A Perfect World? If Only It Were So

Business, China, Company Strategy, Economics, Oil & Gas

ChinadebtMcKinsey

By John Richardson

IN A perfect world everything always turns out for the best in the end.

And so quite a few people who argued that high oil prices were good for the global economy, as they said that expensive crude pointed to robust consumption growth well ahead of demand, are now arguing the exact opposite: That cheap oil is an unambiguous overall benefit to the global economy.

Here is the basis of their argument.

  • The ‘multiplier” effect on consumers of cheaper oil as transportation and other costs plummet.
  •  Lower inflation for big oil importing countries will provide more monetary policy flexibility, according to Moody’s Investors Service.
  • The International Monetary Fund has said that a prolonged oil-price drop could boost global growth by up to 0.7% in 2015 and 0.8% next year.
  • Cheaper crude seems, on the surface, unarguably good for some countries. It has, for example, enabled Indonesia and India to cut wasteful fuel subsidies. The money saved can be now spent infrastructure that will, hopefully, lift hundreds of millions more people out of poverty.

I agree with this last point in the long term. This is where the future for the chemicals industry lies.

But we should not be talking at all about the benefits of lower inflation over  the next few years. Chemicals companies should instead be planning for the consequences of deeply entrenched global deflation.

I am convinced that we are in a deflationary world where, of course, consumers and companies will be focused on paying-down debt. As the value of money falls, servicing debt becomes more in real terms – hence, the focus switches to getting rid of liabilities as quickly as possible.

I also believe that a great deal of debt will have to be written off. It shouldn’t have been acquired in the first place, but the past is the past. There is no point in dragging this process out and further by pretending that this debt is serviceable.

And has been the case in Japan for many years, and is becoming the case in the EU and China, deflation makes consumers delay their purchases. Why buy something today when it might well be cheaper tomorrow?

Overinvestment in oil, leading to today’s huge overcapacities, is just one driver of deflation.

We have seen the same pattern in chemicals and real estate in China and in iron ore in Australia. Capacity across many regions and many industries has bene built on totally false assumptions of global economic strength.

The good news for anybody who has listened is that I have been making this case for a couple of years now. I have been consistently warning that China would become the epicentre of this debt and deflation crisis.

On 2 February 2014, for example, I wrote:

HISTORIANS will end up concluding that falling emerging market currencies and stock markets – the prelude to what could be a full-blown crisis – is really about China and not about the US Federal Reserve.  The Fed is just a sideshow to the main event of what is going to drive not just emerging markets, but also the global economy, over the next few years.

Why? Because China has spent far more on stimulating its economy since 2009 than the Fed – in fact, crunching the data  a little further, when you add shadow lending, it has raised total credit from $1 trillion in that year to $10 trillion in 2013. This compares with Fed spending since 2009 of $2 trillion on Treasury Bonds and $1.5 trillion on Mortgage Bonds.

The great news is that more and more consultants and analysts are falling into line. Only by recognising the problem can we start to fix it.

A great example is this Bloomberg article, which was published yesterday, on a new McKinsey & Co study:

Thanks to real estate and shadow banking, debt in the world’s second-largest economy [China} has quadrupled from $7 trillion in 2007 to $28 trillion in the middle of last year. At 282 percent of GDP, the debt burden is now larger than that of the U.S. or Germany. Especially worrisome to McKinsey is that half the loans are linked to the cooling property sector. 

Bloomberg also detailed how McKinsey has put the debt crisis into an extremely valuable global context, when the wire service wrote in the same article:

The world economy is still built on debt.

That’s the warning today from McKinsey’s research division which estimates that since 2007, the IOUs of governments, companies, households and financial firms in 47 countries has grown by $57 trillion to $199 trillion, a rise equivalent to 17 percentage points of gross domestic product.

While not as big a gain as the 23 point surge in debt witnessed in the seven years before the financial crisis, the new data make a mockery of the hope that the turmoil and subsequent global recession would put the globe on a more sustainable path. Government debt alone has swelled by $25 trillion over the past seven years and developing economies are responsible for almost half of the overall gain.

McKinsey sees little reason to think the trajectory of rising leverage will change any time soon.

This is proof that we do not live in a perfect world. If we did, we would have learnt our lessons from the 2008 Global Financial Crisis.

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