHs and NFCs – the three core “economic groups” comprising the UK private sector – have distinct economic roles. In fulfilling these roles, they produce a stock of contracts that can be represented by financial balance sheets. These balance sheets link each group together (directly and indirectly) and form a highly quantitative, objective and logical analytical framework. A fundamental principle of accounting is that for every financial asset there is an equal and offsetting financial liability. In other words, if we take all of the financial assets and financial liabilities it is a matter of logic that the sum of the financial assets must equal the sum of the financial liabilities.
Financial sector balance sheets by sector as at end 3Q19 (£ billions) Source: ONS; Haver; CMMP analysis
An important implication of this analysis is that for the private sector to accumulate net financial wealth (financial assets minus financial liabilities) it must be in the form of claims on another sector. In the simplified case of a two sector economy, the net financial assets held by the private sector are exactly equal to the net financial liabilities of the government. In this case, it is impossible for the private and public sectors to run surpluses at the same time.
In a simplified, two-sector economy this would not be possible. The UK private and public sectors are running net financial deficits at the same time. (4Q sums, % GDP) Source: ONS; Haver; CMMP analysis
Of course, in reality these domestic sectors are also linked economically to foreign FIs, NFCs, HHs and governments, collectively termed the “rest of the world” (ROW). Hence, the private sector can accumulate net financial assets equal to public sector liabilities, the ROW’s net liabilities or a combination of the two.
The private, public and ROW sectors can be treated as having income and savings flows over a given period. If a sector spends less than it earns it creates a budget surplus. Conversely, if it spends more that it earns it creates a budget deficit. A surplus represents a flow of savings that leads to an accumulation of financial assets while a deficit reduces net wealth. If a sector is running a deficit it must either reduce it stock of financial assets or it must issue more IOUs to offset the deficit. If the sector runs out of accumulated financial assets, it has no choice other than to increase its indebtedness over the period it is running the deficit. In contrast a sector that runs a budget deficit will be accumulating net financial assets. This surplus will take the form of financial claims on at least one other sector.
Implications for growth and policy
Large and persistent imbalances – net financial balances for the UK private and public (G0v) sectors and the ROW (4Q sums, % GDP, averages and snapshots) Source: ONS; Haver; CMMP analysis
Applying this framework to the UK economy, I see large and persistent sector imbalances. Prior to the global financial crisis (GFC), the UK government ran an average net financial deficit of 2.5% GDP between September 1989 and September 2008. Of course, in the aftermath of the GFC, the private sector moved sharply into net financial surplus as one would expect. More surprisingly, given movements in real effective exchange rates, the ROW net financial surplus also remained high. The offset over this period was the widening of the government deficit to 10.4% which was an appropriate and necessary response to prevent a much deeper recession. Since December 2009, the average government net financial deficit has been 5.5% (ie more than double the pre-crisis average). This has been offset by private sector and RoW surpluses of 1.3% and 4.2% respectively.
The UK is becoming increasingly reliant on the ROW as a net lender. The trend in the ROW net financial balance since 1989 (4Q sum, % GDP) Source: ONS; Haver; CMMP analysis
I also see an increasing reliance on the RoW as a net lender to the UK economy. The key (OBR) assumptions behind the policy of fiscal tightening after the GFC were that the move towards a public sector financial surplus would be accompanied by a reduction in the ROWs net financial surpluses and a widening of the private sector’s net financial deficit driven by higher borrowing. The first assumption proved wrong and the second assumption on partly correct.
As at the end of 3Q19, the ROWs net financial surplus was 5.4% of GDP. This was offset by a narrow government deficit of 2.0% GDP and a wider private sector deficit of 3.4% GDP. Both the private and public sectors in the UK are running net financial deficits at the same time, something that can only happen is the ROW is running a compensating net financial surplus.
No borrowing boom. Trends in NFC and HH debt ratios (% GDP) Source: BIS; ONS; Haver; CMMP analysis
NFCs (and FIs) have increased their debt ratios slightly since 2015, but the HH sector debt ratio has remained stable. As discussed in “Poised to disappoint”, the HH sector has been funding consumption by slowing its rate of savings (sharply) and accumulation of net financial assets.
