Beware The Motives of Optimists

By John Richardson

IT is always useful to make a note of both what economists are saying and where they are coming from.

To give you an example, I was at a conference last year when I heard a ridiculously rosy outlook for both emerging and developed economies, delivered by an economist working for a certain bank.

This bullishness remains in stark contrast with a refinery industry grappling with overcapacity in the US, for example, resulting in the need to close operations down.

The same will eventually have to happen in petrochemicals in higher-cost countries such as Japan and South Korea when big volumes of much-delayed polyolefin capacity finally hits the market, according to Mazlan Razak, Kuala Lumpur-based petrochemicals consultant with DeWitt & Co.

True, returns from petrochemicals – a very real industry that makes stuff that is tangible and worthwhile (quite often a perquisite in recent times for actually losing money) – were much better in 2009 than anyone had expected.

How good margins exactly were on a genuinely-valid comparative basis (with 2007 during the economic boom) is something we will look at on this blog a little later.

What we can say for certain right now, though, is that volumes on a global basis were way down as Western companies kept overall operating rates at very low levels. I suspect that those who made the best returns were the chemicals traders who guessed the right way during an unexpectedly strong rebound.

Back to my original point, the banks and other financial institutions have a vested interest in talking up this recovery, potentially creating false and harmful optimism among chemicals and other manufacturing companies.

The weight of evidence remains overwhelming to support the view that in the developed world, recovery is anaemic and far from complete.

China is another story which we have dealt with many times before on this blog. It emerged more clearly last week that inflation followed by interest-rate rises are big threats to China maintaining the sort of growth we saw in 2009.

Back the developed world and a new report from the McKinsey Global Institute (see chart below) – Debt and De-leveraging: The Global Credit Bubble and its Economic Consequences.


McKinseyDebtJan2010.bmpMost rich countries have seen huge increases in their ratios of debt to GDP (gross domestic product) over the last ten year, according to a summary of the report in The Economist.

Britain and France are the most extreme with increases in their ratios by more than 150 percentage points each, to 465% and 365% respectively.

Financial sector debt increased hugely, in line with the big rise in household debt (it was all the exotic financial instruments which caused the economic crisis that enabled household debt to increase so sharply).

In America middle-income families built up most of the debt whereas in Spain it was poorer families, an example of a lack of uniformity in how household debt was built up across the developed world.

Deleveraging has barely started.

The composition of debt has shifted, however, from the private sector to governments with the financial sector cutting back the most.

Half of the ten rich countries in the survey have one or more sectors that are “highly” vulnerable to debt reduction.

These include households in America, Britain and Spain and to a lesser degree, Canada and South Korea – as well as commercial property in America, Britain and Spain.

The survey looked at 32 examples of sustained deleveraging in the past where the debt/GDP ratios have fallen by at least 10% after financial crises.

Typically, deleveraging began two years after the beginning of a financial crisis and lasted six-to-seven years.

In almost every case, output shrank for the first two or three years of the process.

McKinsey identified reasons why this current period of deleveraging could be more protracted than in the past, which include:

*The scale of indebtedness is higher. The highest previous ratio was Britain at 286% after the Second World War, but on this occasion more than half the countries in the McKinsey survey have debt totalling more than 300% of GDP

*The number of countries afflicted simultaneously is a lot greater, meaning that rapid expansions of output through exports is not easy on this occasion (plus, the export competition from China has increased enormously since the 1980s and 1990s recessions)

*Big increases in public debt, while cushioning the declines in demand in the short term, increase the overall debt reduction that will eventually have to take place. Once private sector deleveraging is done then the public-sector wind-down will have to begin

A further problem is that investors might worry about public-sector debt levels before the private sector deleveraging has been completed, pushing up bond yields – for example, the recent concerns over Greece.

The result could be a cut back in public debt before the private sector has completed its own reduction, damaging growth by far more than if an orderly wind-down takes place.

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