Deleveraging and the impact on investments

August 8, 2012, 1:59 pm Julia Lee Yahoo!7

With many advanced economies around the world in a process of deleveraging, how long will this period last and what is the impact that its likely to have on markets and the global economy?

There has been a lot of discussion in the media recently about deleveraging.

Deleveraging is another name for reducing debt. Debt crises are nothing new and the first record of a debt crisis goes back to at least the fourth century B.C.

With many advanced economies around the world in a process of deleveraging, how long will this period last and what is the impact that it’s likely to have on markets and the global economy?

Measuring deleveraging

Debt of a country can be measured by total debt divided by gross domestic product (GDP). Australia’s total debt to GDP ratio is 277% which is similar to Canada at 276% and Germany at 278% as well as the US at 279%.

Household debt + corporate debt + government debt = total debt. Hence the type of debt will also impact how countries deleverage as well as the impact of this deleveraging on the economies.

Australia’s government debt to GDP ratio is relatively low. The lowest ratio over last 30 years was in 2008 where the ratio was at 9.7%. The household debt in Australia however is high compared to other nations. Australia’s household debt to GDP is 205% compared to 67% for Japan, 98% for UK, 82% for Spain and 45% for Italy.

With respect to the reduction in this debt, the deleveraging which is most troublesome to Australia is not the Australian debt but rather deleveraging that is currently happening in Europe. This will have the highest impact on global growth and ultimately growth in Australia.

Debt is good when there is growth but bad when there is no growth

Debt is positive when there is growth. It helps to accelerate returns. Debt is destructive when there is no growth or negative growth. This is because a higher proportion of a countries GDP or in the case of a company, its profits, are used to fund the debt via interest payments. Hence a net decrease in value added for shareholders or stakeholders. Debt when there is extended negative growth or no growth on a company level reduces future output and may mean the need for more funds through asset sales or further loans.

Looking at history and in the 1990’s both Sweden & Finland went through credit bubble, collapse and deleveraging. In the first few years of deleveraging companies, financial institutions and households reduced debt while government debt rose. This led to negative or minimum economic growth. In the second phase, economic growth rebounded while government debt decreased. (Source: [http://www.mckinsey.com/Insights/MGI/Research/Financial_Markets/Uneven_progress_on_the_path_to_growth)|http://www.mckinsey.com/Insights/MGI/Research/Financial_Markets/Uneven_progress_on_the_path_to_growth)]

One of the reasons that the Eurozone deleveraging story is so important is that the Eurozone banking system is 2.5 times the size of the US banking system. Hence deleveraging would offset any re-leveraging by the US banks. Subsequently, it could result in a shortage of funds for fast growing and deficit economies. All in all, deleveraging impacts Australia mainly due to the fall that is expected in global growth.

What does this mean for my investments?

Part of understanding what this will mean for investments and different assets is about understanding the flow of funds from deleveraging. Will it be household, corporate, financial institution or government debt reduction and in what countries?

Deleveraging will take many years for most developed countries but once the first phase is finished, it should clear the way for a return to a growth cycle.

The big question for investments is how long the deleveraging by European banks will last and what the size of the deleveraging will be.

Any protracted deleveraging will have negative growth implications for the global economy. With most European institutions having a presence in many different countries, there could also be implications on the availability of credit in countries outside of Europe such as in Asia.

The key thing to remember is that once deleveraging has started, as past history shows, after a couple of years there is usually a quick return to the growth cycle. The stockmarket tends to move before the economy so investors and traders need to be ready to move even while media headlines might still be negative.

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