Preparing for payback

Author: Craig Scalise

Could the intense focus on Europe’s sovereign debt crisis be obscuring a bigger question: Are we entering an era of global debt unwinding? In this third article in our Eurozone series, the collective government, corporate and household drive to back the surfeit of debt could create highly disruptive challenges for many businesses worldwide in areas ranging from higher taxes and dips in demand to inflation, devaluation and asset price instability. Companies should think about how to curtail the upheaval and adapt their businesses to a thriftier era.

Around the world, developed economies have amassed government debts rivalling levels not seen since the end of World War II.1 These debts could cause a drag on the countries’ growth that lasts for decades, potentially cutting nearly a quarter of their economies.2 The public sector isn’t alone. Corporate and household debts, combined with government debt, have nearly doubled as a proportion of GDP since 1980, rising to over 300% for developed economies.3 High debt across multiple sectors can increase risks to growth and financial stability.4

As the payoff gathers pace, debt unwinding could have severe and unpredictable impacts on the global economy, reshaping the business environment for years to come. In this article, we look at how companies can develop a proactive and effective response.

Trigger to unwind

Debt itself isn’t necessarily a problem. At sustainable levels, debt can strengthen an economy by providing more freedom for people to consume, opportunities for businesses to invest and means for governments to provide services and manage crises. But when it gets out of hand it becomes a problem. Recent analyses suggest government, corporate or household debt levels above 90% of GDP are excessive—debts over this level can reduce growth—while debt levels above 60% are in the danger zone.5 Using these benchmarks, Figure 1 highlights how G10 countries as a whole have excessive government and corporate debts. In contrast, emerging market debt seems generally under control for now.

Figure 1: Advanced economies: Troubling debt across sectors

Tightening the knot

Countries have worked their way through high debts before. However, today’s economic environment and the widespread debts do not leave a clear path forward.

Solutions to high debt usually begin with growth—bolstering incomes and tax bases to grow faster than the debts. But developed countries are stuck in slow growth. Indeed, studies are showing that debts at their current levels may be part of what’s holding down the growth.6 So pressure to act is mounting. These debts leave little room to absorb shocks in an increasingly volatile world. Electorates are concerned about future generations’ debt zoneburdens. Businesses are concerned about drags on growth.

Countries across the world—and sectors within the countries—will likely be compelled to face debt unwinding soon even if it means making tough choices.

Taking action

Guiding the business through debt unwinding begins with accepting less control over circumstances, while preparing to adapt to the consequences. Key considerations include how to pay down debts where required. Businesses may also need to rethink corporate strategy, finances and operations to deal with the impact on investment and demand.

1. Reducing debt

Options for reducing corporate debt are often quite narrow and vary by country. In many cases, businesses can consider buying back debt if they’re liquid enough or exchanging debt for equity if dilution is tolerable. Defaulting on corporate debt through bankruptcy or writedowns may be an option in extreme circumstances.

2. Strategy

Business leaders should identify possible scenarios and prepare contingency plans. The scenarios should be used to ensure strategy is effective under long-term slow growth and volatility. Strategy also needs to be able to withstand the implications of knock-on or even unintended consequences such as high inflation, competitive devaluations or trade wars. It should account for how government budget cuts impact a business directly or through customers that sell to governments. All the while, it is important to consider how competitors might respond. Examples could include a rush to invest in and hence overcrowding in faster-growing emerging markets.

This is likely to lead to a fluid strategy that’s different from the past. Leadership should try to instill a culture that supports innovation and flexibility.

Figure 2: High debt rampant in leading advanced economies

3. Finance

Finance is at the heart of debt unwinding exposure. Are there assets concentrated in currencies at risk of devaluation or hedging techniques that would fail in high volatility? Shocks like inflation spikes need to be modelled in detail to identify knock-on effects that could disintegrate profits. Tax increases around the world should be considered. Portfolio composition also needs to be reviewed—by 2016, one-sixth of once-safe sovereign debt is expected to no longer be considered safe.7

4. Operations

Companies need to determine which circumstances put their income most at risk, and how they can make up the revenue. What resources should be moved to be most productive in the face of slow growth? Procurement can assess solutions to currency fluctuations that mismatch costs and revenues. Even administrative functions may need to prepare. Some companies have found that IT needs significant planning to support payroll processes if the Eurozone crisis causes currency changes.

Once a business has taken stock of possible debt unwinding scenarios and their exposure to consequences, it can form contingency plans and test them for workability.

How the debt may unwind

One of the most important areas of the scenario planning outlined in the strategy implications earlier is how a particular government moves to unwind debt. This is a controversial area in which the approaches advocated by different countries and the politicians within them vary significantly. Indeed, there may be many changes of tack through the unwinding, heightening the potential for instability and disruption.

