Canadian Deleveraging Monitor

Deleveraging Monitor
*Under construction

Canada will likely soon undergo a deleveraging process, whereby the private sector reduces their debt burden due to various factors, the most important being a shift in psychology and risk-taking. The Canadian private sector/households has been going through the process of accumulation of debt to purchase assets, increasing the overall debt burden relative to incomes in an era of progressively lower interest rates. The economy will soon undergo the opposite process where the private sector deleverages, similar to the US. Resources to understand this process from different viewpoints are below:

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Source: Ben Rabidoux

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Source: Karl Schamotta / BIS

Bank of Canada video on the potential for a deleveraging scenario:

Ray Dalio’s view of leverage and economic cycles:
An idealized long term debt cycle, overlayed with a shorter term business cycle:

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Source: Ray Dalio – How the economic machine works
How the economic machine works – leveragings and deleveragings

Basically what happens is that after a period of time, economies go through a long-term debt cycle — a dynamic that is self-reinforcing, in which people finance their spending by borrowing and debts rise relative to incomes and, more accurately, debt-service payments rise relative to incomes. At cycle peaks, assets are bought on leverage at high-enough prices that the cash flows they produce aren’t adequate to service the debt. The incomes aren’t adequate to service the debt. Then begins the reversal process, and that becomes self-reinforcing, too. – Ray Dalio

Most people, says Dalio, think that a depression is simply a really, really bad recession. But in reality, the two are distinct, naturally occurring events. A recession is a contraction in real GDP brought on by a central bank tightening monetary policy, usually to control inflation, and ends when the central bank eases. But a D-process occurs when an economy has an unsustainably high debt burden and monetary policy ceases to be effective, usually because interest rates are close to zero, and the central bank has no way to stimulate the economy. To compensate, the value of debt must be written down (risking deflation) or the central bank must print money (a trigger of inflation), or some combination of both. In recent years the level of debt as a percentage of GDP in the U.S. has skyrocketed past previous highs last seen in the early 1930s. And the Federal Reserve’s benchmark rate is now hovering just above zero. To Dalio, therefore, it’s clear that a D-process is under way. “It seems very likely that stocks will get materially cheaper,” he says. “We have to go through an important debt restructuring process, and a lot of assets are going to be for sale, huge numbers of assets. And there’s going to be a shortage of buyers.

Richard Koo’s view:
Richard Koo does a great job describing the deleveraging process (which he label’s a balance sheet recession) in an interview with Macleans:

“While Canada exhibits none of the signs of a balance sheet recession at present, the sharp increase in household debt due to rising house prices means it is at risk of developing one.”
In an interview from Japan, Koo talked about that risk and how Canada should respond.

For those who are not familiar with the concept, how do you define a balance sheet recession?

A balance sheet recession typically happens after the bursting of a debt-financed bubble. In the bubble days, people leverage themselves up, and once the bubble bursts, liabilities remain, asset prices collapse and people realize their balance sheets are underwater. When that happens, people start repairing balance sheets by paying down debt or increasing savings, which is basically the same thing. That’s the right thing to do at the micro level: everyone in that situation has to get their financial house in order. But when everybody does it all at the same time, then we enter a massive fallacy of composition problem [in other words, while individuals are correct to save and pay down debt, if everyone does this at the same time it hurts the economy by lowering consumption]. If someone is saving or paying down debt, you’ve got to have someone on the other side borrowing and spending money. But when a debt-financed asset bubble collapses, everybody could be paying down debt and no one is borrowing money, even at zero per cent interest rates. In that case, all the savings that are generated and all the debt that’s repaid comes into the financial sector but won’t be able to leave the financial sector. That becomes the leakage to the income stream. And this can happen even with zero interest rates.

