GLOBAL stock markets have rallied sharply because of the promise of yet another bailout of Greece. Despite the euphoria, the massive private and public-sector European debt overhang is as serious as ever. The threat of contagion, leading to one or several crises in the euro zone, remains.
The Bank of International Settlements (BIS), the central banks’ central bank warns banks and investors that they should not regard emerging markets as a haven from sclerotic Europe and the slack US economy and US dollar. It states that debt levels in China, India, Brazil and other emerging nations are also expanding to worrying levels.
European focus should be the strain on banks’ capital following years of irresponsible loans
At the end of 2010, European and global banks had total consolidated foreign claims of US$810 billion on residents of Greece, Ireland and Portugal, estimates the BIS.
The huge increase in corporate and individual borrowing during the bubble years is a heavy burden on the region. According to the BIS, global banks’ total consolidated foreign claims on residents of the euro area stood at a whopping US$7.6 trillion in December 2010.
Government economic stimulation has failed partly because companies and individuals are repaying mortgages and other debt. Banks, which are building up their capital to meet tighter international financial standards, have tightened lending conditions.
China, India and Brazil debt taking off – BIS
It is well known that the credit bubble in the United States and Europe caused the financial crisis of late 2008 and early 2009. The BIS shows in its latest annual report that during the bubble years of 2002 to 2006, the average annual increase of private-sector credit in Ireland and Spain was 20 per cent and 19 per cent respectively.
As a result total credit as a proportion of gross domestic product (GDP) soared to 181 per cent in Ireland and 167 per cent in Spain before their bubbles were pricked in 2007. Similarly, the UK’s total private-sector credit as a proportion of GDP reached 171 per cent at the time.
Using that financial history as a yellow light, the BIS is concerned about recent developments in China, India and Brazil and some other emerging markets.
Bubble in China, Brazil & India accompanied by surge in borrowing
China is trying to rein in expansion after average annual credit growth of 20 per cent from 2006 to the end of 2010 raised credit as a percentage of GDP to a worrisome 132 per cent. This week China raised its one-year lending rate to 6.56pc from 6.31pc. The move, following several recent rate rises, raises worries that monetary tightening will trigger a much steeper slowdown than general expectations of economists.
Illustrating investor concerns, Temasek, Singapore’s state owned investment company, slashed holdings in in Bank of China and China Construction Bank, two of China’s largest banks to raise $3.6 billion. The sale of shares in Bank of China and China Construction Bank come after Moody’s warned of a possible ratings downgrade over fears of a surge in lending to local governments that could be sitting on a mountain of bad debt.
Brazil’s credit growth averaged at 25 per cent during those years and rose to a whopping 26 per cent in 2010, while the rate of expansion in India was not much lower. Total Indian credit as a proportion of GDP was 54 per cent in 2010 and it was 54 per cent for Brazil as well.
The BIS points out that several emerging nations, where there has been rampant speculation in real estate, commodities and other assets, have mimicked the former follies of reckless European states that are now in trouble.
Reasons for the surge in public borrowings and the failure of Keynesian economics
The table above shows how gross debt of European and other governments has surged. Greece’s public borrowings jumped from 113 per cent in 2007 to 157 per cent in 2011 and there were sharp increases elsewhere. A major reason for the public debt increase in Europe and the US is that governments have bailed out banks.
Keynesian economic policies of state borrowing to spend and pull economies out of recession and an ageing population are other factors. Inadequate tax revenues because of flat business conditions, tax avoidance and evasion have also caused higher government borrowing.
Japan’s economic underperformance is a case study on the failure of Keynesian economics. Even before the recent tragedy, the economy has remained weak more than two decades since the Japanese balloon burst in 1990.
Public debt as a proportion of GDP soared from an already high level of 152 per cent in 2002, to 167 per cent in 2007 and 213 per cent in 2011.
High borrowing requirements of the state add to nations’ interest bills. They also ‘crowd out’ job creating corporations that need to raise money to finance operations, capital expenditure and expansion.
Why sovereign bond yields are low in face of soaring state borrowing
The big surprise for most fund managers and bankers is that yields of US Treasury, and German, French, Dutch and UK bonds have remained low. Reasons include generally slack economies and relatively low demand for capital, flight from time to time from equities into bonds, central bank purchases as part of the quantitative ease programmes and bank, pension and insurance company buying to maintain balanced portfolios.
If the US and European economies grow rapidly again, however, bond yields will rise sharply and their prices will fall. In those circumstances, equity, real estate and commodity market could also come under pressure.