Its important, so worth repeating – UK HHs have reduced their absolute levels of savings (£ millions, LH scale) and their savings rate (%, RH scale) Source: ONS; Haver; CMMP analysis
From this, I see risks to consumption and UK GDP and to further fiscal consolidation. High absolute levels of HH debt (% GDP) are constraining HH borrowing. Trends in disposable income and savings are, therefore, likely to be key factors driving HH consumption and growth in the UK. With real growth in disposable income disappointing and savings rates close to historic lows, the risks to UK growth from this analysis appear tilted to the downside.
Previous assumptions behind the policy of fiscal consolidation have already been revised to reflect the persistence of large RoW net financial surpluses. However, even the 2015 OBR forecasts that still assumed a narrowing of this surplus, required ambitious assumptions regarding the propensity of the private sector to increase their borrowing and financial deficits.
With larger than forecast ROW net financial surpluses, further fiscal consolidation requires even more private sector borrowing which I see as unlikely. The 2020 OBR forecasts published in March will shed light on the government’s forecasts but in the meantime, I see further risks to their previous assumptions.
What next? Europe…
In future posts, I will be analysing euro area economies through the same balance sheet framework. Dependency on the ROW is also relevant, but for very different reasons. In direct contrast to the UK trends described above, the German private and public sectors are both running net financial surpluses. These are offset by ROW net financial deficits.
Mirror, mirror – Germany is dependent of ROW remaining net borrowers (4Q sums, % GDP) Source: ECB; Haver; CMMP analysis
The UK is dependent on ROW remaining net lenders, Germany is dependent on the ROW remaining net borrowers.
Please note that the summary comments above are extracts from more detailed analysis that is available separately
UK NFCs are typically net borrowers in financial markets ie, investment vehicles for other sectors in the balance sheet framework (4Q sum, % GDP) Source: ONS; Haver; CMMP analysis
Introduction
This is the fourth in a series of five posts in which I develop a consistent “balance sheet framework” for understanding the relationship between the banking sector and the wider economy and apply it to the UK. The focus here is on the non-financial corporations (NFCs) and their key economic role as:
Producers of good and services
Investors in non-financial assets (which leads to the future production of good and services)
Borrowers (or lenders) in financial markets
Summary
The balance sheet framework allows each of these roles to be considered in the context of the relationship between NFCs and other sectors of the economy.
NFCs are responsible for a large share of economic activity in most advanced economies and their role as producers of goods and services is captured neatly in the “monetary circuit concept” which links NFCs, households (HHs) and banks together (see “Everyone has one…”, earlier this month).
Investment in non-financial assets (NFAs) is critical to ensuring that the capital used in this production process is in place. Unsurprisingly, therefore, NFAs represent an important part in NFC balance sheets. The shift in balance sheet structures back towards NFAs (since the GFC) is also an important indicator that NFCs believe that the returns from investing in productive assets will exceed the returns from financial assets. Productive fixed assets remain the largest segment of non-financial assets but the value of land is an increasingly important driver of the net worth of UK NFCs.
Financial assets are comprised mainly of equity, deposits and loans and their breakdown suggests a increased desire to hold liquid assets. Financial liabilities are dominated by equities, loans and (increasingly) pension fund liabilities.
Between 1999 and 2009, there was a shift away from equities in favour of debt financing that saw debt-equity ratios reach unsustainable levels (111%). The unsustainability of these trends was also reflected in the NFC debt ratio hitting a high of 113% GDP, well above the 90% BIS “maximum” threshold level. Since then the debt-equity ratio has fallen significantly (65%) and the debt ratio has fallen below the BIS average and threshold level (79% GDP).
Non-financial investments are the link between NFCs’ “real accounts” and their “financial accounts”. The NFC sector is typically a net borrower reflecting the fact that they are unable to generate savings that match their investment needs. The NFC sector moved into financial surplus after the GFC but since 1Q11, NFCs have funded investment firstly by reducing this surplus and, since 4Q12, by returning to net borrowing. In contrast to the UK HH sector, debt levels in the NFC sector suggest scope for an increase in borrowing.
These dynamics highlight the final key role of NFCs in the economy – an investment vehicle for investors from other sectors. They offer stakes in their earnings (dividends) or interest payments on debt. The end result, which links directly back to the balance sheet framework, is that claims on NFCs can be found on the balance sheets of other sectors in the economy. Hence, the wider question is, if NFCs widen their deficits further in order to fund investment, which sector will be increasing its financial surplus as an offset? I will return to this question in the fifth and final post in this series.