The question at the heart of these policy deliberations is how to balance growth and debt reduction. Any path they choose will come with trade-offs, uncertainty and risks.

Governments may reduce debt aggressively if it’s primarily structural. They’re likely to attack it directly by raising taxes, lowering spending or both. Japan has already started down this route by doubling its sales tax to 10%. European countries are taking extraordinary steps to reduce spending, and austerity is on the table for many developed countries with little tolerance for tax increases.

Other common tactics for slashing debt may be of limited use. Some inflation could ease debt burdens, but most countries will not accept inflation high enough to put much of a dent in their debt. Inflation is a particularly weak prospect for countries saddled with foreign debt, relying on exports or holding short-term debt that would require a bigger inflation spike.8 There’s also little room to reduce debts through currency devaluation with so many countries in similar positions.

With these options limited, debt-focused governments are likely to look at less conventional measures. Outright default or renegotiation is unlikely among developed countries that prize their reputations and credit ratings. Incremental measures are more likely. Countries with large public sectors may privatise state enterprises. Another candidate is closing tax loopholes and clamping down on evasion; the UK has been taking effective measures to reduce evasion, but findings show that the 2009–10 cost of fraud to the government was still GBP 20 billion.9

Debt-focused governments face the risk that their tactics as a whole will dampen growth, possibly even to the point of recession. The tactics can also increase volatility if policymakers do not fully grasp the consequences of unprecedented debt unwinding.

In contrast, governments that believe their debt is largely cyclical may try to accelerate growth now through lowered taxes and/or increased spending so they can address higher debt later. Lowering interest rates may also be an option, but already-low rates may call for unconventional measures that are not as vetted, including quantitative easing, and increase risks like inflation. Governments can also look to measures that bolster competitiveness, like easing labour laws and supporting innovation. A risk is that this focus may be self-defeating if higher debts weaken growth, either directly or by eroding confidence in the economy. This scenario could leave little to show other than inflation and yet higher debts.

A third option for governments is to split their attention between the two targets, but they’d have a limited arsenal for doing so. These countries may hold tax rates and spending steady while increasing liquidity and focusing on competitiveness. A risk with this approach is that it may increase inflation while missing both targets—failing to jumpstart the economies while letting the debt burdens grow.

Prolonged challenge

These scenarios foreshadow an era of debt unwinding that would challenge the business environment for years to come. In past episodes, which tended to be less complicated, countries experienced weak growth while unwinding household debt for up to 10 years10 or government debt for more than 20 years.11 Other countries that trade with the deleveraging economies could feel the effects.12 Businesses need to take stock of their exposures and be prepared to respond to the consequences of prolonged debt unwinding.

1 Carmen Reinhart and Kenneth Rogoff, ‘Too Much Debt Means the Economy Can’t Grow’,, July 14, 2011.
2 Carmen Reinhart, Vincent Reinhart and Kenneth Rogoff, ‘Debt Overhangs: Past and Present’, National Bureau of Economic Research, Working Paper 18015, April 2012, p. 21.
3 Stephen Cecchetti, M S Mohanty and Fabrizio Zampolli, ‘The real effects of debt’, Bank for International Settlements Working Paper, No. 352, September 2011, p. 5.
4 Global Financial Stability Report—’The Quest for Lasting Stability’, International Monetary Fund, April 2012, p. 4.
5 The Bank for International Settlements determined that economic growth declines when government debt is above 85% of GDP, corporate debt is above 90%, or household debt is above 85%. The analysis states that healthy debt levels, which provide buffers, are well below these limits (Cecchetti, Mohanty and Zampolli, p. 1). An appropriate buffer can be estimated by the 1997 Growth and Stability Pact, which European Union member states negotiated to set the government debt ceiling at 60% of GDP. Based on this, for illustrative purposes considering each form of debt, 60% of GDP is selected as the threshold for entering the debt danger zone, and 90% is selected as the threshold for excessive debt.
6 Carmen Reinhart, Vincent Reinhart and Kenneth Rogoff, p. 21. and Cecchetti, Mohanty and Zampolli, p. 1.
7 Global Financial Stability Report—The Quest for Lasting Stability, p. xi.
8 Carmen M. Reinhart and Kenneth S. Rogoff, This Time is Different—Eight Centuries of Financial Folly, Princeton University Press, 2009, p. 111.
9 National Fraud Authority, Annual Fraud Indicator, March 2012, p. 11.
10 Global Financial Stability Report—The Quest for Lasting Stability, p. 13.
11 Carmen Reinhart, Vincent Reinhart and Kenneth Rogoff, p. 20.
12 China, for example, is exposed to indebted economies through its exports, 44% of which went to the European Union, US and Japan in 2011 (National Bureau of Statistics of China, Statistical Communiqué on the 2011 National Economic and Social Development, February 22, 2012).

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Preparing for the payback