July 11, 2012 / 5:55 AM / 7 years ago

Analysis: From a credit swamp, recovery horizons lengthen

LONDON (Reuters) - If it feels as though efforts to revive the world economy are continually running into the mire, that’s partly because policymakers are still trying to map the extent of the credit swamp.

A man walks past the Bank of England, London June 15, 2012. REUTERS/Paul Hackett

Five years to the month since the credit bubble popped, one of the striking aspects of the recurrent gloom invading households, businesses and investors is how the horizon for sustainable recovery is being pushed years into the distance.

Bank of England governor Mervyn King, who last month said the world was barely half way through this crisis, now speaks with almost biblical foreboding of the big “black cloud” of uncertainty hanging over the world.

And King’s is not the darkest voice out there. Hedge fund manager Jamil Baz from GLG Partners claims the western world’s deleveraging, or debt reduction, process could take another 15 to 20 years if the ratio of economy-wide debts to gross domestic product (GDP) in the United States and Europe is to be cut to anything like sustainable levels.

True or not, this is fast becoming mainstream for many crisis-weary companies and money managers.

For many investors, the timeline may be somewhere in between King and Baz but they are already shaping up for years in which investment opportunities will either be brief, on the back of periodic lifelines from policymakers, or one-off corporate successes such as Apple, or long hard slog in search of relative safety in top-rated bonds or high-dividend blue chips.

“The overriding way we look at the world is it’s in a multi-year deleveraging environment and it’s really only just begun,” said Alex Godwin, head of asset allocation at Citi Private Bank.

“If you look at the private sector debt to GDP ratio in the United States, we’ve seen a little bit of a reduction but this has got a long, long way to go,” he added. “If you take a simple extrapolation of what’s been happening so far, then we’re probably looking at a five, maybe 10-year process.”


This stifling deleveraging has already driven a sharp reduction of lending by banks since 2007 peaks, catalyzed by interbank mistrust, falling credit quality and new regulation aimed at stabilizing previously bloated bank balance sheets.

As the credit shortfall drains money needed to lubricate the underlying economy, central banks have printed more. The big four central banks in the United States, euro zone, Japan and Britain have created more than $6 trillion since 2008 but are barely filling the hole - as spluttering economies attest.

The question on many minds is why it’s been so difficult to calibrate the size of the problem and gauge a recovery horizon.

There are myriad answers to the latter — from the political minefield in Europe preventing a lasting solution to the euro crisis to divisive U.S. and British debates on government debt sustainability and central bank independence in printing money.

But the scale and nature of the original credit bubble too is only now really becoming apparent and, with that, just how broken the private-sector credit generator remains.

A study currently grabbing the attention of economists focuses on the scale of pre-crisis money creation between banks and investment funds — the largely unregulated “shadow banking system” that supercharged credit independently of central banks.

The paper, by International Monetary Fund economist Manmohan Singh and consultant Peter Stella, detail how multiple repledging of collateral between institutions unlocked vast stores of “new” cash and how subsequent interbank mistrust and a shrinkage of what’s acceptable as collateral drained the pool.

The complex process with an appropriately impenetrable name, “rehypothecation”, describes how a hedge fund in Asia or mutual fund in Boston borrows cash from a bank by posting a bond as collateral and then how that bank subsequently repledges that same bond as collateral for its own purposes.

At 2007 peaks, the paper estimates the re-use rate of primary collateral from funds and custodians by the largest banks was about 3 times — creating a total web of intricate collateral chains in excess of $10 trillion. That compares with a U.S. M2 money supply back then of some $7 trillion.

But by 2011, this re-use rate was already down to 2.4, involving almost a halving of the total collateral pool.

“The loss in collateral flow is estimated at $4-5 trillion, stemming from both shorter collateral chains and increased ‘idle’ collateral due to institutional ring-fencing; the knock-on impact is higher credit costs for the economy,” Singh and Stella wrote.

New central bank money via bond buying doesn’t solve this problem because “quantitative easing” to date just gives new cash to banks and removes ever more high-quality collateral from the system. And nervous banks are still hoarding much of the new cash bank at central banks anyway.

Yet refilling reusable collateral pools may require even more, not less, government debt in the short run. This goes to the heart of the political debate about sovereign debt in the United States or even joint government debt in the euro zone.

And if that’s too politically thorny, the question is whether a return to 2007 is even desirable and whether the credit system needs to be taken down a peg for the sake of long-term financial stability.

If going back is deemed unwise, then it’s easier to understand those resigned to a hard slog for years to come.

Additional reporting by Laurence Fletcher; Editing by Ruth Pitchford

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