Role 1: Producers of goods and services
NFCs are responsible for a large share of economic activity in most advanced economies and their role as producers of goods and services is captured neatly in the “monetary circuit concept” which links NFCs, households (HHs) and banks together. In short, this circuit starts with expected demand which leads NFCs to pre-finance production. NFCs pay their employees by a transfer of deposits at banks. These employees demand goods and services which (partially or otherwise) validates the NFCs expectations of future demand. The deposits of the firm will be replenished by the spending of households.
Role 2: Investors in non-financial assets
Investment in non-financial assets (NFAs) is critical to ensuring that the capital used in the production process to meet the demand for goods and services is in place. Put simply, to remain viable, NFCs need to invest in productive assets (gross fixed capital formation or GFCF in national accounts.) In the UK, GFCF typically accounts for just under 20% of annual GDP.
Trends in UK NFC balance sheets 1995-2018 (£ trillions) Source: ONS; Haver; CMMP analysis
Unsurprisingly, therefore, NFAs represent an important part in NFC balance sheets. At the end of 2018, UK NFCs balance sheets totalled £6.4 trillion, comprising £3.9 trillion (61%) NFAs and £2.5 trillion (39%) financial assets (FAs).
Note the contrast here with the HH sector (see “Poised to disappoint”). The UK HH balance sheet has total assets of £12.2 trillion, spilt between £6.5 trillion (54%) of FAs and £5.6 trillion (46%) of NFAs. UK HHs are more exposed to FAs and these FAs, in turn, are larger than the total NFC balance sheets.
Breakdown of UK NFC balance sheets 1995-2018 (% total assets) Source: ONS; Haver; CMMP analysis
The current breakdown of NFC balance sheets indicates that they believe that the returns from investing in productive assets will exceed the returns from FAs. NFCs will invest where they believe returns are highest. If they feel that investing in fixed assets (machines, buildings) will bring significant returns to their owners, they will focus on the acquisition of NFAs. Conversely, if their expectations about the demand for goods and services are weak or declining, they may decide that they can earn better returns by directing funds towards FAs rather than NFAs.
In the mid-1990s, the breakdown of NFC balance sheets was 70%:30% between NFAs and FAs respectively, indicating relatively high expectation of returns from investing in NFAs to support future production. By 2008, however, the split had changed to 56%:44% respectively, highlighting changed expectations of returns between different asset classes. Since then the balance has shifted again with funds increasingly directed towards investment in real assets.
Productive fixed assets remain important but land is playing an increasingly important role in the net worth of UK NFCs(% total of NFAs) Source: ONS; Haver; CMMP analysis
Productive fixed assets remain the largest segment of NFAs but the value of land is an increasingly important driver of the net worth of UK NFCs. NFAs comprise “produced assets” including fixed assets (building, machinery, IP) and inventories and “non-produced assets” (largely land). At the end of 2018, produced assets represented 57% of total NFAs and non-produced assets 43%. This compares with respective splits of 70%:30% in 2002 and 67%:33% in 2008. In other words, the value of land has played an increasingly important part in the net worth of UK NFCs.
Size and structure of NFC financial assets 1999, 2009, 2019 (£ billions, % total) Source: ONS; Haver; CMMP analysis
Financial assets are comprised mainly of equity, deposits and loans, and their breakdown indicates a propensity to hold more liquid assets. At the end of 3Q 2019, NFC financial assets totalled £2.6 trillion, with equities of £1.2 trillion (47%), deposits of £745 billion (29%) and loans of £345 billion (13%). The breakdown of financial assets has remained relatively constant over the past twenty years, other than an increase in holdings of more liquid assets. Deposits currently account for 29% of total financial assets compared with 24% ten years ago and 21% twenty years ago.
NFC financial negative net worth reached its highest point in 3Q19 – an investment vehicle for other sectors… (£ millions) Source: ONS; Haver; CMMP analysis
Financial liabilities are dominated by equity, loans and (increasingly) pension fund liabilities. At the end of 3Q19, NFC financial liabilities totalled £6.2 trillion, with equity of £3.1 trillion (50%), loans of £1.4 trillion (22%) and pension fund liabilities of £1 trillion (16%).
Gearing up, gearing down – trends in UK NFC debt-equity ratio 1999-2019 Source: ONS; Haver; CMMP analysis
Between 1999 and 2009 there was a shift away from equities in favour of loans and debt financing. Balance sheet gearing rose sharply over the period. Using the ONS definition of outstanding debt (debt, loans and receivables) the aggregate NFC debt to equity ratio rose from 52% in September 1999 to 91% in September 2009 (below the March 2009 peak of 111%) before falling back to 65% at the end of September 2019.