Source: Macleans / Andrew Hepburn

Richard Koo, chief economist of Nomura Research Institute, rose to prominence early last year with the publication of his fascinating book, Balance Sheet Recession.
• Koo defines a balance sheet recession as one that emerges “after the bursting of a nationwide asset price bubble that leaves a large number of private-sector balance sheets with more liabilities than assets. In this type of recession, the economy will not enter self-sustaining growth until private-sector balance sheets are repaired”.
• According to Koo, American consumers are suffering from a balance sheet problem and will not increase consumption until their personal finances are back in order. The banks are not lending mainly because nobody wants to borrow and, furthermore, the banks want to build their own balance sheets (raise cash) and get rid of toxic garbage.
• Koo says it’s up to the government to make up for the private sector’s problems by spending and continuing to run deficits. Thus we would be “buying time” through government spending while the private sector has time to repair its balance sheets. He claims it is absolutely necessary for the government to spend and run deficits. If the government cuts back on its spending and stimulus, the US economy will swoon and more money will be lost than was lost during 2008-2009.
• Again, when asked what would happen if the government cuts back on its fiscal stimulus, Koo replies: “Until the private sector is finished repairing its balance sheets, if the government tries to cut its spending, we’re going to fall into the same trap Franklin Roosevelt fell into in 1937 (a crushing bear market) and Prime Minister Hashimoto fell into in 1997, exactly 70 years later.

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Source: Economist

An IMF working paper published last year identified credit growth as “the single best predictor of financial instability”. Yet China is not obviously vulnerable to the two most common types of financial crisis. The first is the external sort, like Asia’s in 1997-98. In such cases, foreign lending sparks a boom that eventually fizzles, prompting loans to dry up. Firms, unable to roll over their debts, must cut spending to save money. As consumption and investment slump, net exports rise, helping bring in the money needed to repay foreign creditors. China does not fit this mould, however. More than 95% of its debt is domestic. Capital controls, huge foreign-exchange reserves and a current-account surplus help defend it from capital flight.

The other common form of crisis is a domestic balance-sheet recession, like the ones that battered Japan in the early 1990s and America in 2008. In both cases, dud loans swamped the banking system. Central banks then struggled to keep demand growing while firms and households paid down their debts.

Kindleberger theory from “Manias, Panics and Crashes: A History of Financial Crises” from this review.

A more detailed outline of his theory, which he claim is build on the Minsky model, is as follows. First, there is some exogenous shock (policy switching, technology, financial innovation). Second, the boom created by the profit opportunities after the shock is fed by increasing money supply. There is little to be done about this because the money supply is endogenous (new banks enter, personal credit increases, new credit instruments are used). Third, the boom leads to speculation that initially has positive feedback; speculators earn money and invest more as well as making more people invest. This leads to what Adam Smith calls “overtrading” which can be caused by pure speculation (buying something with the aim of selling it later at a higher price), overestimation of the true expected return and excessive gearing (low initial cash requirements when buying something). Fourth, the overtrading spreads from one market to another (psychological links and others). Fifth, speculation spreads internationally (again, psychological mechanisms are important, as well as: arbitrage, foreign trade multiplier, and capital flows). Sixth, at the peak some insiders leave the market, there is “financial distress” and a bankruptcy or the revelation of a swindle leads to the final stage; the rush for liquidity. The panic (or “revulsion”) feeds itself until prices become so low that people are tempted to once again go into less liquid assets, trade is cut off or a lender of last resort convinces the market that three is enough money for all.

In sum, economic crises are caused by psychological mechanisms which lead asset prices to be volatile. Combine this with a bank and credit system that is fragile. When asked why it is fragile, Kindleberger answers: “The system is one of positive feedback. A fall in prices reduces the value of collateral and induces banks to call loans or refuse new ones, causing mercantile houses to sell commodities, households to sell securities, industry to postpone borrowing, and prices to fall still further. Further decline in collateral leads to more liquidation. If firms fail bank loans go bad, and then banks fail. As banks fail depositors withdraw their money (…) Deposit withdrawals require more loans to be called …” (and so on , p. 97).

McKinsey’s example of Sweden and Finland deleveraging:

Sweden and Finland: A model for rapid deleveraging (in small, open economies) In Sweden and Finland, bank deregulation in the 1980s led to a credit boom and rising leverage, which fueled real estate and equity market bubbles. A financial crisis in 1990 sparked the collapse of these bubbles, sending the economies into deep recessions.15 The subsequent deleveraging of these economies unfolded in two phases: private-sector deleveraging, followed by reductions in public-sector leverage.16

In the first phase of deleveraging, lasting about five years, private-sector debt was reduced significantly while government debt rose rapidly. In Sweden, private-sector debt (of households and non‑financial corporations) fell, from 153 percent of GDP in 1990 to 113 percent in 1996; in Finland, private-sector debt fell from 121 percent of GDP to 100 percent (Exhibit 7).

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Source: McKinsey

Financialization of the Economy:
*under construction

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Source: Bain

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Source: Goldman Sachs via Twitter

Canadian Housing Monitor