The unsustainability of these trends was reflected in the NFC debt ratio over the same period. In September 1999, the NFC debt ratio was 84% GDP. By March 2009, this had risen to a high of 113% GDP. Since then the debt ratio has fallen back to 90% GDP.
Trends in UK NFC and all BIS reporting countries’ NFC debt ratios 1999-2019 (% GDP) plotted against the BIS maximum threshold level of 90% GDP Source: ONS; Haver; CMMP analysis
Using the narrower BIS definition, it is noteworthy that the current NFC debt ratio of 79% (2Q19) is below the level of 95% for all reporting countries and, more importantly, below the 90% threshold that the BIS considers is the level of NFC debt above which debt becomes detrimental to future growth (see graph above).
NFC and HH net financial worth hit new lows/highs at the same time (£ millions) Source: ONS; Haver; CMMP analysis
Net financial worth – financial assets minus financial liabilities – hit a new low of £3.6 trillion in 3Q19. Interestingly, and coincidently, the net worth of UK HHs and NFCs hit new highs and new lows respectively in 3Q19.
Role 3: Borrowers in financial markets
Non-financial investments are the link between NFCs’ “real accounts” and their “financial accounts”. If NFCs are able to generate savings in excess of their non-financial needs, in a given period, they become net lenders or net financial investors. In contrast, if they are unable to generate savings that match their investment needs, they become net financial borrowers. The relevant balancing item is the net lending/net borrowing position. Non-financial investments can be financed through the use of internal funds (current and retained earnings) or by borrowing funds from other sectors.
To link this back to “Everyone has one”, in the event that NFCs require external funding, other sectors must be willing to provide them with funds.
Typically net borrowers and investment vehicles for other sectors – UK NFC net financial surplus/deficit (4Q sum, % GDP) 1989-2019 Source: ONS; Haver; CMMP analysis
The NFC sector is typically a net borrower reflecting the fact that they are unable to generate savings to match their investment needs. However, as in the HH sector, there were dramatic shifts in their position since the GFC. Since 1989, the UK NFC sector has run an average financial deficit equivalent to 0.5% of GDP. In response to the GFC, NFC increased their net savings from -2.6% GDP in June 2008 to 2.4% GDP in March 2011. This substantial negative shift equivalent to 5% of GDP occurred at exactly the same time as a similar shift in the HH sector. Since then, there has been a reversal of a similar scale to bring the current financial deficit to -2.1% GDP, below the LT average.
Since 1Q11, the NFC sector has been funding investment firstly, by reducing its financial surpluses and since 4Q12 by becoming a net financial borrower. Up until June 2015, UK NFCs were deleveraging. The debt ratio fell from 103% GDP to 87% GDP over the period and aggregate debt equity ratios fell from 77% to 69%. A complicating factor over this period has been the rise in NFC pension liabilities. In March 2011, pension fund liabilities were £339 billion accounting for 8% of total financial liabilities. By June 2015, they had risen to £748 billion accounting for 16% of total financial liabilities. Today, pension fund liabilities account for the same percentage (16%) of total liabilities.
NFC debt service ratio (affordability of debt) has fallen below LT average Source: BIS; Haver; CMMP analysis
In contrast to the UK HH sector, NFCs have scope to increase their borrowing. Debt ratios are below the BIS threshold and debt servicing ratios are below their long term average. Indeed, real NFC growth is now at the highest level recorded in the current (mini) credit cycle.
NFC borrowing has recovered and is growing faster than GDP (% YoY, real terms) Source: BoE; Haver; CMMP analysis
Conclusion
These dynamics highlight the final key role of NFCs in the economy – an investment vehicle for investors from other sectors. They offer stakes in their earnings (dividends) or interest payments on debt. The end result, which links directly back to the balance sheet framework, is that claims on NFCs can be found on the balance sheets of other sectors in the economy.
Hence, the wider question is, if NFCs widen their deficits further in order to fund investment, which sector will be increasing its financial surplus as an offset? I will return to this question in the fifth and final post in this series.
Building to the end game in the final post – UK sector balances for the private sector, government and RoW (4Q sum, % GDP) Source: ONS; Haver; CMMP analysis
Please note that the summary comments above are abstracts from more detailed analysis that is available separately
